President Biden recently issued Executive Order 14105 (EO) declaring a national emergency to deal with the threat of advancement in military, intelligence, surveillance and cyber-enabled technologies and products of China and other countries of concern and aiming to curb investments from the United States in those sectors and in those countries. In accordance with the EO, the U.S. Department of the Treasury on the same day published an advance notice of proposed rulemaking regarding the forthcoming regulations that will prohibit certain transactions in these sectors and establish notification requirements for others. The advance notice proposes a number of key definitions and invites public comment on over 80 specific issues relating to the implementation of the EO. Entities that could be impacted by the EO should consider submitting comments, which are due by September 28, 2023, and also should begin preparing for the EO's implementation.

Scope of the EO

The EO directs Treasury to begin a rulemaking process that will designate specific types of investments by U.S. persons in China or in certain Chinese-affiliated entities that develop or produce semiconductors, quantum computers and artificial intelligence applications as either prohibited or notifiable transactions.

The regulations must cover transactions with "covered foreign persons" of "countries of concern" who engage in activities involving national security technologies or products. This also includes entities owned 50 percent or more by the above parties (which could include, e.g., U.S. subsidiaries of a Chinese parent company). The People's Republic of China, along with the special administrative regions of Hong Kong and Macau, is currently the only nation listed as a "country of concern," but that list is subject to change. Covered national security technologies and products are those technologies and products that are critical for the military, intelligence, surveillance or cyber-enabled capabilities of a country of concern, limited to three sectors:

  1. Semiconductors and microelectronics;
  2. Quantum information technologies; and
  3. Artificial intelligence.

Note that the transaction itself does not need to involve covered national security technologies or products to fall under the EO's purview. If a foreign party engages in any activities concerning those matters, then any transaction with that party may be subject to Treasury regulation.

The forthcoming regulations may also bar U.S. persons from "knowingly directing" transactions by non-U.S. persons if such dealings would be prohibited transactions if engaged in by a U.S. person. This restriction would prohibit corporate officers and directors who are U.S. nationals from ordering or approving investments by foreign branches, subsidiaries or funds into Chinese entities involved in the covered technology sectors. The restriction would also cover, for example, a U.S. person acting as a general partner of a foreign fund or a U.S. person or venture partners launching and directing a foreign fund.

The EO directs Treasury to issue its regulations in consultation with the Secretary of Commerce and the heads of other relevant departments and agencies. The EO also lists a series of other cooperative steps that Treasury must take in its implementation, including consulting with the Secretary of State on foreign policy considerations and the Secretaries of State, Defense, Commerce and Energy and the Director of National Intelligence on the implications for military, intelligence, surveillance or cyber-enabled capabilities of certain covered national security technologies and products.

Opportunity to Comment on the Advance Notice of Proposed Rulemaking

Interested parties will have multiple opportunities to comment prior to the implementation of the EO. As a first step, Treasury published an advance notice of proposed rulemaking on August 14, 2023, clarifying the intended scope of Treasury's regulations and identifying the 83 specific issues where Treasury would most welcome public input. Comments are due on September 28, 2023. In particular, the advance notice describes the types of China-related transactions that Treasury is considering prohibiting or requiring that the U.S. government be notified regarding them.

The advance notice includes and seeks comment on proposed definitions for many key terms, including:

  • U.S. Person: Treasury proposes to define U.S. person as any United States citizen, lawful permanent resident, entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branches of any such entity and any person in the United States.
  • Covered Foreign Person: Treasury is considering elaborating upon the definition of a "covered foreign person" in the EO to mean: (1) a person of a country of concern that is engaged in, or a person of a country of concern that a U.S. person knows or should know will be engaged in, an identified activity involving a covered national security technology or product; or (2) a person whose direct or indirect subsidiaries or branches are referenced in item (1) and that, individually or in the aggregate, comprise more than 50 percent of that person's consolidated revenue, net income, capital expenditure or operating expenses.
  • Person of a Country of Concern: Treasury is considering elaborating upon the definition for the term "person of a country of concern" mentioned in the EO to mean (1) any individual that is not a U.S. citizen or lawful permanent resident of the United States and is a citizen or permanent resident of China; (2) an entity with a principal place of business in, or an entity incorporated in or otherwise organized under the laws of China; (3) the government of China, including "any person owned, controlled or directed by or acting for or on behalf of the government"; or (4) any entity in which a person or persons identified in items (1) through (3) holds individually or in the aggregate, directly or indirectly, an ownership interest equal to or greater than 50 percent.
  • Covered Transaction: Treasury is considering using a single term, "covered transaction," that would apply to the definition of both prohibited and notifiable transactions. Specifically, the Treasury Department is considering defining the term "covered transaction" to mean a U.S. person's direct or indirect (1) acquisition of an equity interest or contingent equity interest in a covered foreign person; (2) provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest; (3) greenfield investment that could result in the establishment of a covered foreign person; or (4) 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.

