In an important decision addressing an issue of first impression, the Delaware Court of Chancery determined that corporate officers owe a fiduciary duty of oversight under Delaware law. The case, In re McDonald’s Corporation Stockholder Derivative Litigation, C.A. No. 2021-0324-JTL (Del. Ch. Jan. 26, 2023), involved derivative claims asserted by stockholders of McDonald’s against its board of directors and certain officers, including McDonald’s former Chief People Officer, who was the subject of the court’s decision resolving his motion to dismiss the claims against him. The complaint alleged that the executive and the human resources department that he oversaw had “turned a blind eye” to sexual harassment at McDonald’s, which had become pervasive under his watch. The complaint further alleged that the executive himself had engaged in sexual harassment on multiple occasions, which eventually resulted in his 2019 termination, and that such conduct separately constituted a breach of the executive’s fiduciary duties.
The Court’s Decision
The court concluded that the plaintiffs stated a claim against the executive, both on account of his failure to exercise proper oversight and his own alleged misconduct. On the first score, the court concluded that the duty of oversight extended to corporate officers, resolving a question that had been left open since 1996. In its seminal 1996 decision, In re Caremark Int’l Inc. Derivative Litigation,1 the court held that directors have a duty of oversight, which includes two obligations: 1) to ensure that proper information and reporting systems exist within the corporation, and 2) to appropriately address “red flags” suggestive of wrongdoing or other failures within those systems that come to the board’s attention. In recent years, oversight claims against boards have proliferated and, in some cases, gained traction.
The court identified several reasons why officers also should have oversight obligations. The court explained that because officers are charged with the day-to-day operations of the business, they are optimally positioned to identify red flags and address them or report them to the board, which relies on officers for timely and relevant information. The court considered other authority, including federal organizational sentencing guidelines, which call for executive officers to undertake compliance and oversight obligations, as well as Delaware Supreme Court precedent holding that officers owe the same fiduciary duties as directors.2 The court further looked to agency law, which supported the position that an officer (as an agent of the corporation) has a duty to use reasonable efforts to provide the principal (i.e., the board) with material information relevant to the affairs entrusted to them. Furthermore, the court noted that if officers did not have oversight obligations, then boards may not be able to sue officers for a fiduciary duty breach where the officer’s oversight failure resulted in harm to the corporation, an insupportable result.
Turning to the claim at hand, the court found that the plaintiffs had adequately pled an oversight claim against the executive in question based on a “red flags” theory—not that an adequate system of controls and reporting was lacking, but that the executive had consciously failed to address red flags and “permitted a toxic culture to develop at the Company that turned a blind eye to sexual harassment and misconduct.” The court pointed to a multitude of factors spanning the executive’s service between 2015 and 2019: the promotion of a “party atmosphere” that “emphasized drinking”; ignoring complaints about the conduct of co-workers and executives; reported fear on employees’ part to report complaints to the human resources department; two separate years in which over a dozen complaints were filed with the Equal Employment Opportunity Commission; a 2018 employee walkout across 30 cities to protest sexual harassment and misconduct; attention from Congress and employee lawsuits relating to sexual harassment at the company; the firing of McDonald’s chief executive officer over a prohibited relationship with an employee; three instances of alleged sexual harassment (including a relationship with an employee) on the executive’s part; and the board’s ultimate decision to terminate the executive for cause.
In addition to concluding that the complaint stated a claim on an oversight theory, the court determined that an executive’s sexual harassment is itself a breach of the fiduciary duty of loyalty, noting as follows: “When engaging in sexual harassment, the harasser engages in reprehensible conduct for selfish reasons. By doing so, the fiduciary acts in bad faith and breaches the duty of loyalty.” Rejecting the executive’s argument that such a breach requires a subjective intent to harm the company, the court noted that bad faith also exists where there is a “conscious disregard for one’s responsibilities,” a “dishonest purpose,” or behavior that violates law and company policy in a manner that could harm the company’s business and subject it to liability.3
What This Case Means
The allegations in the case were stark, but the reasoning in the 65-page decision provides guidance for companies going forward. The court noted that for “red flags” claims of this kind to be pled against officers, a certain level of factual detail must be alleged: “a plaintiff must plead facts supporting an inference that the fiduciary knew of evidence of corporate misconduct” and “that the fiduciary consciously failed to take action in response.” Further, “the pled facts must support an inference that the failure to take action was sufficiently sustained, systematic, or striking to constitute action in bad faith.”
Apart from the red flags theory of liability at issue in McDonald’s, the case provides that officers have an obligation “to make a good faith effort to establish an information system” that allows for adequate controls and reporting all the way up to the board of directors as appropriate. The court observed that the scope of an officer’s responsibilities will matter: some officers, such as the CEO, have a “company-wide remit,” while others have only a particular area of authority and would only be responsible for oversight matters “within that area.” The court remarked, however, that “a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.”
Regarding the applicable standard of review applied to claims against officers, the court acknowledged some arguments in favor of applying a less stringent gross negligence standard to officers charged with violating their oversight duties (including that, unlike outside directors, officers are full-time employees of the corporation with a greater knowledge base and higher compensation). But the court ultimately applied the same bad faith standard that applies to corporate directors in the context of an oversight liability claim. Among other things, the court reasoned that, as with directors, corporations benefit from protecting officers against unjustified lawsuits and from attracting capable people to serve as officers.
The court’s decision clarifies an important but previously uncertain area of Delaware law pertaining to officers’ fiduciary duties. Boards and officers will undoubtedly consider the implications of this decision within their own organizations—including with regard to employment agreements and the protections available to officers, such as the indemnification of officers by corporations and directors’ and officers’ insurance. Delaware corporations could begin to see more claims against officers for breach of their oversight responsibilities, much as we have seen against directors in recent years. That said, corporations and their counsel may take some comfort in the court’s determination that “bad faith” is required, rather than a lesser negligence standard. We also expect that there could be further development in the law pertaining to when stockholders can bring these claims, as compared to boards of directors, who generally control claims alleging harm to the corporation. Where a stockholder seeks to bring such an action, it will still need to show that the board is disabled from considering a litigation demand. There will be conversation about this case in the months ahead, and we will monitor any appeals.
[1] 698 A.2d 959 (Del. Ch. 1996).
[2] See Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009).
[3] Note that the Delaware General Corporation Law was amended effective August 1, 2022, to permit corporations to include provisions in their certificate of incorporations to exculpate officers from personal liability for monetary damages in certain types of breach of fiduciary duty claims—but not derivative claims. Because the McDonald’s case involved derivative claims, the new protection available to officers would not apply to such claims.
