Archives: Non compete

Earlier this year, China’s Supreme People’s Court of China promulgated various interpretations of various employment law issues.  These interpretations were intended to clarify and for the most part, they did.  In particular, what was once unclear about non-competes signed by China employees has now become much clearer.  I am not going to compare the old rules on China non-competes with the new rules, in large part because many of the old “rules” were less than clear.  This post is instead intended to set out what the new rules are so that you as a China employer can act accordingly.

Perhaps most importantly, the Supreme People’s Court has made clear the required compensation for a non-compete to be valid and to remain in effect.  If an employee agrees to a non-compete provision, but the labor contract or confidentiality agreement (signed by the employee) does not mention the compensation the employee must receive as consideration for not competing, and the employee has in fact not competed, the court can award the employee up to 30 percent of his or her average monthly salary. If a 30 percent award of the average monthly salary is less than the minimum salary standard in the city, the minimum salary must be paid instead. The Court also made clear that the employee is entitled to such compensation no matter what the reason is for the employee having not competed.  In other words, even if the employee’s not competing arises from the employee’s inability to find new employment, the employee is still entitled to compensation for not having competed.

The Court also clarified what it takes to terminate (or not) an employee non-compete:

  • An employer may terminate a non-compete agreement and thereby cease having to pay for that non-compete, so long as it pays the employee at least three additional months’ compensation for the non-compete.  In other words, three months notice is essentially required to terminate the compensation requirement
  • An employee may terminate a non-compete if he or she has not been paid for three the required non-compete compensation for at three months by requesting termination of the non-compete agreement. Note though that this non-payment has to be the fault of the employer; the employee cannot deliberately avoid payment in an effort to cancel a non-compete.

Certain aspects of non-compete agreements in China have not changed and remain important, including the following:

  • An employment agreement may include provisions intended to protect the trade secrets of the employer. A non-competition agreement may be included in support of such protections.
  • The employer must pay reasonable compensation on a monthly basis to the employee during the term of the non-competition period.
  • Non-competition agreements are limited to executives, technical personnel and other personnel who have access to trade secrets. Cases have held that senior sales staff are included in this category. On the other hand, blanket agreements that apply to all employees are invalid.
  • The terms of the non-compete restriction must be “reasonable” in length of restriction, business scope and geographic area. A term in excess of two years is prohibited. The scope requirement is strictly interpreted. It is not sufficient that the employee is working in the same general area as the former employer. Competition must be specific and direct.
  • If the employee violates the terms of the non-compete agreement, the employee can be held liable for a payment of contract damages to the employer. The amount of contract damages must be reasonable. Excessive damages that are clearly punitive will be rejected.

Just as is true of any contract that you will eventually seek to/need to enforce in China, your non-compete/trade secret/employee contract should be written in Chinese as the official language.

Renaud Anjoran over at the Quality Inspection Tips blog recently wrote on “How your Chinese suppliers might become your competitors.”  Anjoran provides some excellent suggestions for preventing your China supplier from competing with you, based on his notes from a talk by Paul Melkebeke, Vice President Supply Asia for Samsonite.

Melkebeke talked of how building a brand and a distribution network is a long-term investment.  No doubt about that.

He then noted how Samsonite protects its IP by all available means — patents, design registrations, copyrights, Non Disclosure Agreements (NDA), etc, but these things are “not enough.”  I completely agree.  Companies must do everything they can to protect their IP from China and from elsewhere and doing this requires more than just registrations and contracts, as we noted in our post, How To Protect Your IP From China. Part 2:

Though there are, of course, particular protections you can and should employ depending on what you are doing in China, it will almost always make sense for you do to do the following four things.

  • Do business with the right people in China. Companies with nothing to lose are far more likely to take your IP than those with established businesses and reputations and incentives for not getting sued.
  • Think about what you have that needs protecting. What do you have that others want? What do you have that your competitors would love to get their hands on? Is it your technology?  Your customers?  Your brand?
  • Figure out how you (not your lawyer) can protect what needs protecting. Can you break into subparts whatever it is that you want to protect so that nobody in China gets access to the full thing? Can you get away with sending an older version to China? Can you lock it down in your building in China or on one computer such that your employees cannot leave with it? Can you keep the key portions on a server in the US?  These sorts of protections are usually called structural protections and they can be absolutely critical.

Melkebeke noted how Samsonite helps its suppliers improve on efficiency and quality, knowing that the supplier’s other customers (Samsonite’s competitors) will also benefit from these efforts. This is a really important issue and one that is difficult to address. One way to handle this is to become the exclusive buyer from your supplier. But if you are not Wal-Mart, the odds of your being able to achieve that are incredibly slim.  We have had clients that have purchased equipment for their Chinese suppliers with the proviso that equipment can be used only to make our client’s product. This too is pretty rare though.

