Columbia Law School
Sky Blog
On December 28, 2020, the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) issued five new frequently asked questions (“FAQs”) that clarify the scope of Executive Order (“E.O.”) 13959, the basis for OFAC’s new Chinese Military Companies sanctions program. These FAQs define key terms and clarify how OFAC will interpret E.O. 13959’s prohibition against U.S. investment in the securities of Communist Chinese Military Companies (“CCMCs”), which goes into effect on January 11, 2021. In general, like previous sanctions programs, the new FAQs show that OFAC will read commonly used terms much more broadly than their common usage might suggest. Now that OFAC has clarified its stance on E.O. 13959, those operating in the investment management sector, especially banks, broker-dealers, investment advisers, and funds should review their assets to determine whether E.O. 13959 could affect their operations. The FAQs represent a Trump Administration decision to continue an aggressive approach toward CCMCs, although it remains to be seen how vigorously this E.O. will be implemented by the incoming Biden Administration and, indeed, whether and how this guidance will evolve over time.
Key Takeaways
- While subsidiaries of CCMCs are not automatically subject to E.O. 13959 unless they are identified on OFAC’s new Communist Chinese Military Companies List (“CCMC List”), OFAC indicated that it intends to include on the CCMC List any publicly traded entity that is either (i) 50 percent or more owned by one or more CCMCs or (ii) deemed to be controlled by one or more CCMCs. For now, OFAC’s new CCMC List contains the same 35 entities that were previously identified by the U.S. Defense Department’s “Pentagon List” in the annex to E.O. 13959. The prohibition in E.O. 13959 only applies to the securities of these companies, derivatives thereof, or any securities designed to provide exposure thereto.
- OFAC defines “publicly traded securities” to include securities in any currency that trade anywhere in the world (i) on any securities exchange or (ii) over-the- counter (“OTC”). E.O. 13959 was silent on whether OTC securities would be subject to its restrictions. Interpreting publicly traded securities to include OTC- traded securities may cause confusion amongst many in the investment industry who are used to trading “privately offered” securities OTC. OFAC’s new FAQs make clear that it will consider privately offered securities to be “publicly traded” under E.O. 13959. This interpretation supplements the restrictions in the recently enacted Holding Foreign Companies Accountable Act, a recently enacted statute that targets Chinese issuers that are not subject to inspection by the U.S. Public Company Accounting Oversight Board (see our client alert on that subject here).
- OFAC appears to apply an aggressive “one drop” test to funds holding CCMC securities such that U.S. persons may not invest in any fund holding any amount of CCMC securities, no matter how small a share such securities comprise. O. 13959 restricts U.S. investment in not only publicly traded securities but also “any securities that are derivative of, or are designed to provide investment exposure to such securities.” New FAQ 861 explains that U.S. persons are prohibited from investing in funds, including exchange-traded funds (“ETFs”) and mutual funds, that hold the publicly traded securities of a CCMC, regardless of such securities’ share of the underlying fund.
I. Background
Since 2014, with the introduction of the Russia and Venezuela sanctions programs,
U.S. national security and foreign policy objectives have required OFAC to impose sanctions on ever larger and more globally integrated sanctions targets. This trend continued earlier this year on November 12, 2020, when President Trump issued
E.O. 13959, which prohibits U.S. persons from purchasing for value any publicly traded securities of any CCMC, or any securities that are derivative thereof or are designed to provide investment exposure thereto. E.O. 13959 defines CCMC to mean any person listed by the U.S. Defense Department for being under control of the Chinese military and operating in the United States (the so-called “Pentagon List”), any person the Secretary of the Treasury determines meets the criteria necessary to be placed on the Pentagon List, or any person the Secretary of the Treasury determines to be a subsidiary of any such company. We covered E.O. 13959 in a previous client alert.
After E.O. 13959 was issued, a flood of questions erupted from financial institutions and others seeking to understand the scope of the prohibition against purchasing CCMC securities and whether normal sanctions rules such as OFAC’s “50 Percent Rule” applied to these firms. These questions stemmed from the fact that many funds (including mutual funds, ETFs, and index funds) contain securities subject to E.O. 13959. This means that any forced sales of CCMC securities resulting from U.S. persons withdrawing their investments from funds carrying CCMC securities could create issues not just for those companies’ shareholders, but also many third parties (including retail investors) with exposure to CCMC securities through their retirement and brokerage accounts.
II. The FAQs
On December 28, OFAC started to answer the private sector’s questions through five FAQs addressing some of the concerns related to the prohibition in E.O. 13959. The new FAQs define key terms and clarify the scope of E.O. 13959’s prohibition on purchasing CCMC securities.
