On June 21, 2024, the U.S. Department of Treasury (Treasury) announced a Notice of Proposed Rulemaking (NPRM) implementing President Biden's August 2023 Executive Order (E.O.) 14105, "Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern" (the Outbound Order). The NPRM — which describes proposed outbound investment rules and seeks public comment — was widely anticipated and follows the Treasury's Advanced Notice of Proposed Rulemaking (ANPRM), published concurrently with the Outbound Order last year. The NPRM provides for a public comment period that ends on August 4, 2024. 

Background

The Outbound Order focuses on the national security threat posed by advancements by "countries of concern" in sensitive technologies and products critical for those countries' military, intelligence, surveillance, or cyber-enabled activities. To address this threat, the Outbound Order calls for the regulation of certain outbound U.S. investments that could "accelerate and increase the success of" development of certain so-called national security technologies and products that currently fall into three categories: semiconductors and microelectronics, quantum information technologies, and artificial intelligence (AI). The targeted "countries of concern" are China and its two special administrative regions, Hong Kong and Macau, though the E.O. anticipates the list could change. 
 
The Outbound Order directs the Treasury — in consultation with interagency partners — to promulgate rules and regulations that achieve two primary objectives: 

1. Requiring U.S. persons to notify the government of certain transactions involving covered foreign persons and specified products or technologies
2. Prohibiting U.S. persons from engaging in certain transactions involving covered foreign persons and products or technologies that pose heightened national security risks

The Proposed Rule

Requirement and Prohibitions 

The NPRM proposes new requirements for "U.S. persons" engaged in "covered transactions" involving a "covered foreign person." Some of these covered transactions would require a notification to Treasury (notifiable transactions), while other transactions would be precluded outright (prohibited transactions). 

"U.S. Persons" and "Covered Foreign Persons" 

Under the proposed rule, "U.S. person[s]" include U.S. citizens and lawful permanent residents, any person in the U.S., and any entity organized under U.S. law (including any foreign branches). Foreign entities that have a U.S.-person parent are "controlled foreign entities" and are subject to the same prohibitions and notification requirements as U.S. persons ("parent" is separately defined and includes investment advisers to pooled investment funds).

Meanwhile, a person or entity would be considered a "covered foreign person" if it (a) is a "person of a country of concern" engaged in a "covered activity" (i.e., certain activities related to semiconductors and microelectronics, quantum information technologies, and AI), or (b) has certain voting, board seat, or equity interests in such a person, as elaborated in the NPRM. Importantly, the term "person of a country of concern" is broadly defined to include, inter alia, citizens and permanent residents of China, entities incorporated or headquartered in China, the government of China, and entities that are essentially owned or controlled (directly or indirectly) 50 percent or more in the aggregate by any of these.

"Covered Transactions"

The NPRM specifies that "covered transactions" could include, among others, a U.S. person's direct or indirect acquisition of an equity interest or contingent equity interest, certain types of debt financing, greenfield investments, and other corporate expansions, joint ventures, and some investments in pooled funds. 

Whether those investments are deemed notifiable or prohibited transactions depends primarily on whether a covered foreign person is (or will be) involved. Additionally, under the NPRM, a transaction would usually only be considered a covered transaction where a U.S. person met the requisite level of "knowledge," which is broadly defined and can apply differently depending on the type of investment at issue. Importantly, all covered transactions where the foreign person is engaged in "covered activities" and is included on certain U.S. government sanctions lists or export restriction lists would be prohibited under the proposed rule. 

National Security Technologies and Products

As noted above, the notification requirements and prohibitions primarily target transactions involving covered foreign persons involved in producing, designing, using, packaging, or developing products and technologies related to semiconductors and microelectronics, quantum information technologies, and AI. The NPRM specifies technical criteria about particular items involved in a transaction that determines whether a transaction is considered notifiable or prohibited. These criteria require careful review, as the application of the notification requirements or the prohibition under the proposed rule may turn on highly specific technical capabilities of an item being used, packaged, developed, sold, produced, or designed by a covered foreign person. 

Excepted Transactions

To mitigate potentially disruptive consequences for U.S. persons, certain transactions that might otherwise be deemed covered transactions would be excepted from the prohibitions and notification requirements under the proposed rule. The excepted transactions could cover, among others, publicly traded securities, certain limited partnership investments, buyouts of country of concern ownership, certain intracompany transactions, and certain transactions involving U.S. partner and ally countries (to be determined by the Secretary of the Treasury).

Key Takeaways

• "Knowledge" as a Trigger for Notification: A significant portion of the NPRM delves into what would be considered sufficient due diligence at the time of a transaction and how Treasury will determine whether a person had the requisite "knowledge." One key factor affecting how Treasury will apply this standard and evaluate the sufficiency of due diligence is the type of investment involved. Careful attention may be required at the planning phase of an investment, as there could be scenarios in which a subsequent pivot by an investment target into a covered activity could trigger a notification requirement or a prohibition.
• Expansive Scope of Investments Potentially Affected: The proposed outbound investment regulations would implicate much more than investments by U.S. persons directly into China or Chinese-incorporated companies. With the sweeping (and highly technical) definitions of "covered foreign person" and "person of a country of concern," investments by U.S. persons in other countries – and even in the U.S. itself – could potentially fall within the scope of a covered transaction. Another aspect that is not immediately obvious is that a U.S. person's investment itself does not have to directly involve a covered activity in order to be notifiable or prohibited. Rather, the investment target's engaging in covered activities or the investment target's relationship with another entity (e.g., a subsidiary) that is engaged in covered activities could also trigger the notification requirements or prohibitions. Based on the current draft regulations, many U.S. companies and their foreign subsidiaries will need to incorporate outbound investment due diligence as a matter of course in their general investment and merger and acquisition (M&A) due diligence – not limiting it to investments that directly involve China. 
• Shifting Tides, Detail to Complete: While it is unclear when the final rule will be issued, the NPRM provides early indications of Treasury's approach to regulating outbound foreign investments in specifically defined countries and sectors. Given the NPRM's proposed coverage of both U.S. and foreign subsidiaries, and its proposed mandates, investors should proceed with caution when navigating investment opportunities abroad where there may be even indirect connections to China, Hong Kong, or Macau and covered activities. Since this is only an NPRM, there may be notable additions or subtractions when the final rule is issued. Additionally, there are issues that Treasury discusses but that will likely be addressed outside of the final rule, such as the list of partner and ally countries qualifying for the notification exception, and the details of the online notification form. Companies that may be impacted by the NPRM should strongly consider submitting comments to Treasury, as their input can shape the ultimate scope of prohibited transactions and other requirements.

For more information, please contact:

Timothy P. O'Toole, totoole@milchev.com, 202-626-5552

Laura Deegan, ldeegan@milchev.com, 202-626-5942

Caroline J. Watson, cwatson@milchev.com, 202-626-6083

Melissa Burgess, mburgess@milchev.com, 202-626-5914

Manuel Levitt, mlevitt@milchev.com, 202-626-5921

Annie Cho, acho@milchev.com, 202-626-1570

Summer Associate JP LaBarge assisted with this alert. 

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