Delaware Finds That Officers Have Oversight Duties

POMERANTZ MONITOR | JANUARY FEBRUARY 2023

By Samuel J. Adams

In a case of first impression, the Delaware Court of Chancery found, for the first time, that corporate officers owe a duty of oversight. The Court held that, under Delaware law, corporate officers owe the same fiduciary duties as corporate directors, which logically includes a duty of oversight. Director oversight duties are commonly referred to as “Caremark duties,” after the seminal opinion of Delaware law issued in In re Caremark International Inc. Derivative Litigation. Critically, the Court also found that officers who breach their duty of oversight can be held liable in derivative litigation brought by stockholders.

The case at issue involves a derivative action brought by stockholders of McDonald’s Corporation against David Fairhurst, McDonald’s former Head of Human Resources, among others. The action, In re McDonald’s Corporation Stockholder Derivative Litigation, was filed in the wake of a series of high-profile employee walkouts in protest of allegedly widespread incidents of sexual harassment and retaliation at McDonald’s restaurants. The action also alleges that Fairhurst contributed to a “boys’ club” culture at corporate headquarters, where alcohol use was permitted, and human resources allegedly turned a blind eye to executive misconduct. In addition, the plaintiffs pointed out that Fairhurst himself had been accused of three separate incidents of sexual harassment during his tenure as Head of Human Resources at McDonald’s.

The plaintiffs’ derivative lawsuit alleged that Fairhurst breached his fiduciary duties by allowing a corporate culture to develop that condoned sexual harassment and misconduct. They assert that Fairhurst breached his oversight duties because he did not make a good faith effort to establish an information system necessary to manage the company’s human resources responsibilities, including the responsibility to monitor and respond to allegations of sexual harassment. The plaintiffs also alleged that Fairhurst failed in his obligation to address or report upward to the company’s Board of Directors or CEO any “red flags” regarding sexual harassment that came to his attention. Finally, the plaintiffs alleged that Fairhurst’s repeated acts of sexual harassment constituted a breach of duty in themselves.

Faced with these allegations, Fairhurst argued that no court in Delaware had ever explicitly found that officers owe oversight duties. However, the Court concluded that the plaintiffs stated a claim against Fairhurst, due to both his failure to exercise proper oversight and his own alleged misconduct.

In rejecting Fairhurst’s arguments, the Court looked to the history of Caremark. First, the Court noted that, as a practical matter, responsibility for managing the operations of a corporation is shared between the officers and the directors, with the officers tasked with managing the day-today operations of the corporation. In light of the seriousness of these roles, the Court found that oversight duties should apply with equal force to both officers and directors. The Court added that directors only meet a handful of times per year, adding to the importance of officers rigorously complying with their fiduciary duties.

Second, the Court noted that directors can only fulfill their own oversight duties if corporate officers have a commensurate oversight duty to gather information and bring any red flags to the attention of the board of directors. Logically, if officers did not have oversight duties, the entire system of corporate governance would break down and there would be no mechanism in place to ensure that directors received the information required to effectively oversee company management and the company. In short, failing to confirm that officers owe oversight duties would undermine the directors’ ability to fulfill their own statutory obligation to direct and oversee the business and affairs of the corporation.

While officers and directors owe the same duties, the Court added that the oversight duty is “context-driven” and will vary depending on the role of the individual and the facts of the case. By way of example, CEOs and directors have company-wide areas of responsibility, while other executives may have responsibilities that are more limited. The Head of Human Resources may only be responsible for overseeing HR, while a CFO has responsibility for financial reporting. In those cases, the officer’s obligation to establish an oversight system aligns only with their area of responsibility. However, if an officer becomes aware of a red flag, that officer still has an obligation to address the red flag and report it internally, even if the red flag does not concern their particular area of responsibility at the corporation.

Here, the Court found that the plaintiffs had adequately pled an oversight claim against Fairhurst based on a “red flags theory,” noting allegations that Fairhurst 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 also determined that Fairhurst’s alleged sexual harassment is itself a breach of the fiduciary duty of loyalty, noting Continued from page 1 that “[w]hen 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.”

Will the McDonald’s opinion open a floodgate of stockholder litigation against corporate officers? Perhaps not. Claims against corporate officers arising from alleged misconduct are generally derivative in nature, meaning that the claim against the officer belongs to the corporation and not to the stockholders. As such, before a stockholder can pursue a derivative claim against an officer of a corporation under Delaware law, a stockholder-plaintiff must first either make a pre-suit demand on the board to commence litigation against the officer, or else explain in their own lawsuit why making such a litigation demand on the board would have been futile. This is a high burden for a stockholder to clear under Delaware law. The Court also noted that oversight claims against officers will be subject to the same bad faith standard that applies to corporate directors in the context of an oversight liability claim.

At a minimum, the McDonald’s opinion could lead to an increase in officers being named as additional defendants in derivative lawsuits seeking to hold directors accountable for violating their own oversight duties. As the McDonald’s Court noted, “it seems likely that if a court found a board liable for breach of an oversight obligation, then the officers with responsibility for that area also would be liable…” Accordingly, Delaware may see an increase in senior members of management being forced to answer for their conduct in derivative litigation against directors.

In addition, the opinion invites boards that have been duped by executives to commence litigation against the former officers. McDonald’s notes that where an officer was not providing adequate oversight, but the directors did not have reason to know this, the board may have relied on the officer in good faith. In that scenario, McDonald’s makes clear that a board would be in a position to pursue oversight claims against the officer without facing liability for oversight claims themselves. It remains to be seen whether boards will utilize the playbook provided to them in McDonald’s to sue former officers on their own initiative following instances of misconduct and officer oversight violations.