Treasury Issues Long-Anticipated NPRM on Outbound Investments

On June 21, 2024, the US Department of the Treasury (Treasury) issued a long-anticipated Notice of Proposed Rulemaking (NPRM) to implement Executive Order (EO) 14105, entitled "Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern." EO 14105 authorizes a new national security regulatory regime that will prohibit or require notification of certain US investments concerning China (including Hong Kong and Macau) that involve sensitive technologies and products in the semiconductors and microelectronics, quantum computing technologies, and artificial intelligence (AI) sectors (collectively, "covered national security technology or products").

While China is the only jurisdiction currently targeted by the NPRM's prohibitions and notification requirements, the rules may be expanded in the future to capture a wider range of "countries of concern."

Treasury’s press release explains that the regulations proposed by the NPRM are designed to address national security threats posed by certain US outbound investments, including certain intangible benefits that often accompany such investments, which can enhance China’s military, intelligence, surveillance, or cyber-enabled capabilities.

The NPRM promulgates the proposed regulations implementing EO 14105 and incorporates Treasury's consideration of public comments received in response to last year’s Advance Notice of Proposed Rulemaking (ANPRM). (For detailed coverage of the ANPRM, please see our prior blog post.) Notably, the NPRM does not yet have the force and effect of law. Treasury is soliciting comments on the NPRM, which may be submitted to the Office of Investment Security Policy and International Relations by August 4, 2024.

The NPRM largely adheres to the approach detailed in the ANPRM, but makes a number of important changes and provides additional detail with respect to various aspects of the proposed rule.

Key Takeaways for Industry:

• The NPRM may have a significant impact on a range of actors including, among others, private equity, venture capital, and pooled investment funds; institutional investors; lenders; companies engaged in joint ventures or similar arrangements in China; companies looking to engage in strategic merger and acquisition activity in China; and US persons employed by non-US entities who are involved in considering or approving investment decisions implicating China. That being said, the NPRM targets only certain sensitive industries and not all of the Chinese economy.
• Although Treasury states in the preamble to the NPRM that the regulations are targeted to minimize unintended consequences, it may be challenging in practice, given the proposed knowledge standard and related due diligence expectations, for US persons to determine whether a target is a "covered foreign person" or engaged in "covered activities" and whether a given investment is prohibited, merely notifiable, or outside the scope of the rules altogether. This could have a chilling effect on investment in China by US persons in the covered sectors, by prompting de-risking and over-compliance, particularly given limitations on undertaking due diligence in China, even where specific transactions or activities may still be permissible or not notifiable under the NPRM.
• The NPRM contains a number of important exceptions, including exceptions related to publicly traded securities and certain limited partner interests. The final scope of those exceptions may be critically important for a number of actors weighing the risk of remaining involved in China-related investment activity in the covered sectors.
• The proposed rules would apply directly to US persons, but may also have a significant indirect impact on non-US entities by requiring US persons to prevent their controlled foreign entities from engaging in a transaction that would be prohibited if engaged in by a US person and to file a notice if their controlled foreign entity engages in a transaction that would be notifiable if engaged in by a US person. Similarly, US persons may not knowingly direct a foreign entity to engage in a transaction that would be prohibited if undertaken by a US person.
• Given the self-policing nature of this new regulatory regime, which differs markedly from the inbound investment regime administered and enforced by the Committee on Foreign Investment in the United States (CFIUS), US persons will likely face challenges in ensuring compliance with the new rules, especially when it comes to avoiding prohibited transactions. The manner in which Treasury seeks to enforce the new outbound investment rules, including imposition of civil and criminal penalties and pursuit of divestment, will be a critical component of the new framework as US persons assess and calibrate their risk.
• Treasury has stated that it will consider input from stakeholders on all aspects of the proposed rules prior to issuing a final rule. Notably, Treasury requested comments on 25 specific questions, which signals a willingness to continue to refine the rules with respect to many key issues.

