Out-Of-Court Settlement Thought to Boost TSMC's China Bid

In spite of an offering that was only a fraction of the previously reported US$1-3 billion in cash, the Semiconductor Manufacturing International Co.'s (SMIC's) out-of-court pledge to pay the Taiwan Semiconductor Manufacturing Corp. US$200 million plus 8% of its stock and an option to buy another 2% as compensation in a trade secrets case sent the TSMC share price up by NT$1.7 to close at a three-week high of NT$62.2 on the day following the deal's announcement. .

Industry watchers interpret the Nov. 11 share price surge as a reflection of investors' expectations that TSMC will eventually take control of SMIC, mainland China's No.1 chipmaker, greatly boosting its share of the mainland's foundry market.

The California Supreme Court ruled early this month that SMIC had been making illegal use of TSMC's trade secrets since January 2005, after the two firms reached an agreement to settle allegations of corporate espionage and intellectual-property infringement against SMIC.

TSMC had reportedly demanded US$1-3 billion in damages following the court ruling, but agreed to accept SMIC's lesser offer in consideration of its straightened financial circumstances and continuing losses. Many foreign institutional investors believe that, by taking the smaller amount of money along with the shares, TSMC will gain more than the amount of cash it originally demanded.

The settlement puts TSMC in a superb position to take over a dominant share of the vast mainland Chinese semiconductor market through the SMIC's four operating 300-mm wafer fabs there. Its shareholding is said to make the Taiwanese company the third-largest owner of SMIC equity, after only mainland China's Datang Telecom Technology Co. and Shanghai Industrial Investment (Holdings) Co.

After opening a 200-mm wafer fab offering 0.18-micron manufacturing services at the Z.J. Hi-Tech Park in Shanghai several years ago, TSMC, like many other Taiwanese chipmakers, is keen to expand its production in the mainland to keep up with the staggering pace of growth in the Chinese semiconductor market, now worth over US$80 billion annually-60% of which is still supplied by imports.

Although investing in 300-mm wafer fabs in China is still banned to Taiwanese companies on grounds of national security, the Kuomintang-led Republic of China government is considering an easing of the ban in accordance with the Wassenaar Agreement on Export Controls for Conventional Arms and Dual-Uses Goods and Technologies. Under that agreement, Intel has begun constructing a 300-mm wafer fab in Dalian to offer 90-nanometer manufacturing services, underscoring the self-defeating irrationality of Taiwan's taboo.

No Move Until the Light Turns Green

TSMC Chairman and Chief Executive Officer Morris Chang stresses that his company will not violate the ban by taking over ownership of SMIC unless the government gives it the green light. His company's case is reminiscent of a similar one involving the United Microelectronics Corp. (UMC), TSMC's closest rival.

UMC's board of directors has decided to take over mainland Chinese chipmaker He Jian Technology Co. following a favorable court decision in a case in which UMC's then chairman, Robert Tsao, and several former executives were charged with violating the law by covertly investing in, and providing technological assistance to, He Jian. The prosecutor brought the case against Tsao and the others on the change that He Jian offered UMC 15% of its ownership and US$110 million in cash, but a district court and then an appeals court found no proof of financial or technological ties between UMC and He Jian.

Tsao says that He Jian offered the 15% shareholding and the cash in appreciation for help, unrelated to technology, that his company provided. "The assistance was mostly aimed at passing investment incentives offered us by the Suzhou government on to He Jian, and seeking investors like Softbank for the company," Tsao explained. "We helped He Jian because it was founded by former UMC employees and we didn't want it to be acquired by SMIC." Tsao's company has placed the funds received from He Jian under trust management, and is waiting for the government's permission to recover them.

Once UMC receives the government's permission for this, industry insiders believe, TMSC will have sufficient reason to take over shares in SMIC.

Tsao says that He Jian is already a money-making company and that taking it over is the cheapest way for his company to make inroads into the mainland's semiconductor market.

The same reasoning puts TSMC's prospective acquisition of SMIC in a much brighter light, since the latter runs the largest number of 300-mm wafer fabs in the mainland and is moving toward the development of 45-nm manufacturing. Except for a few years, however, the company has been saddled with losses ever since it was established in 2000 because of a low ratio of defect-free production.

Taiwan venture capitalist Ben Chang attributes the losses mostly to SMIC's lack of talents and technology. "Everybody knows that Richard [Chang, the firm's recently replaced CEO] has a proven track record for fab construction efficiency," Chang comments. "But his company is short of management talent and technologies, although it has spent lavishly to poach talented people from other chipmakers, including TSMC. That was the cause of the lawsuit between TSMC and SMIC.

Ben Chang points out that TSMC and UMC become the world's top silicon foundries not just because of their huge fabrication capacity but, most importantly, because of their 30 years of diligent work in developing technology. "I think in this case," he says, "TSMC can send its specialists to fix SMIC's problems and boost its defect-free ratio. Once the partnership is realized, it could be a wonderful example of semiconductor teamwork across the Taiwan Straits."

Relations Good and Bad

N.K. Wang, who took over from Richard Chang as CEO of SMIC, is said to have had good personal relations with Morris since his days at Applied Materials, which is TSMC's prime supplier of chip-making equipment, while relations between Chang of TSMC and Chang of SMIC have been chilly ever since TSMC took over Richard Chang's Worldwide Semiconductor Manufacturing Corp.

Some industry insiders believe it's still too early for the two companies to talk about cooperation, given the obstacles that remain. One problem is that hard-liners who dominate the SMIC board of directors wanted to continue fighting the lawsuit brought by TSMC, reasoning that only five or six of the 60 patents raised by TSMC in the case are in dispute.

Another difficulty is Beijing's attitude towards TSMC's potential control of SMIC, which as the mainland's iconic chipmaker is strongly backed by Beijing. The loss of the lawsuit must necessarily mean a loss of face for the Chinese government, and so TSMC is particularly careful not to make any move that might be construed as unfriendly. Some industry watchers, however, say Beijing is using SMIC's defeat in the case as a chance to rectify the mainland's chaotic semiconductor industry by bringing overseas Chinese experts in to help out. They say that Morris Chang and N.K. Wang are on Beijing's list of preferred talent.

SMIC executives say that Wang was appointed to the post of CEO on the strong recommendation of Datang and the Beijing authorities. He is reportedly trying to persuade Chiu Tzuyin, CEO of Shanghai Hua Hong NEC Electronics, and Simon Yang, chief technology officer of Chartered Semiconductor, to come on board.

Following the recent settlement, a competitive triangle seems to be taking form in the global silicon foundry market: TSMC-SMIC, UMC-He Jian, and IBM-Global Foundries.

Industry watchers point out that although TSMC has declined to take seats on the SMIC board or to get involved in the company's operation, it has used its 8% shareholding to claim the right to veto any change in the company's shareholding structure and thus to prevent any rival firm from taking over.