Navigating the New Employment Contract Law

On January 1 2008, the Law becomes effective.³ The six month lead time provides employers in the PRC with some time to examine their existing employment contracts and policies and determine what areas need modification for compliance with the Law. Notably, the Law is expected to apply immediately to any contract in effect as of January 1 2008. Accordingly, employers must act quickly to review existing contracts and policies in order to implement changes in advance of the effective date.

OPEN-ENDED CONTRACTS FAVOURED

The Law will impact the current employment contract practice in the PRC. Presently, it is common practice for employers to use fixed-term contracts of a short duration. The current practice allows employers considerable flexibility. The Law will curtail this practice by instituting preferences for open-ended contracts and disadvantages for fixed-term contracts. First, the Law contains a default provision whereby if an employer fails to enter into a written employment contract with an employee within one year of the employee's start date, the employment relationship will be deemed open ended. Second, it mandates that employers must conclude open-ended employment contracts with employees in three circumstances: (a) upon the second consecutive renewal of a fixed-term employment contract after January 1 2008, unless legal justification exists for terminating the contract; (b) if an employee has ten or more years of service, upon the employee's contract renewal;⁴ (c) in a restructuring if an employee has at least ten years of consecutive service and is not more than ten years from the legal retirement age.

If an employer fails to enter into an open-ended contract in one of these circumstances, the employer must pay the employee double his/her monthly wage beginning from the time that the employer should have executed an open-ended contract.

With respect to the first scenario, the employer does not wish to retain the employee, then the employer must pay severance as a price for not extending the employment relationship, as discussed more thoroughly below.

Given these restrictions, employers who currently use short-term employment contracts should evaluate their use and give more thought to using the length of the initial employment contract more strategically and effectively.

PROBATION PERIODS

Similar to the current law, the maximum duration of a probation period will hinge on the length of the employment contract. The Law imposes a new national standard for the permissible length of probation periods, eliminating any chance of extending the probation period for any employee for any reason. The probation period may not exceed one month for a contract lasting at least three months and less than one year. The probation period for a contract lasting at least one year but less than three years may not exceed two months. The probation period for a contract with at least a three-year term, or an open-ended contract, may not exceed six months. These new maximum permissible lengths will affect the appraisal of talent in many companies.

The Law further provides that an employer may not impose more than one probation period on a given employee. This means that an employer may not impose a new probation period in the event of a rehire, a contract renewal, a promotion or a lateral transfer to a new position. For example, if an employee is promoted to a new position, the employer may not impose a new probation period on the employee if the employee has already served one. Or, if an employer re-hires a former employee, the employer may not impose a probation period during the employee's second tenure, if the employee served one previously.

Given these changes, employers can use probation periods strategically, as terminating an employee is far easier during the probation period than after the probation period. Having a "one size fits all" approach to all employment contracts and their length no longer appears viable or sensible. For example, an employer may choose a longer-term, fixed-term contract when hiring a more senior executive to assure sufficent time to evaluate the executive properly during the probation period. Alternatively, the employer could continue to utilize a one-year fixed-term contract for the first year of employment for such executives, switching to a longer-term or open-ended employment contract thereafter. Nothing in the Law requires consecutive contract terms to be of equal duration.

In contrast, shorter-term contracts with shorter probation periods may be preferable for lower-level employees whose performance becomes more readily apparent in a shorter period of time. However, if employee turnover is an issue, providing a longer-term employment contract may reduce turnover by demonstrating a greater commitment to the employee.

Importantly, if the company decides to utilize contracts of varying lengths and types for different employees, the human resources department must closely monitor employment contracts in order to:

1) ensure strategic use of probation periods and periodic evaluation of employees by managers during the probation period; and

2) track notice periods and contract renewal dates to ensure proper notice is provided and open-ended contracts are offered upon the second renewal of a fixed-term contract.

TRAINING EXPENSES AND SERVICE PERIODS

The Law allows an employer to require an employee to agree to a set service period in exchange for the expense of "professional, technical training." Further, the Law permits an employer to recoup liquidated damages from the employee if the employee resigns before completing the agreed-upon service period. The Law limits the liquidated damages to the pro-rata portion of the training expenses related to the remaining portion of the service period.

