On 12 November 2020, President Trump issued an Executive Order on Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies (the Investment EO, or the EO).1 The Investment EO may have significant repercussions for companies involved in securities trading as well as the investment sector.
- The EO prohibits U.S. persons from “purchas[ing] for value” publicly traded securities in designated Chinese companies that the administration believes are directly linked to Beijing’s Military-Civil Fusion efforts. The Investment EO outlines how such companies are and will be formally identified, defines the prohibitions it imposes on U.S. persons with regard to the securities of those companies, and provides for a wind down period for U.S. persons to divest their holdings, even though it remains unclear whether the EO prohibits continued holdings of such securities.
- The Investment EO is part of a broader U.S.-led pushback on China’s efforts to use its private companies to augment its military capabilities, a Chinese strategy referred to as Military-Civil Fusion. To further its military capabilities, the Chinese government has leveraged its private sector to serve the research and development needs of the Chinese defense sector.2 Many of the firms identified under the EO as “Chinese Communist military companies” have been reportedly involved in these efforts.3 Several of these firms have a significant international presence, and the Trump administration has stated these Chinese companies have benefited from their access to U.S. capital markets and more broadly to U.S. investment in a way that presents a national security risk.
- Several important terms in the current version of the EO likely require modification or clarification. These terms—some of which are defined in the EO—include “transaction,” “security,” and “derivative of a security,” as well as clarifying the scope of Chinese entities covered by the EO. For example, because these entities are not Specially Designated Nationals (SDNs), it is not clear if entities owned or controlled by any Chinese military company determined under this EO is automatically subject to the same prohibitions. The Office of Foreign Assets Control (OFAC), the likely implementing agency, will need to further modify or clarify these terms in order for the private sector to effectively comply with the provisions of the EO.
- Companies that foresee challenges in implementing the prohibitions detailed in the EO may consider raising those concerns with the U.S. Department of the Treasury. The prohibitions do not become effective until 11 January 2021, which gives the private sector an opportunity to provide feedback on the implications of the EO and seek the issuance of general licenses or clarifying guidance.
Understanding the Prohibitions
The Investment EO identifies 31 companies as subject to the prohibitions and authorizes the Secretary of Defense and the Secretary of the Treasury to identify additional companies that are “Communist Chinese military companies” or their subsidiaries. The restrictions in the EO apply to the following three groups of companies:
- Any company that the Secretary of Defense has already listed pursuant to Section 1237 of the National Defense Authorization Act for the Fiscal Year 1999. The Department of Defense released two tranches of such determinations in June and August of 2020, listing a total of 31 companies, including prominent Chinese firms such as Huawei, Hikvision, China Railway Construction Corporation, and Sinochem.4
- Any company that the Secretary of Defense, in consultation with the Secretary of the Treasury, determines, in the future, is a Communist Chinese military company.
- Any company that the Secretary of the Treasury publicly lists as meeting the criteria of Section 1237, or as a subsidiary of an already identified Chinese military company.
The Executive Order imposes prohibitions on “purchases for value” of the publicly traded securities of, securities that are derivative of, or securities designed to provide investment exposure to an identified company. While short, the prohibition creates uncertainty about the meaning of “purchases for value,” “derivative securities,” “publicly traded” and “security” itself that we outline further below.
The Executive Order provides a delayed effective date for listed companies. For companies that the Department of Defense has already determined to be a Communist Chinese military company, the ban begins on 11 January 2021. For companies that are determined in the future to be a Communist Chinese military company, the ban takes effect 60 days after that determination is made.
The EO contains a 365-day “wind down” period for purchases for value or sales solely to allow U.S. persons to divest the securities of these Chinese companies. For those companies identified on 11 November 2020 as subject to these prohibitions, the deadline for such transactions is 11 November 2021. For any subsequently identified Chinese military companies, there is a 365-day window for divestment that begins 60 days after the determination is made. Greater clarity may be needed, however, on how the EO applies to sales of securities that occur after the end of the wind down period.
Implications for the Private Sector
The Investment EO is likely to present challenges for investors, investment advisers, and fund managers that are active in international securities markets. They should evaluate their holdings and exposure to listed companies and continue to monitor for updates to the EO, as well as regulations and guidance from the Treasury Department as the administration defines its implementation and enforcement posture. Investors have an opportunity to clarify issues with application of the EO with the U.S. Department of the Treasury in light of the delayed implementation date.
The Investment EO contains elements that may generate confusion with respect to specific compliance requirements. Issues which may require potential clarification include:
- Whether entities owned or controlled by identified entities are subject to the same restrictions. The level of due diligence the U.S. government expects U.S. persons to undertake when considering an investment with potential exposure to a Communist Chinese military company is unclear. For example, the Section 1237 List includes “Huawei,” but it is unclear whether this applies to entities owned or controlled by Huawei, as well as other related entities. Because these entities are not SDNs, it is unclear whether entities they own 50% or more or control are subject to the same restrictions. Understanding the scope of the definition of a Communist Chinese military company will be important in identifying and mitigating risk.
- Whether sales of securities are permitted after the end of the wind-down period. In the EO, transaction is defined as the purchase for value of any publicly traded security. However, if this definition is correct, the 365-day wind-down period allowing U.S. persons to sell publicly traded securities to divest from these Communist Chinese military companies would be unnecessary, as U.S. persons could continue to sell such securities after the 365-day period ended, as such sales would not constitute transactions under the EO and therefore would not be prohibited.
- What implications arise from the EO’s inclusion of certain financial products that are excluded from the definition in U.S. securities laws. In contrast to Section 3(a)(10) of the Securities Exchange Act of 1934, the EO specifically includes within the definition of “securities” any “currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance not exceeding 9 months.” This may include bills of lading, for example, though it is not clear if these are generally “purchased” or “publicly traded.” Additionally, the prohibitions apply only to “publicly traded” securities, without clarifying whether that means only securities traded on public exchanges, and if yes, whether it includes exchanges in the United States, China, Hong Kong, or elsewhere.
- What types of products constitute a “derivative of a security” for the purposes of prohibitions? The term “derivative” is not defined in the EO and it is not clear whether it will include, for example, stock options, trading via mutual or hedge funds, trading in indexes that trace the underlying prohibited securities, or other financial instruments.
- Whether transactions often viewed to be incident to passive shareholdings are prohibited by the Investment EO? The EO appears to leave open the potential for a shareholder to continue to hold shares beyond the wind down period and its application to sales or other activities beyond that period. In addition, the EO leaves open interpretive questions regarding its application to ordinary shareholder actions, such as reinvesting dividends.
1 “Executive Order on Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies” (November 12, 2020), available at https://www.whitehouse.gov/presidential-actions/executive-order-addressing-threat-securities-investments-finance-communist-chinese-military-companies/.
2 As a U.S. State Department primer on Military-Civil Fusion states, “To arrive at this goal, [Chinese leader] Xi [Jinping] has personally directed the entirety of the Chinese system—civilian, military, state-owned and private—to eliminate the barriers between China’s civilian and defense economies, in order to pursue simultaneous economic and military advancement.” https://www.state.gov/chinas-military-civil-fusion-strategy-poses-a-risk-to-national-security/.
3 The full list of Section 1237 entities can be found in the Annex (p. 9) to the Executive Order as published on the U.S. Treasury website, available at https://home.treasury.gov/system/files/126/13959.pdf.