Article New York Law Journal

President Biden Issues Executive Order Prohibiting Certain Investments in Chinese Companies in the Defense and Surveillance Sectors

In this article for New York Law Journal, Kirkland attorneys Mario Mancuso, Anthony Rapa and Jeremy Iloulian discuss an executive order restricting certain investments in the public securities of designated Chinese military-affiliated companies.

On June 3, President Biden issued Executive Order 14032 on “Addressing the Threat from Securities Investments that Finance Certain Companies of the People’s Republic of China” (the CMIC EO or Executive Order 14032), modifying Executive Order 13959 issued by President Trump in November 2020 (the CCMC EO or Executive Order 13959), which had generally restricted certain investments in the public securities of designated Chinese military-affiliated companies. See Exec. Order No. 14032, 86 Fed Reg. 30,145-49 (June 3, 2021); Exec. Order No. 13959, 85 Fed. Reg. 73,185-89 (Nov. 17, 2020). The new CMIC EO clarifies the criteria for designating companies that are subject to investment restrictions, moving away from a prior focus on “Communist Chinese Military Companies” (CCMCs) in favor of “Chinese Military-Industrial Complex Companies” (CMICs) operating in China’s defense or surveillance technology sectors. The nature of the prohibitions under the new CMIC EO largely are the same as under the prior CCMC EO, though there are significant substantive differences as to the mechanics of designation and the scope of their reach.

The View From Washington
The Biden Administration, with bipartisan support from Congress, has continued to describe China as a strategic economic and national security threat, specifically noting in its March 2021 Interim National Security Strategic Guidance that China is the “only competitor” to the United States’ “economic, diplomatic, military, and technological power.” The White House, Interim National Security Strategic Guidance 8 (March 2021). There is a particularly heightened concern about China’s military-civil fusion strategy, i.e., China’s use of civil technology development for military purposes.

Along these lines, the Biden Administration has continued or expanded certain Trump Administration measures regarding China, or imposed additional restrictions. Notable examples include the issuance of subpoenas to Chinese companies to help secure the U.S. information and communication technology services supply chain and the imposition of sanctions in response to human rights abuses in China’s Xinjiang Uyghur Autonomous Region. See Press Release, U.S. Dep’t of Commerce, U.S. Secretary of Commerce Gina Raimondo Statement on Actions Taken Under ICTS Supply Chain Executive Order (March 17, 2021); Press Release, U.S. Dep’t of the Treasury, Treasury Sanctions Chinese Gov’t Officials in Connection with Serious Human Rights Abuse in Xinjiang (March 22, 2021). In a similar vein, the new CMIC EO modifies the tools created by the CCMC EO in an effort to insulate the sanctions regime from judicial challenges that had plagued the prior framework.

What the New CMIC EO Changes
The core element of the CCMC EO was its prohibition on U.S. persons (defined as U.S. citizens and permanent residents, U.S.-incorporated entities and their foreign branches, and persons in the United States) from purchasing or selling publicly traded securities of designated CCMCs, along with derivatives and other instruments with exposure to such securities. Furthermore, the CCMC EO (as amended by Executive Order 13974) prohibited possession of restricted securities beyond certain dates. The new CMIC EO leaves intact the core prohibition on dealings in restricted securities, but changes the criteria for designating sanctioned entities; replaces the prior CCMC list with a new CMIC list; vests primary responsibility for making designations with the U.S. Department of the Treasury (Treasury) rather than the U.S. Department of Defense (Defense); and removes the prohibition on possessing restricting securities.

The Chinese Military Industrial Complex and Chinese Surveillance Technology Entities. With China’s military-civil fusion strategy and “serious human rights abuses” in mind, the CMIC EO alters the scope of the CCMC EO by targeting entities that Treasury, in consultation with the U.S. Department of State and (at Treasury’s discretion) Defense, determines “to operate or have operated in the defense and related materiel sector or the surveillance technology sector” of China.

This is a significant change from the CCMC EO, which targeted parties that were designated as CCMCs by Defense pursuant to the National Defense Authorization Act for Fiscal Year 1999, as amended. See Storm Thurmond National Defense Authorization Act for Fiscal Year 1999 §1237, Pub. L. 105-261 (1999); Ronald W. Reagan National Defense Authorization Act for Fiscal Year 2005 §1222, Pub. L. 108-375 (2004). This framework focused on entities that were owned or controlled, or “affiliated with” China’s People’s Liberation Army (PLA), or owned or controlled by an entity “affiliated with” China’s defense industrial base. The prior construct became the focus of three separate lawsuits by designated CCMCs alleging that they had been wrongfully designated, two of which were successful. See generally Xiaomi Corporation v. U.S. Dep’t of Defense, No. 1:2021cv00280 (D.D.C. March 3, 2021); Luokung Technology v. U.S. Dep’t of Defense, No. 2021-0583 (D.D.C. May 5, 2021); Complaint, GOWIN Semiconductor Corp., v. U.S. Dep’t of Defense, (D.D.C. May 25, 2021) (No 1:21-cv-01396).  By contrast, the CMIC EO focuses on entities that “operate” in China’s defense or surveillance technology sectors.

