Government Regulation

Seagate's $300M Lesson

U.S. regulators are tightening export control rules with a powerful new tool called the Foreign Produced Direct Product Rule.

By
Larry Sussman
January 26, 2024
I

n April 2023, U.S. authorities slapped a $300 million fine on Seagate Technology LLC (Seagate) for selling computer disk drives to Huawei Technologies Co., Ltd. (Huawei), the Chinese telecommunications giant. This penalty marked the largest ever for a U.S. company accused of violating the U.S. Export Administration Regulations (EAR) described in this article.

The record fine stemmed from a little-known aspect of the EAR called the Foreign Produced Direct Product Rule (the FDPR), part of a recently enhanced regulatory scheme that is poised to reshape America's sanctions regime. It also represents a transformative moment in global trade dynamics, largely due to America’s growing concern about China’s development as an economic and geopolitical rival with access to advanced technology that could be used for military purposes.

Unlike traditional export controls, the enhanced FDPR enables the U.S. to ban the sale of products to specified foreign firms, like China’s Huawei, irrespective of where they are produced in the event they were made with or embed American origin intellectual property. This means that products made outside of the United States by anyone (not just U.S. firms), if American origin intellectual property is utilized, even in seemingly minor processing, can't be sold to foreign firms that are labeled as bad actors by the U.S., unless the government specifically authorizes the sale.

This is the first in a two-part series looking at one of America’s most aggressive export control rules: the Foreign Produced Direct Product Rule. 

In the case of Fremont, California-based Seagate, the maker of hard disk drives (HDDs), its overseas factories utilized two machines to coat surfaces and identify minor defects on Seagate’s HDDs as part of the ordinary manufacturing process. These coating and error detection machines are not produced by Seagate. They are produced by third party U.S. technology companies that have been permitted to export their machines to Seagate for use in its overseas factories. However, each machine is classified as “Listed U.S. Technology,” thereby activating the enhanced FDPR against Seagate’s HDDs. 

In a sense, the FDPR meant that each HDD Seagate made overseas became tainted once they were touched by these coating and error detection machines. As a result, Seagate was barred from shipping the HDDs to Huawei without the approval of the U.S. Commerce Department’s Bureau of Industry and Security (BIS), even though the goods were manufactured outside of the United States.

Huawei company profile and corporate relationships mapping available in WireScreen

Global Ripple Effects

But Seagate's saga isn't just about hard drives; it unveils a new era in export-related enforcement for the U.S. The enhanced FDPR’s extraterritorial jurisdiction, for instance, claims control over semiconductor and other electronics factories worldwide because it affects any factory in the world that relies on American origin intellectual property.

There are also much broader implications for the global economy. While Seagate has already paid a large penalty, non-U.S. companies in other countries like Japan and the Netherlands must also comply with the new rules. This means that Japanese and Dutch firms that have utilized any American origin intellectual property are also restricted from selling to Chinese firms like Huawei, leading to a drop in their exports to China. Indeed, Japan and the Netherlands have already adjusted their own policies in recognition of the U.S.’s enhanced FDPR. Other high tech powerhouses will also be impacted by America’s extraterritorial regulations. Data from WireScreen, a business intelligence platform, provides valuable tools that help track the application of the FDPR to China.

The Export Control Labyrinth

To understand what happened with Seagate, it’s necessary to look at how the U.S. traditionally regulates the sale of American-made goods under the EAR, which have long played a major role in regulating global supply chains originating from the United States. For example, General Prohibition One of the EAR prohibits the export or re-export of items listed on the “Commerce Control List” (CCL), unless a license is obtained from the BIS, or a license exception is available.  

The CCL categorizes items into Export Control Classification Numbers (ECCNs), which are used to determine their level of export control.  ECCN categories cover military items, dual-use items (items that have both civilian and military applications), nuclear, chemical, and biological items, information security as well as encryption technologies, electronics, telecommunications and aerospace items. Traditional EAR enforces its prohibitions based on the BIS’ Entity List.

