August 7, 2020

Non-disclosure, non-compete and non-solicitation clauses are commonly used in PRC employment practice. A non-compete clause, in particular, restricts an employee’s activities post-employment and requires close attention to drafting and implementation techniques to achieve the employer’s goals. Understanding the legal requirements and effects for an effective clause is key for both employers and employees.

In a typical non-compete clause, an employee agrees, for a certain period of time and within a certain geographic area following termination of his/her employment, not to manufacture or deal in the same or similar products or services as his/her current employer and not to work for an entity that competes against his/her current employer.  According to Article 23 of the PRC Employment Contract Law, an employer may contract with an employee having access to confidential information to include non-compete provisions in the employment contract. After the contract terminates, the employer is required to pay compensation to the employee on a monthly basis throughout the non-compete period. If the payments are made, the employee is obligated to pay liquidated damages to the employer on the terms agreed in the employment agreement if he/she breaches the non-compete clause.

To be legally binding in China, a non-compete clause must meet all the following conditions:

1. The non-compete obligation must be stated in a written agreement executed by both the employer and employee.
2. Employees should be senior management personnel, senior technical staff, or others with access to confidential information who are bound by a duty of confidentiality.
3. The business field, location and entities that the employee is prohibited from working in or for should be limited to those in actual competition with his/her current employer.
4. The non-compete period is limited to two (2) years.  
5. To implement the non-compete clause, the employer must pay the agreed financial compensation to the employee. No compensation amount is mandated by law, but, in practice, monthly compensation is typically set between 20% - 50% of the average monthly salary of the employee. According to PRC Supreme Court interpretations, if a non-compete agreement does not set a monthly amount, an employee who has complied with the non-compete may demand monthly compensation of 30% of his/her average monthly salary earned during the last 12 months of employment.

If an employee breaches the non-compete clause and, inter alia, could gain a competitive advantage over the former employer by abusing the employer's trade secrets or sensitive information (business secrets, marketing plans, customer or client lists, etc.), he/she must pay liquidated damages to the employer according to the terms of the employment contract. In fact, a non-compete clause is one of only two circumstances where the PRC Employment Contract Law permits an employment contract to include liquidated damages. There are no statutory rules as to maximum damages, but, in practice, regardless of the employer’s actual loss, it is generally appropriate to set the damage amount at 5-10 times the non-compete compensation already paid to the employee. Note, however, that the actual damage amount will remain subject to the discretion of the local Chinese court.

Non-compete agreements can be effective to deter employees from resigning unexpectedly and going to work for a competitor. PRC employment law tends to favor employees.  For example, employment cannot be terminated "at will" in China; the employer must provide evidence sufficient to meet statutory grounds for lawful termination. On the other hand, an employee is allowed to quit his/her job any time following a thirty-day advance notice even though the employment contract provides otherwise.

In practice, many employees resign without giving the required advance notice and without suffering any legal penalties, sometimes disrupting normal business operations. Because the PRC Employment Contract Law provides for liquidated damages and such damages can be enforced in practice, including them in the employment agreement can act as a monetary constraint on an employee quitting his/her job without permission before the end of the agreed term (for example, in response to an offer from a headhunting company or competitor). The employee takes the risk of being required to pay a substantial cash penalty. Since job-hopping is very common in China after an employee works in a company for two or three years, a non-compete clause can help reduce the risk of experienced talent leaving abruptly, possibly allow time for negotiation, and in any event increase the cost of quitting to the employee or to his/her future employer if it reimburses the employee for the cost.

A non-compete clause also plays an important role in the protection of an employer’s confidential information and commercial secrets. If an employer takes legal action without a non-compete clause, it will not only need to prove that the employee disclosed and used confidential information, but also prove the amount of damages suffered by the employer. In contrast, if there is a non-compete clause with liquidated damages, the employer can directly take legal action against the employee and claim the liquidated damages based on proof that the employee is working for a competing business.

Of course, an employer, as a party to a non-compete agreement, is obligated to pay additional monthly compensation to an employee after the termination. Fortunately the employer has some flexibility in exercising its rights. According to current judicial practice in China, the employer is allowed to notify the employee before or at the time of termination that it will not implement the non-compete clause and will not pay any additional compensation, even if the employee wishes to implement the agreement. If handled properly, the employee will not have a legal remedy against an employer that chooses this option. Also, if the employer terminates the non-compete clause during the non-compete period, it is not considered a breach of contract, but the employee will be entitled to an extra three months compensation payment. On the other hand, the employee is not entitled to choose whether to implement the non-compete clause and must honor it, unless the employer has failed to pay the non-compete compensation to the employee for over three months.

While the law does not mandate the amount of non-compete compensation or penalty (liquidated damages), there are some relatively complicated rules based on judicial interpretations and practice that apply to non-compete clauses:

• The non-compete compensation should be paid to the employee only after the termination of the employment.
• A provision in an employment agreement that states that the employee’s compensation for the non-compete clause was already included in his/her monthly salary is invalid and the parties will be deemed not to have agreed on the amount of non-compete compensation.
• In the absence of an agreed amount of monthly compensation during the non-compete period, a non-compete clause in a valid agreement will still be considered effective and the employee is bound by it; the employee is entitled to compensation based on 30% of the average salary of the previous year (in Shenzhen the ratio is 50%) provided that the he/she has duly fulfilled his/her duties stated in the non-compete clause.
• The employee must continue to comply with the non-compete clause even if the employer fails to pay the non-compete compensation on time. However, if payment has not been made for more than three months, the employee is entitled to terminate the non-compete agreement and claim an extra three month’s compensation.
• The employer is entitled to demand that an employee who has failed to honor the non-compete return the non-compete compensation he/she received and pay penalties based on the amount of liquidated damages in the agreement.
• If the liquidated damages are unreasonably high compared to the non-compete compensation, the employee may request a People’s Court to reduce them; the court will decide such requests on a case-by-case basis.
  

Conclusion

In general, non-compete clauses can serve as an effective mechanism for strengthening HR management and IP protection in China and should be included in any employment contract package signed with an employee, especially an employee in a senior management position or with special duties requiring access to confidential information. Considering the complexity of the issues, we recommend consulting a legal professionals with sufficient knowledge and experience regarding employment issues to draft, review and answer your questions on the non-compete clause. Our associated attorneys in California and Beijing are available to answer your questions and assist you.

By Jeff Sun with Allan Marson. Jeff is a founding partner of Jaguar Law in Beijing, P.R.C. and Allan is the founder of Marson Law, P.C. in Palo Alto, CA, U.S.A.