US regulatory regime change – outbound investment and China

December 2023  |  FEATURE | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

December 2023 Issue

On 9 August 2023, President Biden declared a US national emergency in relation to the national security threat posed by certain advanced technologies. He issued an executive order (EO) directing that investment by US persons in such technologies be subject to prior notification or outright prohibition.

The EO, ‘Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern’, instructs the secretary of the treasury, in consultation with the Commerce Department and other agencies, to impose notification requirements, and in some cases prohibitions, with respect to certain investments concerning China that involve semiconductors and microelectronics, quantum information technologies or artificial intelligence (AI).

Objectives and impacts

The EO requires the US Department of the Treasury to launch a new regulatory programme to prohibit or require notification of outbound US investments into China in certain sensitive sectors. Against the backdrop of heightened geopolitical tensions between the US and China, the EO refers to the growing threat to US national security posed by advances in certain ‘sensitive technologies’ which can be used to enhance other countries’ “military, intelligence, surveillance, or cyber-enabled capabilities”.

The goal of the regulations is to ensure better oversight and control of investments that may contribute to national security risks. Thus far, the only country which has been identified as a country of concern is China, along with the special administrative regions of Hong Kong and Macau.

The introduction of the EO reflects an unprecedented expansion of US regulation of outbound investment activity. Historically, regulation of outbound US investment has been largely limited to restrictions imposed by ancillary regimes such as economic sanctions and export controls. That said, the US government has long contemplated introducing regulation of outbound investment into China and other countries perceived to present national security risk, so recent developments are not exactly unexpected.

The EO is notable for many reasons, perhaps most importantly for its unprecedented expansion of US regulation of investment activity. The move could have potentially significant implications for the US, China and the wider global economy. Though initially the programme will be narrowly targeted, with the greatest impact likely on US private equity and venture capital investments into China, its impact may eventually spread.

Details and definitions

There are a number of key features contained within the EO. The first relates to targeted regulations on notifiable and prohibited transactions. Under the EO, the secretary of the treasury, in consultation with relevant departments, will issue regulations requiring US persons to notify the Treasury about specific transactions involving covered foreign individuals or entities.

Furthermore, certain transactions involving covered foreign individuals or entities, or involving certain entities located in or subject to the jurisdiction of a country of concern, will also be prohibited.

A “covered foreign person” is a “person of a country of concern” that is engaged in, or a “person of a country of concern” that a US person knows or should know will be engaged in, an identified activity with respect to a “covered national security technology or product”, or a person whose has direct or indirect subsidiaries or branches that fall into this category, and which, individually or in the aggregate, comprise more than 50 percent of that person’s consolidated revenue, net income, capital expenditure or operating expenses.

A “person of a country of concern” includes any individual who is not a US citizen or lawful permanent resident of the US and is a citizen or permanent resident of a “country of concern”, an entity with a principal place of business in, or an entity incorporated in or otherwise organised under the laws of a “country of concern”, the government of a “country of concern”, including any political subdivision, political party, agency or instrumentality thereof, or any person owned, controlled, or directed by, or acting for or on behalf of the government of such “country of concern”, or any entity in which a person or persons who fall into the previous categories holds individually or in the aggregate, directly or indirectly, an ownership interest equal to or greater than 50 percent.

Importantly, the Treasury is seeking comment on whether these definitions should be changed or elaborated upon, and the potential impact (intended or not) of the definitions as they stand.

A “covered transaction” would apply equally to “prohibited transactions” and “notifiable transactions” and would include a US person’s direct or indirect acquisition of an equity interest or contingent equity interest in a covered foreign person, the provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest, greenfield investment that could result in the establishment of a covered foreign person, or the establishment of a joint venture, wherever located, that is formed with a covered foreign person or could result in the establishment of a covered foreign person.

Technologies of concern

The EO identifies three categories of national security technologies and products for the new programme: semiconductors and microelectronics, quantum information technologies and certain AI systems. The importance of these technologies to the development of advanced military, intelligence, surveillance and cyber-enabled capabilities puts them firmly in the regulatory crosshairs. The EO seeks to mitigate risks associated with accelerated development of these technologies by certain countries, namely China.

Semiconductors are set to be the driving force behind innovations like quantum computing and AI which are poised to revolutionise life over the next century. OpenAI’s ChatGPT, for example, was reportedly trained on 10,000 of the most advanced chips currently available.

Semiconductor development and use has become a serious point of contention in US-Chinese relations. In October 2022, the US government announced plans to limit the sale of advanced computer chips to China with the hope of cutting off supplies of critical technology that may be used across sectors including advanced computing and weapons manufacture.