Melkebeke noted how “many suppliers compare their FOB price to Samsonite’s retail price, and think it is all profit. Many of them start their own brand and push for distribution. But retail space is not cheap in China, and these companies are not expert at this game, so they end up losing money. So far, none has been successful.”  This is something we often discuss with our manufacturing clients that outsource product to China, especially when they claim that “there is no chance our Chinese manufacturer will ever be able to compete with us.” I often give the following example:

We had an outdoor equipment manufacturer (“USA Company”) come to us after its Chinese manufacturer (“China Manufacturer”) had stopped making outdoor equipment for USA Company. China Manufacturer had not only stopped making outdoor equipment for USA Company, but it had also registered USA Company’s brand name as a China trademark in over a dozen different categories/classes (this was before China prohibited this sort of thing by agents).  China Manufacturer’s plans were to sell the outdoor equipment to the two large hardware store chains to whom USA Company had been making the overwhelming bulk of its sales.

China Manufacturer completely struck out in its efforts to sell its own products to the two large hardware store chains. China Manufacturer went to those chains and offered to sell its product for about half the price of what USA Company had been selling them, but both hardware chains basically threw it out because China Manufacturer had no plans and no ability to maintain constant stocking of the products and no plans and no ability to repair the products and no plan and no ability to handle returns and other customer service needs. China Manufacturer’s plans to sell directly into the US market were essentially a joke.

Nonetheless, China Manufacturer had done huge harm to USA Company’s business.  USA Company had to scramble to find a new supplier (it succeeded) and it also had to figure out how to get its products manufactured and shipped out of China without violating China Manufacturer’s trademarks (it did, by securing a trademark for small engines and then prominently plastering its name on the small engines of all of its outdoor products).

The moral of the above story is that you cannot count on your Chinese manufacturer not trying to compete with you even if doing so makes no sense at all.

Melkebeke went on to note how the internet has broken down selling barriers and OEM manufacturers can sell their products online, but only at “a very low price” and “this is not the way to build a brand.”  China is Samsonite’s second largest market after the US. According to Melkebeke, Chinese consumers are willing to pay a premium price for Samsonite product and are “as picky as Japanese consumers.”  Because of this, despite helping its manufacturers improve, Samsonite is not really hurt by suppliers that try to compete with Samsonite because Samsonite prevails because of its quality and brand recognition.  But, Melkebeke rightly notes that companies with a weak brand, and in certain categories (e.g., electronics, where components and specifications are easily compared) are at much higher risk of losing business to a China supplier that seeks to compete with them.  I completely agree.

Anjoran then wrote about how Melkebeke advocated for employing legal methods to keep suppliers in their place, “even if they are not 100% effective.”

The first comment to Anjoran’s post stated that “legal contracts are next to useless in most cases unless you are a Samsonite or an Apple. For SMEs, the only sustainable strategy is relentless innovation.”  I completely disagree.  

From the legal side, there is a lot that can be done to protect yourself from your China supplier, even though, like anything else, these things will not work 100% of the time.  But really, legal protections are probably more important for small and mid-sized companies than for a massive company like Apple!

Let me explain.

First, I would urge everyone to read a post we did last week, entitled, The New Role Of Written Contracts For Product Purchases In China, in which we talked about how the importance of having real contracts with Chinese suppliers has increased and of how American companies are reacting to that:

This approach is changing and more and more foreign buyers are entering into long-term purchase contracts with their suppliers (typically called OEM Agreements, Manufacturing Agreements, Product Supply Agreements, or Product Sourcing Agreements). There are several reasons for this trend.  Probably the most important reason is the drive for standardization on the part of buyers. Chinese product is just one part of a worldwide supply chain. Major retailers have diverse sources of product. All product has to meet a basic standard to fit smoothly into the chain.  Product that is delivered late or that does not meet specifications fouls up the chain. Product that is subject to an intellectual property infringement challenge or that contains pirated, non-standard parts or that contains a non-standard component that raises safety issues disrupts the supply chain.

In the early days of buying product from China, the price was so cheap that these non-compliance issues and their resulting costs were simply absorbed by the foreign buyers at each stage of the purchase chain. However, in the current environment of tight supply chain management, the disruption is normally quite costly and cannot be tolerated by retailers already financially stressed by the current economic environment. As a result, retailers are imposing strict standards on their direct suppliers. The strictness of the controls and the magnitude of potential losses mean that foreign buyers can no longer simply absorb the costs of non-conformance by the Chinese manufacturers.

Foreign buyers now have no choice but to impose the same standards on their Chinese suppliers. Thus foreign buyers must enter into written contracts for product purchases from their Chinese suppliers that mirror their own obligations to their major retailer customers. These contracts must be supplemented with detailed supplier manuals and codes of conduct that seek to regulate the day-to-day business operations of the Chinese manufacturers.

None of this is unusual in North America and Europe, but the approach is very new to most Chinese export oriented manufacturers. The purpose of these agreements is quite simple. The purpose is not to make the situation better but rather to impose liability for non-performance directly on the Chinese manufacturer. That is, the foreign buyer is saying: “I no longer will simply absorb the costs caused by your lack of compliance with the conditions of sale. If you (Chinese manufacturer) do not perform, I will suffer a loss and I am going to pass that loss on to you.”

Second, check out our post from 2011, entitled, Getting Started On Manufacturing In China. The Legal Basics.  In that post we set out the legal basics for manufacturing product in China, in the form of a response to a typical email from a US company seeking to have its products manufactured in China:
The first two things you will likely need are a Non Disclosure Agreement (NDA) and a registered trademark in China. We prefer to do what we call an NNN Agreement — non-disclosure, non-use and non-circumvention. This is an agreement that you use when you are trying to find manufacturers for a product. You have the manufacturer sign the agreement before you show them the product. It prevents manufacturers from stealing your design for themselves and from going around you to sell the product to your US customers.

