China-US relations

Will Donald Trump’s flattery of Xi Jinping offset US red flags around Chinese investment?

Ahead of the American president’s Beijing visit, a declassified report says US may be ‘facilitating China’s technological superiority’ via deals

PUBLISHED : Saturday, 28 October, 2017, 3:52am
UPDATED : Saturday, 28 October, 2017, 5:52am

When Citic Group invested US$20 million last year in NextVR, developer of a virtual reality technology used to broadcast live events, the investment firm linked to China’s central government may have pulled closer to the US in terms of military might.

So goes the thinking behind an effort in Washington to halt such transactions, a move with as many implications for tech investors in Cambridge, Massachusetts and Silicon Valley as it has for the US Department of Defence (DoD) and Department of Homeland Security (DHS).

At stake is more than US$62 billion worth of Chinese investment in early-stage US tech companies, in addition to large-scale investments of a billion US dollars or more.

For US President Donald Trump, who will be in Beijing next month to push for easier access to the Chinese market for American companies, rising concern about what technologies China is sourcing in the US couldn’t come at a worse time.

Trump tweeted about the “extraordinary elevation” of President Xi Jinping at the recently concluded Communist Party congress in Beijing, praising a leader who has made no secret of his plans to marshal state and private resources to foster home-grown tech innovation leaders.

At the same time, US Commerce Secretary Wilbur Ross lauded a “more cooperative” relationship with Beijing in efforts to cut off trade with North Korea and signalled his intention to work for a relaxation of regulations that force US companies operating in China to form joint ventures with local companies and share intellectual property.

While Trump’s administration showers praise on Beijing, DoD officials and others in Washington are warning that China has built a multi-layered and multi-faceted capability involving many thousands of people to access US intellectual property and data in a bid for global economic and military supremacy.

China at top of US deals under security review in 2015, says CFIUS report

The review process for Chinese investments in the US “has until this year been seen as an obstacle that interferes with ‘win-win’ interactions. Now it’s different,” Arthur Waldron, an original member of the US-China Economic and Security Review Commission, said in an interview with the South China Morning Post.

“Lots of people in the defence and industrial complex are scared,” about the extent to which China is sourcing US technology.

Specifically, intelligence officials want more scrutiny of Chinese investment in dual-use technologies that leverage advanced semiconductors and artificial intelligence. These applications often are marketed to investors for their commercial applications, but can be adapted for military purposes.

Driven by these concerns, opposition in Washington to many forms of Chinese investment in the US is gathering momentum behind the scenes as Trump and members of his administration flatter Xi.

Referring to deals involving technologies similar to what NextVR licenses, the US defence department warned in a recently declassified document that “not only may we lose our technological superiority but we may even be facilitating China’s technological superiority”.

The 49-page DoD document’s title says it all: “China’s Technology Transfer Strategy: How Chinese Investments in Emerging Technology Enable A Strategic Competitor to Access the Crown Jewels of US Innovation”.

The report highlights transfers done not only via cyber theft and espionage, but also through VC investments and research centres such as Baidu’s Silicon Valley-based Institute for Deep Learning, conduits that face no legal or regulatory hurdles.

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“When viewed in combination, and with the resources China is applying, the composite picture illustrates the intent, design and dedication of a regime focused on technology transfer at a massive scale,” the report said.

It becomes “even more critical that exports, foreign ownership and technology partnerships with foreign entities do not become conduits for technology transfers that will directly enable key means of foreign military advantage”, according to the report, which lists among its recommendations scrutinising Chinese VC deals in the US valued at as little as $1 million.

These warnings have caught the attention of a growing number of US lawmakers and members of the country’s intelligence community. Many are involved with the Committee on Foreign Investment in the United States (CFIUS), an inter-agency body under the US Treasury Department, which gets input from the DoD, DHS and other government bodies. CFIUS reviews transactions and makes recommendations to the US president on whether certain deals pose a national security threat.

“There’s talk coming out of DC saying that, ‘well, we need to be more expansive at what we are reviewing because there’s lot of ways for technology to migrate,’” Sherman Chu, a lawyer with DLA Piper, who advises companies undergoing CFIUS reviews, told the Post in an interview.

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“There is a degree of discomfort maybe expressed by that [DoD] report with what is truly a financial investor versus a strategic investor,” said Chu, who previously served as Cisco’s general counsel for Greater China and as vice-chairman of the American Chamber of Commerce in Shanghai. “Is there an agenda behind a range of Chinese investors, even ones that are more in the financial investing? That definitely has an impact on the willingness of people to make investments here.”

The issue has moved up the US congressional agenda. A report released this month by the US Congressional Research Service (CRS) highlighted the DoD’s report and possible negative consequences of any moves to tighten controls on Chinese investment in US tech companies.

“Restricting Chinese investment potentially could reduce the domestic pool of funds available for start-ups and venture capital activity in cases where Chinese investment may provide the only option” to address the threat of technology transfers that threaten US national security, the CRS report said.

“The potential loss of funding for some firms may limit the overall development of new technologies at the margin, which potentially could have unintended consequences for the long-term rate of growth of the economy.”

