November 13, 2020 – On November 12, 2020, President Trump issued an executive order that, as of January 11, 2021, will prohibit U.S. persons from “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.”  The order cites China’s national strategy of Military-Civil Fusion for justification, stating that the targeted companies “raise capital by selling securities to United States investors that trade on public exchanges both here and abroad, lobbying United States index providers and funds to include these securities in market offerings, and engaging in other acts to ensure access to United States capital.”

The term “Communist Chinese military company” includes the thirty-one entities identified as of the date of the executive order by the U.S. Department of Defense (“DoD”) pursuant to Section 1237 of the National Defense Authorization Act (“NDAA”) for Fiscal Year 1999 (Public Law 105-261).  To date, two lists have been issued by the DoD on June 12, 2020 and August 28, 2020.  While the executive order prohibits U.S. persons from engaging in “any transactions” with respect to the publicly traded securities of these companies, it provides temporary authorization for one year (until November 12, 2021) for U.S. persons to divest the securities.

Future additions to the DoD list made by DoD “in consultation with the Secretary of the Treasury” are also included in the definition, as well as persons identified solely by the Secretary of the Treasury and publicly listed as “meeting the criteria in section 1237(b)(4)(B) of Public Law 105-261, or . . . as a subsidiary of a person already determined to be a Communist Chinese military company.”  However, the restrictions will not become effective for future designated entities until 60 days after their designation.  Transactions to divest from subsequently listed companies are also permitted for up to a year after the listing.

The term “U.S. person” shares the usual definition under U.S. sanctions programs to mean “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 “securities” includes the definition of that term under the Securities Exchange Act of 1934, as well as “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.”  The term “transaction” means “the purchase for value of any publicly traded security” (although the order implies that sales and other transactions that are not purchases of securities by U.S. persons are also controlled by the order).

The ultimate effect of the order is unclear. In the context of sanctions, many financial institutions are very risk averse, and avoid even legally permissible transactions to manage their compliance and reputational risks.  Considering that the executive order is issued under the authority of the International Emergency Economic Powers Act (“IEEPA”), which is the same statutory authority for most U.S. sanctions programs, we would anticipate at least some of these financial institutions to immediately seek divestment from the listed companies. 

On the other hand, it is not clear whether the executive order will survive the end of the Trump Administration.  The order becomes effective on January 11, 2021, nine days before inauguration on January 20, 2021.  Further, U.S. investors have until November 2021 to divest from the targeted companies.  The order will also almost certainly draw judicial challenges, from both the targeted companies as well as U.S. investors.  Some risk-tolerant U.S. investors may take a wait-and-see approach and simply hold their investments until late summer or early fall 2021 to see if the courts or the Biden Administration will revoke the order.  President Biden could do so unilaterally via executive order.  A Biden Administration could also simply decline to defend the order in court challenges, which would likely lead to a de facto injunction against the order.  Thus far, the Biden transition team has declined to comment on the executive order.

The full scope of the order is also not clear.  On its face, the order says that it reaches securities of the listed companies directly held by U.S. persons as well as “any securities that are derivative of, or are designed to provide investment exposure to such securities.” This would appear to include, e.g., mutual funds or exchange traded funds with investments in the listed companies.  This could potentially reach millions of ordinary Americans with interests in, for example, pension funds, 401K funds, IRAs, index funds, and other investment vehicles with holdings in the listed companies.  It is unclear what diligence would be required by these U.S. persons to determine whether their investments have exposure to securities of the listed companies or how deeply investors will be expected to conduct such diligence.  For example, the order is not clear on the compliance obligations of an investor in a fund that itself is the investor in a domestic or foreign fund (and so on); the further the investment chain extends, the more difficult it would be for U.S. persons to comply with the order.  While we anticipate the Treasury Department to issue guidance (if the order extends beyond the inauguration), the inability of U.S. persons to reasonably comply with the order could serve as a basis for a judicial challenge.