United States: International Client Alert - June 2005

DDTC Begins Returning License Applications Based On New Interpretation Of Part 129 

A number of companies that regularly apply for licenses to export defense articles controlled by the International Traffic in Arms Regulations ("ITAR"), promulgated under the U.S. Arms Export Control Act, have begun to report that license applications are being returned by the Department of State’s Directorate of Defense Trade Controls ("DDTC"). These applications are being returned because the DDTC suspects that an agent listed as a foreign consignee may be a broker who has not registered as required under Part 129. The DDTC has recently informally adopted an interpretation of Part 129 of the ITAR which, in most exporters’ views, widely expands the definition of brokers who are required to register with the DDTC. This new and more expansive definition has led to the increased returns of license applications.

Part 129 defines a broker as any person who, in return for a fee, acts as an agent for another in arranging sales of defense articles. Virtually all exporters of defense articles employ such local agents to assist in promoting and negotiating contracts with foreign governments and militaries. However, not all brokers are required to be registered with the DDTC. Under Part 129, only the following brokers are required to register: (a) U.S. persons wherever located and (b) foreign persons located in the United States "or otherwise subject to the jurisdiction of the United States." It is the "otherwise subject to" language that is at the heart of the current debate.

The DDTC has never issued formal guidance as to the meaning of "otherwise subject to" U.S. jurisdiction. As a result, exporters have had to rely on their own interpretations of this language. A number of approaches have evolved. Many exporters applied some form of a "contact" analysis under which an agent/broker would be otherwise subject to U.S. jurisdiction if the broker had owners resident in the United States, a subsidiary in the United States, had an unrelated business in the United States, or had some other significant contact with the United States. Under this interpretation, a broker would not be otherwise subject to the jurisdiction of the United States if its only contact with the United States consisted of telephone, facsimile and email communications between the agent and the exporter.

On January 4, 2005, the federal appeals court decision in United States v. Yakou seemed to read the statute and the regulations to narrow the registration requirement to U.S. persons wherever located and to foreign persons physically present in the United States. (See Powell Goldstein International Client Alert, dated February 1, 2005). Under that analysis, even if a foreign person had affiliates in the United States, no registration would be required. The United States Government filed a motion with the appeals court asking it to clarify its opinion on this issue. As a result of that motion, the appeals court, on May 9, 2005, amended its opinion to indicate that the registration requirement also applied to foreign persons "otherwise subject to" U.S. jurisdiction. The amendment noted that the United States’ lawyers had not argued that the defendant, a permanent resident of the United States, was "otherwise subject to" U.S. jurisdiction. Accordingly, as amended, the Yakou decision no longer has any bearing on interpretation of the scope of the phrase "otherwise subject to" U.S. jurisdiction, and this issue has been returned to square one.

Although DDTC staff had indicated that it would not follow Yakou before the court released its amended opinion, the amendment gave the DDTC free hand to apply whatever interpretation it desired for "otherwise subject to" U.S. jurisdiction language. Currently, it appears that the DDTC has informally adopted the position that a broker "otherwise subject to" U.S. jurisdiction means a foreign agent who enters into an agreement with a U.S. exporter of defense articles to broker defense articles for the exporter. Under this view, the agreement itself makes the broker "otherwise subject to" U.S. jurisdiction irrespective of whether the broker has any other contacts at all with the United States.

The DDTC had promised to provide formal guidelines on this matter for some time but none has been forthcoming. It seems clear that rather than promulgate an official interpretation, which could be easily subject to judicial review, the DDTC has now determined to unofficially implement its extremely broad reading of "otherwise subject to" the jurisdiction of the United States.

A review of the legislative history of the provisions under which Part 129 was adopted in the Arms Export Control Act indicates that this reading of "otherwise subject to" U.S. jurisdiction is incorrect. This extremely broad reading of the language also comes into conflict with other provisions of Part 129 as explained in more detail below. Finally, such a reading may significantly hinder the ability of U.S. exporters to retain foreign agents, thereby significantly impeding the ability of those exporters to sell defense articles to U.S. allies abroad.

