Delaware Court of Chancery Issues Significant Decision Addressing Fiduciary Duties of Officers, Including Holding that Officers Owe a Duty of Oversight

Key Takeaways

• Corporate officers owe the same fiduciary duty of oversight as directors.
• Just as with directors, officers fulfill their oversight duty by acting in good faith.
• When a corporate officer engages in “selfish” conduct that harms the corporation, that officer is not acting in good faith.

In In re McDonald’s Corporation Stockholder Derivative Litigation,¹  the Delaware Court of Chancery resolved important, outstanding questions for the fiduciary duties of officers under Delaware law, holding that officers owe the same duty of oversight as that owed by a corporation’s directors. In addition, the Court held that “oversight liability for officers requires a showing of bad faith”²–and not a breach of the duty of care. The Court further held that selfish conduct that harms the corporation, such as engaging in sexual harassment, is a breach of the duty of loyalty for acting in bad faith.

The McDonald’s decision is an important addition to the caselaw on the duties of officers, with the potential to impact significantly the relationship between a corporation’s officers and the corporation and its directors and stockholders.

Background

In 2019, McDonald’s terminated David Fairhurst, its Executive Vice President and Global Chief People Officer, for cause. Plaintiffs, McDonald’s stockholders, sued Fairhurst derivatively on behalf of McDonald’s, alleging that during his tenure he breached his fiduciary duties by “allowing a corporate culture to develop that condoned sexual harassment and misconduct.”³ Plaintiffs further asserted that the defendant himself committed at least one act of sexual harassment.⁴

Plaintiffs asserted Fairhurst’s fiduciary duties included a duty of oversight. Plaintiffs thus alleged that Fairhurst needed to address, or report upward to the CEO or Board of Directors, any red flags regarding sexual harassment or misconduct at McDonald’s, and that he failed to do so.

Fairhust moved to dismiss, and principally argued that Delaware law does not impose on corporate officers the same duty of oversight owed by the members of the board of directors as established in the seminal decision of In re Caremark International Inc. Derivative Litigation⁵ and its progeny. The Court rejected Fairhurst’s argument.

The Court’s Decision

Under the Caremark line of cases, the duty of oversight imposes two obligations on directors. First, directors have a duty to implement a reporting or information-system or controls for mission-critical risks.⁶  Second, directors have a duty to monitor such systems or controls and to respond to red flags.⁷ “In short, to satisfy their duty of loyalty, directors must make a good faith effort to implement an oversight system and then monitor it.”⁸

The Court conceded that no Delaware decision formally recognized that officers owe a duty of oversight. The Court nonetheless reasoned that myriad authorities indicated officers owe a fiduciary duty of oversight both as to (1) matters within their areas of responsibility, and (2) matters of sufficient prominence that any officer would have a duty to report upward about it. This result is unsurprising, as the Delaware Supreme Court previously ruled that officers owe the same fiduciary duties as directors.⁹

More significant is the Court’s determination of the standard of conduct for corporate officers fulfilling their duty of oversight. At issue was whether an officer’s failure of oversight required a showing of bad faith or if that failure could be shown by a breach of the duty of care. Previously, the facts in Caremark and its progeny concerned directors who were exculpated from monetary liability for a breach of the duty of care. Thus, director liability for a failure of oversight necessarily required a showing of bad faith through knowing misconduct, and not a failure of care which requires a lesser showing of gross negligence akin to recklessness. In a derivative action such as the one in McDonald’s, however, officers cannot be exculpated for their breach of the duty of care. For these, and other reasons, the question remained whether an officer’s duty of oversight would require a showing of bad faith or gross negligence.

On this question, the Court concluded that “[a]s 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.”¹⁰ In reaching this conclusion, the Court conducted a lengthy discussion of the reasoning in earlier oversight cases, the interplay of various provisions of the Delaware General Corporation Law, and public policy reasons in favor of the competing standards of conduct. While noting that reasonable arguments existed for grounding an officer’s duty of oversight in either good faith or care, the Court ultimately concluded that public policy fell in favor of good faith. The Court noted that officers should enjoy this more protective standard because of “the risk of hindsight bias in judicial decision-making, the relative incompetence of judges in assessing business decisions, the disproportionate level of liability that an individual could face from harm to a large enterprise, the bluntness of liability as a tool for shaping behavior, and a concern that the threat of liability will cause good people to decline to serve.”¹¹

In applying this standard, the Court concluded that plaintiffs’ claims survived the motion to dismiss because they supported a showing of bad faith. The Court held that the complaint pled facts supporting a reasonably conceivable inference that the defendant (1) was aware of potential problems with sexual harassment and misconduct at the company, (2) had committed sexual harassment himself on multiple occasions, and (3) acted in bad faith by consciously ignoring that alleged misconduct.

The Court further concluded that plaintiffs sufficiently alleged the defendant breached his duty of loyalty by acting in bad faith by personally engaging in acts of sexual harassment. There, the Court reasoned that sexual harassment is “reprehensible conduct” done for “selfish” reasons, which undoubtedly harms the company by “violating company policy, violating positive law, and subjecting the Company to liability.”¹² Accordingly, the Court reasoned that an officer engaging in sexual harassment is not acting subjectively to further the best interests of the corporation and, therefore, is acting in bad faith.

Key Takeaways

The McDonald’s decision recognizes not only that officers owe the same fiduciary duty of oversight as directors, but that officers will be subject to the same standard of conduct expected of directors, i.e., good faith, and will not face oversight liability for a failure of care. But the decision raises a host of questions left unanswered, and where the answers could implicate the relationship of officers to the corporation and its directors and stockholders, including:

• What makes a red flag “sufficiently prominent” outside the area of an officer’s responsibility that it would trigger oversight obligations?
• If an officer reports a red flag to the CEO or the board of directors and no action is taken, will the reporting officer still face oversight liability?
• Because the Court’s reasoning for requiring a showing of bad faith for officer oversight liability similarly supports extending protection of the business judgment rule to officers, will Delaware courts ultimately conclude that the business judgment rule protects officers as well as directors?
• Not all Delaware entities exculpate their fiduciaries for gross negligence, i.e., the standard of conduct for a breach of the duty of care. Can the fiduciaries of these entities argue that, as a matter of Delaware law, their duty of oversight requires a showing of bad faith and not gross negligence?
• Because of the high hurdles for bringing a derivative claim against officers when a majority of the board of directors is not implicated in wrongdoing, and where officers’ oversight liability requires a showing of bad faith, will this decision significantly impact D&O insurance premiums?

Footnotes

1. --- A.3d ---, 2023 WL 387292 (Del. Ch. Jan. 25, 2023).
2. Id. at *24.
3. Id. at *1.
4. Id. at *4-5.
5. 698 A.2d 959 (Del. Ch. 1996).
6. See, e.g., Stone ex rel. AmSouth Bancorp. v. Ritter, 911 A.2d 362, 370 (Del. 2006) (en banc).
7. Id.
8. Marchand v. Barnhill, 212 A.3d 805, 821 (Del. 2019) (en banc).
9. See Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009) (en banc).
10. In re McDonald’s, 2023 WL 387292, at *19.
11. Id.at *22. While no Delaware court has held that the business judgment rule applies to officers, the Court observed that these same arguments have been made in favor of extending the protections of the business judgment rule to officers. Id.
12. Id. at *29.