Treasury Finalizes Outbound Investment Regime

On October 28, 2024, the US Department of the Treasury issued a Final Rule that will prohibit or require notification of certain US investments concerning China (including Hong Kong and Macau) that involve sensitive technologies and products in the semiconductors and microelectronics, quantum information technologies, and artificial intelligence sectors (collectively, "covered national security technology or products"). The regulations are effective on January 2, 2025.

As explained in Treasury's press release, the new regime is focused on addressing national security threats posed by certain US outbound investments involving covered national security technology or products that contribute capital as well as intangible benefits, which can enhance China's military, intelligence, surveillance, or cyber-enabled capabilities.

The Final Rule reflects Treasury's consideration of public comments received in response to the June 21, 2024 Notice of Proposed Rulemaking (discussed here) and August 9, 2023 Advanced Notice of Proposed Rulemaking (discussed here) and promulgates final regulations that refine key terms, concepts, and exceptions developed over the course of the rulemaking process.

Below we highlight a number of takeaways for industry and key provisions in the Final Rule.

Key Takeaways for Industry

• The outbound investment regime will have a significant impact on a range of actors involved in investments relating to covered national security technology or products, including both US and non-US persons. Many transactions directly implicating the outbound investment rules may result in the parties choosing not to proceed with the transaction, due to a prohibition or a risk-based preference not to have to submit a required notification, so it may take some time before the full impact is understood.
• It may be difficult, in practice, given the broad knowledge standard and related due diligence obligations, for US persons to determine whether a target is a "covered foreign person" and, if so, whether a transaction is prohibited or notifiable. US persons must undertake a "reasonable and diligent inquiry" in light of the "totality of relevant facts and circumstances." This broad and indeterminate standard is likely to create uncertainty for at least some investments and could lead to a chilling effect on investment in China by US persons in the covered sectors.
• Although the final regulations target only certain sensitive industries and not the entire Chinese economy, the regulations apply to a wide range of investment activity, including the acquisition of an equity interest or contingent equity interest; the conversion of a contingent equity interest; certain loans or similar debt financing; the establishment of certain joint ventures; certain greenfield or brownfield investments; and certain limited partner investments in a pooled investment vehicle.
• The final regulations contain a number of important exceptions, including, for example, exceptions related to publicly traded securities, certain intracompany transfers, and employee compensation in the form of stock or stock options, among others. The final regulations also except US person limited partner investments of not more than two million dollars into a pooled investment fund or limited partner investments where the US person has obtained a "binding contractual assurance" that its capital will not be used to engage in a transaction that would be a prohibited transaction or notifiable transaction if engaged in by a US person. In practice, many transactions by larger or institutional limited partner investors may not be eligible for this exception, given the two-million-dollar threshold.
• The regulations will apply directly to US persons, but may also have a significant indirect impact on non-US entities by requiring US persons to prevent their controlled foreign entities from engaging in a transaction that would be prohibited if engaged in by a US person and to file a notice if their controlled foreign entity engages in a transaction that would be notifiable if engaged in by a US person. Similarly, US persons may not knowingly direct a foreign entity to engage in a transaction that would be prohibited if undertaken by a US person. US persons can recuse themselves from certain activities in order to avoid directing a prohibited transaction. Implementing an effective US person recusal process may also present its own challenges.
• Companies in the semiconductor, quantum, and AI sectors, particularly those with US person investors, employees, officers, or directors, as well as entities that invest in those sectors should consider developing a compliance program to avoid inadvertent violations of the rules and be able to demonstrate to Treasury that appropriate due diligence was undertaken, should the need arise.
• With a second Trump administration set to begin in January 2025, and the increasing likelihood that Republicans may control Congress, further Executive or legislative action on outbound investment seems quite possible if not likely. What shape that may take is an open question, though an expansion of the particular sectors of China's economy targeted by the regulations could be a priority. This is an area that will bear close monitoring by industry.

Overview of the Regulatory Regime

The prohibitions and notification requirements for a "covered transaction" apply to "US persons," defined to include any US citizen, lawful permanent resident, entity incorporated in the United States, including any foreign branch thereof, or any person in the United States.

For the requirements of the rules to apply, a US person must have "knowledge" of relevant facts or circumstances related to a transaction. Under the rules, a US person has "knowledge" if the US person possesses actual knowledge that a fact or circumstance exists or is substantially certain to occur, if the US person possesses an awareness of a high probability of a fact or circumstance's existence or future occurrence, or if the US person could have possessed such information through a reasonable and diligent inquiry.

