Employment law in China: IP rights

Welcome to the latest episode of Gowling WLG's Employment Essentials podcast.

Andrew Bratt: Good morning, everybody. My name is Andrew Bratt, and I am the Head of the National Labour Employment Law Practice at Gowling WLG in Canada.  I am based out of our office in Toronto, Canada, and I am very pleased to be joined today by my partners Annette Knoth in Germany and Elliot Papageorgiou in China. 

I will ask them to introduce themselves in just a moment but before I do, this is the second in our series that we are putting on on employing people in China. And before I ask Elliot and Annette to introduce themselves just to sort of set the theme, Elliot. We hear a lot about restructuring and localising, and specifically localised supply chain in China, and I want you to tell us what exactly is going on, what this all means and specifically what impact it has on IP rights as it relates to employees in China.

Annette Knoth: Many thanks Andrew. So, as mentioned my name is Annette Knoth, I am heading the Labour and Employment Practice of Gowling WLG in Frankfurt, and I am very pleased to be here again and curious what Elliot has to tell us about IP rights in China.

Elliot Papageorgiou: Hi, I am Elliot Papageorgiou I have been in China since 2005.  I am the Head of IP Strategy and Enforcement in Gowling WLG's China offices and a lot of the work that we do relates to how to try and prevent IP from leaking out of companies through among other means employees either taking it with them or it not having been looked after and therefore it just leaking out by accident.

Andrew: Thanks Elliot, so can you tell us a little bit about the lay of the land as it relates to restructuring and localising and what that means for employees and IP protection in China?

Elliot: Yeah so as you can imagine there has been a lot of change in the economic climate in China and that means that a lot of the work that we are looking at now and a lot of the economic movements are about localising China and one of the steps in localisation of course is that more and more is being done in China from the business whether it is the manufacturing, whether it is the development, whether it is the putting together the sourcing of products but also of course a lot more IP is both created and brought into China in that particular process. And I guess the key thing is that we would be looking out for is how does that particular movement, I guess the localisation and also the restructuring, how does that open up some risks, which foreign companies may not be aware of or at least where there may be differences in the approach in China to their home countries whether it is Europe or whether it is North America, there are particular you know structures that companies are familiar with and China may pose for them a new challenge.

Andrew: What I do see from a research and development perspective in terms of ….I would imagine that a lot of R&D is being moved into China, what does that do in terms of IP rights?

Elliot: Yes, you are quite right, and this is a good point, Andrew. Because one of the key things which punctuate R&D in China is that even though you have got R&D centres very often there used to be merely development centres and now, we have got a lot more of the research at least the localisation research in other words making products suitable for purpose in China happening in China. Which means that those people that used to be your technicians and may be just sort of you know slightly adjusted products now are actually contributing and creating IP.  And that opens up the sort of challenges in relation to (1) these people learn about the nuts and bolts of your business, so one of the aspects we look at for example is trade secrets; and then another one is - and these are sort of topics that one can look into a bit more detail - is also what happens if these employees are real innovators and actually create new IP.

Annette: Elliot, just for curiosity reasons when you talk about IP rights, trade secrets and patented rights, I mean foreign investors will think that "oops, that is quite a challenging point when we think about China", but how does Chinese law treat this, do they belong to the company, to the individual, so what is the situation here?

Elliot: Again a very very current topic.  Chinese law has the same type of safeguards, very very analogy safeguards to what you would find in countries such as Germany and indeed I am sure in Canada as well, which is that number one you have got the employment relationship and that sort of underscores as to who owns the IP.  So, if you have got an employment contract, it is an employee, and in the course of that employment relationship IP is created it would accrue to the employer if the right legal structure is in place, so that is the first thing. So, we do have the concept of service inventions and employees who invent in the course of employment their particular invention would then benefit the employer.  Of course, there is also a little tip which we adopted from the German system, which is that the employees can also benefit from it and that brings us to the next topic, which may be interesting as well, which is that a lot of companies forget that in China you have to share some of the benefits with your employees.

