On October 28, the Biden Administration released its long-awaited final rule to restrict U.S. investment in China. This outbound investment regime, which is effective January 2, 2025, will impact all U.S. companies and citizens investing in Chinese businesses that develop artificial intelligence ("AI"), semiconductors and microelectronics, and quantum information technologies. This is a significant development in U.S. economic statecraft and financial regulation and opens the door to potentially more expansive outbound investment controls in the future.
The regime is intended to deter investment in Chinese technologies and products that pose an acute national security threat to the United States. Under the new regulations, U.S. investments in Chinese companies engaged in certain activities related to quantum computing, AI systems with certain military or mass-surveillance end uses or trained using certain computing thresholds, and certain semiconductor activities may be prohibited; other investments in Chinese AI and semiconductor businesses may instead be subject to a mandatory Treasury Department notification requirement within 30 days of closing.
This new outbound investment regime will create significant due diligence requirements and compliance risks for U.S. businesses making investments with a potential nexus to China. There are no safe harbors under the rule, which means companies and individuals that knew or should have known they were making a covered investment will be subject to the rule's prohibitions and notification requirements. The Treasury Department stated that its evaluation of the sufficiency of an investor's due diligence "will be made based on a consideration of the totality of relevant facts and circumstances."
This final rule reflects refinements to key terms and concepts developed over the course of an extended rulemaking process. The Biden Administration first sought public comment on an outbound investment review framework in an August 2023 Advance Notice of Proposed Rulemaking, which was released concurrently with an executive order addressing outbound investment. This was followed by a July 2024 Notice of Proposed Rulemaking for additional public comment.
WilmerHale has created a red-line comparison of the final rule's changes from the proposed rule, which is available here. Please consult the final rule as published in the Federal Register for the authoritative version.
How Does the Outbound Regime Work?
As finalized, the outbound regime will apply to investments made by U.S. persons (and foreign entities controlled by U.S. persons) in Chinese entities (and entities outside of China that are controlled by Chinese persons or entities) engaged in "covered activities" related to three sectors: AI, semiconductors and microelectronics, and quantum computing.
Some covered transactions will be subject to notification requirements, whereas others will be prohibited. With respect to quantum computing, all covered transactions are prohibited. With respect to AI and semiconductors and microelectronics, certain transactions are prohibited, but others are only notifiable. Notifications made to the Treasury Department may be reported to Congress; further, they may be disclosed publicly when they are "determined by the Secretary to be in the national interest."
Although only certain types of transactions are within the scope of the regime (i.e., "covered transactions"), the new rules capture a wide variety of investment activity. Covered transactions include the acquisition of an equity interest or contingent equity interest; loans or similar debt financing that affords a U.S. person certain financial or governance rights characteristic of an equity investment; the conversion of a contingent equity interest into an equity interest; the establishment of certain greenfield, brownfield, or joint ventures that a U.S. person knows will or result in new covered activity; or the acquisition of certain limited partner interests.
Certain very common investment activities will be excepted from the rule, such as investments in a publicly traded security, index fund, or mutual fund – provided that these investments do not give a U.S. person "control" rights over the investment target. The final rule also excepts limited partner investments in funds where the capital commitment does not exceed $2 million aggregated across all investment vehicles of the fund or where the limited partner has secured a "binding contractual assurance" that its capital will not be used to engage in covered activities.
The final rule will also except transactions "with or involving" entities in white-listed countries to be designated by the Treasury Secretary as having implemented similar outbound investment regimes designed to address national security risks. This designation will be based on factors such as whether the country has, and effectively utilizes, legal authorities and regulatory mechanisms to regulate outbound investment and the export of sensitive technologies. Treasury indicates that it will make more information available on its website regarding the final factors to be considered. In effect, this exception means that U.S. investments in Chinese companies that are engaged in covered activities but that are based in a white-listed country may not be subject to the rule's notification requirements or prohibitions.
What Kind of Due Diligence Is Required?
Among the regime's most notable elements is its "knowledge" standard. When evaluating an investor's compliance with the regime, Treasury will consider whether the investor "has or had knowledge of the relevant facts and circumstances at the specified time" – that is, whether the investor knew or should have known as of the time of the transaction that it would involve a Chinese entity engaged in a covered activity. This inquiry will be based on "information a U.S. person had or could have had through a reasonable and diligent inquiry." As was the case in the proposed rule, the final rule presents a list of seven illustrative considerations the Treasury Department will apply in making this determination. These are:
- Inquiries a U.S. person has made regarding an investment target or other relevant transaction counterparty, including the particular questions asked;
- Contractual representations or warranties the U.S. person has obtained or attempted to obtain from the investment target as to its relationship to covered entities or activities;
- Efforts by the U.S. person to obtain and consider available nonpublic information relevant to the target's relationship to covered entities or activities;
- Available public information, the efforts undertaken to obtain and consider such information, and the degree to which other information available at the time may have been consistent or inconsistent with such publicly available information;
- Whether the U.S. person "purposefully avoided learning or seeking relevant information";
- The presence or absence of "warning signs" resulting from the above inquiries, including evasive or non-responses from the investment target; and
- The use of available public and commercial databases to identify and verify information about the investment target and other relevant counterparties.
