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(Bloomberg) -- Few companies are better positioned to benefit from the crippling shortage of computer chips than ASML Holding NV, a Dutch manufacturer whose equipment plays an integral role in making the worlds most advanced semiconductors.

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But four lines tucked halfway into an otherwise upbeat, 281-page annual report from February hinted at a potentially incendiary problem. ASML accused a Beijing-based firm, regarded by Chinese officials as one of the countrys most promising tech ventures, of potentially stealing its trade secrets. Behind the brief disclosure is an extraordinary multiyear tale of intellectual property theft and a broader threat facing the $556 billion semiconductor industry.

In the report, ASML said the Chinese company, Dongfang Jingyuan Electron Ltd., is related to a defunct Silicon Valley firm, Xtal Inc., which ASML sued for intellectual property theft. A 2018 trial in California, which received scant attention at the time, provided more detail. Dongfang and Xtal were essentially the same, created a month apart in 2014 by a former ASML engineer named Zongchang Yu, ASMLs attorney told the court. The two companies worked in tandem toward the same goal: obtaining ASMLs technology and transferring it to China, which is seeking to foster its own semiconductor industry, often at the expense of Western companies, the attorney argued.That technology was secured in sometimes audacious fashion: one engineer was accused of stealing all 2 million lines of source code for critical ASML software and then sharing part of it with Xtal and Dongfang employees in the US and China, according to transcripts of the proceedings.Its not an accident. Its not anything else, Patrick Ryan, ASMLs lead attorney, told the court. But it is a plot to get technology for the Chinese government. Xtal lost and filed for bankruptcy protection. It was ordered to pay $845 million, which ASML deemed uncollectable.ASML declined to comment for this story. A Dongfang representative declined to comment. Yu, 60, who has an outstanding arrest warrant in California on allegations of stealing trade secrets from ASML, couldnt be reached for comment. He now runs Dongfang in Beijing with ample support from the Chinese government, according to company statements and other Chinese documents. The allegations the company made in court and in its annual report reflect the delicate position ASML finds itself in, trying to grow its business in China while pursuing claims of IP theft against a Chinese company.

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China is the worlds largest market for semiconductors. Its electronics factories and growing middle class are vital consumers of chips. Semiconductor companies have struggled for years to balance access to China against concerns the country is seeking to pilfer their intellectual property and overtake them.

For now, China lags in semiconductor manufacturing, leaving its most important industries dependent on technology dominated by foreign companies. Making its own advanced chips is a priority thats complicated by US sanctions that limit access to the latest equipment. Beijing has taken unprecedented steps to clear such hurdles, including launching a $150 billion semiconductor initiative in 2014 to turbocharge domestic production.

China has also encouraged people to steal technology that advances Beijings interests, according to the FBI. China recognizes it needs to make leaps in cutting-edge technologies, FBI Director Christopher Wray said. Instead of engaging in the hard slog of innovation, China often steals American intellectual property and then uses it to compete against the very American companies it victimized.

ASMLs allegations offer a detailed example of what national security authorities describe as Chinas playbook to acquire advanced technology. Its a set of strategies, they say, that depends on inducements from Beijing, theft by well-placed workers, and in at least some cases, a reluctance to complain by corporate victims seeking to preserve or enhance access to the Chinese market.

Taken individually these cases can seem really anecdotal, and some victim companies might say theres not really any master plan, said Anna Puglisi, senior fellow at the Center for Security and Emerging Technology at Georgetown University. But take this together with other cases over time and you can see the silentand in some cases not so silenthand of the Chinese government.

Chinas Ministry of Foreign Affairs called the allegations malicious hype. Anti-China politicians in the US have been using IP theft topics to tarnish China, the ministry said in a statement. China didnt make its technology achievements by stealing or robbing from others.

Veldhoven, Netherlands-based ASML makes technology thats crucial for manufacturing the fastest, most powerful computer chips. According to research firm Gartner Inc., as of 2021, ASML controlled more than 90% of the $17.1 billion global market for lithography equipment, which is used to shrink and then print patterns of transistors onto silicon wafers that are then sliced into individual chips.

A single machine can be the size of a small house and cost roughly $170 million. That technology is why the companys market capitalization has more than quadrupled in four years, to $284 billion at the end of 2021.

At the center of the litigation is software called optical proximity correction, or OPC. It makes up less than 1% of ASMLs revenue. But without it, lithography machines cant accurately print tiny circuits, according to trial testimony.

