On October 28, 2024, the U.S. Department of the Treasury issued its final outbound investment rule, which implements Executive Order 14105, prohibiting certain outbound investments by U.S. persons in Chinese and China-related companies focused on semiconductors and microelectronics, quantum computing and information technologies, and artificial intelligence (“AI”).[1] It also requires U.S. persons to notify Treasury of other types of outbound investment in Chinese companies operating in these sectors.
The Final Rule takes effect on January 2, 2025.
What Investors Need to Know
- The Final Rule is directed at U.S. investments that could enhance China’s military, intelligence, surveillance or cyber-enabled capabilities in a relatively narrow group of sensitive technology sectors.
- Companies exploring China-related investment opportunities must undertake a “reasonable and diligent inquiry” to determine whether the Final Rule would prohibit their proposed activities or would require reporting.
- U.S. companies should implement procedures to prevent foreign companies that they control from engaging in transactions that would be prohibited for a U.S. person.
- U.S. individuals affiliated with non-U.S. entities, such as U.S. employees of non-U.S. companies, must avoid directing transactions by such non-U.S. entities that would be prohibited if performed by a U.S. person.
- Expansion of the restrictions to other countries and technology sectors is possible, perhaps likely. Companies should monitor developments.
Key Elements of the Final Rule
The Final Rule:
- prohibits U.S. persons from knowingly engaging in certain investment transactions involving individuals and entities with ties to China (including Macau and Hong Kong) (a “country of concern”) that are engaged in specified activities in the semiconductor and microelectronics, quantum computing and information technologies, and AI sectors;
- requires U.S. persons to notify Treasury within 30 days of completing certain investment transactions involving specified activities by individuals and entities with ties to China;
- requires U.S. persons to take steps to prevent foreign entities they control from engaging in prohibited transactions;
- requires U.S. persons to notify Treasury of transactions by their controlled foreign entities that would be notifiable transactions if executed by U.S. persons;
- requires U.S. persons to perform adequate diligence to determine whether a transaction is covered by the Final Rule, scrutinizing all information reasonably available to them (including public and commercial databases);
- excludes from its requirements certain investment transactions, including investments in public-traded securities and U.S. limited partner investments in foreign pooled investment funds if the investments are no more than $2 million or the U.S. limited partner obtains binding contractual assurances.
The Final Rule does not establish a process for the U.S. government to review or license transactions. U.S. persons may seek a national interest exemption from the prohibitions or notification requirements, but Treasury expects to grant such exemptions only in exceptional circumstances.
The U.S. government may nullify, void or otherwise require divestment of a prohibited transaction.
The Final Rule establishes a process for voluntarily disclosing potential violations and provides for civil and criminal penalties for violations.
Treasury plans to provide additional guidance on the scope and interpretation of the Final Rule via its Outbound Investment Security Program website and by engaging with stakeholders.
Who Is Covered by the Final Rule?
The Final Rule applies to “U.S. persons.”
- A “U.S. person” is any U.S. citizen, lawful permanent resident, entity organized under U.S. law or any person in the United States.
- A foreign parent or foreign employer of a U.S. person is not a U.S. person simply because it has an affiliate or employees in the United States.
As indicated above, under the Final Rule, U.S. persons are required to take reasonable steps to ensure that their controlled foreign entities forgo transactions that would be prohibited if executed by a U.S. person.
The Final Rule provides that if a controlled foreign entity engages in a transaction that would be a prohibited transaction if engaged in by a U.S. person, Treasury will consider, in determining whether the affiliated U.S. person took all reasonable steps to prohibit and prevent such transaction, the following factors, among others:
- agreements between the U.S. person and its controlled foreign entity regarding compliance;
- existence and exercise of governance or shareholder rights by the U.S. person;
- periodic training and internal reporting requirements by the U.S. person and its controlled foreign entity;
- internal controls of the U.S. person and its controlled foreign entity; and
- testing or auditing processes for the internal controls.
