* Madoff fraud prompts legal drive to protect consumers
* EU executive proposes stricter controls on investment funds
By John O'Donnell and Huw Jones
BRUSSELS/ LONDON, March 23 Retail investment funds across Europe will be subject to stricter controls that safeguard investors, according to proposals from the European Commission designed to prevent a repeat of the Bernard Madoff fraud.
In a draft of a new law seen by Reuters, which will be put to countries and the European parliament for approval in the coming months, the European Commission proposes imposing strict legal liability on trustees of funds should they fail to safeguard investor cash.
The latest round of reforms is part of a push by Michel Barnier, the EU official in charge of financial regulation, to introduce new laws to protect consumers.
Until now, his regulatory drive over more than two years has focused largely on the wholesale financial industry and issues such as bonus payouts and the control of banks and trading.
The new funds law is inspired by the case of Bernard Madoff, who is serving a 150-year prison sentence for his Ponzi scheme which hit investors in both the United States and Europe.
The Luxembourg-based Luxalpha fund recorded losses of around 1.4 billion euros due to Madoff investments which turned out to be fictitious, the draft said.
The new code aims to prevent a repeat of the situation that allowed Madoff take custody of the funds although he was also responsible for investing the money. This allowed the scale of the fraud to go undetected for a long time, officials wrote.
"Bernard Madoff was also the manager and broker responsible for purchasing financial instruments on behalf of Luxalpha's investors," the draft document said.
The European Union's executive wants to separate these two functions - that of the fund manager and the trustee that is in charge of monitoring the work of the manager and safeguarding the funds.
In future, only banks and investment firms, which are subjected to supervision, will be allowed take on this role of trustee. Even if they pass this task of safe keeping on to another custodian, they remain strictly liable.
The draft also proposes public disclosure of total pay in the fund management company.
The draft measure on making retail products safer is part of the revision of the bloc's rules for mutual funds known as undertakings for collective investment in transferable securities or UCITS.
These are marketed under different names across Europe -- in Britain, a common type of UCIT is a unit trust.
The European Commission writes the first draft of laws but the 27 countries in the European Union and its parliament have the final say and often make changes.