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Published: 2008-03-26

What Goes Into an Employment Contract and Why



Most people work without a written employment contract because they don't need one - there is no point in drafting a contract when the deal is the usual exchange of services for a bi-weekly salary plus standard benefits. When the arrangement varies from the plain vanilla "employment at will" relationship, however, one or both of the parties may want a written agreement.

For example, an executive being recruited into a new company may want a guarantee of a fixed term of employment or severance to induce the giving up of a secure position at his former company. Sometimes parties negotiate bonus or incentive pay deals that are complex, or an employer may demand that employees agree to non-compete clauses that are effective only if carefully spelled out in writing.

Since most people have never entered into a written employment contract, it is not surprising that most people don't understand how these agreements work, and even fewer people know how to negotiate one. Employment contracts typically follow a standard format, with clauses chosen or modified to reflect the intent of the parties. The employer's counsel usually prepares the contract, which the employee then takes to a lawyer for review. Whether the ensuing discussions are between the parties or the lawyers, a realistic sense of what is "market" is critical to the future of the employment relationship.

In the interests of promoting smooth courtships between employers and employees, what follows is a detailed explanation of the basic terms of a written employment contract.

  1. The Employment. It is conventional, though not legally necessary, to specify briefly the capacity in which the employee is being hired ("Vice President of Marketing" or "to manage the business of the Company in France"). The employer may want to make clear that it retains the option of changing the employee's job, by stating, "Executive will hold the position of Vice President of Marketing or such other position as the Company may assign to him." The employee, on the other hand, may want to make sure he maintains the level of responsibility at which he is being hired and may even seek to preserve a reporting relationship that will prevent him from being "layered" in the future. Therefore, he will counter-propose language such as: "Executive will be Vice President of Marketing of the Company and will report directly to the Chief Executive Officer."

    Sometimes it is worth spelling out that the employment is full-time and the employee will not engage in other business activities. Conversely, if the employee plans to continue other activities, it is advisable to reserve this right in the agreement to prevent future misunderstandings.

  2. The Term. The heart of an employment contract is the term provision - how long will the promised employment last? Common arrangements are one year and three years; five years is more common in Europe than in the U.S. Shorter agreements, especially those with one-year terms, often have "evergreen" language which automatically renew the contract from year to year unless either party gives notice of intent not to renew. If an employment agreement is not renewed, the employment usually continues on an at-will basis. Some agreements also have no fixed term, but rather provide for payments for notice or severance when the employment ends.

    It is a big mistake to think that, just because an agreement provides for a fixed term of employment, either party is bound to continue the relationship for that entire time period. First-year lawyers are taught in their contracts courses that, "Personal services contracts are not specifically enforceable," which means that if an employee quits, even after signing a five-year contract, there is nothing the employer can do; no court will order the employee to keep working for the employer, nor can the employer collect damages from the employee for refusing to work. State wage laws, however, require the employer to pay the full salary to the employee (though not necessarily any bonus) through the last day worked even if the employee quits without notice. The only thing the employer can do, and this is subject to significant limitations, is try to limit the employee's right to go to work for the competition.

    Just as the employer cannot use a contract to force the employee to work, the employee's contract does not guarantee employment for the entire term. Even an employee with a five-year contract can be fired for any reason or no reason at any time, but if he is fired, he has to be paid. This is the essence of the bargain that an employment contract represents. The simplest agreement is that, if the employer fires the employee before the end of the contract term, other than "for cause," the employer must pay the employee his compensation for the balance of the contract. This basic arrangement is often modified by contract provisions which spell out how long and how much the employee will be paid if he is fired. Thus, a "five-year contract" may or may not end up being a five-year deal, depending, once again, on the terms of the contract.

  3. Base Compensation and Benefits. The contract typically provides for salary or "base compensation" and benefits. Salary is guaranteed at "no less than" a set amount, and the parties sometimes agree that the employee will be eligible for annual salary increases. It is customary to outline benefits, including insurance and retirement benefits, only briefly because most corporations have standard benefits packages: "Executive will participate in the medical, life and other insurance benefits, and the retirement and profit sharing plans that the Company generally provides to employees."

    Stock options are not usually the subject of contract negotiation once the parties get past the business basics of how many options the employee will receive and the vesting schedule. The contract will spell out, however, any specific "perks" that the employee has negotiated as part of his deal, such as club memberships, expense allowances, garage fees, and company cars. One such "perk" may be reimbursement for the fees of the employee's lawyer in reviewing the agreement.

