Trump’s Election Victory: What Impact Will the US ‘Outbound Order’ Have on China? (Pt. 2 of 3)

The Policy Logic of Restricting Artificial Intelligence Investment in China

Under the general trend of expanding national security regulations mentioned in the previous piece, U.S. lawmakers are increasingly concerned about the potential impact investing in China could have on their economy and national security, and proposals to establish a foreign investment review mechanism are receiving growing bipartisan support. The 118th Congress is considering legislation to strengthen foreign investment review agencies and restrict some U.S. investments in “countries of concern” such as China. These ongoing legislative proposals include:

– The “National Critical Capabilities Defense Act of 2023” (H.R.3136), which would establish a committee to review and regulate/prohibit certain U.S. investments in “countries of concern” involving “national critical capabilities”;

– The “Outbound Investment Transparency Act of 2023” (S.2678), which proposes notifications of certain investments in certain industries; and

– the “Preventing Adversaries from Developing Critical Capabilities Act” (H.R.6349), which would prohibit or require notification of certain activities by U.S. persons in covered sectors in countries of concern and which is expected to codify key aspects of Executive Order 14105.

However, during Congress’ “China Week” last month, the House of Representatives did not pass any relevant bills, which shows that the legislative process still faces many doubts and obstacles, even if some lawmakers in both parties support the new measures. With the legislative agenda on hold, the U.S. Treasury has taken the lead in introducing specific regulatory measures to implement the Outbound Order:

Policy Goals: Containing China’s Independent Innovation

The biggest similarity between the U.S. foreign investment mechanism and its rules on chips is that they both share the same goal, namely that the U.S. should not help China to innovate independently. But as a measure to supplement America’s existing export controls and inbound investment screening tools, the mechanism for restricting outbound investment must face a question of necessity: Can U.S. concerns about its supply chain dominance be addressed through existing structures?

As Inu Manak of the Council on Foreign Relations has said, “The United States has a robust export control regime, and it is not clear that an outbound investment screening mechanism would capture any additional national security concerns that the export control regime cannot address.”

In 2023, the Center for Security and Emerging Technology at Georgetown University’s Walsh School of Foreign Service also released a report, “U.S. Outbound Investment into Chinese AI Companies,” aimed at providing data support for the new U.S. policy.

The report admits that American investors have little influence over China in terms of its AI development, and that regulating outbound investment in China’s AI ecosystem is unlikely to hinder China’s progress in that sector because most of its funding comes from domestic Chinese entities.

Therefore, the implementation of the Outbound Order and its specifics is actually aimed at achieving a secondary goal: collecting and controlling factual information on U.S. companies’ investments in China. That is, the U.S. government needs to identify the major American investors active in the Chinese AI market, as well as Chinese AI companies that benefit from American capital. This is why, in addition to prohibiting certain transactions, part of the Final Rule requires U.S. businesses to provide “notifications” of certain transactions. This information will provide the groundwork for further U.S. measures and related legislation against China.

Regulatory Key Points: Curbing the Transfer of Intangible Benefits

Even though U.S. outbound investment in Chinese AI companies is limited, American legislators and law enforcement officials are more concerned about the “intangible benefits” generated behind the capital, including “enhanced standing, managerial assistance, [access to] investment and talent networks, access to markets, and access to additional financing.” Legislators who support the investment review mechanism argue that these intangible benefits are the real loopholes in export controls.

Under the Final Rule, the penalties for failing to comply with the prohibition or notification requirements are therefore quite severe. In addition to civil liabilities of up to a maximum limit (currently $368,136 adjusted for inflation) or twice the value of the transaction, willful violations of the rule carry criminal liabilities of up to $1 million in fines, up to 20 years in prison, or both.

In addition, the U.S. Treasury does not have an explicit “due diligence safe harbor”; that is, for investment targets or non-U.S. collective investment vehicles, the Final Rule does not clearly explain what level of pre-investment due diligence or contractual protections will meet U.S. individuals’ obligations.

Furthermore, the rule extends to both the applicable entities and to foreign persons subject to the regulations. In other words, U.S. entities must not only ensure that “covered foreign entities” comply with the rules in their investments, but, to avoid engaging in regulated transactions, they must also ensure that their investment due diligence is sufficient to identify enterprises outside China.

In summary, the Final Rule could bring on a “chilling effect,” which could force companies into excessive regulatory overcompliance so as not to get trapped in a web of complexity and ambiguity, or it could even stop them investing in China entirely. This is also an area to which Chinese companies should pay close attention.

Exempt Transactions: Leaving the Country’s Capital Flows and Economic Interests as Unaffected as Possible

However, an overly broad foreign investment review system could create too much uncertainty for the business community, reduce the willingness and ability of American companies to maintain operations in China, and even lead to additional domestic supply chain problems for the U.S., potentially reducing their companies’ competitive advantage. The U.S. Chamber of Commerce has raised similar questions and objections during its legislative process.

As such, the Outbound Order purports to target only a small portion of potential “active” investment in China (totaling less than $10 billion in 2022), thereby avoiding restrictions on large “passive” investments in publicly traded Chinese stocks and bonds. The Final Rule features a number of “excepted transactions”:

– publicly traded securities

– investment in securities issued by any investment company

– certain limited partner investments

– derivatives

– buyouts of country of concern ownership

– intracompany transactions

– pre-Final Rule binding commitments

– certain syndicated debt financings

– certain case-specific exemptions

(Part 2 of 3)