TEN ESSENTIAL CONSIDERATIONS FOR ANY EMPLOYMENT AGREEMENT

Theodora Lee & Lisa Chagala

Employment agreements are becoming increasingly common in today’s world. Long reserved for the highest levels of the organization, the need for employment agreements is expanding within the levels of the rank-and-file. This increased need for employment agreements in the lower levels of the organization has been driven primarily by two factors. For one, undoubtedly, employers are facing an increased risk of employment-related litigation. The number of employees suing their employers has increased significantly in recent years, driving employers to take new cautionary measures to reduce the risk and cost of employment litigation. Secondly, today’s highly skilled workforce, and the value of the intellectual property that they possess, must be protected in order for a company to retain its competitive advantage.

However, entering an employment agreement with an employee poses several risks to the employer. The main disadvantage of employment contracts is that they impose structure and rigidity over an otherwise flexible relationship. For example, an employment agreement that requires a term of employment, a certain level of compensation and mandatory arbitration may bind the employer—as well as the employee—to those provisions. The employer’s ability to change the terms, such as in the event of a need to downsize or reduce compensation levels, will be limited unless the contract is carefully and appropriately drafted. Furthermore, inadvertent omissions or ambiguities will likely be construed against the company as the “drafter” of the agreement. These considerations must be balanced against the value of employment agreements.

As employment agreements become increasingly common, company counsel and human resources professionals must be alert to the specific terms of every employment contract. Traditionally, employment agreements drafted for executive staff were highly tailored to the employment relationship of the particular executive. The terms of the employment contract were often negotiated with the executive’s personal counsel. The executive agreement sets forth unique compensation arrangements and prerequisites. However, in today’s world, employers may choose to rely on standard agreements that they can recycle among numerous employees. These “fill-in-the-blank” employment agreements offer opportunity for efficiency, as one agreement is drafted and then used for numerous employees with minimal variation. Although this method increases efficiency, it also increases the need for employers to pay close attention to the terms of that standardized contract. Failure to consider each and every term—and how it will affect the employment relationship of each and every applicant and employee—may have disastrous consequences.

Thus, whether or not the agreement is a highly-tailored, long-negotiated agreement for an executive, or a standardized contract used for a rank-and-file employee, several key considerations apply. The key considerations explored in this paper are:

The employment term;
Compensation;
Arbitration;
Intellectual property;
Work effort;
Prior commitments;
Choice of law;
Integration and amendment;
Liquidated damages;
Execution and document retention strategies.

Rapidly-expanding law, as well as the variation among states with respect to the employment relationship, make drafting of employment agreements a difficult and complex responsibility. Care must be taken in drafting employment agreements to both ensure the utmost possibility that the agreement will be enforceable and to ensure that the agreement does not contain terms that will subject the employer, inadvertently, to legal claims. The following provides an overview of certain considerations; however, given the complexity of the subject matter, consultation with an experienced employment attorney is highly recommended.

1. DEFINING THE TERM OF EMPLOYMENT.

The determination of the employment term is essentially a question of management objective. Does management wish to have maximum flexibility to terminate the employment relationship at any time without notice? Or, does management wish to create a contractual incentive to encourage an employee to remain in employment for a certain period of time?

There are essentially three types of employment provisions that may be applied to achieve these management objectives. These provisions are commonly referred to as “at-will,” “drop dead,” and “evergreen” clauses.

At-Will Employment Relationship

In an at-will employment relationship, either party may terminate the employment relationship at any time. The primary advantage of an at-will employment relationship is flexibility. If circumstances change such that the employer no longer wishes to employ the individual, the employer may (within the bounds of law) contractually terminate the relationship immediately. Furthermore, allowing employees to terminate the employment at-will may avoid the problem of gold bricking—it allows an individual who really does not want to be in that employment relationship and, thus, is likely not optimally productive, to leave the relationship for greener pastures. A specified employment term may be particularly important for employees who are essential for business continuity or who possess skills or knowledge necessary for the company to thrive.

