Employment Contracts

Employment contracts replace the normal hiring arrangement between employer and employee with a legal document in which the employment relationship is spelled out in substantial detail. Important elements of employment contracts deal with compensation, bonuses, stock options, severance packages ("golden parachutes"), fringe benefits (currently and after retirement), non-compete requirements including disclosure of internal information ("post-employment confidentiality"), and non-solicitation of current employees after severance. Less obvious but nevertheless equally binding forms of an employment contract are frequently used. These usually take the form of an agreement the employee is asked to sign during the employment process. The agreement commits the employee to hold certain types of information confidential and/or to prohibits the employee to work for a competitor in any relationship for some specified period of time, e.g., three years. These lower forms of the employment contract, significantly, provide no special compensation for doing what is asked: they are conditions of employment.

BACKGROUND AND TRENDS

Employment contracts became a standard method of attracting high-powered, high-profile executives to a corporation. In the expansionary decades following World War II, personal qualities and charisma became associated (rightly or wrongly) with corporate performance; in consequence market forces worked in such a manner that such contracts became rather surprisingly rich packages—the much-courted executive able to secure, well in advance of doing anything at all, guarantees of high compensation and reward, including a golden parachute. Public resistance to this broad trend did not translate into regulatory action (including self-regulatory action) until the spectacular corporate scandals surrounding Enron and WorldCom surfaced in the early 2000s.

During the dot-com boom of the 1990s—which the retired chair of the Federal Reserve, Alan Greenspan, dubbed "irrational exuberance" in a speech to the American Enterprise Institute given on December 5, 1996—executives of many quite small corporations also got themselves employment contracts in anticipation of earning vast wealth quickly in an Internet enterprise. The dot-com bust, which came in 2000, changed the exuberant mood so that, by the mid-2000s the business press barely mentioned employment contracts except in a negative context.

The passage of legislation aimed at reforming slack or fraudulent corporate behavior (the Sarbanes-Oxley Act of 2002), followed by Securities and Exchange Commission regulations, has brought employment contracts into sharp focus. In the mid-2000s, public as well as private emphasis was on reform, including bringing executive compensation in line with total compensation of all employees. However, executive compensation—the driving force behind employment contracts—appears to be a cyclical phenomenon with periods of reform followed by periods of excess. The only certainty is change.

Employment contracts, especially of the exuberant variety, appear to be rarely used by small businesses except in certain contexts—namely to secure the owner a reasonable retirement income after the business is sold or terminated.

Crafting an Employment Contract

Business owners who are considering introducing employment contracts into their operations should consider the following:

• Employment contracts imposed unilaterally by the employer—rather than by genuine mutual agreement—are at substantial risk in the courts. If the employee is found to have entered into the contract under duress, the agreement will be struck down.
• Employment contracts are an effective means of mitigating the risk of business damage at the hands of ex-employees—the motivation behind confidentiality and non-compete clauses. The confidentiality clauses are easier to enforce. A non-compete clause written so that the employee appears unable to practice an occupation will likely be ignored—and if challenged in court, the court will side with the employee. State law may significantly curb an employer's ability to impose non-compete clauses.
• Employment contracts should, ideally, maintain the rights of the employer to terminate employment "at will"—and such clauses need to be present in the contract even if specific periods of employment are specified. If an "at will" clause is present, of course, the contract must specify how an employee with a three-year contract will be compensated if the contract is terminated after a year.
• Termination "for cause" should always be present and the triggering causes specified—legal offenses, dishonest, fraud, etc.
• Employment contracts—indeed all contracts—should be vetted by a competent attorney. Many states regulate such contracts, and the owner may be unaware of these regulations.
• Employment contracts should be used only for legitimate business relationships. Compensation for services rendered should be reasonable and should be distributed only when they are in fact completed. This element is of particular relevance to family-owned enterprises, which sometimes turn to employment contracts as part of their overall succession plan.
• Employment contracts are not "one-size-fits-all." Employers should recognize that managers and executives can and should be rewarded in different ways, depending on their contributions to the company.
• Severance arrangements should be reviewed on a regular basis to determine their suitability for inclusion in employment contracts. Most severance packages are classified as ERISA (Employment Retirement Income Security Act) welfare benefits.
• Dispute resolution mechanisms are often incorporated into employment contracts. This arbitration language is sometimes limited to certain specified issues within the contract (authority of employee, divisions of intellectual property, bonus calculations, etc.), thus leaving other aspects of the contract to the courts. Other employment agreements, however, include "blanket" arbitration clauses that provide for arbitration of all disputes between the employer and the employee under contract.