Since the 1996 decision In re Caremark International, the duty of oversight has been applied only to the directors of a corporation. The duty of oversight requires directors to make a good faith effort to ensure that an adequate internal corporate information and reporting system exists. This system is required so directors can “reach informed judgments concerning both the corporation’s compliance with law and its business performance.”[1]
Recently, the Delaware Court of Chancery (the “Court”) held for the first time that the concept of the “duty of oversight” applies not only to corporate directors, but to corporate officers as well. Additionally, the Court broadened a corporate officer’s “duty of loyalty” when it ruled that a corporate officer’s engagement in sexual harassment of employees itself violates the duty of loyalty. The holding raises issues that should prompt Delaware corporations to reconsider their reporting systems in place and protections available to their corporate officers.
In the case of In re McDonald’s Corp., the Court denied the motion of David Fairhurst, former McDonald’s executive vice president and global chief people officer, to dismiss a derivative[2] lawsuit against him brought by McDonald’s shareholders. The shareholders alleged that the former vice president violated his fiduciary duties by allowing a corporate culture to develop that condoned sexual harassment and misconduct. In his executive role, Fairhurst was accused of failing to put a stop to workplace harassment. The plaintiffs filed a long list of “red flags” that Fairhurst allegedly ignored or was responsible for, including an atmosphere that condoned male employees engaging in inappropriate behavior toward their female co-workers. He was also directly accused of sexually harassing female employees.
When analyzing a corporate officer’s duties to the corporation in this context, the Court held that the duty of oversight owed by officers is scrutinized under the same two-prong test used in Caremark that applies to directors. Specifically, officers “must make a good faith effort to ensure that information systems are in place so that officers receive relevant and timely information that they can provide to the directors.”[3] Further, officers “have a duty to address [red flags they identify] or report upward.”[4]
Applying the Caremark test, the Court held that the plaintiffs had a valid claim against Fairhurst because he breached his duty of oversight “by consciously ignoring red flags” of a culture congested with sexual harassment and misconduct.[5] The Court reasoned that officers are best situated to identify and address red flags or report them to the board of directors since their role as officers requires them to be involved with the day-to-day operations of the corporation. For “red flags” claims to be successfully pleaded against officers, the Court noted that a plaintiff must plead sufficient facts to support an inference that the officer not only knew of evidence of corporate misconduct, but also that the officer consciously failed to take action in response to such misconduct.[6]
Moreover, the Court held that an officer also violates the separate duty of loyalty when they engage in sexual harassment of employees. The Court explained that sexual harassment by a corporate officer is in furtherance of a private interest rather than “advancing the best interests of the company.[7] Sexual harassment is bad faith conduct, and thus disloyal conduct, with respect to their responsibilities as an officer of the corporation.Because harassment is per se not in the corporation’s best interests and disloyal conduct subjects the corporation to liability, it is a violation of the duty of loyalty and is actionable under the law.[8]
This decision demonstrates that Delaware courts continue to align the duties that are owed by corporate officers with those of directors. However, it also raises some questions about the scope of the additional duties imposed on officers of Delaware corporations. For instance, what if the corporation has a sufficient reporting and information system in place, but it failed to detect an officer embezzling money. Would the other officers be found to have violated their duty of oversight?
Although the trajectory of the case’s impact is unclear, Delaware corporations should consider how they assess risk monitoring, reporting, and compliance systems currently in place, as well as protections available to corporate officers, such as directors’ and officers’ liability insurance.
Please contact us with any questions.
Thank you to Keith O’Brien for his research and writing assistance.
[1] In re Caremark International Inc., 698 A.2d 959, 970 (Del. Ch. 1996).
[2] A derivative lawsuit refers to one or more shareholders bringing an action on behalf of the corporation against a third party, generally the officers or directors of the corporation, to remedy harm done to the corporation.
[3] In re McDonald’s Corp., No. 2021-0324 at 11* (Del. Ch. Jan. 26, 2023).
[4] Id. at *12.
[5] Id. at *27.
[6] Id. at *32.
[7] Id. at *28.
[8] Id. at *30.
