Treasury Releases Final Rule to Implement Executive Order on Sensitive Outbound Investments

The U.S. Department of the Treasury released the Final Rule on Oct. 28, 2024, to implement Executive Order 14105 (EO 14105), which restricts U.S. investments in sensitive technologies and products in countries of concern. In its annex, EO 14105 specified the People’s Republic of China, the Special Administrative Region of Hong Kong and the Special Administrative Region of Macau as countries of concern. The sensitive sectors include semiconductors and microelectronics, quantum information technologies and artificial intelligence. EO 14105 requires U.S. persons to notify the Treasury Department about certain transactions involving sensitive technologies and products in sensitive sectors that may threaten U.S. national security. It also prohibits U.S. persons from engaging in certain prohibited transactions involving sensitive technologies and products in sensitive sectors that pose a particularly acute threat to U.S. national security.

The Final Rule, which took effect on Jan. 2, 2025, provides specific regulations to implement EO 14105. It also provides detailed comments regarding the intent and application of the specific provisions. In general, the Final Rule prohibits or requires notification for covered transactions undertaken by U.S. persons and/or their controlled foreign entities involving covered foreign persons unless the transactions are excepted transactions. These terms are defined below. 

U.S. Person

Under the Final Rule, U.S. persons must comply with the prohibition or notification requirements. The definition of a U.S. person is very broad and includes any (1) U.S. citizen, (2) lawful permanent resident, (3) entity organized under the laws of the U.S. or any of its jurisdictions, (4) any foreign branch of such an entity or (5) any person in the U.S. 

Controlled Foreign Entity

The restrictions under the Final Rule apply not only to U.S. persons but also to their controlled foreign entities, which are defined as “any entity incorporated in, or otherwise organized under the laws of, a country other than the U.S. of which a U.S. person is a parent.” 

A “parent” includes (1) a person who or which directly or indirectly holds more than 50% of the outstanding voting interest in an entity or the voting power of the board of an entity; (2) the general partner, managing member or equivalent of an entity; or (3) the investment advisor to any entity that is a pooled investment fund.

Covered Foreign Person

The definition of “covered foreign person” broadly includes (1) a person of a country of concern that engages in a covered activity, (2) a person that has significant financial ties with the person described in (1), or (3) a person of a country of concern that participates in a joint venture with a U.S. person that knows at the time of entrance into the joint venture that it will engage or plans to engage in a covered activity. These definitions are expanded upon as follows:

A person of a country of concern that engages in a covered activity. EO 14105 specifies in its annex that China is the country of concern at issue. A “person of a country of concern” includes (1) any individual who is a citizen or permanent resident of China but not the U.S.; (2) any entity with its principal place of business or headquarters in China or that is incorporated in or organized under the laws of China; (3) the China government, including its subdivision, political party, agency, representative and state-controlled/owned enterprises; (4) any entity controlled by the person(s) of a country of concern mentioned in (1), (2) or (3); or (5) any entity controlled by the person(s) of a country of concern mentioned in (4). 

The definition of “person of a country of concern” is very broad and captures not only Chinese individuals, entities and government but also foreign entities under their control and foreign entities’ own controlled subsidiaries. If they engage in covered activities described in the definition of “prohibited transaction” (Section 850.224) or “notifiable transaction” (Section 850.217) under the Final Rule, they will likely be considered covered foreign persons under this prong.

A person that has significant financial ties with the person under the first prong. This second prong targets a person that (1) has an ownership or management connection with the covered foreign person under the first prong and (2) attributes more than 50% of its revenue, net income, capital expenditure or operating expenses to the covered foreign person on an annual basis. If the financial metrics are attributable to more than one covered foreign person under the first prong, the aggregate calculations across the covered foreign persons should be subject to a de minimis amount of $50,000 for each covered foreign person.

This second prong further expands the scope of a covered foreign person by including any entity that has significant financial ties with a covered foreign person under the first prong regardless of its location and business activities.

A person of a country of concern that participates in a joint venture with a U.S. person. This third prong targets a person of a country of concern that establishes with a U.S. person a joint venture, wherever located, which the U.S. person knows will engage or plans to engage in a covered activity. This means that any covered transactions between a U.S. person and a covered foreign person under this prong is likely to be subject to the Final Rule. 

