Originally published 28 July 2009
Keywords: outsourcing, China, employment law
For many years China has been developing into one of the world's leading manufacturers of goods. More recently, it has become intent on becoming a leading global provider of services.1 While labor conditions in manufacturing have raised some significant issues of international social concern,2 buyers of Chinese-sourced products have had relatively little occasion to focus on basic human resources and personnel issues associated with their suppliers' employees. As China seeks to attract international businesses to source services from China, however, human resources and personnel issues associated with the supplier employees will take on a new immediacy for buyers of Chinese services.
Human resources and personnel issues are inherently significant issues in any services sourcing transaction. This focus is driven by the obvious fact that the output of a services outsourcing the performance by the supplier's employees. Whether a sourcing of services from China is undertaken through a captive (owned-affiliate) entity or through a contractual outsourcing arrangement, buyers of Chinese services are directly and immediately impacted by employment and labor laws and practices in China. This impact includes the ability to enforce (and exercise) certain rights expected by buyers of services, as well as risks associated with exercising such rights, including the risk of attracting liability as an employer.
This article provides a general overview of employment law in the People's Republic of China, with a focus on how such laws affect the sourcing of services from China. For purposes of facilitating a fuller discussion, this article will largely utilize a hypothetical outsourcing transaction between a Chinese customer and a Chinese supplier. Specifically, this article will utilize a classic outsourcing formulation in which the customer actually transfers responsibility for a scope of its operations (the "Services"), such as information technology or business processes, previously performed by its employees in its facilities in China, to a Chinese supplier that takes over responsibility for the Services and maintains their performance, at least in part, at such customer facilities. Many foreign buyers of Chinese services will not face all of the issues arisingin this hypothetical transaction (particularly those associated with the customer's incumbent employees outside China who are performing the services transferred to the supplier, which may give rise to issues under the local law of such employees' location but not China). Using such a hypothetical Chinese customer for this discussion will allow for a broader review of the issues under Chinese law and practice.3
Overview of the PRC employment law
The past 10 to 15 years have seen dramatic developments in Chinese employment law. The foundation for labor and employment laws in China are the Labor Law (the "Labor Law"), enacted on January 1, 1995, and the Labor Contract Law (the "Labor Contract Law"), which came into force on January 1, 2008. The Labor Law focuses on general rights of employees, such as employment, promotion and training, collective contracts, work hours, wages, social security and benefits, and occupational safety and health. The Labor Contract Law focuses on the more specific aspects of the contractual arrangement associated with the engagement of an individual as the employee of an employer. These laws are generally applicable to any employment relationship established in China.4
A few important threshold considerations associated with employment contracts in China should be noted.
Requirement of Writing
An employer is obligated to enter into a written labor contract with any employee within one month from the date of commencement of employment. Failure to do so results in the employer being required to pay to the employee twice the amount of the agreed remuneration as salary.5 This obligation most likely continues through the period of continuing failure to enter into a written contract.
An employer and employee can agree on the term of employment, which may be definite (defined period), indefinite or piecemeal (dependent upon completion of work assignments. Importantly, however, an indefinite term is deemed to exist in any of the following circumstances:
- Employment under an oral contract that has subsisted for one year or more (following the January 1, 2008, effective date of the Labor Contract Law);
- The employer and employee have entered into a fixed term labor contract twice successively and the parties intend to renew such contract upon its expiry (unless the employee has requested a fixed term); or
- The employee has worked for an employer continuously for 10 years or more (unless the employee has requested a fixed term).6
Further, if the employer fails to sign a written indefinite term labor contract with the employee when the term is or becomes indefinite, the employer becomes obligated to pay twice the amount of salary otherwise payable from the date the employment term became indefinite.7 As noted below, an employer cannot terminate an employee without cause, irrespective of what the labor contract provides, making the term (especially an indefinite term highly significant.
