Delaware Court of Chancery Ruling Imposes a Fiduciary Duty of Oversight on Corporate Officers

On January 26, 2023, the Delaware Court of Chancery resolved a long-standing ambiguity in Delaware law, clarifying, for the first time, that corporate officers owe a fiduciary duty of oversight.  The case, In re McDonald’s Corporation Stockholder Derivative Litigation, No. 2021-0324, 2023 WL 387292 (Del. Ch. Jan. 26, 2023), involved derivative claims by McDonald’s stockholders against the company’s board of directors and certain officers, including the former Chief People Officer.  Vice Chancellor Laster, dealing solely with the former Chief People Officer’s motion to dismiss, held that the complaint sufficiently alleged that the former executive: (i) consciously ignored red flags concerning sexual harassment and (ii) engaged in sexual harassment.  This decision has significant implications for derivative lawsuits concerning environmental, social, and governance (“ESG”) issues and corporate crises alike.  

The Court’s Decision: Officers Owe Oversight Duties 

The McDonald’s ruling resolves a question left open since the 1996 Caremark decision.  Caremark held that directors of Delaware corporations have a duty of oversight that includes two obligations: (i) to ensure that corporations have implemented proper reporting systems, and (ii) to appropriately address “red flags” suggestive of corporate wrongdoing.  For years, Delaware courts cabined this duty to directors, leaving unanswered whether these same duties also apply to officers.  While the Delaware Supreme Court’s subsequent decision in Gantler v. Stephens affirmed the general principle that “the fiduciary duties of officers are the same as those of directors,” it did not address whether officers owe the specific duty of oversight and, if so, how the scope of that duty compares to the one owed by directors.

Recognizing that no Delaware court had explicitly answered these questions, Vice Chancellor Laster opined that the “same policies that motivated Chancellor Allen to recognize the duty of oversight for directors [in Caremark] apply equally, if not to a greater degree, to officers.”  According to Vice Chancellor Laster, any other outcome would “undermine the directors’ ability to fulfill their statutory obligation to direct and oversee the business and affairs of the corporation.” 

Vice Chancellor Laster reasoned that officers have oversight duties for several reasons.  As individuals charged with day-to-day business operations, officers are well-positioned to identify, address, and report potential red flags to the board.  Directors, for their part, rely on this information to fulfill their own oversight obligations.  Vice Chancellor Laster found that several other authorities reinforced his reasoning.  For example, federal organizational sentencing guidelines require executive officers to undertake compliance and oversight obligations.  Agency law likewise suggests that an officer—as agent of the corporation—has a duty to use reasonable efforts to provide the board—as principal—with material information relevant to its oversight.

The Scope of Officers’ Oversight Duty is “Context-Driven”

Having reasoned that the duty of oversight applies “equally” to officers, Vice Chancellor Laster noted that establishing officer liability “requires pleading and later proving disloyal conduct that takes the form 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.”  However, because officers may have different responsibilities within a corporation, the scope of a particular officer’s duty is “context-driven.”  Vice Chancellor Laster elaborated that:

“Some officers, like the CEO, will have a company-wide remit.  Other officers have particular areas of responsibility, and the officer’s duty to make a good faith effort to establish an information system only applies within that area.  An officer’s duty to address and report upward about red flags also generally applies within the officer’s area, although a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.” 

The McDonald’s Plaintiffs Met Their Pleading Burden 

Analyzing the complaint at hand, Vice Chancellor Laster stated that to survive dismissal under Delaware’s notice pleading standard, the complaint need only contain a short, plain statement of facts sufficient to support a claim for breach of the duty of oversight.  The McDonald’s plaintiffs framed their duty of oversight claim as a “red flags” claim—i.e., they were not challenging the adequacy of the company’s system of reporting and controls, but rather the former executive’s alleged failure to address known red flags.  Observing that the defendant was the executive with day-to-day oversight of the human resources function, Vice Chancellor Laster pointed to a number of alleged red flags that he believed fell within the defendant’s domain.  These included complaints of employee misconduct, a 2018 employee walkout to protest purported instances of sexual harassment at the company, complaints to the Equal Employment Opportunity Commission, and employee lawsuits relating to sexual harassment.  Based on these allegations, Vice Chancellor Laster found that plaintiffs had sufficiently pled their oversight claim.

