Nota Bene Podcast Ep. 169
The State of the Semiconductor Industry with Reid Whitten of Sheppard Mullin
Thank you for downloading this transcript.
Listen to the original podcast released December 20, 2023 here:
https://www.sheppard.com/notabene-540
In this episode, Reid Whitten, Managing Partner of Sheppard Mullin’s London office, joins host Scott Maberry to discuss the state of the semiconductor industry, including the U.S. regulatory approach and the lessons it holds for other industries centered on advanced technologies.
Guests:
About Reid Whitten
Managing Partner of Sheppard Mullin’s London office and leader of the firm’s CFIUS Team, Reid Whitten’s practice centers on international trade regulations and investigations.
Reid is a member of Chatham House, the UK's Royal Institute of International Affair, as well as an adjunct lecturer at the New College of the Humanities in London, at the Université Catholique de Lille in France and at Wake Forest University in the U.S, He also conducts seminars on regulatory updates for industry groups in the U.S., France, Belgium, Spain and the UK.
A thought leader on cross-border business regulation, Reid is frequently called upon to provide commentary and analysis for television news channels, international newspapers and trade publications. He is also the lead author and editor of The CFIUS Book.
About Scott Maberry
An international trade partner in Governmental Practice, J. Scott Maberry counsels clients on global risk, international trade, and regulation.
Scott’s practice includes representing clients before the U.S. government agencies and international U.S. Department of Treasury’s Office of Foreign Assets Control (OFAC), the Department of Commerce’s Bureau of Industry & Security (BIS), the Department of Commerce Import Administration, the Department of Homeland Security (DHS), the Department of State Directorate of Defense Trade Controls (DDTC), the U.S. Department of Justice (DOJ), the International Trade Commission (ITC) and the Committee on Foreign Investment in the U.S. (CFIUS). He also represents clients in federal court and grand jury proceedings, as well as those pursuing negotiations and dispute resolution under the World Trade Organization (WTO), North American Free Trade Agreement (NAFTA) and other multilateral and bilateral agreements.
A member of the World Economic Forum Expert Network, Scott also advises the WEF community in the areas of global risk, international trade, artificial intelligence and values.
Transcript:
Scott Maberry:
Welcome to episode 169 of the Nota Bene podcast. I'm your host, Scott Maberry. My guest is International Trade Lawyer Reid Whitten, and we are talking about the state of the semiconductor industry. Before I introduce Reid, I'd like to thank our listeners in over 100 countries worldwide. We're glad you're tuning in and please keep the feedback coming. It definitely influences our programming. You can email me directly with your comments and suggestions. My email address is in the program description. My guest, Reid Whitten, is the managing partner of the London office of a law firm of Shepherd Mullin. Reid is a frequent and valued guest on this show and a good friend. He's an international trade lawyer and also teaches international trade law to law students and undergraduates. He leads the law firm's semiconductor industry team, which is a multidisciplinary team of lawyers serving the sector.
We've talked a lot on this program about the trade war between the United States and China. Over and over our discussions have turned to a specific technology. It's a device that can cost a few pennies to several hundred thousand dollars. It's as ubiquitous as a pencil, but it's regulated like a strategic national asset. We're talking of course about semiconductors. The average car is estimated to have over 1200 semiconductors in it. I counted more semiconductors in my office today than paperclips, and yet, the U.S. government has published over 600 pages of regulations on the export of these devices and the know-how for making them in just the last 18 months. And as we'll see in today's episode, the way those regulations work has lessons for lots of other technologically advanced industry sectors. So let's talk about the state of the semiconductor industry. Let's jump in. So we're talking about the state of the semiconductor industry.
So, why are we talking about semiconductors in this episode? So we've got an audience that is very broad and why are we focusing on such a narrow slice of industry in this particular episode? I mean, you and I both practice international trade and that encompasses the trade of everything. Everything that crosses a border is regulated in some way, whether it's a good or a service. And I know you have more than a dozen semiconductor clients that I know of and that you lead the Shepherd Mullin semiconductor team. And, I've actually seen you on TV doing interviews about U.S./China relations. And, every time that happens, it seems like the discussion comes around a semiconductor. So why are you focused on the semiconductor industry right now?
