Treasury Finalizes China-Focused Outbound Investment Security Program Rule

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On October 28, 2024, the U.S. Department of the Treasury released a final rule (“Final Rule”) to implement the China-focused outbound investment program introduced by Executive Order 14105 (the “Outbound EO”).

Effective January 2, 2025, the Final Rule will:

• Prohibit certain transactions by U.S. persons involving covered foreign persons; and
• Require U.S. persons to notify the Treasury Department of other categories of transactions involving covered foreign persons.

The Final Rule follows a Notice of Proposed Rulemaking (“Proposed Rule”), which was issued on June 21 and summarized in our prior Alert.

1. Who Is Required to Comply?

Consistent with the Proposed Rule, the Final Rule’s restrictions and requirements will apply to “U.S. persons,” 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 branch of any such entity, or any person in the United States.

Of note, U.S. persons’ compliance obligations will extend to certain activities by third parties:

• The Final Rule will obligate U.S. persons to “take all reasonable steps to prohibit and prevent any transaction by a controlled foreign entity that would be a prohibited transaction if engaged in by a U.S. person.” The term “controlled foreign entity” means any non-U.S. organized entity of which a U.S. person is a “parent”—i.e., general partner, managing member, investment adviser (in the case of a pooled investment fund), or owner of a 50% or greater voting interest or voting power of the entity’s board.
• The Final Rule will prohibit U.S. persons from “knowingly directing a transaction by a non-U.S. person that the U.S. person knows at the time of the transaction would be a prohibited transaction if engaged in by a U.S. person.”

2. What Transactions Will Be In Scope?

The Final Rule will impose prohibitions and notification requirements with respect to “covered transactions,” a term that encompasses a variety of equity and non-equity transactions involving “covered foreign persons,” each as discussed below.

A. Knowledge

The Final Rule’s prohibitions and notification requirements generally are triggered when a U.S. person knows that a prospective transaction—whether undertaken by the U.S. person or a controlled foreign entity—is a covered transaction:

• Consistent with other regulatory regimes, the Final Rule’s definition of knowledge encompasses both actual and constructive knowledge (i.e., whether the U.S. person should have known or had a high probability of awareness through a reasonable and diligent inquiry). The adopting release states that both (1) scope of pre-acquisition due diligence and (2) contractual representations may be relevant to determining whether a U.S. person has undertaken a reasonable and diligent inquiry, which will be assessed based on a consideration of the totality of the relevant facts and circumstances.
• U.S. persons that acquire actual knowledge of a covered transaction post-completion must provide notice of the covered transaction within 30 days of learning of the covered transaction.

Of note, limited partners’ knowledge generally will be assessed at the time of investment into a third party-managed fund, as opposed to each individual investment by the fund.

B. Covered Foreign Persons

The term “covered foreign person” is defined broadly to include:

1. A person of a country of concern engaged in a covered activity;
2. An entity with a significant financial connection to a person of a country of concern engaged in a covered activity; and
3. A person of a country of concern that participates in a joint venture with a U.S. person, where the U.S. person knows at the time of entrance into the joint venture that the joint venture will engage, or plans to engage, in a covered activity.

While application of prong (a) appears (relatively) straightforward, assessment of prongs (b) and (c) foreseeably may require detailed due diligence and/or risk-based interpretations.

For example, under prong (b), an entity generally will be deemed to possess a significant financial connection with a person of a country of concern engaged in a covered activity if that entity:

• holds a board seat at, a voting or equity interest in, or any contractual power to direct or cause the management of a person of a country of concern engaged in a covered activity; and
• derives more than 50% of its revenue or net income—or incurs more than 50% of its capital expenditures or operating expenses—from one or more persons of a country of concern engaged in a covered activity (subject to a $50,000 de minimis threshold).

With respect to prong (c), despite multiple requests, Treasury declined to define the term “joint venture,” electing instead to refer to the term’s “plain English meaning.” Treasury observed that “absent other facts, a ‘joint venture’ would not ordinarily result simply where there is a licensing arrangement, the sale or barter of goods and services, or resale of goods and services” (emphasis added), leaving U.S. persons to assess specific facts and circumstances.

