Sanctions – Realinsight

Under Executive Order 13959 (EO)¹, former US President Trump imposed sanctions against a number of communist Chinese military companies in response to perceived national security threats. The sanctions aim to ban US investment in companies developing technologies that will benefit the Chinese Military at the expense of the US. These sanctions prohibit US Persons² from investing in these companies by banning the purchase of certain securities, and forcing divestment of any existing holdings in these securities by certain dates. This Realinsights paper will summarise the current sanctions regime (as at 31 March 2021) and investigate the impacts of these sanctions on the listed equities covered by the EO.

The imposition of these sanctions has led to:

• Sale of sanctioned securities by US Investors to comply with the EO.
• Deletion of sanctioned securities by major Index providers MSCI, S&P & FTSE subsequently leading to the sale by index tracking funds.
• Delisting of the American Depository Receipt (ADR) listing of sanctioned securities by the NYSE
• Price falls around the implementation date as US investors sold out and indexes vendors removed the securities from their respective indexes. Most sanctioned securities recovered these falls the subsequent month.
• Volume in these sanctioned securities jumped in January 2021 as investors sold out – but has returned to the long-term average. We believe that there will continue to be sufficient volume and liquidity in these names. 

There is continuing tensions between the US and China despite a change in administration from Trump to Biden with ongoing tit for tat actions. We therefore do not expect a lifting in sanctions or a back down from either country in the near term. The sanctions are currently being challenged in the US courts by Xiaomi (a Chinese multinational electronics company) being granted a temporary injunction suspending the investment ban. New US sanctions could also be imposed targeting securities involved in the suppression of democracy in Hong Kong or the alleged Uighur genocide.

Realindex, while not a US Person, has opted to act conservatively and hence will not purchase any sanctioned security and will look to sell out of these names over the next 12 months. Realindex will continue to monitor this situation and will act should events and policies change.

What are Sanctions?

Sanctions are punitive measures a country puts on another (generally economic) which are part of diplomatic efforts to force obedience with laws, condemnation of actions or threats to peace.  These sanctions can be imposed multilaterally (mainly by the United Nations) which has a mandate to impose sanctions on behalf of the international community or they can be imposed unilaterally by one country on another. 

Australia implements two types of sanctions regimes³:

• United Nations Security Council (UNSC) sanctions⁴, which Australia (and any country) must impose as a member of the UN under Chapter VII of the Charter of the United Nations; and
• Australian autonomous sanctions, which are imposed by the Department of Foreign Affairs and Trade (DFAT)⁵ as a matter of Australian foreign policy. These sanctions may supplement UNSC sanctions regimes, or be separate from them.

The current Australian sanctions that apply to Australian citizens and Australian registered corporate bodies are detailed in Chart 1.

Chart 1: Current Country and Terrorist Organisation Sanctions applicable in Australia
(Source: https://www.dfat.gov.au/international-relations/what-you-need-know-0 accessed at 22 April 2021)

Similarly other countries can also impose sanctions beyond those imposed by the UN. The US sanctions imposed under EO 13959 are an example of this – they have not been adopted either by the UNSC or the Australian autonomous regime. Typically, Australian investors are therefore not legally obliged to comply with them. However, these sanctions can still affect investors, if they are classified as a US Persons (e.g. US Citizens / Green Card holders); it creates a requirement for funds to comply where investors in those funds might be caught by this.

Sanctions can be applied against countries, specific individuals or entities with the most common measures being:

• Restrictions on trade in goods and services
• Restrictions on engaging in commercial activities
• Targeted financial sanctions (including asset freezes) on designated persons and entities
• Travel bans on certain persons.

Under the EO, the US has applied targeted financial sanctions prohibiting the purchase of designated securities and mandated the forced sale of these securities within 12 months.

The failure to comply with sanctions are a serious criminal offence with penalties including prison and substantial fines⁶ depending on the jurisdiction.

Why has the US applied sanctions against China?

