Tencent case and risks in non-compete commitments

A short time ago, a case in which a former employee of Tencent was ordered to pay the huge sum of RMB19.4 million (US$2.79 million) in compensation triggered heated debate in legal and human resources circles.

Xu Zhenhua, a former senior developer with Tencent Technology (Shanghai), established his own company and developed a number of games similar to games developed by Tencent while he was employed by, and after he left, Tencent. Tencent asserted that Xu Zhenhua had breached the provisions of his employment contract, and the non-disclosure and non-compete undertaking agreement entered into by the two parties, and demanded that he bear liability for breach of contract.

In its judgment, the court at first instance ordered Xu Zhenhua to pay liquidated damages in the amount of RMB3.72 million, which was increased to approximately RMB19.4 million in the judgment of the appeal, setting a new record for the measure of damages in such cases, and leading to the case being dubbed the “No. 1 non-compete case”.

In fact, a close reading of the judgment in this case reveals that the case is not a non-compete dispute in the conventional sense (nor in terms of labour law), because Tencent did not pay Xu Zhenhua monthly non-compete compensation after his dismissal and the source of all of the liquidated damages supported by the court was the stock granted to him by Tencent Holdings.

Accordingly, the liquidated damages paid by Xu Zhenhua were merely a translation of the stock granted Xu Zhenhua into the cash equivalent, which was then returned to Tencent. Although the cause of action was a “non-compete dispute”, the authors are more inclined to see the case as being a dispute based on equity incentive provisions, which may also be the reason why the arbitration commission originally refused to accept the case on the grounds that “the claims of Tencent do not fall within the scope of acceptance of labour disputes”. Nevertheless, how Tencent guarded against non-compete risks is still worth studying.

Clearly enumerating the industries to which the non-compete commitment applies and the names of the competitors. Usually many enterprises, when drafting a non-compete agreement, will specify the scope of the non-compete commitment only as “business that competes with that of the entity” or “business dealing in products similar to those of the entity”. However, if the drafting stops at this step, then the initiative on defining “that competes with that of the entity” or the “products similar to those of the entity” is lost.

From the judgment in the above-mentioned case it can be seen that Tencent nearly covered the entire internet industry, and all of the sectors in which it operates, by placing the restrictions on nine business sectors and listing more than 50 competitors (even including affiliates of competitors), creating a “360-degree blind spot” scope for the non-compete commitment.

The court at first instance held that “the overly broad scope would not necessarily lead to all of the non-compete-related provisions being invalid, and does not mean that Xu Zhenhua is not required to observe the basic non-compete related obligations”. Accordingly, clearly enumerating “industries plus competitors” will make things much easier for an enterprise in the event of legal action.

Expanding the scope of the means of competition to the greatest extent possible. An enterprise will usually list such means as “operating for own account, investment, being employed by a competitor” etc., but such a description fails to keep up with the changes in society. A former employee of Baidu landed a job with Toutiao by establishing an employment relationship with a commercial service firm and then being placed with Toutiao by the service firm.

Faced with such a situation, Baidu recently sought to institute labour arbitration on the grounds of a non-compete dispute, but was rejected. Although the authors do not agree with the opinion of the arbitration commission, feeling that substance over matter should be the determining standard, an enterprise should nevertheless retain the initiative of shaping the definition to the greatest extent possible.

For example, defining the means of competition as “including but not limited to establishing an employment relationship or co-operative relationship with a competitor, providing consultancy, advisory, guidance or other such services to competitors, or ultimately enabling a competitor (or its affiliate) to actually obtain benefits or services, such as indirectly providing services to it through third-party placement, secondment or other means”.

Only valid if non-compete compensation is paid after the end of employment. From the judgment it can be seen that Tencent paid a certain amount in the monthly salary as post-employment non-compete compensation, and, despite subsequent rectification, Tencent did not pay Xu Zhenhua compensation after he left the company, one of the defence arguments that he continuously insisted on during the trial. As the Employment Contract Law expressly specifies that non-compete compensation be paid on a monthly basis after the termination or ending of an employment contract, the same may not be circumvented by way of a provision in an agreement.

Expressly providing for the method of calculating the liquidated damages relating to a non-compete commitment. Currently, laws do not specify the rate for liquidated damages. The main approaches taken by enterprises include return of the compensation paid, specifying that the liquidated damages are to be a multiple of the compensation, or directly specifying a figure. In practice, a court will generally render its determination by considering such factors as the subjective fault of the employee, the extent to which he or she breached the non-compete commitment, the loss that the enterprise incurred as a result, and the amount of compensation that the enterprise paid.

The authors would not recommend simply specifying an overly high figure, but instead opt for a calculation method that is linked with the compensation (e.g., three times the compensation) while also claiming the losses (which the enterprise is required to substantiate).

Using multiple methods to guard against non-compete risks. One of the important revelations that this case provides is that, when a company proposes to grant employees incentive equity, it should make non-disclosure and non-compete one a condition for such grant. The combination of non-compete, as defined in labour law, with an equity incentive can enhance how an enterprise guards against risk, and may lead to the enterprise reaping greater compensation.

Victor Zhao is a senior partner and Sheen Huang is an associate at Co-effort Law Firm