Why Two Chinese Telecom Companies Have A Few Congressmen Completely Freaked Out

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Cisco Systems has ended a sales partnership with ZTE Corp. after an internal investigation into charges that the company sold Cisco networking gear to Iran, according to Reuters.

This comes at the same time as an 11-month investigation by the House Intelligence Committee that warned American companies to stop doing business with Chinese tech firms Huawei Technologies Ltd. and ZTE Corp..

Huawei immediately issued a statement saying the report "employs many rumors and speculations to prove non-existent accusations." And the Committee has been accused of being short of specifics in its report, including clear incidents of theft by either company.

But Huawei hasn't been able to get acquisitions in the U.S. for a while. In 2007, Huawei teamed up with Bain Capital to acquire 3Com Corp, a company which sold network security services to the Defense Department. That move was blocked by regulators. It was also forced to abandon its 2010 acquisition of 3Leaf Systems, according to the Wall Street Journal.

So why is everyone so concerned about Huawei and ZTE?

The biggest source of worry for the House Intelligence Committee has been the involvement of the Chinese government in both companies, and the national security risks that they could pose.

The concern is that the gear produced by both companies could contain malicious code that would allow the Chinese government access to data, and that even software updates pose a similar threat.

These risks were heightened when earlier this year ZTE Corp. admitted that one of its phones had a back door that could allow others with a "hardwired password" control of the device, according to Reuters.

Over $300 billion in U.S. trade secrets were stolen in 2011, according to U.S. Cyber Command, and the Committee's report attributes part of such cyber theft to China:

"Recent cyber-attacks often emanate from China, and even though precise attribution is a perennial challenge, the volume, scale, and sophistication often indicate state involvement.

As the U.S.-China Commission explained in its unclassified report on China’s capabilities to conduct cyber warfare and computer network exploitation (CNE), actors in China seeking sensitive economic and national security information through malicious cyber operations often face little chance of being detected by their targets."

The report alleges that Chinese telecom companies give the Chinese government the opportunity to "tamper with the United States telecommunications supply chain." The Committee also questioned the company's claims that its U.S. subsidiaries operated independently of the company's headquarters.

In fact, one of the biggest reasons the committee is concerned about Huawei is because of its ties with the Chinese government and its failure to disclose these ties. From the report:

"Throughout the investigation, Huawei consistently denied having any links to the Chinese government and maintains that it is a private, employee-owned company. Many industry analysts, however, have suggested otherwise; many believe, for example, that the founder of Huawei, Ren Zhengfei, was a director of the People’s Liberation Army (PLA) Information Engineering Academy, an organization that they believe is associated with PLA, China’s signals intelligence division, and that his connections to the military continue.

Further, many analysts suggest that the Chinese government and military proclaim that Huawei is a “national champion” and provide Huawei market- distorting financial support."
...
"Huawei states in its defense that all economic institutions in China are required to have a state Party apparatus inside the company. This is not, however, a compelling defense for companies seeking to build critical infrastructure in the United States. Indeed, experts in Chinese political economy agree that it is through these Committees that the Party exerts influence, pressure, and monitoring of corporate activities.

In essence, these Committees provide a shadow source of power and influence directing, even in subtle ways, the direction and movement of economic resources in China. It is therefore suspicious that Huawei refuses to discuss or describe that Party Committee’s membership. Huawei similarly refuses to explain what decisions of the company are reviewed by the Party Committee, and how individuals are chosen to serve on the Party Committee."

The Housing Intelligence Committee also said that the company's refusal to offer details about its research and development programs added to concerns about the involvement of Chinese military or intelligence services.

Huawei vice president William Plummer, in an interview with CNBC, defended Huawei saying it financed itself the way other multinationals do and categorically denied any government involvement:

"Enterprise law in china requires a KFC China or Wal-mart China or Cisco China or Huawei to allow for the existence of a communist party committee within the organization. Huawei, like these other companies, allows for that existence. The communist party committee doesn't have any interaction with or influence on our business operations."

The Committee also had similar concerns about the influence of Chinese state owned enterprises and the Communist Party on ZTE Corp. Additionally, it argued that ZTE was uncooperative with the investigation saying that answering the Committee's questions could subject the company's officials to "criminal prosecution in China".

Besides national security threats, the Committee also accused Huawei of violating intellectual property right laws in the country. The Committee's report cited interviews with former Huawei employees that said that Huawei wasn't complying with laws about intellectual property rights and specifically referred to the company's litigation with Cisco.

Cisco had paired up with ZTE Corp. to increase its foot print in China and to directly compete with Huawei, and Huawei has long maintained that a lot of the criticism leveled against the company is directly driven by its competitors.

Some expect this report along with recent U.S. complaints filed with the World Trade Organization about Chinese rare earth export restrictions, and tariffs on Chinese solar panels to heighten trade tensions between the U.S. and China.

Meanwhile China's commerce ministry issued a statement today saying it "strongly opposes" allegations that Huawei and ZTE Corp pose a national security threat to the U.S.. Ministry spokesman Shen Danyang said the move by the U.S. would be a set back to investment between companies from both countries.

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