On June 21, 2024, the U.S. Department of the Treasury (Treasury) issued a Notice of Proposed Rulemaking (NPRM) (formally published in the Federal Register on July 5, 2024) in which it proposed regulations prohibiting or requiring notification of U.S. outbound investments in certain Chinese-affiliated companies in the semiconductor and microelectronics, quantum information technology, and artificial intelligence (AI) sectors.
The NPRM comes 10 months after Treasury outlined elements of the regulations in an Advance Notice of Proposed Rulemaking (ANPRM). The Sidley Update in connection with the ANPRM is here. The NPRM retains the core features described in the ANPRM but modifies certain aspects of the program in meaningful ways.
Treasury’s fact sheet and press release on the NPRM are available here and here. Treasury is soliciting public comments on the NPRM here until August 4, 2024.
What is the purpose of the proposed regulations?
The proposed regulations would limit the ability of “U.S. persons” to invest in, or cause or facilitate investments in, “persons of a country of concern” who are involved in or (in certain circumstances) may become involved in the development or production of certain high-end technologies within the semiconductor and microelectronics, quantum information technology, and AI sectors.
Specifically, the proposed regulations would prohibit or require notification by “U.S. persons” of
(a) certain “covered transactions” described in Attachment 1 to this Update that are
(b) made by “U.S. persons”
(c) into or with a “covered foreign person” or that create a “covered foreign person.”
As discussed further below, a “covered foreign person” is (1) a “person of a country of concern” engaged in one or more of the “covered activities” listed in Attachment 2 to this Update; (2) other persons with interests in, board seats in, or contract-based authority over a “covered foreign person,” when such “covered foreign person” accounts for the majority of the former’s revenue, income, capital expenditures, or operating expenditures; or (3) a “person of a country of concern” that participates in a joint venture (JV), when the formation of the JV is a “covered transaction.”
The proposed regulations would also prohibit U.S. persons from taking certain actions to facilitate transactions that would have been prohibited if undertaken by a U.S. person.
No transactions will be subject to these proposed restrictions until the final regulations are issued and enter into force. However, after the regulations enter into force, Treasury may request information about transactions that were completed or agreed to after August 9, 2023.
Who is a “person of a country of concern”?
A “person of a country of concern” includes
a) a citizen or permanent resident of a country of concern (wherever located, but not including U.S. citizens or U.S. permanent residents);
b) an entity organized or incorporated in, or whose principal place of business or headquarters is in, a country of concern;
c) a government of a country of concern and its instrumentalities, agents, and controlled entities, including entities (whether located inside or outside China) in which the government holds a ≥ 50% interest or otherwise controls the management; or
d) entities (whether located inside or outside China) in which the preceding entities hold certain thresholds of direct or indirect voting interest, board voting interest, or equity interest.
Who is a “covered foreign person”?
A “covered foreign person” includes only
a) a “person of a country of concern” engaged in a covered activity
b) a person that (i) directly or indirectly holds a voting or equity interest (of any size) or a board seat in a person described in (a); or holds the power to direct management of a person described in (a) through a contractual arrangement, and (ii) derives more than 50% of its revenue or net income or incurs more than 50% of capex or opex through persons described in (a)
c) a “person of a country of concern” that is a “covered foreign person” by virtue of its participation in a covered JV with a U.S. person
What are the types of prohibited transactions and related requirements?
Prohibited Transactions: The proposed regulations would prohibit
(1) certain transactions by a U.S. person with or into a “covered foreign person” (including the entrance into a JV with a “person of a country of concern,” when the U.S. person knows that the JV will engage in covered activities (or intends for the JV to do so))
(2) certain transactions by a U.S. person that the U.S. person knows will result in, or intends to result in, the establishment of a “covered foreign person” or the engagement by a “person of a country of concern” in a new covered activity
(3) certain investments by a U.S. person as a limited partner (LP) or equivalent into a non-U.S. person pooled investment fund that in turn invests in a “covered foreign person”
U.S. persons will be prohibited from engaging in the types of transactions described above when they involve “covered foreign persons” (or covered JVs) that engage in particularly high-end activities in the semiconductor and microelectronics, quantum information technology, and AI sectors.
Prohibition Against Knowingly Directing Certain Transactions: The proposed regulations would prohibit a U.S. person from “knowingly directing” a transaction that the U.S. person knows at the time of the transaction would be a prohibited transaction if engaged in by a U.S. person. (A U.S. person “knowingly directs” a transaction by a non-U.S. person if it possesses and exercises the authority to direct or approve the transaction, whether individually or as part of a group). However, when a person with authority to direct or approve a transaction recuses themselves from a particular transaction, they would not be considered to have “knowingly directed” the transaction.
