Corporate Officers Owe the Same Caremark Oversight Duties as Directors

For the past several years, boards of directors have increasingly faced claims that they have failed in their duty of oversight. These so-called Caremark claims can arise in a number of contexts involving allegations of systemic failures or intentional wrongdoing. Recently, the Delaware Court of Chancery held for the first time that officers owe the same duty of oversight as directors, an expansion of Caremark which had previously only been applied to directors.

In In re McDonald’s Corp. Stockholder Derivative Litigation, the Delaware Court of Chancery denied a motion to dismiss a breach of fiduciary duty claim against the former Executive Vice President and Global Chief People Officer of McDonald’s Corporation (“McDonald’s” or the “Company”) relating to alleged sexual misconduct and inadequate oversight.

I. Background

David O. Fairhurst served as head of human resources from 2015 until his for-cause termination in 2019. Fairhurst and Stephen J. Easterbrook, former Chief Executive Officer (“CEO”), worked in the Chicago headquarters, and became close personal friends. Plaintiffs alleged that Fairhurst and Easterbrook promoted a “party atmosphere” and a “boys’ club” with an open bar on one of the floors, as well as happy hour events that made female employees feel uncomfortable. Easterbrook allegedly pursued intimate relationships with staff, and Fairhurst purportedly failed to address complaints about misconduct by executives and employees.

Beginning in 2016, McDonald’s faced public scrutiny concerning sexual harassment and retaliation allegations, and restaurant workers filed complaints with the U.S. Equal Employment Opportunity Commission (“EEOC”). Plaintiffs alleged that the Company’s board of directors (the “Board”) knowingly ignored workplace harassment by not only allowing senior executives—namely, Easterbrook and Fairhurst—to violate certain of the Company’s standards and policies prohibiting misconduct, and also by permitting a culture of widespread harassment and excessive alcohol use to flourish in the corporate headquarters and McDonald’s restaurants across the nation.

Fairhurst himself was accused of misconduct, with the Company’s compliance department concluding that Fairhurst grabbed a female employee and forced her onto his lap at a Company party in November 2018. Fairhurst confirmed to the Company in a letter that the November 2018 incident was not an isolated one, and that his misconduct put the Company at significant risk. Fairhurst continued to serve as head of human resources despite those findings and conclusions.

Easterbrook and Fairhurst were terminated from the Company in the fall of 2019. Thereafter, the Company faced multiple civil lawsuits and EEOC complaints in 2019 and 2020, based on allegations regarding systemic failures to curb sexual harassment, including the McDonald’s stockholder derivative action.

Although plaintiffs assert other claims in the present action, the court ruled solely on plaintiffs’ assertion of a breach of fiduciary claim only against Easterbrook and Fairhurst for allegedly engaging in sexual misconduct with employees and conducting inadequate oversight of enterprise risk management. The court ruled on the claim against Fairhurst, despite the fact that both Fairhurst and the director defendants moved to dismiss the complaint for failure to meet the demand requirement under Court of Chancery Rule 23.1. One would typically expect the procedural “demand futility” issue to be decided before the court would turn to the substantive issues in the case.

II. Breach of Fiduciary Duty Claim Against Fairhurst Survives

Plaintiffs asserted that Fairhurst breached his fiduciary duties in two ways: first, that Fairhurst breached the duty of oversight by consciously ignoring red flags; and second, that he breached his duty of loyalty by engaging in acts of sexual harassment. Fairhurst argued that the claims against him should be dismissed because: (1) a Caremark claim does not lie against officers under Delaware law; (2) even if a Caremark claim is cognizable, plaintiffs failed to allege facts sufficient to state a claim for a Caremark violation or any other breach of fiduciary duty; and (3) a duty of loyalty claim could not be supported unless the facts supporting an inference that Fairhurst subjectively intended to harm the Company. The court rejected those arguments.

