For several years now, boards of directors have increasingly been accused of failing in their duty of oversight. These so-called Caremark claims can arise in a number of contexts involving allegations of systemic failures or willful misconduct. Recently, the Delaware Court of Chancery ruled for the first time that officers have the same duty of oversight as directors, an extension of Caremark that previously only applied to directors.
In In re McDonald’s Corp. Stockholder Derivative Litigation, the Delaware Court of Chancery has dismissed a motion to dismiss a claim for breach of fiduciary duty against the former Executive Vice President and Global Chief Human Resources Officer of McDonald’s Corporation (“McDonald’s” or the “Company”) relating to allegations of sexual misconduct and inadequate supervision.
David O. Fairhurst served as Chief Human Resources Officer from 2015 until his termination for cause in 2019. Fairhurst and Stephen J. Easterbrook, former Chief Executive Officer (“CEO”), worked at the Chicago headquarters and became close friends. The 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 uncomfortable. Easterbrook allegedly had intimate relationships with staff and Fairhurst allegedly failed to address complaints about executive and employee misconduct.
Starting in 2016, McDonald’s came under public scrutiny over allegations of sexual harassment and retaliation, and restaurant workers filed complaints with the U.S. Equal Opportunity Commission. employment (“EEOC”). Plaintiffs alleged that the company’s board of directors (the “board”) knowingly ignored workplace harassment not only by allowing senior executives, namely Easterbrook and Fairhurst, to violate some of the company’s standards and policies prohibiting misconduct, and also allowing a culture of widespread harassment and excessive drinking to flourish at McDonald’s corporate headquarters and restaurants across the country.
Fairhurst himself has been accused of misconduct, with the company’s compliance department finding that Fairhurst grabbed an employee and forced her onto his knees at a company party in November 2018. Fairhurst confirmed to the company in a letter that the November 2018 incident was not an isolated case. one, and that his misconduct posed a significant risk to the Company. Fairhurst continued to serve as Chief Human Resources Officer despite these findings and conclusions.
Easterbrook and Fairhurst were terminated from the company in the fall of 2019. Subsequently, the company faced multiple civil lawsuits and EEOC complaints in 2019 and 2020, based on allegations of systemic failures to address sexual harassment, including McDonald’s shareholder derivative action.
Although plaintiffs assert other claims in this action, the court ruled solely on plaintiffs’ assertion of breach of fiduciary claim only against Easterbrook and Fairhurst for allegedly engaging in sexual misconduct with employees and exercised inadequate oversight of enterprise risk management. The court ruled on the claim against Fairhurst, despite the fact that Fairhurst and the defendant directors requested that the claim be dismissed for failing to meet the demand requirement under Rule 23.1 of the Court of Chancery. One would generally expect the question of the procedural “futility of the claim” to be decided before the court addresses the substantive issues of the case.
II. Breach of fiduciary duty against Fairhurst survives
Plaintiffs claimed that Fairhurst breached its fiduciary duties in two ways: first, that Fairhurst breached duty of care by knowingly 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 rest against agents under Delaware law; (2) even if a Caremark claim is known, plaintiffs have not alleged sufficient facts to assert a claim for breach of Caremark or other breach of fiduciary duty; and (3) a claim of a duty of loyalty could only be substantiated if the facts supported an inference that Fairhurst subjectively intended to harm the Company. The court rejected these arguments.
In considering whether corporate officers have the same fiduciary duty of oversight as corporate directors (a first impression issue in Delaware), the court held that officers have a duty of oversight comparable to that of directors. . However, the court explained that officers’ monitoring duties “do not mean that the situational application of those duties will be the same.” Basically, context matters. The court explained that “officers will generally only be responsible for addressing or signaling red flags within their areas of responsibility”, but that an officer might have a duty to signal a conspicuous red flag in the chain. As for agents’ liability, the court said that “agents will only be liable for breaches of duty of care if a plaintiff can prove that (agents) acted in bad faith and therefore acted unfairly.”
The court found that the plaintiffs pleaded facts to support findings that Fairhurst knew there were red flags indicating potential issues of sexual harassment and misconduct within the company; Fairhurst consciously failed to take action in response to these red flags; and Fairhurst’s inaction was sufficiently systematic to constitute bad faith. Subsequent corrective actions taken in 2019 by the board and management, including Fairhurst, to address issues of sexual harassment and misconduct (i.e. did not override court concerns over Fairhurst’s prior knowing disregard for red flags, and his subsequent termination for another sexual harassment offense was considered by the court to support an inference of knowing misconduct.The court found that Fairhurst’s day-to-day responsibility to oversee human resources and promote a A safe and respectful work environment required him to “listen to” company employees, coordinate EEOC complaints, and escalate or report to the CEO and board of directors. court also found that Fairhurst turned a blind eye to instances of sexual harassment based on allegations that he had engaged in sexually harassed on three occasions, ignored complaints about the conduct of co-workers and managers, and never raised any red flags with management. Advice. The court found that these circumstances supported a breach of duty of care claim against Fairhurst.
With respect to Fairhurst’s duty of loyalty, the court also found that the plaintiffs brought a claim of breach of duty of loyalty regarding Fairhurst’s own involvement in multiple alleged acts of sexual harassment. Rejecting Fairhurst’s argument that the plaintiffs had failed to plead facts supporting an inference that he subjectively intended to harm society, the court held that it was not reasonable to infer that Fairhurst had acted in good faith and remained loyal to McDonald’s when he allegedly sexually harassed, violated McDonald’s policy, violated the law, and held the Company liable. The court concluded with this pointed language: “Sexual harassment is behavior in bad faith. Bad faith behavior is disloyal behavior. Unfair conduct is subject to prosecution.
III. Main takeaways and observations
There are several key takeaways and observations based on this recent McDonald’s decision.
- While this represents an extension of the law regarding duties owed by officers of Delaware corporations, it is debatable whether the courts will have ample opportunity to adjudicate oversight claims against officers. Shareholder lawsuits against executives are almost always brought derivatively. This makes sense because executives are most often accused of acts that affect the company, as opposed to individual shareholders. When there is malfeasance on the part of an executive, it will most often be dealt with by a disinterested and independent board. As such, it will be difficult for shareholders to meet the futility requirement of the claim under Rule 23.1 of the Court of Chancery. Since the McDonald’s court did not decide the question of the futility of the claim, it remains to be decided whether the claims against Fairhurst will survive. Boards of directors should ensure that, when assessing possible misconduct by company officers, they consider whether the relationship of board members with the officer in question could compromise their independence and, where appropriate, If so, whether to delegate the matter to a committee of independent directors.
- It is important for agents to ensure that they implement systems that alert them to problems in their specific areas and that they address any red flags that arise. Boards of directors should oversee the design of these systems and continually assess the completeness and effectiveness of these systems.
- It is important to note that while recent amendments to Section 102(b)(7) of the Delaware General Corporations Act would provide corporations with the ability to shield executive misconduct in certain circumstances, such an exculpation would not be helpful to executives in circumstances similar to McDonalds. The law specifically excludes actions by or on behalf of the company, which would in turn exclude from exoneration any derivative claims for lack of supervision. Further, the claims against Fairhurst for breaches of duty of loyalty and acts of bad faith could not be exculpated.
- It is entirely possible that underwriters of D&O insurance policies will increase the rates payable under such policies based on McDonald’s, regardless of the fact that, as noted, the number of claims for lack of supervision by an agent who will survive an investigation into the futility of the claim should be quite limited.