Protecting Your Company's Competitive and Technological Advantage through Enforcing Restrictive Covenants Against Former Employees in China: Update on Recent Cases and Legislative Developments

In today’s technology-driven society, it is vital for many businesses to keep its technical and competitive edge. However, this may easily come under threat when departing employees who hold key knowhow and skills, not to mention confidential information and trade secrets, join their competitors. This issue has come under increasing scrutiny as China’s rapid transformation from a labour intensive to a knowledge intensive economy brought more competition with Western countries. Indeed, a thorny topic in the Sino-US Trade War is technology transfer.

In the past, the laws in China do not contain detailed guidance on the validity and enforceability of agreements restricting former employees from joining competitors and soliciting customers, as well as agreements that protect trade secrets and confidential information from disclosure by former employees. Moreover, the plaintiff used to bear the full burden of proof, resulting in companies often losing their case against former employees in this uncertain regulatory environment. This situation is evolving quickly in a number of aspects. In this article, we discuss whether and how companies may enforce restrictive covenants and protect their confidential information and trade secrets by looking at some recent cases and legislative developments.

Is a client list a trade secret? ¹

Huayang Xinxing Technology (Tianjin) Group Co., Ltd. (“Huayang”) had a trade secret infringement dispute with its former employees Wang Chenggang, Zhang Hongxing and Liu Fang. Wang was the legal representative of Huayang from 2012 to 2016 and he set up a company named Maida Ke’er (Tianjin) Technology Co., Ltd. (“Maida Ke’er”) in October 2015. Zhang and Liu, who had signed confidential agreements with Huayang joined Maida Ke’er later. Huayang chose a client list containing information about 43 clients as the infringed trade secrets, claiming that the client names, product names, product specifications, the number of sales orders, unit prices, contact persons, telephone numbers, and addresses in transactions regarding the 43 clients were trade secrets stolen from it through these former employees.

One of the key issues for the case is whether such client list constitutes a trade secret. Under the PRC Anti-Unfair Competition Law (“AUCL”), trade secrets refer to any technical information, operational information or commercial information which is (i) not known to the public and (ii) has commercial value, and (iii) for which its right owner has adopted measures to ensure its confidentiality. The Tianjin First Intermediate People’s Court (“the first-instance court”) considered these three aspects. First, the first-instance court held that the list was an in-depth information integration that was not generally known or easily accessible to the relevant personnel in the field. Besides, Huayang used an Enterprise Resource Planning (“ERP”) system to store its client information and signed confidential agreements with its employees. Lastly, Huayang has adopted reasonable protection measures commensurate with the commercial value of the list to protect it. Hence the first-instance court concluded that the client information claimed by Huayang was secret, confidential, valuable and practical, constituting a trade secret, but it awarded damages of RMB 600,000 only. Both parties appealed and the appeal court upheld the former ruling. However, the case was further appealed to the Supreme People’s Court (“SPC”), which overturned the previous rulings. The SPC took an employee-friendly stance, pointing out the client list in dispute could not constitute a trade secret since such information would be easily accessible with online searching resources and acquired by relevant practitioners with their working skills, without covering certain trading patterns or intentions of specific clients.

Enforcing non-compete agreements

Signing non-compete agreements with senior officers who have access to corporate trade secrets is a common method used by companies to protect their knowhow and competitive edge, especially in the technology sector.

Chang Cheng, Ex-Lenovo VP, the former head of Lenovo Group’s mobile phone business, resigned from Lenovo on December 31, 2019. He joined a rival company Xiaomi two days later.

Lenovo applied for arbitration, claiming that it had paid Chang a RMB 5 million equivalent compensation in equity incentives under a non-compete agreement, which restricts Chang from joining a competitor before December 31, 2021.

On October 9, 2019, Beijing Haidian District Labor and Personnel Dispute Arbitration Commission ruled that Chang shall continue to perform his non-compete obligation, pay RMB 5,252,821.09 as penalty for breach, and refund the non-compete compensation of RMB 72,955.85 to Lenovo. However, Chang’s lawyer announced that Chang had filed an appeal against the arbitration award so the ruling has not yet taken effect. Unlike certain other jurisdictions, the lack of injunctive relief in China means that Chang can still continue to work for the competitor while the lawsuit is ongoing. The outcome of this case in terms of the financial penalties for breach (if any) is still pending.

