Your Employment Contract Is Becoming Our Problem

Today’s revolutions in the nature of work seemingly have no end: the rise of working from home and hybrid work; the spread of electronic surveillance; the arrival of the gig economy; the improvement in the quality of coffee; and even office yoga. In his new book, Our Least Important Asset, Peter Cappelli, a professor at Wharton Business School and America’s reigning guru on the nature of work, adds another one to the list: the growing use of legal contracts to manage employees.

The classic employment relationship is an open-ended one: The employer pays you for your time, and you do what you can, within reason, to advance the organization’s interests. In the Anglo-Saxon world, two suitably open-ended Common Law principles govern this relationship: the “duty of care” obliges both workers and employers to look after each other’s interests, and the “duty of loyalty” prevents workers from being critical of their employees in a way that might hurt the business.

The contract relationship is the very opposite of open-ended: It specifies the obligations of the contracting parties and puts a fixed date on the length of the contract. The gig economy is largely governed by contracts (though various courts are wrestling with whether contracts can morph into a more permanent relationship over time). Cappelli notes that contracts are reshaping the regular world of work in two ways: More employees are being employed as contractors rather than regular employees and, just as importantly, companies are superimposing tight legal contracts on the generic employment relationship. It’s not so much that we are all becoming gig workers — in fact, according to Cappelli, the number of gig workers has stabilized — but that regular work is becoming more contractual.

Go to the office and you are probably surrounded by contract workers without realizing it. About a third of the people who work for a typical US corporation are agency workers who are provided under contract. These may well include the people who man the doors repair the computers serve the food or clean the office. And this third only includes the people you can see: It does not include the army of outsourced workers who labor for the company in some remote (and perhaps foreign) location.

US companies are making more use of restrictive contracts that define the rights of workers. The most straightforward are noncompete agreements that limit where employees can work if they decide to leave. Some 20% of US workers have signed non-compete agreements at some point in their career, up from 12% in the early 2000s. Fifty-three percent of US employees have signed contracts that prevent them from suing their employers or joining class-action lawsuits against them. Forty-seven percent have signed non-disclosure agreements that prevent them from spreading trade secrets, and some have also signed non-solicitation agreements that prevent them from taking “their” customers with them or encouraging coworkers to move with them. Roughly one in four companies surveyed in 2018 by Challenger, Gray & Christmas Inc. required employees who are dating each other to register with their employers — some even require employees to sign “love contracts” that prevent them from bringing legal action against their employers if the relationship goes wrong.

These restrictions have spread to the most mundane jobs in the most mundane industries: Non-compete agreements are common among home healthcare workers and in the fast-food business. (A study by Alan Krueger and Orley Ashenfelter found that, based on 2016 data, 58% of major franchisors’ contracts, including McDonald’s, Burger King, Jiffy Lube, and H & R Block, prohibited the franchisee from poaching employees away from their franchises in the same chain.) All told, 62% of US employees are covered by some variety of restrictive covenants.

The most consequential spread of contracts, however, is in the C-suite. In the 1980s contracts were almost unknown in US C-suites despite the cult of the celebrity CEO. In 2000 less than half of CEOs had individual contracts. Now two-thirds of CEOs in S&P 500 companies have contracts. The same is probably true of leading C-suite employees such as the chief financial officer. Two of the most powerful trends in corporate life are driving this trend: the growing fashion for hiring CEOs and CFOs from outside, rather than growing your own, and the preoccupation with stock options.

These contracts are negotiated in great detail between the incoming CEO and the company that has hired them, often running to more than a hundred pages. The most important bit of the contract inevitably covers compensation and the mechanisms governing its payment. Today the CEO’s official salary only accounts for a trivial proportion of his or her compensation; most comes from bonus payments triggered by hitting performance targets or from share options that vest under certain conditions. Employment contracts also cover things ranging from what outside work they are allowed to do to what perks they can receive (debates over the private use of corporate jets are particularly heated) and protections against being dismissed.

These two different ways of managing a company — managing through open-ended employment relations and managing through contracts — rest on two different theories of the firm. The first sees the firm as a collective endeavor that begins where markets end. The very phrase “company” comes from the Italian for breaking bread together. The second sees the company as a “nexus of contracts” that depends on the detailed specification of rights and duties. The “nexus of contracts” leaves no room for loyalty in times of strife let alone wider mutual obligations.

US companies are trying to have it both ways. CEOs negotiate contracts that define exactly what they are supposed to do and then call on their employees to go that extra mile for the team (or even take one for the team). Companies also try to reinforce the generic employment relationship with specific contracts that define what employees can do when they become ex-employees.

But trying to have it both ways can backfire. The proliferation of contracts can undermine the trust that is the essence of healthy employment relations. Why should employees put in discretionary effort for an employer that is determined to limit their freedom to walk out of the door? Restrictive covenants of various kinds exert significant downward pressure on wage levels. You may end up with the worst of both worlds rather than the best: mainstream workers who are demoralized by restrictions on their freedom and contract workers who are only employed to do very specific things.

The fashion for employment contracts for the C-suite is also tipping the balance of advantage yet further in favor of the already privileged. Recent years have seen several CEOs of startups negotiating contracts with their boards, focused on special stock awards, that make previous CEO paydays look like chump change. In 2020, Alex Karp, the co-founder and chief executive of Palantir Technologies Inc. and a self-described socialist, received a compensation package of $1.1 billion — nearly three times Apple CEO Tim Cook’s $378 million pay package when he took over from Steve Jobs in 2011 — to be paid over a ten-year period. The cost of that pay package will be borne by outside investors who had no role in negotiating it.

A backlash against the trend for management by contracts is building. The Federal Trade Commission has proposed a ban on non-compete clauses, arguing that it would increase wages by nearly $300 billion a year. After Krueger and Ashenfelter published their study on non-poaching agreements, the Attorney General’s Office of the State of Washington sued companies to remove those clauses from their franchise contracts. Big pension funds are restive about over-generous contracts for the CEOs of start-ups. The California State Teachers Retirement System has joined Politan Capital Management in taking legal action against a specific employment contract, that of the chairman and CEO of the medical technology company Masimo Corp. The agreement provides Joe Kiani with a payout of some $600 million (more than twice the company’s 2022 earnings) if, for example, the board appoints an independent lead director or Kiani ceases to be chairman or CEO. For his part, Cappelli points to the superior flexibility of the old employment model, which makes room for discretionary effort, unlike the new one, which specifies in detail what people are supposed to do.

But don’t expect a sudden change of fashion. Companies want to reduce their fixed costs, and employing contract workers is an obvious way to do it. For all their happy talk about stakeholder capitalism, CEOs are unlikely to give up their share options. Their focus on their own contracts inevitably colors the way they manage their companies. And AI and surveillance technology make it even easier to micromanage employees and fine-tune individual contracts. With trust on the decline and AI bots on the march, management by contract will continue to fray the human contract that used to be the essence of corporate life.

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