This is the second in a series of articles by Eversheds Sutherland partners Jeff Bialos and Ginger Faulk explaining the legal and regulatory impacts of certain recent US sanctions and export control actions targeting various Chinese entities. Each article explains the regulatory context of the recent rules. Recognizing that this is a highly charged political topic, the article does not condone or promote any governmental actions discussed here but is only explanatory in nature.

As part of the overall realignment of US national security strategy toward China, the US government has taken a series of actions this year to target the Chinese military sector through sanctions and export controls imposed against a range of Chinese companies. The recent promulgation of the expanded China “military end-use” and “military end user” rule mark an expansion of a longstanding US policy to bar certain exports of US “dual-use” goods and technologies that can contribute to China’s military capability. This, combined with the recent release by the Department of Defense of a list of companies considered to be “owned or controlled” by the Chinese military – pursuant to a 20-year-old law – signals increased US government pressure on China and its firms that are viewed as instruments of the Chinese government. These rules together threaten to limit significantly the availability of “dual-use” US goods and technology to Chinese companies on the list.

Unpacking the China “Military End User” Rule

A recent amendment to the Export Administration Regulations (EAR) targeting a broader range of “military end-uses” and “military end-users” in China is designed to curtail exports and re-exports of a range of US origin “dual-use” technology, software, and goods to China’s private sector but only where the private sector end-user is determined to support the Chinese military. Per the US Commerce Department, the new rule “will require increased diligence with respect to the evaluation of end-users in China, particularly in view of China’s widespread civil-military integration.”

Previously, the rule applied only when the item was intended for military end-use, e.g., incorporation into a military end-item. The new rule now expands this approach beyond exports for military end-use, and now requires an export license for exports or transfers of listed items to China if the item is intended entirely OR in part for a “military end-user” in these countries. Under this expanded control, the rule potentially proscribes exports and re-exports not only to the military (e.g., the Peoples Liberation Army (“PLA”)) but also to police, national guard, intelligence organizations and “any person or entity whose actions or functions are intended to support ‘military end-uses.’” In other words, an export of a subject item to a private sector company which also contracts with the Chinese government could be prohibited even if the item itself is neither destined for the military (defined in a traditional sense) nor for a military application.

In addition, the new rule expands the definition of “military end-use” by no longer just restricting exports for “the use, development, production of, or incorporation into” military items, but now also extending to an export that “supports or contributes to the operation, installation, maintenance, repair, overhaul, refurbishing, ‘development,’ or ‘production’ of military items.” A subject item that supports even one of these functions triggers the “military end-use” rule.

The rule also adds products to the scope of the rule under the categories of materials processing, electronics, telecommunications, information security, sensors and lasers, and propulsion. Importantly, now subject to the rule are 5G-capable microprocessors, devices, and components. Finally, the new rule subjects certain exports to China to new country-based licensing controls under a “regional stability” control.

Heightened Due Diligence Obligations for Exporters of Goods, Software and Technologies

Significantly, the new “military end user” rule imposes a broader obligation on US exporters to identify potential military links of Chinese counterparts and assure against diversion of technology to the Chinese military. It places the burden on US exporters to not only (i) determine the end-user of subject items, even if those items are transferred to a third country, but also to (ii) evaluate and determine whether the identified end-user would be considered a “military end user” by virtue of potential links with Chinese military agencies. This applies to exports of all subject items (e.g., 5G devices and certain electrical components, among others) regardless of how the export in question will ultimately be used.

In practical terms, this means enhanced due diligence to identify potential military affiliations of Chinese and third-country customers, distributors, procurement agents, and other intermediaries with respect to all dual-use exports to China. It also means re-evaluating technology sharing arrangements between US companies and Chinese joint venture partners such as commercial partners, research institutes, and academic institutions.

Note, the EAR controls apply not just to US goods and equipment but also foreign manufactured goods and equipment that incorporate US-origin content. The “dual-use” items that are subject to the military end-user rule are listed by category at Supplement No. 2 to the EAR 15 CFR Part 744 and include certain controlled materials and materials processing equipment, telecommunications equipment and software (e.g., 5G technologies), sensors and laser technology, and marine and space vessels. So, technology and software companies in any country whose products rely on these US technologies face a binary choice: either to police China business partners for even tangential connections to the military sector or divorce their China supply chains and technology/software flows from the US.

The PLA/DoD List

Similarly, on June 25^th, 2020, the US Department of Defense (DoD) issued a list of 20 “communist Chinese military companies” operating in the US that meet the criteria of section 1237 of the National Defense Authorization Act (“NDAA”) for FY 1999. Eleven new additions to the list were issued on August 28, 2020. [1] Companies on these lists include massive Chinese state-owned companies in the aerospace, construction and engineering, chemical, electronics, nuclear, telecommunications, and other sectors. The issuance of this list and the Commerce Department’s new end-user” rules are connected in that this list of companies is likely to guide determinations under the EAR “military end user” rule and the direction of future US-China sanctions actions. The DoD List may be a natural place for the US government to start in identifying Chinese “military end-users” subject to further restriction. Thus the implications for US technology partnerships with Chinese companies in these are potentially quite significant.

