The SEC Takes Aim at UFLPA Opacity

God bless 'em for trying!

The UFLPA is a really straightforward and easy-to-understand concept . . . that’s been wrapped in a mystery, shrouded in an enigma, and stuffed into a turducken.

The concept? For U.S.-bound merchandise, supply chain links to Xinjiang or Listed Entities are a no go. And, it’s a big deal because CBP is enforcing the law with single-minded devotion. 

The agency will likely clock a billion and a half dollars of detained merchandise in FY 2023.  CBP’s dashboard of monthly detention volumes looks like a photo-shopped graph of the 1990’s Dow Jones Industrial Average.  The annualized the rate of detentions from June 2023 would be almost $3 billion.  And according to recent public statements by Eric Choy, the head of the Trade Remedy Law Enforcement Directorate (which oversees forced labor trade enforcement in the United States), CBP still plans to hire a few hundred more import specialists as part of the UFLPA detention review army. In other words, they’re just getting started.

For investors in securities of U.S.-listed Chinese companies, this seems like a pretty straightforward syllogism. (A) the law seems like it could definitely have an impact on some U.S.-listed Chinese companies, and (B) that impact could be significant. But that’s where the mystery begins to kick in. Suppose you want to assess the risk that this law will have a material impact on the business operations of those Chinese companies. Can this be done?

We may soon find out. Last week, that the Division of Corporation Finance at the U.S. Securities and Exchange Commission (“SEC“) has sent out letters to certain companies based in China or “with a majority of their operations” in China, to ask about, among other things, the impact of the UFLPA on their business operations.

The question from the SEC is an instant classic:

5. We note that you appear to conduct a portion of your operations in, or appear to rely on counterparties that conduct operations in, the Xinjiang Uyghur Autonomous Region.  To the extent material, please describe how your business segments, products, lines of service, projects, or operations are impacted by the Uyghur Forced Labor Prevention Act (UFLPA), that, among other matters, prohibits the import of goods from the Xinjiang Uyghur Autonomous Region.

(Emphasis added.)

I cannot wait to see these answers start to roll in.  Grabbing my popcorn now.  Seriously, if someone can help me figure out how to track filings in response to this request, I’ll block a Saturday morning to read them all.

Assessing the likely effects of high impact events is of course important. FEMA has to forecast hurricanes to direct evacuations, right?  State Farm needs to asses flooding risk to price out insurance.  But as I live and breathe. How is the UFLPA going to impact business segments, products, lines of service, projects or operations of Chinese companies? Wouldn’t we all like to know!

I’d like to unpack why I think this question is just about impossible to answer, because—as with just about every deficiency in U.S. forced labor trade enforcement—I think it’s all downstream from deficiencies in the law as it is written. (Refresher: Section 307 is an ancient law in dire need of modernization; and the UFLPA is the most trade-impacting law in history, that is not a trade law.)

Why Predicting The Impact of the UFLPA Is So Difficult

Let me start by just clarifying that the UFLPA is not a law that applies to Chinese companies.  I know everyone knows that, but calling it out for the good of the order.  Unless they’re importing into the United States, the UFLPA does not impose any direct affirmative legal obligation on Chinese companies.

Interestingly, the UFLPA also doesn’t impose any direct affirmative legal obligation on U.S. importers.  In the context of import trade, there are many laws that do impose direct affirmative legal obligations on importers.  The UFLPA just isn’t one of them. The UFLPA could have been written to require importers to perform some task under penalty of law, or make some sort of affirmative declaration at the time of entry, but it does not.   

Don’t get me wrong, importers are certainly incentivized to do a lot in response to the UFLPA. An importer can certainly get itself into trouble by importing prohibited merchandise.  Importers do have an affirmative obligation not to slip prohibited merchandise past CBP, and are responsible for exercising “reasonable care” to ensure they don’t inadvertently do as much.  And I suppose there are even scenarios where liability could attach to a Chinese company exporting prohibited merchandise to the United States.  But such liability would require the application of relatively esoteric provisions of law, theories of liability, or both. 

