Contractual termination of employment

What contractual terms would best govern termination of employment? How should we form agreements that would be in the best interests of both parties?

Regardless of what the contract specifies, it will not cover all conceivable states of the world since the parties are neither clairvoyant nor omniscient. In a termination situation, often the contract has proved unworkable to one side or the other for reasons they did not anticipate when they entered the relationship. These are typical problems of incomplete contracting.
 
In jurisdictions with employment protection legislation, it doesn’t really matter what the contract says about termination because any dismissed employee can bring a claim for compensation. In the UK, the Employment Rights Act sets up a position where an employee can quit and claim compensation for having been constructively dismissed. S. 95 says you have the right not to be unfairly dismissed and s. 98 says that if you felt forced to quit because of something bad the employer did to you, that counts as a dismissal.
 
As seen in the case of Uber, the type of contract in operation here is one where the worker says to the firm: ‘let’s agree anything you want, it doesn’t matter what I sign because the law says I am subject to exploitation and therefore I can sue you for my rights regardless of what I agreed to’. Mandatory legislation is designed to protect the weaker party who is suffering from inequality of bargaining power and similar forms of exploitation. Obviously, the weaker contracting party will sign anything without reading or understanding it, because of how exploited they are.

This might be a good way to protect people who need legal protection, but it's not necessarily a very efficient solution to the problem of how to effect a clean separation of contracting parties in a healthy functioning labour market where most people are happy to read contracts and understand them before they sign, or at least accept the risks of signing things they neither read nor understood.

Can this situation be improved upon by private contracts? ​

The issue for the parties, properly framed, is not how to minimize employer abuse, but rather how to maximize the gain from the relationship, which in part depends upon minimizing the sum of employer and employee abuse.

Richard Epstein, 'In Defense of the Contract at Will' (1984) 51 University of Chicago Law Review, 947.
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Both parties will be looking for a contract that protects their interests, and they’ll be trying to specify that position at the outset, before they have embarked on the project. At the outset, the employer does not know whether the worker will shirk and prove to be a costly liability, and the worker does not know whether the employer will begin to exploit him after having locked him in to the employment. Neither party wants to get stuck in a relationship that’s not working. Yet the employer doesn’t want to have to pay £££ just to get rid of the shirking worker, and the worker doesn’t want to bear the cost of quitting without compensation (no income, plus added costs of job-searching, moving house, etc). Classic conflict of interests.
 
What should the contract provide? If you're a legislator, you can resolve all conflicts of interest by checking who has more money. The person with more money should always pay for stuff, regardless of what the contract says. This is known as The Deep Pockets Theory of Justice, and it has the merit of being very easy to enforce, especially in a situation where it's pretty obvious who has more money (the employer).

​But if people are free to make their own agreements, a more rational approach is needed. The questions are going to become a bit more complex than just asking who has more money.

- ​How does each party create incentives for the proper behavior of the other?
- How does each side insure against certain risks?
- How do both sides minimize the administrative costs of their contracting practices?

Richard Epstein, 'In Defense of the Contract at Will'.
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In contracts governed by employment at will, both parties would agree that either party can end the contract at any time without having to give reasons. Goodbye, and no hard feelings. Nobody will sue the other, in the absence of force or fraud or breach of some other legal obligation. The disadvantage is that there would be less work for lawyers to do, which would be a bit disappointing, but the advantage is that both parties would simply get on with their next project. An idea very much like this underpins the gig economy.

An employee who knows that he can quit at will understands what it means to be fired at will, even though he may not like it after the fact. So long as it is accepted that the employer is the full owner of his capital and the employee is the full owner of his labor, the two are free to exchange on whatever terms and conditions they see fit [unless either party is guilty of using force or fraud]

​Richard Epstein, 'In Defense of the Contract at Will'.

​The trouble is that while anybody would be happy to agree to this when starting a new job, things are going to start looking very different down the line. When it comes to it, you might decide that you never want to quit your job at all! You are now comfortable, and you’d like to stay there for life, and now you are worried that you agreed that the employer still has the contractual right to fire you at any time, while you have completely lost interest in your contractual right to quit at any time! Just like going to visit someone for a few days and then deciding that actually, you quite like it there and would prefer to just move in and live there forever.
 
In this situation you’d like a contract that says you can quit any time but the employer can’t fire you. Wouldn’t that be sweet.
 
The trouble is, nobody wants to go into a new job with this proposal because it sounds a bit one-sided. Telling a prospective new employer that you won’t take the job unless he agrees never to fire you doesn’t send quite the right signal during a job interview. Very few people would choose to go into a transaction with a stranger knowing that they’ll be forced to stick together for life no matter how it turns out, and that the only possible exit route requires payment of a hefty financial penalty. 
 
This is why what we agree at the time of entering into the transaction is just as important as what we think we might want after time has passed and we’ve seen how things unfold.
 
What state of mind are most workers in, at the time of entering into the contract? Should we assume that most people are desperate for work and for an income and thus prepared to sign slavery contracts now and worry about exploitation lawsuits later? Or should we assume that most people have sufficient common sense to think before they leap into dodgy employment situations?

To be sure, there are occasional cases of regret after the fact, especially after an infrequent, but costly, contingency comes to pass. There will be cases in which parties are naive, befuddled, or worse. Yet in framing either a rule of policy or a rule of construction, the focus cannot be on that biased set of cases in which the contract aborts and litigation ensues. Instead, attention must be directed to standard repetitive transactions, where the centralizing tendency powerfully promotes expected mutual gain.

​Richard Epstein, 'In Defense of the Contract at Will'.
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The idea of expected mutual gain rests on assumptions about rational decision-making that are becoming hugely unfashionable, as it is now fashionable not only to be as irrational as possible, but to go the extra mile and boast about how irrational you are. This follows from the perceived incompatibility between morality and rationality, because if it must come to a choice most people would rather be moral than rational.