Treasury Issues Proposed Regulations Prohibiting Certain US Investment in Chinese Technology Companies

Key Points

• The Department of the Treasury has issued proposed regulations to implement President Biden’s 2023 EO targeting U.S. investments in Chinese companies engaged in certain activities related to semiconductors, quantum computing or AI.
• Once the regulations become effective, U.S. persons will be prohibited from engaging in certain transactions involving China or Chinese persons in these sectors while others will require a notification to the U.S. government. The focus is on equity, though some debt financing will be covered.
• The proposed rules squarely cover private equity and venture capital funds with a U.S. general partner. In addition, some U.S. limited partner investments in funds with non-U.S. partners will also be captured, although Treasury is contemplating two alternative thresholds for an exception for such investments, indicating that the U.S. government is still actively debating coverage over limited partners.
• Certain subsidiaries and parents of Chinese companies in third countries will be covered, which will necessitate greater due diligence than if the focus were solely investment directly into China. In addition, U.S. persons will need to take steps to prevent their subsidiaries in third countries from making investments that they themselves would not be permitted to make.
• In certain cases, the targeted activities go beyond what is currently regulated under export controls, and the proposed rule expands upon the scope of AI activities that was captured under Treasury’s initial proposal.
• We recommend that U.S. persons implement screening procedures for prospective investments that fall within the descriptions of a covered transaction for touchpoints with Chinese or Chinese-affiliated companies and the covered sectors. Along those lines, covered transactions that are signed after August 9, 2023, that have not closed by the effective date would be covered, meaning transactions that are currently pending could be prohibited by the time the parties are ready to close.
• Treasury is collecting regulatory comments on the proposed rules through August 4, 2024.

Background

The Notice of Proposed Rulemaking (NPRM or the Proposed Rule), issued by Treasury on June 21, 2024, would implement President Biden’s August 9, 2023, Executive Order on outbound investment, which addresses concerns related to China’s advancement in sensitive technologies critical for military, intelligence, surveillance or cyber-enabled capabilities (the EO). As noted in the Proposed Rule, the U.S. government believes that U.S. investments are “often more valuable than capital alone” due to the potential transfer of intangible benefits such as enhanced standing and prominence, managerial assistance, access to investment and talent networks, market access and enhanced access to additional financing.

The EO and NPRM generally target the sensitive technology sectors that are consistent with the “force multiplier” technologies that National Security Advisor Jake Sullivan referenced in his September 2022 remarks at the Special Competitive Studies Project Global Emerging Technologies Summit, where he noted that “microelectronics, quantum information systems, and artificial intelligence” are included in the “select few technologies [that] are set to play an outsized importance over the coming decade” and that, “[g]iven the foundational nature of certain technologies, such as advanced logic and memory chips, we must maintain as large of a lead as possible.”

The EO directs the Treasury Secretary to establish a program to prohibit or require notification regarding certain types of outbound investments by U.S. persons into certain entities that are (1) connected to a country of concern and (2) engaged in activities involving “covered national security technologies and products.” The EO designated China, including Hong Kong and Macau, as the sole country of concern and semiconductors and microelectronics, quantum technologies and artificial intelligence (AI) as “covered national security technologies and products.”

On the same day that President Biden issued the EO, Treasury published an Advance Notice of Proposed Rulemaking (the ANPRM), outlining the proposed scoping for the program and seeking public comments. (See our alert on the EO and ANPRM here.) The Proposed Rule addresses some, but not all, of the public comments received on the ANPRM and provides draft regulatory text and additional details on the contours of the program.

Key Changes from the ANPRM

Key changes from the ANPRM include (i) providing additional guidance on the due diligence required to meet the knowledge standard unpinning key requirements; (ii) prohibiting transactions with entities on certain U.S. government restricted party lists that would otherwise fall into the notification category; (iii) providing alternatives for the potential exception for certain limited partner investments; and (iv) clarifying the scope of the prohibition and notification requirements relating to AI, including expanding coverage through technical thresholds based on compute power. Notably, these last two items have alternative proposals for public comments. Treasury declined to take certain public comments, such as establishing general de minimis standards for covered transactions and narrowing the notification requirement relating to AI systems involving the control of robotics, which could potentially sweep in investment in medical and consumer applications.

Key Parameters in the Proposed Rule

Covered Transactions

The Proposed Rule only applies to certain types of transactions, referred to as “covered transactions.” The Proposed Rule defines “covered transaction” to mean:

• Acquisition of an equity interest or contingent equity interest in a covered foreign person, as well as the conversion of contingent equity.
• Provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest, where the debt affords the lender certain management or governance rights, or where foreclosure on collateral after default results or would result in the acquisition of equity.
• Acquisition, leasing or development of operations, land, property or other assets that could result in the establishment of a covered foreign person (i.e., greenfield investments).
• Entering into a joint venture, wherever located, that is formed with a person of a country of concern and that the U.S. persons knows will engage in or the U.S. intends will engage in a covered activity.
• Certain acquisitions of limited partner (LP) interests in a non-U.S. fund that is “likely” to invest in a person of concern, based on reasonable due diligence.

