Huawei and Beyond: Increasing Scrutiny of China’s Technology Sector

In December 2018, Canadian authorities arrested Meng Wanzhou, based on a U.S. extradition request. Ms. Wanzhou is the CFO of Huawei, the world’s largest telecom equipment provider and third largest mobile phone manufacturer. In January 2019, the U.S. Department of Justice (DOJ) charged Huawei and Meng with 23 counts of fraud related to alleged breaches of U.S. sanctions and trade secret theft.

Huawei is one of the latest Chinese technology companies under scrutiny. China’s technological strength has given rise to several globally competitive, high-tech companies, such as internet giants Alibaba, Tencent and Baidu, telecom equipment providers Huawei and ZTE, the world’s largest power battery manufacturer CATL and the world’s largest drone producer DJI. Correspondingly, concerns about China’s increasing technological power, in terms of national security, intellectual property rights, data privacy and human rights, and sanction compliance, have also been on the rise.

In the context of ongoing trade tensions between the U.S. and China, we take a closer look at a series of incidents involving China’s high-tech companies and explore the impact these incidents might have on them. Although it’s been reported that some of these incidents may be influenced, in part, by political factors, we provide suggestions for mitigating relevant ESG risks.

Growing scrutiny of Chinese high-tech companies

Huawei is not the only Chinese company under investigation for violating U.S. sanctions. In March 2017, the U.S. Government fined ZTE USD 1.19 billion for breaching sanctions imposed on Iran and North Korea. Then, in April 2018, the U.S. Department of Commerce again denied export privileges to ZTE for seven years for failing to comply with the settlement terms of its previous sanctions case . That decision was reversed in July 2018 after the company deposited USD 400 million in a U.S. bank escrow account as part of a USD 1.3 billion settlement agreement.

Despite settling the ZTE sanction case, in August 2018 U.S. Congress passed a law essentially banning U.S. government employees and contractors from using ZTE and Huawei technology. Other countries such as Japan, Australia and New Zealand have also blocked Huawei and ZTE from building fifth-generation (5G) networks in their countries due to concerns about information security and the companies’ possible links to the Chinese government.

Concerns around Chinese companies’ acquisitions and investments have also been steadily increasing, with Western governments intervening to block potential deals. For instance, in September 2017, U.S. President Donald Trump blocked a Chinese-backed private equity firm from buying U.S.-based chipmaker Lattice, citing national security concerns as the deal involved technologies with potential military applications. In July 2018, the German government vetoed, for the first time, the possible Chinese takeover of German precision machinery manufacturer Leifeld Metal Spinning. This decision follows the takeover of German robotics maker Kuka by Chinese appliance maker Midea Group in 2016, and Geely Group’s purchase of a 9.7% stake in Daimler revealed in February 2018, making it the top shareholder of the Mercedes brand. Such government interventions are indicative of growing apprehension towards Chinese technology companies.

China’s technology companies have also been under scrutiny for allegedly spying and violating human rights using surveillance technology. In August 2018, Hikvision, the world’s largest manufacturer of surveillance equipment, and its Chinese competitor Dahua, were banned from selling video surveillance and communications equipment to U.S. federal agencies due to security concerns. Earlier that year, NGO Human Rights Watch and media outlets criticized Hikvision for developing surveillance cameras with facial recognition features that were allegedly used by the Chinese government to monitor the Muslim Uighur minority in the Xinjiang region. Similarly, in October 2018, a Bloomberg report described how Chinese subcontractors secretly inserted microchips into servers that wound up in data centres used by nearly 30 American companies. Although the allegations have been denied by the companies involved, these companies will be further scrutinized and could face an uphill battle to regain their reputation.

Impacts and risks for China’s technology sector

The attention paid to high-tech Chinese companies’ market access, acquisitions, and data privacy and security practices could have significant financial impacts for these companies and their investors.

Most directly, the denial of access to some critical markets could significantly affect company profits and the ability to further advance their technology. For example, Huawei and ZTE have invested heavily in R&D to commercialize 5G technology, one of the key technologies for the next decade. Huawei is the leader in 5G technology in terms of market share, but failure to enter certain key markets, such as the U.S. and Europe, would make it more difficult for Huawei and ZTE to recover these investments.

Compared to 4G, the 5G network is more complex and 5G equipment’s security is more difficult to verify. A lack of confidence in product safety and quality could increase costs for manufacturers of critical telecom equipment such as Huawei and ZTE. Moreover, as in the ZTE case, companies could be banned from procuring critical, difficult to replace components from certain suppliers, which could effectively paralyze their operations.

Companies’ ability to obtain advanced technology through overseas acquisitions and direct investments could also be limited. Cross-border M&As are an important means for multinational corporations to enhance their technological strengths and capabilities. Although China already established a strong technological base, reduced access to the global talent and technology pool could damage its ability to integrate the most sophisticated technology from other parts of the world.

Finally, the business uncertainty associated with this scrutiny could damage Chinese tech companies’ relationships with critical business partners and disrupt companies’ operations considerably. For example, in October 2012, almost five years before the ZTE sanction case was first settled, Cisco Systems ended a longstanding sales partnership with ZTE over concerns that the Chinese telecom equipment maker might sell or had already sold Cisco networking gear to Iran.

Addressing risks from uncertainty

We expect the scrutiny of Chinese high-tech companies to persist for the foreseeable future, as they seek to rebuild trust and confidence. In our view, the companies likely to be most affected will be those that that rely heavily on overseas supply chains or markets, those in sensitive subindustries such as IT and telecom equipment, those developing technologies with potential military applications, and companies seeking technologies that are considered crucial to national competitive advantage.

However, the following measures could be adopted to mitigate relevant ESG risks. Investors and business partners of leading Chinese companies may want to engage in dialogues with their counterparts or assess the factors below as part of due diligence and ongoing relationship monitoring:

• Companies should improve the overall transparency of their operations. Most Chinese companies could benefit from more detailed disclosure on corporate governance practices and business ethics management systems. Generally, as we described in our previous article, Chinese companies do not provide detailed information on their remuneration policies and succession plans. They are also less willing to disclose their internal policies relating to business ethics.
• Companies should improve the management of data privacy and security. Best practice includes developing data privacy and security policies and programmes that are designed to address both existing and emerging threats. These plans should be regularly tested as part of security and privacy risk assessments and updated as technology infrastructure evolves. Additionally, companies should disclose more information about their initiatives to ensure data sharing with governments, as part of legally mandated requests for information, follows due process and is as transparent as possible.
• Companies should clarify and publicly disclose strong commitments to address the human rights issues in their operations and those potential associated with their products and services. They should also implement human rights programmes that include internal and external audit procedures to regularly monitor violations, grievance mechanisms and processes to compensate the victims of human rights abuses.