U.S. Persons Barred from Trading in Securities That Finance Communist Chinese Military Companies

President Donald Trump issued on Nov. 12, 2020, an Executive Order prohibiting U.S. persons from trading in securities, both in the U.S. and abroad, that finance communist Chinese military companies. The EO is issued under the authority of the International Emergency Economic Powers Act (IEEPA) (50 U.S.C. 1701 et seq.), the National Emergencies Act (50 U.S.C. 1601 et seq.) and Section 301 of Title 3, United States Code.

The EO is the response to concerns that "the People's Republic of China is increasingly exploiting United States capital to resource and to enable the development and modernization of its military, intelligence, and other security apparatuses, which continues to allow [China] to directly threaten the United States homeland and United States forces overseas, including by developing and deploying weapons of mass destruction, advanced conventional weapons, and malicious cyber-enabled actions against the United States and its people." The EO goes on to stress that through the national strategy of Military-Civil Fusion, China increases the size of its military-industrial complex by compelling civilian Chinese companies to support its military and intelligence activities, while those companies raise capital by selling securities to U.S. investors that trade on public exchanges both in the U.S. and abroad. In that way, the EO concludes that China exploits U.S. investors to finance the development and modernization of the Chinese military.

In summer 2020, the U.S. Department of Defense identified some 31 companies as being Communist Chinese military companies under Section 1237(b) of the Strom Thurmond National Defense Authorization Act for Fiscal Year 1999 (FY1999 NDAA) (Public Law 105-261), which provides contours to help those not listed determine whether they could be a target for listing. Any company owned or controlled by the People's Liberation Army (which includes, beyond the Chinese military, the Chinese policy and intelligence services) and who provides commercial services, who manufactures or produces products or who exports can be a Communist Chinese military company. Media reports have indicated that President Trump plans to announce a number of additional restrictions on trade with China over the coming weeks before he leaves office on Jan. 20, 2021.

Prohibited Activities

The EO prohibits any U.S. person's transaction in publicly traded securities, or any securities that are derivative of, or are designated to provide investment exposure to such securities, of any Communist Chinese military company, beginning the earlier of Jan. 11, 2021, or 60 days after a person is determined to be a Communist Chinese military company. To date, the U.S. Department of Defense has issued two lists of a total of 31 "qualifying entities," for which the upcoming Jan. 11 no-transaction date applies. The EO provides a limited exception to the prohibited transactions, allowing U.S. persons until Nov. 11, 2021, solely to divest, in whole or in part, from such securities. The divestment deadline of Nov. 11 applies to those Communist Chinese military companies that have already been listed by the Secretary of Defense. Presumably, as new listings of "qualifying entities" are announced, different allowance periods will be set.

Although the EO provides a period to divest, it does not specifically require divestment and uses the term "transaction" rather than referring to blocking of funds or freezing of assets. The question is whether simply continuing to hold investment securities purchased prior to the effective dates of this EO will be considered a prohibited "transaction," or subject the investor to potential liability if a fund or other portfolio manager takes a position in one of the subject companies.¹ While continuing to hold such securities without the ability to sell or transfer (which would be "transactions") may not be the most prudent investment strategy, trying to divest during the grace period while others are doing the same may have its own financial drawbacks.

Communist Chinese Military Company Defined

A Communist Chinese military company is any entity publicly designated as such by:

1. the Secretary of Defense, pursuant to Section 1237 of Public Law 105-261, as amended by Section 1233 of Public Law 106-398 and Section 1222 of Public Law 108-375, if the entity is operating directly or indirectly in the United States or in any of its territories or possessions, or
2. the Secretary of the Treasury, if the entity meets the criteria in Section 1237(b)(4)(B) of Public Law 105-261, or is a subsidiary of an already so designated person.

Section 1237(b) of FY1999 NDAA lists the criteria used to determine whether an entity that is not listed could be a target for listing. Any company owned or controlled by the People's Liberation Army (which includes, beyond the Chinese military, the Chinese policy and intelligence services) and who provides commercial services, manufactures or produces products, or exports can be a Communist Chinese military company under the Statute. However, both the FY1999 NDAA and the EO stress the need for an entity to be publicly listed before the prohibitions apply.

Effects on U.S. Persons' Trading

Notably, the prohibitions apply to U.S. persons' trading both in the U.S. and abroad. The EO does not require a U.S. Exchange to delist a security, but the effect of the EO should cause U.S. Exchanges to notify issuers that the Exchange will halt trading in securities of issuers meeting the definition of a Communist Chinese military company. A number of fund and asset managers should consider now whether they have included in their portfolios issuers who could qualify as Communist Chinese military companies. Additional guidance from the U.S. Department of the Treasury may help Exchanges and asset managers better assess what steps they may need to take to respond to the EO. 