The main disadvantage of the at-will employment relationship is that there is no incentive, in the form of a “stick,” for the employee to remain employed for any period of time. Although employers may still offer incentives for the employee to remain in employment, such as through incentive compensation programs or forfeiture provisions for certain compensation and benefits, the employer will have no claim for damages against the employee if the employee chooses to terminate the employment relationship at an improvident time.

Balancing the advantages and disadvantages of an at-will relationship, some employers choose to combine an at-will provision with a notice period. For example, some employers state that the employment relationship may be terminated at-will by either party with thirty days’ notice. This provides the employer—and the employee—a minimum time period to make alternative arrangements in light of the upcoming termination.

“Drop Dead” Employment Term

A “drop dead” clause is a provision that provides that the employment relationship will end upon a particular date. The advantage of this approach is that it provides a specific end to the employment relationship. This may be appropriate if, for example, an individual is hired to complete a particular project or to serve as a replacement while another employee is out on leave.

The main disadvantage of this approach is that the employer will be bound to employing the individual through the specified date. This may be costly for the employer if, for example, technologies change or it is later discovered that the individual does not possess the necessary skills for the job. It may be unrealistic to predict exactly how long the employment relationship should last. The employer’s guess at the commencement of the employment relationship may be over- or under-optimistic. Furthermore, the “stick” for terminating employment before the stated termination date decreases with time. Early in the relationship, the cost of breach is significantly higher than later in the employment term.

To address the chance that the employment relationship will continue beyond the specified date, employers may combine a “drop dead” provision with an at-will provision, providing that the employment relationship will continue for a specific period of time (until the “drop dead” date) and thereafter will be at-will.

“Evergreen” Employment Term

An “evergreen” provision is a clause that states that the employment relationship will continue for a certain period of time and then automatically renew for successive periods unless either party gives notice of intent to terminate within a certain timeframe. For example, an agreement may provide that the employment relationship will continue for one year, and then automatically renew for successive one-year periods, unless either party gives notice to the other party within thirty days of the end of any one-year period. This has the advantage of permitting the contract to continue indefinitely, such that the incentive to remain in the employment relationship continues indefinitely. However, the automatic renewal may become more of a hindrance than help. As years pass, the employer may forget to provide notice of termination within the required timeframe. The employer may then, unintentionally, be bound for an unwanted additional period of employment with the individual.

Regardless of what employment term the employer chooses, the duration of the contractual employment relationship should be defined within the contract. Either a specified period of employment should be set forth, or it should be clearly stated that employment is at will and that the employment relationship may be terminated at any time, with or without cause. Even if employment is for a stated period, it should be clear that employment may be terminated for cause at any time and cause should be defined.

If a “drop dead” or “evergreen” provision is used, the employer should include a provision that allows the employer to terminate the employment relationship “for cause” without penalty. This is important, for example, in extreme circumstances such as theft, excessive absenteeism, and substantial refusal to perform. Cause is normally defined within the contract and varies including extreme levels of dishonesty and nonperformance on the part of the employee. The contract should also provide for the end of the employment relationship in the event of death or disability.

Furthermore, it is important to keep in mind that the options described above apply to the term of the employment relationship rather than the term of the contract. The employer will, in most cases, want the contract to survive termination of the employment relationship, to ensure that contractual protections relating to intellectual property and arbitration, for example, are effective beyond the end of the term of the employment relationship. If the contract ends upon termination of employment, all contractual protections (including intellectual property protections and provision for arbitration) will end as of the date of the employee’s termination.

2. COMPENSATION.

Traditionally, employment contracts set forth the terms of compensation for the individual, including the amount of base salary the individual is entitled to receive, when pay raises would occur, and what formula would apply to calculation of incentive compensation. Employers traditionally set forth each aspect of the total rewards structure, including base salary, future salary increases, incentive compensation arrangements such as bonus programs, commissions, and stock options, and benefits programs such as medical, retirement, and stock purchase programs.

