P.R.C. Ministry of Commerce (“MOFCOM”) issued an order promulgating “Provisions on the Unreliable Entity List” (the “Provisions”) on September 19, 2020, effective immediately the same day. These implementing rules have been long awaited since the idea was first introduced nearly 16 months ago on May 31, 2019.

The Unreliable Entity List (“UEL”) mechanism will create very challenging difficulties (or even dilemma) for multinational companies doing business in and with China, particularly when the foreign companies have to comply with economic sanctions and export controls under foreign jurisdictions in their dealings with Chinese entities. It is a powerful tool for the government, and it will have profound impacts, at least great uncertainties if not completely negative impacts, on foreign trade and investment, and potentially may even have extra-territorial effects, as this UEL mechanism is designed to protect Chinese companies’ interests.

In this client briefing, we provide an overview of the UEL mechanism and our initial views, as well as some practical recommendations for multinational companies in navigating the upcoming challenges when doing business in and with China.

Why This?

It’s all about Huawei, and MANY OTHERS.

This idea was introduced on May 31, 2019 after Huawei was designated on May 15, 2019 onto the Entity List, one of the many restricted parties lists administered by the U.S. government, and thus was barred from obtaining items and technologies subject to the U.S. export control regulations. Over the decade, especially in the course of the trade war and now technology war between U.S. and China, several hundreds of Chinese entities have been put onto these restricted parties lists, such as Specially Designated Nationals and Blocked Persons (“SDNs”), and subject to economic sanctions and export controls measures imposed by the U.S. government. As the U.S. government is stepping into more sensitive areas, and put some Chinese senior government officials and many large state owned enterprises onto the lists, sentiment in China has grown to the point that the government needs to take countermeasures against the U.S.

How Powerful It Could Be?

When the UEL idea was rolled out, the international community appeared worried but skeptical. The government said “it will take any necessary legal and administrative measures against the designated unreliable entities; and the public will be alerted to be cautious to do business with those entities”. No more specific measures and nothing happened after a few months, it was then thought to be a tiger without teeth.

Now, here seem to come the teeth. The Provisions puts out a menu of measures the government can choose from:

• restricting or prohibiting the foreign entity from engaging in China-related import or export activities;
• restricting or prohibiting the foreign entity from investing in China;
• restricting or prohibiting the foreign entity’s relevant personnel or means of transportation from entering into China;
• restricting or revoking the relevant personnel’s work permit, status of stay or residence in China;
• imposing a fine of the corresponding amount according to the severity of the circumstances;
• other necessary measures.

The Provisions also says, upon the designation, the authority may also make “an alert about the risks of conducting transactions with the said foreign entity”.

Be mindful that the catch-all “other necessary measures” may even be more severe. It gives the authority wide discretions. Could it expand to anything related to China, or anything within the jurisdiction of China?

For example, assets freezing, a sanction measure on the U.S. government’s menu when entities are designated as an SDN. MOFCOM alone might not have the legal authorization to freeze assets, but others do.

As the Provisions explains, the UEL mechanism is “a working mechanism composed of relevant central departments to take charge of organization and implementation of the Unreliable Entity List System”. Relevant central departments, although unspecified, would very likely include the Ministry of Finance and the People’s Bank of China.  The Provisions also mandates “the measures provided …shall be implemented according to law by the relevant departments in light of their respective duties and functions”. So, it wouldn’t be surprising if the designated UEL face with other unspecified measures, or even “extra efforts” at different level of authorities.

Does “investing in China” mean new investments, or could it cover existing investments in China? It is a question asked when the UEL idea was rolled out 16 months ago. By literal interpretation, “investing” means an investment being contemplated, so it means more towards to a new investment, but not an existing investment.

Another unclear issue is that whether the measures would be applied to affiliated companies. Under the U.S. sanction regimes, OFAC has a 50% rule under which subsidiaries that are owned directly or indirectly by an SDN is also a blocked entity. If a foreign entity is designated, would its affiliates/subsidiaries in other countries or even in China be subject to such measures too? Would a subsidiary in China be allowed to continue its business with the designated foreign owner? Whether a new acquisition or investment by an existing FIE is deemed as an investment by the ultimate foreign owner? No answers for now. It is hoped that the government could add some clarity over the time, or at least to be specific in their designation decisions.

