China: Application of Non-Competes To Protect Business Secrets

An enterprise may have no patents or trademarks, but definitely have business secrets.

Business secrets—the enterprise’s core information assets—are important intangible assets that go to the core competence of the enterprise. For this reason, business secret protection is a matter of widespread concern for Chinese businesses. As the recipients or even creators of business secrets, employees are both the live carriers and holders of business secrets, and the group most likely to disclose them.

Over the past 20 years, employee turnover has increased to the point where job-hopping has become a normal state of affairs. As a consequence, the enterprise often faces not only loss of talent but leakage of business secrets, causing it to suffer serious financial losses and also result in loss of competitive edge. In this environment, non-compete agreements are an essential tool in protecting an enterprise against the possibility business secret of leakage as a result of employee mobility.

In communicating with companies, I have found that most of them misunderstand, to a large extent, the definition and application of non-compete agreements. As a result, in the event of a dispute, the legality and validity of many non-compete clauses are not upheld by the courts, rendering such clauses ineffective in achieve their intended purpose of protecting the enterprise’s proprietary and non-public information. To this end, and with consideration for the fact that local judicial practice and legal interpretations differs from place to place, I help clients gain an understanding of non-compete agreements and how they can be used to protect company assets, and advise on their practical operation in Zhejiang, based on my knowledge of judicial practice in this eastern coastal province of China.

Definition and classification of non-compete

A “non-compete” agreement, also known as “competition restriction,” is a covenant under which the employee subject to such special obligation shall not operate, either on its own or on behalf of any other person, the same or similar business as that of the employer, during the employment and/or for a certain period after departure.

There are two types of non-competes: a statutory non-compete and an “agreed upon non-compete.” The statutory non-compete refers to the mandatory non-compete obligation directly stipulated by laws, which cannot be released through consultation. The provisions of such non-competes can be found in department laws, such as Article 149.1 (5) of the Company Law, Article 32 of the Partnership Enterprise Law, Article 20 of the Individual Proprietorship Enterprise Law, Article 37 of the Regulation on the Implementation of the Sino-Foreign Equity Joint Venture Enterprise Law and Article 109 of the Insurance Law, which laws have binding force only on special groups, mainly corporate directors, officers, partnership members, and managers of individual funded enterprises.

Agreed upon non-competes are non-compete obligations based on the contractual agreement between the parties, as allowed under Labor Contract Law and as expressly agreed to by the parties in advance. Certainly such a restriction is never at one’s own sole discretion. To the contrary, in view of the superiority and inferiority of the parties involved in such negotiation, certain limitations on the terms of the non-compete obligation, including geographic scope, duration and type of employment or line of business prohibited, are set forth in Articles 23 and 24 of the Labor Contract Law.

In-service vs. post-departure non-competes

Non-competes fall into two categories based on the start and end dates of the obligation. In-service non-competes refers to the non-compete obligation that the in-service employee should bear while in the employ of the company. Officers are subject to a statutory non-compete obligation under China’s Company Law. However, ordinary in-service employees have no such statutory obligation. In-service non-compete obligations are not addressed in China’s employment laws or the Labor Contract Law, and courts are split on whether to expand the Company Law to include all employees, in one case reasoning that the existence of a post-departure non-compete obligation creates an in-service obligation.

A case in the Bulletin of the Supreme People’s Court, 2011, 10: Unfair Competition Dispute Case – Shandong Food Import & Export Corporation, Shandong Shanfu Group Co., Ltd., Shandong Shanfu Rishui Co., Ltd. vs. Ma Daqing, Qingdao Shengke Dacheng Trading Co., Ltd. [Civil Ruling of the Supreme People’s Court (2009) Min Shen Zi No. 1065] holds that the ordinary employee does not bear a non-compete obligation during employment.

