The Biden Administration released the highly anticipated, “Executive Order on Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern” (“Executive Order”) on August 9, which places increased importance on due diligence when investing in specific foreign countries. The Executive Order will regulate outbound investments in China with a focus on key technologies critical to safeguarding U.S. national security. It also directs the Treasury Department and other agencies to promulgate regulations that will place restrictions on investments within three sectors of China’s economy: semiconductors and microelectronics, quantum information technologies, and technologies involved with artificial intelligence.

The full implementation of the regulations is a long way away, as the Treasury Department released its Advanced Notice of Proposed Rulemaking (“ANPRM”) in parallel with the Executive Order. The timeline provides for a 45-day public comment period, to be followed by draft regulations issued by Treasury and a subsequent comment opportunity prior to the finalization of the regulations.

Lay of the Land: Fortifying National Security with Economic Security

The key facets of the outbound investment regulations as stated in the Executive Order and proposed in the ANPRM include:

  • The Executive Order covers investments in China, which includes Hong Kong and Macau, together “countries of concern.”
  • The Executive Order will pertain to U.S. citizens, lawful permanent residents, entities organized under the laws of the U.S. or any jurisdiction within the U.S., including any foreign branches of any such entities, and any person in the U.S. Treasury is considering whether “indirect” transactions will be in scope of the regulations, to prevent U.S. persons from seeking to end-around the rules by utilizing foreign intermediaries.
  • Regarding technologies under consideration for regulation, the Executive Order and accompanying ANPRM defines the term “covered national security technologies and products” to include “sensitive technologies and products in the semiconductors and microelectronics, quantum information technologies, and artificial intelligence sectors that are critical for the military, intelligence, surveillance, or cyber-enabled capabilities.”
  • The Executive Order imposes two types of restrictions on outbound investments. The first is an absolute prohibition on U.S. investment in certain Chinese “covered national security technologies and products.” The other restriction is more akin to the Committee on Foreign Investment in the United States (CFIUS), as modified by the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) and provides for a notification requirement for U.S. investments in other Chinese “covered national security technologies and products.”
  • The notification process will seek detailed information about the transaction, including the identities and backgrounds of the parties to the transaction, the nature of the technology for which the investment will be applied, and copies of relevant transaction documents and other agreements, all to be provided electronically.

Once final regulations are promulgated, there will be an additional twelve months for the Treasury Department to evaluate the effectiveness of the regulations, and subsequent revisions may be proposed should the rules not be meeting their desired outcomes or catch too many unanticipated investments – just as occurred with the FIRRMA regulations that were modified after a short experience with the original regulations. Given the runway ahead, there is time for organizations and investors to prepare for what this means for the future.

Executive Order and ANPRM: Impact on Investment

The Treasury Department is considering adopting a knowledge standard whereby a notifier’s obligations are premised on a “knowledge of a circumstance (including variations such as “know,” “reason to know,” or “reason to believe”) including not only positive knowledge that the circumstance exists or is substantially certain to occur, but also an awareness of a high probability of its existence or future occurrence.” As such, the proposed regulations and in particular the notification procedures will require a significant amount of due diligence beyond what is customary to satisfy the Treasury Department.

For example, transaction notification will require disclosure of the beneficial owners of parties to the investment, frequently a difficult undertaking in China and other locations in the region given local norms, customs, and laws. In addition, the Treasury Department expects insight into the basis for determining that the transaction is a covered one, with a detailed description of the technologies involved, as well as background on the covered U.S. persons. Lastly, and most importantly, the Treasury Department is anticipating that parties to a covered transaction detail the due diligence undertaken to evaluate the investment, including an understanding of the end-uses of the technologies or components involved in the transaction.

Added Complexity: China’s Enticing Foreign Investment Posture

The Executive Order and the Treasury Department’s ANPRM are consistent with the Biden Administration’s “small yard, high fence” approach to national security matters, with the intent of taking a small but deep bite into certain outbound investing activities. There are pros and cons to the administration’s approach. Some perceive the Executive Order as not going far enough to protect U.S. national security interests and too limiting in its curtailing of investment activities, while others envision the Order as a steppingstone to a much broader impingement on U.S. private equity (“PE”) and other investors, especially with U.S. Treasury’s ability to reassess the regulations one year from release and greater increase the size of the “yard.”

But the Order comes as China’s post-pandemic recovery slows to a worse than anticipated pace. To address these issues and increase foreign investment in the country, China’s State Council released a memo on August 13, 2023, “Opinions of the State Council on Further Optimizing the Environment for Foreign Investment and Increasing the Intensity of Attracting Foreign Investment.” The memo details several steps the Chinese government is prepared to take to encourage and nurture foreign investment in the country, which represent a remarkable departure from historic practices and approach. The steps include, “guaranteeing national treatment for foreign enterprises, enhancing protection of foreign businesses’ rights, strengthening law enforcement and standardizing policy and regulation formation in foreign trade and investment, and optimizing residence policies for employees of foreign enterprises, including exploring a safe management framework for cross-border data flows with less frequent inspection of those with low credit risks.” This is a remarkable departure from China’s usual stance on foreign enterprise in the country and an apparent attempt to make the country more competitive with the U.S. by enticing other foreign investment, free from the usual and customary rights relinquishments that have been an earmark of China’s historical approach to foreign influence in their economy.

Looking Ahead: Impact to Come

The negative impact to China of U.S. companies’ ongoing “de-risking” efforts and U.S. reliance on other import channel like Mexico and Canada, could be mitigated by China’s softer approach to outside investment attracting other foreign investors. This comes at a time that bilateral trade between China and Russia has increased 40% from 2022 to 2023, providing Russia some relief from stringent U.S. sanctions, while potentially heightening tensions between China and the U.S. Meanwhile, U.S. investors are caught between Washington’s effort to balance economic security and national security concerns, and the large returns that can occur with some of these potentially restricted investments. Additionally, China could be deprived of approximately $10 billion a year in PE investment and access to accompanying U.S. technological know-how.

The Chinese government’s loosening of incoming foreign investment rules and the tightening of foreign outbound investment by the U.S. will undoubtedly be a dynamic to watch as both regimes evolve. Regardless of how these competing regulatory schemes play out, the importance of due diligence and thoroughly understanding counterparties and their beneficial owners will continue to be a critical component of investing overseas. CFIUS, FIRRMA and now the newly released Executive Order require it.

This article originally appeared in Cybersecurity Law & Strategy. © 2023 ALM Global LLC. Reprinted with permission.

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About the Authors

David Holley

David A. Holley

David A. Holley, a Partner with StoneTurn, has more than 30 years of investigative and risk consulting experience and frequently serves as a trusted advisor to corporations, law firms, audit […]

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