Here is some more information on NDAs/NNNs:

If you are not concerned about manufacturers in China copying your designs, you do not need an NDA/NNN Agreement.

The one thing you will almost certainly need to do (but maybe not right away) is to register your trademark in China. Before you use any of your trade names (think brands or product names) or trademarks in China (think logos), you absolutely must register them in China or someone else almost certainly will and then you will not be able to use your name in China, even if all you are doing is exporting your product from China. Here’s some info on that: China: Do Just One Thing. Trademarks.

Depending on your situation, you may also want/need a Product Development Agreement. If you are going to work extensively with a Chinese manufacturer to develop a new product, you need a specific product development agreement. These agreements cover the cost and procedure for development and ownership of the developed product. Many companies fail to enter into this kind of agreement and then discover the Chinese side owns “their” product and/or molds at the end of the process.

Once you have chosen the manufacturer for your widget, the next thing you will need is a Manufacturing Agreement (these are also called supplier agreements and OEM Agreements). Many US companies do all their manufacturing in China based on purchase orders. This is very bad for the US side. A good manufacturing agreement covers IP, quality control, NNN issues, warranty, ownership of molds, tooling, supplies, diversion, dispute resolution, and all the other various issues that arise in a manufacturing relationship.

Here is some more information on Manufacturing Agreements:

But what is a small company to do?  The above.  But what about the idea that contracts are “useless” for small companies?  I am not sure why this commenter said this, but I do know that small companies often ask me whether it is worth having a contract if they cannot afford to sue to enforce it.  I often respond by saying that if they cannot afford to sue on a breached contract, they also cannot afford bad product and that is all the more reason they need a contract.  There are many reasons to have a good contract with your Chinese supplier and suing on a breach is but one of them.

As anyone who has been involved in litigation anywhere in the world will tell you, it is a horrible thing. It is expensive, time consuming, and imperfect. Litigation signifies the end of discussion between parties and, as such, it should only be undertaken after all other avenues have been exhausted. As I am constantly telling clients, “if you have to sue, you have already lost. You can win the litigation, but even so, you will have lost.”

Litigation virtually never brings anyone a complete remedy.  If you are owed $250,000 and you sue and the court awards you $250,000 and the other side pays you in fairly prompt order, you still have not achieved a complete remedy.  What about the time you spent trying to settle the case before suing? What about what you might have done with the $250,000 had you received it sooner? What about your attorneys’ fees in dealing with the problem? What about all the time you and your employees had to spend on the case?  Litigation is not a complete remedy, which just underscores point number 1 on how it should always be a last resort.

There is huge value in having a contract with your Chinese counterpart that has little to nothing to do with winning a lawsuit. Even if you never intend to sue anyone in China, it makes sense to have a good contract, preferably in Chinese.  There are three main reasons to have a good contract, and suing and winning on it is only one of them.

One of the main reasons for having a good contract with your Chinese product supplier is to make sure that the two of you are on the same page. We wrote about this reason in Chinese Manufacturing. Delivery Date? What Delivery Date?:

One of the most common problems we see between American companies and their Chinese manufacturers is “late” delivery.  I put late in quotes because many times I think the problem is not so much that the Chinese manufacturer was late, but rather that the contract and the American buyer were unclear on the actual delivery date requirements.

Let me explain.

When we draft an OEM Agreement (a/k/a Manufacturing Agreement or Supplier Agreement), we are always very careful regarding delivery times.  Most of the time, our clients come to us with a term sheet or an oral agreement with their Chinese manufacturer dictating something like 30 days for delivery.  We like strictly tying the Chinese manufacturer to the “agreed-upon” delivery time and we usually do that with a liquidated damages provision tied to late delivery.  Just by way of example, we might put into the OEM Agreement a provision saying something along the lines of delivery shall be within 30 days and for every day beyond thirty the Chinese manufacturer shall be required to pay US Company 1% of the purchase order price within ten days.

Perhaps more than any other contract provision, we tend to get blow-back on the delivery time provision from the Chinese manufacturer. Oftentimes when faced with the reality of having to pay a set amount for late delivery, the Chinese manufacturer gets really serious about delivery times and tells us that they simply cannot promise delivery within the previously “agreed” time frame.  Our client usually realizes it is better to get real agreement (even if longer than originally anticipated) before ordering, rather than getting late delivery after ordering.

The other, somewhat related issue we face on delivery times is that when our client comes to us and says it has agreed with its Chinese manufacturer to a 30 day delivery schedule, we then have to figure out 30 days from what.  We typically go with 30 days from the issuance of the purchase order, but oftentimes the Chinese company pushes for it to be 30 days from its receipt of payment or 30 days from its receiving proof of payment.

Bottom Line:  Certainty is important with respect to delivery dates and, without a doubt, the best way to achieve that certainty is a written contract, in Chinese (so that there is no doubt the manufacturer understands what is on the paper) clearing setting forth the delivery date.

