Doing business with the People's Republic of China these days is challenging on many fronts. As Jay Solomon pointed out in a recent piece in the Wall Street Journal, the U.S. is attempting to reconcile its desire - indeed the necessity - to maintain vigorous levels of trade and investment with China with the increasing suspicions of our military planners of China's efforts to modernize and expand its military capabilities. These factors have led to the emergence of the concept of "congagement" - an awkward fusion of "engagement" and "containment." At the same time as our annual trade imbalance with China has grown to $49 billion and Chinese holdings of U.S. Government debt has soared to $252.8 billion, we worry that China's military build-up threatens to destabilize the region and establish China's hegemony of that part of the world. And adding insult to injury, it's being done with our money and, many fear, our technology as well.
This situation, of course, is not new. The U.S. embargoed all military trade with China after the 1989 Tiananmen Square incident, and has struggled to keep its European friends and allies in our camp ever since. For a brief three-year period in the 90's, American communication satellite technology was available for export to China under Commerce Department regulations, but was taken out of play following the revelation of satellite launch technology transfers to China, the publication of the Cox report that resulted from that episode, and the ensuing congressional decision to move jurisdiction of that trade to the State Department. Whether this has completely stemmed the flow of military technology to China from the U.S. is debatable: U.S. government authorities estimate that there are upwards of 3,000 companies operating in the U.S. that are fronts for Chinese military authorities procuring sensitive U.S. technology.
With this background in mind, we've been told over the past several months that the Commerce Department is about to release its new "catch-all rule" in an effort to impede the flow of U.S. technology to the Chinese military establishment. One might ask whether adequate controls aren't already in place to address this issue, specifically those found in Commerce Department regulations that were designed to deny goods and technologies to entities engaged in the proliferation of WMDs. To answer that question, we must take a step or two back for a broader view of the problem.
Generally speaking, all U.S. exports are carefully regulated. The threshold question facing exporters, especially those contemplating trade with China, is whether their products or technology are regulated as defense articles (products specifically designed for military application) or as so-called "dual use" items, i.e., products with both military and civilian applications. The reason is simple: no defense articles or defense technical data may be exported to China at all whereas exports of dual use items to China are permitted, depending on the nature of the product. Appropriate product classification, therefore, is indispensable to the exporter's ability to manage his regulatory compliance obligations and to avoid delays in licensing actions and, worse, enforcement actions from a withering array of government agencies. Too often inexperienced exporters obtain a formal classification or an export license from the Commerce Department, only to learn to their regret that the State Department asserts jurisdiction of the product. The determination of which regulatory scheme applies is largely a matter of self-classification, and must be undertaken with great care and with the assistance of someone who actually understands the product and technology involved. Where doubt exists, mechanisms to obtain government clarification are available.
The two regulatory schemes are the International Traffic in Arms Regulations ("ITAR"), as authorized by the Arms Export Control Act (the "AECA"), and the Export Administration Regulations ("EAR"), as authorized by the Export Administration Act (the "EAA"). The ITAR regulate the export of all products and technology on the U.S. Munitions List or that otherwise are "specifically designed, adapted, modified, or configured for military application." Under the EAR, exports of all products and their related components and technology that are not regulated by another agency or specifically excluded are regulated by the Department of Commerce. For the most part, "other agencies" means DDTC. The practical effect of this arrangement is that one needs to address the ITAR before reaching for the EAR, as the ITAR impose far stricter limitations and licensing requirements than do the EAR. Also, the ITAR cover more than exports; they also reach manufacturing of defense articles and temporary imports neither of which are covered by the EAR.
It is essential to note that under both the ITAR and the EAR, "exporting" includes everything from manufacturing to shipping, as well as providing access to controlled technologies to foreign national employees, consultants, and plant visitors.
