Outbound Investment Screening Rule Goes into Effect

The U.S. Department of the Treasury's Final Rule on outbound investment screening went into effect on Jan. 2, 2025. The Final Rule establishes a much-awaited outbound investment screening regime, implementing Executive Order (E.O.) 14105 of Aug. 9, 2023, "Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern," and takes into consideration public comments to the Treasury Department's June 21, 2024, Notice of Proposed Rulemaking (NPRM). (See Holland & Knight's previous alerts, "Long-Awaited Executive Order Targets U.S. Outbound Investment in China," Aug. 11, 2023, and "Treasury Department Issues Long-Awaited Proposed Rule on Outbound Investment Screening," June 26, 2024.)

Though the concept of outbound investment screening is new, in promulgating this new regime, the Treasury Department borrows from the definitions and enforcement concepts of other national security-related regulatory mechanisms, including foreign investment reviews by the Committee on Foreign Investment in the United States (CFIUS), economic sanctions and export control regulations.

To assist industry with compliance and implementation of the new outbound investment regime, the Treasury Department issued additional guidance on Dec. 13, 2024, regarding the screening and reporting requirements. This Holland & Knight alert summarizes the screening and reporting requirements and provides practical guidance to U.S. investors considering transactions with Chinese or Chinese-owned companies.

Background

The U.S.-China economic relationship has received significant attention from U.S. policymakers in recent years, with various U.S. government agencies and lawmakers identifying China as a threat to the country's technological leadership. One of the measures to address this concern was the establishment of an outbound investment screening regime, which targets U.S. investments in Chinese or Chinse-owned companies engaged in the development or production of certain products in the semiconductors and microelectronics, quantum information technologies or artificial intelligence (AI) sectors. These sectors were identified as fundamental to the development of the next generation of military, surveillance, intelligence and certain cybersecurity applications. Currently, only the People's Republic of China, along with the Special Administrative Region of Hong Kong and the Special Administrative Region of Macau, is identified as a country of concern under the outbound investment screening regime. The program focuses on U.S. outbound investments that contribute capital as well as intangible benefits to Chinese companies engaged in the targeted activities.

The Final Rule specifically defines "country of concern," "U.S. person," "covered activity," "covered foreign person" and "covered transaction" and sets forth prohibitions and notification requirements in line with the national security objectives stated in the E.O. The rule applies to various transactions carried out by U.S. persons, including equity acquisitions, debt financing and joint ventures, and imposes notification requirements or prohibitions based on certain characteristics of the technology involved. U.S. investments in semiconductors and microelectronics, as well as AI systems, are divided into "notifiable transactions" and "prohibited transactions" based on the nature and capability of the technology, whereas all covered supercomputing and quantum computing transactions are prohibited.

Semiconductors and Microelectronics

• Prohibited: An exhaustive list of covered transactions involving certain electronic design automation software, fabrication or advanced packaging equipment, advanced packaging techniques, and the design and fabrication of certain integrated circuits and high-end or supercomputing applications
• Notifiable: Covered transactions involving the design, fabrication and packaging of integrated circuits not covered by the prohibited transactions

AI Systems

• Prohibited: Covered transactions involving AI systems designed exclusively for or intended to be used for military, government intelligence or mass surveillance end uses or that meet certain technical specifications
• Notifiable: Covered transactions involving AI systems intended by the covered foreign person to be used for cybersecurity applications, digital forensics tools, penetration testing tools, control of robotic systems or that meet certain technical specifications

Supercomputing and Quantum Computing

• All Prohibited: Covered transactions related to the development of quantum computers and production of critical components, the development or production of certain quantum sensing platforms, and the development or production of quantum networking and quantum communication systems

Key Legal Underpinnings of the Outbound Investment Screening

Though largely consistent with the NPRM in scope and structure, the Final Rule contains certain changes addressing public comments by incorporating technical edits, adding specificity to several provisions, including explanatory notes, and providing clarifications where required.

Obligations of a U.S. Person Regarding a Covered Transaction

The prohibition and reporting requirements are addressed to U.S. persons, i.e., any U.S. citizen, lawful permanent resident, entity organized under the laws of the U.S. or any jurisdiction within the U.S., including any foreign branch of any such entity or any person in the U.S.. This broad definition is similar to the definition used in many economic sanctions programs administered by the Treasury Department's Office of Foreign Assets Control (OFAC).

Of note, U.S. persons are required to take "all reasonable steps" to prohibit and prevent foreign subsidiaries or foreign entities that are otherwise controlled by the U.S. persons from undertaking transactions that would have been prohibited if undertaken by U.S. persons. The regulations include an illustrative list of factors that the Treasury Department would consider in determining whether the U.S. person took all reasonable steps, and compliance will be assessed based on a consideration of the "totality of relevant facts and circumstances."

