Recent Guidance on China's Employment Law

Employees in China are generally entitled to severance compensation when their employment relationship with an employer ends. The amount of compensation is based on the number of years they have worked for the employer. As a general rule, the amount paid is one month's salary for each year of service, with a cap on the monthly amount for periods of service after 2008.

When an employee is reassigned or transferred to a new employer pursuant to an acquisition or group transfer, the existing employment relationship needs to be terminated and a new one established with the new employer. In most cases, this happens by mutual agreement between the employer and affected employees. The agreement must also include severance compensation, paid for by either the former or new employer.

If an entire workforce is being transferred, the aggregate severance liability can be substantial and can create uncertainty for employers. This is particularly the case when a sale and purchase agreement does not stipulate how severance pay will be handled. Many situations arose, for example, where a large number of employees were transferred, but the original employer did not pay out statutory severance for prior years of service. Absent specific contractual terms, the new employer would refuse to pay as well, on the grounds that the company had completely new employment relationships with the employees. Arbitrators and courts generally upheld this position, usually leaving the employees with no recourse as the previous employer would often no longer exist.

Under the new guidelines, the Supreme People's Court has now made it clear that where a reassignment or transfer is not attributable to an employee, the years of service with the prior employer are to be recognized by a new employer if the previous employer did not pay severance. Interpretation 4 provides the following examples of where the Supreme People's Court considers a reassignment or transfer not to be attributable to an employee:

• An employee is working in the same location but his employer changes;
• An existing employer seconds or assigns the employee to work for a new employer;
• An employee ends up working for a new employer pursuant to a merger or acquisition; or
• An employee enters into a new employment relationship with an affiliate.

The new rule is meant to avoid situations where employees lose past severance entitlement because there is no one left to pay. Accordingly, from a purchaser's perspective, it is crucial to address this issue in the transaction documentation or the company could be shackled with a substantial liability that had not been expected or included in the cost of the acquisition.

Even with an agreement between the two employers, it is far more common these days for employees to take the opportunity to get some cash at the time of transfer as opposed to some future date. Even if the seller and purchaser agree that the severance liability will be transferred to the purchaser, they have to be prepared for the situation where the employees take a different view, and are willing to strike or otherwise disrupt the deal unless they get paid their accrued statutory severance entitlement. For this reason, it is important to include indemnities in the sale and purchase agreement so that a party that was not anticipating this cost is covered if the statutory severance payment needs to be handled differently to what was agreed by the parties.

Entitlement to Severance Compensation When an Employer's Term of Operation Ends

The ECL set out circumstances where an employer is required to pay severance compensation to an employee. None of the circumstances in the existing law covered the situation where a company's term of operation in China ends. When a company is first established in China, it is approved to operate for a stipulated number of years. Unless this period is extended, the company must cease operations at the end of the term. This would involve terminating all employees.

The Supreme People's Court has now addressed this situation, indicating that an employer must pay statutory severance compensation to employees let go at the end of the term of an employer's operation.

Payment for Post-termination Non-compete Obligations

In order for post-termination non-compete restrictions to be enforceable in China, the ECL requires employers to pay employees monthly compensation during the post-termination non-compete period. It does not, however, indicate how much compensation should be paid, and this has been left to the authorities to regulate in each location. In Shanghai, for example, the employer and employees are free to negotiate the amount of compensation to be paid. Other cities and provinces stipulate a minimum amount that must be paid, which is often a significant percentage of an employee's monthly wage.

The situation becomes even more uncertain if the employment contract does not include a specific amount for compensation. The Supreme People's Court has now provided guidance on this point. If the parties do not stipulate the amount of compensation, Interpretation 4 states that the employee is entitled to 30% of his or her average monthly wage for each month of the post-termination non-compete period. This employee is only entitled to such payment if he or she has complied with the non-compete obligation. The average monthly wage is calculated by dividing the total compensation received in the 12 months prior to termination by 12.

In some locations the local requirement for the monthly compensation is higher than 30% of an employee's average monthly wage. While Interpretation 4 does not specifically state that in such cases the local higher standard should apply, this will likely be true.