What Transactions Are Covered?
The Final Rule pertains to activities of U.S. persons and their controlled foreign entities with respect to “covered transactions” involving “covered foreign persons.”
“Covered transactions” include investments and similar transactions where a U.S. person has knowledge of the involvement of a “covered foreign person” engaged in a “covered activity,” including:
- acquisitions of equity interests or contingent equity interests in covered foreign persons;
- certain debt financings;
- conversions into equity of contingent equity interests acquired on or after January 2, 2025;
- acquisition, lease or other development of land, property or other assets that will result in, or that the U.S. person plans will result in, the establishment of a covered foreign person or the engagement of an existing person of a country of concern in a covered activity; and
- certain joint ventures, limited partnership investments, and greenfield or brownfield investments.
A U.S. person’s provision of debt financing to a person the U.S. person knows is a covered foreign person qualifies as a covered transaction only if the debt financing affords or will afford the U.S. person financial or governance rights characteristic of an equity investment but not typical of a loan.
Debt financing secured by equity collateral generally does not constitute a covered transaction. Nor does acquiring such secured debt on the secondary market. However, foreclosure on collateral – where the debtholder takes possession of the pledged equity – does constitute a covered transaction.
A U.S. person’s use of a non-U.S. person intermediary to engage in a transaction that would be a covered transaction if engaged in by a U.S. person qualifies as an indirect covered transaction.
A “covered foreign person” is:
- a “person of a country of concern” engaging in a covered activity; or
- a person who (i) directly or indirectly holds any voting interest or equity interest in, or has the power to direct, one or more covered foreign person(s) and (ii) either:
- derives at least $50,000 and more than 50 percent of its revenue a year from such covered foreign person(s); or
- incurs at least $50,000 and more than 50 percent of its capital expenditure or operating expenses a year through the covered foreign person(s).
Treasury declined to publish a list of covered foreign persons.
Any level of covered activity by a person of a country of concern is sufficient for the person to be a covered foreign person.
A “person of a country of concern” is:
- a citizen or permanent resident of China who is not a U.S. citizen or U.S. permanent resident;
- an entity that has its principal place of business or headquarters in China or is incorporated in or organized under the laws of China;
- the Chinese government or any person acting on its behalf;
- an entity in which the Chinese government holds, directly or indirectly, 50 percent or more of the outstanding voting interest, board voting power or equity interest or that otherwise has the power to direct or control; or
- an entity in which one or more persons identified above, individually or in the aggregate, directly or indirectly, holds at least 50 percent of the outstanding voting interest, board voting power or equity interest.
The breadth of these definitions means certain investments in non-Chinese entities can be covered transactions. It is crucial for companies to conduct diligence on non-Chinese investment targets that engage in activity in China or that are owned or controlled by Chinese parties.
What Activities Are Covered?
For AI prohibited and notifiable transactions, only substantive modifications of third-party technologies or products qualify as “development” of those technologies or products.
Prohibited transactions include covered transactions involving a covered foreign person on a U.S. government blacklist that performs activities listed in either column of the above chart.
U.S. persons involved in notifiable transactions are required to notify Treasury of each such transaction within 30 days of the transaction’s completion.
A U.S. person who discovers after completing a transaction that it was a covered transaction has 30 days to notify Treasury.
Knowledge Requirement
A transaction that has the attributes of a covered transaction generally is treated as covered only if the U.S. person involved in the transaction has “knowledge” at the time of the transaction that it involves or would result in the establishment of a covered foreign person (or would result in a Chinese person’s engagement in a new covered activity).
For these purposes, “knowledge” means:
- actual knowledge that a fact or circumstance exists or is substantially certain to occur; or
- an awareness of a high probability of a fact or circumstance’s existence or future occurrence; or
- reason to know of the existence of a fact or circumstance.
