U.S. Treasury Department issues Notice of Proposed Rulemaking on outbound investment

On 21 June 2024, Treasury issued an NPRM on the outbound investment security program that sets forth proposed regulations that would implement President Biden’s August 2023 Executive Order 14105, “Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern” (Outbound EO), and follows the Advance Notice of Proposed Rulemaking (ANPRM) it issued in August 2023.

The NPRM includes proposed regulations that, when in final form, will put in place a regime for the outbound investment security program that will be informed by comments received from stakeholders, allies, partners, and the general public in response to the ANPRM and the NPRM. The proposed regulations are accompanied by detailed explanations of key concepts introduced in the ANPRM and are aimed at addressing the national security threat to the United States posed by the actions of “countries of concern” that seek to, among other things, exploit U.S. outbound investments to develop sensitive technologies and products critical for military, intelligence, surveillance, and cyber-enabled capabilities.

In a nutshell: what do the proposed regulations do?

At a high level, the proposed regulations prohibit certain transactions and require notifications of other transactions (defined collectively in the NPRM as “covered transactions”). The proposed regulations affect such transactions by U.S. persons that involve certain “persons of a country of concern” that are engaged in “covered activities” related to specific categories of national security technologies and products. “Countries of concern” are China, Hong Kong, and Macau, although the proposed regulations have several mechanisms through which the program can capture transactions involving persons in other countries.

What are the key changes between the ANPRM and the NPRM?

The NPRM leaves unchanged many of the key structural and substantive elements of the concepts presented in the ANPRM. However, the NPRM expands and elaborates on certain elements identified in the ANPRM, including ones that were ambiguous or lacked clarity. Key changes and clarifications include:

• The NPRM revises and expands the scope of covered transactions by amending the technical descriptions/parameters of prohibited and notifiable transactions and including brownfields and certain limited partner (LP) investments.

• The NPRM adds a knowledge standard to specify the level of knowledge a U.S. person must have about certain facts and circumstances related to a covered transaction in order to trigger obligations or incur a violation and introduces an “intent” standard for certain types of transactions. The standard effectively spells out the diligence that Treasury expects parties to conduct to determine whether their transactions are covered transactions.

• The NPRM refines the scope of the prohibition imposed on U.S. persons “knowingly directing” certain covered transactions.

• The NPRM adds an exception to the outbound investment security program for covered transactions involving persons of third countries that are adequately addressing the national security concerns of outbound investments, as designated by the Secretary of the Treasury.

• The NPRM proposes two alternative approaches for certain U.S. LP investments in funds that would be excepted from the outbound investment security program.

Who has obligations under the proposed regulations?

The NPRM places certain obligations on “U.S. persons,” which include (i) any U.S. citizen or lawful permanent resident; (ii) any entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branch of any such entity; and (iii) any person in the United States.

Specifically, under the proposed regulations, U.S. persons are prohibited from entering into, or alternatively are required to notify Treasury post-closing of, certain covered transactions involving persons that are linked to China, Hong Kong, and Macau and that are engaged in activities involving the three specified technology sectors identified above.

The NPRM also imposes certain obligations on U.S. persons with respect to investments by related non-U.S. entities and persons, as follows:

• U.S.-person-controlled foreign entities: U.S. persons are required (i) to take “all reasonable steps” to prohibit and prevent their “controlled foreign entity” from undertaking a covered transaction that would be a prohibited transaction if undertaken by a U.S. person, and (ii) to notify Treasury if the controlled foreign entity undertakes a covered transaction that would be a notifiable transaction if undertaken by a U.S. person.

  • The proposed regulations contemplate three separate avenues by which a foreign entity would become a controlled foreign entity via a U.S. person’s (i) holding more than 50% of (a) the voting interest in the entity or (b) the voting power of the board of the entity;  (ii) status as a general partner, managing member, or equivalent; or (iii) status as an investment adviser to any entity that is a pooled investment fund.

• U.S. person “knowingly directing” a covered transaction by a non-U.S. person entity: U.S. persons that have the authority to make or substantially participate in decisions on behalf of a non-U.S. person entity (e.g., a U.S. person employee of a foreign company) may not exercise that authority to direct, order, decide upon, or approve a transaction that would be a prohibited  transaction. A U.S. person would have such authority if the U.S. person was an officer, director, or senior advisor, or otherwise possesses senior-level authority. However, U.S. persons who recuse themselves from decisions related to such covered transactions are not deemed to have exercised such authority.

Who do the proposed regulations target?

The proposed regulations target certain covered transactions with “covered foreign persons,” which are “persons of a country of concern” engaged in a “covered activity” related to three key sectors: semiconductors and microelectronics, quantum information technologies, or certain AI systems.