U.S. persons are prohibited from "knowingly directing" prohibited transactions by foreign controlled entities – a U.S. person "knowingly directs" a transaction when they have authority to make, or substantially participate in, decisions on behalf of the foreign entity and exercises that authority to direct, order, decide or approve a transaction that would be prohibited if engaged in by a U.S. person. Specifically, a U.S. person possesses such authority over a non-U.S. entity when they are an "officer, director, or otherwise possess executive responsibilities"¹ at the entity. Notably, the Treasury Department clarified the requirement that the authority has to be exercised with respect to a particular investment for the prohibition to apply; in other words, a U.S. person with such authority will not be assessed to have "knowingly directed" a prohibited transaction unless they actually exercised that authority in decision-making regarding the transaction

Importantly, the program includes a recusal carveout, whereby a U.S. person with authority to direct a transaction will not be deemed to have "knowingly directed" a transaction by a foreign entity, when the U.S. person recuses themself from participation in formal approval and decision-making processes; reviewing, editing, commenting on, approving and signing relevant transaction documents; and engaging in negotiations with the investment target or transaction counterparty (such as a joint venture partner), as applicable.

The Knowledge Standard and Due Diligence Requirement Prior to and After Closing

The obligations of a U.S. person apply if such person has knowledge of relevant facts or circumstances related to a transaction. A U.S. person has knowledge if 1) they possess actual knowledge that a fact or circumstance exists or is substantially certain to occur, 2) the U.S. person possesses an awareness of a high probability of a fact or circumstance's existence or future occurrence or 3) the U.S. person could have possessed such information through a reasonable and diligent inquiry. The Final Rule sets forth an illustrative list of factors that the Treasury Department will consider in assessing whether a U.S. person has undertaken a "reasonable and diligent inquiry." Such factors incorporate information that should be ascertainable, as well as contractual assurances that should be obtainable, through reasonable due diligence.

Of particular importance, the most recent Treasury Department guidance clarifies that the Final Rule does not create an ongoing obligation for a U.S. person to monitor or prevent post-transaction changes to an investment target's activities. Rather, the rule applies to U.S. person transactions involving an investment target that engages in activities at the time of the transaction of which a U.S. person has knowledge (which includes reason to know following a reasonable and diligent inquiry). If a U.S. person later acquires "actual knowledge" of a fact or circumstance that, if known to the U.S. person at the time of the transaction, would have resulted in a notifiable transaction or a prohibited transaction, the U.S. person will be required to submit a notification within 30 days of acquiring such knowledge. This notification requirement applies only to "actual knowledge" of a fact or circumstance and does not include "reason to know."

Covered Foreign Persons

A covered foreign person includes any of the following:

• a person of a country of concern (currently China, including Hong Kong and Macau) who engages in a covered activity
• any person who has a particular relationship with a person of a country of concern that engages in a covered activity – i.e., where 1) the person holds a specific interest in the person of a country of concern (e.g., voting interest, board seat, equity interest or the power to direct management or policies) and, if there is such an interest, 2) more than 50 percent of the first person's revenue, net income, capital expenditure or operating expenses is attributable to such person of a country of concern, individually or in the aggregate
• a person of a country of concern who participates in a joint venture with a U.S. person if such joint venture engages or intends to engage in a covered activity

Determining whether an investment target meets the definition of a covered foreign person is likely to present difficulties in the application of the program and will often require extensive due diligence. This includes situations where U.S. or third-country entities have business relationships in China or with Chinese or Chinse-owned entities – evaluating such relationships will need to become a regular part of due diligence for investors in this area. In response to industry comments, the Treasury Department included in the Final Rule a minimum revenue threshold of $50,000 of the relevant financial metric. The rule also provides an exception for holding certain publicly traded securities that account for 50 percent of the foreign person's revenue or net income.

Notably, based on its response to certain public comments, it appears that the Treasury Department intended the definition of "foreign persons" to be broad enough to potentially restrict investments into third-country and even U.S. persons. This requires that U.S. investors assess potential investments links to China, including in U.S. and third-country transactions, as a regular part of due diligence in the identified industry sectors.

Additionally, follow-on investments as part of subsequent funding rounds are subject to the same screening and notification and prohibition requirements.

Covered Transactions

The Final Rule applies to certain transactions by U.S. persons, including the acquisition of an equity interest or contingent equity interest, certain debt financing that affords certain rights to the lender, the conversion of a contingent equity interest, a greenfield investment or other corporate expansion, entrance into a joint venture and certain investments as a limited partner (LP) or equivalent in a non-U.S. person pooled investment fund.

Importantly, for purposes of the "covered transaction" definition, 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 an LP interest in a venture capital fund, private equity fund, fund of funds or other pooled investment fund when that fund then acquires an equity interest or contingent equity interest in a covered foreign person. Accordingly, absent other facts, a U.S. person LP's investment into a U.S. person pooled investment fund would not itself be assessed to be a covered transaction. This change is apparently intended to avoid prejudicing U.S. LP investors in foreign investment funds. However, if the investment fund is a U.S. person, the fund itself would be subject to the screening and reporting requirements.

With respect to contingent equity interests, a conversion into an equity interest in a person that the U.S. person knows at the time of conversion is a covered foreign person would be considered a covered transaction only where the contingent equity interest was acquired by the U.S. person on or after the effective date of the Final Rule.

