When the Bush administration unveiled the details of regulations meant to discourage missile proliferation, the exporting community gave a collective groan.
Numerous categories of previously unregulated commodities were brought under "foreign policy" export controls. The only good news was that exporters would at least know which countries to avoid.
But if they do not avoid them, their bankers could be in for some bad news.
A bank that knowingly finances an export - perhaps even of seemingly innocuous goods - to a buyer involved in building missiles can now be held to have violated U.S. export control law if neither the bank nor the exporter obtained a Commerce Department export license.
New Categories of Control
Although dissolution of the former Soviet Union and the end of the cold war prompted a considerable liberalization of U.S. export controls imposed for national security reasons, the Saddam Husseins and Moammar Gadhafis of the world inspired the United States and its allies to regulate broad new categories of exports.
The new controls target nuclear weapons and missile proliferation, as well as chemical and biological warfare, under the rubric of the Enhanced Proliferation Control Initiative.
In certain product areas, the regulatory framework has been in place for some time. For example, President Bush announced in February 1991 that 39 chemical-weapon precursors would be subjected to new foreign policy export controls.
Although the framework for controls on missile proliferation was published shortly thereafter, interagency disputes delayed announcement of the specific countries that could be regulated until June, when the Commerce Department announced that missile projects in Brazil, China, India, Iran, North Korea, Pakistan, South Africa, and 14 Middle East countries would be controlled.
Buried in the rules, however, is a potential bombshell for banks.
In its zeal to insure that the missile proliferation controls are effective, the Commerce Department reaches the activities of U.S. persons who "knowingly support an export, reexport, and transfer" that lacks the required "validated license or other authorization."
"Support" is then defined to mean any action, including financing, by which an export is facilitated. Until June, these provisions were merely the subject of academic curiosity, With the announcement of newly controlled missile projects and countries, however, it has become clear that the rules could have far-reaching consequences for banks that finance exports.
Depending on how the rules are interpreted, banks might very easily wind up violating laws that carry severe criminal and civil penalties.
A fundamental principle underlying letters of credit is that their terms and conditions are regarded as independent of the underlying transaction. Where, beneficiaries present the documents called for by a letter of credit, banks generally must honor it without further inquiry.
This fundamental premise is threatened by the export regulatory scheme.
Although the drafters of the rules sought comprehensive ancillary powers to aid in enforcement, the full ramifications of these regulations as applied to financial institutions have not been thought through. Taken literally, the new rules can operate much like presidential authority under the International Economic Emergency Powers Act, which has been used many times to freeze letters of credit and to block assets.
Gulf War Precedents
Many banks are all too familiar with the disruptions that followed when the Office of Foreign Assets Control blocked letters of credit involving transactions with Iraq and Kuwait at the commencement of the Gulf War. The authority the Commerce Department has invoked under the new rules could potentially have the same broad reach.
Commerce Department officials might take issue with this characterization.
They might, for example, point out that the rules only require exporters or their banks to obtain individual validated licenses before letters of credit can be honored and do not specifically block assets.
By the same token, however, if banks engage in transactions subject to validated licensing requirements without obtaining export licenses, they will violate the export control law.
With the June announcement of new controls on missile proliferation, some banks now face exposure unwittingly.
By regulating without advance notice all transactions in which exporters are aware that their products will be used in the "design, development. production, or use of missiles" in any of the countries I have mentioned, the Department of Commerce has asserted licensing jurisdiction over numerous contracts that are in the course of being performed.
For example, a U.S. exporter may have contracted with the Brazilian producer of the VLS space-launch vehicle to ship machine tools that previously could be exported under a general-destination license.
Assume that these goods are now made and ready to be exported. Any bank that pays this exporter under a letter of credit opened for its benefit - without first obtaining an individual export license - violates the law if the bank knows of the destinations and use of the product.
An Ambiguous Term
No doubt the most difficult areas of interpretation will be to determine what constitutes a bank's "knowing" of the regulated use and whether a duty to inquire is mandated.
Will the bank know of this use if the documents presented with the letter of credit indicated that the export would be used somehow to make missiles?
Rather than deal with this issue in the rules, the preamble to the notice announcing the rules' final version simply points out that the regulations deliberately avoid any definition of the term "knowing." When questioned on this point, Commerce Department officials expressed surprise that banks did not file comments on the proposed rules in March 1991, when invited to do so.
In another unusual provision buried deep in these rules, the Commerce Department has established a procedure to help banks obtain the requisite knowledge.
For example, when a bank is formally told by the department that a validated export license is required for a particular deal, no aspect of the financing could be consummated until a validated license was obtained.
It is unlikely, however, that the department will have either sufficient resources or adequate data to tell many banks whether export licenses are required for particular deals.
Lacking further guidance from the department on how the knowledge standard will be applied to banks that honor export letters of credit, banks must ask themselves whether the risk of violating U.S. export law warrants extraordinary inquiries into the underlying transactions - not only for letters of credit already opened but also for future transactions.