EMPOWERMENT OF TRADE UNIONS

The Law increases the pressure on foreign-invested entities to establish a trade union⁵ by suggesting by its plain language that trade unions already exist within every company. The Law confirms that employers must formulate rules and regulations that govern the workplace and affirmatively requires that employers develop these internal rules with the trade union's involvement. More specifically, the Law requires that employers "consult" with the trade union (or employee representative group in the absence of a trade union) regarding the formulation or implementation of an employer's policies that bear directly on the "immediate interests" of the employees. Such interests include remuneration, working hours, rest time, holidays, job safety, social insurance, training, and discipline and work quotas. The Law also reiterates the existing legal requirement that employers give advance notice to the trade union of an employer-initiated termination and listen to the trade union's opinions regarding the termination if it disagrees with the basis.⁶ The full effect that this consultation process will have on the formulation of an employer's policies remains unclear. Only time will tell how the trade unions in China use, or exploit, this increased power and involvement that the Law grants them in areas traditionally left to the absolute discretion of management.

COLLECTIVE CONTRACTS

The government's goal in increasing the significance of trade unions is illustrated in the provisions encouraging the use of collective contracts. The Law not only provides that industry-wide contracts are permissible, limited geographically only by county lines, but also provides that area-wide collective contracts may be concluded. This means that competitors within particular industries - and the Law specifically refers to mining, catering services and construction - may be subject to the same collective contract covering their respective employees, which will undoubtedly have an effect on competition. It also means that unrelated companies in various industries may also find themselves on the same side of a bargaining table because, for example, they are all located within the same industrial park or building. Suggested topics for inclusion in collective contracts include compensation, working hours, benefits, leave, work safety, and a wage adjustment mechanism. Finally, the Law requires that the standards set forth in a collective contract for issues such as wages and working conditions may not be lower than the government's minimum standards.

PART-TIME EMPLOYEES

The Law defines a "part-time employee" as an employee who works generally no more than four hours on average per day or twenty-four hours in total per week for the same employer. Moreover, the Law clarifies that either oral or written employment contracts are acceptable for part-time employees. Either the employer or the employee may terminate the employment contract without notice and with no severance payable. Employers may not impose probation periods on part-time employees presumably because of the ease with which either party may terminate the employment relationship. The relaxed contractual requirements for part-time employees may provide greater flexibility to those employers who can conduct business utilizing a part-time workforce.

NON-COMPETITION PROVISIONS

With the recent trend in mainland China for companies to vie for talented, specialized and technical employees, effective use of non-compete provisions in employment contracts is becoming increasingly essential. Although the Law permits the use of restrictive covenants, only senior management, senior technical personnel and other personnel who are obliged to maintain the employer's trade secrets may be bound by them, and only for a maximum term of two years. The Law leaves the issues of the geographic scope and scope of restricted activities of the non-compete agreement up to the employer and employee to negotiate.

Significantly, the Law does not impose any minimum consideration for a non-compete agreement. Providing separate consideration for a non-compete agreement has been an important issue in the PRC. Not providing separate consideration has created uncertainty for many companies who have incorporated consideration for the non-compete restrictions into the employees' regular remuneration and benefits, without clearly delineating what payments are for the non-compete provision. Under the Law, employers and employees are free to negotiate over the consideration for a non-compete agreement. Many provinces and municipalities have implemented local regulations setting minimum consideration levels that range from one-third to two-thirds of the employee's annual wages. Such local regulations will likely continue to remain in effect.

Although the Law seeks to clarify certain aspects of the payment of consideration, it leaves additional questions unanswered. For example, the Law requires that an employer pay consideration to a former employee "monthly" after the employee' s termination, but it does not clarify whether an employer may pay the consideration up front and in advance during the non-compete period. The Law is also silent with respect to whether the payments during the non-compete period must be in equal installments. Implementing regulations will likely clarify these open issues.

