Taiwanese regulators recently indicted UMC (NYSE:UMC), the country's second largest contract chipmaker, and three of its employees for the alleged theft of trade secrets from U.S. memory chipmaker Micron (NASDAQ:MU). Two of the UMC employees, Ho Chien-ting and Wang Yong-ming, previously worked at Micron's local unit.

Regulators claim that Ho and Wang, who respectively became the technical managers of special projects and components at UMC, illegally replicated Micron's manufacturing techniques for its DRAM business in China. UMC runs that business as a joint venture with Chinese chipmaker Fujian Jin Hua Integrated Circuit.

A man steals confidential documents from a filing cabinet.

Source: Getty Images.

Micron already filed a lawsuit against UMC in February after discovering that its former employees had copied classified files, prompting a raid on UMC's Tainan plant. After that incident, UMC technical division associate Rong le-tien reportedly instructed Ho and Wang to delete all Micron-related information from its databases. This ongoing debacle raises bright red flags for UMC and Micron, which both rallied about 50% this year on robust demand for semiconductors and memory chips.

A black eye for UMC

UMC is often overshadowed by its bigger rival TSMC (NYSE:TSM). To remain competitive, UMC expanded into China via investments and joint ventures with smaller chipmakers.

However, Taiwan is wary of cross-strait partnerships with Chinese chipmakers, since foundries like TSMC and UMC can manufacture more advanced chips than their Chinese counterparts. If a Chinese company gains access to sensitive manufacturing secrets, it could overtake the Taiwanese chipmakers or share that data with the government and its industry peers.

A graphical representation of a semiconductor.

Source: Getty Images.

That could result in Taiwan's chipmakers -- the lifeblood of its economy -- being cut out of the global supply chain by cheaper Chinese rivals. As a result, Taiwan only allows TSMC, UMC, and other chipmakers to manufacture older chips at their mainland plants.

Back in 2005, Taiwanese regulators fined UMC over illegal investments in Chinese chipmaker He Jian Technology, which was founded by former UMC employees. That incident led to the resignations of UMC chairman Robert Tsao and Vice Chairman John Hsuan.

In 2015, UMC opened a joint venture plant in Fujian, making it the first Chinese plant using 300mm wafers sponsored by a Taiwanese company. That investment was allowed after cross-strait investment rules were relaxed under the Beijing-friendly KMT party. But with the pro-independence DPP party now back in power, UMC's dealings in China are now back in the cross hairs -- and the trade secrets debacle gives regulators plenty of reasons to probe its mainland investments.

An alarming development for Micron

The UMC incident started just shortly after Micron increased its investment in Taiwan with the takeover of Inotera Memories in late 2016. But during his visit to Taiwan, former Micron CEO Mark Durcan warned that China's state-backed chipmakers could flood the global market with cheap memory.

A global glut of chips would abruptly end Micron's cyclical recovery, which was mainly fueled by tightening memory supplies and rising prices over the past year. Micron is currently the third largest DRAM manufacturer and fourth largest NAND maker in the world.

A stick of DRAM.

Source: Getty Images.

Samsung leads both markets, but Micron has kept pace by developing new memory technologies and investing in next-gen memory solutions like 3D NAND and 3D Xpoint with its longtime partner Intel. Chinese memory chipmakers don't rank among the world's top chipmakers yet, since their technology trails behind their Korean, American, and Japanese rivals.

That's why the state-backed Tsinghua Unigroup tried to buy Micron two years ago, and why it tried to buy a 15% stake in Western Digital last year. Tsinghua eventually abandoned both efforts as U.S. regulators questioned its motives. Tsinghua is now building a $30 billion memory plant in Nanjing, which will become the biggest one in China upon its completion.

Therefore, the alleged theft of Micron's manufacturing secrets through Taiwan to China is deeply troubling. If Chinese chipmakers like Tsinghua gain access to those designs, they could create a global oversupply of cheap memory chips.

Should UMC and Micron investors be worried?

This incident is bad news for both UMC and Micron. UMC has incurred the wrath of regulators in its home country, and could face much tighter restrictions on its cross-strait investments. Micron let employees take classified manufacturing secrets out the door, and could pay the price if Chinese chipmakers use that data to create cheaper memory chips with comparable performance.

The case shouldn't throttle UMC and Micron's short-term growth, but it could cause other major headaches down the road. Therefore, investors should keep a close eye on these recent developments.

 

Leo Sun has no position in any of the stocks mentioned. The Motley Fool recommends Intel. The Motley Fool has a disclosure policy.