Introduction

This article examines a recent U.S. Court decision suspending economic penalties that the U.S. Government attempted to impose on Xiaomi Corporation (“Xiaomi”) based on loosely alleged connections between Xiaomi and the Chinese military.  This article also analyzes the significance of this decision to other Chinese entities seeking relief from U.S. Government Agency penalties.

I. Court Grants Xiaomi’s Motion for a Preliminary Injunction

On March 12, 2021, United States District Court for the District of Columbia granted Xiaomi’s motion for a preliminary injunction enjoining the Department of Defense (“DOD”) from enforcing its designation of Xiaomi as a Communist Chinese military company (“CCMC”) pursuant to Section 1237 of the National Defense Authorization Act for Fiscal Year 1999, as amended (“NDAA FY99”).  Xiaomi filed its motion in a lawsuit that Xiaomi and certain shareholders, including cofounder Bin Lin, brought against the DOD. The lawsuit ultimately seeks to have Xiaomi removed from the list of companies designated as CCMCs and claims that the DOD’s designation of Xiaomi as a CCMC violated the Administrative Procedure Act (“APA”) and was done outside of the DOD’s proper exercise of its authority.

Xiaomi, the third-largest smartphone manufacturer in the world by volume, was designated as a CCMC by the DOD on January 14, 2021, during the final days of the Trump administration.  As a result of this designation, a prohibition on U.S. persons purchasing or otherwise possessing Xiaomi’s publicly traded securities or any derivatives of those securities was set to go into effect the morning of March 15, 2021.  The court’s ruling prevents this prohibition from taking effect and also casts significant doubt on whether Xiaomi’s designation as a CCMC will be upheld.  In particular, the order focused on both Xiaomi’s high likelihood of success on the merits of its claims and the irreparable harm that Xiaomi would suffer from the negative reputational effects and economic loss caused by the CCMC designation.

II. Section 1237, CCMCs, and Economic Sanctions

Section 1237 defines a CCMC as any entity who “is owned or controlled by, or affiliated with, the People’s Liberation Army or a ministry of the government of the People’s Republic of China or that is owned or controlled by an entity affiliated with the defense industrial base of the People’s Republic of

China.”  NDAA FY99 § 1237(b)(4)(B)(i).  Section 1237 directs the Secretary of Defense, with the input of certain other government officials, to identify CCMCs that operate directly or indirectly in the United States or its territories.

In June 2020, the DOD published its first list of CCMCs, which designated twenty such companies.  An additional fifteen companies were designated as CCMCs by the end of 2020.  The January 2021 listing that included Xiaomi is the most recent CCMC designation.  Under Section 1237, the President of the United States is authorized to exercise certain emergency economic powers against CCMCs.

In November 2020, then-President Trump issued Executive Order No. 13959 (“E.O. 13959”) declaring a national emergency due to the security threat posed by “civilian Chinese companies” that support the People’s Republic of China’s (“PRC”) military and intelligence activities.  E.O. 13959 prohibited U.S. persons from buying securities or derivatives of securities of any CCMC, and a later update to the order explicitly required all U.S. persons to sell any securities they own in a CCMC within a year of that company being designated as a CCMC.

III. Xiaomi’s Designation as a CCMC

The DOD designated Xiaomi as a CCMC in a January 14, 2021 list that the DOD submitted to Congress pursuant to Section 1237.  The list did not provide any explanation or basis for Xiaomi’s designation as a CCMC.  But the DOD did provide a two-page designation decision document for Xiaomi in the context of Xiaomi’s litigation.  The designation document identified two factual grounds for Xiaomi’s designation as a CCMC, both taken from Xiaomi’s 2019 Annual Report.  First, the document noted that the PRC’s Ministry of Industrial Information Technology had recognized Xiaomi’s CEO Lei Jun as an “Outstanding Builder[] of Socialism with Chinese Characteristics.”  Second, the document noted Xiaomi’s five-year plan to invest in 5th generation telecommunication technology (“5G”) and Artificial Intelligence (“AI”), which DOD characterized as important modern military technologies.  The designation decision document then concluded that Xiaomi qualified for CCMC classification.