Overview of the Proposed Regulatory Regime

The prohibitions and notification requirements for a "covered transaction" (discussed below) under EO 14105 and the NPRM would apply to “US persons," defined to include any US citizen, lawful permanent resident, entity incorporated in the United States, including any foreign branch thereof, or any person in the United States, as well as to "controlled foreign entities." The term “controlled foreign entity" would mean any entity incorporated in, or otherwise organized under the laws of, a country other than the United States of which a US person is a direct or indirect parent (i.e., holder of more than a 50% outstanding voting interest or voting power of the board), a general partner or managing member, or in the case of a pooled investment fund, an investment adviser to such fund.

In addition to regulating conduct undertaken directly by US persons, the proposed rule requires US persons to submit notifications and take measures to prevent a prohibited transaction for transactions undertaken by a foreign person in which a US person has certain involvement.

More specifically, a US person would be required to: (1) take "all reasonable steps" to prohibit and prevent a controlled foreign entity from engaging in a transaction that would be prohibited if undertaken by a US person; and (2) notify Treasury if the controlled foreign entity undertakes a transaction that would be a notifiable transaction if undertaken by a US person.  The NPRM does not include a definition of "all reasonable steps" but offers a number of potential factors including: 

1. agreements with respect to compliance with these rules;
2. governance or shareholder rights;
3. periodic training and internal reporting requirements;
4. appropriate and documented internal controls; and
5. documented testing and/or auditing processes for internal controls.

US persons are also prohibited from "knowingly directing" transactions by non-US persons that the US person knows would be a prohibited transaction if engaged in by a US person. Under the NPRM, a US person "knowingly directs" a transaction when such US person has authority to make or substantially participate in decisions on behalf of a non-US person entity and exercises that authority to direct, order, decide upon, or approve a transaction that would be a prohibited transaction if engaged in by a US person. The NPRM specifies that a variety of individuals could be seen as “directing” a non-US entity including officers, directors, senior advisors, or senior-level employees.

The NPRM indicates that the prohibition on "knowingly directing" transactions would not apply to US persons who recuse themselves from decision making regarding a prohibited investment. Treasury is seeking public input on what stage of an investment this recusal carveout should apply to (e.g., negotiation of a transaction, the decision to undertake the transaction, and/or overseeing the investment after the completion date). When the recusal process must begin and how it must be implemented are likely to be key considerations for many companies that have US persons in senior positions.

Consistent with EO 14105 and the ANPRM, the NPRM would prohibit any action that evades or avoids or has the purpose of evading or avoiding any of the prohibitions or reporting requirements of the proposed rule.  We would expect that recusal by a US person that is implemented in accordance with Treasury's final rules (and any further guidance) would not be treated as evasion or avoidance of the regulations.

Covered Transactions

The NPRM would regulate notifiable and prohibited transactions (collectively, "covered transactions"), which are defined broadly to include several types of equity and non-equity investments in "covered foreign persons."

Covered Foreign Persons

The term "covered foreign person" would include, among others (1) a "person of a country of concern" engaged in a "covered activity" and (2) a person that, directly or indirectly, derives more than 50% of its revenue or income from or incurs more than 50% of its capital expenditure or operating expenses, individually or in the aggregate, through any “person of a country of concern” engaged in a "covered activity." A "person of a country of concern” is defined to include citizens or permanent residents of China (including Hong Kong and Macau), excluding US persons; entities domiciled or headquartered in China; the Chinese government, including its agencies and state-owned entities; any entity that is 50% or more owned, individually or in the aggregate, by one or more of the foregoing; and any entity in which one or more of the foregoing holds, individually or in the aggregate, at least 50% of the outstanding voting interest or voting power of the board.

