Impact of reverse CFIUS on American limited partners

US-connected venture capital investors in China are being caught in the net of developing new restrictions.

As early as July 2023, a select committee of the US Congress sent letters to four venture capital funds requesting information on their investments in Chinese artificial intelligence (AI), semiconductor and quantum computing sectors.

In August 2023, America’s Biden administration issued its Executive Order on Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern – the reverse CFIUS executive order.

On the same day, the US Treasury released an advance notice of proposed rulemaking, which elaborated rules based on the reverse CFIUS executive order and sought public comment. The comment period has ended, and the Treasury is in the process of finalising rules based on the executive order and public feedback.

Once the final rules of the reverse CFIUS executive order are implemented, they will have a broader impact on US-dollar funds with Chinese backgrounds.

Key points

The reverse CFIUS executive order aims to regulate certain types of transactions between US “persons” and particular foreign entities by requiring the US side of these deals to provide information about the transactions or by prohibiting the transactions altogether. These are “notifiable and prohibited transactions”.

US persons include US citizens, lawful permanent residents, US entities and their foreign branches, and any person within the US. Under the executive order, the Treasury can also impose responsibilities on US persons for transactions involving foreign entities controlled by them or transactions involving non-US entities knowingly directed by them.

The scope of who is being regulated under the order is broad, especially as it also covers transactions involving certain non-US entities. In practice, even though funds established in the Cayman Islands or the British Virgin Islands may not be US persons, if they are managed by US persons as general partners or if their transactions are conducted under the direction of US persons serving as executives, they will still be subject to the order.

On the other side of transactions are “covered foreign persons”. This refers to individuals or entities engaged in “identified activities” in countries of concern. Currently, countries of concern include China (including Hong Kong and Macau), and the identified activities include semiconductors and microelectronics, quantum information technologies and artificial intelligence.

Depending on the features of certain activities, transactions are categorised as notifiable transactions or prohibited transactions. For the specific scope of covered foreign persons and identified activities, as well as the information declaration requirements, please refer to the US Treasury’s advance notice. Also note there may be adjustments in the final rules, when they emerge.

Covered transactions encompass various interactions, including direct or indirect equity acquisitions, convertible bond investments, greenfield investments, and joint ventures, without any limitations on the transaction scale.

However, the US Treasury is also considering categorising certain low-risk transactions as excepted transactions that might avoid the requirements of the order. These possibilities include investments in publicly traded securities, index funds, mutual funds, exchange-traded funds, or similar products (including related derivatives) offered by an investment company or private investment fund.

Fund investments might be considered excepted transactions if:

• The investor contributes only as a limited partner, does not participate in management decisions, and does not influence or participate in fund or investee decisions or operations; or
• The investment amount does not exceed the set limits.

However, if the investor is granted rights as a member/observer of the board of directors of the investee, or has veto powers or other rights beyond what can reasonably be regarded as standard minority shareholder protections, the transaction will not qualify as an excepted transaction.

Limited partners

For investment funds, the order will have an impact on US persons as LPs. Specifically, for special funds that invest in specific covered foreign persons, if US persons have subjective knowledge of such investment activities, their investments in the funds are very likely to be subject to the order. For them, this will result in declaration obligations or potential termination of transactions. For blind pool funds that involve investments in identified activities in China, US LPs should ensure they continue to meet the conditions for excepted transactions to avoid triggering the order’s regulations.

On the enactment of the order’s final rules, strict compliance requirements will be imposed on US-dollar funds accepting US LPs. These parties should enhance their compliance awareness.

In view of the impacts, US-dollar funds with Chinese backgrounds should consider the following:

• Carefully limit US LPs’ roles in investment decision-making or advisory committees to avoid granting positions that could influence fund operations;
• Control the investment amounts from US LPs, ensuring they do not exceed the limits set by the Treasury Secretary and avoiding situations where US LPs hold a significant portion of the fund;
• Pre-emptively negotiate with US LPs regarding their right to exit the fund or exclude investments due to compliance issues; and
• If declaration is required, consult legal counsel to assess potential risks to data compliance and national security under Chinese law before providing information for US LPs or US regulatory bodies.

Hu Yao is a partner at Han Kun Law Offices. She can be contacted by phone at +86 138 1172 2960 and by email at ally.hu@hankunlaw.com