Annette: I just hope the point you know that employee inventions are treated a bit like in Germany and, I don't want to say that this shocks me, but I mean to copy that law is maybe not the best idea to do. So, for all non-German companies could you maybe explain a little bit, what does this mean if an employee makes an invention, so what is the process, what is in particular the compensation the company would have to pay?

Elliot: And again, this is something with the same view that China felt that the German system has been a way of benefit-sharing with employees it is implemented actually very heavily. So, it has gone so far into it that in the last four-to-five-year plan there has been a particular aim that says that the benefits accrued to these big companies, especially tech companies, should be shared with employees. 

Now the structure for that has been in place for some time so the patent law going back probably about 15/20 years has recognised what originates from Germany, which is employee inventor remuneration, and that is basically a system by which even if the employee is purely employed in an R&D facility and in that particular capacity they invent something which is according to their job description, then the company should still, if that invention is commercially viable, remunerate additionally the employee. 

There must be a system in place, in fact there must be a policy in place, and if there is no employee inventor remuneration policy which contains such matters as how much do employees benefit, what does the company have to do to compensate them, what happens after they are compensated, what happens if the company does not want to absorb that particular IP remuneration? But also more importantly, if they do not have the policy in place there are some fairly heavy penalties in terms of mandatory provisions, which can result in a very large slice of the revenues, not just the profits, accruing to the inventor so there is a very strong push in China to ensure that companies implement an employee inventor remuneration policy which is sort of modelled on the German system, but arguably because it has got less experience it does not work as smoothly yet as perhaps the German system does.

Andrew: In North America we typically see a provision that says the employee acknowledges and agrees that any inventions that are permitted during working hours using company resources on company time belongs to the company.  Can you do that in China, are those kind of permissions enforceable?

Elliot: So Andrew yes, in fact and I do not know if this is the case in Canada and Germany but in China the patent law actually already provides for it, so service inventions are provided for under the patent law and there is actually a number of provisions, one of them we can come to them a little bit later, which is the clawback. So, this applies not only to inventions that the employee generates during employment but up to 12 months after employment right, as long as it is referable as you rightly say Andrew referable to that employment. 

But while that works to accrue the invention to the company, that policy must still be in place - so yes, default is the company has a right to claim and owns that invention.  But a company also carries with it the obligation - you must give the employee some benefit.  Now you can buy them out, and as I know the German system is very sophisticated how you can deal with it, but you can buy them out, or you can make them a beneficiary of any profits of the future. So, there is a number of different things you can do, so yes, the company owns it but it also carries with it a connected obligation that the employee gets something back for it.

Annette: You mentioned Elliot the sophisticated system in Germany and that is a very nice way to name it.  I would say many companies would call it an extremely complicated system, and just according to my experience I mean the most crucial points are to find out or to detail mine what is exactly the part the employee takes in that invention and then also to find out about what is then the value of that part so is that a bit the same situation in China because honestly it is almost impossible to have clear rules on these two points?

Elliot: It is, and that is actually… you have raised a very good point. What a lot of companies tend to do, especially if they come from an established system…let us call it established like in Germany, they try to apply sort of similar rules, they try to say "look we are in good faith so what we will try to do is share the benefit on a pro rata basis on a share of the profits basis with the employee.." and that is highly dangerous in China for a number of reasons. One of them is that if there is a dispute you have to disclose in open court what your profit calculation is, and we will come to that in a moment. What companies tend to do or what we advise them to do is to have a policy whereby they have bracketed or fixed payments to employees at certain milestones if they want to absorb that invention, but not to base that on a particular profit calculation. 

The worst case scenario if you base on a profit calculation is a case of an American company I represented before the Supreme Court in China where the employee had moved from that company to a Dutch competitor, both in electronics so you can imagine who that is, and all of a sudden that particular employee wanted the American company to disclose what the input values were for this profit calculation because the employee entered a remuneration policy said they would get a percentage of the profits.  So this is really…..you are right this is an area rife for disputes and especially well-meaning foreign companies that really want to abide by the rules of the law rather than saying we will buy them out affectively get themselves into hot water.

