Court of Chancery Holds That Corporate Officers Owe Duty of Oversight
On January 25, 2023, the Delaware Court of Chancery held, for the first time, that the rationale for a duty of oversight (Caremark duty) owed by directors of Delaware corporations applies equally, if not to a greater degree, to officers. In re McDonald’s Corp. Stockholder Derivative Litigation, C.A. No. 2021-0324-JTL (Del. Ch. Jan. 25, 2023).
However, this officer duty of oversight will be more context-driven than the duty owed by directors. Some officers, like a chief executive officer or a chief compliance officer, will have company-wide oversight duties while other officers with more constrained areas of responsibility will have a more constrained duty of oversight (i.e., establishing information reporting systems and upward reporting of red flags will be based on the particular officer’s responsibilities and authority). Additionally, as with a director’s duty of oversight, oversight liability for officers will require a showing of bad faith, meaning a plaintiff will need to establish that the officer consciously failed to make a good faith effort to establish information reporting systems or consciously ignored red flags.
FACTS AND HOLDING
McDonald’s Corporation stockholders asserted derivative claims against the board of directors and certain officers of McDonald’s, including David Fairhurst, who served as Executive Vice President and Global Chief People Officer from 2015 until his termination with cause in 2019. Fairhurst was the head of human resources and was the executive officer with day-to-day responsibility of ensuring that McDonald’s provided its employees with a safe and respectful workplace. During his tenure at McDonald’s, the stockholders alleged that Fairhurst breached his fiduciary duties by allowing a corporate culture to develop that condoned sexual harassment and misconduct. Specifically, the stockholders asserted that Fairhurst breached his duty of oversight by failing to exercise adequate oversight in response to risks of sexual harassment and misconduct at McDonald’s. The stockholders also alleged that Fairhurst himself committed acts of sexual harassment while employed at McDonald’s.
Fairhurst moved to dismiss the stockholders’ claim that he breached his duty of oversight and asserted that Delaware law does not recognize a duty of oversight for officers. In denying the motion, the Court held that officers have the same fiduciary duties as directors, including the duty of oversight. In Caremark (In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996)) and its progeny (including Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006), wherein the Delaware Supreme Court adopted the reasoning in Caremark), Delaware courts have held that directors have a duty of oversight, which encompasses two obligations: (1) to ensure that information and reporting systems exist in the organization and (2) to properly address red flags indicative of wrongdoing within those information and reporting systems that come to the attention of the board. These same two obligations are required of officers. However, an officer’s duty of oversight is limited to the area of the corporation to which he or she is responsible, provided that a particularly egregious red flag may require an officer to act even if such red flag falls outside of an officer’s area of responsibility. The Court further stated that duty of oversight liability for an officer requires actions that constitute bad faith (i.e., the officer must consciously fail to make a good faith effort to establish information systems, or the officer must consciously ignore red flags), which would be a breach of the duty of loyalty, and not just actions that constitute gross negligence, which would only be a breach of the duty of care. The Court, in a scholarly discussion, clarified that while the duty of oversight can encompass both the duty of care and the duty of loyalty, liability against an officer for breach of the duty of oversight will only apply to claims of a breach of the duty of loyalty (a Caremark claim, which requires a showing of bad faith), meaning plaintiffs will not be able to survive a motion to dismiss on a duty of oversight claim by pleading mere gross negligence (i.e., duty of care violation).
The Court further concluded that the stockholders adequately pled that Fairhurst breached his duty of oversight by consciously ignoring red flags and permitted McDonald’s to develop a toxic culture that turned a blind eye to sexual harassment and misconduct. The Court pointed to multiple allegations that Fairhurst failed to adequately address employee complaints of discrimination during his tenure at McDonald’s.
This case is the first instance of a Delaware court holding that officers owe the same duty of oversight as directors, but it also limits liability for the duty of oversight to claims that sound in bad faith (Caremark claims) and not claims that sound in gross negligence. This decision expands the path for stockholders (and plaintiffs’ lawyers) to pursue duty of oversight claims against officers and not just directors, however, any such claims must be brought derivatively on behalf of the corporation, meaning a plaintiff must make a demand on the board of directors to bring such a claim (and the board will have the discretion whether to bring or not bring the claim) or such demand must be excused due to the board suffering from a disabling conflict of interest.
As of August 1, 2022, a corporation can provide in its certificate of incorporation (either in its initial certificate of incorporation or by amendment with approval by the board of directors and the stockholders) that officers cannot be subject to monetary liability for claims that an officer acted with gross negligence (a duty of care breach), unless such claim is brought by or in the right of the corporation. While such an exculpatory provision in a certificate of information will not protect officers from duty of oversight (Caremark) claims (since such claims are derivative in nature (brought in the right of the corporation) and are based on allegations of bad faith as opposed to mere gross negligence), we recommend that corporations (particularly publicly-traded corporations) still seriously consider adopting such officer exculpation provisions in order to protect officers from direct stockholder claims of alleged breach of the duty of care (g., disclosure claims).
An officer will have a constrained duty of oversight limited to the area of responsibility he or she has been delegated (g., an officer responsible for human resources will only have a duty of oversight as to human resources but not as to other areas of the company). However, an officer with a broader scope of responsibility will have a broader duty of oversight (e.g., a chief executive officer will have a company-wide duty of oversight).
To state a viable Caremark claim against an officer, a complaint will need to articulate facts that demonstrate a sustained or systematic failure of an officer to exercise oversight over his or her area of responsibility. This means facts must be alleged showing that the officer consciously failed to make a good faith effort to establish information systems, or the officer consciously ignored red flags:
Information-Systems: In order for a “information-systems” duty of oversight claim to survive a motion to dismiss for failure to state a claim, a plaintiff must plead facts supporting an inference that an officer completely failed to implement any reporting or information system, or controls and such failure was a sustained or systematic failure done in bad faith.
Red Flags: In order for a “red flags” duty of oversight claim to survive a motion to dismiss for failure to state a claim, a plaintiff must plead facts supporting an inference that the officer knew of evidence of corporate misconduct and an inference that the officer consciously failed to take action in response. Furthermore, such pled facts must support an inference that the failure to act was sufficiently sustained, systematic or striking to constitute action in bad faith. The mere existence of red flags is not enough to support a duty of oversight claim under the “red flags” theory.
Marina C. Leary also contributed to this article.