On January 13, 2021, President Trump amended the November 12, 2020, Executive Order (EO) 13959 providing greater clarity to the scope of the EO’s ban on trading and investing in certain designated publicly traded securities of “Communist Chinese military companies” (CCMCs). The ban became effective January 11, 2021, but the amended EO, guidance and general licenses issued by the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) add greater clarity on the ban and provide important carve-outs or caveats to its scope. Investors and holders of covered securities should take careful note of these latest developments and anticipate that we will see further guidance, clarifications and possible licenses related to the EO in the coming days and weeks.
The EO Broadly Applies to Securities of CCMCs Identified by the Defense and Treasury Departments
According to the EO, the ban on certain transactions involving securities of CCMCs was prompted by threats posed to U.S. national and economic interests. Specifically, the EO stated that China is pursuing a policy to increase the size of its country’s military-industrial complex through a national policy of “Military-Civil Fusion” by “compelling civilian Chinese companies to support its military and intelligence activities.” In turn, “those companies raise capital by selling securities to United States investors that trade on public exchanges both here and abroad.”
Based on these concerns, the EO prohibited U.S. persons from engaging in “any transaction in publicly traded securities, or any securities that are derivative of, or designed to provide investment exposure to such securities” of CCMCs designated by the EO or that are later added as CCMCs. The EO specifically exempted transactions made “solely to divest, in whole or in part, from securities” held by a U.S. person between January 11, 2021, and November 11, 2021, or from 365 days of the designation of additional CCMCs.
Designated CCMCs are listed in an Annex to the EO. This Annex includes companies that also appear on a list of CCMCs previously released by the U.S. Defense Department (DoD) pursuant to Section 1237 of the National Defense Authorization Act of Fiscal Year 1999 (NDAA). The EO delegates responsibility to the Secretary of Defense and the Secretary of the Treasury to determine additional CCMCs subject to the securities-related ban on an ongoing basis. For those CCMCs that are designated after the publication of the EO, the EO states that prohibitions on transactions with those CCMCs will take effect 60 days after they are designated by DoD or the Secretary of the Treasury. OFAC issued an updated list on January 8, 2021, and DoD added more CCMCs — including COMAC and Xiaomi of China — to Section 1237 on January 14, 2021.
The EO defined “security” by referring to the definition of “security” at Section 3(a)(10) of the Securities Exchange Act of 1934, in addition to “currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding 9 months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.” The definition in the Securities Exchange Act is broad and includes any note; stock; treasury stock; security future; security-based swap; bond; transferable share; investment contract; certificate of deposit for a security; any put, call, straddle, option or privilege on any security; and many more investment instruments, including the American Depository Receipts (ADRs) through which securities of the listed Chinese entities are typically traded on U.S. exchanges.
An Amended EO Clarifies That U.S. Persons Must Sell Covered Securities Within One Year of the Listing of a CCMC
The January 13, 2021, amendment to the EO clarified that possession of any covered securities by a U.S. person is prohibited beginning November 13, 2021. It also clarified that, beginning 365 days from the designation of any additional CCMC, possession of covered securities by a U.S. person is prohibited.
The amended EO also clarified that the term “transaction” meant not just the purchase for value of publicly traded securities, but also the sale of any publicly traded security. Further, the amended EO specified that the listing of a CCMC subject to the EO is not dependent on whether the DoD is required to continue reporting under the Section 1237 NDAA provisions.
OFAC General Licenses Temporarily Authorize Some Transactions in CCMC Securities
As of the date of this article, OFAC has issued two general licenses that permit a limited range of activities related to designated CCMCs that would otherwise be prohibited by the EOs. Specifically, on January 8, 2021, OFAC released a general license that authorizes transactions and activities prohibited by the EO concerning publicly traded securities (or any securities that are derivative of, or are designed to provide investment exposure to such securities) of entities that closely match the name of a CCMC identified in the Annex to the EO, but are not listed on OFAC’s newly issued Non-SDN Communist Chinese Military Companies List (CCMC List). This General License 1 authorizes such transactions through 9:30 am ET on January 28, 2021.
