On August 9, 2023, President Biden issued an Executive Order (the “Executive Order”) restricting certain U.S. investments in Chinese companies which produce technologies and products raising US national security concerns.” On the same day, the Treasury Department issued an “Advanced Notice of Proposed Rulemaking” (“ANPR”) commencing the process to issue regulations imposing the new investment restrictions. The Executive Order establishes a major new national security program, involving new prohibitions and notification requirements for US investment in specific, narrowly targeted sectors of the Chinese economy, including advanced semiconductors and microelectronics, quantum information technologies and artificial intelligence. The Order represents a “sea change” in US sanctions applicable to overseas investment by US persons, establishing a framework which may evolve to apply to further categories of investment over time. Numerous open questions concerning the scope and application of the new restrictions will be addressed in the Treasury Department’s forthcoming rulemaking process.
The Executive Order declares a “national emergency” consisting of “advancement by countries of concern [e.g. the People’s Republic of China (“PRC”)] in sensitive technologies and products critical for . . . military, intelligence, surveillance, or cyber-enabled capabilities,” and directs the Treasury Department, pursuant to the International Emergency Economic Powers Act, to develop and implement targeted investment restrictions in order to address this declared emergency. The Order states that the PRC is engaged in comprehensive, long-term strategies that direct, facilitate, or otherwise support advancements in sensitive technologies and products that are critical to military, intelligence, surveillance, or cyber-enabled capabilities, and that the PRC has eliminated barriers between civilian and commercial sectors for the purpose of achieving military dominance.
The Executive Order directs the Secretary of the Treasury (the “Secretary”) to issue regulations that (1) prohibit US persons from engaging in certain transactions with “covered foreign persons” involving certain technologies and products that are “determine[d]” to pose a particularly acute national security threat to the United States, and (2) require US persons to notify the Treasury Department of certain other transactions with “covered foreign persons” involving certain technologies and products that “may contribute” to a threat to the national security of the United States. The Biden Administration has indicated that the restrictions are designed to target investments that may confer “tangible benefits along with capital” on covered foreign persons, such as private equity, venture capital, joint venture, and greenfield investments, among others.
Senior US officials indicated that the US has coordinated closely with allies and partners in developing the new restrictions, and that the US is encouraged by the statements made by the United Kingdom and the European Union and will be seeking input from its international partners on the implementation of the regulations.
Expected Structure of the New Restrictions
The Treasury’s proposed new rules will generally either prohibit, or require notification to the Treasury Department of, new investments made by US entities into certain entities located in or subject to the jurisdiction of China, and certain other entities owned by Chinese persons, with capabilities or activities in semiconductor and microelectronic technologies and products, quantum information technologies, and artificial intelligence technologies. The ANPR provides more detail on each part of the proposed structure of the new rules; while the final shape of the restrictions will depend on the public comment process, the ANPR offers guidance as to the likely shape of the new regulations in several areas.
First, Treasury will likely adopt the Executive Order’s definition of “United States person,” which defines the term to include 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 within the United States. Treasury is considering applying the restrictions to entities “controlled” by US persons, such as overseas subsidiaries of US companies.
Treasury intends to use the term “covered transaction” to apply to the definition of both prohibited and notifiable transactions under the EO:
- Specifically, “covered transactions” will include a US person’s direct or indirect (1) acquisition of an equity interest or contingent equity interest in a “covered foreign person” (e.g., a Chinese or Chinese-owned business operating in a covered sector); (2) the provision of debt financing to a covered foreign person if it is convertible to an equity interest; (3) the making of “greenfield” investments in a covered sector that “could result in the establishment of a covered foreign person”; and (4) the establishment of a joint venture with a covered foreign person or that “could result in the establishment of a covered foreign person,” wherever the joint venture is located.
- Treasury is currently “considering” whether to include “indirect” transactions within the definition of “covered transactions.” Such indirect transactions may include, but would not be limited to, a US person “knowingly investing in a third-country entity that will use the investment to undertake a transaction with a covered foreign person that would be subject to the [regulations] of engaged in by a US person directly.”
- The ANPR also lists activities that will generally not fall within the definition of “covered transactions,” including research collaborations; procurement of raw materials for the covered national security technologies or products; IP licensing; 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 secondary services related to a transaction.
- The Executive Order expressly grants Treasury the authority to “nullify, void, or otherwise compel the divestment of any prohibited transaction” after the effective date of the regulations.
Treasury has advised that the term “covered foreign person” and “person of a country of concern” will be construed to capture entities located outside of China that are majority-owned by Chinese persons or entities:
- Treasury does not plan to use a list-based approach to identify which entities are considered “covered foreign persons.” Instead, the ANPR sets forth a potential definition of the term “covered foreign person” to include (1) any Chinese person that is, or that a US person knows 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 category (1) and which, individually or in the aggregate, comprise more than 50% of that person’s consolidated revenue, capital expenditure, or operating expenses.