However, Case 3 in the “2012 Top Ten Model Labor Dispute Cases of Jiangsu Courts,” published by Jiangsu High People’s Court, holds that the ordinary employee bears a non-compete obligation during employment. It is set forth in Clause 5 of the Answers of Zhejiang High People’s Court to Certain Questions on the Trial of Labor Dispute Cases (III) that:

“An employer and an employee have agreed that the employee shall not engage on its own or be employed by another employer to engage in any business competitive with that of the employer during his/her employment and a certain period after departure, and agreed upon liability for breach of contract. If the employer breaches the aforesaid agreement during employment, will the employer’s claim against the employee for such liability by reason of non-compete obligation be upheld? Answer: Non-compete term includes, without limitation, the period after termination or ending of the employment contract, so the agreement reached between the employer and the employee on the in-service non-compete obligation shall be valid. The employer’s claim against the employee for liability for breach of in-service non-compete obligation may be upheld.”

It is clear that the Zhejiang court holds that an in-service non-compete agreement (if any) between an employer and an employee shall be valid. Shenyang Intermediate People’s Court and Shenzhen Intermediate People’s Court also hold the same viewpoint1.

“Post-departure” non-competes, for their part, are expressly allowed in Articles 23 and 24 of the Labor Contract Law, which became effective on Jan. 1, 2008, and which codifies certain well-accepted labor practices, based upon the interpretation and/or policies of the Ministry of Labor and local labor bureaus as well as certain provisions under local regulations, making them applicable nationwide. Among other things, they stipulate the maximum duration of a valid non-compete covenant, that the covenant must be specific as to scope and territory, that an employer must compensate the former employee throughout the covenant’s duration, and that liquidated damages are allowed for breach of the covenant. Below, we discuss these elements in greater detail.

Drafting a non-compete clause

In designing a non-compete clause, an enterprise should abide by applicable laws so as to ensure the validity of the clause.

1. Subject of non-compete

In my practice, I have observed that some enterprises adopt an “all-employee non-compete” to protect their business secrets to the greatest extent possible. However, as only a few individuals in such enterprises have access to proprietary and/or confidential information, all-employee non-competes are not only unnecessary and add to costs but, at the end of the day, may not even bind all employees as intended. The Labor Contract Law expressly states that the staff subject to a non-compete obligation shall be limited to the employer’s senior management, senior technicians and other personnel with confidentiality obligations. As stated above, courts are divided on whether this provision applies to ordinary employees. Therefore, when an enterprise determines who must sign a non-compete agreement, it should decide based on who is likely to access its confidential information.

2. Range of non-compete

As stated above, non-competes come in two flavors: in-service and post-departure. In my experience, most enterprises have some knowledge of post-departure non-competes but many are completely unaware that the Company Law imposes in-service non-compete obligations on officers and case law has upheld in-service non-compete agreements with ordinary employees. As a result, many in-service officers are breaching non-compete obligations—in many cases resulting in significant economic harm—and are getting away with it when they could be easily identified and found liable for damages. And as for ordinary employees, under current juridical practice, especially in Zhejiang, in-service non-competes, if agreed to in writing between an employer and an employee, are routinely held valid. Therefore, the enterprise that wants to protect its interests to a greater extent may want to add in-service non-compete clauses to its non-compete agreements.

3. Term of non-compete

The Labor Contract Law stipulates that the maximum duration of a valid non-compete covenant must be no more than two years. Accordingly, as a general rule, the term of a non-compete covenant should cover the employment period plus two years after departure. However, the post-departure duration does not have to be two full years. Practically speaking, the enterprise may determine the term of the non-compete in line with the nature and technical features of the confidential information at issue. For some enterprises with rapidly updating information and technology, the term may be appropriately shortened so as to avoid paying out unnecessary non-compete compensation (see below).

4. Non-compete compensation

I have found in working with many enterprises a widespread misunderstanding that a non-compete agreement that does not include agreed-upon compensation will be found invalid. It is, however, explicitly stipulated in Clause 6 of the Interpretations of the Supreme People’s Court on Certain Issues concerning the Application of Law in the Trial of Labor Dispute Cases (IV) (hereinafter “Interpretations (IV)”) that whether non-compete compensation is agreed upon or whether the amount of non-compete compensation is agreed too low does not affect the enforceability of the non-compete agreement. Similar provisions are set forth in Clause 2 of the Answers of Civil Trial Chamber I of Zhejiang High People’s Court and Zhejiang Labor Dispute Arbitration Commission to Certain Questions on the Trial of Labor Dispute Cases (III).

