In a recent decision, the Delaware Court of Chancery determined for the first time that corporate officers owe a duty of oversight under Delaware Law. The case, In re McDonald’s Corporation Stockholder Derivative Litigation, involved a lawsuit filed by stockholders of McDonald’s Corporation against its board and certain officers, including McDonald’s former Executive Vice President and Global Chief People Officer (an executive officer of the company).  The stockholders claimed the executive officer and the human resources department he oversaw permitted a culture that "condoned sexual harassment" and ignored "red flags" regarding sexual harassment and misconduct within the company ranks. They also claimed that the executive officer participated in sexual harassment on multiple occasions and that such conduct separately constituted a breach of his fiduciary duties.  In response to the executive’s motion to dismiss the claims against him, the Court concluded that the stockholders stated appropriate claims against him under Delaware Law, for his failure to properly exercise oversight and for his own misconduct.

The Duty of Oversight Extends to Officers

In its 1996 decision, In re Caremark Int’l Inc. Derivative Litigation, the Court held that directors have a duty of oversight that includes two obligations:

1) to ensure that proper information and reporting systems exist within the company; and

2) to appropriately address any “red flags” suggestive of wrongdoing or other failures within those systems that come to the board’s attention.

In the present case, the Court noted several reasons why corporate officers should also have oversight obligations:

• Officers are best situated to identify red flags and address them or report them to the board because they are involved with the day-to-day operations of the business.
• Federal organizational sentencing guidelines call for officers to undertake compliance and oversight obligations.
• Delaware Supreme Court precedent holds that officers owe the same fiduciary duties as directors.
• As an agent of the corporation, an officer has a duty to use reasonable efforts to provide the board (the principal) with material information relevant to the business.
• If officers did not have oversight obligations, boards may not be able to sue officers for a breach of fiduciary duties arising from an officer’s oversight failure.

Ignoring Red Flags May Amount to an Officer’s Failure to Meet Duty of Oversight

The Court found that the stockholders’ complaint adequately pled an oversight claim against the executive based on a “red flags” theory that the executive 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 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.”

In this case, the pled facts supporting the “red flags” theory of breach of oversight included the following: the executive's promotion of a “party culture;" an employee strike across several cities to protest the company's failure to address sexual harassment and misconduct; two separate years in which over a dozen complaints were filed with the Equal Employment Opportunity Commission alleging sexual harassment and retaliation; Congressional attention led by Senator Tammy Duckworth, who submitted a formal inquiry to McDonald's regarding the sexual harassment complaints of employees; reports that employees were afraid to bring the complaints to the human resources department; 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 instant executive’s part; the failure on the executive's part to report the sexual harassment issues to the board; and the board’s ultimate decision to terminate the executive for cause.

Other Elements of the Officer’s Duty of Oversight

The Court also held that apart from the red flags theory of liability, corporate officers also 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. Much like directors, corporate officers must (1) make a good faith effort to establish information systems to monitor and oversee risks to the company, and (2) monitor those systems for red (or even yellow) flags implicating those risks. 

The Court noted that the role of an officer informs what oversight matters an officer is responsible for. For example, the duty of oversight for a Chief Executive Officer is more expansive due to the far-reaching nature of the role. However, the Court stated that “a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.”

Breach of Duty of Loyalty based on Executive’s Misconduct

In the decision, the Court permitted a breach of the duty of loyalty claim to proceed against the executive based on his own alleged misconduct. The holding that the officer’s sexual harassment of employees constituted an independent breach of the duty of loyalty expands the duty of loyalty to include “reprehensible” and “selfish” employment-related misconduct that harms the company.

Impact of Decision

This ruling may prompt shareholders to make additional litigation demands alleging officer-level failures of oversight.

Shareholders are likely to closely scrutinize board oversight of corporate officers. The decision suggests that a robust board response that addresses identified misconduct can mitigate liability, and it underscores the importance of addressing officer misconduct promptly.

Shareholders may also file duty of loyalty claims in connection with employment-related misconduct in increasing numbers.

Companies will need to assess the implications of this decision in the context of protections available to officers. These issues will factor into decision-making around exculpatory provisions for officers, employment agreements, and D&O insurance coverage.

The contents of this publication and any attachments are not intended to be and should not be relied upon as legal advice.