On October 28, 2024, the U.S. Department of the Treasury published its Final Rule to implement regulations on outbound investments pursuant to Executive Order 14105 (EO), issued on August 9, 2023. The Final Rule, which goes into effect on January 2, 2025, prohibits or requires notification of certain investments by U.S. persons in “covered foreign persons” engaged in activities related to semiconductors, quantum information technologies, and artificial intelligence (AI) systems.
Background
Over the past two Congresses, multiple bills have been introduced and hearings held on legislative approaches to outbound investment reporting and restrictions. None of the bills advanced. Instead, President Biden invoked the International Emergency Economic Powers Act (IEEPA) as the basis for Executive Branch action to create this new regulatory regime.
On August 9, 2023, President Biden signed the EO proposing (1) prohibitions on certain outbound investments in the three strategic sectors; and (2) mandatory notification requirements for a broader set of transactions in those same sectors and instructing the Secretary of the Treasury to develop regulations to implement the order. Although the EO broadly discussed “countries of concern,” it was expected that the new regulatory system to be developed pursuant to the EO would focus on U.S. investments in China.
Treasury subsequently engaged in rulemaking pursuant to the EO, issuing an advance notice of proposed rulemaking in August 2023 and a notice of proposed rulemaking in July 2024. The Outbound Investment Security Program, now established by the Final Rule, will be administered by the newly created Office of Global Transactions, which sits within Treasury’s Office of Investment Security.
Summary of Requirements and Related Definitions
At its core, the Final Rule prohibits or requires notifications to Treasury when a U.S. person has knowledge of certain covered transactions involving covered foreign persons.
“Covered transactions” include prohibited transactions and notifiable transactions, which pose different levels of national security concerns. “Prohibited transactions” are transactions that pose a “particularly acute” national security threat and are defined by reference to specific levels and types of technology. “Notifiable transactions” are also defined by reference to certain types of technologies and are transactions that may “contribute” to the threat of national security. The Final Rule establishes Treasury’s authority to “take any action authorized under IEEPA to nullify, void, or otherwise compel the divestment of any prohibited transaction entered into after the effective date of this part.” No equivalent authority is set forth for notifiable transactions.
Covered transactions include a U.S. person’s direct or indirect (1) acquisitions of equity interest or contingent equity interests in a covered foreign person; (2) provision of debt financing to a covered foreign person that affords certain rights to the lender; (3) the conversion of contingent interests into equity interests in a covered foreign person; (4) certain greenfield investments; (5) certain joint ventures related to covered activities; and (6) certain investments made as a limited partner (LP) or equivalent interest into a non-U.S. pooled investment vehicle.
“Covered foreign person” means (1) a person of a country of concern (currently China, Hong Kong, and Macau) that engages in a covered activity; or (2) a third person with sufficient nexus to such persons through certain vested financial interests or participation in joint ventures. “Covered activities” include activities related to the design, production, fabrication, packaging, and development of semiconductors, quantum information technologies, and AI systems.
The Final Rule specifies that a transaction can only be a covered transaction if a U.S. person has knowledge of the relevant facts or circumstances at the time of a transaction. “Knowledge” that a target company is engaged in covered activity is deemed to exist (1) where actual knowledge exists (or is substantially certain); (2) where there is an awareness of a high probability; and (3) where such knowledge could have been possessed through a reasonable and diligent inquiry.
“U.S. persons” include 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 branch of any such entity, or any person in the United States.
The Final Rule also extends the notification obligations of U.S. persons for notifiable transactions by its “controlled foreign entities” that would be notifiable if conducted by a U.S. person. The Final Rule requires U.S. persons to take all reasonable steps to prohibit and prevent any prohibited transaction by a controlled foreign entity if such transaction would be prohibited by a U.S. person. The Final Rule also prohibits U.S. persons from “knowingly directing” prohibited transactions by non-U.S. persons if, at the time of the transaction, the U.S. person knows the transaction would be prohibited.
Excepted Transactions and Exemption
The Final Rule carves out certain excepted transactions from the definition of covered transactions. Notable excepted transactions include:
- Investments in a publicly traded security denominated in any currency and trading on a securities exchange or over the counter in any jurisdiction, a security issued by a registered investment company, such as an index fund, mutual fund, or exchange-traded fund.
- Investments made as an LP in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund (1) where such investment is $2 million or less; or (2) where the U.S. person has received a contractual assurance that its capital will not be used by the fund to engage in what would be a prohibited or notifiable transaction.
- Investments in derivatives, 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.
- Full buyouts of all country of concern ownership of an entity, such that the entity does not constitute a covered foreign person following the transaction.
- Intracompany transactions between a U.S. person and its controlled foreign entity to support operations that are not covered activities or to maintain ongoing operations with covered activities that the controlled foreign entity was engaged in before January 2, 2025.
- Transactions pursuant to a binding, uncalled capital commitment entered into before January 2, 2025.
- Where the U.S. person, as a member of a lending syndicate, acquires a voting interest in a covered foreign person upon default and the U.S. person cannot initiate any action vis-à-vis the debtor and is not the syndication agent.
- 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.
Besides the excepted transactions, the Final Rule also provides a national interest exemption, under which, if a covered transaction is determined to be in the national interest of the United States, it is exempt from the applicable provisions in the Final Rule.
