U.S. Treasury rule establishes outbound investment security program

On 28 October 2024, Treasury issued the Final Rule on the outbound investment security program, setting forth regulations that implement President Biden’s August 2023 Executive Order 14105, “Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern” (Outbound EO). The Final Rule follows two public comment periods for an initial Advance Notice of Proposed Rulemaking (ANPRM) issued in August 2023 and the subsequent Notice of Proposed Rulemaking (NPRM) issued in June 2024.

The Final Rule establishes a regime for the outbound investment security program and is accompanied by detailed explanations of key concepts introduced by the NPRM and the ANPRM and Treasury’s response to public comments.  The Final Rule is aimed at addressing the national security threat to the United States that China poses through its exploitation of U.S. outbound investments used to develop sensitive technologies and products critical for Chinese military, intelligence, surveillance, and cyber-enabled capabilities.

In a nutshell: what does the Final Rule do?

Effective 2 January 2025, the Final Rule prohibits, or requires notification, of certain U.S. person transactions that directly or indirectly involve investments in the Chinese semiconductors and microelectronics, quantum information technologies, and AI sectors (defined collectively in the Final Rule as “covered transactions”). Although the outbound investment security program targets China, it includes several mechanisms through which transactions and parties in other countries may be implicated, including U.S. person investments in certain U.S. companies.

What are the key changes between the NPRM and the Final Rule?

The Final Rule leaves unchanged many of the key structural and substantive elements of the regime described in the NPRM. However, the Final Rule expands and elaborates on certain elements identified in the NPRM, including ones that were ambiguous or identified alternative approaches. The changes and clarifications include these:

• The Final Rule clarifies that an indirect “covered transaction” (e.g., where a U.S. person conducts the transaction through the use of an intermediary) is one that would be a “covered transaction” if engaged in directly by a U.S. person.  If a U.S. person acquires a limited partner (LP) interest in a U.S.-based investment fund and that fund then engages in a transaction with a “covered foreign person,” the U.S. person’s acquisition of the LP interest does not constitute such an indirect “covered transaction” if the U.S. person at the time of the acquisition did not know that the fund was likely to invest in “covered foreign persons.”

• The Final Rule revises the exception for certain U.S. LP investments to exclude U.S. person investments of under $2,000,000 or for which the LP secures a binding contractual assurance that its capital in the fund will not be used to engage in a transaction that would be prohibited or notifiable if engaged in by a U.S. person.

• The Final Rule expands “excepted transactions” to include: (i) investments by U.S. persons in a derivative if certain criteria are satisfied; (ii) employment compensation in the form of equity or options (or the exercise of such options) in a “covered foreign person;” and (iii) certain intracompany transfers to maintain a controlled foreign entity’s covered activities that were engaged in prior to the effective date of the Final Rule (i.e., 2 January 2025).

• The Final Rule specifies certain criteria that must be satisfied under the “recusal” exemption applicable to the prohibition on a U.S. person who “knowingly directs” a transaction by a non-U.S. person that would be a prohibited transaction if engaged in by a U.S. person (described below in the “Who has obligations under the proposed regulations?” section). 

• The Final Rule clarifies that neither the issuance of debt that is secured by equity collateral in a “covered foreign person” nor the acquisition of such secured debt on the secondary market is the acquisition of an equity interest for purposes of assessing whether a transaction is a “covered transaction.” However, the acquisition of the pledged equity (e.g., through foreclosure) could be a “covered transaction.”

• The Final Rule permits an otherwise “covered foreign person” or joint venture to “customiz[e], configure[e], or fine-tun[e] a third-party AI model or machine-based system strictly for its own internal, non-commercial use” without triggering the notification or prohibition requirements that otherwise would apply to a U.S. person’s investment in such a “covered foreign person” or joint venture, unless that AI model is used for government intelligence, mass-surveillance, military use, or for digital forensics tools, penetration testing tools, or the control of robotic systems.  This clarification likely reflects Treasury’s acknowledgment that many companies, including those not in the AI space, may customize existing AI models to create non-commercial programs, such as customer support chat bots.

