Treasury’s NPRM marks the next step in multi-year efforts by policymakers in the Biden Administration, Congress, and certain advocacy groups to have the U.S. government institute a novel “outbound investment” (i.e., U.S. person outbound capital flows) regime that restricts certain U.S. person transactions relating to China-based or Chinese person-affiliated entities involved with a subset of technologies that are considered critical to U.S. national security.

Treasury’s proposed rule, set forth in the NPRM, is poised to create significant compliance and due diligence obligations for U.S. persons seeking to conduct an array of transactions related to the technologies covered by the proposed rule and having a China nexus. Importantly, the range of Chinese person-affiliated entities with which the proposed rule could prevent U.S. persons from transacting is quite broad, and the proposed definition of U.S. person covers U.S. affiliates of non-U.S. companies, U.S. persons working at non-U.S. companies, and foreign persons working in the United States. Looking ahead, these and other scoping considerations being deliberated by Treasury illustrate that, over time, whatever “outbound investment” restrictions are established now could grow significantly in scope. This dynamic necessitates that potentially implicated companies plan accordingly.

Origins of the NPRM—and remembering important questions raised by the ANPRM that preceded it

EO 14105 provided the Treasury Secretary broad authority to establish and administer an outbound investment restriction and reporting program (“the Program”) targeting “persons of a country of concern” engaged in activities involving “covered national security technologies and products.” The EO defines these “covered national security technologies and products” as sensitive technologies and products in semiconductors and microelectronics, quantum information technologies, and artificial intelligence (AI) that the Treasury Secretary determines—with input from other stakeholder agencies (e.g., the Commerce Department, the Defense Department)—are critical for the “military, intelligence, surveillance, or cyber-enabled capabilities of a country of concern” (covered technologies and products). The only “country of concern” identified by the President last August is the People’s Republic of China, including Hong Kong and Macau.

EO 14105 was issued simultaneously with a Treasury Advanced Notice of Proposed Rulemaking (ANPRM) that presented 83 questions, and related discussion, aimed at both previewing and refining the scope of the Program. As explained in an August 2023 Patomak Insight, questions raised by the ANPRM were indicative of Treasury’s broad authority to define the scope of transactions and technologies covered under the Program. The ANPRM signaled that Treasury would create a two-tiered program: with certain transactions requiring notification to the U.S. government, and others being outright prohibited.

The long-awaited NPRM indeed adopts this approach. It also shows that Treasury and other agency stakeholders have reached a view on some important questions regarding the scope of transactions and technologies to be covered under the Program. However, many important issues appear unresolved.

Broad range of transaction types are exempted from the Program

The NPRM indicates that the Program will exempt investments in publicly traded securities and funds, as well as buyouts of foreign ownership, certain investments made as a limited partner (LP) in a non-U.S. person pooled investment fund, and binding commitments entered prior to 9 August 2023 (when EO 14105 was issued). These exemptions were all largely expected, although it should be noted that the Treasury Secretary in the future could decide to revoke, for example, the exemptions for publicly traded securities and funds, given that the EO does not speak to exemptions.

The Program as proposed by Treasury would cover most other equity interests (including contingent equity interests), and certain types of debt financing, greenfield investments, expansions of existing businesses, and joint ventures, as well as certain investments by a U.S. person LP into a non-U.S. person pooled investment fund that conducts transactions prohibited for U.S. persons under the Program. The proposed rule appears to cover a modestly broader range of transaction types than the ANPRM initially suggested.

Uncertainties over what transactions are “prohibited” and what are “reportable” remain

Perhaps most importantly, the NPRM indicates that Treasury and stakeholder agencies continue to deliberate over which technological categories would bring about a notification requirement for a transaction versus an outright prohibition. The NPRM proposes several alternative thresholds for notification requirements and transaction prohibitions (importantly, these technical thresholds or contours could be adjusted in future rulemakings following the Program’s implementation).

Specifically, the NPRM contemplates some semiconductor/microelectronics transactions requiring notification and others, involving technologies that meet specified criteria, being prohibited. In a notable change from the ANPRM last August, rather than simply requiring notification, a subset of AI-related transactions involving advanced AI systems that surpass yet-to-be-decided technological thresholds would be prohibited. With respect to in-scope quantum technology transactions, several types are prohibited but no subset requires notification to the U.S. government.

All of the technological thresholds for semiconductor/microelectronics, AI, and quantum technologies being considered under the Program are highly prescriptive and are likely to create compliance difficulties for, for example, companies not familiar with performing technical due diligence related to particular subsets of technologies involved in a transaction. Conversely, the definition of AI—now adapted to reflect a definition used in President Biden’s AI-related Executive Order 14110—is quite broad, creating compliance complexities. The proposed rule would prohibit certain types of transactions when the technologies involved either are designed for a military, government intelligence, or mass-surveillance end uses or, in other cases, are intended for such uses; the extent to which these provisions effect the Program’s scope is likely to be implicated by the Chinese Communist Party’s doctrine of military-civil fusion.

Importantly, the NPRM proposes to prohibit transactions that would otherwise only require notification if the transaction’s China-affiliated entity has been identified on one of several enumerated lists, including the Office of Foreign Asset Control’s Specially Designated Nationals and Blocked Persons List or Chinese Military-Industrial Complex Companies List, and the Commerce Department’s Entity List or Military End User List. The inclusion of these lists effectively enables the U.S. government, by adding companies to such lists, to affect the restrictions associated with the Program without the need for a new Program rulemaking.