Requirement to Take “All Reasonable Steps” With Respect to a “Controlled Foreign Entity”: The proposed regulations would require a U.S. person to take “all reasonable steps” to prohibit and prevent any transaction by a “controlled foreign entity” (i.e., the U.S. person’s foreign subsidiary) that would be a prohibited transaction if engaged in by a U.S. person. “Reasonable steps” include, for example, agreements requiring compliance, exercising shareholder rights, internal training and reporting, internal policies and controls, and testing and auditing.
Prohibited Transactions With Sanctioned Entities: The proposed regulations would prohibit any “covered transaction” with a “covered foreign person” who appears on specified U.S. sanctions and export control lists, even if activities by the “covered foreign person” would otherwise trigger a notification requirement only.
What are the types of notifiable transactions and related requirements?
The proposed regulations would require notification of certain transactions by a U.S. person (or its “controlled foreign entity”) that
(1) are made with or into a “covered foreign person” (including the entrance into a JV with a “person of a country of concern,” when the investor knows that the JV will engage in covered activities (or intends for the JV to do so))
(2) the investor knows will result in, or intends to result in, the establishment of a “covered foreign person” or the engagement by a “person of a country of concern” in a new covered activity
(3) are made as an LP or equivalent into a non U.S.-person pooled investment fund that in turn invests in a “covered foreign person”
U.S. persons will need to notify Treasury of each notifiable transaction within 30 days of the transaction “completion date” (i.e., closing). In addition, if a U.S. person acquires actual knowledge after closing of facts or circumstances that, if known at the time of closing, would have made the transaction either a prohibited or notifiable “covered transaction,” the U.S. person must notify that transaction within 30 days of acquiring such knowledge.
How do the proposed regulations clarify or change the coverage of limited partner investments as compared with the ANPRM?
In a significant change from the ANPRM, the proposed regulations would cover certain LP investments in non-U.S. funds. LP investments in U.S. funds would not be covered as a stand-alone category of “covered transactions,” under the assumption that U.S. funds are U.S. persons and would therefore be directly responsible for complying with the regulations.
The proposed regulations also qualify the scope of covered LP investments in non-U.S. funds with a new knowledge requirement. Specifically, with respect to LP investments in non-U.S. funds, the proposed regulations would cover situations where both of the following conditions are met:
(1) The U.S. person knows, at the time of its investment in the fund, that the fund will likely invest in any “person of a country of concern” in the semiconductors and microelectronics, quantum information technologies, or AI sectors (even if not in the specified covered activities).
(2) The fund then makes an investment that would be a “covered transaction” if made by a U.S. person directly.
The proposed regulations also offer two very different approaches for exempting certain LP investments in pooled funds from the requirements:
- Alternative 1: The first alternative would exempt investments by LPs (or the equivalent) where (1) the LP is passive1 and (2) the LP’s committed capital is no more than 50% of total assets under the fund’s management. Passive LP investments in funds that are neither a U.S. person nor a “controlled foreign entity” of the LP could account for more than 50% of the fund’s assets and still be exempted, as long as the LP receives a binding assurance that its capital will not be used to engage in a transaction that would cause the LP to have made an indirect prohibited transaction.
- Alternative 2: The second alternative would exempt investments by LPs (or the equivalent) where the LP’s committed capital is no more than $1 million.
Under either alternative, the LP could also not have any governance rights with respect to “covered foreign person” portfolio companies beyond standard minority shareholder protections.
How do the proposed regulations clarify or change the coverage of joint ventures as compared to the ANPRM?
The proposed regulations define “covered transactions” to include the entrance by a U.S. person into a JV, wherever located, with a “person of a country of concern,” where the U.S. person knows that the JV will engage in covered activities or intends for the JV to do so.
The scope of coverage of JVs is broader than it was in the ANPRM in at least one important respect. Specifically, the ANPRM proposed to cover 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” (emphasis added). It did not appear that language would have covered the entrance by U.S. persons (or their “controlled foreign entities”) into third-country JVs that engage in covered activities, when the Chinese JV partner is a minority partner and does not engage in covered activities itself. The NPRM reworded the JV-related provisions to now cover such arrangements.
The NPRM may include other important clarifications to the scope of coverage of JVs. For example, the NPRM may no longer cover certain JV engagements by U.S. persons, where the Chinese JV partner is a “covered foreign person” but the JV itself will not engage in any covered activities.
What types of transactions would be exempted from the requirements of the proposed regulations?
The proposed regulations would exempt (1) certain investments in publicly traded securities (2) certain investments in the securities of investment companies (e.g., index funds, mutual funds, and exchange-traded funds) and business development companies (3) certain minor or passive LP investments in pooled funds (as discussed in the preceding section) (4) certain intracompany transactions (5) fulfillments of binding uncalled capital commitments made before August 9, 2023 (6) U.S. persons’ buyouts of Chinese interests, such that a target company no longer qualifies as a “covered foreign person” (7) certain syndicated debt financings, where a U.S. person participates passively in the syndicate but acquires a voting interest in a “covered foreign person” upon default or other condition of the financing and (8) certain transactions involving a third country, where Treasury determines that that country is already adequately addressing national security concerns posed by outbound investment.
