U.S. to Impose Reverse CFIUS on China
Corporates, PE/VC funds, limited partners, and senior individuals are regulated by an evasion-resistant framework blocking a host of investment strategies including variable interest entities, offshore structures, multi-tiered investments, and certain planned investment activities.
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n June 21, 2024, the U.S. Department of the Treasury issued a comprehensive set of proposed rules, marking a significant step in regulating outbound investments into China, Hong Kong, and Macau. This follows President Biden’s Executive Order 14105, signed on August 9, 2023, and the department’s prior notice of proposed rule-making.
The new regulations, known as the “Outbound Provisions,” represent an unprecedented initiative to establish a screening mechanism for outbound investments—commonly referred to as a “reverse CFIUS.” This term draws a parallel to the Committee on Foreign Investment in the United States (“CFIUS”), which scrutinizes inbound investments for national security risks. However, unlike CFIUS, the Outbound Provisions do not involve a case-by-case review by government officials. Instead, they rely on self-determination and self-reporting by U.S. investors.
This self-regulatory approach requires all covered U.S. investors (and certain lenders) to assess their own transactions and either not proceed with them or report them accordingly, marking a shift from the traditionally government-driven review process. The introduction of these rules follows several unsuccessful attempts to implement such a mechanism in the past.
For the proposed rules, the Treasury Department has set a public comment deadline of August 4, 2024. After processing the feedback, the final regulations are expected to be enacted shortly thereafter, signaling a new era of oversight for U.S. investments abroad.
In brief, here is what the Outbound Provisions entail:
The framework of the Outbound Provisions is built on a set of technical definitions, including terms such as “U.S. person”, “covered foreign person”, “covered activity”, and “covered transaction.” These definitions1 form the backbone of the new rules.
For those seeking a concise overview of the Outbound Provisions, this blog consolidates the application of these technical definitions into the following key topics:
• Who is considered a U.S. investor?
• Who is considered a Chinese2 investee?; and
• What are the Listed Industries?
In addition, this blog covers various special cases of concern, the importance of the knowledge standard, enforcement tools, and the limited exceptions provided by the rules.
The U.S. Investors: Direct, through offshore entities, and those who “direct”
The Outbound Provisions apply to U.S. investors making outbound investments directly or through any controlled foreign entity (a “CFE”). CFEs are regulated by requiring U.S. investors to: (1) take all reasonable steps to prohibit their CFEs from making investments in certain Listed Industries and (2) report on their CFE’s investments in certain other Listed Industries. In addition, a special obligation is imposed on certain U.S. individuals (and entities) involved with directing offshore entities in connection with the types of investments that would be prohibited if they were undertaken by U.S. investors.
It should be noted that “investing” includes a wide range of instruments, from plain vanilla equity to contingent equity interests, debt financings with convertibility or rights features, the conversion of contingent equity interests, and their equivalents. Thus, certain U.S. lenders may also be regulated. In addition, there is also no de minimis exception on the quantum of investment so any amount of investment by U.S. investors into Chinese Investees is regulated. This is consistent with the rationale that U.S. investments lead to other intangible benefits apart from the funding itself.
CFEs include foreign subsidiaries and offshore U.S. managed PE/VC funds
Adopting a bright line test, a CFE is a foreign entity in which a U.S. investor directly or indirectly holds more than 50 percent of its voting interest or voting power of its board. In addition, CFEs include foreign partnerships with U.S. general partners, managing members (or the equivalent) and offshore investment funds that have U.S. investment advisors. Hence, the authorities are targeting investments through U.S. controlled offshore intermediaries and by U.S.-advised offshore PE/VC funds.
CFEs tier exponentially, similar to the OFAC 50 Percent Rule
In addition, CFE status applies exponentially down a tiered structure. Similar to the OFAC 50 Percent Rule, voting interest and voting power of a more than 50 percent owned subsidiary is 100 percent attributed to its parent. Less than 50 percent owned subsidiaries are proportionately attributed to their parent and both forms of attribution are aggregated on a direct and indirect basis for CFE classification purposes. Under this “more than 50 percent equals 100 percent” concept plus the aggregation rule, CFEs can be found multiple levels down a tiered structure for what would normally appear to be minority stakes held by foreign entities on an indirect ownership basis.
