In this Ropes & Gray podcast, partner Ama Adams, counsel Brendan Hanifin, and associate Emerson Siegle discuss the implications and key questions surrounding Executive Order 13959, “Addressing the Threat from Securities Investments that Finance Communist China Military Companies.”
Brendan Hanifin: Hello, and thank you for joining us on this Ropes & Gray podcast, during which we will be discussing Executive Order 13959, titled “Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies” (or the “Executive Order”). I am Brendan Hanifin, counsel in Ropes & Gray’s Chicago office. Joining me for today’s discussion are Ama Adams, a partner, and Emerson Siegle, a senior associate, both based in our Washington, D.C. office.
Emerson, to set the stage for our discussion, would you provide an overview of the Executive Order, its background, and its prohibitions?
Emerson Siegle: The Executive Order is borne of concerns within the U.S. government regarding China’s so-called military-civil fusion policy. Military-civil fusion refers to a national strategy of the Chinese government to leverage commercial relationships and activities to acquire technology and intellectual property, with the objective of enhancing the technological capabilities of China’s military. The underlying premise of the Executive Order is that investments in Chinese companies involved in the military-civil fusion strategy help to finance the development of the Chinese military, to the ultimate detriment of U.S. national security interests.
As of January 11, 2021, the Executive Order prohibits U.S. persons from transacting in publicly traded securities of designated Communist Chinese military companies, as well as securities that are derivative of, or are designed to provide investment exposure to, such securities. In addition, the Executive Order requires U.S. persons, by November 2021, to divest of targeted securities held as of January 11.
For entities designated as Communist Chinese military companies after the date of the Executive Order (November 12, 2020), the prohibition on new transactions takes effect 60 days after the designation date. U.S. persons have one year to divest of the newly targeted securities.
Ama Adams: The term “Communist Chinese military company” refers to (1) any company that the Defense Department (“DOD”) has designated pursuant to Section 1237 of the National Defense Authorization Act for fiscal year 1999; (2) any company designated by the Defense Department after the Executive Order’s effective date; and (3) any company that the Treasury Department publicly lists as a subsidiary of an already designated Communist Chinese military company.
Of note, several entities that have been designated to date as Communist Chinese military companies are parent-level entities whose shares are not traded on public exchanges. This led to confusion regarding whether the Executive Order’s prohibitions were intended to apply to the publicly traded subsidiaries of designated companies. OFAC attempted to address this confusion through the publication of multiple Frequently Asked Questions (FAQs), though these FAQs have not yet fully clarified the picture. For example, one FAQ stated that OFAC intends to designate subsidiaries of Communist Chinese military companies in due course, but another FAQ stated that the Executive Order’s prohibitions would apply immediately to both designated companies and any entity whose name “closely matches” the name of a designated Communist Chinse military company. Because the “closely matches” standard requires a subjective determination, investors and fund managers struggled to understand the precise scope of the Executive Order’s prohibitions. Ultimately, OFAC added certain key subsidiaries to the list, clarifying the issue in some cases. In addition, OFAC has published a general license authorizing transactions in securities of entities whose names “closely match” a designated Communist Chinese military company until May 27. The general license effectively provides OFAC a grace period to clarify which subsidiaries and affiliates of designated Communist Chinese military companies are within the scope of the Executive Order.
Brendan Hanifin: OFAC has published a “Chinese Military Companies Sanctions” program page on its website, which includes the operative list of Communist Chinese military companies, as well as certain identifying information, in PDF and Excel format. Importantly, the Communist Chinese military companies list is not reflected in OFAC’s online search tool or in the Consolidated Screening List available at www.export.gov. As a result, parties performing manual restricted party screening are required to consult OFAC’s Chinese Military Companies Sanctions program page, in addition to performing keyword searches using the search tool. Parties that use an automated restricted party screening tool would be wise to confirm whether their screening solution has been updated to incorporate the Non-SDN Communist Chinese Military Companies List.
Notably, the current list of Communist Chinese military companies does not identify the date on which each entity was designated as a Communist Chinese military company, presenting practical challenges. First, because the prohibition on new transactions does not take immediate effect, and the divestment period is calculated from the date of designation, investors must consult multiple sources—and perform their own date calculations—to determine their compliance obligations under the Executive Order. Second, OFAC has stated that the Executive Order’s requirements apply to any entity whose name “closely matches” a designated Communist Chinese military company. As a result, it can be difficult to discern if new additions to the list on OFAC’s website are new designations (subject to a 60-day grace period) or “close matches” of already designated companies (not subject to the full 60-day grace period).