Reid Whitten:
Well, thanks Scott, and thanks for having me on again to talk about semiconductors.
Scott Maberry:
Great to have you.
Reid Whitten:
Every time we talk about U.S., China, it does come around to those. And let's not forget, we, you and I, are focused on semiconductors, because we have semiconductor clients and you're also on that semiconductor industry team. And yes, it's not the only industry that we serve. We have clients all over the space, aerospace, defense, manufacturing, banking, telecoms, universities. Really, as you said, anything that crosses a border will be regulated, folks will have questions about it, and we usually have the answers to those questions. But semiconductors are critical right now because they are in a strange position. And, I was talking with a client of ours in the Netherlands and a chief counsel for them asked me a great question. He said, "What other industry has this regulatory issue? What other industry is regulated like semiconductors?" And I said, "Finance? Because they have lots of rules that follow their products around the world." He's like, "No, no, no. Finance is different. What manufactured product is regulated like this?"
And, we thought about it for a while. And there is, as far as I can tell, no other product that is as heavily regulated as semiconductors but also as prevalent, right? So, you have enormous amounts of restrictions on chemical, biological, nuclear items, but they are not everywhere. They have national security threats and we don't want them diverted places, so we have lots of regulations around them, but that's a narrow slice of what is bought and sold around the world. You have things like pens, and pencils, and chairs, and they're bought and sold around the world, but they're not heavily regulated. But semiconductors are as ubiquitous as pens, and pencils, and chairs. They're in literally everything electronic that we use these days. And, at the high end, they're regulated as much like nuclear items as they are like anything else. So you have this very interesting confluence and only in the semiconductor industry of ubiquity and extreme regulation.
So, it is a place where an international trade lawyer like myself or like you can add real value. And I think that that's why our clients are really interested in a lot of discussions with us these days. And it's why it's been a focus of my practice and of our practice for the last few years.
Scott Maberry:
Yeah, I think you're absolutely right and I think it's a very important insight for every business to understand. And, as I've been thinking about this since you had that conversation, I've challenged myself to think of something that has the same combination of ubiquity and heavy regulation. And there isn't one I can think of. And the example that came to me is sitting in my office right now, I have as many semiconductors sitting with me as I have pens and pencils, so they're just as ubiquitous in my office as a pen or pencil. However, there's probably only one or two items in my office that I cannot lawfully export to China right now or to particular end users in China at least, and those are electronic devices. And so, I think, if you polled every office in the world, you'd have a similar answer. And that makes it a really unique situation, because 25 years ago that wasn't really true. They weren't as ubiquitous and they weren't as highly regulated.
Reid Whitten:
That's right. And you make a good point. So, I know that we like to talk about what is current in both world events and the law on this show, but the history here is important because the change that we are seeing in the regulation of semiconductors is a microcosm of the change that we are seeing in the way export controls are designed and implemented. And so, before everyone who hasn't already turned this off, because they're like, "Oh, I'm not the semiconductor industry." Turns off their, well, radio or digital equivalent, we should mention that what's really interesting about how semiconductors are being regulated now is that those regulations are new and developing. So we're seeing innovation in the way that the U.S. Department of Commerce is regulating these items and that innovation is something for which the rest of industry should be prepared, because there are tools and weapons that are being unveiled and unleashed now in the semiconductor industry that are at the disposal of regulators and maybe unleashed elsewhere.
Scott Maberry:
I think you're absolutely right about that too. And I think we have to think about that with our clients. We're constantly advising clients, both in and outside this industry, about what's coming in the future in terms of regulation that's going to affect your business model. And we'll talk a little bit later about some of that big picture that's happening. One piece of the big picture you've already mentioned, which is the way semiconductors are regulated now as a model for the way other strategically important goods are going to be regulated in the future. And also, more generally, the reason for that type of regulation is a massive change in U.S. national strategy and foreign policy that you've encapsulated on this show previously with the term technological containment. And, I think, almost any business would benefit from understanding what's going on in U.S. policy on technological containment. So we'll get to that in a minute.
Let's start first though, talking about what is new in the regulation of semiconductors. And for everyone in this industry, you already know that's what happened this past October with regulations propagated by the U.S. Department of Commerce, Bureau of Industry and Security or BIS. So let's talk about those regulations.
