On June 21, 2024, the US Department of the Treasury issued a Notice of Proposed Rulemaking (“Proposed Rule”) to implement Executive Order 14105 (“EO”) establishing a new Outbound Investment Program ("OIP") to prohibit or require notification of certain outbound US investments to China (including Hong Kong and Macau) in several technology sectors relevant to military, intelligence, surveillance, or cyber-enabled capabilities. The Proposed Rule reflects an attempt to balance the relatively narrow scope of the OIP with coverage that avoids loopholes. Notably, the Proposed Rule clearly puts the onus on US persons to determine the application of its requirements to their transactions—including via provisions attaching a “knowledge” standard requiring due diligence in connection with compliance.
Our key takeaways regarding the Proposed Rule are discussed below.
1. The Proposed Rule applies to US persons in connection with covered transactions that involve or would result in the establishment of a covered foreign person.
Under the Proposed Rule, these terms are defined broadly:
- A “US person” includes any US citizen or lawful permanent resident, any entity organized under the laws of the United States or any jurisdiction within the United States (including an entity’s foreign branches), and any person in the United States. The Proposed Rule does not, however, take an overly narrow approach to US person obligations. Notably, the Proposed Rule also applies to certain transactions undertaken by controlled foreign entities, which are non-US persons controlled by a US person. Moreover, US persons are prohibited from knowingly directing a transaction that would be prohibited if undertaken by a US person.
- A “covered foreign person” includes a (i) person of a country of concern (the only such country is currently China, including Hong Kong and Macau) that engages in covered activities (i.e., those subject to notification or prohibition requirements under the Proposed Rule); (ii) a person that holds an interest in and receives more than 50% of its revenue, net income, capital expenditure, or operating expenses from a person of a country of concern that engages in covered activities, even if it is not itself a person of a country of concern or engaged in covered activities; and (iii) a person of a country of concern that participates in a joint venture with a US person if such joint venture is engaged in covered activities.
- A “person of a country of concern” includes an individual who is a citizen or permanent resident of a country of concern (and not a US citizen or permanent resident of the United States); an entity that is organized under the laws of a country of concern, headquartered in, incorporated in, or with a principal place of business in a country of concern; the government of a country of concern (including any political subdivision, political party, agency, or instrumentality thereof; any person acting for or on behalf of the government of such country of concern; or any entity with respect to which the government of such country of concern holds individually or in the aggregate, directly or indirectly, a majority or more of the entity’s outstanding voting interest, voting power of the board, or equity interest, or otherwise possesses the power to direct or cause the direction of the management and policies of such entity); or an entity that is directly or indirectly majority-owned or -controlled, individually or in the aggregate, by any of the foregoing.
- A “covered transaction” is one that is subject to prohibition or notification requirements under the Proposed Rule—i.e., relevant transactions involving “covered activities.” In terms of types of transactions, covered transactions include, with respect to a covered foreign person, a US person’s direct or indirect: (i) acquisition of an equity interest or contingent equity interest; (ii) provision of certain debt financing that is convertible to an equity interest or that affords certain management or governance rights to the lender; (iii) conversion of a contingent equity interest or convertible debt; (iv) greenfield investment or other corporate expansions that either will establish a covered foreign person or will cause an existing person of a country of concern to pivot into a new covered activity; (v) entrance into a joint venture (regardless of location) that will undertake a covered activity; and (vi) limited partner investment into a non-US person fund that is likely to (at the time of the limited partner investment) and does invest in a covered foreign person.
The Proposed Rule also excepts certain types of transactions from being captured, including investments in publicly traded securities or mutual funds, certain limited partner investments in funds, outright acquisitions of covered foreign persons, and certain intercompany transactions.
2. “Covered activities” are limited to three technology areas: semiconductors and microelectronics, quantum information technologies, and AI systems.
