The Executive Order (EO) directs the U.S. Department of the Treasury (Treasury) to create a program (Program) to  prevent new U.S. investments from bolstering three sensitive technology sectors of the People’s Republic of China mainland, Hong Kong and Macau (collectively, PRC). Treasury recently received comments from the public on the details of the Program.

The Program’s restrictions will apply to U.S. persons – U.S. citizens, lawful permanent residents, and entities organized in the United States, including foreign branches of such entities (U.S. Persons).

The Program also has an extraterritorial impact because it imposes obligations on U.S. Persons in connection with actions taken by any entities that they control and also prohibits U.S. Persons from “knowingly directing” transactions that would be prohibited if engaged in by a U.S. Person. 

A Treasury statement noted that “as part of a comprehensive, long-term strategy to advance the development of sensitive technologies and products, the PRC is exploiting, or has the ability to exploit, U.S. investments to further its ability to produce a narrow set of sensitive technologies critical to military modernisation”. The statement went on to say that “[s]uch U.S. investments are often accompanied by certain intangible benefits that help companies succeed, such as managerial assistance, investment and talent networks, and market access”.

On the same day the EO was issued, Treasury published an advance notice of proposed rulemaking (ANPRM), which makes clear that, unlike the U.S. process for screening inbound foreign investment, the Program would not involve a case-by-base review process.  As expected, the Program also will not employ a restricted parties list. Nevertheless, the Program will affect a range of transactions with certain parties in the PRC, Chinese-owned entities worldwide, non-Chinese entities with Chinese subsidiaries, and worldwide subsidiaries of U.S. companies.

The Program would require notification of certain transactions by U.S. Persons with certain entities located in, or with certain nexus to, the PRC that are engaged in activities involving the targeted technology sectors and would outright prohibit other transactions by U.S. persons with such entities.

What transactions are covered?

The ANPRM contemplates capturing four types of transactions as “covered transactions” that will be subject to the Program, including a U.S. person’s direct or indirect:

• Acquisitions of an equity interest or contingent equity interest in a covered foreign person (see below);
• Provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest;
• Greenfield investment that could result in the establishment of a covered foreign person; or
• 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.

What types of technologies are covered?

The EO describes certain so-called “national security technologies and products” to be included in the Program. The EO says these were selected “due to their critical role in accelerating the development of advanced military, intelligence, surveillance and cyber-enabled capabilities”. These national security technologies and products fall into three sectors: semiconductors and microelectronics; quantum information technologies; and certain artificial intelligence systems.

Who are “persons of a country of concern” and “covered foreign persons”?

The ANPRM contemplates that a “person of a country of concern” will include:

• Any individual that is not a U.S. citizen or permanent resident and is a citizen or permanent resident of a country of concern (i.e., currently China, Hong Kong, and Macau);
• Any entity organised under the laws of, or with a principal place of business in, a country of concern;
• The government of any country of concern and any person owned, controlled, or directed by or acting for or on behalf of such government; or
• Entities that are 50 per cent or more owned, directly or indirectly, by persons described above.

The ANPRM further contemplates that “covered foreign persons” will include (i) a “person of a country of concern” that is engaged in certain defined activities involving “national security technologies and products”, and (ii) persons whose subsidiaries or branches are engaged in such activities, if such subsidiaries or branches, individually or in the aggregate, comprise more than 50 per cent of that person’s consolidated revenue, net income, capital expenditure, or operating expenses.

Exemptions from covered transactions

The ANPRM notes that the Program may exclude certain activities from the definition of “covered transaction”, including:

• Investments into publicly traded securities;
• Investments into index funds, mutual funds, exchange traded funds;
• Investments made by limited partners (LPs) into venture capital funds, private equity funds, fund of funds or other pooled investment, where the investment satisfies certain passivity criteria;
• A full buyout by a U.S. Person of an entity or assets located outside of the PRC that are owned by a Chinese company;
• Intracompany transfer of funds from a U.S. parent company to a subsidiary in the PRC; and
• A transaction made pursuant to a binding, uncalled capital commitment entered into before the date of the EO.

The LP exemption referenced above will be important for U.S. private equity investors. LP investments made by U.S. Persons must be purely passive and the exemption will only apply in cases in which the “limited partner’s contribution is solely capital into a limited partnership structure and the limited partner cannot make managerial decisions, is not responsible for any debts beyond its investment, and does not have the ability (formally or informally) to influence or participate in the fund’s…. decision making or operations..”. In addition, the proposed LP exemption will apply only if the LP’s “investment is below a de minimis threshold to be determined by the Secretary”. The de minimis threshold that Treasury adopts could materially impact certain fund structures.

Separately, the ANPRM makes clear that “covered transactions” are not intended to capture certain other arrangements, including, for example, contractual arrangements for the procurement of material inputs for covered national security technologies or products, intellectual property licensing arrangements, and bank lending, unless undertaken as part of an effort to evade the Program.

Comments from the public

During the 45-day comment period, the public submitted approximately 61 comments to Treasury. The comments focused on various topics consistent with their respective stakeholders – however, a few recurring points include:

• Emphasis on clarifying terms and definitions, including the term “engaged in” (which is relevant to identifying “covered foreign persons”) and the definition of U.S. Person;
• Emphasis on consistency with definitions in existing regimes (e.g., tying the Program’s “U.S. Person” definition to the existing definition in the Export Administration Regulations; tying more terms within the “national security technologies and products” definition to existing U.S. export control classification regimes to clarify technical parameters);
• Emphasis on focusing “national security technologies and products” on those with military end-uses, not commercial end-uses; and
• Emphasis on ensuring that parties are able to comply with the Program efficiently (e.g., comments emphasising that Treasury should clarify the level of due diligence to be conducted by U.S. Persons; comments emphasizing the difficulties in identifying a “covered foreign person” using the contemplated 50 per cent test in that definition).

Takeaways

The outline of the Program, as set forth in the ANPRM, has been criticised in some quarters for being overly broad and ambiguous in its scope, despite its focus only on three technology sectors.

As expected, the Program does not envisage the creation of a list of restricted entities, thereby putting the burden on the U.S. Person to work out which investments come under the scope of the Program and how best to comply.

Importantly, the Program will have a wide-ranging impact on Chinese and non-Chinese companies and investors throughout the region – from certain Chinese-owned businesses operating throughout the APAC region in the semiconductor/microelectronics, AI, and quantum sectors, to APAC businesses with Chinese subsidiaries operating in these sectors, to APAC companies operating in these sectors that are subsidiaries of U.S. businesses, to APAC businesses and investment funds with U.S. managers or executives investing in these sectors.

Despite the breadth of the Program, the ANPRM did include a welcome bit of clarity – the Program will not apply retroactively to existing investments. However, Treasury may, after the effective date of the Program’s final regulations, request information about transactions by U.S. Persons that were contemplated or agreed to after the issuance of the EO. Further, the ANPRM makes clear that Treasury is still considering how to treat follow-on transactions that may be related to transactions that took place prior to the effective date of the Program.