Amid an intensifying rift with the US, China recently announced a new list-based sanctions framework that enables the Chinese government to sanction foreign entities and individuals engaged in activities deemed to endanger the fundamental economic and national security interests of China and of Chinese entities.

Foreign entities, both US and non-US based, active in China or conducting business with Chinese parties may face legal, reputational and political risks under this framework. Companies doing business with both China and the US are particularly susceptible to this new development, given the clashing sanction regimes they may face. We recommend that multinational companies, where possible, closely monitor legislative and enforcement developments, assess the resulting risks they face and take mitigation measures, as outlined in this article.

Background

Chinese entities are increasingly being scrutinised by foreign governments and are facing, among a host of measures, export control restrictions, economic sanctions and investment reviews. In response, the Chinese government has been developing countermeasures, as demonstrated by its enactment of the Provisions on the Unreliable Entity List (UEL), which took effect on 19 September 2020.

In brief, this list-based sanctions framework (English translation available here) allows the Chinese government to sanction foreign entities and individuals deemed to endanger fundamental Chinese interests. The framework aims to safeguard China's national sovereignty, security and economic interests, to maintain a fair and free international economic and trade order, and to protect the legitimate interests of Chinese entities and individuals.

The UEL framework will be administered by the Working Mechanism, an inter-departmental body coordinating the various government agencies involved.

Sanctions against designated Unreliable Entities

According to the UEL framework, measures can be taken against foreign entities engaged in international economic, trade and other activities that:

1. endanger China's national sovereignty, security or development interests; or
2. suspend normal transactions with, or apply discriminatory measures against, a Chinese entity, thereby violating normal market transaction principles and causing serious damage to this entity.

The first category would include, for example, measures taken against parties involved in arms sales to Taiwan, deemed by Beijing to endanger China's national sovereignty. The second category includes the issuing of sanctions against companies which have cut off supplies to a Chinese company pursuant to US sanctions or export control restrictions.

If a foreign entity is announced as having been added to the UEL, the announcement may specify a grace period for the foreign entity to rectify its actions. If the foreign entity fails to rectify within the grace period (provided this has been granted), the Working Mechanism may take one or more measures against the foreign entity. These can include restrictions or prohibitions on the foreign entity's China-related trade, investment, visa, work permits and residence permits of relevant personnel.

Although the measures do not explicitly prohibit Chinese entities from doing business with an entity on the UEL altogether, they may effectively restrict all or part of such business depending on the specific measures imposed on the "unreliable" entity. The announcement of a foreign entity having been added to the UEL may include an alert about the risks of conducting transactions with that foreign entity. As a result, the reputation of the foreign entity, its affiliates and their brands could be dealt with a major blow in the Chinese market. This could make doing business with a designated foreign entity unattractive to many Chinese entities.

There is also the possibility of a fine being issued on the foreign entity, without any range specified. The UEL framework further arms the Working Mechanism with the authorisation to take "other necessary measures" against the foreign entity.

The restrictive measures stipulated in the UEL framework are all phrased in broad terms and open for further implementation and interpretation. For example, the criteria for granting a grace period have not been specified. In terms of restrictions on investment, it is not clear if they will only apply to new investments or if they will also have an impact on existing investments.

Scope of application

The UEL framework's scope is defined as capturing "foreign entities", which covers foreign enterprises, organisations and individuals. The concept includes companies incorporated in a jurisdiction other than mainland China, but excludes foreign-invested enterprises established in China by foreign entities. Nevertheless, given the potentially close ties between an UEL-designated foreign entity and its Chinese affiliates in terms of reputation, intercompany transactions, deployment of personnel and reinvestment, any sanction imposed on a foreign entity is likely to have a direct or indirect impact on its Chinese affiliates.

Investigation and designation

When determining whether or not to designate a foreign entity to the UEL, the Working Mechanism will evaluate how dangerous and damaging the entity's actions are to the interests of China and Chinese entities, and whether those actions comply with internationally accepted economic and trade rules. The factors to be weighed by the Working Mechanism seem to be vague and broad, leaving ample discretion to the Working Mechanism to interpret and implement the UEL mechanism. For example, what "development interests" include and what qualifies as "serious damage" remains unclear.

The Working Mechanism has the discretion to decide whether to investigate a foreign entity's conduct, based on its own authority or at the suggestion of relevant parties, which could also include relevant reports. If an investigation is opened, this decision will be made public. During the investigation, the foreign entity has the right to make statements and defend its case. Investigative measures that the Working Mechanism is authorised to take include: launching an inquiry into any relevant parties, reviewing or copying relevant documents and materials, and taking other such measures as necessary. Once an investigation ends, the Working Mechanism will decide on whether to add the relevant foreign entity to the UEL. This decision will be made public.

