After months of deliberation, on August 9, 2023, President Biden issued the executive order “Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern” (Order), with China (including the Special Administrative Regions of Hong Kong and Macau) as the only country initially designated as a country of concern. In parallel, the US Department of the Treasury (Treasury) issued an advanced notice of proposed rulemaking outlining, and requesting public comment on, proposals that Treasury is considering as it drafts the regulations to implement the Order (Program).
Public comments are due to Treasury by September 28, 2023. If your organization has any questions about the Order or the Program or is interested in submitting comments to Treasury, please feel free to reach out to any of the Eversheds Sutherland contacts below.
What Are the Biggest Takeaways?
As the Biden Administration has broadcast over the months leading up to the Order, the Program is intended to be narrowly tailored in a number of ways – limited to countries of concern (currently only China, including Hong Kong and Macau) and specific technologies, products, and activities that present risks to the national security of the United States – and with a broad swath of exceptions. As Treasury has emphasized, the Program focuses on investments that could enhance a country of concern’s military, intelligence, surveillance, or cyber-enabled capabilities through the advancement of technologies and products in particularly sensitive areas. The Program also reflects a clear focus on front-end investment in start-ups and emerging companies engaged in developing new technologies and products rather than established, publicly traded firms working with mature technologies and products.
The major question for both potential investors and Treasury is whether the cumulative effect of the definitions and standards Treasury is considering, including the use of a knowledge or reason-to-know standard for investors, will create a chilling effect on a broader range of potential transactions than intended given the challenges of obtaining transparency in China regarding whether and to what degree such covered activities are being conducted. Indeed, ironically, the very military-civil fusion among some Chinese companies that underpins the Biden Administration’s national security concerns will add to the difficulty of discerning whether Chinese firms are engaged in covered activities. Thus, will prudent investors, even after conducting reasonable diligence, be able to discern the dividing line between Prohibited Transactions and Notification Transactions, and if not, will they simply step back from a broader range of transactions?
Certainly, Treasury should consider these concerns and others as it formulates its regulations. For example, will the controls be sufficiently multilateral in nature if enough other capital-intensive countries fail to join? And to what extent will the proposed rules on “indirect” investments and anti-evasion be effective?
Program Scope: What Is a “Covered Transaction”?
Treasury makes clear at the outset that the proposed Program would not impede all US investments or impose sector-wide restrictions on US person activities. Rather, the Program will target high-level categories of these technologies and products that are the focus of the Program: (1) semiconductors and microelectronics; (2) quantum information technologies; and (3) AI systems (see Covered National Security Technology or Products).
What Types of Transactions Are Covered? Treasury is considering covering a US person’s direct or indirect:
- acquisition of an equity interest or contingent equity interest in a covered foreign person;
- provision of debt financing convertible to an equity interest to a covered foreign person;
- greenfield investment that could result in establishment of a covered foreign person; or
- establishment of a joint venture, wherever located, formed with a covered foreign person or that could result in the establishment of a covered foreign person.
Notably, in contrast to reviews of inbound investment, where greenfield transactions are not subject to review by the Committee on Foreign Investment in the United States (CFIUS), Treasury is intentionally covering such early-stage investment, reflecting a desire to prevent the early-stage development of certain national security technologies and products.
Coverage of Indirect Transactions – an Anti-Evasion Measure. Significantly, Treasury is considering including “indirect” transactions as “covered transactions” in order to close loopholes that would otherwise exist and clarify that attempts to evade prohibitions on certain transactions cannot find safe harbor in the use of intermediary entities that are not “US persons” or “covered foreign persons.” For example, a US person who knowingly invests in a third-country entity that then uses the invested funds to undertake a covered activity in a covered country would theoretically be covered. Thus, to the extent US venture capital funds or private equity firms seek to invest through third-country intermediaries, such third-country investments would then trigger additional due diligence obligations and ultimately might be captured under the Program.
Scope: Who Are “Covered Foreign Persons” and “Persons of a Country of Concern”?
The Order defined “covered foreign person” to mean: (1) a “person of a country of concern” and (2) who or that is engaged in activities (identified in Treasury regulations) involving one or more “covered national security technologies and products.”