Covered and Excepted Transactions

Covered transactions include the following types: (1) acquisition of an equity interest or contingent equity interest in a covered foreign person; (2) provision of debt financing to a covered foreign person that affords the lender rights that are characteristic of an equity investment; (3) conversion of a contingent equity interest acquired on or after Jan. 2, 2025, into an equity interest in a covered foreign person; (4) acquisition, leasing or other development of assets in a country of concern that the U.S. person knows will or plans to result in the establishment of a covered foreign person or the engagement of an existing person of a country of concern in a covered activity; (5) entrance into a joint venture with a person of a country of concern where the joint venture will or plans to engage in a covered activity; and (6) acquisition of a limited partner interest in a non-U.S. person pooled investment fund that invests in a covered foreign person.

Each of the above transaction types includes a requirement for what a U.S. person “knows” for a transaction to be a covered transaction. Knowledge not only includes actual knowledge but can also include an awareness of a high probability or reason to know of a fact’s existence. The Final Rule requires a U.S. person to conduct a reasonable and diligent inquiry by the time of a given transaction.

If a U.S. person acquires actual knowledge after the completion date of a transaction that the transaction would have been a covered transaction (whether prohibited or notifiable) had the U.S. person possessed such knowledge at the time of the transaction, the Final Rule requires the U.S. person to submit a notification pursuant to Section 850.404 no later than 30 calendar days following the acquisition of the knowledge.

Certain transactions are carved out from the above-mentioned covered transactions, including those involving (1) an investment made by a U.S. person in publicly traded securities, securities issued by investment/business development companies, a pooled investment fund as a limited partner or derivatives; (2) buyouts of the equity of persons of a country of concern in a covered foreign person; (3) intracompany transactions; (4) fulfillment of binding capital commitments made prior to Jan. 2, 2025; (5) certain syndicated debt financings; and (6) transactions involving certain excepted countries. 

Requirements for Prohibited and Notifiable Transactions

Under the Final Rule, a covered transaction is either prohibited or notifiable, depending on the specific covered activity undertaken by the covered foreign person involved in the transaction. If a covered foreign person engages in a prohibited activity, the covered transaction between a U.S. person and the covered foreign person will be a prohibited transaction. Section 850.224 of the Final Rule details the prohibited activities in the three sensitive sectors identified. 

Neither a U.S. person nor its controlled foreign entity is allowed to engage in a prohibited transaction unless a national interest exemption for that transaction has been granted under Section 850.502 of the Final Rule. A U.S. person is responsible for taking all reasonable steps to prohibit and prevent its controlled foreign entity from undertaking any prohibited transactions. Section 850.302(b) lists the factors to be considered by the Treasury Department regarding “all reasonable steps.” 

In addition, the Final Rule does not allow a U.S. person to knowingly direct a transaction by a non-U.S. person that the U.S. person knows at the time of the transaction would be a prohibited transaction if engaged in by a U.S. person. A U.S. person “knowingly directs” a transaction when the U.S. person (1) has authority to make or substantially participate in decisions on behalf of a non-U.S. person and (2) exercises that authority. This authority exists when a U.S. person is an officer or director of, or otherwise possesses executive responsibilities for, a non-U.S. person. If a U.S. person with this authority recuses itself from the activities specified under Section 850.303(b) of the Final Rule, however, the U.S. person will not be considered to have exercised its authority.

If a covered foreign person engages in a notifiable activity, the covered transaction between a U.S. person and the covered foreign person will be a notifiable transaction. Section 850.217 of the Final Rule lists the notifiable activities in the semiconductors, microelectronics and artificial intelligence sectors. With respect to a notifiable transaction either undertaken by a U.S. person or its controlled foreign entity, the U.S. person is required to notify the Treasury Department in accordance with Section 850.404. The content of the notification should comply with Section 850.405(b).

Penalties for Violations

Any violations are subject to significant penalties under the Final Rule, including civil or criminal penalties and/or a divestment order. 

According to the Final Rule, the maximum civil penalty is the greater of (1) $368,136 (subject to regular adjustment for inflation) or (2) twice the amount of the transaction that is the basis of the violation. Any willful violation could result in a criminal penalty of up to $1 million and/or imprisonment of up to 20 years. The Treasury secretary may also take any action to nullify, void or otherwise compel the divestment of any prohibited transaction entered into after the effective date of the Final Rule. 

The Final Rule also makes it possible for a U.S. person potentially in violation of the Final Rule to submit a voluntary self-disclosure in the form of a written notice describing the conduct that may constitute a violation and each of the persons involved.