The Long(er) Arm of US Export Controls: US Moves to Close “Loophole” in Latest Bid to Hamper Huawei’s Access to Supply of Chipsets

On May 15, 2020, the US Department of Commerce, Bureau of Industry and Security (“BIS”) announced an interim final rule that will further restrict the use by non-US persons of certain US technology, software and equipment in the design, development and production abroad of semiconductors for Huawei Technologies Co., Ltd. and 114 of its affiliates around the world.¹ The rule is the latest in a series of recent actions by the United States intended to address US national security concerns relating to China’s drive for 5G dominance and to enhance national security controls on related transactions. The rule has already drawn reaction from the Chinese government and will have far-reaching implications for US and non-US foundries, chipset design firms and others in Huawei’s global supply chain.

The interim rule took effect May 15, 2020, and includes a conditional grace period for covered items the production of which was initiated as of that day, as well as for certain in-transit shipments. On or before July 14, 2020, BIS is requesting comments on the impact of this rule. This Legal Update provides background on BIS’s actions targeting Huawei and an overview of the rule change and its potential ramifications.

Background

Entity List Designation of Huawei

As discussed in our previous Legal Update, on May 16, 2019, BIS added Huawei Technologies Co., Ltd. and dozens of its non-US affiliates (collectively, “Huawei”) to the Entity List. That action imposed a license requirement on exporting, reexporting or transferring (in-country) items subject to the Export Administration Regulations (“EAR”) to Huawei. BIS issued a Temporary General License (“TGL”) authorizing certain limited categories of transactions for a 90-day period and has issued successive extensions of that general license.² Outside of these narrow exceptions, the Entity List designation effectively cut Huawei off from both US and non-US items, whether goods, technology or software, (collectively, “items”) when they are subject to the EAR. For example, items made outside of the US may also be subject to the EAR if they incorporate greater than de minimis controlled US-origin content (generally, greater than 25 percent) or, in certain limited cases, are produced as the direct product of certain controlled US-origin technology subject to national security controls. As discussed in our recent Legal Updates,³ the Entity List designation of Huawei is part of the US government’s assessment of critical national security risks associated with China’s efforts to secure cutting-edge technologies as part of its “military-civil fusion” initiative, which aims to merge China’s defense and commercial economies as part of its strategy to advance Chinese interests.

Huawei’s Adapting Supply Chain

As the above suggests, foreign-made items with less than de minimis US content and items that do not fall within the “foreign direct product” category of US technology fall outside the reach of the rule. In the year since Huawei’s designation, Huawei has demonstrated an ability to adapt and leverage its substantial market position by working to reduce its reliance on US content across its supply chain and has itself continued to secure lucrative contracts as a global supplier of 5G telecommunications infrastructure. At the same time, US officials have internally debated a number of proposals to impose further restrictions on the company, including possible changes to the de minimis content and foreign direct product rules.

Following several months of consideration, the interim final rule adopts a change to BIS’s long-standing foreign direct product rule to address, as BIS states in its May 15, 2020, announcement, Huawei’s efforts to undermine the Entity List through a “loophole.”⁴

The Foreign Direct Product Rule

Prior to the latest change, the foreign direct product rule has long provided that when certain non-US-made items are the direct products of US software or technology subject to national security controls under the EAR (or are direct products of plants or equipment that are based on such US software or technology), such foreign-made items may themselves be subject to the EAR. Specifically, the rule has been based on three criteria: (i) the reason for control applicable to the US technology or software, (ii) the reason for control applicable to the foreign-produced item or classification and (iii) the country of destination of the foreign-produced item.

Before the amendment, unless these criteria were met, a non-US-made item with de minimis US content was not subject to the EAR and would not face any restrictions for export, reexport or transfer (in-country) to Huawei despite its designation on the Entity List. For example, if the transaction satisfied the national security controls in the first two criteria, but the destination did not satisfy the third criterion, the rule did not render the item subject to the EAR. Moreover, the rule did not distinguish between transactions involving restricted Entity List entities and parties who are not the subject of BIS end-user restrictions. With the amendment, BIS maintains the current rule under the three criteria above but expands the rule by adding a separate test for certain Entity List entities as an alternative basis for application of the foreign direct product rule.

The Amendment

The amendment expands the foreign direct product rule for Huawei (including its 114 affiliates) by establishing a separate basis for control (while leaving intact the existing control) under the foreign direct product rule.

