DUE DILIGENCE CONSIDERATIONS WHEN EXPORTING TO CHINA
by Keil J. Ritterpusch
Senior Compliance Associate
Jenny A. Hahn
The current climate between the U.S. Government and China related to export controlled commodities is quite hostile and is not likely to change in the near term, even with a new U.S. President in place. The U.S. Government, concerned with national security threats, human rights abuses, military modernization, theft of U.S. technology, and theft of U.S. personal information by Chinese actors, has gone on the offensive from an export regulatory perspective to attempt to prevent parties supportive of the Chinese Government and Chinese military from acquiring US-origin products, including, in some cases, products that are EAR99.
The U.S. Government, acting through the U.S. Department of Commerce's Bureau of Industry & Security ("BIS"), has recently added a large number of Chinese companies, including companies that are predominantly involved with commercial enterprises, to the Entity List under the Export Administration Regulations ("EAR"). By being added to the Entity List, any export from the U.S. to a listed party is subject to an export license requirement under the EAR, with a presumption of denial applicable in most cases. Listed parties cannot receive U.S. exports indirectly either, such as by buying through intermediary parties. These intermediary parties know that it is not lawful for U.S. exporters to engage in transactions involving ultimate end use by parties on the Entity List. Thus, in many cases, they disguise the intended end-use, end-users, and parties to the export transactions.
Beyond the expansion of the Entity List, BIS has taken steps to expand the EAR's Foreign Direct Product Rule at EAR Section 736.2(b)(3) to specifically target Chinese telecommunications giant, Huawei Technologies Group Co. Ltd. ("Huawei") and affiliates in China and worldwide. The EAR's Foreign Direct Product Rule was expanded so that foreign origin products built in plants with U.S.-origin equipment and technology that are exported from abroad or re-exported to Huawei and affiliates are subject to the EAR and prohibited without a license from BIS.
In addition to the broad prohibitions that have been placed on numerous Chinese companies, preventing them from receiving exports of any commodity from the United States, a large number of Chinese companies and organizations have recently been identified under the EAR as Military End Users ("MEUs"). The action to formally identify companies as MEUs, in China, as well as Russia and Venezuela, follows their identification by the U.S. Department of Defense as parties with strong ties to military end-users and military end-uses. By adding entities as MEUs under the EAR, U.S. exporters are officially on notice that any export transaction involving these entities where an item on the EAR's Commerce Control List ("CCL") -- meaning any item with an Export Control Classification Number ("ECCN") requires an export license approved by BIS.
Given the extensive expansion of export restrictions involving China (as well as Russia and Venezuela), it is more important than ever for parties exporting from the United States to carefully identify the parties to their export transactions and the export classifications of products being exported. Even items that are EAR99 or are otherwise No License Required ("NLR") to most worldwide destinations now require licensing for export to certain end-users and for certain end uses in China. Thus, exporters must take formalized steps to document their export due diligence for transactions involving China, as well as Hong Kong and Macau (which are now treated as part of China by the U.S. Government).
BIS has published "Know Your Customer Guidance and Red Flags" as a supplement to the Ten Prohibitions listed in EAR Part 736. The guidance explains the appropriate due diligence required for U.S. export transactions and provides context as to how to sufficiently establish "knowledge" of the particulars of export transactions, including the proper identification of parties, end uses, and end-users. The General Prohibitions cover a gamut of export-related matters but generally prohibit exporters and re-exporters from engaging in export transactions involving prohibited end uses and prohibited end-users. In order to comply with the EAR's General Prohibitions, exporters and re-exporters must establish "reasonable " knowledge regarding the parties to their export transactions and the ultimate end-use and end-users of the exports.
The industry standard for validating this information is through the End User Statement ("EUS")/End User Certification ("EUC"). Without a EUS/EUC, an exporter is arguably self-blinding with respect to compliance with the EAR General Prohibitions, as well as overall export compliance with EAR requirements. Companies that fail to establish sufficient "knowledge" of the details of export transactions can be hit with substantial fines when export transactions result in end uses or end users that are prohibited.
What is Reasonable Due Diligence?
An array of documentation can be used by exporters and re-exporters to validate the parties, end uses, and end users involved with export transactions. The following are tools that should be used by exporters and re-exporters in varying degrees as part of the due diligence to validate export transactions.