In my view though, the main reason to have a good contract is to prevent problems on which you might need to sue:  We wrote about this way back in 2006, in China OEM the Smart Way:

The best solution for this is to prevent it from happening in the first place and the best way to do that is to choose the right supplier and use a good OEM contract.  When we draft OEM contracts for our clients, we always put in a provision precluding the Chinese manufacturer from subcontracting out production. Without exception, the Chinese manufacturers have agreed to this provision and, again without exception (at least as far as we know), they have always abided by it.  The reason for this is simple.  The manufacturer may have twenty some companies for whom it produces goods, but probably less than half of them forbid subcontracting.  When the Chinese manufacturer is so busy as to require subcontracting, it makes sense for it to first subcontract out work for those foreign companies for whom it is NOT prohibited by contract from doing so.  I am always analogizing this to bike locks.  Even the best bike lock cannot prevent all thefts, but its efficacy comes from the fact that bike thieves generally find it easier to steal a bike with a poor quality lock or none at all than one that is difficult to break.

Any contract that makes your Chinese counter-party think twice about messing with you has at least some value.  My law firm has settled a number of matters with Chinese companies based on well-written contracts, but we decline to take on cases without contracts.  Having a well written contract does not mean you will always win your lawsuit if you are forced to sue on it. But it does mean you will have some leverage if things go wrong and it does mean you will at least have a chance. Having no contract means no chance.

How do you stop your Chinese supplier from becoming your competitor?

  1. Choose the right Chinese supplier.  A company that is thriving has a lot more to lose than one that is tanking.
  2. Register your intellectual property (trademarks, copyrights and patents).
  3. Make sure your supplier signs well-written (preferably in Chinese) contracts that forbid it from competing with you or improperly using your IP.

It is that simple.

What do you think?

Many American companies (at least outside California where employee non competes are generally considered invalid) love non competes and they use them as a matter of course with most (sometimes all) of their employees.  Generally a non-compete agreement or a non-compete provision in an employee contract provides that the employee cannot work for one of the employer’s competitors and/or engage in the same business as the employer.

The well crafted non compete provision is usually limited to a certain period of time following the employee’s termination and also usually limited geographically. Just by way of example: if you own a small sushi restaurant in Peoria, Illinois, a well-crafted non-compete with your sushi chef might prohibit him or her from working as a chef at another sushi restaurant within a 25 mile radius. The poorly crafted non-compete provision might prohibit him or her from doing anything in the food business anywhere in the world for the next five years.

For obvious reasons, courts are loathe to enforce over-broad non-compete agreements simply because they do not think it fair or right to preclude someone from making a living at their profession or craft, especially when doing so poses no real threat to anyone.  China’s laws on non-competes are not so different on this point, but they are quite different on others.

China’s Labor Contract Law specifically permits employers to include non-compete provisions in labor contracts or confidentiality agreements with their employees. But these sorts of provisions are valid only if all of the following are the case:

  •   The employee is senior management or a senior technical person. China’s courts take this requirement very seriously and few employees will qualify.
  •   The period of the non-compete and its geographic scope must be reasonable and the non-compete period must be for less than two years.
  •   The employer must pay the employee during the non-compete period or the non-compete provision ceases to be valid.

Note again that for the non-compete agreement to remain valid after the employee has left the company, the employee must continue receiving compensation from the company.  In other words, the employee must get paid for not competing.

How much must the employer pay the employee during the non-compete period?  We used to advise our clients to put in the contract this amount and to make it between 30 and 50% of the employee’s salary, depending mostly on the locale.  China’s Supreme Court recently issued some national level guidance on these payments and it appears that the terminated employee’s monthly compensation should be 30% of the employee’s average monthly salary over the previous year, or the local statutory minimum wage, whichever is higher.  This 30% should be deemed the minimum; employees may be able to negotiate a higher amount when signing their employee contracts.

We used to tell our clients that they “might as well” put in a non compete clause into their contracts with their high level employees since they would always be free to back out of any payment post termination if they wished.  I now have my doubts as to that advice going forward as the Supreme Court has said that though employers are free to terminate a non-compete clause at any time, they must pay three months compensation to do so. We will now be advising our clients to think a little longer and a little harder before just throwing in non-compete provisions.

What are you seeing out there with non-compete provisions in employee contracts?

Probably 99% of the Non Disclosure Agreements we see that have been used “quickly” by American companies with their potential Chinese counter-parties are defective, usually terminally so.  One of the things that most frequently makes them defective is that they call for disputes to be resolved in the United States. The problem with that is that Chinese courts do not enforce US court judgments and so even if the American company were to prevail in the United States, they typically have no recourse against the Chinese company unless the Chinese company has assets in the United States. Knowing this, the Chinese company feels free to violate the NDA with impunity.

A China NDA should not be simply pulled “off the shelf” because an “off the shelf” U.S. style NDA is just not going to work.  I am not going to tell you that NDAs with China need be super complicated, because they don’t.  But I am going to tell you that they need to be done right and that means not just pulling something off the shelf. In fact, when we do these sorts of agreements with Chinese companies, we nearly always do them as an NNN (Non Disclosure, Non Use/Non Compete, Non Circumvention) Agreement, not just an NDA.  We also ask a fairly long list of questions to our NNN client so as to tailor the NNN to its specific situation and to thereby maximize the likelihood that it will not be breached by the Chinese counter-party and to provide the best chance of recourse if it is.  To a certain extent, these two goals are the same in that providing the best chance of recourse against a Chinese company is what is going to have the most impact on preventing that company from violating the agreement.

