*Reproduced with permission from Foreign Investment Watch. The article was first published on November 1, 2024.
Last week, the Treasury Department unveiled its final outbound rule, which regulates U.S. investment in China. According to experts, the rule could actually ensnare U.S. companies, particularly if they have significant Chinese ownership or significant financial connections to China.
WHAT HAPPENED
The Treasury Department issued its final outbound investment rule, titled, "Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern."
According to Treasury, the outbound program — which will become effective on Jan. 2, 2025 — "complements the United States' existing export control and inbound screening tools by preventing U.S. investment from advancing the development of sensitive technologies and products in countries of concern."
The final implementation includes a few updates from Treasury's advanced notice, which was published back in August of last year; the notice was published for comment in June.
As many Foreign Investment Watch readers know, the rule is the culmination of a multi-year saga dating back to the COVID-19 era, which we had been covering closely.
KEY PROVISIONS
As expected, the final rule prohibits certain transactions in China by U.S. citizens, and imposes a notification requirement for other types of transactions, depending on the technology and other factors.
Importantly, the rule includes a "knowledge standard" that will apply if an American citizen is aware of a "fact or circumstance" related to a covered transaction. This is not a unique provision; we recently covered other knowledge standards as outlined in, for example, recent BIS guidance for financial services firms regarding export controls.
The Treasury Department published a helpful fact sheet and FAQ regarding the rule, but we'll summarize some key provisions here:
- Technologies — The rule applies to three key
capabilities, similar to the original ANPRM. According to one
former Treasury staffer, it's worth noting that the list is
"markedly shorter" than the White House list of 19 Critical and Emerging Technologies that
animate the inbound and export control regimes. The three
technologies are:
- Semiconductors and Microelectronics
- Quantum Information Technologies
- Artificial Intelligence
- Notifications vs. Prohibitions — Depending on the type of transaction, there will be a prohibition or 30-day notification process with Treasury; the notification process will include details on the transaction in question and the parties involved. The rule provides a list of which types of technologies, above, are subject to prohibitions vs. notifications. For example, in the Semiconductors category, covered transactions involving supercomputing are prohibited, but those related to "the design, fabrication, or packaging of integrated circuits" may only require notification (see FAQ for details).
- Types of Transactions — The rule covers a number of types
of investments, including:
- Equity — Acquisition of an equity interest
- Contingencies — Contingent equity interest, and the conversion of contingent equity interest
- Debt Financing — Certain types that provide "certain rights" to the lender
- Greenfields — And "other corporate expansion"
- Joint Ventures
- Limited Partners — "Certain investments as a limited partner or equivalent (LP) in a non-U.S. person pooled investment fund."
- Exceptions — As anticipated, a number of transactions
were excepted from the final rule, including:
- Publicly Traded Securities — Includes mutual funds, index funds, etc.
- Certain LP Investments — If under $2 million and if other assurances apply (see rule for details)
- Derivatives
- Buyouts — Assuming the entity is not a "covered foreign person" following the transaction (refer to the full rule for full definitions)
- National Interest Exemptions — There will also be a category of "national interest exemptions"; details will be posted soon
- Decisions and Violations — Treasury will have the power to "nullify, void, or otherwise require divestment" of prohibited transactions, and the final rule includes a penalty framework for violations. In the event of a violation, Treasury will have the power "to impose civil penalties and could also refer criminal violations to the Attorney General."
According to Sarah Bauerle Danzman, an associate professor of International Studies at Indiana University who has testified before Congress on the outbound rule proposal, one consistent question throughout the drafting process was how broadly the rule would define transactions involving AI systems. "The final rule mostly takes a narrow approach," she says, "focused on investments in foreign covered persons that are designing AI systems for military, surveillance, or weapons systems use."
In addition to end-use related restrictions, adds Danzman, AI systems over a particular computing threshold will be prohibited or notifiable. "It is an open question as to whether that computing threshold will be modified on a regular basis to account for advancement in computational capabilities," she said.
Not coincidentally, the White House published a national security memorandum on AI just a few days after Treasury's rule was published. That memorandum requires, among another things, that the Commerce Department "develop or recommend benchmarks or other methods for assessing AI systems' capabilities and limitations" in a variety of categories.
EXPERT INSIGHTS
Generally speaking, experts were not surprised by the rule or its contents.
"This is mostly what we expected to see," said one member of the CFIUS bar who asked to remain anonymous.
"The only surprise is that it was released before, rather than after, the 2024 election," said Bauerle Danzman. According to her, the final rule included "only minor changes aimed to scope out some de minimis and arms-length transactions."
Ropes & Gray partner Ama Adams agrees. "There were no significant surprises in the final rule," she said, "as it largely tracks the Notice of Proposed Rulemaking in several areas."
Here's are a few points of interest that were highlighted by multiple parties:
1. LIMITED PARTNERS
According to Morgan Lewis partner David Plotinsky, the biggest "disappointment" for investors may be the limited exception for limited partner investment in non-U.S. pooled investment funds. "Unless an investor obtains a contractual assurance from a fund that it will not make investments that would be prohibited or notifiable for a U.S. investor," he says, "the exception will only apply to investments under two million dollars, which is a very low threshold that most investments will certainly exceed."
