May.17, 2010, 6:50 P.M. ET, Source: DOW JONES NEWSWIRES

BRUSSELS (Dow Jones)--Lawmakers at the European Parliament Monday night approved new rules for hedge funds and private-equity firms, rejecting complaints that the legislation could unduly restrict European investors from using offshore funds.

The legislation passed 33-11 at the parliament's key Economic and Monetary Affairs committee. European Union finance ministers at the European Council are expected to approve their version of the legislation Tuesday night, kicking off what will likely be months of talks between the council, the parliament and the European Commission, the EU's executive arm, over a final version that will become law.

The parliament's legislation will require funds to register with European authorities. Fund managers that use borrowed money, or leverage, will have to file plans with the authorities setting limits on how much leverage they can use, and a new EU regulator would have the power to cap leverage at funds that pose "systemic" risks.

Most controversially, the legislation would effectively black-list some nations: European investors would be forbidden from sending their money to funds based in countries that lack adequate financial regulation.

The prospect of a black list has sparked strong opposition from European hedge funds, which are mostly managed from London but rely heavily on funds based in the Cayman Islands. The legislation sets five criteria for determining whether a country has sound financial regulation, including tax laws modeled on standards developed by the Organization for Economic Cooperation and Development and rules to fight money laundering and terrorism financing.

Jean-Paul Gauzes, the center-right French politician who is leading debate on the legislation at the parliament, has said it's unclear whether the Cayman Islands would fail to satisfy the five criteria. The Cayman Islands financial industry says it can meet the standards.

Fund managers based outside the EU would be able to get a "passport" to raise money from investors across the EU if they pledged to follow the new rules.

"Short selling"--selling borrowed shares to bet that a stock's price will decline--will face new limits under the parliament's legislation. Hedge funds will be required to disclose large short positions to regulators, who would also have the power to ban short-selling by some funds if financial stability is threatened. "Naked" short selling--selling borrowed shares without owning the underlying shares--would be banned, the legislation says.

The final legislation will likely differ significantly from the legislation approved by the parliament. The version that finance ministers are expected to pass Tuesday allows national governments to opt out from some of the rules. The council's version doesn't contain the black list concept, a provision that EU diplomats say is strongly opposed by national governments at the council.

The council's legislation, however, has drawn criticism from US Treasury Secretary Timothy Geithner, because it would prevent funds and fund managers based outside the EU from obtaining a passport to raise money and market themselves across the 27-nation bloc.

The parliament committee spared private-equity firms from tough limits on their ability to sell assets of a company they acquire or increase leverage on that company to the point where EU authorities determine the company's viability is threatened. Gauzes and socialists in the parliament sought those provisions, but parliamentary rules gave precedence to weaker language written by the parliament's legal affairs committee.