On December 28, 2020, the US Treasury Department’s Office of Foreign Assets Control (“OFAC”) released guidance on the implementation of sanctions targeting securities of Communist Chinese military companies (“CCMCs”) imposed through Executive Order 13959 (“Order”), which was issued by President Trump on November 12, 2020. The guidance, issued in the form of five Frequently Asked Questions, indicates that OFAC will take an expansive interpretation of the sanctions – particularly with respect to the scope of funds and other securities affected by the Order. As prohibitions will start taking effect from January 11, 2021, funds and other financial services companies dealing in securities that provide any investment exposure to publicly traded securities of CCMCs must act quickly to assess the impact of the Order on their activities.

Background

Our prior OnPoint provides a summary of the scope of the restrictions set forth in the Order. In brief, the Order generally prohibits U.S. persons from investing in any publicly traded securities of CCMCs, any security that is derivative of such publicly traded securities, or any security that is designed to provide investment exposure to such publicly traded securities. The effective date of the new sanctions (“Effective Date”) is January 11, 2021 for publicly traded securities of the 31 CCMCs that were identified by the U.S. Department of Defense as of the issuance of the Order and February 1, 2021 for publicly traded securities of the four additional CCMCs added by the DOD on December 3, 2020.

Analysis

While the guidance from OFAC does not address all of the questions raised by the financial industry regarding the scope of the Order, it provides several important clarifications that will have a dramatic impact on the financial sector:

• Broad Application to Funds and other Instruments that Provide Investment Exposure: One of the key questions following the initial release of the Order was what types of securities would be considered to be “derivative of” or “designed to provide investment exposure to” publicly traded securities of CCMCs. In FAQs 860 and 861, OFAC has taken the position that as of the Effective Date, U.S. persons will be prohibited from investing in securities of any U.S. or foreign fund, including ETFs or mutual funds, that are designed to provide investment exposure to CCMC securities, regardless of such securities’ share of the underlying fund.

• Other captured securities include derivatives (e.g., futures, options, swaps), warrants, American depositary receipts (ADRs), global depositary receipts (GDRs), exchange-traded funds (ETFs), index funds, and mutual funds that provide investment exposure to CCMC securities (to the extent such instruments also meet the definition of “security” set forth in the Order, which is linked to the definition of “security” in the 1934 Exchange Act).
• In a press release, U.S. Secretary of State Michael Pompeo confirmed the broad application of the Order to funds and other securities. He stated that the Order is intended to “allay concerns that U.S. investors might unknowingly support CCMCs via direct, indirect, or other passive investments including those linked to educational, ETFs, venture funds, private equity, Real Estate Investment Trusts, commodities, endowments, pensions, or any other investment funds tracking bonds, loans, lease lines, debt or equity indices that include securities of CCMCs or subsidiaries publicly listed by the U.S. government.”
• This guidance indicates that OFAC considers any security that provides any amount of investment exposure to a publicly traded security to be a security “designed to provide investment exposure to” such CCMC securities within the scope of the Order – even if there are arguments that such funds generally are not “designed” to provide investment exposure to the CCMC securities and that any such exposure is incidental as part of a broader investment objective. As a result, as of the Effective Date, U.S. persons will be prohibited from purchasing new shares of any U.S. or foreign fund that holds any publicly traded securities of a CCMC or any securities that otherwise provide any investment exposure to such CCMC securities. While funds that have exposure to CCMC securities will not be required to divest such holdings prior to the Effective Date, if they do not do so they generally will risk becoming off-limits for new U.S. investment.

 

• Scope of Covered CCMCs: In FAQ 858, OFAC stated that the prohibitions apply to publicly traded securities of an entity “with a name that exactly or closely matches the name of an entity” identified in the CCMC list.
  • To assist in assessing which entities are covered, OFAC has published a new “Non-SDN Communist Chinese Military Companies List” that provides identifying information for targeted CCMCs. The list identifies the 35 currently-named CCMCs and also provides aliases and issuer names connected to such entities.
  • For certain CCMCs, the OFAC list identifies specific publicly traded equity securities of certain CCMCs (all of which are traded on the Shanghai or Hong Kong stock exchanges). OFAC notes, however, that “other securities, including debt securities, issued by identified issuers are also subject to prohibitions.” The OFAC list therefore should not be considered an exhaustive list of all sanctioned publicly traded CCMC securities, and any publicly traded security issued by an entity named in any column of the OFAC list should be considered within scope.
• Application to Subsidiaries or Controlled Affiliates of CCMCs: In FAQ 857, OFAC confirmed that prohibitions on CCMC securities do not apply to securities of subsidiaries unless and until the subsidiary is publicly listed (ostensibly by being added to the “Non-SDN Communist Chinese Military Companies List”). Prohibitions on publicly traded securities of the newly listed subsidiary or affiliate will then take effect 60 days after the subsidiary is listed.
  • Importantly, OFAC intends to publicly list as subsidiaries any entity that issues publicly traded securities and that is: (i) 50 percent or more owned by one or more CCMCs; or (2) otherwise determined to be controlled by a CCMC. This means that while subsidiaries of CCMCs are not currently captured, OFAC intends to expand the list to capture majority-owned or otherwise controlled subsidiaries (though it is unclear when such additions will occur).
  • We note that on December 8, 2020, the U.S. State Department issued a fact sheet that identified more than 150 entities determined to be subsidiaries or affiliates of the 35 CCMCs. While these subsidiaries and affiliates are not currently subject to any restrictions unless and until publicly listed by OFAC, the State Department list demonstrates the large number of entities that could be targeted by the Order in the future.
• “Publicly Traded” Securities: In FAQ 859, OFAC stated that it intends to interpret the term “publicly traded securities” to include “securities” denominated in any currency that trade on a securities exchange or “over-the-counter” in any jurisdiction. This confirms that restrictions apply not only to securities traded on U.S. exchanges (which would have had a narrow effect) but also to those traded on any global exchange or OTC market.

Conclusion

It is possible that OFAC might issue additional guidance on other areas of the Order that arguably remain unclear, such as the appropriate treatment of dividend/interest payments linked to CCMC securities or to what extent U.S. persons (including U.S. custodians, broker-dealers, and other intermediaries) can be involved in actions of non-U.S. persons dealing in CCMC securities. The guidance provided to date, however, will result in significant compliance burdens for many funds and financial services companies – any fund or other security that provides any investment exposure to CCMC publicly traded securities, no matter how minimal, is captured by the sanctions. As the prohibitions will take effect as early as January 11, 2021, companies must act quickly to assess their exposure and consider appropriate actions to comply with the Order.