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Use of the U.S. Department of Commerce’s ability to block U.S. export activities may have significant consequences for one of China’s largest telecom equipment producers.

ZTE Denial Order: Growing Tensions between the U.S. and China’s Economic Actions and Policies

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Use of the U.S. Department of Commerce’s ability to block U.S. export activities may have significant consequences for one of China’s largest telecom equipment producers.On April 16, 2018, the U.S. Department of Commerce Bureau of Industry and Security (“BIS”) issued a <a target="_blank" href="https://www.commerce.gov/sites/commerce.gov/files/zte_denial_order.pdf">denial order</a> against Zhongxing Telecommunications Equipment Corporation of Shenzhen and China and ZTE Kangxun Telecommunications Ltd of Hi-New Shenzhen, China (collectively, “ZTE”) after determining that ZTE failed to fully comply with the terms of a March 7, 2017, Settlement Agreement (the “2017 Settlement”) and provided false information to BIS during the negotiations leading up to the 2017 Settlement.The denial order restricts ZTE from participating in any transaction involving hardware, software, or technology subject to the U.S. Export Administration Regulations (“EAR”) for a period of seven years. This effectively bars ZTE from acquiring U.S. origin items (or items otherwise subject to the EAR), whether directly from the United States or indirectly from third parties outside the United States.ZTE is currently China’s second-largest manufacturer of telecom equipment and, at the time of the order, was valued in the marketplace at $20 billion. The consequences of the ban, however, may have a profound impact on its business: ZTE reportedly purchases between 25-30% of the components used in its equipment from U.S. companies and had established itself as the fourth-ranked seller of smartphones in the United States.<a class="anchor" id="_ftnref1" name="_ftnref1" href="#_ftn1">[1]</a>The denial order comes at a time of mounting tensions between the two countries. In the past few weeks alone, the United States and China have threatened each other numerous times with tariffs as part of an escalating confrontation with significant risks for the world’s two largest economies.  In addition to growing fears of a trade war, U.S.-China relations are also strained by broader national security considerations, including recent findings by the U.S. Trade Representative (“USTR”) on the potential threats to national security posed by Chinese investments in U.S. technology companies. Animated by China-focused national security concerns, there is pending legislation in Congress that would sweep substantial additional technology transactions—a vast number of which would involve Chinese investments in the United States—into the jurisdiction of the Committee on Foreign Investment in the United States (“CFIUS”).2017 Settlement against ZTEIn 2017, ZTE agreed to pay a combined $1.19 billion to the U.S. government to settle criminal and civil charges for illegally shipping telecommunications equipment to Iran and North Korea. ZTE was accused of operating an elaborate scheme to re-export U.S. items to Iran and North Korea, both of which had been blocked by U.S. sanctions. As part of its alleged scheme, ZTE was accused of covering its tracks by making false statements to U.S. authorities and destroying export records.Prior to the settlement, the U.S. government had discovered a ZTE memo that explained in detail a plan under which ZTE would set up a chain of shell companies through which U.S. goods would pass. BIS stated that the activity was “part of an unacceptable pattern of false and misleading statements and related actions.”As part of the settlement agreement, ZTE agreed to be subject to U.S. compliance monitoring for three years. It also agreed to fire four senior employees and discipline 35 others by either reducing their bonuses or reprimanding them.Alleged Actions Leading to the Denial OrderThe April 16 denial order alleged that ZTE not only failed to comply with the terms of the settlement but made false statements to U.S. government officials regarding its compliance. ZTE admitted that while it fired four senior employees involved in the illegal activity, it failed to take action against the others. Rather, BIS determined that ZTE paid full bonuses to the employees that had engaged in illegal conduct and failed to issue letters of reprimand. According to Secretary of Commerce Wilbur Ross, “ZTE misled the Department of Commerce. Instead of reprimanding ZTE staff and senior management, ZTE rewarded them. This egregious behavior cannot be ignored.”Details of the Denial OrderThe denial order was issued pursuant to a formidable power of the BIS to bar entities from participating in export activities subject to the EAR.  Under the denial order, ZTE is banned from participating in any way in transactions involving any commodity, software, or technology exported or to be exported from the United States that is subject to the EAR, including:<ul><li>Applying for, obtaining, or using any BIS export license, license exception, or export control document;</li><li>Carrying on negotiations concerning, or ordering, buying, receiving, using, selling, delivering, storing, disposing of, forwarding, transporting, financing, or otherwise servicing in any way, any transaction involving any item exported or to be exported from the United States that is subject to the EAR or engaging in any other activity subject to the EAR; and</li><li>Benefiting in any way from any transactions involving any item exported or to be exported from the United States that is subject to the EAR or from any other activity subject to the EAR.</li></ul>The denial order also bans any person from engaging, directly or indirectly, in certain EAR-related activities involving ZTE, including:<ul><li>Exporting or re-exporting to or on behalf of ZTE any item subject to the EAR;</li><li>Taking any action that facilitates the acquisition or attempted acquisition by ZTE of the ownership, possession, or control of any item subject to the EAR that has been or will be exported from the United States, including financing or other support activities related to a transaction whereby ZTE acquires or attempts to acquire such ownership, possession, or control;</li><li>Taking any action to acquire from or to facilitate the acquisition or attempted acquisition from ZTE of any item subject to the EAR that has been exported from the United States;</li><li>Obtaining from ZTE in the United States any item subject to the EAR with knowledge or reason to know that the item will be or is intended to be exported from the United States; or</li><li>Engaging in any transaction to service any item subject to the EAR that has been or will be exported from the United States and that is owned, possessed, or controlled by ZTE, or service any item, of whatever origin, that is owned, possessed, or controlled by ZTE if such service involves the use of any item subject to the EAR that has been or will be exported from the United States (including installation, maintenance, repair, modification, or testing).