New Export Rule for Defense-Funded Technology Raises Alarms

By Sandra I. Erwin

U.S. manufacturers have hailed the Obama administration’s six-year effort to ease the red tape for exporters. Defense companies that make products with commercial applications especially have benefitted from reforms that have sought to draw a clear distinction between technologies that are uniquely military and those that are dual use.

One of the key goals of the reforms was to specify what items are regulated as “defense articles” by the State Department — as opposed to commercial products regulated by Commerce — and end the ambivalence that has vexed exporters.

So it might come as a surprise to Pentagon contractors that a new rule that affects electronic equipment would by default classify as a “defense article” any electronics developed with Defense Department funding, regardless of whether the technology is a sensitive military system or intended also for civilian applications.

The regulation, which affects electronic systems whose development is funded by any Defense Department contract dated July 1 or later, has the potential to become a compliance nightmare for companies that rely on government contracts to design products that they hope to commercialize later.

The rule has industry attorneys scratching their heads because it seems to run counter to the spirit of the administration’s export control reform effort. Many industry CEOs have said the reforms have helped simplify the licensing process and removed onerous red tape from the exports of commercial technologies that once were categorized as defense articles under the U.S. Munitions List.

The electronics provision could have significant ramifications, said Jason M. Silverman, a partner at McKenna Long & Aldridge who specializes in government contracting. “Basically anything with a digital component that was developed with Defense Department funds would be controlled under ITAR.”

The International Traffic in Arms Regulation controls exports of defense-related products and services. The U.S. Munitions List has 21 broad categories of products that are subject to the ITAR. The reforms have focused on each separate category. Electronic equipment and systems fall under category 11. The newly introduced federal regulation applies to “developmental electronic equipment or systems funded by the Department of Defense via contract or other funding authorization.”

The definition of what is being regulated under ITAR is very broad, Silverman told National Defense. The government arguably is departing from the original purpose of export control reforms, which was to stop using catchall designations for product categories. “There’s no clarity on what is developmental,” he said. “This definitely has the potential to expose companies” that may not be aware that the technology they are developing under a defense contract falls under ITAR control. “I can see people being caught off guard.”

The specific impact of the rule on exporters might not be known for years, but attorneys like Silverman and others are warning of a possible regulatory quagmire particularly for small businesses that might not have the legal expertise. Big defense contractors have a compliance apparatus in-house to deal new regulations, but startups and commercial firms may be ill equipped to handle complex regulatory requirements, said Silverman.

A sticky situation would be, for instance, a company developing technology that, even though it was funded by the Pentagon, would have applicability in civilian markets such as medical devices or surveillance sensors. In such cases, the only way to avoid ITAR control would be to have the contract specifically state that the technology is both for “military and civilian applications.” Another option would be to file a “commodity jurisdiction” request to the State Department that would exempt that product from the ITAR.

The rule could come into play for any U.S. company that does any offshore research, development or manufacturing.

“Government contracting officers and contractors are going to have to be sensitive to this,” said Silverman. For contractors, especially, there is a lot at stake if all of a sudden they find themselves having to comply with regulations of which they were not aware. This is precisely the type of confusion that export control reforms were intended to avert, he said. “There’s supposed to be added clarity to these categories. You’re supposed to be able to classify items as either military or commercial and the reform was supposed to facilitate that process.”

Under the new rules, contractors might have to factor the cost of ITAR compliance into their negotiations with the government, or they could work out an agreement so the contracting officer states the product has commercial applications and therefore would not be ITAR controlled.

The notion that a product is ITAR controlled by nature of its funding is not new in export regulations, Silverman pointed out. “But this takes it a step further.”

A similar provision was put in category 15 for space systems. Hosted payloads and other subsystem development funded by the Defense Department would automatically be ITAR controlled unless it is exempted by language in the contract or by a State Department commodity jurisdiction ruling. Under category 8 (aircraft) the same rule covers developmental aircraft funded by the Defense Department.

The issue with category 11 is that, unlike aircraft, the lines between military and civilian application in electronic equipment and systems are much fuzzier so the rule could impact a wider universe of companies that make products in this category.

It is conceivable that, as a result of this rule, commercial companies might think twice before taking Pentagon money for any development work out of fear of falling under the ITAR regime, although that should not be a deterrent, said export attorney TJ Ogden. Companies should not use the ITAR as a crutch or fear the regulations, but should make sure they have proper knowledge of export control rules and set up a compliance program to deal with both the State and Commerce departments, said Ogden, who is director of defense exports at Defense Export & Logistics, a division of Pacific Propeller International.

Most of the export control reforms in general have been “very positive,” he said, although the electronics rule is likely to cause some confusion. “It would be important for the government to make sure they make regulation more specific as opposed to broad brushing all electronic systems.”

Topics: Defense Contracting, International, Procurement

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