Non-compete obligations can only apply to senior level employees and those who have a confidentiality obligation. Employers should carefully consider the practical effectiveness of such obligations before incurring the substantial payments required to be paid to employees to enforce them. Injunctive relief is generally not available, so even if an employer has a non-compete obligation in place, employers cannot prevent employees from taking up employment with competitors. Absent injunctive relief, the only incentive for employees to comply with the obligation, aside from the monthly payment, is the prospect of having to pay damages. It is important for employers to stipulate a liquidated damages amount in the event of breach, as proving actual damages is extremely difficult. This is typically this is the equivalent of one year of the employee's salary, but it can be adjusted if a judge deems it to be unreasonable.

Termination of Post-termination Non-compete Obligations

The ECL does not address the enforceability of post-termination non-compete obligations when an employer fails to pay the required compensation. Additionally, according to the local practice in many locations, an employer could immediately terminate a post-termination non-compete obligation by issuing a written waiver, with no further compensation being payable to the employee. Interpretation 4 provides new rules for the early termination of a post-termination non-compete obligation.

If an employer has not paid the non-compete compensation for three months, the Supreme People's Court has indicated that the employee can terminate the non-compete obligation. Additionally, the Supreme People's Court has now indicated that an employer needs to pay three months of the agreed non-compete compensation in order to terminate the obligation prior to the end of the agreed term.

In addition to paying the three months' compensation, employers should also issue a written waiver releasing the employee from the non-compete obligation. In the past, employers have wrongly assumed that if they simply did not pay the agreed compensation, the non-compete agreement would be automatically null and void. However, employees have filed claims after the post-termination non-compete period expired, stating that they had complied with the non-compete obligation and should be paid the agreed compensation. Many arbitrators and judges have ruled in favor of employees in such cases, ordering employers to pay the non-compete compensation when the employers had no intention of enforcing the obligation. Given these precedents, employers should issue a written waiver in addition to making the required payment.

Verbal Amendments to Employment Contracts

The ECL requires that amendments to employment contracts be made in writing. The Supreme People's Court has now indicated that verbal amendments to employment contracts are also valid, provided that the amendment is lawful and the amendment has been in effect for more than a month. This interpretation appears to contradict what is required by the ECL. However, the ECL also recognizes de facto employment relationships that exist despite the lack of a written employment contract, if certain criteria are satisfied. The Supreme People's Court has aligned verbal amendments to an employment contract with this principle.

Employment of Foreigners

There have been situations where foreign employees have signed employment contracts but have failed to obtain a valid work permit. Uncertainty as to whether an employment relationship has been established arises when the employee attempts to enforce the employment contract in arbitration or litigation. The Supreme People's Court has now made it clear that unless a foreign employee has obtained a valid work permit, his or her employment relationship with an employer in China will not be recognized.

Notifying Trade Unions of Terminations

The ECL requires an employer to give the applicable labor union advance notice of any unilateral terminations. However, it does not specify the consequences for failing to do so. The Supreme People's Court has now addressed this point by stating that an employee may seek damages for unlawful dismissal if an employer has not notified the labor union in advance. An employee would not be entitled to damages if the employer rectifies the situation and notifies the labor union before the employee files a lawsuit. The applicable damages are the same as those set out in the ECL for unlawful termination, which are two times the amount of severance compensation an employee would have been entitled to had he or she been lawfully terminated. Therefore, although the Supreme People's Court has now stipulated the consequences for failing to notify the labor union of a unilateral termination, it has allowed some flexibility for an employer to rectify the matter as long as it does so before an employee files a lawsuit to claim damages.

Conclusion

Interpretation 4 provides some much-needed clarity regarding the application of labor and employment law in China. It addresses many situations that have created problems for employers in the past. Foreign employers, especially, must understand that the main aim of the ECL, as with most laws in China, is to maintain social harmony and avoid public disruptions. Keeping this fact in mind is key when considering any action involving employer-employee relations in China.

Kevin L. Jones is a partner with Faegre Baker Daniels. Based in Shanghai, he chairs the firm's labor and employment practice in China. He can be reached at [email protected].

China's Employment Contract Law (ECL), which governs relationships between employers and employees, took effect on Jan. 1, 2008. However, it has become apparent over the years that there are gaps in the ECL and related regulations that create uncertainty in their application. Authorities in different locations often have different views as to how to fill these gaps, resulting in the uneven application of the law. In light of that, the Supreme People's Court, the highest court in China that issues guidance on the application of Chinese law, recently provided a set of clarifications to the ECL.

