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UPDATE 1-China's Huawei, ZTE should be kept from U.S. -draft Congress report

* China's top 2 telecom gear makers said to pose potential risk to U.S.

* House Intelligence Committee seeks to block any mergers, acquisition

* Huawei is world's second-biggest telecommunications equipment maker

(Adds Huawei, ZTE comment, ZTE share moves, Rogers quote, background)

By Jim Wolf

WASHINGTON, Oct 7 (Reuters) - China's top telecommunications gear makers should be shut out of the U.S. market because potential Chinese state influence on them poses a security threat, the U.S. House of Representatives' Intelligence Committee said in a draft of a report to be released on Monday.

U.S. intelligence must stay focused on efforts by Huawei Technologies Co Ltd and ZTE Corp to expand in the United States and tell the private sector as much as possible about the purported espionage threat, the panel leaders said, based on their 11-month investigation of the pair.

Employee-owned Huawei is the world's second-biggest maker of routers, switches and other telecommunications equipment after Sweden's Ericsson . ZTE ranks fifth.

The broadside comes as Huawei mulls a possible initial public offering, sources said, as part of a possible effort to overcome suspicions that have all but blocked its U.S. efforts, including business combinations.

Huawei spokesman William Plummer rejected the committee's allegations in a statement emailed to Reuters.

"Baseless suggestions otherwise or purporting that Huawei is somehow uniquely vulnerable to cyber mischief ignore technical and commercial realities, recklessly threaten American jobs and innovation, do nothing to protect national security, and should be exposed as dangerous political distractions from legitimate public-private initiatives to address what are global and industry-wide cyber challenges," he said.

For its part, ZTE released a copy of the letter it sent to the committee, stating it "profoundly disagrees" with the claim that it is directed or controlled by the Chinese government.

"ZTE should not be a focus of this investigation to the exclusion of the much larger Western vendors," it said.

ZTE's Hong Kong-listed shares fell as much as 3.4 percent early on Monday, lagging a 0.2 percent drop in the benchmark index . Its shares down 2.4 percent at 0229 GMT after news of the company's earlier response to the U.S. committee.

It was not immediately clear whether the blackballing would curb mobile phone sales that both companies do with customers such as Verizon , Sprint and T-Mobile EVEVE.UL.

The panel's draft report faulted both companies for failing to satisfy the committee's requests for documents to allay its concerns, including detailed information about formal relationships or regulatory interaction with Chinese authorities.

U.S. companies mulling purchases from Huawei should "find another vendor if you care about your intellectual property; if you care about your consumers' privacy and you care about the national security of the United States of America," panel chairman Mike Rogers said in comments broadcast Sunday night on the CBS News program "60 Minutes."

Rogers and the committee's top Democrat, C.A. Ruppersberger, have scheduled a 10 a.m. Eastern time (1400 GMT) news conference to release the final, unclassified version of their report.

"CREDIBLE ALLEGATIONS"

The panel said it had received credible allegations from unnamed industry experts and current and former Huawei employees suggesting Huawei, in particular, may be guilty of bribery and corruption, discriminatory behavior and copyright infringement.

The committee plans to refer such allegations to the Justice Department and Department of Homeland Security, according to the draft made available to Reuters.

"U.S. network providers and system developers are strongly encouraged to seek other vendors for their projects," it said.

The document cited what it called long-term security risks supposedly linked with the companies' equipment and services. But it did not provide detailed evidence, at least not in an unclassified version.

A classified annex provides "significantly more information adding to the committee's concerns," the draft said.

Based on classified and unclassified information, Huawei and ZTE, which are both based in Shenzhen, China, "cannot be trusted to be free of foreign state influence and thus pose a security threat to the United States and to our systems," it said.

Huawei and ZTE are rapidly becoming "dominant global players" in the telecommunications market, which is intertwined with computerized controls for electric power grids; banking and finance systems; gas, oil and water systems and rail and shipping, the document said.

ZTE's US telecom infrastructure equipment sales last year were less than $30 million.

In contrast, two of the larger Western vendors alone had combined U.S. sales that topped $14 billion, ZTE told the committee in its Sept. 25 letter, an apparent reference to Espoo, Finland-based Nokia Siemens Networks NOKI.UL and Paris-based Alcatel Lucent .

"It seems self-evident that the universe of companies examined by the Committee is so small as to omit most of the equipment actually employed in the U.S. telecom infrastructure system," the letter said.

"MEANS, OPPORTUNITY, MOTIVE"

Huawei and ZTE may not be the only companies that present a risk to U.S. infrastructure, the committee's draft report said, but they are the two largest Chinese-founded, Chinese-owned companies seeking to market critical network equipment to the United States. Beijing has the "means, opportunity and motive" to use them to its own ends, it added.

Top executives of both told a committee hearing on Sept. 13 that their companies would never bow to a hypothetical Chinese government effort to exploit their products for espionage, equating any such move with corporate suicide.

"Huawei has not and will not jeopardize our global commercial success nor the integrity of our customers' networks for any third party, government or otherwise," senior vice president Charles Ding testified at the time.

The draft showed that the committee is calling on an interagency government group that reviews national security implications of foreign investments to block acquisitions, takeovers or mergers involving Huawei and ZTE.

In addition, it said Congress should give thorough consideration to legislation seeking to expand the role of the interagency group, known as the Committee on Foreign Investments in the United States, to include purchasing agreements.

U.S. intelligence officials have publicly denounced China as the world's most active perpetrator of economic espionage against the United States.

Huawei has marketed its network equipment in the United States since last year. It has sold to a range of small- to medium-sized carriers nationwide, particularly in rural areas. It has marketed mobile phones through a broader range of U.S. carriers, for the last four years.

(Additional reporting by Lee Chyen Yee in Hong Kong; Editing by Bernard Orr and Ken Wills)

((jim.wolf@thomsonreuters.com)(+1 202 898 8402))

Keywords: USA CHINA/HUAWEI ZTE

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