However, employers may wish to reconsider the practice of specifying compensation within the employment agreement. Such contractual terms restrict—or eliminate—an employer’s flexibility. For example, circumstances may change such that the incentive compensation model specified in the agreement no longer fits today’s business model. Pay increases that seem appropriate at the time of execution of the agreement may not be valid at the time they become effective. Stock options programs and other benefits programs may change or may include terms that conflict with the entitlements specified in the employment contracts. Because employers generally wish to retain flexibility to structure the compensation package according to changing business needs, it is typically considered an advantage to the employee, and a disadvantage to the employer, to include specified compensation terms within the employment agreement.

In the event that an employer chooses to include a specified level of compensation within the contract, despite the disadvantage of decreased flexibility, the compensation provision within the contract should include certain information. For example, the provision should state the exact amount of base salary, the method in which salary is calculated (hourly, weekly, monthly, yearly), the frequency of payment (typically, in accordance with the employer’s normal payroll policies), and what deductions will be made from pay (for example, applicable tax withholdings). If permitted by local law, the agreement should provide for the employer's right to offset from regular periodic pay or the employee's final pay amounts owed to the employer. If equity is offered as part of the compensation structure, an equity buy-back provision may be important.

3. ARBITRATION.

An arbitration clause is a provision that secures an employee’s consent to binding arbitration as a means of resolving disputes between the employee and the employer. Such clauses can be especially valuable in disputes over termination of employment, which often trigger large claims for damages.

The value of arbitration clauses in the employment context have been debated among legal professionals and human resources professionals (and within the popular press) for years. Most employers have determined resolution of disputes through arbitration offer several advantages. Arbitration can be significantly less costly than resolving a dispute through the court. Disputes are often resolved much faster through arbitration than through the courts. Disputes resolved through arbitration are significantly more private than those resolved through the courts. Additionally, the outcome of the case may be more predictable with the use of an arbitrator than a jury.

On the other hand, employers have also experienced several disadvantages in arbitration. Some employers experience an increased number of disputes, due to the reduced cost to an employee of bringing a claim. Judicial review (through appeal or otherwise) is extremely limited, leaving little wiggle room in the event of a disappointing arbitration result. Furthermore, arbitration may have negative employee relations consequences, as employees may believe (perhaps incorrectly) that arbitration erodes their substantive rights. These advantages and disadvantages must be weighed before deciding whether or not to implement a mandatory arbitration policy.

Federal courts have generally come to accept arbitration as a permissible means of resolving disputes, provided that the arbitration is procedurally and substantively fair.[1] In order to increase the chance that a court will find an arbitration provision to be procedurally and substantively acceptable and, therefore, enforceable, a number of factors must be considered:

Preservation of Substantive Rights. The arbitration policy may not diminish a party’s substantive rights. Generally, the following is required to ensure that rights are not diminished: a neutral arbitrator; adequate discovery; a written award; all relief otherwise available in court; and no requirement that the employee pay unreasonable costs or fees.[2] Forcing an employee to pay all, or even an equal share, of the arbitration fees may render the arbitration clause unenforceable.

Mutuality. The arbitration clause must bind both the employee and the employer. Additionally, the arbitration clause must apply to the types of claims that are typically brought by employers, as well as claims typically brought by employees. That is, the arbitration clause must apply to claims typically brought by employers based on employee’s breach of the employment term and the employee’s breach of intellectual property protections.

Coverage. The arbitration clause should cover “all employment disputes” or “all legal disputes with the employer” to make clear that the clause applies to statutory claims in addition to claims that arise out of the employment contract. Without this statement, a court could determine that arbitration applies only to disputes that arise directly out of the contract.

Severance. Some employers choose to design the employment agreement and arbitration agreement as separate documents. If the arbitration agreement is combined with the employment agreement, the arbitration agreement may be found unenforceable if the underlying employment contract is found unenforceable. For example, if the court finds that a non-competition provision within an employment contract is unenforceable, some courts might throw out the employment contract as a whole—including the arbitration clause. This risk can be eliminated by issuing the arbitration agreement and employment agreement as separate contracts.