Who has obligations under the regulations?

The Final Rule places certain obligations on “U.S. persons,” which include (i) any U.S. citizen or lawful permanent resident; (ii) any entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branch of any such entity; and (iii) any person in the United States.

Specifically, under the regulations, U.S. persons are prohibited from entering into, or alternatively are required to notify Treasury within 30 days of the closing of, certain covered transactions involving persons that are linked to China and that are engaged in activities involving the three specified technology sectors identified above.

The Final Rule also imposes certain obligations on U.S. persons with respect to investments by related non-U.S. entities and persons, as follows:

• U.S.-person-controlled foreign entities: A U.S. person is required (i) to take “all reasonable steps” to prohibit and prevent its “controlled foreign entity” from undertaking a covered transaction that would be a prohibited transaction if undertaken by a U.S. person, and (ii) to notify Treasury if the controlled foreign entity undertakes a covered transaction that would be a notifiable transaction if undertaken by a U.S. person.

  • The Final Rule contemplates three separate avenues by which a foreign entity would become a controlled foreign entity – namely, via a U.S. person’s (i) holding more than 50% of (a) the voting interest in the entity or (b) the voting power of the board of the entity; (ii) status as a general partner, managing member, or equivalent of the entity; or (iii) status as an investment adviser to any entity that is a pooled investment fund.

• U.S. person “knowingly directing” a covered transaction by a non-U.S. person entity: U.S. persons that have the authority to make or substantially participate in decisions on behalf of a non-U.S. person entity (e.g., a U.S. person employee of a foreign company) may not exercise that authority to direct, order, decide upon, or approve a transaction that would be a prohibited transaction if engaged in by a U.S. person. A U.S. person would have such authority if the U.S. person was an officer, director, or otherwise possesses executive responsibilities. However, U.S. persons who recuse themselves from three distinct activities (a further clarification introduced in the Final Rule) related to such covered transactions are not deemed to have exercised such authority and therefore deemed not to have “knowingly directed” such transactions.  Such activities are: (i) participating in formal approval and decisionmaking processes, including recommendations; (ii) reviewing, editing, commenting on, approving, or signing transaction documents; and (iii) engaging in negotiations.

Whom does the Final Rule target?

The Final Rule targets “covered foreign persons,” which are “persons of a country of concern” engaged in a “covered activity” related to three key sectors: semiconductors and microelectronics, quantum information technologies, or certain AI systems.

“Persons of a country of concern” means:

• individuals that are citizens or permanent residents of China (excluding U.S. citizens and U.S. permanent residents);

• entities that have their principal place of business in, or are headquartered in, incorporated in, or organized under the laws of a country of concern;

• governments of a country of concern and persons acting on behalf of such governments and persons controlled by or directed by such governments; and

• entities, wherever located, in which persons of a country of concern, directly or indirectly, hold at least 50% of the outstanding voting interest, voting power of the board, or equity interest.

In defining “covered foreign persons,” the Final Rule has retained the broad scope reflected in the NPRM, in that the term includes certain non-Chinese entities located in third countries (including the United States) that:

• directly or indirectly hold a board seat on, or a voting or equity interest (other than those carved out by the definition of “excepted transactions”) in, a person of a country of concern that is engaged in a covered activity, or any contractual power to direct or cause the direction of the management or policies of any person of a country of concern engaged in a covered activity; and

• derive more than 50% of their revenue, net income, capital expenditure, or operating expenses individually from a person of a country of concern engaged in a covered activity, or as aggregated across such persons (provided that any such aggregation excludes persons from which the first person derives less than $50,000 (or equivalent) of the relevant financial metric).

Which types of transactions are covered by the Final Rule?