IV. Xiaomi’s Lawsuit and Preliminary Injunction Motion

On January 29, 2021, Xiaomi filed a lawsuit challenging its CCMC designation on certain grounds, including that the designation violated the APA and that the designation exceeded the DOD’s authority under Section 1237.  Shortly thereafter, on February 17, 2021, Xiaomi filed the motion for emergency injunctive relief that the court recently granted.  Because the DOD’s designation of CCMCs relates to national security, the court was required to afford the DOD substantial deference in its decision.  But even in such cases, courts still serve an oversight function and check to ensure that the government agency was engaged in reasonable decision making and could articulate an acceptable explanation for its action with a rational connection between the facts and the agency’s decision.

When considering a motion for a preliminary injunction, the most important factor that the court evaluates is the moving party’s likelihood of success on the merits, i.e., how likely the moving party is to ultimately prevail in the case after the factual record is fully developed and the relevant laws are applied to the facts.  The next most important factor is the likelihood that the moving party will suffer irreparable harm if the court does not grant the preliminary relief requested.  Finally, courts may also consider whether the balance of equities favors the moving party and whether the requested injunction is in the public interest.  Here, the court found that all relevant factors favored granting Xiaomi’s motion and enjoining the DOD from enforcing its designation of Xiaomi as a CCMC and the resulting restrictions on U.S. persons owning Xiaomi’s securities and associated derivatives.  The court paid particular attention to Xiaomi’s likelihood of success on the merits and irreparable harm.

A. Xiaomi is Likely to Succeed on the Merits

In its motion, Xiaomi made three arguments as to why the DOD’s decision to designate Xiaomi as a CCMC was unsupported and Xiaomi was therefore likely to succeed on the merits in this case.  First, Xiaomi argued that the reason given for the designation was inadequate and did not articulate a satisfactory explanation as required by the APA.  Second, Xiaomi argued that it fails to meet the Section 1237 statutory criteria for a CCMC classification, and that designating Xiaomi as a CCMC was therefore outside of the DOD’s authority.  Third, Xiaomi argued that the DOD’s decision lacked the required “substantial evidence” necessary for an agency to arrive at a factual conclusion under the APA.  The Court agreed with all three of Xiaomi’s arguments and found that Xiaomi was highly likely to succeed on the merits of its case.

In considering Xiaomi’s first argument, the court noted that the DOD’s brief two-page designation decision document for Xiaomi consisted of a misquoted recitation of the CCMC criteria, citation of two facts (Xiaomi’s CEO receiving an award from a certain Chinese ministry and Xiaomi’s investment in 5G and AI technology) pulled from Xiaomi’s annual report, and the blanket conclusion that Xiaomi met the CCMC criteria.  In the court’s view, the DOD’s analysis was missing the critical step of connecting the facts to the conclusion.

Regarding Xiaomi’s second argument, the court agreed that Xiaomi did not meet the criteria to be designated a CCMC under Section 1237, and therefore the DOD had likely acted outside of its authority in doing so.  The DOD did not dispute that Xiaomi was not owned or controlled by any of the specific Chinese entities identified in Section 1237.  Instead, the DOD argued that Xiaomi was “affiliated” with the Chinese military and defense establishment under the DOD’s broad interpretation of the term affiliated.  But the court rejected the DOD’s argument and definition of affiliate, finding that substantial precedent supported a narrower definition of affiliate as a company effectively controlled by another, which did not include Xiaomi.  The court noted that Xiaomi is a publicly traded company controlled by its independent board and controlling shareholders.

In considering Xiaomi’s third argument, that the DOD’s designation lacked the requisite substantial evidence, the court focused on the context of the two pieces of evidence offered by the DOD to support its designation of Xiaomi as a CCMC.  Regarding Xiaomi’s investment in 5G and AI technologies, the Court noted that Xiaomi is a consumer electronics company and 5G and AI technology are quickly becoming standard in consumer electronics devices, as evidenced by Xiaomi’s competitors offering smartphones with 5G and AI features.  That 5G and AI also have military applications was insufficient to convince the court that Xiaomi is a CCMC.  Regarding the award that Xiaomi’s CEO received, the court noted that since 2004, over 500 entrepreneurs in varied industries, including industries with no conceivable apparent link to the Chinese military, had received the reward in recognition of their contribution to China’s economic development.  Accordingly, the court did not find any substantial link between the award and the Chinese military.