Reid Whitten:
All right. So, well, those regulations are an update, he says making air quotes, to regulations that were promulgated in October of '22, which were 140 pages of new regulations in October of 2022 that really started to change the way this industry was regulated. It brought in a number of new elements that we can talk about in a minute. And what's really interesting about this update is that first it's 435 pages, so it's a pretty solid piece of reading.
Scott Maberry:
It's not a cute little update to the extent you ever think of regulation as cute.
Reid Whitten:
It's not an asterisk of a footnote tidying up the margins. It's substantive. And, what's interesting about it, and this is one of the first things we can pull out as a lesson is that BIS, the agency or the office in the Department of Commerce, the promulgate against these regulations, is paying attention to how these regulations are put into practice and how companies operate within the regulations or around the regulations, and is adjusting to a developing situation. We have sometimes indulged in a bit of levity about how regulation can be a somewhat hand-fisted when it's trying to catch up with technology. And that's sometimes true, but there's been a change and there's a much more nuanced understanding. I think you saw the history of that star or the change that there was that more nuanced ability to regulate export controls in ECR.
Scott Maberry:
Yeah, referring to export control reform during the Obama administration, which was one of the huge bellwether changes in regulation in my field and yours in our lifetimes, that was a very concerted effort to get much more sophisticated about the way the U.S. government regulated technology around the world. The idea of export control reform in the Obama administration was essentially to erect higher walls around fewer products and technologies. So, a lot of things happened during that era that were very, very good for regulation and also very, very good for business. And I attribute that really to a couple of people at BIS. One is Eric Hirshhorn and the other is Kevin Wolfe. They were the leaders of this movement to really refine the way the United States regulated exports. And it's been a change for the better, at least in terms of how sophisticated the regulators are. And I think, the legacy of that inside the agency now is a bunch of smart people thinking about a bunch of smart ways to regulate industries. And their big focus right now is this industry.
Reid Whitten:
Yeah. And so, one of the ways that we saw that in this update is that... So, there are a couple of lessons to takeaway. So one is that there are new controls, right? Across industries, you should know that regulation is not static. There were new export control classification numbers, ECCNs, that came out with the 2022 regulations. And, interestingly, those controlled semiconductors, among other things, based on their performance, how quickly they could process information. And those controls basically said if you send a semiconductor that can reach this level, it's going to be controlled for export to these places, China among them.
And so, companies saw that they could send several semiconductors that individually would not meet that threshold, and then they could be put together in an end item and reach that threshold, and not violate the law, and not even really be a circumvention of law. It was lawful under how the law is as drafted. And this is the nuance, this is the element of seeing how it goes into practice and seeing how industry reacts and adjusting. BIS now has come up with this idea of performance density, and performance density is effectively the amount of processing that a chip can do divided by, or over the amount of area on the chip. So, how much performance, how much processing do you get out of a certain amount of space? And that, again, a very simple and elegant adjustment allows the regulators to capture items that they weren't capturing before.
And so, not only can we take away that there are changes to the rules, so we can't assume that the status quo will remain, but the changes will adjust to things that we think are going to be working now and we're going to have to adjust with them. So if we have something that we think is close to the line, the line might move to encompass it. Obviously actually, you have that in the new notification of advanced computing exemption. So there's a line that BIS has drawn in the semiconductor market and there is a gray area below that line for which you have to give a notification to BIS in order to export it.
So you haven't met the threshold, but if you're close and it's for a data center, which is one of the concerns that the commerce depart is trying to address, you're going to have to notify them in order to use this exemption. They have 25 days to tell you whether or not your notification is accepted and you can export under that license exemption. And, what that's going to do is give the regulators an idea of how much the area just below the line is being used and they can then determine whether or not there'll be another adjustment. But that's, as far as I know, an entirely novel approach for BIS to take on this.
Scott Maberry:
And it's one of several in this regulation. This October 17th regulation that you're talking about took a long time to come out. We were anticipating it for months and months before it came out, if I recall correctly. And, part of what it did, and the reason it's over 400 pages long, and it took so long, is that there's a lot of this really subtle, sophisticated stuff going on. And, I like that you pointed this out, because we should expect this at other industries. We expect to see other industries where commerce is going to want to know what the trade looks like that's out there that's not being regulated. And this is a great way of figuring it out.