- Who is a “person of a country of concern"? Treasury is considering defining this term to include the following: an individual who is not a US citizen or lawful permanent resident of the United States and a citizen or permanent resident of a country of concern; entities with a principal place of business in, or incorporated in or otherwise organized under the laws of, a country of concern; 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; and an entity in which a person or persons identified above hold individually or in the aggregate, directly or indirectly, an ownership interest equal to or greater than 50%.
- When is a “person of a country of concern” covered? Treasury is considering defining covered foreign persons to mean:
- a person of a country of concern that is engaged in, or a person of a country of concern that a US person knows or should know will be engaged in, an identified activity with respect to a covered national security technology or product; or
- a person whose direct or indirect subsidiaries or branches are referenced in the definition above and, individually or in the aggregate, comprise more than 50% of that person’s consolidated revenue, net income, capital expenditure, or operating expenses.
The Two-Step 50% Rule. Borrowing from its economic sanctions constructs, the Program would cover entities that are 50% or more owned by a person of a country of concern and that comprise more than 50% of the revenue, net income, or other economic measures of such person. In effect, this construct covers entities majority-owned by other firms – providing an expansive definition – but mitigates the effect of that by also adding a revenue threshold. On the other hand, the 50% rule (i.e., with a focus on ownership rather than control rights) may also allow foreign firms to restructure their ownership to avoid the application of the rule.
Whose Burden Is It to Decide If an Investment Is Covered? Defining a covered foreign person in part by reference to what a US person “knows or should know” is covered in effect shifts the obligation, and the burden, to the potential investor to assess whether its investment is subject to the prohibition or notification requirements. This raises the question of whether it is reasonable for an investor to have knowledge of relevant circumstances (i.e., actual or constructive knowledge that the covered foreign person is engaged in, or will foreseeably be engaged in, certain activity regarding the technology or product).
Treasury has indicated it may adopt a definition of “knowledge” similar to that in the Export Administration Regulations (EAR), where “knowledge” means not only positive knowledge that a circumstance exists or is substantially certain to occur, but also an awareness of a high probability of its existence or future occurrence. Awareness is inferred from evidence of a person’s conscious disregard of facts known to that person or from a person’s willful avoidance of facts. Generally, these types of “reason to know” standards impose a diligence duty on the party with the obligation (here, the investor) – i.e., to ascertain what it can through publicly available information and a reasonable and appropriate inquiry as to whether the transaction involves a covered transaction.
Needless to say, this type of burden will be challenging for investors. Realistically, in a country like China, there is limited transparency into the business activities of many companies – making it unknowable or unforeseeable whether an entity is covered, even with reasonable due diligence. Indeed, it is highly unlikely the potential investor will be able to determine whether the two-step 50% rule is met if the target will not open its books. In short, in these scenarios, what option does the prudent investor have other than to walk away?
National Security Technologies and Products – the Linchpin of the Proposed Rules
Pursuant to the Order, Treasury is considering regulations that would define in detail two levels of “covered national security technologies and products”1 in each of three discrete areas: semiconductors and microelectronics, quantum information technologies, and artificial intelligence. As Treasury noted, investments in these advanced technologies and products were selected because they could “enhance a country’s military intelligence, surveillance, or cyber-enabled capabilities.”
The distinctions between technologies and products that are prohibited and those that are subject to a lesser notification requirement are very detailed and specific to each particular business sector; they should be carefully reviewed by potential investors and other industry participants. In some areas, the distinction relates to whether the technology or product (e.g., artificial intelligence systems) is designed exclusively (or possibly primarily used) for military end uses, government intelligence, or mass-surveillance end uses; in other areas, military usage is not a distinguishing criterion.
As discussed above, a key question is how a potential investor would necessarily know, or be able to find out through reasonable diligence, whether a company is engaged in “prohibited” versus “notified” activities in semiconductors and microelectronics, quantum information technologies, and artificial intelligence. The highly technical nature of the definitions and relative lack of transparency of the activities of many target firms in countries of concern will make this determination very challenging.