“Persons of a country of concern” means:

• individuals that are citizens or permanent residents of China, Hong Kong, or Macau (excluding U.S. citizens and U.S. permanent residents);

• entities that have their principal place of business in or are headquartered in, incorporated in, or organized under the laws of a country of concern;

• governments of a country of concern and persons acting on behalf of such  governments and persons controlled by or directed by such governments; and

• entities, wherever located, in which persons of a country of concern, directly or indirectly, hold at least 50% of the outstanding voting interest, voting power of the board, or equity interest.

In defining “covered foreign persons,” the NPRM has retained the broad scope introduced in the ANPRM, in that the term includes certain non-Chinese entities located in third countries (including the United States) that:

• directly or indirectly hold a voting interest, board seat, or equity interest in a person of a country of concern that is engaged in a covered activity, or hold any power to direct any person of a country of concern engaged in a covered activity through a contractual arrangement; and
• derive more than 50% of their revenue, net income, capital expenditure, or operating expenses from a person of a country of concern engaged in a covered activity.

What types of transactions are covered by the proposed regulations?

The proposed regulations would only apply to certain categories of direct or indirect transactions – so-called “covered transactions.” These are:

• acquisitions of equity interests or contingent equity interests (e.g., via mergers and acquisitions, private equity, venture capital, and other arrangements);

• certain debt financing transactions that are convertible to equity interests or that afford the U.S. person certain management or board appointment rights;

• conversions of a contingent equity interest (or interest equivalent to a contingent equity interest) or conversion of debt to an equity interest;

• certain acquisitions, leasing, or other development of operations, land, property, or other assets (i.e., greenfield or brownfield investments);

• entrance into a joint venture, wherever located, that is formed with a person of a country of concern that will engage in a covered activity; and

• certain acquisitions of an LP or equivalent interest in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund (where the fund is not a U.S. person).

Treasury noted in the NPRM that indirect transactions can also be considered “covered transactions” regardless of the number of intermediary entities involved. For example, if a U.S. person purchases shares in a special purpose vehicle, wherever located, and knows that such vehicle would be acquiring an equity interest in a “covered foreign person,” then that transaction would be a “covered transaction” regardless of the U.S. person’s indirect ownership.

What types of transactions are prohibited by the proposed regulations?

A U.S. person is prohibited from engaging in covered transactions with a “covered foreign person” that is engaged in the following “covered activities”:

• developing or producing any electronic design automation software for integrated circuit (“IC”) or advanced packaging design or certain fabrication equipment;

• designing, producing, or packaging certain advanced ICs;

• developing, installing, selling, or producing certain supercomputers;

• developing quantum computers and producing quantum computer critical components;

• developing or producing certain quantum information technologies, including quantum networks or quantum communication systems designed or intended for certain end uses;

• developing certain AI systems designed to be exclusively used for, or which the relevant covered foreign person intends to be used for, any military end use or government intelligence or mass surveillance end use; or

• developing certain AI systems trained using certain quantities of computing power.

In addition, covered transactions that would be “notifiable” (as described below) but that involve parties on U.S. Government restricted parties lists (e.g., the Specially Designated Nationals and Blocked Persons List, the Entity List, the Non-SDN Chinese Military-Industrial Complex Companies list) are instead deemed prohibited.

What types of transactions must be notified under the proposed regulations?

A U.S. person would be required to notify and submit relevant information to Treasury within 30 calendar days following the completion of a covered notifiable transaction with a “covered foreign person” that is engaged in activities involving the following technologies:

• designing, fabricating, or packaging ICs not captured by the “prohibited” IC definitions referenced above; and

• AI systems that are not covered by the definition of a prohibited transaction above and that are designed to be used for certain end uses (e.g., government intelligence or mass-surveillance, military, cybersecurity applications) or that meet certain technical parameters (Treasury is considering three potential alternatives for the level of computational operations defined in the technical parameters).

Treasury affirmed in the NPRM that under the proposed regulations, notification is also required if the U.S. person acquires knowledge following the completion date of a transaction that the transaction would have been a covered transaction if the U.S. person had known of relevant facts or circumstances as of the completion date. In such circumstances, the U.S. person would be required to submit a notification to Treasury no later than 30 calendar days following the acquisition of knowledge that such a transaction would have been a covered transaction.

Will the program only affect U.S. persons’ investments in Chinese companies engaged in certain covered activities?

No. Although the proposed regulations primarily target individuals and entities in China, Hong Kong, and Macau that are engaged in covered activities, they also apply to non-Chinese persons that have a certain relationship with a person of a country of concern engaged in a covered activity, whether or not they themselves are engaged in a covered activity. Thus, covered foreign persons could be persons or entities from anywhere in the world, including from the United States.

