U.S. Department of the Treasury publishes outbound investment proposed rule

Background

The purpose of the Outbound Investment Security Program is to address the national security threat to the United States posed by so-called Countries of Concern – currently defined to include the People’s Republic of China, the Special Administrative Region of Hong Kong, and the Special Administrative Region of Macau – seeking to develop sensitive technologies and products critical for military, intelligence, surveillance, or cyber-enabled capabilities.

The Proposed Rule, which incorporates significant updates and clarifications from the ANPRM process, would prohibit – or, in some cases, require notification of – certain investments involving Covered National Security Technologies and Products in the following three sectors:

• Semiconductors and microelectronics;
• Quantum information technologies; and
• Artificial intelligence.

These prohibitions and notification requirements would apply to transactions with a Covered Foreign Person (defined to include persons of a Country of Concern engaged in certain specified activities) by (i) a U.S. Person or (ii) a Controlled Foreign Entity of a U.S. Person.

Treasury is requesting comments on the Proposed Rule until August 4, 2024. Although there is no deadline for Treasury to issue the final rule after the comment period ends, it is anticipated that the final rule could be issued as early as the fourth quarter of 2024 or early 2025.

As a practical matter, the Proposed Rule – if and when it becomes effective – would require parties seeking to invest in Chinese entities and non-Chinese entities with holdings in China to conduct additional due diligence to determine whether their investments are captured by the new regulations.

We have included below a summary of the key features and takeaways from the Proposed Rule.

Covered Transactions

The Proposed Rule would apply to Covered Transactions (broadly defined to encompass various types of equity and non-equity investments) involving a Covered Foreign Person.

• Covered Foreign Persons: The Proposed Rule defines Covered Foreign Persons to include:
  • A Person of a Country of Concern that engages in a Covered Activity (i.e., certain activities involving Covered National Security Technologies and Products);
  • A person that holds an interest in a Covered Foreign Person if more than 50% of the persons revenue, net income, capital expenditure, or operating expenses are attributable to the Covered Foreign Person; and
  • A Person of a Country of Concern involved in a joint venture with a U.S. Person if such joint venture is engaged in a Covered Activity.
• Persons of a Country of Concern: Relatedly, the Proposed Rule defines Persons of a Country of Concern to include:
  • An individual who is a citizen or permanent resident of a Country of Concern (not including U.S. citizens and U.S. permanent residents);
  • An entity with its principal place of business in, headquartered in, incorporated in, or organized under the laws of a Country of Concern;
  • The government of a Country of Concern, persons acting on behalf of such a government, and persons controlled by or directed by such a government; and
  • Any entity, wherever located, in which one or more persons of a Country of Concern, individually or in the aggregate, hold at least 50 percent of any outstanding voting interest, voting power of the board, or equity interest, regardless of whether the interest is held directly or indirectly.

Given these broad definitions, the Proposed Rule could capture investments in entities both in and outside China (e.g., an investment in a non-Chinese parent company with Chinese subsidiaries engaged in Covered Activities).  

The Proposed Rule provides the following examples of investments that would constitute Covered Transactions:

• Acquisition of an equity interest or contingent equity interest in a Covered Foreign Person;
• Provision of debt financing convertible to an equity interest in a Covered Foreign Person or provision of debt financing that affords the lender certain management or governance rights in a Covered Foreign Person;
• Conversion of a contingent equity interest or convertible debt in a Covered Foreign Person;
• Greenfield investment or certain other corporate expansions that either will establish a Covered Foreign Person, or will cause an existing Person of a Country of Concern to pivot into a new Covered Activity;
• Entrance into a joint venture, wherever located, with a Person of a Country of Concern where the joint venture will undertake a Covered Activity; and
• Investment as a limited partner or equivalent (LP) into a non-U.S. Person pooled investment fund that invests in a Covered Foreign Person.

As described below, whether a Covered Transaction would be prohibited or simply require notification to Treasury depends on the nature of the Covered Activity in question.

