This is a great time to be David Einhorn. The revelation that Lehman Brothers was systematically falsifying its balance sheet vindicated the manager of hedge fund Greenlight Capital, who was one of the firm’s most vociferous critics. But the news that emerged last week on another of Einhorn’s adversaries, Allied Capital, is more than another vindication. SEC inspector general H. David Kotz determined that the SEC had failed to properly investigate Einhorn's allegations of wrongdoing at Allied, a Washington, D.C.-based private equity fund that had a former SEC regulator on its payroll.

The report raises a question that has never been satisfactorily addressed: Is the regulatory process tainted by the “revolving door”? That’s the innocent-sounding name given to regulators getting high-paying jobs with the companies they regulate. Defenders of the practice say that poorly paying agencies can’t get competent people if they are kept from getting lucrative jobs after leaving the government.

The problem is that the revolving door can turn the entire regulatory process into a bad joke. Just look at the devastating report from Kotz, describing how the SEC loused up its investigation of Allied Capital. A heavily redacted version of the report can be found here. It reads like a bureaucratic handbook as written by Mario Puzo, with a heavy dose of Inspector Clouseau thrown in.

The tale begins in 2002, when Einhorn started bringing to the SEC credible evidence of asset overvaluation at Allied. Instead of investigating Allied, the SEC was jiu-jitsued by the company into an unwarranted investigation of Einhorn, without a shred of evidence that he had done anything wrong. The probe swiftly showed he was innocent, but only after he went to considerable trouble and expense. When the SEC finally did deign to probe Allied, it was grotesquely disorganized, with the Enforcement Division unaware that the Office of Compliance Inspections and Examinations was also investigating the company.

The SEC approached Allied with all the enthusiasm of a patient undergoing a root canal. Nobody from the SEC even bothered to visit Allied’s offices during the OCIE’s 18-month investigation, even though it was located just a few blocks away. All the while, Allied was lobbying ferociously to make the whole thing go away, and it pretty much got its way.

In 2007, the SEC agreed to a settlement with Allied that was less than a wrist slap. No penalties were imposed on the company or any of its officers, even though Allied admitted that one of its factotums had engaged in “pretexting” to get Einhorn’s phone records (though Allied denied authorizing the pretexting). And then, poof! When Kotz commenced his probe in 2009, all of the work papers from the OCIE examination were “inexplicably deleted” from a computer drive shared by various OCIE officials. An unidentified official testified that the files were probably deliberately zapped.

If something smells fishy about all this, it’s because something was fishy—and the fishy something is the revolving door.

When the SEC decides to bring charges against a company, it is required to give the company something called a Wells Notice, a notice that the SEC is about to commence enforcement action. Thanks to the “high-powered counsel” hired by Allied, including an unidentified former SEC enforcement director, the company got special treatment. They obtained a highly irregular “pre-Wells” meeting with the SEC Enforcement Division, which apparently resembled the surrender ceremony on the USS Missouri in 1945—with the SEC playing the role of the Japanese. Allied’s lawyers talked the SEC out of bringing fraud charges against the company or its officers, including one found to have overvalued the investments on its books.