On Jan. 25, 2023, the Delaware Court of Chancery issued an opinion with significant implications for American corporate law. In denying the defendants’ motion to dismiss in In re McDonald’s Corporation Stockholder Derivative Litigation, Vice Chancellor J. Travis Laster held, for the first time, that corporate officers owe a specific duty of oversight comparable to that of directors.
The plaintiffs alleged that a former human resources executive breached his fiduciary duties of care and loyalty by consciously ignoring systemic issues of sexual harassment and misconduct in the organization, as well as through his own acts of sexual harassment. The defendants moved to dismiss the claim, alleging that Delaware law does not impose a duty of oversight upon corporate officers.
While noting that “[n]either the Delaware Supreme Court nor this court has said explicitly that officers owe oversight duties[,]” Laster drew upon a wide array of authorities for the groundbreaking holding that officers owe a company — and its stockholders — a duty of oversight, including Delaware Supreme Court and Court of Chancery jurisprudence, academic commentary, principles of agency law and the Federal Organizational Sentencing Guidelines.
The court noted two primary types of an officer’s duty of oversight. The first is that an officer must “make a good faith effort to establish an information system that [will] generate the information necessary to manage the [officer’s] function.” The alleged failure to do so would result in an information systems claim, which requires plaintiffs to prove an officer knowingly failed to adopt such a system. The second is that an officer must address or report upward problematic issues in the company. Not doing so would comprise a red flags claim, which requires plaintiffs to prove an officer knew of corporate misconduct and consciously failed to take action in response.
Laster opined that, “[a]s with a director’s duty of oversight, establishing a breach of the officer’s duty of oversight requires pleading and later proving disloyal conduct that takes the form of bad faith.” To survive a motion to dismiss, plaintiffs must establish that a defendant acted in bad faith by consciously failing to make a good faith effort to establish internal reporting systems, or by consciously ignoring red flags. It is imperative that plaintiffs plead sufficient facts to raise an inference of an officer’s scienter in this regard.
In arriving at this conclusion, Laster traced a path from the Delaware Supreme Court’s 1963 opinion, Graham v. Allis-Chalmers Manufacturing Co., which established liability for directors who consciously ignored “red flags indicating wrongdoing”; through In re Caremark International Inc. Derivative Litigation, which clarified and expanded director oversight duties; and to the present day. As the court here noted, “just as a senior manager with supervisory duties can hold a junior manager accountable for failing to fulfill the junior manager’s supervisory duties, so too can a board with a duty of oversight hold an officer accountable for failing to fulfill the officer-level duty.”
Laster stated that, though oversight duties of corporate officers are equal to those of directors, the application of the duties is context-driven and will differ. While “[s]ome officers, like the CEO, have a company-wide remit … [o]ther 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.” Additionally, though the bounds of an officer’s duty to report red flags upward in the company generally share a similar breadth, Laster noted that “[a] particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.” What constitutes an “egregious” red flag likely will be the subject of dispute in future litigation regarding breach of officers’ oversight duties.
Also noteworthy was the court’s refusal to dismiss the plaintiffs’ claims that the officer breached his fiduciary duty of loyalty by personally engaging in acts of sexual harassment. The court remarked that, “[w]hen [he] engaged in sexual harassment, he was not acting subjectively to further the best interests of the Company[,]” and was therefore acting in bad faith. Laster concluded that “[s]exual harassment is bad faith conduct. Bad faith conduct is disloyal conduct. Disloyal conduct is actionable.” Sexual harassment claims, typically brought under the framework of employment law, have not historically formed the basis of derivative suits under Delaware law, and allowing plaintiffs to plead such officer misconduct as a breach of the duty of loyalty could have wide-ranging ramifications.
Despite Laster’s expression that “[a] flood of new employment-style claims seems unlikely[,]” this opinion could lead to a substantial increase in litigation directed at officers for breaches of oversight duties. This new liability is best understood amidst recent legislative changes to allowable officer exculpatory clauses in corporate charters in the state of Delaware, which authorized corporations to insulate officers from care-based liability for direct claims by stockholders, but not derivative suits. This lack of protection, combined with Laster’s ruling, could result in a chilling effect on the service of qualified officers. Companies and corporate officers should watch the Delaware legislature closely for potential further amendments to Section 102(b)(7) permitting exculpation of corporate officers for derivative suits.
Other areas for companies and corporate officers to consider in light of this opinion include:
- how corporations augment their internal information reporting systems;
- how Delaware Court of Chancery jurisprudence evolves when determining the scope of officers’ oversight duties;
- how the market for directors and officers insurance responds, and whether there are increases to premiums and retentions as a result of this decision; and
- how corporations structure their insurance portfolios, including possible additions of supplemental indemnification coverage or additional defense coverage.