November 13, 2006

Given the concerns raised by industry, the Department of Commerce has extended the period of time to comment on the regulations until December 4, 2006. Since the proposed rule may come into effect with little or no grace period, companies need to immediately begin considering how they will address these additional requirements in their export compliance procedures and contractual arrangements with Chinese companies.

Major Aspects of the Proposal

Expanded List of Items That May Require Licenses to China

The rule, proposed by the U.S. Department of Commerce, Bureau of Industry and Security (BIS), would require U.S. exporters to obtain licenses for certain products and related software, as well as technology, which currently do not require licenses, where the exporter has knowledge that the item will have a military end-use. These products include many items currently on the Commerce Control List that are only controlled for “anti-terrorism” reasons, including:

• Chemical mixtures containing certain percentages of Chemical Weapons Convention (CWC) precursors

• Certain manufacturing equipment such as gear-making/finishing machines, dimensional inspection/measuring equipment, machine tools for making optical quality surfaces and certain multi-axis machine tools

• Specific electronics manufacturing design and test equipment including most semiconductor manufacturing equipment and related test equipment, oscilloscopes and flash x-ray machines

• Computers with adjusted peak performance exceeding 0.1 Weighted TerraFLOPS (WT)

• Certain telecommunications equipment including equipment utilizing lasers, QAM techniques, phased array and telecommunications equipment capable of operating at extreme temperatures

• Software and commodities containing encryption functionality, except for mass market (over-the-counter) encryption products

• Certain lasers, avionics and underwater systems

• Commercial aircraft, engines and related systems

To understand the scope of this rule, the following are explanations of some of the key terms/restrictions:

• Knowledge As drafted, the rule only requires a license if the U.S. exporter “knows” that the item will be used for a military end-use. In this context, knowledge is broader than actual knowledge, and would include constructive knowledge where the exporter had reason to know or believe, based on the circumstances, that there was a military end-use, or intentionally blinded himself/herself to the facts.

• Military End-Use Military end-use does not necessarily mean sale to the Chinese military, but rather export for use in an item on the U.S. Munitions List, which includes, in addition to specialized military equipment, commercial satellites and satellite ground control equipment, certain GPS receivers and certain chemicals used in conventional explosive or chemical weapons.

• No License Exceptions In general, no license exceptions will be applicable where there is a military end-use. This means that virtually all commercial software that contains encryption (other than mass market encryption) will no longer be eligible for export to China under license exception encryption commodities software (ENC), if a military end-use is indicated.

• Presumption of Denial BIS would adopt a formal “presumption of denial” for any license applications for the export of items controlled for national security, chemical, biological proliferation, or where the item would make a material contribution to the military capabilities of China, with the implication that exports for bona fide civil uses would still be approved.

Validated End-User (VEU)

BIS proposes a method for a Chinese company to receive advance screening as a “Validated End-User” that would then allow it to receive many otherwise licensable items without a license (except for items controlled for missile technology or crime control reasons). The VEU could only obtain the items for its own use, or transfer the goods in accordance with the Export Administration Regulations (EAR), and would be subject to reporting, compliance visits, etc.

End-Use Certificates

BIS has proposed that an “End-Use” certificate be required for any export that requires a license to China and that also exceeds $5,000 in value. This End-Use certificate is issued by MOFCON, the Chinese Ministry of Commerce.

The Bottom Line: How Can U.S. Companies Prepare?

Any U.S. company affected by these new rules for exporting to China should start developing a plan of action for how it will conform with these requirements, which likely will not vary significantly from the proposal. Compliance with these new rules will not be easy to implement because of the uncertainty regarding the level of due diligence expected from the BIS. Some of the issues are the following:

• Currently, products which are listed on the Commerce Control List (CCL) only for anti-terrorism reasons can generally be sold to all but embargoed countries, subject to checks of the various barred entity lists. However, unlike barred entity lists, there is no affirmative list to screen, and the exporter who does not ask about the end-use could potentially be prosecuted for willful blindness under the BIS definition of knowledge.

• It is unclear whether the added categories of restricted products could be sold to distributors in China, since the end-user/end-use will be unknown at the time of sale.

• While the VEU program could be a benefit to certain companies, particularly U.S. subsidiaries in China, it is unclear what type of showing is required to meet the VEU standards. If a Chinese company applies and is rejected for VEU status, that company could face difficulties in obtaining licenses in the future. Further, it is unclear how VEU status would be flagged on export documentation to avoid problems clearing U.S. customs on export.

• Although the definition of military end-use appears to apply only where a product will be specifically incorporated or used in a military article, in practice it may make it difficult to sell any of these products to the multitude of Chinese companies that are owned by, or otherwise tied to, the Chinese government and military.

• It is likely that the “presumption of denial” of licenses will, as a matter of practice, “bleed over” to applications for commercial uses in China, requiring exporters to go to great lengths to demonstrate the bona fide commercial use by its Chinese customers.

In terms of a plan of action, U.S. exporters should start to consider now how they will incorporate aspects of this rule into their due diligence. Steps may include:

• Determining whether any company products are on the list of additional items subject to control

• Revising existing export control documentation (e.g., customer certificates, contractual language) to prohibit military end-use for certain items

• Determining what additional due diligence will be required for exports to China

• Considering whether the VEU program may be beneficial if conducting offshore production in China

Getting Off The List

Companies whose products will be captured by the expanded list of products controlled for export to China should consider filing comments with BIS on this proposed rule. In particular, if an industry can demonstrate that products controlled under a particular classification are widely available from other countries without restriction, BIS may consider removing such items from these controls. This may be difficult to do given BIS statements that exporters have a high burden of proof to show international availability. However, removing a product from the list would terminate a huge compliance burden. Comments are due by December 4, 2006.

Conclusion and Editorial Comment

While it is unclear that the proposed rules will significantly affect U.S. exports to China, it certainly will create additional compliance costs and uncertainty for U.S. exporters, and may have a chilling effect well beyond its stated scope. Further, because the products on the expanded list are not generally subject to export restrictions in other countries, the proposal is unlikely to effectively deny the Chinese military access to these items. In the end, regardless of the cost/benefit analysis and given the political realities of the day, the Commerce Department is likely to implement these rules.

For more information, e-mail Jonathan M. Epstein at [email protected] or call toll free, 1-888-688-8500.