Each of these types of transactions includes either a knowledge or intent requirement by the U.S. person. The NPRM defines knowledge as actual knowledge that a fact or circumstance exists or is substantially certain to occur, awareness of a high probability of the existence or future occurrence of a fact or circumstance, or reason to know of a fact or circumstance’s existence. Treasury will consider whether the U.S. person could have had knowledge of the relevant fact or circumstance through a reasonable and diligent inquiry. Based on public comments, Treasury has provided further guidance on what constitutes a sufficiently diligent inquiry, including seeking representations and warranties, reviewing publicly available information, making efforts to obtain non-public information, utilizing commercial databases and following up on evasive responses.

Excepted Transactions

The Proposed Rule expressly carves out certain types of transactions from the definition of “covered transaction” – these types of transactions are referred to as “excepted transactions.” The Proposed Rule identifies the following “excepted transactions”

• Certain types of passive investments, such as investments in publicly traded securities or into an index fund, where the investor does not receive rights beyond certain minority protections.
• Certain U.S. LP investments, where the investor does not receive rights beyond certain minority protections. Treasury proposed two different alternatives for excepting U.S. LP investments in funds that are likely to make investments covered under the program. The alternatives:
  • Where the LP is effectively passive and either its committed capital is not more than 50% of the total assets under management or the LP secures a binding commitment that its capital will not be used for prohibited transactions.
  • Where the LP’s committed capital is not more than $1 million.
• Full buyouts of all Chinese ownership in a company.
• Intracompany transactions that support ongoing operations or other activities that are not covered activities.
• Transactions made pursuant to a binding, uncalled capital commitment entered before the effective date of the EO.
• Certain syndicated debt financing, where the U.S. person acquires a voting interest in a covered foreign person upon default as a member of a lending syndicate and cannot initiate an action vis-à-vis the debtor.

U.S. Persons

To be covered by the Proposed Rule, a transaction must be by a U.S. person or an entity under the control of a U.S. person. The Proposed Rule defines U.S. person to mean: (i) U.S. citizens and lawful permanent residents, (ii) entities organized under U.S. law or any jurisdiction of the United States (including branches) and (iii) any person in the United States.

With respect to entities under the control of a U.S. person, the Proposed Rule would require U.S. persons to take “all reasonable steps” to prohibit and prevent its controlled entities from undertaking transactions that the U.S. person itself would be prohibited from taking. Essentially, “controlled by” means that the U.S. person is a “parent” of such entity. Parent is defined as an entity that holds more than 50% of the voting interest or voting power of the board of the entity, the general partner of a fund or an investment adviser to a pooled investment fund.

In addition, U.S. person senior management personnel at non-U.S. companies would be prohibited from “knowingly directing” transactions by non-U.S. persons (i.e., their employer) that a U.S. person would be prohibited from undertaking.

Covered Foreign Persons

To be in scope, transactions must also be with “covered foreign persons,” which is scoped through a two-step definition. Essentially, a covered foreign person is a “person of a country of concern” that is engaged in a “covered activity.”

• A covered foreign person includes:

(i) Any person of a country of concern that engages in a covered activity.

(ii) A person that either directly or indirectly holds any voting interest, board seat, or equity interest in or holds the power to direct policies (including variable interest entities) in one or more persons engaged in a covered activity (i.e., a person described in prong (i)), if persons covered by prong (i) individually or in the aggregate comprise more than 50% of its consolidated revenue, net income, capital expenditure or operating expense in the prior year (e.g., certain parent companies, including in third countries).

(iii) The person of a country of concern that participates in a covered joint venture.

• A person of a country of concern includes:

(i) Any individual that is a citizen or permanent resident of China and is not a U.S. citizen or permanent resident.

(ii) An entity with a principal place of business in, headquartered in, or incorporated in or otherwise organized under the laws of China.

(iii) The Chinese government and persons controlled by or acting on behalf of the government (including the power to direct or cause the direction of the management or policies of an entity).

(iv) Any entity in which one or more persons under (i) – (iii) hold at least 50% of the outstanding voting interest, voting power of the board or equity interest (e.g., subsidiaries).

(v) Any entity in which one or more persons identified in (iv), individually or in the aggregate, directly or indirectly, holds at least 50% of the outstanding voting interest, voting power of the board or equity interest (e.g., subsidiaries of subsidiaries).

Covered Activities Involving National Security Technologies and Products

To be a covered foreign person, an entity must be engaged in “covered activities” involving certain technologies and/or products in the semiconductors and microelectronics, quantum information technologies or AI sectors. Depending on the activities, the transaction may be either prohibited or requirement notification. The Proposed Rule defines each of these categories in further detail.

