Final U.S. Outbound Investment Rule: Overview and Key Takeaways for Investors

The Department of the Treasury (“Treasury”) issued its Final Rule (“Rule”) to implement President Biden’s Outbound Investment Executive Order (“Outbound Investment EO”). The Rule, which will take effect on January 2, 2025, prohibits certain investments and subjects others to a reporting requirement, in each case where there is a U.S. person involved in the investment and a direct or indirect investment in a Chinese company engaged in certain technology activities in China (including Hong Kong and Macao). 

The Rule’s focus on China and on three technology areas (semiconductors and microelectronics, quantum computing, and AI) means that a relatively small number of transactions ultimately will be affected by the rule.  However, the AI component of the rule (which reaches uses that may be fully commercial), the fact that the rule can be implicated even if the principal target of the investment is not in China, and the application of the rule to U.S. nationals wherever they are in the world, all mean that the rule may still have broad implications for M&A transactions globally.

The Rule establishes diligence standards that parties are expected to meet in order to comply with what is essentially a strict liability regime rather than a licensing or approval process. Violations of the Rule are subject to potential civil and criminal penalties (the higher of $250k or twice the value of the transaction), along with forced divestment. Those falling within the scope of the Rule should, therefore, conduct thorough, systematic diligence of relevant outbound investments to avoid exposure to liability.

Congress also continues to deliberate over passage of outbound investment legislation. Current draft legislation is roughly similar to the Treasury Rule as it relates to prohibitions on U.S. person investment in Chinese companies, adding certain additional technologies such as hypersonic technologies and certain other export-controlled technologies. The draft also would subject identified companies engaging in significant operations in the Chinese defense and surveillance technology sector to sanctions. 

Summary of the Rule

The Final Rule maintains the framework described in Treasury’s August 2023 Advanced Notice of Proposed Rulemaking (“ANPRM”) and June 2024 Notice of Proposed Rulemaking (“NPRM”).  Three elements are required for a transaction to fall within scope of the Rule: (A) a “U.S. person,” (B) a “covered foreign entity,” and (C) a “covered transaction.” Following is a high-level summary of each of these three elements.

1. US Person and its Controlled Foreign Entities
   • The Rule applies to U.S. persons, which includes U.S. citizens, permanent residents, and entities, including their foreign branches.
   • Individuals who are U.S. persons would each individually be prohibited from “knowingly directing” a transaction by another entity (e.g., as an executive or board member of a European company) if the U.S. person knows at the time of the transaction that it would be prohibited if engaged in by a U.S. person. The Rule provides that U.S. persons would be deemed not to have engaged in such knowing direction if they have recused themselves from certain activities that are part of the decision-making process (further explained below).
   • The Rule also places obligations on U.S. persons with respect their “controlled foreign entities,” which are entities of which a U.S. person is a parent (i.e., 50%+ voting interest, a general partner, or an investment adviser).  Specifically, the U.S. person would be required to take all reasonable steps to prohibit and prevent the controlled foreign entity from engaging in any activities that the U.S. person itself could not undertake.  Reasonable steps may include, for example execution of agreements between the parent and subsidiary with respect to compliance; exercise of governance or shareholder rights as applicable; training, reporting and compliance policies and procedures; and testing and auditing of compliance. A U.S. person is also required to file a notification with respect to any transaction by its controlled foreign entity if such transaction would be notifiable if undertaken by the U.S. person.
      
2. Covered Foreign Entity 
   • The Rule concerns certain transactions involving entities in China, entities outside of China that have certain interests in entities in China, or entities owned by Chinese persons, that engage in defined types of technology development, design, or production activities (“covered foreign entities”). These activities are either “prohibited” or “notifiable.”
   • A “covered foreign entity” is:
     1. Chinese entity: An entity (a) established or with principal place of business in China (including Hong Kong or Macau) or (b) an entity 50%+ owned by such an entity, the Chinese government, or a citizen/permanent resident of China, where (c) the entity engages in a covered activity; 
     2. Entity with Chinese ties: An entity that (a) has certain governance, voting or equity interests (except certain publicly traded securities), or management rights in an entity identified in (1) and (b) attributes 50%+ of revenues, net income, capital expenditures, operating expenses to such person; and 
     3. JV partner: In a JV, the entity described in (1) that is a party to the JV.
   • “Covered activity” here is an activity that is listed in the regulations as either being prohibited or notifiable. The following chart summarizes the activities that cause an entity engaged in such activities in China to be a covered foreign person, such that a Covered Transaction involving such covered foreign person would be subject to prohibition or notification, as indicated in this chart.
     Note that if the covered foreign entity has been placed on one of the Treasury Department, Commerce Department, or State Department lists of entities subject to export control, sanctions, or investment restrictions, then any otherwise notifiable activity becomes prohibited.
      