Putting in a requirement that says if your export is, in a defined way, near the line of what's controlled, you're going to now have to notify us about it in a defined way. And, they've gotten much better as every agency has at data mining and data analytics. And they'll start looking at those data right away, first of all, in this industry under this regulation and figure out whether they need to make more regulation. And, the difference when you think about it between last year or all of the last 100 years of regulation where they had to feel around blindly what the trade was doing and pass a regulation and then figure out whether that was working or not, versus this approach, which is, "We're going to have a regulation that allows us to get a feel for what the trade is like and then regulate it." I think is really important change. And I would be stunned not to see this as an approach in regulating other industries.
And while we're at it, we may as well talk about what we think the other industries are that are going to be follow-ons to the semiconductor industry. The main ones I'm thinking of right now are artificial intelligence, autonomous vehicles, probably anything in aerospace and defense, and anything in advanced computing just outside of chips. But there's a reason why they've started with chips, which we ought to mention and think about a little bit, which is that, semiconductors are at the heart of basically all of those advanced industries.
Reid Whitten:
Right. They're the pinch point that you can grab onto and regulate from there. Now, it's not easy to do, and as you said, the information collection is vital to that, but it is probably the jumping off point, because anything smaller than semiconductors and you're getting down to little components, the control of which would be too much of a burden on the supply chain, anything past semiconductors, and you've already started making end items, so that if you don't regulate the semiconductors, then the wherewithal to make those end items can get to places where you don't want it to be.
So, the salty nuance of the regulation and the clever construction of these regulations is not just a better way of stopping business from happening, which is I think is often how regulations are perceived. I think that companies should recognize that there are opportunities in all of this, because in their work you can pull out ideas that will then help you anticipate what comes next. So for instance, that gray zone, if you are trading in that gray zone and you're using the NAC license exception, you may want to make some plans about where your sales are going, because it may not be available to you in a year or two years and that helps you do your logistics planning. It's not great, but it gives you a market advantage, because then you can focus your resources on businesses that you can continue and that won't be burdened by a license requirement at some point in the future.
Scott Maberry:
Let me pause you there for a second and have you draw that out just a little bit more, because I think that's a really good idea and it's something that our audience should think about as a matter of business strategy. So, say the hypothetical again where you're in the industry, in the sector or sub-sector that's taking advantage of this license exception, what do you think somebody could be doing? First of all, what does that band of exports look like? And, what do you think somebody in a business strategy position ought to be doing right now to take advantage of that and create an advantage in the future?
Reid Whitten:
Well, so I'll make it a little more general. So, BIS has drawn a line of the performance of some integrated circuits, some semiconductors, yes. They've drawn that line and any item that's being exported that's over that technological capability line will need a license to be exported and may not get that license to certain countries, including China. BIS has implemented below that line a requirement for notification to BIS in order to export. So it's not a license, it's a notification in order to use an exemption where your item is going to be used for a data center, which is a threat vector that they've seen, because they think the data center chips are going to be the generative AI frontier.
So, they draw a line, they draw a gray zone below that line, they require reporting in that gray zone, that's signaling that somewhere in that gray zone or all of that gray zone may eventually be subject to a license requirement that's currently not subject to. And so, that's the previewing that they're giving industry. So, industry now has time, we consider it like a proposed rule, right? It's being floated, it's being socialized, they're putting the feelers out to see how that's going to go. And that's just within the semiconductors. That's not happened anywhere else, but it may. You may happen in autonomous vehicles, right? They might be like, "All right, you've advanced this far in autonomous vehicles, but these autonomous vehicles could become autonomous military drones for China and we don't want autonomous military drones for China.
So, if you're advancing in that direction, we're going to say, you can't send it to China if it beats this tech spec. And we're going to check and see how much trade there is in this gray area just below that tech spec." And then, you'll know in your area that maybe your development, especially if you're selling it to the Chinese market or you have some Chinese companies in your supply chain or your logistics chain, your production facilities there, that you might have to start planning ahead. And that's what I think is really interesting about the semiconductors for all other industries is that the regulations that are happening here are showing us ways that we can prepare in other industries for regulations that are coming.
