The SEC's FOIA exemption won't matter. It's not protecting investors anyway

FORTUNE -- It's hard to believe, but it seems the SEC has managed to anger the public and the media again. Fox Business has reported that the oft-maligned agency has put in place a new rule that will stop the public, usually journalists, from accessing certain SEC-investigative information using the Freedom of Information Act, or FOIA.

Alarm bells are ringing loudly, with many complaints centering on the idea that the SEC has enforced this change solely to avoid criticism stemming from its failed efforts to catch the Madoff and Stanford frauds.

While the above certainly merits scrutiny, the SEC arguably withholds a far more crucial item, one that mysteriously generates no press and no public outrage: its practice of keeping ongoing investigations into businesses private, only revealing who they are investigating to the public after a determination has been reached.

Why is this so bad? Recall from the Stanford case that the examinations unit in the Fort Worth office of the SEC long had doubts regarding Stanford Financial, and in fact opined loudly and for almost a decade that the firm might be a fraud and absolutely merited further action from the Enforcement division. If you were considering buying Stanford CD's during this time, wouldn't it have been useful to have been aware of this little piece of information? Problem is, this information only became available in February 2009, when the SEC finally decided to act and charged Stanford with fraud.

Yes, it's valid to argue over how much should be made public, via FOIA, after a federal agency messes up. But isn't it more important to argue over what should be made public before an agency messes up, meaning during an investigation, when the public can evaluate the information and possibly make changes to its investments based on this information?

The SEC likely would assert that the reason to maintain secrecy is to protect the rights of the innocent, i.e., the folks it is investigating. The fallacy in this line of reasoning is that every day, civil and criminal lawsuits are filed and made public, long before a determination of "guilt," wrongdoing or liability is made. Most lawyers with whom I have spoken liken SEC examinations to Federal criminal investigations, which like SEC matters are typically not made public (absent a news leak) until an indictment is made.

The solution is this: allow the SEC to continue its policy of keeping its investigations secret while reviews are in the examination stage. But the minute these exams are referred to the Enforcement division, they should go public. In weighing the public's right to know against the privacy rights of entities being investigated, the real issue is whether investors are sophisticated enough to understand that an investigation doesn't necessarily mean someone has done something wrong.

The above two-step method goes a long way toward addressing the fact that simply "examining" an entity without filing charges happens frequently, but once the investigation is referred, the odds of an action go up quite a bite. (That's a bit of conjecture of course, since the SEC doesn't release statistics regarding its investigations.)

Still, the current system is untenable. No amount of explanation helps Stanford or Madoff investors feel better, especially when many of them undoubtedly based their decision to invest on the idea that regulatory bodies would have let investors know if they had information that something was wrong, even though they did have that information and simply chose not to release it.

As I wrote in a book on due diligence, by not releasing information about funds it has looked at, the SEC serves very little function to the common investor. The principle of innocent until proven guilty must be respected, but in our current system, by the time the public learns of an SEC check, indeed often by the time the SEC even gets involved, the horse has left the barn, the barn is burning, and the only thing that remains is the SEC holding a very hot pitchfork.

Think through the history of hedge fund blow-ups. Did the SEC ever come out and saying something before the fact, thus potentially saving people who might have invested from losing their money? And if they didn't, what exactly are our tax dollars paying for?

The FOIA battle of the week, in my mind, is just another red herring we can ill-afford to spend time and energy focusing on. It'd be far better to review the commission's recent record, in order to establish better procedures for the future. Meanwhile, here in the present, the agency could become more transparent now, so the average citizen could have a chance of avoiding losing all their investments, rather than being told about the reasons they did.

--Randy Shain is executive vice president of First Advantage Litigation Consulting/BackTrack Reports and author of Hedge Fund Due Diligence: Professional Tools to Investigate Hedge Fund Managers. These are his personal opinions and not those of First Advantage Litigation Consulting/BackTrack Reports.