Awareness in Foreclosure: Impacts of the Outbound Investment Regulations on Business Development Company Revolvers
The US Department of the Treasury (“Treasury”) promulgated the Outbound Investment Regulations1 (the “OIR”) on October 28, 2024, and the OIR took full effect on January 2, 2025 (the “effective date”). Through the OIR, Treasury implemented restrictions on US persons’ investments qualifying as “covered transactions,” which involve persons of countries of concern (and certain parents and subsidiaries thereof) that conduct activities in certain sensitive technologies and products–specifically, semiconductors and microelectronics, quantum information technologies, and certain artificial intelligence systems. While these restrictions may impact a variety of domestic and international businesses and financings, they present particular challenges in the context of a credit facility (“BDC credit facility”) provided to a Borrower that is a business development company (“BDC”), because the OIR can impact a collateral agent’s ability and right to foreclose on certain assets pledged to secure such facilities.
I. Outbound Investment Regulations Background
The OIR is chiefly comprised of two categories of restricted transactions: notifiable transactions and prohibited transactions. If a “US person” knowingly engages in a “covered transaction” with a “covered foreign person” counterparty, the covered transaction may be considered either a “notifiable transaction” or a “prohibited transaction” (each as defined under the OIR). In summary, a US person may not, directly or indirectly, knowingly engage in or direct a prohibited transaction and must take all reasonable steps to prevent and prohibit “controlled foreign entities” from engaging in transactions that would be prohibited transactions if the US person had engaged in such transaction. Further, a US person that knowingly engages in, or has a controlled foreign entity that engages in, a notifiable transaction must file a notification with Treasury within 30 days of the transaction.2
Two terms defined in the OIR are of particular relevance in the application of the OIR to BDC credit facilities: “covered transaction” and “knowledge.” The OIR defines “covered transaction” to mean, in part, (a) a US person’s direct or indirect acquisition of an equity interest or contingent equity interest in a person that the US person knows at the time of acquisition is a covered foreign person; and (b) the provision of a loan or other debt financing arrangement that contains equity-like characteristics to a person that the US person knows at the time of provision is a covered foreign person.3 Although it is clear that providing financing via a BDC credit facility is not, in and of itself, a covered transaction (provided the financing does not involve equity-like characteristics), a note (“Note 2”) to the definition of “covered transaction” also specifies that the foreclosure on, and taking possession of, pledged equity is an acquisition of an equity interest and that, therefore, the foreclosure can be a covered transaction unless (i) the debtholder did not know at the time of issuing or acquiring the debt that the pledged equity was in a covered foreign person or (ii) the covered foreign person pledged the equity prior to January 2, 2025.
While the OIR’s restrictions are knowledge-qualified, this is a constructive knowledge standard. Under the OIR, “knowledge” includes actual knowledge of a fact or circumstance that exists or is substantially certain to occur, as well as “an awareness of a high probability of a fact or circumstance’s existence or future occurrence” and reason to know of a fact or circumstance’s existence.4 A determination of whether a US person had knowledge of a particular fact or circumstance at a certain point in time focuses on the knowledge “a US person had or could have had through a reasonable and diligent inquiry.”5 Further, a “US person that has failed to conduct a reasonable and diligent inquiry by the time of a given transaction may be assessed to have had reason to know of a given fact or circumstance,” including whether the transaction would be a covered transaction.6 The OIR provides a list of considerations that Treasury deems relevant as to whether a US person has conducted a reasonable and diligent inquiry, but it notes the ultimate determination of the reasonableness of the inquiry is based on the totality of the facts and circumstances.7
II. BDC Credit Facility Background
BDCs are investment vehicles that have elected to be regulated as “business development companies” under the Investment Company Act. Once formed, BDCs often obtain first lien financing in the form of syndicated credit facilities. These BDC credit facilities are led and syndicated by a lender that acts as administrative agent (the “Administrative Agent”) and as collateral agent (the “Collateral Agent”) on behalf of the lenders.
After initial closing, BDC credit facilities are often amended each year to extend the commitment termination and maturity dates and make other market-related adjustments (each, an “extension amendment”). With the adoption of the OIR at the beginning of the year, extension amendments closing in 2025 have focused on its applicability to BDC credit facilities. BDC credit facilities are secured by investments held in the asset portfolio of the BDC borrower (the “Borrower”) and any of its subsidiaries that provide a guaranty of the Borrower’s obligations (the “Subsidiary Guarantors” and, together with the Borrower, the “Obligors”), including equity interests, notes and other debt instruments, loans and other extensions of credit, as well as the Obligors’ equity interests in their respective subsidiaries. With each extension amendment, the Obligors reaffirm the security interests granted to secure the facility.
BDC credit facilities are particularly susceptible to OIR risks for two principal reasons:
1. BDC credit facilities permit Obligors to invest in both debt and equity portfolio investments, including preferred equity, convertible debt and “equity-like” debt instruments, and to receive borrowing base credit for such investments. While first lien debt typically receives the highest advance rate, Borrowers also receive credit for preferred equity and debt securities that have the ability to convert to equity ownership.
