On January 25, 2023, the Delaware Court of Chancery rendered an important decision that clarifies that corporate officers owe a duty of oversight equal to, if not greater than directors’ duty of oversight. As with the directors’ duty of oversight, establishing a breach of the officer’s duty of oversight requires pleading and later proving disloyal conduct that takes the form of bad faith. This duty includes addressing red flags and reporting them upward. The decision in In re McDonald’s Corporation Stockholder Derivative Litigation, No. 2021-0324-JTL (Del. Ch. Jan. 25, 2023) has far reaching consequences in determining corporate officer liability in derivative litigation.
McDonald’s employs over 200,000 people, mostly young people in entry-level positions and the Company boasts that its “America’s best first job.” While over half of McDonald’s employees are women, at more senior levels, the percentage of women drops dramatically. Beginning around 2015, McDonald’s Chicago headquarters allegedly began to take on a “party atmosphere” where the eighth floor of the office had open bar happy hours and employees frequently drank alcohol at other company affiliated events.
Chief Executive Officer (“CEO”) Stephen J. Easterbrook (“Easterbrook”), together with Executive Vice President and Global Chief People Officer David Fairhurst (“Fairhurst”) developed reputations for flirting with female employees, including their executive assistants. Recruiters were encouraged to hire “young, pretty females” from high-end stores to work in administrative roles at the Chicago headquarters and the CEO became known as a “player” who pursued intimate relationships with staff. The human resource function overseen by Fairhurst allegedly ignored complaints about the conduct of co-workers and executives and two former executives reported that employees felt as if they had little recourse for reporting bad behavior.
By October 2016, employees began to file complaints with the Equal Employment Opportunity Commission (“EEOC”) that contained disturbing allegations about sexual harassment and retaliation. Following the uptick in EEOC complaints, McDonald’s employees in over 30 cities across the U.S. organized a walkout, which was covered by major media outlets. By September 2018, EEOC complaints were identifying broad systemic issues throughout the Company in addition to individual instances of sexual harassment. Failure by management to address these problems led to a one-day, ten city strike in protest and attracted the attention of federal lawmakers.
Despite the Company’s ostensible zero-tolerance policy for acts of sexual harassment and the Company’s Board of Directors (the “Board”) receiving reports that Fairhurst was sexually harassing employees, nothing changed. It was not until October 2019 that the Board terminated Easterbrook, purportedly upon learning that Easterbrook was engaging in a prohibited relationship with an employee. Notably, the Board elected to terminate Easterbrook “without cause,” enabling Easterbrook to depart the Company with a massive severance package worth tens of millions of dollars.
Soon thereafter, the Board terminated Fairhurst based on his documented history of sexually harassing the Company’s employees.
Less than two weeks after Easterbrook left McDonald’s and the Board terminated Fairhurst, Company employees filed a class action lawsuit challenging the Company’s systemic problems with sexual harassment, alleging that McDonald’s had a toxic culture where sexual harassment was pervasive throughout its restaurants and that two thirds of restaurant employees worked at locations that did not provide any sexual harassment training. McDonald’s workers also alleged that employees lacked access to any human resources support and that the company’s human resource department under Fairhurst refused to help workers at franchise restaurants. Another class action was filed shortly thereafter, this time on behalf of company owned restaurants, alleging 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 that employees were discouraged from lodging complaints.
After the public allegations about sexual harassment and misconduct at the company, a group of plaintiffs filed a stockholder derivative action alleging 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.
In denying Fairhurst’s motion to dismiss, the court, for the first time, expressly held that corporate officers also owe a duty of oversight. While neither the Delaware Supreme Court nor the Delaware Court of Chancery said explicitly that corporate officers owe oversight duties, they have equated officer duties with director duties.