Rights of Termination of Employment
An employee has the unilateral right to terminate his or her labor contract without reason, subject only to 30 days' advanced written notice. This notice period is reduced to three days during any probationary period stipulated in the labor contract (which can be up to six months in the case of an indefinite term or greater than three-year-term labor contracts). No prior notice is required if the employer has breached the law or labor contract (for example, failed to timely pay wages or social insurance contributions).
On the other hand, an employer has no unilateral right to terminate its employees. Termination of employment by an employer can legally occur only in two broad circumstances. First, in the case of definite or piecemeal term employment, termination can occur when employment in fact ends with the natural expiration of the employment contract (that is, expiration or completion, as the case may be). However, premature termination of employment can occur only in the following limited situations:
- Employee fault8
- The employee suffers from a disease or from non-work-related injuries, and is unable to perform his/her original job or any other job arranged by the employer after the medical treatment period;
- The employee is incapable of performing the job assigned, and remains incapable after being provided with the relevant training or being assigned to another position; and
- The labor contract is no longer executable due to "material changes in the objective conditions" existing at the time the contract was originally entered into, and both parties fail to agree on any variation to the original contract.
Even in cases of permissible termination (other than those based on employee fault), 30 days' prior written notice (or relevant payment in lieu of such notice) is required, and severance is payable upon the termination of employment, unless the termination is for employee fault.9 These limited employer termination rights highlight the significance of indefinite term employment.
Reinstatement for Wrongful Termination
If an employer wrongly dismisses an employee, the employee is entitled to reinstatement to his or her job position, or if the employee does not request reinstatement or the contract is no longer capable of being performed, the employer is obligated to pay twice the severance otherwise payable to the employee as damages.
Other Labor Standards and Entitlements
There are a number of laws establishing various labor standards and employee entitlements, especially at the local levels. These include statutory benefits for employees, such as minimum wages, maximum work hours, right to overtime payments, public holidays, statutory leave and social insurance. Local standards are subject to variation.
Specific HR and Personnel Considerations for Outsourcing Transactions
Over the life of an outsourcing transaction, a number of events or activities impacting the supplier's employees can occur that may carry significant implications under Chinese law. Although a number of these events or activities can occur at multiple times over the course of an outsourcing, their incidence is often associated with a particular phase of the outsourcing—namely, the inception or beginning of the transaction (sometimes referred to as the transition); the period of ongoing performance (sometimes referred to as steady-state), and the termination or end-phase of the outsourcing. The following discussion identifies some of the more significant activities or events associated with these phases and describes the likely treatment under Chinese employment law.
Transition Phase: Transfer of Customer Employees to Supplier
A first generation services outsourcing involves the transfer of Services performance from customer employees (each an "Incumbent Employee") to supplier employees (each a "Supplier Employee").10 In some cases (where Incumbent Employees transition to the supplier), these Incumbent Employees and Supplier Employees are the same individuals. Typically, the customer and the supplier will have relatively well-developed objectives respecting what should occur with respect to Incumbent Employees. Of course, each Incumbent Employee also will have legitimate interests (and in some cases, concerns) about the impact of the outsourcing on his or her job. From a transition end-game perspective, an Incumbent Employee will either become a Supplier Employee, or not; and if not, the Incumbent Employee will either remain an employee of thecustomer, or not. Getting to the actual result is impacted and in some cases driven by the actions of the parties in the context, and through the application, of employment law.
Even in mature outsourcing markets familiar with outsourcing transactions, labor issues are often significant during the transition phase, and the human resources teams of both the customer and the supplier are integral transaction participants. It should not be surprising then, that given the relatively recent adoption of the applicable employment laws in China as well as the general immaturity of the service outsourcing market in China,11 there is uncertainty about exactly how some of the activities and events of the transition phase will be treated. Fortunately, customers and suppliers can draw on lessons learned from many years of sourcing experience in other environments, although application of the laws of China will undoubtedly produce some unique aspects for Chinese outsourcings.
