Wall Street Journal (Nov. 19, 2010)

Small Deal Brings Scrutiny to Huawei

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Huawei Technologies Ltd., whose efforts to buy big U.S. companies have been stymied by security concerns, has landed in hot water in Washington for acquiring a small technology firm without first running the deal by the government.

In May, the Chinese telecom gear maker paid $2 million to acquire staff and intellectual property of 3Leaf Systems, a Bay Area start-up that developed technology for making collections of server computers work together like a more powerful machine.

Huawei and former 3Leaf executives say they didn't think the acquisition required a review by the Committee on Foreign Investment in the U.S., or CFIUS, because they didn't buy all of the company's assets. The inter-agency body reviews acquisitions that could have national security implications.

But Pentagon officials, who found out about the acquisition after it was completed, disagreed and have taken the unusual step of asking the company to retroactively clear the deal with CFIUS, people familiar with the matter said.

The dustup over such a small purchase is a reminder that U.S. security officials are keeping Huawei on a short leash. Huawei has grown quickly overseas to become the world's No. 3 seller of telecom network equipment, but security concerns have thus far kept it from completing major acquisitions or winning big contracts in the U.S. market.

Attorneys representing Huawei submitted a CFIUS application for the 3Leaf deal late last week, company executives said. Retroactive reviews have only happened in a handful of cases. If CFIUS decides the deal poses a threat to U.S. national security, the panel could force Huawei to sell the company or limit its use of the technology it purchased. The Treasury Department, which speaks for the interagency panel, declined to comment.

Huawei executives insist they weren't trying to hide anything from the government and note that they filed with the Commerce Department seeking to classify the technology under export control requirements before the company completed the acquisition. The Department of Commerce does not have the authority to stop an acquisition.

"From the outset, we've been very transparent," said Bill Plummer, vice president of external affairs for Huawei USA. "At that time the perception was because of the unique nature of the activity and the acquisition of the patents that it simply wouldn't trigger a CFIUS review."

The administration views the 3Leaf transaction differently, since the company has been repeatedly turned away from deals. In 2008, CFIUS blocked the Chinese telecommunications firm and Bain Capital from acquiring U.S. electronics manufacturer 3Com due to national security concerns. The company's acquisition attempts since, including an attempt to buy into Harbinger Capital LLC's high-speed wireless network, have been quashed due to security-related concerns as well, according to a report by the U.S.-China Economic and Security Review Commission.

The 3Leaf transaction falls into a gray area for CFIUS. The start-up had received more than $67 million in funding from investors like Intel Capital and LSI Corp., but put itself up for sale early this year after its efforts to raise more money were unsuccessful.

Huawei bought intellectual property and hired 16 of the roughly 50 employees at 3Leaf, leaving behind hard assets like buildings and equipment for creditors. CFIUS doesn't review patent purchases or hiring, but the panel felt Huawei effectively bought the company, people familiar with the matter said.

The incident comes as Huawei seeks to repair its image with U.S. officials. In an effort to crack into the U.S. market, the company has hired a bevy of former U.S. officials and lobbyists to make the case that it doesn't pose a threat to U.S. security.

Stewart Baker, an attorney with Steptoe and Johnson and former assistant secretary for policy at the Department of Homeland Security, said the incident shows Huawei has a ways to go. "At a minimum, it shows they still don't understand Washington," he said.

Politics can be an issue, so companies need to be conservative, said Nancy McLernon, chief executive of the Washington-based Organization for International Investment, an association representing foreign companies that invest in the U.S. "Politics and the overreaction of political concerns factor in a great deal with these companies," Ms. McLernon said.

Huawei has been accused of having close ties to the Chinese government and military. Huawei has repeatedly denied such links and says it will open its equipment and software to third-party inspection. Its gear is widely used in Europe.

Huawei executives continue to build their presence in the U.S., having closed deals with smaller operators like Clearwire Corp. and Cox Communications Inc.

WHAT IS CFIUS?

· What it does: The Committee on Foreign Investment in the U.S., or CFIUS, was created by Congress in 1950. It serves the president in reviewing mergers and takeovers by foreign companies that may have an impact on U.S. national security.

· Who serves on it: An inter-agency body whose nine voting members include the heads of the Treasury, Defense, State, Homeland Security, Commerce, Justice and Energy departments.

· Major areas of interest:

· Natural resources and technology that may be critical for national defense.

· How it works: Companies voluntarily file with CFIUS. There is a 30-day review process, and potentially another 45-day investigation. Based on that information, the president makes a formal decision to permit or deny the acquisition. The entire process is confidential.

· Limitations: The process is limited to mergers and acquisitions. CFIUS doesn't review greenfield projects or investments in physical structures. It also doesn't have oversight over the purchase of intellectual property or the hiring of employees.

Since creating its North American headquarters in 2001, the company has opened 13 offices and eight R&D centers throughout North America. Its American work force doubled in the past year to more than 1,000, and executives plan to hire several hundred more people in 2011.

Huawei has also increased its patent portfolio in the U.S., purchasing patents and filing for hundreds based on its own technology. In June, Huawei bought most of the patent portfolio of the U.S. network equipment maker Avici Systems. The Massachusetts-based company was liquidated in June 2009. Huawei didn't hire any Avici employees or purchase assets aside from the patents.

"To build up your reputation, you have to do that step by step," said Charlie Chen, senior vice president for North American marketing and development for Huawei USA. The company is committed to growing in the U.S., "no matter how long it takes," he said.