Scott Maberry:
Absolutely. And within this industry, the point you're making that I want to draw out is that if I have a business unit that is making money right now on products that are within that gray band that are subject to this license exception and subject to this notification requirement, I ought to take a very careful look at my business unit and do two things. One, I need to plan for whether that is going to become more regulated in the future.
So, that may indicate how much money I pour into that sector or what geographies I'm focusing that sector on and I ought to be prepared. And the better I am able to understand that particular business unit, the more of a competitive advantage I'm going to have in the future, because it's going to enable me to put into place whatever things I need to as a business to be nimble if and when the regulation on that little band of performance is increased. That's the point. And, companies that are able to do that now are going to have an advantage. And then, companies outside the sector that are able to recognize that that's a way that the government's going to start regulating, they're going to be able to be on the lookout for that type of regulation in their industries.
Reid Whitten:
And that's not the only type. There are so many different tools and weapons that we're seeing in the recent regulation in the semiconductor industry. The enhanced foreign direct product rule is a great example.
Scott Maberry:
Let's get to that. So we're talking about now another aspect of this October 17th rule, which is a revision, and as you say, rightly an enhancement of what's been known as the foreign direct product rule. So let's just start with that now.
Reid Whitten:
Yeah. All right. So, it kicked off in 2020, and Huawei is the great example of it because that was the first target for this. But effectively, BIS designed... They didn't stumble upon it, they actively designed a way to target a single company and make sure that nothing U.S. gets in the supply chain. And that's not just some U.S. origin content that's in a German made item that then goes to Huawei. That is, if you design a semiconductor in China, and you manufacture that semiconductor in China, and you sell that semiconductor in China to Huawei, you may still require a license if your semiconductor was designed on U.S. origin software. The foreign direct product rule makes it such that any item made outside the United States that is the foreign direct product of U.S. origin technology, or U.S. origin software, or U.S. origin plant or major component of a plant, which, let's just say, major equipment, if any of that is U.S., it doesn't matter that you did the design and the manufacturer outside the United States, it's still the foreign direct product of the U.S. origin, and it's controlled, and you need a license to sell it to the targeted entity.
Scott Maberry:
Now, license from the U.S. government?
Reid Whitten:
That's right.
Scott Maberry:
A license from Department of Commerce, Bureau of Industry and Security to sell your Chinese origin article or wherever it's originating to Huawei, wherever that sale occurs.
Reid Whitten:
Exactly. And so, the point is, that, I mean, the U.S. government does not assert jurisdiction over everything that's made from anything U.S. It does do that in the cases of these targeted entities. And so, all it needs to do is name a company, name their affiliates, and just put them on this list, and put a footnote, and they are now subject to this enormous block of a long, long, long chain back to the U.S. So, it's a really interesting target. It's currently used primarily in electronics and it's currently used with primarily Chinese companies and their affiliate companies elsewhere. But it could be used, as you say, across industries. And so, it's a fascinating extension of extraterritoriality. I'm calling it super extraterritoriality, because I like the ring of that word, but I made it up. And, it could be called anything you like. What it really shows is that the U.S. has found a capability to reach out and do surgical strikes on certain entities that it sees as operating in contravention of U.S. national security interests or foreign policy.
Scott Maberry:
Yeah. To me, it doesn't ring, because it's hard for me to get my mouth around the word extraterritoriality, but I do like it, because once you master how to say it, you're almost in a Disney movie and singing a song with a difficult word in it.
Reid Whitten:
Right. So yeah, we watch a lot of Mary Poppins in this house. I've got a 2 and a 4-year-old. So, I did actually... No.
Scott Maberry:
I thought so. Hence, the appeal. But it is true that it is both extraterritorial in the way that U.S. regulation has been for a long time, but also supercharged in a way in the sense that the rule is so broad that it can literally affect the bottom line of a non-U.S. company as it has with Huawei.
Reid Whitten:
Yeah.
Scott Maberry:
And it's so surgical that it could do that at the stroke of a pen tomorrow to any other company. And that's important for our audience, not just because our audience is Huaweis of the world or the future Huaweis of the world, our audience are suppliers to them. And that is going to affect your bottom line if tomorrow another company is added to the footnote in the regulation, that is the foreign direct product rule. And that's the beauty of this regulation if you're a regulate.