Annette: I guess Andrew, I mean this all sounds very familiar to me but maybe something not understandable for North American ears?

Andrew: Very foreign concept coming from a North American perspective but I am curious in terms of the 'buyer' so to speak, will the courts look at the advocacy of …or the sufficiency of the buyer itself or can you for example say "in exchange for all of the wonderful inventions that you have created for us over the past how many years we will give you five dollars"?

Elliot: So you have hit the nail on the head there is actually, even within that reasonable stance, it will be familiar to Annette, and indeed a very very important topic for non-continental European companies that are not familiar with the system or even some continental European companies do not have the system, but a key thing is it must be reasonable and it must be ex post facto reasonable, which means that you could have a totally reasonable policy generally and then Andrew and Annette you have a blockbuster. 

Let us say it was not intended, I mean pharmaceutical companies deal with it very well but they are the ones that come up with an expected blockbuster and then all of a sudden you have to be prepared that it will be reviewed by the court because you did not expect it to be you know the Ozempic of engineering right you didn’t expect it to be that and …you know what I mean and that it is like everybody is there going like "..but we promised them we would give them 5% of the net profits.." that is reasonable. Except here it becomes in some situations the major product of that rather small company, then the courts in China will ex post facto look at it and say "..yes you had a policy so you will not be penalised but you should be paying more.." so we will actually supplement and give you a multiplier of what you should be paying that employee.

Andrew: And will that affect never go into reverse will the court ever say "..that was reasonable at the time is no longer reasonable because it was too much.." for example if you say "..we will give you 50% of profits.." not expecting it is going to be next Ozempic, will the Court ever say that was not something the company would have agreed to if they had realised how much money this product was going to make them?

Elliot: China is not a capitalistic country some people would say, so what do you think would happen in this situation?  I do not think you could every rachet downwards, just like as I am sure when you were discussing the earlier podcast you cannot rachet salaries downwards either in China, so it will never rachet downwards. So, our advice would be come up with a reasonable model in fact this is where companies coming out of Annette's jurisdiction have a huge advantage because if you say we are applying the same system as in Germany but different you know multipliers, different weightings because China is let us say second city is a less expensive jurisdiction than Germany, then the Courts will look at it and say "..okay the policy generally is fair..". Here, we may have an exception Andrew because it is a blockbuster but you have done here nothing wrong you could not anticipate it, but we will still for these particular products we will rachet it up. And what they may do in affect is say "we are ratcheting it up.." and then … I have had companies who have said "well that product benefit has passed because we run out of patent or whatever.." but then of course the remuneration stops as well Andrew, so once the patent expires that gave us that competitive advantage so does the employee inventor remuneration obligation.

Now, one of the key things thought which I guess Andrew may be needs to be mentioned is that even if you decide not to file a patent and keep it as a trade secret will you still need to renumerate.

Andrew: Wow.

Annette: Elliot, you mentioned a couple of times that we give or we advise clients to set up policies to avoid the hassle that may come later then. Do you have any employee representation unions who would be involved when you set up policies or is that something the company just do?

Elliot: This is again right on point Annette and so two things; number one, there are employee counsels which deal with things such as employee handbook, once you get to a certain size you have to have that amended.  Now, why do I mention employee handbooks? Because again some companies who try to make it compact put these policies into employee handbooks, big mistake, because firstly as you mentioned you need the employee counsel to then approve amendments to the employee handbook, that's the first thing, which makes it very hard to change if Andrew as you were saying the product changes, the policy changes, the times change you cannot afford to pay 5% anymore so that is the first point. 

The second one is an employee handbook is always disputed and litigated before an employment tribunal which is almost always, very employee leaning. So, affectively you want to have your employee inventor remuneration policy that is structured outside of that, almost a separate contractual structure so that it does not get adjudicated on by people whose main purpose is to look after employees rather than finding something which is a workable commercial solution.