If you didnt do any OPC, then the pattern on the chip is totally scummed, testified Yu Cao, an ASML executive who was general manager of the division that develops the software. This would be a chip that doesnt work.

China is developing its own lithography machines, but it could take years to catch up to ASML, if ever, according to Robert Castellano, president of The Information Network, a Pennsylvania-based semiconductor research firm. Mastering OPC software could close some of the gap by allowing Chinese manufacturers to improve those machines and pack more transistors onto chips they produce, he said.

That leap could have implications beyond consumer devices. This is not about making a better smartphone, Castellano said. Its about making weapons that are more sophisticated than they are right now.

The year 2014 was important for Chinas semiconductor ambitions. Thats when the country created its $150 billion fund to jumpstart companies to compete with foreign behemoths.

Its also when Yu started his two companies. Educated in China, he had worked mostly in Japan and the US, including at ASML, which he left in 2012, according to court documents. In January 2014, he incorporated Xtal, based in an office park near San Jose International Airport. A month later, he founded Dongfang, in a government-funded industrial enclave in Beijing.

Yu created the companies at the direction of Jingyuan Han, a member of Chinas economic elite who retains close ties to the Communist Party, Ryan, ASMLs attorney, alleged in court. Han serves as chairman and chief executive officer of China Oriental Group Co., a large steel producer, where his biography lists multiple Communist Party roles.

The goal was to tap into incentive programs while delivering critical technologies for Chinas semiconductor initiative, Ryan alleged.

Despite its industrial-age specialization, China Oriental is a player in the countrys race to become a global technology superpower, often through investments by the company or by Han personally, according to corporate filings and Ryans courtroom arguments. Until 2019, China Oriental, through subsidiaries, owned more than 50% of Dongfang, according to Datenna, a Dutch firm that tracks the ownership of Chinese companies. It has since sold its stake as other investors have come onboard, Datenna said.

Representatives for China Oriental didn't return messages seeking comment.

As trial testimony alleged, Yu recruited engineers from the ASML division where they worked developing OPC software, and the departing employees assured their managers they would be working on unrelated technologies.

But after Song Lan, director of engineering, resigned in August 2015, ASML examined his computer. Investigators found he was working for both companies at the same time and had downloaded ASML files to a hard drive that he took to his new employer, according to a filing by the Dutch company in Xtals bankruptcy proceedings. The company said it found similar violations involving others who left for Xtal.After Xtal began marketing OPC software, ASML sued.

The data taken by Lan, who became Xtals vice president of engineering, included source code for ASMLs OPC software, according to the filing. Lan testified that he took the code inadvertently, while backing up his ASML email to preserve personal data. The code was in a file attached to an email that Lan said he never opened.

ASMLs attorneys said they werent able to learn the full scope of Lans activities. After ASML informed Xtal of its intent to sue, Lan used a wiper program on the hard drive and erased as much as 61 gigabytes of data, according to the filing. Lan didnt address the deletion in his testimony, as Xtals attorneys objected to a question about it.

Another former employee, Wanyu Li, who became Xtals IT director, downloaded the source code for ASMLs OPC softwareall 2 million lines of itto a hard drive, according to testimony from ASML forensic experts. Investigators found evidence that Li used it immediately at Xtal, uploading part of the code to a GitHub server where it was accessible to about 30 engineers with Xtal and Dongfang, according to the testimony.

The judge informed the jury that Li admitted to destroying evidence, breaking the hard drives circuit board into pieces before turning it over to Xtals attorneys on the eve of trial, according to trial transcripts.

Xtals attorney, Donald Putterman, acknowledged that Li stole the source code and damaged the hard drive. There's no sugarcoating with what Wanyu Li did, Putterman told the court. You cant do it. It was wrong. It was illegal. Off the charts.

However, he said no one at Xtal knew that Li had the stolen code. It was never actually used by Xtal, he said. Xtal never made a penny on it.

ASML attorneys referred the case to Santa Clara Countys District Attorneys Office, which filed criminal charges in April 2019 alleging theft of trade secrets against Yu, Li and Lan, according to court documents.

Li, 56, pleaded guilty to a felony charge and Lan, 48, to a misdemeanor charge, both for taking computer data, according to prosecutor Erin West. Li was sentenced to seven months of electronic monitoring, and Lan to 90 days of community service, she said.

Both men, through their attorneys, declined to comment. When authorities went to arrest the three men in May 2019, Yu had left for China, West said.

