United States: Delaware VC Laster Finds A "black Swan"—A Fiduciary Duty Of Oversight For Officers

In In re McDonald's Corporation, defendant David Fairhurst, who formerly served as Executive Vice President and Global Chief People Officer of McDonald's Corporation, contested a stockholders' claim that he had breached his fiduciary duty of oversight by arguing that there is no fiduciary duty of oversight for officers, only for directors. VC Laster of the Delaware Chancery Court responded this way: "That observation is descriptively accurate, but it does not follow that officers do not owe oversight duties. For centuries dating back to the Roman satirist Juvenal, Europeans used the phrase 'black swan' as a figure of speech for something that did not exist. Then in the late eighteen century, Europeans arrived on the shores of Australia, where they found black swans. The fact that no one had seen one before did not mean that they could not or did not exist.... Framed in terms of the issue in this case, decisions recognizing director oversight duties confirm that directors owe those duties; those decisions do not rule out the possibility that officers also owe oversight duties." With that—and a lengthy exposition—Laster confirmed that Fairhurst did indeed have a duty of oversight, much like the Caremark duties applicable to corporate directors.

In this case, plaintiff stockholders sued derivatively, alleging that Fairhurst consciously ignored red flags and thus breached his fiduciary duties as an executive officer "by allowing a corporate culture to develop that condoned sexual harassment and misconduct." The defendant moved to dismiss the oversight claim under Rule 12(b)(6), contending that officers do not have Caremark duties, and, even if they did, that the plaintiffs failed to allege sufficient facts to state a claim against him. The Court thought otherwise. According to the Court, Fairhurst "had an obligation to make a good faith effort to put in place reasonable information systems so that he obtained the information necessary to do his job and report to the CEO and the board, and he could not consciously ignore red flags indicating that the corporation was going to suffer harm." In addition, based on the allegations in the complaint, the Court believed that it was "reasonable to infer that Fairhurst knew about and played a role in creating the Company's problems with sexual harassment and misconduct, which led to the external signs that took the form of employee complaints and a ten-city strike." Not to mention that the claims of breach of duty regarding Fairhurst's own acts of sexual harassment also survived the motion. While the Court observed that, in Gantler v. Stephens, the Delaware Supreme Court held that officers owe the same fiduciary duties as directors, the Court here augmented that ruling by invoking the same type of oversight obligations that were established for directors in Caremark—obligations arising out of the duty of loyalty and premised on the same policies: "Although no Delaware decision has stated the proposition in so many words,...[t]his decision confirms that officers owe a duty of oversight." It's worth remembering that former Delaware Chief Justice Strine has indicated that "Caremark claims are difficult to plead and ultimately to prove out," and constitute "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." (See this PubCo post.) Nevertheless, the decision here certainly opens the door wide for more litigation against officers.

Background

Based on the facts alleged in the complaint, which, at this stage of the litigation, are presumed to be true, the Court states that McDonald's is one of the world's biggest employers, with over 200,000 employees, and another two million employed at franchises, over half of whom are women. Its Standards of Business Conduct and Human Rights Policy provide for "respectful workplaces" and an environment that "builds trust, protects the integrity of our brand and fuels our success." In 2015, the Company promoted Stephen Easterbrook as CEO, who in turn promoted Fairhurst to Global Chief People Officer. Both had been long-term employees and friends. They proceeded to promote a "party atmosphere" at headquarters, complete with an open bar and conduct by male executives, including particularly Easterbrook and Fairhurst, that included "inappropriate behavior" and even relationships with female employees. Given the new "boys' club" environment, Fairhurst's human resources function was alleged to have ignored or failed to address adequately complaints about incidents of bad behavior.

By 2016, public scrutiny increased as various complaints were filed with the EEOC alleging sexual harassment and retaliation at the Company, followed by a 30-city walkout and major media coverage, followed by another round of EEOC complaints in 2018 and a one-day strike. Senator Tammy Duckworth stepped in with an inquiry. You get the drift.

At about same time in 2018, the Board received reports about Fairhurst's own acts of sexual harassment, which were deemed by the compliance department to be "inconsistent with the Company's Standards of Business Conduct." The Audit & Finance Committee of the Board discussed his conduct. Notwithstanding the Company's zero tolerance policy for sexual harassment, at the urging of Easterbrook, the Committee required only that Fairhurst forfeit half of his bonus and execute a "Last Chance Letter," which confirmed that the incident was not isolated, that he had violated the Company's Standards of Business Conduct and that the misconduct had put "the Company at significant risk." He stayed on in the same capacity.

