U.S. investors interested in investing in advanced Chinese technology companies may now be constrained by the U.S. Government’s first-ever outbound investment rule (Final Rule) which took effect on Jan. 2, 2025. The Final Rule will require heightened due diligence and strict attention to reporting requirements.
The Final Rule imposes restrictions on investments in certain advanced electronic technologies by U.S. investors in certain entities or persons in the greater China area. Some investments are prohibited, while others require post-closing notification to the U.S. Treasury Department. U.S. investors, including private equity funds and their investors, are held to a high level of due diligence. Violations can result in substantial civil monetary and criminal penalties. First published in November 2024, the Final Rule stems from an executive order issued by President Biden in August 2023.
The rule focuses on investments in “Countries of Concern” defined as the Peoples Republic of China, Macao and Hong Kong, and covers the technologies involving the design, development, and/or production of certain advanced semiconductors and microelectronics, quantum information technologies and AI systems.
The Executive Order is designed to protect U.S. national security interests, to maintain and promote a competitive edge in favor of the U.S. over China in these particular industry sectors, and to limit investments that may convey capital and intangible benefits to these sensitive critical technologies that can be used for military, intelligence, surveillance or security purposes by China. The Final Rule is intended to complement other U.S. laws such as export controls with foreign regimes.
The Final Rule
The Final Rule affects “covered investments” by a “U.S. Person” in a “covered foreign person” carrying on a “covered activity.” It prohibits certain covered investments and mandates notification for others to the U.S. Department of Treasury within 30 days after closing on the transaction through the U.S. Department of Treasury portal, which can be found on the Treasury Department’s website.
Unlike the regulation of inbound foreign transactions for national security purposes by the Committee on Foreign Investment in the United States (CFIUS), there is no pre-closing review. An investor cannot obtain guidance from government officials before making an investment.
Covered Activities
“Covered activities” are the design, development, fabrication and/or production of semiconductors and microelectronics, quantum information technologies, and AI systems as specified in the Final Rule. Prohibited investments include:
- The design, development, fabrication, production and packaging of integrated circuits that meet or exceed prescribed performance parameters or that use certain specified architecture or components, as well as the development or production of certain related equipment and software.
- The development, installation, sale or production of any supercomputer enabled by advanced integrated circuits that meets or exceeds prescribed performance parameters.
- The development of a quantum computer or production of its critical components.
- The development or production of any quantum sensing platform or quantum network or quantum communication system designed for or to be used for military, government intelligence or mass-surveillance end use or to be used for other specified purposes.
- The development of any AI system designed exclusively for or to be used for military, government intelligence or mass-surveillance end use or that is trained using a prescribed level of computing power.
In addition, investments in a foreign person or entity included on certain governmental lists such as the Specially Designated Nationals List or designated as a foreign terrorist organization by the Secretary of State are prohibited.
The following are covered activities that are permitted but require notification to Treasury:
- The design, development or fabrication of any integrated circuit that is not included in the list of prohibited covered activities.
- The development of any AI system that is not included in the list of prohibited covered activities and meets any of the following:
- Is designed to be used for military, government intelligence or mass-surveillance end use.
- Is intended to be used for cybersecurity applications, digital forensic tools, penetration testing tools, or the control of robotic systems.
- Is trained using a prescribed level of computing power.
Who is a ‘Covered Foreign Person?’
A covered foreign person is a Person of a Country of Concern that engages in a covered activity. It also includes any person or entity that holds a board seat on or a voting or equity interest in a Person of a Country of Concern if it derives more than 50% on an individual or aggregated basis of its revenue or its net income from such Person of a Country of Concern or incurs on an individual or aggregate basis more than 50% of its capital expenditures or its operating expenses from such Person of a Country of Concern. A “Person of a Country of Concern” includes:
- Citizens or permanent residents of a Country of Concern who are not U.S. citizens or permanent residents of the United States.
- An entity with a principal place of business or headquarters or otherwise organized under the laws of a Country of Concern.
- A government of a Country of Concern (including political subdivisions and state-owned enterprises).
- Certain persons acting on behalf of a company of a Country of Concern.
- Government-controlled entities
- Any such person who holds at least a 50% voting interest, voting power on the board or equity interest in any of the above entities.
In other words, a “covered foreign person” generically is a Chinese individual, company or governmental unit that owns, controls or derives a significant economic benefit from a covered foreign person engaged in a covered activity.
Who is a ‘U.S. Person?’
A U.S. Person is any U.S. citizen, lawful permanent resident, person in the United States, or entity organized under U.S. law and includes foreign branches of any such entity.
What types of transactions does the final rule cover?