2. KNOWLEDGE STANDARD
Adams at Ropes & Gray says that the clarifications around the "knowledge standard" — as referenced above — are also important to understand. "Knowledge will be deemed to exist where actual knowledge exists or where there is a 'high probability' that a covered foreign person is engaged in a covered activity," she says. Although Treasury refrained from proscribing diligence steps, Adams said, "it did focus on 'reasonable efforts,' suggesting that reviewing available information, utilizing contractual representations and warranties, and evaluating potential red flags could be sufficient, depending on the circumstances."
Olga Torres, founder of Torres Trade Law, agrees, noting that obligations can be triggered not only when someone has actual knowledge, but "an awareness of a high probability of, or reason to know of certain facts or circumstances" related to a covered transaction. "U.S. persons must conduct a 'reasonable and diligent inquiry' into a relevant transaction to ascertain whether obligations under the final rule are triggered," she says, "and thus cannot self-blind to potential compliance issues."
3. REPS AND WARRANTIES
Wilson Sonsini partner Stephen Heifetz warns that the reps and warranties referenced by Adams, above, are likely to become a default requirement "for an incredibly broad array of transactions, particularly those in which U.S. persons are making loans or equity investments or establishing joint ventures" in certain circumstances. According to Heifetz, U.S. investors may need to get a representation that the counter-party is not involved in the three areas covered by the rule, or a representation that the counter-party does not have the kinds of ties to China that are covered by the rule.
"This applies to ostensibly domestic transactions," adds Heifetz. For example, he says, if a U.S. fund is investing in a San Francisco headquartered robotics company, one of the representations above may be needed because "the robotics company might have AI covered by the rule, and it might have Chinese ownership covered by the rule."
4. COMPLIANCE, COMPLEXITY AND COSTS
This more broad interpretation will add a level of complexity and cost that may be unforeseen by transaction parties. "The diligence implications of the rule are incredibly broad," says Heifetz.
Plotinsky at Morgan Lewis agrees. "Compliance will definitely be more burdensome than the government has estimated, both in terms of money and time," he says. However, Plotinsky adds that he expects "investors and their counsel will quickly adapt to incorporate outbound investment into the due diligence they conduct on deals, and will also quickly develop new contractual language to reflect the representations that are made both by investors and by Chinese companies in the course of that diligence."
Torres adds that "U.S. persons contemplating investments in China or in entities involving Chinese ownership will need to review the involved technology carefully and identify aspects such as the technology's use, potential uses, production capabilities, and in the case of AI systems, the computing power and training methods." According to Torres, this type of review "may become tedious and time-consuming for U.S. parties if dealing with foreign parties that are not forthcoming with information requests and communications."
Like others, Adams at Ropes & Gray warns that "businesses that are located outside of China but have Chinese ownership or significant financial connections to China could be captured." Again, this will add a level of diligence currently not considered by U.S. investors. "U.S. companies will also now be required to take steps to ensure that their 'controlled foreign entities' are not engaging in activities that would be prohibited if engaged in by a U.S. person."
WHAT NOW?
Either way, U.S. companies will need to "carefully review their touch points" involving China, says Adams, "which could be broader than they might initially consider given the scope of the final rule."
Akin Gump senior counsel Laura Black says companies should do that sooner rather than later. "If they have not already, investors need to start preparing."
Akin Gump senior counsel Laura Black advises that U.S. investors start preparing now. "Not all transactions for which there was a binding commitment prior to January 2 but haven't closed will be grandfathered, in contrast with the approach under the CFIUS regulations," she says, "This makes advance preparation even more important."
To make her point, Black — who previously served at CFIUS — says her firm has already begun working with domestic entities on outbound activity. "For example," she says, "we have been assisting U.S. operating companies — such as semiconductor companies — in determining whether their Chinese subsidiaries constitute 'covered foreign persons' and in setting up compliance policies and procedures." Black says her firm has also recently assisted foreign entities with U.S. officers or directors in establishing recusal policies, as well as helping general and limited partners "in preparing diligence procedures, excusal policies, and contractual provisions such as covenants and representations and warranties to ensure compliance."
Others agree that getting ahead of the rule now is wise.
"Engaging in this practice now will assist companies with spotting potential triggers of obligations for U.S. parties when reviewing potential covered transactions in the future," says Torres at Torres Trade Law. She adds that U.S. parties should ensure that all due diligence steps related to compliance are thoroughly documented and that records are maintained "in case they are needed to demonstrate a party's compliance efforts to relevant U.S. government authorities once enforcement of the outbound investment regulations begins in 2025."
Plotinsky at Morgan Lewis says that, given the effective date of January 2, both investors and Chinese companies need to work quickly to make sure that any deal closing on or after that date has been closely reviewed for compliance. "If deal diligence has not yet included outbound investment," says Plotinsky, "that needs to get done now, to ensure most importantly that the deal is not prohibited, but also to determine whether even a transaction that is not prohibited will need to be notified to the government."
MORE INFORMATION
The full text of the rule is available, as is a FAQ and a fact sheet from Treasury.
Our extensive coverage of the outbound saga is also available.
It's worth remembering that this is likely not the end of the outbound story. Already, Congressional leaders like House China Select Committee chair John Moolenar (R-Michigan) have called the rule a good start, but advocate for more comprehensive outbound investment legislation. "Congress should build on these rules and address a broader set of technologies and transactions that threaten our national security," he said after Treasury rule was published.
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