U.S. Economic Sanctions Targeting Chinese Military Companies

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November 17, 2020U.S. Economic Sanctions TargetingChinese Military CompaniesNew Executive Order Prohibits U.S. Persons from “Transacting” inPublicly Traded Securities of “Communist Chinese MilitaryCompanies”SUMMARYOn November 12, 2020, President Trump issued an Executive Order prohibiting U.S. persons from“transacting” in publicly traded securities of “Communist Chinese military companies.” The new restrictions,which go into force on January 11, 2021, initially target 31 companies that have been identified by the U.S.Department of Defense as “Communist Chinese military companies.” Those targeted include some ofChina’s largest industrial and technology firms, with several having subsidiaries that are listed on U.S. stockexchanges. The Executive Order also prohibits “transacting” in publicly traded securities of companies thatmay be identified by the Department of Defense or the Department of the Treasury as “Communist Chinesemilitary companies” in the future, and provides authority to the Treasury Department to further targetsubsidiaries of any company determined to be a Communist Chinese military company.BACKGROUNDSection 1237 of the National Defense Authorization Act for Fiscal Year 1999 (“NDAA 1999”), as amended,directs the Secretary of Defense to identify companies operating directly or indirectly in the United Statesor in any of its territories or possessions that are linked to China’s military, and provides the President withadditional authorities to sanction such companies. 1 Specifically, pursuant to § 1237(a)(1) of the NDAA1999, as amended,2 the President is authorized, but not required, to impose sanctions under theInternational Emergency Economic Powers Act (“IEEPA”)3 in the case of any commercial activity in theNew YorkWashington, D.C.Los Angeles Palo Alto London ParisTokyo Hong Kong Beijing Melbourne Sydneywww.sullcrom.comFrankfurtBrussels

United States by a person that is on the list of “Communist Chinese military companies” published by theDepartment of Defense.On June 12, 2020, following Congressional correspondence, the Defense Department issued its firsttranche of identifications, naming 20 Chinese companies.4 The June 2020 list included major state-ownedindustrial corporations, as well as technology firms such as Huawei and Inspur Group. 5 The DefenseDepartment identified additional firms on August 28, 2020, bringing the total number of identified companiesto 31.6EXECUTIVE ORDEROn November 12, 2020, President Trump issued Executive Order 13959 declaring a national emergencywith respect to the threat to the national security, foreign policy and economy of the United States posedby the People’s Republic of China’s military-industrial complex and authorizing certain IEEPA-basedrestrictions on identified “Communist Chinese military companies.” 7The Executive Order defines the term “Communist Chinese military company” in two principal ways. First,it includes any person identified by the Department of Defense, either currently or in the future, as meetingthe criteria in § 1237 of the NDAA 1999, as amended. 8 Second, the term “Communist Chinese militarycompany” also includes any entity that the Secretary of the Treasury may publicly list as meeting the criteriaof being “owned or controlled by the People’s Liberation Army and . . . engaged in providing commercialservices, manufacturing, producing, or exporting,” or as a subsidiary of a company already determined tobe a Communist Chinese military company. 9 In each case, the identification is valid until such time as theSecretary of Defense or the Secretary of the Treasury, as applicable, removes the listing and identificationof such entity. The Executive Order does not block the property of identified entities; therefore, it appearsthat OFAC’s “50-Percent Rule”, which provides that entities owned 50 percent or more by blocked partiesare property of the blocked party, and also blocked, does not apply to automatically subject majority-ownedsubsidiaries of identified entities to the transactional prohibitions. 10 Thus, it appears that U.S. persons arenot prohibited from transacting in securities of a subsidiary of an identified firm, provided the subsidiaryitself has not been identified by the Department of Defense or the Treasury Department. However, asubsidiary potentially could be identified as a Communist Chinese military company by either Defense orTreasury in the future, or as a subsidiary of a company already determined to be a Communist Chinesemilitary company by Treasury, in which case the prohibitions would attach.Beginning at 9:30 a.m. Eastern Standard Time on January 11, 2021, U.S. persons are prohibited fromengaging in “any transaction in publicly traded securities, or any securities that are derivative of, or aredesigned to provide investment exposure to such securities” of Communist Chinese military companiesidentified by the Defense Department as of November 12, 2020. 11 The same prohibition on “transactions”will apply to Communist Chinese military companies identified by the Defense Department or the Treasury-2U.S. Economic Sanctions Targeting Chinese Military CompaniesNovember 17, 2020

