Authors: Aaron Wolfson, Meg Utterback, Richard Mazzochi, Minny Siu and Leonie Tear, Wang Feng, Dai Menghao, King Wood & Mallesons

On 3 June 2021, President Biden signed an Executive Order (EO14032) overhauling the sanctions regime introduced by the Trump administration that targeted securities linked to so-called “Communist Chinese Military Companies” (CCMCs).

As compared with Executive Order (EO13959), which introduced the CCMC sanctions regime in November 2020, EO14032 is “targeted and scoped”, according to the U.S. Treasury Department’s press statement accompanying the publication of EO14032.[3]  EO14032 clarifies EO13959, which caused market confusion in its original form, as to which see our previous alert.  For example, EO13959 originally listed brands, company group names and non-issuers, making it hard to know which issuers, and therefore which securities, were affected by the sanctions.  The confusion was compounded with the release of a Frequently Asked Question (FAQ) by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) that sought to extend the prohibitions to companies with names that “closely matched” the listed names, leaving it to market participants to work out how similar a name needed to be for the entity to be considered designated.

EO14032 amends EO13959 (as previously amended by Executive Order 13974), replacing and superseding sections 1–5 thereof, and was published with a revised set of FAQs to provide further clarity and guidance.[4]  EO14032 and the related FAQs seek to redefine the parameters outlined in EO13959.  EO14032 still imposes prohibitions on U.S. investment in Chinese companies deemed to threaten U.S. national security.

This alert summarises the current status of EO13959, as amended by EO14032 (referred to by OFAC in FAQs as “EO13959, as amended”) and the key changes that have been made.  It also considers how compliance with U.S. sanctions might violate the laws of Hong Kong SAR and China, leaving financial institutions in Hong Kong SAR walking a tightrope between compliance with U.S. and local laws.

What is prohibited?

EO13959, as amended by EO14032, primarily applies to U.S. persons, meaning:

Ø  any U.S. citizen or legally permitted U.S. resident (eg green card holder), wherever located;

Ø  any person, of any nationality, within the United States; and

Ø  any entity organised under the laws of the United States or any jurisdiction within the United States (including foreign branches of U.S. companies).[5]

Upon the sanctions taking effect (see “When do the prohibitions come into effect?” below), U.S. persons are prohibited from engaging in the purchase or sale of any:

Ø  publicly traded securities;

Ø  publicly traded securities that are derivative of securities; or

Ø  publicly traded securities that are designed to provide investment exposure to publicly traded securities

of any CMIC named in the Annex to EO14032 or in the future (Affected Securities).[6]

The U.S. Secretary of the Treasury may designate a person or entity as a CMIC upon a determination that the person or entity: (1) operates or operated in the defence and related materiel sector or the surveillance technology sector of China; (2) owns or controls, or is owned or controlled by, directly or indirectly, such a person or entity.

All transactions, whether by a U.S. person or non-U.S. person, that evade or avoid, have the purpose of evading or avoiding, cause a violation of, or attempt to violate the prohibitions above are also prohibited, as are conspiracies to violate the prohibitions.  Therefore, a non-U.S. investment firm that aids a U.S. person to invest in the Affected Securities could be subject to an enforcement action under this provision.

Key changes

The scope has been extended to companies in the Chinese surveillance technology sector. 

Non-U.S. persons are now brought into the prohibitions relating to evading, avoiding or causing a violation of sanctions.  Under EO13959 previously, only the offence of conspiracy clearly extended to non-U.S. persons.  That said, the “causing” offence already applied to non-U.S. persons due to the underlying powers contained in Section 1705 of the International Emergency Economic Powers Act.   

What companies have been designated?

There are 59 entities listed in the Annex to EO14032, available here.

OFAC has also published a complete list of the CMIC-designated entities in PDF, the non-SDN[7] Chinese Military-Industrial Complex Companies List (NS-CMIC List), available here.[8]  This includes aliases and identifiers such as addresses and equity tickers, in line with OFAC’s usual approach to clearly identify designated parties.

In addition, OFAC’s online search tool has also been updated and can be filtered to list all CMIC entities, which should provide an easy and up-to-date way to identify what sanctions apply, to what entities and from what dates. The tool is available here.

Key changes

Previously the prohibitions applied to listed CCMCs and any entity “with a name that exactly or closely matches the name of an entity identified” as a CCMC. 

It is now only the companies clearly identified in the NS-CMIC List that are designated. Subsidiaries are not included until specifically listed, and new FAQ 899 makes it abundantly clear that only entities with names that exactly match those on the NS-CMIC List are subject to the prohibitions.

The NS-CMIC List is closely aligned with the previous NS-CCMC List but is more specific.  However, there are some entries that appear to be entirely new.

It is important for those in the securities industry to carefully screen against the latest NS-CMIC List.  

What types of securities are impacted?

