New Regulations Will Require Additional Diligence for a Broad Array of Transactions, Including Many Investments in U.S. and Global Businesses

On June 21, 2024, the U.S. Treasury Department (Treasury) issued a Notice of Proposed Rulemaking (NPRM) to implement the “Outbound Investment” Security Program. This program was mandated by President Biden’s Executive Order on August 9, 2023. The NPRM eventually—but likely not for at least several months—will be followed by final rules that bind U.S. persons with potentially significant civil penalties and even criminal penalties of up to 20 years imprisonment.

These new rules will have significant implications for conducting diligence across a broad array of technology transactions. In particular, these rules will restrict certain U.S. persons from engaging in equity, debt, and other transactions that provide resources to businesses active in the semiconductor/microelectronics, quantum information technology, and artificial intelligence (AI) areas, i.e., businesses that are engaged in “covered activity” in the lingo of the NPRM. The restrictions only apply if the businesses engaged in covered activity also have certain significant ties to the People’s Republic of China (including Hong Kong and Macau) (the PRC). However, the restrictions may apply even if the business that is engaged in the covered activity is a business in the United States or anywhere else in the world—if, for example, a California AI company is majority-owned by PRC citizens, a U.S. person’s investment may be prohibited or require notification to Treasury. As a result, even parties to U.S.-to-U.S. transactions will need to perform diligence, at a minimum, to rule out the applicability of the regime.

Interested parties have until August 4, 2024, to submit comments on the NPRM; Treasury will consider these comments before issuing the final rules.

To determine when and to whom this rule may apply, parties should consider the following conjunctive test:

1. Does the transaction involve a “U.S. person”?
2. Is the U.S. person engaging in a type of transaction covered by the rule?
3. Is the target of the transaction engaged in a “covered activity”?
4. Does the target have the requisite ties to a “country of concern,” i.e., the PRC?

All four of these tests must be met before a transaction is covered. If diligence can rule out any one of the four tests, the restrictions and/or prohibitions contemplated by the NPRM should not apply. Below we briefly discuss each of these points.

I. Which U.S. Persons Might Be Restricted?

The NPRM includes detailed rules concerning restrictions on certain transactions by “U.S. persons.” This includes U.S. citizens and permanent residents, U.S. legal entities, and any person otherwise present in the United States (regardless of residency or visa status). In addition, a U.S. person is responsible for ensuring that any “controlled foreign entity,” e.g., a foreign subsidiary of a U.S. person, complies with these rules.

II. What Types of Transactions Are Covered by the Rule?

The types of transactions that potentially create obligations to notify Treasury, or that might be prohibited, go far beyond traditional equity investments. They include transactions in which a U.S. person:

1. acquires equity or “contingent equity” (such as convertible notes);
2. makes a loan or provides other debt financing that is either convertible or affords the right to be involved in the target's management in certain capacities;
3. converts contingent equity;
4. acquires, leases, or develops property or assets in the PRC;
5. forms a joint venture; or
6. obtains a limited partner or equivalent stake in an investment vehicle known to invest in the Chinese semiconductor/microelectronics, quantum, or AI areas.

If a U.S. person engages in any of these six transaction types (directly or indirectly), then it might be a “covered transaction,” which means the transaction might be prohibited or trigger a notification to Treasury. Of course, these restrictions apply only if the transaction also involves a business that is engaged in a “covered activity” and has certain significant ties to the PRC, as discussed below. In addition, certain exceptions will apply—e.g., for investments in publicly traded securities, LP investments in funds below certain rights thresholds, and so on—though the scope of those exceptions has been left open for comments in the NPRM.

Outside of the direct restrictions on U.S. person transactions, U.S. companies are also bound to take steps to prohibit their foreign subsidiaries from engaging in any prohibited or notifiable transactions, or face penalties themselves. And even when working with a foreign partner or employer, a U.S. person cannot “knowingly direct” a foreign person to engage in a transaction that would be prohibited if it were undertaken by a U.S. person. This may occur if, for example, a foreign business employs or otherwise engages a U.S. person while undertaking a transaction that would be prohibited, with that U.S. person officer, director, or senior adviser directing, deciding, or approving the transaction. That U.S. person must recuse herself as needed to ensure compliance with any prohibition.

III. What “Covered Activity” Can Trigger Restrictions?

The restrictions apply to direct or indirect transactions that involve businesses operating in the semiconductor/microelectronics, quantum information technologies, and AI areas—i.e., a business involved in any of the three areas of “covered activity”—if the business has certain significant ties to the PRC.

Covered activity in each of the three areas is defined with detailed technical specifications. Depending on the specifics of the covered activity, a transaction of the types detailed above may be strictly prohibited or may merely require the provision of a notice to Treasury.

