(FORTUNE Magazine) - The arrest of Internet mogul Takafumi Horie on fraud charges last month triggered a spasm of recrimination in Japan. The Livedoor CEO's brash attempts to buy a baseball team and TV network had made him a hero to some, a demon to others. Those who'd seen him as a standard-bearer for a more freewheeling capitalism professed shock at allegations that the 33-year-old billionaire falsified accounts and used shadowy investment trusts to manipulate Livedoor's share price. Traditionalists, meanwhile, decried Horie's alleged actions as evidence of the excesses of American-style "market fundamentalism." But there was surprisingly little discussion of a larger scandal: Japan's securities regulators had been monitoring Livedoor for three years but never took action. Indeed, the episode exposes the woeful inadequacy of Japan's securities laws and the regulators who enforce them.

Japanese prosecutors aren't required to disclose details of their indictment, and because they can detain suspects for up to a month, the only word from the Horie camp was an assertion of innocence published on his blog before his arrest. But if reports leaked by prosecutors to the Japanese press can be believed, Horie is charged with egregious fraud: manipulating the share prices of companies he secretly owned by trumpeting plans to acquire them; falsifying financial statements by reporting stock gains as operating income; and diverting money to secret Swiss accounts.

Officials at Japan's Securities and Exchange Surveillance Commission dithered in the face of overwhelming evidence that Livedoor was flouting the rules, says Waseda University law professor Tatsuo Uemura, an advisor to the Tokyo Stock Exchange. "It's not like they didn't know what Horie was up to," he says. "They just couldn't work up the nerve to declare it illegal." In parliamentary testimony, Financial Services Minister Kaoru Yosano offered an odd defense of the SESC, over which he has jurisdiction, citing its scrutiny of Livedoor as proof regulators had been "highly effective."

Few would agree. The SESC is toothless, struggling to supervise the world's second-largest equity market with a staff of just 320, compared with 3,800 at the U.S. Securities and Exchange Commission. Few SESC employees are trained in finance or securities law. It doesn't help that the SESC is subordinate to an agency whose mandate is to protect financial institutions.

But the rules--or lack of them--are also to blame. After Japan's bubble collapsed in the early 1990s, the government dispensed with many financial restrictions in an effort to restructure and dismantle Japan's clubby corporate system. In the process it opened giant loopholes. As a result, some of Horie's most outrageous tactics were entirely legal. For example, Livedoor's repeated share splits exploited liberalizations intended to attract more investors. But because the Tokyo exchange took more than 50 days to issue new stock certificates, Horie found he could create temporary supply squeezes--which lifted the stock price--by splitting Livedoor shares again and again.

So far the Japanese media have speculated more often--and more wildly--about why the prosecutors acted than why the regulators didn't. Everything from political revenge to mob links has been floated as a theory. Adding to the intrigue: The day after the Livedoor raid, the head of an investment fund that handled deals for Horie turned up dead under murky circumstances.

With Horie now in an unheated cell, it's too early to tell whether he was a newfangled revolutionary or just an old-fashioned crook. Either way, Japan's regulators may have as many questions to answer as he does.