Accordingly, failure to agree upon financial compensation will not result in the inevitable invalidity of the non-compete agreement, which still has binding force upon the parties and according to which the enterprise is still likely to claim against the employee for liability for breach of non-compete obligation. However, the enterprise may face the risk of a claim for non-compete compensation made by the separated employee.

The amount of non-compete compensation may be different for in-service and post-departure non-competes. With respect to the former, considering that such obligation originates from the employee’s duty of loyalty and good faith, for which the employee already receives remuneration, the court generally has not upheld in-service non-compete compensation, which is to say the employer is not required to pay in-service non-compete compensation. As for post-departure non-competes, a floor has been set in the case law, e.g., “30% of the employee’s average salary over the twelve-month period preceding the termination or ending of the employment contract and not lower than the minimum salary standard applicable in the place where the employment contract is performed.”

5. Liability for breach

Two provisions of the Labor Contract Law specify the liability for breach of a non-compete agreement: (1) the employee shall pay penalty for breach as agreed; and (2) the employee shall be liable for damages, if any, caused to the employer. Reasonable application of such provisions can effectively protect employers’ business secrets and prevent breaches by employees.

Although, the penalty amount may be agreed to between the employer and the employee, it should not be too high, otherwise it would not be likely to restrain employees and might be subject to judicial adjustment. In judicial practice, courts have tended to adjust the amount of penalties deemed excessive by taking into consideration the non-compete compensation amount actually received by the employee as well as resulting damages, by reference to Article 114 of the Contract Law, e.g., “If the stipulated penalty for breach of contract is excessively higher than the loss caused by the breach, the party concerned may apply to a people’s court or an arbitration institution for an appropriate reduction.”

Similarly, the employer may claim against the employee for the part of damages (if any) caused by the employee’s breach of non-compete obligation in excess of the agreed-upon penalty amount. Moreover, the employer has the right to request that the employee continue to abide by the non-compete agreement even after the employee has paid such penalty to the employer.

When circumstances change

Generally speaking, the post-departure non-compete obligation shall automatically take effect upon termination or ending of the employment contract, unless otherwise agreed to by both parties. In practice, a non-compete agreement generally has been signed at the beginning of the employment relationship, but over time, the employer’s information once considered confidential may no longer be so; the confidential information accessed by the employee may have gone public or other circumstances may have caused the post-departure non-compete to lose practical effect.

Pursuant to the Interpretations (IV), after the post-departure non-compete agreement takes effect, and even though the parties have not agreed on non-compete financial compensation, the employer shall pay the financial compensation if the employee has fulfilled the obligations under the non-compete agreement. in addition, the employer has the right to unilaterally terminate the non-compete agreement, provided that it pays an extra three-month financial compensation for obligations thereunder. Further, if the employer has not paid any financial compensation for three months, the employee shall have the right to terminate the agreement by express act.

Therefore, at an employee’s departure, the employer should consider whether it is necessary to require the employee to continue to adhere to the non-compete agreement. If the answer is “no,” the employer should consider promptly informing the employee in writing that it is terminating the non-compete agreement in order to avoid unnecessary costs and suits.

[1] Non-Compete Dispute Case – Shenyang Mingjun Properties Co., Ltd. Vs. Wei Xiaoshuang, Shenyang Yike Real Estate Agency Co., Ltd. [2015] Shen Zhong Min Zhong Zi No. 539; Employment Contract Dispute Appeal Case – Shenzhen Lifang Qunying Digital Technology Co., Ltd. vs. Qiu Qiulan [2014] Shen Zhong Fa Lao Zhong Zi No. 1258.

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