Treasury’s definitions could both exclude certain Chinese conglomerates and impact non-Chinese start-ups

One component of the NPRM likely to receive scrutiny from congressional policymakers and other proponents of outbound investment restrictions is that it ostensibly allows continued U.S. investment into conglomerates with Chinese subsidiaries that are involved with covered technologies and products—that is, when those subsidiaries do not collectively account for the majority of the company’s revenue, income, profit, or capital expenditures. Indeed, if a company (Company A) that is a person of a country of concern and primarily involved with covered technologies and products is controlled by another company (Company B), then the Program appears only to apply to U.S. transactions with Company B when Company B’s activities associated with the covered technology or products comprise more than 50 percent of its consolidated revenue, net income, capital expenditures, or operating expenses.

By contrast, with this 50 percent threshold the Program would implicate transactions with China-linked companies primarily involved with covered technologies and products even if the companies are incorporated in offshore financial centers or elsewhere in Asia. Treasury’s proposed definition of “person of a country of concern” includes “any person acting for or on behalf of the government of such country of concern,” which the NPRM explains could include any political party or instrumentality thereof. This raises the question: what companies, inside or outside of China, could be viewed by the U.S. government as acting on behalf of the Chinese Communist Party and covered under the Program? For example, given the very broad intelligence-gathering provisions of China’s 2015 National Security Law and its 2017 National Intelligence Law applicable to Chinese persons, as well as the reports of many Chinese-led AI companies establishing headquarters in Singapore, should entities establishing Program compliance policies and procedures assess potential investments into Chinese-led Singaporean AI companies?

Novel compliance challenges for foreign affiliates of U.S. firms and non-U.S. companies

There are also uncertainties surrounding the full range of activities and individuals involved in a transaction that would be subject to compliance with the Program. The NPRM proposes prohibiting a U.S. person from “knowingly directing” a transaction prohibited under the Program. It defines U.S. persons covered by the Program to include any U.S. citizen, permanent resident, or entity organized under U.S. laws or any jurisdiction within the United States, including any foreign branch of entities organized under U.S. law, as well as any person in the United States.

The NPRM makes clear that U.S. persons would, in certain circumstances, be viewed as engaging in transactions that are prohibited or require notification even though those transactions are made by their non-U.S. subsidiaries or affiliates. The proposed rule requires that a U.S. person “take all reasonable steps to prohibit and prevent any transaction by its controlled foreign entity that would be a prohibited transaction if engaged in by a U.S. person,” and Treasury would, in making a determination as to whether reasonable steps were taken, consider governance arrangements, periodic training and internal reporting requirements, and relevant regularly-reviewed internal policies, procedures, or guidelines in place both at the U.S. person and its controlled foreign entity.

Importantly for foreign firms with U.S. operations, the NPRM contemplates that a U.S. affiliate of a foreign company or even an executive from that company visiting the United States could, under certain circumstances, violate the proposed regulations. The definition of a U.S. person includes any person in the United States, meaning that foreign persons visiting the United States that knowingly direct a prohibited transaction would presumably violate the Program restrictions.

The NPRM also provides an example of how a U.S. person at a foreign company could, under certain circumstances, knowingly direct a transaction prohibited by the Program. The NPRM appears to assuage concerns that this dynamic could create challenges for Americans working at foreign entities. The NPRM would carve out any U.S. person who “recuses themself from an investment” covered by the Program. Yet like many other exemptions set forth in the NPRM, a future Treasury rulemaking could revoke this exemption.

More broadly, companies simultaneously doing business in the United States and China will have to consider the complications under the Program created by their presence and activities in both jurisdictions. For example, complying with the Program’s investment prohibitions could invite retaliation by Chinese authorities under the 2021 Anti-Foreign Sanctions Law.

Compliance considerations and the path ahead

The Program contemplates strict civil monetary and criminal penalties analogous to those contemplated under U.S. economic sanctions programs—these should motivate both foreign persons and entities and U.S. persons covered by the Program to implement robust compliance programs. The criminal penalties for willfully violating the investment prohibitions or notification requirements set forth in the Program include fines up to $1,000,000 and imprisonment for up to 20 years. Civil monetary penalties implicate a maximum scope of twice the value of the underlying transaction, depending on the particular facts and circumstances, as well as the potential for the U.S. government to force divestment in the case of a prohibited transaction.

Given the strong likelihood that the final rule adopts highly technical thresholds for the types of covered technology and products, the inherently broad definition of AI, and the possibility that Treasury adopts a broad or vague definitions for identifying covered China-linked persons and entities, detailed due diligence in advance of any transactions involving technology companies with a China nexus will be a necessity. Comments on these important Program parameters are due to Treasury by 4 August 2024.

As Treasury works to finalize the Program in fiscal year 2025 (beginning 1 October 2024), the Biden Administration will almost certainly face intense pressure from policymakers and proponents in the public to expand and make more strict the contours of the Program. Many will likely feel that the NPRM falls short. For example, Senator Bob Casey (D-PA), a proponent of strict outbound investment restrictions, called the NPRM a “good start,” but endorsed his previous Senate-passed legislation, which would entail more expansive restrictions across a broader range of technologies. Conversely, House of Representatives Financial Services Committee Chairman Patrick McHenry (R-NC) released a statement calling the NPRM “a step in the right direction,” but criticizing a “multi-year process to propose and stand up a new bureaucracy to regulate outbound investments.” Instead, he endorsed Congressman Andy Barr’s Chinese Military and Surveillance Company Sanctions Act, which would entail far-reaching and significant economic sanctions against Chinese companies identified by the U.S. government as supporting the Chinese military-industrial complex.