Ideally, the outsourcing agreement should expressly define the extent to which the supplier is obligated to make (or prevented from making) offers of employment to Incumbent Employees. Sophisticated suppliers have developed significant experience in recruiting and hiring employees from customers, and in many cases a large percentage of supplier personnel consist of employees successfully transitioned from customers. Notwithstanding such defined objectives, however, this is an area where employment law plays a particularly significant role in defining the respective responsibilities of the customer and the supplier.
For purposes of this discussion, two potential scenarios involving an Incumbent Employee during the transition phase will be analyzed:
Scenario One: The customer does not want to retain the Incumbent Employee but also does not want the Incumbent Employee to become a Supplier Employee (that is, does not want the Incumbent Employee to continue performing the Services) (the "Released Employee"). This scenario frequently arises from an accommodation of the supplier's interest that the Incumbent Employee not become a Supplier Employee (as when the supplier has sufficient employees to provide the Services without the Incumbent Employee).
Scenario Two: Where the customer wants the Incumbent Employee to become a Supplier Employee (and presumably continue performing the Services) but the Incumbent Employee does not want to become a employee of the supplier and seeks to remain an employee of the customer (the "Resistant Employee").
Scenario One: Released Employee
In this scenario, the customer's objective is termination of the Incumbent Employee. Absent fortuitous timing under an employment contract of definite or piecemeal duration coinciding with the outsourcing, the most likely permissible ground for the customer's termination of the Incumbent Employee would be the "material change in objective conditions" ground described above. For this, the customer would argue that the objective conditions for the Incumbent Employee's employment (namely, the operational mode whereby the customer was performing its own services through its own employees, including the Incumbent Employee) have undergone a material change by virtue of the outsourcing, making it impossible to continue to perform the original employment contract (the Services no longer existing with the customer). Although the Incumbent Employee would likely not succeed in a claim for reinstatement of employment with the customer, he or she would be entitled to the notice and severance payments described above.
Significantly, however, it is possible that the Incumbent Employee may seek to maintain that he or she should be entitled to employment with the supplier—that is, that he or she should become a Supplier Employee, despite the intentions of the customer (and presumably the supplier) to the contrary. Such an argument would likely be based upon Article 34 of the Labor Contract Law ("Article 34"), that provides the following:
In case of any merger, spin-off, or like circumstances of the employer, the original labor contract shall remain valid and shall continue to be performed by the employing entity which succeeds to the rights and obligations under such contract.
Under this provision, the Released Employee might argue that his or her employment has transferred to the supplier, because the outsourcing transaction constituted a "merger, spin-off, or like circumstance of the employer." In fact, such treatment would not be dissimilar to the treatment of customer employees under European laws implementing the Acquired Rights Directive.12 The counter argument of the supplier (as the party against whom the Incumbent Employee would most likely be making such a claim) would be simply that an outsourcing transaction is not a "merger, spin-off, or like circumstance of the buyer," but rather a mere change of business operational mode and therefore not a transaction to which Article 34 protections apply. The treatment here remains uncertain; the law is simply too new and untested. Similar periods of uncertainty existed under European laws and this is an example of an area where the customer and the supplier may draw on the experiences of customers and suppliers in other uncertain situations to acceptably allocate associated risks.
Scenario Two: Resistant Employee
In scenario two, the customer (and presumably the supplier) desires that the Incumbent Employee transfer his or her employment to the supplier, but the Incumbent Employee seeks to remain an employee of the customer. Depending on the circumstances, the customer and the supplier may benefit from application of Article 34 to this transaction, as described above. However, irrespective of the application of Article 34, the Incumbent Employee cannot be required to remain a Supplier Employee, and would be entitled to terminate his or her employment, subject only to required written notice of termination. Nonetheless, if Article 34 were applicable so that the employment contract transfers to the supplier, the Incumbent Employee would risk losing severance payments if he or she voluntarily resigned.13 Such risk would likely encourage the Incumbent Employee to continue performance under thesupplier, even if only temporarily.
