By Marcy Gordon
The Associated Press

WASHINGTON - Federal regulators Wednesday proposed to close a loophole that allows illegal after-hours trading in mutual funds. It was a bid to help restore investor confidence in funds that has been shaken by a spreading scandal.

The Securities and Exchange Commission voted 5-0 to tentatively adopt and open to public comment a new trading rule, the first step in its planned overhaul of how the $7 trillion fund industry operates.

To stem illegal late trading, the rule would impose a "hard cutoff" of 4 p.m. Eastern time for pricing of fund shares.

The SEC is acting as problems spread through the mutual fund and brokerage industries, more big-name companies are cited for allowing special trading deals that disadvantage ordinary investors and a money stampede continues out of implicated funds. About 95 million Americans invest in mutual funds.

The SEC move comes two weeks after the House overwhelmingly passed legislation requiring mutual fund companies to disclose more information to investors about fees and operations, and making directors on fund company boards more independent from fund managers.

In January, the SEC will consider far-reaching proposals, including requirements for mutual funds to provide more information, and for board chairmen of fund companies to be wholly independent from the companies managing the funds.

By going through brokerage firms and other third parties, some big investors such as hedge funds are able to cash in on after-hours news ahead of most shareholders, who at that hour would be forced to chance buying at the next day's closing price.

Under the new rule, mutual funds rather than third parties would have to receive trading orders by 4 p.m., before the funds price their shares for the day. So the order must be in by then for the investor to receive that day's price.

An SEC official acknowledged that could mean that investors in and managers of 401(k) and other retirement plans, with slower order processing systems than other market participants, would be forced to make their fund trades several hours before the 4 p.m. stock market close.

"There definitely is a tradeoff" in the proposed rule, said Cindy Fornelli, deputy director of the SEC's investment management division. "We did appreciate that there was this cost."

However, the agency believes that the benefits of cutting off late trading far outweigh the potential disadvantage to some investors, Fornelli said

Moreover, having to get the next day's price could be a disadvantage one day but beneficial another so that the effect could even out over time, SEC staff says.

At a public meeting, the five SEC commissioners also proposed new rules requiring mutual fund companies to clearly disclose their market-timing policies and procedures in sales material. Market timing, which capitalizes on short-term movements in stock prices with quick "in and out" trading of shares, is not illegal but violates the rules of most fund companies.