Semiconductors/microelectronics. With respect to semiconductors/microelectronics, the triggering activity involves designing, fabricating, or packaging integrated circuits, with the design/fabrication/packaging of certain cutting-edge integrated circuits giving rise to a prohibition and other integrated circuits giving rise to a notification obligation.

Quantum. With respect to quantum information technologies, the development, installation, sale, and/or production of certain supercomputers, components, sensing platforms, and/or communication systems can give rise to a prohibition (there is no notification process regarding quantum information technologies—the restriction is a flat prohibition).

AI. With respect to AI, a notification may be triggered if an AI system is a) designed for government intelligence, mass surveillance, or military end uses; or b) intended for use with cybersecurity applications, digital forensics tools, penetration testing tools, or the control of robotic systems; or c) trained using a specified quantity of computing power (Treasury is still mulling the appropriate level of computing power to specify). A prohibition may also be triggered if the AI system is designed “exclusively” for, or the foreign person intends to use the AI system for, military end use or government intelligence/mass surveillance, or if the AI system is trained using a specified quantity of computing power.

IV. What Ties to the PRC Can Trigger the Restrictions?

Even if a U.S. person undertakes one of the six types of activity, such as an investment or loan, with respect to a business that is engaged in a “covered activity” (i.e., regarding semiconductors/microelectronics, quantum, or AI), there are no notification obligations or prohibitions unless the business that is engaged in a covered activity has certain significant ties to the PRC.

The NPRM specifies the significant ties to the PRC start with the question of whether a person is a “person of a country of concern” (i.e., a PRC person), which term is defined to include:

• a person who is a PRC citizen or permanent resident and who is not a U.S. citizen or permanent resident;
• a legal entity that has its principal place of business in the PRC or is headquartered, incorporated, or otherwise organized in the PRC;
• the PRC government and any agent thereof; and
• any entity in which the PRC government holds (directly or indirectly) a 50 percent or greater voting interest or voting power of the board or equity interest, or otherwise has the power to direct management and policies of the entity.

In addition, any entity in which one or more of the above PRC persons individually or collectively hold 50 percent or greater voting interest or voting power of the board or equity interest, is itself a “person of a country of concern.” For example, if three PRC citizens collectively own 60 percent of a California company, that company is a “person of a country of concern.” And if that California company, in turn, owns 50 percent of a London-headquartered UK company, that London company also is a “person of a country of concern.” Moreover, because the threshold necessary to hold the power to direct management and policies of the entity is unclear, a minority stake in an otherwise non-PRC affiliated U.S. business held by a PRC government entity—or even by an entity affiliated in some way with the Chinese Communist Party—may still make the minority-held U.S. business a “person of a country of concern.”

More broadly, ties to the PRC may be sufficient to trigger restrictions if the target of the transaction is a “covered foreign person.” This term includes not only any “person of a country of concern” but also any non-PRC entity that has specified influence over a person of a country of concern if the PRC-affiliated entity's operations are sufficiently important to the non-PRC entity. For example, if a European company (or a company anywhere in the world) is engaged in a covered activity and has a board seat, voting interest, or equity interest in a PRC company, and if that European company is subject to a specified level of influence from that PRC company (e.g., 50 percent of the European company’s operating expenses are attributable to the PRC company), then the European company, though not a “person of a country of concern,” is a “covered foreign person”—i.e., the ties to China are sufficient such that an investment in the European company would be deemed an investment in a PRC company.

Conclusion

The effect of this rule goes far beyond potential U.S. investments into China. Under the Outbound Investment Security Program detailed in the NPRM, before a U.S. person engages in any of the six types of transactions described in Section II above, that U.S. person will need to obtain comfort that the transaction counterparty is either not engaged in “covered activity” or else is not a “person of a country of concern” or otherwise a “covered foreign person.” Failing to do so could result in significant penalties.

It seems likely that representations by the counterparty often may provide sufficient comfort, though the NPRM includes a discussion of when a U.S. person might be deemed to have knowledge that the counterparty is engaged in covered activity and/or is a covered foreign person. Basic due diligence on the counterparty is strongly advisable.

In any event, if a U.S. person cannot obtain comfort that the counterparty is either i) not engaged in a covered activity or ii) not a covered foreign person, then the U.S. person may face a notification obligation or a prohibition on the transaction.

For more information about the new outbound investment rules, their implications for transactions of all kinds, or the NPRM comment process, please contact Stephen Heifetz, Joshua Gruenspecht, another member of Wilson Sonsini’s national security practice, or Weiheng Chen, head of the firm’s Greater China practice.