Covered Activities

The term "covered activity" would encompass any activity that is prohibited or notifiable under EO 14105, which the NPRM would define as follows:

• Prohibited Covered National Security Technologies or Products: The following activities with respect to covered national security technologies or products would trigger a prohibited transaction:
  • Advanced integrated circuit design and equipment:
    • Developing or producing any electronic design automation software for the design of integrated circuits or advanced packaging;
    • Developing or producing (i) certain front-end semiconductor fabrication equipment designed for performing the volume fabrication of integrated circuits, (ii) equipment for performing volume advanced packaging, or (iii) other items designed exclusively for use in or with extreme ultraviolet lithography equipment.
  • Advanced integrated circuit design and production:
    • Designing any integrated circuit that meets or exceeds certain advanced technical thresholds, or integrated circuits designed for operation at or below certain temperatures;
    • Fabricating advanced integrated circuits that meet the technical criteria specified in the proposed regulations;
    • Packaging of any integrated circuit using "advanced packaging" techniques.
  • Supercomputers:
    • Developing, installing, selling, or producing any supercomputer enabled by advanced integrated circuits that meets a number of technical parameters outlined in the NPRM.
  • Quantum computers and components:
    • Developing a "quantum computer," as defined in the NPRM, or the critical components required to produce quantum computers;
    • Producing any of the critical components required to produce a "quantum computer."
  • Quantum sensors:
    • Developing or producing any quantum sensing platform designed for – or which the covered foreign person intends to be used for – military, government, intelligence, or mass-surveillance end uses.
  • Quantum networking and quantum communications systems:
    • Developing or producing any quantum network or quantum communication system designed for or which the covered foreign person intends to be used for: (1) networking to scale up the capabilities of quantum computers; (2) secure communications, such as quantum key distribution; or (3) any other application that has military, government intelligence, or mass-surveillance end use.
  • AI systems:
    • Developing AI systems that are to be exclusively used for – or which the covered foreign person intends to be used for – any military end use or government intelligence or mass surveillance end use;
    • Using AI systems that are trained using a quantity of computing power greater than a yet-to-be determined computing power threshold.
  • Notifiable Covered National Security Technologies or Products: The following activities with respect to covered national security technologies or products would trigger a notifiable transaction:
    • Integrated circuit design and production:
      • Designing, fabricating, or packaging any integrated circuit that does not meet the parameters necessary to trigger a prohibited transaction;
    • AI systems:
      • Developing an "AI system" that is: (i) "designed" to be used for any government intelligence or mass-surveillance end use or military end use; or (ii) "intended" by the covered foreign person to be used for or cybersecurity applications, digital forensics tools, penetration testing tools, or the control of robotics systems; and
      • Using AI systems that are trained using a quantity of computing power greater than a yet-to-be determined computing power threshold.
      • The term "AI system" is defined in keeping with President Biden's recent AI EO to mean either (1) a machine-based system that can, for a given set of human-defined objectives, make predictions, recommendations, or decisions influencing real or virtual environments; or (2) any data system, software, hardware, application, tool, or utility that operates in whole or in part using such a system.

In addition, US persons are prohibited from transactions with or involving entities engaged in notifiable activities that are subject to certain export restrictions, sanctions, or designations imposed by Treasury’s Office of Foreign Assets Control, the Department of Commerce's Bureau of Industry and Security (BIS), or the US Department of State's Bureau of Counterterrorism.

Covered Transactions

The NPRM defines the term “covered transaction” broadly to include a US person’s direct or indirect acquisition of an equity or continent equity interest, certain loans or debt financing that are convertible into equity or afford the US person certain powers related to management decisions or board appointments, conversation of a contingent equity interest, certain greenfield and brownfield investments, and certain investments in non-US investment funds.

With respect to the acquisition of a limited partner or equivalent interest in a non-US fund, the US investor must know the fund will “likely” invest in a person of a country of concern that is involved with covered national security technology or products, and such fund must actually undertake a transaction that would be a covered transaction if undertaken by a US person. Treasury states in the NPRM that it is possible for an LP to know, through a reasonable and diligent inquiry, where a pooled fund is "likely" to invest in terms of geography and sector by researching past investments made by the fund’s manager, engaging with the general partner, or reviewing such fund’s prospectus or other documentation. This may be another area of particular interest for US person investors, and where additional clarity or guidance may be sought, given the somewhat amorphous standard used in the NPRM and the practical difficulties investors may face when conducting such due diligence.

