Units of Luxembourg to become a leading fund domicile faces a severe test next year, when investors who lost money, 65 billion U.S. dollars in fraud Bernard Madoff to seek compensation from UBS (UBS - news - people) through a court Luxembourg.

The push to attract alternative investment vehicles such as hedge funds recorded as funds available to investors across Europe will also depend on how the Luxembourg financial regulator maintains standards of investor protection.

‘It is very important, Luxembourg () rules are applied from an investor point of view. Some sophisticated investors rely on this, “said Dermot Butler, chairman of Italy-based fund administrator Custom House Group.

Litigation Madoff Innovation is the key to assess whether the rules protect investors Luxembourg “not only fraud but also against the sloppy work, negligence and mistakes costly,” said Butler.

The dispute focuses on the role of custodian banks UBS and HSBC (HBC - news - people), both of which acted as depositary for the Luxembourg-based LuxInvest and LuxAlpha feeder funds that lost over $ 2 billion dollars to scam Madoff’s .

A court case testing program in early 2010 will determine whether investors can act directly custodian bank UBS for losses. Claims may also be submitted by the liquidators of the funds, the lawyers said.

Lawyers representing investors say UBS, which set up the funds, was, as custodian, responsible for the safety of property.

UBS counters that the funds were established by the will of investors’ funds specifically for food Madoff, and that investors know their activities have been held with investment companies Madoff Securities and signed a waiver removing responsibility from UBS.

The Luxembourg financial regulator CSSF, has repeatedly said that the EU rules on the responsibilities oblige banks custodian depository of knowledge in every moment as assets are invested and where and how they are available.

“This responsibility is not affected by the fact that the depositary has entrusted to a third party all or part of the assets in its custody”, said the CSSF in a statement earlier this year.

THREAT OF LUXEMBOURG

Disgruntled investors have complained that the standards of investor protection are not accepted in Luxembourg.

“When we now look at what has happened with this case Madoff strongly feel betrayed,” said Luc Schaack, a lawyer for the shareholders group Deminor lawyer acting for some investors who lost money on Madoff.

“They think that Luxembourg is not a safe place to put money because, despite all the legal guarantees, nothing has happened, in order to exert sufficient pressure on UBS to get back the money,” said Schaack.

Player 1.7 trillion euros in Luxembourg funds industry say that any decision would be welcome in so far brings clarity to the landscape of investment in Luxembourg.

“If UBS is judged negligent as a custodian, people will say the protection of investors in Luxembourg is robust and the rules are applied to everyone,” said Martin Kloeck, partner at Zurich-based Asset Manager Signina Capital, which has just recorded one of its funds in Luxembourg.

“If the bank is exempt, because it will set up the fund, which was not available to the public on request.”

Asset managers and service providers such as custodian banks, auditors and fund managers also want clarity on their legal obligations to holders of funds regulated as Luxalpha of UBS, which carried a UCITS-compliant tags.

EU directives known as UCITS are designed to protect retail investors by setting strict rules for investment funds open to the public.

“If the law is strictly enforced then the responsibility is clear,” said Marc Clapasson, Managing Director of Global Millennium, a Guernsey-based $ 14 billion alternative asset manager that you are registering a number of funds in Luxembourg.

“But it is very difficult to judge. Madoff was an exceptional case which involved a lot of experienced investors, and a lot of people made mistakes, not just the custodians. The story is much more complex,” said Clapasson.

Investors are also suing the auditor Ernst & Young for damages to one of the funds involved. Administration could also find its liability for damages.

A ruling against UBS could ultimately push up the costs of custody, because the level of higher risk for providers of services would increase insurance costs and duties than could be extensive and expensive, making this business less attractive in Luxembourg.

“You could change the industry completely. Would guardians take that risk for a few basis points of assets? If caretakers have a greater load of responsibility and risk, which may need to ask for higher fees,” said Tushar Patel, chief investment officer HFIM, London-based fund of funds.