Key Takeaways
- The U.S. Department of the Treasury (“Treasury”) has published a long-awaited final rule (“Final Rule”) restricting or requiring U.S. persons to report certain investments into covered foreign persons with respect to Chinese emerging technologies (the “U.S. Outbound Investment Security Program”).
- The U.S. Outbound Investment Security Program will take effect on January 2, 2025, and will impact outbound U.S. investment that Washington views as critical to the modernization of China’s military.
- The Final Rule does not prohibit all U.S. investments in China, as Treasury seeks to establish a balance between the United States’ traditional support for open investment and the protection of U.S. national security.
- In this OnPoint, we highlight the key takeaways regarding the final shape and form of the U.S. Outbound Investment Security Program for the investment community.
Background
Through the Committee on Foreign Investment in the United States (“CFIUS”), the U.S. Government has long had the authority to review inbound investment. The Final Rule formalizes the U.S. Government’s authority to regulate investments made by U.S. persons. As the White House made clear in a press release, the primary motivating concern for the U.S. Outbound Investment Security Program is to “prevent[ ] countries of concern – namely, the People’s Republic of China (“China”) – from advancing in key technologies that are critical to their military modernization.” The Biden Administration describes U.S. outbound investments as also being valuable to persons from countries of concern because they often include the transfer of “intangible benefits” in addition to capital. Such intangible benefits include enhanced standing, managerial assistance, access to investment and talent networks, access to markets, and access to additional financing.
The Final Rule was preceded by a lengthy review process through which the public and investment community provided input on the regulations. You can find our prior OnPoints on the proposed rules here and here.
Although other countries (including China, Taiwan, and South Korea) already employ some form of an outbound investment security regime, the U.S. Outbound Investment Security Program will be the first of its kind in a major Western economy. Going forward, Treasury’s newly established Office of Global Transactions will administer the outbound program. The U.S. Government also continues to work with allied countries (including G7 members and others) to encourage the development of parallel outbound investment restrictions, and Treasury noted in its press release for the Final Rule that the European Union and United Kingdom have begun the process to consider the development of their own outbound investment security programs.
Form & Scope
In brief, the U.S. Outbound Investment Security Program will include prohibitions and notification obligations for U.S. persons related to certain outbound investments involving “countries of concern” (currently defined to include China, the Special Administrative Region of Hong Kong (“Hong Kong”), and the Special Administrative Region of Macau (“Macau”)). U.S. persons will need to determine for themselves whether and to what extent those restrictions and requirements apply. The U.S. Outbound Investment Security Program is not a “reverse CFIUS” process. Although certain covered transactions will require notification to Treasury, there will be no governmental review and approval mechanism akin to CFIUS for outbound investment transactions of concern.
The U.S. Outbound Investment Security Program is narrowly tailored to restrict and allow for monitoring of U.S. investment into specific areas of advanced technologies and products that countries of concern could use to undermine U.S. national security. Accordingly, the U.S. Outbound Investment Security Program is focused on participation by “U.S. persons” in “covered transactions” that could aid in the advancement of three types of advanced technologies and products that pose a risk to U.S. national security: semiconductors and microelectronics, quantum information technologies, and artificial intelligence (“AI”) systems.
What to Know
The Final Rule (1) prohibits U.S. persons from engaging in certain transactions involving covered foreign persons engaged in a covered activity, and (2) requires U.S. persons to notify Treasury of certain transactions involving covered foreign persons engaged in a covered activity. Below we highlight key considerations for navigating the Final Rule.
1. Broad Range of U.S. Persons Captured
Consistent with the proposed rule, the definition of “U.S. person” in the Final Rule remains unchanged (and broad). “U.S. person” is defined as any U.S. citizen, lawful permanent resident, entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branches of any such entity, and any person in the United States. The Final Rule will apply to U.S. persons wherever they are located (which would capture actions of individuals who are U.S. citizens or legal permanent residents and are employed by a non-U.S. entity and/or residing outside the United States).
