The new Executive Order (EO or the Order) bans transactions by US persons in publicly traded securities of companies identified as “Chinese military companies,” and includes a ban on trading in derivatives of those securities and any securities designed to “provide investment exposure” to such securities, thereby capturing Exchange Traded Funds and arguably extending to funds that rely on those companies’ securities in any manner. The EO provides an 11-month wind down for divestiture of covered securities and positions.
On November 12, 2020, President Donald Trump took further action in the ongoing whole of government approach to dealing with the national security threats the administration has identified arising from China’s “Military-Civil Fusion.” Invoking the authority of the International Emergency Economic Powers Act, 50 U.S.C. § 1701 et seq. (IEEPA), the EO declares a national emergency with respect to the ability of those companies to continue to tap into the US capital markets as a source of funding for China’s “development and modernization of its military.” The EO prohibits “any transaction in publicly traded securities, or any securities that are derivative of or are designed to provide investment exposure to” securities, of any “Communist Chinese military company” – a defined term both in the EO and in the laws upon which it rests to identify those entities.
The Order goes well beyond prohibiting direct trades of those securities. Anticipating questions that have arisen in other sanctions programs aimed at limiting securities, the EO impacts trades in derivatives and potentially even in index funds that simply rely on those securities. Assuming that the Office of Foreign Assets Control (OFAC), which will likely implement the Order, interprets its scope consistent with prior orders and guidance, the implications for the identified companies are significant, as it could require their removal from numerous indexes, ETFs, and other derivative markets and funds. Even if multiple agencies implement various portions of the Order, these broad restrictions remain, and there is no reason to believe a narrower scope will be implemented.
The EO prohibits the establishment of any position after January 11, 2021, and requires the divestiture of any position, properly established before January 11, by November 11, 2021. While not articulated, this lengthy wind down allows for:
- An orderly transition of the numerous funds and indexes impacted;
- The addition of more entities to the list as the US national security apparatus identifies more Chinese public companies it believes are tied to the Chinese military-civil fusion effort; and
- For potential changes in policy, whether pursuant to a new administration or otherwise.
The EO rests upon the assertion that the People’s Republic of China (PRC) is “increasingly exploiting United States capital to resource and to enable the development and modernization of its military, intelligence, and other security apparatuses, which continues to allow the PRC to directly threaten the United States homeland and United States forces overseas.” By requiring US persons to divest and avoid further investment in these entities, the EO seeks to effectively curtail their access to the international capital markets. According to the EO, this will prevent and limit the PRC’s development and deployment of weapons of mass destruction, advanced conventional weapons and cyberattacks against the United States and its citizens.
The Order, while broad, is not surprising and reflects the continued efforts by the Trump administration to address long-unattended concerns over what China’s policy of military-civil fusion, which concerns were raised more than a decade ago. This EO also follows the recent discussion in US national security and financial policy circles about the possibility of delisting Chinese companies that do not follow US accounting disclosure standards and further, it is aligned with the Department of Justice’s China Initiative.
WHO ARE COMMUNIST CHINESE MILITARY COMPANIES?
The EO expressly identifies the scope of the term, “Communist Chinese military companies.” Section 4 of the EO indicates that the following entities are included in this definition:
- Any entity that the US Secretary of Defense, separately or in consultation with other agencies, identifies as a Communist Chinese military company operating directly or indirectly in the United States or its territories under Section 1237 of the Strom Thurmond National Defense Authorization Act for Fiscal Year 1999 (the 1999 NDAA), Section 1233 of the Floyd D. Spence National Defense Authorization Act, or Section 1222 of the Ronald W. Reagan National Defense Authorization Act for Fiscal Year 2005 (the 2005 NDAA);
- Any person that the Secretary of the Treasury publicly lists as satisfying Section 1237(b)(4)(B) of the 1999 NDAA; or
- Any subsidiary that Treasury publicly lists of a person already identified as a Communist Chinese military company.
The current list of Communist Chinese military companies identified under these acts already numbers more than 30, including a number of publicly traded entities. Several entities are widely traded and are included in numerous ETFs and other indexes. The immediate impact within financial markets appears muted, but that impact may grow as the initial deadline approaches in early January. Alternatively, there may be those anticipating a reversal based on potential changes in a new administration.
BROAD PROHIBITIONS AND ANTICIPATED IMPACT
The Order appears designed to impact not just direct trades in the securities of the identified companies. Prohibiting “any transaction” by US persons, and including in that prohibition actions relating to any securities that are derivative of, means the EO will result in investment exposure for holders of the securities of any Communist Chinese military company. Clearly, the EO is designed to stifle indirect trading in these securities as well as direct trades. Although coverage of derivatives is not new in the sanctions realm (See OFAC FAQs XX and YY), the language in the EO appears designed to cast a wider net even than derivatives and ETFs that include them, and appears designed to capture index funds such as the S&P 500 index funds or Nasdaq 100 index funds.