Andrew: In terms of structuring the tail or the bio if it is not advisable to tie it to profits and I certainly understand why but you also might want to go on to something that might be reasonable as time progresses, but what is the main sort of structure that you see or the most common model that we recommend to clients that they put in place for compensating these types of inventions?

Elliot: So we recommend milestones which are in the Chinese context not small, some will be when the invention is declared, then there will be another milestone when a patent has been filed. Because from the invention to writing up a patent that means it has been fleshed out more, and there can be some assessment about how commercially successful it may be and then when the patent is granted. Then we usually recommend from then onwards it being a fixed payment on the expectations of how useful the patent may be, and of course Andrew and Annette a lot of these patents are not licensed out right and it is so difficult. 

Let us say a particular product has six patents and it has got multiple inventors, it is hard to tell how much each contributed. So if you have a particular model that you generally apply, so Andrew, we would say apply this model and make sort of milestone payments even during the duration of the patent, depending on whether it is active patent or not you may have two stages.  You may say it is a really active patent we are using it in our products constantly, you get this fixed sum year-on-year, and if it is a passive patent - yes we have got it we may give some defensive purpose but it is not actually something which is creating an additional value or a barrier for competitors, then it would be a lower payment. And you do that for a certain period and of course employers can always decide that they may not want to keep the patent up, in other words after X number of years if they feel there is no commercial value you drop the patent and then that obligation would fall away as well. So it is a very good question but we would always recommend milestones because as I said employees move very quickly in China. 

On average there is a turnover between 15% and 20% from industrial companies per year minimum, 15/20% in some very high tech industries or very hot industries like AI, Quantum etc. it is probably closer to 30% to 40% of the employees moving. So, from that perspective it has got one aspect which is that you want to make sure that you do not have a formula which you may have to disclose in Court. Because in camera hearings, so hearings that are closed are very rare in China. And then the second I think important element here and this is something that Annette alluded to earlier is the administrative burden, because you know you have to trace this employee wherever that employee is so Andrew that employee may have jumped three companies and moved house twice but you still have an obligation of finding them to pay them their remuneration, even if they have not kept up with you that obligation exists so they have to put the money aside if you cannot find them right, so it becomes a real administrative….you basically have a department in the end that deals with managing. And I think in Germany it is a very common thought that you spend so much admin that it is almost more than the amount you pay for the employees.

Annette: Elliot, at least from side of it thank you and it is definitely clear to me that it is a mystery or definitely no longer true that employing people in China is easier and much less complicated than in Germany and my view is that if China wanted to copy some legal provisions from Germany I would have had better recommendations instead of doing this as you call it the 'administrative monster'.

Andrew: Yeah I think it is a good subway into another question I have for you because you mentioned that there is a lot of turnover in China and I have often kind of heard that. So, with that in mind how do companies protect their trade secrets, specifically how do you avoid a scenario where somebody comes to work for you, spend a couple of years learns the secrets and then walks across to your biggest competitor and spills the beans?

Elliot: Sometimes it is underestimated Andrew, we are all aware of it, we all know it, yourself and Annette spend a large slice of your advisory time advising clients on how to formulate employment contracts and I will make my segway to trade secrets which is one important aspects. But what a lot of companies do not do, and this happens to companies from around both North American, European companies, and that is not to update their employment contracts.  By update either mean the law changes you need to update it but your employees have migrated to a higher importance level right and then they leave you. For example, in China you can impose restrictive covenants provided you compensate appropriate you can have up to two years of restrictive covenant not to work for certain employers that may be competitors. 

But you cannot impose it on a guy who was your simple technician, but your simple technician over a five-year period - especially if you are a quickly growing company or if you are localised - will of a sudden could become your R&D head certainly after ten years, but some companies have not updated their employment contracts and then all of a sudden they realise "oh we have no non-compete or we only have a three-month non-compete whereas we could have two years". 