State Law Considerations. State law must be carefully analyzed to determine the value of arbitration in that state. Where the Federal Arbitration Act does not apply, such as to transportation workers, state law regarding mandatory arbitration in the employment context will apply. Many states, through statute or case law, place different and greater requirements on arbitration agreements than other states.

4. PROTECTIONS OF INTELLECTUAL PROPERTY.

In today’s increasingly competitive marketplace, employers must protect and preserve the key assets that are essential to competitive advantage. Often, these assets are in the form of intellectual property. Employers are willing to take great efforts to preserve confidential information and intellectual property from walking out the door (and to a competitor) with a terminated employee.

Employment agreements are simply one factor within a program for protecting intellectual property. Normally, such program includes informing employees and others on an ongoing basis of confidentiality requirements and adopting company-wide policies for trade secret protection. Without a comprehensive, company-wide policy, it is not likely that any clause within any employment agreement will be effective.

Covenants Not To Compete.

One means of protecting valuable intellectual property is with a covenant not to compete. Such covenants restrict the activities of an employee after the employee stops working for the employer. Because non-compete covenants are post-employment restrictions on an employee’s ability to earn a living, they are viewed in most states with disfavor and are narrowly construed.

Generally, courts view covenants not to compete as enforceable only to the extent they are necessary to protect the employer’s interest in its goodwill, confidential information, and customer relationships. Covenants not to compete must be narrowly tailored as to the time, geographic scope, and prohibited activity necessary to protect a legitimate employer interest. Defining what activity is prohibited is critical. Typically, the covenant will prevent persons from working for a competitor for a specific period of time in specific locations, may even name the competitors to which the clause applies, and specifies the particular work that is prohibited.

State law considerations cannot be ignored. States impose varying standards to determine whether or not covenants not to compete are enforceable, and some states altogether do not permit covenants not to compete. California is famous (or infamous) in this regard. An employer who uses a non-compete clause in California not only risks having the clause declared unenforceable, but also risks being found to have committed an unlawful business practice by including the clause in its agreements. For this reason, state law must be carefully analyzed before placing such a covenant into an employment agreement.

Non-Disclosure Covenants

Non-disclosure covenants are clauses that preclude the employee from disclosing or making use of the employer’s confidential information. Whether or not such provision is enforceable is a matter of state law. Generally, in order to be enforceable, such provision must be properly restricted as to time and territory and the employer must have a strong proprietary interest in protecting trade secrets. Again, analysis of state law is essential for ensuring that such a clause is enforceable and that the employer does not act unlawfully in requesting that the applicant or employee enter into such a covenant.

5. WORK EFFORT.

A provision regarding “work effort” generally states that the employee shall apply his or her best efforts at all times. The provision may also state that the employee must devote his or her entire work time and effort to the employer and will not engage in other gainful employment during the term of employment with the employer.

This type of provision has certain advantages that are appealing to any employer. Restrictions on the employee’s time avoids scheduling conflicts and prevents situations where transfer of intellectual property may occur.

However, important legal considerations exist for such provisions. Many jurisdictions prohibit certain restrictions on an individual’s personal time. For example, in New York, adverse employment actions on the basis of an employee’s off-duty recreational and political activities are generally prohibited. Similar laws exist in Colorado, California and North Dakota.

For these reasons, “work effort” provisions must be carefully drafted. A blanket prohibition on moonlighting may be replaced with a requirement that employees must avoid actual or potential conflicts of interest, or the appearance of conflicts of interest, as well as outside activities that would interfere with the employee's loyalty to the employer and ability to fulfill all job responsibilities. Furthermore, employers must carefully consider and tailor the provision to the particular intricacies of applicable state law.

6. PRIOR COMMITMENTS.

A “prior commitments” clause is a clause that requires the employee (or applicant) to certify that he or she is not subject to any contractual commitments (such as employment agreement with former employers) that conflict with the obligations to the new employer.

Such clause is important for two reasons. As a practical matter, an employer will want to know if it will only receive the benefit of part of the employee’s knowledge. The new employer typically expects the employee to devote his or her best knowledge, skill, and dedication to the new employer. The “prior commitments” reminds employees—who may have forgotten about a prior commitment or is fearful that he/she may lose the new opportunity if he or she speaks up—of the obligation to make prior commitments known to the new employer. Restrictions on an applicant’s ability to share information may be a deal-breaker.

