Twenty Questions: Outbound Investment Security Program Targets China’s Semiconductor, Quantum Computing, and AI Industries

On October 28, 2024, the US Department of the Treasury issued final regulations governing certain outbound investments in the semiconductor, quantum computing, and artificial intelligence (AI) sectors of the People’s Republic of China, along with Hong Kong and Macau (collectively referred to herein as China). This action follows President Biden’s Executive Order 14105 (August 9, 2023), an advance notice of proposed rulemaking (August 14, 2023; see our prior client alert on this topic here), and a notice of proposed rulemaking (July 5, 2024).

We refer to the final rule as the Outbound Investment Security Program, or the OISP. Below, we offer answers to 20 common questions.

1. What is the OISP?

The OISP is a new regulatory regime that regulates certain “covered transactions” between US persons (including through foreign entities they own or control) and investment targets, referred to as “covered foreign persons,” that are (i) sufficiently tied to China (or another future-designated “country of concern”) and (ii) engaged, directly or indirectly, in prescribed activities within the semiconductor, quantum computing, or AI technology sectors.

For some covered transactions, the US person will be required to submit a notification within 30 calendar days after closing. Other covered transactions will be prohibited — in some cases, with an obligation for US persons to prevent such transactions by foreign entities they own or control, to obtain contractual commitments from non-US funds that invest US capital, or else to submit a notification of a transaction that would be prohibited for US persons.

Therefore, US and non-US entities will need to be aware of any ties to China that could cause them to become a covered foreign person. Similarly, non-US investment funds will be asked about their investment activities, and the activities of their portfolio companies, by US limited partners (LPs) — whether with respect to China, the specified technology sectors, or both.

2. What is the policy objective of the OISP?

The President determined that certain investments pose a threat to US national security by accelerating China’s development of advanced technologies that contribute to military, intelligence, surveillance, and cyber-enabled capabilities.

The OISP would slow the flow of US capital and associated intangible benefits — credibility, management support, and access to investment and talent networks — to covered foreign persons in the key technology sectors discussed in Question 6.

3. When is the OISP effective? Will it be retroactive for existing investments or pending transactions?

The OISP takes effect on January 2, 2025. It will cover pending transactions that have not yet closed, even if the parties have already executed a binding agreement.

The new rule will not apply to the maintenance of ongoing activities between a US person and its “controlled foreign entity” (see Question 11) nor to the conversion of a contingent equity interest acquired before January 2; a binding, uncalled capital commitment entered into before January 2; or the conversion of equity pledged as collateral under a lending agreement entered into before January 2.

4. Who will be affected by the OISP?

The OISP primarily applies to investment activity by “US persons,” which include entities organized under US law and their foreign branches, as well as natural persons who are citizens of, lawful permanent residents of, or located in the United States (e.g., foreign nationals residing in the United States). Natural US persons — for instance, someone employed by or acting for a non-US fund — should be mindful that they do not “knowingly direct” activities by a non-US person that would be prohibited if undertaken directly by a US person. See Question 10 for further discussion of this point.

Foreign persons will also be affected, such as non-US entities that are controlled by US persons (see discussion of controlled foreign entities in Question 11) and non-US investment funds that source US capital. The OISP creates an exception for US limited partners that make purely passive investments and obtain binding, contractual assurances concerning the use of capital they provide. As such, non-US funds should expect questions from US investors regarding intended investment activities and new contractual terms on the use of US-person capital contributions to address exposure to China and/or the specified technology sectors.

5. How does the OISP determine whether an investment target is sufficiently tied to China (or a future country of concern)?

China (including Hong Kong and Macau) is the only jurisdiction currently designated as a country of concern. Persons with sufficient ties to China — which the OISP refers to as a “person of a country of concern” — include (i) natural persons that are citizens or permanent residents of China and not the United States; (ii) entities that are organized, headquartered, or have their principal place of business in China; (iii) entities that constitute, or that are owned or controlled 50% or more by, the Chinese government; and (iv) entities that are owned or controlled 50% or more by any of the foregoing (regardless of location).

Also covered by the OISP are entities, wherever located, that derive 50% or more of their revenue or net income, or incur 50% or more of their capital expenditures or operating expenses, from persons of a country of concern that engage in covered activities (see Question 8) — provided that the entity also holds a board seat, voting interest, or managerial rights in such persons. These parties are referred to collectively with the relevant persons of a country of concern as “covered foreign persons.”

The OISP extends beyond the physical borders of China, requiring investors to conduct diligence on an investment target’s China nexus, regardless of the entity’s apparent location. Indeed, even a US entity could be a covered foreign person.

