U.S. Takes First Step to Regulate Outbound Investment into China

On August 9, 2023, President Biden issued his long-anticipated “Executive Order on Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern” (the “Executive Order”), which represents the first step by the Biden administration to curb certain categories of U.S. investment into China.

The Executive Order instructs the Secretary of the Treasury, in consultation with the Commerce Department and other agencies, to impose notification requirements—and, in some cases, prohibitions—with respect to certain U.S. person investments concerning China that involve semiconductors and microelectronics, quantum information technologies, or artificial intelligence.

The Executive Order delegates the specifics of the prohibition and notice requirement to a rulemaking process, which will be subject to public notice and comment. Concurrent with the Executive Order, the U.S. Department of the Treasury issued an advance notice of proposed rulemaking¹ and associated fact sheet² (collectively, the “ANPRM”) that (1) explain how Treasury anticipates defining and interpreting key aspects of the Executive Order; and (2) solicit public feedback on over 80 discrete questions.

The Executive Order marks an unprecedented expansion of U.S. regulation of investment activity, with potentially significant implications for the global economy. However, the full effects of the Executive Order will depend on the outcome of the rulemaking process that has just been initiated.

Background

In contrast to some other major economies, regulation of outbound U.S. investment has been largely limited to restrictions imposed by ancillary regimes, namely economic sanctions and export controls. For several years, however, the U.S. government has contemplated a range of proposals to introduce regulation of outbound investment into China and other countries perceived to present national security risk. For example, one legislative proposal would establish an analog to the Committee on Foreign Investment in the United States (CFIUS)—the National Critical Capabilities Committee (NCCC)—to review, prohibit, or impose mitigation measures relating to outbound investments in certain key sectors, such as semiconductors, artificial intelligence, quantum computing, large capacity batteries, critical minerals and materials, active pharmaceutical ingredients, and automobile manufacturing. Other, more modest legislative proposals would require parties engaging in certain outbound investment activities to provide advance notice to the U.S. government.

Against this backdrop, the Biden administration has spent many months developing an executive action that would seek to curb U.S. investment in Chinese industries perceived to present national security risk without unduly restricting free trade. The Executive Order represents the culmination of the Biden administration’s efforts on this important and cutting-edge issue and is the first concrete step taken by the U.S. government to restrict and control certain categories of outbound investment.

The Executive Order and ANPRM

The Executive Order directs the Secretary of the Treasury, in consultation with the Secretary of Commerce and other agency heads, to promulgate regulations that “require United States persons to provide notification of information relative to certain transactions involving covered foreign persons (notifiable transactions) and that prohibit United States persons from engaging in certain other transactions involving covered foreign persons (prohibited transactions).”

Notifiable transactions will be categories of transactions that involve technologies and products that “may contribute to the threat to the national security of the United States.” Prohibited transactions will be a smaller subset of transactions that involve technologies and products that “pose a particularly acute national security threat because of their potential to significantly advance the military, intelligence, surveillance, or cyber-enabled capabilities of countries of concern.” The Treasury Secretary is empowered to nullify or compel the divestment of prohibited transactions entered into after the effective date of the forthcoming regulations. The Executive Order also authorizes the imposition of civil and criminal penalties against parties that violate, or conspire to violate, the Executive Order’s requirements.

The Executive Order identifies three key jurisdictional elements, to be further developed during the rulemaking process.

First, the Executive Order applies to transactions that involve “covered national security technologies and products.” While this definition will be formally defined through the rulemaking process, in broad strokes, the term will include “sensitive technologies and products in the semiconductors and microelectronics, quantum information technologies, and artificial intelligence sectors that are critical for the military, intelligence, surveillance, or cyber-enabled capabilities of a country of concern.”

Per the ANPRM, Treasury is considering the following, summary-level prohibitions and notification requirements:

	Prohibitions	Notification Requirements
Semiconductors and Microelectronics	Entities engaged in the development of electronic design automation software or semiconductor manufacturing equipment Entities engaged in the design, fabrication, or packaging of advanced integrated circuits Entities engaged in the installation or sale of supercomputers	Entities engaged in the design, fabrication, and packaging of less advanced integrated circuits
Quantum Information Technologies	Entities engaged in the production of quantum computers and certain components Entities engaged in the development of certain quantum sensors Entities engaged in the development of quantum networking and quantum communication systems	None currently contemplated
Artificial Intelligence	Entities engaged in a narrow set of activities related to software that incorporates an artificial intelligence system and is designed for particular end uses with national security implications (e.g., military surveillance)	Entities engaged in activities related to software that incorporates an artificial intelligence system and is designed for certain end uses that may have military or intelligence applications (e.g., cybersecurity, digital forensics, robotics systems, facial recognition, etc.)