Based on this analysis, the court found that Xiaomi is highly likely to succeed on the merits of its claims because the DOD’s designation process was deeply flawed and failed to adhere to applicable requirements.

B. Xiaomi was Irreparably Harmed by its Designation as a CCMC

The court also found that Xiaomi was irreparably harmed by the DOD’s designation of Xiaomi as a CCMC and that this factor weighed in favor of granting the preliminary relief requested by Xiaomi.  In its briefing, Xiaomi identified several ways in which it was irreparably harmed, including harm to Xiaomi’s reputation, business relationships, unrecoverable monetary losses including the impending loss of access to certain capital markets, loss of market share, and difficulty recruiting and retaining talent.  For each type of harm, Xiaomi identified specific examples that the court found persuasive.

V. Xiaomi’s Success Challenging its CCMC Designation in U.S. Court Provides a Roadmap to Relief for Other Chinese Entities Penalized by U.S. Government Agencies

Xiaomi’s case provides an example of a Chinese entity successfully obtaining relief from U.S. Government Agency penalties through the U.S. court system, including a roadmap of how to do so.  A few points about the Xiaomi case are worth noting.

First, Xiaomi acted quickly to seek a remedy from the U.S. courts, and in doing so, was able to obtain relief from an economic penalty that was about to take effect after only a few weeks of warning.  Xiaomi was not listed as a CCMC until January 14 and the prohibition on U.S. persons purchasing Xiaomi securities or derivatives was set to take effect on March 15.  Xiaomi filed its lawsuit on January 29 and on February 17 filed its motion for emergency preliminary relief.  After briefing by the parties and a hearing before the court, the court issued an order granting Xiaomi the relief it requested on March 12, less than a month after Xiaomi filed its motion.  Chinese entities that believe they have been improperly penalized by a U.S. government agency should act quickly to seek the advice of U.S. counsel on whether they may be able to obtain relief through U.S. litigation, and if so, move quickly to file suit and request relief.

Second, through litigation, Xiaomi was able to obtain relevant information about its CCMC designation that Xiaomi did not have access to previously.  This information formed the basis for Xiaomi’s successful request for relief from the court.  As the court noted, the initial listing by the DOD of Xiaomi as a CCMC did not provide a basis or explanation for that designation.  But by pursuing litigation against the DOD, Xiaomi was able to obtain the documentation that provided the basis for Xiaomi’s, which proved to be weak and unconvincing to the court – leading the court to grant Xiaomi the relief it requested.  If a Chinese entity has been penalized by a U.S. government agency that has not provided a basis or explanation for the penalty, the Chinese entity should seek the advice of U.S. counsel on whether it may be able to obtain that information, and potentially challenge the appropriateness of the penalty, through U.S. litigation.

Finally, when a U.S. Government Agency has acted improperly, U.S. courts are willing to provide relief to the negatively affected party, even when the decision of the Agency is afforded substantial deference such as in the Xiaomi case.  Because a CCMC designation implicates U.S. national security, courts are required to give the designating agency substantial deference in its decision.  But that deference is not absolute.  The Xiaomi case shows that courts will provide relief such as enjoining government agencies that act improperly or outside of their authority, even in situations where the decisions of those agencies are afforded substantial deference.  Chinese entities that believe they have been improperly penalized by U.S. government agencies should seek the advice of U.S. counsel on whether U.S. courts may provide an avenue for obtaining appropriate relief.

Conclusion

CCMC designation and other penalties from U.S. Government Agencies are likely to create a costly and unwanted burden for any affected company.  But the example of Xiaomi and its recent success in court shows that, in cases where the CCMC designation or other penalty might have been unwarranted, companies may be able to obtain relief through the U.S. court system.

KWM has a team of legal experts in both China and the United States who are ready to assist clients who need assistance with the U.S. legal system.

Authors: Aaron Wolfson, Meg Utterback, Eric Berger, Jing Yunfeng, New York Office, Corporate and Commercial Group