The prohibitions apply to any “security” as that term is defined in section 3(a)(10) of the U.S. Securities Exchange Act of 1934 (Securities Exchange Act), denominated in any currency, that trades on a securities exchange or through “over-the-counter” trading, in any jurisdiction.

The definition of securities is very broad and includes anything generally known as a security.  It includes futures, options, swaps, warrants, callable bull/bear contracts, American depositary receipts, global depositary receipts, exchange-traded funds (ETF), index funds, and mutual funds that have an underlying in all or part of stocks relating to CMICs.[9]  This is regardless of the securities’ share of the underlying index fund, ETF, or derivative thereof.[10]

Key changes

The previous inclusion of “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” that extended the definition of “security” in Securities Exchange Act has been removed from EO13959.

Otherwise the broad definition of securities and the inclusion of OTC securities remains unchanged.

When do the prohibitions come into effect?

The prohibitions commence at 12:01 a.m. EDT on 2 August 2021 with respect to the 59 entities designated as a CMIC in the Annex to EO14032.  For any entities subsequently designated as a CMIC, the prohibitions commence 60 days from the date of designation.[11]

Key changes

Prohibitions commenced for CCMCs on 11 January 2021, 1 February 2021, 28 February 2021 and 9 March 2021, depending on the particular CCMC.  Further prohibitions for entities that “closely matched” those named were repeatedly delayed due to the issuance of a series of OFAC “General Licenses”.  Those prohibitions now do not apply.  However, as new prohibitions start in early August, including for most companies previously designated as a CCMC, we do not expect a market rush from U.S. investors purchasing Affected Securities.

Is there a wind-down period?

Yes, a 365-day wind-down period is afforded. For the 59 CMICs listed in the Annex to EO14032, the wind-down period commenced on 3 June 2021 and extends to 3 June 2022.  For entities designated in the future, the wind-down period will end 365 days after the date of determination.  During the wind-down period, U.S. persons may make purchases or sales of Affected Securities if they are made solely to effect the divestment, in whole or in part, of such securities.  This includes permitting market intermediaries, including market makers, to engage in activities necessary to effect divestiture during the wind-down period, including the conversion of American depositary receipts of a CMIC into underlying securities of the CMIC on the foreign exchange where the underlying securities are listed.[12]

Key changes

The commencement date of prohibitions and the end-date of the wind-down period is now later for many impacted entities.  Prohibitions for all CMICs listed in the Annex to EO14032 commence on 2 August 2021, and the wind-down period will end on 3 June 2022.

What is not prohibited?

U.S. persons are permitted to provide the following services in relation to Affected Securities, to the extent they are not provided to U.S. persons in connection with prohibited transactions:  investment advice, investment management or similar services, and clearing, execution, settlement, custody, transfer agency, back-end services and other support services.[13]

New FAQ 903 specifically states that U.S. persons employed by non-U.S. entities are not prohibited from being involved in, or otherwise facilitating, purchases or sales related to an Affected Security on behalf of their non-U.S. employer, provided that such activity is in the ordinary course of their employment and the underlying purchase or sale would not otherwise violate EO13959, as amended.

In practice, this means that, so long as a transaction does not involve a U.S. person purchasing or selling Affected Securities, a U.S. person can be involved in the process.  For example:

  • S. staff members may continue to execute trades involving Affected Securities;
  • S. entities that provide settlement services may continue to do so;
  • a U.S. individual acting as the fund manager for a non-U.S. investment fund, or a U.S. entity that is the investment adviser or investment manager for a non-U.S. investment fund may authorise, direct, or approve purchases or sales of Affected Securities by the non-U.S. investment fund,

Provided that: (1) neither the purchase nor sale is for the ultimate benefit of a U.S. person, (2) the purchase or sale is not a wilful attempt to evade the prohibitions of E.O. 13959, as amended, and (3) the underlying purchase or sale would not otherwise violate EO13959, as amended.

Finally, U.S. persons are not prohibited from engaging in other activities with CMICs such as the sale of goods and services,[14] except as prohibited by other U.S. laws (eg export restrictions related to the Entity List).

Key changes

The guidance confirming that U.S. individuals and entities may continue to provide investment advice and investment management related to Affected Securities is new, as is the specific reference to U.S. staff members at non-U.S. entities in FAQ 903.  This new guidance should provide relief and reassurance to U.S. persons employed by or acting for non-U.S. companies in the securities market who would otherwise have been concerned that such actions could be deemed to be a facilitation offence for which there can be serious consequences.

Further, new FAQ 901 states that, in assessing whether certain purchases or sales are permissible under EO14032, U.S. persons, including financial institutions, registered broker-dealers in securities, securities exchanges, and other market intermediaries and participants, may rely upon the information available to them in the ordinary course of business.  This provides reassurance that where selling restrictions that prohibit sales to U.S. persons are in place and/or there is no indication that a purchaser or seller is a U.S. person, a non-U.S. person involved in the trade will not violate EO14032.  This is significant for non-U.S. entities who may otherwise have been concerned about falling foul of the “causing a violation” offence by unwittingly selling an Affected Security to a U.S. person, for example.