While the above categories are subject to public comment and further revision, the currently contemplated scope of covered technologies and products is narrower than some recent legislative proposals (which would include, for example, certain biotechnologies). In addition, the Executive Order states that the scope of covered technologies and products may be limited by reference to specific end uses.

Second, the Executive Order applies to “United States persons.” This term will include “any United States citizen, lawful permanent resident, entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branches of any such entity, and any person in the United States.”

Notably, the Executive Order may implicate certain non-U.S.-person activity, depending on the scope of final regulations promulgated by the Secretary of the Treasury. For example:

• The Executive Order states that United States persons shall be restricted from “engaging, directly or indirectly, in [prohibited] transactions” and authorizes the Treasury Secretary to prevent U.S. persons “from knowingly directing transactions if such transactions would be prohibited transactions . . . if engaged in by a United States person.”

  In this regard, the ANPRM identifies three examples of potentially prohibited activity:

• A U.S. person General Partner manages a foreign fund that undertakes a transaction that would be prohibited if performed by a U.S. person.
• A U.S. person is an officer, senior manager, or equivalent senior-level employee at a foreign fund that undertakes a transaction at that U.S. person’s direction when the transaction would be prohibited if performed by a U.S. person.
• Several U.S. person venture partners launch a non-U.S. fund focused on undertaking transactions that would be prohibited if performed by a U.S. person.

By contrast, the ANPRM observes that certain conduct that Treasury deems more “attenuated from the risks to U.S. national security identified in the Order” may be excluded, such as “the provision of a secondary, wraparound, or intermediary service or services such as third-party investment advisory services, underwriting, debt rating, prime brokerage, global custody, or the processing, clearing, or sending of payments by a bank, or legal, investigatory, or insurance services.”

• The Executive Order states that the Secretary of the Treasury may—but is not obligated to—require U.S. persons to (1) provide notice of transactions by controlled foreign affiliates that would be notifiable if engaged in by a U.S. person; and (2) take all reasonable steps to prohibit and prevent transactions by controlled foreign affiliates that would be prohibited if engaged in by a U.S. person. On this point, the ANPRM states that Treasury is considering defining a “controlled foreign entity” to include any foreign entity in which a U.S. person owns, directly or indirectly, a 50% or greater interest.

According to the ANPRM, Treasury is contemplating regulations that condition U.S. persons’ obligations under the Executive Order to a knowledge standard—“e.g., where the U.S. person has actual or constructive knowledge that [a] covered foreign person is engaged in, or will foreseeably be engaged in, certain activity regarding the technology or product.” Similar to the definition of “knowledge” under the U.S. Export Administration Regulations, this standard might encompass not only “positive knowledge … but also an awareness of a high probability of its existence or future occurrence,” where such awareness may be inferred from evidence of “conscious disregard” or “willful avoidance” of the underlying facts. A constructive knowledge standard foreseeably may imply an expectation that U.S. persons will conduct appropriate due diligence prior to pursuing investment opportunities.

Third, the Executive Order requires the involvement of a “covered foreign person,” meaning a “person of a country of concern” engaged in activities involving one or more covered national security technologies and products. A person of a country of concern is (1) a citizen or permanent resident of a “country of concern” (who is not a U.S. person); (2) an entity organized under the laws of, or with a principal place of business in, a country of concern; (3) a government of a country of concern; or (4) an entity majority owned (individually or in the aggregate, directly or indirectly) by any of the foregoing.

The ANPRM states that Treasury is considering defining “covered foreign person” to encompass (1) non-U.S. companies whose Chinese subsidiaries engage in covered activities, where the Chinese subsidiaries represent 50% or more of the parent’s consolidated revenue, net income, capital expenditure, or operating expenses; and (2) majority owned subsidiaries of Chinese companies organized under the laws of third countries, in each case to ensure that the Executive Order’s restrictions apply as broadly as intended.

The Executive Order identifies only China (inclusive of Hong Kong and Macau) as a “country of concern,” but contemplates that additional jurisdictions could be so designated in the future.