U.S. person compliance obligations extend to activities by third parties. The Final Rule requires U.S. persons to “take all reasonable steps to prohibit and prevent any transaction by a controlled foreign entity if such activity would be prohibited by a U.S. person. The Final Rule also prohibits U.S. persons from “knowingly directing” certain transactions by non-U.S. persons if, at the time of the transaction, the U.S. person knows the transaction would be prohibited.
Knowledge is defined in the Final Rule to capture both actual and constructive knowledge (i.e., knowledge that a person should have based on reasonable diligence and inquiry) by a U.S. person. Treasury will consider the totality of relevant facts and circumstances in assessing the reasonableness of diligence undertaken by a U.S. person in a potential enforcement context (e.g., scope of pre-acquisition due diligence, representations and warranties in contracts). Treasury declined to specify the amount of pre-investment due diligence that would satisfy the obligations of a U.S. person to comply with the Final Rule. U.S. persons should work with experienced outside counsel to ensure they are approaching pre-investment diligence with appropriate caution.
2. Identifying a “Covered Foreign Person”
The Final Rule defines “covered foreign person” to include both persons of a country of concern engaged in covered activities and third parties that have certain relationships with such persons. A “country of concern” currently is defined to include China, Hong Kong, and Macau, though the list can be expanded to other countries. Although requested by commenters to the proposed rule, Treasury declined to institute a de minimis exception with respect to what it means to “engage” in a covered activity in the Final Rule, leaving the concept undefined.
With respect to relationships with persons of a country of concern engaged in covered activities, the relevant points of consideration are (i) whether such person has a “specified interest” (which can take the form of a voting interest or equity interest, board seat (voting or observer), or the contractual power to direct or cause the direction of the management or policies) in the person of a country of concern, and (ii) the amount of a person’s revenue, net income, capital expenditure, or operating expenses attributable to the person of a country of concern. Such criteria must be established by U.S. persons, which adds to the overall due diligence burden with respect to compliance with the Final Rule.
Similar to the proposed rule, the Final Rule broadly reaches ex-China businesses (i.e., businesses that are majority owned by covered foreign persons engaged in a covered activity and businesses that have significant financial connections to such businesses (subsidiaries)).
3. Broad Range of “Covered Transactions”
The Final Rule defines “covered transaction” broadly, though there are certain important exceptions described in more detail below. A covered transaction will capture, among other categories, a U.S. person’s direct or indirect acquisition of certain equity interests or contingent equity interests in covered foreign persons, the provision of a loan or similar debt financing arrangement to a covered foreign person that will afford a U.S. person certain rights, and certain transactions involving U.S. persons and real estate in countries of concern (e.g., acquisitions, leases, and other developments on land and property).
In response to comments on the proposed rule, the Final Rule also offers a few points of clarification with respect to the scope of covered transactions.
First, the issuance of debt financing secured by equity collateral or the acquisition of such secured debt in the secondary market will be considered an “acquisition of an equity or contingency equity interest” and will not constitute a covered transaction. However, a foreclosure on equity pledged as collateral will constitute a covered transaction if a U.S. person has knowledge at both the time of issuance or acquisition of the secured debt, and at the time of foreclosure, that the equity in question is the equity of a covered foreign person.
Second, although requested by commenters to the NRPM, Treasury has declined to define the term “joint venture,” since other regulatory regimes similarly do not define the term. Instead, Treasury refers to the “plain English meaning” of the term: “involving the contribution of capital and/or assets by two parties and the sharing of profits and losses.” Treasury also provided that the point and purpose of the inclusion of the establishment of joint ventures is to capture situations in which a covered foreign person does not exist prior to the time of the transaction, but the “transaction structure presents the opportunity and incentive for the transfer of intangible benefits from a U.S. person to a person of a country of concern through the joint venture.”
