On July 25, 2023, the Senate overwhelmingly approved a measure to add mandatory notifications of certain investments in China to the National Defense Authorization Act (“NDAA”). The Outbound Investment Transparency Act, authored by Senators John Cornyn (R-TX) and Bob Casey (D-PA), would require U.S. companies to notify the government of investments in certain Chinese sectors, but does not allow for blanket investment bans. Last year, a more expansive version of the bill[i] that would have established an interagency process for reviewing investments in China involving critical supply chains and specific critical and emerging technologies sectors was ultimately dropped from the CHIPS and Science Act[ii].
The amendment, which passed by a 91-6 vote, would require notification to the U.S. Department of the Treasury of investments in countries of concern – understood to include China – in national critical capabilities, defined to include semiconductors, microelectronics, large capacity batteries with dual use applications, quantum, artificial intelligence, satellite-based communications, hypersonics, network laser scanning systems with dual use applications, and any other export controlled technology. Notably, not only does the amendment require notification of equity investments, but also requires notification of the establishment of subsidiaries and joint ventures in China for the purpose of production, design, testing, manufacturing, fabrication, or research involving one or more national critical capabilities sectors.
U.S. companies that plan to engage in a covered activity would have to submit to the Secretary of the Treasury a complete written notification of the activity not later than 14 days before the anticipated completion date of the activity. Though styled as an information collecting mechanism, the bill allows for referral to the Attorney General of any activity that potentially should be prohibited, and requires a process to be established for the identification of non-notified transactions.
The Senate version of the NDAA will need to be reconciled with the House version that passed earlier in July and does not include investment notifications.
Heightened Scrutiny of Investments in China
Apart from mandatory notifications, due to the U.S.-China political climate, investors could also find themselves under more immediate scrutiny regarding existing investments in China. On July 19, the House Select Committee on the Chinese Communist Party sent letters to four venture capital firms – GGV Capital, GSR Ventures, Qualcomm Ventures, and Walden International – demanding information about the firms’ investments in Chinese AI, semiconductor, and quantum companies.
Moreover, escalating geopolitical tensions between the United States and China have placed multinational companies in the crosshairs of dueling trade and national security controls, resulting in competing tariffs and the weaponization of export controls, all of which can affect the valuation of investments.
Anticipated Executive Order on Outbound Investment
The White House is expected to issue an executive order establishing some form of outbound investment rules in the next few weeks. While the contours remain to be seen, it’s expected that the executive order will provide the Executive Branch the authority to review and potentially prohibit U.S. investments in China’s quantum computing sector and other critical technology sectors such as advanced semiconductor sectors and artificial intelligence.
Inbound Chinese investment in U.S. companies has long been subject to heightened scrutiny by the interagency Committee on Foreign Investment in the United States (“CFIUS”), resulting in forced divestiture or the abandonment of transactions. The recent expansion of its authorities that allow CFIUS to exert jurisdiction over certain minority investments underscores the necessity of a rigorous review and CFIUS analysis of any injection of Chinese capital into U.S. businesses, particularly critical infrastructure and critical technology ones. The same may soon hold true for outbound investment, including the establishment of joint ventures, in China.
While ultimately not included in the final text, the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”), the 2018 legislation that modernized CFIUS, initially included outbound investment provisions, listing joint ventures and licensing agreements as covered transactions subject to review. Since then, support for national security reviews of outbound investments, particularly U.S. investments in China, has steadily gained momentum in both Congress and the Executive Branch. The omnibus spending bill signed in December 2022 provides the U.S. Departments of the Treasury and Commerce with $10 million dollars each to consider establishing “a program to address the national security threats emanating from outbound investments from the United States in certain sectors that are critical for U.S. national security.” The bill also directed the two agencies to submit reports describing such a program and identifying the resources that would be required to establish and implement it.