In 2019, management and the Board then buckled down in an effort to respond to the harassment problems it faced with a comprehensive plan, including steps such as policy revisions, training, establishment of a hotline and engagement of an anti-sexual violence organization to provide guidance. Still, in 2019, the risk was identified to the Board as one that has the "[p]otential for sustained, negative impact to brand, long term financial grown, or strategy position, " and was "[m]ore likely to become Tier 1 risk[] given the circumstances."

In late 2019, after learning of his affairs with employees, the Company terminated Easterbrook without cause (see this PubCo post), and subsequently terminated Fairhurst for cause, presumably for violation of his Last Chance letter. Shortly thereafter, a number of employees filed class actions charging "systemic failures to curb sexual harassment at Company restaurants while Fairhurst served as Global Chief People Officer." One of the actions alleged that "three out of every four female non-managerial McDonald's employees have personally experienced sexual harassment at McDonald's, ranging from unwelcome sexual comments to unwanted touching, groping, or fondling, to rape and assault," and 70% of those who reported problems experienced retaliation.

After the public allegations about harassment surfaced, a complaint was filed against the Company, adding Fairhurst and Easterbrook as defendants, including a claim against Fairhurst for breach of fiduciary duty. In particular, the complaint alleged that Fairhurst "engaged in inappropriate conduct with female employees and exercised inadequate oversight in response to risks of sexual harassment and misconduct at the Company and its franchises." Fairhurst moved to dismiss this count. The Court concluded that both claims—for breach of the duty of oversight and breach of the duty of loyalty as a result of his own acts of sexual harassment—stated claims on which relief could be granted.

Analysis

Duty of Oversight. Fairhurst contended that Delaware did not recognize an oversight duty for corporate directors. The Court disagreed: "Although no Delaware decision has stated the proposition in so many words, diverse authorities indicate that officers owe a fiduciary duty of oversight as to matters within their areas of responsibility. Those authorities include the reasoning of the original Caremark opinion, the Delaware Supreme Court's holding that the duties of officers are the same as the duties of directors, decisions from other jurisdictions and academic commentary, and the additional duties that officers owe as agents. This decision confirms that officers owe a duty of oversight."

The Court looked both to Caremark, which has generally been credited with creating the duty of oversight, and to an earlier case, Graham v. Allis-Chalmers Manufacturing Co., which has been viewed to "establish 'the protective "red flags" rule,' under which directors could be liable for failing to take action only if they were aware of red flags indicating wrongdoing and consciously chose not to act."

In Caremark, Chancellor Allen determined that directors had a fiduciary duty to establish reporting systems to facilitate board oversight but would be exposed to liability only in the event of "a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists." In Stone v. Ritter, the Delaware Supreme Court adopted a two-pronged test to survive a motion to dismiss: "a plaintiff must allege particularized facts supporting a reasonable inference that 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 latter being essentially a "red flags" claim.

All of these cases applied the duty of oversight only to directors; as the Court acknowledged, "[n]either the Delaware Supreme Court nor this court has expressly held that officers also owe oversight duties." The Court contended that the three premises established in Caremark for recognizing the information-systems aspect of the duty of oversight "easily encompass officers." First, the Court said that the same seriousness attributable to the role of director also applies to officers. Second, the Court noted Chancellor Allen's recognition of the need of both senior management and the board for actionable information, because both management and the board need to be able to make decisions, thus providing further support for the proposition that officers have oversight obligations. Third, the Organizational Sentencing Guidelines also explicitly call for executive officers to undertake compliance and oversight obligations. In addition, based on Allis-Chalmers, the Court reasoned that red-flags obligations also apply to officers. According to the Court, Chancellor Allen "proceeded from the premise that senior officers could be liable on a Red-Flags Claim under the Allis-Chalmers rationale if they knew about information that foreclosed reasonable reliance on the integrity of the company's employees." And, given that officers manage the entity day to day, "officers are optimally positioned to identify red flags and either address them or report upward to more senior officers or to the board."

In addition, the Court observed, the Delaware Supreme Court has previously equated the general fiduciary obligations of officers with those of directors. Although the Supreme Court has not explicitly imposed an oversight duty on officers, academics have found the duty based on the logic of Supreme Court cases, as have the Federal Bankruptcy Courts. The Court also located another source of authority for officers' oversight obligations in officers' duty as agents who report to the board. For example, Delaware courts have found that, "as agents, officers 'owe a duty to disclose relevant information if they have notice of facts which they should know may affect the decisions of their principals as to their conduct.'" In addition, the Court reasoned, officers must be accountable to the board for gathering information, identifying red flags and reporting up: "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. 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."

