Treasury Department Issues Long-Awaited Proposed Rule on Outbound Investment Screening

The U.S. Department of the Treasury's Office of Investment Security on June 21, 2024, issued a Notice of Proposed Rulemaking (Proposed Rule) implementing Executive Order (E.O.) 14105 that was announced on Aug. 9, 2023, "Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern."

The Proposed Rule succeeds the Treasury Department's Advance Notice of Proposed Rulemaking (ANPRM) from Aug. 14, 2023, and reflects the Treasury Department's consideration of the comments received to the ANPRM. (See Holland & Knight's previous alert, "Long-Awaited Executive Order Targets U.S. Outbound Investment in China," Aug. 11, 2023.) The Proposed Rule will be followed by final implementing regulations at a later date.

The public is encouraged to submit comments on the Proposed Rule by Aug. 4, 2024.

Background

Scrutiny from the U.S. Congress, the White House and regulators of the economic and trade relationship between the U.S. and China has grown in recent years, culminating in additional export controls on sensitive technologies, sanctions such as the Chinese Military-Industrial Complex Sanctions Regulations program and heightened scrutiny on Chinese investments in the U.S. by the Committee on Foreign Investment in the United States (CFIUS). On Aug. 9, 2023, President Joe Biden issued E.O. 14105, which directed the Treasury Department to establish an outbound investment screening regime focused on addressing the potential risks of certain U.S. investments in so-called "countries of concern," including intangible benefits that often accompany these investments. The E.O. directed the establishment of a new and targeted national security program aimed at addressing these threats and hindering efforts by countries of concern to develop sensitive technologies or products that are critical to the next generation of military, intelligence, surveillance or cyber-enabled capabilities.

In line with the E.O., the ANPRM issued by the Treasury Department on Aug. 14, 2023, announced that certain transactions will be prohibited, while others will require a notification by the U.S. investor, if the transactions involve entities from a country of concern engaged in activities related to technologies and products in the semiconductors and microelectronics, quantum information technologies (IT) or artificial intelligence (AI) sectors.

Scope of the Proposed Rule

The Proposed Rule offers regulations to implement the E.O. and reflects the Treasury Department's consideration of the public comments received on the ANRPM. Namely, the Proposed Rule clarifies the scope of the program and the definitions under consideration, aligns the program where possible with other relevant U.S. government programs and aims to reduce unintended consequences for U.S. competitiveness.

The Proposed Rule describes the new outbound investment screening regime as narrow and targeted. In practice, the breadth of the screening regime will depend on the ultimate final rule and how broadly the Treasury Department interprets certain definitions, as outlined below. The Proposed Rule's restrictions are focused on only three industries: semiconductors/microelectronics, quantum IT and AI. Recognizing that advanced technologies and products are increasingly developed and financed by the private sector – along with concern that advancements in the identified sensitive technologies will accelerate the development of advanced computational capabilities that will enable new applications that pose significant national security risks such as the development of more sophisticated weapons systems, breaking of cryptographic codes and other applications that could provide a country of concern with military advantages – the stated intent of the program is to focus only on certain U.S. outbound investments that contribute to capabilities of a country of concern involving these sensitive technologies and products that could pose risks to U.S. national security. The Proposed Rule justifies the increased scrutiny of certain U.S. investments on the basis that U.S. investments are often more valuable than the dollar amount of the capital contribution, because the investment often also includes the 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.

Key Elements of the Proposed Rule

Countries of Concern

The Proposed Rule defines "country of concern" by reference to the annex to the E.O. that identifies only the People's Republic of China (PRC), along with the Special Administrative Region of Hong Kong and the Special Administrative Region of Macau, as a "country of concern." Though this could change in the future, this definition is in line with the U.S. government's focus on national security risks arising from Chinese transactions.

U.S. Person

"U.S. Person" means 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 branch of any such entity or any person in the United States. This broad definition is similar to the definition used in many economic sanctions programs administered by the Treasury Department's Office of Foreign Assets Control (OFAC).

Although the definition covers the U.S. subsidiaries of a foreign company, the Proposed Rule clarified that it would not cover the foreign parent of a U.S. Person solely because of its relationship to the U.S. Person. Similarly, the definition covers personnel of a non-U.S. person working in the U.S. branch office of the foreign company based on their presence in the U.S., but would not extend to the non-U.S. person's employer solely on the basis of the employee's presence in the U.S. 

Conversely, foreign subsidiaries of U.S. Persons would be captured by the rule. Notably, if a non-U.S. entity has a U.S. Person majority owner, general partner or equivalent, or investment adviser to a pooled investment fund, the non-U.S. entity is considered a "controlled foreign entity," and the U.S. Person must take "all reasonable steps" to prohibit or prevent covered transactions by the controlled foreign entity that would be a prohibited transaction if undertaken by the U.S. Person and to notify the Treasury Department if the "controlled foreign entity" undertakes a transaction that would be notifiable if undertaken by a U.S. Person.