A U.S. person is required to perform reasonable and appropriate diligence to determine whether a transaction is covered. Treasury’s assessment of whether a U.S. person has undertaken a “reasonable and diligent inquiry” will be based on the totality of relevant facts and circumstances, and U.S. persons are only required to scrutinize information reasonably available to them (including public and commercial databases). Treasury advises that U.S. persons may wish to obtain representations or warranties from relevant transaction counterparties regarding pertinent information such as the investment target’s or counterparty’s ownership, investments and activities.
Excepted Transactions
Transactions excepted from the Final Rule include:
- Publicly traded securities: An investment by a U.S. person in any publicly traded security or a security issued by certain types of investment and business development companies, unless the investment affords the U.S. person rights beyond standard minority shareholder protections with respect to the covered foreign person.
- Equity compensation: The receipt of employment compensation in the form of stock or stock options, or the exercise of such options.
- Binding commitments consummated before the Final Rule takes effect: A transaction made after January 2, 2025, pursuant to a binding, uncalled, capital commitment entered into prior to January 2, 2025.
- Third country measures: A transaction involving a person of a foreign country or territory if the Treasury Secretary determines the country or territory adequately addresses national security concerns posed by the outbound investment. The Treasury Secretary has not yet designated any countries for which this exception would apply.
- Certain limited partner investments: An investment by a U.S. limited partner in a non-U.S. person pooled investment fund where the investment does not afford the U.S. person rights beyond standard minority shareholder protections with respect to the covered foreign person, and:
- the limited partner’s committed capital is not more than $2 million in the aggregate, or
- prior to making the investment, the limited partner secures a binding contractual assurance that its capital will not be used to engage in a prohibited or notifiable transaction by a U.S. person.
- Non-U.S. person transactions from which a U.S. person is recused: A U.S. person with the authority to “knowingly direct” an otherwise prohibited transaction by a non-U.S. person will be deemed not to have “knowingly directed” the transaction (and the transaction, therefore, will not be a covered transaction) if the U.S. person recuses themself from:
- participating in formal approval and decision-making related to the transaction, including making a recommendation,
- reviewing, editing, commenting on, approving, and signing relevant transaction documents, and
- negotiating with the investment target or the relevant counterparty, such as a joint venture partner.
- Full buyouts of Chinese ownership: A U.S. person’s full buyout of all interests of any person of a country of concern in an entity, such that the entity would not constitute a covered foreign person following the transaction.
- Intracompany transactions: An intracompany transaction between a U.S. person parent and its subsidiary that supports operations that are not covered activities or that maintains covered activities in which the foreign entity was engaged prior to January 2, 2025.
- Certain syndicated debt financings: A U.S. person’s participation as a passive member of a lending syndicate that acquires a voting interest in a covered foreign person upon default of a loan.
- Derivative transactions: A derivative transaction that does not confer the right to acquire equity, any rights associated with equity, any assets or rights beyond standard minority shareholder protections related to a covered foreign person.
- National interest transactions: A transaction the Treasury Secretary determines to be in the national interest of the United States.
Violations and Penalties
A U.S. person can face penalties for engaging in a prohibited transaction, failing to timely notify Treasury of a notifiable transaction, making material misrepresentations in or omitting material information from submissions to Treasury. Civil monetary penalties can reach the greater of $368,137 (subject to annual adjustment for inflation) or twice the amount of the transaction.
U.S. persons who or that willfully violate the Final Rule can face imprisonment or civil fines up to $1 million.
Disclosure of Confidential Information
Treasury may disclose submitted information that is not publicly available, subject to confidentiality and classification requirements, (i) to Congress, (ii) in connection with a judicial or administrative proceeding, or (iii) to others in the U.S. or allied country governments if it deems the information important to the national security analysis or actions of such parties. In addition, Treasury may disclose confidential information (including to the public) if the Treasury Secretary determines it is in the national interest to do so.
[1] The Final Rule finalizes a proposed rule issued on June 21, 2024, covered by our prior alert.
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