Impact of U.S. Outbound Investment Rules on Loan Transactions in China and Practical Considerations

The final rule on the new U.S. outbound investment security program (Outbound Investment Rules), implemented by the U.S. Department of the Treasury (Treasury) and effective on January 2, 2025, represents a significant regulatory framework aimed at prohibiting, or requiring notification to Treasury of, investments directed by, or undertaken by subsidiaries of U.S. persons in Chinese-affiliated companies that design, develop, or manufacture certain sensitive technologies deemed important to U.S. national security. Understanding the implications of the Outbound Investment Rules will be essential for both borrowers and lenders operating within these jurisdictions.

This article summarizes the key provisions of the Outbound Investment Rules and examines their potential impact on loan transactions and debt financings, alongside practical considerations for both borrowers and lenders. Sidley’s recent Update on details and application of the final rule is available here.

While this article discusses the Outbound Investment Rules currently in force, it is possible that these rules will be revised in the coming months. On February 21, 2025, President Donald Trump issued his America First Investment Policy, in which he ordered a review to consider new or expanded restrictions on outbound investment in the PRC with respect to sectors and categories of investment not covered by the current rules. It is important to continue to monitor these developments and updated compliance policies accordingly.

Overview of the Outbound Investment Rules

The Outbound Investment Rules prohibit or require notification of “covered transactions” undertaken or directed by U.S. persons or their subsidiaries involving “covered foreign persons” (CFPs). A CFP includes entities or individuals with ties to China (including Hong Kong and Macau) (“countries of concern”) engaged in “covered activities” related to semiconductors and microelectronics, artificial intelligence, and quantum computing. The primary goal of the Outbound Investment Rules is to prevent U.S. outbound investments from indirectly supporting foreign military, cybersecurity, and surveillance advancements in countries of concern.

CFPs may be located in China; located outside China when they are owned or controlled by Chinese entities or persons; or may even be owned by non-Chinese investors if they derive 50% of the revenue or income from, or spend 50% of their capital expenditure or operating expenses on, CFPs.

Whether a transaction is fully prohibited or only notifiable depends on the specific type of technology involved.

U.S. persons

The Outbound Investment Rules apply to all U.S. citizens, lawful permanent residents, entities organized under the laws of the United States or any jurisdiction within the United States, including any foreign branch of any such entity, or any person located in the United States. The new Outbound Investment Rules even cover non-U.S. citizens when traveling through the United States.

The rules could apply to lending activities undertaken by non-U.S. entities, including entities from Hong Kong. For example:

• A U.S. citizen sits on a decision-making body of a Hong Kong company. Under the Outbound Investment Rules, the U.S. citizen may not “knowingly direct” the Hong Kong company to undertake a transaction that would be a prohibited transaction if it were undertaken by a U.S. person. This is true even if the U.S. person is only one of many persons sitting on such body and directing or approving the transaction.
• A Hong Kong subsidiary of a U.S. parent is not a U.S. person. However, under the Outbound Investment Rules, the U.S. parent entity must take “all reasonable steps” to ensure that the Hong Kong subsidiary does not undertake a transaction that would be a prohibited transaction if it were undertaken by a U.S. person and must notify transactions by the Hong Kong subsidiary if the transactions would have been notifiable if they were undertaken by a U.S. person.
• Similarly, a U.S. investment manager of a Hong Kong fund must take “all reasonable steps” to ensure that the Hong Kong subsidiary does not undertake a transaction that would be a prohibited transaction if it were undertaken by a U.S. person and must notify transactions by the subsidiary if the transactions would have been notifiable if they were undertaken by a U.S. person.
• A Hong Kong branch of a U.S. company is treated as a “U.S. person” and so must not undertake a transaction that would be prohibited under the Outbound Investment Rules and must notify transactions that would be subject to the notification requirement.
• A non-U.S. citizen who is traveling within the United States will be considered a “U.S. person” for purposes of the Outbound Investment Rules for the time that they are traveling or located in the United States. The person cannot undertake a prohibited transaction while in the United States and must notify any transactions that they undertake while in the United States that are within the notifiable category.

Coverage of debt financing

Loans or debt instruments are generally not covered except in the following circumstances:

1. Loans or debt instruments with characteristics typical of an equity investment: A loan or debt instrument extended to a CFP may be covered if it affords the lender an interest in profits of the CFP, the right to appoint members of the board of directors (or equivalent) of the CFP, or other comparable financial or governance rights characteristic of an equity investment but not typical of a loan. Loans structured with royalty or revenue-sharing terms may be interpreted as equity-like interests, particularly if they grant rights to profit participation.
2. Convertible debt: Loans or debt instruments convertible into equity of a CFP are classified as “contingent equity interests” and qualify as covered transactions, although the passive holding of publicly traded securities is exempt. Acquiring publicly traded securities will not be considered passive if the investor is afforded rights other than standard minority shareholder protections. Identifying rights that go beyond standard minority shareholder protections can be difficult. For example, Treasury noted that in some jurisdictions, including China, rules for listed companies give shareholders owning a very low percentage of shares the right to put forward for a shareholder vote a proposal to nominate directors. Treasury has indicated that this right, which is simply part of the background rules and not necessarily a negotiated right, is not a standard minority shareholder protection and so would take the investment out of the excepted category.
3. Secured loans: While secured loans initially do not fall under the classification of covered transactions, a foreclosure that results in possession of the pledged equity may trigger relevant compliance obligations if the lender knew or had reason to know at the time the loan was extended that the borrower was a CFP. (Foreclosure is not within the scope of the Outbound Investment Rules if the collateral was pledged as part of a transaction that was completed before January 2, 2025.)

