New Sheriff in Town: Treasury Proposes Unprecedented Outbound Investment Screening Regulations

On June 21, 2024, the Biden administration rolled out outbound investment screening regulations. Last year, the Biden administration published an advanced notice of proposed rulemaking (ANPRM) that outlined the broad parameters of this program and asked for feedback. The latest publication addresses this feedback, adds important details, and again asks impacted parties for feedback. As a proposed rule, the regulations will not be effective until publication of a final rule.

The updated proposed regulations would place obligations on any U.S. person in connection with certain transactions involving or resulting in the establishment of a “covered foreign person.” The regulations focus on the foreign person’s relationship to China (the sole country designated as a “country of concern”), and its involvement in one or more “covered activities,” which are related to sensitive national security related technologies and products, such as certain artificial intelligence systems, quantum computing, and microelectronics.

The Committee on Foreign Investment in the United States (CFIUS) scrutinizes analogous inbound investments by foreign persons in U.S. businesses. CFIUS has the authority to review transactions that give foreign persons control over a U.S. business and certain non-passive, non-controlling investments by foreign persons in U.S. businesses engaged in sensitive activities. 

The outbound investment screening regulations would allow the U.S. government—for the first time—to scrutinize investments by U.S. persons in companies outside the United States. Much like CFIUS, the outbound investment screening program jurisdiction hinges on three elements—a covered foreign person, a U.S. person, and a transaction. We cover each of these elements in detail below.

Transactions that meet these criteria are called “covered transactions,” which can be “prohibited,” meaning the transaction cannot legally be undertaken, or “notifiable,” meaning that it is permitted under the proposed rule but would require the submittal of information to the Department of the Treasury. A U.S. person would also have certain obligations under the outbound investment screening regulations in connection with certain transactions undertaken by any non-U.S. person entity that it controls.

I. Key takeaways and open questions

The proposed rule is more mature than the broad strokes of the ANPRM, and this maturation reveals important takeaways for the investment and technology sectors. Nevertheless, the proposed rule leaves many important questions unanswered. 

a. Key takeaways

• Knowledge and diligence are crucial to compliance. A U.S. person’s obligations under the proposed rule would apply if such person had knowledge of relevant facts or circumstances related to a transaction. This standard includes scenarios where the U.S. person possesses an awareness of a high probability of a fact or circumstance’s existence or future occurrence, or if the U.S. person could have possessed such information through a reasonable and diligent inquiry. This knowledge standard will be familiar to export control practitioners where it remains an inherent and frustrating source of risk.
  
  Counterparty diligence will be one of the keys to compliance with this program. The regulations contemplate transaction parties conducting diligence, but there may be language barriers and other information imbalances that will make it difficult to conduct sophisticated and technical diligence on target companies located outside the United States.
  
  The regulations separately contemplate representations from target companies regarding a transaction’s status (i.e., whether it is considered a notifiable transaction). This proposal is interesting, as it envisions transaction-document language in addition to diligence and a representation involving facts from both the investor and target (i.e., the transaction does not meet the jurisdictional elements of the program—there is no U.S. person, covered transaction, or covered foreign person).

• Debt and convertible instruments can trigger multiple filings. The treatment of contingent equity interests (i.e., financial instruments that currently do not constitute an equity interest but are convertible into, or provide the right to acquire, an equity interest upon the occurrence of a contingency or defined event) is also a key component. The proposed rule contemplates two potential filings (one at execution and one conversion) for what would be—in the commercial sense—thought of as one transaction.  
• Focus on artificial intelligence (AI). The proposed rules include a prohibition on certain transactions related to the development of any AI system designed to be exclusively used, or intended to be used, for military end use (e.g., weapons targeting, target identification, combat simulation, military vehicle or weapon control, military decision-making, weapons design, or combat system logistics and maintenance), government intelligence or mass surveillance (e.g., through mining text, audio, or video; image recognition; location tracking; or surreptitious listening), or any AI system trained using a specific quantity of computing power (the proposed rule asks for comments on several proposed thresholds for computing power). 
  
