The Consequences of Export Reform—Intended and Unintended

The Export Control Reform Initiative began in earnest four years ago, when, in August 2009, the U.S. government commenced a broad, interagency review of the U.S. export control system. The goal of that review was described as "strengthening national security and the competitiveness of key U.S. manufacturing and technology sectors by focusing on current threats, as well as adapting to the changing economic and technological landscape." This review was a direct response to assertions by certain industries, most notably the U.S. satellite industry, that the current export control system, and in particular the International Traffic in Arms Regulations, 22 CFR Parts 120-130 ("ITAR"), over-regulated commercial technologies not essential to national security.

After decades of intensive lobbying, industries with substantial amounts of products and technologies subject to ITAR control found supporters in Defense Secretary Robert Gates, the National Security Advisor, and the White House. Arguing that the then-current system was "overly complicated, contains too many redundancies, and, in trying to protect too much, diminishes our ability to focus our efforts on the most critical national security priorities," the Export Control Reform Initiative ("ECR Initiative") was launched to provide "a comprehensive overhaul of the system to meet the current and anticipated U.S. national security and foreign policy objectives of the 21st century." Export Control Reform Initiative Fact Sheet # 1: The Basics, at page 1.

Designed to "fundamentally reform the U.S. export control system," the ECR Initiative is being implemented in three phases: Phases I and II will purportedly "reconcile various definitions, regulations, and policies for export controls." This "reconciliation" refers to the current rewrite of the ITAR, with almost 90 percent of the items currently controlled by the ITAR destined for control under the Commerce Department's Export Administration Regulations, 15 CFR Parts 730 to 774 ("EAR"). Phase III will implement legislative changes, including establishment of a single licensing entity, which will have jurisdiction over both munitions and dual-use items and technologies. The intended result is "to build high walls around a smaller yard" by focusing enforcement efforts on the "crown jewels" of national security. White House Fact Sheet on the President's Export Control Reform Initiative.

The agencies involved in implementing this Initiative determined that the phases' objectives required both legislative and executive branch action. These agencies decided to press forward with those aspects of reform that the Administration believes do not require Congressional approval—specifically, the rewrite of the ITAR and the transfer of 90 percent of articles and technology from the ITAR to the EAR. This effort has seen significant strides, and this year, the State and Commerce Departments have begun these transfers.

Those following the ECR Initiative (which is to say, everyone with export control responsibilities, whether inside industry, legal advisors, or consultants) are well aware that the Commerce and State Departments have issued a series of proposed rules (and two final rules) implementing those transfers. To enable, and normalize, this process, the Commerce Department has created a new CCL class of items—Commerce controlled "munitions" or "defense articles"—and both Departments have written rules addressing definitional and administrative issues.

With ECR now gaining momentum, the impact of this fundamental rewrite is imminent. Companies with goods and technology formerly in Category VIII are feverishly working to meet the looming October 15, 2013, effective date of the first transfers from the U.S. munitions list ("USML") to the Commerce Control List ("CCL"). Administration sources report that they anticipate an acceleration of final and proposed rules for each of the USML's 21 categories, except USML Categories I, II, and III. As such, ECR will soon affect almost all companies that export from the U.S. and many overseas entities as well.

As a general rule, as transfers like this occur, industry will have six months to adapt to the new realities of export control. And, while the easing of license requirements applicable to these defense articles has been trumpeted as justification for this entire effort, the consequences (intended and unintended) of Export Control Reform are only beginning to garner attention. For example, at the recent BIS Annual Update in July 2013, Assistant Secretary of Commerce for Export Administration Kevin Wolf acknowledged that some of the changes would be "painful" in the short run, but that the Obama administration believes the long-term benefits outweigh the short-term growing pains associated with this wholesale change in the U.S. export control system. It is, of course, too soon to tell whether this assessment will be validated.

Regulatory upheaval of the magnitude of the ECR Initiative necessarily yields side effects—some positive, some not positive; some known or intended, some unexpected or unintended. Thus, industry responded to export reform's early proposed rules with comments and requests seeking up to four years to implement the software, system, and process changes that export reform will require. (In response, as noted in the April 2013 Rule, the agencies have given industry six months to adapt). But outside of the licensing context, many of the consequences of export reform have not been discussed or commented on, leading to the question of whether they are intended or unintended. Some of those consequences are capable of being remediated, by rule, legislation, or Executive action. Others, however, may not be so easily alleviated, and thus represent a new reality in the rapidly changing landscape of export controls.