Department (or a subsidiary thereof identified by the Treasury Department) in the future. The transactionalprohibition for such companies will apply following a 60-day period from the date of identification.The prohibitions in the Executive Order appear to be narrowed by the definition of the term “transaction,”which for purposes of the Executive Order means “the purchase for value of any publicly traded security.” 12As such, the Executive Order, read literally, prevents only any transactions (i.e., the purchase for value ofany publicly traded security) in publicly traded securities, or any securities that are derivative of, or aredesigned to provide investment exposure to such securities, of any Communist Chinese military company.Thus, it does not appear to prohibit the passive holding of investments or the sale of securities to non-U.S.persons. The inclusion of the phrase “of any publicly traded security” within the definition of “transaction”also raises a question as to how to interpret the application of the prohibition to the purchase for value of“securities that are derivative of, or are designed to provide investment exposure to such [publicly traded]securities,” as these derivative or synthetic investment vehicles may not themselves be publicly traded.Additional interpretive complications arise from the fact that the terms “investment exposure” and “publiclytraded” are not defined in the Executive Order. If interpreted broadly, the term “investment exposure” couldencompass a wide range of activity. Although the term “publicly traded” is not defined, the reference to“public exchanges” in the preamble text of the Executive Order may indicate that the goal is to targettransactions related to investment securities traded in public markets. However, the definition of “security”in § 4(d) of the Executive Order, though based on the definition of the same term in the Securities ExchangeAct of 1934 (“Exchange Act”), also includes a number of financial products expressly excluded from thedefinition of “security” in the Exchange Act and not typically viewed as investment securities or traded inpublic markets.13The Executive Order expressly authorizes purchases for value or sales solely to divest from securities heldby U.S. persons in identified Communist Chinese military companies, so long as those transactions aremade by November 11, 2021 for securities of companies identified by the Defense Department as ofNovember 12, 2020 (or within 365 days from the date of identification for companies identified at a latertime). This authorization may suggest that the Executive Order is intended to incentivize divestment byU.S. persons of any securities of Communist Chinese military companies, despite the apparent limitationbuilt into the definition of “transaction,” as described above.The Executive Order provides regulatory and enforcement authority to the Secretary of the Treasury, andit appears likely that the Office of Foreign Assets Control (“OFAC”) will be responsible for publishing relevantregulations, as well as clarifying guidance.-3U.S. Economic Sanctions Targeting Chinese Military CompaniesNovember 17, 2020

IMPLICATIONSAccording to National Security Adviser Robert O’Brien, the measures “serve[] to protect American investorsfrom unintentionally providing capital that goes to enhancing the capabilities of the People’s Liberation Armyand People’s Republic of China intelligence services.” 14 It is clear that the new Executive Order will impedetrading of the securities of Communist Chinese military company securities on U.S. exchanges, andpresumably will threaten the inclusion of such securities in U.S.-based indexes and funds, as well as limittrading in such securities by U.S. persons on foreign exchanges. Less certain is how the order will affectsubsidiaries of identified firms. At this time, only a small number of the 31 identified companies are listedon public exchanges, and all of these listings are outside the United States. However, nearly all havesubsidiaries or affiliates that are themselves listed on exchanges, both within the United States and abroad.While the Executive Order grants the Treasury Department the authority to identify subsidiaries ofCommunist Chinese military companies, subsidiaries are not automatically subject to the prohibitions, asthe 50% Rule does not apply.The Executive Order also provides that “transactions” (as defined by the Executive Order) that “cause aviolation” of the prohibitions are prohibited. Therefore, it is possible that the Executive Order could havewide-ranging effects on non-U.S. holders of securities that have ties to the United States. For instance, anon-U.S. investor could potentially be subject to liability for purchasing securities of an identified entity ona non-U.S. exchange if the payments are routed through the United States or a U.S. financial institutionwherever located. Similarly, U.S. investors may be concerned about investing in non-U.S. funds that holdprohibited securities. The ambiguities highlighted above also raise questions regarding the scope of theExecutive Order’s prohibitions and potential liability that may arise out of transactions in financial productsnot typically viewed as investments or securities.Finally, the potential for future identification as aCommunist Chinese military company will likely dampen enthusiasm for future public offerings of securitiesby Chinese companies that are not yet identified but which have ties to the Chinese military.***Copyright Sullivan & Cromwell LLP 2020-4U.S. Economic Sanctions Targeting Chinese Military CompaniesNovember 17, 2020