2. Obligors reaffirm the pledge of their assets to the Collateral Agent, on behalf of the lenders, at the closing of each extension amendment, and the reaffirmation muddles the Collateral Agent’s ability to utilize exceptions and safe harbors in the OIR.
Due to the mix of debt and equity portfolio investments that become collateral under BDC credit facilities and the reaffirmation of the Obligors’ pledges, Collateral Agents for BDC credit facilities must be aware of the OIR and the implications of foreclosing on the Obligors’ assets in the event of default.
III. Impact of the OIR on BDC Credit Facility Foreclosures by Collateral Agents
The Loan Syndications and Trading Association (the “LSTA”) published a Market Advisory on January 2, 2025 providing an overview of the OIR and recommending the implementation of a new representation and covenant to address the OIR. The LSTA-recommended representation and covenant follow:
Representation
Neither [BORROWER] nor any of its subsidiaries is a ‘covered foreign person’ as that term is used in the Outbound Investment Rules. Neither [BORROWER] nor any of its subsidiaries currently engages in, or has any present intention to engage in the future, directly or indirectly, in (i) a ‘covered activity’ or a ‘covered transaction’, as each such term is defined in the Outbound Investment Rules, (ii) any activity or transaction that would constitute a ‘covered activity’ or a ‘covered transaction’, as each such term is defined in the Outbound Investment Rules, if the [BORROWER] were a US person or (iii) any other activity that would cause [AGENT/LENDERS] to be in violation of the Outbound Investment Rules or cause [AGENT/LENDERS] to be legally prohibited by the Outbound Investment Rules from performing under this [AGREEMENT].
Covenant
The [BORROWER] will not, and will not permit any of its subsidiaries to, (a) be or become a ‘covered foreign person’, as that term is defined in the Outbound Investment Rules, or (b) engage, directly or indirectly, in (i) a ‘covered activity’ or a ‘covered transaction’, as each such term is defined in the Outbound Investment Rules, (ii) any activity or transaction that would constitute a ‘covered activity’ or a ‘covered transaction’, as each such term is defined in the Outbound Investment Rules, if the [BORROWER] were a US person or (iii) any other activity that would cause [AGENT/LENDERS] to be in violation of the Outbound Investment Rules or cause [AGENT/LENDERS] to be legally prohibited by the Outbound Investment Rules from performing under this [AGREEMENT].8
The LSTA-recommended representation and covenant generally protect the Administrative Agent and the lenders against violations of the OIR by the Obligors as they acquire investments for their asset portfolios (indeed, this language prohibits certain investments that have no connection to a “covered foreign person”—and thus are not regulated by the OIR) and may also provide some protection in the event of the Collateral Agent’s foreclosure on such portfolio investments or on equity interests in the Borrower’s subsidiaries. The LSTA language, however, may not fully protect the Collateral Agent in certain events of foreclosure.
Areas of Concern for Collateral Agents
Even if the LSTA-recommended language is included in the relevant credit documentation, the Collateral Agent must be aware of certain OIR-related risks in a foreclosure.
First, an Obligor may acquire a portfolio investment in an issuer that is a person of a country of concern, and, after such investment has been made, the issuer may change its activities such that it would now be considered a covered foreign person. If the Obligor could not have been aware, after a “‘reasonable and diligent inquiry’ at the time of [the] transaction”9 that the issuer may later engage in prohibited or notifiable activity, the Obligor has likely complied with the OIR due to the knowledge requirement. As Treasury noted in the release accompanying the final rule (the “Adopting Release”), “an investment that is permitted at the time of the transaction does not need to be divested later due merely to post-transaction changes in an [issuer]’s finances or activities of which the US person did not have knowledge at the time of the investment.”10 The Obligor’s knowledge that an issuer has engaged in activity subject to the OIR after the Obligor’s investment, therefore, does not, on its own, require it to divest from the investment. Further, the Obligor would still be able to make the LSTA representation and comply with the LSTA covenant, because such a post-transaction change in activities would not render the Obligor a covered foreign person or a US person engaged in a covered activity.
Once the issuer has engaged in prohibited or notifiable activity, however, this activity may be discoverable by the Collateral Agent’s reasonable and diligent inquiry, and thus the Collateral Agent could be considered to “know” that the issuer is a covered foreign person. As noted above, a debtholder’s acquisition of pledged equity through strict foreclosure is an acquisition of an equity interest and, therefore, a covered transaction unless the debtholder did not know at the time of issuing the debt that the pledged equity was in a covered foreign person. This caveat alleviates some industry concern that foreclosure on an Obligor’s assets (including equity interests in subsidiaries) would trigger a covered transaction, but the revolving nature of BDC credit facilities means the lenders are issuing debt on a recurring basis. As this debt may be issued after the issuer engages in prohibited or notifiable activity that may be discoverable by the Collateral Agent’s reasonable and diligent inquiry, Note 2 does not provide a safe harbor for the Collateral Agent’s foreclosure on the equity interest. This subjects the Collateral Agent to an extensive diligence requirement before it can foreclose on the collateral to confirm that an issuer has not engaged in such activity after the Obligor’s initial investment—or, if it has, whether foreclosure would require notification or be prohibited altogether.
