President Biden Orders Establishment of New Program to Restrict US Outbound Investment in Certain Tech Sectors in China

On August 9, 2023, President Biden issued a long-awaited Executive Order ("the EO") establishing a new Outbound Investment Program ("OIP") to prohibit certain outbound US investments to China (including Hong Kong and Macau) in several technology sectors relevant to military, intelligence, surveillance, or cyber-enabled capabilities. Notification of other outbound investments to China in these sectors will also be required. The details of the OIP will be set in regulations promulgated by the US Department of the Treasury ("Treasury"). Treasury has released an advance notice of proposed rulemaking ("ANPRM") addressing in significant detail its current thinking on implementation of the EO and soliciting feedback on a wide variety of issues related to the forthcoming regulations. Notably, unlike the inbound foreign investment review process administered by the Committee on Foreign Investment in the United States ("CFIUS"), the OIP would not involve a case-by-case review process for transactions subject to the EO. Although the new outbound investment controls will prohibit, or require notification of, US investments into China in only a few sectors, the EO represents a major change that will impact a variety of transactions with parties in China or owned by Chinese parties.

Overview

Under the EO, Treasury, in consultation with other agencies such as the Department of Commerce, will be responsible for administering the OIP requiring prohibitions or notifications for certain US investment in China. The OIP will be implemented by Treasury through regulations issued after public notice and comment.

The EO focuses on investments involving three technology sectors:

• Semiconductors and microelectronics
• Quantum information technologies
• Artificial intelligence ("AI") capabilities

Treasury issued a detailed ANPRM alongside the EO elaborating on Treasury's current thinking regarding implementation of the EO and requesting public input on 83 questions covering a range of issues such as definitions and contours of the OIP, potential unintended consequences, possible loopholes, and practical implications for industry and investors. Public comments are due by September 28, 2023.

While the ANPRM does not include complete draft regulations, the level of detail in the ANPRM and the questions posed to the public make clear that Treasury and other elements of the US Government have been carefully considering how to implement the EO for some time. In addition to the ANPRM, Treasury launched a new webpage on the "Outbound Investment Program" providing an overview of the program and links to additional information, such as a fact sheet and press release.

What will be Covered Initially Under the OIP

The EO instructs Treasury to "establish a program to prohibit or require notification of certain types of outbound investments by United States persons into certain entities located in or subject to the jurisdiction of a country of concern [currently China, including Hong Kong and Macau], and certain other entities owned by persons of a country of concern, involved in discrete categories of advanced technologies and products." In essence, this means that an investment by a US person in a Chinese entity involved in identified sensitive technologies must be notified to Treasury or may be prohibited. The ANPRM sets forth key elements of Treasury's proposed plan for implementing the EO, which are discussed further below.

Who is Covered

The EO applies to investments by US persons, which is broadly defined in the EO as "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." Notably, the definition applies to foreign branches of US companies.

The EO's prohibition or notification requirements apply to investments by US persons in covered foreign persons, which the ANPRM proposes defining as "(1) 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 (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 percent of that person's consolidated revenue, net income, capital expenditure, or operating expenses." The ANPRM clarifies that item (2) of this definition "is intended to capture parent companies whose subsidiaries and branches engage in activities related to a covered national security technology or product."

The ANPRM further proposes to define person of a country of concern as "(1) any individual that is not a US 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; or (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 percent." Importantly, under the EO and as discussed further in the ANPRM, any entity organized under the laws of China, including subsidiaries of US persons, would be a covered foreign person if the entity is engaged in the identified activities. In addition, the ANPRM states that Treasury is considering defining a covered foreign person to include an entity located outside of China that is engaged in the identified activities and is at least 50% owned by a Chinese government entity, citizens or permanent residents of China, or entities organized under the laws of, or with a principal place of business in, China.

What Types of Transactions are Covered

Transactions subject to the EO must involve activities relating to "covered national security technologies and products," which are identified broadly as (i) semiconductors and microelectronics, (ii) quantum information technologies, and (iii) certain artificial intelligence systems, in each case that are critical for the military, intelligence, surveillance, or cyber-enabled capabilities of a country of concern. As discussed below, the ANPRM further describes what is being contemplated for notification or prohibition requirements in these areas.