A summary of the NPRM’s prohibited and notifiable transactions with respect to the “covered activities” in each technology sector is included below and the full test is included as an annex:

• Semiconductors and microelectronics: The NPRM generally targets advanced node integrated circuits and front-end semiconductor fabrication equipment that is currently controlled under U.S. export controls, but also targets all semiconductor electronic design automation (EDA) software and advanced packaging technology, some of which are currently not the subject of U.S. export controls.
  • Prohibited transactions: Covered transactions related to electronic design automation software; certain fabrication and advanced packaging tools; any items exclusively for use in or with extreme ultraviolet lithography (EUVs); the design of 3A090.a graphics processing units (GPUs) or integrated circuits (ICs) designed for operation at or below 4.5 Kelvin, fabrication of advanced nodes ICs or certain special ICs, or IC packaging using advanced packaging techniques; and certain supercomputers.
  • Notifiable transactions: Covered transactions related to the design, fabrication or packaging of ICs not otherwise covered by the prohibited transaction definition.
• Quantum information technologies: The NPRM targets the development of quantum computers and the production of critical components of quantum computers, including some components that BIS is expected to soon add to the Commerce Control List. It also targets certain quantum sensing platforms and quantum networking and communication systems.
  • Prohibited transactions: Covered transactions related to the development of quantum computers and production of critical components; the development or production of certain quantum sensing platforms; and the development or production of quantum networking and quantum communication systems.
  • Notifiable transactions: None.
• Certain AI systems: The NPRM targets AI systems that are used for certain military, government intelligence or government mass surveillance end uses, all of which are end uses that are consistent with current and past U.S. government interagency reviews in the U.S. export control context, while also targeting AI systems, regardless of end use, trained using certain specified computational power thresholds which are consistent with, and in some cases higher than, those specified in the October 30, 2023, “Executive Order on the Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence.” The NPRM defines AI system very broadly, to include not only machine-based systems themselves, but also any data system, software, hardware, application, tool or utility that operates using a machine-based system.
  • Prohibited transactions: Covered transactions related to the development of any AI system designed to be exclusively used for, or intended to be used for, certain military, mass surveillance or government intelligence end uses. The proposed regulations also prohibit transactions related to the development of any AI system, regardless of end use, that is trained using a specified quantity of computing power—Treasury is considering 10^24, 10^25 or 10^26 computational operations as possible thresholds—or trained using a specified quantity of computing power using primarily biological sequence data.
  • Notifiable transactions: Covered transactions related to the development of any AI system not otherwise covered by the prohibited transaction definition, where such AI system is designed or intended to be used for certain end uses (including control of robotics systems, which is potentially broad) or is trained using a specified quantity of computing power at a threshold set below the levels in the prohibited transaction definition (i.e., 10^23, 10^24 or 10^25).

Additional Key Aspects of the Proposed Rule

• The prohibitions would extend to otherwise notifiable investments in Chinese persons on certain sanctions and export control lists maintained by the Departments of Treasury, Commerce or State.¹
• Parties may apply for a national interest exemption that would permit the transaction to proceed. Treasury will publish procedures on its website. We anticipate that there will be a high bar for exemptions, and U.S. persons would need to demonstrate factors such as the transaction’s effect on critical U.S. supply chain needs; domestic production needs in the United States for projected national defense requirements; United States’ technological leadership globally in areas affecting U.S. national security; and impact on U.S. national security if the U.S. person is prohibited from undertaking the transaction.
• Treasury is considering introducing a “white list” approach for covered transactions involving entities in third countries. This would except certain types of transactions (yet to be identified) with entities in countries that have been designated according to criteria (yet to be developed) that relate to actions by that country to address outbound investment risk. We anticipate that this will be a narrow exception.
• Violations could result in (i) civil penalties up to the maximum allowable under the International Emergency Economic Powers Act, which is currently $356,579 per violation, and (ii) criminal penalties up to $1 million or 20 years in prison for willful violations.
• Application to transactions signed prior to effectiveness. The proposed regulations contemplate that covered transactions that are signed between the date of the EO (August 9, 2023) and the effective date of the regulations but have not closed prior to the effective date of the regulations would be covered. Therefore, such transactions could be prohibited from closing. We advise that U.S. persons account for this when entering into potentially covered transactions.

What’s Next?

There will be a 45-day public notice and comment period, with comments due on August 4, 2024. After reviewing public comments, Treasury will publish final regulations, and the new program will become effective most likely 30 days thereafter, which may be early 2025.

Annex: Covered Activities Involving National Security Technologies and Products

^{1  These include persons (i) on the Bureau of Industry and Security’s (BIS) Entity List and Military End User List; (ii) that meet BIS’s definition of “Military Intelligence End-User”; (iii) on Treasury’s Specially Designated Nationals and Blocked Persons (SDN), including entities owned 50% or more by SDNs, or Non-SDN Chinese Military-Industrial Complex Companies (NS–CMIC List); or (iv) designated by state as a foreign terrorist organization.}