1. Person of a Country of Concern

The Final Rule defines “person of a country of concern” broadly and, consequently, the Final Rule’s prohibitions and requirements capture entities both within and outside of China. This definition includes:

• An individual who is a citizen or permanent resident of a country of concern (and not a U.S. citizen or permanent resident of the United States).
• An entity that is organized under the laws of, headquartered in, incorporated in, or with a principal place of business in, a country of concern.
• The government of a country of concern (inclusive of any political subdivision, agency or instrumentality thereof, or other subordinate entity, as well as a person acting on behalf of a government of a county of concern).
• Any entity that is 50% or more owned, individually or in the aggregate, by one or more of the foregoing.
• Any entity in which one or more of the foregoing holds, individually or in the aggregate, at least 50% of the outstanding voting interest, voting power of the board, or equity interest.

2. Covered Activity

The term “covered activity” encompasses any activity that is prohibited or notifiable under the Outbound EO, which the Final Rule defines as follows:

Sector	Prohibited Transactions	Notifiable Transactions
Semiconductors and Microelectronics	Entities engaged in the development or production of any electronic design automation software for the design of integrated circuits or advanced packaging. Entities that develop or produce (1) front-end semiconductor fabrication equipment designed for performing volume fabrication of integrated circuits; (2) equipment for performing volume advanced packaging; or (3) commodity, material, software, or technology designed exclusively for use in or with extreme ultraviolet lithography fabrication equipment. Entities that design integrated circuits that meet or exceed specified performance parameters or that are designed for operation at certain temperatures. Entities that fabricate integrated circuits that meet specified criteria. Entities that package integrated circuits using advanced packaging techniques. Entities that design, sell, or produce supercomputers enabled by advanced integrated circuits that can perform at certain thresholds.	Entities engaged in the design, fabrication, or packaging of any integrated circuit that does not meet the parameters necessary to trigger a prohibition.
Quantum Information Technologies “Quantum computer” is defined as “a computer that performs computations that harness the collective properties of quantum states, such as superposition, interference, or entanglement.”	Entities engaged in the development of quantum computers or the critical components required to produce quantum computers, such as dilution refrigerators or two-stage pulse tube cryocoolers. Entities engaged in the development or production of quantum sensing platforms designed for, or intended to be used for, military, government intelligence, or mass-surveillance end uses. Entities engaged in the development or production of quantum networks or communication systems designed for, or intended to be used for, networking to scale up capabilities of quantum computers, secure communications, or any other application that has any military, government intelligence, or mass-surveillance end use.	None.
Artificial Intelligence “AI system” is defined broadly as either (1) a machine-based system that can, for a given set of human-defined objectives, make predictions, recommendations, or decisions influencing real or virtual environments; or (2) any data system, software, hardware, application, tool, or utility that operates in whole or in part using such a system.	Entities engaged in the development of AI systems exclusively designed for, or intended to be used for, military, government intelligence, or mass surveillance end uses. Entities engaged in AI systems trained using a specified quantity of computing power.	Entities engaged in the development of AI systems that are designed for military, government intelligence, or mass surveillance end uses (but not exclusively). Entities engaged in the development of AI systems intended to be used for cybersecurity applications, digital forensics tools, penetration testing tools, or the control of robotics systems. Entities engaged in AI systems trained using a specified quantity of computing power (i.e., at a threshold lower than that for prohibited transactions).
Other Categories of Transactions	Entities engaged in covered activities (i.e., notifiable activities) that are subject to certain sanctions, export restrictions, or designations imposed by the Office of Foreign Assets Control, the U.S. Department of Commerce’s Bureau of Industry and Security, or the U.S. Department of State.	None.