EAR99 Classification

Under traditional EAR (prior to the advent of the enhanced FDPR), if an item is subject to the EAR but is not specifically described by an ECCN on the CCL, it is classified as “EAR99,” meaning it is not controlled for a specific reason.  For example, legacy or low-tech technology usually falls into EAR99.  While items classified as EAR99 generally do not require a license to be exported, they may still be subject to restrictions if intended for export to an embargoed country, an end-user of concern, or in support of a prohibited end-use.

Indeed, U.S. companies and their trading partners take great pains in seeking to clarify that their products are classified as EAR99 (or not subject to the EAR whatsoever).  As our case in point for this article, technology companies, like Seagate, maintain a dedicated online search tool to ensure their exported products are safely confirmed to be EAR99.

But in April 2023, the days of straightforward export of EAR99 products all changed when the BIS charged Seagate and its Singapore subsidiary with violations of the EAR for selling EAR99-classified HDDs that it manufactures outside of the U.S. to Huawei.  Of a potential maximum penalty of up to approximately $2.2 billion, the BIS reached a settlement agreement with Seagate for $300 million in penalties. According to the BIS, this case constitutes the “largest standalone administrative penalty in BIS history.”

Foreign-Produced EAR99 Products Destined for China Get Tainted

Standard HDDs are often legacy technology and hence are easily classified to be EAR99. Indeed, Seagate freely produces its HDDs in China, Ireland, Malaysia, Singapore, and Thailand for export around the world. More to the point, Seagate was never accused of selling a special type of sensitive HDD that would be classified as other than EAR99. Instead, all of Seagate’s HDDs in this case became tainted pursuant to an unprecedented enhancement of General Prohibition Three of the EAR, known as the FDPR.

The Foreign-Produced Direct Product Rule 

Originally created in 1959, the FDPR was based on a policy prompted by the Cold War. It was narrowly tailored to prohibit the sale of items subject to strict national security controls in the event they were produced overseas either as a direct product of U.S. technology or in a factory utilizing U.S. technology. Given its strict national security focus, the FDPR did not see any action with respect to commoditized items (such as HDDs) and was only slightly amended over time.

But in 2020, the Trump administration enhanced this FDPR, and in 2022 the Biden administration added two additional FDPRs, all three sets of rules activated specifically for China.  Separately, other FDPRs were activated for Iran, Russia, and Belarus. This article covers the first FDPR targeting China in the context of the Seagate case. This FDPR is technically known as the “Entity List FDPR”, in the form of “Entity List FDPR-Footnote 1” and “Entity List FDPR-Footnote 4.” Part two of our article will discuss the Advanced Computing FDPR, and the Supercomputer FDPR, as well as important enhancements to export controls on semiconductor manufacturing items. 

Pursuant to the Entity List FDPR-Footnote 1 and the Entity List FDPR-Footnote 4, an item produced outside of the United States is subject to U.S. export control if the item satisfies the “Product Scope” test and the “End-User” test.

A foreign produced item satisfies the Product Scope test if it is: (1) a direct product of “Listed U.S. Technology” (defined below) or (2) produced by a factory (or a major component therein) that is itself a direct product of Listed U.S. Technology.

A foreign produced item satisfies the End-User test if it: (1) will be incorporated into, or will be used in the production or development of any part, component, or equipment produced, purchased, or ordered by any “Footnote 1 Entity” or a “Footnote 4 Entity” (defined below) or (2) the Footnote 1 Entity or Footnote 4 Entity is a party to any transaction involving the foreign-produced item, e.g., as a purchaser, intermediate consignee, ultimate consignee, or end-user.

For Seagate, the End-User test was easily satisfied because its customer, Huawei, is listed as a Footnote 1 Entity. As such, all of Seagate’s HDDs produced overseas with the help of machines subject to these rules were not permitted for re-export to Huawei without a license from the BIS (and such licenses are not forthcoming). Under traditional EAR, Seagate’s HDDs would not be caught even if exported to entities on the Entity List, like Huawei.