Semiconductors and Microelectronics

The Proposed Rule would prohibit Covered Transactions involving the following categories of Covered Foreign Persons:

• Companies involved in creating or producing electronic design automation software used for designing integrated circuits or advanced packaging;
• Companies that manufacture front-end semiconductor fabrication equipment for large-scale production of integrated circuits, equipment used in large-scale advanced packaging, commodity materials, software, or technology exclusively intended for use with extreme ultraviolet lithography equipment;
• Developers of integrated circuits meeting or surpassing specific performance standards or are designed for specific operational temperatures;
• Manufacturers of integrated circuits meeting defined criteria;
• Companies employing advanced packaging techniques to package integrated circuits; and
• Entities involved in the design, sale, or manufacture of supercomputers powered by advanced integrated circuits capable of achieving specified performance thresholds.

Notifiable transactions related to semiconductors and microelectronics would include Covered Transactions involving Covered Foreign Persons designing, fabricating, or packaging any integrated circuit that are not prohibited.

U.S. investors should pay particular attention to the rules as they apply to advanced packaging and testing, which has not historically been an area of U.S. government concern in the export controls context.

Quantum Information Technologies

With respect to quantum information technologies, the Proposed Rule would prohibit Covered Transactions involving the following categories of Covered Foreign Persons:

• Companies involved in advancing quantum computing technology or essential components necessary for their production, such as dilution refrigerators or two-stage pulse tube cryocoolers;
• Entities focused on creating or manufacturing quantum sensing platforms intended for military, government intelligence, or mass-surveillance applications; and
• Organizations dedicated to developing or manufacturing quantum networks or communication systems designed to enhance quantum computing capabilities, ensure secure communications, or support applications with military, government intelligence, or mass-surveillance objectives.

For quantum information technologies, there are no transactions that would require notification to Treasury.

Artificial Intelligence

Finally, the Proposed Rule would prohibit Covered Transactions involving: (i) Covered Foreign Persons developing AI systems that are specifically designed or intended to be used for military, government intelligence, or mass surveillance; and (ii) Covered Foreign Persons interacting with AI systems that are trained using a not-yet-determined amount of computing power.

Notifiable transactions related to artificial intelligence would include Covered Transactions involving the following categories of Covered Foreign Persons:

• Entities creating artificial intelligence systems that are designed for military, government intelligence, or mass surveillance end uses, but are not exclusively for these purposes;
• Entities developing artificial intelligence systems for cybersecurity, digital forensics, penetration testing, or robotics control; and
• Entities utilizing or interacting with artificial intelligence systems trained using a not-yet-determined amount of computing power (i.e., at a threshold lower than that for prohibited transactions).

The Proposed Rule adopts the definition of “artificial intelligence” from an October 2023 Executive Order on “Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence.” Thus, for purposes of the Proposed Rule, artificial intelligence means “a machine-based system that can, for a given set of human-defined objectives, make predictions, recommendations, or decisions influencing real or virtual environments. Artificial intelligence systems use machine and human-based inputs to perceive real and virtual environments; abstract such perceptions into models through analysis in an automated manner; and use model inference to formulate options for information or action.”

Critically, the Proposed Rule does not incorporate the October 2023 Executive Order’s definition of “generative artificial intelligence”, and it remains to be seen whether the final version will explicitly consider such resources.

Definition of U.S. Person and Controlled Foreign Entity

The prohibitions and notification requirements outlined in the Proposed Rule would apply to U.S. Persons, who would also be required to ensure compliance by their Controlled Foreign Entities.

• U.S. Person: Under the Proposed Rule, U.S. Person means “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 [physically] in the United States.”
• Controlled Foreign Entity: The Proposed Rule defines Controlled Foreign Entity as “any entity incorporated in, or otherwise organized under the laws of, a country other than the United States of which a U.S. Person is a parent.”
  • The term “parent” contained in the above definition includes any individual or entity that: (i) directly or indirectly holds more than 50 percent of the outstanding voting interest or voting power of the board of an entity; (ii) is the general partner, managing member, or equivalent of an entity; or (iii) is the investment adviser to any entity that is a pooled investment fund.