Can designations be challenged?

The listing of X company as a CCMC is reported to have knocked around 10% off the price of its Hong Kong SAR-listed shares.[16]  X company responded, denying ties to China’s military. In March 2021, the U.S. District Court for the District of Columbia issued a preliminary injunction halting X company’s inclusion as a CCMC, which the court found to be based on a flawed rationale.  X company’s designation was based on two factors:

Ø     X company’s development of 5G technology and artificial intelligence (AI), which the U.S. Department of Defense considered essential to military operations; and

Ø     an award given to X company founder and Chief Executive Lei Jun from an organisation said to help the Chinese government eliminate barriers between commercial and military sectors.

The court noted that 5G and AI technologies are becoming standard in consumer electronics and that over 500 entrepreneurs had received the same award as Lei since 2004, including the leaders of an infant formula company.  The reasons for designating X company were therefore found to be weak, and on 25 May 2021, the court ordered that the listing of X company as a CCMC be vacated.  Consequently, the prohibitions in EO13959 do not apply with respect to X company, and X company has not been re-designated pursuant to EO14032 or included in the Annex thereto.

L company had been designated pursuant to EO13959 on the basis that it was a company “affiliated with” China’s military. It successfully challenged in court the wide definition of “affiliated with” used to justify the designation.

Neither X company nor L company is included in NS-CMIC List.  It is possible that some CMICs will seek to challenge their inclusion on the NS-CMIC List following the successes of X company and L company challenging their inclusion on the NS-CCMC List.  A CMIC with a weak or tenuous connection to China’s military would be most inclined to file such challenges.  However, EO14032 has widened the scope of the sanctions, with surveillance technology companies also subject to sanctions, so CMICs will need to evaluate whether their designation could be justified based on such activities and whether they wish to have any such activities closely examined in a U.S. court.

Conclusion

Whilst the impact on the securities market continues to be significant, just as it was following the original issuance of EO13959, the scope of the prohibitions are now clearer, and market participants have additional time to assess their implications for their businesses.  Identifying all impacted securities must remain a priority for market participants.

The reassurances now provided for U.S. staff members of non-U.S companies involved in securities trading and investment management provide greater clarity and allow those companies with a large U.S. staff, or with senior U.S. staff in management, to breathe a sigh of relief and largely revert to business as usual.

Further, the confirmation that market participants may rely on information available to them to assess whether a transaction is permissible will lighten the compliance and due diligence burdens considerably for those concerned about inadvertently causing a sanctions violation.

CMICs may wish to challenge the reasons for their inclusion on the NS-CMIC List following the successful challenges from X company and L company.

Since EO13959 was published, we have been assisting numerous clients to navigate its scope and application. Please reach out to us if you require guidance.

[1]    For the purposes of this alert, China refers to the People’s Republic of China excluding Hong Kong SAR, the Macau Special Administrative Region and Taiwan.

[2]    This list of CMICs is not to be confused with a list of “Chinese military companies” released on June 4, 2021 by the U.S. Department of Defense in accordance with its reporting obligations under Section 1260H of the National Defense Authorization Act for Fiscal Year 2021.  Although many CMICs appear on that list, inclusion on the Department of Defense list does not automatically subject a listed company to any sanctions.

[3]    https://www.whitehouse.gov/briefing-room/statements-releases/2021/06/03/fact-sheet-executive-order-addressing-the-threat-from-securities-investments-that-finance-certain-companies-of-the-peoples-republic-of-china/

[4]    EO14032 also revokes Executive Order 13974 in its entirety and replaces the Annex to EO13959 with the Annex to EO14032. EO14032 §§ 3, 4.

[5]    Section 3(d), EO13959, as amended by EO14032.

[6]    Section 1(a), EO13959, as amended by EO14032.

[7]    “Non-SDN” simply refers to the designated entities not being included in OFAC’s Specially Designated and Blocked Persons List. Specific and extensive rules apply to those on the SDN List that do not apply to persons specified to be on a “non-SDN” list.  There are other non-SDN lists in addition to the CMIC list, such as the Sectoral Sanctions Identifications List, with each list having distinct rules.

[8]    The NS-CMIC List replaces the previous “Non-SDN Communist Chinese Military Companies List” (NS-CCMC List).

[9]    Section 3(c), EO13959, as amended by EO14032; FAQ 860.

[10]   FAQ 861.

[11]   Section 1(b), EO13959, as amended by EO14032.

[12]   OFAC FAQ 865 and FAQ 904.

[13]   OFAC FAQ 863 and FAQ 902.

[14]   OFAC FAQ 905.

[15]   OFAC also provides a route for designated persons to request that they be removed from a sanctions list, but this is unlikely to be successful for a CMIC.

[16]   https://www.cnbc.com/2021/01/15/X company-added-to-us-blacklist-of-chinese-military-companies-.html.