President Trump issued an Executive Order on November 12, 2020 that will prohibit U.S. persons from investing in publicly traded securities of certain companies determined to be affiliated with China’s military. Executive Order 13599 (the “Order”), entitled “Executive Order on Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies”, does not take effect until January 11, 2021. U.S. persons in the financial services industry, however, should start assessing potential risks now.
Summary of the Order
Citing a threat to U.S. national security posed by China’s military-industrial complex, President Trump issued the Order to prevent China from exploiting U.S. investors to finance the development and modernization of its military. The key elements of the Order are summarized below:
- As of January 11, 2021, U.S. persons generally are prohibited from transacting in “publicly traded securities” (or related derivatives) of any “Communist Chinese military company” (“CCMC”). U.S. persons can, however, engage in transactions until November 11, 2021 to divest any publicly traded securities of CCMCs that they held as of January 11, 2021. As a practical matter, this means that U.S. persons:
- Can purchase publicly traded securities of CCMCs until January 11, 2021, after which time such purchases generally are prohibited;
- Can – but are not required to – divest any such holdings any time until November 21, 2021, provided that such divestments are to a non-U.S. person; and
- Can continue to hold, but cannot divest or otherwise increase positions in, any CCMC securities held as of November 21, 2021.
- The Order initially affects publicly traded securities of 31 companies identified as CCMCs on lists issued by the U.S. Department of Defense (“DOD”) in June and August of this year (available here and here). Many, but not all, of these currently have securities that are publicly traded on U.S., Chinese, or other exchanges.
- Additional companies could be targeted under the Order if: (i) the DOD expands its CCMC lists; (ii) the U.S. Treasury Department publicly lists a company as meeting the definition of a CCMC (even if it is not identified on the DOD lists); or (iii) the U.S. Treasury Department publicly lists a subsidiary of an already-listed CCMC.
- Prohibitions would take effect 60 days after a company has been added to the list of covered CCMCs. U.S. persons would thereafter be prohibited from purchasing publicly traded securities (or derivatives) of such companies after that time, but could divest any captured holdings up to one year after the company was added to the CCMC list.
- The Order only prohibits actions of “U.S. persons,” defined to include companies organized under U.S. law or any individual who is a U.S. citizen, U.S. legal permanent resident, or otherwise located in the United States.
- Unlike certain other sanctions programs (e.g., Iran and Cuba), the Order does not expressly apply to non-U.S. entities that are owned or controlled by U.S. persons.
- The Order does not restrict U.S. persons from engaging in activities with CCMCs or their property or subsidiaries, other than with respect to publicly traded securities. Restrictions may apply under other authorities, however, as some of the CCMCs are subject to export restrictions under the U.S. Commerce Department’s Entity List or certain prohibitions related to involvement in U.S. Government federal contracts.
The Order represents a dramatic expansion of sanctions that directly targets activities of the U.S. financial services sector. The U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) has targeted publicly-traded securities in other programs, including with respect to Russian, Venezuelan, and – to a lesser extent – other Chinese entities. The Order, however, could potentially affect a much larger range of publicly traded securities than past actions.
There are many issues that remain ambiguous unless and until OFAC issues additional clarification in the form of Frequently Asked Questions (“FAQs”) or general licenses:
Effect on Indices/Funds: The Order does not provide guidance on the effect on U.S. persons seeking to invest in exchange-traded or other funds or to track indices that include sanctioned CCMC securities. As a general matter, U.S. funds and other U.S. investors would be prohibited from purchasing CCMC securities after January 11, 2021, even if the inability to purchase the securities results in tracking errors related to the relevant index. These restrictions would not apply to non-U.S. funds/investors, however, and U.S. investors in non-U.S. funds that hold sanctioned CCMC securities generally should not be prohibited from investing in such funds – particularly if sanctioned securities comprise less than 50% of the holdings of the fund. Index providers also likely will reconstitute the indices to exclude sanctioned securities, which could reduce potential risks in this area. Additional clarity from OFAC, however, would be helpful given that many of the CCMCs have publicly traded securities that are included in numerous indices and held by global funds.
Application to Subsidiaries: The Order as drafted imposes restrictions only on publicly traded securities of companies that are affirmatively listed as CCMCs by the U.S. Treasury or Defense Department. This is in contrast to other U.S. sanctions programs in which restrictions apply not only to listed persons but also any entity in which sanctioned parties hold an ownership interest of 50% or more. In certain cases, the company currently identified as a CCMC is just a holding company, and publicly traded securities related to that entity have been issued by a wholly-owned subsidiary. Such securities would not be captured under the current Order unless that issuing entity is separately listed as a CCMC (or unless OFAC issues clarifying guidance).
Treatment of dividend/interest payments linked to sanctioned securities: The Order does not specify whether receiving dividend, interest, or principal payments linked to a CCMC security would be considered a prohibited “transaction” in the security. In other contexts, OFAC has issued FAQs and general licenses that clearly authorized U.S. persons to receive dividend, interest, and principal payments related to sanctioned securities.
U.S. custodians/broker-dealers: Similarly, the Order does not specify whether U.S. custodians, broker-dealers, or other intermediaries would be permitted to act on behalf of a non-U.S. person seeking to transact in CCMC securities after January 11, 2021. In other contexts, OFAC has issued FAQs and general licenses that clearly authorized U.S. persons to engage in activities related to facilitating, clearing, and settling activities in connection with divestments by U.S. persons to non-U.S. persons, but not in connection to regular-course-of-business transactions between and among non-U.S. persons.
What is a “publicly traded” security: The Order does not define what constitutes a “publicly traded” security (though it does define “security” consistent with the provisions of the Securities Exchange Act of 1934). Any security that is listed on an exchange (U.S. or otherwise) and generally available to the retail public almost certainly would be captured by the definition. It is unclear, however, whether the Order is intended to target securities such as Regulation S or Rule 144A that are not traditionally considered to be “publicly traded” even though they are traded on a regulated market that is available to certain members of the public.
What will President-elect Biden do: The Order was issued under the executive authority of President Trump and did not require any authorization from Congress. It is scheduled to take effect on January 11, 2021 – 9 days before President-elect Biden will assume office. Mr. Biden could at that time choose to modify or completely revoke the Order and remove all restrictions on transacting in publicly traded CCMC securities. In our view, however, it is unlikely that Mr. Biden will take any such action immediately upon assuming office. While he might seek to tone down the public rhetoric regarding U.S.-China relations, Mr. Biden repeatedly has stated an intention to remain “tough on China,” and modifying or revoking the Order shortly after assuming office would seem to run counter to this approach. It is possible, however, that he will take some action to modify or revoke the Order sometime before November 11, 2021 when the divestment authorization is scheduled to expire.