Ongoing legislative developments

Notwithstanding the above cases, there are numerous legislative developments recently which appear to provide businesses better protection against former employees.

• On April 23, 2019, the AUCL clarified the definitions of trade secrets and infringements of trade secrets, widened the scope of infringers, added punitive damages for malicious and serious infringements, and reversed burden of proof if a trade secret owner can provide prima facie evidence of an infringement. (AUCL, Article 9, 17, 21 and 32)
• On May 28, 2020, the PRC Civil Code (“Civil Code”), included punitive damages in intentional intellectual property infringements with severe consequences, to be consistent with the 2019 AUCL. (Civil Code, Article 1185)
• On September 4, 2020, China’s State Administration for Market Regulation (“SAMR”) released the Draft Provisions on Protection of Trade Secrets (“Draft Provisions”). The Draft Provisions provided a broader scope of “business information” (i.e., “any type and form of information related to business activities, including, but not limited to, technical information and operational information”). Another point worth noting is that according to the Draft Provisions, the right to any trade secret(s) researched or developed by employees who use the company’s material and technical conditions or experience outside their work assignment(s) should belong to the employees, but the company has the right to use the trade secret(s) within its business scope after paying a reasonable consideration. (Draft Provisions, Article 5 and 10)
• On September 10, 2020, the SPC released the Provisions on Several Issues Concerning the Application of Law in Trial of Civil Cases of Infringement of Trade Secrets (“Trade Secret Provisions”), which came into effect on September 12, 2020, defining “technical information” and “operational information” by listing examples. Furthermore, the Trade Secret Provisions provided a simplified definition of “client information”. However, echoing the decision in Huayang case, a particular client may not been deemed as a trade secret merely on account of a long-term and stable trading relationship. If a client does business with an employer based on its trust in the employee, and after the termination of employment, the employee can prove that the client voluntarily chooses to do any transaction with himself/herself or his/her new employer, the people’s court should determine that the employee does not obtain the right holder’s trade secret by any improper means. (Trade Secret Provisions, Article 1 and 2)
• On September 12, 2020, the SPC and the Supreme People’s Procuratorate (“SPP”) have jointly issued the Interpretation on Several Issues Concerning the Specific Application of Law in Handling Criminal Cases Involving Infringements of Intellectual Property Rights (“Interpretation III”), lowering the threshold for establishing a trade secrets breach with “significant losses” from RMB 500,000 to RMB 300,000 in terms of damages or illegal gains and listing other circumstances that may constitute “significant losses”. (Interpretation III, Article 4)

Takeaways for employers

• The rapid legislative developments summarized above indicate that China is trying to improve the regulatory environment for businesses that seek to protect their knowhow and trade secrets. Employers will be able to resort to remedies available in civil, criminal and administrative law, bearing a comparatively light burden of proof.
• However, there are still various challenges, including the limits placed on pursuing a former employee for dealing with a customer, the requirement to pay compensation to employees for using employee’s works developed outside work assignments, and the difficulty to enforce non-compete and other restrictive covenants.
• Meanwhile, employers should take various measures to avoid trade secrets leakage by employees and mitigate the risk of trade secret infringements before and during employment with employees. Given the limits on simply relying on the law to protect its interests, it is important to ensure the company has non-compete, non-solicitation and/or confidentiality clauses with its employees that maximizes protection for the company on the contractual level.. Based on prior court decisions, a well drafted agreement with specific definitions is more likely to be enforceable than a basic agreement with high level and general provisions only. Meanwhile, employers are advised to adopt security measures to protect trade secrets and confidential information. Regular and systematic compliance training can also be arranged for employees to raise their awareness and enhance protection and data security. Good departure and exit interview processes can help identify relevant risks, and of course businesses should not forget about creating incentives to retain key employees to prevent the departure in the first place.