Proposed Outbound Investment Rules: Understanding New Restrictions on U.S. Outbound Investments in Artificial Intelligence (AI), Semiconductors, and Quantum Computing | Sheppard Mullin Richter & Hampton LLP

In an era in which technological prowess and economic security are more intertwined than ever, the United States has refined its approach to restricting outbound investment. Since we have been blogging since 2022, over the last two years we have made efforts to limit outbound investment for national security reasons. These efforts come both from Congress through legislation and the White House through executive order.

On August 9, 2023, the Biden Administration issued Executive Order 14105 to restrict U.S. investment in certain national security technologies and products in countries of concern (defined as China, including Hong Kong and Macau).

Now, on Friday, June 21, the Treasury Department published a Notice of Proposed Rulemaking (NPRM) containing proposed regulations for outbound investments.

Proposed regulations

The NPRM represents a critical step in U.S. policy to regulate outbound investments to protect critical technologies from foreign adversaries. The key elements of the NPRM are:

• Prohibited investments: The proposed regulations would prohibit U.S. persons from engaging in certain transactions involving affected countries as follows:
  • Semiconductors and microelectronics: Electronic design automation software transactions; specific production tools and advanced packaging tools; design, manufacture or packaging of certain advanced integrated circuits; and supercomputers.
  • Quantum information technologies:Transactions related to the development of quantum computers and the production of key components; the development or production of certain quantum sensor platforms; and the development or production of quantum networks and quantum communication systems.
  • Artificial intelligence systems: Transactions related to the development of any AI system intended for:
    • be used exclusively or intended for military purposes (e.g.for weapons targeting, target identification, combat simulation, control of military vehicles or weapons, military decision making, weapons design, or logistics and maintenance of combat systems);
    • be solely used or intended to be used for government intelligence or mass surveillance purposes (e.g., through text, audio or video mining; image recognition; location tracking; or hidden listening devices); Or
    • be trained using computational power greater than a certain level of computational operations (e.g., integer or floating-point operations). Treasury is considering three potential COP level alternatives: 10^24, 10^25, or 10^26, but for cases using primarily biological sequence data, the COP level considered is 10^23, 10^24, or 10^25.
• Notification requirements: The proposed regulations would require U.S. persons participating in covered transactions to notify the U.S. Treasury as follows:
  • Semiconductors and microelectronics: Transactions involving the design, manufacture or packaging of integrated circuits not otherwise included in the definition of a prohibited transaction.
  • Artificial intelligence systems: Transactions relating to the development of any AI system not covered by the above prohibition, where such AI system is designed or intended to:
    • be used for any government intelligence or mass surveillance purposes (e.g.(by text, sound or image extraction, image recognition, location tracking or eavesdropping) or for military purposes (e.g.(e.g., for weapon targeting, target identification, combat simulation, military vehicle or weapon control, military decision-making, weapons design, or combat systems logistics and maintenance);
    • be used in cybersecurity applications, digital forensics and penetration testing or robotic system inspection tools; Or
    • be trained using an amount of computing power greater than a certain level of computational operations (e.g., integer or floating-point operations). In this case, Treasury is considering three potential alternatives for the compute operation level: 10^23, 10^24, or 10^25.
• Notification deadline: The proposed regulations provide that notifications must be submitted no later than 30 days after the completion of the transaction or where the U.S. person obtains actual knowledge after the completion date of the transaction that the transaction would have been covered had he or she known about it at the time the transaction was entered into, no later than 30 days after the U.S. person obtained such knowledge.
• Restrictions on foreigners covered by insurance: The proposed regulations would apply to transactions with covered foreign persons involving the above subset of technologies and products. A person from the country concerned is defined as including:
  • an individual who is a citizen or permanent resident of a country (and not a U.S. citizen or permanent resident);
  • an entity organized under the laws of a given country, domiciled in a given country, incorporated or having its principal place of business in a given country;
  • the government of the country of interest; Or
  • an entity in which the majority of the shares are owned, directly or indirectly, by persons or entities belonging to any of the above categories.

