The United States District Court for the District of Columbia ruled last week that certain securities trading restrictions will not be effective against Xiaomi Corporation (“Xiaomi”) under Section 1237 of the Securities Act. the national defense authorization for the 1999 financial year, as amended. (“Item 1237”). In its opinion, the court found that Xiaomi was likely to prevail on the merits of its claims that the US government’s designation of Xiaomi as a Communist Chinese Military Company (“CCMC”) was not supported by substantial evidence and violated the Administrative Procedure Act. (“APA”). As a result, the court imposed trading restrictions on Xiaomi securities and derivatives that had been imposed due to its CCMC designation. Although the preliminary injunction order applies specifically to Xiaomi, the case could ultimately impact other Chinese companies designated as CCMCs under Section 1237, or US persons investing in securities. designated CCMCs.
Background to Section 1237 Designations.
On January 14, 2021, the US Department of Defense (“DoD”) designated Xiaomi as CCMC. Section 1237 defines a CCMC as: (i) an entity owned or controlled by, or affiliated with, the People’s Liberation Army, or a government department of the People’s Republic of China, or that is owned or controlled by a entity affiliated with the China Defense Industrial Base; and who (ii) is engaged in the provision of business services, manufacture, production or export. Pursuant to Executive Order 13959 issued November 20, 2020, as amended (“EO 13959”), U.S. persons may not engage in certain transactions in publicly traded securities and derivatives of CCMCs 60 days after designation by the DoD . We previously posted an update on EO 13959 and Section 1237. The DoD has designated a total of 44 entities under Section 1237 in five tranches issued since June 2020.
Following Xiaomi’s designation by the DoD, U.S. persons would have been prohibited from engaging in certain transactions involving Xiaomi securities or derivatives beginning March 15, 2021. EO 13959 allows U.S. persons to s Engage in divestiture transactions for one year following a Section 1237, after which mere possession of the securities becomes prohibited for US persons.
The Office of Foreign Assets Control (“OFAC”) of the United States Department of Treasury is responsible for administering and enforcing sanctions against CCMCs. The OFAC guidance states that EO 13959 broadly applies not only to CCMC securities, but also to derivatives and other investment vehicles that provide exposure to CCMC securities (e.g., exchange traded funds (” AND F “)). Some of the CCMCs have securities traded on US exchanges while others have securities traded on non-US exchanges. Notably, EO 13959 applies to the trading activities of US Persons and covers transactions outside the United States that involve US Persons, including US Persons who facilitate or have tangential involvement in the trading of CCMC securities. . Accordingly, the impact of EO 13959 includes companies involved in investing in a variety of financial instruments and financial activities worldwide. OFAC has issued a general license authorizing certain activities of stock exchanges operated by US persons.
Opinion of the Court.
Xiaomi challenged the DoD designation of Xiaomi as a CCMC and the restrictions under EO 13959 in a complaint and subsequent request for a preliminary injunction in the United States District Court for the District of Columbia. In an opinion issued on Friday, March 12, 2021, the court granted Xiaomi’s preliminary request to prohibit the entry into force of restrictions on transactions by American persons in Xiaomi securities or derivatives. The court opinion concluded, on a preliminary basis, that:
- The DoD’s explanation for designating Xiaomi as CCMC is inadequate. The court found that the DoD failed to properly relate its findings to the facts relating to Xiaomi.
- Xiaomi does not meet the statutory criteria to be designated CCMC. Xiaomi is a publicly listed company with an independent board of directors and majority shareholders and therefore the court did not find support for naming Xiaomi as owned or controlled by or affiliated with the Chinese government, the PLA or to other Chinese security services (e.g. China Defense Industrial Base).
- Xiaomi’s designation by the DoD lacked substantial evidence under the APA. The DoD defended its decision by pointing to Xiaomi’s involvement in fifth-generation (“5G”) internet networks and artificial intelligence, and Xiaomi’s founder’s receipt of an award from the Chinese government. The court found that this evidence was insufficient to conclude that Xiaomi is a CCMC and said it was “troubled by the absence of any limiting principle” in the DoD’s interpretation of Section 1237 as it stood. applied to Xiaomi.
The court then found that Xiaomi had established imminent irreparable harm due to the EO 13959 restrictions and CCMC designation, and that the balance of harms favored Xiaomi’s preliminary injunction request. It’s unclear at this time how the Xiaomi trial will unfold in light of this decision.
Impact on other CCMCs.
The court’s preliminary injunction order specifically only applies to Xiaomi. However, the DoD has so far designated 43 other Chinese companies as CCMCs. The Xiaomi case could impact those other CCMCs, or US persons who trade their securities or derivatives.
Other than Xiaomi, the DoD has not released any information as to why it has designated other Chinese companies as CCMC, or what factual support exists for such designations. However, other CCMCs could also challenge their designations in federal court. Their likelihood of success will depend on the DoD’s factual support for the designation and the Chinese entity’s proximity to the Chinese government, the PLA, and other parts of China’s defense industrial base.
For example, Luokung Technology Corp. (“Luokung”) has also filed a lawsuit in the United States District Court for the District of Columbia and is represented by Dorsey & Whitney in this case. OFAC also issued a Frequently Asked Questions (“FAQ”) on March 14, 2021 stating that the restrictions on Luokung had been delayed until May 8, 2021 because the DoD misspelled the company’s name. Luokung had originally been designated by the DoD on January 14, 2021 in the same tranche of CCMC that included Xiaomi. The DoD corrected the error in Luokung’s name on March 9, 2021, after Luokung filed his complaint against the DoD.
Additionally, it is possible that the Biden administration could review CCMC designations and the scope of restrictions under EO 13959, although the Biden administration has not indicated that it intends to do so. . Additionally, to date, neither the DoD nor OFAC has established a process for administrative review of Section 1237 designations.