The Incumbent Employee's objective of remaining an employee of the customer, however, would almost certainly be unsustainable. To succeed in such an effort, the Incumbent Employee would need to successfully characterize the outsourcing transaction (and associated transfer of employment to the supplier) as an illegal variation or breach of the original employment contract. Such an argument would seem wholly inconsistent with the very existence of the "material change in objective conditions" ground for termination. Particularly where an entire function of the customer is outsourced so that no job remains for the Incumbent Employee, it would seem highly unlikely that any arbitrator or judge applying Chinese law would uphold such a contention. This would seem even more unlikely where (as in this scenario) the "same" job is available to the Incumbent Employee with the supplier.
Critical Service Provider Personnel
It is common practice in outsourcing transactions where Incumbent Employees have become Supplier Employees that the supplier is contractually committed to retain a core group of identified Incumbent Employees for a designated period. Customers seek such commitments from suppliers as a means of reducing overall transaction risk, by seeking to ensure that the supplier has the benefit of employees with known experience and knowledge of the customer and Services, especially during the Services' initiation period. Typical minimum retention periods are 12 to 18 months, beyond which the retention obligation expires and further retention of such Supplier Employee is within the discretion of the supplier, subject to applicable employment laws.
One important aspect of minimum retention obligations is that the retention commitment runs from the supplier to the customer, and not to the employee. Such arrangements would seem entirely consistent with Chinese employment law.
Service Period Credit
Certain employee benefits under Chinese employment law are affected by the length of an individual's employment.14 Thus, in the case of an Incumbent Employee becoming a Supplier Employee, it can be important whether such Incumbent Employee is credited with the period of his or her prior employment with the customer. In this area, credit often will be given, under authority of an Implementation Rule of China's State Council, providing as follows:
Where an employee has been arranged by an employer, otherwise than for the personal reason of such employee, to work for a new employer, his/her service period with the original employer shall be added in the calculation of his/her past service period with the new employer.15
This crediting rule could be significant to an employee's entitlement to an indefinite term labor contract for continuous service of 10 years or more. Attaining an indefinite term contract through such a 10-year period of continuous service, whether through actual years worked for the supplier or with credit given for prior years as a customer employee, would preclude the supplier from terminating such Incumbent Employee without statutory cause.
Often the personnel provisions of outsourcing agreements expressly define circumstances for which Incumbent Employees hired by the supplier should be given credit for years of service with the customer. While the necessity for and functionality of such a provision is lessened with the interpretative ruling, best practice and clarity would support clear documentation in any event.
Terms of Employment with the Supplier
Although not entirely clear, in circumstances where Article 34 applies to effect the transfer of an Incumbent Employer's employment to the supplier, the terms of employment with the supplier will most likely be those of the pre-existing labor contract with the customer. Even if otherwise desired, suppliers seeking to hire and maintain Incumbent Employees would be hard-pressed to reduce salary and other employment terms, risking that Incumbent Employees might seek to resist (or terminate) employment with the supplier.
It is typical in outsourcing agreements that the customer and the supplier allocate between themselves responsibility for employee-related liabilities (for example, responsibility for payment of wages and social insurance contributions during the period of employment with the respective party). Often this allocation is effected through indemnities for the various liabilities from the party allocated responsibility. It is also likely that during periods of uncertainty around the treatment of Incumbent Employees under Chinese law (notably, for example, with respect to applicability of Article 34), the parties will likely provide for an allocation of the uncertainty risk betweem them through the use of tailored indemnities. This is an area where customers and suppliers can draw on many years of prior experience of (other) customers and suppliers in mature outsourcing jurisdictions.
