Clarity needed to implement Biden's China order, industry says

The Treasury Department has started the rule-making process to implement an executive order curbing investments in certain Chinese technology sectors, but industry players say the department must clarify the nuances of the rule.

President Joe Biden issued an executive order on Aug. 9, preventing new private equity, venture capital and joint venture investments, among others, in Chinese companies involved in the semiconductors and microelectronics, quantum information technologies and artificial intelligence sectors.

The order applies to U.S. persons, which a Treasury fact sheet defines as individual citizens, lawful permanent residents, U.S. businesses or U.S. units of offshore businesses. It also requires such individuals and groups to notify the Treasury Department of certain investments in those sectors.

U.S. businesses would include money managers, but the details remain unclear until the rule comes out.

The executive order directs the Treasury to issue a rule-making implementing the order, so the department issued an advance notice of proposed rule-making on Aug. 9. Comments relating to that rule-making were accepted until Sept. 28

Industry groups and lawyers say they want more clarity on how the rule applies to a U.S. person working for an offshore business and how to differentiate between activities that are prohibited or that the government must be notified of, among other concerns.

"What's interesting about this rule-making is it exists at all," said Adam M. Smith, partner at law firm Gibson, Dunn & Crutcher and co-chair of its international trade practice group.

"What I mean by that is that it's very rare for Treasury authorities promulgated under IEEPA, (or the) International Emergency Economic Powers Act ... to have a rule-making. In almost all cases, a rule-making is exempt because of the national security issue," he said. Smith explained that when a new regulation deals with national security issues, it often bypasses the typical rule-making process, which includes a need for a public comment period.

The International Emergency Economic Powers Act gives the president a variety of powers to control financial transactions when there is a national emergency. In his executive order, the president declared a national emergency to deal with the threat posed by the "advancement by countries of concern in sensitive technologies and products critical for the military, intelligence, surveillance, or cyber-enabled capabilities of such countries."

The only "countries of concern" listed in the order are China and the special administrative regions of Hong Kong and Macau.

One of the general concerns is how the rule will define the investments covered "in a way that is both clear, so you actually know what the red flags look like and what you can't do, and yet does not risk collateral consequences that are significant to not just the U.S., but our allies and partners around the world who rely upon China," Smith added.

The U.S. Chamber of Commerce wrote in a comment letter that "it is imperative that the implementing regulations are narrowly tailored to target specific national security concerns in a transparent, efficient, and predictable manner. The rules should be clear so that businesses can make appropriate plans for compliance."

One of the uncertainties of the rule is how it will apply to a U.S. person when that person is working for a foreign entity, especially a foreign investment fund, according to Janet Kim, partner at law firm Baker & McKenzie.

"Right now, the dividing line seems to be if there's a U.S. person that sort of drives decision-making (at an investment fund offshore), that's caught by this regime," Kim said. "But if it's a U.S. person who's just … helping with the implementation or the execution of a decision after it's (made), they're probably not going to be caught by this regime."

Ultimately, the Treasury needs to provide more clarity on that, Kim said. In a comment letter, the Securities Industry and Financial Markets Association asked for the same.

The final rule should clarify that U.S. persons knowingly directing the actions of a non-U.S. entity "refers only to the situation in which a U.S. person has the authority to make decisions on behalf of the non-U.S. entity … and exercises that authority with respect to the transaction in question," SIFMA President and CEO Kenneth E. Bentsen Jr. wrote in the letter.

While it's unclear how the rule-making will address this, Smith said it's a reasonable concern, and "one that I think will need to be sorted out in the context of whatever final rule comes out." He added that there might be more clarity in the FAQs issued alongside the rule-making, which are a typical feature of IEEPA-based regulations.

According to Baker & McKenzie's Kim, there are some investments that are flat out prohibited by the rule-making, while others are subject to a "notification," meaning these must be disclosed to the Treasury.

But if those are mixed up, "the stakes are really, really quite high," Kim said.

"(With the way) it's currently structured, you just have to make the right determination as to whether you've got something that's prohibited, you have something that's just subject to notification, or you have something that's just not a concern," she added.

"That's a very real practical challenge that some companies are worried about," Kim said.

If things do get mixed up, there's also concern about what the penalties will look like, according to Kim. While the Treasury has signaled it will likely issue civil and criminal monetary penalties, some companies worry they might be required to divest, she said.

Ultimately, once the rule goes into effect, some wonder "what happens next," like if the rule will expand the scope of the sectors it restricts or if the rule will start evaluating investments on a case-by-case basis, Smith said.

Congress could also take action through a simple codification of the executive order or through further legislation, he added.

"I think it's still likely there'll be more legislation," Smith said, as concerns over China are "fairly bipartisan."

As Kim pointed out, there is already "proposed legislation that would go farther than what this proposed regime will do."

In early August, a Republican group of lawmakers reintroduced a bill in the House and Senate that would require public pension plans and endowments to divest all their investments in Chinese companies or lose their tax-exempt status.

One of those bill sponsors — Rep. Mike Gallagher, R-Wis., chairman of the House Select Committee on the Chinese Communist Party — also sent a letter to the president on Aug. 3, urging him to restrict both public and private investments in China, among other requests.

For now, in light of the proposed rule-making, "the inclination (for investment funds) seems to be (for) anything that's sort of China-specific, that might touch on these spaces, they'll just exclude U.S. investors from (them) to reduce their exposure," Kim said.

But according to Smith, the order itself won't cause a chilling effect.

"There's a whole host of other export controls, sanctions, tariffs, that are still sort of being laid and could still be further laid on China," he said, and investor sentiment on the country had already been starting to cool prior to the executive order.

"This (rule-making) would just add to that — not necessarily create new avenues for (it)," Smith added.