With China and the US at loggerheads on trade, we asked three experts for the top three us legal risks for Chinese companies and executives this year. Richard A Mojica, Brian J Fleming and Collmann Griffin give their views
US enforcement actions against Chinese companies and executives made headlines in 2018, and into early 2019. In January this year, the US Department of Justice (DOJ) announced multiple charges against Huawei Technologies, and several related subsidiaries and individuals.
In 2018, Chinese companies and individuals that faced either criminal or civil enforcement actions included ZTE Corporation, Fujian Jinhua Integrated Circuit, Huawei, its CFO Meng Wanzhou, former Hong Kong government official Patrick Ho, and Macau-based billionaire David Ng Lap-seng.
Simultaneously, from May 2018, the US began rolling out tariffs on approximately US$250 billion worth of yearly imports from China, launching a trade war between the two countries that is ongoing. Then, in November 2018, then US attorney-general Jeff Sessions announced the DOJ’s “China Initiative”, a legal and prosecutorial initiative that ties together US objectives connected with intellectual property, international trade, anti-corruption and national security, and suggests that China-focused enforcement will continue for the foreseeable future.
The US has long been known to interpret its jurisdiction aggressively to target non-US companies and individuals, for example in the EU, Brazil, Venezuela, Turkey and Iran. In addition, the US has also long targeted US companies and individuals operating in China, for example by bringing dozens of enforcement actions against US companies and their Chinese subsidiaries in connection with foreign corruption and export controls. Never before, however, has the attention of US authorities been focused on Chinese companies and individuals as it appears to be today.
Chinese companies and individuals hoping to stay out of the crosshairs of the new US legal focus on China need practical advice for understanding and analyzing US legal risks. Accordingly, the authors set out the three biggest US legal risks that they believe Chinese companies and individuals may face this year.
Aggressive enforcement of economic sanctions and export controls. Two leading lights of China’s technology sector, ZTE and Huawei, faced US economic sanctions and export controls enforcement actions in 2018 and early 2019, both allegedly in connection with the export of products with US components or technology to Iran.
Just as importantly, US authorities quietly launched dozens of lower-profile economic sanctions and export control enforcement cases throughout the year, for example: Imposing civil penalties against Chinese oilfield service company Yantai Jereh in connection with its business in Iran; cutting off the Chinese military’s equipment development department (EDD) from the US economy for dealings with Russia; and bringing criminal charges against several Chinese companies and individuals alleged to have willfully provided sensitive technologies to China.
US authorities have also leveraged economic sanctions and export controls in the ongoing IP/technology transfer dispute with China. For example, in late 2018, US authorities indicted the state-owned integrated circuit company, Fujian Jinhua Integrated Circuit, for alleged economic espionage, and then added the same company to the list of entities prohibited from receiving exports of US-origin goods or technology, a one-two punch that brought a common export control tool into the IP space.
Expect US prosecutors’ use of economic sanctions and export controls to increase in 2019. Certain business dealings may be particularly risky, including those concerning: US-embargoed regions such as Iran, Syria, North Korea, Cuba and the disputed Russian/Ukrainian region of Crimea; targeted sectors of the Russian and Iranian economies, such as finance and energy; and companies or individuals blacklisted by the US, such as so-called specially designated nationals (SDNs) or specially designated global terrorists (SDGTs).
To mitigate economic sanctions and export controls risk, consider these three recommendations in 2019:
- Be aware of US jurisdictional “touch points”. Chinese companies and individuals can only face criminal or civil penalties if the US has jurisdiction over them. As a rule of thumb, a Chinese company or individual may be subject to US jurisdiction when there is any US “touch point” involved – such as US territory, a US person, US goods, US services, or US technology. Although this rule of thumb can be helpful, the precise rules for US jurisdiction can be very technical and complex, so companies and individuals should proceed with care. For example, US authorities have read the term “US person” to include: dual US/Chinese nationals, US green-card holders who have not yet obtained US citizenship, and US-registered companies, subsidiaries, and financial institutions. The involvement of any such “US persons” may be enough for US prosecutors to assert jurisdiction over the entire transaction.
- Watch out for secondary sanctions. Even when a transaction lacks US jurisdictional touch points, US authorities may impose so-called “secondary sanctions” that do not impose civil or criminal penalties, but instead seek to cut off a sanctioned party from the US economic system, including the US financial system. Most secondary sanctions target certain sectors or activities in Iran – such as petroleum, natural gas, petrochemicals, automobiles, or the Iranian government’s stockpiling of gold and US-dollar bank notes. Since 2017, however, some secondary sanctions have targeted certain activities in connection with Russia. For example, the US State Department imposed secondary sanctions on the Chinese military’s EDD in connection with the purchase of Russian combat aircraft and surface-to-air missile components. US authorities have also traditionally focused secondary sanctions enforcement on companies that behave evasively or deceptively, for example by seeking to conceal the true nature or parties involved in potentially sanctionable transaction.