You cannot impose it subsequently, so the best way to protect your trade secrets is to recognise that your employees after two years become really hot property for your competitors and then to say "..ok let us put a marker in our… whether it is a company in Germany or in Canada… let us every two years review our contracts against the employees and after a period we will have four or five different levels of contracts, but let us just check into which bracket this employee should fit.." And when we give them a pay rise let us get them to sign a new contract, which has got additional obligations. Because otherwise we will be surprised and Peter Wong who was the technician is now Peter Wong who is the Head of R&D and he has now gone to a competitor and our terms do not give us any bite as far as the trade secrets are concerned that he has learnt.

Then the second element, and I guess we will be discussing in a little bit more detail, is how much effort do you put in as company to actively protect your trade secrets against local employees. So this is an area where a lot of companies that have obligations in Canada imposed by law that have obligations either for example the Trade Secrets Directive in the EU and they already know from their home jurisdiction they need to do something to be able to show that it was secret and that they have kept it secret and therefore claiming they dropped the ball with China entirely. So, they do not do the basics, they do not have a trade secrets policy in place in order to be able to then stop the employees from taking anything because the employees will say "..well that is all stopping trade and you never expressly categorised it as a trade secret and therefore all I am taking is what I have learnt..", so that is I think the biggest risk actually.

Andrew: Yes and not to stray too far off topic because I appreciate we can spend an entire day talking about restrictive covenants, but in terms of protecting trade secrets by dealing with it via protection in the employment contracts, how enforceable are restrictive covenants non-compete for example in China? Because I can tell you that you know some jurisdictions in Canada now have actually banned non-compete with very few acceptance and even before the ban they were largely unenforceable unless you can really demonstrate that they were critically necessary to protect legitimate business interest. So, it is easy in theory to say you know the ways to protect your trade secrets are to prevent competition or prevent solicitation or to have non-disclosure agreements, but how enforceable are those in China?

Elliot: That is a really good question as well.  In China, it really relies on two factors one of them is; are you paying additional remuneration after the employee has ceased working for you?  In some jurisdictions, I know that there are some in Asia as well, where you say "..you are getting a higher salary and therefore that is already compensation that after you leave us for X period you cannot work for a competitor.." you cannot do that in China. 

In China, you basically have to pay them, very often their continuing salary or large proportion of it, for the maximum two-year period.  Now you have to do that and you have to have that agreed from the beginning, so you have to have a clause in your contract that says 'once you have finished we have the option for a certain period of time, six months to two years, two years is maximum, of continuing to pay you to not work for a competitor'. 

Now the other thing Andrew and Annette is that it must be reasonable, so the point that you mentioned is implicit in this Andrew, which is you have to be able to explain. And usually in a contract you will say which competitor, there may be a schedule, or you will indicate which industries and sort of allude to why you. You won't flesh it all out but if it comes to a dispute, because usually the Chinese new employer that would go in fighting and say "..well they should be able to work for us.." that is when you lay out and say "..look we paid from the beginning, we knew that it was going to be sensitive, we have continued paying and here is why it is unreasonable for that period..". And what can happen in practice is that a court might say "..two years was a little bit long but we are good with one year.." And again that is on the basis Andrew… and in some sensitive industries we have had clients who continue to pay the existing salary, the existing salary on departure, for at least six months so that the employee really is on garden leave, because you cannot really force a gardening leave, but with that you can say "..well you cannot work for these list of companies.." which affectively of course makes it also more difficult or less attractive for them to move, because the hot employers, there will be some employers that will be really hot for them may be carved out for that period of time.

Andrew: So, in China the Courts will 'blue pencil' a provision, so if they feel that the provision is otherwise enforceable but is too long they will hear it, they will fix it and substitute what they believe is a more reasonable period of time?

Elliot: Well, if we have a feeling in a dispute that the issue with the Court is the duration of it then… and very often the Court will want to say "well, now it has already expired and so yes it was valid until now" because that means of course that the employer is also going to have to repay anything, if you are saying 'up until now'. So, this is where you are sort of pushing and the courts might say two years is unreasonable. 

Of course, the real work should be done Andrew at the time when you are creating the contract and signing the contract that you already have all that outlined so that you are ready for it. Just a little bit like preparing for the employee departing because Andrew as certain as 'Amen' in church, employees will move between two and four years and especially if they have been valuable to you and have been trained up well. 