Specifically, as explained above, a non-Chinese entity would nonetheless be a “covered foreign person” if it:

• directly or indirectly holds a voting interest, board seat, or equity interest in a person of a country of concern that is engaged in a covered activity, or holds any power to direct any person of a country of concern engaged in a covered activity through a contractual arrangement; and

• derives more than 50% of its revenue, net income, capital expenditure, or operating expenses from the person of a country of concern engaged in a covered activity.

What types of transactions will be excepted from coverage under the proposed regulations?

The NPRM sets forth the following categories of “excepted transactions”:

• Publicly traded securities: An investment by a U.S. person in a publicly traded security or a security issued by an investment company, such as an index fund, mutual fund, or exchange traded fund;

• Certain LP investments: Treasury is considering two alternative approaches for an investment of a U.S. person LP in a pooled investment fund where its committed capital: (i) is a passive investment and is not more than 50% of the total assets under management of the fund or, pursuant to a binding contractual assurance with the fund, will not be used for a prohibited transaction; or (ii) is $1 million or less, provided that the LP’s rights do not go beyond standard minority shareholder protections;

• Buyouts of country of concern ownership: A U.S. person’s full buyout of all interests of any person of a country of concern in an entity, such that the entity would not constitute a covered foreign person following the transaction;

• Intracompany transactions: An intracompany transaction between a U.S. person parent and a subsidiary (that constitutes a controlled foreign entity) to support ongoing operations (or other activities that are not covered activities);

• Pre-Outbound EO binding commitments: Fulfilment of a U.S. person’s binding capital commitment entered into prior to the date of the Outbound EO;

• Certain syndicated debt financings: The acquisition of a voting interest in a covered foreign person upon default or other condition involving a loan, where the loan was made by a lending syndicate and a U.S. person participates passively in the syndicate; and 

• Third-country measures: Certain transactions with or that involve a person of a non-U.S. country or territory that, as designated by the Secretary of the Treasury, is adequately addressing national security concerns posed by outbound investment.

In the NPRM, Treasury did not explicitly exclude activities such as university-to-university research collaborations or intellectual property licensing arrangements. However, Treasury noted that the proposed definition of “covered transaction” has been crafted to refer to a narrow set of specific transaction types that meet the definitional elements laid out, and the proposed regulations therefore do not need to explicitly specify a list of activities excluded from this definition.

Are there any other ways to seek exemption from coverage?

The proposed regulations allow a U.S. person to seek an exemption from the application of the prohibition or notification requirements by submitting certain information (such as the scope of the transaction, the basis for the request, and an analysis of the transaction’s potential impact) to show that an otherwise covered transaction is in the national interest of the United States. Treasury anticipates, however, that such exemptions would only be granted in exceptional circumstances.

Will the proposed regulations apply retroactively?

Consistent with the ANPRM, the prohibition and notification requirements in the proposed regulations are not intended to apply retroactively. However, Treasury notes that it may nonetheless request information about certain transactions that were completed or agreed to by U.S. persons after the issuance of the Outbound EO in order to better inform the development and implementation of the outbound investment program moving forward.

When are the proposed regulations expected to go into effect?

The proposed regulations will go into effect at a date specified by the final regulations, which will take into account comments provided during the NPRM comment period. This comment period is designed to allow stakeholders to weigh in on the details of the program prior to the promulgation of the final regulations. Public comments on the NPRM must be received by Treasury by 4 August 2024. Given the comment period and subsequent refinement of the proposed regulations, the outbound investment program may not take effect until late 2024 or early 2025.

Next steps

Companies should consider the potential impact of the outbound investment program on their businesses and investments, particularly those that relate to China, Hong Kong, and Macau or involve activities related to the sectors detailed above. Companies will want to consider whether the outbound investment security program requires them to implement changes to their internal compliance program, particularly with respect to conducting diligence on the activities of potential business partners. Companies should also take into account the possibility that U.S. allies and partners may adopt similar outbound investment restrictions. In particular, Treasury has indicated that the European Commission and the United Kingdom have begun processes to consider whether and how to address outbound investment risks.

In order to help shape the proposed regulations, it will be critical for the public to submit comments by the 4 August 2024 deadline. Please contact any of the listed Hogan Lovells lawyers if you would like assistance in providing comments to Treasury or otherwise have questions on how the proposed regulations could affect your business or how to prepare for the coming implementation of the U.S. outbound investment security program.

Authored by Anne Salladin, Brian Curran, Zachary Alvarez, Annika Lichtenbaum, Tyra Walker, and Meghan Anand.