Second, an Obligor may have acquired an equity interest in a covered foreign person prior to the effective date11 and then subsequently reaffirm its pledge in an extension amendment after the effective date. As noted, while Note 2 specifies that a debtholder’s foreclosure on pledged equity is an acquisition of an equity interest, it excepts acquisitions of equity pledged prior to the effective date. A reaffirmation of the Obligors’ pledges, however, in combination with an extension of the facility’s commitment termination and maturity dates, is likely a new pledge of the Obligors’ assets and/or equity for purposes of the OIR. If considered a new pledge, the Collateral Agent cannot qualify for the exception to Note 2, and the foreclosure on any assets pledged after the effective date (or subject to a pledge reaffirmed after the effective date) may be considered a covered transaction.
Third, a portfolio investment issuer may not be a covered foreign person or engaged in prohibited or notifiable activity at the time of the Obligors’ investment but could be captured by a later update and expansion of the OIR. The Adopting Release notes that, if “a US person . . . invests in an entity that was not a covered foreign person at the time of the transaction but becomes a covered foreign person because of a future regulatory update, [Treasury] would not expect to apply such a regulatory update retroactively.”12 If Treasury expands the OIR’s list of countries of concern, for example, Obligors will likely not violate the OIR by owning equity in a newly-designated person of a country of concern. This concept may also apply in the event of an expanded list of prohibited or notifiable activities. Absent a specific carve-out in conjunction with the expansion, however, foreclosure on such equity would constitute a covered transaction.
Under Note 2, a strict foreclosure would be considered an acquisition of an equity interest by the Collateral Agent. The Adopting Release states that Note 2’s safe harbor for equity pledged prior to the effective date is intended to protect lenders’ ability to foreclose on equity pledged prior to the implementation of the OIR.13 This safe harbor, however, does not address future regulatory updates and does not protect lenders’ ability to foreclose on newly-regulated equity pledged after the effective date but before the effectiveness of a regulatory update. Similar to the above, unless Treasury grants an expansion of relief under Note 2 at the time of a regulatory update, foreclosure on such equity would likely violate the OIR. The Collateral Agent, therefore, must keep apprised of any updates to the OIR that expand its scope and conduct renewed diligence on issuers, portfolio investments and the Borrower’s subsidiaries prior to acquiring equity interests in a foreclosure.
IV. Implications for Collateral Agents
To protect themselves, Collateral Agents may consider instituting requirements in the credit documentation that Borrowers obtain contractual assurances from their portfolio investment issuers that the issuers have not, and will not, engage in activities that would be subject to the OIR in the event of foreclosure by Collateral Agents. If a Borrower requires that its issuers implement restrictions in their organizational documents that they are not covered foreign persons, will not become covered foreign persons, and will not engage in activities that would make foreclosure prohibited or notifiable, this could provide evidence toward the Collateral Agent’s reasonable and diligent inquiry of whether foreclosure on a portfolio investment is a covered transaction. These restrictions would protect a Collateral Agent in the event an issuer is not engaging in such activities at the time of foreclosure, but at a later time initiates them, because Treasury would look at whether the Collateral Agent, at the time of foreclosure, knew or could have discovered upon a reasonable and diligent inquiry that the issuer was likely to engage in future covered activities. Negotiating covenants into credit documentation that a Borrower must at least reasonably attempt to add OIR limitations to their issuers’ organizational documents, therefore, could protect a Collateral Agent by demonstrating awareness of the OIR and an active precautionary approach to prevent issuers from engaging in such activities.
If contemplating strict foreclosure, the Collateral Agent must conduct diligence on each equity investment, equity-like debt investment and contingent equity interest of the Obligors issued by a covered foreign person.14 If this diligence reveals that any of these persons have engaged in a covered transaction and/or are covered foreign persons, the Collateral Agent should carefully consider whether it may acquire these assets in foreclosure or whether such acquisitions would require notification to Treasury. Further, Collateral Agents must be mindful of any regulatory updates to the OIR, particularly those that increase the scope of persons of countries of concern or that broaden the definition of what is considered a covered activity. The implementation of the OIR emphasizes the importance for Collateral Agents to engage in a thorough and detailed diligence process prior to any acquisition of a Borrower’s portfolio investments in a foreclosure.
8 Market Advisory, Outbound Investment Regulations, Loan Syndications & Trading Ass’n (2025).
9 Provisions Pertaining to US Investments in Certain National Security Technologies and Products in Countries of Concern, 89 Fed. Reg. 90398, 90405 (Nov. 15, 2024).
11 Id. at 90420 (“[T]he Final Rule applies only on a forward-looking basis.”).
14 Notably, clause (a)(2) of the definition of “covered foreign person” includes each person that directly or indirectly holds a board seat on, a voting or equity interest in, or any contractual power to direct the management or policies of a person of a country of concern that derives or incurs, as applicable, at least $50,000 or 50% of the person’s annual revenue, net income, capital expenditure or operating expenses. Id. § 805.209(a)(2). These inclusions, in addition to each person of a country of concern, present a broad scope of inquiry for the Collateral Agent.
