Treasury issues proposed rule restricting US outbound investment in China, including Hong Kong and Macau

On June 21, the US Treasury Department (Treasury) issued a Notice of Proposed Rulemaking (NPRM) to implement President Joe Biden’s August 2023 “Outbound Order” (Executive Order 14105) that restricts certain investments abroad in technologies and products deemed to pose a threat to US national security.

The long-anticipated rule would monitor and restrict US investments in “countries of concern” with a particular focus on artificial intelligence (AI), quantum computing, and semiconductors and microelectronics. The People’s Republic of China, along with the Special Administrative Region of Hong Kong and the Special Administrative Region of Macau, are identified as countries of concern.

According to the White House, the key objective of the Outbound Order and the proposed new rule is to prevent potential adversaries from access to sensitive technologies or products that play a critical role in developing the next generation of military, intelligence, surveillance, or cyber-enabled capabilities. 

Pursuant to the proposed rule, US investors are put on notice that they are expected to conduct due diligence to determine if a foreign investment transaction is covered under the rule or if any covered foreign persons are involved.  Those failing to conduct due diligence will risk violations that could give rise to civil and criminal liability ranging from significant civil penalties per violation, to criminal prosecution resulting in enhanced fines and up to 20 years of incarceration.  The Secretary of the Treasury will have the authority to nullify, void, or force divestiture of any prohibited transaction.

The NPRM requests public comment from stakeholders until August 4, 2024.  The implementation date for the final regulations is not set, but final regulations could be issued as soon as this fall and likely before the end of the year. 

Overview of proposed rule

Prohibited and notifiable covered transactions

The NPRM creates two categories of “covered transactions” that are either “prohibited” outright or “notifiable.” 

Unless an exception applies, US persons[1] will either be prohibited from engaging in, or required to notify the US government of, any:

(1) “covered transaction”

(2) that involves (or results in the establishment of) a “covered foreign person” 

(3) engaged in “covered activities” related to national security technologies and products. 

As described in further detail below, the rules on prohibited and notifiable transactions may also extend to a US person’s controlled foreign subsidiaries.  

(1) The following qualify as “covered transactions”:

• Acquisition of an equity interest or contingent equity interest in a covered foreign person
  
  
• Provision of debt financing convertible to an equity interest in a covered foreign person or provision of debt financing that affords the lender certain management or governance rights in a covered foreign person
  
  
• Conversion of a contingent equity interest or convertible debt in a covered foreign person
  
  
• Greenfield investment or certain other corporate expansions that either will establish a covered foreign person, or will cause an existing person of a country of concern to begin to engage in a new covered activity
  
  
• Entrance into a joint venture, wherever located, with a person of a country of concern where the joint venture will undertake a covered activity, and 
  
  
• Investment as a limited partner or equivalent into a non-US person pooled investment fund that invests in a covered foreign person.

(2) A “covered foreign person” includes:

• A citizen or permanent resident of a country of concern who is not a US citizen
  
  
• An entity incorporated, headquartered, or having a principal place of business in a country of concern
  
  
• The government of the country of concern, any person acting on behalf of the government, or any entity of which the government can otherwise direct the management and policies, or
  
  
• Any entity where any of the individuals or entities listed above own 50 percent (individually or in the aggregate) of outstanding voting interest, voting power of the Board, or equity interest.

(3) The proposed rule defines “covered activities” broadly to include developing, designing, selling, fabricating, and other actions related to advanced integrated circuit design and equipment, supercomputers, quantum computers and components, quantum networking and quantum communication systems, and AI systems.  The details of these activities are outlined in Annex A, below.

The proposed rule prohibits US persons from engaging in any transaction that meets the three defined prongs above – “covered transactions” involving a “covered foreign person” that undertakes any “covered activities.”  By contrast, the proposed rule requires US persons to notify Treasury within 30 days of the completion date of any covered transaction that involves a covered foreign person taking certain actions relating to integrated circuits or AI systems but are not included in the definition of “covered activities,” including, for example, designing, fabricating, or packaging any integrated circuit or developing any AI system that is not described in the definition of a prohibited transaction but is designed for any military, government intelligence, or mass-surveillance end use or intended to be used for cybersecurity applications.  

Exceptions for investment funds and publicly traded securities

Certain transactions would be excepted from the rule’s coverage, including investments in publicly traded securities or in a limited partnership, so long as the US investor is not afforded certain rights that are not standard minority shareholder protections (consistent with those included in the regulations on the Committee on Foreign investment in the US).