The DoD estimated in its report that Chinese investors took part in almost 10 per cent of investments in early-stage US tech companies in 2015.

Still, lawmakers are forging ahead with plans to make the CFIUS review process more rigorous when it comes to China, despite the possible decline in foreign direct investment.

US aims to ramp up scrutiny of foreign investment in defence technology companies

In June, Texas Senator John Cornyn, the second-highest-ranking Republican senator, announced his intention to introduce a bill that directly addresses perceived threats Chinese tech investments pose to national security.

Cornyn’s bill, driven in part by concerns raised by the DoD’s then-classified report, would give CFIUS the authority to review joint ventures that result in technology transfers even where these tie-ups do not result in majority control of a US business. This expansion of the inter-agency committee’s review mandate would include JVs outside the United States that involve a transfer of US technology.

CFIUS’s current powers only cover acquisitions that give foreigners majority control of US companies with technology, data or real estate that could be used to create a national security vulnerability.

A June 23 thought leadership post by Covington&Burling LLP, an international law firm that advises clients on CFIUS issues, said Cornyn’s proposed legislation would be the most significant overhaul of the inter-agency body’s mandate in more than a decade.

“The concerns driving Senator Cornyn’s reform effort relate in part to a belief within some parts of the US government that China is circumventing CFIUS to gain access to technologies that may have current or future military applications,” Covington said.

“In particular, Senator Cornyn cited minority investments by Chinese parties in technology start-up companies engaged in developing commercial technologies that may also have defence or intelligence applications.”

US looking at restricting Chinese investment in artificial intelligence on security grounds

Cornyn’s office didn’t reply to a request by the Post for details about the status of his CFIUS bill.

The effort to curtail Chinese tech investments has made an impact even without the passage of new laws or regulations.

“We must be aware of the Chinese government’s strategic, systematic effort to infiltrate key American infrastructure through what appear to be benign business transactions,” US Representative Robert Pittenger announced in a statement issued last month, after Trump blocked a deal based on a CFIUS recommendation.

In that review, CFIUS recommended against a proposed US$1.3 billion takeover of Portland-based Lattice Semiconductor by Canyon Bridge Capital Partners – a private equity firm backed by China Venture Capital Fund.

Pittenger said he’s leading efforts to block other deals by Chinese buyers, including Ant Financial’s $880 million proposal to take over Dallas, Texas-based electronic payment platform MoneyGram International. Lawmakers and national security officials have raised more red flags over Chinese access to large sets of personal data that companies such as MoneyGram control.

Ant Financial is a unit of China’s e-commerce giant Alibaba, which owns the South China Morning Post.

“Granting China direct access to key military technology, the US financial system and other soft-power targets is simply unwise,” Pittenger said. “The global economy creates new national security risks not faced by previous generations.”

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Opposition around Ant Financial’s proposed acquisition highlights another dilemma in efforts to tighten security around Chinese investments in the US: MoneyGram doesn’t leverage any technical breakthroughs that would fall under the category of sensitive dual-use technology.

However, as the world’s second-largest provider of money transfers, the company has vast amounts of data on millions of Americans.

“If a foreign adversary gets certain kinds of personal information about US government employees, for example, then one of CFIUS’s concerns would be that these employees might potentially be subject to pressure, blackmail, or recruitment by a foreign intelligence service,” said Brian Curran, a Washington-based partner at law firm Hogan Lovells, who has represented clients facing CFIUS reviews.

“The US government’s concern is heightened by the number of significant data breaches that have allegedly emanated from Chinese sources,” Curran said. “But CFIUS’s specific concerns may in part be based on classified information, so the parties aren’t privy to all of the details, including how the government believes an adversary might potentially exploit a particular data set.”

One of the biggest challenges in addressing the ways China might potentially undermine US national security is the lack of human resources, said one Washington-based consultant who requested anonymity because of his previous work as a government contractor.

Not only does the government lack the number of people needed to police every transaction that might involve national security, but personnel at CFIUS agencies often don’t have the understanding of the newest technologies sought by Chinese investors and the potential vulnerabilities any transfer of these technologies might create for the US, the source said.

Chinese merger and acquisition deals in US down in first half of 2017

While the Trump administration aims to score foreign policy points in a bid to broaden access to the Chinese market for US companies, changes prompted by the latest warnings about China may undermine a key component of the bilateral investment relationship.

The mounting pressure to tighten control over China’s tech investments in the US is likely to clash with Beijing’s agenda during Trump’s visit on November 8-10.

In interviews with the Post earlier this month, Chinese trade officials appealed for easier US national security reviews as a concession during Trump’s visit.

“We’re paying particular attention to the problem of the very high ratio of Chinese companies caught up in the review process,” said Zhou Shanqing, economic and commercial counsellor at China’s New York consulate.

“Chinese companies have been number one for the past five years in terms of the ones undergoing CFIUS reviews, even though China represents a fairly small portion of foreign investment in the US.”

China’s filing of 74 acquisition notices to CFIUS was the most for the three years ended December 31, 2015, according to the most recent US Treasury Department data available on the body’s activity.

China was followed by Canada with 49 notices in the same period and Britain at 47. The report did not say how CFIUS responded to the notices.