Reid Whitten:
And the expansion of that enhanced foreign direct product rule has already started, it was used in Russia controls. So we termed them Russia sanctions as a catchall, but it's actually export controls that go along with Russia sanctions. But there are foreign direct product rules on exports to Russia and even stricter ones on exports to Russian military. So, the U.S. has in 2020 designed the new tool and has now used it in other scenarios. So it can be something that spreads.
And another one that you should absolutely consider that was novel as of the October, 2022 regulations, it's U.S. person activity. And you and I have talked about this a couple of times. This continues to be in the latest in the October 17th ones that came out in this year. I think you've been practicing in this industry for 100 years, so you probably know better. But I think, it's a new area of regulation for the commerce department. They don't typically regulate services or activity of U.S. persons. Is that right?
Scott Maberry:
That's right. And, we always used to be able to draw a bright line between if I'm looking at commerce regulations, I'm looking at the flow of goods and technology. And, by contrast, if I'm looking at the Treasury Department Office of Foreign Assets Control sanctions and regulations, that's the agency that gets into, in addition to trade and goods, also the trade in services and the activities of persons. So yeah, to see a U.S. person activity regulation starting in 2022 in a commerce department regulation, that was a surprise. And so, let's talk about what that regulation does more or less, and whether that's been expanded by the new October, 2023, Reid.
Reid Whitten:
All right. So it targets U.S. person activity, in that, U.S. persons are prohibited from providing non-EAR information, which just about any information. BIS has walked that back, it's not every bit of information, but basically, if U.S. persons are facilitating the provision of non-U.S. items, moving technology and software, to Chinese fabrication facilities that are capable of making advanced node ICs, that is the highest end integrated circuits that the semiconductors that we are aiming to control, those U.S. persons would need a license for that activity. And that was clarified but not changed or reduced at all in the latest regulations. And I think what that does for companies in all industries is caused them to do a quick check and say, "Okay, we're selling items that are controlled. And we're making them in Europe. We're selling them to China, and that's all lawful. But if I have a U.S. president of our Dutch subsidiary, of our Spanish affiliate, of our German parent company, is that U.S. person involvement going to at some point be regulated, because this U.S. person activity rule, novel as of last year, it may be something that BIS attempted to use elsewhere."
Scott Maberry:
I agree with that. And so, if we think about what the paradigm case of that regulated activity would be, I think it would be if there's a U.S. person, meaning a U.S. citizen or lawful permanent resident helping a Chinese company and helping them in a way that is providing substantive assistance in the production of advanced node integrated circuits, that person needs a license from the U.S. Commerce Department to do that activity. That's brand new. Which by the way, I hadn't really thought of this until now. That's another reason that other industries ought to be paying attention, because that person might be a consultant and have not necessarily think of themselves as a semiconductor person, maybe just a management consultant.
So, I think there's a sector there that ought to be paying attention to these rules, because newly there are regulations on American person activity. But more broadly as you say... And we've explored the contours of that rule with some of our clients already. And, we've more or less determined that if there's a U.S. person sitting in a Chinese joint venture in a facility that's capable of manufacturing those ICs, but isn't assisting in that manufacturer, like they're doing logistics for the rest of the business, that person isn't really covered, even though it felt like they would be when this rule first came out. But, if you're a U.S. person and you're involved in or assisting a Chinese company manufacturing advanced note chips, that activity is covered. And then more broadly, coming to that bigger point you're making, that's a type of regulation that could be expanded immediately tomorrow in any other industry at the stroke of a pen with a new regulation from commerce, then that's very important.
Reid Whitten:
Yeah, I agree. It is not an easy one to navigate, particularly where you have a Chinese national who came and did a study to the United States.
Scott Maberry:
Yep.
Reid Whitten:
Became a citizen here, started a business here, not a green card, and maybe has a family here in the United States, and then wants to build his machines or his ICs back in China. That person's business is really under threat, because its leader is now prohibitive from activities that support their-
Scott Maberry:
I think this regulation is designed to capture a fairly narrow band of activity, but it's going to capture a lot more than some people think, I think.
Reid Whitten:
Yeah.
Scott Maberry:
And, we should say, and I think this is a segue into something else I want to talk with you about today, if you zoom out just a little bit and think about why this rule came about, it's because as we've discussed in earlier episodes, the United States has determined as a matter of national security policy that it is in a global struggle with China over technological dominance in certain defined areas of technology, semiconductor production being one of them.
