Yesterday, President Trump issued an Executive Order that will, following an initial two-month grace period and a further ten-month wind-down period in which only dispositions are permitted, prohibit U.S. persons (including citizens and U.S. legal entities acting outside the United States and foreign citizens and legal entities acting inside the United States) from engaging in any transactions in publicly traded securities (debt or equity) issued by companies that the U.S. government designates as tied to the Chinese military (Designated Entities), as well as in any securities linked (in an undefined manner) to the targeted Chinese securities. The 31 current Designated Entities are listed at the end of this note.Scope of the Executive Order
The Executive Order was issued under the International Emergency Economic Powers Act, as sanctions administered by the Office of Foreign Assets Control (OFAC) generally are, but it does not follow the pattern of typical OFAC sanctions, and the intended scope of the new language is often unclear. It is striking that the Executive Order was issued under 20-year-old authority to sanction “Communist Chinese military companies” in a completely new form with no accompanying guidance (although one would hope that the relevant agencies will provide guidance shortly).
The Executive Order first prohibits “any transaction in publicly traded securities” of any Designated Entities “by any United States person.” Pending further guidance, this would appear to encompass not only sales and purchases of such securities, but also transactions in an intermediary capacity, including brokerage, custody, and the like. It is not clear, however, whether transactions related to securities of Designated Entities that do not directly involve the securities themselves, most notably U.S. dollar payment services in connection with sales or distributions, would be considered “transactions in” those securities. It is clear that purchases and sales of securities of Designated Entities by U.S. persons, including trading on U.S. exchanges, will be prohibited absent further guidance or licensing, but the impact on U.S. dollar transactions relating to securities transactions outside the United States among non-U.S. persons is less certain.
Still more unclear is the intended impact of the Executive Order’s novel prohibition on transactions by any U.S. persons in “any securities that are derivative of, or are designed to provide investment exposure to,” publicly traded securities of Designated Entities. Public statements accompanying the Executive Order, and the prefatory language of the Executive Order itself, seem to indicate that this prohibition is aimed at mutual funds and similar collective investment vehicles and at derivatives (including index-based derivatives), but the critical terms are undefined and the scope is unclear. Given that investment funds that are U.S. legal entities would already be directly prohibited from acquiring securities of Designated Entities, it appears that this prohibition on indirect investment is also intended to capture foreign investment funds. However, it is completely unclear what it means for such a fund to be “designed to provide investment exposure to” securities of Designated Entities. If a European global bond fund includes bonds of one or more Designated Entities among its holdings, is the whole fund automatically tainted such that a U.S. person may not transact in fund interests? What about an Asian equities fund with 10% of its holdings in Designated Entities? A Hong Kong-based China-focused fund with 20% of its holdings in Designated Entities? With respect to derivatives, if an index contains any security of Designated Entities, are all derivatives referring to that index prohibited? What about transactions like repurchase agreements using securities of Designated Entities as collateral? No answers are given.
Of course, the questions posed regarding intermediary transactions connected to direct investment above also remain for derivative and other transactions (for example, it’s clear that a U.S. person may not enter into a cash-settled total return swap on securities of a Designated Entity, but if a Swiss bank does so, may the transaction be settled in dollars clearing through U.S. correspondent accounts)? Again, the answers are unclear.
Timing of the Executive Order
None of the restrictions under the Executive Order take effect until January 11, 2021. After that, transactions by U.S. persons in listed securities of Designated Entities, or derivatives or securities “designed to provide economic exposure” to such listed securities, are prohibited unless made to divest, in whole or in part, securities held by U.S. persons as of January 11, 2021 (in which case they are permitted until November 11, 2021). There is no explicit prohibition on continuing to hold such securities after that date, but whether the receipt of coupon payments, dividends, and other distributions is permissible depends on whether U.S. persons will be permitted to engage in ancillary transactions not involving the transfer of publicly traded securities in Designated Entities or the relevant indirect instruments.
Additional companies that become Designated Entities in the future will become subject to the prohibitions set forth in the Executive Order 60 days after they are designated, after which transactions to permit U.S. persons to divest the relevant securities may take place for an additional ten months (365 days from the date of designation).
The Executive Order invokes authority that has been used in many previous OFAC sanctions programs, but it does so in a way that does not parallel any of the prior programs. As was the case with sectoral sanctions in Russia and restrictions on new debt and equity issued by Venezuelan government entities, it will take some time for OFAC to articulate the contours of the prohibitions; unlike those programs, however, the novel structure was released without accompanying guidance.
In our experience, informed especially by the reactions to novel Russian and Venezuelan sanctions, it is quite possible that major financial institutions will refuse all transactions within U.S. jurisdiction connected in any way with securities of Designated Entities, including securities of investment vehicles that hold securities of Designated Entities, unless and until clearer guidance is given regarding categories of transactions that are permissible. While divestment is one theoretical solution, divestment by all U.S., U.S.-held, and USD-denominated investment funds of all securities of Designated Entities within 60 days may well be challenging, particularly if institutional investors are unwilling to buy those securities pending clarification of the scope of the Executive Order. This may result in greater disruption to the market for international investment funds in particular than was anticipated or intended.
We will continue to monitor and report on developments associated with the Executive Order.
List of Designated Entities
Aero Engine Corporation of China
Aviation Industry Corporation of China (AVIC)
China Academy of Launch Vehicle Technology (CALT)
China Aerospace Science and Industry Corporation (CASIC)
China Aerospace Science and Technology Corporation (CASC)
China Communications Construction Company (CCCC)
China Electronics Corporation (CEC)
China Electronics Technology Group Corporation (CETC)
China General Nuclear Power Corp.
China Mobile Communications Group
China National Chemical Corporation (ChemChina)
China National Chemical Engineering Group Co., Ltd. (CNCEC)
China National Nuclear Corp.
China North Industries Group Corporation (Norinco Group)
China Nuclear Engineering & Construction Corporation (CNECC)
China Railway Construction Corporation (CRCC)
China Shipbuilding Industry Corporation (CSIC)
China South Industries Group Corporation (CSGC)
China State Construction Group Co., Ltd.
China State Shipbuilding Corporation (CSSC)
China Telecommunications Corp.
China Three Gorges Corporation Limited
China United Network Communications Group Co Ltd
Dawning Information Industry Co (Sugon)
Hangzhou Hikvision Digital Technology Co., Ltd. (Hikvision)
Panda Electronics Group
Sinochem Group Co Ltd
 Executive Order of November 12, 2020, available at https://www.whitehouse.gov/presidential-actions/executive-order-addressing-threat-securities-investments-finance-communist-chinese-military-companies/.
 The Executive Order defines U.S. person as “any United States citizen, permanent resident alien, entity organized under the laws of the United States or any jurisdiction within the United States (including foreign branches), or any person in the United States.”
 Designated Entities are those identified by the U.S. Department of Defense as Communist Chinese military companies operating directly or indirectly in the United States pursuant Section 1237 of the National Defense Authorization Act for Fiscal Year 1999 (NDAA 1999), or by the U.S. Department of the Treasury as subsidiaries of such companies. Although this authority (and the authority to impose sanctions on Designated Entities) has been in place for more than twenty years, the Department of Defense only actually named Designated Entities under NDAA 1999 in June 2020 and August 2020. See U.S. Dept. of Defense, “DOD Releases List of Additional Companies, in Accordance with Section 1237 of FY99 NDAA (Aug. 28, 2020), available at https://www.defense.gov/Newsroom/Releases/Release/Article/2328894/dod-releases-list-of-additional-companies-in-accordance-with-section-1237-of-fy/.