On October 8^th, the U.S. House of Representative’s Intelligence Committee issued an investigative report (the “Report”) on issues related to the operations of Huawei Technologies Company Ltd. and ZTE Corporation.  The Report potentially has far-reaching implications for the U.S. telecommunications supply chain.

Huawei (pronounced Wah-Way) and ZTE are both engaged in the telecommunications equipment industry.  Both companies have U.S. offices and are trying to grow their U.S. operations.

Huawei, a private entity owned by its Chinese employees, was formed more than twenty years ago by Ren Zhengfei, a former officer in the Chinese People’s Liberation Army.  Huawei is now the largest manufacturer of telecommunications hardware in the world.

ZTE, which grew out of Chinese stated-owned enterprises, is now a publicly traded company and the globe’s fifth largest manufacturer of telecommunications equipment.

The Intelligence Committee Investigation

The Intelligence Committee initiated its investigation in November of 2011 in response to the perceived security threat posed by the U.S. operations of telecommunications companies with possible ties to the Chinese government, the Chinese Communist Party and the PLA.  The Report noted that there is an “ongoing onslaught of sophisticated computer network intrusions that originate in China, and are almost certainly the work of, or have the backing of the, the Chinese government.”  In particular, the Report expressed concerns that:

“[m]alicious Chinese hardware or software  . . . would  . . . be a potent espionage tool for penetrating sensitive national security systems, as well as providing access to the closed American corporate networks that contain sensitive trade secrets, advanced research and development data[.]”

The Intelligence Committee concluded that in connection with its investigation:

• Huawei failed to clearly or adequately explain its ownership structure or its relationship with the Chinese government or the Chinese military.
• Huawei failed to clearly or adequately explain the operations, financing or management of its U.S. subsidiary.
• Huawei had exhibited a disregard for U.S. intellectual property rights of other parties.
• Huawei failed to provide details of its Iranian operations or its compliance with U.S. export laws.
• Huawei whistleblowers provided evidence of illegal behavior of Huawei officials.
• ZTE failed to provide the House Committee with answers and evidence in response to key questions (including evidence in connection with its U.S. activities and evidence as to whether they were in compliance with U.S. intellectual property and export control laws).
• ZTE failed to alleviate concerns regarding the degree of control of Chinese stated-owned enterprises in ZTE’s business decisions.
• Both Huawei and ZTE failed to clarify the operation of the Chinese Communist Party within their companies.

The Report’s Recommendations

The Report included multiple recommendations.  However, most relevant for U.S. private sector entities was the recommendation that such entities:

“are strongly encouraged to consider the long-term security risks associated with doing business with either ZTE or Huawei for equipment or services. U.S. network providers and systems developers are strongly encouraged to seek other vendors for their projects.”

Given the pointed warnings in the Report, at a minimum, U.S. companies doing business with Huawei and ZTE should strongly consider conducting enhanced due diligence and testing with respect to any equipment or services received from the two Chinese entities.   Public companies engaged in highly regulated critical infrastructure industries (such as financial services, energy and utilities) may also need to evaluate whether the benefits of doing business with Huawei and ZTE are outweighed by the risks of increased shareholder and regulatory scrutiny given the concerns raised in the House Intelligence Committee’s Report.

Other Bad News for ZTE

Almost contemporaneously with the release of the House Intelligence Committee’s Report, ZTE’s Board of Directors issued an announcement on the Hong Kong Stock Exchange noting that ZTE’s strategic cooperation agreement with Cisco had recently been terminated.  According to press reports, Cisco terminated its relationship with ZTE shortly after learning that ZTE had allegedly shipped Cisco routers and other U.S. manufactured equipment to Iran in violation of various U.S. export laws and regulations prohibiting the export or re-export of goods or services to Iran.

In light of this disclosure (and the House Report), U.S. suppliers should consider adopting heightened controls when transmitting products to ZTE as such suppliers potentially have criminal liability if they have knowledge (or reason to know) that their goods may ultimately be destined for Iran.