Additionally, on January 14, 2021, OFAC released a second general license that authorizes certain transactions and activities by securities exchanges operated by U.S. persons involving the subject securities of CCMCs (and derivatives thereof). This General License 2 authorizes such transactions for 365 days after a CCMC is added to the CCMC List.
OFAC FAQs Inform Key Terms and Concepts From the EOs
Since the first EO was promulgated, OFAC has been issuing a series of frequently asked questions and answers (FAQs) that provide guidance on several of the key terms and concepts articulated in the EO and amended EO. These FAQs are summarized thematically below.
a. Application to Specific CCMCs
The EO included specific names of CCMCs that had been previously designated by the DoD under Section 1237 in an Annex. However, these names did not in all cases exactly match the names of actual issuers of publicly traded securities. OFAC, in FAQ 858, addressed this issue and explained that the EO applies to securities of CCMCs “with a name that exactly or closely matches the name of an entity” identified in the Annex to EO 13959 or subsequently identified by the DoD or OFAC. OFAC’s CCMC List provides additional identifying information relevant to this point.
b. Application to Subsidiaries of CCMCs
The EO did not specify whether and precisely how subsidiaries of listed CCMCs would be covered by the restrictions. Normally, OFAC takes the position that, under its “50 percent rule,” subsidiaries of sanctioned entities are also subject to sanctions that apply to their listed direct or indirect parent entities. Accordingly, there was initially uncertainty concerning whether this “50 percent rule” would apply to the EO. For example, as has been widely reported, uncertainty over the scope and application of the OFAC “50 percent rule” apparently contributed to the New York Stock Exchange’s initial decision to delist certain subsidiaries of CCMCs and the subsequent temporary reversal of that decision.
OFAC has now addressed this issue in a FAQ. Specifically, according to OFAC FAQ 857, OFAC intends to identify subsidiaries of CCMCs that are issuers of publicly traded securities and (i) 50 percent or more owned by one or more CCMCs, or (ii) determined to be controlled by one or more CCMCs. The restrictions on these identified subsidiaries take effect 60 days after their identification. By implication, therefore, nonidentified subsidiaries will not be covered unless and until they are thus designated by OFAC.
That said, OFAC has emphasized that subsidiaries of CCMCs need not be separately listed if their names exactly or closely match the name of a previously listed CCMC. For example, FAQ 864 states that U.S.-listed ADRs of three particular CCMC subsidiaries (i.e., China Telecom Corporation Limited (NYSE: CHA), China Mobile Limited (NYSE: CHL) and China Unicom (Hong Kong) Limited (NYSE: CHU)) are subject to the EO because their names “exactly or closely match the name of an entity identified in the Annex to EO 13959.” Therefore, investors should continue to conduct due diligence to review whether entities whose securities they hold or transact in are designated CCMCs or have names that closely match those of designated CCMCs.
c. Application to Publicly Traded Securities, Derivatives and Foreign Funds
The EO and amended EO adopt the Exchange Act definition of “security,” but do not define the scope of related terms “publicly traded securities” or “derivatives” as used in the EO. In FAQ 859, however, OFAC explains that the term “publicly traded securities” includes both exchange-listed and over-the-counter securities in any jurisdiction.
Additionally, OFAC FAQ 860 provides examples of financial instruments that are “securities that are derivative of, or are designed to provide investment exposure to” publicly traded securities of CCMCs. Examples include “derivatives (e.g., futures, options, swaps), warrants, ADRs, global depositary receipts (GDRs), exchange-traded funds (ETFs), index funds, and mutual funds, to the extent such instruments also meet the definition of ‘security’ as defined” in the EO.
Finally, OFAC FAQ 861 clarifies that the EO applies to both U.S. and foreign funds, including ETFs and mutual funds that hold publicly traded securities of CCMCs. According to OFAC, the EO’s restrictions apply “regardless of such securities’ share of the underlying index fund, ETF, or derivative thereof.” This interpretation is problematic for mutual funds, ETFs and other funds that would be prohibited from selling to U.S. persons regardless of the amount of CCMC or derivative exposure. Index-based funds that sell to U.S. investors may not be able to closely track their indexes if the index provider does not remove CCMCs from its index.
d. Prohibited Transactions
The original EO provided that U.S. persons (including U.S. funds and related market intermediaries and participants) were prohibited from engaging in transactions beginning on January 11, 2021, but did not address whether U.S. persons are required to divest their current holdings (i.e., those that may have been acquired prior to January 11, 2021). In response, OFAC (in FAQ 862) explained that the EO does not require U.S. persons to divest such holdings as long as they do not engage in further transactions involving them (and separately addresses transactions involving divestiture).