The Final Rule would only apply to certain categories of direct or indirect transactions – so-called “covered transactions.” These are:

• acquisitions of equity interests or contingent equity interests (e.g., via mergers and acquisitions, private equity, venture capital, and other arrangements);

• certain debt financing transactions that afford the U.S. person certain rights or interests characteristic of an equity investment but not typical of a loan;

• conversions of a contingent equity interest into an equity interest if such contingent equity interest was acquired on or after January 2, 2025;

• certain acquisitions, leasing, or other development of operations, land, property, or other assets (i.e., greenfield or brownfield investments);

• entrance into a joint venture, wherever located, that is formed with a person of a country of concern where the joint venture will or plans to engage in a covered activity; and

• certain acquisitions of an LP or equivalent interest in a non-U.S. venture capital fund, private equity fund, fund of funds, or other pooled investment fund.

Indirect transactions can also be considered “covered transactions” regardless of the number of intermediary entities involved. For example, if a U.S. person establishes an acquisition vehicle and knows that such vehicle would be acquiring an equity interest in a “covered foreign person,” then that transaction would be a “covered transaction” regardless of the U.S. person’s indirect ownership.

Which types of transactions are prohibited by the Final Rule?

A U.S. person is prohibited from engaging in covered transactions with a “covered foreign person” that is engaged in the following “covered activities”:

• developing or producing any electronic design automation software for integrated circuit (“IC”) or advanced packaging design or certain fabrication equipment;

• designing, fabricating, or packaging certain advanced ICs;

• developing, installing, selling, or producing certain supercomputers;

• developing quantum computers and producing quantum computer critical components;

• developing quantum sensing platforms designed for or intended to be used for certain end-uses;

• developing or producing certain quantum information technologies, including quantum networks or quantum communication systems designed or intended for certain end uses;

• developing certain AI systems designed to be exclusively used for, or which the relevant covered foreign person intends to be used for, any military end use or government intelligence or mass surveillance end use; or

• developing certain AI systems trained using a quantity of computing power greater than 10^25 computational operations (e.g., integer or floating-point operations) or 10^24 computational operations (e.g., integer or floating-point operations) using primarily biological sequence data.

In addition, covered transactions that would be “notifiable” (as described below) but that involve parties on U.S. Government restricted parties lists (e.g., the Specially Designated Nationals and Blocked Persons List, the Entity List) are instead deemed prohibited.

Which types of transactions must be notified under the Final Rule?

A U.S. person would be required to notify and submit relevant information to Treasury within 30 calendar days following the completion of a covered notifiable transaction with a “covered foreign person” that is engaged in activities involving the following technologies:

• designing, fabricating, or packaging ICs not captured by the “prohibited” IC activities; and

• developing AI systems that are not covered by the “prohibited transactions” and that are (i) designed to be used for certain end uses (e.g., government intelligence or mass-surveillance, military), (ii) intended to be used for cybersecurity applications, digital forensics tools, penetration testing tools, or control of robotic systems, or (iii) trained using a quantity of computing power greater than 10^23 computational operations (e.g., integer or floating-point operations).

Notification is also required if the U.S. person acquires knowledge following the completion date of a transaction that the transaction would have been a covered transaction if the U.S. person had known of relevant facts or circumstances as of the completion date. In such circumstances, the U.S. person would be required to submit a notification to Treasury no later than 30 calendar days following the acquisition of knowledge that such a transaction would have been a covered transaction.

Will the program only affect U.S. persons' investments in Chinese companies engaged in certain covered activities?

No. Although the Final Rule primarily targets individuals and entities in China that are engaged in covered activities, it also applies to non-Chinese persons that have a certain relationship with a person of a country of concern engaged in a covered activity, whether or not they themselves are engaged in a covered activity. Thus, “covered foreign persons” could be persons or entities from anywhere in the world, including from the United States.

Specifically, as explained above, a non-Chinese entity would nonetheless be a “covered foreign person” if it:

• directly or indirectly holds a board seat on, or a voting or equity interest (other than those carved out by the definition of “excepted transactions”) in, a person of a country of concern that is engaged in a covered activity, or any contractual power to direct or cause the direction of the management or policies of any person of a country of concern engaged in a covered activity; and

• derives more than 50% of their revenue, net income, capital expenditure, or operating expenses individually from a person of a country of concern engaged in a covered activity, or as aggregated across such persons (provided that any such aggregation excludes persons from which the first person derives less than $50,000 (or equivalent) of the relevant financial metric).