The Proposed Rule also provides proposed scoping of the three technology categories identified in the EO for notifiable and prohibited transactions:
- Semiconductors and microelectronics. The Proposed Rule prohibits covered transactions related to development or production of electronic design automation software for the design of integrated circuits or advanced packaging; development or production of certain fabrication and advanced packaging equipment (as well as certain related commodities, materials, software, and technologies); design of integrated circuits controlled by ECCN 3A090 or able to operate below 4.5 degrees Kelvin; fabrication of a range of integrated circuits (including logic, NAND, DRAM, gallium, graphene, or carbon nanotube integrated circuits) that meet certain specifications; packaging any integrated circuit using advanced packaging techniques (i.e., 2.5D or 3D); and development, installation, sale, or production of certain supercomputers. There is also a notification requirement for covered transactions related to the design, fabrication, or packaging of any integrated circuits not otherwise covered by the prohibited transaction definition.
- Quantum information technologies. The Proposed Rule prohibits covered transactions related to the development of quantum computers or production of critical components for quantum computers; development or production of certain quantum sensing platforms; and development or production of certain quantum network and quantum communication systems. The Proposed Rule does not include any notification requirements relating to quantum computing; all the quantum information technologies covered by the Proposed Rule are classified as prohibited transactions.
- Certain artificial intelligence (“AI”) systems. The Proposed Rule prohibits covered transactions related to the development of any AI system designed to be solely used for, or intended to be used for, military, government intelligence, or mass surveillance end uses. The Proposed Rule also prohibits covered transactions related to the development of any AI system that is trained using a specified quantity of computing power or trained using a specified quantity of computing power using primarily biological sequence data, though the final thresholds for such computing powers are still being determined. There is also a notification requirement for covered transactions related to the development of any AI system not otherwise covered by the prohibited transaction definition, where such AI system is designed to be used for any government intelligence, mass surveillance, or military end use; is intended by the covered foreign person to be used for cyber security applications, digital forensics tools, penetration-testing tools, or the control of robotic systems; or is trained using a quantity of computing power over a certain threshold.
The Proposed Rule also prohibits covered transactions (even if they would otherwise just be subject to notification requirements) where the covered foreign person (including joint ventures) is listed on the Department of Commerce Bureau of Industry and Security’s (“BIS”) Entity List or Military End User List; the Department of the Treasury’s Office of Foreign Assets Control’s (OFAC) List of Specially Designated Nationals and Blocked Persons (SDN List) or Non-SDN Chinese Military Industrial Complex List (NS-CMIC List); or is designated as a foreign terrorist organization (FTO) by the Department of State. The prohibition also extends to cases where the covered foreign person meets the definition of a “Military Intelligence End-User” by BIS as well as covered foreign persons that are 50%-or-greater owned in the aggregate, directly or indirectly, by one or more persons on the SDN List.
3. The Proposed Rule applies a knowledge standard requiring US persons to conduct due diligence to ensure compliance.
Under the Proposed Rule, the definition of “covered transaction” builds in a knowledge standard for US persons entering covered transactions. For example, the Proposed Rule definition of a “covered transaction” specifies that the US person knows at the time of an equity acquisition that the target is a covered foreign person, or that the US person acquires limited partner interests in a fund that it knows likely will invest in a person of a country concern in the technology sectors covered by the Proposed Rule, or that the US person knows the joint venture it is entering into with a covered foreign person will or intends to engage in covered activities. However, the rule also defines “knowledge” or “know” to include facts or circumstances a person was aware had a high probability of occurring or had reason to know.
In assessing compliance or potential violations, the Proposed Rule states that Treasury will assess whether the US person has or had knowledge of the relevant facts and circumstances at the specified time. Notably, however, such assessments will consider both information the US person had or could have had through a reasonable and diligent inquiry. The Proposed Rule further clarifies that a US person that has failed to conduct a “reasonable and diligent inquiry” prior to entering the transaction may be assessed to have had “reason to know” of a given fact or circumstance, including facts or circumstances that would cause the transaction to be a covered transaction. The Proposed Rule also enumerates various considerations Treasury will consider assessing whether proper diligence was conducted, including questions asked by the US person or its counsel as part of transaction due diligence, representations and warranties obtained from the counterparty, and any potential red flags that were present or ignored.
