United States: "When Exporting, You Must "Know Your Customer"

The $60,000 Lesson

On May 23, 2006, the Department of Commerce, Bureau of Industry and Security ("BIS") announced a settlement related to illegal exports made by Structural Dynamics Research Corporation ("SDRC"). According to charging documents released by BIS, SDRC exported computer-aided drafting software classified under Export Control Classification Number ("ECCN") 5D992 to China and India. Exports to India and China of software classified under ECCN 5D992 do not normally require an export license under the Export Administration Regulations ("EAR"). However, in the 15 instances documented by BIS, SDRC sold these particular software products to individual customers in India and China which were included on the Department of Commerce Entity List and subject to specific export restrictions. In other words, although SDRC was generally permitted to sell these products to end-users in India and China without first obtaining an export license, certain end-users within these countries were subject to a licensing requirement based on specific restrictions imposed on these end-users by BIS. These exports were ultimately voluntarily disclosed by SDRC’s successor in interest, UGS Corporation, which paid $57,750 to settle the ensuing charges. How could SDRC have prevented these violations? Clearly, it pays to "know your customer."

In assessing diversion risks, identifying potential export violations, verifying end-uses, and determining the suitability of end-users to receive U.S. commodities or technology, BIS places an enormous amount of responsibility on U.S. exporters. U.S. export control laws and regulations require that exporting firms come to "know their customers" by exerting all reasonable efforts to ascertain the end-use, the end-user, the ultimate destination, and other facts relating to a transaction or activity.

Armed with this information, exporters are required to confirm that none of the entities involved or affiliated with the particular transaction is subject to restriction by any U.S. government agency. To facilitate this process, the U.S. government has developed several lists to assist exporters in complying with applicable U.S. export controls laws and regulations:

• Denied Persons List: the names of individuals and entities that have been denied export privileges

• Unverified List: the parties involved in prior transactions where BIS could not verify the end use

• Entity List: the parties who are subject to specific export restrictions by the Department of Commerce

• Specially Designated Nationals List: exporters are prohibited from participating in any transactions with any individual or entity appearing on this list compiled by the Treasury Department, Office of Foreign Assets Control

• Debarred List: a group of individuals and entities barred by the State Department from participating in export transactions

See http://www.bis.doc.gov/ComplianceAndEnforcement/ListsToCheck.htm.

In order to "know their customer," exporters are also required to review all export transactions to ensure that no information they have received could provide them with a reasonable indication that an export violation could occur. In order to provide guidance on this requirement, BIS has developed a list of "red flag" indicators to use as a checklist of issues to consider before proceeding with an export transaction. These "red flag indicators" consist of the following:

• The customer or its address is similar to one of the parties found on the Commerce Department’s list of denied persons.

• The customer or purchasing agent is reluctant to offer information about the end-use of the item.

• The product’s capabilities do not fit the buyer’s line of business, such as an order for sophisticated computers for a small bakery.

• The item ordered is incompatible with the technical level of the country to which it is being shipped, such as semiconductor manufacturing equipment being shipped to a country that has no electronics industry.

• The customer is willing to pay cash for a very expensive item when the terms of sale would normally call for financing.

• The customer has little or no business background.

• The customer is unfamiliar with the product's performance characteristics but still wants the product.

• Routine installation, training, or maintenance services are declined by the customer.

• Delivery dates are vague, or deliveries are planned for out-of-the-way destinations.

• A freight forwarding firm is listed as the product’s final destination.

• The shipping route is abnormal for the product and destination.

• Packaging is inconsistent with the stated method of shipment or destination.

• When questioned, the buyer is evasive and especially unclear about whether the purchased product is for domestic use, for export, or for reexport.

See http://www.bis.doc.gov/Enforcement/redflags.htm

Before engaging in a transaction or activity, an exporter must determine whether "red flag indicators" are present. These "red flag indicators" are specifically intended to assist exporters in exploring whether abnormal circumstances exist such that the transaction or activity may be destined for an inappropriate end-use, end-user, or destination. The "red flag indicators" were developed to illustrate the types of circumstances that should cause reasonable suspicion that a transaction or activity may violate U.S. export control laws and regulations.

In order to determine whether any potential "red flag" issues are present in a given transaction, an exporter must request and evaluate certain information regarding the transaction or activity from its customer. Once information is received from the customer, and the exporter discovers the presence of a "red flag indicator," the exporter must inquire and reevaluate all information received from the customer to determine whether the danger of an export violation may exist. This reevaluation process allows the exporter to determine if the identified "red flag" issue can be explained. The exporter may also need to request additional information from the customer in order to resolve the issue. If the reevaluated "red flag" issues can be reasonably explained—i.e., if the "red flags" are "lowered"—then the exporter may move forward with the transaction or activity. On the other hand, if the reevaluation does not adequately resolve the "red flag" issue, then the transaction should not proceed, and an exporter may consider taking further actions, such as:

• Blocking all further contact or orders from that particular customer;

• Reporting the customer to U.S. enforcement authorities;

• Investigating all prior transactions with that customer to confirm that no "red flags" or positive knowledge of export violations were present in any prior transactions;

• Investigating all related transactions to ensure that "red flags" have not been present in other prior transactions with other customers; and

• Filing a voluntary disclosure with

However, if no "red flag indicators" are present following the receipt of information from the customer, the exporter may proceed with the transaction or activity in reasonable reliance on the information received. U.S. export control laws and regulations do not place a responsibility on the exporter to inquire about or verify the customer’s representations so long as the exporter has no reason to discount the validity of the customer information. Reasons to doubt the validity of customer information may include the following:

• A lack of understanding of the information requested;

• Unexplained changes in the information provided;

• A history of red flags in prior transactions;

• Information provided without proper diligence or issued from a source unlikely to have knowledge of the information provided; or

• A statement by the customer indicating that it is relying on suspect information, such as an out-of-date product sheet or website reference, in making representations.

It is important to recognize that knowledge possessed by any company employee can be imputed company-wide, making the entire company liable for U.S. export controls’ violations technically caused by a single person. These types of violations most frequently occur among companies which have not developed export compliance processes to identify and address denied party information and "red flag" indicators which may be received by sales personnel, engineering personnel, order entry personnel, or shipping personnel without ever coming to the attention of those responsible for export compliance within the company. Unless procedures are in place to ensure that all relevant information is screened and reviewed with each export transaction, and unless all company employees are trained to understand and meet their individual responsibilities under the compliance processes, companies are merely playing a waiting game until they themselves become subject to enforcement scrutiny.

In summary, exporters are required to "know their customer" in any export transaction, and to confirm that none of the information provided by their customer is indicative of an actual or a potential export violation. Only a properly functioning export compliance program can detect the possible presence of denied parties or the existence of "red flag" indicators in a proposed transaction. Failing to have an export compliance program that allows exporters to "know their customer" can lead to significant export controls’ liability even if the product itself may generally be exported without a license.

This article is presented for informational purposes only and is not intended to constitute legal advice.

Jason Matechak

Reed Smith

Keith Coleman

Reed Smith

Benjamin Lindorf

Reed Smith