The types of covered transactions are broad. Transactions include acquisitions of equity interests and contingent equity interests, certain debt financing arrangements where the debt financing affords the U.S. Person certain prescribed equity-like rights, conversion of a contingent equity interest acquired on or after January 2, 2025, greenfield and brownfield investments, joint ventures, and certain limited partner investments as described below. In all the above instances, the U.S. Person must know at the time of the investment that the investment is in a covered foreign person. This “knowledge” standard imposes on the U.S. person a high level of due diligence, as discussed in more detail below.
A limited partner investment by a U.S. Person in a non-U.S. fund is also a covered transaction if the U.S. Person knows at the time of the investment that the fund likely will invest in a Person of a Country of Concern that is involved in a covered activity, and such fund undertakes a transaction that would be a covered transaction if undertaken by a U.S. Person. There is an exception for limited partner investments for either investments of US $2 million or less on a fund-aggregated basis or for investments for which there are binding contractual assurances by the fund that the U.S. Person’s capital will not be used to engage in a covered transaction.
The Final Rule lists a number of investments that do not constitute covered investments. Moreover, if a U.S. Person acquires the entire equity interest held by a Person of a Country of Concern so that following the acquisition the entity does not constitute a covered foreign person, that investment is not a covered transaction.
‘Knowledge’ Standard
What does it mean for a U.S. Person to know that their investment was being made in a covered foreign person? “Knowledge” is defined as either (1) “actual knowledge that a fact or circumstance exits or is substantially certain to occur; (2) an awareness of a high probability of a fact or circumstance’s existence or future occurrence; or (3) reason to know of a fact or circumstance’s existence.”
The assessment of whether the U.S. Person has or had such knowledge requires the U.S. Person to conduct “reasonable and diligent inquiry,” which will be assessed by Treasury on a case-by-case basis on “consideration of the totality of relevant facts and circumstances.” The Final Rule sets forth certain factors Treasury will examine, such as the level of inquiry and efforts made regarding the investment target, the contractual representations and warranties made to the U.S. Person, and the use of available public information and commercial databases.
This knowledge standard imposes a high level of due diligence on the part of the U.S. Person. Failure to meet the standard could result in severe criminal penalties, particularly with respect to prohibited transactions. Private equity funds that do not intend to invest in Covered Foreign Persons should revise their investment documentation to include the appropriate representations and warranties. The inquiry by a U.S. Person may be expensive and consideration should be given to allocation of those expenses to the parties involved. Moreover, since there is no governmental agency review or approval of the investment, a U.S. Person will not know whether it satisfied the knowledge standard at the time of the transaction. It will make the investment at its own peril, with the risk that it could be fined subsequent to the transaction. The Committee on Foreign Investment in the United States has a unit that investigates transactions with China, so there is a strong likelihood that transactions will be uncovered after-the-fact.
Knowingly Directing a Transaction
A U.S. Person is prohibited from “knowingly directing” a prohibited transaction by a non-U.S. Person had it been engaged in by a U.S. Person. This applies to a U.S. Person who has authority, individually or as part of a group, to make or substantially participate in decisions on behalf of the non-U.S. Person and exercises that authority to participate in approving the transaction. That includes an officer or director of a non-U.S. Person or a U.S. Person serving on the investment committee of a non-U.S. fund. However, the Final Rule makes an exception if that U.S. Person recuses himself or herself from participating in the decision-making process or participating in the transaction, as defined in the Final Rule. Care must be taken to properly document such recusal.
Violations and Penalties
The Final Rule grants the Treasury Department the authority to impose civil monetary and criminal penalties. Civil penalties cannot exceed the greater of $250,000 or twice the amount of the transaction. Criminal penalties are capped at not more than $1,000,000 or 20 years’ imprisonment, or both. Moreover, the Secretary of Treasury has the power to void a prohibited transaction or order its divestiture. There is a voluntary self-disclosure process that potentially can ameliorate or avoid penalties if reported to the Department prior to Treasury learning of the violation.
Confidentiality
Notifications and other submissions to the Treasury Department are confidential and not subject to Freedom of Information requests, with certain exceptions.
Key Takeaways
The Final Rule tries to maintain a balance between maintaining longstanding U.S. policies and tradition of allowing an open investment environment while protecting the U.S. national security. However, the knowledge standard is not well defined, is fact-sensitive, and will be judged by Treasury retrospectively. It is crucial that U.S. Persons contemplating an investment in semiconductors, microelectronics, quantum information technologies or AI systems with a potential China tie seek appropriate written representations from covered foreign persons and from private equity funds that may be investing in companies involved in these covered activities and conduct extensive due diligence to assure themselves that the investment either is not prohibited under the Final Rule or, if it requires notification to Treasury, that the appropriate filing will be made. Since there is no pre-transaction governmental review, there is a high level of risk, with significant civil and criminal penalties.
Congress is also considering legislation to curtail U.S. investments in Chinese technology. The proposed Comprehensive Outbound Investment National Security Act of 2024 (the COINS ACT) legislatively mandates requirements similar and in addition to the Final Rule, and it is likely under the new Trump Administration we will see additional action.
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