Steady State Phase
Rights Held by Customer
During the steady state phase of an outsourcing, a number of continuing employee-related issues may give rise to employment law considerations. Among these are a number of customer rights frequently contained in outsourcing agreements that require or direct certain conduct by, or treatment of, Supplier Employees, including:
- The right to require the supplier to replace an individual Supplier Employee in the performance of Services if the customer deems such replacement to be in the customer's best interest;
- The requirement that Supplier Employees comply with customer rules and practice requirements (for example, code of conduct or customer site rules such as substance abuse policies); and
- The right to give input on Supplier Employee compensation (for example, through satisfaction survey input and the like).
Another set of rights involve "flow down" rights that the supplier is obligated to make directly enforceable against the Supplier Employees by the customer. These may include:
- Obligations respecting confidentiality of customer information accessed or created by Supplier Employees, where the customer may feel that contractual responsibility of the supplier alone is not sufficient; and
- Restrictions on the performance of services for competitors of the customer.16
Finally, outsourcing agreements frequently contain a clear commitment by the supplier of responsibility for the acts of Supplier Employees, even if those acts constitute negligence, willful misconduct and/or fraud. Such a clear specification can be important where (as may be the case under Chinese law) the supplier may have the ability to claim that wrongful actions of the Supplier Employee are outside the scope of responsibility of the supplier.
Major outsourcing agreements often contain a number of reciprocal obligations and rights related to supplier and customer employees. One of the more significant of these is the prohibition against hiring employees of the other, unless expressly permitted (including as exceptions the activities associated with the transition of employees to the supplier and at the termination or expiration of the outsourcing.
The ultimate enforceability of these provisions is not clear under Chinese law, especially those that can be viewed as placing restrictions on the individual employee's ability to work. As in most jurisdictions, contractual restrictions on employment are not viewed favorably; however, to the extent these restrictions are applicable between the supplier and the customer (and not to individual employees) they are more likely to be enforceable. Future developments in the law will certainly clarify these issues.
Disclaimer of co-employment
Customers in outsourcing transactions must take care respecting the risk of being considered an employer (most likely co-employer) of Supplier Employees. This risk typically arises in connection with the customer possessing (and exercising) rights over Supplier Employees performing the Services, including rights such as those described above. This risk is sometimes exacerbated by the fact that for some Supplier Employees day-to-day work activities may have changed relatively little from when they were Incumbent Employees. In such circumstances, the risk is that employer status may arise and result in the Customer having employer responsibilities and liabilities, such as for wages or underpaid social insurance contributions. Outsourcing agreements typically expressly disclaim co-employer status on the part of the customer; however, because any such claim would likely be made by individual Supplier Employees who are not party to the outsourcing agreement, such a declaration may have limited impact on an employment-related claim by the Supplier Employee. Consequently, outsourcing agreememts typically also include a supplierindemnity for the benefit of the customer against any such Supplier Employee claims. In some cases the risk is viewed as sufficiently great by the customer that it agrees to reduced rights directly related to Supplier Employees under the outsourcing agreement.
The final phase of an outsourcing transaction is termination or expiration. As with the other phases of an outsourcing, certain labor issues or considerations arise in connection with the activities occuring or undertaken during this phase, or in connection with the rights possessed and exercised by the parties during this period.
One of the first issues is the potential follow-on applicability of Article 34 to the re-sourcing or in-sourcing of the Services. Such treatment would presumably be similar to that applicable in the transition phase, as discussed above. Again, this is an area where the customer and the supplier may draw on the experience of outsourcing in jurisdictions with laws similar to those required by the Acquired Rights Directive. To the extent treatment is uncertain given the developing law in this area, express allocation of risk between the customer and the supplier through inclusion in the outsourcing agreement of appropriate indemnities between the customer and the supplier would be appropriate.
Even without applicability of Article 34, an important right often required by the customer in outsourcing agreements is the express right to hire (or allow its successor supplier to hire) Supplier Employees engaged in the performance of the Services at the end of the term. Frequently, the customer seeks to include within this right Supplier Employees who performed Services within the final year under the agreement, in order to avoid the risk of the supplier evading the obligation by assigning its most desirable employees away from the customer account. Such a clear customer right may be unnecessary if no-hire provisions are in fact found unenforceable in China, but best practice on part of the customer would call for seeking to include such a clear right in the outsourcing agreement.
