While this opinion provides answers to the questions many have been asking, it also raises concerns.
Since Chancellor William T. Allen’s seminal ruling in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), the question of the duties owed by corporate officers, not directors, has remained unclear. For years, practitioners, academics and the courts have grappled with this question and others. Are officers agents, fiduciaries or both? What duties do officers owe? What is the source of those duties? Are they the same as those of directors? What standard is applied to officers? The list goes on.
Recently, in In re McDonald's Corporation Stockholder Derivative Litigation, Vice Chancellor J. Travis Laster answered some of these questions and provided long-needed clarity, holding that corporate officers “owe a fiduciary duty of oversight as to matters within their areas of responsibility.” 2023 WL 407668, *9 (Del. Ch. Jan. 26, 2023).
Background
In this case, the shareholders of McDonald's derivatively sued the company’s former Executive Vice President and Global Chief People Officer David Fairhurst for, among other things, a breach of the duty of oversight. The plaintiffs claimed that Fairhurst consciously ignored (and participated in) red flags relating to sexual harassment and misconduct taking place companywide. The plaintiffs alleged that Fairhurst created a “party atmosphere” and the human resources department (which Fairhurst oversaw) failed to adequately address complaints of sexual harassment and misconduct. Fairhurst moved to dismiss the claim, arguing that Delaware law does not recognize oversight claims against officers. Vice Chancellor Laster, however, disagreed. Instead, he confirmed that corporate officers owe a duty of oversight.
The Delaware Court of Chancery articulated four main reasons why officers do owe a duty of oversight:
The Source of Oversight Duties
Starting with the history of the Caremark decision, in its predecessor case, Graham v. Allis-Chalmers Manufacturing Co., 188 A.2d 125 (Del. 1963), and successor case, Stone v. Ritter, 911 A.2d 362 (Del. 2006), the court found that the reasoning behind these cases lent support for the extension of oversight duties to corporate officers. The court focused on three principles articulated in Caremark as a basis for recognizing a corporate board’s duty of oversight, and found those principles equally apply to officers.
The first Caremark premise is the “seriousness with which the corporation law views the role of the corporate board.” Caremark, 698 A.2d at 970. The court explained that Delaware corporate law applies the same view to the role of officers, as officers are generally the ones “running the business of the corporation.” McDonald's, 2023 WL 407668, at *10. In fact, given corporate officers’ domain over the day-to-day management, the court suggested that officers may have a “greater capacity” and be more suited for the oversight role under Caremark. Id. at *11.
The second Caremark premise is the “fact that relevant and timely information is an essential predicate for satisfaction of the board’s supervisory and monitoring role under Section 141” of the Delaware General Corporation Law (DGCL). Caremark, 698 A.2d at 970. Under this reasoning, the court noted that in order for timely information to reach the board, the officers, who are in charge of the day-to-day business of the corporation, “have a duty to make a good faith effort to establish an information system as a predicate to fulfilling their obligation to provide that information to the board.” McDonald's, 2023 WL 407668, at *11.
The third Caremark premise is the importance of having compliance systems in place in order to receive credit under the federal Organizational Sentencing Guidelines. Caremark, 698 A.2d at 970. The guidelines themselves, the court explains, “explicitly call for executive officers to undertake compliance and oversight obligations.” McDonald's, 2023 WL 407668, at *12.
While Caremark established oversight liability for a corporate board’s failure to implement proper information systems, the court clarified that oversight liability for a corporate board’s conscious failure to respond to red flags produced from those required information systems originated from Graham v. Allis-Chalmers Manufacturing Co. Id. Chancellor Allen in Caremark followed Allis-Chalmers and endorsed director liability for conscious failure to respond to red flags once presented. See Caremark, 698 A.2d at 969-70.
From this background, the court separates two “species” of oversight claims. McDonald's, 2023 WL 407668, at *10. The first, stemming from Caremark, is the information-systems claim, which places liability for the failure to adopt “an internal information and reporting system that is ‘reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance.’” Id. at *10, *11 (citing Caremark, 698 A.2d at 970).
The second species of oversight liability, which was at issue in McDonald’s, was labeled a red-flags claim and stems from Allis-Chalmers. This type of claim arises where a fiduciary is aware of the existence of red flags and acts in bad faith by consciously disregarding its duty to respond to the red flags. Id. at *10, *25.
Delaware Supreme Court Precedent
Next, the court relied on the Delaware Supreme Court precedent in Gantler v. Stephens, which held that the “fiduciary duties of officers are the same as those of directors.” 965 A.2d 695, 709 (Del. 2009). The court reasoned that if Gantler holds true, “then as to matters within their areas of responsibility, officers owe a duty of oversight.” McDonald's, 2023 WL 407668, at *13.