Interestingly, the Order exempts “[a]ny purchases for value or sales made” during the wind down period – on or before 11:59 pm EST on November 11, 2021 – so long as those transactions are made “solely to divest from” covered securities held as of 9:30 am EST on January 11, 2021. Not only does this provision provide US individuals and entities sufficient time to divest securities held in Communist Chinese military companies, including equity and debt securities, derivatives, swaps, futures, and similar contracts for such securities, it also provides ample time for US investors to reposition themselves, to the extent that they may be required to pull out of funds or indices that track such securities or that otherwise involve trading in securities of Communist Chinese military companies. The “for value” condition appears designed to address the short closeout issue that has frequently arisen when securities, most notably debt, have been subject to sanctions.
The EO also provides a 60-day implementation/wind down for transactions in publicly traded securities, derivatives, etc. of any Communist Chinese military company added to the current list after January 11, 2021. Once an entity is added going forward, there is a one-year wind down period during which divestitures can occur, provided that the initial purchase occurred before the end of the 60-day grace period. This provides US individuals and entities up to one year from the date that a company is designated to divest the securities of Communist Chinese military companies or derivatives thereof or exit from funds that track or involve such securities.
DEFINITION OF SECURITIES
The EO defines “security” or “securities” more broadly than the definition found in the Securities Exchange Act of 1934, as amended (the Securities Exchange Act). Thus, the EO includes not only the definition found in the Securities Exchange Act, 15 U.S.C. § 78c(a)(10), but it also adds back the following under the definition of security, which is specifically excluded from the Securities Exchange Act: “any currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.” § 4(d) EO.
THE ROLE OF THE SECRETARY OF THE TREASURY
While the EO allocates certain authorities to the Secretary of the Treasury to issue regulations and rules, the Secretary must consult with the Secretaries of State and Defense, as well as the Director of National Intelligence, and the heads of other executive departments and agencies as Treasury deems appropriate. This appears to apply not only to rules and regulations, but also with respect to any decisions related to the issuance of licenses for transactions prohibited under the EO.
This process aligns with other national security and foreign policy intragovernmental engagements, as we see in licensing for sanctions, export controls and actions taken pursuant to the Foreign Investment Risk Review Modernization Act governing the Committee on Foreign Investment in the US (CFIUS). Given this approach, it appears that OFAC will take a lead role in implementing the designations provided by other agencies.
POTENTIAL ISSUES FOR FURTHER CONSIDERATION
The EO also includes several additional points of interest, similar to some, but not all, of the recent sanctions activity:
- The EO prohibits any transaction by a US person or entity or any transaction within the United States that:
- Evades or avoids; or
- Has the purpose of evading or avoiding;
- Causes a violation of or attempts to violate the requirements; or
- Constitutes a conspiracy to violate these prohibitions.
§ 2(a) and § 2(b), EO. While evasion is a well-established concept in the legal lexicon, avoidance is less so and signals a potentially less restrictive standard whereby parties could be more readily found to be in violation of the provisions.
- In authorizing the Secretary of the Treasury to issue regulations and procedures pertaining to licenses, the EO requires Treasury to consult with the Secretaries of State and Defense as well as the Director of National Intelligence, signaling that the determination whether a transaction is acceptable will consider much more than the traditional factors taken into consideration by OFAC, and substantially lessening the likelihood that licenses will be issued.
- Though the EO addresses derivatives more fully than many prior orders, the EO leaves unanswered whether the prohibitions will apply to many types of derivatives, or other securities. A number of questions remain, including, for example:
- Are derivatives, swaps, futures, forwards, and other similar contracts whose value is based on securities of Communist Chinese military companies prohibited?
- Are other derivative transactions, including credit default swaps that reference securities of Communist Chinese military companies banned?
- Does the Order prohibit investments in index funds that follow securities of Communist Chinese military companies, but do not actually own such securities?
Although these questions exist, the general understanding of the EO and its policy objectives is that US individuals and entities, including investment funds, need to distance themselves from any publicly traded securities of “Communist Chinese military companies,” including derivatives and other securities, and structure their investments in such a way as to exclude any financing, direct or indirect, of those entities’ securities.
As noted earlier, this EO, while far-reaching is neither unexpected nor outside the scope of objectives articulated by the President Trump, the US Attorney General, and the US Secretaries of Treasury, Commerce, and Defense. Whether it will survive a Biden administration is unclear, although the prior three years reflect a bipartisan interest in addressing serious concerns regarding the issues included in the EO. Coupled with a new administration’s other priorities, it may be that this EO continues into 2021 and beyond.
 See, e.g., Alex Stone and Peter Wood, China’s Military-Civil Fusion Strategy: A View From Chinese Strategists, China Aerospace Studies Institute (2017)(discussing long history of military-civil fusion doctrine in the PRC); Military and Security Developments Involving the People’s Republic of China 2020, Annual Report to Congress, Office of the Secretary of Defense.
 These lists were submitted to Congress by the Department of Defense (DOD) on June 24, 2020 as part of the department’s standard reporting under Section 1237 of the NDAA of 1999. This marked the first time that DOD published the list at the time it notified Congress.