Questions Surround Enforcement of Outbound Investment Restrictions, Former Official Says

The restrictions, outlined in an executive order last week, will lead to new prohibitions or notification requirements for certain U.S. capital investments in China’s semiconductor, quantum and artificial intelligence industries (see 2308090066). Bauerle Danzman, now a senior fellow with the Atlantic Council, said there are questions surrounding how the restrictions will impact investments or other transfers made between two affiliates, such as those made between a U.S. firm and its Chinese subsidiary.

Administration officials said they are primarily seeking to block private equity investments, venture capital investments, joint ventures and other investments accompanied by sensitive technological know-how that would aid China’s military. But when examining investments between affiliates, Bauerle Danzman said the administration will have to ask: “What type of intercompany transfer is really just for status quo, versus what is for a real capital investment?”

Some intercompany investments, for example, may be used to perform maintenance on a “current piece of equipment” or upgrade that equipment, she said. “As equipment needs to be replaced, will that be considered status quo or not?”

“I do have questions about monitoring and enforcement, because I do think that it will be a little bit more complicated than maybe some people” think, Bauerle Danzman said. “I do think that there are some questions about how this actually works in practice.”

Peter Harrell, a former National Security Council official with the Biden administration, said he believes the “conceptual intent” of the U.S.is “to not require notification or any prohibition on what would be sort of routine, ongoing business activities” between a U.S. firm and its Chinese subsidiary. Instead, the U.S. will likely require notifications or prohibit activities that “they would view as a new capital investment in that subsidiary.”

“I think that's the line they're trying to draw with some of this language,” said Harrell, a nonresident fellow with the Carnegie Endowment for International Peace. “They'd allow some money to flow to a subsidiary in China where it’s for operations, but I think that this is not going to create some sort of an exception where a U.S. company can sort of massively plus up.”

Bauerle Danzman said she hopes Treasury provides guidance on this and other topics whenever it releases its final regulations, particularly because the agency doesn’t plan to oversee a case-by-case review process for outbound investments, similar to how the Committee on Foreign Investment in the U.S. reviews inbound investments.

“It is not a reverse CFIUS,” she said. “It would be very helpful to have a lot of illustrative, hypothetical examples to help firms understand and investors understand their notification requirements and prohibitions, because, of course, they're on the first line of enforcement -- of voluntary enforcement -- of the rule.”

Harrell said he expects the restrictions to have significant impacts on the specific technology areas the administration is targeting. He referenced an Aug. 10 Financial Times report, which quoted an anonymous Shanghai-based chip executive who said they were looking at moving some of their operations out of China to avoid the new financing restrictions. “I think that is actually the impact that we are expecting to see,” Harrell said.

He added that China has access to “plenty of capital” but doesn’t have the “deep expertise to deploy that capital in ways that help potentially innovative, young startups or sort of mid-stage companies go to market and come to scale.” Harrell expects to see “a real shift in some of the global early stage investors in high-tech companies."

“For these kinds of select, high-end technologies in China, they're just going to have to look elsewhere,” he said. “So I think we are going to see some real impact on the intended target of this executive order.”

Although the restrictions appear to be narrowly targeted, Harrell also said certain parts of the order are a “tad broader than certain folks might have expected.” He pointed specifically to the notification requirements for investments in China’s quantum sector and chip sector. “On the notification side,” he said, “it looks to me like you're basically not going to be able to invest in the semiconductor sector in China, except maybe in publicly traded securities, without notifying the U.S. government about what you're doing.”

Some lawmakers criticized the administration this week for crafting rules they said were too narrow and don’t restrict a broad enough range of investments in China’s critical technology sectors (see 2308100045). They also said the administration was approaching the rulemaking process too slowly -- it has been consulting allies and industry for months and is accepting public comments for 45 days before it begins to craft its regulations.

“The pessimistic way to look at this is the administration spent a year briefing everyone and consulting on this process really only to start a new consulting clock here,” said Eric Sayers, managing director of Beacon Global Strategies and a nonresident fellow at the American Enterprise Institute. “And it's likely another year before the final rule in this process even comes out.” For “the casual observer, it's hard to understand how impactful this would be,” he said.

But Sayers, a former Senate Armed Services Committee staffer, said he has a more “optimistic take” on the administration’s approach. He said the regime creates a foundation that Congress can build on, adding that CFIUS wasn’t formed “overnight in some perfect form that everyone was happy with.”

“The lead-off batter isn't going to hit a grand slam, right? Maybe they can get a solid single or double,” Sayers said. “And so, if you think of it in those ways, I think that's where we are.”