So, a good idea is to have a really detailed rationale why you wanted that two-year period because then that is something that lessens your burden afterwards and you can also say we made this notice, we made this notice that perhaps we attached it as a commented ending for the contract explaining why we think this period is necessary, and also that is why we paid him so much.

Annette: And if I understood correctly Elliot, even non-compete covenants are not the perfect instrument to avoid the monetary compensation for employee inventions so it is just an add on?

Elliot: Correct, and usually they work hand-in-hand with something that you and Andrew raised earlier, which is the service invention provision. Under China's patent law and regulation the service invention provisions extend for anything the employee may file within 12 months of leaving an employer as long as the employer can show: (1) it fell within the scope of their responsibility; and (2) it falls within the business scope of the employer. If you show those two factors you can clawback. So anything that is an employee leaves and we have heard exactly this case and then within three months they file six patents this is for a German company in the industrial sector and this was the general manager who left and he took the head of R&D with him and a couple of R&D staff, and then all of a sudden starting for a family-funded Chinese company that was funded with three million euro filed six patents which directly compete with the next technology stage for this particular German client.

Now what you can do under the patent law is if you prove those two factors that: (1) it was within the scope of their responsibilities; and (2) it falls within the business scope of the former employer, you can then claim anything that is filed it does not have to be published, it does not have to have been granted but any patent that has been filed within 12 months of them departing the former employer can clawback. But again, it makes total sense to have a good labour contract that update their duties because the first thing the employee will say is "oh it didn't fall within the scope of my duties." And then the second thing is that with really good documentation of what they corresponded during employment. 

In that particular case, if you want to look at it as a case study, the German employer had deleted all mailboxes in China.  Luckily, the IT department had kept a copy of the mailboxes and we were able to reconstruct correspondence between some of the culprits - the general manager and Head of R&D – which showed they had discussed these inventions before they left the German company. So, a lot of the time, a lot of big issues here when you are talking about employee inventions and not about remuneration but just the service inventions is being able to prove that they were created within the scope of employment, so this is again something where companies can prepare but very often drop the ball.

Andrew: What is fascinating to me is that in Canada and frankly North America we often at the time of hiring and employment time focusing on the long-term careers and equity and different kinds of compensation structures that will incentivise people to want to maintain a long-term relationship with the company. It sounds like in China it is actually quite the opposite where you have to be very very methodical and mindful about the end of the relationship recognising that it is almost inevitable?

Elliot: That is unfortunately exactly the situation. There is a German saying that 'after the game is before the game', we are talking about football. And the bottom line is it is like in China - before the employment is after the employment. So, in other words you have to expect the employee leaving and especially if you are in this hot area. 

Now, there are some things you can do from the structure and we all know Andrew and Annette, if you are the key employer in an area, let us say you go to a second/third-tier city and you are that North American company or you are that European company that has got that cashier and you pay well etc. then your employees will be more sticky. But a lot of the time these companies look at the supply chain and they may go to a place like Shenzhen or may go to a place like Guangzhou or some of these hubs for particular technologies where there is a lot of competitors, which then of course is quite seductive for employees to hop and skip. So a lot of the time when you are hiring employees look at their record before that, are they jumpers anyway and number two, consider all your competitors around you because you can guarantee that once they realise you have got a few start employees then raising the salaries by 25 – 50% may not make commercial sense for you, but for your competitor which would give them a huge you know bump up…..spring board up, to catch up with your know how makes a huge difference.  So, these are sort of environmental factors but again they directly impact your IP because it goes with the employee.

Annette: Once again Elliot, big thank you from my side I mean I heard so many new things and a lot of information flying around in my head that at least I am running out of questions so once again from my side big thank you and hopefully this was interesting for clients as well.

Andrew: Yes, and I echo those comments, this was hugely inciteful so thank you for your time and thank you Annette as well for your time and I hope everybody has a wonderful day and stay tuned for our next series in employment law in China, thank you everyone.

Elliot: Thank you.

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