Exceptions (1), (2), and (3) are available only if the investor does not receive any governance rights with respect to the relevant “covered foreign person” beyond standard minority shareholder protections.
Other Issues
- No case-by-case reviews. Transaction parties will need to determine themselves whether their transaction is prohibited or requires notification. Further, Treasury is not contemplating a case-by-case review and approval process for investments under this program. Rather, prohibited transactions are outright prohibited, and notifiable transactions are fully permissible but always subject to the notification requirement. However, Treasury will allow U.S. persons to seek exemptions from the regulations for otherwise-prohibited or notifiable transactions that are in the U.S. national interest.
- No strict liability. U.S. persons’ obligations under the program will apply when they have actual or constructive “knowledge” of relevant facts or circumstances related to a transaction. The NPRM retains a “knowledge” threshold and offers some clarity as to how Treasury will assess a U.S. person’s constructive knowledge about (i.e., “reason to know of”) a particular transaction (based on, e.g., efforts to conduct diligence, obtain contractual representations and warranties, and evidence of warning signs or noncooperation by the target entity). A person will be deemed to have the requisite “knowledge” if the person has
- actual knowledge that a fact or circumstance exists or is substantially certain to occur,
- an awareness of a high probability of a fact or circumstance’s existence or future occurrence, or
- reason to know of a fact or circumstance’s existence.
- Potential penalties for noncompliance. Treasury will have authority to impose a wide range of penalties for violations of these regulations, including mandated divestment, prohibition, or nullification of a transaction, civil penalties, or even criminal prosecution. However, the proposed regulations would also establish a process by which parties could submit voluntary self-disclosures (VSDs) to Treasury for potential violations of the regulations. Treasury would consider the submission of a timely VSD as a mitigating factor when contemplating penalties for a violation.
Conclusion
Treasury will issue final regulations only after considering public comments on the NPRM. As noted, no transactions will be prohibited or subject to notification requirements until final regulations are issued and enter into force. While the timing of final regulations remains uncertain, it is possible that they will come before the November elections.
Given the complexity of this proposed program, we expect at least some changes between the NPRM and the final regulations. It is also possible that Congress will pass legislation placing further conditions on Treasury’s outbound investment program (whether before the final regulations are issued or after the fact).
Sidley attorneys are closely monitoring Treasury’s development of this outbound investment program and are available to answer your questions about navigating the forthcoming regulations.
ATTACHMENT 1
COVERED TRANSACTIONS
(A covered transaction requires both the investment in the first column and the knowledge in the second column)
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TYPE OF DIRECT OR INDIRECT INVESTMENT |
KNOWLEDGE REQUIREMENT |
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EQUITY INTEREST: Acquisition of an equity interest or a contingent equity interest (or equivalent) (i.e., a financial instrument that currently does not constitute an equity interest but is convertible into, or provides the right to acquire, an equity interest upon the occurrence of a contingency or defined event). |
The U.S. person knows at the time of the acquisition that the target is a “covered foreign person.” |
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LOAN / DEBT: Provision of a loan or a similar debt financing arrangement that is (a) convertible to an equity interest; or (b) affords or will afford the U.S. person the right to make management decisions or the right to appoint members of the board of directors (or equivalent). |
The U.S. person knows at the time of the provision that the recipient is a “covered foreign person.” |
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CONVERSION OF CONTINGENT EQUITY INTEREST: Conversion of a contingent equity interest (or interest equivalent to a contingent equity interest) or conversion of debt to an equity interest. |
The U.S. person knows at the time of the conversion that the target is a “covered foreign person” (note that both the acquisition of the convertible interest and the conversion of the interest may each be a “covered transaction”). |
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ASSET DEVELOPMENT: Acquisition, leasing, or other development of operations, land, property, or other assets in a “country of concern.” |
The U.S. person knows at the time of the acquisition etc. that the transaction will result in (or the U.S. person intends for it to result in) (a) the establishment of a “covered foreign person”; or (b) the engagement of a “person of a country of concern” in a covered activity where it had not previously engaged in such covered activity. |
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JOINT VENTURE: Entrance into a JV, wherever located, with a “person of a country of concern.” |
The U.S. person knows at the time of entrance into the JV that the JV will engage in, or the U.S. person intends the JV to engage in, a covered activity. |
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LIMITED PARTNER INTEREST: Acquisition of a limited partner or equivalent interest in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund (in each case where the fund is not a U.S. person). |
The U.S. person knows at the time of its investment in the fund that the fund is likely to invest in a “person of a country of concern” that is in the semiconductors and microelectronics, quantum information technologies, or AI sectors, and such fund undertakes a transaction that would be a “covered transaction” if undertaken by a U.S. person. |