This Commentary is the first in a series where we will examine some of the impacts and consequences of export reform on the U.S. export control system, businesses that export, and on national security. We began this effort in February 2013 with a presentation entitled, The Unintended Consequences of Export Reform. During that presentation, we identified several consequences that, at that point, had received little or no attention during the ECR Initiative. Since that presentation, some of these consequences have been discussed in other fora.[1] Further, we have continued to identify consequences of the ECR Initiative that it appears have thus far escaped the attention of industry and policy makers, and therefore include those in this discussion.

In each Commentary in this series, we will address one or more of the consequences of the ECR Initiative that we have identified, and discuss resolutions available (if any) to mitigate those consequences. Not all consequences can be mitigated, however. In certain cases, we anticipate that as the consequences are considered, certain aspects of the ECR Initiative will need to be adapted to account for these consequences or to avoid them altogether. Where corrective or remedial action appears unavailable, we hope to identify the new realities applicable to export compliance.

The consequences of the ECR Initiative will be many. Not all will be negative, but positive consequences hardly require analysis, except insofar as they may be argued to outweigh any adverse consequences (as the administration has begun to assert with respect to the administrative burdens associated with learning a new system, for those previously engaged in only ITAR activity, and the costs associated with software changes and new training regimes). That argument will not be the focus of this series. Rather, this series will identify issues not previously discussed with the goal of engaging in a more in-depth discussion.

The Consequences of Export Reform—Intended and Unintended

We intend to address the following issues in this series:

Enforcement Issues. Export enforcement will change in at least two fundamental ways:

Once the jurisdictional transition occurs, everything on the USML will be "crown jewels," and unauthorized exports of USML articles and data should automatically result in "harm to national security." The proponents of export control reform (including the administration) have argued that the ECR Initiative will result in "higher fences around smaller yards." The "smaller yard" refers to a drastically reduced USML, which will ultimately include only "those items that provide a significant military or intelligence advantage to the United States." Export Control Reform Initiative Fact Sheet #2: Myths and Facts ("Myths and Facts").[2] The government "is recalibrating the controls and licensing requirements on items that, if diverted, pose a low risk to national security, so the government can focus its review on and improve its ability to protect more critical items." Id. This development is significant because only a small percentage of the published consent agreements issued by the Directorate of Defense Trade Controls ("DDTC") include a determination that the actions resulted in "harm" to national security. As one would expect, where such determinations occurred, the penalties were generally higher. We will explore in greater detail the implications of the logical conclusion that violations involving the "crown jewels" should naturally result in harm to national security.

For at least two years (and potentially longer) following implementation of the ECR Initiative's transfer of items from the USML to the CCL, violations that would have been reportable only to DDTC will now need to be disclosed, in most cases, to both DDTC and the Commerce Department's Bureau of Industry and Security ("BIS") when voluntary disclosures are made. It is true that before the reform effort, if an exporter determined that its actions violated both the ITAR and the EAR, at least two disclosures could be needed. However, this was a relatively rare occurrence, and it occurred most often in cases where BIS and the Office of Foreign Assets Control ("OFAC") possess overlapping jurisdiction. Under pre-reform rules and practices, one had to identify independent violations of both the EAR and the ITAR before disclosures with both agencies occurred. Thus, two disclosures could be necessary if a single shipment included both ITAR and EAR controlled goods or technology; but even in these situations, dual disclosures would not automatically be needed. For example, if the shipment included EAR articles for which no license was required (and ITAR licenses were not obtained), there would still be an ITAR disclosure to consider, but not an EAR disclosure. With the transition and definitional changes expected, however, dual disclosures may be required simply because of the shift in jurisdiction.

After the EAR transfers occur, in order to properly disclose export violations, and once the decision is made to disclose, dual disclosures will be required in at least two circumstances: (i) when the exports occurred both before and after the jurisdictional shift, and licenses would have been required under either regime; and (ii) when violations occurred while the articles were ITAR controlled, even if post-transfer exports do not constitute independent violations. Exporters may need to file disclosures at both agencies to ensure that they are not omitting information material to Commerce Department licensing decisions, since Commerce will now coordinate activities and therefore examine a license applicant's history at State. We will explore how these scenarios, and others where dual disclosures may be required, will add to compliance burdens.