What May Trigger The UEL, And How Far It Can Reach?

At its outset, the Provisions sets forth that:

The State shall establish the Unreliable Entity List System, and adopt measures in response to the following actions taken by a foreign entity in international economic, trade and other relevant activities:

(1) endangering national sovereignty, security or development interests of China;

(2) suspending normal transactions with an enterprise, other organization, or individual of China or applying discriminatory measures against an enterprise, other organization, or individual of China, which violates normal market transaction principles and causes serious damage to the legitimate rights and interests of the enterprise, other organization, or individual of China.

It is noteworthy that, such actions are not limited to activities in China. So, the government is exerting long arm jurisdiction here.

Any activities that are viewed to be endangering national sovereignty, national security or development interests of China could invoke the UEL designation. It could be interpreted as widely as possible. It is recalled that the Ministry of Foreign Affairs made several announcements, in July 2019 and July 2020, that the government would impose sanctions over certain U.S. companies involving in the arms sales to Taiwan. No specific measures were announced at that time. It seems now that the UEL designation could be one of the measures the government can opt to take, as such actions may well be viewed as endangering the national sovereignty of China.

If you are familiar with the International Economic Emergency Power Act (“IEEPA”) in the U.S., which grants the U.S. President wide authority to impose sanctions and trade controls measures on the “deal with any unusual and extraordinary threat, which has its source in whole or substantial part outside the United States, to the national security, foreign policy, or economy of the United States”, this UEL Provisions is very similar in many sense. It essentially provides the legal authorizations for the government to impose measures on anyone that acts in contrary to the interests of China.

Putting aside the long arm jurisdiction and broad authorizations, the Provisions specifically addresses the scenarios where foreign entities suspending normal transactions or applying discriminatory measures against a [Chinese person], which violates normal market transaction principles and causes serious damage to the legitimate rights and interests of the [Chinese person].

It clearly relates to the Huawei situation and other Chinese persons (entity or individual) who have been designated onto the Entity List or the SDNs list by the U.S. government, and thus are subject to the U.S. economic sanctions and export controls, or other restrictions (such as the U.S. CBP’s Withhold Release Order). They are essentially cut off from the supply chain, e.g. not able to obtain U.S. items (e.g. Huawei), not able to access to the U.S. market (such as fabrics/clothing containing Xinjiang cottons), or even cannot deal with non-U.S. companies (with secondary sanction exposure) or in U.S. dollars (when they are designated as an SDN).

This UEL mechanism is made to retaliate and deter in order to help protect the interests of Chinese companies in those situations. It sounds very similar to the “Blocking Statute” of the European Union, but in fact is not the same kind of protection (see footnote^[1] for details). It will put multinational companies (not just U.S. companies) in a very difficult situation.

In the case where anyone is sanctioned by the U.S government (either under sanction programs or export controls), any items subject to the U.S. Export Administration Regulations (“EAR”) cannot be supplied to such person without a license from the U.S. government. Otherwise, it is a violation of U.S. law. In the case of fabrics/clothing containing cottons from Xinjiang, the products could be subject to detention under a Withhold Release Order issued by the U.S. Customs. For these reasons, foreign counterparties would have to comply with the U.S. law when the items are subject to the EAR or are entering the U.S. market. Such compliance would require them to discontinue the supply to or the purchase from a Chinese entity sanctioned by the U.S. government if no license can be obtained. With this UEL mechanism, complying with U.S. law in such a situation would possibly trigger the UEL designation. Once designated, foreign companies could be cut off from supply chains from China, meaning sourcing from China or supplying into Chinese market would be impossible. While this UEL could put pressure on foreign companies, it’s worrisome that it may accelerate the “de-China” trend in the global supply chain restructuring.

How To Navigate The Dilemma?

Honestly we don’t know how, unless one would be willing to circumvent the U.S. laws.

