The New Labor Contract Law of China: Its Impact on Business

By Margaret Lu, Ron Cai and Sisi Liu
[August 2007]

On June 29, 2007, the Standing Committee of the National People’s Congress of China published the new Labor Contract Law (the “New Law”), effective Jan. 1, 2008. Until then, matters relating to labor contracts in China, including those of foreign invested enterprises (FIE), are governed by pertinent provisions contained within existing national laws and regulations such as The Labor Law of China (1995), Measures Regarding Economic Compensation for Violation and Termination of Labor Contracts 1995, the Company Law of China (as amended in 2006), and local regulations on labor contract promulgated pursuant to the Labor Law of China such as the Provisions of Beijing Municipality on Labor Contracts (2002) and the Regulations of Shanghai Municipality on Labor Contracts (2002). In addition, the Ministry of Labor and local labor bureaus have issued interpretations of specific provisions of the Labor Law and policies that guide the formation, performance and dispute resolution of labor contracts in China from time to time. These interpretations together with the law and regulations listed above, hereafter collectively are referred to as (“Existing Law”).

In general, the New Law clarifies and supplements, but does not supersede, the Existing Law. The New Law, however, codifies certain well-accepted labor practices based upon the interpretation and/or policies of the Ministry of Labor and local labor bureaus and certain provisions under local regulations, making them applicable nationwide. A close comparison of the New Law against the Existing Law reveals differences, changes and new requirements concerning labor contracts and their management in China. Specific examples addressed in this bulletin include:

• Labor’s expanded role in formulating company rules and policies
• Employment-in-fact recognition
• The employer’s obligation to timely entry into written employee contracts
• Freedom to seek employment
• Labor contracts with open-ended terms
• Probation periods
• Non-compete covenants
• Termination of labor contracts by employees
• Termination of labor contracts by employers
• Lay-offs
• Automatic termination of labor contracts
• The employer’s economic compensation obligation upon contract termination
• Calculation of economic compensation
• Part-time employment
• Employment service agencies and related matters

Labor’s expanded role in formulating company rules and policies

The New Law seems to have expanded the union’s role and participation in the formulation and implementation of company rules and policies, and in major decisions concerning employee interests. For instance, Article 4 of the New Law gives the union or company employees the right to object to that company’s rules and policies as well as to major decisions concerning employee benefits and welfare that the union and employees deemed inappropriate during the process of formulation or implementation. It also gives them the right to revise rules, policies and decisions through consultation with the employer. Existing Law requires an employer to consult with the union and employees only in formulating company rules and policies. Additionally, in Beijing area, the union or employees have the right to object and request correction only when an employer is found to be in violation of law.

Employment-in-fact recognition

Article 7 of the New Law recognizes the establishment of a labor relationship in the event an employee works for an employer without a written labor contract in place, whereas the language of the Existing Law seems to indicate that a labor relationship must be established by execution of a written labor contract. Even though official interpretations of the Existing Law by some local labor bureaus have consistently upheld an employment relationship between a worker and an employer where the worker has worked without a written labor contract in place, the New Law now leaves no ambiguity in this aspect.

The employer’s obligation to timely entry into written employee contracts

Even though it explicitly recognizes an employment-in-fact, the New Law still requires an employer to enter into written contracts with its employees in a timely manner and is very strict on enforcing the requirement. Article 10 of the New Law provides a grace period of one month, commencing on the date an employee starts to work for an employer, for the employer to enter into a written labor contract with the employee without being subject to any penalties. Upon expiration of the one-month grace period, an employer will be subject to a penalty of paying the employee double his/her monthly salary for each month, up to one year, during which a written labor contract is not in place. In the event an employer fails to enter into a written contract with an employee after a one-year period, starting from the date the employee starts to work for the employer, it will be deemed that the employer has already entered into a written labor contract with the employee with an open-ended contract term.

Freedom to seek employment

Article 9 of the New Law upholds an employee’s right to freely seek employment by prohibiting an employer from taking custody of any employee’s personal identification card or other documentation, or from requiring any employee to provide guarantee in money or property, or from using any other means to collect money or property from the employee during his/her employment. The Existing Law, in Article 24 of the Beijing Regulation, contains wording very similar to that effect. The codification of this prohibition by the New Law broadens the scope of its application to apply nationally. Furthermore, Article 84 of the New Law imposes liabilities and penalties on an employer for its violation of the prohibition.

Labor contracts with open-ended terms

The New Law encourages labor contracts with open-ended terms by mandating a statutory obligation for an employer to enter into such a contract with its employees when specified circumstances occur. This requirement is not entirely novel. The Existing Law in Article 20 of the Labor Law of China, provides that an employee who has worked for the same company/employer continuously for 10 years may request to sign a labor contract with an open-ended term when his/her labor contract is up for renewal, and that the employer must honor this request.