Reduction in Supplies of Defense Products; Adverse Impacts on the Defense Industrial Base. One of the main arguments advanced by the proponents of export control reform relates to the desire to help maintain the U.S. defense industrial base. According to the ECR Initiative, "[c]ontrolling every part and component in perpetuity threatens to strangle the U.S. defense industrial base and erode the U.S. security of supply such that the United States will eventually need to foreign source to be able to manufacture weapons systems for its own use." Myth and Facts at 1–2.[3] This argument postulates that the current ITAR controls encourage companies to move production overseas and/or lead to the establishment of overseas competitors whose products are not subject to ITAR controls. ECR Initiative supporters have not provided empirical evidence to support these arguments; however, there is anecdotal evidence that certain foreign purchasers have sought out non-U.S. suppliers for parts and components that are not subject to ITAR controls in order to avoid the "see through" rule traditionally applied by DDTC. U.S. manufacturers, and ECR Initiative supporters, cite these cases as evidence of lost sales and increased competition that have harmed the U.S. industrial base. These arguments fail to account for numerous other factors that affect not only buying decisions but decisions on where to produce products (i.e., labor costs, taxes, shipping costs, etc.). We will discuss in greater detail the relative role of export controls and other externalities on these decisions.

In addition to addressing the impact of other factors, with transfers from the USML to the CCL occurring, it is becoming evident that export reform may actually hurt the U.S. defense industrial base as much as, or even more than, the existing system. This harm has already been revealed in two ways:

First, U.S. companies whose product offerings include both ITAR controlled and non-ITAR controlled products have indicated that they will cease producing and/or offering ITAR controlled goods completely. This decision results from the following scenario: Company A's product offerings previously include 10–20 percent ITAR controlled goods. As a result, Company A could justify the compliance costs associated with producing and offering ITAR controlled products. Company A could not afford to forego that large a portion of its business. The ECR Initiative is expected to result in the transfer of 90 percent of Company A's products to the CCL. Company A has decided that the small amount of revenues from ITAR products (1–2 percent of total revenues) no longer justifies maintaining an ITAR-compliant system, ITAR registration, and related compliance costs. As a result, Company A cancels production of the smaller number of products that will remain under ITAR control and exits the business entirely. Company A's exit leaves fewer competitors for the ITAR-controlled business (or, in some cases, no suppliers of the parts or components). Faced with the choice of maintaining an ever smaller revenue stream subject to ITAR control, U.S. companies are electing, quite rationally from a business perspective, to exit ITAR-controlled businesses because the small amount of remaining ITAR business cannot justify the associated compliance costs. These situations are real and multiplying.

In addition to the voluntary cessation of production, the elimination of restrictions on the export of technical data previously subject to the ITAR opens the floodgates to the transfer of production technology, and the accompanying production, to lower-cost labor markets. In many cases, ITAR controls acted as an effective restriction against moving production overseas, either because of the costs of compliance or because the licenses needed to shift production could not be obtained. These restrictions kept the production in the U.S., simultaneously serving the goals of protecting the defense industrial base and denying other countries the production technology, skills, and advances developed in the U.S. With no ITAR controls, and with the CCL controls intentionally aimed at making these exports easier, U.S. companies will take advantage of the opportunity to move production to lower-cost markets (of which there are plenty). The net result will be reduction or elimination of essential part and component production capacity in the U.S. defense supply chain. The U.S. defense branches will then be forced to source critical parts and components from overseas—which is one of the issues that the ECR Initiative was intended to solve. These transfers of production will be accompanied by job losses, as noted during the April 24, 2013 House Hearing.

Changes in U.S. Government Policy Prohibiting the Acquisition of Defense Articles from the People's Republic of China. In 2006, the National Defense Authorization Act included, at section 1211, the following provision:

SEC. 1211. PROHIBITION ON PROCUREMENTS FROM COMMUNIST CHINESE MILITARY COMPANIES.

(a) Prohibition- The Secretary of Defense may not procure goods or services described in subsection (b), through a contract or any subcontract (at any tier) under a contract, from any Communist Chinese military company.

(b) Goods and Services Covered- For purposes of subsection (a), the goods and services described in this subsection are goods and services on the munitions list of the International Trafficking [sic] in Arms Regulations….

