“View, with Brocken Spectre, from top of cliff – geograph.org.uk – 1043735″ by Lairich Rig is licensed under CC BY-SA 2.0
Named after the highest peak in the German Harz Mountains, a Brocken spectre is an optical illusion caused by clouds or mist projecting an enlarged shadow. The ghostly figure in the image above may appear as tall as a mountain, but, alas, it was cast from a human-sized mortal, like you or me.
Similarly, the Biden Administration has issued a Final Rule that appears immense at first glance. Titled “Outbound Investment Security Program,” this rule weighs in at a whopping 297 pages and takes effect in less than two months. Robert Friedman and Paul Stimers of the 2,300-attorney law firm Holland & Knight have dispelled this illusion, however, and determined that the scope of the rule is actually quite narrow.
The rule is Inspired by Americans investing in Chinese advanced technology companies, as such investments often bring transfers of knowledge and other intangible benefits that help companies succeed. Certain advanced technologies should not enhance China’s military, intelligence, and cyber-enabled capabilities. The rule also focuses on the other elements that accompany financing that may accelerate successful technology development, such as the prestige, access, talent networks, and notoriety associated with having US investors.
The Good
When an Executive Order was issued in August 2023, the business community was appalled by its potential implications. Considering this initial concern, the final rule has turned out to be relatively limited in scope. It is not intended to capture a large number of transactions and is neither an export control regime nor an economic sanctions regime. Only three industries are targeted, and only certain transactions involving certain activities are applicable.
The rule is designed to limit unintended consequences for American investors. There is a range of excepted transactions and exemptions, such as certain corporate expansions, certain intracompany transactions, and certain kinds of pooled investments (such as limited partner investments) by US persons.
Although the rule might affect follow-on and incremental investments, it does not apply retroactively to investments that were made prior to the rule.
The Bad
Although the coverage is narrow, the definition of a covered foreign person involves all entities that are directly or indirectly owned at least 50% by a Chinese company. This means that it can apply everywhere in the world, including inside the United States. Included with China are Hong Kong and Macau.
Despite calls for the Treasury Department to name specific Chinese companies, the department declined to do so. Consequently, greater due diligence is required than could otherwise have been the case.
Although the Biden Administration is incentivizing allies to adopt analogous restrictions, the rule will initially give investors in allied countries an advantage in regard to investing in China. Allies will be encouraged to join the initiative instead of undermining it, but the US rule nonetheless takes effect first.
The Ugly
Although the actual rule is narrow, there are a set of “prohibited” transactions and a set of “notifiable” transactions that meet certain criteria and will require notifying the Treasury Department. Transactions involving artificial intelligence (AI), microelectronics, and semiconductors are more often notifiable. Quantum technologies have more stringent restrictions and more outright prohibitions. Extensive due diligence will be required for transaction parties to determine if a transaction qualifies for either category. The good news, therefore, is that few transactions will. The ugly news, however, is that compliance will be onerous whether or not they do. There is a need to understand the ownership of a company as well as the full extent of its activities.
The knowledge standard is particularly controversial. Parties have to understand the definition of a US person and the definition of a covered foreign person. A US person has knowledge if the US person possesses actual knowledge that a fact or circumstance exists or is substantially certain to occur, if the US person possesses an awareness of a high probability of a fact or circumstance’s existence or future occurrence, or if the US person could have possessed such information through a reasonable and diligent inquiry. Although the rule provides some guidance on factors that will be considered in assessing whether enough diligence has been performed, when in doubt, parties will have to dig deeper before dealing with other parties.
Conclusion
According to Mr. Friedman and Mr. Stimers, American investors have not verbally expressed concerns about this rule. Broader investment firms, however, are still trying to make sense of it. Fortunately, the Outbound Investment Security Program casts a shadow much larger than its actual regulatory scope.