In addition, with respect to greenfield and brownfield investments, the Treasury Department will look at the "plans" of the U.S. person for its actions to result in the establishment of a covered foreign person or to shift an existing entity's operations into a covered activity, underscoring that the U.S. person is responsible for the information it had or could have had through a "reasonable and diligent inquiry" at the time of the transaction. Indicators relevant to a U.S. person's plans include, for example, correspondence with the investment target or relevant government, business plans and presentations to potential investors.

Finally, with respect to entrance into a joint venture, the rule introduces a knowledge requirement. Accordingly, a joint venture would be covered only when 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.

Excepted Transactions

Certain excepted transactions include:

• investments by U.S. persons in publicly traded securities (both on U.S. and non-U.S. exchanges) and securities issued by a registered investment company such as an index fund, mutual fund or exchange traded fund or issued by any company that has elected to be a business development company
• certain LP investments by U.S. persons in a venture capital fund, private equity fund, fund of funds or other pooled investment fund if such investment is $2 million or less, or if 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
• investment in certain derivative securities
• a U.S. person's full buyout of all country of concern ownership of an entity, such that the entity does not constitute a covered foreign person following the transaction
• an intracompany transaction between a U.S. person and its controlled foreign entity to support operations that are not covered activities or to maintain ongoing operations with respect to covered activities that the controlled foreign entity was engaged in prior to Jan. 2, 2025
• a transaction fulfilling a binding, uncalled capital commitment entered into prior to Jan. 2, 2025
• cases 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 with respect to the debtor and is not the syndication agent
• receipt of employment compensation in the form of an award or grant of equity or an option to purchase equity in a covered foreign person or the exercise of such option
• certain transactions involving a person of a country or territory outside of the U.S., where the Treasury Secretary determines that the country or territory is addressing national security concerns related to outbound investment and the transaction is of a type for which associated national security concerns are likely to be adequately addressed by the actions of that country or territory

National Interest Exemption

The regime provides for a national interest exemption if a U.S. person's transaction is in the national interest of the U.S. Notably, the Treasury Department stated that it anticipates that such exemptions would be granted only in exceptional circumstances, as opposed to a licensing regime, which is typically more frequent, indicating that this exemption may not be readily available to most investors.

Technical Specifications for Certain AI Systems

The Final Rule honed and clarified the technical thresholds for notifiable and prohibited transactions, specifically as they apply to AI systems.

The Final Rule sets the computing power threshold for prohibited transactions involving AI systems at 10^25 computational operations for an AI system generally and at 10^24 computational operations for an AI system using primarily biological sequence data.

Regarding the computing power threshold for notifiable transactions involving the development of AI systems, the Final Rule sets the threshold at 10^23 computational operations. The definition of a notifiable transaction involving an AI system includes end-use thresholds and technical thresholds. This approach captures for notification those transactions involving AI systems that are relevant to national security either because of their end use or because they meet the technical threshold of greater than 10^23 computational operations.

The computing power shall be periodically assessed to determine whether those quantities remain effective in addressing threats to U.S. national security.

Implications of the Outbound Investment Regime for Investors and Companies

Companies and investors operating in the designated sectors should take immediate steps to review and adjust their operations to ensure compliance. Proactive steps include:

• conducting comprehensive reviews to assess current operations, investments and partnerships and identify any activities that might fall under the Final Rule's scope
• implementing robust compliance programs by developing and enforcing policies and procedures that align with the Final Rule's requirements, including training employees on new compliance obligations
• engaging legal and compliance experts to help interpret the Final Rule accurately and apply it to specific business contexts
• performing due diligence for new investments or partnerships to ensure all parties comply with the Final Rule or, alternatively, incorporating the Final Rule's requirements into existing due diligence processes to avoid potential violations
• monitoring regulatory updates and staying informed about forthcoming details on the program and guidelines on providing notifications or requesting national interest exemptions

This proactive approach will help mitigate risks, guarantee that relevant stakeholders remain updated and included in the Final Rule's implementation process and ensure adherence to the evolving regulatory landscape.

Conclusion

The Final Rule solidifies the regulatory framework outlined by E.O. 14105, addressing national security risks posed by U.S. outbound investments in certain sensitive technologies in China. By incorporating stakeholder feedback, refining definitions and clarifying compliance expectations, the Treasury Department aimed to provide U.S. persons a clear understanding of their obligations under the new rule, which went into effect on Jan. 2, 2025.

Considering that several requirements and definitions – such as the definition of "covered foreign person" remain broadly interpreted under the Final Rule – U.S. entities are encouraged to carefully consider and implement compliance and due diligence procedures.

For more information on the implications of the outbound investment screening regime or assistance with complying with the Treasury Department's regulations, please contact the authors or another member of Holland & Knight's International Trade Group.

Notes

¹ The Final Rule was modified to remove "senior advisor" from the list, thereby narrowing the scope of persons who may knowingly direct a non-U.S. person, in line with other national-security regulatory requirements administered by the Treasury Department.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.