- End-Use and End-User Statements
- Denied Party Screening
- Internet research validating the parties to the export transaction
- Business licenses and other documents validating the bona fides of the parties, should information regarding the entities to the transaction not be easily discovered through internet searches.
Of these tools for performing due diligence, the most important, by far, is the End User Statement/End-Use Certification. In our opinion, this document should be obtained for all export transactions. After receipt of the EUS/EUC, the U.S. exporter should perform Denied Party Screening on the names of the parties to the export transactions, including the purchaser, intermediate consignees, ultimate consignee, and end-user, doing "fuzzy" searches of company names and variations on the company name. In addition, the Denied Party Screening should search for companies at the same or similar addresses. Widely scoped Denied Party Screening is crucial to the overall due diligence, as it demonstrates to the U.S. Government that the exporters (and re-exporters) took steps to validate that the parties to the transaction are not prohibited from receiving U.S. exports.
Following the Denied Party Screening, we recommend that exporters and re-exporters perform an internet search to ensure that the parties named on the EUS/EUC exist and are in a business with a connection to the product to be exported. Should information on the parties not be able to be readily found on the internet, the exporter or re-exporter should contemplate getting a more detailed EUS/EUC and having it signed both by their customer and the ultimate consignee/end-user. Even in cases where a multi-party signed EUS/EUC is received. It may be necessary to receive copies of business formation documents if the exporter or re-exporter cannot find information on a party to the export transaction after an internet search, particularly the stated end-user/ultimate consignee.
What Flags Should a Prospective Exporter Look For?
Exporters and re-exporters are responsible under the EAR for engaging in lawful export transactions and not engaging in export transactions where they "know" or have "reason to know" that the export transaction may involve an unauthorized party, end-use, or end-user. When evaluating the due diligence collected in relation to prospective export transactions, exporters and re-exporters should highlight any facts where there is missing information or where answers to questions about the parties, end-use, and end-users do not "add up."
For example, if a party receives a completed EUS/EUC that lists a distributor as an end-user, the entire export transaction is a red flag since details regarding the true end-use and end-user are not being provided. Similarly, if a party receives a completed EUS/EUC that lists various parties, including the purchaser, ultimate consignee, and end-users, that cannot be validated through an internet search, there is a red flag to the export transaction, and additional due diligence should be performed.
Liability In the Event that a Party to An Export Transaction Provides Incorrect Information?
Entities in China that have been placed on the Entity List or designated as MEUs still need to receive components to manufacture their products. Companies like Huawei and Semiconductor Manufacturing International Corporation ("SMIC") have not slowed their production of products for the commercial marketplace or for the Chinese Government. As a result, we fully expect that "front" companies will be formed solely for the purpose of diverting goods to companies like Huawei and SMIC in contravention of the EAR. Exporters and re-exporters cannot afford to completely stop exporting to China and Hong Kong (and other destinations) solely because there are a possibility that their shipments will be diverted for unauthorized end uses or unauthorized end users.
To mitigate the risks associated with diversions downstream in export transactions, exporters and re-exporters need to be able to rely on certifications made by legitimate parties to export transactions. There is no requirement to perform post-delivery validation of export transactions involving products that are EAR99 or controlled by the EAR for Anti-Terrorism ("AT) reasons alone. However, exporters and re-exporters need to be able to validate before shipment that the parties to export transactions are legitimate legal entities and that other red flags are overcome.
Therefore, a critical burden on exporters and re-exporters is to ensure that the parties who sign EUS/EUC for prospective export transactions are legitimate legal entities. Once the EUS/EUC is received and the bona fides of the parties have been established and export classifications validated, exporters and re-exporters can export/re-export freely, whether under an export license, under a license exception, or as NLR, if applicable. If an exporter or re-exporter learns after the fact that there has been a diversion, the matter should be reported to BIS, and steps taken internally to document concerns with the pertinent parties to the export transaction resulted in diversion should be undertaken to avoid any recurrence of the diversion.
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**FD Associates notes that there are financial sanctions applicable to other parties to export transactions that do not relate to the EAR but rather are implemented under U.S. Department of Treasury regulations. This article does not address such requirements, but parties engaged in export transactions with a nexus with the United States should consult the U.S. Department of Treasury regulations and website to validate that other parties to export transactions, including freight forwarders, banks, and issuers of credit, are not debarred from engaging in transactions involving U.S. jurisdiction.