Friday morning's headlines were full of news about a new report from the GAO that concludes that the SEC failed to adequately keep watch over fund firms. While some fund firm executives may have cracked a smile at the criticism, others may have reached a grim conclusion: scrutiny of the SEC could mean more heat on the fund industry.

According to the Washington Post, the criticism of the SEC in response to the report was flowing from politicians from both parties. James Sensenbrenner (R, Wisconsin) and John Conyers (D, Michigan), were both quick to fault the agency.

Sensenbrenner was crystal clear about what the SEC needs to do: "The SEC must take a stronger position on finding, preventing and punishing abuses by insiders, or Congress will be forced to take another look at how mutual funds are examined and regulated," the regulator said in a statement.

What exactly did the GAO find? In language as plain as day, the GAO concluded that "[the] SEC has determined that undisclosed market timing arrangements, in particular, existed at many large mutual fund companies for as long as 5 years. However, prior to 2003, SEC did not identify the undisclosed arrangements between investment advisers and favored customers through the agency’s oversight process."

The GAO also made three recommendations to the SEC, in addition to its current efforts: to keep tabs on the independence of fund firm chief compliance officers, to review fund firm internal compliance reports, and to create a system to receive annual compliance reports from fund firms.

Meanwhile, because funding for the SEC has increased dramatically, the SEC has even fewer excuses for future failures. In response to the bigger budgets, the agency has increased information technology spending, created a new unit to assess risk, and vowed to ramp up hiring.

Unfortunately, the increased scrutiny of the SEC comes right as key officials at the agency have said farewell. Paul Roye, the former director of the Division of Investment Management, and Stephen Cutler, director of the Division of Enforcement have both called it quits within recent months (Roye left in March and Cutler plans on exiting in May). With politicians raining criticism down on the SEC, it's probably no coincidence that Roye and Cutler have left the spotlight.

It's not a good sign that their positions are vacant right as politicians are cracking down. Although it's not clear who will replace the two, the timing of the GAO report will probably have some influence on their replacements.

Staff leadership is not the only "X factor" at the SEC. Leadership in the commissioner ranks is up in the air, with Harvey Goldschmid, one of the two Democratic commissioners, slated to leave this summer. Chairman William Donaldson has also been the subject of more and more criticism -- from both sides.

Although the fund scandal headlines are fading, the uncertainty at the SEC, paired with more scrutiny from legislators, boils down to bad news for the fund industry.  

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