Transactions that meet the jurisdictional requirements of the EO (to be further defined in regulations) are called "covered transactions". The ANPRM anticipates that covered transactions will include the following types of transactions:

• Acquisition of an equity interest or contingent equity interest in a covered foreign person;
• Provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest;
• Greenfield investment (i.e., a new business venture) that could result in the establishment of a covered foreign person; and
• 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.

Though these categories are broad, the ANPRM clarifies a number of transactions and activities that are expected to be excluded from the scope of the OIP—including notably certain passive limited partner investments in fund structures that are below a to-be-determined threshold—that are discussed in more detail below. Notwithstanding contemplated carveouts, the ANPRM states that any investment that affords a US person rights beyond those reasonably considered to be a standard minority shareholder protection could constitute a covered transaction, including if the US person obtains the following rights (which appear to draw on certain CFIUS jurisdictional concepts):

• Membership or observer rights (including nomination rights) on the Chinese business's board of directors or equivalent governing body; or
• Any other involvement, beyond the voting of shares, in the substantive business decisions, management, or strategy of the Chinese business.

The ANPRM also proposes covering "indirect" transactions to "close loopholes that would otherwise result." One such example provided in the ANPRM involves a US person knowingly investing in a third-country entity that will use the investment to undertake a transaction with a Chinese business that would be subject to the OIP if engaged in by a US person directly. Both the EO and ANPRM make clear that they intend to capture attempts to evade the OIP.

In addition, the ANPRM makes clear that Treasury plans to use some of the authority provided in the EO to prohibit US persons from knowingly directing transactions by foreign persons that would be prohibited if engaged in by a US person. Treasury proposes, for example, to include under the prohibited activities scenarios in which a US person is a general partner managing a foreign fund, a US person is an officer or senior manager of a foreign fund, or US person venture partners launch a non-US fund and engage in transactions that would be prohibited if performed by a US person. The ANPRM proposes that Treasury does not intend to include US bank processing of payments, signing paperwork for real estate transactions, or activities from which the US person has recused themselves.

What will be Prohibited or Require Notification

Whether a covered transaction requires a notification to Treasury or is prohibited will depend on the specific type of technology or products involved in the Chinese business and in certain cases the end-uses of such technology or products. The specific requirements contemplated in the ANPRM are summarized in the table below. Notably, in addition to changes that might be made following public comment on the ANPRM, some specific technologies are clearly subject to ongoing deliberation within the US Government—for example, the ANPRM language surrounding AI technology describes a potential approach "if the Treasury Department were to pursue a prohibition in this category"—indicating it is possible that covered transactions involving AI technology could be limited at least initially to a notification requirement (and not a prohibition). Treasury is also considering whether to qualify the AI end-use standard by technology designed "exclusively" or "primarily" for given applications.

The ANPRM makes it clear that Treasury's goal is "developing clearly defined and well understood definitions with respect to each designated covered national security technology and product as well as the identified activity linking the foreign person to the technology or product." The ANPRM seeks public comment and has 12 pages of descriptions and questions regarding the technology categories and activities listed below.

Compliance Considerations

The Secretary of the Treasury will have the authority to "nullify, void, or otherwise compel the divestment of any prohibited transaction." The ANPRM clarifies, however, that this would only apply to such covered transactions entered into after the regulations take effect—i.e., the OIP will not have retroactive authority. The ANPRM does, however, ask questions regarding the treatment of follow-on transactions related to investments that occurred prior to the effective date of the regulations, indicating that Treasury could potentially decide that such follow-on transactions can be prohibited or require notification. The ANPRM notes that Treasury is considering imposing the maximum allowable penalties under the International Emergency Economic Powers Act (IEEPA) for (i) material misstatements or omissions in submissions, (ii) undertaking a prohibited transaction, and (iii) failure to timely make a required notification.

What is not Covered

Certain Passive Limited Partner Investments And Other Investments

Treasury proposes to exempt certain types of investments from being considered covered transactions subject to the OIP as they are less likely to present the types of national security concerns targeted by the EO. Specifically, the ANPRM contemplates excepting the following types of transactions:

• Investments into publicly traded financial securities;
• Investments into index funds, mutual funds, exchange traded funds, or similar instruments offered by an investment company; 
• purely passive investments by limited partners into a venture capital fund, private equity fund, fund of funds, or other pooled investment fund (subject to additional requirements, as discussed below);
• a complete buyout by a US person of a subsidiary or assets located outside of China that are owned by a Chinese company;
• intracompany transfers of funds from a US parent to a subsidiary in China; and
• a transaction made pursuant to a binding, uncalled capital commitment entered into before the date of the EO.

