More than 25 years ago in In re Caremark, the Delaware Court of Chancery held that corporate directors owe a duty of oversight, which requires that directors in good faith both (a) implement a reasonable system for causing information to be transmitted to the board and (b) monitor that system. Because the duty of oversight is part of the duty of loyalty, oversight claims cannot be included within a corporation’s exculpation provision, leaving the individual personally liable for monetary damages associated with any breach. Stockholders suing derivatively have asserted such so-called “Caremark” claims with increasing frequency in recent years, including in the claims asserted against directors of Blue Bell Creameries USA, Inc. in connection with that company’s listeria outbreak. In last week’s In re McDonald’s Corporation Stockholder Derivative Litigation decision, the Delaware Court of Chancery held for the first time that corporate officers also owe a fiduciary duty of oversight.
In In re McDonald’s, stockholders suing derivatively on behalf of the company asserted breach of fiduciary duty claims against several former and current officers and directors, including the company’s former Global Chief People Officer, who served when the company faced increasing public scrutiny and litigation concerning allegations of sexual harassment and misconduct within the organization. The officer, who in his role oversaw the company’s human resources function, was himself disciplined and ultimately terminated reportedly based on allegations of sexual harassment. The stockholders alleged that the officer (1) breached his duty of oversight by exercising inadequate oversight in response to risks of sexual harassment and misconduct at the company and its franchises and (2) breached his duty of loyalty by personally engaging in acts of sexual harassment.
Officer Duty of Oversight
The officer moved to dismiss, arguing in part that Delaware law did not impose on officers any obligation comparable to the duty of oversight imposed on directors. Vice Chancellor Laster disagreed. While acknowledging that “to date, Delaware cases have only applied the duty of oversight to directors,” the Court held that the reasons for that duty’s application to directors applied equally to officers and noted the Delaware Supreme Court’s prior pronouncement that “the fiduciary duties of officers are the same as those of directors.”
While the Court confirmed that officers owe a duty of oversight, its holding does not open the door to broad officer liability for any claims where a company’s reporting system is inadequate or not reasonably monitored. Importantly, the Court held that officers and directors both owe duties of oversight, but it acknowledged that an officer’s scope of oversight—and thus the scope of duty—may be narrower than a director’s. As the Court put it, “Although the duty of oversight applies equally to officers, its context-driven application will differ.” Some officers, like the CEO or the Chief Compliance Officer, “likely will have company-wide oversight portfolios.” Other officers have particular areas of responsibility, and the officer’s duty applies only within that area. “For example, the . . . Chief Legal Officer is responsible for legal oversight and for making a good faith effort to establish reasonable information systems to cover that area.”An officer’s duty to address and report serious misconduct generally only exists within the officer’s area, although a “sufficiently prominent” red flag—for example, credible information that the corporation is violating the law—might require an officer to act even if it falls outside the officer’s domain.
Moreover, as with the director’s duty of oversight, establishing a breach of an officer’s duty of oversight requires pleading, and later proving, disloyal conduct that takes the form of bad faith. That is, the officer must consciously fail to make a good faith effort to establish information systems, or the officer must consciously ignore red flags.
And because these breach of fiduciary duty claims must be brought in the name of the company, a stockholder cannot bring any breach of the duty of loyalty claim against an officer without showing that the company’s board wrongfully refused a demand to bring the claim or that demand would be futile. Indeed, the Court described this requirement as the “bulwark against the stockholders liberally asserting oversight claims against officers.”
Officer Duty of Loyalty
Delaware law has long recognized that officers owe a fiduciary duty of loyalty. As to the second claim against the former Global Chief People Officer, for alleged breach of this duty based on his alleged personal engagement in acts of sexual harassment, the Court also held that plaintiffs adequately stated a claim. The Court reasoned that engaging in sexual harassment is necessarily not in the best interests of the company, and thus an allegation that a fiduciary engaged in such acts that harmed the company is a colorable claim for breach of the duty of loyalty.
In re McDonald’s breaks new ground by expanding the duty of oversight to include corporate officers and by holding that an officer’s own acts of sexual harassment constitute a breach of the duty of loyalty. But the existence of an officer duty of oversight does not mean that officers will be liable when they lack perfect vision into the operations and reporting systems below them. Rather, as the Court described in discussing this officer’s alleged disregard of his oversight duties: “He was supposed to have his ear to the ground and be knowledgeable” about his area of responsibility, and upon learning of red flags he “should have been figuring out whether something was seriously wrong and either addressing it or reporting it upward.” This case underscores the importance for directors, and now corporate officers, to make a good faith effort to implement information reporting systems or controls and to address and report upward about serious misconduct.
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