Treasury Department Issues Proposed Rule To Implement Restriction on Certain U.S. Investments in China

On June 21, 2024, the U.S. Department of the Treasury announced a Notice of Proposed Rulemaking (NPRM) to implement the August 9, 2023 Executive Order 14105, “Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern” (the Outbound Order). The NPRM outlines proposed restrictions and notification regulations for U.S. persons making certain investments in “countries of concern,” namely the People’s Republic of China (PRC) and the Special Administrative Regions of Macau and Hong Kong, that involve sensitive technologies and products in the areas of semiconductors and microelectronics, quantum information technologies, and artificial intelligence (AI).

The Outbound Order requires that the Treasury Department issue regulations that identify categories of “notifiable transactions” and “prohibited transactions.” In accordance with that direction, the NPRM outlines the Treasury Department’s proposed approach, which if adopted, would (1) require U.S. persons to notify the Treasury Department when participating in “a covered transaction” with a “covered foreign person” that is engaged in certain activities involving covered national security technologies and products and (2) prohibit U.S. persons from participating in “a covered transaction” with a “covered foreign person” that is engaged in certain activities involving covered national security technologies and products. The NRPM provides different categories of covered activities for “notifiable transactions” and “prohibited transactions.”

Interested parties have until August 4, 2024 to submit comments on the NPRM.

Covered Transactions

The Treasury Department proposes that a “covered transaction” would include a U.S. person’s direct or indirect:

1. Acquisition of an equity interest or contingent equity interest in a covered foreign person (see definition below)

2. Provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest

3. Greenfield investment that could result in the establishment of a covered foreign person

4. 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

By including indirect investments, acquisitions, or financings within the scope of a “covered transaction,” the proposed rule would prevent (or at least deter) the use of intermediary non-U.S. persons as a means to evade the proposed restrictions and notification requirements. “Covered transactions” under the proposed rule would not include, however, “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” so long as those activities are not structured to evade the prohibitions or notice requirements.

The Treasury Department also proposes to apply a “knowledge” standard and an “intent” standard as a determinant of whether a transaction is a covered transaction. While generally the proposed restrictions and notice requirements would apply only if the U.S. person engaging in the transaction had “knowledge of the relevant facts or circumstances at the time of a transaction,” the NPRM states that “A U.S. person’s intent (as distinct from knowledge) would be sufficient in [certain] cases for the transaction to be a covered transaction.” For example, in the context of a greenfield or brownfield investment, a U.S. person may not know at the time of the transaction that the investment will result in a covered activity, but the Treasury Department seeks to cover activities intended to bring about the establishment of a covered foreign person or a person of a country of concern’s engagement in a new covered activity, “since such a situation is likely to convey intangible benefits from the U.S. person to a covered foreign person.”

While the NPRM states the proposed rule would cover only future investments, it also states that the Treasury Department may request information about transactions already completed or agreed upon after the rule goes into effect.

Covered Foreign Persons

The Treasury Department proposes the definitions of a “covered foreign person” to include:

1. A person of a country of concern that is engaged in, or a person of a country of concern that a U.S. person knows or should know will be engaged in, an identified activity with respect to a covered national security technology or product

2. A person whose direct or indirect subsidiaries or branches are referenced in item (1) and which, individually or in the aggregate, comprise more than 50% of that person’s consolidated revenue, net income, capital expenditure, or operating expenses

And the Treasury Department proposes the following definition of “person of a country of concern”:

1. Any individual that is not a U.S. citizen or lawful permanent resident of the United States and is a citizen or permanent resident of a country of concern

2. An entity with a principal place of business in, or an entity incorporated in or otherwise organized under, the laws of a country of concern

3. The government of a country of concern, including any political subdivision, political party, agency, or instrumentality thereof, or any person owned, controlled, or directed by, or acting for or on behalf of the government of such country of concern

4. Any entity in which a person or persons identified in items (1) through (3) holds individually or in the aggregate, directly or indirectly, an ownership interest equal to or greater than 50%

These definitions of a “covered foreign person” and “person of a country of concern” capture both (1) parent companies whose subsidiaries are involved in activities related to a covered national security technology or product and (2) entities located outside of a country of concern that are majority-owned by persons of a country of concern.

Under the Outbound Order, the NPRM applies to one country, the PRC, along with the Special Administrative Regions of Hong Kong and Macau as a country of concern. However, this list can be updated and expanded by the president in the future.

Excepted Transactions and Exemption

Not all transactions that meet the scope of the proposed rule will be subject to a prohibition or notification requirement. The proposed rule lists several instances when an otherwise covered transaction would be treated as an excepted transaction, including:

1. An investment by a U.S. person in a publicly traded security

2. 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

3. Certain investments made by a U.S. person limited partnership into a venture capital fund, private equity fund, fund of funds, or other pooled investment funds

4. 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

5. An intracompany transaction between a U.S. person parent and its subsidiary to support ongoing operations (or other activities that are not covered activities)

6. Fulfillment of a U.S. person’s binding capital commitment entered into prior to the date of the Outbound Order

7. 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

8. Certain transactions occurring in a country or territory outside the United States involving certain partner and ally countries that commit to implementing outbound investment review measures to address the potential national security concerns

The Treasury Department has determined these kinds of transactions “present a lower likelihood of concern” and seek to minimize “unintended consequences.”