The ANPR also sets forth two types of restrictions on covered investments:
- First, the ANPR proposes a flat prohibition on U.S. investments in “covered national security technologies and products” involving sub-sets of advanced semiconductor and microelectronic technologies and products, quantum information technologies, and artificial intelligence where the impacts or consequences of the technology include end uses related to the military, intelligence, mass surveillance, cybersecurity applications, the use of digital forensics tools, and other similar applications.
- Second, the ANPR proposes a notification requirement (but not a prohibition) for other transactions falling within the scope of the Rule, but raising less substantial national security concerns.
The initial rulemaking notice for the new Executive Order reflects numerous areas of uncertainty regarding the shape of the ultimate restrictions. Open questions include:
- Key Exceptions for Public Securities and Some Investment Funds. It appears that the final Rule may exempt investments in publicly-traded securities, as well as investments in Exchange-Traded Funds (“ETFs”) and certain other investment funds, from the reporting requirements and prohibitions at issue. This would contrast with the position under the Chinese Military-Industrial Company (“CMIC”) sanctions, which prohibit US person dealings in public equity of CMIC companies and treat ETF investments as investments in the ETF’s underlying securities. However, “indirect” transactions will likely otherwise be prohibited; the ANPR notes that an investment in a third-country company “that will use the investment to undertake a [restricted] transaction with a covered foreign person” may be subject to the new restrictions.
- Exceptions for Certain Bank, Brokerage, and IP Licensing Functions. The early Treasury guidance reflects potential exceptions for, inter alia, bank lending, payment processing, underwriting services, securities custodial, debt rating and equity research services; and intellectual property licensing. However, these exceptions are not final and may change.
- 50% Revenue Threshold. The Rule is likely to apply investment restrictions not only to Chinese-owned entities operating in the identified sectors, but also to any parent entities which derive 50% or more of their revenue, income, or expenditures from subsidiaries which operate in the identified sectors.
- Knowledge Standard. The ANPR states that Treasury is “considering” introducing a knowledge standard that would predicate a US person’s obligations on the person’s “actual or constructive knowledge that the covered foreign person is engaged in, or will foreseeably be engaged in, certain activity regarding the [targeted] technology or product.” The ANPR cites the formulation of the knowledge standard codified in the Export Administration Regulations, the primary source of US export controls, which may be triggered by “an awareness of a high probability” of the existence or future occurrence of a state of affairs.
- Subsidiaries of US Companies. The ANPR suggests that the regulations will impose significant additional compliance responsibilities on US companies for their foreign subsidiaries. The Executive Order itself requires US persons to (i) notify Treasury if any foreign entity “controlled” by the US person engages in what would be a “covered transaction” if performed by a US person; and (ii) “take all reasonable steps to prohibit and prevent” its controlled subsidiaries from engaging in what would be “covered transactions” if performed by a US person. A “controlled” subsidiary is an entity owned 50 percent or more, directly or indirectly, by the US parent. The ANPR states expressly that the Executive Order “places responsibility on the US parent [entity]” for its foreign subsidiaries’ compliance. Treasury also indicates that the regulations may define the “reasonable steps” that US parent companies must take to ensure their foreign subsidiaries remain compliant, including, but not limited to, entering into “binding agreements” with such subsidiaries and “the exercise of governance or shareholder rights, where applicable,” in addition to developing internal compliance policies, auditing such policies, and providing training to employees. Combined with the Executive Order’s requirement that US persons maintain adequate records of compliance, the Executive Order’s handling of indirect investments may impose a substantial additional compliance burden.
- Follow-on Investments to Grandfathered Investments. The ANPR indicates that Treasury is currently “considering how to treat follow-on transactions into a covered foreign person and a covered national security technology or product” where the original investment was made prior to the effective date of the implementing regulations. Treasury asks persons commenting on the proposed regulations to give examples and information on why “follow-on transactions” should or should not be covered.
The Administration’s briefing on the Executive Order indicated that the White House conducted consultations with over 175 industry stakeholders prior to issuing the Executive Order. However, as the Treasury Department has not issued any new rules yet, the scope of the upcoming restrictions is not clear, and will likely be informed by industry responses to the 83 detailed questions posed in the ANPR, responses to which are due by September 28, 2023. The potential risk of liability and scope of companies’ enhanced compliance burdens will depend on the final form of the regulations. The Administration has indicated that it views the Executive Order and forthcoming regulations as compatible with the Outbound Investment Transparency Act, which was included in the version of the National Defense Authorization Act for Fiscal Year 2024 passed by the US Senate in July 2023. Senior officials commented that the White House will seek to “align” the approaches of the Executive and Legislative Branches in the coming weeks and months.
Finally, although the rules to be implemented under the Executive Order will only apply to investments in Chinese-owned entities or entities in China, the text of the Executive Order is drafted generally and refers only to “countries of concern.” The breadth of the text suggests that the application of the Executive Order may be broadened in the future to implement similar restrictions on investments in other countries or territories.
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