China Outbound Investment Regulations: An Update
The Biden-era U.S. Outbound Investment Regulations (OIR) became effective on January 2, 2025. How is the market implementing the OIR, and does it appear to be having its intended effect of reducing U.S. investments in certain Chinese technology sectors? The well-known law firm of Sidley Austin LLP has recently released a report on the first six months of the OIR’s implementation, and generally finds that it appears to be effective, and has even had a chilling effect on other so-called “notifiable transactions” that are nonetheless permissible and do not require approval. Ambiguities in the regulations are also having a similar effect on investments. Due diligence requirements seem to be presenting challenges as well, and the market has apparently not yet settled on a standard approach to “binding contractual representations” from general partners (GPs) to limited partners (LPs) concerning the use of the LP’s capital in the fund. Finally, the U.S. Department of the Treasury (Treasury) has already begun to reach out to certain investors seeking details of particular transactions, apparently for enforcement purposes.
[By way of background, in June 2024, Treasury issued a Notice of Proposed Rulemaking (NPRM) to implement the Biden Executive Order of August 9, 2023, entitled “Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern.” These rules were finalized in late October of last year and implement outbound investment controls applicable to certain technologies in regions identified as “countries of concern” – currently limited to the People’s Republic of China, Hong Kong and Macao. The restrictions affect investments in three main sectors seen as critical to U.S. national security – semiconductors, quantum computing and artificial intelligence (AI).
U.S. investments in China will fall under three categories: (i) prohibited; (ii) require notification; or (iii) permitted (with no further process required under the outbound investment regulation). Post-transaction notification will be provided to the newly created Office of Global Transactions within Treasury, which is charged with implementing and overseeing the outbound investment requirements. Importantly, the rule does not prohibit general investment in China outside the three specific areas seen as critical to U.S. national security.
Instead of a governmental review, the new rule requires industry to conduct sufficient due diligence before engaging in “covered transactions” to determine if such transactions are prohibited or notifiable. In other words, outbound investments are not subject to a lengthy review process such as that imposed by the Committee on Foreign Investment in the United States (CFIUS), chaired by Treasury. For more information concerning the final rule, see the “NCTR FYI” for November 8. 2024, entitled “China Outbound Investment Screening Rule Finalized.”]
Sidley breaks their overview of the OIR implementation into several components, as follows:
“The OIR Has Blunted Interest Even in Notifiable Transactions.” Even though “notifiable transactions” – requiring “ostensibly only an obligation to share certain information with Treasury” — are permissible, and there is no formal approval process required for a such a notified transaction, Sidley’s review has found that “many investors are nevertheless reluctant to undertake notifiable transactions.”
Why? Sidley says the reasons can vary:
- Investors might not want to undertake the administrative burden of notifying Treasury;
- they might not want to attract the attention of the U.S. government as an investor in Chinese technology due to real or imagined fear of political, reputational, or regulatory consequences;
- they might not want to face questions from Treasury on their investments or ultimate investors; or
- they might feel that they are putting themselves at risk if Treasury ultimately decides that the investment was actually in the prohibited category, which might result in an enforcement action.
“Perhaps investors will feel more comfortable with notifiable transactions as time goes on, but, for now, it appears that many investors are holding back from making notifiable transactions,” Sidley concludes.
“Ambiguities in the OIR Have a Chilling Effect.” Sidley says the January 2 regulations are “glitchy.” This, the firm suggests, is “largely due to ambiguities in the definitions of key terms used in the OIR.”
As an example, they note the uncertainty in connection with the definition of “covered activities.” As they point out, this term refers to certain activities (development, production, etc.) that a Chinese-affiliated entity (or “person of a country of concern”) might take with respect to one of the designated technology sectors. “Depending on the type of activity, an investment into the covered foreign person may be notifiable or prohibited,” they explain.
However, the distinction between covered activities that are notifiable and those that are prohibited “is not always clear,” the law firm cautions, and they provide a somewhat detailed explanation of covered activities specifically related to AI systems that involve the “[d]evelopment of any AI system designed to be exclusively used for, or which the relevant ‘covered foreign person’ intends to be used for, any [of a variety of ends uses, including, for example] … mass surveillance.”
The U.S. government has expressed concern that certain Chinese social media companies have been used or could be used for surveillance, Sidley points out. However, at the same time, “Treasury has explained that the policy behind the OIR is not supposed to ‘broadly captur[e] investments into entities that develop AI systems intended only for consumer applications or other civilian end uses with no potential national security consequences.’” Where the line should be drawn is not clear, Sidley stresses.
“Whether by design or not, the consequence has been that many investors are reluctant to take the risk of getting it wrong, and the chilling effect on investment can be quite broad,” the law firm concludes.
