Nine days before the end of his term, President Trump will ban any transaction by a U.S. person involving the securities or derivatives of securities of any "Communist Chinese military company" as identified by the government.1 Although this new Executive Order 13959 (EO), which was issued on November 12, 2020 but goes into effect in January, falls short of banning Chinese companies from investing in the United States, U.S. persons (including U.S. citizens, U.S. companies, permanent residents, and individuals and entities located within the U.S.) will be prohibited from owning shares of any of the 31 Chinese companies identified by the U.S. Department of Defense in June and August 2020 as companies owned or controlled by the Chinese military (Designated Companies). Many of the identified companies are currently trading on stock exchanges around the world.
Specifically, the EO prohibits U.S. persons from engaging in "any transaction in publicly traded securities, or any securities that are derivative of, or are designed to provide investment exposure to such securities" (Covered Transactions). While the act of directly transacting for public securities of these Designated Companies is clearly prohibited, exactly what constitutes transactions that are "derivative" of, or "designed to provide investment exposure" to the targeted securities remains unclear. However, in a concurrent statement issued by National Security Advisor Robert O'Brien, O'Brien hinted that the EO also is intended to cover "passive institutional investment vehicles such as mutual funds and retirement plans." The EO also provides both the Secretary of Defense and Secretary of Treasury authority to add other entities to the list of companies subject to these prohibitions.
The EO directs that U.S. persons are prohibited from engaging in Covered Transactions beginning January 11, 2021, and must divest of any securities of Designated Companies obtained prior to January 11, 2021, by November 11, 2021.
This new EO, which will be primarily administered by the US Department of Treasury's Office of Foreign Assets Control (OFAC) should essentially be viewed as the beginning of a new, limited China-focused sanctions program. It represents a new front in President Trump's efforts to diminish Chinese access to global markets even in the waning days of his administration.
New, Limited Sanctions on China
Despite its limited nature, make no mistake that the EO does indeed impose new financial sanctions on China. Unlike other OFAC sanctions programs, however, the EO takes a more limited approach to sanctions, aimed at restricting the growth of civilian Chinese companies alleged to be supporting the Chinese military, intelligence and security organizations (a strategy the Administration refers to as Military-Civil Fusion) while falling far short of an outright ban on transactions involving these companies. The EO is more limited than other sanctions programs administered by OFAC for several reasons, including:
- First, while the EO was issued under a legal authority common to other sanctions regimes, the International Emergency Economic Powers Act (IEEPA), the EO adopts the narrow approach of creating a separate list restricting only securities transactions, rather than adding identified companies to lists that carry a more significant prohibition, primarily the Specially Designated Nationals (SDN) list which results in a near total ban on any dealing with SDN listed companies.
- Second, the EO does not appear to invoke OFAC's "50 percent rule," which applies sanctions automatically to any entity owned, directly or indirectly, 50% or more by one or more designated entity, even if that majority-owned entity is not specifically identified as subject to the sanctions regime. There also is no provision that the prohibitions apply to entities controlled by these designated entities. Thus, companies owned or controlled by the 31 currently designated companies appear to be not subject to the EO unless independently designated by the U.S. Department of Defense and/or the U.S. Department of the Treasury. However, Treasury could issue a rule or clarifying guidance that the 50 percent rule applies to this new regime. In addition, the Department of the Treasury may choose to add "subsidiaries" to the list, as explicitly authorized by the EO.
Securities Enforcement Risks
The EO appears to be a manifestation of the concerns flagged in a Risk Spotlight article published by the Division of Economic and Risk Analysis of the U.S. Securities and Exchange Commission (SEC) that highlighted, among other things, the "indirect flow of investments from U.S. investors into companies that are either on "the U.S. government's Entity List or have been designated as a national security threat by certain U.S. agencies." Specifically, the article noted that the increasing inclusion of "Chinese domestic securities" in "various global financial market indexes" presents a "significant risk of U.S. investors becoming more exposed to companies potentially subject to U.S. policies, sanctions, and/or tariffs." Although the SEC, tasked with enforcing the U.S. Securities law is not a primary enforcer of sanctions violations, it has recently brought an enforcement action based in part, on violation of U.S. sanctions and export control laws, and has been increasingly focused on public companies sanctions related disclosures.
While investors and companies have until November 11, 2021 to divest from the banned securities, the negative impact on the value of the securities has already been felt in Asian markets. Given that the EO's reach is still unclear at this point, it remains to be seen whether and to what extent the EO will stem the "indirect flow of investments" that the SEC identified as a "significant risk" of violating U.S. sanctions. U.S. individuals and companies will need to scrutinize their direct, indirect, and derivative holdings to ensure compliance and closely monitor any forthcoming guidance from Treasury and/or the SEC.
The EO follows a steady stream of measures the Trump Administration has taken to isolate and limit Chinese technology companies, including the April 2020 rule banning export of goods to broadly defined "military end users" in China and the continued expansion of U.S. export controls on Huawei, its affiliates, and other prominent Chinese tech companies.
That being said, it is still unclear what change in approach, if any, the incoming Biden Administration will take on U.S.-China trade relations. The EO is scheduled to take effect on January 11, 2021, a mere nine days before President-elect Biden will take office. Although it is unlikely that we will see full-scale reversal of the EO, President-elect Biden could reverse, alter, or modify (or leave as is) any of the specific restrictions in the EO upon taking office. In any case, the EO is a compliance issue that U.S. investors must carefully evaluate. Also, for any future investment in U.S. or Hong Kong IPOs by Chinese companies, U.S. investors may need to conduct due diligence on the issuers to make sure their prospective investment will not violate the EO.
1. The U.S. Department of Defense has authority to designate "Communist Chinese military companies" pursuant to Section 1237 of the National Defense Authorization Act for FY 1999.
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