In 1999, Congress enacted a provision authorizing the DoD to issue a list of “communist Chinese military companies” operating in the US that are “owned or controlled by the People’s Liberation Army” and are “engaged in providing commercial services, manufacturing, production or exporting.”

On June 24, 2020, nearly 22 years later, DoD finally issued the list. This was in response to a letter sent by a bipartisan group of Senators to Secretary of Defense Mark Esper requesting that DoD issue the list as a tool to confront China and its stated strategy of “military-civilian fusion” to achieve its national objectives. The DoD compiled the list of companies that support the Chinese military as the basis for subsequent US policy actions to address the competitive Chinese threat. The specific risks under consideration included: 1) the transfer of “dual-use” technology to these companies that could, in turn, be used for military purposes given their relationships with the PLA; and 2) the supply chain risks associated with the participation of these companies in US supply chains (e.g., through providing equipment such as semiconductors). Such supply chain risks include the risks that such Chinese firms could introduce malevolent software into US products or use its equipment as a basis for surveillance (i.e., espionage).

It should be recognized that the companies on the DoD List by no means encompass the universe of Chinese government-owned or controlled companies, as there are numerous such state-owned or controlled companies not on the DoD List. Rather, the focus is on companies considered to be owned or controlled by the PLA itself. Further, the term “control,” as used in this context, appears to be broad in scope and seems to be utilized by DoD to reach companies that have some significant engagement with the PLA (i.e., where it might be the case that the PLA supervises or directs some functional activity or area at the company). In this regard, there are at least several companies on the DoD list not generally considered to be government-owned or controlled, let alone PLA owned or controlled in a traditional sense—a small number of which are publicly traded. Thus, in these circumstances, the “control” must relate to some functional areas of engagement.  For example, in the case of Huawei, the control might arguably relate to the idea that the PLA can direct Huawei to utilize its platforms and equipment for surveillance or other activities.

Notably, being listed on the DoD list has no direct and immediate legal consequences for the listed companies. However, the law does make it easier for the president to impose sanctions. Once a company is on the section 1237 list, the president can impose the full array of economic sanctions without any additional finding, including prohibitions on US persons doing business with that company, export restrictions, and the like. Note also that the president can also impose an import ban on companies on the DoD list upon declaring an international economic emergency – an action that, if undertaken, is not subject to challenge in federal courts.

Further, as noted above, the recent listings of Chinese companies on the DoD List are likely to lead to additional export control restrictions on the named parties under the new Commerce rule that requires licenses, and establishes a “presumption of denial” policy, for exports, re-exports, or transfers (in-country) of certain products and technologies to Chinese “military end-users.” Since this new rule defines “military end-users” to include any “person or entity whose actions or functions are intended to support ‘military end uses,” it is reasonably likely that Commerce will find that parties listed on the DoD list would be considered a military “end-user,” and as such, any license applications for covered products and technologies will be subject to a presumption of denial.    

Finally, the list is a tool that can generally build pressure on China. In releasing the list, DoD officials observed that “As the People’s Republic of China attempts to blur the lines between civil and military sectors, ‘knowing your supplier’ is critical … We envision this list will be used as a tool for the US government, companies, investors, academic institutions and like-minded parties to conduct due diligence with regard to partnerships with these entities….”

In conclusion, while the DoD/PLA list itself has no direct legal effect, in combination with the EAR’s military end-user rule, it signals a US desire to limit the availability of “dual-use” American technologies to these companies. To comply with the rule exporters and re-exporters of the listed US technologies must conduct heightened diligence of Chinese SOE end-users and will require a US export license where an end-user also uses, develops or produces items for the Chinese military. This places the impetus on the Chinese companies to demonstrate to US exporters and to the US government that, as applicable: 1) there is sufficient separation between subsidiaries with defense-related operations and those engaged in purely commercial activities; or 2) for those with purely commercial operations, they are not providing US-based dual-use products or technologies to support China’s military.

In some circumstances, it also means that Chinese companies on the list may be forced to look elsewhere (outside of the United States) for the equivalent non-US technologies and products and restructure their supply chains accordingly. Notably, the US position places it as an outlier among allied Western governments. If the US has a new President in 2021, we would expect to see a more multilateral approach on these and other China-related trade issues.

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[1] Both lists are available here.

Jeffrey P.  Bialos, partner at Eversheds Sutherland, assists clients in making multi-faceted business decisions, structuring transactions and complying with complex regulatory requirements. As former Deputy Under Secretary of Defense for Industrial Affairs, he brings deep experience in defense, homeland security and national security matters, including antitrust, procurement, export controls, industrial security and the Foreign Corrupt Practices Act.

Ginger T. Faulk, partner at Eversheds Sutherland, represents multinational companies in matters involving US government regulation of foreign trade and investment. She has extensive experience advising and representing global companies, counseling clients in matters arising under US sanctions, export controls, import and other national security and foreign policy trade-related regulations.