ANALYSIS-Proposed EU rules could impede U.S. hedge funds

* Proposed EU rules erect barriers to U.S. managers

* Rules could compel U.S. firms to create units in EU

NEW YORK, June 17 - While U.S. hedge fund managers brace for tougher regulation out of Washington, rules proposed in Europe could prove even more disruptive.

British fund managers for months have been up in arms about the European Commission's proposed Alternative Investment Funds Directive, which could limit leverage, influence investment strategy and force funds to use specified EU-based firms for valuation, custody and other services.

The rules may also impose barriers for American fund managers, making it more difficult for them to reach out to European investors, industry executives say.

"The draft EU directive is anti-competitive and would seriously restrict U.S. hedge funds that are marketing and managing funds in the EU," said Julian Korek, founder of London-based consulting firm Kinetic Partners.

Last year's market meltdown prompted lawmakers to seek tougher rules for hedge funds, lightly regulated investment pools widely accused of exacerbating the crisis through their use of leverage, short-selling and secretive ways. The Madoff fraud exposed the need for independent audits and bookkeeping.

The Obama administration on Wednesday announced regulatory changes designed to prevent another meltdown, including making the Federal Reserve the supervisor of large, systemically important and interconnected firms. On Tuesday, a key member of the U.S. Senate Banking Committee submitted a bill to require hedge funds with more than $30 million to register with the U.S. Securities and Exchange Commission.

BARRIERS

The European Commission is taking a far more aggressive stance, drafting rules that require fund firms to be based in the EU and meet specific rules on leverage and short-selling.

Privately, critics say the EU proposal is driven by France and Germany, which are not global hedge fund centers, and is targeted at London and, to a lesser extent, New York. For example, the directive mandates using EU depositary banks to play a role that in the United States is filled by prime brokers.

"Many managers would move offshore to avoid this requirement, and it would prevent further U.S. managers opening operations in the UK," Kinetic's Korek said.

Dermot Butler, chairman of Dublin-based Custom House Global Fund Services, a hedge fund administration firm, said some form of the directive could be approved this year, implemented for EU members no sooner than 2011 and for nonmembers by 2014.

The biggest problem, he said, is the requirement that fund management firms set up shop in the EU if they want to market to EU investors.

"If this goes through as written, it is going to cause absolute mayhem," Butler said. "The biggest thing is, you're prohibiting European investors from getting access to U.S. managers, and that is hardly fair or reasonable."

Critics also say the rules will cost managers millions of dollars a year for reporting and risk management systems, as well as higher capital requirements.

"This is the European equivalent of the Sarbanes-Oxley Act -- a knee-jerk solution to non-problems that will hamstring U.S.- and UK-managed hedge funds," Korek said.

Even as some of Britain's biggest hedge funds told government officials they might leave the country rather than submit to such rules, U.S. hedge funds have been mute.

Officials from such large U.S. managers as Och-Ziff Capital Management Corp, Citadel Investment Group and Tudor Investment Corp -- firms that were briefed by British officials earlier this year on the directive -- declined to comment on the proposal.

James Chanos, president of hedge fund Kynikos Associates LP and chairman of the Coalition of Private Investment Companies, also declined comment. But in March he told the SEC that the EU restrictions and mandates "seem to be aimed less at protecting investors and the EU economy than serving certain constituencies."

Even the main lobbying group for U.S. hedge funds, the Managed Funds Association, has refrained from public criticism. It says it is watching how the new EU Parliament takes shape and expects the directive will be amended before it is adopted.

"The draft raises any number of serious concerns, especially for non-EU managers," John Gaine, the MFA's head of international affairs, told Reuters. "This is going to be a focal point for us, and hopefully there will be significant improvements."