  4. Variable Compensation - Incentive or Bonus Payments. The employer and employee must understand what this element of compensation represents in their business setting. Is the "bonus" simply a traditional extra to reward a good job in a good year? Or does the company pay "incentive compensation" designed to motivate employees to generate revenue in future periods? Employees may also receive commissions (based on gross revenue or sales) or a share of profits (revenues net of direct and sometimes indirect costs). The importance of setting forth the precise terms of such compensation is obvious, especially because the case law on this subject is confusing at best and contradictory at worst.

    Where bonus payments are the traditional expression of employer satisfaction, the agreement often provides that the amount of bonus is "discretionary," which means anything from nothing to a very large amount, based on the employer's judgment of the employee's work performance. Such provisions, which offer the employee no assurances, may contrast sharply with fulsome promises made during the courtship process about the company's big bonuses. The only protection for employees in this situation is competitive reality - an employer that doesn't pay fair bonuses will eventually lose its talented workers. In the short run, the employee can usually bargain for and obtain a contract guaranteeing a minimum bonus for at least the first year or two of the agreement.

    The most sensitive contract issue regarding variable compensation or bonus payments is whether the employee will receive any or all of this compensation if he leaves the company during the year. Companies argue that incentive compensation is meant to induce employees to remain employed, so if an employee quits, he should not share in incentive compensation. Where the size of a bonus pool is based on profitability, which is determined at the end of the year, the company will also argue that employees who leave prematurely cannot share in the pool. This reasoning often leads to the inclusion of language stating, "Executive will be eligible for bonus compensation only if he is in the Company's employ on the date when bonuses are paid to employees."

    Employees, on the other hand, argue that when their bonus is not a "little extra" but is a significant or even the principal component of their annual compensation, they should not forfeit this money if they are let go right before the end of the year. Their point of view leads to the inclusion of language stating, "Executive will not be paid a bonus for any year in which he resigns his employment. However, if Executive's employment hereunder is terminated by the Company (other than "for cause"), Executive will be eligible for a prorated bonus for the year in which such termination occurs." Of course, if the amount of bonus is discretionary and the employer views it as an incentive to induce performance in the coming year, the former employee's bonus is likely to be small.

  5. Early Termination. The contract typically provides for a fixed term but, as noted above, the term is not a measure of how long the employee will actually work because either party can terminate the employment at will. What matters, therefore, are the financial consequences of early termination, which usually differ depending on the circumstances in which the relationship ends:
    1. Resignation. The employee usually agrees that if he resigns, he receives nothing other than his salary through his last day worked plus accrued vacation. If he is contractually entitled to commissions, a guaranteed bonus, a share of the profits or other payment for completed work, the contract may provide for him to receive this money even if he resigns before the end of the term.
    2. "Good Reason" Resignation. Employment contracts sometimes distinguish a resignation "without good reason," for example, to take a job with a competitor, from a resignation "with good reason," which is effectively a constructive discharge as, i.e., when the employer does not pay the employee's compensation or demotes him. "Good reason" resignation may include a change of corporate control and thus constitute a "golden parachute" for the employee and a "poison pill" for the new employer. This is because the agreement usually requires the employer to pay the same contractual benefits to the employee in the event of "good reason" resignation that he would receive if the employer terminated his employment "without cause."
    3. Termination "For Cause". Employment can always be terminated "for cause" which usually means bad acts such as intentional misconduct, conviction of a felony, insubordination, job abandonment or material breach of the contract. "For cause" clauses vary in detail and are often subject to intense negotiation concerning the precise situations that will constitute "cause" for termination and whether "cause" requires notice and an opportunity to cure before the employer's axe falls. Virtually every "for cause" clause, however, provides that the employee receives no compensation except his salary through the last day worked.

      An important point that eludes many employers is that "cause" does not include the employer's judgment that the employee has a poor attitude, is not making enough money, is not a "good fit," or any of the thousand and one business reasons why an employer might correctly and reasonably conclude that the company would be better off without the employee. From the employee's point of view, the purpose of the "for cause" provision is to insure that, except in the unlikely event he commits a workplace "high crime or misdemeanor," he will obtain the full economic benefit of the contract. The "for cause" provision, in other words, by not defining poor performance as a ground for termination, protects the employee financially against the risk that the employer will decide, for any of a myriad of reasons, that the employment relationship is not working.