A Broad Range of Technologies and Products Are Likely to Require Notification. What is clear, however, is that the categories covered under the notification requirement are broad in scope and will cover a wide swath of businesses in China. For example, in the semiconductor and microelectronics area, the notification requirement for integrated circuits include all integrated circuits technology, as well as products not subject to the prohibition. Suffice to say, this would probably include most of the semiconductor sector of the Chinese economy. In effect, the notification requirement may apply to a broad segment of the Chinese economy, including, for example, many firms working with artificial intelligence (which is increasingly common across a wide range of business sectors).
Program Scope: Key Exemptions and “Excepted Transactions”
As noted at the outset, Treasury is considering a range of coverage exceptions and “excepted transactions” that, if promulgated, will effectively narrow the scope of the Program.
Activities Not Covered. Activities and transactions not covered (or exempt) include those that, fundamentally, are not viewed as “investments” and are in the nature of day-to-day business activities or other types of transactions. These include 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; and other services secondary to a transaction.
Excepted Transactions. Treasury also is considering proposing four types of “Excepted Transactions” that would not be subject to the Program. Such transactions would include:
- investments (1) into a publicly traded security; (2) into an index fund, mutual fund, exchange-traded fund, or similar instrument (including associated derivatives) offered by an investment company or by a private investment fund; or (3) made as a limited partner into a venture capital fund, private equity fund, fund of funds, or other pooled investment fund, provided that the limited partner’s contribution is solely capital into a limited partnership structure, with no managerial authority, no responsibility for any debts beyond its investment, and no ability to influence or participate in the fund’s or a covered foreign person’s decision-making or operations, and the investment is below a de minimis threshold to be determined by Treasury;2
- acquisitions of the equity or other interest owned or held by a covered foreign person in an entity or assets located outside of a country of concern when the US person is acquiring all interests in the entity or assets held by covered foreign persons;
- intracompany transfers of funds from a US parent company to a subsidiary located in a country of concern; and
- transactions involving a binding, uncalled capital commitment entered into before the date of the Order.
Beyond Minority Rights Coverage. In evaluating the possible exemptions for investments in certain securities noted above, Treasury also is considering adopting a proviso that any investment that affords the US person rights beyond those reasonably considered to be standard minority shareholder protections will not constitute an “excepted transaction.” These rights may include, but are not limited to:
- membership or observer rights on, or the right to nominate an individual to a position on, the board of directors or an equivalent governing body of the covered foreign person; or
- any other involvement, beyond the voting of shares, in substantive business decisions, management, or strategy of the covered foreign person.
Anti-Evasion Measures
As in its economic sanctions regulations, Treasury also proposes a series of measures to expand and avoid the evasion of the prohibition and notification requirements.
Knowingly Directing Transactions. The Order provides Treasury with authority to issue regulations that would prohibit a US person from knowingly directing transactions if such transactions would be prohibited if engaged in by a US person. To that end, Treasury is considering promulgating regulations that would define “knowingly” for this purpose to cover situations in which the US person had actual knowledge, or should have known, about the conduct, the circumstance, or the result and define “directing” to mean that a US person had ordered, decided, approved, or otherwise caused a transaction to be executed that would be prohibited if engaged in by a US person. One question is whether a US private equity fund that invests passively in a third-country fund with known investments in China would be covered under this approach.
Controlled Foreign Entities and Obligations of US Persons. The Order also authorized Treasury to issue regulations requiring US persons to take all reasonable steps to prohibit and prevent any transaction by a foreign entity controlled by that US person that would be a Prohibited Transaction if engaged in by a US person. Treasury is considering whether to define “controlled foreign entity” to mean a foreign entity in which a US person owns, directly or indirectly, a 50% or greater interest. Treasury is also considering whether to define the meaning of “all reasonable steps.” If defined, “all reasonable steps” could include a variety of factors, such as (1) relevant binding agreements between a US person and the relevant controlled foreign entity or entities; (2) relevant internal policies, procedures, or guidelines that are periodically reviewed internally; (3) periodic training and internal reporting requirements; (4) effective internal controls; (5) a testing and auditing function; and (6) the exercise of governance or shareholder rights.
