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Are Company Officers Responsible for Maintaining Oversight?

On Behalf of | Jan 30, 2023 | Business Litigation

The Delaware Court of Chancery recently ruled that corporate officers have a duty of oversight. While courts in other jurisdictions may not need to follow the Court of Chancery’s lead, they’re likely to review it closely. As a result, many in the legal field have already hailed this as a landmark decision that will likely influence future litigation.

Notably, the Court of Chancery did not offer a final judgment on the facts of the case. It merely reviewed and wrote about the legal issues in question. Prior to this ruling, Delaware courts had not found officers liable for breaches of oversight. So, why did the Court of Chancery say they could be liable?

In RE McDonald’s Corporation Stockholder Derivative Litigation

The Court of Chancery’s finding came after David Fairhurst, the former Chief People Officer for McDonald’s, moved to dismiss the shareholder lawsuit against him.

Fairhurst’s attorneys argued that the shareholders had no legitimate claim. The shareholders claimed Fairhurst had breached his fiduciary duties by ignoring the worsening culture of sexual harassment. His actions, they claimed, had breached his fiduciary duties of oversight, but Fairhurst argued that Delaware had never ruled that corporate officers owed a duty of oversight. That duty traditionally resided with the Board of Directors and its members.

Simultaneously, the lawsuit against Fairhurst claimed he had breached his duties of loyalty. Fairhurst allegedly committed multiple acts of sexual harassment while serving as Chief People Officer, and the shareholders claimed these acts prioritized his own interests over those of the company.

Despite the seriousness of the second claim, it is the first claim that has drawn the most attention. Fairhurst’s attorneys rightly noted that Delaware had not previously ruled that officers owed a duty of oversight. They cited the ruling by Chancellor Allen in In re Caremark International Inc. Derivative Litigation. They said that precedent did not “impose any obligation on officers comparable to the duty of oversight” that case placed on directors.

With this recent ruling, the Court of Chancery clarified that, yes, officers do owe a duty of oversight. Moreover, the court claimed, “The same policies that motivated Chancellor Allen to recognize the duty of oversight for directors apply equally, if not to a greater degree, to officers.”

Two Basic Types of Oversight Claims

As the court noted, there are two basic types of oversight claims:

  • First, there are systems claims. These allege the failure to establish any information and reporting systems that would reasonably allow directors and senior management to “reach informed judgments concerning both the corporation’s compliance with the law and its business performance.”
  • Second, there are “red flags” claims. These allege that directors, or officers, had become aware of “red flags indicating wrongdoing” but chose not to take corrective action.

The Court of Chancery identified the claim against Fairhurst as the latter. It additionally noted that the legal idea of “red flags” oversight dated back farther than Caremark. It found its origin in the Delaware Supreme Court’s ruling in Graham v. Allis-Chalmers Manufacturing Co. That case settled that directors could be liable for failing to take action when they had reason to suspect wrongdoing. Caremark was notable for clarifying that directors could also be liable for failing to implement reasonable information and reporting systems.

Notably, while neither of these cases explicitly stated that officers owed the same duty, neither argued that officers were exempt from oversight duties.

Addressing the Lack of Precedent

The Court of Chancery noted that the absence of precedent was circumstantial, rather than intentional. The courts had not ruled against officer oversight duties in prior cases. Instead, they simply hadn’t addressed them.

The court compared this to the way Europeans previously used the phrase “black swan” to talk about things that didn’t exist. “Then,” the court noted, “in the late eighteen century, Europeans arrived on the shores of Australia, where they found black swans. The fact that no one had seen one before did not mean that they could not or did not exist.”

Accordingly, the court took a fresh look at whether the law and business standards supported officer oversight. It offered several arguments that supported the idea that officers owed a duty of oversight:

  • The Delaware Supreme Court had previously equated the fiduciary obligations of officers with those of directors
  • Officers typically have the authority to make strategic decisions for the business concerns which they handle on a day-to-day basis
  • The fact the board needs to respond to information creates a mandate for officers to “generate and provide” that information
  • The expectations for compliance systems do not stop with directors but apply to “high-level individuals,” such as officers, or any “individual in charge of a major business or functional unit of the organization”

Indeed, the court noted, that compliance “[g]uidelines thus explicitly call for executive officers to undertake compliance and oversight obligations.”

The lack of precedent quickly collapsed beneath this avalanche of supporting arguments, and the Court of Chancery made sure there would be no doubt going forward. “This decision,” it wrote, “clarifies that corporate officers owe a duty of oversight.”

The Lawsuit’s Resolution Is Another Matter

It is again worth noting that the Court of Chancery did not offer a final ruling in the case. Instead, it merely denied Fairhurst’s motion to dismiss.

However, this meant that the court did more than look at whether officers could owe a duty of oversight. It also meant that it reviewed the facts presented to see if they might possibly support a legal argument. While the court noted that, at this stage, it must view all the plaintiff’s assertions as true, those assertions could weigh heavily against Fairhurst if the case proceeds to trial.

All told, the Court of Chancery listed 18 different incidents that suggested Fairhurst had ample reason to be concerned about wrongdoing within the company. Specifically, it singled out two rounds of coordinated EEOC complaints, in 2016 and 2018, each of which was followed by employees walking off the job.

From these, the court turned to Fairhurst’s own sexual harassment concerns, which it said were reason to infer he was not acting in the company’s interests. It also noted two other points that might speak to Fairhurst’s state of mind:

  • The fact that employees complained McDonald’s human resources were not responsive during Fairhurst’s tenure
  • The fact that employees who reported sexual harassment during Fairhurst’s tenure feared retaliation

Indeed, the court noted that a 2020 class action suite against the complaint stated that “three out of every four female non-managerial McDonald’s employees have personally experienced sexual harassment at McDonald’s, ranging from unwelcome sexual comments to unwanted touching, groping, or fondling, to rape and assault.”

Whether Fairhurst succeeds in the case or not, the complaint presents some heavy allegations.

Will Other Courts Follow Suit?

As noted earlier, other courts may not choose to follow this precedent. Courts from other jurisdictions may work from other laws and sets of circumstances toward other decisions. However, the Delaware Court of Chancery is one of the nation’s leading courts for business law questions such as this. Its arguments tend to echo, and the 66 pages of this argument are carefully constructed and clearly articulated.

Because of these reasons, it is likely to expect that other courts will take note of the decision and follow its logic. Certainly, businesses, shareholders, directors and officers will want to understand how the decision may impact any litigation they find themselves facing in the future.