The carveout for limited partner investments will be particularly important for private equity and other fund investors, where absent such exemption the EO could have much broader implications. It is important to note, however, that the ANPRM makes clear that Treasury intends to require such exempted limited partner investments to be purely passive, noting that this exception is only expected to apply in cases where "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 or a covered foreign person's decision making or operations." 

Moreover, the ANPRM contemplates that the limited partner exception will apply only if the limited partner's "investment is below a de minimis threshold to be determined by the [Treasury] Secretary." The reasoning is that "transactions above a threshold are more likely to involve the conveyance of intangible benefits such as those often associated with larger institutional investors, including standing and prominence, managerial assistance, and enhanced access to additional financing." Put another way, Treasury wants to ensure that the size and role of the excepted limited partner in the fund, notwithstanding its contractual governance position, does not provide benefits that the OIP is seeking to cover. The ultimate level of the excepted investment threshold and how it is determined are likely to have a significant impact on how broadly this exception can be used for fund structures.

Exempting these types of transactions demonstrates how the OIP is intended to specifically limit intangible benefits associated with outbound investment that the US Government believes flow from having American investor participation.

Pre-Existing Transactions

Treasury does not propose applying the new rules retroactively, though the ANPRM suggests Treasury may request information regarding older transactions to better inform its development of the OIP. Accordingly, Treasury intends for the outbound OIP to be forward-looking.

Certain Ancillary Activities

Treasury contemplates exempting from the OIP certain non-investment or investment-ancillary activities as long as they would not otherwise qualify as covered transactions and are not being used to evade the OIP. The ANPRM identifies the following such activities: (i) university-to-university research collaborations; (ii) contractual arrangements or the procurement of material inputs for any of the covered national security technologies or products (such as raw materials); (iii) intellectual property licensing arrangements; (iv) bank lending; (v) the processing, clearing, or sending of payments by a bank; (vi) underwriting services; (vii) debt rating services; (viii) prime brokerage; (ix) global custody; (x) equity research or analysis; or (xi) other services secondary to a transaction.

Covered Transactions Deemed to be in the National Interest

The EO authorizes Treasury to exempt from coverage any transaction determined by the Treasury Secretary to be in the national interest of the United States. The ANPRM contemplates this happening for a prohibited transaction only if it "either (i) provides an extraordinary benefit to US national security; or (ii) provides an extraordinary benefit to the US national interest in a way that overwhelmingly outweighs relevant US national security concerns." Accordingly, this exemption is not likely to permit many otherwise prohibited transactions under the OIP. Moreover, even though this exemption contemplates the possibility that some covered transactions might not be prohibited or need to be notified, they would have to be notified in advance in order for Treasury to review and deem them exempt.

Notification Contents, Process, and Timing

The ANPRM discusses the contemplated process and timing requirements for notifying a covered transaction as well as the required contents of such a notification. Notably, the ANPRM makes clear that Treasury does not contemplate the OIP involving a case-by-case review process like CFIUS currently conducts for inbound investments. Instead, covered persons are expected to determine on their own if a given transaction is prohibited, subject to a reporting requirement, or permissible without notification.

Notwithstanding the fact that Treasury will generally not review individual investments as part of the OIP, the EO provides Treasury with the authority to investigate violations and pursue penalties for transgressors. This highlights the importance of appropriate investment due diligence, particularly if Treasury ultimately establishes a process to identify non-notified outbound investments subject to the OIP, which seems likely given Treasury's ramped-up non-notified efforts with respect to its CFIUS authorities.

Content of Notifications

The ANPRM lists the following categories of information likely to be required for notifications of covered transactions:

• the identity of the person(s) engaged in the transaction and nationality (for individuals) or place of incorporation or other legal organization (for entities);
• basic information about the parties to the transaction, including name, location(s), business identifiers, key personnel, and beneficial ownership;
• the relevant or expected date of the transaction; 
• the nature of the transaction, including how it will be effectuated, the value, and a brief statement of business rationale; 
• a description of the basis for determining that the transaction is a covered transaction—including identifying the covered national security technologies and products of the covered foreign person; 
• additional transaction information including transaction documents, any agreements or options to undertake future transactions, partnership agreements, integration agreements, or other side agreements relating to the transaction with the covered foreign person and a description of rights or other involvement afforded to the US person(s);
• additional detailed information about the covered foreign person, which could include products, services, research and development, business plans, and commercial and government relationships with a country of concern; 
• a description of due diligence conducted regarding the investment; 
• information about previous transactions made by the US person into the covered foreign person that is the subject of the notification, as well as planned or contemplated future investments into such covered foreign person; and
• additional details and information about the US person, such as its primary business activities and plans for growth.

