Executive Summary
The Biden Administration on August 9, 2023 released its long-awaited Executive Order on Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern (the “EO”) proposing (1) prohibitions on certain outbound investments in the semiconductors and microelectronics, quantum information technologies, and artificial intelligence sectors, and (2) mandatory notification requirements for a broader set of transactions in those same sectors, in each case focused on China. The EO marks the first time that the United States, or any other major Western democratic economy, has sought to regulate and control outbound capital flows and other investments for national security reasons.
Notably, the exact contours of this new regime are far from settled. The EO directs the Treasury Department to issue regulations implementing the order. Thus, in parallel with the release of the EO, the Treasury Department issued an Advance Notice of Proposed Rulemaking (“ANPRM”) describing the Administration’s implementation plans and requesting public comment on more than 80 specific questions concerning aspects of the regulations still under consideration. Written comments are due to the Treasury Department 45 days after the ANPRM is formally published in the Federal Register, which is expected in the coming days.
According to the ANPRM, transactions subject to the notification requirements and prohibitions would include any transaction by a “U.S. person” with a “covered foreign person”—i.e., a “person of a country of concern” that is engaged in certain defined activities involving “covered national security technologies and products”—subject to certain exceptions. The EO and ANPRM would define these terms broadly:
- “U.S. persons” would include not only U.S. citizens and lawful permanent residents, but also persons of any nationality “in the United States”; it also would include entities incorporated in the United States along with their foreign branches. U.S. persons would be prohibited from “knowingly directing” transactions that would be prohibited if undertaken by a U.S. person, and would be obligated to “take all reasonable steps to prohibit and prevent any transaction by a foreign entity controlled by such” U.S. person that would be prohibited if undertaken by a U.S. person. The same rules would apply to transactions that are not prohibited but that are subject to notification requirements.
- A “covered foreign person” would include any Chinese entity or individual—as well as any entity, anywhere in the world, owned 50 percent or more, individually or in the aggregate, directly or indirectly, by a Chinese entity or individual—engaged in one or more enumerated activities with respect to “covered national security technologies and products.” The ANPRM also proposes to include in this definition any person whose direct or indirect subsidiaries or branches are covered foreign persons and which, individually or in the aggregate, comprise more than 50 percent of that person’s consolidated revenue, net income, capital expenditure, or operating expenses.
- “Covered national security technologies and products” would include certain (1) semiconductors and microelectronics; (2) quantum information technologies; and (3) artificial intelligence systems. Transactions undertaken by U.S. persons with covered foreign persons would be subject to a notification requirement or a prohibition depending on the specific subset of national security product or technology with which the covered foreign person is engaged. (Note, however, that there would not be a separate notification requirement for transactions involving quantum information technology.)
- The EO does not define the types of transactions that would be subject to its notification requirements and prohibitions. The ANPRM therefore proposes to define a new term, “covered transaction,” that would specify the types of transactions between U.S. persons and covered foreign persons that could be subject to a notification requirement or a prohibition, including a U.S. person’s direct or indirect (1) acquisition of equity; (2) financing involving convertible debt; (3) greenfield investment “that could result in the establishment of a covered foreign person”; and (4) joint venture “wherever located, that is formed with a covered foreign person or could result in the establishment of a covered foreign person.”
When combined, these terms would cause the notification requirements and prohibitions of the EO to apply broadly to transactions not only in China, but globally—including in the United States—where the transaction parties are U.S. and Chinese, or ultimately U.S.- and Chinese-owned—in particular across much of the global semiconductor industry.
There also remains the prospect of additional Congressional action. The EO comes just weeks after the Senate voted 91-6 to adopt a bipartisan outbound investment screening proposal (the “Senate Proposal”) as an amendment to the Fiscal Year 2024 National Defense Authorization Act (“NDAA”). The Senate Proposal—formally, the Outbound Investment Transparency Act—is sponsored by Senators John Cornyn (R-TX) and Bob Casey (D-PA). The House version of the NDAA, which passed earlier in July, did not include any outbound investment provisions, but certain Members of the House are advocating for more extensive limitations on investments in China. We could also see efforts in Congress to codify and enhance the rules proposed in the EO, affording Congress a greater role in the oversight of the regulatory process established by the EO rather than deferring to the Executive Branch.
Thus, in addition to the forthcoming rules under the EO, the debate in Congress—and between Congress and the Executive Branch—over the potential scope of outbound investment screening could further shape the ultimate regulatory landscape, and bears monitoring.