The guidance is clear that the Treasury Department will have significant discretion to assess whether U.S. investors have exercised sufficiently rigorous due diligence when evaluating compliance with the rules. There are no safe harbors or specific diligence activities that will shield U.S. businesses from scrutiny with respect to covered transactions. Rather, the final rule added a provision stating that the "assessment of whether a U.S. person has undertaken a reasonable and diligent inquiry shall be based on a consideration of the totality of relevant facts and circumstances." Put another way, whether diligence for a particular investment is sufficient will be subject to Treasury's "rear-view-mirror" evaluation based on a broad and malleable standard.
What Has Changed From the Proposed Rule?
Some of the most important changes from the proposed rule are the following:
The final rule provides further details on which "AI systems" would be subject to the regime. In addition to establishing limitations on investments associated with certain AI end uses (such as Chinese companies that develop AI for the Chinese military or surveillance activities), the final rule establishes a notification requirement for transactions with entities developing AI systems that are "trained using a computing power greater than 10^23 computational operations (e.g., integer or floating-point operations)" and a prohibition on transactions with those developing AI systems "trained using computing power greater than 10^25 computational operations (e.g., integer or floating-point operations); or 10^24 computational operations (e.g., integer or floating-point operations) using primarily biological sequence data."
The final rule also introduces explanatory notes regarding the definition of "develop" as it relates to AI systems. The notes state that an entity must "develop" an AI system in order to be subject to the rules – a term that is defined to include actions such as "design or substantive modification." However, a note added to both the prohibition and notification provisions states that "a person customizing, configuring, or fine-tuning a third-party AI model or machine-based system strictly for its own internal, non-commercial use (e.g., not for sale or licensing) would not implicate the [notification or prohibition] requirements for related transactions solely on that basis unless the person's internal, non-commercial use is for" any of the proscribed end uses.
It is not clear what this note would mean for certain types of transactions, including a transaction with a Chinese consumer technology company that customizes a third-party AI system that was trained using a computing power above the threshold described in the rule for its operations. For example, would a Chinese food delivery app that customizes a third party's AI system trained using more than 10^23 computational operations to improve its food delivery service be doing so for "internal, non-commercial use"? Although the company would not be customizing the AI system itself for "sale or licensing," the AI system's customization would have a commercial purpose. The Treasury Department may address such ambiguities in future guidance.
The final rule also clarifies which intracompany transfers are subject to the regime. In particular, it excepts transactions between a U.S. person and its controlled foreign entity that "supports ongoing operations that are not covered activities or that maintains covered activities" that were ongoing prior to the effective date of the rule (i.e., January 2, 2025). Thus, the regulations allow a U.S. entity to continue to support its foreign subsidiary's preexisting covered activities, as well as other non-covered activities, without triggering notification requirements or prohibitions. However, a U.S. company's transaction that supports its foreign subsidiary's engagement in new covered activities could be subject to either the notification requirement or prohibition, depending on the activity.
Conclusion
The final rule on outbound investment is scheduled to take effect on January 2, 2025. Although this final rule represents the culmination of the Biden Administration's efforts to regulate outbound investment, the regime as a whole is likely to continue to evolve in the future. For example, the President could continue to use executive authority to impose additional restrictions on U.S. outbound investment to China, including adding covered sectors, regardless of who wins the November 2024 presidential election.
Additionally, Congress has debated two alternative approaches to restricting outbound investment, namely sector-based generally take a similar approach to the final rule, and list-based proposals, which would result in the outbound investment regime operating similarly to existing economic sanctions programs. There does not appear to be consensus on which approach is better, and Congress has not taken any actions to supersede or augment the former approach taken by the Biden Administration. In any event, legislative action is unlikely at least until the new Congress is seated in January.
Finally, the U.S. government is likely to encourage partners and allies to adopt similar restrictions in the future – just as it has done since 2018 with rules governing inbound foreign investment and more recently with export controls and other China-targeted economic restrictions. The inclusion of investments with or involving entities in white-listed countries in the definition of "excepted transactions," discussed above, is one indication of this. International adoption of similar rules will likely determine whether the outbound investment regime is effective at deterring capital flows to China's strategic industries with significance for U.S. national security.
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