New Executive Order Revises Prohibition on Transactions Involving Publicly Traded Securities of Certain Chinese Companies

New Executive Order Revises Prohibition on Transactions Involving Publicly Traded Securities of Certain Chinese Companies

June 7, 2021, Covington Alert

On June 3, 2021, President Biden signed an Executive Order (the “Order”) that, beginning on August 2, 2021, will prohibit U.S. persons from purchasing or selling the publicly traded securities of 59 entities determined (i) to operate (or to have operated) in the defense and related materiel sector, or the surveillance technology sector, of the economy of the People’s Republic of China (“PRC”), or (ii) to own or control, or be owned or controlled by, an individual or entity that operates (or has operated in) in any such sector (collectively, “Chinese Military-Industrial Complex Companies” or “CMIC Companies”).[1] The Order also authorizes the Secretary of the Treasury―in consultation with the Secretary of State and, as the Secretary of the Treasury deems appropriate, the Secretary of Defense―to designate additional CMIC Companies in the future.

Notably, the revised prohibition introduces human rights as consideration for designating entities with its focus on surveillance technology, consistent with the Biden Administration’s emphasis on human rights in its China policy.

Finding that “additional steps are necessary to address the national emergency declared in Executive Order 13959 of November 12, 2020 . . . including the threat posed by the military-industrial complex of the [PRC] and its involvement in military, intelligence, and security research and development programs,” the Order expands the scope of Executive Order 13959. That order, as thereafter amended by Executive Order 13974 (January 13, 2021), prohibited transactions in the publicly traded securities of “Communist Chinese Military Companies” (“CCMCs”).

Section 1 of the Order supersedes the operative provisions (Sections 1-5) of Executive Order 13959 and revokes in its entirety Executive Order 13974, leaving in place the national emergency declared in the original order. The Order went into effect upon its issuance on June 3, 2021.

In connection with the Order, the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) removed its previous Chinese Military Companies Sanctions FAQs and published new FAQs (the “FAQs”). Certain of the FAQs adapt to the Order guidance that had been applicable to conduct under Executive Order 13959.[2]

Under the Order, U.S. persons have until 12:01 a.m. Eastern Daylight Time on August 2, 2021, to engage in the purchase or sale of the publicly traded securities of a CMIC Company initially listed in an Annex to the Order, except that U.S. persons have until 12:01 a.m. Eastern Daylight Time on June 3, 2022, to engage in purchases or sales of publicly traded securities of a CMIC Company solely to divest such securities. Other activities with CMIC Companies are not prohibited as to U.S. persons by the Order, such as purchases of goods or services from these companies or sales of goods or services to these companies, although they could be restricted by other applicable export control or sanctions measures.

In addition, for companies later designated as CMIC Companies pursuant to the Order, U.S. persons have (i) until 12:01 a.m. Eastern Daylight Time on the date that is 60 days from the date of designation to engage in the purchase or sale of the publicly traded securities of that company, and (ii) until 12:01 a.m. Eastern Daylight Time on the date that is 365 days from the date of designation to engage in purchases or sales of publicly traded securities of the relevant company solely to divest such securities.

The Order introduces ambiguity about whether U.S. persons must divest from CMIC Companies. Although the Order does not specifically require U.S. persons to divest, it only permits purchases or sales of publicly traded securities of CMIC Companies, made solely to divest, for the first year after the date the entity is designated as a CMIC Company. After this date, and assuming OFAC issues no guidance to the contrary, U.S. persons presumably must hold these securities in perpetuity (or until the Order is modified or rescinded). When Executive Order 13959 was in effect, an OFAC FAQ had clarified that U.S. persons must divest from CCMCs, but that FAQ has been taken down from the OFAC website and thus no longer applies.

The Order also introduces ambiguity over prohibited conduct applicable to the publicly traded securities of those companies that had been designated as CCMCs under Executive Order 13959 and have now been designated as CMIC Companies under the Order. Under Executive Order 13959, U.S. persons had been prohibited from purchasing the publicly traded securities of CCMCs as of January 11, 2021, or a later date for subsequently designated CCMCs. One interpretation of the Order is that U.S. persons may now purchase securities of CMIC Companies until August 2, 2021, even for companies that were previously designated as CCMCs under Executive Order 13959.

We anticipate that OFAC will provide further clarification as to aspects of the Order, which may address some or all of the ambiguities noted above.