ATTACHMENT 2
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Notifiable |
Prohibited |
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Semiconductors and Microelectronics |
Design of any integrated circuit that is not described in the prohibited category of semiconductors and microelectronics. Fabrication of any integrated circuit that is not described in the prohibited category of semiconductors and microelectronics. Packaging of any integrated circuit that is not described in the prohibited category of semiconductors and microelectronics. |
Development or production of any electronic design automation software for the design of integrated circuits or advanced packaging2; Development or production of any
Packaging of any integrated circuit using advanced packaging techniques; Development, installation, sale, or production of any supercomputer enabled by advanced integrated circuits that can provide a theoretical compute capacity of 100 or more double-precision (64-bit) petaflops or 200 or more single-precision (32-bit) petaflops of processing power within a 41,600 cubic foot or smaller envelope. |
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Quantum Information Technologies |
None |
Development of a quantum computer3 or production of any of the critical components required to produce a quantum computer such as a dilution refrigerator or two-stage pulse tube cryocooler; Development or production of any quantum sensing platform designed for, or that the relevant “covered foreign person” intends to be used for, any military, government intelligence, or mass-surveillance end use; Development or production of any quantum network or quantum communication system designed for, or which the relevant “covered foreign person” intends to be used for
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AI Systems4
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Development of any AI system that is not described in [the prohibited category of AI systems] and that is (1) designed to be used for any government intelligence or mass-surveillance end use (e.g., through mining text, audio, or video; image recognition; location tracking; or surreptitious listening devices) or military end use (e.g., for weapons targeting, target identification, combat simulation, military vehicle or weapons control, military decision-making, weapons design, or combat system logistics and maintenance); (2) intended by the “covered foreign person” to be used for cybersecurity applications, digital forensics tools, and penetration testing tools, or the control of robotic systems; or Alternative 1 for paragraph (d)(3): (3) Trained using a quantity of computing power greater than 10^23 computational operations (e.g., integer or floating-point operations). Alternative 2 for paragraph (d)(3) (3) Trained using a quantity of computing power greater than 10^24 computational operations (e.g., integer or floating-point operations). Alternative 3 for paragraph (d)(3): (3) Trained using a quantity of computing power greater than 10^25 computational operations (e.g., integer or floating-point operations). |
Development of any AI system that is designed to be exclusively used for, or which the relevant “covered foreign person” intends to be used for, any (1) military end use (e.g., for weapons targeting, target identification, combat simulation, military vehicle or weapon control, military decision-making, weapons design, or combat system logistics and maintenance) or (2) government intelligence or mass surveillance end use (e.g., through mining text, audio, or video; image recognition; location tracking; or surreptitious listening devices); Development of any AI system that is trained using a quantity of computing power greater than Alternative 1 for paragraph (k)(1): (1) 10^24 computational operations (e.g., integer or floating-point operations); Alternative 2 for paragraph (k)(1): (1) 10^25 computational operations (e.g., integer or floating-point operations);Alternative 3 for paragraph (k)(1): (1) 10^26 computational operations (e.g., integer or floating-point operations);
or Alternative 1 for paragraph (k)(2): (2) 10^23 computational operations (e.g., integer or floating-point operations) using primarily biological sequence data. Alternative 2 for paragraph (k)(2) (2) 10^24 computational operations (e.g., integer or floating-point operations) using primarily biological sequence data. |
1The NPRM does not use the word “passive.” Rather, we use this term as a shorthand. The NPRM specifically provides that the LP’s investment must be solely capital, the LP must bear no financial obligations of the fund beyond its own investment, the LP cannot participate in the fund’s investment decisions, portfolio strategy, or operations of portfolio companies that are “covered foreign persons,” and the LP cannot unilaterally determine the selection, dismissal, or compensation of the fund’s general partner or equivalent.
2The term “advanced packaging” means to package integrated circuits in a manner that supports the two-and-one-half-dimensional (2.5D) or three-dimensional (3D) assembly of integrated circuits, such as by directly attaching one or more die or wafer using through-silicon vias, die or wafer bonding, heterogeneous integration, or other advanced methods and materials.
3The term “quantum computer” means a computer that performs computations that harness the collective properties of quantum states, such as superposition, interference, or entanglement.
4The term “AI system” means (a) a machine-based system that can, for a given set of human-defined objectives, make predictions, recommendations, or decisions influencing real or virtual environments —i.e., a system that uses data inputs to (1) perceive real and virtual environments; (2) abstract such perceptions into models through automated or algorithmic statistical analysis; and (3) use model inference to make a classification, prediction, recommendation, or decision; (b) any data system, software, hardware, application, tool, or utility that operates in whole or in part using a system described in (a).
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