When it comes to trading on foreign exchanges, the prohibition seems to be a bit more straightforward: U.S. persons are allowed a grace period to divest from such securities that otherwise have not been traded in the prohibited period. This should permit institutional investors and asset managers index time to consider whether they own securities of Communist Chinese military companies overseas and divest if necessary.

The EO appears to impose heavy burdens on all U.S. institutional and individual investors, from mutual funds to sophisticated investment advisors and even the casual investor, in the U.S. or abroad. First, the EO extends not only to any entity organized in the U.S. but to any U.S. citizen or permanent resident alien acting anywhere at home and abroad, as well as a foreign branch of a U.S. entity or any person in the U.S. For example, a "United States person's" trading in a listed entity on a foreign exchange would constitute a violation of the EO. Fundamentally, however, U.S. investors will now be required to examine their portfolios for prohibited trades and holdings – individual securities and derivatives as well as the underlying securities held or traded by mutual funds, exchange-traded funds (ETFs) and alternative investments – and also undertake proactive defensive strategies and ongoing strict vigilance. Investment managers of mutual funds and individual investors also will be required to take a deep dive into the underlying investments – the trades that mutual funds make or would be eligible to make under the terms of the fund. Managers will be called upon to scrutinize their portfolios and implement measures proactively to avert trades that could involve the subject securities. Some may take the additional measure of divesting at the outset. In addition, as part of their compliance program, U.S. funds, managers and investors will be required to identify subsidiaries and foreign branches of the subject companies and monitor postings of both the Secretaries of Defense and the Treasury for published lists of "qualified entities."

Mutual funds or ETFs tied to international index funds will have to be scoured, especially those with holdings in Asia and the emerging markets. Moreover, financial institutions will be taking inventory of their American depository receipts (ADRs) and other depository receipts (DRs) to see if they include shares in the subject companies. They also will implement trip wires to prevent acquiring new positions in them. Managers will have to assess whether it would be financially advisable to divest now or sometime closer to Nov. 11, 2021.

The EO may affect capital raising in the U.S. for those non-U.S. companies seeking to list in the U.S. and for non-listed foreign private issuers. For quite some time, Chinese companies have sought to raise capital in the U.S., and U.S. investors have had an appetite for the potential for growth afforded by China's commercial markets. Nevertheless, U.S. regulators have for some time keenly scrutinized Chinese issuers because some have engaged in questionable accounting practices. For example, the U.S. Securities and Exchange Commission (SEC) has examined carefully reverse mergers involving Chinese companies. Reverse mergers were previously a popular way to allow a Chinese company to enjoy an initial public offering without the scrutiny of registering the operating company's securities and engaging in a traditional underwriting process. To effect a reverse merger, a Chinese operating company would merge with and into a U.S. shell company that had already gone through the S-1 registration process and had its registration statement declared effective. Upon the closing, the Chinese company's business would be represented by U.S. securities that were freely tradable in the U.S.

Through its investigatory powers, the SEC made the U.S. markets well aware that the SEC would examine Chinese issuers' accounting practices to ensure that Chinese companies were not misleading U.S. investors. As a result, opportunities to invest in Chinese issuers decreased, and the U.S. began to see more traditional methods used to offer securities of Chinese issuers in the U.S. President Trump's EO represents yet another tool that the U.S. government can deploy to regulate the ability of Chinese companies to access liquidity and capital in the U.S.

Finally, the EO leaves it to the Treasury Department to issue rules and regulations to help implement the EO, as well as to consider establishing procedures for licenses to authorize specified transactions that otherwise would be prohibited under the EO. As a practical matter, managers and investors can quickly take inventory of their portfolios, ensure that no purchases of all listed companies will be undertaken and wait to see if the incoming Biden Administration will reverse or modify the instant EO.

Conclusion

China's growing military aspirations have been a recurring motif in U.S. national security deliberations for some time. The EO is an example of how the U.S. government is using the power of an Executive Order to address China's increasing economic and military power. How the EO will be implemented in practice will become clearer when the Treasury Department issues regulations. The EO does not seem to intend to harm U.S. investors, as it affords them generous grace periods to divest from the affected securities; however, selling under these circumstances or merely designating an entity as a Communist Chinese military company could have material adverse consequences on the market value of the underlying security.

The EO comes in the wake of an earlier action by the Trump Administration, a June 4, 2020, Presidential Memorandum on Protecting United States Investors from Significant Risks from Chinese Companies. (For details on that action, see Holland & Knight's previous alert, "U.S. Government to Take Actions Against U.S.-Listed Chinese Companies," July 28, 2020.)

For any questions about the implications of the above proposed rules and the effects on your business, contact the authors.

Notes

¹ While an investor's mere holding may not constitute a transaction, holding shares in a mutual fund that trades in a subject company could subject both the fund and the investor to a violation.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.