Enforcement and Penalties
The Final Rule establishes the related penalty and voluntary self-disclosure framework. Violations are subject to civil and criminal penalties as set forth in IEEPA. In the event of a violation, Treasury could impose a civil penalty that is the greater of $368,136 (as adjusted annually for inflation) or twice the value of the underlying transaction. Treasury could also refer violations to the Department of Justice for appropriate criminal penalties. Furthermore, Treasury can take any action authorized under IEEPA to nullify, void, or otherwise compel the divestment of any prohibited transaction.
The Final Rule allows a U.S. person to submit a voluntary self-disclosure if they believe their conduct may have resulted in a violation of any part of the Final Rule, which will be taken into consideration by Treasury in determining the enforcement response to the disclosed activity.
Key Takeaways for Businesses
With the January 2, 2025 effective date fast approaching, we highlight some key takeaways for businesses that have existing investments or plan to invest in the three strategic sectors involving China, Hong Kong, and Macau.
The “knowledge” standard compels businesses and other investors with global operations to review and refine their investment due diligence process. A U.S. person is deemed to have “knowledge” when there is actual knowledge or constructive knowledge, i.e., knowledge that could have been possessed through a reasonable and diligent inquiry. Treasury declined to include a safe harbor or specify what level of pre-investment due diligence would be considered as a “reasonable and diligent inquiry.” However, the Final Rule indicates that such a determination will be based on a “consideration of the totality of relevant facts and circumstances.” Furthermore, the Final Rule prescribes a list of due diligence activities that Treasury will consider, including the U.S. person’s efforts to obtain and evaluate public and nonpublic information, contractual representations and warranties, and any “red flags” or “warning signs.” Accordingly, businesses and other investors with global operations should review and refine their investment due diligence processes to support compliance with the Final Rule.
The intracompany transactions exception provides U.S. persons a path for continued investments into their controlled foreign entities. First, the Final Rule exempts intracompany transactions between a U.S. person and its controlled foreign entity that supports any ongoing operations that are not covered activities. Second, intracompany transactions to maintain covered activities that the controlled foreign entity was engaged in before January 2, 2025 are also excepted. Many had hoped that Treasury would allow U.S.-citizen and green-card-holding founders of companies to invest further in their companies. The intracompany transaction exception may be useful in that context, but it requires that the U.S. person hold more than 50 percent of the voting interest of the entity, more than 50 percent of the voting power of the board, or be the general partner or managing member of the entity.
The publicly traded security exception establishes a low cap for U.S. persons’ investments. Investments in a security traded on a U.S. exchange, a non-U.S. exchange, or over the counter are excepted from the Final Rule. However, such investments cannot afford the U.S. person rights beyond standard minority shareholder protection for the covered foreign person. As noted by Treasury in response to public comments, standard minority shareholder protection rights are “typically defensive in nature” and do not include a right to make a shareholder proposal. Despite acknowledging that certain jurisdictions, including China, may provide shareholder proposal rights to relatively low-percentage shareholders in companies listed in those jurisdictions, Treasury declined to consider these rights to be standard minority shareholder protection rights. This could potentially impose a low cap on a U.S. person’s potential shareholding in public traded security of covered foreign persons, though this is not clearly provided for in the regulations.
The capital commitment exception may provide an avenue for investment managers and funds to maintain their strategies. Treasury limits the capital commitment exception to where the U.S. person has made a binding capital commitment to a fund or similar investment entity before January 2, 2025, and the capital is then called after the effective date, recognizing that often a fund’s investment targets have yet to be determined at the time of the capital commitment. In commentary, Treasury noted that the exception does not apply if at the time the U.S. person signed the binding agreement the fund (or similar investment entity) has determined to invest in covered foreign persons. Nonetheless, because many investment agreements include ongoing capital call rights held by the manager, this exception may allow for continued investments in covered foreign persons at least in the near term. Investment firms and managers with global operations should review their current and potential capital commitments to support compliance with the Final Rule.
U.S. persons may passively invest in non-U.S. pooled funds under the LP exception. The exception permits (1) any U.S. LP investment of $2 million or less, aggregated across any investment and co-investment vehicles of the fund; or (2) U.S. LP investments where the LP receives binding contractual assurance that its capital will not be used to engage in a prohibited or notifiable transaction, provided that such investments do not afford the U.S. person rights beyond standard minority shareholder protection for the covered foreign person. Note 1 to § 850.210 of the Final Rule explicitly provides that U.S. LP investments into U.S. pooled funds that then invest in covered foreign persons are not considered covered transactions. In other words, without other relevant facts, U.S. LPs will not be held liable for investments made through U.S. pooled funds that fail to comply with the Final Rule.
Investment firms should review their organizational structure to determine the applicability of the Final Rule to their activities. Investment funds ultimately owned or controlled by U.S. persons will be directly affected by the Final Rule. But non-U.S. firms should also review their structure and the nationalities of their decision-makers and consider potential reorganization or recusal, as provided for in Section 850.303, to ensure compliance.
Looking Ahead
The Outbound Investment Security Program, now established by the Final Rule, ushers in a new era of trade between the United States and China, particularly new and emerging technologies. We also note that, with an effective date of January 2, 2025, the implementation of the Final Rule ultimately will be carried out by the next administration. Therefore, the result of the upcoming presidential election could impact the administrative and enforcement priorities of the newly created Office of Global Transactions.
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