The August 9 Executive Order aims to restrict certain U.S. investments in key technology areas, including semiconductors and microelectronics, quantum information technologies, and artificial intelligence (AI) systems. The order directs the U.S. Department of the Treasury to issue regulations prohibiting and requiring notifications for U.S. investments in these technologies. As a result of this EO, Treasury is considering an outbound investment program and laid out the initial framework in an Advance Notice of Proposed Rulemaking (ANPRM). 

In a previous post, we proposed a list-based end-user approach to craft an AI investment prohibition that leverages existing entity-based tools. In this post, we rely on existing transactions to test scenarios where such U.S. investment in China’s AI ecosystem would or would not be covered under the proposed program and discuss additional questions that need further clarification.

Key Definitions in Treasury’s ANPRM

The ANPRM defines key terms and parameters under consideration:

• “Person of a Country of Concern” is (1) not a U.S. citizen or lawful permanent resident of the United States and is a citizen or permanent resident of the People’s Republic of China (PRC), (2) any entity incorporated in or with a principal place of business in the PRC, (3) any PRC government entity, (4) or a subsidiary (defined as 50 percent ownership) of any of the aforementioned entities.
  • Examples: a PRC national, Huawei Technologies, Chinese state-owned enterprise Aviation Industry Corporation of China (AVIC), or a subsidiary of AVIC
• “Covered Foreign Person” is (1) a person of a country of concern and (2) a person whose direct or indirect subsidiaries or branches are referenced in item (1) and which, individually or in the aggregate, comprise more than 50 percent of that person’s consolidated revenue, net income, capital expenditure, or operating expenses who engaged in an activity in covered national security technology as shown below.
  • Examples:
    • A PRC national who works at an AI company that incorporates systems for military uses.
    • A PRC parent company that owns an AI company engaging in AI systems for military purposes that accounts for greater than 50 percent of the parent company’s consolidated revenue, net income, capital expenditure, or operating expenses.
    • A third-country parent company that draws 50 percent of its revenue from a China-based subsidiary engaged in AI systems for military uses.
•  “Covered National Security Technologies” are those that are used “exclusively” or “primarily” for military, government intelligence, or mass surveillance end uses.
  • Definition: The proposed definition of AI is “an engineered or machine-based system that can, for a given set of objectives, generate outputs such as predictions, recommendations, or decisions influencing real or virtual environments.”

• “U.S. Person” is any United States citizen, lawful permanent resident, entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branches of any such entity, and any person in the United States.
  • Examples: a U.S. citizen, Vertex Ventures, or Vertex Ventures’ Chinese subsidiary
• “Covered Transaction” refers to a U.S. person’s direct or indirect acquisition of equity in, provision of debt financing to, or joint ventures with a Covered Foreign Person. Specific cases are discussed in the following section.

AI Investment Scenario Testing

Our February 2023 report discusses a number of venture capital and private equity transactions that may have national security implications. Below we use a number of real and hypothetical transactions to test whether they would or would not have been covered by the proposed regulatory framework. While Treasury’s rules are not applied retroactively, these past transactions can shed light on the initial framework under consideration.

Case Study #1: U.S. investment in 4Paradigm is likely prohibited.

U.S. investment in a company like 4Paradigm, a Chinese AI company that was contracted by the PLA in 2020, would likely be captured and, thus, prohibited by Treasury’s proposed program.

• Covered Transaction: Cisco invested in a Series C in 2020 and, as of September 2023, still lists 4Paradigm as one of its portfolio companies. In 2021, Goldman Sachs, along with 14 other investors, provided 4Paradigm with $700 million in a Series D funding round, which was reportedly the largest VC investment in an AI startup in that year.
• U.S. Person(s): Cisco and Goldman Sachs
• Person of a Country of Concern: 4Paradigm
• Covered Foreign Person: 4Paradigm was contracted by the People’s Liberation Army (PLA) in 2020.

Outstanding Challenges

• Due diligence: U.S. investors would need to do prudent due diligence to determine whether a potential portfolio company is contracted to supply to Chinese military entities. Not only would investors have to identify the potential portfolio company’s past contract history with Chinese military actors, but they would also have to try to ensure that the company would not partake in the PLA’s procurement processes in the future.
• Distinguishing between “military” and “civilian” AI: In the previous post, we noted the difficulties in drawing a distinction between military and civilian AI systems and determining the primary or exclusive use of AI for a military or commercial environment. We proposed a list-based approach that focuses on end users. If Treasury seeks to capture transactions made by U.S. persons in Chinese AI companies that have connections to military end-users, then transactions involving 4Paradigm may be covered. However, we do also acknowledge the difficulties associated with an end user-based program, particularly in China, where the government has worked to blur the lines between military and civilian entities.

Case Study #2: U.S. investment in 7Invensun is likely prohibited.