There is an exception to the Outbound Investment Rules for lenders who acquire a voting interest in a CFP upon the borrower's default where the loan was made by a syndicate of banks and where the U.S. person lender in the syndicate (i) cannot on its own initiate any action vis-à-vis the debtor and (ii) is not the syndication agent.

Impact and practical considerations for lenders

For many lenders, potentially including those operating in China (including Hong Kong and Macau), the Outbound Investment Rules necessitate a reevaluation of compliance procedures and risk management. Key considerations include the following:

1. Assessing whether the Outbound Investment Rules apply: A lender would need to assess whether the Outbound Investment Rules would apply to it because it is a U.S. person or a U.S. parent of a non-U.S. subsidiary. U.S. citizens that sit on decision-making bodies of a non-U.S. lender must also seek to ensure their own compliance with the Outbound Investment Rules.
2. Updating loan documentation: As the regulatory landscape evolves, loan agreements may need to include new representations, warranties, and covenants designed to address compliance risks associated with extending loans or debt instruments to companies involved in sensitive sectors. Certain covenants and undertakings in the finance documentation may need to be included in order to safeguard against inadvertent violations of the Outbound Investment Rules. The Loan Syndications and Trading Association (LSTA), via a market advisory published on January 2, 2025, has suggested certain representations, covenants, and relevant definitions for lenders to consider when negotiating loan and security documents with potential investment targets. However, such template provisions may not be suited to particular transactions and should not be adopted without consulting with counsel. Indeed, in some cases, the LSTA provisions may be overbroad, and some borrowers have pushed back on them as being too wide ranging and onerous from a borrower’s perspective.
3. Due diligence compliance: Lenders subject to the Outbound Investment Rules are now required to conduct a “reasonable and diligent inquiry” to assess whether potential borrowers are or are likely to become CFPs. Key due diligence actions may include investigating the borrower’s ownership structures and affiliations with China, asking questions of the borrower to understand its business, incorporating contractual representations and warranties in loan agreements to confirm that the borrower is not a CFP or engaged in any covered activities, and reviewing publicly available information or information derived from commercial databases.
4. Monitoring framework and in-house compliance: Lenders subject to the Outbound Investment Rules may consider incorporating ongoing monitoring and reporting systems into loan documentation to track whether the borrower is or will become a CFP, allowing for early detection of potential issues and risk mitigation in a timely manner. To the extent applicable, lenders should also update their internal policies and staff training programs to align with the compliance requirements under the Outbound Investment Rules.
5. Segregation of investments: To minimize regulatory exposure, lenders subject to the Outbound Investment Rules may consider establishing separate funds or investment vehicles to segregate investments tied to CFPs or high-risk jurisdictions.

Practical considerations for borrowers in China (including Hong Kong and Macau)

By imposing stricter requirements and redefining compliance obligations, the Outbound Investment Rules are likely to reshape the financing landscape in China (including Hong Kong and Macau), including the availability of credit and structure of financing arrangements offered to potentially affected borrowers. Changes could include the following:

1. Stricter loan terms: The heightened due diligence obligations on lenders may lead to stricter loan terms and conditions. Potentially affected borrowers are likely to expect more rigorous covenants and financial reporting required from lenders to maintain visibility into the borrower’s operations and any potential ties to CFPs. Such conditions could include enhanced representations, covenants, or more frequent financial audits/delivery of compliance certificates.
2. Longer transaction timeline: The complexity introduced by the Outbound Investment Rules may lead to delays in the execution of loan transactions. The additional compliance checks and the need for consultations with legal and regulatory advisers can prolong the negotiation and closing processes, affecting borrowers’ access to timely financing.
3. Increased disclosure requirement: The Outbound Investment Rules require lenders subject to the Outbound Investment Rules to conduct a “reasonable and diligent inquiry” to assess whether a counterparty is engaged in covered activities. Potentially affected borrowers should be prepared for increased scrutiny by ensuring full transparency regarding their ownership structures, operational activities, and any affiliations with CFPs. Failure to comply may result in significant civil or criminal penalties on the lenders, including fines of up to US$377,700 (as adjusted annually for inflation) or twice the transaction value, forced divestment, and potential criminal liability.
4. Strategic transaction structuring: Borrowers may consider alternative financing structures that could minimize compliance risks, including exploring local financing options or structuring transactions to ensure compliance.

The U.S. Outbound Investment Rules represent a significant regulatory shift with major implications for loan transactions involving borrowers in China (including Hong Kong and Macau). Whether the Outbound Investment Rules may affect transaction pricing or borrower accessibility remains to be seen, but both borrowers and lenders should maintain open lines of communication to better position themselves to navigate the new compliance frameworks under the Outbound Investment Rules while continuing to pursue their investment objectives. They should seek legal advice accordingly.