The Proposed Rule would require U.S. parents to take “all reasonable steps to prohibit and prevent” any transaction by a Controlled Foreign Entity that would be a prohibited transaction if engaged in by a U.S. Person. The Proposed Rule indicates that Treasury would consider the following factors (among others) in determining whether the U.S. Person took “all reasonable steps to prohibit and prevent” such a transaction:

• The execution of agreements with respect to compliance with the Outbound Investment Security Program between the U.S. Person and its Controlled Foreign Entity;
• The existence and exercise of governance or shareholder rights by the U.S. Person with respect to the Controlled Foreign Entity (if applicable);
• The existence and implementation of periodic training and internal reporting requirements by the U.S. Person and its Controlled Foreign Entity with respect to compliance with the Outbound Investment Security Program;
• The implementation of appropriate and documented internal controls, including internal policies, procedures, or guidelines that are periodically reviewed, by the U.S. Person and its Controlled Foreign Entity; and
• Implementation of a documented testing and/or auditing process of internal policies, procedures, or guidelines.

Knowledge Standard

The Proposed Rule's prohibitions and notification requirements would only apply when a U.S. Person has knowledge that a potential transaction, whether conducted by the U.S. Person or a Controlled Foreign Entity, qualifies as a Covered Transaction.

The Proposed Rule defines "knowledge" broadly, encompassing both actual awareness and constructive knowledge. Specifically, a U.S. Person could be deemed to have knowledge if the U.S. Person has:

• Actual knowledge that a fact or circumstance exists or is substantially certain to occur;
• An awareness of a high probability of a fact or circumstance’s existence or future occurrence; or
• Reason to know of a fact or circumstance’s existence.

The Proposed Rule also clarifies that if a U.S. Person has undertaken a reasonable and diligent inquiry and still does not have knowledge of a fact or circumstance relevant to whether a transaction is a Covered Transaction, then Treasury ordinarily (absent other circumstances) would not attribute knowledge of that fact or circumstance to such U.S. Person even if the transaction has all of the other attributes of a Covered Transaction. Several factors could play a role in determining whether a U.S. Person has conducted a reasonable and diligent inquiry. These include:

• The inquiry a U.S. Person, its legal counsel, or its representatives have made on behalf of the U.S. Person regarding an investment target or relevant counterparty, including questions asked of the investment target or relevant counterparty, as of the time of the transaction;
• The contractual representations or warranties the U.S. Person has obtained or attempted to obtain from the investment target or relevant counterparty with respect to the determination of a transaction’s status as a Covered Transaction and an investment target’s or relevant counterparty’s status as a Covered Foreign Person;
• The effort by the U.S. Person at the time of the transaction to obtain available non-public information relevant to the determination of a transaction’s status as a Covered Transaction and an investment target’s or relevant counterparty’s status as a Covered Foreign Person, and the efforts undertaken by the U.S. Person to obtain and review such information;
• Available public information, the efforts undertaken by the U.S. Person to obtain and review such information, and the degree to which other information available to the U.S. Person at the time of the transaction is consistent or inconsistent with such publicly available information;
• Whether the U.S. Person, its legal counsel, or its representatives have purposefully avoided learning or sharing relevant information;
• The presence or absence of warning signs, which may include evasive responses or non-responses from an investment target or relevant counterparty to questions or a refusal to provide information, contractual representations, or warranties; and
• The use of public and commercial databases to identify and verify relevant information of an investment target or relevant counterparty.

While these examples are helpful for purposes of building a compliance program, it is not clear from the text of the Proposed Rule that there is a standard of review for government assessment of due diligence compliance.

For funds, the Proposed Rule considers that the knowledge of LPs would typically be evaluated when they initially invest in a fund managed by a third party, rather than for each specific investment made by the fund thereafter.

U.S. Persons would also be prohibited from “knowingly directing” transactions by non-U.S. Persons that would be prohibited for a U.S. Person to engage in. Under the Proposed Rule, a U.S. Person knowingly directs a transaction if the U.S. Person has authority to make or substantially participate in decisions on behalf of a non-U.S. Person and exercises that authority to direct, order, decide upon, or approve a transaction that would be prohibited if undertaken by a U.S. Person. However, the Proposed Rule would not restrict a U.S. Person from working at any entity that receives or makes investments, provided that the U.S. Person recuses themselves from any Covered Transactions that would be prohibited for a U.S. Person undertake.