We ask the following questions before we begin work on NNN Agreements for our clients (along with follow-up questions based on the answers):

  1. Please provide us with a one or two paragraph description of what you will be doing in China that you want to be covered by the NNN agreement. Note that what what we mean by an NNN agreement is: 1) Non-disclosure, 2) non-use/non-compete and 3) non-circumvention. For China, 2) and 3) are far more important than 1). The danger with Chinese manufacturers is that they will use the idea you provide them for their own production and that they will then attempt to sell that product to your own customers. These actions are what we seek to prevent through the NNN agreement.
  2. Provide the full legal name of your company, including state/province/country of formation.
  3. Provide the address and related contact information that you will want for the agreement.
  4. Provide the name and title of the person from your side who will execute the agreement.
  5. Does your company have a Chinese name? If so, what is it?
  6. Will you use this agreement for a single product or for multiple products?
  7. What is the best way to identify the products for which the agreement will be used? Please provide us with a clear, descriptive name that does not require attaching specifications or other proprietary information. Sometimes, even the name is proprietary. So we want to develop a designation that is clear but that does not reveal more than you want to reveal.
  8. Will you use this agreement with a single potential manufacturer or with multiple manufacturers?
  9. What types of information will you be providing to the Chinese side that would be protected by the NNN agreement. Our clients range from providing a general concept all the way to providing the full production specifications as the preliminary to a hard price quote.
  10. Will you expect the Chinese side to do any design work during the initial discussion period?
  11. Is your product protected by trademark, copyright or patent anywhere in the world? Where? What about China?
  12. After you disclose this product in China, are you interested in preventing the Chinese side from contacting any of your existing customers concerning your product or related products? If so, do you want a general prohibition or do you wish to attach a specific list of persons/companies that the Chinese side should not contact (a “No Contact List”).
  13. We normally require the Chinese manufacturer NOT contact any potential sub-contractors who would work in the production process. Please advise if you believe that this would be a concern in your situation. Note that some Chinese “manufacturers” are not actually manufacturers. They serve only as a “middle man” for the actual manufacturers. If you use that kind of company, they will need to be able to discuss your product with their subcontractors and we will need to allow for this.
  14. Please advise on any specific technology items that you wish to have protected in a heightened manner.
  15. Note that this Agreement will apply only to PRC China manufacturers. It does not cover Taiwan or Hong Kong or Macau companies that may handle manufacturing for you as intermediaries. If you will be dealing with companies from Taiwan or Hong Kong or Macau (or from any country other than the PRC), please let us know so we can make allowances for that.
  16. Note that the NNN agreement applies only to the preliminary negotiation stage for your product. If you move on to production, you will need a formal OEM agreement. If you will engage the Chinese side to do design, you will need a formal design agreement. The NNN agreement is NOT a replacement for these other agreements.

For more on China NNN Agreements, check out the following:

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This is part II of our series on what are commonly referred to as non disclosure agreements or NDAs. In Part I, “Why Non Disclosures (NDAs) Alone Are Not Enough For China,” we talked about how many companies are using inadequate, off the shelf American NDAs in China. Those agreements are inadequate for three primary reasons. First, they typically fail to cover internal disclosure within a network. Second, they oftentimes fail to prevent the Chinese signing party from manufacturing or using the product or information sought to be protected. To remedy this, non-use provisions are required. Third, they usually fail to prevent the Chinese signing party from circumventing the foreign company by going directly to the foreign party’s customers or clients. To remedy this, non-circumvention provisions are required.

But even if these NDA agreements were to account for the three issues discussed in Part I and more briefly above, most of the ones we see would still not be worth the paper on which they are printed because they are pretty much unenforceable in China. Let’s let co-blogger, Steve Dickinson, explain:

Most NDA agreements I see are just modifications of the standard NDA used in the U.S. The non-disclosure provisions do not deal with the special problems of related parties in China and the non-use/non-circumvention is treated inadequately or not at all. Only a carefully thought out NNN Agreement (non-disclosure, non-use, non-circumvention) that treats all the issues is of any real use in China.

Even the best agreement is of no use if it cannot be enforced. This is the other major defect of the typical NDA agreements I review: the agreement is usually not enforceable. It is absolutely required that an NNN Agreement be enforceable in China. And yet, most of the NDA agreements I read are governed by U.S. or English law with enforcement by litigation in the U.S. or England or by arbitration outside of China. This approach is almost always useless. U.S. courts almost never have jurisdiction over Chinese companies, so a judgment from a U.S. court is of no value. Arbitration outside of China is expensive and slow and proof is difficult or impossible and denies access to injunctive type remedies that would be available for arbitration in China.