The monthly payment requirement may cause difficulties for employers who want to enforce a pre-existing non-compete after January 1 2008. For example, if a company entered a one year non-compete agreement with a senior manager in exchange for 10% additional pay during the manager's employment term, and the manager leaves for a competitor in January 2008, the non-compete will likely be unenforceable because the consideration was not paid during the non-compete period. If the Law is interpreted in this manner, employers should consider entering into new, fully compliant non-compete agreements with key personnel before January 1 2008.

Moreover, the Law codifies the employer's right to demand liquidated damages for an employee's breach of a non-compete agreement. Employers should consider including a formula or monetary figure as the penalty for a breach as PRC law is silent on this issue.

MASS LAYOFFS

The Law reflects the goal of encouraging longer term employment relationships by increasing the administrative burden with respect to conducting a mass layoff. The Law considers a "mass layoff" to consist of a layoff of at least twenty employees or 10% or more of the "total number" of the employer's workforce. The Law is unclear, however, as to how to calculate the "total number" of employees. For example, in determining whether the company is terminating 10% of its workforce, should it consider the operational site or its PRC workforce in total?

Further, the Law prescribes specific provisions for the retention of employees without regard for employee performance or job function. Indeed, the Law provides preferential retention provisions for those employees (a) with comparatively longer-term fixed-term contracts, (b) with open-ended contracts; or (c) who are the sole wage earners and support an elderly person or a minor. Clearly, determining who is eligible for a layoff will take more careful investigation and inquiry in order to discern who fits into the third category.

The Law also expands on the existing grounds to justify a mass layoff by permitting a mass layoff pursuant to a major change in production, technology development or business methods. As manufacturing facilities automate their production lines, this additional ground will become important.

TERMINATING AN EMPLOYMENT CONTRACT

The Law broadens the legally permissible grounds under which an employee may terminate an employment contract without prior notice and collect severance. If the employer fails to pay the legally required social insurance contributions for the employee, or the employer has a workplace policy that violates PRC law and causes harm to the employee, the employee may terminate the employment contract without notice. Under either scenario, the employer must pay severance to the employee. The second ground in particular should encourage employers to ensure that their policies comply with PRC law or otherwise risk providing employees with legal grounds to terminate the employment contract without notice and while collecting severance.

SEVERANCE PAY

The Law expands upon the circumstances under which an employer must pay severance. Marking a significant departure from current practice, the Law requires an employer to pay severance upon the expiration of a fixed-term contract that the employer does not renew, unless the employee refuses to renew the contract which contains the same or better conditions. In addition, the Law imposes on the employer the obligation to pay severance when the termination is due to bankruptcy, dissolution or revocation of the business license.

To minimize the effects of the increased situations requiring the payment of severance, the Law places a cap on the amount of required severance. This cap will reduce the effect of this new provision on employers with highly paid workforces. The Law limits the severance amount to (a) three times the average "monthly wage" of employees for the previous year in the city where the employer is located, and (b) for no more than twelve years of work.

The Law clarifies that the "monthly wage" is based on the employee's wages for the twelve months immediately preceding the employee's termination.

The Law provides that employers must round up service periods of six months or more to one year for purposes of calculating severance. The employee is entitled to an additional half-month's wage for service periods of less than six months.

The Law, however, provides that the cap on severance will not apply to severance entitlements that accrued prior to the Law's effective date. Rather, the Law in effect creates a two-tiered severance calculation system that leaves the current applicable laws intact and effective so that employees will not be shortchanged of the current severance they accrue prior to January 1 2008. This provision will minimize the benefit employers receive from the statutory cap for current long-term employees.

It is clear, however, that the Law will increase the price companies must pay for terminating employees because it removes the current cost-free ability to let a contract expire if an employer is unsatisfied with the employee's performance. Moreover, for larger companies or those companies with many employees with significant amounts of tenure or higher salaried employees, the new severance requirements may result in significant future severance liabilities on the night of December 31 2007 that increase liabilities as salaries increase.

OVERTIME

Article 31 of the Law states "[i]f an Employer arranges for a worker to work overtime, it shall pay him overtime pay in accordance with the relevant state regulations." This is a restatement of the current law⁷ and further emphasizes the Law's aim to increase the power of the employee in relation to the employer. Indeed, if an employer fails to pay wages