The aim of EO13959 issued by former US President Donald Trump was to address a perceived national security threat to the US from investments that finance these communist Chinese military companies (CCMC).

The EO states that this finance allows the “the People’s Republic of China (PRC) to directly threaten the United States homeland and United States forces overseas, including by developing and deploying weapons of mass destruction, advanced conventional weapons, and malicious cyber enabled actions against the United States and its people.” The EO states that “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. In that way, the PRC exploits United States investors to finance the development and modernization of its military.”

Who do the EO13959 Sanctions apply to?

The US has gone it alone in issuing these sanctions against Chinese companies under its autonomous sanctions regime. The UNSC has not ratified them, and hence they only require compliance from “US Persons”.

US Persons can broadly be defined as:

• US nationals and green card holders
• Persons in the United States
• US-incorporated companies and their foreign branches (but excluding foreign subsidiaries).

The EO13959 sanctions apply to all publicly traded securities (including American Depository Receipts (ADR’s) and Global Depository Receipts (GRD’s), derivatives (e.g. futures / options / swaps), or instruments designed to provide investment exposure to such securities (e.g. ETF’s, index & mutual funds). They prohibit further purchase of the securities listed in the original EO from 11 Jan 2021 (or 60 days after any further security additions) and compel US Persons to sell out of any security on the sanctions list prior to 365 days after their initial inclusion.

Initially there was a lot of concern regarding the broad impact of these sanctions, requiring compliance by large US based financial institutions. Under FAQ863⁷, the US Treasury clarified that support services provided to non-US persons in connection with any transaction is permissible.  Subject to the risk tolerance of a service provider (for example, an investment bank), these securities can continue to be traded by non-US investors following an attestation that no US Persons were involved in the transaction.

Sanctioned Securities under EO13959

Under EO13959 there are currently 44 companies named (see Appendix 1):

• Tranche 1, 2, & 3⁸:
  31 entities listed on the 11th November 2020.
  Sanctions effective 11 Jan 2021.
  Sale by 11 Nov 2021.
• Tranche 4⁹:
  4 additional names listed on the 1st December 2020.
  Sanctions effective 1 Feb 2021.
  Sale by 3 Dec 2021.
• Tranche 5¹⁰:
  9 additional names listed on the 15th of January 2021.
  Sanctions effective 15 Mar 2021.
  Sale by 14 Jan 2022.

The current list of exclusions are detailed in Appendix 1.

Subsequent to these announcements there were a number of updates and guidance issued¹¹ by the Office of Foreign Assets Control (OFAC) to clarify some of the uncertainties regarding these sanctions.

Some companies have started to challenge the EO in court. Xiaomi has been granted¹² a temporary injunction that they do not meet the criteria to be designated as a CCMC under the relevant statutory provisions. We expect further legal action from affected companies.

Future Impacts

The US Treasury has stated¹³ that it will include related securities if they are more than 50% owned or determined to be controlled by one or more communist Chinese military company as well as companies with a close name match. Investors should expect that additional affiliated / subsidiary securities could soon be explicitly named and added to the published Non-SDN CCMC sanctions list¹⁴.

Identifying subsidiaries with ties to sanctioned entities is not as straight forward as it seems. All Chinese State Owned Enterprises are managed and ultimately owned by the State-Owned Assets Supervision and Administration Commission of the State Council. Therefore if you look the security up most data vendors have this entity as the parent and this masks the actual ownership structure. Relationships between entities are not always obvious without detailed analysis. Fortunately most companies publish on their websites the subsidiaries that they control but this does require a manual and time consuming review.

Example: China General Nuclear Power Corp

China General Nuclear Power Corp has been sanctioned but its listed subsidiary CGN Power Co has not yet been identified. Chart 2 below shows that for CGN Power Co (1816-HK), its parent is the China State Owned Asset Supervision and Administration Commission and ultimately the Government of China.

