After months of speculation, the US government took steps to regulate outbound investment in specific foreign industries of concern. President Biden on August 9, 2023, issued Executive Order 14105 directing the Department of the Treasury to regulate US investments in the semiconductor, quantum computing, and artificial intelligence (AI) sectors of the People’s Republic of China (including Hong Kong and Macau). The Treasury Department issued an Advance Notice of Proposed Rulemaking (ANPRM) for regulations to be promulgated, seeking comment by September 28, 2023. We refer to the proposed rules as the Outbound Investment Program, or OIP.
The OIP responds to concerns expressed across political persuasions that a combination of US-sourced capital and intangible benefits (e.g., enhanced standing, managerial assistance, access to investment and talent networks) has fueled China’s domestic advancement of these technologies, with perceived negative implications for US national security interests. The OIP would fill a gap in existing legal authorities — principally, those exercised by the Committee on Foreign Investment in the United States (CFIUS); the US export control regimes; and the US economic sanctions administered by the Office of Foreign Assets Control (OFAC) — which are believed inadequate to address the perceived threats.
With US-China relations broadly deteriorating and members of a divided US Congress agitating for strict investment restrictions, the OIP strikes a moderate approach characterized as a “derisking” rather than a “decoupling” from China. But this effort presents issues difficult to reconcile with the potential harm to commercial interests, as evidenced by 83 specific topics for comment in the ANPRM.
Unlike the CFIUS regime with which it will be compared, the OIP would not establish a mechanism for review of transactions but would instead prohibit transactions in certain sectors, while requiring notification of others (suggesting the scope of the rule will yet evolve). The OIP proposes criminal, civil, and divestment penalties, as available under the International Emergency Economic Powers Act and Executive Order 14105. The OIP is not intended to be retroactive but would enable the US government to request information about transactions completed or agreed to after August 9, 2023 (the date of the Executive Order).
What Investment Targets Would Be Within the Scope of The OIP?
The OIP targets certain investments in a “covered foreign person,” meaning entities that are (1) a “person of a country of concern” and (2) engaged in activities related to a narrowly defined set of “covered national security technologies or products.”
Person of a Country of Concern
The OIP identifies the People’s Republic of China (including Hong Kong and Macau) as the country of concern, citing government-led initiatives to leverage private-sector technologies to advance military, intelligence, and cyber-enabled capabilities. It proposes a broad interpretation of “person of a country of concern,” including:
- entities organized under the laws of a country of concern, or with a principal place of business in a country of concern
- the government of a country of concern (including entities owned, controlled, or directed by, or acting for or on behalf of, such governments)
- citizens or permanent residents of country of concern (excluding US citizens and green card holders)
- entities owned 50% or more, individually or in the aggregate, by the foregoing (e.g., by Chinese citizens)
This last category could yield unexpected results — e.g., even a US-domiciled company in which four Chinese citizens collectively hold a 55% interest engaged in AI development could be implicated by the OIP.
Covered National Security Technologies and Products
The OIP introduces three categories of “covered national security technologies and products” that could trigger a prohibition or notification requirement:
- Semiconductors and Microelectronics. Mostly consistent with existing and recently expanded export control restrictions, the proposed prohibitions target the design, fabrication, and packaging of advanced integrated circuits, along with the installation or sale of certain supercomputers. The notification requirement would cover activities related to the design, fabrication, and packaging of other integrated circuits.
- Quantum Information Technologies. The proposed prohibitions cover most quantum computing applications, with limited exceptions for quantum sensors used for commercial applications. There is no category of “notifiable” quantum computing transactions.
- AI Systems. Although the majority of AI applications should remain unaffected, the OIP proposes a prohibition related to AI software designed “exclusively” (or “primarily,” depending on how the rule is finalized) for military, government intelligence, or mass-surveillance end uses. A notification requirement would apply to transactions involving software designed to be exclusively (or primarily) used for cybersecurity applications, digital forensics tools, and penetration testing tools; the control of robotic systems; certain surreptitious listening devices; non-cooperative location tracking; and facial recognition. The proposed construct would not reach software platforms intended for a broad set of end uses.
Parent Companies and Future Activities
While these country- and technology-based elements may be discernible by transaction parties at the time of the investment, two additional bases for “covered foreign person” status could prove more challenging.
First, the definition of “covered foreign person” includes a parent company if its direct or indirect subsidiaries (together accounting for 50% or more of its consolidated revenue, net income, capital expenditures, or operating expenses) meet the criteria for covered foreign persons, even if the parent does not. The expanded scope may introduce challenging technology and financial accounting analyses concerning companies operating in China.
Second, the OIP proposes a knowledge element that would capture investments if the US person knows or should know that the investment target will be engaged in covered activities in the future. The knowledge standard — particularly vexing in greenfield and early-stage investments, where future plans may be unclear — contemplates diligence before engaging with investment targets tied to a country of concern.
What Transactions Involving a “Covered Foreign Person” Would Be Subject to The OIP Prohibitions and Notification Requirements?
