Outbound Tech Investment Rules Underscore Due Diligence, Training

In this Bloomberg Law article, partners Mario Mancuso and Luci Hague and associate Chad Crowell discuss the possible impacts of recent draft regulations released by the U.S. Department of Treasury surrounding the implementation of President Biden's August 9, 2023 executive order on "addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern."  

The Treasury Department this month released draft regulations to implement President Joe Biden’s executive order on US investments in certain national security technologies and products in countries of concern. Although the regulations would apply to a small subset of all outbound US investments if promulgated in their current form, we expect the practical impacts on transactions potentially within their ambit will be substantial.

Commonly referred to as an “outbound Committee on Foreign Investment in the United States,” the new rules reflect the US government’s determination that US investments in the semiconductor, quantum computing, and artificial intelligence sectors in so-called “countries of concern” pose risks to national security that can’t be adequately addressed by other US legal authorities. The draft regulations aren’t currently effective; they can change based on public comments, which must be submitted to the Treasury no later than Aug. 4.

Despite the convenient “outbound CFIUS” appellation, the new rules differ significantly from CFIUS. The draft regulations don’t establish a case-by-case review process that would permit US persons to obtain approval of regulated investments.

Instead, they prohibit US persons from engaging in—or require US persons to submit notifications for—covered transactions, which are defined as a narrow subset of all outbound investments into or involving certain companies engaged in specified activities in the semiconductor, quantum computing, and AI sectors.

The regulations refer to such companies as covered foreign persons. Determining whether a counterparty is a covered foreign person, and whether a contemplated transaction is a covered transaction, will require a technical, fact-specific analysis by the US person involved.

The broadly drafted regulations would cover virtually all types of transactions that a US investor could undertake in China or with Chinese-owned companies related to semiconductors, quantum computing, and AI, including equity investments, joint ventures, and (in some cases) indirect investments as a limited partner.

The Treasury has made clear that the regulations will apply to direct and indirect transactions and suggested it won’t be possible to avoid application of the regulations through complex investment structures with non-US intermediate entities.

US persons who control foreign entities, such as offshore funds, must submit notifications to the Treasury if a covered transaction is undertaken by their controlled foreign entities, and they must take “all reasonable steps” to prevent their controlled foreign entities from engaging in prohibited transactions. These steps should include training for the controlled foreign entity’s personnel.

But what about US nationals employed in senior roles by foreign investors and companies—for example, a US citizen on the board of a French venture capital fund, or serving as a senior adviser to a Chinese semiconductor company? The regulations bar them from “knowingly directing” a prohibited transaction but don’t require them to notify the Treasury of their own involvement in notifiable transactions undertaken by non-US persons.

The Treasury’s proposed knowledge standard is low and covers actual and constructive knowledge. US persons in senior roles at entities undertaking prohibited transactions must at a minimum recuse themselves from the investment and likely avoid any discussions or meetings about it.

US persons engaged in notifiable transactions must submit notifications to the Treasury no more than 30 days after the covered transaction closes. After submission, the US person may receive questions from the Treasury—or it may not hear anything at all. The Treasury can’t prevent or force divestment of a notifiable transaction, but it may void a prohibited transaction.

If a US person doesn’t realize at the time of the transaction that it is covered but later becomes aware of this fact, they must submit notification within 30 days of the US person’s learning of the transaction’s status, whether prohibited or notifiable.

In general, more sensitive transactions (such as those involving more advanced semiconductors) are prohibited, and less sensitive transactions are notifiable. But all covered transactions involving quantum computing are prohibited, as is any otherwise notifiable transaction with a person or entity that is on an identified US government restricted party list. This makes intuitive sense—designation on such a list means the government has already found the designee to present a threat to US national security or foreign policy priorities.

The draft regulations highlight a few key impacts for investors. First, due diligence matters. The Treasury expects that US persons will conduct and preserve fulsome due diligence on any transactions that could be covered, and that they will seek contractual representations and warranties from counterparties about their covered foreign person status.

Second, although the regulations were issued in draft form, they are unlikely to materially change based on public comments. The intellectual groundwork for the regulations has been laid for years, and we don’t expect there will be a significant change in the direction of travel, regardless of the 2024 presidential election’s outcome.

Finally, US investors with controlled foreign entities should take proactive steps to educate their board members and senior personnel on how to manage obligations under the new rules. In case of a later foot-fault, documentation of these steps will be critical to mitigating potential penalties.

With the increasing focus on national security concerns surrounding China, we expect scrutiny over Chinese business ties to continue to grow. US businesses—particularly those in semiconductors, quantum computing, and AI—should carefully assess their ties to China. US investors should keep a close eye on the final regulations and prepare for their practical implications.