To greatly increase your chances of having an NNN Agreement that will actually be enforced, the following nearly always makes sense:

  1.  The Agreement must include an accurate translation into the Chinese language.
  2. The agreement must provide for enforcement through litigation in a Chinese court or through CIETAC arbitration. To further ensure that the NNN Agreement will be enforced, the NNN Agreement should provide for specific monetary damages that will be awarded in the case of a breach. Though U.S. and other common law systems sometimes discourage using this sort of liquidated damage provision, the Chinese system is the opposite. Specific contract damage provisions are encouraged since they ease the court’s work.
  3. Most NDA type agreements rely almost exclusively on injunctive relief as the primary enforcement mechanism. This is a a major mistake in China. The preference for injunctive relief in common law systems (such as the United States or England) is because it is often difficult or impossible to prove the amount of economic damages that result from a breach. This is not really an issue under Chinese law, where parties to a contract are encouraged to set a fixed amount for damages that will result from a breach. If written correctly, the liquidated damage amount sets a floor on damages, but if actual damages exceed that amount, it is permissible to seek damages for the excess. In addition, money damages and injunctive relief are not exclusive. A court or arbitrator is free to order that damages be paid and that the infringing/breaching party terminate the infringing action.

NNN Agreements that set forth a specific damage amount that will result from a breach make the cost of a breach clear to the Chinese manufacturer and if set high enough, will go a long way towards discouraging a breach. Having a properly written liquidated damages provision in your NNN Agreement also makes for quick and effective litigation/arbitration, which is much to the advantage for the damaged party.

Many Chinese manufacturers quickly sign the traditional poorly drafted and unenforceable non disclosure agreement without even thinking about it. Why is that? Because they know that their signing it comes with little to no risk.

When a Chinese manufacturer sees a well drafted NNN Agreement, they will sometimes resist signing. For some manufacturers, the reason is simple. Their whole reason for doing your outsourcing work is to acquire your technology and designs for their own products. So long as your technology is not protected by patent or trade secrecy law, and you have failed to require the Chinese manufacturer sign a strong NNN Agreement, the Chinese manufacturer is free to use your technology for its own purposes. Absent an agreement that prevents them from doing otherwise, it is perfectly legal for a Chinese manufacturer to use your unprotected information for their own products manufactured under their own trademarks. However, if an NNN Agreement makes clear that the Chinese manufacturer cannot appropriate your technology and contacts, then the manufacturer that wanted your OEM manufacturing solely for these reasons is no longer motivated to enter into the arrangement with you.

Sometimes the manufacturer has more complex reasons for refusing to sign a well drafted and enforceable NNN Agreement. A well drafted and enforceable NNN agreement shows the Chinese manufacturer that the foreign party knows its way around China and that it plans to hold the Chinese manufacturer to the terms of their contractual commitments. For this reason, the Chinese manufacturer may reasonably decide it would be better off just manufacturing for those foreign companies that do not manifest an intent to hold the Chinese side to their commitments.

Therefore, using a well drafted and enforceable NNN Agreement does actually increase the risk that the Chinese side will refuse to sign. However, we see this as a good thing. If the Chinese side has a good reason for not signing, they will say so and the agreement can be modified to account for that. If the reason for the Chinese side refusing to sign is not a good one, the Chinese side will be forced to make this clear also. In either case, the foreign company benefits from finding out in advance what is really going on. This “advance notice” function is one of the main advantages of a good NNN Agreement; it forces both sides to face up to the real situation and to engage in a frank discussion of what is really required for a successful and long term relationship. This is a much better situation than ritually executing a meaningless agreement.

The other day, I did a post on why Non-Disclosure Agreements are so often critical for those doing business with China. Within a few hours of that post, entitled, “China Non Disclosure Agreements (NDA). A Really Good Thing,” my co-blogger, Steve Dickinson, was pointing out how if we were going to talk about non disclosure agreements (commonly referred to as an NDA), we should also discuss how and why we nearly always recommend such agreements contain non-use and non-circumvention provisions as well. I agreed with Steve, suggested he write such a post, and, voilà, here it is:

Most lawyers tell their clients who are doing outsourcing work in China that they need an NDA. Many businesses I work with see this as an example of an attorney demand with little practical application. They see the typical NDA as an unnecessary and unenforceable “piece of paper” that they only use if their legal department forces them to do so. The normal comment I receive is “1) how can I prove the information was revealed, 2) how can I prove what was revealed was actually confidential and 3) how can I enforce the agreement even if I could prove the facts?” I am usually dealing with experienced business people and, frankly, their concerns are well founded. In fact, most of the NDAs I see in China are useless because they are both directed at the wrong issues and are unenforceable. Pulling your English language NDA and having it translated into Chinese is pretty much a complete waste of time.