Which types of transactions will be excepted from coverage under the Final Rule?

The Final Rule sets forth the following categories of “excepted transactions”:

• Publicly traded securities: An investment by a U.S. person in a publicly traded security or a security issued by an investment company, such as an index fund, mutual fund, or exchange traded fund, if the investor’s rights are limited to “standard minority shareholder protections”;

• Certain LP investments: An investment of a U.S. person LP in a pooled investment fund where: (i) its committed capital is $2 million or less in the aggregate or (ii) the LP secures a binding contractual assurance that its capital in the fund will not be used to engage in a transaction that would be prohibited or notifiable if engaged in by a U.S. person; each option is contingent upon the LP’s rights being limited to “standard minority shareholder protections”;

• Derivatives: A U.S. person’s investments in a derivative, if such derivative (i) does not confer rights to acquire equity, any rights associated with equity, or assets in or of a “covered foreign person” and (ii) does not grant any investor rights beyond “standard minority shareholder protections”;

• Buyouts of country of concern 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 constitutes a controlled foreign entity) to support operations that are not “covered activities” or to maintain “covered activities” that the controlled foreign entity was engaged in prior to 2 January 2025;

• Pre-effective date binding capital commitments: Fulfilment of a U.S. person’s binding capital commitment entered into prior to 2 January 2025;

• Certain syndicated debt financings: The acquisition of a voting interest in a “covered foreign person” upon default or other condition involving a loan, where the loan was made by a lending syndicate and a U.S. person participates passively in the syndicate;

• Employment compensation: 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; and

• Third-country measures: Certain transactions with or that involve a person of a non-U.S. country or territory that, as designated by the Secretary of the Treasury, is adequately addressing national security risks substantially similar to those described in the Outbound EO and related to outbound investment. The Secretary of Treasury is able to, in consultation with other relevant agencies such as the Secretary of Commerce and the Secretary of State, rescind the designation.

In the Final Rule, Treasury did not explicitly exclude activities such as university-to-university research collaborations or intellectual property licensing arrangements. However, Treasury noted that the definition of “covered transaction” has been crafted to refer to a narrow set of specific transaction types that meet specific definitional elements, and the regulations therefore do not need to explicitly specify a list of activities excluded from this definition.

Are there any other ways to seek exemption from coverage of the Final Rule?

The Final Rule allows a U.S. person to seek an exemption from the application of the prohibition or notification requirements of the program by submitting to Treasury certain information (such as the scope of the transaction, the basis for the request, and an analysis of the transaction’s potential impact) to show that an otherwise “covered transaction” is in the national interest of the United States. Treasury anticipates, however, that such exemptions would only be granted in exceptional circumstances. Treasury also reiterated that it will not grant retroactive waivers or exemptions (i.e., waivers or exemptions after a prohibited transaction has been completed).

Will the Final Rule apply retroactively?

Consistent with the NPRM and the ANPRM, the prohibition and notification requirements in the outbound investment security program are not intended to apply retroactively.

When will the Final Rule go into effect?

The Final Rule will go into effect on 2 January 2025.

Next steps

Companies should consider the potential impact of the outbound investment program on their businesses and investments, particularly those that relate to China or involve activities related to the sectors detailed above. Companies will want to consider whether the outbound investment program requires them to implement changes to their internal compliance program, particularly with respect to conducting diligence on the activities of potential business partners. In particular, companies will likely need to develop questionnaires, including to address the risk of notifiable or “covered transactions” outside of China (including in the United States), and new provisions (e.g., representations) for transaction documents.

Authored by Anne Salladin, Brian Curran, Zachary Alvarez, Annika Lichtenbaum, Tyra Walker, Meghan Anand, and Mark Han-sen Ye.