FAQ 857 clarifies that the 50 Percent Rule does not apply to CCMCs. Rather, the prohibition against purchasing the CCMC securities only applies to subsidiaries of such companies that have been specifically identified in OFAC’s newly published CCMC List, effective 60 days after such listing. This stands in contrast to OFAC’s typical blocking sanctions and its sectoral sanctions against Russia that automatically apply to any subsidiaries owned 50 percent or more by a listed party immediately upon listing under the 50 Percent Rule. OFAC states that, to be consistent with the 50 Percent Rule, it intends to publicly list all subsidiaries owned 50 percent or more by a CCMC, as well as those deemed to be controlled by a CCMC.
FAQ 858 clarifies that, as in other sanctions programs, U.S. persons may not rely on an exact name match to identify CCMC securities, but rather must exercise due diligence, including identifying similar names, to determine whether securities are subject to the prohibition in E.O. 13959. This should come as no surprise, given that OFAC regularly penalizes companies for failing to identify Specially Designated Nationals (“SDNs”). See e.g. OFAC’s Settlement with Cobham Holdings, Inc. Like other sanctions programs, OFAC states that it will provide identifying information on CCMCs through a new Non-SDN CCMC List to help U.S. persons with their due diligence, including alternative names (i.e., “a.k.a.” names) and equity tickers. However, FAQ 857 makes clear that the ultimate responsibility for complying with E.O. 13959 will fall to those U.S. persons dealing in such securities.
FAQ 859 clarifies the key term “publicly traded security” from E.O. 13959. As noted above, E.O. 13959 only restricts transactions in “publicly traded securities.” Thus, whether or not a CCMC security is “publicly traded” is determinative of whether
U.S. persons may purchase it. In FAQ 859, OFAC states that it intends to interpret the term “publicly traded securities” to include securities (as defined in 15 U.S.C.78c(a)(10)) denominated in any currency that trade on a securities exchange or OTC in any jurisdiction. The breadth of this definition, while not unusual in the sanctions context, is likely to surprise many financial institutions and securities practitioners who are accustomed to thinking of “publicly traded” securities as those issued through a public offering subject to registration with the Securities and Exchange Commission (“SEC”) and traded on a securities exchange. However, by including OTC-traded securities in its definition of “publicly traded securities,” OFAC appears to be including many privately offered securities, such as those offered through Regulation D Rule 504 and resold via Rule 144A.
FAQ 860 clarifies that financial institutions should read the prohibition against purchasing not just securities issued by CCMCs, but also “any securities that are derivative of, or are designed to provide investment exposure to such” securities broadly. OFAC notes that these securities include, but are not limited to, derivatives (e.g., futures, options, swaps), warrants, American depositary receipts (“ADRs”), global depositary receipts (“GDRs”), ETFs, index funds, and mutual funds, to the extent such instruments also meet the definition of “security” under U.S. securities laws. While OFAC does not state so explicitly, the reference to securities “designed to provide investment exposure” to CCMC securities likely means that synthetic assets designed to simulate exposure to CCMC securities are prohibited as well.
In FAQ 861, OFAC appears to impose a “one drop” rule on funds holding CCMC securities. OFAC states that it views the prohibition against purchasing CCMC securities as applying to U.S. or foreign funds, such as ETFs or other mutual funds that hold publicly traded securities of a CCMC, “regardless of such securities’ share of the underlying index fund, ETF, or derivative thereof.” This is an aggressive stance, given OFAC’s 50 Percent Rule and other sanctions ownership tests like the 33 percent rule in Directive 4. OFAC’s one drop rule for CCMC securities effectively means that U.S. persons may not purchase any shares in a fund that holds a CCMC security, no matter how small the position. This is likely to greatly increase due diligence costs for investment advisers and any funds seeking investment exposure to East Asia.
III. Conclusions
E.O. 13959 created a new sanctions program that generally prohibits U.S. persons from purchasing securities of CCMCs. OFAC’s new FAQs show that the Trump Administration is taking an aggressive posture with respect to interpreting this prohibition requiring financial institutions, investment advisers, and investment funds to rethink commonly used terms like “publicly traded” and to conduct significant due diligence to make sure they are not purchasing even de minimis amounts of CCMC securities. Financial institutions should review any assets under custody to see if their holdings are affected by E.O. 13959.
This post comes to us from Morrison & Foerster LLP. It is based on the firm’s memorandum, “OFAC FAQs Clarifying and Broadening Sanctions on Chinese Military Companies,” dated December 30, 2020, and available here.