At times likened to a “reverse CFIUS,” discussions surrounding outbound investment reviews have ranged from notification requirements of investments in China such as those set forth in the Outbound Investment Transparency Act to the establishment of a committee that would review – and potentially prohibit – outbound transactions for “unacceptable risks” to national security and national critical capabilities when the outbound transaction relates to a critical capability or supply chain and involve China.
While much uncertainty remains surrounding the executive order, the government will have to clearly define (1) who is subject to the screening requirements, (2) what types of investments are covered, (3) whether reviews would be retroactive to include all covered investments (which would present obvious challenges), and (4) the scope of the reviews (e.g., would it merely be a requirement to notify a committee of investments in certain industries or a designated list of companies moving forward, or would the committee have the authority to prohibit those investments).
China’s Strategy and Reaction?
While China’s reaction to these developments remains to be seen, China has been engaging in a “charm offensive” to court private equity and technology-intensive investors back to China. Concerned with the faltering economy and a retreat from China by global private equity investors, the China Securities Regulatory Commission reportedly met with more than 30 investor groups on July 21, 2023, to discuss ways to encourage investment back to China. This follows a forum held in Tianjin, China where Premier Li Qiang reportedly sought warmer relations for foreign business executives in an attempt to curb corporate de-risking and de-coupling from China. China faces a challenge in satisfying its own “hawks” eager to engage in aggressive “wolf warrior diplomacy” to respond to U.S. action while at the same time responding to other government officials who are concerned about the loss of business and tax revenue resulting from investor and corporate departures from China.
The 91-6 vote indicates renewed enthusiasm for scrutiny of U.S. investment in China, and should put U.S. companies and investors with exposure to China on alert for additional measures, including any prohibitions set forth in the much anticipated executive order. In the meantime, U.S. companies and investors can take preliminary action in anticipation of mandatory notifications and potential restrictions on investments and activities in China.
- Understand Your China Law Risk Exposure: With the development and use of the new Chinese legal regimes, U.S. and multinational companies with operations in China should assess their risks and exposure to potential violations of Chinese law, as well as any aggravating factors (g., activities related to compliance with the Uyghur Forced Labor Protection Act (“UFLPA”), U.S. export controls, or involving Taiwan), since there is little precedent and some legal regimes can be quite broad with limited checks provided by local administrative law.
- Assess Exposure to Potential Outbound Investment Restrictions: Investment firms should examine their holdings for investments in China, with a particular focus on investments in artificial intelligence, quantum, and semiconductors, and be prepared to notify U.S. government of those investments. Companies considering greenfield investments, or the establishment of subsidiaries or joint ventures in China related to national critical capabilities should also consider the impact of mandatory filing requirements.
- Be Prepared for Scrutiny of Those Investments: Investment firms should also take notice of the letters recently issued to U.S. venture capital firms by the House Select Committee on China, and create a plan for responding to a similar letter. We also recommend that investment firms engage in geopolitical-focused reviews before making any future investments with a nexus to China, particularly those Chinese-owned or -controlled tech companies involved in artificial intelligence, semiconductors, or quantum. Given the rapidly evolving developments related to national security and trade controls and China, such a process could help identify information relevant to a firm’s assessment of the legal, commercial, and reputational risks associated with a potential investment. Companies might also consider engaging in preemptive scenario planning to determine what actions it might take were any of the trade and national security restrictions applied to any of its portfolio companies.
- Evaluate Exit Strategy: Review and consider limited partner agreements and credit facilities to identify any provisions that could be triggered in the event that a portfolio company is designated on any restricted party lists, including the Specially Designated Nationals and Blocked Persons List (the “SDN List”), the Chinese Military Industrial Complex Companies List (“CMIC List”), or the Department of Commerce’s Entity List. Also, consider amending clauses in these agreements to limit the effects were a portfolio company added to a sanctions or export restricted list, and include contractual provisions that would facilitate an exit if it becomes legally or functionally required to do so in any future agreements.
[i] National Critical Capabilities Defense Act of 2021, S. 1854, 117thCong. (2021).
[ii] CHIPS and Science Act, Pub. L. 117-167, 136 Stat. 1366.