Compliance Deadline Approaches for New Regs Targeting U.S. Investment in Chinese AI, Semiconductors, Quantum Tech

On November 15, the U.S. Department of the Treasury published final regulations to implement its long-awaited “Outbound Investment” Security Program, which the Biden Administration originally introduced in August 2023 under Executive Order 14105, to address national security issues around “countries of concern” that seek to develop certain products and sensitive technologies that the U.S. government views as critical for military, intelligence, surveillance, or cyber-enabled capabilities. The regulations are set to become effective January 2.  

The new regulations cover certain U.S. and U.S.-directed investments that might support entities or facilities located in the People’s Republic of China (including Hong Kong and Macau) in specific technology industries–semiconductors and microelectronics, quantum information technologies, and artificial intelligence. U.S. investors and strategic partners will need to undertake robust diligence to determine whether a proposed transaction is prohibited or alternatively subject to post-closing notification. Violations can result in both civil and criminal penalties, as well as potential divestment of a prohibited transaction.

What Types of Investments and Transactions Are Covered?

The rule covers transactions made by a U.S. person with a “covered foreign person” that is engaged in defined activities involving certain sensitive products and technologies described below. Covered transactions include:

• Acquisitions of equity or contingent equity
• Debt financing that is convertible to equity or that carries equity-like rights
• Greenfield or brownfield investments or other corporate expansions
• Creation of joint ventures
• Certain limited partnership (LP) investments

Importantly, covered transactions do not include full acquisitions; passive investments in publicly traded securities, mutual funds, or index funds; intracompany support to maintain existing operation, equity-based employment compensation, and relationships that are limited to typical commercial business transactions like the sale or exchange of goods and services, technology licensing, or consulting.

Also, the rules exclude LP investments of $2 million or less, or any LP investment accompanied by a binding contractual assurance that the limited partner’s capital would not be used by the investment fund for a covered transaction. However, activities that do not meet the covered transaction definition may still be covered where they are undertaken to evade or avoid the rule.

In addition to traditional investments, a U.S. person’s acquisition, leasing, or other development of operations, land, property, or other assets in China would be a covered transaction where the U.S. investor knows at the time of the acquisition, leasing, or other development that it will result in, or it is the U.S. investor’s plan to either:

• Establish a new covered foreign person
• Engage a Chinese entity in covered activity

The rules do not provide further specificity as to what would constitute other assets, leaving room for broad interpretation by Treasury in its administration and enforcement.

What Types of Investors Are Covered?

A U.S. person is any U.S. citizen or lawful permanent resident no matter where located, any other person regardless of nationality who is located (even temporarily) in the U.S., and any entity organized under U.S. law, including any foreign branch of any such entity. The rules cover not only transactions by U.S. persons, but also reach various related entities, i.e.:

• A U.S. person that is the direct or indirect parent of a controlled foreign entity must take all reasonable steps to prohibit and prevent any transaction by such entity that that the person knows or should know would be a prohibited transaction if engaged in by a U.S. person.
• A U.S. person that is an officer, director, or similar executive of a non-U.S. entity cannot “knowingly direct” such entity to engage in a transaction that the person knows or should know would be a prohibited transaction if engaged in directly by the U.S. person.
• However, while U.S.-based employees of a non-U.S. entity would be subject to the restrictions and requirements governing covered transactions, their physical presence in the U.S. alone will not cause the employer to be covered.

The restriction against a U.S. person knowingly directing a prohibited transaction carries broad jurisdictional reach into foreign-headquartered and controlled entities, although the outbound investment regime does not go as far as the U.S. person facilitation concept seen in sanctions administered by Treasury.

To be considered within the scope of this restriction, the U.S. person must both:

• Have the authority individually or as part of a group to make or substantially participate in the investment decision
• Exercise that authority in directing, ordering, deciding upon, or approving a transaction

Further, the rules provide for a recusal practice to exclude a U.S. person from such involvement, where the U.S. person is in fact recused from all three of the following with respect to the transaction:

• Participating in approval or decision-making
• Reviewing, editing, commenting on, approving, or signing transaction documents
• Engaging in negotiations with counterparties

Once a transaction is complete, U.S. persons need not be recused from ordinary operational management of the business.

What Investment Targets and Partners Are Covered?