Chart 2: Corporate Structure of China General Nuclear Power Corp (Source: FactSet as at 31 March 2021)

Further, if you then visit the China General Nuclear Power Corp corporate website, they helpfully provide a listing of all subsidiaries. We can see (Chart 3 below) that CGN Power Co is a subsidiary and hence it may fall under sanctions in future.

Chart 3: China General Nuclear Power Corp Subsidiaries (Source - Organization_CGN (cgnpc.com.cn) accessed 1 March 2021 )

What has been the impact of these sanctions?

A        Performance

The sanctions have affected the returns of sanctioned securities with most underperforming the broader market and the MSCI China index since announcement until the end of January 2021. There has been a reversal in February with about half outperforming the MSCI China and Emerging Market indexes in the period to 31 March 2021 as seen in Table 2. This reversal is even more pronounced for Tranche 1 securities.

Table 2: Monthly returns on Chinese Sanctioned Securities to end of March 2021

(Source: FactSet - returns are local currency unless specified.)

Below we look at an event study of the sanctioned stocks around the effective date (date no purchases are allowed by US Persons). We see prior to the effective date (time 0 in our graph in Chart 4) there is a steady fall in the sanctioned stocks average return relative to the MSCI China benchmark in Hong Kong dollars. This is not surprising as a number of investors liable under the sanctions will have looked to sell out of their positions. Subsequent to the effective date we can see some downward pressure for the following month before stocks recovered and are subsequently back to their pre announcement levels indicating that the imposed sanctions only had a short term impact on the stock price.

Chart 4: Event Study – sanctions stock performance event plot around the sanctions stocks effective date for tranches 1-5. See Appendix 1 for list of stocks and effective dates. CAR - cumulative abnormal returns (Source: Realindex / FactSet - returns are calculated relative to MSCI China index, in HKD)

B        Liquidity

There was a large increase in volume in January 2021 due to the sanctions forcing some investors to divest their holdings and index vendors removing the sanctioned securities from their indexes. Chart 5 highlights the large increase in 1m median daily value (MDV) across most sanctioned securities in January 2021 compared to the previous year. Liquidity has remained high and has actually increased for some securities since the implementation of the sanctions (Table 3). Investor concern that liquidity would dry up has not eventuated so we currently do not anticipate any issues selling out of these securities over the next 12 months. Realindex will continue to monitor the liquidity of these sanctioned securities and will act should there be a large decrease in liquidity. 

Chart 5: 1m MDV Volume in Local Currency 31/01/20 vs 31/03/21.
(Source: FactSet, data as at 31 March 2021)

Table 3: 1m MDV Volume (millions) in Local Currency from 31/01/20 to 31/03/21.
(Source: FactSet, data as at 31 March 2021)

C        Index

Some of the heightened volume near the 11^th January 2021 cut off was due to index vendors removing these stocks from their cap-weighted indices. Major index vendors including MSCI, S&P and FTSE announced¹⁵ that they would delete the named sanctioned securities in Tranches 1-4 from their main indices prior to 11th January 2021.

Table 4 shows the names and weights of the sanctioned constituents of the MSCI ACWI / MSCI EM indexes. Appendix 2 has the full list of names in the MSCI GIMI universe affected and the timeline of index actions.

^* Xiaomi  has not yet been deleted by MSCI

Table 4: Names and Weights of Chinese Sanctioned Securities in MSCI ACWI and MSCI EM

(Source: FactSet / MSCI as of 22 April 2021)

OFAC has not included any companies listed in Tranche 5 on its Non-SDN List¹⁶ of companies subject to the EO or provided any guidance with respect to Tranche 5. Index vendors have therefore not yet deleted securities from Tranche 5 and are currently seeking further feedback from market participants on the next course of action. They have only deleted the names explicitly covered in the OFAC list and have not deleted any un-announced affiliates/subsidiaries. We expect that once OFAC explicitly names any security (as per their treatment of tranches 1-4), then the index providers will have to act. Due to the temporary injunction granted to Xiaomi, MSCI has also held off removing this name from their indexes.