Special obligation: U.S. decision makers “directing” offshore investments
U.S. individuals in key positions face strict prohibitions on “directing” offshore investments into certain Listed Industries. This includes any U.S. officer, director, senior advisor, or other person in a senior position with an offshore entity who exercises their authority in a manner that would be prohibited for a U.S. investor. Such actions are deemed violations, requiring these individuals to recuse themselves from decision-making roles to comply with regulations. Thus, the Outbound Provisions apply to foreign investment activities where U.S. persons hold influential positions.
Extraterritorial reach: any person in the United States
The definition of a “U.S. person” in the Outbound Provisions extends to “any person in the United States,” thus including foreign companies and individuals. The Treasury Department clarifies that this does not apply to foreign company employees merely working in or passing through the U.S. However, it does apply if such employees engage in transactions that “trigger program coverage.” The concern is that individuals transiting through the U.S. may gain valuable knowledge, experience, networks, and other intangible assets, which could benefit their foreign employers.
The Chinese Investees: Direct, indirect, and doesn’t have to be Chinese
Unless exceptions apply, U.S. investors face prohibitions or notification requirements when investing in any Chinese investee (broadly defined as “Chinese Investees”) engaged in Listed Industries. Below is a survey of the various types of possible Chinese Investees.
Basic case: direct investments in Chinese companies
As anticipated, direct investments in Chinese companies within a Listed Industry are covered by the rules. Entities with their principal place of business in, headquartered in, or incorporated in or otherwise organized under the laws of China are treated as Chinese Investees.
Non-Chinese entities (and their subsidiaries) having Chinese interests
Non-Chinese entities are treated as Chinese Investees if a Chinese person, entity, or government holds at least 50 percent of their voting interest, board voting power, or equity interest, either directly or indirectly. Subsidiaries of such entities are similarly classified. Additionally, entities with Chinese government, persons acting on their behalf, and entities with “golden shares” are considered Chinese Investees. The Treasury Department’s Example #10 illustrates this rule, deeming Company N (formed in any country, including the U.S.) with six Chinese citizens each holding a 10 percent equity interest, are a Chinese Investee.
Variable interest entities (“VIEs”) and indirect investments
VIEs and other common transaction structures, where investments are funneled into parent or holding companies, are classified as Chinese Investees. This classification is determined by a two-factor test: (1) An offshore entity directly or indirectly holds any voting interest, board seat, equity interest, or power to direct the management or policies of one or more Chinese Investees; and (2) The entity derives more than 50 percent of its revenue or net income, or incurs more than 50 percent of its capital expenditures or operating expenses through these Chinese Investees. These metrics are aggregated but evaluated independently for the same entity.
Other indirect investments are regulated and Treasury specified that if a U.S. investor purchased shares in a company (wherever located) that later acquired an equity interest in a Chinese Investee, and this was known at the time, that would also be deemed to be a Chinese Investee.
PE/VC funds targeting China (relevant to U.S. limited partner commitments)
The Outbound Provisions extend to limited partner commitments (or equivalent interests) made to pooled investment funds—including venture capital, private equity, and fund of funds—under specific conditions. These conditions are:
- The U.S. limited partner (LP) knows at the time of commitment that the fund is likely to invest in a Chinese Investee involved in semiconductors and microelectronics, quantum information technologies, or artificial intelligence sectors; and
- The fund undertakes a transaction that would be prohibited if executed by a U.S. person.
This rule addresses the issue that investment funds may not have identified specific targets when soliciting investments. U.S. LPs are expected to conduct due diligence on the general partner’s (GP) track record. The Treasury Department illustrates this in Example #8: a U.S. LP invests in a pooled investment fund (Company M). While Company M has not yet made any investments, its manager has a strong track record of investing predominantly in China’s AI sector, satisfying the first condition.
Greenfield and brownfield projects
The Outbound Provisions capture U.S. investors' acquisition, leasing, or development of operations, land, property, or other assets in China when the U.S. investor knows these activities will establish a Chinese Investee in the Listed Industries. This includes preparatory transactions such as acquiring land or retrofitting an old factory with the intent (not just knowledge) to convert it into a Listed Industry operation. The Treasury Department emphasizes that even these preparatory stages can convey intangible benefits from the U.S.
Joint ventures, wherever located
Entering into a joint venture with a Chinese partner, regardless of location, is covered if it will engage in the Listed Industries. The Chinese JV partner is considered a Chinese Investee engaged in the Listed Industries by its participation in the joint venture. This rule is based on intent (not just knowledge), even before the JV actively engages in the Listed Industries. The Treasury Department believes these structures offer opportunities and incentives for transferring intangible benefits from the U.S.
