A recent executive order issued by President Biden aims to prohibit or oversee investments in certain sensitive technologies that could threaten the national security of the United States. The executive order, which was issued August 9, encompasses the U.S. investment into sensitive technologies and products involving semiconductor and microelectronic technologies, quantum information technologies, and artificial intelligence (AI) technologies that are critical for the military, intelligence, surveillance or cyber-enabled capabilities of a “Country of Concern.” Prior to the executive order, the U.S regulated only inbound foreign direct investments through the Committee on Foreign Investment in the United States (CFIUS). Congress is also considering legislation on outbound foreign direct investment.
The Executive Order
The executive order seeks in certain instances to prohibit certain types of investments by what is termed “United States Persons” in these technologies, which the executive order calls “national security technologies and products,” (NSTPs), and in other instances to require notification to the U.S. Department of the Treasury on investments by United States Persons in NSTPs. The Countries of Concern identified in the executive order are limited to the Peoples Republic of China, the Special Administrative Region of Hong Kong, and the Special Administrative Region of Macau. Prohibited transactions are described as those that pose a particularly acute national security threat because of their potential to significantly advance the military, intelligence, surveillance or cyber-enabled capabilities of a Country of Concern. Notifiable transactions are described as those that contribute to the threat to the national security of the United States.
The executive order covers investment transactions in “Covered Foreign Persons”. A Covered Foreign Person is a foreign (i.e., non-U.S.) individual, entity or government of a Country of Concern who or that is engaged in activities involving one or more NSTPs. If it is an entity, it must be organized under that country’s laws or have its principal place of business there or be “owned” by a Covered Foreign Person. The executive order mandates the U.S. Department of the Treasury, together with the Department of Defense, the Department of Commerce, the Department of Energy and the Director of National Intelligence, to engage with allies in the national security concerns posed by Countries of Concern advancing NSTPs. The order also mandates that the Treasury Department, in consultation with other agencies, issue regulations to implement this Executive Order, including considering enforcement penalties, civil administrative subpoena power, civil money penalties, divestment orders for prohibited transactions and potential criminal referrals.
Proposed Regulations
Less than a week later, on Aug. 14, 2023, the Department of the Treasury issued an Advanced Notice of Proposed Rulemaking, commonly known as an ANPROM, setting forth initial guidelines and seeking public comment on these guidelines. Comments must be submitted by Sept. 28. The guidelines are set forth below, but it should be kept in mind that these guidelines are subject to revision once the notice period has expired and the Treasury Department issues final regulations. The ANPROM poses 83 questions for public input on its proposed regulations. Nonetheless, the proposed regulations provide a glimpse at the scope of the final regulations. Given that the ANPROM followed the executive order by only nine days, one can speculate that these proposed regulations were in process well before the anticipated executive order was issued.
The focus of the ANPROM is on technologies that forms a basis of next-generation military, intelligence, surveillance and cyber-enabled capabilities. The ANPROM expresses concern that these technologies can lead to improving speed and accuracy of military decision-making and planning in logistics, can enable the compromise of encryption and other cybersecurity controls, and can advance mass surveillance capabilities. It also states that the risks of U.S. investment are not merely the flow of capital into these technologies, but the provision of indirect benefits such as the transfer of other intangible benefits from the U.S. investor in the form of enhanced standing, managerial assistance, access to investments and talent networks, market access and enhanced access to additional financing. As mandated by the executive order, the proposed regulations address both investments that would be prohibited and those for which notification would be required. The Treasury Department seeks to prohibit with respect to the prohibited investments described below any conspiracy formed to violate the regulations, any action to evade the regulations, any action by a United States Person to “knowingly direct transactions that would otherwise be prohibited” and to require a United States Person to “take all reasonable steps to prohibit and prevent any transaction that would otherwise be prohibited.” The proposed regulations elaborate on what constitutes “knowingly directing a transaction” to mean “to order, decide, approve or otherwise cause to be performed a transaction that would be prohibited under these regulations if engaged by a United States Person.” The regulations are to have a prospective impact only, although the Treasury Department is considering how to treat follow-on transactions of transactions existing prior to implementation of the regulations. The ANPROM states that the Treasury Department will review this program no later than one year after the regulations become effective to consider any changes in or expansion of the regulations.
Who Is Covered?
In keeping with the executive order, the proposed regulations encompass investments by a “United States Person” in a “Covered Foreign Person” with respect to a “Covered Transaction”. A United States Person would be defined as either a (i) U.S. citizen, (ii) a lawful resident of the United States, (iii) an entity organized under the laws of the United States or any of its jurisdictions, including such entities, and (iv) any person in the United States. This definition would encompass foreign branches, which has far-reaching implications.