Will Allies Follow? Another critical question is whether US-allied and "aligned” countries will adopt similar restrictions. While some US allies, including Germany, the United Kingdom, and the European Union, have expressed interest in similar regimes, Japan, a staunch US ally in the Pacific, has reportedly already made clear it does not intend to revise legislation governing outbound investments to China.3 Unilateral US action would restrict a significant flow of US capital and investment from supporting the development of covered national security technologies and products by foreign persons, but multilateral support is needed for effective implementation.
The Hong Kong Connection. Finally, it is worth noting that Hong Kong, historically a financial hub in Asia, is expressly included in the definition of country of concern. Thus, any foreign branches of US entities located in Hong Kong are considered US persons and subject to Program requirements relating to Prohibited Transactions and Notification Transactions. Hence, the Program would potentially affect Hong Kong’s role as a western financial hub.
Takeaways
In sum, there are many questions about the scope and effect of the regulations Treasury has been directed to develop. Treasury will need to consider two core issues.
Scope of Requirements – Will There Be a Broader-Than-Intended Chilling Effect on Investment in China? While the intent of the Program is to narrowly tailor the prohibitions and notifications to a discrete set of technologies and products with a clear national security nexus, the burden is on Treasury to reflect this intent in practice. In this regard, Treasury should carefully evaluate whether the cumulative effect of the application of the proposed definitions and standards, and in particular the use of the proposed “knowledge and reason to know” standard, will create so much uncertainty that prudent investors will simply avoid a broader swath of investments than Treasury intended. The pervasive use of the targeted technologies throughout a range of Chinese businesses in various sectors will make it challenging for investors to draw reasonable distinctions.
Efficacy Requirements – Can the Program Achieve Its Goals? At the same time, Treasury faces the question of whether the Program will be effective. First, given the fungibility of money, a key issue is whether other sources of foreign capital, including the European Union, Australia, and other key US allies and partners, will join in this type of outbound investment regime. Their failure to follow the US' lead may result in a situation in which only US investors are burdened and investors from other countries step into the breach created by the departure of US investors. Second, it remains to be seen if the proposed rules on “indirect” transactions and evasion will be effective in closing loopholes that would undermine the efficacy of the Program.
Table I – Prohibited Transactions
US persons would be prohibited from undertaking a transaction with a covered foreign person engaged in activities involving:
Table II – Notification Transactions
US persons would be required to notify Treasury, no later than 30 days following the closing of a covered transaction, if undertaking a transaction with a covered person engaged in activities involving any of the following:
________
1 The Order defined “covered national security technologies and products” as sensitive technologies and products in the semiconductors and microelectronics, quantum information technologies, and artificial intelligence sectors that are critical for the military, intelligence, surveillance, or cyber-enabled capabilities of a country of concern, as determined by the secretary in consultation with the secretary of commerce and, as appropriate, the heads of other relevant agencies (and may be limited by reference to certain end uses of those technologies or products).
2 Treasury is also considering whether this limited partner exception should only apply to investors or investments into funds beneath a defined threshold (e.g., the size of the limited partner’s investment in the fund or the size of the limited partner itself).
3 Financial Times, White House unveils ban on US investment in Chinese tech sectors (Aug. 8, 2023), available at https://www.ft.com/content/64ef2042-9ece-4b0c-ad02-184c3454f43b?emailId=f24ee311-6eb3-4e16-bb45-e1a527b625d6&segmentId=13b7e341-ed02-2b53-e8c0-d9cb59be8b3b.
4 “Fabrication of integrated circuits” means the process of forming devices, such as transistors, poly capacitors, non-metal resistors, and diodes, on a wafer of semiconductor material.
5 “Packaging of integrated circuits” means the assembly of various components, such as the integrated circuit die, lead frames, interconnects, and substrate materials, to form a complete package that safeguards the semiconductor device and provides electrical connections between different parts of the die.
6 “Quantum computer” means a computer that performs computations that harness the collective properties of quantum states, such as superposition, interference, or entanglement.
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