6. What technologies are targeted by the OISP?

The OISP focuses on companies that undertake certain activities in three key technology sectors:

• Semiconductors and Microelectronics, including the design, fabrication, and packaging of advanced integrated circuits (ICs), the development or production of related design software and manufacturing equipment, and the installation or sale of certain supercomputers
• Quantum Information Technologies, encompassing most quantum computing and quantum communication applications, with an exception for quantum sensing intended for commercial uses
• Artificial Intelligence, covering only AI systems that are either designed or intended for certain sensitive end uses (e.g., military, government intelligence, mass-surveillance, cybersecurity applications, digital forensics tools, penetration testing tools, control of robotic systems) or trained using a significant amount of computing power

7. What types of transactions are included within the scope of the OISP?

The OISP applies to a wide range of investment transactions, whether engaged in directly or indirectly by a US person, including:

• Acquisition of an equity interest or contingent equity interest
• Debt financing arrangements that afford board representation or other rights characteristic of an equity investment
• Conversion of a contingent equity interest
• Acquisition, leasing, or other development of operations, land, property, or other assets in a country of concern
• Joint ventures
• Acquisition of a limited partner interest (which are addressed separately from indirect acquisitions of equity interest)

8. What types of transactions are prohibited? Which require a notification?

Whether the OISP requires a notification or prohibits a transaction depends on the type of “covered activities” undertaken by an investment target in specified technology sectors.

A prohibited transaction “poses a particularly acute national security threat because of its potential to significantly advance the military, intelligence, surveillance, or cyber-enabled capabilities” of a country of concern, and includes transactions involving companies engaged in:

• Development or production of advanced semiconductor manufacturing equipment or design software
• Advanced IC design, fabrication, or packaging
• Development, installation, sale, or production of supercomputers or quantum computing items
• Development of AI systems designed exclusively for, or intended to be used for military, government intelligence, or mass-surveillance end uses
• Development of AI systems trained with a large amount of computing power (currently 10²⁵ computational operations, or 10²⁴ computational operations when primarily using biological sequence data)

In contrast, a notifiable transaction involves a covered activity that “may contribute to the threat to the national security of the United States.” These activities include:

• IC design, fabrication, or packaging activities that are not specified under prohibited transactions
• Development of AI systems designed (but not exclusively so) for military, government intelligence, or mass-surveillance end uses (i.e., intended to be used for those end uses and commercial end uses)
• Development of AI systems intended to be used for cybersecurity applications, digital forensics tools, penetration testing tools, or the control of robotic systems
• Development of AI systems trained with a certain lower, but still large, amount of computing power (currently 10²³ computational operations)

9. What types of transactions are excepted from the scope of the OISP?

Specifically excepted from OISP coverage are the following investments, assuming the transaction does not confer upon the investor any rights beyond standard minority shareholder protections:

• Investments in publicly traded securities, index funds, mutual funds, exchange-traded funds, and similar instruments issued by regulated investment companies
• Certain LP investments (as further described in Question 12)
• Investments in derivatives, provided that the derivative confers no rights to acquire equity or any associated rights (including contingent equity interests) in, or any assets of, a covered foreign person

The OISP also excludes:

• Acquisitions of equity or other interests held in an entity by person(s) of a country of concern, provided that (i) all such interests (from all persons of a country of concern) are acquired as part of the transaction and (ii) the entity does not, following the transaction, constitute a covered foreign person
• Transactions between US persons and their controlled foreign entities maintaining covered activities that were engaged in prior to January 2, 2025
• Transactions made pursuant to binding, uncalled capital commitments entered into before January 2, 2025
• Certain investments resulting from lending arrangements (as further described in Question 16)
• Certain employee stock grants

US persons also have the option to request an official determination that the transaction is in the US national interest and should be exempted from the OISP.

10. How does the OISP regulate the activities of natural US persons?

Natural US persons serving as officers, directors, or equivalent are prohibited from “knowingly directing” a transaction by a non-US person that the natural person knows would be prohibited if engaged in by a US person. A natural US person could be within the scope of the OISP if they both (i) have the authority to make or substantially participate in decisions on behalf of a non-US person and (ii) exercise that authority to direct, order, decide upon, or approve a transaction.

A recusal mechanism would allow US persons to continue serving foreign companies that engage in otherwise covered transactions, so long as the US person does not participate in decision-making or approval of the transaction, review or signing of transaction documents, or negotiations with the target company.

Although US citizens and lawful permanent residents are probably aware they are US persons, non-US persons while physically located in the United States will also need to be aware of these limitations.

11. How does the OISP address foreign entities that are owned or controlled by US persons?

The OISP applies to both US persons and their “controlled foreign entities,” i.e., non-US entities of which a US person is a “parent.” A US person is a parent if it (i) holds, directly or indirectly, more than 50% of the voting interest or board voting power in an entity; (ii) acts as the general partner, managing member, or equivalent of an entity; or (iii) with respect to pooled investment funds, acts as the investment adviser.

Controlled foreign entities are subject to the same OISP prohibitions as US persons, and US persons have an obligation to prevent their controlled foreign entities from engaging in transactions that would be prohibited if engaged in by a US person. US-person parents are also responsible for fulfilling any notification requirements that apply to transactions by their controlled foreign entities.

12. How does the OISP affect a US limited partner investment in a non-US fund?

US LP investors in funds can make passive investments that are excepted from the OISP requirements. The OISP will not apply to LP investments for which the LP obtains from the fund a binding, contractual commitment not to use the invested capital (in whatever amount) to engage in a transaction that would be a prohibited or notifiable transaction if engaged in by a US person.