Agency Theory
The court’s third reason in support of its decision is simple. Agents are fiduciaries who owe duties to their principal, including the duty to keep the principal informed. See id. at *14-15. And officers are agents, the court reasoned. Lending further support, the court pointed to Hampshire Gp. Ltd. v. Kuttner, where then-Vice Chancellor Leo E. Strine, relying on the Restatement of Agency, held that officers have a duty to disclose “material information relevant to the affairs of the agency entrusted to them.” 2010 WL 2739995, at *13 (Del. Ch. July 12, 2010).
Necessity to Hold Officers Accountable to the Board
Last, the court reasoned that given an officer’s role “on the ground” within the corporation and in the corporate oversight structure, a holding that officers do not owe oversight duties would undermine the corporate board’s ability to fulfill its obligations under DGCL Section 141 (i.e., to oversee the business and affairs of the corporation). McDonald's, 2023 WL 407668, at *15-17.
How Much Oversight Is Owed?
The court then clarified the scope of its ruling, noting that officers, unlike directors, might not have oversight duties regarding the corporation as a whole. McDonald's, 2023 WL 407668, at *19. Instead, the court held that an officer’s oversight duties are context-specific to their area of authority, noting that certain officers tasked with companywide authority, such as CEOs or presidents, may owe companywide oversight duties―but as a general matter, officers owe oversight duties “as to matters within their areas of responsibility.” Id.
What’s the Standard?
The court then answered another long-contested question: What is the standard of liability applied to officers―bad faith or gross negligence?
The court detailed the evolution of Caremark’s oversight duty, which originated under both the duties of care and loyalty, then progressed “to a strictly loyalty-based regime.” Id. at *19. The court went on to discuss the debate of whether officers should be held to the same loyalty-based standard as directors or whether the officers’ breach of oversight duties should be reviewed under the duty of care specifically. Id. at *21. While the court acknowledged arguments among scholars for applying a less protective standard, it chose to instead follow the loyalty-based standard. Id. at *20, *22-24. The court rooted this holding in keeping with Caremark and other Delaware precedent. Id. at *20, *22. See also Caremark, 698 A.2d at 971. (“[A] demanding test of liability in the oversight context is probably beneficial to the corporate shareholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors.”); Marchand v. Barnhill, 212 A.3d 805, 864 (Del. 2019) (“If Caremark means anything it is that a corporate board must make a good faith effort to exercise its duty of care. A failure to make that effort constitutes a breach of the duty of loyalty.”)
Thus, the court concluded that the standard applied to officers’ failure to exercise their oversight duty is bad faith, requiring a showing that the officer consciously failed to make a good faith effort to establish information systems or consciously ignored red flags. McDonald's, 2023 WL 407668, at *24.
As Applied in McDonald’s
It is against this backdrop that Vice Chancellor Laster found that the red-flags claim against Fairhurst adequately pled (i) the existence of red flags (evidence of sexual harassment and a toxic workplace) and (ii) Fairhurst’s conscious disregard of those red flags (through his own repeated alleged acts of sexual harassment even after receiving disciplinary measures and warnings). Id. at *25-*28.
The court explained that, as McDonald’s global chief people officer, Fairhurst was tasked with promoting a safe and respectful work environment. Aside from his own actions, following the multiple EEOC complaints of sexual harassment received by McDonald’s and the multiday employee walk outs, Fairhurst “should have been figuring out whether something was seriously wrong and either addressing it or reporting upward to the CEO and the directors.” Id. at *26. Given the numerous events that took place between 2016 and 2019, the court found that the plaintiffs pled facts sufficient to support the inference that Fairhurst was aware of the red flags existing since as early as October 2016. Id. at *27. That said, the court noted that Fairhurst’s participation in the remedial measures taken in 2019 may shield him from liability for conduct that occurred during that year, but that could not be determined at the pleading stage. Id. at *28.
Why This Matters
As mentioned, this ruling lends Delaware practitioners some needed clarity in the over 20 years following the Caremark decision. While this opinion provides answers to the questions many have been asking, it also raises concerns. Some practitioners warn that this decision may open Delaware corporations up to more claims against officers for breach of their oversight responsibility, while others are less concerned about the potential rush of lawsuits and more focused on the new unknown of just how far the liability extends.
In any circumstance, this decision is a signal to Delaware boards and officers (and the attorneys advising them) to consider the implications of this decision and the protections available to officers, including directors and officers liability coverage, and indemnification and advancement provisions that cover officers of Delaware corporations. Further, while the relatively newly amended exculpation provisions of DGCL Section 102(b)(7) do not apply to duty of loyalty claims, Delaware corporations should also consider the protections the statute offers to officers.
For More Information
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