U.S. Treasury Department promulgates final rule to implement outbound investment program

The U.S. Department of the Treasury (the “Treasury Department”) issued a final rule (the “Final Rule”) on October 28, 2024 to implement Executive Order 14105, imposing a prohibition or a notification requirement regarding certain investments in Chinese entities engaged in activities related to certain technology (i.e., semiconductors and microelectronics, quantum information technologies, and artificial intelligence). The Final Rule follows the June 21, 2024 Notice of Proposed Rulemaking (the “Proposed Rule”), which we discussed in our previous post.  A Treasury Department press release and fact sheet are available here and here.  

In general, the Final Rule largely tracks the Proposed Rule. However, the Final Rule contains several substantive changes, which we discuss below. Notably, operators of non-U.S. investment funds will likely face requests by U.S. investors to represent that it will not invest in covered foreign persons. In the absence of such representation, non-U.S. investment funds may find themselves unable to attract U.S. investors.

Like the Proposed Rule, the Final Rule regulates investments in certain sectors by “U.S. persons” (any U.S. citizen, permanent resident, entity organized under U.S. law (including any foreign branch of U.S. entity), or any person in the U.S.) in a so-called “country of concern” (currently the People’s Republic of China, including Hong Kong and Macau). It imposes a notification requirement, or outright prohibits, “covered transactions” (consisting of six categories, discussed below) if the U.S. person has “knowledge” (defined as actual knowledge, an awareness of a high probability, and reason to know, of a fact or circumstance’s existence or future occurrence)¹ that the transaction involves a “covered person” (defined as “persons of a country of concern”² and entities that attribute more than 50% of their revenue, net income, capital expenditure, or operating expenses to persons of a country of concern)³ engaged in a “covered activity” as referred to in the sections summarizing prohibition and notification requirements. Further, a U.S. person is prohibited from “knowingly directing an otherwise prohibited transaction.” A U.S. person “knowingly directs” a transaction when the U.S. person has authority, individually or as part of a group, to make or substantially participate in decisions on behalf of a non-U.S. person.⁴

The Final Rule will take effect on January 2, 2025. A violation of the Final Rule could result in forced divestment or nullification of the transaction. In addition, a violation could result in monetary penalties of up to twice the value of the transaction (or approximately $370,000 if greater) with respect to violations of the Final Rule.⁵  Consequently, it is important to understand whether a transaction would be prohibited or subject to notification requirements, pursuant to the Final Rule.

Scope of Covered Transactions

The Final Rule considers the following categories of transactions by U.S. persons to be a “covered transaction.” Except as discussed below, these categories generally cover the same scope as the Proposed Rule.  

1. 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. Unlike the Proposed Rule, the Final Rule clarifies that neither the issuance of debt financing secured by equity collateral nor the acquisition of such secured debt on the secondary market is an “acquisition of an equity or contingent equity interest” and hence will not, absent other facts, constitute a covered transaction.  However, foreclosure on equity taken as collateral continues to be considered an acquisition of an equity interest when a U.S. person has knowledge at both the time of the issuance or acquisition of the secured debt, and at the time of foreclosure, that the equity is that of a covered foreign person.
2. 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, if it affords the U.S. person an interest in profits of the covered foreign person, the right to appoint members of the board (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 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.
4. 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: (i) the establishment of a covered foreign person; or (ii) the engagement of a person of a country of concern in a covered activity. Notably, pursuant to the Proposed Rule, these transactions would have been considered “covered transactions” if a U.S. person intends the resulting entity to engage in a covered activity. 
5. 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. Under the Proposed Rule, these transactions would have been considered “covered transactions” if a U.S. person intends the resulting entity to engage in a covered activity.
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 (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. 

Unlike the Proposed Rule, the Final Rule clarifies that a U.S. person is not considered to have indirectly acquired an equity interest or contingent equity interest in a covered foreign person when the U.S. person acquires a limited partnership interest in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund and that fund then acquires an equity interest or contingent equity interest in a covered foreign person. However, a U.S. person’s limited partnership investment into such a fund would be considered a “covered transaction” if it falls under the definition used in this category of transactions.