 

C. Covered Transactions

The term “covered transaction” encompasses a range of transaction types:

• Acquisition of an equity interest or contingent equity interest in a person that the U.S. person knows at the time of the acquisition is a covered foreign person.
• Provision of a loan or a similar debt financing arrangement to a person that the U.S. person knows at the time of the provision is a covered foreign person, where such 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 (including, inter alia, an interest in profits or board rights).
• Conversion of a contingent equity interest into an equity interest in a person that the U.S. person knows at the time of the conversion is a covered foreign person, where the contingent equity interest was acquired by the U.S. person on or after January 2, 2025.
• Acquisition, leasing, or other development of operations, land, property, or other assets in a country of concern that the U.S. person knows at the time of such acquisition, leasing, or other development will result in, or that the U.S. person plans to result in the (1) establishment of a covered foreign person; or (2) engagement of a person of a country of concern in a covered activity.
• Entrance into a joint venture, wherever located, that is formed with a person of a country of concern, and that the subject U.S. person knows at the time of entrance into the joint venture that the joint venture will engage, or plans to engage, in a covered activity.
• Acquisition of a limited partner or equivalent interest in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund (in each case where the fund is not a U.S. person) that a U.S. person knows at the time of the acquisition likely will invest in a person of a country of concern that is in the semiconductors and microelectronics, quantum information technologies, or artificial intelligence sectors, and such fund undertakes a transaction that would be a covered transaction if undertaken by a U.S. person.

D. Excepted Transactions

Consistent with the Proposed Rule, the Final Rule contemplates certain exemptions (excepted transactions) from the definition of “covered transaction,” including for:

• Publicly traded securities: Acquisition of publicly traded securities, as defined under the Securities Exchange Act of 1934, as amended, if such transaction does not afford the U.S. person rights beyond standard minority shareholder protections.
• Investment companies: Investment in a security issued by any “investment company,” as defined in the Investment Company Act of 1940 (e.g., index fund, mutual fund, or exchange traded fund), if such transaction does not afford the U.S. person rights beyond standard minority shareholder protections.
• Certain limited partner investments: Certain limited partner investments in non-U.S. pooled investment funds, where (i) the committed capital is not more than $2,000,000 in the aggregate; or (ii) the limited partner has secured a binding contractual assurance that its capital in the fund will not be used to engage in transactions that would be prohibited or notifiable for U.S. persons to engage in.
• Derivatives: Investments in derivatives, provided that they do not confer rights beyond standard minority shareholder protections or the right to acquire equity, any rights associated with equity, or assets in or of a covered foreign person.
• Buyouts of country of concern ownership: A buyout of all of the ownership of a person of a country of concern in an entity, such that the entity post-transaction is no longer a covered foreign person.
• Intracompany transactions: An intercompany transaction between a U.S. person and its controlled foreign entity that supports ongoing operations or other activities, provided these transactions do not involve covered activities, or support only covered activities in effect prior to the Final Rule’s effective date of January 2, 2025.
• Pre-effective date binding commitments: A transaction fulfilling a binding, uncalled capital commitment entered into prior to the Final Rule’s effective date of January 2, 2025.
• Certain syndicated debt financings: A syndicated debt financing, where the U.S. person lender (1) cannot on its own initiate any action vis-à-vis the debtor; and (2) does not have a lead role in the syndicate.
• Transactions involving certain excepted countries: A transaction involving a person of a country or territory that Treasury determines to exempt from the restrictions, based on the laws of that country or territory.
• National security exemption: A transaction that the Secretary of the Treasury, in consultation with heads of other relevant agencies, determines is in the national interest of the United States (including upon application of a U.S. person).

3. What Does Notifiable Transaction Reporting Entail?

Where a covered transaction is notifiable (versus prohibited), notification must be submitted within 30 days of completion. Under the Final Rule, notices of covered transactions must include, inter alia:

• The contact information of a representative of the U.S. person filing the notification who can communicate with Treasury regarding the filing;
• A description of the U.S. person (including its place of incorporation, principal place of business, and ownership);
• Post-transaction organizational charts of the U.S. person and covered foreign person that include the name, principal place of business, and place of incorporation of the intermediate and ultimate parent entities of both parties;
• A description of the commercial rationale for the transaction;
• A description of why the U.S. person determined the transaction is notifiable;
• The status of the transaction (including actual or expected completion date);
• The total transaction value in U.S. dollars;
• The aggregate equity interest, voting interest, and board seats of the U.S. person in the covered foreign person;
• Information about the covered foreign person (including its place of incorporation, principal place of business, ownership, officers, and directors);
• Identification and description of each of the covered activity or activities undertaken by the covered foreign person that makes the transaction a covered transaction, as well as a brief description of the known end use(s) and end user(s) of the covered foreign person’s technology, products, or services; and
• Where the notice is submitted more than 30 days post-closing, a description of why the U.S. person lacked sufficient to knowledge to timely submit (including a description of any pre-transaction diligence conducted).

