Ponzi schemes could never originate from a mutual fund because the Investment Company Act requires mutual funds to use an independent custodian, testified John C. Coffee Jr., a Columbia law school professor, at a Jan. 27 Senate hearing on the SEC's role in the Madoff scandal. By contrast, the Investment Advisers Act permits "self-custody" in certain circumstances, or custody of client assets with affiliated broker-dealers, as was the case with Madoff and his clients' assets.

Congress and the SEC continue to seek increased regulatory oversight of private funds, even though it was not the regulatory regime that failed, but rather the enforcement function. The proposed Hedge Fund Transparency Act, which was introduced to the Senate last Friday, Jan. 29, would seek to go further than subjecting investment advisers to mandatory registration by requiring private funds themselves to be registered with the SEC, in addition to their managers. The Senate Banking Committee follows a House hearing on the same topic, where Rep. Carolyn Maloney (D-NY) asked SEC Inspector General H. David Kotz to investigate whether requiring the use of independent custodians could have prevented the scandal.

Related Alert: Hedge Fund Transparency Act to Increase Government Oversight of Hedge Funds (Feb. 2, 2009) (PDF)