MSCI’s treatment of these Chinese names is different to the Russian Sanctions that were imposed back in 2014. There, the sanctioned names were not deleted but instead retained at their current weights but with the limitation of no future increases in their Number of Shares (NOS) or Foreign Inclusion Factor (FIF)¹⁷. The key difference in treatment can be explained by the application of the sanctions – for the Russian sanctions they only applied to new issuances by sanctioned companies whereas the Chinese sanctions require the divestment of the shares by a certain date.

MSCI has released an index series called the J Series that still contains the sanctioned securities for those customers who continue to hold them in their investment portfolios.

D        Ownership

We can also see that EO 13959 has un-surprisingly had an impact on the ownership of the sanctions securities. Looking at China Telecom Corp (728-HK) from the end of 2020 until 31 March 2021, we can see foreign ownership has fallen from 26.36% to 11.52% (Table 5) and ownership from North American has nearly halved to 10.08% form 18.55% (Table 6).  There has also been a significant drop in ownership form European investors who are likely taking a conservative view and reducing their ownership as well. As expected, due to the removal from a number of major indices the % owned by index investors has fallen from 11.12% to under 1% (Table 7). We expect to see further sales by US investors in these names as we get closer to the 12-month sale deadline.

Table 5: Holding Type Trend (Mutual Funds / ETF’s) for China Telecom Corp (728-HK) grouped via Foreign vs Domestic Investors. (Source FactSet ownership data as of 7 April 2021)

Table 6: Holding Type Trend (Institutions / Insiders) for China Telecom Corp (728-HK) grouped via Region.

(Source: FactSet ownership data as of 7 April 2021)

Table 7: Holder Type Trend (Mutual Funds/ETF’s) for China Telecom Corp (728-HK) group by Holdings Style.

(Source: FactSet Ownership Data as of 7 April 2021)

While there has been selling from US investors, most of the sanctioned names are State Owned Enterprises (SOE’s). A large percentage of the company is owned by the China State-Owned Assets Supervision and Administration Commission of the State Council¹⁸ and hence the overall ownership change as a result of US sanctions has been minimal. SOE’s are more dependent on bonds for capital as the Chinese government owns the majority of the equity. To raise capital without diluting the State’s ownership, SOE’s need to issue bonds. We would therefore expect to see the sanctions having a larger impact on the future bond issuances by these sanctioned securities, as they will no longer be able to raise capital to US persons.

E        Delisting from US Exchanges

Also impacted were the following Chinese companies with US listed American Depositary Share (ADR) listings:

• China Mobile Ltd. ADR (Ticker: CHL-US) 
• China Telecom Corporation Ltd. - H Shares (Ticker: CHA-US)
• China Unicom (Hong Kong) Ltd. ADR (Ticker: CHU-US)

There was some confusion regarding the implementation of sanctions against these ADRs. Following the issuance of a new guidance¹⁹ by the US Treasury it was finally confirmed²⁰ that these would be delisted by the NYSE.

Luokung Technology Corp is currently only listed in the US on the NASDAQ with no Hong Kong or Chinese listing and hence it would be the most affected by any government forced delisting of sanctioned names from US exchanges.

We therefore anticipate that US listings of Chinese stocks will continue to be viewed unfavourably by regulators and US investors and hence expect more Chinese securities instead choosing to list in Hong Kong or other markets.

China Responds

In January, China responded to these sanctions by issuing new rules²¹ to protect its firms from "unjustified" foreign laws and allowing Chinese courts to punish global companies for complying with foreign restrictions. This new law is in addition to China’s Ministry of Commerce Provisions on the Unreliable Entity List which can list any enterprise, organization, or foreign citizen if they are found to have done something that endangers the national sovereignty, security, or development interests of China.

The list is understood to be a direct response to the United States’ Entity List, which several Chinese companies have landed on in recent years, the most notable being the Chinese global telecom giant Huawei. Under China’s new regime, a foreign entity included in the Unreliable Entity List could bear severe consequences that could cripple their business in China. So far, no entity has been listed but the threat remains.