Emerson, one of the questions we’ve been receiving relates to the consequences of violating the Executive Order, by either engaging in a prohibited transaction or failing to divest within the prescribed wind-down period. From a legal perspective, what types of penalties could U.S. persons face for violations of the Executive Order?
Emerson Siegle: The Executive Order was issued pursuant to the International Emergency Economic Powers Act (or IEEPA), one of the primary U.S. sanctions authorities. As a regulatory matter, violations of IEEPA can result in civil penalties up to $307,922 or twice the value of the impermissible transaction, whichever is greater. Accordingly, U.S. persons that engage in prohibited transactions in targeted securities face potentially significant monetary penalties, although it is not entirely clear how OFAC would calculate transaction value in the context of a purchase or sale of a targeted security.
The Executive Order also prohibits U.S. investors from possessing targeted securities beyond the applicable divestment deadline. This prohibition was clarified in a supplemental executive order, issued on January 13, and a corresponding FAQ. The supplemental order made certain, minor amendments to the Executive Order as issued on November 12. Based on the new guidance, continuing to hold a targeted security after the applicable divestment deadline would constitute a violation of the Executive Order, presumably subjecting the investor to potential penalties under IEEPA. Again, however, it is not exactly clear how such penalties would be calculated, as sanctions penalties typically are imposed on a per-violation basis. For example, would continued possession of a targeted security for 30 days beyond the divestment deadline constitute a single violation, or 30 violations, of the Executive Order? Would continued investment in a fund with exposure to five prohibited securities be considered one violation, or five? For purposes of determining the statutory maximum penalty under IEEPA, how would OFAC calculate the transaction value of a transaction that did not occur, because an investor did not comply with the divestment requirement? These are open questions until OFAC provides further guidance.
There is another key point that distinguishes the Chinese Military Companies Sanctions from traditional sanctions programs. Under a traditional OFAC sanctions designation, a U.S. person would be required to block (or freeze) the targeted security—i.e. by refraining from engaging in any transactions involving the targeted security—and file a report with OFAC. The blocking requirement typically would take effect after the end of any applicable wind-down period, if the U.S. person had not divested in accordance with its obligation to do so. However, to date, OFAC has not clarified the obligations of U.S. persons who possess targeted securities beyond the divestment period, other than to clarify that failure to divest is prohibited under the Executive Order. Because the Non-SDN Communist Chinese Military Companies List is distinct from OFAC’s Specially Designated Nationals List, the blocking obligations that both regulated parties and sanctions practitioners are accustomed to may not apply.
Brendan Hanifin: From our discussion so far, one of the emerging themes appears to be that there is considerable uncertainty regarding the implementation of the Executive Order. Ama, is this typical, and what are the other key outstanding questions at this point?
Ama Adams: In the first instance, it’s important to understand that the Executive Order has introduced a novel type of sanctions restriction, for which there is limited precedent to guide practitioners and regulated parties regarding how OFAC will interpret and apply the Order’s prohibitions. The Executive Order’s restrictions also are new for OFAC, and our impression is that OFAC staff is identifying and attempting to work through implementation questions in real time, which presents practical challenges for all parties involved.
In the immediate wake of the Executive Order, a major question related to the treatment of new investments by U.S. persons in investment vehicles that hold targeted securities. Specifically, would such investment by a U.S. person constitute a prohibited new investment in a targeted security, even if the investment vehicle did not make a new purchase of targeted securities after January 11? In recent weeks, OFAC has provided guidance clarifying that U.S. persons can continue to invest in vehicles that hold targeted securities past January 11, provided the investment vehicle is itself in compliance with the Executive Order. In other words, U.S. investors can continue to invest in funds that held targeted securities prior to January 11, at least until the applicable divestment deadline, provided that the fund does not make any new purchases of targeted securities after January 11, and will take steps to divest by November 11. The investment vehicle also would be obligated to monitor new designations and ensure compliance with the acquisition and divestment restrictions, which come into effect on a rolling basis.
Brendan Hanifin: While the guidance is a helpful clarification, it does not address the treatment of U.S. persons who lack control over the investment decisions of third-party managers with whom they are invested. For example, assume a U.S. investor holds an interest, acquired prior to January 11, in a fund that held targeted securities as of January 11. Existing guidance indicates that the U.S. investor could continue to make investments in the fund, so long as the fund does not make new purchases of targeted securities after January 11. However, if the fund manager proceeded to purchase a targeted security after January 11, OFAC’s position is unclear. Logically, the U.S. investor would argue that its new exposure to a targeted security—caused by a third-party manager—does not constitute a prohibited transaction in a targeted security by the U.S. investor. But until OFAC clarifies this point, we expect to see some U.S. investors seek covenants from managers—particularly managers outside the United States that are not ordinarily subject to OFAC’s jurisdiction—that the manager will not cause the U.S. investor to inadvertently violate the Executive Order. As a practical matter, non-U.S. managers may feel compelled to comply with the Executive Order to accommodate the compliance concerns of current and prospective U.S. investors.