Unlike 4Paradigm, it is less clear whether U.S. investment in Chinese eye-tracking company 7Invensun would be considered for prohibition. 7Invensun has not, to our knowledge, won any contract to supply the PLA. However, we did find evidence of the firm co-publishing AI research with known Chinese military firms. These various collaborations could (or have already) contributed to the PLA’s AI R&D, and as such, if similar transactions were to occur after the establishment of Treasury’s outbound investment program, we believe they would be prohibited.

• Covered Transaction: Qualcomm made a venture capital investment in 7Invensun in 2016.
• U.S. Person: Qualcomm
• Person of a Country of Concern: 7Invensun
• Covered Foreign Person: 7Invensun has co-published research with the PLA’s Air Force Aviation University on technology for tracking eye movement during pilot training tasks, as well as with China’s Academy of Launch Vehicle Technology (CALT) on research pertaining to improving visual technology for astronauts.

Outstanding Challenges

• Indicators of military vs. civilian AI systems: Tracking companies’ contracts with the PLA is only one avenue to locate military end-users of their AI systems, and thanks to Xi Jinping’s efforts to bolster and reform China’s military-civil fusion strategy, there are likely many more companies that support PLA efforts without ever contracting directly with the military. When conducting due diligence before deciding to invest in Chinese AI companies, U.S. investors will need to expand their investigation beyond contract relationships.

Case Study #3: Sequoia Capital China’s investments in 4Paradigm and Yitu Technologies are likely prohibited.

Treasury is attempting to close potential loopholes by building a program that captures transactions involving subsidiaries (defined as 50% or more ownership) of U.S. Persons and Covered Foreign Persons. As it stands now, Sequoia Capital’s Chinese subsidiary would likely be captured as a “U.S. Person,” and its investments in 4Paradigm and Yitu Technologies would be prohibited under Treasury’s proposed rules.

• Covered Transaction: Sequoia Capital China funded 4Paradigm in multiple funding rounds between 2015 and 2021 and Yitu Technologies in 2015 and 2017. 
• U.S. Person: Before the corporation split, Sequoia Capital China was considered a subsidiary of Sequoia Capital headquartered in Menlo Park. 
• Person of a Country of Concern: 4Paradigm and Yitu Technologies
• Covered Foreign Person: 4Paradigm and Yitu Technologies are part of China’s military-industrial complex or complicit in surveillance regimes against ethnic minority groups.

Outstanding Challenges

• U.S. Person subsidiaries splitting off: In July 2023, Sequoia Capital announced plans to split up its American, Chinese, and Indian businesses, claiming that by March 2024, the companies will no longer share investors or returns. Other U.S. investors have since followed suit. Although it’s early to tell, this development may make it more difficult for Treasury’s proposed program to capture the activities of affiliates or spin-offs of U.S. companies.

Case Study #4: U.S. investment in Horizon Robotics is likely subject to a notification requirement.

Given the dual-use nature of AI, some companies that develop such AI systems sit in the gray zone between military and civilian realms. U.S. investments in companies like Horizon Robotics, an AI chip developer for autonomous vehicles (AV), are likely to be subject to a notification regime, particularly if there is no hard evidence that the company itself has collaborated with the military-industrial complex in China.

• Covered Transaction: Horizon Robotics has received investment from multiple U.S. investors across several funding rounds (each funding round with each unique investor would be a unique covered transaction):
  • Sequoia Capital and GSR Ventures provided seed funding in 2015 
  • Vertex Ventures (along with its Chinese subsidiary) invested in 2016 in Series A, followed by Intel Capital in 2017
• U.S. Person(s): Sequoia China, GSR Ventures, Vertex Ventures, Vertex Ventures China, and Intel Capital
• Person of a Country of Concern: Horizon Robotics
• Covered Foreign Person: Horizon Robotics develops AI chips, AV, and robotics that may or may not have military uses. Horizon Robotics’ direct connection to Chinese military entities is unclear.

Hypothetical Scenarios and Outstanding Questions

While the ANPRM offers key definitions and proposed scoping of covered investments, several areas require further clarification. Unlike the examples illustrated above, the cases below involve hypothetical situations where we believe Treasury and the interagency should provide additional explanation.

Hypothetical Case Study #1: U.S. investment in Alibaba, a parent company of Alibaba Cloud, is likely prohibited.

Another loophole the Department seeks to close concerns transactions between “U.S. Person” and the parent company of “Covered Foreign Person.” This would mean capturing U.S. investments in Chinese conglomerates with subsidiaries that engage in the development of covered technologies. While Alibaba operates ecommerce, retail, and internet businesses, its division Alibaba Cloud works on AI systems like the AI image generation model Tongyi Wanxiang. Imagine a situation where a U.S. Person wants to invest in Alibaba.