Discussion
Overview of the EO and ANPRM
As expected, the EO proposes a two-tiered approach whereby: (1) certain transactions are subject only to a notification requirement (“Notifiable Transactions”); and (2) certain other investments are subject to aprohibition (“Prohibited Transactions,” and together with Notifiable Transactions, “Covered Transactions”). While the scope of Prohibited Transactions appears relatively narrow and consistent with the Administration’s so-called “small yard, high fence” approach, the scope of Notifiable Transactions (i.e. transactions subject to the notification requirement, but not prohibitions) is more expansive, seeming to cover most activities in the semiconductor manufacturing industry. The “notification” itself is expected to be more than perfunctory, requiring U.S. parties to provide details regarding: their diligence on the foreign person; any previous transactions with the foreign person; planned or contemplated future investments; the foreign person’s products, services, business plans, and commercial relationships; and more.
Whether a transaction would be subject to a notification requirement or a prohibition under the EO would depend principally on four factors: whether (1) a “U.S. person” undertakes (2) a “covered transaction” with (3) a “covered foreign person” (i.e., a “person of a country of concern”) that is (4) engaged in certain defined activities involving “covered national security technologies and products.”
The following provides an initial summary of key points from the EO and ANPRM.
1. Whether the transaction is undertaken by a “U.S. person”
The EO applies to transactions undertaken by “U.S. persons,” which is defined as “as 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 in the United States.”
The EO also provides authority to prohibit U.S. persons from “knowingly directing transactions” that would be Prohibited Transactions if engaged in by a U.S. person, and to require U.S. persons to “take all reasonable steps to prohibit and prevent any transaction by a foreign entity controlled by such United States person that would be a prohibited transaction if engaged in by a United States person.” With respect to notifiable transactions, the EO provides authority to require U.S. persons to provide notification of “any transaction by a foreign entity controlled by such United States person that would be a notifiable transaction if engaged in by a United States person.”
The ANPRM proposes to define “knowingly” for purposes of this provision to mean that the U.S. person “had actual knowledge, or should have known, about the conduct, the circumstance, or the result.” The ANPRM proposes to define “directing” to mean that a U.S. person “orders, decides, approves, or otherwise causes to be performed a transaction that would be prohibited under these regulations if engaged in by a U.S. person.” The ANPRM provides certain examples of activities that would be covered transaction to illustrate this analysis:
- Scenario 1: A U.S. person General Partner manages a foreign fund that undertakes a transaction that would be prohibited if performed by a U.S. person.
- Scenario 2: A U.S. person is an officer, senior manager, or equivalent senior-level employee at a foreign fund that undertakes a transaction at that U.S. person’s direction when the transaction would be prohibited if performed by a U.S. person.
- Scenario 3: Several U.S. person venture partners launch a non-U.S. fund focused on undertaking transactions that would be prohibited if performed by a U.S. person.
The application of the EO thus potentially could sweep broadly to include certain extraterritorial transactions that involve U.S. persons.
2. Whether the transaction is a “covered transaction”
The EO does not define the types of transactions that would be subject to its notification requirements and prohibitions. The ANPRM therefore proposes to define a new term, “covered transaction,” that would specify the types of transactions between U.S. persons and covered foreign persons that could be subject to a notification requirement or a prohibition, including a U.S. person’s direct or indirect:
- Acquisition of an equity interest or contingent equity interest in a covered foreign person;
- Provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest;
- Greenfield investment that could result in the establishment of a covered foreign person; and
- Establishment of a joint venture, wherever located, that is formed with a covered foreign person or could result in the establishment of a covered foreign person.
The ANPRM indicates that the inclusion of “indirect” transactions is intended to “close loopholes that would otherwise result, and to clarify that attempts to evade prohibitions on certain transactions cannot find safe harbor in the use of intermediary entities that are not ‘U.S. persons’ or ‘covered foreign persons,’ as defined.” That said, it is not clear what it would mean for a covered transaction to be “indirect.” We believe that this will need to be clarified by Treasury through the rulemaking process.
The ANPRM further indicates that the Treasury Department does not intend for “covered transactions” to include university-to-university research collaborations; contractual arrangements or the procurement of material inputs for any of the covered national security technologies or products (such as raw materials); intellectual property licensing arrangements; 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; or other services secondary to a transaction; so long as such transactions do not independently meet the definition of a “covered transaction.”