In the past, Article 20 has been repeatedly interpreted by responsible labor authorities to mean, for instance, that a green-field joint venture FIE in China is obligated to honor requests of long-term employees of the Chinese partners to the joint venture FIE to enter into labor contracts with an open-ended term. The New Law not only clarifies and codifies this interpretation and keeps the original provision of continuously working for the same employer for 10 years, it adds a new circumstance under which an employee shall have the right to request a labor contract with an open-ended term upon a third renewal of his/her labor contract. Failure to enter into labor contracts with an open-ended term when these circumstances are met will subject an employer to penalties and liabilities.

Probation periods

The New Law provides new requirements on the length of permissible probation periods in labor contracts that compare with the Existing Law. For instance, the New Law allows a labor contract with a term of no less than three months but no more than one year to have a one-month probation period, whereas Beijing Regulation allows only 15 days and Shanghai Regulation allows no probation period for a labor contract with a term of less than six months. The New Law also clarifies and mandates a nationwide requirement that an employer is only allowed to set a probation period once in labor contracts with the same employee, regardless of how many times the labor contract is renewed with the employee. The New Law imposes penalties on employers for violation of probation-period requirements and sets a new minimum-wage requirement for salary payable to employees during permitted probation periods.

Non-compete covenants

The Existing Law recognizes the principle of a non-compete covenant as part of a labor contract for employees whose job responsibility exposes these employees to the confidential information of their employers; but only certain localities, such as Shanghai, provide guidance as to how to make the covenant valid. Articles 23 and 24 of the New Law, among other matters, stipulate that the maximum duration of a valid non-compete covenant must be no more than two years, that the covenant must specify the scope and territory of the non-compete agreement, that an employer must pay monthly economic compensation throughout the duration of the non-compete covenant, and that liquidated damages are allowed for breach of a non-compete covenant. The New Law remains silent, however, regarding the amount of monthly economic compensation that will be considered adequate to make a non-compete covenant valid.

Termination of labor contracts by employees

There are several changes in the New Law relating to this matter: 1) it adds a new three-day notice requirement for employee-initiated termination of a labor contract that is still within its probation period; 2) it provides four additional causes under which an employee may initiate termination of labor contract, including, among other things, the employer’s failure to pay social benefits; and 3) most importantly, it gives an employee the right to terminate without any notice in the event an employer has coerced the employee to work by force, threat or illegal measures that restrain the personal freedom of the employee, or if the employer has illegally demanded or instructed an employee to work under a risky environment that endangers the employee’s personal safety.

Termination of labor contracts by employers

One major difference between the Existing Law and the New Law in this area is reflected by the two new causes for termination of labor contracts by the employer under the New Law: 1) when an employee establishes a second employment relationship with another employer that affects seriously the employee’s ability to do his/her job under the first employment, or when the employee refuses to terminate the second employment relationship when he/she is notified to do so by the first employer; and 2) when an employee has coerced his/her employer into a labor contract by force, threat or other improper means that renders the labor contract invalid. These two causes are “embedded” within the Existing Law under a more general term of “violation of company rules,” but are now clarified and codified under the New Law.

Lay-offs

In this area, the New Law takes an approach closer to what’s embodied under local rules, such as the Beijing Regulation and Shanghai Regulation, and gives an employer greater latitude in satisfying conditions for lay-off. In addition to situations where an employer is facing insolvency, reorganization or grave business and operational distress, the New Law also allows a lay-off when a company is changing its production lines; going through a major technology reformation or adjustment in its management method; or when, objectively, an employer’s economic situation, upon which labor contracts were based, has changed substantively, rendering the employer economically unable to honor the contracts. The New Law qualifies a lay-off as a workforce reduction in which an employer needs to reduce more than twenty of its employees, or a number of employees that is less than twenty, but consists of more than 10 percent of its total number of employees.

The employer’s obligation to inform the union and all employees 30 days in advance, to consult with the union and all employees of a contemplated lay-off, and to hire back employees who have been laid off if an employer is in the position to hire again within six months, remain essentially the same under the New Law. However, the New Law requires an employer to exclude long-term employees, employees with open-ended contracts, and employees who are the sole bread-earner with small children and elderly relatives to support at home from a planned lay-off.

Automatic termination of labor contracts

By comparison with the Existing Law, the New Law provides for several more new events, the occurrence of which will trigger automatic termination of labor contracts—when an employer’s business registration is cancelled by regulatory authorities, when an employer is ordered to close down its business operation or when an employer decides to dissolve its business operation before expiration of its duration.

Most importantly, Article 45 of the New Law codifies a provision under the Shanghai Regulation, which provides that under circumstances in which an employer is not allowed to unilaterally terminate a labor contract pursuant to Article 42 of the New Law, a labor contract which otherwise would have automatically terminated pursuant to Article 45 will have to continue until the situations under Article 42 go away. This brings up an interesting scenario—when a company is bankrupt or ordered to shut down, should there be an employee of that company who has worked continuously for more than 15 years and is yet four years away from his legal retirement age, the New Law will require the company to maintain this employee’s labor contract for four more years. How such a scenario will play out in reality is yet to be seen.