3. Covered Transactions
   • The Rule does not cover all commercial activities of U.S. persons or their controlled foreign entities with a covered foreign person.
   • “Covered Transactions” include, subject to certain limited carveouts:
     1. acquisition of an equity interest or contingent equity interest; 
     2. provision of a loan or a similar debt financing arrangement that affords the U.S. person an interest in profits, right to appoint members of the board of directors (or equivalent), or other comparable financial or governance rights characteristic of an equity investment but not typical of a loan; 
     3. conversion of a contingent equity interest; 
     4. greenfield and brownfield investments; 
     5. joint ventures; and 
     6. acquisition of a limited partner or equivalent interest in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund. 
   • If the Covered Transaction involves a prohibited activity, then the U.S. person cannot engage in the Covered Transaction and, as described above, must take certain steps to prevent controlled foreign entities from engaging in such Covered Transactions. If the Covered Transaction involves a notifiable activity, then the U.S. person must notify the U.S. government after engaging in a Covered Transaction.
      
4. Excepted Transactions
   The Rule establishes certain categories of transactions that otherwise would be “covered transactions,” which are excepted from being “covered transactions.” The most relevant for strategic and fund investors include:
   
   1. Publicly traded security and other securities exception: An investment by a U.S. person (that does not afford the U.S. person rights beyond standard minority shareholder protections enumerated in the Rule) in a:
      • publicly traded security; 
      • security issued by:
        • any “investment company” as defined in section 3(a)(1) of the Investment Company Act of 1940, as amended, at 15 U.S.C. 80a-3(a)(1), that is registered with the U.S. Securities and Exchange Commission, such as index funds, mutual funds, or exchange traded funds; or
        • any company that has elected to be regulated or is regulated as a business development company pursuant to section 54 of the Investment Company Act of 1940, as amended, at 15 U.S.C. 80a-53; 
      • derivative, so long as such derivative does not confer the right to acquire equity, any rights associated with equity, or any assets in or of a covered foreign person.
   2. Limited partner exception: An investment made as a limited partner or equivalent in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund where:
      • the limited partner or equivalent's committed capital is not more than $2,000,000, aggregated across any investment and co-investment vehicles of the fund; or
      • the limited partner or equivalent has secured a binding contractual assurance that its capital in the fund will not be used to engage in a transaction that would be a prohibited transaction or notifiable transaction, as applicable, if engaged in by a U.S. person.
   3. Chinese owner divestment exception: The acquisition by a U.S. person of equity or other interests in an entity held by one or more persons of a country of concern; provided that:
      • The U.S. person is acquiring all equity or other interests in such entity held by all persons of a country of concern; and
      • Following such acquisition, the entity does not constitute a covered foreign person.
   4. Intracompany transfer exception: A transaction that, but for this paragraph, would be a covered transaction between a U.S. person and its controlled foreign entity that supports operations that are not covered activities or that maintains covered activities that the controlled foreign entity was engaged in prior to January 2, 2025. The Rule is ambiguous as to when an entity is considered to be maintaining a covered activity versus engaging in a covered activity that is outside the scope of this exception and would be considered a brownfield covered transaction. For example, for a developer of electronic design automation (“EDA”) software for the design of integrated circuits (which is a single paragraph in the definition of "prohibited transaction" in the Rule), can a company already engaged in development of EDA software produce new types of EDA software? New versions of the same software application? Or only maintain the existing version of that application?
   5. Other exceptions:
      • “Covered transactions” into countries designated by the Secretary of the Treasury that have adopted similar programs to address outbound investment risks;
      • The receipt of employment compensation by an individual in the form of an award of equity or the grant of an option to purchase equity in a covered foreign person, or the exercise of such option;
      • A transaction made after January 2, 2025, pursuant to a binding, uncalled capital commitment entered into before January 2, 2025; and
      • Certain acquisitions of a voting interest in a covered foreign person by a U.S. person upon default or other condition involving a loan or a similar financing arrangement, where the loan was made by a syndicate of banks in a loan participation.

Key Takeaways for Investors

A.  Deal Considerations:

• Diligence:
  
  1. The Rule applies if a person “knows” a fact or circumstance that would cause the transaction to be a covered transaction. Knowledge includes having reason to know if one were to conduct a reasonable and diligent inquiry. Thus, it is imperative that investors conduct such an inquiry, including seeking public and non-public information.
  2. Prepare due diligence questions and conduct desktop research to assess whether a target is a covered foreign person or holds an interest in a covered foreign person.
  3. Plan for the possibility that Chinese targets may be unwilling or unable to share information necessary to fulfill the Rule’s due diligence requirements. 
  4. Assess whether the transaction documents should include representations and warranties from the target confirming that it is not a covered foreign person and does not hold an interest in a covered foreign person.
      