• First, the country of destination for the export, re-export or transfer (in-country) of the foreign-produced item is not a factor under the new control, unlike under the existing control.

• Second, the rule only applies to Entity List entities whose designation specifically includes new Footnote 1, a marker for application of this new control. All of the Huawei entities on the Entity List have this marker.

• Third, for such entities, a foreign-produced item will be subject to the EAR by virtue of the new control only where (i) the item satisfies the new control criteria, discussed below, and (ii) there is “knowledge” that the item is destined for the designated entity. Where the second prong is not satisfied, the new control does not trigger application of the EAR, even if the item would otherwise qualify as a foreign-produced direct product under the new rule. Note, however, that “knowledge” does not require actual knowledge but “reason to know” and that BIS has long-adopted a broad view of the term in practice based on a consideration of all of the facts and circumstances surrounding a transaction or set of transactions.

• Finally, as to the new control for such entities, the rule adopts more expansive control criteria to cover two categories of foreign-produced items. The items in the first category are foreign-made items (such as integrated circuit designs) produced or developed by Huawei and its affiliates on the Entity List that are the direct product of certain software or technology subject to the EAR and controlled for national security reasons (e.g., electronic design automation software).
  
  The items in the second category are foreign-made items that are the direct product of a plant or major component of that plant outside of the US (including semiconductor manufacturing equipment) where that plant/major component is itself a direct product of certain software or technology controlled under Categories 3, 4 and 5 of the Commerce Control List under the EAR and where the foreign-produced item is a direct product of software or technology produced or developed by the Huawei entity.⁵ BIS provides as an example a chipset, “when produced from the design specifications of Huawei or an affiliate on the Entity List (e.g., HiSilicon), that are the direct product of certain [controlled] semiconductor manufacturing equipment located outside the United States.”

In an effort to mitigate the immediate harm to companies that are involved in Huawei’s semiconductor supply chain, BIS will exempt certain items subject to the new controls and implement a wind-down period for companies that have initiated shipment or production for items based on Huawei design specifications as of the effective date (May 15, 2020) of the amendment. In particular, shipments of non-US-made items subject to the new controls that were on dock for loading, on lighter, laden aboard an exporting or transferring carrier, or en route aboard a carrier to a port of export or to the consignee/end-user on the effective date pursuant to actual orders for exports, reexports and transfers (in-country) to a foreign destination or to the consignee/end-user are authorized to proceed to such destination. Moreover, foreign-produced items will not be subject to these new licensing requirements provided they were in production prior to the effective date and are reexported, exported from abroad or transferred (in-country) before September 14, 2020, i.e., 120 days after the effective date.

Chinese Response

Although it has not taken any official action in response to BIS’s announcement, the Chinese government responded to media inquiries that China will take necessary actions to protect the legitimate interests of Chinese companies. According to media reports, China’s responsive actions may include one or more of the following: (i) designate certain US technology companies on the “unreliable entities list” (see our May 31, 2019, Legal Update for more information), (ii) investigate or impose restrictions on US companies pursuant to Cyber Security Review Measures and the Antitrust Law and (iii) cease airplane purchases from the United States.⁶

Implications

Aimed at curtailing Huawei’s ability to obtain semiconductor chips derived from US software or technology, the amendment will also affect many other US and non-US companies. Non-US suppliers of semiconductor chips to Huawei, and the US companies that provide these suppliers with US-origin software or technology for their manufacturing processes, will need to immediately begin reevaluating their direct and indirect relationships with Huawei or its affiliates listed on the Entity List. Part of this re-evaluation will require determining which products have newly become subject to the EAR, identifying what transactions will qualify for the wind-down period and ensuring that the proper procedures are in place to avoid the potential for non-exempt products under the savings clause making their way to Huawei. Moreover, non-US and US companies will need to reevaluate and update their compliance measures (e.g., contractual provisions) to factor in the new amendment. US technology companies will also need to monitor developments regarding China’s “unreliable entities list.”

Finally, in the context of the broader US government campaign to comprehensively address national security risks relating to China’s role in 5G development more broadly, companies not directly involved in the export, reexport or transfer of controlled US-origin technology or software should also closely monitor additional steps likely to be taken by the US government for national security purposes in the area of 5G-related technologies.⁷