An amendment to the Arms Export Control Act which requires registration of brokers as well as notification or approval of various brokerage transactions (the "Brokering Amendment") was passed by Congress in 1996. Most commentators have seen the Brokering Amendment as a response to growing concerns that private brokers were supplying various weapons, particularly small and light arms, that were being used in human rights violations such as the 1994 Rwandan genocide.

Because of anticipated opposition to a broker registration and licensing scheme from the defense industry, the Brokering Amendment was given a low profile. As a result, the legislative history is sparse but still sufficient to provide some guidance in the interpretation of the Brokering Amendment and any rules passed thereunder. The House Report on the Brokering Amendment stated that the new provision:

[p]rovides those new authorities to ensure that arms export support the furtherance of U.S. foreign policy objectives, national security interests and world peace. More specifically, in some instances U.S. persons are involved in arms deals that are inconsistent with U.S. policy. Certain of these transactions could fuel regional instability, lend support to terrorism or run counter to a U.S. policy decision to sell arms to a specific country or area. The extension of U.S. legal authority under this provision to regulate brokering activities would help to curtail such transactions.

In other words, because these brokers were not exporting from the United States and were not brokering U.S. weapons, the arms export laws did not reach those transactions prior to the adoption of the Brokering Amendment. Brokers, therefore, could easily frustrate policies which the export laws were designed to implement with respect to regional stability, non-proliferation, national security and the like. The brokering amendment was designed to close that loophole.

The broad interpretation of "otherwise subject to" U.S. jurisdiction that the DDTC has sought to implement goes much farther than closing the loophole that the brokering amendment was designed to close. By expanding coverage of Part 129 to all agents who have agreements with U.S. exporters of defense articles, the DDTC is adding a second layer of regulation to export transactions. In those transactions, the DDTC already has the opportunity to implement U.S. policy by denying or conditioning the license for export. Congress intended for the brokerage amendment to cover transactions that the DDTC would otherwise not have the opportunity to review.

In addition, this broad brush application of Part 129 to all overseas agents of U.S. exporters seems inconsistent with other provisions of Part 129. For example, Section 129.4(a) requires that a party registering as a broker submit documentation that the party is either incorporated in the United States or qualified to do business in the United States. This requirement suggests that brokers under the rule would already be sufficiently connected to the United States so that they would need to have either incorporated here or obtained qualification to do business in the United States as a foreign corporation. It does not appear to contemplate, nor is there any conceivable policy reason to require, that a foreign person wholly outside the United States who has an agreement with a U.S. exporter must file documents qualifying the broker to do business in the United States in order to register with DDTC.

An even greater inconsistency occurs between the broad definition of "otherwise subject to" U.S. jurisdiction and the licensing provision of Part 129. Under Sections 129.7(c) and 126.13(a)(4), license applications for brokerage transactions must be submitted by the broker and must be signed by an "empowered official" of the broker who must be a U.S. citizen or permanent resident. Where the U.S. exporter of defense articles is dealing with a foreign agent, it is usually the case that the agent will not have an officer or director who will be a U.S. citizen or permanent resident. The application of this provision will make it impossible for the broker to obtain a brokerage license even where the related export license would be easily granted by the DDTC.

These provisions are not only inconsistent with the new broad definition adopted by the DDTC, but also if they are applied they will potentially prevent U.S. exporters from using any foreign agents in entering into agreements with allied governments and militaries throughout the world. Foreign agents are unlikely to wish to subject themselves to U.S. taxes and other non-export regulations and therefore are likely to refuse to file documents qualifying them to do business in the United States. Nor are they likely to agree to make a U.S. citizen or permanent resident a company officer so that they could have an empowered official sign license applications. As a result, defense exporters, who often cannot effectively do business in foreign countries without a local agent, will be unable to export defense articles to U.S. allies even in cases where if a license application were filed it would be routinely granted. Accordingly, although the DDTC may think that its expansive definition of "otherwise subject to" U.S. jurisdiction advances U.S. interests abroad, it may instead harm those interests.

