All employment relationships are contractual. The essence of the relationship is the employee’s promise to work in exchange for the employer’s promise to pay wages. However, employers and employees enter into more formal employment contracts to define the employment relationship in more precise terms.
Employers often use formal employment contracts when they seek to recruit and retain high-level employees because of their particular industry knowledge or reputations for generating profit and success. Additionally, the most sought after executives frequently demand, and receive, employment agreements. At least one source recently reported that 56 chief executives of the largest 100 U.S. companies signed contracts before beginning their jobs.
An employment contract is like any other äóñ the terms are decided and negotiated between the parties. Either side can agree to any term, or refuse it. Like other contracts, once the parties agree on a contract, they must abide by its terms. Particularly in uncertain economic times such as these, employers should carefully draft their employment agreements to avoid unintended and enduring obligations. Here are just some of the things to consider when drafting executive.
The Basic Objectives of an Employment Agreement
The terms of an employment agreement can be as broad or as narrow as the parties decide. Agreements typically describe the duties and performance expectations, specify compensation and benefits, define the agreement’s term and the circumstances under which it will be terminated, provide protections against unfair competition by the executive, and protect the company’s intellectual property.
Sometimes these terms are not combined into one contract. For example, the employment relationship might be memorialized in an offer letter, a compensation plan, a confidentiality/proprietary information agreement and a stock/stock option agreement. The corporate bylaws may contain additional provisions and protections, particularly for senior-level managers. The drafter of an employment agreement should address how provisions such as confidentiality agreements, stock option plans, and by-laws will be affected by an individual employee’s contract, and vice versa. The agreement should include a provision addressing the effect of the employee handbook and other unilaterally issued policies as well.
The Term of an Employment Agreement
In California, employees are presumed by statute to be employed “at-will.” That means either the employee or the company can end the employment relationship with or without notice or cause. To avoid claims of an implied contract contrary to employment at will, employers should expressly address the term of the contract as well as the circumstances under which employment will end.
The employee, particularly executives, and even the Company may desire a specific contract length, specific grounds for termination of the contract and the employment relationship, or both. However, if the parties agree, it is (of course) permissible to specify that employment is at will.
Even when a contract provides for at-will employment, legal protections apply. For example, the employer may not discharge because of illegal discrimination, or because an employee engages in protected activity. At-will employment also may not protect an employer’s decision to terminate for the purpose of avoiding contractual rights. For example, an employer may decide to discharge an executive to avoid paying a bonus. If the bonus is “earned,” the right to discharge “at will” may not confer a shield against the employee’s claim that the bonus is due, or that the termination was for the purpose of avoiding the payment of wages.
If the employer and employee desire an employment term rather than an indefinite one, there are several considerations. Labor Code section 2855 generally provides that a contract for personal services cannot be enforced for a period greater than seven years. A contract for a certain term becomes employment “at will” if the contract is not renewed. The parties therefore should consider specifying what will occur when the term expires. Some contracts contain “evergreen” clauses that automatically renew the contract if it is not terminated during a “window” period, which typically occurs a few months before expiration. Automatic renewal may result in undesirable contractual obligations.
A contractual term offers job security for the employee, but not necessarily a guarantee of services for the employer. As Civil Code section 3390 provides, employers usually cannot require employees to perform services, although there are some narrow exceptions. Still, employers may not want to retain an unwilling employee who may not perform to his or her best ability. In some instances, the employer may obtain an injunction to prevent a breaching executive from performing the same personal services for another entity. Including a liquidated damages provision in the contract for breach by either party may also help deter non-performance, particularly when it is impossible to measure the damage caused by a breaching employee.
When employment is for a specified term, the Labor Code provides several provisions regarding how employment may be terminated before the expiration of the term. These include section 2924, which provides that early termination may be justified if the employee commits a willful breach of duty, habitually neglects his or her duty or demonstrates a continued incapacity to perform. Section 2925 provides that the employee can terminate an agreement for a specified term if the employer commits a willful or permanent breach of the agreement.
Sometimes the parties will agree on an indefinite term, but will specify the grounds for termination of employment, such as “good cause.” The parties are permitted to define what “good cause” means. If the agreement does not do so, a fact finder (jury, judge or arbitrator) will, in the event of a dispute. Therefore, it is essential that the parties define not only the grounds on which the contract may be terminated, but also the economic consequences of doing so. For example, the agreement may provide for payment (or non-payment) of certain compensation if the employment relationship ends by resignation, termination without cause, termination with cause, disability or even the untimely death of the employee. The parties should be specific regarding whether bonuses or other compensation will be paid if the employment relationship ends before the expiration of the agreement’s term.
The compensation component of an agreement can be complex, depending on the employee’s level within the organization. This particularly includes considering the applicability of tax provisions and consequences. Forms of compensation are numerous and can include base salary, deferred compensation, incentives, benefits, stock/stock options, bonuses, commissions, royalties, expense/relocation reimbursement and automobile/travel allowances and conditions. Many of these compensation arrangements are subject to scrutiny by the taxing authorities, as well as shareholders and other third parties. For example, the IRS has issued new and vexing regulations regarding “deferred compensation” agreements. “Golden parachutes,” stock option plans, retiree benefits, and the like are subject to complex rules beyond the scope of this article.
Both parties should consult with knowledgeable tax and benefits advisors before these financial terms are finalized.
Inventions, Trade Secrets and Competition
It is important to address inventions, trade secrets and competition in employment agreements, particularly if the employee will have access to sensitive internal information. Confidentiality agreements that protect trade secrets generally are valid in California. Agreements requiring the assignment of inventions are also generally legal, subject to certain limitations contained in the Labor Code.
Although covenants not to compete are generally unenforceable in California, an agreement by an employee not to engage in unfair competition is legal. Unfair competition includes unauthorized use of a former employer’s trade secrets or confidential customer lists to solicit the former employer’s customers or employees. This protection is particularly important when dealing with a high-level executive who has unfettered access to customer and trade secret information, and who has established relationships with the employer’s key business managers and talent. Agreements not to solicit employees and customers also may be enforced to the extent necessary to protect trade secrets.
Additional matters to consider when determining the terms of separation include whether the employer has the right to assign the agreement; whether the agreement survives if there is a merger, acquisition or sale of the business; and the duty of the executive to cooperate with the company after termination.
The agreement also should include standard contractual protections, such as an integration clause, severability of illegal provisions, choice of law, and perhaps a forum selection clause. Speaking of which, some employers may wish to consider including provisions for how disputes will be resolved. Some employers favor arbitration to resolve employment claims; some do not. Those employers who wish to include such provisions should ensure the language complies with California’s exacting standards.
Of course, there are other issues not covered here, limited only by the parties’ needs and creativity.
Employers can best protect themselves from drafting errors and ambiguities by partnering with qualified and experienced employment counsel experienced in drafting and reviewing employment agreements. The investment will pay dividends if even one costly dispute is avoided. Experienced counsel will also look for consistency between the draft agreement, employer policy, any letters of intent or offer letters, relevant internal memoranda or other communications and with applicable bylaws. It may be necessary for multiple third parties to review more complex agreements, particularly where complex tax laws and accounting rules come into play.