Extraterritorial Reach

The Seagate case illustrates the sweeping extraterritorial jurisdiction of the enhanced FDPR. The products in question do not originate in the U.S. and do not include as one of their components, a technology that is subject to an U.S. export license. Rather, the nexus triggering the rule is the mere fact that a machine, itself subject to an U.S. export license, provided said machine constitutes a major component of the factory producing the products, in effect taints all products it touches.

The enhanced FDPR looks at how products are produced and asks whether Listed U.S. Technology was either used to help produce them or is indirectly embedded in them. Since so many products are made with technology or software subject to U.S. export control or otherwise embed Listed U.S. Technology, the Seagate case represents the beginning of a new era in export related enforcement and penalties.  According to The Economist, U.S. FDPRs “lets the [U.S.] government claim jurisdiction over almost every chip factory in the world, because almost every one contains hard-to-replace American tools.”

But it is not just chip factories.  Taken to an extreme, the products of any overseas factory using certain ECCN classified-American technology or software as their major components can become subject to this enhanced FDPR. WireScreen provides proprietary collections and search features to conveniently track and monitor these controls. 

As of this writing, the type of technology and software constituting Listed U.S. Technology for the Entity List FDPR-Footnote 1 and Entity List FDPR-Footnote 4 purposes are contained in the following table.

The Seagate case also illustrates the technical cascading nature of applying the FDPR.  The machines used in Seagate’s overseas factories were classified as ECCN 3B992, which is not included in the list above (code B refers to equipment in the CCL).  However, the machines themselves were a direct product of ECCN 3E991 technology.  As such, they pass on the FDPR taint to Seagate’s HDDs that were in turn touched by them. 

Footnote 1 Entities and Footnote 4 Entities are uniquely annotated on the BIS’ Entity List which contains all other entities subject to traditional EAR. To date, the Entity List FDPR only applies to those entities on the Entity List with these special footnote designations. Entities on the Entity List which do not carry the special footnote designation are only subject to traditional EAR (meaning EAR99 products may be exported to them).  There are 800 Chinese entities (including their offshore subsidiaries) on the Entity List subject to traditional EAR as of this writing. WireScreen tracks those and separately tracks all designated FDPR entities as shown in the screenshot below.

More Enhancements to Traditional EAR for China

The Entity List FDPR represents an expansion of traditional EAR. As the U.S. began adding more Chinese entities to the Entity List for traditional EAR enforcement, it quickly became clear that the goals for such additions were undermined due to offshore production capabilities. While the Entity List FDPR helps resolve some of these problems, it is only a jumping off point to many more EAR enhancements targeting China.

Conclusion

As will be introduced in part two of our article, the next round of FDPRs issued for advanced computing and supercomputers (in late 2022 and upgraded in late 2023) address China’s indigenous semiconductor industry. These rules target items such as high-end AI chips and related semiconductor manufacturing equipment. According to White House press releases, these rules reflect a fundamental revision of EAR premises. In the past, the premise was to maintain the technological advantage only a couple of generations ahead of strategic competitors under a so-called “relative advantage” concept. The new premise is to maintain “as large a lead as possible” given the importance of these new technologies as they relate to unprecedented leaps in military modernization efforts. WireScreen plays a crucial role by offering vital insights into Chinese companies operating in EAR relevant industries, aiding businesses in navigating complex regulatory requirements.

This is the first in a two-part series looking at one of America’s most aggressive export control rules: the Foreign Produced Direct Product Rule.

Larry is an experienced lawyer who worked for over 20 years as a partner and Head of China at O’Melveny & Meyers in Beijing, and as a partner at Hogan Lovells. As Special Counsel at WireScreen, he specializes in analyzing Chinese ownership structures and their associated national security and sanctions implications.

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