The UEL framework also provides that, in cases where the facts are clear, the Working Mechanism may immediately make a decision, without an investigation having taken place. This decision will also be made public. In this type of fast-track process, the Working Mechanism does not have to give notice to the relevant foreign entity, denying the entity the chance to defend itself against its envisaged inclusion on the UEL.

Although the UEL framework sets the process that the Working Mechanism must follow in carrying out investigations and making decisions, various uncertainties remain, leaving ample discretionary power to the Working Mechanism. For instance, in terms of investigative measures, it is unclear what "other necessary measures" can be taken by the Working Mechanism. As regards fast-track cases, what qualifies as "clear facts" is also unknown.

Remedies

As to remedies, the UEL framework is silent on whether any investigation or decision by the Working Mechanism is subject to administrative review or administrative litigation. However, the foreign entity may apply with the Working Mechanism for its removal from the UEL. The UEL framework stipulates that, in response to the application for removal from the UEL, the Working Mechanism must make a decision based on "actual circumstances". This wording grants the Working Mechanism a lot of discretion. The Working Mechanism may also delist a foreign entity from the UEL at its own initiative. Any removal decision must be made public, with the sanction measures being lifted immediately.

Permitting system

As an exception, the UEL framework stipulates that, in special circumstances, a Chinese entity may apply to the Working Mechanism Office for a permit to engage in necessary import/export transactions with a UEL designated foreign entity that is otherwise prohibited from conducting China-related import/export transactions. Such permit may be granted if Chinese interests are better served by allowing the specific relevant transactions, despite the foreign entity's inclusion on the UEL. The permit may only be applied for by a Chinese entity; that is, not by the UEL designated foreign entity itself. For non-trade related engagements with designated unreliable entities, however, there is no exception.

Implications for Chinese parties dealing with designated unreliable entities

As the UEL framework does not explicitly prohibit a Chinese entity from doing business with a UEL designated entity, in cases where a Chinese entity chooses not to suspend or terminate its business with that entity, the consequences the Chinese entity may face remain unclear.

Broader implications

The introduction of the UEL makes it more urgent for companies to take note of the interests of China and of Chinese entities. If their activities have the potential to seriously affect those interests, companies may find themselves at risk of being designated an unreliable entity. This could seriously impact their business in China and with Chinese business partners, including outside of China, for example, if Chinese investors are involved or if the company sources supplies from China.

Companies active in both China and the US seem to be especially at risk, as they may face conflicting Chinese and US interests, with sanctions being issued to promote those interests. The same applies to companies that have to comply with US sanctions or export control restrictions against China, for example, companies prohibited from supplying items with controlled US content exceeding the 25% de minimus threshold to a Chinese entity included in the US Entity List. Simply complying with this prohibition by cutting off the supply of such products to the relevant Chinese entity may land the company on the UEL. Given the extra-territorial applicability of this prohibition to any party involved in the export of such items, this risk is not limited to US-based parties alone, but could affect EU corporates as well.

Risk assessment and mitigation

Multinational companies active in China or engaging with Chinese business partners would be advised to closely monitor geopolitical developments relating to China, specifically regarding US-China relations, and assess the potential effect on their business. To that end, they should assess:

• the risk of having to comply with US or other sanctions or export controls against China, thereby affecting Chinese economic and national security interests;
• the risk of their activities negatively affecting Chinese economic and national security interests otherwise;
• the implications of a potential designation as an unreliable entity to their business inside and outside China.

In order to mitigate the risks involved, companies are advised to also raise awareness with key management, allowing them to better assess the potential implications of, for example, entering into certain transactions, which could affect Chinese interests.

Companies may also want to consider reducing their exposure to US export controls, which at some point may require them to terminate their supply to certain Chinese parties, putting them at risk of being designated an unreliable entity. To that end, they could consider replacing or reducing the percentage of any US export controlled content included in their own products in order to avoid applicability of US export controls to those products.

Furthermore, companies are advised to include proper sanctions and export controls clauses in their contracts, allowing them to terminate a contract or suspend performance without liability. This is especially recommended in order to address situations where US, Chinese or other sanctions or export controls may come to prohibit these companies from continuing to performance their contract. If, for example, a company is forced to discontinue its supplies to a Chinese party pursuant to US export controls, the contract clauses may not prevent it from being designated an unreliable entity, but at least its contractual liability risk vis-à-vis the Chinese party would be limited.

Conclusion

The UEL system appears to have been created in response to the simmering tensions between the US and China. Even so, it can go well beyond retaliating against US entities only, allowing the Chinese government to impose sanctions on any foreign entity deemed to be acting in contravention of Chinese interests or to be discriminating against Chinese parties. These sanctions may have far-reaching implications for a company in and outside China. We recommend that multinational companies closely monitor relevant developments, assess the resulting risks they face and take mitigation measures where they can, as set out above.

We will closely monitor relevant legal developments ourselves, including China's export controls and sanctions regime, and provide further updates in due course.