When we work with sourcing companies and related OEM manufacturing arrangements, we almost never just draft a “straight NDA.” Instead, we draft a “non-disclosure/non-use/non-circumvention agreement” that we refer to as an NNN Agreement. When a foreign company contracts with a Chinese company to manufacture a product, the NNN focuses on the three primary “bad acts” that the foreign company needs to prevent:

  1. The foreign company does not want its design revealed to a third party. To prevent this, a non-disclosure agreement is required. Though this is an important issue in China, disclosure to an entirely unrelated third party is actually fairly uncommon. The bigger risk is disclosure to a related party. Many Chinese businesses have multiple subsidiaries and manufacturing is often done through a large network of subcontractors. Chinese companies are quite relaxed about passing around information within this network. A good non-disclosure agreement must focus on control of information within a network that the Chinese manufacturer itself may not consider as falling within the scope of a non-disclosure requirement.
  2. The biggest concern of the foreign company is usually not disclosure to a third party. The real concern is that the foreign company does not want the Chinese manufacturer to make use of the product design to compete with the foreign company. For this purpose a non-use agreement is required. A good non-use agreement focuses on two issues. First, the agreement identifies the applicable intellectual property or confidential information of the foreign company and then authorizes the Chinese manufacturer to use that property/information solely to manufacture the product for the foreign company. Second, the agreement requires the manufacturer agree not to manufacture the product or any similar product under any circumstances, other than for the foreign company. This second provision is the most important as it prevents the Chinese manufacturer from manufacturing a similar product under its own trademark. Since many products are not covered by patent or other IP protections, the only way to prevent such “copy-cat” manufacturing is with such a non-use provision. Normal IP protections will not work, so a contractual agreement is essential. Virtually all “off the shelf” NDAs fail to account for this.
  3. The foreign company also does not want the Chinese manufacturer to go around the foreign company by selling the product directly to the foreign company’s existing or future customers. After the Chinese manufacturer has manufactured the product for some time, it will likely have learned about the market and the customers for the product. It is only natural for the Chinese manufacturer at some point to go to the ultimate customer and say: “Look, WE are the company ACTUALLY making this product and since there is no patent or other IP protection applicable to the product, why don’t you just buy the product from us, for less?” This is called circumvention and it is extremely common in China. If you want to avoid getting “cut out” in this way, a non-circumvention agreement is required. Again, an “off the shelf” NDA is not going to cover this.

Most non disclosure agreements I see are just modifications of the standard NDA used in the United States or in England and those agreements simply do not deal with the special problems of related parties in China and they treat non-use/non-circumvention either inadequately or not at all. Only a carefully thought out NNN Agreement that thoroughly resolves treats all of these issues is of any real value in China.

Stay tuned, as the day after tomorrow we will talk about the other typical fatal flaw of “off the shelf” NDAs and why those NDAs are usually not enforceable in China.

By Steve Dickinson

Chinese employment law presents many challenges to US employers. One issue that causes much confusion is the proper use of non-compete agreements with Chinese employees. Before China adopted its Labor Contract Law (“LCL”) in 2008, it was common for foreign employers to require all of their Chinese employees to enter into non-compete agreements. This blanket use of employee non-compete agreements in China was never a good policy under Chinese law. This is because the Chinese labor arbitration board and the courts view non-competes with great suspicion as an infringement on the basic employment right of the employee. This is not unlike how US courts view these agreements.

Consistent with this basic hostility towards employee non-competition agreements, the LCL provides for clear provisions on such agreements. On the positive side, the LCL makes it clear that “reasonable” non-competition agreements are enforceable. On the other hand, the LCL provides a set of rules for non-compete agreements that significantly reduces their utility for employers. We find that many employers ignore the new rules and continue to operate under the old system. This has two bad results. First, the employer believes it is protected when it is not. Second, the inclusion of a provision that openly violates the terms of the LCL weakens other provisions that arguably comply with the law. The only rational course of action is to proceed in careful compliance with the law.

Non-competition agreements are authorized by Articles 23 and 24 of the LCL. The basic rules are as follows:

  • An employment agreement may include provisions intended to protect the trade secrets of the employer. A non-competition agreement may be included in support of such protections.
  • The employer must pay reasonable compensation on a monthly basis to the employee during the term of the non-competition period. There is no definition of “reasonable compensation.” Commentaries suggest employees should be compensated in a manner equivalent to their salary with the company. Others suggest that compensation is only required at the level of the current minimum wage in the relevant jurisdiction.
  • Non-competition agreements are limited to executives, technical personnel and other personnel who have access to trade secrets. Cases have held that senior sales staff are included in this category. On the other hand, blanket agreements that apply to all employees are invalid.
  • The terms of the restriction must be “reasonable” in length of restriction, business scope and geographic area. A term in excess of two years is prohibited. The scope requirement is strictly interpreted. It is not sufficient that the employee is working in the same general area as the former employer. Competition must be specific and direct.
  • If the employee violates the terms of the non-compete agreement, the employee can be held liable for a payment of contract damages to the employer. The amount of contract damages must be reasonable. Excessive damages that are clearly punitive will be rejected.

We have seen many cases where employment agreements contain provisions that violate the requirements of the LCL. By far the most common issue is failure to pay compensation to the employee during the non-competition period. Many foreign employers strongly object to the notion of paying an employee to abide by the terms of a non-compete agreement. This is especially true when an employee voluntarily resigns and then goes to work for a potential competitor. However, the law is very strict on this issue. Reasonable compensation must be paid on a monthly basis. Failure to pay or a delay in payment voids the entire non-competition provision. The vast majority of employee non-competition claims are rejected for failure to make payment. The requirement applies even if the employee has found employment elsewhere and does not “need” the compensation for not competing.