Further, on 20 January 2021, China declared²² sanctions against 28 US citizens, including former Secretary of State Mike Pompeo and other Trump administration officials. This was in response to Pompeo’s declaration that China had committed crimes against humanity against Uyghur Muslims. The impact of these Chinese sanctions will be minimal and instead, these retaliatory sanctions are symbolic with the main audience being domestic to reassure its domestic population of the regime’s political strength.

With the US continuing to call out China on human rights violations in Xinjiang, Tibet and Hong Kong, we expect continued tension between these two super powers. We therefore do not expect any winding back of currently announced sanctions by either country.

What is Realindex doing?

Realindex is not a US Person and hence not subject to the US sanctions but have taken a conservative view and approach. That is, except where we have received a specific client instruction, Realindex

• is continuing to hold these Chinese securities within our portfolios if we held them prior to 11 January 2021.
• will not purchase any sanctioned security from 11 January 2021.
• aims to divest the sanctioned stocks from our portfolios by the dates specified unless there are future actions which change the situation.

The challenge for our clients (which includes super funds / mutual funds) is to ensure that none of their underlying investors are US Persons and hence subject to the sanctions. Realindex will continue to monitor the liquidity of the sanctioned securities so that any existing holding can be sold if required. Realindex will also continue to closely monitor any other developments in this area.

Summary

The imposition of sanctions by the US against Chinese companies has led to the forced sale by US Persons in these sanctioned entities achieving the EO policy aim of US investors not funding designated Chinese Military companies. As the sanctions are US only and not endorsed by the UN, only US investors have been forced to comply. As a result, we can see that US investors have been primarily selling out of these securities along with index tracking funds.

As US investors have 12 months to divest from the date of identification, we expect to see further sales in these sanctioned securities over the next six months. Liquidity has remained consistent with long term averages. Selling when everyone else is selling will lead to poorer investment returns as demonstrated by the event study. Investors should therefore try to avoid selling immediately after sanctions are imposed – and instead be patient and wait a month or two before selling out.

The change in administration from Trump to Biden and ongoing legal action has led to a pause in new sanctions activity. Should there be a deterioration in the China / US relationship (e.g. in response to suppression of Hong Kong democracy) then we would expect further sanctions to be applied – with new names and subsidiaries of existing sanctioned securities potentially being explicitly listed. We do not think that the current sanctions will be lifted anytime soon.

Realindex has opted to not purchase any sanctioned security and will look to sell out of these names over the next 12 month sell-down period. Realindex will continue to monitor this situation and will act should events and policies change.

Appendix 1: Full List of Affected Securities

Source: Non-SDN Chinese Military-Industrial Complex Companies List (NS-CMIC List) accessed 7 April 2021

Key dates and events:

Table 1: Key Dates

Source: Realindex - updated 16 April 2021

¹ Executive Order 13959 - https://home.treasury.gov/system/files/126/13959.pdf

² See formal definition below

³ https://www.dfat.gov.au/international-relations/what-you-need-know-0

⁴ https://www.un.org/securitycouncil/sanctions/information

⁵ https://www.dfat.gov.au/international-relations/security/sanctions/Pages/sanctions

⁶ For example, https://www.thenationalnews.com/business/banking/us-sanctions-enforcement-penalties-reach-1-28bn-in-the-first-half-of-2019-1.891032

⁷ FAQ863 - https://home.treasury.gov/policy-issues/financial-sanctions/faqs/863

⁸ Tranche 1: https://media.defense.gov/2020/Aug/28/2002486659/-1/-1/1/LINK_2_1237_TRANCHE_1_QUALIFIYING_ENTITIES.PDF

Tranche 2&3: https://media.defense.gov/2020/Aug/28/2002486689/-1/-1/1/LINK_1_1237_TRANCHE-23_QUALIFYING_ENTITIES.PDF

⁹ Tranche 4: https://media.defense.gov/2020/Dec/03/2002545864/-1/-1/1/TRANCHE-4-QUALIFYING-ENTITIES.PDF