“Administrability Can Be Challenging.” As Sidley points out, the OIR does not impose strict liability for violations of the regulation. Instead, “liability is premised on whether the U.S. person ‘knew’ or had reason to know, after a ‘reasonable and diligent inquiry,’ whether relevant facts and circumstances exist or are substantially certain to occur or are highly probable to exist or occur,” they explain. Consequently, a person subject to the regulations “must undertake due diligence when making an investment and must do so for every investment that they undertake,” they stress. The question, then, is how much diligence is enough?
Furthermore, Sidley notes that unlike U.S. sanctions programs, “there is no list of covered foreign persons” that investors can use to “code” their systems to block investments in covered foreign persons. Also, any attempt to do so “would likely be overly broad,” they suggest.
“A case-by-case analysis is, therefore, required,” Sidley says, which could “significantly slow down investment activity and, given the realities of today’s trading environment, may prompt some to simply ignore the problem.” Also, just assessing whether an investment falls within the scope of an exception can be difficult, they note. They give an example involving the OIR exemption from coverage in the case of an acquisition of publicly traded securities where the U.S. person does not obtain rights “beyond standard minority shareholder protections.” Long story short, Sidley says that “Treasury seems to expect that before investing in publicly traded securities, investors must understand what rights they might get by default in the listing jurisdiction, the jurisdiction of incorporation, the target company’s bylaws or articles of incorporation, and so on.” The feasibility of doing that in every case, “particularly in a fast-moving trading environment,” can be “challenging” – an understatement, surely.
“The Burden Sits with the U.S. Investor.” The OIR imposes obligations on U.S. persons, not the Chinese-affiliated target entities in which, for example, the U.S. person or its controlled foreign entity is investing. “This means that the target entities may have little incentive to be fully forthcoming during the diligence process,” Sidley observes. As a result, Sidley warns that the relevant U.S. persons “must take particular care to collect whatever information they can from public or other sources to confirm the information that [the] target entity might provide about its operations.”
“Tug of War Among Market Players.” A U.S. person’s investment as LP in non-U.S. funds is covered by the OIR if the U.S. LP has knowledge at the time of the acquisition that the fund undertakes a transaction that would be covered if undertaken by a U.S. person. However, certain exceptions apply, specifically in cases where the LP “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 prohibited transaction or notifiable transaction, as applicable, if engaged in by a U.S. person.”
Sidley says that even though this “segregation of capital” rule seems clear enough on its face, “there is an ongoing tug of war over how such segregation should be accomplished, the extent to which a fund is willing to take on the obligation of conducting the necessary diligence and ensuring that the segregation is done properly, and whether the segregation must be made definitively at the outset with no ability to opt in to an investment in the future.”
Similarly, a foreclosure on a loan may be a covered transaction, so lenders often require representations of whether the borrower is or may become, or may invest in, a covered foreign person or even whether the borrower engages in covered activities. “Borrowers often push back on these demands as being overly broad,” Sidley observes, with the point being that “the market has not yet settled on a standard approach to contractual representations.”
“Enforcement.” Treasury has already begun to reach out to certain investors looking for details of particular transactions, Sidley stresses. In some cases, “there are clear, public disagreements about whether the OIR is applicable to a particular investment,” with investors protesting that “X number of law firms have looked at this and told us the investment was not within scope.” Hopefully, Sidley observes, through this process Treasury will clarify aspects of the OIR that remain difficult to understand and implement.
“Conclusion.” Sidley expects that the OIR will continue to evolve through practice as well as “further elaboration and clarification from Treasury,” such as additional FAQs, issued more frequently.
Also, Sidely points out that on February 21 President Trump issued his “America First Investment Policy Memorandum,” which Sidley notes indicated that more changes with respect to the regulation of outbound investment are coming. In short, Sidley says the administration proposes to retool U.S. inbound and outbound investment screening “to make investment into and by U.S. allies easier while making investment into or by the People’s Republic of China (PRC) and other U.S. adversaries more difficult.” The Memorandum does not itself impose new regulatory requirements but directs several agencies to begin rulemaking procedures to implement its directives.
With regard to outbound investments, Sidley says President Trump indicates that he will revise and expand the existing OIR to further restrict investment by U.S. persons in U.S. adversaries. Also, the Memorandum suggests that the scope of the outbound investment regulations could be expanded to cover new technologies in the “semiconductor, artificial intelligence, quantum, biotechnology, hypersonics, aerospace, advanced manufacturing, directed energy, and other areas implicated by the PRC’s national Military-Civil Fusion strategy.”
Finally, the Memorandum indicates that certain types of investments that are carved out of the existing outbound investment regulations may be covered in the future. Specifically, the Memorandum states that restrictions may extend to “private equity, venture capital, greenfield investments, corporate expansions, and investments in publicly traded securities, from sources including pension funds, university endowments, and other limited-partner investors.” Some of these categories are already covered by the outbound investment regulations, but others are not — such as passive acquisition of publicly traded securities on public markets.
There is certainly the likelihood there will be more to come regarding outbound investments in China with potentially new and burdensome restrictions on pension fund investments. Stay tuned!