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Investors Spooked by Notification Requirement in Outbound Investment Rules, Law Firm Says

The new U.S. outbound investment regulations appear so far to be blunting American investments in sensitive Chinese technology sectors, even for investments that only require a notification to the Treasury Department, law firm Sidley Austin said in a client alert this month.

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The rules, which took effect in January, set new prohibitions and notification requirements for U.S. outbound investments in China’s semiconductor, artificial intelligence and quantum sectors (see 2410280043). Even though the rules allow investors to make certain deals in China if they inform Treasury, Sidley said it has noticed “many investors are nevertheless reluctant to undertake” those notifiable transactions.

Some investors may not want to “undertake the administrative burden” of notifying Treasury, while others may not want to “attract the attention of the U.S. government as an investor in Chinese technology due to real or imagined fear of political, reputational, or regulatory consequences,” the firm said. Others want to avoid possible questions from the government altogether, or “they might feel that they are putting themselves at risk if Treasury ultimately decides that the investment was actually in the prohibited category, which might result in an enforcement action.”

Sidley said investors may grow more comfortable with the notification requirement in the future, “but, for now, it appears that many investors are holding back from making notifiable transactions.”

The firm also said portions of the regulations remain unclear, including its definition of “covered activities.” That term refers to activities that a Chinese-affiliated entity might take with respect to an investment that may make the deal notifiable or prohibited. But Sidley said the “distinction between covered activities that fall in the notifiable or prohibited categories is not always clear.”

It specifically pointed to how the regulations describe AI systems. Investments related to Chinese AI systems are prohibited if the system will be "exclusively used for" mass surveillance or other end-uses. Meanwhile, the notifiable category for AI systems covers certain activities that are “not described in the prohibited category of AI systems" and that are "designed to be used for … mass-surveillance,” the law firm noted.

“Treasury has tried to explain the distinction, but it nonetheless remains difficult to understand and apply in practice,” the firm said. Treasury has said in FAQs that the rule is intended to cover investments in companies that design AI systems for nongovernment mass surveillance, Sidley said, but it’s still not known what nongovernment mass surveillance might capture.

“Where the line should be drawn is not clear," it said.

The firm also said it remains unclear how much due diligence around a potential investment is enough to satisfy Treasury, an issue raised by many lawyers and investors as the agency was crafting the regulations in 2023 (see 2310050035). Sidley said companies are “moving toward standard diligence questionnaires that ask targets to indicate whether they engage in covered activities, but in practice those questionnaires should be viewed as the starting point, not the ending point.”

Sidley noted that Treasury already has begun to reach out to investors with questions about specific transactions, although no enforcement outcomes have so far been disclosed. In some cases, Sidley said, there have been “clear, public disagreements” about whether the rules apply to a particular investment, and investors have argued that they received advice from law firms that told them their deals weren't covered by the rules.

“Whatever the law firms may conclude, the ultimate decision will rest with Treasury,” it said. “Perhaps through this process, Treasury will clarify aspects of the [rules] that remain difficult to understand and implement.” Sidley said it expects Treasury to issue more FAQs, “but it would be helpful if the FAQs were issued more frequently.”

A Treasury spokesperson didn't respond to a request for comment.