- Treat US financial institutions and US dollars with special care. Even if US prosecutors cannot assert jurisdiction over the substantive conduct through US “touch points” or other means, they still may use money laundering, wire fraud, and bank fraud statutes to bring charges related to the alleged misuse of the US financial system. Such statutes are favoured tools of prosecutors because they are relatively easy to prove and automatically involve a US person, providing jurisdiction. Notably, if charges against Huawei CFO Meng Wanzhou proceed, she will likely be prosecuted for bank fraud for concealing her company’s Iran business, rather than for the actual exports of products to Iran.
Anti-corruption enforcement targeting Chinese competitors of US companies. US companies operating outside the US are now well accustomed to the Foreign Corrupt Practices Act (FCPA), which prohibits companies and individuals from offering, promising or giving anything of value to non-US officials to influence their decision making. Each year, several US companies and individuals face civil penalties or criminal prosecution under the FCPA arising out of alleged bribes paid in China.
However, until recently, few Chinese-based companies and individuals had been penalized under the FCPA. That may be about to change.
Notably, the DOJ’s above-mentioned China Initiative specifically promises to work to identify FCPA cases “involving Chinese companies that compete with American businesses”. Here, the DOJ appears to be responding to longstanding complaints by US companies that their Chinese competitors enjoy a competitive edge in the developing world – particularly Latin America and Africa – because they are freer to pay bribes in order to facilitate market access or win government contracts. Regardless of the truth of these complaints, Chinese competitors with US companies may now be forced to consider their FCPA risk.
A recent case shows how the DOJ may enforce this initiative. In 2018, the DOJ successfully convicted former Hong Kong government official and Chinese businessman Patrick Ho Chi-ping on FCPA and money-laundering charges. According to the DOJ, Ho offered US$2 million to the president of Chad, in northern Africa, in order to facilitate oil rights for a Chinese energy company, as well as US$500,000 to the foreign minister of Uganda, in central Africa, in exchange for support for the energy company’s acquisition of a bank.
However, Ho is not a US citizen, and conducted much of his business outside the US. Accordingly, his lawyers sought to dismiss the charges against him on the grounds that the US lacked jurisdiction over some of his conduct. To counter this assertion, prosecutors made two FCPA jurisdictional arguments: First, prosecutors argued that Ho had acted as an “agent” of a US “domestic concern” (company), because he allegedly made the unlawful payments while working at an Arlington, Virginia-based non-government organization he founded. Second, prosecutors were able to show that some of Ho’s conduct in support of the payment took place within US territory, including e-mails Ho sent on his iPad while staying in the US. The US judge accepted both arguments and Ho was convicted on seven out of eight counts, some of which have a maximum sentence of up to 20 years in prison. He is due for sentencing on 25 March.
To avoid entanglement with US anti-corruption law in 2019, Chinese companies and individuals should consider the following recommendations:
- Rely on US DOJ and SEC guidance for implementing anti-corruption best practices. Both the DOJ and Securities and Exchange Commission (SEC) have developed best practices for anti-corruption compliance programmes including: company policies against improper payments; due diligence procedures for assessing potential business partners; and anti-corruption training for company personnel. Both agencies have shown a willingness to dramatically reduce penalties, or even decline to file charges, when a company has such best practices in place, even when the conduct would otherwise be prosecutable. Accordingly, Chinese companies may consider adopting new anti-corruption best practices or tweaking their existing anti-corruption programmes to take into account US law, especially when competing with US companies in high-risk countries in Africa and Latin America.
- Be aware of US jurisdictional “touch points”. As with economic sanctions and export controls, US authorities must be able to assert jurisdiction in order to impose criminal or civil penalties. Chinese companies and executives with potential anti-corruption issues should therefore be aware of the bases for such FCPA jurisdiction, including: involvement of US companies, subsidiaries or employees; conduct that takes place within the US; or use of the US financial system. Companies that have issued securities registered on US stock exchanges are subject to additional books-and-records and internal accounting controls provisions under the FCPA, which may give rise to liability even when there is no connection to foreign bribery.
Tariffs on Chinese-origin goods and customs enforcement. At the time of writing, the US and China appeared closer to negotiating a deal that would reduce at least some of the additional US tariffs imposed on Chinese products. Nevertheless, we anticipate that US importers of Chinese products and their Chinese partners will continue to face some tariff risk in 2019.