President Xi Jinping has ordered the People’s Liberation Army to become a “world class” military by 2049, the centenary of the Chinese Communist Party’s rule. A large part of that progression will involve developing autonomous weaponry, including hypersonic missiles, and using AI for a range of applications including electronic warfare.

Though China is a world leader in some technological areas, its domestic industry is not yet able to produce the most advanced semiconductors that power many of these technologies. Chinese businesses and the military therefore rely on imports to acquire the advanced chips.

In December 2022, the US government added Chinese memory chipmaker YMTC and dozens of other Chinese firms to its trade blacklist. The EO, in league with other measures, will continue to target China’s access to US-origin semiconductors and related products. Going forward, businesses and individuals in China will be unable to buy advanced chips and chipmaking technology from US suppliers without the seller obtaining a specific licence from the US government.

The US is also encouraging other jurisdictions which are key producers of semiconductors, such as Japan, South Korea, Taiwan and the Netherlands, to stifle Chinese access to their producers.

While these measures introduced by the Biden administration will not permanently stop China from developing semiconductors, they will slow the country down and permit the US and its partners to extend their lead in key technologies.

Next steps

In line with the EO, the Treasury issued an advance notice of proposed rulemaking (ANPRM) and an associated fact sheet which explains how it intends to define and interpret key aspects of the EO. The document also solicits public feedback on over 80 relevant questions.

The EO emphasises the government’s commitment to ongoing assessment and adaptation – a process that begins with the Treasury’s issued ANPRM. The ANPRM is meant to provide transparency and clarity about the intended scope of the programme, and to solicit comments on its development and implementation.

Following the ANPRM, the Treasury will issue draft regulations. The EO provides that within a year of the regulation’s enactment, the secretary of the treasury will review the effectiveness of the measures and consider amendments, potentially expanding or refining the scope of covered national security technologies and products.

Much like the Committee on Foreign Investment in the United States (CFIUS), the secretary of the treasury will play a central role in implementing the EO. This will include communicating with Congress and the public, consulting with other CFIUS-member departments such as the departments for commerce, state, defence and energy, as well as engaging with allies and partners, and investigating potential violations. Collaboration between these agencies will be aimed at ensuring a comprehensive approach to addressing national security risks.

While the EO and CFIUS share the goal of safeguarding US national security interests, they differ in terms of scope, emphasis and process. The EO is indicative of the US government’s proactive stance and focus on managing investments in critical national security technologies. Once the Treasury releases the draft regulations, it will be interesting to see how the Outbound Investment Program will develop. Will it remain somewhat narrow in scope or will it expand its jurisdiction to become more like CFIUS?

Other possibilities have also been considered, including establishing a National Critical Capabilities Committee (NCCC) to operate alongside CFIUS and review, prohibit or impose mitigation measures relating to outbound investments in certain key sectors, such as semiconductors, AI, quantum computing, large capacity batteries, critical minerals and materials, active pharmaceutical ingredients, and automobile manufacturing. Other legislative proposals include requiring parties that engage in certain outbound investment activities to provide advance notice to the US government.

Penalties

Enforcement of the new regime will be a key area of interest. Though the EO envisions both civil and criminal penalties for violations of the proposed regulations, the ANPRM focuses on civil penalties, as is standard, with potential criminal activities being referred to the US Department of Justice.

The ANPRM proposes imposing penalties up to the maximum allowed under the International Emergency Economic Powers Act (IEEPA) – currently $356,579 per violation – for material misstatements made in or material omissions from information or documentary material submitted or filed with the Treasury, undertaking a prohibited transaction, or failing to timely notify a transaction for which notification is required.

Importantly, the EO also gives the secretary of the treasury the power to “nullify, void, or otherwise compel the divestment of any prohibited transaction entered into after the effective date of the regulations”. The Treasury has established that it will not look retroactively at transactions that were not prohibited at the time of their completion, but reserves the right to request information from parties to cover investments that were completed after the effective date of the EO.

Trade tension

The US is not the only jurisdiction to consider measures related to outbound transactions and investments. In June 2023, the European Commission (EC) and the High Representative published a Joint Communication on a European Economic Security Strategy, which called upon the EC to “examine, together with Member States, what security risks can result from outbound investments and on this basis propose an initiative” by the end of 2023. The UK is also believed to be contemplating similar steps.

Going forward, the economic and geopolitical relationship between the US and China is likely to remain characterised by tension. But given the reliance that the West has on doing business with China, it will be challenging for countries to implement export control measures in a strategic way. Globalisation of the economy means most companies investing in the US and other Western nations also have strong business interests in China. Ties to the Chinese market will muddy the waters, but the direction of travel for the US regulatory regime is becoming clearer.

© Financier Worldwide

BY

Richard Summerfield