But, if you want to know where the next one of these regulations is going to occur, you might look at the other areas that U.S. policy has determined that the United States is in a global struggle for technological dominance with China, and those include the ones that we mentioned and some others too. But we mentioned autonomous vehicles, and artificial intelligence, and robotics. So, you wouldn't be too surprised to see a reg in the next year or two in any of those areas restricting U.S. person activity, for example, aiding China's ability to manufacture those things. And, I think that's a segue into the idea of technological containment, which is part of how the United States is implementing this strategy that was first announced in 2017 of engaging in global struggle for technological dominance with China as the United States' adversary. So, talk to me a little bit about the state. What is technological containment and what's the state of U.S. technological containment of China right now?
Reid Whitten:
So, technological containment is another term I made up. You guys leave me alone over here to write blog articles.
Scott Maberry:
We do. And then, we put you on podcasts to podcast a lot of wacky ideas to 10,000 people at a time.
Reid Whitten:
Yes, that's a good one. Well, I think it holds up, because containment is the Cold War notion that the U.S. would surround communist Russia with allies that would then contain the spread of the ideology. And so, we're taking it here to mean the alignment of U.S. policy with that of its allies to surround China and cut it off from the technology, or commodities, or software that would help its technological or economic advancement in that global struggle that you referenced earlier.
So, there are a couple of examples of that. As we discussed before, the U.S. has been working with the countries that are at the leading edge of semiconductor manufacturer and the equipment to manufacture those semiconductors, Japan and the Netherlands primarily, and have been pushing on them diplomatically to say, "Look, can you get your export is in line with ours, because that's important that the means for creating these semiconductors aren't available to China, even though our allied nations." So, last year there was a commitment from the Netherlands and Japan to start to move towards the U.S. lines of restrictions on China. But then, Netherlands came a little bit short. They decided that there were some areas in semiconductor manufacturing equipment export controls that they didn't think they would go as far as the United States. They had different red lines. But Japan did line up with the United States.
And so, in these new regulations, there is a carrot. There is a benefit that Japan has that the Netherlands does not. And it has to do with the de minimis. We could get into the technical details, but basically, if you have a U.S. laser in your Dutch chip making machine, it doesn't matter what percentage of the value that laser is in your shipping machine, it's going to be considered U.S. origin, even though it's made in the Netherlands for export to China because of this rule. It's a 0% de minimis rule. It applies in the Netherlands, but it does not apply in any country whose export controls on manufacturing machines are the same as the United States.
So the carrot there is, "Well, that's Japan. That's just Japan. They did it the way we wanted them to. So we're not going to give them this restriction that we are going to give to every other country. And for most of the countries it won't matter. But for the Netherlands it will." And so, it's a really interesting carrot and we'll talk about the stick in a second to put into our regulations incentives for countries to align their policy with ours.
Scott Maberry:
Awesome. And, another example of the subtlety of the regulatory writing. This is something I really don't think the commerce department... I mean, not to cast dispersions but could not really have managed to write this regulation a few years ago. They've grown much more sophisticated in writing regulations. So that's the carrot. The message to the allies is, "Align your export controls with ours against China mostly, and we will give your industry whatever sector we're talking about, a little bit of an advantage over the other ones that don't align with ours." Which is, you might say evil genius. It's really good regulatory writing. What's the stick?
Reid Whitten:
The stick is not exactly the inverse of the carrot, but it is clear that it's part of this containment. And, if China is the country that the U.S. is aiming to contain, this is a widening of the perimeter of that containment. So, in these regulations, there are prohibitions on exports to China, but there are also prohibitions on exports to a group of countries the U.S. sees as being a risk for diversion to China. And so, there are varying sizes of that perimeter. But at its broadest, there is a prohibition on exports to 40 countries. They're groups D1, D4, and D5, and includes countries like the UAE and Saudi that are fairly normal trading partners of the United States, but they are viewed as having such a risk of diverting technology to China that they are subject to some of the same controls that are present on exports to China. So, the stick is, if we think that you are a country that would risk being on the other side of our containment wall, we're going to spread that wall out and we're going to cut you off as well.
