Export controls and sanctions shape boundaries of defense deal-making

Export controls govern the export of military and dual-use goods, services and technology (g/s/t). Investing in the defense sector presents a particular set of export control challenges, including navigating trade controls restrictions and having to comply with relevant FDI regimes (an issue we explore in more detail here).

Compliance with applicable export control regulations is at the core of a defense company’s license to operate; a failure to adhere to export controls could result in civil and criminal penalties both for companies and individuals, as well as reputational damage.

Diligence should closely scrutinize a target’s dealings in controlled goods and technologies

When diligencing targets, investors should closely scrutinize a target’s dealings in controlled goods and technologies, including whether the export of controlled items has been properly licensed, who has access to controlled items within the organization, and the maturity of the target’s export compliance program.

Depending on the findings of the DD process and the risk profile of the target, it may be appropriate to include in the deal agreement tailored export control representations, warranties and/or indemnities to address export control risks connected with the proposed acquisition. However, it should also be noted that export control risks may not be covered under certain W&I policies. Post-acquisition, an investor may consider requiring a target company to conduct a review of the effectiveness of its export compliance program.

‘Deemed export’ rule creates risk without physical technology transfers

It is also important to understand that, in some cases, export controls can be triggered even where goods are not transferred across borders. In the U.S., the “deemed export” rule can apply to information-sharing with foreign nationals involved in an investment.

A deemed export occurs when controlled technology, technical data or software is released to a foreign national within the United States. This is treated as an export to that person's country of origin, even though the relevant items do not physically leave the country.

As a broader point, U.S. export control jurisdiction has extensive extraterritorial reach. Military g/s/t are generally governed by the International Traffic in Arms Regulations (ITAR). If an item incorporates any other item that is subject to ITAR, that “taints” the product such that it also becomes subject to ITAR, regardless of how small the other item is or where the original item is manufactured.

Additionally, any item that is “U.S. origin” is subject to the Export Administration Regulations (EAR). This includes both dual-use items and EAR99 items (which are U.S. origin, but not dual-use). Any item that is subject to the EAR remains subject to U.S. export control jurisdiction going forwards, including where that item is re-exported from one non-U.S. country to another.

CFIUS uses export control classifications to determine filing obligations

The Committee on Foreign Investment in the United States (CFIUS) also uses export control classifications to determine filing obligations, treating the investment itself as a national security-relevant transaction even absent any actual export. Mandatory notifications are necessary when a foreign investor acquires an interest in a U.S. business involved in critical technologies, critical infrastructure or sensitive data (so-called “TID” businesses) and a U.S. government license would hypothetically be required to export the relevant TID items to the foreign investor.

The UK has a similar mandatory notification requirement to the Investment Security Unit (ISU) under the National Security and Investment Act (NSIA) in connection with certain acquisitions of target companies that hold military and/or dual-use assets, among other things. (We explore the dynamics surrounding foreign investments in the defense sector in more detail here).

Against this backdrop, investors must evaluate a target’s historic compliance with applicable export control regulations as well as any future licensing requirements. This includes understanding the robustness of the target’s existing export compliance program, establishing the target’s dealings with military and dual-use goods and technologies, and assessing whether the target has obtained all necessary licenses and registrations to deal in such goods and technologies. This analysis should take place alongside FDI due diligence.

Sanctions compliance requires careful checks

Sanctions compliance is another important consideration. Defense companies frequently operate in geopolitically sensitive markets and may have historical trading relationships with countries or entities that have since become subject to sanctions.

Arms embargoes (which prohibit or restrict the sale, supply or transfer of arms and related materials to specified countries or non-state actors) are a prominent feature of sanctions regimes. In addition, many sanctions programs include sectoral measures specifically targeting military and defense activities (for example, the EU and UK sanctions regimes targeting Russia’s defense sector). Investors should therefore assess whether a target company has adequate sanctions compliance programs in place covering OFAC (U.S.), UK, EU and other international sanctions regimes.