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January 7, 2021

OFAC Issues Guidance on the Implementation of Trump Executive Order Banning Transactions Involving the Securities of “Communist Chinese Military Companies”


UPDATE: On January 13, 2021, the Trump Administration issued a new Executive Order (EO) requiring divestment of securities of "Communist Chinese Military Companies." The new EO amends EO 13959, which banned transactions involving the securities of such companies, to now require that US persons also divest any such holdings. The new EO can be found here. Our Advisory about the original EO and subsequent OFAC guidance about the implementation of the original EO can be found below and here. OFAC previously clarified that US persons, including US funds and other market participants, were not required to divest their holdings of the securities of identified "Communist Chinese military companies." However, the January 13, 2021 EO now requires divestment by banning "possession of [securities of Communist Chinese military companies"] by a United States person" by "11:59 p.m. eastern standard time on November 11, 2021." In addition, US persons are required to divest their holdings in any newly designated "Communist Chinese military companies" within 365 days of designation.

Last November, President Trump issued an Executive Order (EO) that banned transactions by US persons involving the securities or derivatives of securities of any "Communist Chinese military company" as identified by the US government. You can read our November 2020 Advisory about the ban here. In advance of the January 11 effective date for the prohibitions of the EO, the Department of the Treasury's Office of Foreign Assets Control (OFAC) has created a list of such designated companies (available here) and published several Frequently Asked Questions (located here) related to implementation of the EO.

Although this securities-based approach to sanctions is more limited in nature than an outright ban on transactions involving the affected companies, the full impact of the EO remains unclear. For example, the New York Stock Exchange reportedly decided to delist three Chinese telecommunications companies—China Mobile, China Telecom, and China Unicom—in response to the EO, then abruptly reversed its decision "after consulting regulators." Now, as of publication of this advisory, the New York Stock Exchange is reportedly reverting back to the original plan to delist the companies.

That being said, the new guidance does help to clarify the scope of the restrictions in some important ways.

First, OFAC has clarified that subsidiaries of the listed companies subject to the "50 percent rule" may in fact be subject to the restrictions as well—but only to the extent OFAC actually identifies and publicly lists such companies.

In our November 2020 Advisory, we wrote that the EO did not appear to invoke OFAC's "50 percent rule" but that OFAC could issue clarifying guidance that the 50 percent rule applies to the new regime. The new OFAC guidance now indicates that the securities prohibitions "apply to any subsidiary of a Communist Chinese military company, after such subsidiary is publicly listed by Treasury" and that "Treasury intends to publicly list as subsidiaries any entity that issues publicly traded securities and that is … 50 percent or more owned by one or more Communist Chinese military compan(ies) identified in or pursuant to E.O. 13959, consistent with OFAC's 50 Percent Rule Guidance." In practice, this means that investors should be wary of engaging in transactions involving subsidiaries of any of the identified companies that would be subject to the 50 percent rule, because the restrictions can be imposed on their securities at any time, but that there is not an automatic application of the restrictions to such subsidiaries, unlike in other OFAC sanctions contexts.

However, the guidance also clarifies that the EO bans transactions in securities of subsidiaries of the listed companies with a name that exactly or closely matches the names identified in the Annex to the EO.

Second, the new guidance clarifies the types of financial instruments that the EO covers. OFAC has indicated that it will interpret the term "publicly traded securities" to include securities "denominated in any currency that trade on a securities exchange or through the method of trading that is commonly referred to as 'over-the-counter,' in any jurisdiction." Specifically, the EO will cover (but is not limited to) the following types of financial instruments: "derivatives (e.g., futures, options, swaps), warrants, American depositary receipts (ADRs), global depositary receipts (GDRs), exchange-traded funds (ETFs), index funds, and mutual funds, to the extent such instruments also meet the definition of "security" [under the EO]." The EO defines "security" broadly to include "the definition of 'security' in section 3(a)(10) of the Securities Exchange Act of 1934, Public Law 73–291, as codified as amended at 15 U.S.C. 78c(a)(10), except that 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, shall be a security for purposes of [the EO]."

The EO is therefore broad and includes US and foreign funds, such as exchange-traded funds (ETFs) or other mutual funds, that hold publicly traded securities of a Communist Chinese military company. The EO prohibits transactions in any securities that are "derivative of, or are designed to provide investment exposure to such securities, of any Communist Chinese military company [that] is prohibited regardless of such securities' share of the underlying index fund, ETF, or derivative thereof."

Third, the new guidance clarifies that at least certain services involving the covered securities can be provided by US persons to investors, if such services are not provided to US persons in connection with prohibited transactions: "clearing, execution, settlement, custody, transfer agency, back-end services, as well as other such support services." This guidance suggests that brokers, banks, IT services companies, and other US persons that are not directly trading covered securities but rather are supporting transactions involving them can continue to do so, unless such transactions are directly prohibited. For example, the guidance suggests that US person service providers can provide services to non-US persons with respect to the covered securities, even after the effective date. OFAC has further confirmed that US person market intermediaries and other participants may engage in ancillary or intermediary activities that are necessary to effect divestiture during the relevant wind-down period for US persons (from January 11 through November 11, 2021), or that are otherwise not prohibited under the EO.

While this is helpful guidance, intermediaries and service providers will have to carefully adapt their practices, because after January 11 they will be at a compliance risk if they assist in a transaction that is prohibited. For example, while a broker is permitted to facilitate some trades in the covered securities, if they mistakenly assist in a trade for a US person that is prohibited, they too would be in legal jeopardy for violating the EO prohibitions. OFAC sanctions operate under a "strict liability" regime, meaning that a violation of OFAC sanctions can be found and penalized even where it was entirely inadvertent. Thus, all service providers involved in securities sales and transactions must assess whether they have systems in place to confirm that any transactions involving any covered securities are prohibited.

Fourth, OFAC has clarified that the EO does not require US persons, including US funds and other market participants, to divest their holdings of the securities of identified "Communist Chinese military companies." While the EO prohibits "transactions" involving these securities and derivatives of these securities, as noted above, the EO does not itself require divestment. As a practical matter, however, holding onto the securities would seem to result in encumbering any derivative securities, such as ETFs, with a restriction on any subsequent "transaction." Therefore, how US persons can effectively maintain such holdings is unclear. Furthermore, the EO provides a safe harbor until 11:59 pm on November 11, 2021, for US persons to engage in purchases for value or sales "solely to divest, in whole or in part, from securities that any United States person held as of 9:30 a.m. eastern standard time on January 11, 2021" of any of the affected companies. Therefore, the window within which US persons can divest these securities without running afoul of the transaction prohibition is limited.

This additional guidance published by OFAC has helped bring about some clarity regarding the magnitude and scope of the EO's impact on the securities market. However, this clarity only serves to confirm that, in effect, the EO is designed to dissuade any continued investment in any securities that touch the identified companies (or their subsidiaries).

© Arnold & Porter Kaye Scholer LLP 2021 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.