Important Ruling: Delaware Court of Chancery Formally Recognizes and Delineates Oversight Duties of Corporate Officers

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On January 26, 2023, Delaware Vice Chancellor J. Travis Laster issued an opinion of which those serving as or advising officers of Delaware corporations should take note: In re McDonald’s Corporation Stockholder Derivative Litigation, in which the court formally recognizes the oversight duties of officers of Delaware corporations.

Oversight Duties Generally
Delaware has long recognized the oversight obligations of Delaware directors. While its conceptual origins date back to earlier Delaware Supreme Court precedent, the directorial duty of oversight was crystalized in the often-cited Caremark decision.¹ There, the court wrote that directors must make a good faith effort to ensure that information and reporting systems exist that are reasonably designed to provide senior management and the board with timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning the corporation’s legal compliance and business performance. For board members to be held liable for breaching the oversight duty, it must be shown that there was a sustained or systematic failure to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists. Later decisions² recognized two species of Caremark oversight claims: (1) where the directors failed to implement any reporting or information system or controls (an “Information-Systems Claim”); or (2) where, having implemented such a system or controls, the board consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention (a “Red-Flags Claim”).

Until In re McDonald’s Corporation, however, no Delaware Chancery or Supreme Court decision explicitly associated oversight claims with corporate officers, as opposed to directors. That now has changed.

In re McDonald’s Corporation Stockholder Derivative Litigation
Vice Chancellor Laster’s analysis is characteristically detailed and draws on a wide range of authorities, and therefore should be reviewed carefully. The derivative claims it addresses were leveled at McDonald’s former Executive Vice President and Global Chief People Officer, David Fairhurst, who in that executive role assumed day-to-day responsibility for ensuring that one of the world’s largest employers provided its employees with a safe and respectful workplace. During his tenure, however, McDonald’s was plagued by rampant employee sexual harassment accusations, culminating in publicized and very expensive litigation in multiple venues. Fairhurst himself was once disciplined and later terminated for sexual harassment.

The plaintiffs alleged that Fairhurst breached his fiduciary duties by permitting a corporate culture that condoned sexual harassment and misconduct. They asserted that Fairhurst’s fiduciary duties included a duty of oversight, which required that he make a good faith effort to establish a system that would generate the information necessary to manage the Company’s human resources function. They further asserted that Fairhurst had a duty to use the resulting information to execute his executive duties and to report on his areas of responsibility to the CEO and the board. Those duties, plaintiffs alleged, required that he address or report upward about any red flags regarding sexual harassment and misconduct. The plaintiffs did not allege that Fairhurst failed to make a good faith effort to establish information systems, but rather that he breached his duty of oversight by consciously ignoring red flags (hence, a Red Flags Claim).

Fairhurst moved to dismiss, arguing in part that the duty of oversight had not been extended to officers under Delaware precedent.

The court acknowledged that no Delaware decision explicitly held that officers owe the duty of oversight. It found, however, that the reasoning of Caremark, the Delaware Supreme Court’s holding that the duties of officers are the same as the duties of directors³, decisions from other jurisdictions, academic commentary, and the additional duties that officers owe as agents all support the conclusion that they do. Accordingly, the court held definitively that officers, and not just directors, owe a duty of oversight, and oversight liability for officers requires a showing of bad faith – that is, the officer must consciously fail to make a good faith effort to establish information systems, or the officer must consciously ignore red flags. The court further found that the plaintiffs’ allegations (viewed through the forgiving lens of Rule 12(b)(6)) sufficiently alleged (i) red flags indicating that sexual harassment occurred at the Company, and (ii) facts supporting a reasonable inference that Fairhurst knew about the red flags. Separately, the court found that the allegations sufficiently pleaded that Fairhurst’s own acts of sexual harassment constituted a breach of duty in themselves, insofar as they elevated self-interest over the best interest of the company.

Other Important Points Raised in the Opinion

• Although the duty of oversight applies equally to officers, the court noted that it is context-driven, and so its application may differ as between officers and directors and among officers. For example, some officers, like the CEO, have a company-wide remit, while others have particular areas of responsibility. The officer’s duty to make a good faith effort to establish an information system and to address and report upward red flags only applies within her area of responsibility, although a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.
• While Section 141(a) of the Delaware General Corporation Law creates a board-centric governance construct (“[t]he business and affairs of every corporation . . . shall be managed by or under the direction of a board of directors”), most corporations are managed under the direction of the board, rather than directly by the board. Given this practical reality, nondirector officers may have a greater capacity to make oversight and strategic decisions on a day-to-day basis.
• The court acknowledged that reasonable minds can disagree about whether, as a matter of policy, stockholders should be able to sue to hold an officer accountable for a failure to exercise oversight, leaving this issue open to future debate or legislative clarification. The court further noted: “But wherever one might stand on that issue, it is hard to argue that a board of directors should not be able to hold an officer accountable for a failure of oversight . . . [and] in a case where the officer’s failure to exercise oversight had caused the corporation harm, a board could decide to assert a claim for breach of fiduciary duty against an officer.”
• As with directors, officers only will be liable for violations of the duty of oversight if a plaintiff can prove that they acted in bad faith and hence disloyally; however, there is “room to debate whether the same loyalty-based framework that governs directors should apply to officers, or whether officers could be held liable for a failure of oversight caused by a breach of the duty of care.” For now, however, liability will be found only for disloyal conduct.

¹In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).

²See, e.g., Stone v. Ritter, 911 A.2d 362 (Del. 2006).

³Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009).

This alert was authored by R. Montgomery Donaldson, partner in Montgomery McCracken’s Delaware office and Chair of the Business Litigation Practice Group. R. Montgomery can be reached at 302-504-7840 or rdonaldson@mmwr.com.