Investments by LPs of $2 million or less are also excepted, even without this contractual commitment.

In either case, the LP investment must be truly passive and not confer upon the LP any rights beyond the six specific minority shareholder protections described in the OISP (which are identical to such protections exempted from the definition of “control” in the regulations of the Committee on Foreign Investment in the United States).

13. My fund invests only in commercial AI companies. Does the OISP concern me?

Yes. Even if your fund invests in purely commercial AI companies, you should consider whether any of your transactions are notifiable “covered transactions.” Commercial AI companies that could trigger a notifiable transaction include those developing an AI system trained using a quantity of computing power greater than 10²³ computational operations; designed for military, government intelligence, or mass-surveillance end uses, but also intended for use by commercial end users; or intended to be used for cybersecurity applications, digital forensics tools, penetration testing tools, or the control of robotic systems, regardless of the end user.

Commercial AI companies are unlikely to fall within the scope of prohibited transactions (assuming that they do not engage in the IC or quantum computing activities described in Question 8) because their products are generally not designed to be used exclusively for military, government intelligence, or mass-surveillance end uses.

14. Could my investment in a US-based company developing AI technologies be subject to the OISP? What about investments in other companies with no direct operations in China?

Yes. For instance, a US person’s investment in a US company that develops a specified AI system could be an OISP-prohibited transaction, depending in part on who owns the target company and/or how it is governed.

Also prohibited by the OISP, for example, could be a US person’s investment in a French company with no direct operations in China but board rights in a Chinese quantum computing company from which the French company derives 55% of its annual revenue.

15. What if I learn after my investment has been made that the target company is a covered foreign person?

If a US person obtains actual knowledge (as distinct from the broader “knowledge,” defined in the OISP) that the transaction that would have been prohibited or notifiable at the time of the investment, the US person must notify the Treasury Department within 30 calendar days of acquiring such actual knowledge.

16. How does the OISP affect lending activity?

The OISP excludes bank lending: neither the issuance of debt financing secured by equity collateral nor the acquisition of such secured debt on the secondary market constitutes a covered transaction. But debt financings that afford an interest in profits, board appointment rights, or financial or governance rights more characteristic of an equity investment may be covered transactions.

Foreclosure on collateral could also be a covered transaction, provided that the US person knew at the time of issuing or acquiring the debt that the pledged equity was in a covered foreign person. The OISP excludes a US person’s receipt of passive equity interest through a lending syndicate.

17. How does the OISP affect joint ventures?

The formation of a joint venture (JV), wherever it is located, could be a covered transaction subject to the OISP if the JV is formed by a US person (directly or indirectly) with a person of a country of concern and the US person knows at the time of its formation that the JV will or plans to engage in a covered activity (see Question 8).

18. What types of due diligence should I undertake to determine whether a transaction is within the scope of the OISP?

Parties to a transaction that is potentially subject to the OISP should be directed by the OISP’s definition of “knowledge,” which means not just actual knowledge, but also awareness of a high probability, or reason to know, of a fact or circumstance. This standard is applied as of the time of the transaction and considers information the US person “had or could have had through a reasonable and diligent inquiry.”

For diligence, this totality-of-the-circumstances test will consider, as applicable to any transaction, the questions asked in the diligence inquiry; the contractual representations or warranties sought or obtained from the target issuer; efforts to obtain and consider available public and non-public information and databases; whether one purposely avoided learning or seeking information; and the presence or absence of warning signs, such as evasive responses or non-responses to questions, requests for contractual representations, or warranties.

19. What information is required in an OISP notification? What are the potential penalties for failing to report a notifiable transaction or engaging in a prohibited transaction?

Notifications must be submitted within 30 calendar days after closing. The notification requires information about the parties; details about the transaction and its terms; description of the covered transaction status (with information about the covered foreign person and its business activities); identification of the covered foreign person’s officers, directors, and management personnel; and post-transaction organizational charts.

The OISP contemplates both civil and criminal penalties. A civil penalty can be imposed up to the greater of the statutory maximum (currently $368,136 and adjusted annually for inflation) or an amount that is twice the value of the transaction that is the basis of the violation. For willful violations, maximum criminal penalties include additional fines of up to $1 million and imprisonment of up to 20 years.

20. What should I be doing between now and January 2, 2025, when the OISP takes effect?

Investors, whether or not they are organized in the United States, should consider whether and how the OISP will affect their activities. For instance, US-person LPs might begin seeking contractual assurances from non-US funds that their investment is free from OISP jurisdiction, meaning those non-US funds will want to consider the due diligence they will undertake to support those contractual assurances. Moreover, natural US persons will want to be sure they are not “knowingly directing” the activities of their non-US company — their employer, companies on whose board they sit, and so on — in a manner captured by the OISP.

******

If you would like additional information about the issues addressed in this client alert, please contact Rich Matheny, Jake Osborn, Justin Pierce or the Goodwin lawyer with whom you typically consult.

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.