Process and Timing

The ANPRM says Treasury is considering a requirement that notifications must be submitted no later than 30 days following closing of a covered transaction, though Treasury has requested public comment on whether a pre-closing notification should be required. As with CFIUS filings, Treasury proposes that required notifications be submitted through an online portal. Treasury is also considering "encouraging" notifications to be made jointly by the US person and the covered foreign person, which would be similar to the process for CFIUS filings.

Consistent with the EO, the ANPRM contemplates confidentiality requirements in connection with notifications, though it identifies certain exceptions. Overall, the filings under the OIP appear intended to be generally confidential.

Investor Diligence Required

Treasury is considering regulations that condition the outbound investment obligations on the investor's knowledge of relevant circumstances. In other words, a US person would not be subject to the regulations where the US person has no actual or constructive knowledge that the Chinese business is engaged in, or will foreseeably be engaged in, activity regarding the covered technology or product.

The approach contemplated in the ANPRM is to adopt a definition similar to the "know or should have known" definition used in the US Export Administration Regulations (EAR). This approach would establish a standard of "knowledge" whereby a US person knows or reasonably should know that it is undertaking a transaction involving a covered foreign person and that the transaction is a covered transaction based on publicly available information and other information available through a reasonable and appropriate amount of due diligence. Importantly, the EAR knowledge definition includes not only positive knowledge, but an awareness of a high probability that something exists or may occur in the future, with the awareness inferred from a conscious disregard of facts or willful avoidance of facts. This knowledge standard would also apply to end uses that apply to some of the definitions of covered national security technologies and products. In practice, this standard is likely to encourage transaction parties to more carefully conduct due diligence to determine whether prohibition or notification requirements might apply to a contemplated transaction

Outbound Investment Legislation

The issuance of the EO on August 9 follows a 91-6 vote in the US Senate late last month to amend the Senate version of the Fiscal Year 2024 National Defense Authorization Act (NDAA) to include notification requirements for certain outbound investment transactions. If the version of this amendment passed in the Senate becomes law, it would require US companies to report certain investments in Chinese, North Korean, Russian, and Iranian companies involved with advanced technologies, which are contemplated to be a broader list than what is included in the EO. As the legislation moves forward, there may be additional changes as the final legislation is negotiated between the Senate and the US House of Representatives—e.g., to more closely align the new statutory authority to the EO by prohibiting, rather than just requiring notification of, certain transactions.

Implications for Investors

The EO ushers in landmark changes for US cross-border investment policy. While the OIP will have a significant impact on certain types of transactions, it is important to be mindful that the EO and the proposed regulatory framework is currently narrowly targeted at a specific country and specific categories of technology. The EO does contemplate the potential for future changes to the countries and technologies that are covered, so as the OIP is implemented and geopolitical dynamics evolve, it is possible outbound investment controls could expand. Indeed, the ANPRM makes clear that the notification process is itself aimed at increasing US Government visibility into these transactions and related trends, including to inform future policy development.

Given the technology sector's global interdependence, and subject to the contents of the final regulations implementing the EO, we anticipate the new requirements will likely need to be assessed in a fair number of investments for notification purposes but will only prohibit investments in a limited set of transactions. To anticipate how a given transaction may be affected, parties will need to conduct deeper due diligence and plan early for potential regulatory challenges. Indeed, this will be a new issue that needs to be considered when planning for outbound investments. Unlike the CFIUS process for reviewing foreign direct investment into the United States, the outbound investment EO and the ANPRM do not contemplate a committee review of notified transactions or a safe harbor for notified transactions. To ensure compliance, careful diligence and planning will be needed for any US person contemplating investment in China or Chinese-owned entities outside China, and will be particularly important for large private equity firms and multinational companies that may structure their transactions through various jurisdictions around the world.

_{1 The ANPRM contemplates defining AI Systems 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. AI systems are designed to operate with varying levels of autonomy."}

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