Below is a discussion of what these new guidelines, known as Interpretation 4, mean for U.S. companies with operations in China.

Recognition of Prior Years Of Service in Employee Transfers and Reassignments

Employees in China are generally entitled to severance compensation when their employment relationship with an employer ends. The amount of compensation is based on the number of years they have worked for the employer. As a general rule, the amount paid is one month's salary for each year of service, with a cap on the monthly amount for periods of service after 2008.

When an employee is reassigned or transferred to a new employer pursuant to an acquisition or group transfer, the existing employment relationship needs to be terminated and a new one established with the new employer. In most cases, this happens by mutual agreement between the employer and affected employees. The agreement must also include severance compensation, paid for by either the former or new employer.

If an entire workforce is being transferred, the aggregate severance liability can be substantial and can create uncertainty for employers. This is particularly the case when a sale and purchase agreement does not stipulate how severance pay will be handled. Many situations arose, for example, where a large number of employees were transferred, but the original employer did not pay out statutory severance for prior years of service. Absent specific contractual terms, the new employer would refuse to pay as well, on the grounds that the company had completely new employment relationships with the employees. Arbitrators and courts generally upheld this position, usually leaving the employees with no recourse as the previous employer would often no longer exist.

Under the new guidelines, the Supreme People's Court has now made it clear that where a reassignment or transfer is not attributable to an employee, the years of service with the prior employer are to be recognized by a new employer if the previous employer did not pay severance. Interpretation 4 provides the following examples of where the Supreme People's Court considers a reassignment or transfer not to be attributable to an employee:

• An employee is working in the same location but his employer changes;
• An existing employer seconds or assigns the employee to work for a new employer;
• An employee ends up working for a new employer pursuant to a merger or acquisition; or
• An employee enters into a new employment relationship with an affiliate.

The new rule is meant to avoid situations where employees lose past severance entitlement because there is no one left to pay. Accordingly, from a purchaser's perspective, it is crucial to address this issue in the transaction documentation or the company could be shackled with a substantial liability that had not been expected or included in the cost of the acquisition.

Even with an agreement between the two employers, it is far more common these days for employees to take the opportunity to get some cash at the time of transfer as opposed to some future date. Even if the seller and purchaser agree that the severance liability will be transferred to the purchaser, they have to be prepared for the situation where the employees take a different view, and are willing to strike or otherwise disrupt the deal unless they get paid their accrued statutory severance entitlement. For this reason, it is important to include indemnities in the sale and purchase agreement so that a party that was not anticipating this cost is covered if the statutory severance payment needs to be handled differently to what was agreed by the parties.

Entitlement to Severance Compensation When an Employer's Term of Operation Ends

The ECL set out circumstances where an employer is required to pay severance compensation to an employee. None of the circumstances in the existing law covered the situation where a company's term of operation in China ends. When a company is first established in China, it is approved to operate for a stipulated number of years. Unless this period is extended, the company must cease operations at the end of the term. This would involve terminating all employees.

The Supreme People's Court has now addressed this situation, indicating that an employer must pay statutory severance compensation to employees let go at the end of the term of an employer's operation.

Payment for Post-termination Non-compete Obligations

In order for post-termination non-compete restrictions to be enforceable in China, the ECL requires employers to pay employees monthly compensation during the post-termination non-compete period. It does not, however, indicate how much compensation should be paid, and this has been left to the authorities to regulate in each location. In Shanghai, for example, the employer and employees are free to negotiate the amount of compensation to be paid. Other cities and provinces stipulate a minimum amount that must be paid, which is often a significant percentage of an employee's monthly wage.

The situation becomes even more uncertain if the employment contract does not include a specific amount for compensation. The Supreme People's Court has now provided guidance on this point. If the parties do not stipulate the amount of compensation, Interpretation 4 states that the employee is entitled to 30% of his or her average monthly wage for each month of the post-termination non-compete period. This employee is only entitled to such payment if he or she has complied with the non-compete obligation. The average monthly wage is calculated by dividing the total compensation received in the 12 months prior to termination by 12.

