Just three days before restrictions under Executive Order (EO) 13959 arising from Xiaomi Corporation’s designation by the US Department of Defense (DoD) as a Communist Chinese military company (CCMC) were to go into effect, on March 15, 2021, the US District Court for the District of Columbia granted Xiaomi’s request for a preliminary injunction order (the Court Order) against enforcement of the restrictions.

Following the Court Order, on March 14, 2021, the US Treasury Department’s Office of Foreign Assets Control (OFAC) published a new Frequently Asked Question (“FAQ”) confirming that, for now, US persons are not prohibited from transacting in publicly traded securities of Xiaomi under EO 13959. OFAC also published a new FAQ concerning the application of EO 13959 to Luokung Technology Corp., which is also designated as a CCMC.

The Court Order

Preliminary Relief

The 26-page Court Order, issued March 12, 2021, temporarily prevents the enforcement of restrictions on US persons transacting in publicly traded securities of Xiaomi under EO 13959 resulting from the DoD’s designation of the company as a CCMC under Section 1237 of the National Defense Authorization Act for Fiscal Year 1999 (NDAA).

In granting Xiaomi’s motion for preliminary relief, the Court found that Xiaomi had shown both a likelihood of success on the merits of its case challenging the CCMC designation and that without such relief while the case was pending, Xiaomi would suffer irreparable harm in the form of serious reputational and unrecoverable economic injuries. The Court agreed that Xiaomi would likely succeed in showing that the US government had violated the Administrative Procedure Act (APA) and exceeded its authority under the NDAA owing to the weakness of the government’s evidence linking Xiaomi to the Chinese military. Therefore, it did not need to reach Xiaomi’s due process rights arguments, but noted that the US government had conceded many of the serious concerns Xiaomi had raised.

The Court Order is unusual in the overall lack of deference given to a US federal agency’s determination under a presidential EO, particularly in a case involving national security. Notably, the Court found that the DoD’s designation process as to Xiaomi was “deeply flawed” and that Xiaomi had met its strict burden of proof and relief was justified until a full hearing on the merits.

Inadequate Evidence

The Court found that the DoD’s two-page decision memo in support of Xiaomi’s designation began on “shaky ground” by among other things, failing to identify its statutory authority and then, misquoting the statutory criteria on which it relied to make the designation. “These errors do not inspire confidence in the fastidiousness of the agency’s decision-making process,” the Court wrote.

More importantly, the Court found that the DoD’s explanation for designating Xiaomi as a CCMC was inadequate and that the designation determination lacked “substantial evidence” to support it. The facts cited by DoD to support its conclusion that Xiaomi met the CCMC criteria consisted of no more than the following two “generally innocuous” references drawn from Xiaomi’s 2019 Annual Report: (i) its CEO had been recognized as an “Outstanding Builder[] of Socialism with Chinese Characteristics,” by the PRC Ministry of Industry and Information Technology, which the US government identified as “an organization of the PRC that helps manage military-civil fusion for the state,” and (ii) Xiaomi’s five-year plan to invest in 5G and artificial intelligence (AI), two types of technology that the US government asserted are “essential to modern military operations.”

In finding that “reasonable minds would be hard-pressed” to accept these two pieces of evidence as adequate, the Court contextualized them by pointing out that Xiaomi is a consumer electronics company and that 5G and AI are the industry standard for consumer electronics devices, without which Xiaomi could not compete with other consumer smartphone manufacturers and would soon be obsolete. The Court was “troubled by the lack of any limiting principal on the DoD’s CCMC designation power” if the DoD’s logic in using potential alternative military applications as a justification for designation were allowed to stand, since even US companies with Chinese subsidiaries could be caught.

And the Court noted that over 500 entrepreneurs had received the same recognition as Xiaomi’s CEO, including the makers of infant formula, chili sauce, and wine. The involvement of these industries with the military-civil fusion seemed implausible to the Court and the link to the PRC Ministry was deemed equally tenuous as the honorees are nominated by local officials and committees. Interestingly, given an opportunity to supplement the factual record in opposition to the motion, the US government declined, according to a footnote.

The Court held that Xiaomi was not owned or controlled by, nor was it affiliated with the Chinese military and defense establishment.  The Court, in accepting Xiaomi’s definition of “affiliated with” and rejecting the DoD’s broad interpretation of the term, noted that Xiaomi is a publicly traded company that produces commercial products for civilian use, controlled by its independent board and controlling shareholders, and not by others under the ownership or control of the PRC or its security services. The Court held, therefore, that Xiaomi’s classification as a CCMC exceeded DoD’s statutory authority under Section 1237, in violation of the APA.

Irreparable Harm

The Court accepted Xiaomi’s demonstration of the reputational and financial harm it would suffer without relief, including loss of access to capital and other business opportunities, loss of market share, and difficulty recruiting and retaining talent.

Further, the Court could not fathom how the former president’s description in EO 13959 of CCMCs as being linked “to weapons of mass destruction, advanced conventional weapons, and malicious cyber-enabled actions against the United States” could not have caused Xiaomi severe and irreparable reputational harm. The financial harm, including loss in share price, suspension of trading, cancellation of contracts, rescission of planned strategic partnerships—even before the restrictions were to become effective, met the burden for preliminary relief.

National Security versus the Public Interest

Finally, the Court found the government’s reliance on the threat to national security posed by Xiaomi was undermined by the facts that it could not identify any transfers of technology from Xiaomi to the PRC and that the CCMC designation authority had been unused for almost 20 years before the final months of the Trump administration. Rather, the public interest in having government agencies abide by the federal laws governing their operations outweighed the less than compelling national security interests cited by the government.

OFAC FAQs

Newly issued FAQ 880 confirmed that restrictions under EO 13959 “do not apply with respect to Xiaomi pending further order of the Court.” As a result, US persons are not prohibited from transacting in publicly traded securities of Xiaomi or securities that are derivate of, or designed to provide investment exposure to, such publicly traded securities.

A second FAQ, FAQ 881, stated that restrictions under EO 13959 with respect to Luokung Technology Corp. will take effect on May 8, 2021, while US persons will have until March 9, 2022, to divest of securities subject to EO 13959 with respect to the company. According to the FAQ, the clarification follows the DoD’s re-designation of Luokung on March 9, 2021—an earlier designation on January 14, 2021, which erroneously identified the company as Luokong Technology Corp.

Conclusion

The Court Order granting preliminary injunctive relief to Xiaomi demonstrates that there is a solid basis in the courts to challenge the recent designations of companies as CCMC or on lists such as the Entity List or the List of Specially Designated nationals that have the potential to cause great harm, and are supported by less than substantial evidence.

Beyond the immediate case, the Court Order also provides a basis for challenging other CCMC designations that are based on similarly weak factual assertions and unsupported conclusions. Where, as was the case with Xiaomi, the agency’s explanation runs counter to the evidence or is so implausible that it cannot be ascribed to a difference in view or a product of agency expertise, courts may cast aside the action, even in cases supposedly based on national security.

For more information on the Court Order or EO 13959, including OFAQ’s FAQs, contact a member of Steptoe’s Economic Sanctions practice in Beijing, Hong Kong, or Washington. D.C.