• Could be broadened to capture more sensitive technologies
• AI mandate broad and needs further definition, lawyer says
• Impact on overseas companies and GPs requires increased due diligence
• Office in place inside the US Treasury Department, could be swiftly enforced

Dealmakers are already gearing up for a proposed new rule that will require them to notify the US government about outbound investment into sensitive sectors in China and which may restrict M&A if there is a US individual involved in the transaction.

Though the draft rules could come into force as soon as the end of this year, questions are emerging on Capitol Hill over whether the new regime on US outbound M&A could be expanded from its currently narrow scope or even rewritten entirely under a Trump administration.

The draft rule follows President Joe Biden’s August 2023 executive order that instructs the Treasury Department to set up a program to prohibit or require notification of outbound investments in three specific areas: semiconductors and microelectronics, quantum information technologies and artificial intelligence into China, Hong Kong and Macau.

Freshfields Bruckhaus Deringer partner and head of CFIUS practice Aimen Mir explained that “the executive order reflects the government’s thinking that if China is not permitted to acquire certain sensitive technological capabilities by buying them from the United States, US persons should not be facilitating the indigenous development of those technological capabilities in China. It seems intuitive.”

The rule came about due to growing tensions over national security, particularly towards sectors linked to military, intelligence, surveillance, or cyber-enabled capabilities. It is a significant change in the US government’s involvement in capital flow towards these investments. Freshfields senior advisor Brian Reissaus said: “The policy basis for the Outbound Investment Program makes more sense when put in the context of technologies restricted from being exported to China. If you can’t export a technology, why can you invest in a company in China that is seeking to develop that same technology.”

The effect of the new rule will initially be limited in impact because of the three areas it’s restricted to, said Michelle Weinbaum, a lawyer in the National Security and International Trade practice in the Washington, DC, office of law firm Gibson, Dunn & Crutcher.

Some members of the industry are concerned that the application to artificial intelligence is overly broad and have suggested that Treasury narrow the application with the intended end use of the technology in mind, she added.

Regardless of the outcome of the forthcoming election, national security is expected to remain a priority, so the lawyers felt that this rule would not only come into force, but could be reshaped and evolved.

Freshfields’ Reissaus said: “The question is more around whether this would be expanded. Would they add additional sectors or technologies? Some policymakers may attempt to double or triple down on this,” he said.

Several lawyers focused on national security regulatory review of deals involving inbound investment into the US said their practices are already actively advising clients on the outbound regime, and they expected overlap between the outbound program and deals notified to the Committee on Foreign Investment in the United States (CFIUS), which is also housed inside the Treasury Department.

“There’s a lot of discussion right now in Congress around a potential revamp of the outbound program,” said Mark Skerry, a partner in the National Security Regulatory practice at Simpson Thacher.

“It’s certainly possible that we see it rewritten as part of a legislative package in the near future,” he added.

Technologies that Congressional proposals have suggested adding to the outbound program include satellite-based communications and hypersonics.

The US government likely wanted to start out small and focus on the most sensitive sectors, said Skerry, but could certainly expand as the program unfolds and the impact of it can be better assessed.

“Once it gets a handle of how things are going with these few sectors, the US government may evaluate whether it should expand the program to cover more countries, more sectors, and whether it should expand the program to encompass additional types of transactions,” he said.

Weinbaum also said she expected the rule to be expanded, but it wouldn’t happen overnight. The first step would likely be additional expansions on notice requirements, with prohibitions or restrictions on transactions following later on, she said.

“I think the initial step will be to use notice requirements for folks working on the policy side of outbound investment, to get more understanding of the industry and the transactions before they decide and design what the extension would be,” she said.

Brooks Allen, a partner and lead coordinator of the International Trade practice at Skadden Arps Slate Meagher & Flom, said he didn’t expect major changes to the rule, although he does expect there to be some modest refinement of the sectors in the final rule – primarily with respect to the definition of AI systems.

“I would not expect those sectors to expand significantly in the near term. This is a big enough change that I think that the Treasury is going to be cautious about expanding the scope any time soon,” Allen said.

“The technology limitations are helpful, but they are also not so limiting that they just make this rule irrelevant for most everyone,” he added.

Weinbaum added that she didn’t think the rule would have a material effect on deal flow, “but it is another area for M&A diligence.” Global companies in particular will need to consider their connections to and how much their supply chains touch China, she said.

Impact overseas

The new US outbound regime is being watched closely around the world, Skerry said, including by some European countries that may be considering the value of implementing a similar program of their own.

A more pressing point, however, is how the rule will be applied to companies and private equity outside of the US. The new rules could stretch to foreign companies or private equity general partners who have a US limited partner. Mir said: “It’s not only direct investments into China that can be captured. Investment in a company outside of China could be restricted if the company is majority owned by a Chinese entity or if the company’s revenues or expenditures are predominantly from China.”

Under the draft rules that have been consulted on, the level of LP investment that would draw scrutiny has not yet been finalized. The draft rule suggests either a USD 1m dollar investment or 50% of assets under management.

Non-US-based private equity firms will be uniquely affected by the rule, said Weinbaum. “It impacts them in a different way … Especially for a non-US private equity firm, they need to think about how their US LPs are going to subject their investments to the outbound investment rule,” she said.

If the final outbound investment rules cap the LP exception at USD 1m versus at 50% of a fund’s assets, many more funds will be impacted, she added.

Reissaus said: “Most people said that the AUM option is preferable in the comments. The USD 1m option would capture most passive limited partner investment, undermining the intent of the exemption.”

Hogan Lovells partner Brian Curran pointed out that the outbound investment regime’s new draft rules are broad enough to capture, for example, a US investment into a UK company or fund that derives 50% of its revenues from a Chinese AI company.

He said the outbound investment regime is unlikely to impact a US firm’s direct loans to UK or other non-U.S. companies, unless the loan can be converted into equity or grants the U.S. firm certain governance rights in the borrower.

“Under the outbound investment regime’s draft rule, an American manager of a UK fund may not knowingly direct a transaction that she knows would be a prohibited transaction if engaged in by a U.S. person, but a UK fund can set up internal recusal rules to carve out the American manager from investment decisions that would run afoul of the rules,” he added.

Gearing up for enforcement

Skadden partner Allen has already been planning for the new rule with clients, he said. Some areas of consideration include how it could apply to entities that may have overseas affiliates or subsidiaries – while there is an intracompany exception to the rule, he said, clients want to understand how far that goes. Future investments or joint ventures that might have been planned are also being carefully considered, he added.

Mir said: “The most significant impact will be on direct US investment into China. They wanted it to be fairly tailored, covering a limited set of technologies, but there are some areas of ambiguity in the proposed rule. For those areas within the scope of the rule, it will significantly limit the ability of U.S. persons to invest in those areas in China.”

Given the advanced stage of the process, with consultations on the rule already complete and an office already established in the Treasury, the rule could be swiftly brought into place. “They have the resources and they are aiming for the year end,” Reissaus said.

Congress had debated different proposals on an outbound investment screening, including a bill giving CFIUS broad powers to scrutinize investments into countries of concern. Biden’s executive order instead calls on the Treasury to establish the program, giving it the power to block transactions, albeit in a more narrow pool of sectors.

Reissaus said the Outbound and CFIUS regimes are fundamentally different, which has raised questions from some on the Hill about whether the Treasury office responsible for CFIUS is the right organization to be doing this. Due to the nature of the transactions the Outbound regime seeks to cover, it is not reasonable for transactions to be assessed on a case-by-case perspective, due to the extensive resources and information that would be required to assess transactions on their individual merits, he said.