Until now, an exporter contemplating exports to China had only to determine that his product or technology was not captured by the ITAR and find its proper classification in the EAR Commodity Control List. This is not a free pass. Many dual-use products destined for China already attract stringent licensing requirements under the EAR. For example, sales of high performance computers to Western European countries don't trigger license requirements, but will do so in the case of China. Moreover, Part 744 of the EAR lists companies for whom BIS imposes additional licensing requirements reflecting sharpened regulatory concerns emanating from a product's end use or the intended end-user of that product, usually due to so-called "proliferation" concerns, i.e., an entity engaged in the production of yellow cake, an enriched form of uranium hexafluoride. In perusing those lists, one can see how the U.S. concern to minimize proliferation of these highly sensitive technologies finds expression in terms of specific companies in specific countries. China is not the only country with business entities on that list; Israel, India, Pakistan, Russia and Syria are represented there as well, but the lion's share of those entities is Chinese.
The proposed new "catch-all" regulation extends these end-user concerns to any entity in a country embargoed for arms exports purposes. The Commerce Department explains that the regulation is the result of the U.S. implementation of its obligations under the Wassenaar multilateral export control regime. Under the proposed regulation, there will be new license requirements for the export, reexport, or transfer of certain items to specific destinations when the exporter "knows at the time of the export, reexport, or transfer that the items are intended, entirely or in part for a military end-use; or 'is informed' by BIS that the items are or may be intended, entirely or in part, for a military end-use." The proposed rule also adds a so-called "red flag" (suspicious circumstances) applicable to military customers or end-users located in specified countries who are purchasing certain sensitive items. While ostensibly applicable to some 19 countries, BIS makes no secret that its intended target is China.
Industry's reaction to the proposed regulation, as one might expect, has been hostile. China's reaction is even more hostile, one of righteous indignation. First and perhaps most important, despite protestations to the contrary, this is no multilateral initiative. The U.S. will be the only country to adopt this measure, which means that once again, U.S. companies will be placed at a competitive disadvantage. Second, the obligation of U.S. exporters to screen against an open-ended, ill-defined class of end-users will become burdensome to the extreme, particularly on small and medium-sized exporters. The definition of "military end-user" is elusive at best, especially as applied in China where many commercial businesses are owned in whole or in part by military organs. Worse yet, entities in that category will not necessarily find their way onto any government lists.
The same can be said of the definition of "military end-use." Hypothetically, the "catch all" regulation would prohibit the sale of bathroom tissue to a Chinese trading company whose primary customer is the People's Liberation Army. Also, although there is nothing in the proposed regulation that explicitly equates a military end-use with a military end-user, there is no question that an inference will be drawn that a commercial company that is partly owned or controlled by the Chinese military establishment will deploy its purchases to military end-uses. When such an inference is coupled with an aggressive definition of "reason to know" (i.e., that the facts in a given transaction place a person on notice that there are questions in the context of the regulation), even in the absence of the exporter being "informed" by Commerce that the proposed customer is a military end-user or will deploy the product to a military end-use, the government will be tempted to engage in "Monday morning quarterbacking." In the past few years, the Commerce Department's Office of Export Enforcement has noticeably stepped up its enforcement activities and exacted increasingly tough fines from errant exporters - even those making voluntary disclosures. The proposed regulation opens the doors to even more enforcement actions.
Finally, the sweep of the proposed regulation is extraordinary, reaching any product that is "subject to the EAR" even though it is not sufficiently sophisticated to fall into a higher rung on the control classification ladder.
As noted above, comments received thus far from industry have been negative. One might wonder, then, why on earth the administration is moving forward with this initiative. One could speculate that it is a strategy to avert far more draconian measures. During this past year, several bills were introduced in Congress that would impose far more stringent controls on exports to China than those envisioned by the proposed "catch-all" regulation. When asked at a meeting last November what he thought of the proposed regulation, Will Lowell, former director of DDTC and now a consultant to the House International Relations Committee, scoffed, "You mean the 'Catch-Nothing' rule?" In his view, and the views of several key members of the House of Representatives, nothing short of a total embargo of exports of technology-based products to China will do. Many of the worst provisions of one early bill, H.R. 3100, fortunately did not survive the next iteration, the National Defense Authorization Act, H.R. 1815. As far as a number of Members are concerned, we'd be better off shutting down all trade with China.
Until the "catch-all" rule has been released for public comment, nothing will happen. Its implementation assuredly will impose substantial additional burdens on exporters. We are encouraging our clients to carefully scrutinize the proposed rule and to submit critiques of the proposed rule that illustrate how the rule will affect their business. I hope that you do the same.
Published April 1, 2006.