Treasury has indicated that it will consider the following factors, among others, in determining whether a reasonable and diligent inquiry was conducted:

• Diligence inquiries made of the target or counterparty at the time of the investment;
• Contractual representations or warranties obtained or sought with respect to whether a counterparty is a covered foreign person and whether a transaction is a covered transaction;
• Efforts made to obtain and consider available non-public information relevant to determine whether a counterparty is a covered foreign person and a transaction is a covered transaction;
• Use of available public information and the degree to which other information available to the US person as of the time of the transaction is consistent or inconsistent with such information;
• Whether the US person purposefully avoided learning or seeking relevant information;
• The presence or absence of warning signs (which may include evasive responses or non-responses from an investment target); and
• The use of available public and commercial databases to identify and verify relevant information of an investment target or other relevant counterparty.

The rules also require US persons to take certain actions with respect to "controlled foreign entities." In particular, US persons must take "all reasonable steps" to prevent a "controlled foreign entity" from engaging in a transaction that would be prohibited if engaged in by a US person and US persons must submit a notification for any transactions by a controlled foreign entity that would be notifiable if engaged in by a US person.

The term "controlled foreign entity" means any entity incorporated in, or otherwise organized under the laws of, a country other than the United States of which a US person is a direct or indirect "parent." A parent includes any person that that directly or indirectly holds more than 50 percent of the entity's outstanding voting interest or voting power of the board or is a general partner, managing member or equivalent or an "investment adviser" to a pooled investment fund.

In evaluating whether the relevant US person took "all reasonable steps," the regulations specify that Treasury will consider the totality of relevant facts and circumstances, including any of the following with respect to the US person and its controlled foreign entity:

1. agreements with respect to compliance with these rules;
2. governance or shareholder rights;
3. periodic training and internal reporting requirements;
4. appropriate and documented internal controls; and
5. documented testing and/or auditing processes for internal controls.

US persons are also prohibited from "knowingly directing" transactions by non-US persons that the US person knows would be a prohibited transaction if engaged in by a US person. Under the regulations, a US person "knowingly directs" a transaction when the US person has authority, individually or as part of a group, to make or substantially participate in decisions on behalf of a non-US person, and exercises that authority to direct, order, decide upon, or approve a transaction. Such authority exists when a US person is an officer, director, or otherwise possesses executive responsibilities at a non-US person.

The prohibitions on "knowingly directing" transactions would not apply to US persons who recuse themselves from each of the following activities:

1. Participating in formal approval and decision-making processes related to the transaction, including making a recommendation;
2. Reviewing, editing, commenting on, approving, and signing relevant transaction documents; and
3. Engaging in negotiations with the investment target (or, as applicable, the relevant transaction counterparty, such as a joint venture partner).

Covered Transactions

The outbound investment regime will regulate notifiable and prohibited transactions (collectively, "covered transactions"), which are defined broadly to include several types of equity and non-equity investments that involve or create "covered foreign persons."

Covered Foreign Persons

The term "covered foreign person" is defined as (1) a "person of a country of concern" that engages in a "covered activity" or (2) a person that, directly or indirectly, derives more than 50 percent of its revenue or income from or incurs more than 50 percent of its capital expenditure or operating expenses, individually or in the aggregate, through any "person of a country of concern" engaged in a "covered activity."

A "person of a country of concern" is defined to include:

• any individual citizens or permanent residents of China (including Hong Kong and Macau), excluding US persons;
• any entity domiciled, headquartered, or incorporated in China (including Hong Kong and Macau);
• the Chinese government, including any political subdivision, political party, agency, or instrumentality thereof and any person acting for or on behalf of the Chinese government;
• any entity in which the Chinese government holds individually or in the aggregate, directly or indirectly, 50 percent or more of the outstanding voting interest, voting power of the board, or equity interest, or otherwise possesses the power to direct or cause the direction of the management and policies of such entity (whether through the ownership of voting securities, by contract, or otherwise);
• any entity in which one or more of the foregoing (e., individual, entity, or Chinese government) holds individually or in the aggregate, at least 50 percent of the outstanding voting interest, voting power of the board, or equity interest; and
• any entity in which one or more entities directly above, individually or in the aggregate, holds, individually or in the aggregate, at least 50 percent of the outstanding voting interest, voting power of the board, or equity interest.

Covered Activities

The term "covered activity" encompasses any activity that is prohibited or notifiable under the rules, which the regulations define as follows: