Human Asset Management: Employment Issues in M&A Deals

In a typical deal where a foreign investor buys the assets and business of a Chinese company, there are several employee issues that commonly have to be resolved in order to close the deal, including:

• how do you properly transfer the employees?

• what severance or other payments are you liable to pay?

• how can you restrict the key personnel from competing with the business after the deal? and

• what measures can be taken to incentivize key personnel so that they will stay?

Legal Mechanisms for the Transfer of Employees

Since there is no legal mechanism for the automatic transfer of employees with a business undertaking under Chinese law, the transfer can only be affected by terminating the existing employment contracts of the employees with the seller and entering into new employment contracts with the new entity.

Under the M&A Tentative Provisions, an employment resettlement plan should generally be submitted when applying for the approval of an acquisition of assets from a Chinese company. According to our enquiries with local officials, a resettlement plan will not normally be challenged if it provides that the new entity will take on 70% to 80% of the employees of the target. If redundancies are necessary as part of the deal, a redundancy plan should be included in the resettlement plan.

In an asset acquisition, if the target is a state-owned enterprise (SOE), the SOE Reorganization Provisions and the Assignment of State-owned Assets Tentative Provisions provide for additional steps to be taken to protect the employees. In particular, the employees' representative congress of the seller must be consulted about the transaction and a proper resettlement plan prepared for the employees. The plan should be discussed and approved by the representative congress of the employees, and then examined and verified by the local labour administrative authorities before being submitted for government approval. The seller should use its existing assets to settle in full all unpaid wages, medical expenses, housing funds and unpaid social security contributions. The SOE Reorganization Provisions further require that economic compensation should be paid to those employees whose contracts of employment are terminated.

Severance Payments

Except where an employee is fired on the grounds of fault on the part of the employee or where the term of an employment contract expires, an employer is generally required to make severance payments when the employment contract of an employee is terminated. As a rough rule of thumb, severance payment is calculated on the basis of one month's wages for every full year of service (see table one). Unlike in other countries, there is no exception under Chinese law for M&A deals where the buyer of a business undertaking offers the employees of the seller employment on the same or more favourable terms. As a result, the seller is technically liable for severance payments to those employees whose contracts of employment are terminated irrespective of whether they are taken on by the new entity. To ensure that the new entity does not end up liable for any of these severance costs, the foreign buyer will normally ensure there are contractual indemnities in the transaction documents that make it clear that the seller is responsible for all liabilities in relation to the employees arising from their period of service before the deal closes and for all severance and other payments that the seller is liable to pay to the employees as a result of the termination of their existing employment contracts and re-employment by the new entity on its standard terms.

It is also recommended that the new entity include a clause in the new employment contract with the transferred employees stating that their service period will commence on the date of the signing of the new employment contract, and compensation payments for future termination of their employment (if applicable) will be calculated based only on their period of service with the new entity and will not be based on the aggregate of their period of service with the new entity and the earlier period of service with the seller.

When terminating the existing employment contract with the transferred employees, any separate confidentiality and non-compete agreement previously signed with the seller should be terminated on the same date that the new employment contract with the new entity is executed (so that the transferred employees are released from their obligations to the seller and are legally permitted to work for the new entity) and, simultaneously, new confidentiality and non-compete agreements should be executed with the new entity.

SOEs and Large-scale Redundancies

In China, one of the traditional problems in acquiring an SOE is that they are often heavily overstaffed and may have non-productive social assets on their books such as hospitals and schools. The foreign investor is usually unwilling to take on all of the employees and these social assets. The seller and the approval authorities, on the other hand, are reluctant to agree to large-scale redundancies because of the potential social upheaval and political costs. In these circumstances, it is essential to agree upfront to a redundancy plan that is acceptable not just to the buyer and seller but also to the local government and the employee representatives' congress of the seller.

To make a redundancy plan acceptable to the seller, compromise is often necessary. In one deal, for example, the parties agreed that the seller's parent would set up a service company as part of the transaction in order to provide provisional employment to some of the unwanted employees for a fixed period of several years, during which period the new entity was committed to purchasing services from the service company. In another deal, the ultimate redundancy plan that was agreed contemplated a staged reduction in staff numbers over a period of several years. The buyer undertook that not more than one employee would be made redundant from any one family (since the SOE employed several people from the same family in certain cases) and the plan was combined with an early retirement programme for those close to retirement age.

Non-compete Restrictions

For those employees who hold important posts and have access to confidential information, many Chinese companies insist on confidentiality and non-compete agreements or include such clauses in their employment contracts to prevent the employees from setting up a competing business or joining a competitor when they leave the company.

In order to make sure that a non-compete clause is enforceable, three basic principles should be followed (see table two). Firstly, the period for the post-contractual non-compete obligation should be limited to three years. In general, Chinese law does not protect a longer period.

Secondly, the non-compete obligation should include payment of compensation to the employee for the term of the non-compete provision. Otherwise, the obligation is not binding on the employee. Chinese law does not specify what constitutes a reasonable level of compensation, so the amount is open to negotiation between the employee and the employer. Some local regulations and court interpretations, however, have provided guidance on the appropriate level of compensation by suggesting it should be in the range of 20% to a third of the average salary of the employee in the previous 12 months. As a matter of practice, we have seen companies refer in the employment contracts with their key management personnel to compensation equal to somewhere between 30% and 50% of the employee's salary. Where compensation for the non-compete obligation is linked to the employee's "salary", his stock options, dividends and other investment-related income are not generally included in the calculation of his "salary".

Thirdly, the non-compete clause should be specific about the kind of business in which the employee is restricted from participating. Although Chinese law does not expressly state what are acceptable limits on the freedom of the employee to seek alternative employment elsewhere, it is prudent to ensure these limitations are reasonable in nature.

Finally, it is worth noting that courts in China will generally not support an agreement that provides that the compensation for the non-compete clause has already been included in the salary paid to the employee.

Management Incentive Schemes

A major concern when acquiring a Chinese company is how to retain key management and other staff, at least for the first few years when the foreign investor is still learning the business. One retention method used where the key employees are also the founders and shareholders of the business is to structure the transaction price so that part of the premium to be paid over and above the book value of the assets is actually paid in the form of a bonus to the key employees under their employment contracts or as a final instalment of the purchase price paid to the shareholders for the business, and this payment is linked to the continuing participation of the key staff in the new entity and the achievement of certain performance targets. If the premium is paid in the form of a final instalment of the purchase price, it must be included in the asset acquisition agreement approved by the Chinese approval authorities and, strictly speaking, the longer payment schedule requires special consent and should in any event provide that the full price will be paid within at least one year after completion of the deal (although, in practice, the authorities may be more flexible on the timetable).

Another popular incentive option is to offer key management personnel options in the stock of the foreign investor or its listed parent. Generally, as long as the issuance or offering of the options is limited to a specific group of people, the China Securities Regulatory Commission's (CSRC) current view is that the option plan does not constitute a "public offering of securities", and therefore is regarded as outside its jurisdiction. However, structuring a stock option plan can be complicated by restrictions under PRC law on the remittance of foreign currency out of China to pay the exercise price, and on the repatriation of the proceeds of sale into China since PRC law will view the stock as an offshore investment in securities by Chinese nationals.

There are two main ways to overcome these restrictions. One is to structure the plan to permit the cashless exercise of the stock options. As a result, the employee who is granted the stock option does not have to remit foreign currency out of China in order to pay the exercise price. When the option is exercised, the offshore company will either issue to the relevant personnel a number of shares equal to the difference between the total number of shares subject to the option minus the number of shares having the market value equal to the exercise price that should have been paid by that person, or pay the relevant personnel a cash amount equal to the value of the shares sold minus the exercise price that should have been paid by that person.

The other way to structure the plan is to use a phantom/shadow stock option, under which no real shares are issued. Instead, the relevant employee will receive a cash "bonus" calculated as if that person had participated in the stock option plan.

Although the cashless exercise of the option circumvents any problem in remitting foreign exchange out of China, there is still a potential issue for the Chinese national when he eventually receives foreign exchange proceeds from the option in China. Since the monies received from the exercise of the options may be regarded as a "capital account" foreign exchange transaction, strictly speaking the employee must provide approval documents relating to the initial "offshore investment" in the option and then obtain the requisite approval for the investment and subsequent receipt of foreign exchange funds. However, currently there is no mechanism for employees as individuals to apply for approval for the initial "offshore investment". It is therefore practically impossible for the employee to provide the supporting documents to the State Administration of Foreign Exchange (SAFE). As a practical matter, since SAFE will generally not monitor foreign exchange transactions for current account items where the amount received is below US$10,000, option holders who expect to receive sums above this through the cashless exercise of their options often circumvent the regulatory issues by opening an offshore bank account to hold the funds or by planning the exercise of their options in discrete amounts under the threshold. The Chinese authorities generally recognize that the legal framework needs to be developed for stock option plans so that some of the current regulatory hurdles can be resolved. Until such time, modified stock option plans like those described above will continue to develop.