Importantly, however, the amended EO now provides that U.S. persons will have only until November 13, 2021, to divest their shares of CCMCs listed in the Annex to the EO (and 365 days from the designation of any new CCMCs). Specifically, the amended EO prohibits possession of any covered securities by a U.S. person after those dates.
Having made that clarification, OFAC (in FAQ 863) nevertheless has explained that U.S. persons can continue to engage in activity related to the “clearing, execution, settlement, custody, transfer agency, back-end services, as well as other such support services” of CCMC securities “to the extent that such support services are not provided to US persons in connection with prohibited transactions.” Whether U.S. exchanges, broker-dealers, and other financial institutions will be willing to continue these support transactions given the scrutiny that CCMC securities will receive remains an open question, however.
The EO and amended EO provide that transactions made “solely to divest, in whole or in part” from the covered securities are not subject to a ban. However, the EO is unclear on whether intermediaries who are U.S. persons will be permitted to process such divestiture transactions.
In response to this ambiguity, OFAC (in FAQ 865) has clarified that “market intermediaries and other participants may engage in ancillary or intermediary activities that are necessary to effect divestiture.” Specifically, the FAQ states that investment fund transactions involving U.S. person investors and intermediaries who are seeking to divest are permitted. Additionally, OFAC (in FAQ 874) clarifies that any transaction (including purchases for value and sales) entered into before November 11, 2021, (or 365 days from the date of designation, if applicable) solely to divest, in whole or in part, from the covered securities is permitted. Neither FAQ specifically addresses, however, the role of market makers in such divestitures nor the level of due diligence that intermediaries should undertake to ensure they are only processing transactions intended to divest from the covered securities.
The EO, amended EO and evolving OFAC guidance underscore the complexity and broad scope of this prohibition and its potentially sizable market impact. Investors should take careful note of the prohibitions and deadlines established by the EOs for divestiture and begin to take action now to protect their interests. At this point, it is unclear whether the incoming presidential administration will preserve these restrictions, begin to walk them back, or add new or expanded restrictions on CCMCs.
The EOs are already having a significant impact on the financial industry, as illustrated by the comments of various financial industry groups, such as the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA) on the new EOs and OFAC guidance. These comment letters requested clarification of the EO, and the FAQs address some of those requests for clarification, but not all. In a related development, on January 6, 2021, the SEC’s Division of Examinations issued a Risk Alert to notify investment advisers, broker-dealers and other market participants of the EO, and urged them to review and assess the impact of the EO, for their own investments as well as on behalf of investors and clients, and to evaluate their related processes.
We recommend that fund managers, advisers, broker-dealers and other market participants assess their current and potential exposure to the CCMCs and compliance deadlines, and review existing controls, due diligence practices and communications with clients, prospective clients and shareholders, as well as disclosures in prospectuses and other documents. Firms should also continue to monitor the OFAC and DoD websites for updates to the list of CCMCs and additional guidance. The EO prohibitions will apply automatically to companies added by DoD or OFAC 60 days after their inclusion, regardless of whether OFAC simultaneously adjusts its list. Impacted firms should also consider whether it will be necessary to apply for a specific license from OFAC to transact in or continue to hold impacted securities beyond the deadlines established by the EOs. At this point, it is unclear what OFAC’s approach to any such licenses will be, or how long a review of a license application will take.
In addition, all companies and investors should be aware that most of the CCMCs designated pursuant to the EO are subject to additional U.S. export controls. For example, in December 2020, the Department of Commerce’s Bureau of Industry and Security (BIS) added 88 Chinese companies — including several entities that are also CCMCs under the EO — to its Entity List. As a result, licenses are now required to engage in many transactions with these entities.
Additionally, BIS recently issued a list of restricted Military End-Users in China that are subject to expanded export license requirements. Again, this list includes most of the CCMCs identified under the EO. Additional restrictions on CCMCs may be imposed in the coming weeks and months.