As a legal matter, the new employer could be held liable for intentional interference with an employment contract, if it intentionally and improperly interferes with the employee's employment contract with a third person. This claim is governed by state law principles and, thus, varies from state to state. For example, to establish a claim for tortious interference with an employment contract in Michigan: (1) a contract must exist; (2) a breach of that contract must have occurred; and (3) the defendant was unjustified in its instigation of that breach.[3] A “prior commitments” clause arguably reduces the risk of a potential claim for tortious interference with a contract, because the clause will likely serve as evidence that the employer did not intentionally instigate the breach.

Such “prior commitments” clause is particularly important in certain industries or for certain positions in which employment agreements are commonplace. For example, such a clause is likely to be appropriate—and useful—for highly skilled employees and executives who were likely contractually bound in their previous employment relationships.

7. CHOICE OF LAW PROVISION.

A “choice of law” provision is a clause within an agreement that indicates what state law will apply in the event of a dispute. Choice of law provisions are commonly found in all types of contracts.

The choice of law provision is particularly important in the arena of the employment relationship. Many aspects of the employment relationship are governed by state law. For example, as discussed above, covenants not to compete and arbitration provisions (where the Federal Arbitration Act does not apply) are typically governed by state law. Certain jurisdictions may be preferable to the employer than others. Procedural rules also differ among jurisdictions. For example, the statute of limitations for a contract may be four years, six years, or longer depending on the jurisdiction.

Choice of law provisions are presumptively valid in most jurisdictions.[4] However, a choice of law provision may be overcome if, for example, the jurisdiction does not have a reasonable relationship to the circumstances of the employment relationship. For example, an employer who does business only in California would have a difficult time convincing the court or an arbitrator to apply Massachusetts law.

Choice of law provisions may also be overcome if they pose a hardship that effectively eliminates an individual’s substantive rights. A provision that effectively precludes an individual from having his or her day in court (for example, requiring a disabled or financially-strapped individual to travel cross-country for litigation) will not likely be enforced.[5] Furthermore, statutory protections (such as state wage and hour or anti-discrimination laws) may set forth specific provisions for extra-territorial reach and, thus, cannot be overcome with a contractual choice of law provision.

Despite these limitations, choice of law provisions can go a long way in securing a favorable jurisdiction for many types of disputes that may arise in the employment context. Assuming that the employer has diligently considered the pros and cons of its choice of law, the choice of law provision within an employment contract poses little disadvantage to the employer.

8. INTEGRATION AND AMENDMENT.

Integration Clause

An integration clause states that the terms of the contract constitute the complete and exclusive statement of the terms of the agreement, and that no other agreements, oral, written, or otherwise, which are not stated in the agreement will be valid. An integration clause is essential to any contract, both inside and outside of the employment context.

The integrations clause is particularly important in the employment setting. Prior to execution of the agreement, the employee has likely spoken with numerous individuals (including management and supervisors) who have made various promises and statements about the terms and conditions of the individual’s employment. Often such statements are made in the efforts to “woo” a potential, valuable new hire. The company, of course, may not wish to be bound by each and every one of these statements. Thus, the integrations clause—rendering null and void any such promises not included in the contract—is essential for fending off potential claims of breach of contract, especially claims of breach of oral contract. The integration clause was particularly important in the case of Nieves v. Bell Industries,where an employee claimed that the interviewer told him that the at-will language of the employment contract did not apply to him. The court upheld the language of the agreement stating that he would be an at-will employee. Notably, the application for employment stated the at-will policy could only be changed in writing by an authorized company representative.[6]

Amendment of the Agreement

The provision for amendment of the agreement is similarly important. The provision for amendment specifies how the agreement may be amended.

