On November 12, 2020, the White House issued an Executive Order (“EO”), “Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies,” which will prohibit US persons from purchasing securities of certain “Communist Chinese military companies,” including 31 companies previously identified by the US Department of Defense (“DoD”) in June and August 2020 (available here and here). The prohibitions in the EO will take effect on January 11, 2021.

Background

The EO, which was issued pursuant to the president’s authority under the International Emergency Economic Powers Act (“IEEPA”), declares a national emergency with respect to the “PRC’s military-industrial complex,” which is said to be “directly supporting the efforts of the PRC’s military, intelligence, and other security apparatuses” and threatening the national security, foreign policy, and economy of the United States.

In response to this stated threat, the EO will prohibit US persons from purchasing publicly listed securities of specific “Communist Chinese military companies,” as that term is defined  in Section 1237 of the National Defense Authorization Act for Fiscal Year 1999, as amended (“NDAA 1999”).  Restrictions will go into effect on January 11, 2021 against the 31 companies already identified by DoD, and will take effect 60 days after any subsequent listings by the DoD or the US Department of the Treasury.

(Click here for Steptoe’s blog post of August 31, 2020, with more information on the DoD’s earlier identifications of “Communist Chinese military companies” under Section 1237 of the NDAA 1999.)

The EO also builds on proposals advanced by members of Congress and others to limit investments in Chinese companies that are engaged in activities perceived to threaten US interests. One of these proposals, the American Financial Markets Integrity and Security Act (S.4872), would, if passed, prohibit the listing of shares of “Chinese military companies” and other “covered entities” on US exchanges and restrict investments in such companies by US-regulated financial firms.

The EO also reflects concerns about transparency of publicly traded Chinese companies raised in the Presidential Working Group on Financial Markets July 2020 “Report on Protecting United States Investors from Significant Risks from Chinese Companies,” and also reflected in the Holding Foreign Companies Accountable Act, which was passed by the Senate earlier this year.

Separately, the US State Department has gone as far as to say that US universities should stop investing endowment portfolios in Chinese companies, warning about “the likely outcome that enhanced listing standards lead to a wholesale de-listing of PRC firms from US exchanges by the end of next year.”

Summary of Prohibitions

The EO, at Section 1(a)(i) will prohibit US 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,” of any Communist Chinese military company included on the current DoD list and identified in the Annex to the EO, beginning at 9:30 a.m. EST on January 11, 2021.

The term “transaction” is defined as “the purchase for value of any publicly traded security.”

“US person” is defined to include any US citizen or permanent resident alien, any person in the United States, or any entity incorporated in the United States (including foreign branches). The term does not include foreign subsidiaries of US companies.

The EO uses the broad definition of “Communist Chinese military company” provided in Section 1237 of the NDAA 1999.  This definition includes any company “owned or controlled by, or affiliated with, the People’s Liberation Army or a ministry of the Government of the People’s Republic of China, or that is owned or controlled by an entity affiliated with the defense industrial base of the People’s Republic of China” and “is engaged in providing commercial services, manufacturing, producing, or exporting.”

Specifically, the restrictions in the EO apply to:

  • Any entity previously identified by the DoD pursuant to Section 1237 of the NDAA 1999 (these entities will be included in an annex to the EO);
  • Any entity identified in the future by the DoD, in consultation with the Treasury Department, pursuant to Section 1237; and
  • Any entity identified by the Treasury Department as meeting the definition of “Communist Chinese military company” under Section 1237 of the NDAA 1999, or that Treasury “publicly lists as a subsidiary” of any identified Communist Chinese military company.

The term “security” has the same meaning as in 15 USC. § 78c(a)(10), which includes:

“any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a ‘security’; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing.”

However, the EO adds to this definition of “security” (which is excluded from the statutory definition above) the following: “currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.”

Section 2(a) and (b) of the EO prohibit any “transaction by a United States person or within the United States that evades or avoids, has the purpose of evading or avoiding, causes a violation of, or attempts to violate” the EO, as well as any conspiracy to violate the prohibitions in the EO.

Enforcement of the EO could include both civil and criminal penalties under IEEPA.

Grace Periods

For companies identified after November 12, 2020, the prohibitions will take effect 60 days after their identification.

The EO contains an exception, at Section 1(b), that will allow “purchase for value or sales” of securities of a listed company by US persons to continue until November 11, 2021, if the transactions are “solely to divest, in whole or in part” securities (including derivatives) held by a US person as of January 11, 2021.

This provision may be interpreted as a “wind-down” period allowing US persons to divest securities until November 11, 2021. However, given the definition of “transaction,” which is limited to purchases, the EO does not expressly prohibit US persons from continuing to hold or sell shares of Chinese military companies past November 11, 2021, although this interpretation is subject to further clarification by the Treasury Department. This provision could be especially relevant for US persons acting as intermediaries (e.g., broker-dealers).

For any company listed after November 12, 2020, this “wind-down” period will run for 365 days after the date of the company’s listing.

The EO’s prohibitions will apply until the DoD or Treasury Department removes an entity from the list.

Takeaways

According to a statement from National Security Advisor Robert O’Brien, the EO is primarily intended to prevent “individual investors in the United States” from “unknowingly provid[ing] funds to [such companies] through passive institutional investment vehicles such as mutual funds and retirement plans.” However, we caution that this statement does not serve as a legal interpretation of the scope of the Executive Order.

While the EO is subject to further guidance from the Treasury Department, the EO appears to be designed to prohibit purchases for value of publicly listed securities of “Communist Chinese military companies” by US persons. The EO is not limited to US-listed securities.

On its face, the EO does not appear to prohibit the receipt (without an exchange of value), sale, custody, settling, or otherwise facilitating trades of securities, or other activities such as advising on securities of Chinese military companies. However, the Treasury Department may provide additional guidance in the coming weeks on the EO’s intended scope, and ultimately issue regulations which could expand the scope of the prohibitions.

The EO does not provide for blocking sanctions, and does not appear to implicate the “50 Percent Rule.”  While some companies currently identified by DoD under Section 1237 of the NDAA 1999 are subject to other restrictions under US law (e.g., through inclusion on the US Commerce Department’s Entity List), none of the companies are currently designated as Specially Designated Nationals.