In addition, a U.S. person may seek an exemption from the prohibition or notification requirement if the transaction is in the national interest of the United States. Such an exemption would be granted if the Secretary of the Department of the Treasury, in consultation with the heads of other relevant departments, as appropriate, determines the transaction should be permitted because it “provides an extraordinary benefit to U.S. national security or provides an extraordinary benefit to the U.S. national interest in a way that overwhelmingly outweighs relevant U.S. national security concerns.”

Prohibited Transactions and Notifiable Transactions

Executive Order 14105 defines “covered national security technologies and products” to include sensitive technologies and products in the semiconductors and microelectronics, quantum information technologies, and artificial intelligence sectors. However, under the NPRM, the Treasury Department intends to differentiate when specific technologies and products falling within the scope of “covered national security technologies and products” would be considered a prohibited transaction versus a notifiable transaction.

As described above, the proposed rule covers instances when a transaction would be prohibited and other instances when the transaction is not prohibited but is subject to a notification requirement. According to the NPRM, this ensures the U.S. government is kept abreast of “U.S. person transactions involving the defined technologies and products that may contribute to the threat to the national security of the United States.” However, in the instances where a U.S. person does not have “knowledge” at the time of the transaction, no notification requirement would apply unless there is an indication of intent. In cases where the U.S. person acquires knowledge later, the notification requirement will apply after the fact. These requirements could create potential challenges for compliance, and U.S. persons will need to be vigilant and cognizant of the notification requirements for such transactions.

Therefore, the Treasury Department is making a distinction for the purposes of prohibited versus notifiable transactions “based on a description of the technology or product and the relevant activities, capabilities, or end uses of such technology or product, as applicable.” Please see the table below for the Treasury Department’s distinction between prohibited and notifiable transactions regarding certain technologies.

The Treasury Department proposes defining an AI system as “an engineered or machine-based system that can, for a given set of objectives, generate outputs such as predictions, recommendations, or decisions influencing real or virtual environments.”

In addition, the proposed rule would prohibit a U.S. person from “knowingly directing” a transaction if such a transaction would be prohibited if engaged in by a U.S. person. However, certain attenuated conduct would not be captured within this restriction, such as providing secondary, wraparound, or intermediary services (e.g., 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).

Finally, the Treasury Department is also proposing certain requirements for U.S. persons and the foreign entities subject to their control (i.e., a foreign entity in which a U.S. person owns, directly or indirectly, 50% or more interest). These requirements include notifying the Treasury Department of any transaction by a controlled foreign entity if such a transaction would be a notifiable transaction if undertaken by a U.S. person and “tak[ing] all reasonable steps to prohibit and prevent” such transaction. The NPRM provides several examples of “reasonable steps,” including:

1. Relevant binding agreements between a U.S. person and the relevant controlled foreign entity or entities

2. Relevant internal policies, procedures, or guidelines that are periodically reviewed internally

3. Implementation of periodic training and internal reporting requirements

4. Implementation of effective internal controls

5. A testing and auditing function

6. The exercise of governance or shareholder rights, where applicable

For these obligations, the Treasury Department intends to adopt a knowledge standard similar to the standard applied under the Export Administration Regulations administered by the U.S. Department of Commerce. In other words, U.S. persons “would need to know, or reasonably should know based on publicly available information and other information available through a reasonable and appropriate amount of due diligence, that it is undertaking a transaction involving a covered foreign person and that the transaction is a covered transaction.”

However, the restrictions would not prohibit a U.S. person from generally working at a foreign entity that receives investment or working for a foreign entity making such an investment.

Conclusion

Companies and individuals that invest, or seek to invest, in sensitive technologies and products should carefully review the Treasury Department’s proposed definition of “person of a country of concern” and analyze the potential impact on their business and/or investment. While some of the definitions are aligned with other regulatory regimes (e.g., U.S. export controls on advanced semiconductor manufacturing), the proposed rule covers additional categories of products and technologies.

The proposed rule, if adopted, would require U.S. persons to conduct additional due diligence prior to their investments. In particular, U.S. persons will need to conduct due diligence to understand whether the contemplated foreign investment would be a prohibited or notifiable transaction. Such diligence may include, for example, further inquiries about whether the investment target may be engaged in activities involving the covered national security technologies and products and whether the investment target’s subsidiaries or branches engage in such activities (and if so, whether the consolidated revenue, net income, capital expenditures or operating expenses relating to such activities exceed the 50% threshold). Even after the investment, U.S. persons will need to remain vigilant about the investment target’s activities because the U.S. persons would be required to submit a notification to the Treasury Department should they acquire the requisite knowledge after the investment.

The Treasury Department has requested additional input from the public on the proposed rules, and U.S. entities and individuals engaged in the semiconductors, quantum computing, and artificial intelligence sectors should anticipate the effects that the expected regulations will have on their businesses. Once received, the Treasury Department will issue its final implementing regulations at a later date and set an effective date for the outbound investment program.

We will continue to monitor the rulemaking stemming from the new NPRM and any additional measures targeting these sectors. Please contact any author of this Advisory for more information.

© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.