China is experiencing dramatically swift change and development in both its law and its commercial practices, and this is very much evident within its services outsourcing industry. Employment law is a critical area for all service outsourcings and it will be important for customers and suppliers of Chinese services to carefully evaluate their undertakings in light of continuing developments in the law. As these developments unfold, parties to Chinese service outsourcing transactions can look to how such issues have been handled in outsourcing transactions over the years in other jurisdictions, particularly during periods of development and clarification in applicable laws. The outsourcing business model has developed and been proven over many years and through periods of uncertainty, providing guidance that can be applied to the benefit of customers and suppliers of Chinese services. Ultimately, however, there is little doubt that the law and commercial practices in China will develop in ways that support the successful sourcing of services.
The authors would like to thank Rachel Zhang and Chen Song, associates in the Mayer Brown JSM Shanghai office, for their assistance in the writing of this article.
1. See "Going to China", Business & Technology Sourcing Review, Mayer Brown LLP, Issue 11, Q1/Q2 2008 and republished in Asian Counsel (May 2008).
2. Excluding concerns associated with important issues such as child labor and working conditions that are beyond the scope of this article.
3. It should be noted that this hypothetical transaction would include the case of a foreign-owned captive entity in China transferring its operations to a Supplier. Such a scenario will likely become an increasingly frequent one as the Chinese services sector matures.
4. In addition, local regulations and rules issued by provincial, municipal and other lower level authorities are only applicable in the relevant local regions. These laws involve a variety of matters, including minimum wages, calculation of wages, application of special work hour systems and social security contributions.
5. Articles 10 and 82 of the Labor Contract Law.
6. Article 14 of the Labor Contract Law.
7. Article 82 of the Labor Contract Law.
8. Employee fault for this purpose includes:
- The employee is proved not to fulfill the requirements of recruitment during the probation period;
- The employee seriously violates the labor discipline or the work rules and regulations of the employer;
- The employee is in serious breach of his/her duties, or engages in misconduct that has caused material loss to the employer;
- The employee has entered into an employment relationship with another employer which materially affects the completion of his/her tasks with the (first) employer (and the employee refuses to rectify the situation after the matter is brought to his/her attention by the employer);
- The employee enters into the labor contract by means of fraud, threat, force or exploitation; or
- The employee is prosecuted for criminal liability.
9. Severance in connection with employment termination is provided for under Article 47 of the Labor Contract Law and the relevant local labor contract regulations and generally involves a payment of one month's salary for each year of continuous employment with the employer.
10. In the case of a successor outsourcing (sometimes referred to as a re-sourcing) or a repatriation of the services to the Customer (sometimes referred to as an in-sourcing), the Incumbent Employee would be the employee of the incumbent Supplier. Such transactions occur with relative frequency in mature outsourcing markets, and the applicable considerations should be generally consistent with an initial outsourcing.
11. See "Going to China" referenced in footnote 1 above.
12. That is, the implementing legislation of member states under the Council of European Communities Directive 77/187 of 14 February 1977 (the "Acquired Rights Directive").
13. Under Article 46 of the Labor Contract Law, an employee is not entitled to severance in the case of voluntary resignation.
14. Employment benefits affected by length of employment include annual leave entitlement and severance entitlements.
15. Rule 10 of the PRC Labor Contract Law Implementation Rules by and effective from September 18, 2008.
16. The Supplier may enter into confidentiality and non-compete covenants with a Supplier Employee restricting him or her from providing Services to competitors of the Customer during the term of employment. However, if such restriction is to be effective even after the termination of employment between the Supplier and the Supplier Employee, such non-compete period cannot exceed two years following such termination, and the Supplier is obligated to pay compensation to the Supplier Employee within such post-employment restrictive period.
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