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Delaware Court of Chancery

Mar 6, 2023

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Delaware Court of Chancery Clarifies Corporate Officers Owe Oversight Duties


The Delaware Court of Chancery, in a very important recent opinion, clarified that corporate officers owe a fiduciary duty of oversight. In In re McDonald's Corporation Stockholder Derivative Litigation, 2023 WL 387292 (Del.Ch., 2023), the Delaware Court of Chancery denied McDonald’s former Chief People Officer David Fairhurst’s motion to dismiss. The court held that stockholders pleaded facts supporting an inference that Fairhurst acted in bad faith by consciously ignoring red flags, in support of the stockholders’ claim that Fairhurst breached his duty of oversight. Among other things, the plaintiffs alleged that Fairhurst knew about evidence of sexual misconduct and acted in bad faith by consciously disregarding his duty to address the misconduct.

The court discussed how the application of a corporate officer’s oversight duty will differ based on the context. Some officers, like the CEO or the chief compliance officer, have a company-wide remit to make good faith efforts to put in place reasonable information systems so that they obtain information necessary to do their jobs. Others, like the Chief Legal Officer or the Chief People Officer, have certain areas of responsibility, and the officer’s duty to make a good faith effort to establish an information system only applies within their area of responsibility.

As to an officer’s duty to address and escalate red flags, an egregious red flag might require an officer to say something even if it fell outside the officer’s domain. As with the director’s duty of oversight, establishing a breach of the officer’s duty of oversight requires pleading and later proving disloyal conduct that takes the form of bad faith.

Analysis of the McDonald’s Case

Certain stockholders sued Fairhurst derivately on behalf of McDonald’s for breaching his duties by allowing a “party atmosphere” work environment to develop that facilitated sexual harassment and misconduct. Those stockholders further alleged that in December 2016 and November 2018, Fairhurst himself engaged in sexual harassment. McDonald’s disciplined Fairhurst for the November 2018 incident, then terminated him a year later for another act of sexual harassment.

Plaintiffs’ complaint cited statements from McDonald’s employees who asserted that under Fairhurst's watch, human resources turned a blind eye to sexual harassment complaints. In October 2016 and May 2018, several McDonald’s employees filed EEOC complaints alleging sexual harassment and retaliation. McDonald’s also faced public relations issues in 2018 relating to sexual harassment, including coordinated complaints filed by restaurant workers and a ten- city strike.

In holding that corporate officers have a duty of oversight, the opinion first discussed what a plaintiff must allege to survive a motion to dismiss an oversight claim for failure to plead demand futility under Rule 23.1, citing Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). In Stone, the Delaware Supreme Court adopted the reasoning of Caremark as a standard of liability for director oversight and identified two types of Caremark claims (1). The Delaware Supreme Court in Stone wrote that to survive a motion to dismiss an oversight claim for failure to plead demand futility under Rule 23.1, a plaintiff must allege particularized facts supporting a reasonable inference that either “(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.” Id.

The Stone opinion has led to oversight claims being called either a prong-one Caremark claim or a prong-two Caremark claim (2). A plaintiff typically pleads a prong-one Caremark claim by alleging that the board lacked the requisite information systems and controls (i.e. an “Information-Systems Claim”). A plaintiff typically pleads a prong-two Caremark claim by alleging that the board's information systems generated red flags indicating wrongdoing and that the directors failed to respond (i.e. a “Red-Flags Claim”). Cf. City of Detroit Police & Fire Ret. Sys., Inc. v. Hamrock, 2022 WL 2387653, at *17 (Del. Ch. June 30, 2022).

The McDonald’s stockholders pleaded a Red-Flags Claim against Fairhurst. In clarifying that officers have a duty of oversight, Vice Chancellor Laster in McDonald’s opined that denying a board of directors the ability to hold officers accountable for oversight failures would undermine the board's statutory authority under Section 141(a) (3). A holding that officers did not owe oversight obligations would also undermine the efforts of other actors who can pursue the corporation's claims. The court reasoned, for instance, that a bankruptcy trustee can act free of past ties to the officer and without concern that a lawsuit might generate discovery that would support a claim against the directors themselves. When a firm fails because officers have failed to establish proper information systems or ignored red flags, a bankruptcy trustee should be able to pursue the culpable parties. Failing to recognize a duty of oversight for officers would prevent a bankruptcy trustee from pursuing those causes of action on behalf of the estate and its beneficiaries.

The decision did conclude that oversight liability for officers requires a showing of bad faith. The officer must consciously fail to make a good faith effort to establish information systems, or the officer must consciously ignore red flags.

Thoughts Going Forward

  • The McDonald’s opinion could lead to more books and records demands from shareholders. Such books and records demands would seek to discover information about officers’ and directors’ duties, their compliance with those duties, and whether any “red flags” existed.
  • Several issues could be fertile litigation ground including:
    1. What “red flag” is considered egregious enough to require an officer to escalate the matter to comply with such duty?
    2. How will the duty of oversight be applied to different officers in different industries with different scopes of supervision and responsibilities?
    3. Does a sexual misconduct claim against an officer become a D&O claim brought by shareholders as well as a claim brought by the victim of the alleged misconduct?
  • The McDonald’s opinion could lead to more lawsuits from both shareholders and bankruptcy trustees alleging officer violations of the duty of oversight.

(1) In the hallmark decision of In re Caremark International Inc. Derivative Litigation, 698 A.2d 959, 971 (Del. Ch. 1996), then-Chancellor Allen held that directors of a corporation owe stockholders the fiduciary duty of oversight. The Caremark court explained that the fiduciary duty of loyalty includes a duty to make a good-faith effort to ensure that “information and reporting systems exist in the organization that are reasonably designed to provide senior management and to the board itself timely, accurate information . . . concerning both the corporation’s compliance with law and its business performance.” Id. at 970. A director breaches this duty only if a stockholder plaintiff is able to demonstrate the director’s “lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight.”Id. at 971. The court expanded Caremark oversight duties in In re Boeing Company Derivative Litigation, 2021 WL 4059934 (Del.Ch., 2021) and required directors, to “rigorously exercise [their] oversight function” with respect to all “essential and mission critical” aspects of the business.
(2) McDonald’s, 2023 WL 387292 at * 10
(3) Section 141(a) of the General Corporation Law of the State of Delaware provides: “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation. If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.”