Three aspects of this shift are particularly notable:

  1. Entities designated as CMICs face a heightened risk of being considered “military end users” in the U.S. export control context, and are thus subject to more stringent export control restrictions. 15 C.F.R. §744.17.
  2. Treasury broadly interprets operation in China’s surveillance technology sector to include support for “(1) surveillance of persons by Chinese technology companies that occurs outside of [China]; or (2) the development, marketing, sale, or export of Chinese surveillance technology that is, was, or can be used for surveillance of religious or ethnic minorities or to otherwise facilitate repression or serious human rights abuse.” Frequently Asked Question 900, U.S. Dep’t of the Treasury (June 3, 2021). This potentially could include non-Chinese entities that support such activities.
  3. The new designation criteria, which is a more familiar sanctions construct, may better withstand judicial scrutiny.

Restricted Parent and Subsidiary Entities. Like the CCMC EO, Treasury can designate subsidiaries of CMICs as subject to investment restrictions under the CMIC EO. However, in order for restrictions to apply, Treasury must specifically designate the subsidiary. The “50% Rule” for unlisted entities, operative in other sanctions programs, does not apply. Frequently Asked Question 857, U.S. Dep’t of the Treasury (June 3, 2021).

However, unlike the CCMC EO, Treasury also can designate any parent entity of a CMIC.

Treasury Leads the Process for Designation. The new CMIC EO makes clear that Treasury is now the lead agency responsible for designating CMICs, as opposed to Defense, which previously had lead responsibility. Treasury’s longstanding experience in making sanctions designations may make the process run more smoothly and help ward off the judicial challenges that had proven nettlesome for the Biden Administration under the CCMC EO.

No More Prohibition on Possessing Restricted Securities. The CMIC EO removes the prohibition against U.S. persons possessing restricted securities beyond one year past a targeted entity’s designation date (i.e., after the end of the permitted divestment period). This essentially rolls back the framework to where it was when President Trump first issued the CCMC EO in November 2020, before he amended it via Executive Order 13974 in January 2021. The practical effect of this is that U.S. persons are not required to divest restricted securities, but are prohibited from divestment once they hold them beyond the one-year divestment deadline.

CMIC Companies
The CMIC EO includes an Annex that lists the designated CMICs, which includes many prior CCMCs and certain newly designated entities. Many (but not all) of the new entities are within the same corporate family as those entities previously designated as CCMCs.

Yet, not all of the prior CCMCs have been designated as CMICs. Notably, none of the CCMCs designated on Jan. 14, 2021 (the last tranche of designations made by the Trump Administration) were listed as CMICs. This is not particularly surprising, as all three entities that challenged their designation in court were listed in this tranche. However, other entities were delisted without explanation.

Upcoming Deadlines
As under the CCMC EO, investment restrictions under the CMIC EO will take effect 60 days from the date of designation (i.e., Aug. 2, 2021 for those listed in the Annex of the new CMIC EO), with the exception of purchasing or selling securities for the sole purpose of divesting from them. U.S. persons are authorized to engage in such divestment transactions for one year after the entity is designated (i.e., June 3, 2022 for those listed in the Annex of the new CMIC EO). Nevertheless, as noted above, there is no requirement to divest lawfully purchased securities.

Key Takeaways

  • Actual or perceived dealings in the Chinese defense and surveillance sectors create a risk for any public company, even if the company is not owned, controlled, or affiliated with the PLA.
  • Dealings by Chinese parent or subsidiary entities in the defense and surveillance sectors can also elevate the potential risks for their affiliates.
  • Treasury broadly interprets what constitutes “operat[ing]” in the Chinese surveillance technology sector, such that technology investors may wish to examine their Chinese investments.
  • Prior to purchasing securities of Chinese entities, U.S. persons should consider engaging in appropriate diligence to determine whether there is a risk that the entity could be designated and that the U.S. person will need to sell their securities in the future.
  • As under the CCMC EO, U.S. person investors that make investments in underlying vehicles should consider engaging in appropriate diligence to confirm that the vehicle will not invest in restricted securities.
  • CMIC designations may trigger follow-on effects, as the new designations may implicate (1) exports of sensitive items subject to U.S. jurisdiction, or (2) provisions in commercial agreements with lenders related to dealings with sanctioned persons.
This article originally appeared in the June 18, 2021 edition of New York Law Journal. Further duplication without permission is prohibited.