But the UFLPA is most closely patterned after a sanctions regimes, which means, it’s an enforcement driven law.  In other words, the most likely scenario under which the UFLPA would create a material business disruption would be if you’re targeted for enforcement.

Consider the Global Magnitsky Sanctions as a point of comparison.  This law authorizes the U.S. to impose sanctions on the basis of certain human rights violations.  At any given moment, there is LOTS of conduct occurring around the world that is sanctionable.  But you have to actually be sanctioned to experience a material impact.

That’s not a perfect analogy to the UFLPA, but it’s close.  Because the UFLPA doesn’t impose affirmative legal obligations on importers (or exporters) (i.e., it doesn’t mandate due diligence or require importers to make an import declaration, or specify the traceability materials that must be produced at the time of entry), then, overwhelmingly, the greatest risk of material business disruption will be as a result of enforcement. In other words, you have a problem if you get hit with enforcement.

So, for example, if a U.S.-listed Chinese company that sells goods to the U.S. market were to be UFLPA Entity Listed, that would cause a material impact.  But remember, we can’t even always tell why a company was UFLPA Entity Listed after it happens.  Predicting it in advance seems all but impossible.

That’s especially true because of how exceedingly rare UFLPA Entity Listing is.  You almost want to compare it to getting struck by lightning, but I looked up statistics on the frequency of lightning strikes in China (oh yes I did), and while there have been 2 entity listings this year, between 1997 and 2009, this academic journal says there were 61,614 reported instances of property damage due to lightning strikes in China, which is 4,739 per year, so. Remote indeed.

This means that the real risk of material business impact from the UFLPA for a Chinese company (what the SEC is really looking for) would be as a result of being caught up in detention activity.  And that, of course, is predictable by no one.

Of the few things we do know about UFLPA detention activity, one surprising characteristic does seem to make it less likely that any given company will be subject to detention: being Chinese.  According to CBP’s detention statistics, less than 13% of UFLPA detentions to date have targeted goods manufactured in China.  The overwhelming majority of detentions (almost 84%) have targeted goods made in Vietnam and Malaysia.

From here, forecasting only gets more difficult.  Consider the Tier 2 Chinese supplier to Malaysia or Vietnam that could get implicated in enforcement activity.  Suppose this supplier has some nexus between its enterprise and Xinjiang, but that it understands and respects the requirements of U.S. law, and so is only supplying non-Xinjiang content to the Tier 1 supplier in Malaysia or Vietnam.

It might supply perfectly compliant materials to such Tier 1 customers, and so adjudge is exposure to UFLPA enforcement as low. But it could still get absolutely hammered in the course of enforcement. It could become functionally unable to serve the U.S. market, notwithstanding a strong commitment to supply goods that comply with U.S. law. 

If you suspect that the inverse might also be true, you’d be correct! Imagine a U.S.-listed Chinese enterprise with extensive production activity in Xinjiang. And for the sake of argument, let’s say all of its output is exported to India and Pakistan. 

This Chinese company might have no way of knowing the downstream customers of its customers, and where, ultimately, its Xinjiang-produced content ends up. It’s also entirely possible—and we know that fact patterns like this exist—that huge percentages of such XJ-produced content could be making its way, eventually, into the U.S.  But because of the remoteness of the supply chain, it’s entirely likely that such Chinese enterprise might never experience any sort of business disruption, material or otherwise, as a result. 

I sketch this out not to be a downer, and certainly not to discourage the collection of information that might be deemed relevant to investor decision making. But rather, to illuminate a truth. 

If the U.S. wants to end supply chain links for forced Uyghur labor, it’s going to take a lot more than establishing a single rebuttable presumption, and then funding it to the hilt. All things considered, that was a decent start. But the law needs to evolve.