Update on Hong Kong Autonomy Act: State Department Report and Treasury Department Guidance Issued

On October 14, 2020, the US State Department released its report required under Section 5(a) of the Hong Kong Autonomy Act (“HKAA”). As detailed in our prior Legal Update, Section 5(a) of the HKAA requires the Secretary of State to issue a report to Congress identifying foreign persons who are materially contributing to, have materially contributed to or attempt to materially contribute to the failure of China to meet its obligations under the Sino-British Joint Declaration or Hong Kong’s Basic Law. Section 6 of the HKAA requires blocking sanctions to be imposed on each foreign person identified in the State Department report. The persons listed in the report include Carrie Lam, the Chief Executive of Hong Kong, and nine other Hong Kong and Chinese government officials. Each of these listed persons has already been sanctioned under President’s Trump Executive Order on Hong Kong Normalization (“Executive Order”) (see our Legal Update). Notably, the State Department did not go beyond the group of officials already sanctioned. On the same day that the State Department released its report, the Office of Foreign Assets Control (“OFAC”) of the US Treasury Department issued guidance highlighting the secondary sanctions risk targeting foreign financial institutions (“FFIs") determined to knowingly engage in a significant transaction with a person named in the report. As we discuss below, as result of the State Department report, FFIs are now on notice of the secondary sanctions risk under the HKAA posed by transacting with these individuals.

Treasury Department Guidance

The HKAA requires the Treasury Department to submit its own report to Congress 30 to 60 days after the State Department’s report, identifying any FFI that knowingly conducts a significant transaction with one of the parties listed by the State Department. The issuance of the Treasury Department’s report will start the clock ticking on the imposition of mandatory sanctions under the HKAA. Section 7 of the Act requires that five of 10 categories of possible sanctions be imposed against FFIs within one year of being included in the Treasury report, and all 10 within two years of inclusion.

On the same day that the State Department report was released, OFAC issued guidance on the HKAA and its forthcoming report and provided the following important clarifications and considerations for FFIs.

• First, OFAC set a 30-day window for FFIs to “wind down” transactions with persons identified in the report as a safe harbor. Such wind-down transactions undertaken in good faith will be exempt from consideration as “significant.” This wind-down period is new and consistent with approaches OFAC has taken under other sanctions programs.

• Second, OFAC confirmed that Treasury will only consider transactions undertaken after a person’s inclusion in the State Department report for purposes of imposing secondary sanctions against FFIs under the HKAA provisions.

• Third, the HKAA provided no definition of what would constitute a “significant transaction,” but it was believed that OFAC would likely apply its long-standing interpretation of that term as used in other sanctions contexts. OFAC confirmed in its guidance that it will apply that multi-factor, highly discretionary standard in considering what constitutes a significant transaction.

OFAC explained that the totality of the facts and circumstances would be considered when determining whether transactions are “significant.” Treasury may consider some or all of the following factors in determining whether a transaction is “significant”:

(1) the size, number and frequency of the transaction(s);

(2) the nature of the transaction(s);

(3) the level of awareness of management and whether the transaction(s) are part of a pattern of conduct;

(4) the nexus between the transaction(s) and a foreign person identified in a report submitted by the Secretary of State under Section 5(a) of the HKAA or in updates to that report;

(5) the impact of the transaction(s) on statutory objectives, including whether the transaction(s) (A) have a significant and lasting negative effect that contravenes the obligations of China under the Joint Declaration and the Basic Law, (B) are likely to be repeated in the future and (C) have been reversed or otherwise mitigated through positive countermeasures taken by that FFI;

(6) whether the transaction(s) involve deceptive practices; and

(7) such other factors that the Secretary of the Treasury deems relevant on a case-by-case basis.

We note that the fifth factor includes the basis provided in Section 5(d)(2) of the HKAA for excluding or removing an FFI from the Treasury report so that sanctions under the HKAA would not apply.

• Finally, Treasury confirmed that it will contact an FFI to “inquire” about its dealings before including it in its report. This is an important acknowledgement from Treasury and reflects a possible opportunity for engagement with the agency prior to inclusion in the report.

Given that the first report is due within a 30-to-60 day window, FFIs who may have dealings with persons named in the State Department report should ensure they have a carefully coordinated legal and government affairs strategy in connection with any potential communications with Treasury. In addition, they should bear in mind potential compliance considerations under China’s National Security Law, its newly implemented unreliable entity regime and other local law requirements.

While OFAC’s guidance indicates that FFIs will receive advance notice of potential action by Treasury under the HKAA, the State Department report nonetheless triggers secondary sanctions risk for FFIs who have dealings with the identified officials. FFIs should continue to evaluate dealings with these persons for possible secondary sanctions exposure under the HKAA. FFIs and other non-US person entities that maintain a commercial relationship with them should also ensure they have adequate controls in place to ensure there is no US nexus to transactions involving these already sanctioned officials in order to manage potential risk exposure under the Executive Order.

China’s Response

As was increasingly expected among US-China watchers, the State Department report did not reach beyond the group of officials already sanctioned by Treasury over the summer under the Executive Order. As a result, the report’s issuance is not expected to escalate tensions with China in the short term. China typically has taken what it deems “reciprocal actions” in response to US sanctions. Thus far, China has issued a statement noting that it “firmly opposes and strongly condemns” the HKAA and describing the report as a gross interference in China’s internal affairs. Whether any further action will be taken is unclear at this point, but China will likely monitor closely the progress of the Treasury Department report. We expect that the Treasury Department will take a similarly targeted approach as the State Department when it issues its report in the coming weeks to limit the strain on the US-China relationship. We will continue to monitor the Trump administration’s implementation of the HKAA and China’s response.