Vice Chancellor Laster also found that plaintiffs had sufficiently pled a breach of loyalty claim against the defendant for his own alleged acts of sexual harassment.  The Court opined that “[i]t is not reasonable to infer that [the defendant] 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.  It is reasonable to infer that [the defendant] acted disloyally and for an improper purpose, unrelated to the best interests of the Company.”

What this Case May Mean for Officers and Corporations

The McDonald’s opinion establishes a long-anticipated legal framework for derivative actions challenging officers’ conduct.  Although corporations and their counsel may take some comfort in the Court’s pronouncement that “bad faith,” rather than the lesser negligence standard, is required to establish liability, the opinion raises a host of questions and considerations for Delaware corporations confronting this developing area of legal risk.  Other jurisdictions may also follow Delaware’s lead, thereby introducing additional risks for non-Delaware corporations.

First and foremost, Vice Chancellor Laster articulated a flexible legal framework that will likely evolve. In the past few years, Delaware courts have limited directors’ Caremark liability to instances where the oversight at issue concerns “mission critical” risks, like, for example, airplane safety in the Boeing derivative case or food safety in the Marchand v. Barnhill litigation. This “mission critical” limitation is missing from Vice Chancellor Laster’s analysis.  Also missing from the analysis is language, which has appeared in Caremark opinions for decades, reminding litigants that Caremark claims are among the most difficult theories to sustain under Delaware law.  These omissions may be telling. 

What the McDonald’s opinion appears to articulate is a flexible standard for officer liability that is not limited to oversight of “mission critical” risks or even readily-defined issues.  This could subject officers to a broader duty of oversight than directors.  It also creates a host of practical questions for companies.  For example, what types of risks are subject to an officer’s duty of oversight?  How will courts define a particular officer’s domain?  What risks might trigger liability even if they are not within the officer’s “domain”?  These are important issues and their resolution will determine perhaps the most significant question of all:  whether Caremark claims will remain as difficult to plead and prove as Chancellor Allen intended.  With more questions than answers at this point, officers should continue to assess the steps they can take to ensure adequate oversight of issues relevant to their particular roles.

Second, companies may wish to re-define their corporate officers and re-evaluate their respective employment and indemnification agreements as well as their D&O coverage structure.  Delaware law defines officers as individuals who are appointed/removed by the board or who are designated as officers under the company charter and by-laws.  In light of the McDonald’s opinion, it is important to ensure that those officers are covered under the company’s D&O insurance program. 

Third, companies may wish to amend their charters to incorporate the August 2022 amendments to Section 102(b)(7) of the Delaware General Corporation Law.  That amendment allows Delaware corporations to adopt exculpatory language in their certificates of incorporation limiting the personal liability of directors and officers, including the CEO, COO, CFO, and CLO.     

The opinion also has broader implications beyond the Caremark context. Scrutiny by shareholders and would-be plaintiffs over ESG, or environmental, social, and governance initiatives, has intensified in recent years.  Although the SEC’s proposed ESG rulemaking has provided some guidance about the contours of companies’ environmental obligations, the scope of their social obligations—the “S” in ESG—remains somewhat ambiguous, and questions about duties surrounding social factors will likely persist even after the SEC’s adoption of final ESG rules.  Litigants to date have made scattershot attempts to define the “S,” initiating a spate of cases over diversity initiatives and #MeToo claims.   Vice Chancellor Laster’s opinion, while not ostensibly a statement about the scope of what “social” claims should encompass, may provide litigants with a roadmap to credibly pursue a variety of ESG claims in Delaware courts and potentially elsewhere.  At a minimum, the McDonald’s holding paves the way for plaintiffs to use sexual harassment allegations as a means of pleading breach of the duty of loyalty against corporate officers.  Although this has sparked fears of a flood of employment-style litigation in Delaware, that outcome seems unlikely.  As Vice Chancellor Laster correctly pointed out, because such claims need to be litigated derivatively, “all of the protections associated with derivative claims” remain intact, including pre-suit demand hurdles.

Even though the opinion raises several questions, one thing remains clear:  Vice Chancellor Laster’s decision will not only shape the running discourse about the scope of officer liability; it will add fuel to the broader conversation about corporate responsibility that is occupying a generation of stockholders seeking greater accountability.