Upon receipt of a notified transaction, Treasury may submit questions or document requests with which the U.S. person must comply within the Treasury-specified timeframe. Information received by Treasury will be treated as confidential, subject to certain limited exceptions.

4. Will the Final Rule Establish a Reverse CFIUS Regime?

No. The Final Rule will not establish a review or licensing approval regime for covered transactions similar to the Committee on Foreign Investment in the United States (“CFIUS”) process. As noted above, the Final Rule provides that, in exceptional circumstances, parties to a covered transaction may apply to the Treasury Department to seek an exemption to the Outbound EO’s requirements for a covered transaction that is in the national interest of the United States.

5. What If I Do Not Comply?

Under the Final Rule, failure to comply with a prohibition or notification requirement could result in (1) civil liability of the statutory maximum (set at $250,000, adjusted regularly for inflation, currently $368,136) or twice the value of the transaction, whichever is greater; or (2) criminal liability of up to $1,000,000 and imprisonment of up to 20 years per violation, if a breach is committed willfully. In addition to statutory penalties, the Final Rule accords Treasury the authority to nullify, void, or compel the divestment of prohibited transactions (although, depending on the facts, Treasury may face practical limitations in attempting to exercise this authority).

6. Initial Reactions

• Application to Businesses Outside of China: Consistent with the Proposed Rule, the Final Rule’s prohibitions and notification requirements will extend to a broad swath of businesses located outside of China including, with limited exceptions, ex-China businesses that (1) are majority-owned by Chinese citizens and engaged in a covered activity; or (2) have significant financial connections with Chinese businesses (e.g., subsidiaries) engaged in a covered activity. As a result, U.S. investors will need to ensure that their investment due diligence protocols are sufficiently robust to identify covered transactions involving businesses that are not headquartered, organized, or principally operating in China.
• Limited Partner Investments: Treasury has clarified the scope of the exemption for certain limited partner investments in non-U.S. investment funds. While this clarification provides some guidance for U.S. limited partners, questions remain, particularly around the scope of contractual assurances required to rely on the exemption (e.g., knowledge or best efforts standards). In addition, the Final Rule does not squarely address whether other mechanisms commonly employed to mitigate regulatory risk—such as excuse/opt-out rights or parallel investment structures—would satisfy the Final Rule’s “knowledge” standard (discussed further below). In the absence of further guidance from Treasury, we anticipate that a range of approaches to documentary protections will emerge in the near term, informed by both (1) individual U.S. investors’ risk tolerance; and (2) individual non-U.S. fund managers’ willingness to accommodate U.S. investors’ regulatory considerations.
• No Explicit Due Diligence Safe Harbor: Treasury declined to specify what level of pre-investment due diligence or contractual protections—with respect to either investment targets or non-U.S. pooled investment vehicles—would satisfy U.S. persons’ obligation to refrain from knowingly (i.e., with reason to know) (1) engaging in a prohibited transaction; or (2) failing to notify Treasury upon engaging in a notifiable transaction. While market practices are likely to coalesce with time (as occurred following implementation of the Foreign Investment Risk Review Modernization Act of 2018), in the short-to-medium term, U.S. investors may exhibit particular caution in their approach to pre-investment due diligence and negotiation of documentary protections.
• Activities by Controlled Foreign Entities: The Final Rule obligates U.S. persons to (1) take all reasonable steps to prevent controlled foreign entities from engaging in prohibited transactions; and (2) file reports on behalf of controlled foreign entities when such entities engage in notifiable transactions. This requirement will obligate U.S. entities to develop guidance and monitoring mechanisms to ensure that controlled foreign entities are aware of these new legal requirements, as well as to consider how to monitor the activities of subsidiaries or portfolio companies involving potential covered activities.