On June 21, 2024, the U.S. Department of the Treasury published a Notice of Proposed Rulemaking (the "Proposed Rule") to limit certain outbound U.S. investments into critical technology in the People's Republic of China, Hong Kong, and Macau (collectively, "China"). As described in our prior alert, the Proposed Rule comes after the Biden administration issued Executive Order 14105 ("the Outbound Order") in August 2023, which declared a national security emergency with respect to countries of concern—namely, China—and their efforts to develop and deploy advanced technologies for military, intelligence, surveillance, and cyber-enabled operations. Following the direction of the Outbound Order, the Proposed Rule creates notification requirements and prohibits U.S. persons from engaging in certain investments in China that involve semiconductors and microelectronics, quantum information technologies, and artificial intelligence ("AI") technologies.
Notably, the Treasury Department states in the Proposed Rule that the United States "has long maintained an open investment policy" with respect to cross-border investment and indicates that the Proposed Rule would only apply to a "relatively modest volume of potential covered transactions." Transactional data analyzed by the Treasury Department for the period between 2021 and 2023 suggests that, had the Proposed Rule been in effect during this time, it would have only impacted 60 investors across 106 covered transactions annually.
WHAT DOES THE PROPOSED RULE DO?
The Proposed Rule would impose prohibitions or notification requirements on "U.S. persons" with respect to "covered transactions" involving a "covered foreign person."
A. "U.S. Persons"
The Proposed Rule would apply to "U.S. persons," which includes any U.S. citizen, lawful permanent resident, entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branch of any such entity, and any person located in the United States.
The Proposed Rule would also apply to any "controlled foreign entity" of a U.S. person, which is defined 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 (i.e., directly or indirectly controlling a majority of the voting interest, acting as the general partner or managing member, or acting as an investment adviser to a pooled investment fund). The Proposed Rule would require the U.S. parents to take "all reasonable steps" to ensure its controlled foreign entity complies with the requirements of the Proposed Rule. Examples of "reasonable steps" include using binding agreements, modifying governance or shareholder rights, and introducing compliance policies and internal controls.
In addition, the Proposed Rule would prohibit a U.S. person from "knowingly directing" a non-U.S. person to engage in a transaction that would otherwise be prohibited for a U.S. person. "Knowingly directing" would include having the authority "to make or substantially participate in decisions on behalf of a non-U.S. person" and exercising that authority to "direct, order, decide upon, or approve a transaction." Any U.S. person who is an officer, director, or senior advisor, or otherwise possesses senior-level authority over an entity would be presumed to have this authority.
B. "Covered Transactions"
Under the Proposed Rule, a "covered transaction" is any transaction that a U.S. person knows at the time of the transaction involves a "covered foreign person." This includes a U.S. person's direct or indirect:
- Acquisition of an equity interest or contingent equity interest;
- Provision of debt financing that is convertible to an equity interest or that affords the lender certain management or board rights;
- Conversion of a contingent equity interest or convertible debt;
- Greenfield investment or other corporate expansions;
- Entry into a joint venture, wherever located; and
- Investment as a limited partner or equivalent interest into a non-U.S. investment fund.
For purposes of this definition, "knowledge" would include any of the following:
- 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; and
- Reason to know of a fact or circumstance's existence.
In assessing whether a U.S. person had reason to know of a fact or circumstance's existence at the time of the transaction, the Treasury Department will consider not only whether the person had subjective belief as to the fact or circumstance's existence, but also whether the investor conducted a "reasonable and diligent inquiry" into the matter. In particular, the Treasury Department will consider the following factors in assessing whether a U.S. person has undertaken such an inquiry:
- Due diligence questions posed to the counterparty/investment target at the time of the transaction;
- Representations or warranties solicited from the counterparty/investment target;
- Efforts to obtain non-public information relevant to whether the transaction is covered or covered foreign persons are involved;
- Available public information and whether such information was obtained, reviewed, and the extent to which it is consistent with other available data or intelligence;
- Presence or absence of warning signs, including evasive responses, non-responses or a refusal to provide information, representations or warranties;
- Whether parties have purposefully avoided learning or sharing relevant information; and
- Use of public and commercial databases to identify and/or verify relevant information about a counterparty/investment target.
Therefore, reasonable due diligence that does not reveal a covered transaction or a covered foreign person would serve as a potential defense to any alleged violation of the Proposed Rule. The Treasury Department notes that if, following a "reasonable and diligent inquiry," a U.S. person still is not aware of a fact that would make the transaction a covered transaction, the Treasury Department "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."
C. "Covered Foreign Persons"
The term "covered foreign person" means a person of a country of concern (i.e., China) that is engaged in a "covered activity." This definition would include an individual who is a citizen or permanent resident of a country of concern (and not a U.S. citizen or permanent resident of the United States); an entity that is organized under the laws of, headquartered in, incorporated in, or with a principal place of business in a country of concern; the government of a country of concern; or an entity that is directly or indirectly majority-owned by any of the previous persons or entities.