  The proposed rules contemplate a notification requirement for certain transactions related to any AI systems that are not otherwise prohibited, designed to be used for any government intelligence or mass-surveillance end use, cybersecurity applications, digital forensics tools, penetration testing tools, or control of robotic systems, or trained using a specified quantity of computing power (set below the levels in the prohibited transaction definition).

• Transactions taken by or through non-U.S. persons. The proposed rule requires a U.S. person to “take all reasonable steps to prohibit or prevent” a transaction by a foreign entity controlled by the U.S. person that would be prohibited if engaged in by a U.S. person. The regulation provides several factors that Treasury would consider, among (unspecified) others, to evaluate whether a U.S. person took all reasonable steps. The proposed rule also prohibits a U.S. person, who has the authority to make or substantially participate in a non-U.S. person’s transaction decisions, from “knowingly” directing a transaction by the non-U.S. person that the U.S. person “knows” would be prohibited if engaged in by a U.S. person—again an indication of the significance of the knowledge standard.

b. Open questions

• What is a qualifying passive investment? Although the proposed rule contemplates exceptions for certain types of passive and other investments that pose lower national security threats, the final parameters are not yet known. The exemptions include, for example, certain U.S. investments in publicly traded securities, index funds, mutual funds, exchange-traded funds, and certain investments made as a limited partner.
  
  The proposed rule requests comments on alternatives for the scope of the limited partner investment exception, one where the exception could only apply when the limited partner’s committed capital is not more than $1 million, aggregated across any investment and co-investment vehicles that comprise the fund, or a second alternative where the limited partner is passive and cannot “influence” the investment decisions of the fund or decisions made by the general partner, managing member, or equivalent. The dollar threshold related limitation would capture all but the smallest investors, but the restrictions in the alternative language could also cover all but the most passive investors. 

• Ongoing diligence requirements possible. The proposed rule includes provisions that could be read to require ongoing obligations and, potentially, post-transaction diligence. For example, when a U.S. person acquires actual knowledge, after a transaction is consummated, that it would have been a covered transaction if certain information was known at the time of the transaction, the U.S. person must submit a notification no later than 30 days after acquiring such knowledge. What, if anything, U.S. persons must do to monitor compliance with these obligations is unclear. Investors will, however, need to monitor investments to some degree to ensure compliance with the regulations.

II. Who is a covered foreign person?

The regulations define the term “covered foreign person” as a person of a country of concern that engages in a covered activity or, directly or indirectly, holds certain rights or derives certain income from covered persons or activities. The following graphic identifies these elements and illustrates that, in many cases involving complex structures, parties may have a difficult time definitively delineating covered foreign persons from others. 

The proposed rule also provides helpful examples, including an example indicating that when a company holds equity interests in one or more persons of a country of concern engaged in a covered activity that comprise 51 percent of the net income of the company, it is a covered foreign person under the regulations. Treasury declined to include a de minimis threshold below which a person of a country of concern’s activity would not trigger the definition of covered activity, partly because the financial significance of a covered activity in relation to any particular entity does not necessarily correspond to the national security significance of such activity.

III. Who is a U.S. person?

As with similar regulatory regimes, the outbound investment screening regulations apply to any (i) United States citizen, (ii) lawful permanent resident, and (iii) 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 (iv) any person in the United States.

IV. What types of transactions are covered?  

The outbound investment screening regulations cover transactions where a U.S. person, directly or indirectly:

• Acquires an equity interest or contingent equity interest in a covered foreign person;
• Provides a loan or similar debt financing arrangement to a covered foreign person that is:
• Convertible to equity interest, or
• Affords the U.S. person rights make management decisions or appoint members of the board of directors (or an equivalent group);
• Converts a contingent equity interest;
• Acquires, leases, or develops operations, land, property, or other assets in a country of concern that the U.S. person knows at the time of such activity will result in, or that the U.S. person intends to result in:
• The establishment of a covered foreign person, or
• The engagement of a person of a country of concern in a covered activity where that person was not previously engaged in such covered activity;
• Enters into a joint venture, wherever located, formed with a person from a country of concern that will engage in a covered activity; or
• Acquires 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 is likely to invest in a person from a country of concern that is in the regulated sectors, and such fund undertakes a transaction that would be a covered transaction if it were undertaken by a U.S. person.