This "China Prohibition" is specific to "goods and services on the munitions list of the [ITAR]." Purchases by the Defense Department of EAR controlled items, even those in the new "600 series," are not prohibited under this section. Thus, as each transfer rule takes effect, the result will be to authorize the acquisition of previously prohibited parts and components to be made in China for use in U.S. military systems. Whether this was an intended consequence remains to be seen. The Departments of Defense, State, and Commerce are aware of the China Prohibition and its limited scope. Thus, they should be aware that moving items from the USML to the CCL removes them from section 1211's restrictions.

If those involved in the ECR Initiative did not intend this result, changes to the scope of section 1211 would need to be enacted. While such statutory changes can affect future contracts, the ability to expand the prohibition to include certain CCL items in existing contracts is not certain. The administration may seek to amend the DFARS to address any potential Congressional concerns in this area. For example, the Department of Defense may consider changes to DFARS 252.225-7007(a), which implements section 1211 to add the new 600 series to that rule. Assuming that DOD has the authority to issue such a rule, such a change may partially address some unintended consequences but would leave open for future consideration whether to include in section 1211 items not specifically moved to the 600 series. The ECR Initiative envisions that some items transferred from the USML to the CCL will be classified in categories other than the 600 series. These transferred articles and technology would not be subject to the China Prohibition through DFARS changes that address only the 600 series. Nor is it practical to expand section 1211 (or the DFARS) to the entire CCL, as such an expansion is contrary to Congress's intent to limit section 1211 to USML articles. Thus, the ECR Initiative will authorize the acquisition for Defense contracts of numerous parts and components previously on the USML, substantially reducing the limitations imposed by the effect of the China Prohibition.[4]

The Invalidation of Licenses Resulting From Corporate Transactions (Acquisitions, Divestitures, and Mergers). A current oversight in the implementation of the ECR Initiative will leave businesses involved in corporate transactions without effective licenses during the transition period following transactions. This problem will arise because of the Commerce and State Departments' transition rules, published on June 21, 2012 (77 Fed. Reg. 37346) (the "Transition Rule"), in which DDTC and BIS recognized the need to allow DDTC licenses to remain in effect, even after the transition of items from the USML to the CCL became official.

According to the published guidance, DDTC licenses will remain effective for up to two years after items are transferred: "Licenses for items transitioning to the CCL that are issued in the period prior to the date of final rule publication for each revised USML category will remain valid until expired, returned by the license holder, a license amendment is required, or for a period of two years from the effective date, whichever occurs first." 77 Fed. Reg. 37347 (emphasis added). The intent of this provision is to allow companies to continue to export pursuant to existing ITAR licenses while they implement the various systemic and procedural changes needed to adapt to the new classification of the items already licensed by DDTC. According to the Federal Register notice, "This phased implementation plan is designed to mitigate the impact on U.S. license holders, while assuring that all defense trade that should be licensed remains so. Under the plan U.S. license holders will continue to use their approved licenses at the time the transition takes place." Unfortunately, by including the italicized language—that DDTC licenses are no longer valid if "a license amendment is required"—the provision inadvertently creates a logistical quagmire when corporate transactions occur.

When businesses are sold, merged, or reorganized, under ITAR § 122.4, the registrant is required to amend any licenses applicable to the business being transferred to account for the name change. ITAR § 122.4(b). Under the June 21, 2012, Transition Rule, when such amendments are required, this will have the effect of invalidating any ITAR licenses for items transferred to the CCL pursuant to the ECR Initiative.

While DDTC had implemented procedures for ensuring that existing licenses were not adversely affected for properly notified transactions, no such plan or rule has yet been proposed as part of the ECR Initiative. Thus, from the time that a company files its five-day notice under ITAR §122.4(a), its ITAR licenses will, according to this rule, no longer be effective. Commerce has not proposed or implemented rules allowing for a grace period or other means by which these licenses will remain effective until licenses can be obtained from BIS. As a result, companies will find themselves without authorizations to export during whatever time period is required to obtain Commerce Department licenses to replace the DDTC licenses. Parties can take measures to prevent this problem. For example, the parties to a transaction can transfer all licenses from DDTC to BIS ahead of the transaction closing. However, for those who do not take steps to avoid this problem, the consequences will be severe.

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