¹⁰ Tranche 5: https://media.defense.gov/2021/Jan/14/2002565154/-1/-1/0/DOD-RELEASES-LIST-OF-ADDITIONAL-COMPANIES-IN-ACCORDANCE-WITH-SECTION-1237-OF-FY99-NDAA.PDF

¹¹ OFAC is the US Office of Foreign Assets Control, part of the US treasury. FAQs appear in https://home.treasury.gov/policy-issues/financial-sanctions/faqs/topic/5671

¹² Temporary injunction Xiaomi vs US Dept. of Defence -  https://cdn.vox-cdn.com/uploads/chorus_asset/file/22367849/xiaomi_v_us_dept_of_defense.pdf

¹³ Subsidiaries & 50% Rule - OFAC FAQ:857 - https://home.treasury.gov/policy-issues/financial-sanctions/faqs/857

¹⁴ Non-SDN CCMC List published by US Treasury - https://www.treasury.gov/ofac/downloads/ccmc/ns-ccmc_list.pdf

¹⁵ MSCI - https://www.msci.com/documents/1296102/17875700/QA_Impact_of_the_US_Presidential_Executive_Order_dated_Nov_12_2020_on_MSCI_Indexes.pdf
S&P - https://www.spglobal.com/spdji/en/documents/indexnews/announcements/20201209-1275560/1275560_spdjiexecorderprohibitingustransactionsinchinesecompaniesresults12-09-2020.pdf
FTSE - https://research.ftserussell.com/products/index-notices/home/getnotice/?id=2598662

¹⁶ List of Specially Designated Nationals and Blocked Persons

¹⁷ MSCI treatment of Russian Sanctions https://www.msci.com/documents/10199/c5409169-3e0c-4a7b-b2aa-ef8975e4979c
https://app2.msci.com/webapp/index_ann/DocGet?pub_key=Ms0s6XhmQGg%3D&lang=en&format=html
https://app2.msci.com/webapp/index_ann/DocGet?pub_key=u4%2BYI9cQsnc%3D&lang=en&format=html

¹⁸ China State-owned Assets Supervision and Administration Commission of the State Council - http://en.sasac.gov.cn/directory.html

¹⁹ OFAC FAQ 864 – Communist Chinese military company subsidiary with a name that exactly or closely matches the name of an entity identified - https://home.treasury.gov/policy-issues/financial-sanctions/faqs/topic/5671

²⁰ 31/12/2020 - NYSE delisting notice to comply with EO13959: https://ir.theice.com/press/news-details/2020/NYSE-to-Commence-Delisting-Proceedings-in-Securities-of-Three-Issuers-to-Comply-with-Executive-Order-13959/default.aspx
4/1/2021 - NYSE Updates Guidance in relation to EO13959 - https://ir.theice.com/press/news-details/2021/NYSE-Updates-Guidance-on-Delisting-Determination-for-Securities-of-Three-Issuers-in-Relation-to-Executive-Order-13959--/default.aspx
6/1/2021 – NYSE Proceeds with delisting - https://ir.theice.com/press/news-details/2021/NYSE-Announces-Suspension-Date-for-Securities-of-Three-Issuers-and-Proceeds-with-Delisting/default.aspx

²¹ MOFCOM Order No. 1 of 2021 on Rules on Counteracting Unjustified Extra-territorial Application of Foreign Legislation and Other Measures - http://english.mofcom.gov.cn/article/policyrelease/announcement/202101/20210103029708.shtml

²² Chinese Sanctions on anti-China politicians in the US - https://www.fmprc.gov.cn/mfa_eng/xwfw_665399/s2510_665401/t1847554.shtml

²³ SDN = Specially Designated Nationals and Blocked Persons, which is an OFAC list of “of individuals and companies owned or controlled by, or acting for or on behalf of, targeted countries”. The Non-SDN list is a further list of sanctions covering more specific items like Foreign Sanctions Evaders. (See https://home.treasury.gov/policy-issues/financial-sanctions).

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