ENDNOTES1§ 1237 of Pub. L. 105-261 (1999)2§ 1237 of Pub. L. 105-261 (1999), as amended by § 1233 of Pub. L. 106-398 (2001) and § 1222 ofPub. L. 108-375 (2004).350 U.S.C. §§ 1702–05.4See Letter from David L. Norquist, Deputy Sec’y of Defense to Sen. Tom Cotton (June 24, %201237%20Response%2006242020.pdf.5U.S. Dep’t of Defense, “Qualifying Entities Prepared in Response to Section 1237 of the NationalDefense Authorization Act for Fiscal Year 1999” (June 12, 2020), available /-1/-1/1/LINK 2 1237 TRANCHE 1QUALIFIYING ENTITIES.PDF.6U.S. Dep’t of Defense, “Qualifying Entities Prepared in Response to Section 1237 of the NationalDefense Authorization Act for Fiscal Year 1999” (August 28, 2020), available /-1/-1/1/LINK 1 1237 TRANCHE23 QUALIFYING ENTITIES.PDF. An Annex to the Executive Order consolidates the twoDepartment of Defense listings into a single source. See Exec. Order No. 13,959, 85 Fed. Reg.73,185 (November 17, 2020), available at df/X20-11117.pdf7Id.8Under § 1237 of the NDAA 1999, as amended, the term “Communist Chinese military company”includes any entity that has been identified in specified Defense Intelligence Agency publications,and also includes any entity that is identified by the Department of Defense as operating directly orindirectly in the United States or any of its territories and possessions that is “owned, or controlled,or affiliated with, the People’s Liberation Army or a ministry of the government of the People’sRepublic of China or that is owned or controlled by an entity affiliated with the defense industrialbase of the People’s Republic of China; and is engaged in providing commercial services,manufacturing, producing, or exporting.” Pub. L. 105-261, § 1237(b)(4)(B)(i)–(ii), as amended by§ 1233 of Pub. L. 106-398 (2001) and § 1222 of Pub. L. 108–375 (2004).9The definition of “Communist Chinese military company” for purposes of the Secretary of theTreasury’s identification of companies is a narrower definition, taken from the original version ofthe NDAA 1999 and not the definition of the term as amended by Pub. L. 108-375 (2004) as usedby the Secretary of Defense. The definition used by Treasury omits expansions covering: (i) entities“affiliated with” the People’s Liberation Army and (ii) entities owned or controlled by, or affiliatedwith, “a ministry of the government of the People’s Republic of China or [ ] owned or controlledby an entity affiliated with the defense industrial base of the People’s Republic of China.”10It is possible that the Treasury Department could issue a rule or clarifying guidance that all 50percent or more owned companies of listed Communist Chinese military companies are coveredby the transactional prohibitions.11Id. § 1(i). “Securities” are defined as in § 3(a)(10) of the Securities Exchange Act of 1934, with theaddition that “currency or any note, draft, bill of exchange, or banker’s acceptance which has amaturity at the time of issuance of not exceeding 9 months, exclusive of days of grace, or anyrenewal thereof the maturity of which is likewise limited, shall be a security for purposes of thisorder.” Id. § 4(d).12Id. § 4(e).-5U.S. Economic Sanctions Targeting Chinese Military CompaniesNovember 17, 2020

ENDNOTES (CONTINUED)13The expansion of the definition of “security” beyond § 3(a)(10) of the Securities Exchange Act of1934 may be designed to prevent evasion of the restrictions by the Communist Chinese militarycompanies through selling in the capital markets short-term obligations that would not otherwisemeet the definition of security. See supra note 11.14Statement from National Security Advisor Robert C. O’Brien (November 12, 2020), available -111220/.-6U.S. Economic Sanctions Targeting Chinese Military CompaniesNovember 17, 2020

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On November 12, 2020, President Trump issued an Executive Order prohibiting U.S. persons from “transacting” in publicly traded securities of “Communist Chinese military companies.” The new restrictions, which go into force on January 11, 2021, initially target