An equally important new requirement is contained in Article 46(5) of the New Law. Under Existing Law, an employer is not required to pay any economic compensation (or, severance pay) when a labor contract terminates on its own upon expiration of its term. The New Law, however, provides that this will remain true only if the employer has offered to renew the labor contract with the same or more favorable terms and conditions, but the employee refuses to take up the offer for renewal. Additionally, a new requirement under Article 46(6) requires an employer to pay economic compensation/severance pay to its employees when their labor contracts terminate automatically upon cancellation of the employer’s business license by administrative authorities, or if the employer is ordered to shut down or close up its business operation, or when the employer decides to dissolve its business operation before expiration of its approved duration.

The employer’s economic compensation obligation upon contract termination

The New Law codifies the requirements under both the Shanghai Regulation and Beijing Regulation that require an employer to pay economic compensation upon termination by an employee when his/her employer has failed to provide labor protection or conditions as agreed to in the labor contract (Shanghai), has not paid the full salary amount in a timely manner (Shanghai), or has used force, threat or illegal measures that restrict the personal freedom of the employee to force the employee to work (Shanghai and Beijing).

The New Law also provides that an employer must pay economic compensation upon termination of a labor contract by an employee if the termination is based upon the employer’s failure to pay social insurance on behalf of the employee in accordance with law; or if the employer’s rules and policies have violated laws and damaged the employee’s rights and interests; or if the employer has cheated or threatened the employee into signing the labor contract which renders the contract invalid; or simply if the employee is entitled to terminate the labor contract pursuant to any laws, regulations and administrative rules.

Calculation of economic compensation

The New Law codifies a provision under the Shanghai Regulation, which provides that when counting the number of years an employee has provided service to an employer for calculation of economic compensation, if in a given year the employee has worked six months or more, but less than a full year, it will be counted as one full year. It sets up a new requirement, which provides that if in a given year, the employee has worked less than six months, it will be counted as half a year in calculating economic compensation. It also provides a cap on the amount of economic compensation payable to an employee whose salary is higher than three times the average monthly salary of the previous year, as published by the People’s Government, in the place where his/her employer is located, and at an amount that is three times of that locality’s average monthly salary. Thus, if the average monthly salary of the previous year published by a certain locality is 1,000 RMB, whereas an employee’s monthly salary is 4,000 RMB or higher, the economic compensation payable by his/her employer, if any, will be calculated using a monthly salary capped at the amount of 3,000 RMB.

Article 97 of the New Law provides that in calculating economic compensation payable to labor contracts existing before the New Law comes into effect, but which are terminated after the New Law’s effective date, the economic compensation payable by an employer pursuant to the New Law will be calculated based upon the number of years of service, starting from the date the New Law comes into effect. In the event an employer is obligated to pay an employee economic compensation pursuant to the Existing Law before the New Law has come into effect, the amount of economic compensation will be calculated pursuant to Existing Law.

Part-time employment

Under the Existing Law, only localities such as Shanghai area have laws regarding part-time employment. The New Law adopts the concept and makes it national, and provides many guidelines that are new and different from the rules under the Shanghai Regulation regarding how to structure a valid part-time employment arrangement. Essentially, a part-time employee must work less than 4 hours a day and less than 24 hours a week cumulatively; part-time employment may be based upon an oral agreement; and part-time employment is “at-will” and can be terminated by either party at any time by notice, without requiring an employer to pay any economic compensation. However, the New Law remains silent regarding social benefits and insurances of part-time employees, which has caused confusion in Shanghai area under the Existing Law. It remains to be seen whether any implementation rules will follow upon the New Law coming into effect, that will shed any light on this issue.

Employment service agencies and related matters

The New Law devotes an entire section to employment service agencies (such as the well-known FESCO) and related matters, and codifies the “triangular” employment relationship which is unique to foreign representative offices registered in China. Certain incorporated FIEs voluntarily use this type of arrangement, believing it helps to reduce costs in managing employee social benefits and insurances. Under the New Law, however, incorporated FIEs may wish to think twice before deciding to utilize the services provided by an employment service agencies, because Article 91 of the New Law provides that the entity using the services will be held jointly and severally liable to the seconded employee for damages sustained by the employee due to a violation of the New Law by the employment service agency. The bottom line—under the New Law, a simple human-resource administrative oversight may result in a very expensive employment contract for an employer.

For more information, please contact:

Margaret Lu, Seattle, Washington, (206) 622-3150, margaretlu@dwt.com
Ron Cai, Shanghai, China, (011) 86-21-6279-8560, roncai@dwt.com
Sisi Liu, Shanghai, China, (011) 86-21-6279-8560, sisiliu@dwt.com

This advisory is a publication of the China Practice of Davis Wright Tremaine LLP. Our purpose in publishing this advisory is to inform our clients and friends of recent legal developments in China. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations. Attorney Advertising. Prior results do not guarantee a similar outcome. Thank you.

Copyright © 2007, Davis Wright Tremaine LLP.

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