    4. Termination "Without Cause". Employers rarely terminate employment contracts "for cause" as defined in the contract. Far more commonly, they end the relationship because of ordinary human differences and business disagreements. Classically, an employee fired other than "for cause" receives the full value of the contract, which means payment of his compensation, fixed as well as variable, plus benefits or their value, for the entire unexpired term of the contract.

      The employee who is serious about securing this "guaranteed" contract will insist that the contract provide for payment in lump sum upon termination of his employment without a requirement that he mitigate damages by finding other employment. The employee says in effect, "I am giving up a good job with a secure future to come run your company. If the Board doesn't like me or the market turns down I could be out in a month. I'm not taking that risk. If you want me, you guarantee me the full compensation for five years, even if things do not work out."

      Sometimes, especially where the contract has a long term, the employer will be unwilling to take on such an onerous obligation to an untested employee, and will insist on limiting the amount that will be paid in a "without cause" termination to a lesser period, such as six months. In effect the fixed term of the contract then converts into a severance agreement. "If we let you go, we'll pay you for a year and you'll get your bonus, which we think is adequate protection for you."

      Reaching an agreement on the penalty for early termination can be the most difficult part of the negotiation, because it requires the parties, at a point when they are getting to know each other, to discuss what happens if disenchantment sets in. When one side argues for what amounts to severance, and the other side holds out for payment for a full term, the impasse can sometimes be broken by shortening the contract term so the unexpired term does not represent such a large burden.

    5. Death and Disability. Some agreements spell out what benefits will be paid to the estate of an employee who dies during the employment term. This may be important where an executive is recruited at a point in his career when the company's retirement plan will not provide a substantial death benefit to his survivors. The parties may also negotiate the consequences of a termination due to disability as well as a procedure for determining when a disability has occurred. Typically disability payments are somewhat less than the amount paid for a "without cause" termination.
  6. Confidentiality. Many contracts contain a provision requiring the employee to protect the confidentiality of the employer's trade secrets, technology and proprietary business information during and after employment. Such confidentiality is required as a common law matter whether or not the protection is written in the agreement. Nevertheless, inclusion of such a clause is helpful to the employer because courts expect to see it as a sign that the employer was serious about protecting its secrets, especially its intellectual property.
  7. Restrictive Covenants. In addition to confidentiality requirements, some companies require employees to agree not to engage in competitive activities during and after their employment. The subject of restrictive covenants is too complex for treatment in this newsletter. (Hoguet Newman & Regal, LLP would be happy to hear from you on this subject, or any other.)
  8. No Prior Contracts. The employer may ask the employee to agree that he has no contract with any other company that would bar him from joining the new employer and that he will not bring any customer lists, plans or specifications, or information of any kind that is proprietary to a former employer. These provisions protect the employer in the event that a previous employer disputes the employee's change of jobs for competitive reasons.
  9. The Boilerplate. Employment contracts contain provisions that are chiefly significant to lawyers but should be appreciated by parties who sign them as well:
    1. Governing Law. The usual choice for governing law is the law of the place where the employee will work. A company headquartered in one state with employees working elsewhere may seek to have its agreements governed by the law of that state. An employee who is unfamiliar with the state may want to have the contract reviewed by a lawyer in that place and may also want to insist that, if a dispute arises, he at least has the option of litigating in his home state.
    2. Choice of Forum. An employee usually wants the employer to agree to litigate disputes in the employee's home state. The parties may or may not agree to litigate exclusively in one forum.
    3. Arbitration. An important choice for the parties is whether to agree to arbitrate future disputes. Employers often demand arbitration because it is cheaper and faster than courts and is confidential. Employers may also believe arbitration will result in smaller judgments because punitive damages are rarely awarded and arbitrators are thought to be more "reasonable" than juries. Employees often disdain arbitration for the same reasons, but there are many circumstances where arbitration is sensible for the employee as well as the employer and such clauses are quite common.
    4. Merger or Entire Agreement. The contract may contain a sentence stating that the agreement is the "entire agreement of the parties" and no party is relying on verbal assurances or other promises outside the contract. This clause renders unenforceable side deals people sometimes make when they negotiate agreements.

The lesson is simple; if it isn't written, don't count on it.