Corporate Officer Beware: Delaware Court of Chancery Says You Owe Caremark Duties

On January 25, 2023, the Delaware Court of Chancery submitted its opinion in In re McDonald’s Corporation Stockholder Derivative Litigation, No. 2021-0324-JTL, 2023 WL 387292 (Del. Ch. Jan. 25, 2023), holding for the first time that a corporation’s officers owe a duty of oversight.

The McDonald decision clarifies the scope of corporate officer duties, applying the rationale of In re Caremark Int’l Inc. Derivative Litig. 698 A.2d 959 (Del. Ch. 1996) and its progeny to determine that officers owe an equal duty of oversight to corporate directors. As a result, officers of Delaware corporations are now subject to the same standard of oversight as directors.

Key Takeaways

1. Corporate officers, like directors, owe a duty of oversight to the corporation.
2. Officers are held to a good-faith standard of conduct and oversight claims against corporate officers require a showing of bad faith.
3. Based on this decision, officers may be exposed to individual liability for their actions in failing to oversee corporate activity.

Background

This litigation arose after public allegations about sexual harassment and misconduct at McDonald’s led stockholders to request company books and records to investigate potential corporate wrongdoing. The plaintiffs sued Defendant David Fairhurst, a former McDonald’s Corporation Executive Vice President and Global Chief People Officer, for breach of his duty to oversee the company’s human resources function when he failed to address or report upward red flags regarding a culture of sexual harassment and misconduct at the company. The plaintiffs also alleged that Fairhurst’s own acts of sexual harassment constitute selfish conduct in breach of his duty to act in the best interests of the company.

Fairhurst moved to dismiss these claims, arguing that In re Caremark does not impose the duty of oversight on corporate officers and the plaintiffs otherwise failed to allege sufficient facts to support a claim that he breached the duty of loyalty and the alleged duty of oversight.

Decision

Vice Chancellor Laster, writing for the Court, denied Fairhurst’s motion to dismiss, holding that the plaintiffs pled sufficient claims against Fairhurst not only for breach of the duty of loyalty, but also that Fairhurst breached the duty of oversight. Despite the Court’s concession that no other Delaware decision explicitly addresses a corporate officer’s duty of oversight, the Court reasoned that “officers who serve as the day-to-day managers of the entity must make a good faith effort to ensure” that any red flags generated by information systems in place to uncover wrongdoing are reported or addressed. In re McDonald’s, 2023 WL 387292 at **30-33.

Decisions by the Delaware Supreme Court and the United States Bankruptcy Court for the Central District of California concluded that officers are subject to the same fiduciary obligations as directors, as well as previous rulings that officers owe additional duties as agents of the board, indicate that officers owe oversight duties. The Court explained that this decision represents the next step in the evolution of the “Red-Flags Rule” initially set forth in Graham v. Allis-Chalmers Manufacturing Co. in 1963.[1] Because officers are tasked with identifying, reporting, and addressing red flags that concern their area of responsibility, they serve a critical role in a corporation’s oversight structure. “A contrary holding would create a gap in the ability of directors to hold officers accountable.” In re McDonald’s, 2023 WL 387292 at *45.

In what is perhaps most important section of the decision, the Court engaged in an extensive discussion of the scope of an officer’s oversight duty. While directors are charged with plenary oversight of the company’s business, officers are typically tasked with narrow areas of responsibility. Thus, officers may only be responsible for reporting or addressing red flags in their own area. However, officers must note that they cannot turn a blind eye to “sufficiently prominent” red flags or violations of the law simply because the issue is not in their area of corporate responsibility.

Next, the Court proceeded to clarify that, just as directors must be held liable if a plaintiff can prove that they acted in bad faith, so must officers be. In order to sustain a Red-Flags claim, the plaintiffs must allege sufficient facts to support an inference that the officer knew of the misconduct and consciously failed to take responsive action. The facts must also support an inference that this failure was severe enough to constitute bad faith conduct.

While Fairhurst argued that the plaintiffs could not prove that he acted with a subjective intent to harm the company, the Court rejected his position and reasoned that the facts sufficiently alleged that Fairhurst acted for an improper purpose unrelated to the company’s best interests. Thus, the Court concluded that when a corporate officer commits “selfish” acts that cause harm to the corporation, the officer has engaged in bad faith conduct and can be held liable.