Exceptions and Exclusions

The Proposed Rule includes the below list of Excepted Transactions that would not be subject to any prohibition or notification requirement:

• An investment by a U.S. Person in a publicly-traded security;
• An investment by a U.S. Person in a security issued by an investment company, such as an index fund, mutual fund, or exchange traded fund;
• An investment of a certain size by a U.S. Person LP in a pooled investment fund;
• A U.S. Person’s full buyout of all interests of any Person of a Country of Concern in an entity, such that the entity would not constitute a Covered Foreign Person following the transaction;
• An intracompany transaction between a U.S. Person parent and its subsidiary to support ongoing operations (or other activities that are not Covered Activities);
• Fulfillment of a U.S. Person’s binding capital commitment entered into prior to August 9, 2023;
• The acquisition of a voting interest in a Covered Foreign Person upon default or other condition involving a loan, where the loan was made by a lending syndicate and a U.S. Person participates passively in the syndicate; and
• Certain transactions that occur in a non-U.S. country or territory that has been designated by the Secretary of the Treasury.

Certain of the transaction types described above would not qualify as an Excepted Transaction if the U.S. Person involved in the transaction were to acquire governance rights beyond standard minority shareholder protections.

The Proposed Rule also contemplates that a U.S. Person could seek an exemption from the requirements of the regulations for a transaction deemed to be in the national interest of the United States.

Some commentors to the Proposed Rule have requested that certain activities be either included in the definition of Excepted Transaction or explicitly excluded from the definition of Covered Transaction. These include:

• University-to-university research collaborations;
• Contractual arrangements or the procurement of material inputs for any of the Covered National Security Technologies and 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; and
• Equity research or analysis.

While Treasury has indicated that these activities are unlikely to qualify as Covered Transactions, the Proposed Rule does not explicitly exempt them.

Penalties for Non-compliance

Under the Proposed Rule, failure to comply with the requirements of the Outbound Investment Security Program could result in civil or criminal penalties pursuant to the International Economic Emergency Powers Act (IEEPA). Violations of IEEPA can result in: (i) a civil penalty up to the statutory maximum (currently USD368,136, adjusted regularly for inflation) or twice the value of the transaction, whichever is greater; or (ii) criminal liability of up to USD1,000,000 and imprisonment of up to 20 years per violation, if a breach is willful. In addition to statutory penalties, the Proposed Rule would accord Treasury the authority to nullify, void, or compel the divestment of prohibited transactions (although, depending on the facts, Treasury may face practical limitations in attempting to exercise this authority).

Key Takeaways

The Outbound Investment Security Program is likely to impact a range of stakeholders, including investors across asset classes, financial institutions, and companies with ties to China.

Given the complex nature of the requirements under the Proposed Rule, U.S. Persons that may be impacted should plan in advance to ensure business continuity once the Outbound Investment Security Program is in place, and develop contingency strategies to mitigate risks posed by the new rules. Although the breadth of transactions types that could be captured by the Proposed Rule remains to be seen, at a minimum heightened due diligence will be warranted when dealing with counterparties with ties to China.

In addition, though the scope of Covered Transactions is relatively narrow under the Proposed Rule, this could change. For example, proposed congressional legislation would expand the list of Countries of Concern (to include Russia, Iran, and North Korea) and sectors targeted by the Outbound Investment Security Program (to include hypersonics, satellite-based communications, and network laser scanning systems with dual-use applications). Certain members of Congress have also indicated interest in focusing on “passive flows of money” into China. Companies should be prepared for the prospect that the scope of these regulations could widen in the future. Further, as we have seen in connection with other regulatory efforts aimed at China, the Chinese government has indicated it would take certain actions in response to the Proposed Rule.

A&O Shearman’s foreign direct investment and CFIUS experts are tracking these developments closely and will provide additional updates in due course. Individuals interested in submitting comments or seeking further information can contact the authors or another member of the A&O Shearman team.