In a significant new Executive Order (“Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies”) (Order) issued on November 12, 2020, the current US Administration has prohibited “any transaction” in either the “publicly traded securities,” or “derivative[s]” of securities of companies determined to be “Communist Chinese military compan[ies]” by US authorities. Thirty-one companies, collectively estimated to comprise more than $500 billion in market capitalization, have been designated since June 2020 as “Communist Chinese military compan[ies]” (Targeted Companies) within the meaning of the Order. Additional companies may be added by designation of the US Secretary of Defense or the US Secretary of the Treasury.
The short-term impact of the Order may be significant for US persons with exposure to the Targeted Companies’ securities, while the long-term impact of the Order remains unclear.
We provide further detail on the Order below.
Broad scope of the prohibition
Section 1(a)(i) of the Order prohibits “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 . . . by any United States person” beginning at 9:30 EST on January 11, 2021. The term “United States person” means 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.
The term transaction is defined in Section 4(e) of the Order as “the purchase for value of any publicly traded security.” The term “security” is in turn defined broadly, with reference to the definition in the Securities Exchange Act of 1934, such that it includes a wide range of debt and equity instruments. Section 4(d) of the Order excludes from the above definition of “security” any “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 . . . .”
In summary, the ban appears to encompass by its express terms the purchase of (i) Targeted Securities, (ii) “derivative[s],” or financial instruments that derive their value from the value of the Targeted Securities, e.g., publicly traded futures, forwards, swaps, or options in the Targeted Securities; and (iii) any “securities” that are “designed to provide investment exposure” to the Targeted Securities. While the meaning of “derivative[s]” is clarified based on the reference to the definition of a “security” in the Securities Exchange Act of 1934, the Order does not define the scope of the phrase “designed to provide investment exposure.”
In connection with the issuance of the Order, US National Security Adviser Robert C. O’Brien indicated in a statement that US investors could “unknowingly provide funds to [the Targeted Companies] through passive institutional investment vehicles such as mutual funds and retirement plans,” and that the Order was designed to “protect American investors” from exposure to the securities of the Targeted Companies. On this basis, it is not entirely clear whether the phrase “designed to provide investment exposure” may include the holding of index funds or exchange-traded funds that in turn directly or indirectly hold a position in one or more of the Targeted Securities.
The prohibition on “any transactions” involving securities in the Targeted Companies takes effect on January 11, 2021 with respect to the 31 companies currently designated as “Communist Chinese military compan[ies]” by the US Department of Defense (DoD). Transactions for purposes of divesting, in whole or in part, of securities in the Targeted Companies are permitted until 11:59 EST on November 11, 2021. Section 1(c) of the Order authorizes “purchases for value or sales made on or before 365 days from the date of [designation of any company], solely to divest, in whole or in part, from securities that any United States person held in such person, as of the date 60 days from the date of such [designation].” This provision effectively creates a rolling divestment deadline (i.e., beyond November 11, 2021) for divestment from securities in any companies that may be designated in the future by US authorities.
The Order specifically contemplates the designation of additional companies as “Communist Chinese military compan[ies]” under Section 1(a)(ii). Pursuant to that section, US persons must not engage in any transactions of newly designated companies beginning on 9:30 EST on the date that is 60 days after designation by the US Secretary of Defense or the US Secretary of the Treasury. In other words, bans on transactions in the securities of companies that may be designated in the future will take effect two months after the date of designation, but the rolling divestment window cited above will continue to apply.
Definition of “Communist Chinese military company”
The companies targeted under the Order are limited to “Communist Chinese military company[ies],” a term which is defined in Section 4(a)(i) of the Order with reference to Section 1237 of Public Law 105-261, the National Defense Authorization Act for Fiscal Year 1999 (1999 NDAA). Whereas the 1999 NDAA delegated responsibility for naming such companies to the DoD, the Order also contemplates a role for the US Department of the Treasury.
The DoD designated 20 companies as “Communist Chinese military companies” on June 24, 2020. The DoD designated an additional 11 companies on August 28, 2020. There have been no additional designations of companies as “Communist Chinese military compan[ies]” as of the date of this writing.
Ambiguities in the Order’s Terms
As of this writing, key concepts in the Order remain unclear in application. For example, the definition of a prohibited “transaction” covers the purchase of Targeted Securities after the effective date of January 11, 2021. However, the definition does not expressly reference the sale or mere holding of Targeted Securities at any time. It is possible that the Treasury Department’s Office of Foreign Assets Control (OFAC) will issue guidance concerning the scope and interpretation of the Order in the coming days. Such guidance may, e.g., address whether the receipt of dividends incident to the holding of the Targeted Securities falls within the scope of the prohibition. Finally, the Order does not define what it means for a security to be “designed to provide investment exposure” to Targeted Securities (emphasis added), and how this prohibition would apply to investment vehicles which incidentally include Targeted Securities within, e.g., a market index.
* * *
The current US Administration remains in office until January 20, 2021, and further developments are possible over the coming months. We will continue to monitor all developments. Please reach out to your usual Herbert Smith Freehills contacts with any questions.