ASMLs attorneys accused Yu of orchestrating the thefts. Yu was on emails where his employees discussed using the Dutch companys source code to help speed up Xtals software development, according to testimony from ASMLs forensic experts. He also had copies of confidential ASML technical manuals and emailed them to his staff, they testified.

Yu testified that at the time he didnt believe there was a problem using some internal ASML materials to help guide Xtals work.

It is very good reference for our modeling work, Yu wrote in one email.

By using stolen data as a roadmap, Xtal shaved years off the time needed to develop the software, Ryan argued.

In January 2016, Xtal won a $27 million contract with South Korea's Samsung Electronics Co., a longtime ASML customer, to supply OPC software, according to trial testimony. In two years, Yus company had replicated a technology that ASML said it had spent $100 million and 10 years developing.

Xtal didnt have to go down dead ends, because it knew which ones were dead ends, and it knew which ones were the path to glory, the path to speed, the path to development, the path to the money, Ryan told the jury.

Samsung said it doesnt have a current relationship with Xtal or Dongfang. The company pointed to a statement by ASML saying that Samsung wasnt involved in any malicious actions against ASML. The Dutch company didnt lose any business because the work between Samsung and Xtal was thwarted when the theft was discovered, according to the statement.

After ASMLs court victory, a Dutch newspaper Het Financieele Dagblad published a report alleging a link between the thefts and China. ASML refuted it and offered a different motive that didnt involve China. The wide speculation about a government-directed conspiracy to steal our IP and trade secrets is therefore just that: wide speculation, ASML said, in an April 2019 press release.

Chief Executive Officer Peter Wennink reiterated that position. The suggestion that we were somehow victim of a national conspiracy is wrong.The facts of the matter are that we were robbed by a handful of our own employees based in Silicon Valley who had broken the law to enrich themselves, he said.

The suggestion that we were somehow victim of a national conspiracy is wrong ASML CEO Peter Wennink

However, months earlier, ASMLs own attorneys had directly linked Yus companies to Chinas technology ambitions. Its consistent with a broader strategy that is being employed the Chinese government, Andrew Winetroub, an ASML attorney, told the court. ASML had evidence, he argued, that Dongfang was receiving funds from the Chinese government and that Xtal is intimately involved.They want to essentially be ASML in China, Ryan, the lead ASML attorney, argued. Stealing our software was a step in the right direction.

ASML sought to introduce evidence that its lawyers said would support those claims. Putterman, Xtals attorney, argued that it amounted to repetitive efforts to back-door prejudicial intonation about China. The judge instructed ASML to focus on allegations limited to the US company, Xtal.

ASMLs case highlights the complications many Western companies face dealing with China.

China is ASMLs third-biggest market. Since 2019, the Dutch government has prevented the company from selling its most advanced lithography equipment there because the chips the equipment makes have potential military uses. ASML has opposed the restrictions.

Nick Eftimiades, a senior fellow at the Atlantic Council, said China put ASML in an extraordinarily awkward position.

This isnt the first time that a companys been stolen from and refused to make it a big issue publicly, said Eftimiades, a former US Department of Defense official who tracks Chinese IP theft and espionage cases. Many companies go to extraordinary lengths to keep these events from being known to the public, stockholders and investors."

For Yu, Xtals troubles did little to slow Dongfangs ascent.

In 2015, Dongfang signed a research agreement with the Institute of Microelectronics of the Chinese Academy of Sciences, the governments semiconductor research center, according to Chinese documents. There, Yu caught the attention of Tianchun Ye, the institutes director and the chief scientist directing Chinas chip equipment development. Dongfang and the institute created a joint venture for chip technology development. Since then, Dongfang has won repeated honors and praise from the Chinese government.

Despite losing the Xtal case, Chinese authorities granted Dongfang a wide-ranging patent in 2019 that includes OPC software. Last year, Dongfang announced that it was named a little giant by Chinas Ministry of Industry and Information Technology, a designation often followed by significant new investment and expectations of rapid growth.

Since returning to Beijing, Yu has raised millions of dollars while being courted by Chinese officials. He appeared on the reviewing stand for a military parade marking the 70th anniversary of Chinas foundingan invitation-only affair reserved for elites.

A 2020 book of interviews with Chinese tech entrepreneurs portrayed Yu as a flagbearer for semiconductor development. He told the authors one of his biggest dreams was to help China create its own OPC softwareand break the foreign monopoly.

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