Emerson Siegle: Another open question is whether OFAC will interpret the Executive Order to prohibit facilitation of prohibited transactions. The facilitation provisions in U.S. sanctions prohibit covered parties from arranging, assisting, supporting, or approving non-U.S. persons’ dealings with sanctioned parties, if those dealings would be unlawful if carried out by a covered party. Facilitation is broadly defined and, in recent years, OFAC has continued to expand its application of this principle. For example, OFAC has applied the prohibition against facilitation to preclude U.S. persons from providing certain transaction-specific advice, such as recommending a particular structure for a transaction involving a sanctioned country or party.
Although the Executive Order does not explicitly prohibit facilitation, OFAC has broadly applied the facilitation concept across most of its sanctions programs. If OFAC were to apply the facilitation principle to the Executive Order, market intermediaries subject to U.S. jurisdiction would be prohibited from, among other actions, facilitating transactions in targeted securities by non-U.S. persons who are not required to comply with the Executive Order. Likewise, application of the facilitation principle theoretically would prohibit U.S. persons, such as U.S.-based investment personnel, from advising non-U.S. investment vehicles to engage in transactions that are contrary to the Executive Order. This question is particularly pertinent, as many investment vehicles advised by U.S. managers are organized outside the United States (and therefore would not qualify as United States persons under the plain language of the Executive Order). Relatedly, would failure by a non-U.S. investment vehicle, advised by a U.S. manager, to timely divest a targeted security constitute a violation of the Executive Order? And if so, who faces potential liability—the non-U.S. investment vehicle, the U.S. manager, or both?
To date, OFAC has published an FAQ clarifying that market intermediaries may engage in ancillary or intermediary activities that are necessary to effect divestiture of targeted securities, provided that the underlying transaction is not prohibited under the Executive Order. It would follow logically that U.S. market intermediaries may not engage in ancillary or intermediary activities, even on behalf of non-U.S. clients, that are inconsistent with the Executive Order. In other words, even assuming a non-U.S. investment vehicle with a U.S. adviser is beyond OFAC’s jurisdiction—which OFAC has not squarely addressed—the U.S. adviser reasonably may be concerned that its provision of services to the non-U.S. investment vehicle would constitute impermissible facilitation.
Brendan Hanifin: Ama, an executive order can be undone or modified by Congressional legislation or a subsequent executive order. Should we expect President Biden to reverse course on the Communist Chinese military company Executive Order?
Ama Adams: While the Biden administration could overturn the Executive Order, we don't anticipate significant changes in the near term. The underlying premise of the Executive Order, which Emerson summarized at the outset of our discussion, has broad bipartisan support in the Congress. The Executive Order is also consistent with other regulatory actions, ranging from expanded export controls to use of the Committee on Foreign Investment in the United States (CFIUS) review process, which administrations of both parties have employed to address China’s growing influence. I’d note that, in recent weeks, Biden administration officials have expressed an intent to adopt a more multilateral approach toward China. This leads us to believe it is unlikely that the Biden team will implement significant changes to China policy in the near term, prior to engaging in consultation with U.S. allies. As a general matter, we anticipate that the Biden administration, like the Trump and Obama administrations, will continue to take a fairly aggressive position with respect to China.
Brendan Hanifin: Emerson, what should investors and managers be doing now, aside from closely monitoring for further developments and OFAC guidance?
Emerson Siegle: We’re recommending that U.S. firms prioritize three things. First, refrain from making any new purchases of targeted securities, which would violate the Executive Order. Second, identify any existing holdings of targeted securities, which will be subject to the divestment requirement. Third, for firms that have invested with third-party managers, consider seeking sanctions covenants or certifications, to help guard against the risk of a third-party manager causing the U.S. firm to be in inadvertent violation of the Executive Order. Because there are many open questions regarding interpretation of the Executive Order, as we have discussed, agility and continued diligence will also be key.
Brendan Hanifin: Thank you, Ama and Emerson, for joining me today for this discussion. And thank you to our listeners. For more information regarding the topics discussed today, as well as links to our recent client alerts and analyses, please visit Ropes’ anti-corruption and international risk practice page at www.ropesgray.com. If we can help you to navigate these issues, please do not hesitate to contact us. You can also subscribe and listen our podcasts wherever you usually listen to podcasts, including on Apple, Google or Spotify. Thanks again for listening.
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