Duty of Oversight Extended to Corporate Officers: A New Expansion of Delaware Fiduciary Duties
Posted on Feb 28, 2023Chen Fu
Introduction
It has been well established in the Delaware corporate governance regime that directors owe a duty of oversight to the company since Caremark.[1] In the landmark decision, the Delaware Court of Chancery held that directors would violate the duty of good faith if “a sustained or systematic failure of the board to exercise oversight,” such as failing to establish a “reasonable information and reporting system,” exists.[2] Ten years later, the test was further elaborated into two prongs in Stone v. Ritter, as the plaintiffs have to prove either “(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention” (the “Information System” and “Red Flag” claims).[3] For nearly three decades, those “Caremark claims” are known as “among the most difficult of corporate claims” for plaintiffs to plead due to the high standard of proof.[4]
Recently, a new building block was added to this legal domain. For the first time, the Delaware Court of Chancery explicitly extended the duty of oversight beyond the original scope of directors to company officers in In re McDonald’s Corporation Stockholder Derivative Litigation, signaling possible incoming changes in the current corporate law landscape.[5] Corporate executives and their lawyers may need to make adjustments accordingly.
Factual Background and Legal Analysis
In McDonald’s, the court denied Defendant’s motion to dismiss a derivative claim brought by stockholders against David Fairhurst, the former Chief People Officer of the global fast food chain McDonald’s but not a board member. Plaintiffs claimed that Fairhurst failed his duty of oversight while in office. He allegedly allowed a corporate culture that condoned sexual harassment to develop by consciously ignoring red flags and engaging in misconduct himself.[6] Regulatory investigations and lawsuits emerged after those scandals were known to the public, causing economic and reputational losses to the company.[7] Fairhurst filed a 12(b)(6) motion to dismiss the claim for breach of the duty of oversight against him, arguing that under Delaware law, as outlined in the seminal Caremark ruling, there is no recognizable duty of oversight imposed on officers.[8]
In the decision, Vice Chancellor Laster held that officers are subject to the same duty of oversight as directors.[9] Unlike directors’ company-wide duty of oversight, officers’ scope of duty is generally “context-driven” and limited to their particular areas of responsibility, along with certain exceptions.[10] Laster based his conclusion on (1) the original Caremark reasoning, (2) the Delaware Supreme Court’s holding in Gantler v. Stephens that “the fiduciary duties of officers are the same as those of directors,”[11] (3) agency theory applicable to officers, and (4) corroborating judgments from other jurisdictions and academic work.[12] Applying the duty of oversight to officers, the court found that the Plaintiffs pleaded sufficient facts to pass the motion to dismiss.
Implications
This decision does not serve as a binding precedent on Delaware courts and may be overruled in later litigations. However, it is groundbreaking because the Delaware court “clarifies that corporate officers owe a duty of oversight,” an issue of first impression.
A possible broad reading of the decision may indicate the Delaware court’s willingness to impose other fiduciary duties, traditionally applied to directors only, on officers. Gantler’s wide-ranging holding laid the legal groundwork for Delaware courts to apply fiduciary duties to both directors and officers equally. In this decision, the court, from a policy perspective, pointed out that “nondirector officers may have a greater capacity [than the board] to make oversight and strategic decisions on a day-to-day basis”[13] to support its conclusion. That finding may also pave the way for future courts to consider an individual's actual position and capacity in the corporation, rather than merely the identity, such as officer or director, in deciding whether to impose specific fiduciary duties on them. Specifically, the court reasoned that the CEO and other senior officers should have the same company-wide duty of oversight as directors because of their commensurate authority.[14] The overtone seems that the scope of a single fiduciary duty should be more tailored to a particular individual’s authority and responsibility, which may leave courts more room for discretion and case-by-case analysis.
Notwithstanding the potential impact, the decision at this point provides plaintiffs with an additional path to hold individual non-board officers accountable since the duty of oversight is a duty of loyalty, nonwaivable by a 102(b)(7) exculpation provision.[15] Future plaintiffs will happily name more officers in their Caremark suits against the company and its directors. It might still be early to gauge the response on the company side, given that the litigation is ongoing and the allegations against the Defendant are egregious, including both consciously ignoring red flags of sexual misconduct and his personal involvement. It remains to be seen whether the court will maintain or narrow the scope of this decision in adjudicating more “normal” Caremark claims against officers in the future. However, out of precaution, directors of Delaware companies might wish to consider putting more compliance efforts on officers. As the most decisive factor in any Caremark case is the existence or absence of good faith, directors and officers would strive to put all their diligence and efforts in oversight on file to gain the benefit of the business judgment rule.[16] More comprehensive record-keeping and a clear definition of each officer’s area of responsibility could be the first step. The board may also want to update its existing information system to clarify the reporting obligations of officers at various levels, as the court identified officers’ duty to report red flags upward.
[1] In re Caremark International Derivative Litigation, 698 A.2d 959, 970 (Del. Ch. 1996).
[2] Id. at 42.
[3] Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006).
[4] See Gail Weinstein, Warren S. de Wied, and Philip Richter, Caremark Liability for Regulatory Compliance Oversight, Harv’ L. Sch. F. on Corp. Governance (July 8, 2019), https://corpgov.law.harvard.edu/2019/07/08/caremark-liability-for-regulatory-compliance-oversight/.
[5] In re McDonald’s Corporation Stockholder Derivative Litigation, C.A. No. 2021-0324-JTL (Del. Ch. Jan. 26, 2023), https://courts.delaware.gov/Opinions/Download.aspx?id=343130.
[6] Id. at 7–10.
[7] See, e.g., McDonald’s Franchise to Pay Nearly $2 Million to Settle EEOC Sexual Harassment Lawsuit, EEOC (Jan. 6, 2023), https://www.eeoc.gov/newsroom/mcdonalds-franchise-pay-nearly-2-million-settle-eeoc-sexual-harassment-lawsuit; McDonald’s Faces Class Action Lawsuit Over Sexual Harassment, Hostile Work Environment Accusations, JDSUPRA (Jan. 5, 2023), https://www.jdsupra.com/legalnews/mcdonald-s-faces-class-action-lawsuit-7441752/.
[8] In re McDonald’s, 1–2.
[9] Id. at 27.
[10] Id. at 2.
[11] Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009).
[12] In re McDonald’s at 19.
[13] Id. at 23.
[14] Id. at 41.
[15] 8 Del. C. §102(b)(7).
[16] See Gregory Markel, Daphne Morduchowitz, and Mathew Catalano, A Director’s Duty of Oversight After Marchand in “Caremark” Case, Harv’ L. Sch. F. on Corp. Governance (Jan. 23, 2022), https://corpgov.law.harvard.edu/2022/01/23/a-directors-duty-of-oversight-after-marchand-in-caremark-case/.