Such provision is important in the event that the employee claims that the agreement was modified after execution. For example, a supervisor may “promise” a pay increase to an employee or, unwittingly, make statements that are contrary to the intellectual property protections set forth in the contract. Specifying who may modify the agreement and how the contract may be modified minimizes the risk of unintended modifications. For example, the contract may provide that only the senior-most member of the HR team may amend the contract and, if so, such action may only be effective if in writing and signed by both the senior HR person and the employee.

Although in extreme circumstances the integration clause and provision for amendment provision may be overcome, such provisions are generally considered essential to any employment agreement.

9. LIQUIDATED DAMAGES.

A “liquidated damages” provision states an amount of money the employee will have to pay if he or she breaches the contract. For example, such provision may state the amount of money the employee must pay to the employer if he or she ends the employment relationship without cause prior to the end of the employment term.

Liquidated damages provisions will be enforceable only if the actual damages would be extremely difficult to ascertain. If the value of an employee is readily ascertainable (such as an employee who brings in a constant, highly-visible level of revenue for the company) the court or an arbitrator will not likely enforce such provision. Fortunately for employers, however, the value of a particular employee—especially an executive or highly skilled employee—will often be difficult to ascertain.

Additionally, the amount of the liquidated damages must be “reasonable.” Employers may be tempted to state a high level of liquidated damages, hoping to get as much money as possible from the breaching employee. However, courts will generally not enforce a liquidated damage provision that is intended to punish an employee or that calls for an amount that is far in excess of actual damages that will be incurred. Determining whether to include a liquidated damages provision is not an exact science and is, thus, a matter of balance and judgment.

It is important to note that the potential for damages is the essence of the employment agreement. With little or no potential for damages, the employee will have little incentive to comply with the terms of the agreement. For example, an employee considering termination before the end of the employment relationship will balance the cost of the breach of the employment agreement with the value he or she will receive by going to work for the new employer. Similarly, an employee considering improper use of an employer’s confidential information will weigh the costs of violating the contract with the value he or she will receive from exploiting that confidential information. Thus, the cost to the employee of breaching the agreement is essential to creating an employment contract that is of value to the employer.

Of course, in many circumstances of breach, the individual’s new employer will “buy-out” the liquidated damages provision. The new employer will pay a signing bonus to cover the cost of the breach of a commitment to be employed for a specified term. However, the liquidated damages provision will, at least, raise the cost of hiring away the valuable employee and will also provide the company with some compensation to assist in dealing with the loss of talent.

10. EXECUTION AND DOCUMENT RETENTION STRATEGIES.

After all the effort in drafting the agreement, the final steps are most crucial: making sure the agreement is executed and retained.

Execution

Execution of the contract may be surprisingly difficult. When hiring the next superstar, managers may overlook hiring procedures in an effort to bring the applicant in the door. Often, at the beginning of the relationship, the parties are optimistic and do not anticipate that any dispute will arise down the line. An applicant who is cautious about entering employment agreements may attempt to sweep the draft agreement under the rug. General counsel and HR professionals will want to devise a system to ensure that each and every employment agreement is actually executed. Without execution, the agreement (despite all the efforts involved in drafting) is of little or no value.

Document Retention

Retention and accessibility of the executed employment agreement is key. Often, disputes occur many years after the agreement is executed. HR managers and supervisors, at that point, may be forced to search through mountains of dusty file boxes in search of the single piece of paper evidencing the employee’s execution of an agreement. Furthermore, pages to the agreement may be misplaced or lost, calling into question the validity of the agreement as a whole. Worst case scenario is that an employer is forced to rely on what the employee claims is the agreement that he or she entered with the employer. The employer, without its own copy, may be forced to take at face value whatever the employee presents to the court or arbitrator.

Needless to say, organization in this regard is invaluable. Steps must be taken to ensure that executed employment agreements make their way from supervisors’ desks and file drawers to the company’s formal document retention system. Many employers today are considering electronic storage of documents in order to overcome problems associated with storage of critical personnel information. While the pros and cons of electronic document retention is beyond the scope of this paper, it is sufficient to say that retention and accessibility is arguably the most important aspect of the employment agreement. After all, the employment agreement—no matter how well drafted—is of no value if it cannot be located at the time of dispute.

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