On May 20, 2005, Diagnostic Products Corp. ("DPC") and a wholly-owned Chinese subsidiary reached an agreement with the U.S. Securities and Exchange Commission (the "SEC") to settle a probe of alleged violations of the Foreign Corrupt Practices Act (the "FCPA") and agreed to pay disgorgement of $2,038,727 and prejudgment interest in the amount of $749,895. DPC’s Chinese subsidiary, DPC (Tianjin) Co. Ltd. ("DPC Tianjin"), separately pled guilty to charges brought by the U.S. Department of Justice (the "DOJ") and agreed to pay an additional criminal penalty of $2,000,000. DPC is a publicly-traded company based in Los Angeles that manufactures automated laboratory instrumentation and related products in the field of immunodiagnostics. The FCPA prohibits, among other things, U.S. companies from making bribes to foreign government officials in order to obtain or retain business. The FCPA also requires publicly-traded U.S. companies to keep accurate books, records and accounts and to devise and maintain strong internal accounting controls.

The SEC cease-and-desist order indicates that DPC, through DPC Tianjin, regularly made payments to doctors and laboratory staff employed by state-owned hospitals in China in order to induce them to purchase DPC products. According to the SEC order, most of the payments were made by DPC Tianjin’s sales staff to the recipients in cash, and totaled more than $1,600,000 between 1991 and 2002. The payments were typically calculated as a percentage of the sales made to the Chinese hospitals involved and allowed DPC to earn roughly $2,000,000 in profits. Moreover, the SEC stated that the payments were improperly recorded as legitimate marketing expenses on DPC Tianjin’s books and records. DPC Tianjin’s financials were part of the consolidated financial statements included with DPC’s public filings.

The SEC materials state that DPC discovered the conduct when DPC Tianjin’s auditors raised Chinese tax concerns related to the payments. Thereafter, DPC ordered DPC Tianjin to cease the payments and conducted an internal review of the matter. The review led DPC to revise its internal code of ethics and certain of its procedures and to adopt an FCPA compliance program.

The DPC settlement represents a growing number of FCPA investigations focusing on the international activities of U.S. medical and pharmaceutical companies. In 2002, Syncor International Corporation, now a unit of Cardinal Health, Inc., and its Taiwanese subsidiary pled guilty to violating the FCPA and agreed to pay a total of $2.5 million in fines and penalties in connection with benefits given to physicians employed by government hospitals in Taiwan, Mexico, Belgium, France and Luxembourg. In June 2004, Schering-Plough entered into a settlement with the SEC and agreed to pay a fine of $500,000 arising from charitable donations made by an affiliate in Poland. The charity was headed by a Polish government official who also served as the head of a regional health fund that provided money to hospitals for the purchase of pharmaceutical products. The SEC alleged that the contributions were made to induce the government official to purchase Schering-Plough’s pharmaceutical products for use in Polish hospitals. In March 2005, Micrus Corporation agreed to pay $450,000 in fines to the DOJ arising from payments made to doctors employed by government hospitals in France, Spain, Germany and Turkey as incentives to purchase Micrus medical devices.

The Syncor and Micrus cases, together with the DPC settlement, demonstrate that U.S. enforcement agencies are increasingly focusing on U.S. companies or their foreign subsidiaries that pay commissions, referral fees and other incentives to doctors employed by foreign state-owned hospitals in order to obtain business. These cases underscore the fact that doctors and staff at state-owned hospitals outside of the United States are considered foreign officials under the FCPA; gifts or other benefits given to them to secure the sale of products can therefore constitute prohibited bribes under the statute.

In addition to the fines and penalties imposed by the DOJ and SEC, DPC agreed to appoint an independent monitor to review on an annual basis DPC’s compliance with its internal FCPA policies and procedures for a period of three years. The SEC order prohibits DPC from retaining the compliance monitor on a privileged or confidential basis and requires that the monitor report its findings in writing every year to DPC’s board of directors and to the SEC. The enforcement agencies have imposed independent compliance monitors in most of the recent FCPA settlements. Public statements made by personnel at the DOJ and SEC indicate that the agencies intend to make continued use of this tool.