In addressing the issue of whether corporate officers owe the same fiduciary duty of oversight as corporate directors (an issue of first impression in Delaware), the court held that officers owe a duty of oversight comparable to that of directors. However, the court explained that the officers’ oversight duties do “not mean that the situational application of those duties will be the same.” In essence, context matters. The court explained that “officers generally only will be responsible for addressing or reporting red flags within their areas of responsibility,” but that an officer might have a duty to report a prominent red flag up the chain. As to liability for officers, the court instructed that “officers only will be liable for violations of the duty of oversight if a plaintiff can prove that [the officers] acted in bad faith and hence disloyally.”

The court found that plaintiffs pleaded facts to support inferences that Fairhurst knew that there were red flags indicating potential sexual harassment and misconduct problems at the Company; Fairhurst consciously failed to take action in response to those red flags; and Fairhurst’s failure to take action was sufficiently systematic to constitute bad faith. Subsequent remedial actions taken in 2019 by the Board and management, including Fairhurst, to address issues of sexual harassment and misconduct (i.e., engaging outside experts, revising policies, offering trainings, providing new tools to franchisees and authoring a memorandum addressing the topic), did not override the court’s concerns about Fairhurst’s prior conscious disregard of red flags, and his subsequent dismissal for another sexual harassment offense was seen by the court as supporting an inference of knowing misconduct. The court reasoned that Fairhurst’s day-to-day responsibility of overseeing human resources and promoting a safe, respectful work environment required him to “have his ear to the ground” on the Company’s employees, coordinate EEOC complaints, and address or report upward to the CEO and Board. The court also found that Fairhurst turned a blind eye to instances of sexual harassment based on the allegations that he engaged in acts of sexual harassment on three occasions, ignored complaints about the conduct of coworkers and executives, and never reported any red flags upward to the Board. The court concluded that these circumstances supported a claim for breach of the duty of oversight against Fairhurst.

Turning to Fairhurst’s duty of loyalty, the court also found that plaintiffs stated a claim for breach of the duty of loyalty as to Fairhurst’s own participation in multiple alleged acts of sexual harassment. In rejecting Fairhurst’s argument that plaintiffs failed to plead facts supporting an inference that he subjectively intended to harm the Company, the court reasoned that it was not reasonable to infer Fairhurst acted in good faith and remained loyal to McDonald’s when he was allegedly committing sexual harassment, violating McDonald’s policy, violating the law, and subjecting the Company to liability. The court ended with this pointed language: “Sexual harassment is bad faith conduct. Bad faith conduct is disloyal conduct. Disloyal conduct is actionable.”

III. Key Takeaways and Observations

There are several key takeaways and observations based on this recent McDonald’s decision.

• Although this represents an extension of the law regarding duties owed by officers of Delaware corporations, it is questionable whether courts will have many opportunities to decide oversight claims against officers. Stockholder suits against officers are almost always brought derivatively. This makes sense because officers are most often accused of acts that affect the company, as opposed to stockholders individually. When there is malfeasance by an officer, it will most often be addressed by a disinterested, independent board. As such, it will be difficult for stockholders to satisfy the demand futility requirement under Court of Chancery Rule 23.1. Given the fact that the McDonald’s court did not decide the demand futility issue, it is yet to be decided whether the claims against Fairhurst will survive. Boards should take care to make sure that when evaluating potential wrongful conduct of company officers that they consider whether Board members’ relationships with the officer in question could compromise their independence, and if so, whether to delegate the matter to a committee of independent directors.
• It is important for officers to make certain that they are implementing systems that will alert them to problems in their specific areas, and that they are addressing any red flags that arise. Boards should be overseeing the design of such systems and continually assessing the comprehensiveness and effectiveness of such systems.
• It is important to note that while the recent amendments to Section 102(b)(7) of the Delaware General Corporation Law would allow corporations the opportunity to shield officer misconduct in certain circumstances, such exculpation would not be helpful to officers in circumstances similar to McDonald’s. The statute specifically excludes actions by or in the right of the corporation, which would in turn exclude from exculpation all derivative claims for lack of oversight. In addition, the claims against Fairhurst for breaches of the duty of loyalty and bad faith actions could not be exculpated.
• It is a distinct possibility that underwriters of D&O insurance policies may increase rates payable under such policies based on McDonald’s regardless of the fact that, as discussed, the number of claims for lack of officer oversight that will survive a demand futility inquiry should be quite limited.