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 potentialrisk to U.S.

* House Intelligence Committee seeks to block any mergers,acquisition

* Huawei is world's second-biggest telecommunicationsequipment maker

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

By Jim Wolf

WASHINGTON, Oct 7 (Reuters) - China's top telecommunicationsgear makers should be shut out of the U.S. market becausepotential Chinese state influence on them poses a securitythreat, the U.S. House of Representatives' IntelligenceCommittee said in a draft of a report to be released on Monday.

U.S. intelligence must stay focused on efforts by HuaweiTechnologies Co Ltd and ZTE Corpto expand in the United States and tell the private sector asmuch as possible about the purported espionage threat, the panelleaders said, based on their 11-month investigation of the pair.

Employee-owned Huawei is the world's second-biggest maker ofrouters, switches and other telecommunications equipment afterSweden's Ericsson . ZTE ranks fifth.

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

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

"Baseless suggestions otherwise or purporting that Huawei issomehow uniquely vulnerable to cyber mischief ignore technicaland commercial realities, recklessly threaten American jobs andinnovation, do nothing to protect national security, and shouldbe exposed as dangerous political distractions from legitimatepublic-private initiatives to address what are global andindustry-wide cyber challenges," he said.

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

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

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

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

The panel's draft report faulted both companies for failingto satisfy the committee's requests for documents to allay itsconcerns, including detailed information about formalrelationships or regulatory interaction with Chineseauthorities.

U.S. companies mulling purchases from Huawei should "findanother vendor if you care about your intellectual property; ifyou care about your consumers' privacy and you care about thenational security of the United States of America," panelchairman Mike Rogers said in comments broadcast Sunday night onthe 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 conferenceto release the final, unclassified version of their report.

"CREDIBLE ALLEGATIONS"

The panel said it had received credible allegations fromunnamed industry experts and current and former Huawei employeessuggesting Huawei, in particular, may be guilty of bribery andcorruption, discriminatory behavior and copyright infringement.

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

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

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

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

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

Huawei and ZTE are rapidly becoming "dominant globalplayers" in the telecommunications market, which is intertwinedwith computerized controls for electric power grids; banking andfinance systems; gas, oil and water systems and rail andshipping, the document said.

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

In contrast, two of the larger Western vendors alone hadcombined U.S. sales that topped $14 billion, ZTE told thecommittee in its Sept. 25 letter, an apparent reference toEspoo, Finland-based Nokia Siemens Networks NOKI.UL andParis-based Alcatel Lucent .

"It seems self-evident that the universe of companiesexamined by the Committee is so small as to omit most of theequipment actually employed in the U.S. telecom infrastructuresystem," the letter said.

"MEANS, OPPORTUNITY, MOTIVE"

Huawei and ZTE may not be the only companies that present arisk to U.S. infrastructure, the committee's draft report said,but they are the two largest Chinese-founded, Chinese-ownedcompanies seeking to market critical network equipment to theUnited 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. 13that their companies would never bow to a hypothetical Chinesegovernment effort to exploit their products for espionage,equating any such move with corporate suicide.

"Huawei has not and will not jeopardize our globalcommercial success nor the integrity of our customers' networksfor any third party, government or otherwise," senior vicepresident Charles Ding testified at the time.

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

In addition, it said Congress should give thoroughconsideration to legislation seeking to expand the role of theinteragency group, known as the Committee on Foreign Investmentsin the United States, to include purchasing agreements.

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

Huawei has marketed its network equipment in the UnitedStates since last year. It has sold to a range of small- tomedium-sized carriers nationwide, particularly in ruralareas. It has marketed mobile phones through a broader range ofU.S. carriers, for the last four years.

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

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Keywords: USA CHINA/HUAWEI ZTE