A recent Delaware Court of Chancery decision exposes corporate officers to significant liability for breach of fiduciary duties and indicates a trend in Delaware courts in which it is now possible for plaintiffs to assert and prevail on claims based on an officer’s failure to dutifully oversee the company’s operations. In light of an expected increase in shareholder activism in 2023, the Court’s ruling creates a critical risk for public and private companies and their management.
The case, In re McDonald’s Corporation Stockholder Derivative Litigation, explicitly extends what is known as the Caremark duty of oversight to officers. Historically, this duty applies to directors only.
Background: The Caremark Duty of Oversight
In 1996, the Delaware Court of Chancery issued a seminal decision in In re Caremark International Inc. Derivative Litigation, establishing “oversight liability” for directors of private and public companies. A subset of the duty of care, the duty of oversight requires directors to be adequately informed of alleged violations of applicable law, regulations, or corporate policy, and requires directors to act in good faith to remediate such violations once they become known to the Board.
The Caremark ruling established the following two-pronged test to determine whether corporate directors have breached their duty of oversight:
- Failure to implement any reporting or information system or controls relating to violations of applicable law or corporate policy.
- Conscious failure to oversee operations of a system or controls, preventing themselves from being informed of risks or problems requiring their attention.
In cases affirming Caremark, the Court explained that the second prong may be met if the board’s information systems generate “red flags” indicating wrongdoing, but the directors choose to ignore or otherwise fail to respond.
There is a growing trend among Delaware courts to hear the merits of oversight-related claims and rule in favor of stockholders, as the court did in In re McDonald’s Corporation Stockholder Derivative Litigation.
In re McDonalds – Key Facts
In In re McDonalds Corporation Stockholder Litigation, McDonald’s shareholders alleged that the former Executive Vice President and Global Chief People Officer, David Fairhurst, breached his fiduciary duties by allowing a corporate culture to develop that condoned sexual harassment.
Specifically, shareholders asserted that Fairhurst breached his duty of oversight by consciously ignoring “red flags” related to sexual misconduct at McDonald’s locations and failing to report such allegations to the CEO and board of directors.
Fairhurst moved to dismiss the complaint for failure to state a claim, arguing instead that only directors, and not officers such as himself, are required to fulfill oversight obligations.
In re McDonalds – The Holding
The Delaware Chancery Court refuted Fairhurst’s defense and ultimately found him liable for breach of the duty of oversight. In so doing, it became the first Delaware court to explicitly hold that corporate officers, in addition to directors, have a duty of oversight.
Notably, the Court limited officer oversight obligations to areas within their responsibility. There may, however, be exceptions to this general rule in the case of the Chief Executive or Chief Compliance Officer, who typically have company-wide oversight responsibility. However, if a “red flag” is sufficiently prominent within the organization, then any officer is likely to have a duty to address it.
The Court also held that officers breach the fiduciary duty of loyalty when they themselves engage in misconduct because they are not acting in the best interest of the company. Fairhurst himself was found to have sexually assaulted McDonald’s employees on a number of separate occasions, and thus was found to have breached his duty of loyalty under this theory as well.
What Does this Ruling Mean for Your Officers?
It is imperative that all of a company’s officers maintain adequate reporting systems within their areas of responsibility. While tedious, these controls will provide the most complete protection from oversight liability. Of course, this will also identify issues before they escalate and enable the company and its officers to resolve those issues timely. It also remains incumbent on officers to act accordingly once “red flags” are reported.
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