It is also worth noting that acquisition of a contingent equity interest could require two notifications to Treasury: one at the time the contingent interest is acquired and one when the interest converts. In addition to being duplicative, this dual structure may lead to a variety of difficulties for investors, including the inability to convert a previously obtained contingent interest if the covered foreign person's activities have changed since the time the interest was obtained, such that conversion would now be prohibited. This is a topic for which Treasury is seeking additional comments.

"Knowledge" means (1) actual knowledge that a fact or circumstance exists or is substantially certain to occur; (2) awareness of a high probability of a fact or circumstance's existence of future occurrence; or (3) information that could have been obtained through a reasonable and diligent inquiry. This definition largely tracks the definition used by BIS under the Export Administration Regulations, (EAR), but may present a number of unique challenges in the outbound investment context (and, as many exporters can attest, it is not without its difficulties in the EAR context).

In response to industry comments on the ANPRM, the NPRM now includes a number of specific factors that Treasury will consider when assessing whether a US person has undertaken a "reasonable and diligent inquiry" such that it would not be viewed as having "knowledge" under the above definition. The NPRM factors include:

• inquiries made to the target company;
• contractual representations or warranties obtained or attempted to be obtained from the investment target;
• the US person's review of relevant and available public and non-public information;
• whether the US person purposefully avoided learning relevant information;
• the presence or absence of warning signs or red flags; and
• the use of public and commercial databases to identify and verify relevant information.

The NPRM proposes several exceptions from the coverage of the rules, including for the acquisition of publicly traded securities, certain limited partner investments in pooled investment funds, certain complete buyouts, certain intra-company transactions, certain loan syndicates, and certain binding commitments incurred prior to issuance of the EO.

A number of these exceptions, particularly those related to publicly traded securities and limited partner interests, are likely to be important for industry and the investment community, making them potential targets for public comments. Notably, Treasury is actively soliciting comments on the exception for limited partner investments, where it is continuing to decide between a number of possible approaches.

Where a covered transaction is notifiable, notification must be submitted within 30 days after completion, or under circumstances where a US person acquires actual knowledge after the completion date of a fact or circumstance such that the transaction would have been a covered transaction, notification shall be made promptly, and no later than 30 days after acquiring such knowledge.

Enforcement and Voluntary Self-Disclosures

Under the NPRM, any person who violates, attempts to violate, conspires to violate, or causes a violation of the new regulatory regime would be subject to civil and criminal penalties as set forth in Section 206 of the International Economic Emergency Powers Act (IEEPA), the statutory regime underpinning the EO and accompanying rules. Additionally, the Secretary of the Treasury, in consultation with the heads of relevant agencies, may nullify, void or otherwise require divestment of any prohibited transaction entered into after the effective date of the final regulations. 

The NPRM also sets forth a process for submitting a voluntary self-disclosure (VSD) to Treasury. The VSD must be in the form of a written notice that describes the conduct that may constitute a violation and each person(s) involved. The VSD must include, or be followed within a reasonable period of time by, a report of sufficient detail to afford a complete understanding of the conduct that may constitute the violation.

Although the current outbound investment regime is far more limited in scope than the inbound investment regime administered and enforced by CFIUS, both fall under the auspices of

Treasury's Office of Investment Security Policy and International Relations. Given CFIUS's recent increase in focus on enforcement, it would not be surprising to see Treasury take a similarly active approach with respect to the outbound investment rules, particularly when it comes to prohibited transactions.

Conclusion

For assistance in preparing a comment or advice regarding the NPRM generally please contact a member of our National Security and CFIUS Practice.