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Potential Impact of the Outbound Investment Rule which restrict US outbound investments in China, Hong Kong and Macau on non-US Funds

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Co-authored by Sarah Lau of Deacons, David Plotinsky and Eli Rymland-Kelly  of Morgan, Lewis & Bockius LLP

On 28 October 2024, the U.S. Treasury Department issued the Final Outbound, Investment Rule (Outbound Investment Rule or Rule) to implement Executive Order 14105 on “Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern”. The Outbound Investment Rule took effect from 2 January 2025. We discuss below some of the potential impacts of the Rule on non-U.S. Funds with U.S. fund managers and/or U.S. limited partners.

The Outbound Investment Rule would restrict investments by U.S. persons in specified industries deemed to pose a threat to US national security in “countries of concern” which currently cover China, including Hong Kong and Macau. For this purpose, a U.S. person would include a U.S. citizen, a U.S. lawful permanent resident (i.e. “green card holder), an entity organized under the laws of the U.S. (including any foreign branches), subsidiaries of U.S. companies and any person in the U.S., irrespective of nationality. In other words, this would include non-U.S. nationals that are in the United States for any reason, including visiting executives. U.S. persons are also obligated to take all reasonable steps to ensure its “controlled foreign entity” complies with the Outbound Investment Rule and this, inter alia, captures any entity in which a U.S. person:

  • directly or indirectly holds more than 50% of the outstanding voting interests or voting powers of the board;
  • is the general partner, managing member or equivalent of the entity; or
  • (in respect of a pooled investment fund) is the investment adviser.

At a high level, unless any exemptions apply, the Outbound Investment Rule would prohibit U.S. persons from engaging in, or require such U.S. persons to notify the Treasury of “covered transactions” involving a “covered foreign person” who is engaged in “covered activities”.

Covered transactions” refer to when a U.S. person is directly or indirectly involved in the:

  • acquisition of an equity interest or contingent equity interest or convertible debt;
  • debt financing;
  • conversion of a contingent equity interest (including convertible debt);
  • greenfield or brownfield investments
  • entrance into a joint venture; and
  • investment as a limited partner or equivalent in a non-U.S. person pooled investment fund.

Covered foreign persons” include:

  • a person of a country of concern that engages in a covered activity;
  • persons with a particular relationship (including a board seat, voting interest, equity interest, or control rights) with a person of a country of concern engaged in a covered activity, with more than 50% of net revenue, net income, capital expenditure, or operating interest stemming from the person of a country of concern engaged in a covered activity; and
  • a person of a country of concern involved in a joint venture that engages in a covered activity:

A “person of a country of concern” includes:

  • an individual who is a citizen or permanent resident of a country of concern (and not a U.S. citizen or permanent resident of the United States);
  • an entity organized under the laws of a country of concern, or headquartered in, incorporated in, or with a principal place of business in a country of concern;
  • the government of a country of concern; or
  • an entity that is directly or indirectly owned 50 percent or more by any persons in any of the aforementioned categories.

Currently, a “country of concern” is defined to include China and Hong Kong and Macau.

Covered activities” include certain specified activities related to artificial intelligence systems, quantum computing and semiconductors and microelectronics and the transaction may be classified as prohibited or notifiable based on the criteria of the Outbound Investment Rule.

Potential Impact on non-U.S. Funds managed by U.S. Persons

Under the current rules, U.S. fund managers or advisers managing or advising on non-U.S. domiciled investment funds would be captured under the Outbound Investment Rule and will be subject to its compliance requirements and could potentially face liabilities for the activities of those investment funds. In this instance, such U.S. fund mangers or advisers, as a controlled foreign entity of a U.S. person would need to take all reasonable steps to prevent the investment fund from entered into transactions prohibited under the Outbound Investment Rule or file notifications for any transactions classified as a notifiable transaction if engaged by a U.S. person.

Potential Impact on U.S. Limited Partners

From the investor perspective, certain exemptions under the Outbound Investment Rule would apply. A U.S. limited partner’s passive investment in a non-U.S. fund will be an excepted transaction provided that the limited partner’s committed capital is not more than US$2,000,000 on an aggregate basis or the limited partner secures a binding contractual assurance at the time of the capital commitment that their contributions will not be used to engaged in transactions that would be classified as prohibited or notifiable under the Outbound Investment Rule if engaged in by a U.S. person.

The Outbound Investment Rule also provides for an exception where a transaction is made after 2 January 2025 pursuant to a binding, uncalled capital commitment entered into before such date.

Aside from the exemptions provided under the current regime, the Outbound Investment Rule would mean that U.S. limited partners would need to ensure that it conducts reasonable and sufficient due diligence where it intends to invest in non-U.S. investment funds to determine if such investment fund’s activities may be caught under the Outbound Investment Rule.

In light of the introduction of the Outbound Investment Rule, it may be time for fund managers, investment advisers and limited partners affected to consider whether there are sufficient mechanisms under their existing fund structures to deal with the segregation of potential affected investments (including potentially at the general partnership level) and to consider the necessity of entering into side letters.

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