Separately, U.S. Persons are prohibited from "knowingly directing" transactions by non-U.S. persons that would be prohibited if undertaken by a U.S. Person. (This type of restriction draws parallels to the Treasury Department's rules in the area of economic sanctions.) This requirement extends beyond the foreign subsidiaries of a U.S. Person and would capture situations "such as a U.S. person senior manager at a foreign fund that invests in a covered foreign person or otherwise directs a transaction that would be prohibited if engaged in by a U.S. person." However, the Treasury Department advises that the intent is not to capture "the provision of third-party services such as banking services, as well as routine administrative work by a U.S. Person who lacks substantial involvement in an investment decision."

Covered Activity

The term "covered activity," in the context of a particular transaction, means any of the activities referred to in the definition of "notifiable transaction" or "prohibited transaction" and in each case relevant to the technology or product within each category. Thus, there will be covered activities that relate to semiconductors and microelectronics, quantum IT and AI. Some covered activities in the context of notifiable transactions include design, fabrication or packaging of integrated circuits (IC), along with development of certain AI systems designed to be used for government intelligence, mass surveillance or cybersecurity applications. Some covered activities in the context of prohibited transactions include development or production of electronic design automation software for the design of IC or advanced packaging, certain IC that meet or exceed specified performance parameters, certain supercomputers enabled by advanced IC and quantum computers. The list is detailed and technical and should be reviewed for each specific transaction.

Covered Foreign Persons

The E.O. requires that the Treasury Department prohibit or require notification of certain transactions involving covered foreign persons. The E.O. defines "covered foreign person" as a person of a country of concern who is engaged in a covered activity involving covered national security technologies and products.

The Proposed Rule expands the E.O. definition of a covered foreign person, describing three sets of circumstances that would cause a person to be a covered foreign person: 

• a person of a country of concern (who is also not a citizen or permanent resident of the United States), namely, a citizen or permanent resident of, an entity organized under the laws of or with a principal place of business in a country of concern; the government of a country of concern; persons acting on behalf of, controlled by or directed by the government of a country of concern; and an entity that is directly or indirectly majority-owned by any persons of a country of concern
• a person who is not a person of a country of concern but has a particular relationship with a person of a country of concern who is engaged in covered activity, if such person holds a specified interest in the person of a country of concern (e.g., a voting interest, a board seat, equity interest) and more than 50 percent of the revenue, net income, capital expenditure or operating expenses of such person is attributable to a covered activity undertaken by one or more persons of a country of concern, in the aggregate (each financial metrics to be evaluated independently, not in combination); these circumstances are intended to capture those entities who, while not directly engaged in a covered activity themselves, are significantly financially connected to entities who are engaged in a covered activity
• a person of a country of concern by virtue of its participation in a joint venture with a U.S. Person, if the joint venture is engaged in a covered activity (even if the person of a country of concern itself is not engaged in a covered activity)

Covered Transactions

The Proposed Rule would apply to certain direct and indirect transactions by U.S. Persons, including:

• the acquisition of an equity interest or contingent equity interest in a covered foreign person
• the 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
• the conversion of a contingent equity interest or convertible debt in a covered foreign person
• a greenfield investment or other corporate expansion that either will establish a covered foreign person or will cause an existing person of a country of concern to begin engaging in a new covered activity
• the entrance into a joint venture, wherever located, with a person of a country of concern where the joint venture will undertake a covered activity
• certain limited partner or equivalent investments in a non-U.S. person pooled investment fund that invests in a covered foreign person

Of note here is the indirect involvement by a U.S. Person, for example, through a foreign subsidiary.

Obligations of U.S. Persons Regarding a Covered Transaction

The Proposed Rule places a notification requirement for certain transactions and completely prohibits other transactions. At this time, U.S. investment in semiconductors and microelectronics technology, as well as AI systems, are divided into "notifiable transactions" and "prohibited transactions" based on the nature and capability of the technology, whereas all covered supercomputing and quantum computing transactions would be prohibited under the Proposed Rule.

• Semiconductors and Microelectronics: Covered transactions involving design, fabrication and packaging of integrated circuits are generally notifiable, while activities relating to mass manufacture of integrated circuits and high-end or supercomputing applications are prohibited. An exhaustive list of prohibited activities relating to semiconductors and microelectronics can be found at Sections 850.224(a)-(e) of the Proposed Rule.
• AI Systems: Covered transactions involving AI systems designed exclusively for military end use, government intelligence or mass surveillance end uses or that meet certain technical specifications are prohibited, though the Treasury Department's proposed definition of "notifiable" transactions includes many similar applications that are not designed "exclusively" for such end uses. It is unclear whether the Treasury Department will further clarify these definitions. Covered transactions involving AI systems intended by the covered foreign person to be used for cybersecurity applications, digital forensics tools, penetration testing tools, control of robotic systems or that meet different technical specifications are notifiable.
• Supercomputing and Quantum Computing: 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 are prohibited.

