China: Human Resources and Personnel Issues in Chinese Sourcing Transactions

Originally published 12 February 2010

Keywords: China, employment law, labor conditions, outsourcing, PRC employment law

Over the last 30 years, China has become one of the world's leading manufacturing powers. While labor conditions in manufacturing have raised some significant issues of international social concern, buyers of Chinese-sourced products for the most part have had relatively little occasion to focus on basic human resources and personnel issues associated with their suppliers' employees.¹ More recently, China has become intent on becoming a leading global provider of services.² As China seeks to attract international businesses to source services from China, human resources and personnel issues associated with supplier employees will take on a new immediacy for buyers of Chinese services.

Human resources and personnel issues are inherently significant in any services sourcing transaction. Their importance is driven by the obvious fact that the output of a services outsourcing is largely comprised of the performance of services by the supplier's employees. Whether a sourcing of services from China is undertaken through a captive (i.e., 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 laws in the People's Republic of China, with a focus on how these laws impact the sourcing of services from China. For purposes of discussion, the article will utilize a hypothetical outsourcing transaction between a customer that is a Chinese entity and a supplier that is also a Chinese entity. Specifically, this discussion 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 process, previously performed by its employees in its facilities in China, to the Chinese supplier that, in turn, takes over responsibility for the Services and continues their performance, at least in part, at the customer's Chinese facilities.

Many foreign buyers of Chinese services will not face all of the issues arising in this hypothetical transaction. This is particularly true regarding issues associated with the customer's incumbent employees outside China who are performing the services being transferred to the supplier ( this may raise questions under the local law of such employees' location but not China). Nonetheless, 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 PRC Employment Law

The past 10 to 15 years have seen dramatic developments in Chinese employment law. The foundations for labor and employment laws in China are (1) the Labor Law that was enacted on January 1, 1995, and (2) the Labor Contract Law that 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 concentrates 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

General

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 salary⁵ This obligation most likely continues through the period of continued failure to enter into a written contract.

Employment Term

The term of employment has important implications with respect to termination of employment. An employer and employee can agree on the employment term, which may be definite (i.e., for a defined period), indefinite or piecemeal (i.e., dependent on the completion of assigned work). It is important to note that an indefinite term is deemed to exist in any of the following circumstances:

• The employee has been employed 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 expiration (unless the employee has requested a fixed term)
• The employee has worked for an employer continuously for ten years or more (unless the employee has requested a fixed term⁶

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 indefinite⁷ 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

Termination by Employee — An employee has the unilateral right to terminate his or her labor contract without reason, subject only to 30 days' advance 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 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, if the employer has failed to pay wages or social insurance contributions in a timely manner).

Termination by Employer — 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), a 30-day 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. If the employee does not request reinstatement, or if 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

China's employment statutes encompass laws establishing various labor standards and employee entitlements, especially at local levels. These may 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, various events or activities impacting the supplier's employees occur that carry significant implications under Chinese law. Although some 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. These phases notably include 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 their probable 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 (i.e., those in which 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 regarding 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 the customer or not. Getting to the actual result is impacted by, and in some cases is driven by, the actions of the parties in the context and through the application of employment law.

Even in mature outsourcing markets in which all parties are 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 nation's service outsourcing market, there is uncertainty regarding exactly how some of the activities and events of the transition phase will be treated.¹¹ Fortunately, customers and suppliers can draw on lessons learned from many years of sourcing experience in other environments, although application of China's employment laws 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 is 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 portion of supplier personnel consists of employees successfully transitioned from customers. Notwithstanding such defined objectives, however, this is an area in which 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 — "Released Employee": 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). This scenario frequently arises from an accommodation of the supplier's interest that the Incumbent Employee does not become a Supplier Employee (as when the supplier has sufficient employees to provide the Services without the Incumbent Employee).
• Scenario Two — "Resistant Employee": Where the customer wants the Incumbent Employee to become a Supplier Employee (and presumably to continue performing the Services) but the Incumbent Employee does not want to become an employee of the supplier and seeks to remain an employee of the customer.

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 that coincides with the outsourcing, the most likely permissible ground for the customer's termination of the Incumbent Employee would be "material change in objective conditions" described above.

To meet this acceptable criterion, 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. It is impossible, then, to sustain the original employment contract because the Services are no longer performed by the customer. The Incumbent Employee would probably not succeed in a claim for reinstatement of employment with the customer. But he or she would be entitled to the notice and severance payments described above.

Significantly, 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 objective 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, which provides that:

Under Article 34, 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 make such a claim) would be simply that an outsourcing transaction is not a "merger, spin-off, or like circumstance of the buyer," but is merely a change of business operational mode. The outsourcing, then, is not a transaction to which Article 34 protections apply.

The ultimate treatment described in this scenario remains uncertain because the law is new and untested. Consequently, its operation is somewhat unpredictable. Similar periods of uncertainty existed under European laws, however, and the scenario illustrates an area in which the customer and the supplier may draw on the experiences of customers and suppliers in other, equally uncertain situations to identify and 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 a customer employee. Depending on the context and its specific circumstances, the customer and the supplier may benefit from application of Article 34 to this transaction, as described above. Regardless of the application of Article 34, however, 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.

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 the supplier, even if only temporarily.