In making the decision of UEL designation, the authority would look into the factors including (i) the degree of danger to national sovereignty, security or development interests of China; (ii) the degree of damage to the legitimate rights and interests of [Chinese persons]; (iii) whether being in compliance with internationally accepted economic and trade rules; and (iv) other factors that shall be considered.

If “suspending normal transaction” is a must-do under the U.S. laws, then the only possible argument is “being in compliance with internationally accepted economic and trade rules”. Arguments like the designation would do more harm to other Chinese interests (e.g. other Chinese companies still need American chips) could be helpful in negotiating with the government to impose restrictions as narrow as possible.

The third factor “whether being in compliance with internationally accepted economic and trade rules” is vague. Unlike the previous factor “whether the actions of the entity are not for commercial purposes and are in violation of market principles and contractual obligations”, as explained by MOFCOM officials in May 2019 when the UEL concept was introduced, although vague too, it at least easier to comprehend. In any event, being obliged to comply with U.S. laws is definitely not among the “internationally accepted economic and trade rules”.

So, the burden is for the foreign entity to demonstrate if there is any cause existing under any “internationally accepted economic and trade rules” (such as WTO rules, UN Convention on Contracts of International Sales of Goods, INCOTERMs) that could serve as a justifiable ground to suspend the transaction. Not sure how effectively one can navigate there, a few things might worth pondering –

• Carefully examine the compliance requirements. Try not to over-comply.
• Contract terms. Sanctions or trade controls clauses are very common in contracts drafted by sophisticated multinational companies. It would be suggested to think it twice. Indicating the items are subject to EAR and requesting representations and warranties with respect to end user/end use and non-diversion would unlikely become an issue. It could be problematic to directly put the events like the buyer becomes an SDN or put on the Entity List by the U.S. government as a ground for terminating the contract. No-obligation to supply at discretion would be a good clause to have. Revisit the governing law and the dispute resolution clauses for better protection in case being sued for commercial losses.
• Establish affirmative defenses. Building up the case on breach of contract by the counterparty, or citing some other causes (such as inability to obtain supply of materials) when deciding to terminate the contract. In addition, demonstrating efforts to seek licenses from U.S. government could be helpful.
• Plan B, especially for those major deals. Both sides of the deal should carefully review the MAC (Material Adverse Change) or MAE (Material Adverse Effect), as well as exit plans, to accommodate this UEL situation.

Maintain low profile when the business relationship is suspended. Develop a crisis management protocol is recommended.

What’s The Designation Procedure; What To Prepare For Investigations?

It is applaudable that the government follows a better due process in the designation procedure, unlike the U.S. government doesn’t provide any opportunity to argue.

• The Provisions says the authority will make an announcement when it opens an investigation. Under the U.S. sanctions and export controls regimes, the investigation is un-announced. One wouldn’t know until it is designated.
• During the course of investigation, the foreign entity can present its arguments. The U.S. regimes do not offer that.
• The Provisions further provides that, the authority may suspend or terminate the investigation based on the actual circumstances, and resume when the facts warranted the suspension change materially. This seems there might be an opportunity to negotiate and reach a settlement.

According to the Provisions, the authority can self-initiate the investigation process, or initiate the investigation “upon suggestions and reports from relevant parties”. So, be mindful that the counterparties may exploit this as a leverage if the parties are at disputes.

During the course of the investigation, the authority can “inquire the relevant parties, consult or copy the relevant documents and materials, and take other necessary means”.

Note that an investigation is not always a must-do procedure before the designation. The Provisions also provides that, “[w]here the facts about the actions taken by the relevant foreign entity are clear, the working mechanism may, by taking into overall consideration the factors specified in Article 7 of these Provisions, directly make a decision on whether to include the relevant foreign entity in the Unreliable Entity List; if a decision is made to include in the Unreliable Entity List, an announcement shall be made.”

A few suggestions for multinational companies –

• When an investigation is initiated, be cooperative and act proactively, so that your arguments can be heard.
• Protocols for responding to investigations. Companies and their affiliates in China should develop and implement policies and procedures for properly responding to government investigation or even just an inquiry.
• Be prepared for an investigation. Companies and their affiliates should act quickly and be prepared once an investigation is announced. It’s recommended to conduct an internal investigation and review relevant transaction records and correspondences with the Chinese counterpart, so as to develop a good defensible story.