The ANPRM, moreover, proposes to carve out a category of “excepted transactions” from the scope of “covered transactions,” including certain passive investments, certain intracompany transfers, certain acquisitions outside China, and transactions made pursuant to a binding, uncalled capital commitment entered into before the date of the EO.
Lastly, the ANPRM specifies that its regulations will not be applied retroactively to capture transactions that occurred before the EO, although the Treasury Department is still considering how to treat “follow-on transactions” into a covered foreign person when the original transaction relates to an investment that occurred prior to the effective date of the implementing regulations, and has asked for input regarding the consequences of covering such follow-on transactions. The ANPRM notes, however, that Treasury may request information about transactions by U.S. persons completed or agreed to after the date of the issuance of the EO—which would be August 9, 2023.
3. Whether the transaction is with a “covered foreign person”
The EO defines a “covered foreign person” as a “person of a country of concern who or that is engaged in activities, as identified in the regulations issued under this order, involving one or more covered national security technologies and products,” whereas the ANPRM proposes to broaden the definition as follows:
(1) A person of a country of concern that is engaged in, or a person of a country of concern that a U.S. person knows or should know will be engaged in, an identified activity with respect to a covered national security technology or product;
(2) A person whose direct or indirect subsidiaries or branches are referenced in item (1) and which, individually or in the aggregate, comprise more than 50 percent of that person’s consolidated revenue, net income, capital expenditure, or operating expenses.
The ANPRM in turn proposes to define a “person of a country of concern” as:
(1) Any individual that is not a U.S. citizen or lawful permanent resident of the United States and is a citizen or permanent resident of a country of concern;
(2) An entity with a principal place of business in, or an entity incorporated in or otherwise organized under the laws of a country of concern;
(3) The government of a country of concern, including any political subdivision, political party, agency, or instrumentality thereof, or any person owned, controlled, or directed by, or acting for or on behalf of the government of such country of concern; or
(4) Any entity in which a person or persons identified in items (1) through (3) holds individually or in the aggregate, directly or indirectly, an ownership interest equal to or greater than 50 percent.
Notably, prong (4) indicates that subsidiaries and portfolio companies of Chinese companies, anywhere in the world, could be “covered foreign persons.” In fact, the definition indicates that even U.S.-incorporated entities operating in the United States could be “covered foreign persons” if a Chinese person or persons own a 50 percent or greater interest. This places an obligation on U.S. parties to undertake diligence and obtain shareholding information—information that may not be easy to obtain—from transaction parties, including even U.S. companies, to evaluate the potential application of the EO.
4. Whether the transaction includes “covered national security technologies or products”, and if so, whether it would be a prohibited transaction or a notifiable transaction
In addition to a “country of concern,” a “covered foreign person” is defined by reference to “covered national security technologies or products.” Covered national security technologies or products fall into three categories: (1) semiconductors and microelectronics; (2) quantum information technologies; and (3) artificial intelligence systems. Transactions undertaken by U.S. persons with covered foreign persons would be subject to a notification requirement or a prohibition depending on the specific subset of national security product or technology with which the covered foreign person is engaged, though there would not be a separate notification requirement for transactions involving quantum information technology.
a. Semiconductors and Microelectronics
The subset of “advanced semiconductor and microelectronic technologies and products” that would give rise to a prohibition is defined with technical specificity—e.g., to include advanced chips designed to “exceed the thresholds in ECCCN 3A090” or “for operation at or below 4.5 Kelvin.”
By contrast, the subcategory that would be subject to a notification requirement is defined much more broadly to include any “integrated circuit design, integrated circuit fabrication, and integrated circuit packaging” that are not in the prohibited category.
b. Quantum Information Technologies
With respect to quantum information technologies, the Treasury Department is considering a prohibition on any U.S. person undertaking a transaction with a covered foreign person engaged in activities involving “Quantum Computers and Components,” “Quantum Sensors,” and “Quantum Networking and Quantum Communication Systems,” which terms are defined in the ANPRM. The Treasury Department, however, is not considering a separate notification requirement for transactions involving quantum information technologies.
c. Artificial Intelligence Systems
The Treasury’s Departments proposals regarding notification requirements and prohibitions applicable to AI systems are the least developed of the three categories of national security technologies and products. Currently, the Treasury Department is considering whether it will implement a notification requirement or a prohibition, or both, with respect to covered transactions with covered foreign persons engaged in activities related to AI systems.