Intercompany activities
Certain intercompany activities with existing Chinese Investees—such as the sale and purchase of inventory or fixed assets, the provision of services, or the licensing of technology—may trigger the Outbound Provisions if they exceed support activities that are not regulated (e.g., the preparatory activities described in greenfield investments).
U.S. entities as Chinese Investees
In limited circumstances, a U.S. entity could be classified as a Chinese Investee. This could occur if the U.S. entity meets the metrics or ownership criteria described in the offshore holding company or 50 percent Chinese-held tests. The Treasury Department has requested commentary on the inclusion of certain U.S. entities in the technical definitions of Chinese Investees.
The Listed Industries: Prohibited vs. Notifiable
The Outbound Provisions categorize investments by U.S. investors into Chinese Investees as either strictly prohibited or merely notifiable. This classification depends on the specific categories within the Listed Industries in which the Chinese Investee operates. Each category is designed to be mutually exclusive.
In addition, there is no de minimis exception for the level of Listed Industry activity engaged in by a Chinese Investee. As such, a start-up or a newly opened division of an existing larger company would be covered by engaging in a Listed Industry. The Treasury Department indicated that setting a threshold would not respond to the national security objectives of Executive Order 14105. The table below provides a summary for quick reference.
The categories involving Artificial Intelligence above are prominent from a number of standpoints. First, the distinction between notifiable and prohibited status seems to be based on the exclusivity characteristics of end-use. In practice, the dividing line between dual-use and exclusive use could be problematic. Second, an “AI system” is broadly defined to be one that can make predictions, recommendations, or decisions influencing real or virtual environments as well as any data system, software, hardware, application, tool, or utility that operates in whole or in part using such a system. These definitions may need to be applied to industries that may add such systems to their primary technology as ancillary features. Some commentators have argued that the definition of AI Systems is potentially so expansive that it could apply to a wide range of software that was not intended.
WireScreen maintains proprietary collections and flagging methodologies to help identify Chinese Investees engaging in AI Systems with various levels of military or state supply relationships.
The Knowledge Standard
The Outbound Provisions follow a knowledge standard mirrored off the Export Administration Regulations. As such, U.S. investors must have actual knowledge that a fact or circumstance exists or is substantially certain to occur, an awareness of a high probability of a fact or circumstance’s existence or future occurrence, or reason to know of a fact or circumstance’s existence. A reasonable and diligent inquiry is required to avoid liability.
The use of commercial databases to identify and verify relevant information of an investment target or relevant counterparty is expressly listed by the Treasury Department as a factor that shows an appropriate inquiry was made. In addition, Chinese language materials are required to be submitted in connection with notifiable transaction obligations (in addition to English translations). WireScreen maintains comprehensive Chinese language source material on Chinese Investees for this purpose.
Other factors include the presence or absence of warning signs, which may include evasive responses from a counterparty, whether the U.S. investor purposefully avoided learning or sharing relevant information, and efforts undertaken to obtain and review available public and non-public information.
Limited Exceptions
The following constitute exceptions to the Outbound Provisions:
• investments in publicly traded securities (including OTC markets), index funds, mutual funds, or exchange traded funds;
• investments of a certain nature or size by a U.S. LP in a fund;
• full buyouts of Chinese Investees such that they no longer constitute Chinese Investees;
• purely standard intercompany transactions between a U.S. parent and its subsidiary to support ongoing operations (see greenfield, brownfield, and joint ventures above);
• fulfillment of a binding capital commitments entered into prior to August 9, 2023;
• acquisitions in connection with a defaulting syndicated loan where the U.S. investor participates passively in the lending syndicate; and
• certain transactions in third countries/territory that are designated by the Treasury Department as having their own rules to safeguard against national security concerns.
In addition, a “national interest exemption” is available upon request pursuant to a rigorous review procedure and certain official U.S. government business transactions are exempted.
The Treasury Department noted in its discussion of the Outbound Provisions that it would not be creating exceptions for additional transactions suggested by commentators. Notably, university-to-university research collaborations were not treated as exceptions. In addition, the sale of goods and services, the purchase, sale, and licensing of intellectual property, and a variety of financial and non-financial services ancillary to a transaction such as the processing, clearing, or sending of payments by a bank were not expressly excepted.