Assuming a transaction involves a “covered foreign person,” the question is whether the transaction itself is an OIP “covered transaction” such that the prohibition or notification requirements could apply. At a minimum, there must be a “US person” investing (or involved in the investment, for example by directing it) in the “covered foreign person.” If so, the OIP proposes certain types of transactions that would fall within the program’s scope and others that would be excluded, as explained in further detail below.
Covered “US Person” Involvement
- Transactions by a US person. The OIP will apply to transactions conducted by a “US person,” which 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 in the United States” (the same definition applied in the context of US sanctions). For example, a non-US citizen living or working in the United States or a non-US entity engaging in financing activities from the United States could be subject to the OIP’s requirements.
- Transactions by entities “controlled” by US persons. The OIP may require US persons to notify Treasury of transactions undertaken by a foreign entity “controlled by” that US person (proposed to be defined as an entity in which the US person owns, directly or indirectly, a 50% or greater interest), if the transaction would require a notification if undertaken by a US person. And if the transaction would be prohibited if undertaken by a US person, the OIP may require US persons to “take all reasonable steps to prohibit and prevent” the transaction.
- Prohibited transactions that are “knowingly directed” by US persons. US persons would also be prohibited from “knowingly directing” transactions that would be prohibited if engaged in by a US person. Although similar to the OFAC “facilitation” concept, the OIP regulations may offer more helpful guidance. Supported by six proposed examples, the OIP would regard “knowingly directing” as cases where a US person “orders, decides, approves, or otherwise causes” the transaction to be performed, but not where the US person’s involvement is attenuated from the transaction itself, such as third-party investment advisory services, underwriting, bank payments, or legal services. The knowledge standard in this context could also borrow from the Export Administration Regulations and include both actual knowledge and situations in which the US person should have known about the conduct, circumstance, or result of the transaction.
Transactions That Would Be OIP “Covered Transactions”
An OIP “covered transaction” would include the following transactions with a “covered foreign person” (subject to exemptions discussed below):
- acquisitions of equity interest or contingent equity interest
- debt financing, where such debt is convertible into equity interest (e.g., a convertible note)
- “greenfield investments” that could result in the establishment of a covered foreign person
- joint ventures, wherever located, with a covered foreign person or that could result in the establishment of a covered foreign person
(This scope would be broader than “covered transactions” under the CFIUS rules, which typically do not include debt financing transactions and greenfield investments.)
Although the OIP is forward-looking and imposes no requirements until the regime takes effect (expected in 2024), Treasury may request information about transactions completed or agreed to after August 9, 2023.
Transactions That Would Not Be OIP “Covered Transactions” or Would Be “Excepted” From The OIP
The OIP does not propose to reach the following activities, unless designed for evasion and otherwise within the scope of an OIP “covered transaction”:
- 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
- services “secondary to a transaction,” such as the processing, clearing, or sending of payments by a bank; underwriting services; debt rating services; prime brokerage; global custody; or equity research or analysis
- into a publicly traded security
- into an index fund, mutual fund, exchange-traded fund, or similar instrument offered by an investment company or private investment fund
- as a limited partner (LP) into a venture capital fund, private equity fund, fund of funds, or other pooled investment funds, as long as (a) the LP’s contribution is solely capital into a limited partnership structure and the LP does not have certain decision-making rights, debt responsibilities, or influence or participation in the fund or the covered foreign person; and (b) the investment size is below a to-be-defined threshold
But any such investments would not be excepted if they afford the US person “rights beyond those reasonably considered to be standard minority shareholder protections,” such as board membership or observer rights or involvement in substantive business decisions, management, or strategy.
Additional “excepted transactions” under consideration include:
- the acquisition by a US person of all the interests held by a “covered foreign person” in an entity or assets located outside of the People’s Republic of China
- an intracompany transfer of funds from a US parent company to a subsidiary located in the People’s Republic of China
- a transaction undertaken pursuant to a binding, uncalled capital commitment entered into before August 9, 2023
What Should I Consider Before The OIP Takes Effect?
Interested parties should consider whether and how their activities could be regulated under a final OIP rule, likely to be issued in 2024. Among the important near-term questions are whether the party is (or is controlled or directed by) a “US person”; whether the party invests in the semiconductor, quantum computing, and/or AI sectors in the People’s Republic of China (including Hong Kong and Macau); whether the party’s activities may be “excepted” from the rule (for instance, as a passive LP investing in a fund); what diligence processes and contractual representations inform these questions and how they could be enhanced; and whether the ANPRM presents questions meriting the party’s comments by September 28, 2023.
Charlie Brown spent 50 years attempting to kick a football that Lucy consistently yanked away at the last second. Through an Executive Order instructing the establishment of the OIP, the US government has finally made contact with the football, but interested parties can still affect its trajectory as it sails towards the goalposts.
* * * * * *
If you would like additional information about the issues addressed in this client alert, please contact Rich Matheny, Jacob Osborn, Amy Josselyn or the Goodwin lawyer with whom you typically consult.