“Covered Foreign Person” is a “Person of a Country of Concern” who has engaged in, or a Person of a Country of Concern that a United States Person knows or should know will be engaged in an identified activity with respect to a covered NSTP. The term also includes an entity whose direct and indirect subsidiaries or branches constitute Covered Foreign Persons and which, individually or in the aggregate, comprise more than 50% of that entity’s consolidated revenue, net income, capital expenditure or operating expenses. This latter category captures parent companies whose subsidiaries and branches are otherwise covered. The term “Person of a Country of Concern” as used in the definition of “Covered Foreign Person” includes the following individuals and entities: (i) 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; (ii) an entity with a principal place of business in, or entity incorporated in or otherwise organized under the laws of, a Country of Concern; (iii) the government of a Country of Concern, including agencies, states and provinces, municipalities and instrumentalities, or any individual owned or controlled or directed by or acting for or on behalf of the government of such Country of Concern; and (iv) any entity in which a person or persons identified in the first two categories holds individually or in the aggregate, directly or indirectly, an ownership interest equal to or greater than 50%. This last category is intended to capture entities outside of a Country of Concern that are majority-owned by persons or entities of a Country of Concern. The ANPROM specifically asks for comment on the challenges a United States Person would face in conducting due diligence imposed on a United States Person in determining whether the investment is a Covered Transaction.
The ANPROM states that the Treasury Department is considering adopting a knowledge standard to be applied to the United States Person, and which would be based on either actual or constructive knowledge. The ANPROM states or sets forth the standard it is considering. The United States Person 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. This standard is intended to avoid a United States Person from inadvertently violating the executive order and being subject to its regulations and sanctions.
What Types of Transactions Are Covered?
The types of transactions that constitute “Covered Transactions” include (i) equity investments through mergers and acquisitions, private equity and venture capital, (ii) greenfield investments, (iii) joint ventures, and (iv) certain debt financing transactions. The Treasury Department is considering how to treat convertible debt financings, particularly with respect to convertible debt outstanding prior to the effective date of the regulations. The proposed regulations exclude publicly traded securities and exchange-traded funds from the definition of “Covered Transactions”. The Treasury Department is also considering excluding certain types of limited partner investments into investment funds if certain parameters are met that would entail no involvement in the investment transaction by the United States Person or where it is beyond the United States Person’s ability to control the investment. It is also considering a di minimis threshold for limited partner investments. The Treasury Department is also considering several exemptions, including ones for buyouts of the entire interest of a “Covered Foreign Person” in an entity or assets located outside of a Country of Concern, for intracompany transfers of funds from a U.S. parent company to its subsidiary located in a Country of Concern, and a national security exemption for transactions that provide either an extraordinary benefit to the U.S. National Security or an extraordinary benefit to the U.S. national interest in a way that overwhelmingly outweighs U.S. national security concerns.
Finally, the Treasury Department is considering the following carveouts: (i) university-to-university research collaborations, (ii) contractual arrangements or the procurement of material inputs, such as raw materials, for any of the covered NSTPs, (iii) intellectual property licensing arrangements, (iv) bank lending, (v) processing, clearing or sending payments to a bank, (vi) underwriting services, (vii) debt rating services, (viii) prime brokerage, (ix) global custody, (x) equity research or analysis, and (xi) other services secondary to a transaction.
What Are the Covered NSTPs?
The proposed regulations set forth in relative detail the NSTPs that would be covered by the regulation, and identify those that would be prohibited and those on which simply notification is required. The Treasury Department stated its intention in the ANPROM to provide as much definition as possible so that a United States Person would know whether it can invest and/or whether notification is required. It identifies three technologies to which the executive order would apply. The first NSTP is semiconductors and microelectronics as related to certain advanced technologies and products. The investments that would be prohibited include (i) specific technology, equipment and capabilities that enable the design and production of advanced integrated circuits or enhance their performance; (ii) advanced integrated circuit design, fabrication and packaging capabilities; and (iii) the installation or sale to third-party customers of certain supercomputers which are enabled by advanced integrated circuits. The transactions that would require only notification are those for the design, fabrication and packaging of other integrated circuits. Set forth in Annex I is a delineation of specific semiconductor and microelectronics technologies that would be prohibited under the regulations and those technologies for which only notification would be required.
The second category of NSTPs is quantum information technologies. These investments would be prohibited. Annex II sets for the delineation of quantum information technologies to which the prohibition would apply.
The third category is AI systems related to certain advanced technologies and products. The proposed regulations contemplate 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.” Investments into Covered Foreign Persons engaged in the development of software that incorporates an AI system and is designed to be exclusively used for military, government, intelligence or mass-surveillance and uses would be prohibited. Investments into Covered Foreign Persons engaged in the development of software that incorporates an AI system and is designed to be exclusively used for (i) cybersecurity applications, digital forensic tools, and penetration testing tools; (ii) the control of robotic systems; (iii) surreptitious listening devices that can intercept live conversations without the consent of the parties involved; (iv) non-cooperative location tracking (including international mobile subscriber identify (IMST) Catchers and automatic license plate readers) or facial recognition would not be prohibited and would require notification only. The Treasury Department specifically asked for comment on whether the exclusivity standard for both the prohibited AI investments and the notification AI investments should be replaced with a “primarily” standard.