In some locations the local requirement for the monthly compensation is higher than 30% of an employee's average monthly wage. While Interpretation 4 does not specifically state that in such cases the local higher standard should apply, this will likely be true.

Non-compete obligations can only apply to senior level employees and those who have a confidentiality obligation. Employers should carefully consider the practical effectiveness of such obligations before incurring the substantial payments required to be paid to employees to enforce them. Injunctive relief is generally not available, so even if an employer has a non-compete obligation in place, employers cannot prevent employees from taking up employment with competitors. Absent injunctive relief, the only incentive for employees to comply with the obligation, aside from the monthly payment, is the prospect of having to pay damages. It is important for employers to stipulate a liquidated damages amount in the event of breach, as proving actual damages is extremely difficult. This is typically this is the equivalent of one year of the employee's salary, but it can be adjusted if a judge deems it to be unreasonable.

Termination of Post-termination Non-compete Obligations

The ECL does not address the enforceability of post-termination non-compete obligations when an employer fails to pay the required compensation. Additionally, according to the local practice in many locations, an employer could immediately terminate a post-termination non-compete obligation by issuing a written waiver, with no further compensation being payable to the employee. Interpretation 4 provides new rules for the early termination of a post-termination non-compete obligation.

If an employer has not paid the non-compete compensation for three months, the Supreme People's Court has indicated that the employee can terminate the non-compete obligation. Additionally, the Supreme People's Court has now indicated that an employer needs to pay three months of the agreed non-compete compensation in order to terminate the obligation prior to the end of the agreed term.

In addition to paying the three months' compensation, employers should also issue a written waiver releasing the employee from the non-compete obligation. In the past, employers have wrongly assumed that if they simply did not pay the agreed compensation, the non-compete agreement would be automatically null and void. However, employees have filed claims after the post-termination non-compete period expired, stating that they had complied with the non-compete obligation and should be paid the agreed compensation. Many arbitrators and judges have ruled in favor of employees in such cases, ordering employers to pay the non-compete compensation when the employers had no intention of enforcing the obligation. Given these precedents, employers should issue a written waiver in addition to making the required payment.

Verbal Amendments to Employment Contracts

The ECL requires that amendments to employment contracts be made in writing. The Supreme People's Court has now indicated that verbal amendments to employment contracts are also valid, provided that the amendment is lawful and the amendment has been in effect for more than a month. This interpretation appears to contradict what is required by the ECL. However, the ECL also recognizes de facto employment relationships that exist despite the lack of a written employment contract, if certain criteria are satisfied. The Supreme People's Court has aligned verbal amendments to an employment contract with this principle.

Employment of Foreigners

There have been situations where foreign employees have signed employment contracts but have failed to obtain a valid work permit. Uncertainty as to whether an employment relationship has been established arises when the employee attempts to enforce the employment contract in arbitration or litigation. The Supreme People's Court has now made it clear that unless a foreign employee has obtained a valid work permit, his or her employment relationship with an employer in China will not be recognized.

Notifying Trade Unions of Terminations

The ECL requires an employer to give the applicable labor union advance notice of any unilateral terminations. However, it does not specify the consequences for failing to do so. The Supreme People's Court has now addressed this point by stating that an employee may seek damages for unlawful dismissal if an employer has not notified the labor union in advance. An employee would not be entitled to damages if the employer rectifies the situation and notifies the labor union before the employee files a lawsuit. The applicable damages are the same as those set out in the ECL for unlawful termination, which are two times the amount of severance compensation an employee would have been entitled to had he or she been lawfully terminated. Therefore, although the Supreme People's Court has now stipulated the consequences for failing to notify the labor union of a unilateral termination, it has allowed some flexibility for an employer to rectify the matter as long as it does so before an employee files a lawsuit to claim damages.

Conclusion

Interpretation 4 provides some much-needed clarity regarding the application of labor and employment law in China. It addresses many situations that have created problems for employers in the past. Foreign employers, especially, must understand that the main aim of the ECL, as with most laws in China, is to maintain social harmony and avoid public disruptions. Keeping this fact in mind is key when considering any action involving employer-employee relations in China.

Kevin L. Jones is a partner with Faegre Baker Daniels. Based in Shanghai, he chairs the firm's labor and employment practice in China. He can be reached at [email protected].