Thus, the proposed regulations cover certain types of acquisition of equity shares or conditional shares in share capital, debt financing convertible into shares in share capital, conversion of a conditional share in share capital or convertible debt, and greenfield, brownfield or joint venture investments. Additionally, the proposed rule would cover certain transactions involving an entity that does not have a voting interest, board seat or equity interest in a foreign controlled person for which more than fifty percent (50%) of one of several key financial indicators of the entity is attributable to such foreign person covered by it.

• Requirements for US citizens: The NPRM is limited to U.S. persons. U.S. Person means any United States citizen or lawful permanent resident, as well as any entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branch of such entity, and any person in the United States.
• Knowledge standard: The proposed regulations include a “knowledge standard” that determines how aware a U.S. citizen is about the impact of his or her investments on national security technologies. The standard is therefore that a U.S. person should know, or reasonably should know, based on publicly available information or available through reasonable and appropriate due diligence, that he or she is entering into a transaction involving a covered foreign national and that the transaction is a covered transaction. The standard ensures that investors cannot claim ignorance of the potential consequences of their investment.
• National interest exemption: The proposed regulations authorize a national interest exception to permit certain transactions that might otherwise be restricted if they are deemed to advance the national interest of the United States. The proposed regulations establish procedures under which a U.S. citizen may seek a national security exemption from the notification and prohibition requirements.
• Exceptional transactions: Certain transactions may be exempt based on criteria such as the nature of the investment or affiliation with a foreign entity, intended to balance national security concerns with the need for international cooperation and innovation.
  • Publicly traded securities: An investment by a U.S. person in a publicly traded security or a security issued by an investment company, such as an index fund, mutual fund, or exchange-traded fund;
  • Some LP investments: an investment of a specified size by a U.S. person as a limited partner or equivalent in a venture capital fund, private equity fund, fund of funds or other pooled investment fund;
  • Redemption of property in the country of interest:Full purchase by a U.S. Person of all ownership rights of an entity in a supervised country such that the entity will not be considered a supervised foreign person after the transaction;
  • Intracompany transactions: An intra-group transaction between a US parent company and a majority-controlled subsidiary intended to support ongoing operations or other activities outside the scope;
  • Binding Order Obligations Before Dispatch: Transaction constituting the implementation of a binding, non-callable capital commitment concluded before August 9, 2023;
  • Some syndicated debt financing: If a U.S. person, as a member of a loan syndicate, acquires a voting interest in a covered foreign person in the event of default, and the U.S. person cannot initiate any action against the debtor and does not have a leading role in the syndicate;
  • Third country measures: Certain transactions involving a person from a non-U.S. country or territory may constitute exempt transactions if the Secretary of the Treasury determines that the country or territory is addressing national security concerns arising from outbound investments and the nature of the transaction is related to national security concerns likely to be adequately addressed through the actions of that country or territory.
• Breaches, divestment and VSD: The NPRM establishes penalties for violations of the regulations, including fines, civil penalties, referrals for criminal violations, and potential restrictions on future investments. Additionally, divestment may be required for investments made in violation of the rules. The proposed regulations also provide a U.S. citizen the opportunity to voluntarily self-disclose if he or she believes that his or her conduct may have resulted in a violation of any part of the regulations.
• Request for comment and effective date: The Treasury Department is seeking public comments on the NPRM until August 4, 2024. Importantly, the proposed regulations do not currently have a specific effective date, which should provide time for thorough analysis and consideration of the feedback received.

Impact on business and strategic technologies

For companies, especially those operating in the semiconductor, artificial intelligence and quantum computing industries, the implications of the NPRM are significant. Companies may need to reassess their international investment strategies, increase transaction due diligence and prepare for a more complex regulatory environment. Strategies may include engaging with legal advisors early, developing compliance mechanisms and monitoring regulatory changes. Adapting to this regulatory framework requires businesses to have knowledge and adaptability.

Application

The Treasury Department’s NPRM represents a significant step. Once the regulations are finalized, companies, particularly in key technology sectors, must prepare to take these restrictions into account in future investments covered by the regulations. We will continue to provide information on how to navigate the complexities of outbound investment restrictions.