5. The “knowledge standard”
The ANPRM appears to recognize that determining whether an entity is a “covered foreign person” may be challenging or impossible in some circumstances, and accordingly Treasury is not proposing to apply a strict liability standard. Rather, the ANPRM explains that Treasury is considering implementing a “knowledge standard” where knowledge means “knowledge of a circumstance (including variations such as “know,” “reason to know,” or “reason to believe”) including not only positive knowledge that the circumstance exists or is substantially certain to occur, but also an awareness of a high probability of its existence or future occurrence.” Specifically, Treasury would condition a person’s obligations on whether the U.S. person has “actual or constructive knowledge that the covered foreign person is engaged in, or will foreseeably be engaged in, certain activity regarding the technology or product.” This knowledge standard would, in turn, be incorporated in the first prong of the “covered foreign person” definition above.
6. What is the rulemaking process going forward?
Written comments are due to the Treasury Department 45 days after the ANPRM is formally published in the Federal Register, which is expected in the coming days. In addition to written comments, Treasury has indicated that it will honor requests for stakeholder meetings “as resources permit.” The fact that the ANPRM describes Treasury’s approach (rather than proposing a full draft set of regulations) suggests that many of the key terms and provisions remain subject to further deliberation within Treasury. We expect that Treasury will make a good faith effort to engage with a broad range of stakeholders on the many issues raised in the ANPRM as it continues to refine the regulations.
The EO and ANPRM do not set forth a precise timeline for completing the rulemaking. We expect that the implementing regulations could take several months to a year (or more) to be finalized through the rulemaking process. That said, we cannot rule out the possibility that the Treasury Department could face institutional pressure to move faster, including based on reactions from Congress.
Potential Congressional Action
Senate Proposal – Outbound Investment Transparency Act
The EO follows the U.S. Senate’s bipartisan 91-6 vote to add the investment screening legislation to the FY2024 NDAA. The amendment, the Outbound Investment Transparency Act, scales back the more sweeping National Critical Capabilities Defense Act (“NCCDA”) sponsored by Senators Cornyn and Casey since 2021, along with a bipartisan House counterpart led by Reps. Rosa DeLauro (D-CT), Bill Pascrell (D-NJ), and Brian Fitzpatrick (R-PA). The House version of the NDAA, which passed earlier in July, did not include any outbound investment provisions. Key House Republicans have suggested that they would like to conference the Senate outbound investment language with enhanced sanctions provisions that they support.
The Senate Proposal differs in several key respects from the EO. Fundamentally, it is a less onerous regime that does not contemplate any prohibitions. However, the scope of covered activities and sectors subject to the notification requirement under the Senate bill would be broader than those covered by the EO.
Specifically, in addition to the industry sectors covered by the EO, the Senate bill would require notification for covered activities involving hypersonics, satellite-based communications, and networked laser scanning systems with dual-use applications.
The Senate bill also requires notification for a “covered activity”—a definition that encompasses not only transactions but also activities, including, for example, “operational cooperation, such as through supply or support agreements,” and the establishment of “new relationships…to provide businesses services such as but not limited to financial services, marketing services, maintenance or assembly functions related to a national critical capabilities sector.”
Finally, while the EO limits covered foreign entities to those with connections to China, the Senate bill defines “covered foreign entity” to include entities incorporated in, headquartered in, or organized under the laws of, a “country of concern,” which includes China, Russia, Iran, and North Korea.
Legislative Outlook
Although the Senate outbound amendment passed with overwhelming bipartisan support—only five Republicans and one Democrat opposed it—its future in the coming months is now unclear. The release of the EO, given its partial overlap with the Senate provision both in timing and substance, complicates the debate in Washington over outbound investment screening more generally. Key Members of Congress, including Senate Majority Leader Chuck Schumer (D-NY), Senate Banking Committee Chair Sherrod Brown (D-OH), Senator Casey, and House Financial Services Committee Chair Patrick McHenry (R-NC), have suggested codifying the EO into law. It remains to be seen whether the EO will be codified or whether Congress will negotiate new language. The House-Senate conference committee negotiation on the NDAA is expected to continue late into the fall.
Meanwhile, other House lawmakers have floated alternatives to outbound investment legislation, including Rep. Andy Barr (R-KY), who has introduced legislation to expand sanctions on certain companies based in China by “harmonizing” the U.S. government’s various sanctions lists. While Rep. Barr’s bill was not included in the House NDAA, supporters may attempt to include it in the final bill through conference.
Covington will continue to monitor these important developments. In the meantime, If you have any questions concerning the material discussed in this client alert, please contact the members of our CFIUS and PPGA practices.
Back