Although only in proposed form (and subject to public comment), the ANPRM offers directional guidance on key, practical aspects of the Executive Order:

• Categories of “Covered National Security Technologies and Products.” The ANPRM provides guidance regarding the categories of technology and products of greatest interest to the U.S. government, as summarized in the above table.

• Categories of Transactions Subject to Notice Requirements and/or Prohibitions. The ANPRM identifies anticipated, in-scope investments (“covered transactions”) to include:

  • the acquisition of an equity interest or contingent equity interest in a covered foreign person;
  • the provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest;
  • greenfield investments that could result in the establishment of a covered foreign person; and
  • the establishment of a joint venture, wherever located, that is formed with a covered foreign person or could result in the establishment of a covered foreign person.

  Although the definition of “covered transaction” is intended to be forward-looking, the ANPRM states that Treasury may request information about transactions that are completed prior to the regulations’ effective date “to better inform the development and implementation of the [outbound investment] program.”

  Per the ANPRM, Treasury does not intend the definition of “covered transaction” to cover the following activities, provided the activities do not meet the definitional elements of a “covered transaction” and are not undertaken to evade a prohibition or notification requirement:

  • university-to-university research collaborations;
  • contractual arrangements or the procurement of material inputs for any of the covered national security technologies or products (such as raw materials);
  • intellectual property licensing arrangements;
  • bank lending;
  • the processing, clearing, or sending of payments by a bank;
  • underwriting services;
  • debt rating services;
  • prime brokerage;
  • global custody;
  • equity research or analysis; or
  • other services secondary to a transaction.

  In addition, the ANPRM states that Treasury is contemplating a range of exempted transactions, including:

  • Certain investments into publicly traded securities, index funds, mutual funds, and exchange-traded funds;

  • Passive investments made as a limited partner into a venture capital fund, private equity fund, fund of funds, or other pooled investment funds, where:

    • the limited partner’s contribution is solely capital into a limited partnership structure and the limited partner does not have the ability (formally or informally) to influence or participate in the fund’s or a covered foreign person’s decision making or operations; and
    • the investment is below a (to be determined) de minimis threshold.³
  • Committed but uncalled capital investments; and
  • Intracompany transfers of funds from a U.S. parent company to its subsidiary.

  Importantly, the ANPRM contemplates that an investment in publicly traded securities or as a limited partner that affords a U.S. person rights beyond “standard minority shareholder protections”—such as board member or observer rights or involvement (beyond voting of shares) in substantive business decisions—would not qualify as an excepted transaction.

• Contents of Notices. The ANPRM contemplates that notices—in respect of notifiable transactions—would need to be submitted within 30 days of closing and include the following information:

  • the identity of the person(s) engaged in the transaction and nationality (for individuals) or place of incorporation or other legal organization (for entities);
  • basic business information about the parties to the transaction, including name, location(s), business identifiers, key personnel, and beneficial ownership;
  • the relevant or expected date of the transaction;
  • the nature of the transaction, including how it will be effectuated, the value, and a brief statement of business rationale;
  • a description of the basis for determining that the transaction is a covered transaction – including identifying the covered national security technologies and products of the covered foreign person;
  • additional transaction information including transaction documents, any agreements or options to undertake future transactions, partnership agreements, integration agreements, or other side agreements relating to the transaction with the covered foreign person and a description of rights or other involvement afforded to the U.S. person(s);
  • additional detailed information about the covered foreign person, which could include products, services, research and development, business plans, and commercial and government relationships with a country of concern;
  • a description of due diligence conducted regarding the investment;
  • information about previous transactions made by the U.S. person into the covered foreign person that is the subject of the notification, as well as planned or contemplated future investments into such covered foreign person; and
  • additional details and information about the U.S. person, such as its primary business activities and plans for growth.

Timing

The ANPRM solicits public comment through September 28, 2023. Given the time required to process public comments, issue draft regulations, and ultimately publish a final rule, the Executive Order’s requirements likely will not be effective for several months (and potentially into early 2024).

Conclusion

While a key milestone in the introduction of outbound U.S. investment regulation, the Executive Order and the ANPRM represent only initial steps. Interested parties will need to continue to monitor—and, in some cases, may feel constrained to delay key decision-making around fundraising and investment activities—pending publication of final regulations by the Secretary of the Treasury.