The Court appeared to acknowledge that recognizing a fiduciary duty of oversight for officers could amp up the level of litigation against officers on that basis, but a "bulwark" would provide some protection. According to the Court, "the oversight duties of officers are an essential link in the corporate oversight structure. The bulwark against the stockholders liberally asserting oversight claims against officers is not the invalidity of the legal theory. Rather, it is the fact that oversight claims are derivative, so the board controls the claim unless a stockholder can plead demand futility or show wrongful refusal. It is those doctrines, applied at the pleading stage under Rule 23.1, that minimize the risk of oversight claims against officers, not the absence of any duty of oversight."

What is the scope of an officer's oversight duty? That depends on the context of the action: "Although the CEO and Chief Compliance Officer likely will have company-wide oversight portfolios, other officers generally have a more constrained area of authority." That constrained area of responsibility also leads to a constrained version of the duty that would support a claim. Consequently, officers would, as a rule, only "be responsible for addressing or reporting red flags within their areas of responsibility," although there may be exceptions for red flags that are very prominent. In addition, to succeed in a claim that an officer violated the duty of oversight, plaintiffs will need to show, as with directors, that the officers "acted in bad faith and hence disloyally." Although the duty of oversight has "overtones of care," to impose liability, bad faith is required. Essentially, as Justice Strine said in Marchand v. Barnhill (see this PubCo post), the failure to make a good faith effort to exercise the duty of care "constitutes a breach of the duty of loyalty." However, the Court noted, although "there is room to debate whether the same loyalty-based framework that governs directors should apply to officers," even under the "duty of care" standard, a showing of gross negligence would be required, which is "akin to recklessness." The Court concluded that "oversight liability for officers requires a showing of bad faith. The officer must consciously fail to make a good faith effort to establish information systems, or the officer must consciously ignore red flags."

Plaintiffs' claim

As described by the Court, plaintiffs asserted a "red-flags" oversight claim based on Fairhurst's knowledge of evidence of sexual misconduct and his bad faith conduct in consciously disregarding his duty to address the misconduct: a "claim that a fiduciary had notice of serious misconduct and simply brushed it off or otherwise failed to investigate states a claim for breach of duty." Here, citing a series of events, including the employee walk-out, EEOC complaints and Fairhurst's own incidents of sexual harassment, plaintiffs asserted that "Fairhurst permitted a toxic culture to develop at the Company that turned a blind eye to sexual harassment and misconduct."

The Court concluded that "[t]hese allegations support Fairhurst's knowledge of red flags." He was the officer "with day-to-day responsibility for overseeing the human resources function and promoting a safe and respectful environment," and these events should have led him to "figure[e] out whether something was seriously wrong and either address[] it or report[] upward to the CEO and the directors." The Court determined that, at the pleading stage, it was "reasonable to infer that there were problems with sexual harassment and misconduct at the Company" and "that Fairhurst knew about them." The plaintiffs also had to plead "facts supporting an inference that Fairhurst acted in bad faith by consciously ignoring red flags." The Court found that there were a number of facts alleged to support an inference of scienter, including the allegations of Fairhurst's own acts of sexual harassment, the conduct of the human resources department in ignoring employee complaints and engaging in retaliation, and the absence of evidence that Fairhurst reported up to the Board or that the Company was taking meaningful action, at least prior to 2019 when management (including Fairhurst) attempted to address the problem (although, the Court noted, Fairhurst did engage in misconduct personally in 2019, which cuts the other way). Based on these allegations, the Court found "enough to hold that the complaint's allegations support a claim against Fairhurst for breach of the duty of oversight."

In addition, the Court found that the plaintiffs also stated a claim on which relief could be granted based on the allegation that Fairhurst's personal acts of sexual harassment constituted a breach of his fiduciary duties. His acts of harassment were not acts subjectively intended "to further the best interests of the Company. He therefore was acting in bad faith. The allegations against Fairhurst accordingly support a claim for breach of the duty of loyalty." "It is not reasonable," the Court said, "to infer that Fairhurst acted in good faith and remained loyal to the Company while committing acts of sexual harassment, violating company policy, violating positive law, and subjecting the Company to liability." But, the Court observed, some might question the propriety of the Court of Chancery's viewing the conduct as a breach of duty and not as an ordinary employment-related claim? (To paraphrase Matt Levine's mantra, is everything a breach of fiduciary duty? See this PubCo post.) In response to that rhetorical question, the Court concluded that it was "reasonable to infer that when a fiduciary engages in sexual harassment, the fiduciary acts directly against the corporation's interest by harming an employee, jeopardizing the corporation's relationship with that employee and other employees, and subjecting the company to potential liability." According to the Court, "[s]exual harassment is bad faith conduct. Bad faith conduct is disloyal conduct."

In conclusion, the Court denied Fairhurst's motion to dismiss.

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