In addition, the advance notice of proposed rulemaking includes and seeks comments on the proposed parameters for the prohibited and notifiable transactions involving the "covered national security technologies and products," defined as semiconductor and microelectronic technologies and products, quantum information technologies and AI systems. Specifically, Treasury seeks comment regarding any suggested modifications to the definitions under consideration to enhance clarity or close any loopholes, including modifications to the proposed definitions for particular technologies such as "supercomputer," "electronic design automation software," "quantum computers and components," "quantum sensors," and "AI system."

The advance notice also seeks comments on the liability standards to be included in the regulations, including the "knowledge" standard, the definition of "knowingly directing" transactions and potential obligations for U.S. persons regarding foreign entities that they control.

The advance notice does not itself implement the EO and is not draft regulatory text. It will be followed by draft regulations at a later stage in the process. Written comments are due on September 28, 2023, and may be submitted electronically through the federal government's eRulemaking portal.

Reactions to the EO

This EO comes on the heels of numerous national security developments both international and within China. On the international front, several other countries and the European Union have expressed interest in implementing similar outbound foreign investment-related regulations to address the international security risks posed by foreign misuse of sensitive technologies.

The Biden administration said in a press conference that the EO aims to pursue national security objectives without hindering the economic benefits of cross-border investments. The EO therefore expressly permits Treasury to exempt certain transactions from the prohibited transactions and notifiable transactions categories if doing so would "be in the national interest of the United States." Notable potential exclusions include certain passive or other investments that pose a lower likelihood of conveying intangible benefits. For example, Treasury is considering excepting certain U.S. investments into publicly traded securities, index funds, mutual funds, exchange-traded funds, certain investments made as a limited partner, committed but uncalled capital investments and intracompany transfers of funds from a U.S. parent company to its subsidiary.

Meanwhile, China has responded to recent U.S. measures by issuing tightened national security-related rules, including ones concerning cybersecurity and data privacy. In addition, Chinese authorities have taken targeted actions against certain Western companies, such as the banning of U.S.-based Micron Technology's chips from being used in critical infrastructure. It is therefore reasonable to anticipate a Chinese response to the EO and related rulemaking.

However, there is hope that any Chinese reaction to the EO may not be outsized. During U.S. Commerce Secretary Gina Raimondo's recent visit to China in August, the United States and China agreed to establish several new forums to discuss areas of tension in the commercial relationship, including:

  • A new commercial issues working group for U.S. and Chinese government officials and private sector representatives to seek solutions on trade and investment issues;
  • A new export control enforcement "information exchange" that will seek to reduce any misunderstanding of U.S. national security policies;
  • A commitment to convene subject matter experts from both sides to hold technical discussions regarding strengthening the protection of trade secrets; and
  • A commitment for U.S. Secretary Raimondo and Chinese Commerce Minister Wang Wentao to communicate regularly about commercial and economic issues.

As Secretary Raimondo explained, "The economic relationship between the United States and China is one of the most significant in the world," and therefore "it is profoundly important that we have a stable economic relationship which is to the benefit of both of our countries."

Conclusion

The EO's initial lack of detail notwithstanding, the potential breadth of the forthcoming regulations is such that any U.S. entities currently investing or contemplating investing in China, Hong Kong or Macau should take note.

It is not proposed that the program provide for retroactive application of the provisions related to the prohibition of certain transactions and the notification of others. In other words, no transactions will be prohibited or notifiable until the final regulations are issued and in effect. However, given the current opportunities for public comment to shape the forthcoming regulations, U.S. investors and potential investors should now begin assessing their investments and the extent to which this EO and its corresponding regulations may affect them (or their future investment strategy).

About Duane Morris

Attorneys in the firm's Corporate Practice Group and International Group have considerable experience in assisting clients on a wide range of matters, including assisting in determining the applicability of foreign direct investment control laws that are administered in various jurisdictions (e.g., the United States, United Kingdom and European Union) and performing comprehensive due diligence relating to international M&A transactions. The firm's attorneys also have experience in preparing public comments for submission to the government, and several have taken leadership roles in assisting associations in preparing comments on the advance notice of proposed rulemaking.

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