The court follows the same rationale for directors’ duty of oversight and applies it to officers. “In the typical corporation, it is the officers who are charged with, and responsible for, running the business of the corporation.” Megan W. Shaner, The (Un)Enforcement of Corporate Officers’ Duties, 48 U.C. Davis L. Rev. 271, 285 (2014). “In fact, without officers, there would be no one to make important day-to-day operational decisions or to supervise the lower-level employees who keep a firm running.” Nadelle Grossman, The Duty to Think Strategically, 73 La. L. Rev. 449, 488 (2013) (“Think Strategically”). Because of this governance, “[m]onitoring and strategy are not exclusively the dominion of the board. Actually, nondirector officers may have a greater capacity to make oversight and strategic decisions on a day-to-day basis.” Omari Scott Simmons, The Corporate Immune System: Governance from the Inside Out, 2013 U. Ill. L. Rev. 1131, 1160–61 (2013). From this perspective, the Caremark oversight role “is more suited to corporate officers who are responsible for managing the day-to-day affairs of the corporate enterprise.” Dominick T. Gattuso & Vernon R. Proctor, Reining in Directors and Officers in Corporate America in Delaware, the Answer Is Not to Expand Their Personal Liability, Bus. L. Today, January/February 2010, at 46, 49.
Resultantly, the officers who serve as the day-to-day managers of the business must make a good faith effort to ensure that information systems are in place so that they receive relevant and timely information that they can provide to the directors. Think Strategically, supra, at 488. The reality that officers require information to function in their roles provides further support for officers having oversight obligations. The court proposed the following hypothetical:
Pause for a moment and envision an officer telling a board that the officer did not have any obligation to gather information and provide timely reports to the board. The directors would quickly disabuse the officer of that notion, and an officer who did not get with the program would not hold that position for long.
Another critical part of an officer’s job is to identify red flags, report upward, and address them if they fall within the officer’s area of responsibility. Once again, pause and envision an officer telling the board that their job did not include any obligation to report on red flags or to address them. A similar learning opportunity would result.
In the unrealistic hypothetical where an officer declares those contrarian beliefs upfront, the directors are in a position to disabuse the officer of his misconceptions or terminate the officer’s role. But directors may only learn about an officer’s failure to establish information systems or to identify and report red flags after a corporate trauma has occurred. It is unfathomable that a board would sign off on an officer’s expressed intent to put his head in the sand, not make any effort to gather information or report to the board, and not make any effort to address red flags. It is similarly unfathomable that a board could not take action if an officer failed to fulfill those obligations. Yes, a board might determine that disciplining or terminating the officer was sufficient and that a lawsuit was not necessary. But in a case where the officer’s failure to exercise oversight had caused the corporation harm, a board could decide to assert a claim for breach of fiduciary duty against an officer. The board should be able to do so.
The McDonald’s plaintiffs successfully alleged officer oversight claims allowed a culture of sexual misconduct and sexual harassment to develop at the Company. Specifically, they alleged that Fairhurst knew about evidence of sexual misconduct and acted in bad faith by consciously disregarding his duty to address the wrongdoing. The McDonald’s plaintiffs pointed to several major red flags that for someone in Fairhurst’s position, should have been figuring out whether something was seriously wrong and either addressing it or reporting upward to the CEO and the directors. Despite numerous red flags, Fairhurst allegedly engaged in serial sexual harassment himself, had the human resource department ignore complaints about the conduct of his co-workers and other executives, and the Company’s Section 220 production had no evidence that McDonald’s was taking meaningful action to address problems with sexual harassment and misconduct until early 2019.
The court was clear that Fairhurst’s alleged conduct, if proven, would be a breach of fiduciary duty of oversight and loyalty case and not a sexual harassment case. “Like an oversight claim, a claim for breach of duty based on the officer’s own acts of sexual harassment is derivative, so all of the protections associated with derivative claims apply” and is not duplicative of other remedies. In sum, “[s]exual harassment is bad faith conduct. Bad faith conduct is disloyal conduct. Disloyal conduct is actionable.” As a result of this decision, Delaware expressly applied directly fiduciary duties of oversight to the officer in the derivative litigation context and found that the McDonald’s plaintiffs successfully pleaded breach of the duty of oversight and breach of the duty of loyalty. This holding means that oversight liability in the derivative context can extend beyond directors to company officers in certain situations.
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