The Order can be distinguished from Executive Order 13959 in a number of ways, including as follows:

• Scope of national emergency. Executive Order 13959 declared a national emergency with respect to companies that “directly support the PRC’s military, intelligence, and security apparatuses and aid in their development and modernization.” The Order incorporates this finding but also expands the scope of the national emergency to include those companies that develop or use surveillance technology “to facilitate repression or serious human rights abuse.” While the majority of CMIC Companies fall into the first category, the Order also designates several companies on the basis that they are part of the “Surveillance Technology Sector” of the Chinese economy.
• Legal basis and mechanism for designation. Executive Order 13959 prohibited U.S. persons from transacting (except as authorized) in the publicly traded securities of companies that the Department of Defense (“DoD”) has identified as CCMCs pursuant to Section 1237 of the National Defense Authorization Act (“NDAA”) for Fiscal Year 1999. Although the mandate to promulgate a list of CCMCs is more than 20 years old, the DoD had only issued the first names, in response to Congressional interest, in June and August 2020. The Order, meanwhile, authorizes the Secretary of the Treasury, in consultation with the Secretary of State (and the Secretary of Defense, if deemed appropriate by the Treasury Secretary), under the International Emergency Economic Powers Act to designate additional individuals or entities that meet specified criteria listed in the Order. The Order thus employs a more conventional legal framework for the U.S. sanctions regime, focusing designation authority more clearly on the Treasury Department in consultation with the State Department.
• List of CMIC Companies. In an Annex, the Order designates 59 entities as CMIC Companies. Certain of these entities are affiliates of the same CMIC Company. Eighteen companies previously designated as CCMCs under Executive Order 13959 do not appear on the list of CMIC Companies (including two companies―Xiaomi and Luokung―that prevailed in litigation to be removed from the CCMC list), while 26 companies previously designated as CCMCs do appear on the new list, along with a number of additional companies not previously designated as CCMCs by the Trump Administration.

These changes appear designed to broaden the scope of the underlying national emergency and accompanying designation authority and to bring the responsibility for designations within the well-established process administered by the Department of the Treasury. In a fact sheet accompanying the Order, the White House stated that the Order is intended to create “a sustainable and strengthened framework for imposing prohibitions on investments in Chinese defense and surveillance technology firms.”

Securities Law Analysis

The Order generally retains key securities law concepts from Executive Order 13959, but clarifies certain definitional ambiguities in that order:

• Definition of covered security. The definition of “publicly traded security” under the Order replaces the prior definition of “security” under Executive Order 13959. Both definitions refer to the same statutory provision (Section 3(a)(10) of the Securities Exchange Act of 1934), but the new definition only captures securities that are included in this definition and are traded on a securities exchange or over-the-counter. The change removes other securities products that are included in this provision of the Securities Exchange Act of 1934 but would otherwise be out of scope for the Order (i.e., notes, drafts, bills of exchange, banker’s acceptances, and commercial paper) because these products are not traded on a securities exchange or over-the-counter.
• "Transaction” versus “purchase or sale.” Where Executive Order 13959 applied to any “transaction” in covered securities of CCMCs, the Order applies to the “purchase or sale” of covered securities of CMIC Companies. This helpful change clarifies some of the ambiguity that existed under Executive Order 13959 regarding whether certain securities activities would fall within the scope of the order. However, ambiguity will continue to exist for other securities activities; for example, the change does not address whether the Order would apply to shares granted to U.S. person employees of CMIC Companies in employee benefit plans.
• Broad set of covered securities and financial instruments. Like Executive Order 13959, the Order generally applies to a broad set of securities products and financial instruments. The Order applies to publicly traded securities denominated in any currency and traded on a securities exchange or over-the-counter in any jurisdiction, as well as any publicly traded securities that are derivative of such securities or are designed to provide investment exposure to such securities. In effect, this means that the Order applies to all CMIC Companies with any publicly traded securities, regardless of where those securities are traded, because it is virtually impossible to demonstrate that the company’s securities do not trade over-the-counter in any market.
• Application to collective investment vehicles. The FAQs clarify that, as with Executive Order 13959, the Order applies to exchange-traded funds, index funds, and mutual funds holding any publicly traded securities issued by a CMIC Company, regardless of how de minimis the CMIC Company securities may be as part of the overall collective investment vehicle. This maintains a powerful market effect from Executive Order 13959, as many investment vehicles sought to preserve the ability of U.S. persons to hold their securities by removing the securities of CMIC Companies from their holdings.
• Role of market intermediaries and other participants. The FAQs clarify that securities exchanges, broker-dealers, and other market makers and participants may engage in activities that are necessary to effect divestiture during the 365-day periods in which divestment transactions are permitted or that are not otherwise prohibited under the Order. Moreover, as was the case under Executive Order 13959, U.S. persons may provide clearing, custody, and other back-office services to the extent that such support services are not provided to U.S. persons in connection with prohibited purchases or sales under the Order. In addition, OFAC has confirmed that U.S. persons are not prohibited from providing investment advisory, investment management, or similar services to a non-U.S. person, including a foreign entity or foreign fund, in connection with the non-U.S. person’s purchase or sale of a covered security, provided that the underlying purchase or sale would not otherwise violate the Order. The FAQs state that, for purposes of assessing whether certain purchases or sales are permissible under the Order, U.S. persons may rely upon the information available to them in the ordinary course of business. This guidance may provide helpful relief to market intermediaries and participants seeking to comply with the Order.