Excepted transactions also include: 

• A US person’s full buyout of all interests of any person of a “country of concern” in an entity
  
  
• An intracompany transaction between a US person parent and its subsidiary to support ongoing operations
  
  
• Fulfillment of a US person’s binding capital commitment entered into prior to August 9, 2023
  
  
• The acquisition of a voting interest in a covered foreign person upon default or other condition involving a loan, where the loan was made by a lending syndicate and a US person participates passively in the syndicate, and
  
  
• Certain transactions that occur in a country or territory outside the United States that the US government determines is sufficiently addressing national security concerns.[2]

Transactions for official US government purposes would also be exempt.

Extension of US person obligations to foreign subsidiaries

US persons are further obligated under the proposed rule to take “all reasonable steps” to prevent a controlled foreign entity[3] from undertaking a transaction that would be prohibited for a US person to undertake, and to notify Treasury if the transaction would be notifiable for the US person.  US persons will be required to assess their corporate structures to determine what obligations, if any, they may have under the rules for their controlled foreign entities.[4]

Expectations for a “reasonable and diligent inquiry”

In assessing a potential violation, Treasury will consider whether the US person has or had knowledge[5] of the relevant facts at the time of the transaction, including whether the person could have had knowledge of the information through a “reasonable and diligent inquiry.” 

Therefore, reasonable due diligence that did not reveal a covered transaction or covered foreign person would serve as a defense to a potential violation of this rule. Conversely, in the absence of a “reasonable and diligent inquiry,” Treasury will determine that the US person knew or should have known of the underlying conduct (and is, therefore, more likely to find that a violation has taken place in the event a covered transaction or covered foreign person is later identified).

Treasury will consider the following in assessing whether a US person has undertaken a reasonable and diligent inquiry: 

• Due diligence questions posed to the counterparty/investment target at the time of the transaction
  
  
• Representations or warranties solicited from the counterparty/investment target relevant to whether the transaction is covered or covered foreign persons are involved
  
  
• Efforts to obtain non-public information relevant to whether the transaction is covered or covered foreign persons are involved
  
  
• Available public information and whether such information was obtained and reviewed and whether the public information is consistent with other available information
  
  
• Presence or absence of warning signs, including evasive responses, non-responses or a refusal to provide information, representations, or warranties from a counterparty/investment target
  
  
• Whether parties have purposefully avoided learning or sharing relevant information, and
  
  
• Use of public and commercial databases to identify and/or verify relevant information about a counterparty/investment target.[6]

Restrictions on “knowingly directing” prohibited activity

The proposed rule further prohibits a US person from knowingly directing a non-US person to undertake a transaction that the US person knows would be prohibited if engaged in by a US person.  A US person “knowingly directs” a transaction when the person has authority to make or substantially participate in decisions on behalf of a non-US person, and exercises that authority to direct, order, decide upon, or approve a transaction. Such authority generally exists when a US person is an officer, director, or senior advisor at a non-US person. The prohibition is also intended to address a potential loophole that could otherwise permit a US person to transfer capital and intangible benefits to a covered foreign person via a non-US person entity.[7]

Comment period 

Treasury has requested comments from stakeholders on “any and all aspects” of the proposed rule by August 4, 2024 and includes a list of specific requests in the NPRM.[8]

Public response to the NPRM

On June 24, 2024, China's Ministry of Commerce expressed strong opposition to the proposed rule, and a Ministry spokesperson indicated that “China reserves the right to take corresponding measures.”

The US-China Business Council (USCBC), a private, nonpartisan, nonprofit organization of more than 270 American companies that do business in China, reiterated its support for the “small yard, high fence” approach cited by White House National Security Advisor Jake Sullivan, “given the vast majority of trade with China does not involve U.S. national security.”

Initial reaction on Capitol Hill, where lawmakers have struggled to find consensus on legislation to mandate an outbound investment screening program, was cautiously positive, but continued attempts at further legislation over outbound investments is expected.

US Senator Bob Casey (D-PA), a leader of efforts in Congress to pass legislation known as the Outbound Investment Transparency Act, called the Administration’s proposal “a good start, but I will keep pushing to pass my bipartisan legislation to make permanent an outbound investment screening program.”

Representative Patrick McHenry (R-NC-10), chair of the House Financial Services Committee, said he supported Treasury’s efforts “to narrow the rule’s scope to be more targeted,” but added, “using a multi-year process to propose and stand up a new bureaucracy to regulate outbound investments lacks the urgency needed to confront the threat posed by the Chinese Communist Party.”

Conclusion

This NPRM has the potential to seriously impact how US persons conduct their investments abroad. We are happy to work with companies interested in establishing appropriate compliance practices or submitting comments on the proposed rule, and will continue to monitor and report on developments on the proposed and final rule. 