Summary of Prohibition and Notification Requirements 

With the exception of certain minor changes related to the definition of artificial intelligence (“AI”), the Final Rule maintains the same prohibition and a notification requirements as outlined the Proposed Rule. These requirements are summarized below.
 

Excepted Transactions

Consistent with the Proposed Rule, the Final Rule exempts certain types of transactions, provided that such transactions do not afford a U.S. person rights beyond standard minority shareholder protections. Except as discussed below, the scope of these exemptions are nearly identical to the exemptions outlined in the Proposed Rule.  

1. Publicly traded securities, including securities issued by an investment company such as an index fund, mutual fund, or exchange-traded fund.
2. Certain limited partner investments, so long as the 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 notifiable or prohibited transaction if engaged in by a U.S. person. The Final Rule combines the two proposed alternative definitions used in the Proposed Rule.
3. Buyouts of a country of concern’s ownership, so long as the U.S. person acquires 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. Certain derivatives. Although the Proposed Rule contained an exemption related to “any derivative” of certain limited partner investments, the Final Rule limits this exemption to derivatives that do not confer the right to acquire equity, any rights associated with equity, or any assets in or of a covered foreign person. 
5. Otherwise covered transactions between a U.S. person and its controlled foreign entity that are not covered activities or that maintains covered activities prior to January 2, 2025. The Proposed Rule did not reflect this exemption.  
6. Covered transactions engaged in pursuant to a binding, uncalled capital commitment entered into before January 2, 2025.
7. The acquisition 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 where the U.S. person lender(s) in the syndicate: (i) cannot on its own initiate any action vis-à-vis the debtor; and (ii) is not the syndication agent.
8. 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. This exemption was not contained in the Proposed Rule.  
9. Third country measures, which includes any transaction that is: (i) with or involving a person of a country or territory outside of the United States designated by the Secretary, after taking into account whether the country or territory is addressing national security risks substantially similar to those described in Executive Order 14105 and related to outbound investment; and (ii) of a type for which the Secretary has determined that the related national security concerns are likely to be adequately addressed by measures taken or that may be taken by the government of the relevant country or territory.
10. National interest exemption, which permits a person to seek an exemption from the application of the prohibition or notification requirement on the basis that a transaction is in the national interest of the U.S.

We will continue to monitor developments in this area, and encourage you to subscribe to be kept informed of latest developments. Please contact the authors or your usual Herbert Smith Freehills contacts for more information.
 

¹ Unlike the Proposed Rule, the Final Rule clarifies that inquiries related to non-parties may be necessary to determine whether a party to a transaction is a person of a country of concern or a covered foreign person.
² A “person of a country of concern” is defined as any individual that is a citizen or permanent resident of a country of concern, and not also a citizen or permanent resident of the U.S. This definition also covers entities with a principal place of business in, headquartered in, or incorporated in or otherwise organized under the laws of a country of concern. This definition further includes the government of a country of concern, as well as any entity that is directly or indirectly majority-owned by any person or entities otherwise considered a person of a country of concern.
³ Unlike the Proposed Rule, the Final Rule clarifies that only persons that directly or indirectly hold a board seat on, a voting or equity interest in, or any contractual power to direct or cause the direction of the management or policies of any person of a country of concern that engage in a covered activity are considered “covered foreign persons.” Furthermore, unlike the Proposed Rule, the Final Rule clarifies that only those persons of a country of concern (engaged in a covered activity) that account for at least $50,000 (or equivalent) of the relevant financial metric of the U.S. person’s investment target or relevant counterparty (such as a JV partner) are considered “covered foreign persons.”
⁴ The Final Rule clarifies that the U.S. person must be an officer, director, or their functional executive equivalent and exercise its authority to direct, order, decide upon, or approve a transaction. If the U.S. person properly recuses itself from exercising that authority, it does not “knowingly direct an otherwise prohibited transaction.”
⁵ The Proposed Rule also provides for criminal penalties of up to a $1 million fine and/or 20 years imprisonment for “willful” violation of its provisions.