Employers simply need to face the fact that non-competition agreements have very limited utility under Chinese law. The better approach is to deal with the whole issue under the terms of a trade secrecy agreement. Employees are bound by the terms of any trade secrecy agreement they execute. Employees who will truly be exposed to trade secrets should be required to execute a non-disclosure and non-use agreement. Such an agreement will make the use of trade secrets in their new employment a contractual violation subject to action by litigation. The main issue is that the employer must prove that the employee is actually making use of trade secrets in the new position.

The most common reason such claims fail is that there is in fact no trade secrecy violation. For example, a common claim is that sales personnel are making use of the client list of the former employer. However, client lists that are kept in an open Rolodex or in an open file or in an open access computer file are not secrets. In other cases, the employee in fact had no access to trade secrets applicable to the claim. For example, a common claim is made against sales personnel, but the trade secret is highly technical information concerning the product. In this case, sales personnel can successfully argue that though the product is the same, they had no access to or ability to use highly technical information related to the product.

Years ago, our Chinese lawyers used to get a fairly steady stream of panicked American callers who would call us a month or so after returning from China where they had showed their product, prototype or product drawings to Chinese OEM companies.These Americans were calling us in a panic because they had shown their product, prototype, or product design drawings around China (in some instances they had even left it there) and now everyone there had gone silent.

They would typically ask if we thought a Chinese company might be using their information to copy their product. I would then ask them if they had required the Chinese companies to sign any sort of secresy agreement before turning over the information. After a long pause, they would invariably answer, “no,” and then usually ask about suing. I would then explain how the copying of a product in this sort of situation was probably a violation of Chinese law, but . . . .

I realized the other day that these calls have almost completely ceased and I think the increasing use of nondisclosure agreements is why. Our more typical call now is from a consultant or manufacturer seeking our help in drafting a non-disclosure agreement (NDA) before heading off to China with a prototype/product/drawing for OEM quotes.

Smart.

We love NDAs for foreign companies doing business in China. They are simple, effective, and telling.

Simple, because they tend not to vary all that much from company to company or from product to product.  We like putting in an attorneys’ fee provision and a provision regarding injunctive relief. We always do them in both English and Chinese, nearly always for a flat fee. We virtually always make Chinese the official language.

Effective, because the Chinese courts are getting familiar with them and will generally enforce them.

Telling, because we have found that if a Chinese manufacturer refuses to sign one, this is probably not the Chinese manufacturer with whom you want to do business.

NDAs:  Do not leave home without one.

Even better though is to use what we call an NNN Agreement.  When we work with sourcing companies and related OEM manufacturing arrangements, we almost never just draft a “straight NDA.” We instead prefer to draft a “non-disclosure/non-use/non-circumvention agreement” that we refer to as an NNN Agreement. When a foreign company contracts with a Chinese company to manufacture a product, the NNN focuses on the three primary “bad acts” that the foreign company needs to prevent:

  • The foreign company does not want its design revealed to a third party. To prevent this, a non-disclosure provision is required. Though this is an important issue in China, disclosure to an entirely unrelated third party is actually fairly uncommon. The bigger risk is disclosure to a related party. Many Chinese businesses have multiple subsidiaries and manufacturing is often done through a large network of subcontractors. Chinese companies are quite relaxed about passing around information within this network. A good non-disclosure agreement must focus on control of information within a network that the Chinese manufacturer itself may not consider as falling within the scope of a non-disclosure requirement.
  • Usually, the biggest concern for the foreign company is to prevent the Chinese manufacturer from making use of the product design to compete with the foreign company. For this purpose a non-use agreement is required. A good non-use agreement focuses on two issues. First, the agreement identifies the applicable intellectual property or confidential information of the foreign company and then authorizes the Chinese manufacturer to use that property/information solely to manufacture the product for the foreign company. Second, the agreement requires the manufacturer agree not to manufacture the product or any similar product under any circumstances, other than for the foreign company. This second provision is the most important as it prevents the Chinese manufacturer from manufacturing a similar product under its own trademark. Since many products are not covered by patent or other IP protections, the only way to prevent such “copy-cat” manufacturing is with such a non-use provision. Normal IP protections will not work, so a contractual agreement is essential. Since nearly all “off the shelf” American-style NDAs completely fail to account for this they are virtually worthless for China.
  • The foreign company also does not usually want the Chinese manufacturer to go around the foreign company by selling the product directly to the foreign company’s existing or future customers. After the Chinese manufacturer has manufactured the product for some time, it will likely have learned about the market and the customers for the product. It is only natural for the Chinese manufacturer at some point to go to the ultimate customer and say: “Look, WE are the company ACTUALLY making this product and since there is no patent or other IP protection applicable to the product, why don’t you just buy the product from us, for less?” This is called circumvention and it is extremely common in China. If you want to avoid getting “cut out” in this way, a non-circumvention provision agreement is required. Again, an “off the shelf” American-style NDA is not going to cover this.

Most non disclosure agreements we see are just modifications of the standard NDA used in the United States or in England and those agreements simply do not deal with the special problems of related parties in China and they treat non-use/non-circumvention either inadequately or not at all. Only a carefully thought out NNN Agreement that thoroughly resolves all of these issues is of any real value in China.

NNN Agreements work well for China so don’t leave home without one.