People's Republic of China Persons: The rule applies to transactions with any “covered foreign person,” which includes the following individuals and entities if engaged or to be engaged in a covered activity:

• An individual who is a citizen or permanent resident of the PRC (and not a U.S. citizen or permanent resident of the United States)
• An entity that is organized under PRC law, or having headquarters or a principal place of business in the PRC
• Any agency of the PRC government
• An entity that is directly or indirectly majority-owned by any persons or entities in any of the above categories
  

Other Entities with Ties to PRC Persons: Importantly, the rule also captures transactions involving an entity than has a voting interest, board seat, or equity interest in a covered foreign person where more than 50% of that person’s annual revenue, net income, capital expenditure, or operating expenses in its last fiscal year was attributable to the covered foreign person. This could include, for example, a company that is organized and headquartered in a third country, where a preponderance of the company’s activities occur in the PRC.

What Technologies are Covered?

The outbound investment regime is focused on three key technology areas, and it either results in a covered transaction being prohibited or subject to a notification requirement within 30 days after the transaction has closed (or within 30 days after the investor later realizes the deal was a covered transaction).  

Semiconductors and Microelectronics

• Prohibited Transactions: Covered transactions related to electronic design automation software; certain front-end volume or lithography fabrication equipment and advanced packaging tools; the design, fabrication, or packaging of certain advanced integrated circuits (including semiconductors that meet or exceed the performance parameters in ECCN 3A090.a for export control purposes); and developing, installing, selling, or producing advanced performance supercomputers
• Notifiable Transactions: Covered transactions related to the design, fabrication, or packaging of integrated circuits not otherwise covered by the prohibited transaction definition (including those involving EAR99 technology and mature processes)

Quantum Information Technologies

• Prohibited Transactions: Covered transactions related to the development of quantum computers and production of critical components; the development or production of quantum sensing platforms intended for military, intelligence, or mass surveillance end use; and the development or production of certain quantum networking and quantum communication systems
• Notifiable Transactions: None–all are prohibited

Artificial Intelligence

• Prohibited Transactions:
• Covered transactions related to the development of any AI system designed for exclusive use for or intended to be used for military, intelligence, or mass surveillance end use
• Covered transactions related to the development of any AI system trained using a quantity of computing power greater than 10^25 computational operations (e.g., integer or floating-point operations) or 10^24 computational operations 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, designed for any military, intelligence, or mass surveillance end use; or intended to be used for cybersecurity applications, digital forensic tools, penetration testing tools, or robotic systems control; or trained using a quantity of computing power greater than 10^23 computational operations

What Diligence is Required?

To be a covered transaction subject to the outbound investment regime, the U.S. person must know one or more of the following at the time of the transaction:

• It involves a covered foreign person
• It will result or is planned to result in the establishment of a covered foreign person through a greenfield, brownfield, or joint venture investment
• It will result or is planned to result in a PRC person’s engagement in a covered activity (in the case of a brownfield investment).

However, the U.S. person is responsible for knowledge the U.S. person had or could have had through a “reasonable and diligent inquiry.”

The level of inquiry required is evaluated based on a consideration of the totality of relevant facts and circumstances, but should include, at a minimum:

• Reasonable efforts to obtain and consider available non-public and public information;
• Appropriate diligence requests and representations and warranties of the counterparty; and
• Attention to any evasive or incomplete responses or other warning signs.

This affirmative diligence obligation is measured as of closing. Nevertheless, if the U.S. person acquires actual knowledge following the closing of a transaction that the transaction would have been a covered transaction (either prohibited or notifiable) if the U.S. person had known (or should have known) of relevant facts or circumstances as of closing, then the U.S. person must provide the notice required by the rule within 30 days of discovery.

What’s Next?

As with the growing restrictions on exports of sensitive technology to China and limits on use of CHIPS Act funding for the benefit of semiconductor operations in China, the new rules implementing the Outbound Investment Security Program require companies seeking to invest in or engage in collaborations with Chinese entities to carefully evaluate the companies and technologies involved to ensure the contemplated transactions continue to conform to this evolving legal landscape. Moreover, compliance protocols for foreign subsidiaries, and guardrails for U.S. persons involvement in foreign companies such as recusal policies, will become increasingly important.

If you have questions regarding the Outbound Investment Security Program reach out to trusted counsel.

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