</li></ul>The restrictions in the denial order will last until March 13, 2025.Mounting Tensions between the United States and ChinaThe denial order comes while the United States faces growing concerns about safeguarding its telecommunications technologies and slashing its trade deficit. The technology sector has become one of the United States’s greatest areas of consideration regarding its potential for continued economic prowess.In November 2017, key members in both the House and the Senate introduced the Foreign Investment Risk Review Modernization Act of 2017 (“FIRRMA”), a bipartisan legislation that would significantly expand CFIUS’s authority to review and supervise transactions by sweeping “critical technology” companies into its jurisdiction. Under the bill as introduced, CFIUS review would be required for transfers of “intellectual property and associated support” to a foreign company or individual through joint ventures and other business arrangements that fall outside of “an ordinary customer relationship.” While the bill does not single out China by name, many of its sponsors and proponents have cast it as a direct response to growing national security concerns over Chinese investments in the United States (for more on these developments, see “Congress to Consider a Broad Overhaul of CFIUS” <a href="/resources/publications/171109-cfius-overhaul.html">here</a>).In March, President Trump issued a <a target="_blank" href="https://www.whitehouse.gov/presidential-actions/presidential-memorandum-actions-united-states-related-section-301-investigation/">memorandum</a> directing the U.S. government to take several actions related to China’s acts and policies related to technology transfer, intellectual property, and innovation. The memorandum instructed the government to propose possible restrictions on Chinese investment in the United States and imposing higher customs duties on Chinese imports. The memorandum followed findings by the USTR that China’s actions, among other things, (i) undermine the value of U.S. investments and technology, and (ii) systematically facilitate investments in and acquisitions of U.S. companies to obtain technology transfers from U.S. companies to Chinese entities.Given the national security concern over safeguarding of the U.S.’s intellectual property, some speculate that the President may expand CFIUS’s authority to review transactions involving the U.S. transfer of goods to foreign entities even before FIRRMA may take effect. Under the International Emergency Economic Powers Act (“IEEPA”), the President may declare an emergency and grant CFIUS such authority despite the fact that current CFIUS regulations require a transfer of “control” to trigger its jurisdiction.Practical ConsiderationsThe denial order against ZTE may be the most significant sanctions enforcement action taken by the current administration to date. We note the following takeaways:First, BIS’s power to block the export activities of entities can have severe consequences. In ZTE’s case, the denial order could substantially impair its sourcing of products and components, which in turn may have a significant impact on ZTE’s ability to provide its customers with ZTE-manufactured equipment. In effect, BIS, like the U.S. Department of Treasury Office of Foreign Assets Control, can “specially designate” entities and restrict their ability to participate in U.S. trading activity. The economic consequences of such actions may outstrip even criminal penalties—thus underscoring the importance of a well-functioning, effective compliance program for companies engaging in any activities related to international transactions.Second, BIS had discretion as to the type of enforcement action to take in response to ZTE’s actions, including monetary fines. The issuance of the denial order as a penalty for making misrepresentations to the U.S. government emphasizes the importance of providing verifiable information to enforcement agencies and honoring commitments made to the U.S. government.Third, the denial order highlights the U.S. government’s willingness to use all tools at its disposal under its sanctions and national security authorities. The current administration has overseen a record number of CFIUS and sanctions-related enforcements, and BIS’s unprecedented use of the denial order is consistent with the United States’ increasingly aggressive approach to sanctions enforcement policy.Finally, the ZTE denial order may signal the latest move in a larger duel between the United States and China regarding economic policy, as well as the potential use by the U.S. government of a broad range of remedies to address national security concerns related to Chinese activities involving U.S. origin technologies and products.U.S. suppliers should conduct careful diligence when engaging in foreign transactions, especially if they may be exporting items to companies that are engaged in transactions with ZTE. Such companies should take care to consider that any item of U.S. origin subject to the EAR may not be resold to ZTE without running afoul of the BIS denial order even if the transaction occurs outside of the United States. Finally, companies should ensure that their compliance programs are robust and effective since non-criminal enforcement activities may have particularly significant consequences.<div data-type='hr' style='border-top: 3px solid #bbb'></div><a class="offset" id="_ftn1" name="_ftn1" href="#_ftnref1">[1]</a> Reuters, U.S. ban on sales to China’s ZTE opens fresh front as tensions escalate (April 16, 2018), <a href="https://www.reuters.com/article/us-china-zte/u-s-ban-on-sales-to-chinas-zte-opens-fresh-front-as-tensions-escalate-idUSKBN1HN1P1">https://www.reuters.com/article/us-china-zte/u-s-ban-on-sales-to-chinas-zte-opens-fresh-front-as-tensions-escalate-idUSKBN1HN1P1</a>.

ZTE Denial Order: Growing Tensions between the U.S. and China’s Economic Actions and Policies