*The CBP document can be found at:

http://www.cbp.gov/linkhandler/cgov/import/communications_to_industry/trade_2004/trade_answers.ctt/trade_answers.doc

In yet another example of the Department of State and the Department of Commerce stepping on each other’s toes in the export control arena, the Department of Commerce’s Bureau of Industry and Security ("BIS") has announced that it is likely to adopt regulations that would require BIS approval of exports that already would require approval by the Department of State’s Directorate of Defense Trade Controls ("DDTC").

According to remarks made to the Eighth National Forum on Export Controls by Peter Lichtenbaum, Acting Undersecretary of BIS, BIS will propose rules to require licenses for export to China of non-dual-use goods and dual-use goods that would normally not require licenses for export to China. Under these "catchall" regulations, a license would be required where such goods are for the use of the Chinese military. According to Lichtenbaum, all such applications would be reviewed under a policy presuming denial.

BIS is either unaware of, or unconcerned by, DDTC regulations that currently require approval of many such exports. The DDTC requires prior approval before a U.S. company can provide a "defense service" to a foreign government – including China. A "defense service" is defined as furnishing assistance in the design, production or use of defense articles. The provision of certain items that are not defense articles to the Chinese military might well be a defense service under DDTC regulations. For example, provision of computers to the Chinese military certainly could assist the Chinese military in its design and use of weapons and other defense articles. Accordingly, provision of those computers would only be prudent after obtaining DDTC’s approval of a Technical Assistance Agreement pursuant to which the computers would be sold to the Chinese military.

Obviously, there are some articles that could, under DDTC rules, be supplied to the Chinese military without qualifying as a "defense service" (e.g., musical instruments to its military bands) and others which would likely be a "defense service" (e.g., computers, design software, etc.). The line in many instances may be difficult to draw, leading most exporters to err on the side of over-inclusion. As a result, the "catch all" rules mentioned by Mr. Lichtenbaum, if proposed and adopted, could mean that shipment of purely civilian items to China might require approval of two agencies, whereas shipments of defense articles and dual-use items would require the approval of only one agency.

The Bureau of Customs and Border Protection ("CBP") just released on its website answers to a number of questions that were posed at the last Customs Trade Symposium conducted in January 2005.* A number of interesting issues that have not otherwise been addressed publicly by CBP are addressed in this document. Some of the more significant issues raised in the CBP responses are summarized here.

• Customs is developing an Air Cargo Security Strategy to interdict the shipment of terrorists, terrorist weapons and components, and other implements of terror into the United States. This initiative is separate from the inspection of outgoing cargo by the Transportation Security Administration ("TSA") pursuant to the last Department of Homeland Security Appropriations Act.

• A regulation requiring all ocean-going containerized cargo to be sealed utilizing a high security bolt seal meeting the specifications of International Standardization Organization Publicly Available Specification 17712 (ISO/PAS 17712) has been drafted and is currently under review for implementation by the end of the year.

• The CBP and the Food and Drug Administration are in discussions to see if there is a method of coordinating submissions under CBP’s advance manifest rules and the FDA advance notice rules both as to timeframe and content in a manner consistent with the statutory requirements imposed on both agencies.

• The CBP rejected criticism that U.S. customs and their foreign counterparts in Container Security Initiative ("CSI") ports were not cooperating and sharing information. (A recent GAO report, however, underlined the problems in CSI ports by noting that up to 28 percent of U.S. -bound containers targeted by U.S. customs for inspection in foreign ports are never inspected by foreign customs counterparts.)

• The decision to exclude third-party logistics ("3PL") providers from the Customs-Trade Partnership Against Terrorism ("C-TPAT") was reaffirmed by CBP which has no current intention to expand the program to include them. The rationale for this exclusion, according to Customs, is that it considers 3PL providers while reviewing the programs of importers, carriers and brokers.

• There has been significant feedback from C-TPAT participants that membership has not in fact resulted in fewer inspections of imports by C-TPAT participants. The website document dismisses these concerns and asserts that C-TPAT participants can expect "six times fewer examinations for security-related reasons than non-C-TPAT members, and four times fewer traderelated examinations than non-C-TPAT members."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.