Rules for internal and external communications, and recordkeeping. Companies and their affiliates should exercise caution in communication with counterparties, particularly during the contracting negotiation on sanction clauses and during the time of considering suspension and termination of contract. Also be careful in internal communications. Be mindful that the affiliates in China could be requested to submit internal records like email correspondences with foreign parties.

What About Chinese Counterparties?

The Provisions mandates that, “other units and individuals shall cooperate in the implementation”. This means it is a mandatory requirement that the counter-parties in China needs to comply with in their trading and investment dealings with the foreign UEL entities.

According to the Provisions, “[w]here, under special circumstances, it is necessary indeed for an [Chinese person] to conduct transactions with the foreign entity that is restricted or prohibited from engaging in China-related import or export activities, an application shall be submitted to the Office of the working mechanism, then the transactions with the foreign entity in question may be conducted upon approval”. So, for trading with a UEL entity, a prior approval is required, and the approval is granted on a case-by-case review.

Notably, such approval is only for import and export activities, but not for investment related activities. Not sure if this is intentional, it is hard to comprehend anyway. As the MOFCOM spokesman reiterated this UEL mechanism does not in any way discourage foreign investments, it would make more sense if this case-by-case approval can be granted for investment related activities.

It is also noteworthy that, there is no penalty clause for violations, either by foreign entities or by the Chinese counterparties. In practice, for import and export activities, the Customs can enforce such trading ban at the border. Under the customs regulations, such violation would be a smuggling.

Technically such trading ban is susceptible for circumvention. But what if the Chinese counterparties have no knowledge that the products being imported or exported are from or to the designated UEL? In a long global supply chain, it is not uncommon to sell to or buy from intermediary trading companies or distributors, without knowing the ultimate supplier or buyer. It would be more difficult for affiliated companies to demonstrate no knowledge.

How Long Can The Designation Last, and Process of Removal?

The Provisions does not specify how long the designation would last, rather, it leaves to the authority to decide in the designation.

Grace Period. The Provisions provides that “[w]here, the time limit for the relevant foreign entity to make rectifications is specified in the announcement of the inclusion of the said foreign entity in the Unreliable Entity List, the measures …shall not be implemented within the time limit. Where the relevant foreign entity fails to make rectifications within the time limit, the measures shall be implemented…”

According to the Provisions, there are several ways to seek removal.

• “[w]here the relevant foreign entity rectifies its actions within the time limit specified in the announcement and takes measures to eliminate the consequences of its actions, the working mechanism shall make a decision to remove it from the Unreliable Entity List”;
• The authority can remove on its own initiative;
• The foreign designated entity can apply for removal, and the authority shall decide whether to remove based on actual circumstances. There is no application procedure specified.

The Provisions do not provide the criteria for removal, and it leaves them to the authority’s discretion “based on actual circumstances”. If the foreign entity is designated after an investigation is opened, probably the only way is to demonstrate that “the foreign entity has taken measures to eliminate the consequences of its actions”, or the actual circumstances do not warrant maintaining the entity on the UEL list.

Outlook

A few notes taken from the explanation by the Head of MOFCOM’s Department of Law and Treaty on this UEL mechanism on a press conference on September 20, 2020:

• The UEL is not targeted to any specific country or enterprise.
• The government would only designate those acting in contrary to the interests of China pursuant to the Provisions and other laws, and the number of designation would be limited. The authority has no intent to freely exercise the designation.

There is no timeline to roll out the first UEL list, and there is no list of potential targets being considered.

To view the order, click here.

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[1] EU Blocking Statute only relates to the application of U.S. sanctions concerning Cuba and Iran, having nothing to do with export controls. Further, the protection by the EU is by nullifying the effect in the EU of any foreign court ruling based on the foreign laws, and by allowing EU operators to recover in court damages caused by the extra-territorial application of the specified foreign laws.