The Notification Process
For Covered Transactions subject to the notification requirement, it is proposed that the notification must be filed within thirty days after the closing of the transaction. It is contemplated that filings could be made electronically through a government portal. The content of the notice would include (i) the identity and nationality or place of incorporation of the persons engaged in the transaction; (ii) basic business information about the parties; (iii) the date of the transaction; (iv) the nature of the transaction; (v) a description of the basis for determining that the transaction is a Covered Transaction; (vi) additional transaction information, including transaction documents; (vii) additional prescribed detailed information about the Covered Foreign Person; (viii) description of the due diligence conducted; (ix) information about previous transactions made by the United States Person into the Covered Foreign Person, as well as planned or contemplated future investments into such Covered Foreign Person; and (x) additional details and information about the United States Person. The Treasury Department will, in the final regulations, include confidentiality restrictions, with certain exceptions.
Proposed Penalties
The Treasury Department indicates that it will consider civil money penalties for material misstatements or material omissions made in the notification filing, the failure to timely file a notification, and the undertaking of a prohibited transaction. The Treasury Department asks for public input on other sanctions, including the ability to unwind a transaction or required divestment.
Conclusion
Based on the specificity of the proposed regulations and the shortness of time in issuing the proposed regulations, this author surmises that the general parameters of the proposed regulations will for the most part be included in the final regulations. There is a strong push to effectuate the executive order as soon as possible.
It is also worth noting that these regulations could form the basis for Congressional action, assuming a consensus can be reached in Congress. The structure of the Executive Order does not require the establishment of a separate governmental unit to review transactions, as is the case for CFIUS transactions, and will not require the budget expenditure that is akin to the financial commitment required for the operation of CFIUS.
It will be interesting to see how the Peoples Republic of China responds to the executive order. In the past, that government has counteracted in a relatively corresponding fashion to U.S. action, as witnessed by China’s Measures for the Security Review of Foreign Investments setting up a similar structure to CFIUS. However, in this instance, it would not be in furtherance of China’s interest to restrict investment into the United States, particularly into U.S. technology companies. We will see how the PRC responds.
Annex I
Semiconductors and Microelectronics
Prohibited Investments
Technologies that Enable Advanced Integrated Circuits
• Software for Electronic Design Automation: The development or production of electronic design automation software designed to be exclusively used for integrated circuit design.
- Integrated Circuit Manufacturing Equipment: The development or production of front-end semiconductor fabrication equipment designed to be exclusively used for the volume fabrication of integrated circuits.
Advanced Integrated Circuit Design and Production
• Advanced Integrated Circuit Design: The design of integrated circuits that exceed the thresholds in Export Control Classification Number (ECCN) 3A090 in supplement No. 1 to 15 CFR part 774 (https://www.ecfr.gov/current/title-15/part-774) of the Export Administration Regulations (EAR), or integrated circuits designed for operation at or below 4.5 Kelvin.
• Advanced Integrated Circuit Fabrication: The fabrication of integrated circuits that meet any of the following criteria: (i) logic integrated circuits using a non-planar transistor architecture or with a technology node of 16/14 nanometers or less, including but not limited to fully depleted silicon-on-insulator (FDSOI) integrated circuits; (ii) NOT–AND (NAND) memory integrated circuits with 128 layers or more; (iii) dynamic random-access memory (DRAM) integrated circuits using a technology node of 18 nanometer half-pitch or less; (iv) integrated circuits manufactured from a gallium-based compound semiconductor; (v) integrated circuits using graphene transistors or carbon nanotubes; or (vi) integrated circuits designed for operation at or below 4.5 Kelvin.
○ “Fabrication of integrated circuits” is defined as the process of forming devices such as transistors, poly capacitors, non-metal resistors, and diodes, on a wafer of semiconductor material.
• Advanced Integrated Circuit Packaging: The packaging of integrated circuits that support the three-dimensional integration of integrated circuits, using silicon vias or through mold vias.
○ “Packaging of integrated circuits” is defined as 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.
Supercomputers
• Supercomputers: The installation or sale to third-party customers of a supercomputer, which are enabled by advanced integrated circuits, that can provide a theoretical compute capacity of 100 or more double-precision (64-bit) petaflops or 200 or more single-precision (32-bit) petaflops of processing power within a 41,600 cubic foot or smaller envelope.
Notification Investments
• Integrated Circuit Design: The design of integrated circuits for which transactions involving United States Persons are not otherwise prohibited.
• Integrated Circuit Fabrication: The fabrication of integrated circuits for which transactions involving United States Persons are not otherwise prohibited.
• Integrated Circuit Packaging: The packaging of integrated circuits for which transactions involving United States Persons are not otherwise prohibited.