Most notably, initial reporting on the US-China trade deal suggests that tariffs will remain in place for some products, in particular high-tech, strategically important products covered by the initial tranches of tariffs imposed under section 301 of the Trade Act of 1974. In addition, the US is likely to include “snap-back” provisions, allowing it to re-impose tariffs if it determines that China has not lived up to its IP, technology transfer, or market access commitments.
Given this uncertain landscape, the following tariff mitigation strategies may be of use both to Chinese companies that are importers of record (IORs) in the US, as well as for Chinese exporters, to discuss with their US trading partners. It is important to take the necessary steps to ensure these tariff mitigation strategies are properly implemented. For example, companies should memorize the legal justifications for any change in existing practice and, when appropriate, request binding rulings from US Customs and Border Protection (CBP). Moreover, if you suspect another company is evading tariffs through the improper use of these techniques (e.g., misclassifying products or undervaluing merchandise), consider raising the matter with the CBP, which is devoting significant resources to prevent tariff evasion.
- Re-evaluate the tariff classification of products sourced from China. Section 301 tariffs on Chinese-origin products currently affect a little more than 60% of the eight-digit codes in the Harmonized Tariff Schedule of the US (HTSUS). While those HTSUS codes account for almost half of imports from China (US$250 billion out of US$505 billion), there are currently almost 4,000 eight-digit HTSUS codes that are not affected by the tariffs. The number of HTSUS codes not affected by the tariffs may increase if the US and China reach a deal. As such, companies should take another look at the classification of products sourced from China, considering the applicable legal framework (e.g., the section and chapter notes to the HTSUS, the explanatory notes, and CBP rulings). Through additional diligence, some companies are realizing that a number of their products were incorrectly classified, a fact that went unnoticed in the past when no duties applied.
- Reassess the declared country of origin. To determine origin for tariff purposes, the CBP applies the “substantial transformation” test. A product assembled from multiple components is deemed to have undergone a substantial transformation if, as a result of the assembly or processing activity, the components are transformed into a new and different article of commerce with a different name, character or use. In applying this test, the CBP examines the totality of circumstances, with a focus on the complexity of the manufacturing or assembly process (the number of steps, worker hours, tools and technical skill required), and the local value added. Not every product assembled in China is of Chinese-origin for section 301 tariff purposes, as demonstrated by a few recent rulings where the CBP ruled that products assembled in China did not undergo a substantial transformation because their most essential components are foreign-made.
- Consider the “first sale rule” of customs valuation. Where there are multiple sales of goods prior to their importation into the US (sales involving an intermediary), the first sale rule allows importers, in certain circumstances, to use the price paid in the first or earlier sale as the basis for the customs value of the goods, rather than the price the importer ultimately pays for the goods. The earlier sale price is generally lower because it does not account for the intermediary’s markup, so using the first sale rule can reduce an importer’s tariff exposure. Not every multi-tier transaction is eligible for first-sale valuation, however. To qualify, three criteria must be met: (1) there must be a bona fide sale of the merchandise from the manufacturer to an intermediary; (2) the goods must be destined for export to the US at the time of the first sale; and (3) the manufacturer and the intermediary must negotiate at arm’s length. Importers that rely on first sale must maintain a documentation trail to substantiate each of the above requirements. Accordingly, we generally recommend that importers confer with the CBP about whether proposed arrangements with certain key vendors would qualify for first sale ahead of time, especially now that the CBP is scrutinizing this valuation methodology as part of a broader, tariff-related enforcement push.
- Tariff engineering. For decades, companies have tweaked the design of imported products to achieve favourable tariff treatment – a practice known as tariff engineering. The concept of tariff engineering is rooted in the longstanding legal principles that: (1) merchandise is classifiable in its condition as imported; and (2) an importer has a right to fashion merchandise to obtain the lowest rate of duty, provided it does not resort to fraud or artifice. The general position expressed by the CBP in its rulings is that, if the imported product is a commercial reality (i.e., the article enters into the stream of commerce in the condition as imported), then tariff engineering is permissible. So tariff engineering can alleviate the tariff burden on products subject to the section 301 tariffs, but importers must tread carefully.
- Perform the final step of the production process outside of China. Finally, importers may seek to sidestep the trade war entirely by sourcing components from China but performing final manufacturing activities in a third country. As long as the final manufacturing activities result in a change in the components’ name, character and use, even products made entirely of Chinese components may not be Chinese-origin for section 301 tariff purposes.
Richard A Mojica is a member at Miller & Chevalier, and previously served as an attorney at the US Customs and Border Protection’s Office of Regulations and Rulings. Brian J Fleming, a member at Miller & Chevalier, and Collmann Griffin, an associate, co-authored this article