In connection with the Order, OFAC announced that it will list the initial CMIC Companies on its new Non-SDN Chinese Military-Industrial Complex Companies List as of August 2, 2021. This list replaces and supersedes the OFAC Non-SDN Communist Chinese Military Companies List, which is aligned with the CCMCs designated under Executive Order 13959. OFAC also confirmed in its FAQ guidance that the restrictions implemented through the Order apply only to designated subsidiaries of CMIC Companies, not entities that are owned by CMIC Companies but not designated as CMIC Companies themselves.

The FAQs state that OFAC will continue to use its discretion to target persons whose operations include or support (i) surveillance of persons by Chinese technology companies that occurs outside of the PRC, or (ii) the development, marketing, sale, or export of Chinese surveillance technology that is, was, or can be used for surveillance of religious or ethnic minorities or to otherwise facilitate repression or serious human rights abuse.

On June 3, 2021, the DoD also issued its list of “China military companies” operating directly or indirectly in the United States, in accordance with the statutory requirement of Section 1260H of the NDAA for Fiscal Year 2021. This list does not currently have any legally operative effect with respect to the Order. Nonetheless, there is substantial overlap in the companies designated as “China military companies” under Section 1260H of the 2021 NDAA and those designated as CMIC Companies under the Order.

Section 1260H of the 2021 NDAA likely applies to a broader set of entities than Section 1237 of the 1999 NDAA, which was the original basis for designation under Executive Order 13959. Section 1260H of the 2021 NDAA authorizes designation of companies that are, among other things, “directly or indirectly” owned or controlled by, or “beneficially owned by,” or “in an official or unofficial capacity acting as an agent of,” either the People’s Liberation Army or a Central Military Commission of the Chinese Communist Party. Section 1237 of the 1999 NDAA, meanwhile, generally authorizes designation of companies “owned or controlled by the People’s Liberation Army.”

Although designation under Section 1260H of the 2021 NDAA does not directly affect those entities covered by the Order, it is possible that the Department of the Treasury may consider adding entities designated under Section 1260H of the 2021 NDAA to the list of CMIC Companies in the future―particularly given that the Order, like Section 1260H of the 2021 NDAA, focuses on the addressing military-industrial complex of the PRC.

A spokesperson from China’s Ministry of Foreign Affairs reportedly denounced the Order, saying: “What the U.S. has done violates the law of the market and undermines the rules and order of the market . . . China urges the United States to respect the laws and principles of the market, remove various so-called lists formulated to suppress Chinese companies, and provide a fair, just and non-discriminatory business and investment environment for Chinese companies.” The spokesperson added that “China will take necessary measures to resolutely safeguard the legitimate rights and interests of Chinese companies,” but China has not announced any specific countermeasures and has recently encouraged greater participation by foreign financial services firms and deeper integration with international capital markets.

The Order appears to signal that the Biden Administration intends to maintain a forceful U.S. posture toward China while implementing a more rigorous process for identifying individual companies that are subject to U.S. action. Toward that end, it seems likely that the Department of the Treasury will designate additional companies as CMIC Companies in the future. The fact sheet accompanying the Order states that the Department of the Treasury will continue to update the list of CMIC Companies as appropriate.

If you have any questions concerning the material discussed in this client alert, please contact the members of our International Trade Controls practice.

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