The Incumbent Employee's objective of remaining an employee of the customer would almost certainly be unsustainable. To succeed in such an effort, the Incumbent Employee would need to successfully characterize the outsourcing transaction (and the 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 customer function is outsourced so that no job remains for the Incumbent Employee, it would seem highly unlikely that any an arbitrator or judge applying Chinese law would uphold such a contention. This would appear even less likely when (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 often require such commitments from suppliers as a means of reducing overall transaction risk by seeking to ensure that the supplier has benefit of employees with known experience and knowledge of the customer and Services, especially during the Services initiation period. In this context, typical minimum retention periods range from 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 such 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:

This crediting rule could be significant with respect 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, without statutory cause, such Incumbent Employee.

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 Employee'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 the possibility that Incumbent Employees might seek to resist (or terminate) employment with the supplier.

Indemnities

It is typical in outsourcing agreements that the customer and the supplier allocate responsibility between themselves 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 that is allocated responsibility.

It is also likely that during periods of uncertainty regarding the treatment of Incumbent Employees under Chinese law (notably, for example, with respect to applicability of Article 34), the parties will provide for an allocation of the uncertainty risk between them through the use of tailored indemnities. This is another area in which 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, 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 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
• Restrictions on the performance of services for competitors of the customer¹⁶

Outsourcing agreements frequently also contain a provision stipulating that the supplier is responsible for the acts of Supplier Employees, even if those acts constitute negligence, willful misconduct and/or fraud. Such a clear specification can be important to customers 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 the supplier's responsibility.

Major outsourcing agreements often contain a number of reciprocal obligations and rights related to supplier and customer employees. One of the most 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 at contract inception, and rights of the customer to seek to employ Supplier Employees at the termination or expiration of the outsourcing).

The ultimate enforceability of these provisions is not clear under Chinese law. This is especially true of provisions that can be viewed as restricting the individual employee's ability to work. In China, as in most jurisdictions, contractual restrictions on employment are not viewed favorably. To the extent that these limitations are applicable between the supplier and the customer (rather than individual employees), they are more likely to be enforceable. Future developments in China's law will certainly help to clarify these issues.

Disclaimer of co-employment

Customers in outsourcing transactions must take care to minimize or eliminate the risk of being considered an employer (most likely, a 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. As a result, the Customer may be found to take on employer responsibilities and liabilities such as responsibility for wages or underpaid social insurance contributions.

Outsourcing agreements typically expressly disclaim co-employer status on the part of the customer. But because claims of this nature would most likely be made by individual Supplier Employees who are not party to the outsourcing agreement, such a disclaimer may have limited impact on an employment-related claim by the Supplier Employee. Consequently, outsourcing agreements typically include a supplier indemnity for the benefit of the customer against any such Supplier Employee claims. When the customer perceives this to be an especially significant issue, it may act to mitigate its risk by accepting reduced rights directly related to Supplier Employees under the outsourcing agreement.

Termination Phase

The final phase of an outsourcing transaction is termination or expiration. As is true of the outsourcing's earlier phases, certain labor issues or considerations arise relative to activities occurring or undertaken during the termination phase or in connection with the rights possessed and exercised by the parties during this period.

A key concern during the termination phase 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 outsourcing's initial transition phase, with the possibility of successor employer responsibility passing to the successor provider of the services (whether another supplier or the customer itself). This is another area in which the customer and the supplier may draw on the experience of outsourcing in jurisdictions with laws promulgated under the Acquired Rights Directive and similar laws. Until Chinese employment law in this area is settled, it is likely that outsourcing the customer and the supplier will seek to allocate such risks between themselves through appropriate customer and supplier indemnities contained in the outsourcing agreement.

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 outsourcing engagement's 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 ultimately found to be unenforceable in China. But best practice on the customer's part would typically call for a clear right of this nature to be included in the outsourcing agreement.

Conclusion

China is experiencing dramatically swift change and development, including in its laws and its commercial practices. Dynamic growth in these areas is very much evident within the nation's 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 and practice.

As legal change in China continues and accelerates, parties to Chinese service outsourcings should consider how similar issues in other jurisdictions have been addressed over the years. Much can be learned from collective experience, and particularly from experience gained during periods of development and clarification in applicable laws.

It is reassuring to note that the outsourcing business model has developed and been proven over many years in many differing legal environments, including through periods of substantial uncertainty about the treatment of a variety of issues, including specifically human resources and personnel issues. As a validated, time-tested paradigm, experience with outsourcing from such contexts can provide powerful guidance that can be applied to the benefit of customers and suppliers of Chinese services. Given the model's effective application over time, coupled with the leverage of experience and the focused support of Chinese leadership, the law and commercial practice in China should continue to evolve in ways that increasingly support the successful sourcing of services on a global scale.

Footnotes

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. Excluding concerns associated with important issues such as child labor and working conditions that are beyond the scope of this article.

2. See "Going to China" in this publication.

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 increasingly common 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 (first) employer)
• The employee enters into the labor contract by means of fraud, threat, force or exploitation
• 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 Note 2 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 impacted by length of employment include, for example, annual leave 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.

Learn more about our Asia offices and Business & Technology Sourcing practice.

Copyright 2010. JSM, Mayer Brown International LLP and/or Mayer Brown LLP. All rights reserved. Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: JSM, a Hong Kong partnership, and its associated entities in Asia; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; and Mayer Brown LLP, a limited liability partnership established in the United States. The Mayer Brown Practices are known as Mayer Brown JSM in Asia.

This article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein. Please also read the JSM legal publications Disclaimer.