Note that the Proposed Rule lays out multiple alternative variations for the technical specifications for prohibited and notifiable transactions for AI systems, as well as semiconductors and microelectronics.

The definition of prohibited transaction also includes covered transactions with or involving a covered foreign person undertaking any covered activity (whether prohibited or notifiable) if the covered foreign person is included on one of several U.S. government lists such as the Entity List maintained by the U.S. Department of Commerce's Bureau of Industry and Security (BIS), Specially Designated Nationals and Blocked Persons (SDN) or OFAC's Non-SDN Chinese Military-Industrial Complex Companies Lists, or are foreign terrorist organizations as designated by the U.S. Department of State.

The Proposed Rule states that a U.S. Person subject to the notification requirement must file a notification form within 30 days after completing a covered transaction, or where the U.S. Person acquires actual knowledge after the completion date of a transaction that the transaction would have been a covered transaction, within 30 days of the U.S. Person's acquisition of such knowledge.

Knowledge Standard

The Proposed Rule lays out a knowledge standard according to which the obligations under the Proposed Rule would apply if the U.S. Person has knowledge of relevant facts or circumstances related to a transaction. Under the proposed standard, a U.S. Person may be assessed to have knowledge if 1) they possess actual knowledge that a fact or circumstance exists or is substantially certain to occur, 2) they are aware of a high probability of a fact or circumstance's existence or future occurrence or 3) they could have possessed such information through a reasonable inquiry. In general, a U.S. Person is expected to undertake a reasonable and diligent inquiry prior to engaging in a transaction.

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 the Proposed Rule. Conversely, in the absence of a "reasonable and diligent inquiry," the Treasury Department will determine that the U.S. 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).

The Treasury Department will consider the following in assessing whether a U.S. 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
• use of public and commercial databases to identify and/or verify relevant information about a counterparty/investment target

Excepted Transactions and Exemptions

The Proposed Rule includes exceptions for certain types of covered transactions, provided that they do not afford a U.S. Person certain investor rights beyond standard minority shareholder protections. Such exempted transactions include, for example, an investment by a U.S. Person in a publicly traded security or a security issued by an investment company; a U.S. Person's full buyout of all interests of any person of a country of concern such that the entity would not constitute a covered foreign person following the transaction; and an intracompany transaction between a U.S. parent and a majority-controlled subsidiary to support ongoing operations.

The Proposed Rule includes an additional category of excepted transactions involving "third country measures" where the Secretary of the Treasury determines that the third country is addressing the national security concerns posed by outbound investment and the transaction is of a type for which the third country's measures adequately address the associated national security concerns.

The Proposed Rule also provides for a national interest exemption to be determined on a case-by-case basis by the Secretary of Treasury, in consultation with the Secretary of Commerce, the Secretary of State and the heads of relevant agencies, as appropriate. In practice, this exemption is most likely to be used in cases of prohibition, since an application for an exemption provides inherent notification to the Treasury Department. Use of this exemption may ultimately function similarly to requesting license applications under various sanctions programs, though this remains to be seen.

Penalties

According to the Proposed Rule, violations would be subject to civil and criminal penalties as set forth in the International Economic Emergency Powers Act (IEEPA). Under the Proposed Rule, the Treasury Department may impose a civil penalty on any person who violates the rule and the Secretary of the Treasury may refer potential criminal violations to the U.S. Attorney General. Additionally, the Secretary of the Treasury could take action to nullify, void or otherwise require divestment of any prohibited transaction.

The Proposed Rule also describes a process for submitting a voluntary self-disclosure of actual or possible violations. Such self-disclosure would be taken into consideration as a mitigating factor during the Treasury Department's determination of the appropriate response to the potential violation.

Conclusion

The long-awaited Proposed Rule signifies another step toward a U.S. outbound investment regime, at this point proposing to capture U.S. investments to China or benefiting China's ability to enhance its capabilities related to sensitive technologies. The E.O. was issued under the IEEPA authority and has many features similar to an OFAC sanctions program. However, it is notable that the Proposed Rule was issued by the Treasury Department's Office of Investment Security, and the main point of contact is the Director of Office of Investment Security Policy and International Relations, who also oversees the development of CFIUS regulations under the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA).

The Treasury Department has indicated that it will carefully consider input from stakeholders prior to issuing a final rule and requested comments on 25 specific questions. These requests signal that issuance of the final regulations may require significant time or effort, and the final regulations may vary from what is proposed in the Proposed Rule. Therefore, U.S. and foreign businesses are encouraged to make their views known by submitting comments to the Proposed Rule prior to Aug. 4, 2024, if they anticipate that the Proposed Rule may impact their operations.

For more information on the implications of this Proposed Rule or assistance with complying with the Treasury Department's regulations, please contact the authors or another member of Holland & Knight's International Trade Group.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.