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In its scramble to win back the trust of individual investors, the mutual fund industry has asked for increased federal regulation to thwart the next big potential problem among funds -- the use of soft money.

The Investment Company Institute, the lobbying arm of the fund industry, on Monday asked the

Securities and Exchange Commission

to issue regulations that would "dramatically curtail" the use of soft dollars, according to a statement by ICI Chair Paul Haaga.

Soft dollars -- while legal -- are essentially kickbacks fund managers receive from overpaying transaction costs. In such arrangements, a manager would essentially overpay a brokerage for executing transactions in exchange for research (from a third party) the manager uses to make buying and selling decisions. Because transaction costs are not included in a fund's expense ratio, fund managers often use soft dollar arrangements to keep expense ratios low and finance their management needs other ways.

All too often, though, the soft dollars also finance computer purchases, news services,


terminals and the like. And since the overpayment does not reap a similar amount in research or equipment, the end result is that funds simply end up with inflated transaction costs with little to no benefit to the individual investor -- who pays these transaction costs.

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The ICI wants the SEC to limit the items that can be purchased by soft dollars in two ways. First, ICI says the SEC should restrict the research that can be acquired with soft dollars -- essentially eliminate all products and services that are otherwise available in the marketplace.

Second, ICI wants the SEC to restrict any research products and services from third parties. That means fund managers wouldn't be able to use soft dollars to pay for anything they could acquire on their own -- soft dollars would have to be used solely for proprietary research issued by the brokerage with which it has the arrangement.

The ICI also asked the SEC to abolish the practice of directed brokerage. This arrangement, while subject to strict regulations, essentially allows fund companies to give some preference to the brokerages that sell its mutual funds when choosing a broker to execute portfolio trades.

The practice of directed brokerage could lead to some conflicts of interest, Haaga said, wherein fund companies opt to hire brokerages to handle their transactions simply because the brokerages sell its mutual funds, rather than basing the decision on cost and efficiency.

The ICI's initiative comes in the wake of an ongoing investigation of trading practices in the mutual fund industry. New York Attorney General Eliot Spitzer initiated a sweeping probe of the fund industry in August, with the commonwealth of Massachusetts as well as the SEC taking up the charge. Many of the fund companies involved -- such as

Alliance Capital Management

(AC) - Get Associated Capital Group, Inc. Class A Report

-- have already fired executives and entered settlement talks. Alliance's case is particularly noteworthy because it has agreed, as part of its settlement with Spitzer, to cut its fund fees -- despite the fact none of the charges levied against it had to do with its fee structure.