Following a five-year investigation and a scandal that threatened the loss of its supply chain, China’s Zhongxing Telecommunications Equipment Corporation, its subsidiaries and affiliates (collectively “ZTE”) have concluded settlement agreements with the US Departments of Justice, Commerce, and the Treasury. In total, ZTE agreed to combined civil and criminal penalties of $1.19 billion and pled guilty to shipping US-origin items illegally to Iran and North Korea, obstructing justice and making a material false statement. As part of the settlement, ZTE will remain under probation for an additional seven-year period and submit itself to active auditing and monitoring by the US government.
The settlement follows a key turning point in the case last year when the Commerce Department took a bold and aggressive action to blacklist ZTE, one of China’s largest companies and one of the largest telecommunications equipment firms in the world. Faced with a crippling loss of its supply chain, ZTE was forced to negotiate with US enforcement officials regarding allegations of an elaborate and far-reaching diversion scheme involving company management. The case is just the latest example of the US government’s intention to pursue and penalize both US and non-US companies that violate US export control and sanctions laws. While the case is noteworthy for both the nature of the conduct and the sheer size of the penalties involved, it also conveys important lessons for the board and management of any company that wishes to avoid a similar fate.
According to ZTE’s settlement agreements, over the course of more than six years, ZTE exported or reexported nearly $40 million worth of US-origin goods through China to Iran in knowing violation of US export control and sanctions laws against those countries. In addition, the company also made hundreds of shipments of controlled goods to North Korea in violation of export control laws. ZTE’s practices were specifically designed to evade these laws through the use of third-party “isolation companies,” were approved by the highest levels of company management and continued in secret even while the company was under investigation—a trifecta of damning actions that led to the record penalty imposed.
As ZTE bid on and secured contracts worth hundreds of millions of dollars to install cellular and landline network infrastructure in Iran, it developed an elaborate system to fulfill those contracts using US-origin items, including dual-use goods controlled by the US government for national security and anti-terrorism reasons. This evasive system included:
- Importing US-origin goods into China with the purpose of reexporting them to Iran;
- Using third-party “isolation companies,” including a company called Beijing 8 Star, to serve as parties to contracts and to be responsible for supplying the US-origin goods while ZTE itself effectively controlled these companies throughout the process; and
- Removing logos and other markings from shipments containing the goods and comingling them with foreign-origin goods in an effort to conceal them and evade detection.
Following press coverage in 2012 of the company’s business dealings in Iran and alleged violation of US sanctions, ZTE temporarily stopped its business dealings with Iran. The coverage prompted a US government investigation into the company’s dealings in Iran. Although ZTE informed the US government that it was winding down operations, leaders at the highest levels of the company decided to resume the company’s business dealings with Iran, including its efforts to divert US goods to the country.
ZTE took several steps to conceal its new procurement campaign from investigators. The company sought and used a “new, more capable third-party” to serve as the isolation company in the scheme. ZTE also assembled a team of IT employees to engage in a project to “alter, process, sanitize, and/or remove references to Iran in the company’s internal databases” and then had the IT team delete their emails related to the project. In addition, ZTE apparently deleted and concealed records from, and otherwise provided “incomplete and/or otherwise altered information” to, outside counsel and forensic accountants retained in the investigation, knowing that such information would eventually be shared with the US government.
In 2016, the Commerce Department placed ZTE on the Entity List, thereby prohibiting all third parties from trading in goods, software and technology originating in the United States or containing more than de minimis US content. This prohibition immediately threatened to cut off ZTE from its suppliers, prompting the Chinese company to enter into settlement discussions with the US government.
The sheer size of the penalties against ZTE has attracted the attention of companies around the world and sends a message about the seriousness with which the US government will pursue both US and non-US companies that violate its export control and sanctions laws. But the case also holds broader lessens for the boards and management of any company that wishes to avoid ZTE’s fate.
Enforcement Focus on Diversion, Transshipment and Illicit Procurement. The conduct at the heart of the case highlights a high-priority focus for US enforcement officials—the use of procurement agents and transshipment routes to divert goods to prohibited countries and end users/end uses. As the case record demonstrates, ZTE’s scheme arose from its need to procure US export-controlled components in order to fulfill its contracts with Iran, as well as a belief that it could evade US law through schemes to conceal the actual intended destination and end user. Significant US government resources are focused on evaluating and monitoring customs and export declarations, parties to the transactions, end-user and end-use information and other risk factors. Indeed, the lengths to which ZTE went appear to reflect a recognition of this enforcement focus and an elaborate yet ultimately failed effort to evade scrutiny.
Extraterritorial Reach and Leverage. The case reflects the extensive reach of the US government over non-US parties that deal in goods and technology with a US nexus and the overlapping regulatory regimes governing that activity. Many non-US companies may wonder why ZTE, a non-US company, would concede US jurisdiction and settle these charges with the US government at all. When the Commerce Department designated the company on the Entity List in 2016, it effectively made it illegal for third parties, whether US or non-US, to provide critical US parts, components and related software and technology to ZTE. In addition, US banks were prohibited from clearing dollar transactions for ZTE. The threatened loss of its supply chain and dollar payments brought ZTE quickly to the negotiating table to deal with the US government and begin a process that ultimately led to this extraordinary settlement.
Aggravating Factors. The case also offers an important illustration of the aggravating factors that exacerbated ZTE’s penalties and treatment in the case with respect to both civil and criminal liability. With respect to the civil penalties, both the Commerce and Treasury Departments maintain enforcement guidelines under which the primary drivers of any penalty amount are the number and value of the violative transactions, whether the violations were voluntarily self-disclosed to the agencies and whether the case involves certain aggravating factors that make it “egregious.” In determining whether a particular case is “egregious,” both agencies give substantial weight to (1) the willfulness or recklessness of the conduct, (2) senior management’s awareness of the conduct at issue, (3) the harm to sanctions programs’ objectives and (4) the individual characteristics of the party that committed the violation. In this case, the facts as publicly reported clearly supported a determination that the civil violation was “egregious,” and indeed there were referrals to the Justice Department for parallel criminal prosecution.
Multi-Agency Investigations and Enforcement. ZTE was pursued aggressively over a five-year period, as multiple US agencies investigated. The case reflects the significant investigative resources that the US government brings to bear in these matters. Over the course of five years, the joint investigation involved investigative agents from the Departments of Justice, Homeland Security, Commerce, and the Treasury, as well as from the FBI. The multi-agency settlement drove higher penalties in this case. ZTE had to settle with not just one agency but three—$661 million (Commerce), $100 million (Treasury) and $430 million (Justice)—thus compounding the impact of its conduct.
Management and Board Governance Considerations. As with other notorious cases, perhaps the most significant lesson of this case relates to the critical impact that management and boards can have on the ultimate outcome of a case when violations are discovered or suspected. Much of the narrative in the settlement documents focuses not just on ZTE’s initial diversion scheme or management’s involvement in that scheme but on the company’s subsequent cover-up (including misleading its own outside counsel and advisors) when it became clear that the US government was investigating the matter.
Rather than taking steps immediately to bring ZTE’s conduct into compliance, management’s elaborate effort to conceal was ultimately futile and in the end involved an expensive and years-long campaign that drained significant resources and guaranteed harsher treatment. The initial decisions a company makes in response to the discovery of violations, including those involving its own management, regarding whether, how and in what manner to manage an investigation and disclose violations are critical. Companies that wish to avoid ZTE’s fate must be prepared to protect themselves by having in place appropriate and robust governance mechanisms, including appropriate board oversight and a plan to ensure independent investigation of potentially significant violations.