DLA Piper has a robust foreign direct investment, sanctions, and export controls practice that provides global coverage and deep experience with complex compliance, licensing, and enforcement matters. Find out more about the implications of these new restrictions for your business and compliance obligations by contacting any of the authors, or any of the partners in the National Security and Global Trade practice: Christine Daya, Melanie Garcia, Nicholas Klein, Richard Newcomb, and Ignacio E. Sanchez.

Annex A – Covered activities

Covered activities include: 

• 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 any front-end semiconductor fabrication equipment,[9] equipment for performing volume advanced packaging, or commodity/material/software or tech designed exclusively for use in or with extreme ultraviolet lithography fabrication equipment
    
    
  • Designing any integrated circuit that meets or exceeds certain performance parameters[10]
    
    
  • Fabricating any integrated circuit that meets certain criteria[11]
    
    
  • Packaging any integrated circuit using advanced packaging techniques
    
    
• Supercomputers
  
  
  • Developing, installing, selling, or producing any supercomputer enabled by advanced integrated circuits[12]
    
    
• Quantum computers and components, quantum sensors, quantum networking, and quantum communication systems
   
  • Developing a quantum computer or producing any critical components required to produce a quantum computer
    
    
  • Developing or producing any quantum sensing platform designed for or intended for any military, government intelligence, or mass-surveillance end use
    
    
  • Developing or producing any quantum network or quantum communication system designed for or intended to be used for any military, government intelligence, or mass-surveillance end use, secure communications, or networking to scale up quantum computer capabilities
    
    
• AI systems
  
  
  • Developing an AI system designed to be exclusively used for or intended to be used for any military, government intelligence, or mass-surveillance end use, or
    
    
  • Developing any AI system trained using a certain quantity of computing power.[13]

Covered activities also include engaging in any of the above-listed activities while being included on one of several US government trade restrictions lists.[14]

Annex B – Topics for comments

Treasury has requested comments to the NPRM by August 4, 2024, including specifically requesting comments on the following areas, along with empirical evidence to support the comments:

• Whether the proposed rule is broader or narrower than necessary to address the national security concerns identified in the EO
  
  
• How to ensure that the regulations are responsive to the evolution of the semiconductor and microelectronics, quantum information technologies, and artificial intelligence sectors
  
  
• Whether and how the knowledge standard should be clarified
  
  
• What Treasury should consider in assessing the burden on US persons’ compliance with the rule, including information about the scope of information required to be submitted for a “notifiable transaction”
  
  
• Adjustments to the scope of “covered activities”[15] and “covered transactions”[16] including how to distinguish between “notifiable transaction(s)” and “prohibited transaction(s)”
  
  
• Adjustments to the scope of the definition of a “covered foreign person”[17] and how a US person would ascertain the information necessary to comply
  
  
• How Treasury may further refine or clarify the following terms: “controlled foreign entity,” “person of a country of concern,” “knowingly directing,”[18] “AI system,” and “U.S. person”
  
  
• The likelihood of a company identified as a “person of a country of concern” or a “covered foreign person,” including a “U.S. person” entity, as well as the types of instances in which such overlapping classification may occur
  
  
• The due diligence a US person would need to conduct to determine whether a transaction involving AI systems would meet the definition of a “notifiable transaction” or a “prohibited transaction”[19]
  
  
• Whether the scope the categories of transactions included in “excepted transactions” should be modified,[20] and
  
  
• Whether and how a national interest exception should exist for notifiable and prohibited transactions and what information a US person should be required to provide to seek such exemption. 

[1] The definition of US person includes any US citizen or lawful permanent resident, any entity organized under the laws of any US jurisdiction – including its foreign branches – or any person in the US.

[2] This exception will apply where the Secretary of the Treasury determines that the country is addressing national security concerns posed by outbound investment and the transaction is of a type for which associated national security concerns are likely to be adequately addressed by the actions of that country.

[3] A controlled foreign entity is defined as an entity of which a US person is a parent, meaning that the US person directly or indirectly holds more than 50 percent of the outstanding voting interest or voting power of the board of the entity.  Further, a foreign entity may be a controlled foreign entity if a US person is a general partner or managing member (or equivalent of either), or if a US person is an investment adviser to a pooled investment fund. Notably, if a US person holds both direct and indirect holdings in the same entity, the direct and indirect holdings will be aggregated to determine whether the US person has 50 percent or more of the outstanding interest or voting power of the board.  The rule also contemplates control with regard to multiple levels of ownership. In order to determine whether a US entity indirectly holds voting interest or the voting power of the board, the rule looks to the relationship between the parties.  If the relationship between an entity and another entity is that of parent and subsidiary, the voting power of the subsidiary is fully attributed to the parent.  However, if the relationship is not one of a parent and subsidiary (ie, an entity owns less than 50 percent of the interest of another entity), the interest of the partially owned entity is not attributed to the entity with less than a 50-percent interest. 