Enforcement Tools
The Treasury Department may take action to compel divestment of investments classed as prohibited under the Outbound Provisions. In addition, monetary penalties imposed (which can be up to US$1,000,000 and 20 years imprisonment) for willful violations are considered debts due to the U.S. government. As such, the Treasury Department may directly take action to collect such penalties. In addition, fines and prison may be imposed on Chinese and offshore parties where any branch of the U.S. government gains jurisdiction where parties willfully falsify, conceal, make any materially false, fictitious, or fraudulent statements or representations, or make or use any false writing or document.
Future Prospects
There are a number of issues yet to be resolved for the forthcoming Outbound Provisions. Among them, how the rules may evolve from launch, numerous practical application issues, and what types of countermeasures will be viewed as constituting evasion.
Visibility and future refinement
The Treasury Department emphasized that the materials submitted to it with respect to notifiable transactions will provide it with visibility on identifying sector trends, related capital flows, volume and nature of investments, intangible benefits conferred, and details on relevant technologies and products to inform future policy developments. Using this for the basis of an expansion of U.S. government programs was noted in this regard.
In addition, the content of notifiable transaction reports are mandated to include the known end uses and end users of the Chinese Investee’s technology, products, or services and identification of the technology nodes at which any applicable product is produced. Moreover, the Outbound Provisions give additional power to the Treasury Department to obtain additional reports on demand. This power applies “at any time as may be required.” Further powers include the ability to conduct investigations, hold hearings, subpoena, and obtain records regardless of whether any report has been required or filed under ordinary reporting.
The above may presage modification and possibly future expansion of the Listed Industries. Similarly, the Outbound Provisions are drafted to define “country of concern” by way of an Annex, and the current Annex lists China, Hong Kong, and Macau only. Additional countries of concern may be easily added in the future. Some commentators raised the prospect of Russia, Iran, and North Korea.
Monitoring activities that change over time, follow-ons, and various indirect investments
Treasury does not appear to address situations where an investee engages in a Listed Industry after the investment has taken place. Instead, the rules merely state that U.S. investors who learn after the deal closes that it is notifiable or prohibited “if such knowledge had been possessed by the relevant U.S. person at the time of the transaction” shall submit a notification to Treasury within 30 days. The rules may not be workable when it comes to investments that do not engage in the Listed Industries at the outset but may move into those industries over time. It remains to be seen whether investments need to be monitored for such changes, and perhaps certain investors will request side letters from their investees to avoid such complexities. On the other hand, follow-on investments into Chinese Investees following original investments that pre-dated the Outbound Provisions would be covered. This could be problematic for situations where there was no binding commitment but there was some plan or expectations for follow-ons which can no longer be made. Finally, it is yet to be seen how far indirect investments can be regulated in practice. Similar to the start-up company scenarios, how will investors diligence investments into larger Chinese conglomerates that may have small units engaging in the Listed Industries.
Evasion or not?
For years, US Dollar denominated private equity funds have partnered with RMB denominated RMB funds to co-invest inside and outside of China. Due to Chinese currency controls and foreign investment restrictions, such co-investments are structured using various techniques, including through swap contracts. Using a swap contract, a US Dollar fund would, without owning, participate in some of the economic upside of investments made by related or unrelated RMB funds and vice versa. While swap contracts such as these do not appear to be addressed by the rules, questions may arise as to whether the intangible benefits that Treasury is looking to guard against are conveyed through these arrangements.
1 For example, U.S. investors, Chinese investees, listed industries, and the instruments and investment formats discussed herein are generally derived from the definition of “U.S. persons”, “covered foreign person” (based on its sub-definition of “person of a country of concern”), “covered activity”, and “covered transaction” found in the proposed rules.
2 In this blog, “China” and “Chinese” includes the mainland, Hong Kong, and Macau.
3 Entities include branches, partnerships, associations, estates, JVs, trusts, corporations or divisions, groups, sub-groups, or other organizations whether or not they are organized under law.
4 Principal place of business includes the primary location where the entity’s management directs, controls, or coordinates its activities, or for funds, where the fund’s activities are primarily directed, controlled, or coordinated by or on behalf of the general partner, managing member, or equivalent.
5 The alternatives under consideration are an LP’s committed capital of not more than $1,000,000 or a non-anchor LP position (as defined). It should also be noted that under these standards the Limited Partner Advisory Committee (LPAC) cannot have the ability to approve, disapprove, or otherwise control investment decisions of the general partner. Presumably, this could implicate certain veto rights that might be obtained by an LPAC.
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