4. The onus is on US persons to determine the applicability of the OIP to their transactions.
The Proposed Rule puts the responsibility on US persons to understand and comply with the OIP requirements, with violations potentially subject to both civil and criminal penalties. Specifically, US persons are obligated “to determine whether the given transaction is prohibited, permissible but subject to notification, or not covered by the rule because either it is an excepted transaction or it is not within the jurisdiction set forth under the Proposed Rule.” Unlike the US export control regimes or the Committee on Foreign Investment in the United States (CFIUS) process, outbound investors will not have the benefit of a license process or case-by-case reviews where parties could obtain prior authorizations for transactions. Moreover, given the broad knowledge standard discussed above (and its attendant obligations on conducting appropriate diligence), it is critical for US persons to be aware of OIP requirements and conduct appropriate due diligence in connection with transactions. This extends as well to foreign subsidiaries of US persons, as the Proposed Rule requires US persons to take “all reasonable steps” to prohibit and prevent its controlled foreign entities from engaging in a transaction that would be prohibited if engaged in by a US person.
Where a US person’s controlled foreign entity engages in a transaction that would be prohibited if done by a US person, the Proposed Rule says that Treasury will consider various factors in assessing the US person’s compliance including: (i) agreements between the US person and controlled foreign entity regarding OIP compliance; (ii) the existence and exercise of governance or shareholder rights by the US person with respect to the controlled foreign entity; (iii) the existence and implementation of periodic training and internal reporting requirements by the US person and its controlled foreign entity regarding OIP compliance; (iv) the implementation of appropriate and documented internal controls, including policies and procedures regarding OIP compliance that are periodically reviewed by both the US person and controlled foreign entity; and (v) implementation of a documented testing and/or auditing process of such internal compliance policies, procedures, or guidelines. These criteria, while focused on a provision relating to controlled foreign entities, also provide a useful framework for US persons to consider generally as they seek to ensure OIP compliance for transactions.
Although the OIP is a new and unprecedented regime, the Proposed Rule’s approach to examining the existence of reasonable due diligence when assessing a “knowledge” determination is not in uncharted waters. Indeed, the Proposed Rule’s acknowledgement that it adopted a knowledge definition similar to that used by BIS indicates that Treasury’s outbound investment enforcement personnel will be aware of BIS’s extensive experience in reviewing exporters’ due diligence. It is reasonable to assume Treasury will leverage BIS and other US Government agency experience when examining a US person’s transactional due diligence and compliance efforts.
Outbound investors accordingly may find it prudent to review BIS and other US Government guidance on these issues. For example, BIS’s “Know Your Customer” and Red Flags guidance, which identifies suspicious facts and abnormal circumstances warranting further inquiry by exporters to avoid violating export controls. Such “red flags” can also be relevant for outbound investors in conducting due diligence. Though the examples in the Proposed Rule are useful, there is no clear benchmark for achieving “reasonable” due diligence as Treasury would assess this on a case-by-case basis. Nonetheless, the more robust and focused an OIP compliance program—likely integrated within overall internal trade compliance policies as part of general best practices—the better chance an outbound investor has of avoiding potential violations.
5. Treasury is still working to finalize some elements of the OIP.
The Proposed Rule seeks public comment on the Proposed Rule generally and specifically requests input on 25 different questions. This reflects that, while the Proposed Rule is largely a complete draft (with some provisions like AI computing-power thresholds considering alternative approaches), this is a new regulatory regime and Treasury is trying to understand practical implications and considerations as it finalizes the regulations. Comments on the Proposed Rule are due by August 4, 2024
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