[4] Treasury will consider a multitude of factors in determining whether a US person has taken all reasonable steps with regard to a controlled foreign entity.  The NPRM focuses on the existence and implementation of periodic training and reporting requirements at the foreign controlled entity, as well as broader compliance efforts, to determine whether a US person acted reasonably given the entity’s size and sophistication.

[5] “Knowledge” exists when a person (1) has actual knowledge of certain facts, (2) possesses an awareness of a high probability of certain facts, or (3) has or had reason to know of certain facts.

[6] Treasury also indicated that reasonable transactional due diligence includes identifying information about parties to a transaction such as, for example, their ownership and the nature of the business of those parties, the commercial rationale for the transaction, the transaction structure, financial details about counterparties, and the proposed transaction completion date.

[7] The proposed rule would carve out a US person who recuses themself from an investment even if that person has the authority to make or substantially participate in decisions on behalf of a non-US person entity.

[8] See Annex B for a list of topics for comment.

[9] Equipment designed for performing the volume fabrication of integrated circuits, including equipment used in the production stages from a blank wafer or substrate to a completed wafer or substrate (ie, the integrated circuits are processed but they are still on the wafer or substrate).

[10] Parameters listed in Export Control Classification Number 3A090.a in supplement No. 1 to 15 CFR part 774, or integrated circuits designed for operation at or below 4.5 Kelvin.

[11] These include (1) Logic integrated circuits using a non-planar transistor architecture or with a production technology node of 16/14 nanometers or less, including fully depleted silicon-on-insulator (FDSOI) integrated circuits; (2) NOT-AND (NAND) memory integrated circuits with 128 layers or more; Dynamic random-access memory (DRAM) integrated circuits using a technology node of 18 nanometer half-pitch or less; (4) Integrated circuits manufactured from a gallium-based compound semiconductor; (5) Integrated circuits using graphene transistors or carbon nanotubes; or (6) Integrated circuits designed for operation at or below 4.5 Kelvin.

[12] The circuits would need to 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.

[13] The amount is still undefined. The NPRM proposes between 10^23 computational operations and 10^26 computational operations. 

[14] US government trade restrictions lists include the US Department of the Treasury Specially Designated Nationals and Blocked Persons List as well as the Non-SDN Chinese Military-Industrial Complex Companies, or the Bureau of Industry and Security Entity List and Military End User List.

[15] The NPRM requests specific comments on the scope of “covered activities” involving supercomputers.

[16] The NPRM requests specific comments on the following aspects of “covered transactions”:

• How “the definition of covered transaction [should] be modified with respect to the conversion of a contingent equity interest or convertible debt.”
  
  
• How “the definition of covered transaction [should] be modified with respect to the LP investments.” 
  
  
• How Treasury can ensure there is US government visibility into the instances of conversion while also not putting undue compliance burdens on US persons.
  
  
• What adjustments should be made to clarify whether a greenfield investment, brownfield investment, or a joint venture is a “covered transaction” as opposed to an intracompany transaction or other “excepted transaction.” 

[17] The NPRM requests specific information regarding compliance with paragraph (a)(2) of the definition of a “covered foreign person” at § 850.209 regarding where a “covered foreign person” “is not itself a ‘person of a country of concern’ or engaged in a ‘covered activity’ but has a particular relationship with” such a person, including how the definition should be adjusted for a situation where no financial statement is available for a covered foreign person. 

[18] The NPRM requests the following specific information about the prohibition on “knowingly directing”, including: 

• Whether the prohibition on “knowingly directing” should be modified specifically to address US persons employed at foreign companies. 
  
  
• The practical utility of a recusal carveout from the prohibition on “knowingly directing” a transaction and at what stage the recusal carveout should apply. 

[19] The NPRM requests specific information on the impact of the prohibition involving entities that develop AI systems trained using a various computing power thresholds (specifically greater than 10^24, 10^25, or 10^26, and greater than 10^23 or 10^24 applied to biological sequence data). 

[20] The NPRM requests specific information about “which of the two proposed alternatives for the exception for LP investments in the definition of “excepted transaction” best addresses the relevant national security concerns while also minimizing the disruptive effects” and whether and why the thresholds should be adjusted. Treasury is interested in specific confirmation about the compliance considerations for US persons