4. Important Exceptions Maintained for Limited Partner Investments, Investments in Publicly Traded Securities, and Investments in Certain Funds
Treasury solicited comments under the proposed rule on two different proposals for the scope of excepted transactions involving limited partner (“LP”) investments. Ultimately, Treasury landed on a hybrid approach in the Final Rule, and the applicable definition of excepted transaction for LP investments is “any LP investment of $2,000,000 or less, or any LP investment accompanied by a binding contractual assurance that the LP’s capital invested in the pooled investment fund would not be made to effect an indirect prohibited transaction or notifiable transaction, as applicable.” With respect to the exception for binding, uncalled capital commitments, the Final Rule notes that the exception does not apply in situations where a U.S. person signs a binding agreement with respect to an investment target where the transaction’s completion date is after January 2, 2025, even if the binding agreement was signed prior to the effective date of the Final Rule.
In addition, note that an investment in a covered foreign person that would qualify as an excepted transaction cannot afford a U.S. person rights beyond standard minority shareholder protection with respect to the covered foreign person, each of which is enumerated in the Final Rule. Treasury also declined to provide an “explicit affirmation” that investments that provide only minority shareholder protections qualify as excepted transactions. U.S. investors must take note that their investments in covered foreign persons will be capped at $2,000,000 and limited to minority shareholder protections for transactions entered into on January 2, 2025 and thereafter.
The Final Rule also confirms that investments in “publicly traded securities” are excepted. This includes investments in a “security” (as defined under the Securities Exchange Act of 1934) of a covered foreign person that is traded on a U.S. or non-U.S. exchange or “over-the-counter” in any U.S. or non-U.S. exchange. Investments in derivatives also are excepted as long as the derivative does not confer the right to acquire equity, rights associated with equity, or any assets in or of a covered foreign person.
Also of note, the Final Rule maintains the exception for investments in investment companies (such as an index fund, mutual fund, exchange traded fund, or business development company). As a result, the requirements of the Final Rule will not apply to investments by U.S. persons in such funds that in turn might hold or make investments in covered foreign persons.
5. Notice Process
The Final Rule provides that any required notice regarding a covered transaction must be submitted to Treasury electronically (via a forthcoming e-portal) and must be filed no later than 30 calendar days (i) following the completion date a covered transaction, or (ii) after the U.S. person acquires the knowledge of a covered transaction (whether it was a notifiable transaction or a prohibited transaction). The Final Rule sets forth at least thirteen specific areas of information the notice must provide, including beneficial ownership information for all transaction parties, a description of the rights or other involvement afforded to the U.S. persons participating in the transaction, a description of the due diligence conducted regarding the transaction, and information regarding the attributes that cause an entity to be a covered foreign person.
6. Potential Enforcement Consequences for Non-Compliance
The Final Rule provides that Treasury will have the power to “nullify, void, or otherwise compel the divestment” of any prohibited transaction entered into after the effective date of the Final Rule. The Final Rule also provides for the imposition of civil penalties (up to the maximum permitted under the International Emergency Economic Powers Act (“IEEPA”)) for material misstatements and omissions in filings, entry into prohibited transactions, and failure to timely notify (when required). Civil penalties for violations under the implementing regulations could be the greater of $368,136 or twice the value of the transaction that is the basis of the violation.
Next Steps
Investors should begin to develop their U.S. Outbound Investment Security Program compliance plans to be ready for transactions that might close on or after January 2, 2025. A thoughtful strategy is key to ensuring that an actionable compliance program is developed and in place to implement and oversee U.S. persons’ obligations under the U.S. Outbound Investment Security Program.
As always, Dechert is available to consult regarding compliance with the U.S. Outbound Investment Security Program, help develop compliance strategies tailored to meet the requirements of the Final Rule, and establish effective controls to mitigate the risks of engaging in cross-border investments in an increasingly complicated regulatory environment.
This post was originally published on here
