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Companies Facing Uncertainty, Due Diligence Questions as US Crafts Outbound Investment Rules

Dealmakers are hoping for more certainty when the Treasury Department finalizes regulations for its August executive order on outbound investment restrictions, which may force companies to make difficult investment decisions without assurances that their deals won’t be later unwound.

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The order will eventually lead to new restrictions for U.S. investments in China’s quantum information technology, artificial intelligence and semiconductor industries (see 2308090066). Although some observers thought Treasury was considering a regime that would act as a mirror opposite to its Committee on Foreign Investment in the U.S. -- which reviews investments for national security risks on a case-by-case basis -- the agency is instead considering full prohibitions on investments in those three technology sectors along with a set of separate notification requirements.

David Crosby, a CFIUS lawyer with Nixon Peabody, said he views the restrictions more like an export control regime that sets strict prohibitions on certain activities involving China. Crosby, who has worked as an engineer and official in the U.S. Patent and Trademark Office, said he believes that approach is a “mistake,” pointing to the considerable uncertainty it will cause investors who may be unsure if their deal will be captured by the new restrictions but who may have no option to seek safe harbor.

“As an engineer, I can evaluate something and say it fits into one of these categories on the Commerce Control List,” he said in a recent interview. “For the outbound investment rules, you're sort of living or dying on [Treasury’s] decision, and it becomes a risk-based analysis. There's no way for you to get certainty.”

He said clients before CFIUS “want certainty that the transaction is not going to be unwound,” and they can often gain clarity through a filing with the committee or through other means. “On the outbound side, we have the same kinds of problems, but there's no clarity,” Crosby said. “There's no way for me to say, ‘OK, this transaction is a risk.’ Can I file a notice with the Treasury Department to say, ‘Am I OK here?’”

He added that investors would be “happy” to make those regulatory filings on the outbound side. “I think investors are used to that at this point.”

Without the certainty of a filing, Crosby suggested companies may hesitate to follow through with investments in China out of fear Treasury may force them to unwind the deal. He pointed to a situation in which a U.S. company makes a seemingly authorized investment in a Chinese company, but soon after the Chinese firm decides to start developing technologies that are covered under the U.S. executive order.

“Are they going to force you to unwind the transaction now because this Chinese company is now developing quantum, crypto or some advanced semiconductor technology that they didn't have before?” Crosby said. “I would expect to see a lot of questions, a lot of comments about this.”

The Biden administration has said it plans to deploy experts to give guidance to companies about their potential investments, but it also said the parties to the transaction will ultimately be responsible for determining whether the deal is prohibited.

Larry Ward, a CFIUS lawyer with Dorsey & Whitney, said his firm has multiple clients “following” the outbound investment restrictions “closely.” He said investments that may fall under the scope of Treasury’s definition for AI may present the most compliance challenges.

“AI, that has a pretty expansive catch to it,” Ward said. “It’s the one that's certainly bigger and could certainly pick up more companies than you would ordinarily think of as traditional tech companies.”

Regardless of which Chinese industry a U.S. investor is contemplating, much of the due diligence practices should remain the same, said David Lynch, global head of analytical solutions for Sayari, a risk intelligence firm. He said firms should be able to rely on some of the same practices they use to analyze potential CFIUS-related ownership risks.

“Even though you're looking in the opposite direction, there is a ton of crossover from CFIUS,” Lynch said. “There's a lot that can be done in just simply mapping ownership structures and mapping investment flows.”

Dorsey made similar points, adding that although Treasury has yet to settle on what would qualify as a covered transaction, if that definition is similar to the one used by CFIUS,“then I think the due diligence practices would largely be similar." But if Treasury takes "a more expansive definition of covered transaction,” then “potentially the diligence exercise that would be necessary and the types of deals where the diligence would be necessary might have to expand.”

After the outbound rules take effect, Lynch said U.S. businesses should be screening potential investment targets in China for any connections to Chinese military-civil fusion investment funds and whether they’re located in a military-civil fusion innovation zone, which he described as Chinese “business parks” that are “dedicated to a specific innovation.”

He also stressed the importance of screening against various government watch lists. While Lynch said that “might sound easy,” the “biggest challenge” Sayari hears from its customers stems from differences in the English trade name of a company and the legal registered name of that entity in China. Some watch lists might not include the U.S. trade name.

“Even if you think you're doing or conducting good diligence, you might inadvertently be doing business with something that is on a watch list, just because we've got a different naming convention.”

Lynch also said screening against a list of bad actors isn’t “even half the battle,” adding there may be “hundreds or thousands of subsidiaries that are beneficially owned by those watch-listed companies.”

“Frankly, there are more subsidiaries of these companies than there are listed entities,” he said. “That creates a really potentially dangerous operating environment.”

Crosby said Treasury risks creating an even more fraught business environment for American investors if it doesn't introduce a mechanism to block certain outbound investments before they are completed.

“I think that's going to be the challenge for them,” Crosby said. “And I don't envy the person that's going to be making that decision, but I think that's a better way to protect national security than what they're proposing.”