In addition, this definition would include certain transactions involving an entity than has a voting interest, board seat, or equity interest in a covered foreign person where more than 50 percent of the revenue, net income, capital expenditure, or operating expenses of the entity is attributable to such covered foreign person. These circumstances are intended to capture entities that, while not directly engaged in a covered activity themselves, are significantly financially connected to entities that are engaged in a covered activity.
A "covered activity" is any activity related to the development or production of specific national security technologies and products in three key industries: semiconductors and microelectronics, quantum information technologies, and AI systems. Based on the nature of the activity, the transaction would either be prohibited or notifiable. Typically, activities relating to technologies that present higher national security concerns would be prohibited, while other designated activities would be subject to a notification requirement.
D. Prohibition and Notification Requirements
A summary of the prohibition and notification requirements as they relate to the identified covered activities is as follows:
1. Semiconductors and microelectronics
Covered transactions related to electronic design automation software; certain fabrication and advanced packaging tools; the design, fabrication, or packaging of certain advanced integrated circuits; and supercomputers are prohibited, while covered transactions related to the design, fabrication and packaging of integrated circuits that are not otherwise prohibited are generally notifiable.
2. Quantum information technologies
Covered transactions related to the development of quantum computers and production of critical components; the development or production of certain quantum sensing platforms; and the development or production of quantum networking and quantum communication systems are prohibited.
3. Certain AI systems
Covered transactions involving AI systems designed exclusively for military, government intelligence or mass surveillance end uses or that meet certain technical specifications are prohibited. Covered transactions involving AI systems designed for cybersecurity applications, digital forensics tools, penetration testing tools, control of robotic systems or that meet different technical specifications are notifiable.
When there is a notification requirement, U.S. persons must submit notifications electronically to the Treasury Department no later than 30 days after the completion date of the covered transaction. The Proposed Rule sets out the information required to be submitted in a notification, which includes, among other things, identification of the U.S. person and relevant contact information, a description of the transaction, information about the covered foreign person, a summary of each covered activity undertaken by the covered foreign person, and an explanation of why the transaction is a covered transaction.
ARE THERE ANY EXCEPTIONS TO THE PROPOSED RULE?
The Proposed Rule includes exceptions for certain types of covered transactions, provided that they do not provide a U.S. person with certain investor rights that are above the standard protections provided to minority shareholders. These exempted transactions include:
- Publicly traded securities: An investment by a U.S. person in a publicly traded security or a security issued by an investment company, such as an index fund, mutual fund, or exchange-traded fund;
- Certain LP investments: A U.S. person's investment of a certain size made as a limited partner in a venture capital fund, private equity fund, or other pooled investment fund;
- Buyouts of country of concern ownership: A U.S. person's full buyout of all country of concern ownership of an entity, such that the entity would not constitute a covered foreign person following the transaction;
- Intracompany transactions: An intracompany transaction between a U.S. parent and a majority-controlled subsidiary to support ongoing operations or other non-covered activities;
- Pre-Outbound Order binding commitments: A transaction fulfilling a binding, uncalled capital commitment entered into prior to August 9, 2023;
- Certain syndicated debt financings: Where the U.S. person, as a member of a lending syndicate, acquires a voting interest in a covered foreign person upon default and the U.S. person cannot initiate any action through the debtor and does not have a lead role in the syndicate; and
- Third country measures: Certain transactions involving a person of a country or territory outside of the United States may be excepted transactions where the Secretary of the Treasury determines that the country or territory is addressing national security concerns posed by outbound investment and the transaction is of a type for which associated national security concerns are likely to be adequately addressed by the actions of that country or territory.
The Proposed Rule also provides for a national interest exemption on the basis that a transaction is in the national interest of the United States. Such determination would be made on a case-by-case basis by the Secretary of the Treasury, in consultation with the Secretary of Commerce, the Secretary of State and the heads of relevant agencies, as appropriate.
WHAT ARE THE PENALTIES FOR NON-COMPLIANCE?
Violations of the Proposed Rule would be subject to civil and criminal penalties as set forth in the International Economic Emergency Powers Act. Under the Proposed Rule, the Treasury Department may impose a civil penalty on any person who violates the requirements and could also refer potential criminal violations to the U.S. Attorney General. In addition, the Secretary of the Treasury could take action to nullify, void or otherwise require divestment of any prohibited transaction.
Pursuant to the Proposed Rule, any voluntary self-disclosure of violations would be considered a mitigating factor during the Treasury Department's determination of the appropriate response.
WHAT ARE THE NEXT STEPS?
The Treasury Department is soliciting written comments on the Proposed Rule; these comments may be submitted via an online portal by August 4, 2024. The Treasury Department will then consider comments and publish final implementing regulations at a later date.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.