V. Restrictions.

If the transaction is a “covered transaction,” it can be either prohibited or subject to notification requirements, depending on the activities (or covered activities) of the target.

Prohibited transactions. For a transaction to be prohibited, the covered activity will include:

Notifiable Transactions. For a transaction to be notifiable, the covered activity will include:

VI. When do the rules apply?

The obligations of U.S. persons under the outbound investment screening regulations apply if such person has knowledge of relevant facts or circumstances related to a transaction. As with other similar regimes, the rule elaborates on what it means for a person to “have knowledge” of a fact or circumstance. A U.S. person may be assessed to “have knowledge” if the U.S. person possesses actual knowledge that a fact or circumstance exists or is substantially certain to occur; possesses an awareness of a high probability of a fact or circumstance’s existence or future occurrence; or could have possessed such information through a reasonable and diligent inquiry.

VII. What are the exceptions?

The outbound investment screening regulations contain exceptions for certain types of transactions, which include:

• Investments in public securities: Investments 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;
• Certain investments in funds: Certain U.S. person investments made as a limited partner or equivalent in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund that do not provide the U.S. person specified (control) rights and do not result in committed capital exceeding certain thresholds;

• Buyouts: Buyouts of country of concern ownership, such that the entity would not constitute a covered foreign person following the transaction;

• Certain internal transactions: Intracompany transactions between a U.S. parent and a majority-controlled subsidiary to support ongoing operations or other non-covered activities;

• Preexisting commitments: Transactions fulfilling a binding, uncalled, capital commitment entered into prior to August 9, 2023; and 

• Lending syndicates: Where U.S. persons, as members of a lending syndicate, acquire a voting interest in a covered foreign person upon default and the U.S. person cannot initiate any action vis-à-vis the debtor and does not have a lead role in the syndicate.

Additionally, certain transactions involving a person from a country or territory outside the United States may be excepted transactions where the Secretary of the Treasury determines that the country or territory is addressing national security concerns posed by outbound investment and the transaction is of a type for which the associated national security concerns are likely to be adequately addressed by the actions of that country or territory.

VIII. What happens if there are violations?

The outbound investment screening regulations include a penalty and disclosure framework.

• A violation would be subject to the civil and criminal penalties as set forth in the International Economic Emergency Powers Act (IEEPA). The civil penalty amount is set at $368,136 or twice the value of the transaction, whichever is greater, and criminal liability is authorized up to $1 million and imprisonment of up to 20 years per violation, if willfully committed. The Treasury can impose civil penalties and refer criminal violations to the Attorney General.
• The Secretary of the Treasury could take any action authorized under IEEPA to nullify, void, or otherwise require divestment of any prohibited transaction.
• The proposed rule provides a process for a U.S. person to submit a voluntary self-disclosure if they believe their conduct may have resulted in a violation of any part of the proposed rule. Such self-disclosure would be taken into consideration during the Treasury’s determination of the appropriate response to the self-disclosed violation.          

IX. What’s next?

Comments for the outbound investment screening regulations are due by August 4, 2024. Although the outbound investment screening regulations are not yet final, the proposed regulations illustrate the framework for what will likely become law. So impacted parties, in addition to considering comments, should start assessing the effects of these regulations on their operations and what, if any, steps they should proactively take prior to the regulations becoming effective.

[1] For the computation power thresholds, the outbound investment screening regulations contain alternative proposals for public comment.

[2] For the computation power threshold, the outbound investment screening regulations contain alternative proposals for public comments.