The Commerce Department Modifies “Direct Product Rule” to Restrict Transfers of More Foreign-Made Items to Huawei

On May 15, 2020, the Department of Commerce Bureau of Industry and Security (BIS) issued an interim rule (“Interim Rule”) significantly expanding its control of certain foreign-produced items when there is “knowledge” that the items are destined for specified companies on BIS’s Entity List, including Huawei and numerous of its non-U.S. affiliates. Under the Interim Rule, it is a violation of the Export Administration Regulations (EAR) knowingly to provide Huawei and its Entity List affiliates semiconductors and other items manufactured outside the United Sates using certain technology or software that is subject to the EAR, or produced in a plant or by equipment that itself is the direct product of certain U.S.-origin technology or software.

This measure came almost a year to the day that BIS added Huawei to the Entity List, and Secretary of Commerce Wilbur Ross was clear the Interim Rule is meant specifically to target Huawei’s ability to obtain semiconductors from U.S. sources, even when the items are produced at non-U.S. facilities. These new measures are aimed directly at disrupting Huawei’s semiconductor supply chain.

Non-U.S. entities producing semiconductors and other items for Huawei will need to review the technology, software, and equipment used to produce such items to determine whether the items are covered by the rule. If so, they cannot be provided to Huawei and its Entity List affiliates absent a BIS export license, and BIS reviews license applications to export items to an Entity List company with a presumption of denial. Civil monetary penalties for violating the EAR can be up to approximately $300,000 per violation or twice the value of the underlying transaction, whichever is greater.

This rule comes two weeks after BIS issued two final rules and one proposed rule further restricting U.S. exports to China when intended for a military end-user, and expanding end-use restrictions on exports to China (and also Russia and Venezuela), broadening the definition of “military end-use,” expanding the list of items requiring a license for a military end-use or end-user in those countries, and eliminating or limiting certain BIS license exceptions.

The “Direct Product” Rule

The Direct Product rule, set forth under General Prohibition 3 of the EAR, is intended to capture items manufactured outside the United States that are produced using certain controlled U.S. technology. (“Controlled” in this context means an export license is required to export such technology.)

The Direct Product rule historically applied to a foreign produced item only when (i) the item is produced from U.S. technology or software controlled for national security reasons (as designated in the Export Control Classification Number (ECCN) for such item), and (ii) the foreign produced item is being shipped to specified countries of destination, including China. If both of these elements are not met, the item is not subject to the EAR unless caught by another rule (e.g., if the item has more than a de minimis amount of controlled U.S. content or the specific rules applicable to “600 Series” military items). This remains the rule except for the Entity List entities covered by the Interim Rule.

The Entity List

BIS’s Entity List is a list of certain foreign parties that are subject to specific licensing requirements for the export, reexport, or transfer of any item subject to the EAR because these foreign parties have been deemed to pose a significant risk of involvement in activities contrary to U.S. national security or foreign policy interests. The Entity List is published in Supplement 4 to Part 744 of the EAR. In May 2019, BIS designated Huawei and dozens of its non-U.S. affiliates on the Entity List, marking a significant escalation of the trade tensions generally between the United States and China and disrupting commerce between Huawei and its U.S.-based suppliers.

Although Huawei’s designation on the Entity List significantly curtailed Huawei’s direct access to U.S. suppliers, Huawei was still able to source items, in particular semiconductors, from production facilities outside the United States. Even if those items contained U.S.-origin content or were produced using U.S. technology, software, or equipment, such foreign produced items were not “subject to the EAR” so long as the underlying U.S. technology and foreign-produced item fell outside of the Direct Product rule as described above and contained less than 25% controlled U.S. origin content (the “de minimis” rule).

Since Huawei’s initial designation on the Entity List, Commerce and other executive branch agencies have been evaluating measures to curtail Huawei’s further access to semiconductor technology with a U.S. nexus. The U.S. semiconductor and other industries in the Huawei supply chain have been expecting potential changes to both the de minimis and the direct product rules early in 2020, given the popular press descriptions of the de minimis rule as a “loophole.” EAR amendments to address the de minimis issue, however, seem to have been shelved after President Trump tweeted his concern that such measures would harm U.S. industry.

Although the May 15 Interim Rule effected significant changes to the Direct Product rule, it is not clear whether BIS will also implement changes to the de minimis rule, which might be similarly disruptive to Huawei’s supply chain. However, the Interim Rule demonstrates the willingness of the Trump administration to expand the application of export control laws in new and unique ways.

Modified Application of the Direct Product Rule for Huawei

The Interim Rule is designed to control items that are a product of U.S.-origin technology or software, such as semiconductor designs and chipsets, but potentially captures a broader set of items. It applies to foreign-produced items based on two criteria: (i) when the reason for control of the U.S. technology or software falls under certain ECCNs in the EAR Commerce Control List Category 3 (Electronics Design Development and Production, including semiconductors), Category 4 (Computers), and Category 5 Part 1 (Telecommunications), and (ii) when there is “knowledge” that the foreign-produced item is destined to an entity BIS designates on the Entity List, which includes Huawei and its non-U.S. affiliates.

Under the Interim Rule, no one may reexport, export from abroad, or transfer without a license from BIS or a license exception any foreign-produced item when there is “knowledge” that the item is destined for an Entity List company as identified by footnote 1 to the Entity List designation and:

• The item is produced or developed by such Entity List company and is a direct product of technology or software subject to the EAR classified under any of the below-listed ECCNs (e.g., an integrated circuit designed using technology or software from these ECCNs, such as Electronic Design Automation Software); or
• The item is produced by any plant or “major component” of a plant (that is, equipment that is essential to the production of the item), when the plant or major component itself is a direct product of U.S.-origin technology or software classified under any of the below-listed ECCNs, and is a direct product of software or technology produced or developed by such Entity List company (e.g., a semiconductor based on Huawei technical specifications).

In addition to determining whether and when an item is a direct product of technology or software, parties also need to understand the EAR’s definition of “knowledge” as it encompasses circumstances the parties actually know or should know.  Knowledge, in this context, “includes not only positive knowledge that the circumstance exists or is substantially certain to occur, but also an awareness of a high probability of its existence or future occurrence. Such awareness is inferred from evidence of the conscious disregard of facts known to a person and is also inferred from a person’s willful avoidance of facts.” Companies are encouraged to review and understand BIS’s Know-Your-Customer (KYC) rules and guidance, and implement risk-based procedures to adhere to KYC policies.

As an Interim Rule, the requirements are effective immediately. As is common for interim rules, there is a savings clause, which, in short, exempts certain items otherwise subject to the new rule. For items that are the direct product of a plant or equipment, shipments may proceed without a license, so long as the foreign foundries have initiated production steps as of May 15, 2020, and the items are shipped/transferred before September 14, 2020. For items that are the direct product of technology or software subject to the EAR, shipments may proceed without a license if the foreign-produced items were on dock for loading or en route pursuant to an actual order on or before May 15, 2020. Parties should consult the specific language in the Interim Rule to verify whether the savings clause is applicable to any particular items in production.

Comments on the Interim Rule must be submitted by July 14, 2020.

ECCNs Subject to Modified Direct Product Rule