On November 15, 2024 the Treasury Department published the Final Rule on Outbound Investment in Critical Technologies, to be codified under 31 CFR Part 850.

This rule implements Executive Order 14105 and it establishes new notification requirements and restrictions for U.S. investments in “countries of concern” relating to semiconductor technology, quantum computing, and artificial intelligence.

The restrictions currently apply to China, Hong Kong, and Macau, and the rules are set to take effect January 2, 2025; the rule will apply to transactions after this date, although commitments that existed prior to the effective date are generally exempt.

Scope

• Applies to U.S. investments in semiconductors/microelectronics, quantum technology, and AI (§850.208), with a focus on technologies that are critical to military/intelligence capabilities
• Currently applies only to China, Hong Kong, and Macau (§850.207)
• Affects U.S. persons and controlled foreign entities (§850.229, §850.206)
• Applies to U.S. persons and controlled foreign entities

Key Implications

• Creates mandatory notification requirements and prohibitions for certain investments
• Focuses on investments that could transfer both capital and intangible benefits
• Affects direct investments, joint ventures, greenfield investments, and certain fund investments
• Includes exceptions for publicly traded securities and certain passive fund investments

Background

Executive Order 14105 (issued August 9, 2023), ‘‘Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern,’’ declared a national emergency. The EO was intended as a way for the United States to address the threats that certain countries pose in their development and/or exploitation of critical military, cyber-enhanced, intelligence, or surveillance products or technologies.

The EO defines a “country of concern” as “a country or territory listed in the Annex to this order that the President has identified to be engaging in a * comprehensive, long-term strategy* that directs, facilitates, or otherwise supports advancements in sensitive technologies and products that are critical to such country’s military, intelligence, surveillance, or cyber-enabled capabilities to counter United States capabilities in a way that threatens the national security of the United States”. President Biden listed three countries of concern: The People’s Republic of China, The Special Administrative Region of Hong Kong, and The Special Administrative Region of Macau.

The final rule - “Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern” - was published by the Office of Investment Security within the Department of the Treasury.

As a caveat, Executive Orders can be revoked (though the fact that a rule has been developed makes it slightly more complicated) - with an administration change on the horizon (literally weeks after this is scheduled to take effect!), there’s some uncertainty as to how this rule will stand in the long-run.

Codification

The rule has not yet been published in the eCFR as of November 15, 2024, but will be codified under Chapter VIII of Title 31 after Parts 800, 801, and 802.

Key Requirements

Prohibited Transactions

The rule establishes a complete ban on certain investments (including both direct and indirect investments) in advanced technology. At a high level, these include investments in advanced semiconductors/microelectronics, quantum computers/sensors, and AI systems for military/intelligence use.

The prohibition applies to investments in a “covered foreign person” (§850.209) engaging in the types of activities listed above who is located in/organized under the laws of a country of concern, owned or controlled by persons in a country of concern, or significantly financially connected to covered activities in a country of concern.

Notifiable Transactions

This category of transactions is broader in scope and includes less advanced technology tiers. It focuses on military and intelligence applications.

For “notifiable transactions” that involve the development of non-advanced semiconductors, AI systems above certain computing thresholds, and military/surveillance applications that are less technologically advanced than those of the prohibited transactions (i.e., covered transactions that are not prohibited), reporting is required.

Organizations must report information about such transactions to the Department of Treasury within 30 calendar days of the completion of a notifiable transaction.

Knowledge Standard

Certain requirements within the final rule apply only when a U.S. person has “knowledge” of facts and circumstances (§850.104). But what does the Treasury Department consider to be the standard for such knowledge? The short answer is that it’s based on what an investor knew or should have known based on “reasonable and diligent inquiry.”

Knowledge can be triggered in multiple ways: actual knowledge, “reason to know of a given fact or circumstance,” or awareness of a high probability of such fact or circumstance (either currently or in the future). These are based on the information available to the U.S. person at the time of the transaction.

What does “reasonable and diligent inquiry” look like? Among other things, the Treasury Department will consider whether the U.S. person engaged in the following:

• Inquiry of the investment target (or other relevant counterparty), including specific questions asked as of the time of the transaction;
• Contractual representation and/or warranties obtained (or attempted to obtain) by the U.S. person from the target regarding the determination of a transaction’s status as a covered transaction and the target’s status as a covered foreign person;
• Effort to obtain and review available public and non-public information relevant to such determinations (as well as assessment of consistency of such information);
• Avoidance of learning or sharing of relevant information;
• Consideration of the presence or absence of warning signs (e.g., avoidance of response or evasive answers); and
• Review of additional public and non-public information about the target.

Board consideration: Is our existing due diligence process sufficient to meet the “reasonable and diligent inquiry” requirement? Do we have sufficient documentation processes in place to be able to demonstrate these efforts?

Notable Exceptions and Exemptions

Transactions that would otherwise be considered a “prohibited transaction” or a “notifiable transaction” are exempt from the rule if they meet the conditions of an excepted transaction.

Excepted transactions include:

• Publicly traded securities
• SEC-registered investment funds
• Limited partner investments under $2M
• Certain intracompany transfers
• Pre-existing binding commitments (prior to the rule’s effective date)

In addition, the U.S. government may determine that a covered transaction is exempt from certain provisions of the rule if the covered transaction is in the national interest of the United States. The process for the request of such determination will be made available on the Department of the Treasury’s Outbound Investment Security Program website, likely upon the effective date of the rule.

Compliance Considerations

In addition to the 30-day notification period mentioned previously, the rule imposes a 10-year record retention period for filings and supporting documentation. This includes pitch pitch decks, marketing letters, offering memoranda, transaction documents (including side letters and investment agreements), and due diligence materials related to the transaction (as covered in the Knowledge Standard section). This documentation must be made available to the Department of Treasury upon request.

There are civil and criminal penalties associated with violation of this rule, as well as potential compelled divestment of prohibited transactions. The Department of Treasury will offer a voluntary self-disclosure program for violations of the rule, provided that the disclosure isn’t disqualified.

Strategic Impact

This rule may affect companies’ investment strategies in countries like China, and could impact fund structures, operations, and portfolio companies. Companies that are subject to the rule may need to update their existing policies and procedures relating to investment due diligence.

Board consideration: Action may be required by the board of directors to ensure compliance with this rule. Boards should:

• Review investment policies for compliance before the effective date
• Establish due diligence protocols
• Conduct a portfolio review and consider implications for future investment strategies
• Develop notification procedures and reporting mechanisms
• Train relevant personnel
• Document compliance processes

Applicability to Domestic Companies

Boards should care about this regulation for several key reasons, even if they do not operate or invest globally. The definition of a “U.S. Person” is broad, and could affect foreign branches of U.S. entities or U.S. investments.

Supply Chain Implications

The restrictions relating to semiconductors and AI suppliers could impact domestic vendor relationships, possibly affecting procurement options for such technology (either directly or indirectly, as such effects ripple throughout the supply chain). Access to certain technologies may be limited as a result of the enactment of this rule, and boards should consider the risk accordingly. In addition, even domestic research and development partnerships could be impacted.

Investment Considerations

Boards should consider whether this rule exposes their organization to risk through their portfolio investment or other investment fund participation. In particular, retirement or pension fund investments should be reviewed, even if they are passive investments.

Boards should ensure compliance frameworks are in place regardless of direct international operations.