• Fund Investments:
  To ensure compliance and benefit from the carveout for investments in funds, we expect that U.S. limited partner investors will require either: 
  
  1. a binding contractual assurance in either their partnership agreements or side letters that requires the general partner and fund manager to not use the U.S. limited partner’s capital in the fund to engage in a transaction that would be a prohibited or notifiable transaction; or 
  2. that the general partner or fund manager provide the limited partner the opportunity to review any proposed investment in advance and the option to opt out of any particular investment in order to comply with the requirements of the Final Rule.
      
• Non-U.S. Investors with U.S. Person Executives/Management
  
  1. U.S. persons working for non-U.S. companies will individually have responsibilities to comply with the requirements of the Rule. 
  2. Non-U.S. companies may need to establish internal policies and processes to ensure that U.S. persons serving in decision-making roles in the company (e.g., member of the board or investment committee) are recused from each of the following activities to ensure that they will not be considered to have exercised their authority to direct, order, decide upon, or approve a “covered transaction.” 
     • Participating in formal approval and decision-making processes related to the transaction, including making a recommendation;
     • Reviewing, editing, commenting on, approving, and signing relevant transaction documents; and
     • Engaging in negotiations with the investment target (or, as applicable, the relevant transaction counterparty, such as a joint venture partner).
     • (Note that, the criteria to benefit from this recusal provision are more expansive than the actual prohibition, as the recusal provision requires not just that the individual not exercise their authority, but that they do not participate in the decision-making process even short of taking action to approve the prohibited activity.)
  3. Steps to ensure that such individuals fall within the recusal provision of the Rule can include, for example, having the board pass a resolution and adopt procedures to exclude them from involvement in any decision making related to investment in companies that are covered foreign persons and excluding them from involvement in any subsequent decision making related to that investment.
• Indirect Investments and Carveouts:
  1. The Rule applies to both direct and indirect investments but does not provide clear guidance on how to apply it in the indirect context, leaving some ambiguity as to the circumstances in which an investment into a non-Chinese entity can be considered an “indirect” investment into its Chinese subsidiaries. 
  2. The intent (based on the definition of “covered foreign entity”) appears to be to cover investment in non-Chinese entities only where (a) 50% or more of the financial metrics in the definition of “covered foreign entity” are attributable to the Chinese subsidiary or (b) where the purpose of investing in the non-Chinese entity is to make an investment in the Chinese entity.
  3. However, Treasury explicitly stated that it chose not to implement any changes in the Rule despite public comments asking Treasury to resolve the conflict caused by the “covered foreign entity” definition and coverage of indirect investments.
  4. We cannot exclude that Treasury included the covered foreign entity metrics provision purely for diplomatic reasons to avoid labeling companies from partner countries a “covered foreign entity”, while maintaining the notification and prohibition requirements into any company that has subsidiaries that engage in “covered activities” in China (rendering the covered foreign entity metrics provision essentially meaningless as a practical matter). 
  5. We anticipate that Treasury will provide additional guidance to clarify its thinking, but the risk related to “indirect” investments can only be fully avoided at this point by carving of the scope of an acquisition any covered foreign entity in which the target holds an equity interest. 
• Timing:
  1. The Final Rule will likely have less impact on deal timing compared to foreign investment review processes such as CFIUS, as it does not establish a review and approval requirement. 
  2. Any timing impact on transactions will likely arise due to additional diligence that investors must conduct to ensure compliance with the Final Rule.

 B.  Compliance

• Immediate actions to consider: Assess whether any transactions that are expected to close on or after January 2, 2025, could be covered by the rules.
  1. If so, conduct additional diligence to determine whether the transaction is either prohibited or notifiable.
  2. Consider seeking additional representations and warranties from the investment target to confirm that it is not a “covered foreign person” nor holds an interest in a “covered foreign person”. 
  3. The Final Rule is generally not retroactive; however, any investments made after August 9, 2023, may be subject to information requests from the government. 
• Internal policies and procedures:
  1. Establish clear, systematic due diligence procedures and internal controls.
  2. Ensure these internal procedures and controls are promulgated to “controlled foreign entities” in order to comply with the requirements of the Final Rule.
  3. Maintain clear documentation and records of diligence conducted to demonstrate efforts to comply with the regulation in advance of making any investments.

C.  Enforcement: The Final Rule allows disclosure of information when in the national interest. We expect that this exception will be used to publicly identify entities who have been penalized or found to have violated the Final Rule.