• Covered Transaction: U.S.-headquartered investor provides post-IPO debt financing to Alibaba
• U.S. Person(s): U.S. investor 
• Person of a Country of Concern: Alibaba Cloud
• Covered Foreign Person: Alibaba would be considered a “Covered Foreign Person” only if Alibaba Cloud comprises more than 50 percent of Alibaba’s consolidated revenue, net income, capital expenditures, or operating expenses. Alibaba is reportedly complicit in China’s surveillance regimes.

Outstanding Questions

• The 50 percent revenue rule: Alibaba Cloud’s revenue for the first quarter of 2023 was 18.6 billion RMB ($2.55 billion), which accounts for only 9 percent of Alibaba’s total revenue during the same period. As such, this transaction would not be covered under the current drafting. The proposed 50 percent revenue rule also may not capture the value of Alibaba Cloud’s AI products that are directly incorporated into Alibaba’s existing products and services. Even if Alibaba develops the technologies used for mass surveillance, under the current definition in Treasury’s ANPRM, U.S. investment in this conglomerate would not be covered. 
• Intangible benefits: Conglomerates are often publicly traded, and the types of funding they typically receive include debt financing or post-IPO equity. Alibaba has not received any private investment from U.S. investors since it went public in 2014. But U.S. investors GGV Capital and Glade Brook Capital Partners both invested in Alibaba Group before it was publicly listed. Any intangible benefits that the Biden administration wants to capture might not accompany any debt financial equity investment.

Hypothetical Case Study #2: U.S. investment in Dahaua’s subsidiary in Singapore is likely prohibited.

Imagine a scenario where a U.S. investor funds a Singapore-based company that is majority-owned by Dahua, a Chinese company that the U.S. government has confirmed is complicit in China’s mass surveillance regime. This type of transaction would likely be prohibited by Treasury’s proposed program.

• Covered Transaction: In a hypothetical scenario, BlackRock invests in Dahua’s subsidiary in Singapore in a private equity round.
• U.S. Person: U.S. investor
• Person of a Country of Concern: Dahua Technology Singapore Pte. Ltd. is a Singapore-based subsidiary of Chinese AI surveillance company Dahua.
• Covered Foreign Person: While parent company Dahua is part of China’s mass surveillance efforts against the minority population, it is unclear whether its subsidiary in Singapore develops any AI systems that contribute to China’s surveillance regime.

Outstanding Questions

• Extraterritorial effect: In an effort to prevent potential evasion that involves third-party countries, Treasury may risk overextending its jurisdiction to cover transactions that may not be of national security concern. In this case, Singapore-based Dahua may not be engaged in Treasury’s definition of covered national security technologies. In response to the ANPRM, we recommend a two-part test to reduce the likelihood of jurisdictional overreach.

Hypothetical Case Study #3: U.S. indirect investment in Hikvision is likely prohibited.

To prevent any circumvention of the EO’s prohibitions, Treasury is considering capturing such indirect investments that might occur via funds transfers managed by U.S. persons through a third country. Although Treasury has tried to outline a path to capturing these cases, they are difficult to assess, as the intermediary third-party entity does not fit neatly into any of the proposed definitions.

• Covered Transaction: In a hypothetical case, a U.S. investor invests in India-headquartered BankBazaar, which then uses the fund to invest in Hikvision, a Chinese company that the U.S. government has confirmed is complicit in China’s mass surveillance regime.
• U.S. Person: U.S. investor 
• Person of a Country of Concern: Hikvision
• Covered Foreign Person: Hikvision’s participation in China’s mass surveillance regime.

Outstanding Questions

Treasury is considering defining indirect investments to “include, but would not be limited to, a U.S. person knowingly investing in a third-country entity that will use the investment to undertake a transaction with a covered foreign person that would be subject to the program if engaged in by a U.S. person directly.”

• Indirect investment: Under this definition, it is unclear whether this hypothetical U.S. investment in India-based BankBazaar triggers a blanket restriction on BankBazaar’s investment in Chinese AI companies that engage in covered national security AI. We assume that there would need to be evidence of intent on the part of the U.S. investor to use the intermediary in question to access prohibited parts of the Chinese ecosystem; however, we believe that this requires further clarification from Treasury, as it has the potential to both overcapture and undercapture transactions, depending on how it is enforced. 

Conclusion

In this follow-on post, we rely on existing and hypothetical transactions to test scenarios where U.S. investments in China’s AI ecosystem would or would not be covered under the Treasury’s proposed program. The cases examined in this post, albeit not be affected retroactively, help surface some key outstanding questions that we believe Treasury will need to clarify in order to live up to the intent of the August 9th EO. Carefully craft the regulatory framework is key to achieving the key objectives and reducing unintended consequences that can hinder U.S. competitiveness.