Scott Maberry:
What's interesting to me, and it's occurred to me a couple of times in this conversation, is that, during the Cold War, the idea of containment was fairly easy to visualize because it was literally physically containing. You could paint different countries on the map, either red or blue, depending on whether the dominoes were falling. Here, just talking about Japan and the Netherlands, that gives you a sense of the global scale of all of this, because one of those countries borders China, but the other one doesn't. But technologically, that's how we're containing. And it's the same with Saudi and UAE. And, those are just two examples. If you take all of those group D countries that you just mentioned, as you say, there's 40 of them at least, but not all of them are in physical proximity. But, the idea is that they are in the world of the global supply chain now, they're close enough.
Reid Whitten:
Right. Yeah, it doesn't matter. The containing is definitely not a wall around a contiguous group of countries. It can be anywhere. And it's very much based on the third country's policy with respect to the United States and with respect to China.
Scott Maberry:
Yep. And, to bring it back to the beginning here, I do want to think about what's the broader message. And maybe, I'd ask you to think of it in two different ways and let's talk about it. One is, in the semiconductor industry, what's the big takeaway we're talking about here? And the other is, in every other industry that is our audience here, what is the big takeaway from where we're at with this type of regulation?
Reid Whitten:
Okay. So for the semiconductor industry, yes, things are changing and will continue to change, but we do have to know that there's a dynamic balance that's required here. Recall that while the advanced node, the highest end chips are something the U.S. wants to keep for itself and its allies, there is no country in the world like China for the scope and scale of mature node chips. We, the U.S., the entire world economy need the economic engine that is the Chinese chip fabrication. And so, there's going to have to be a balance. I think that you saw that in President Xi and President Biden talk. You saw President Xi said, "There's room for both of us to succeed." Which echoes what Secretary Yellen said when she was in China.
And so, are they ever going to hold hands and sing? Probably not. But, it is clear that both sides are looking for a way that work can be done together. The U.S. would prefer that China stay entirely in its lane and only do mature node manufacturer. China would rather have indigenous production of the highest end chips. Then we're probably going to end up somewhere in between, as the two sides push back and forth. But I think that the semiconductor industry should recognize that there're going to be ways to do business. And, the paths might be a little narrower, but they're going to be there because the two sides, I think, need each other and will continue to each other. The infrastructure that's been built around the global production of semiconductors is too great to undo. Although it's shifting, it's changing, but I don't think it's going to be broken apart.
Scott Maberry:
Semiconductors and everything else. And this reminds me of a couple things briefly before we go to the other industries. But, you and I have long had the debate of, is this going to be a Cold War with China that results in a separation of the two and a decoupling and a anti-globalization? And I've said, "That's my instinct." You've said, "There's too much business between the two to let the whole thing fall apart." And what you just said is a great example of that position in that debate. And reminds me of a headline I read just the other day, it was brilliant. It talked about United States and China. And it called them the most successful joint venture in history, talking about U.S./China trade relations. So, turning from the narrow sector, the semiconductor sector into the rest of the world, what for you is the takeaway for every other industry from understanding what's happening right now in semiconductor?
Reid Whitten:
I think that other industries should be looking at the semiconductor industry not necessarily for the details of the regulations. You can leave that to your outside counsel to read the now totaling nearly 600 pages of semiconductor regulations. But, for the takeaways, for the big lessons, what can we learn about the regulation of new technologies under new export control classification numbers? What can we learn about super extraterritoriality as it's expressed in this control on U.S. person activity or this control under the foreign direct product rule? What do we learn about technological containment? If we are making something somewhere else and the US wants to go and lean on that country to get them in line with the U.S. policy, how is that going to impact our business? What ways are we susceptible to that? And I think that by learning those things, companies can get an advantage in their market because they can anticipate the type of regulation that they may see based on the strategic risks that their industry presents, the global footprint that it has, and can plan and prepare based on what they've seen being regulated in the semiconducting industry.
Scott Maberry:
Well, that's great. And, I don't think I have anything that I would add to that. This has been really good, and I really appreciate having you all in again to talk about these regulations and about the broader impact of them. So, I think we'll end it there. And thank you very much for spending some time with me. This has been great.
Reid Whitten:
It's a pleasure, Scott. Thank you so much.
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