In a shareholder claim against the former global head of HR at McDonald’s, the Delaware Chancery Court has held that liability for breach of the duty of oversight, which Delaware courts had previously extended only to corporate directors, can also extend to corporate officers, as well. In addition, in a separate part of the opinion that may not gain as much attention as the duty of oversight ruling, the same court also held that a breach of fiduciary duty claim can be alleged against an officer based on sexual harassment allegations. The court’s January 25, 2023 opinion in this case, a copy of which can be found here, is likely to be the subject of scrutiny, commentary, and controversy.

Background

From 2015 through his termination for cause in 2019, David Fairhurst served as Executive Vice President and Global Chief People Office of McDonald’s. Fairhurst assumed this position shortly after Stephen Easterbrook became the company’s CEO. (The two had previously been colleagues in the company’s London office). The plaintiffs in the subsequent shareholder action alleged that Easterbrook and Fairhurst promoted and participated in a “party atmosphere” that included alcohol at company events.

Beginning in October 2016, the company faced increasing public scrutiny concerning alleged sexual harassment and misconduct. In 2016 and 2018, the company was the subject of rounds of EEOC complaints alleging both individual instances of misconduct and broader systemic issues. In September 2018, company workers in ten U.S. cities organized a strike to protest sexual harassment and the company’s alleged failure to address the issue. In December 2018, a U.S. senator sent the company a letter inquiring about sexual harassment complaints.

In November 2018, the company’s board received a complaint that at a party for human resources staff, Fairhurst had himself committed an act of sexual harassment. He was alleged to have pulled a female employee onto his lap. In its investigation of this incident, the board uncovered a previously unreported 2016 incident in which Fairhurst also allegedly engaged in sexual harassment. Fairhurst was not terminated but was disciplined and was required to sign a “Last Chance” letter, acknowledging his misconduct and committing to avoiding further actions.

As a result of the 2018 developments, in 2019 the company’s board engaged on the sexual harassment issue. The company’s General Counsel organized an inquiry and reporting effort, that also recommended and implemented actions intended to be remedial. During the course of 2019, the board received reports and updates, including from Fairhurst, on these efforts.

However, in October 2019, the Board learned that Easterbrook, the CEO, had engaged in a prohibited relationship with an employee. After engaging outside counsel to investigate the situation, the board, on November 1, 2019 approved a separation agreement and terminated Easterbrook without cause. (The company’s disclosures relating to Easterbrook’s termination was separately the subject of an SEC enforcement action, as discussed here).

At its November 1, 2019 meeting, the company’s board also addressed “employment issues” related to Fairhurst. The Board elected to terminate Fairhurst for cause. The court in the subsequent shareholder suit said with respect to Fairhurst’s termination that “it is reasonable to infer at the pleading stage that Fairhurst engaged in an additional act of sexual harassment that violated the Last Chance letter.”

Company shareholders subsequently filed a derivative action against the company’s board of directors, as well as against Easterbrook and Fairhurst. The plaintiffs asserted a claim against Fairhurst for breach of fiduciary duty, alleging both that he breached his duty of oversight and that he breached his duty of loyalty by engaging personally in acts of sexual harassment. Fairhurst filed a motion to dismiss, arguing that the liability for breach of the duty of oversight, which Delaware’s courts have extended to corporate directors, does not extend to corporate officers.

The January 25, 2023 Opinion

In a detailed 64-page opinion, Vice Chancellor Travis Laster denied Fairhurst’s motion to dismiss, holding that the plaintiffs had adequately pleaded both a claim for breach of the duty of oversight and a claim for breach of the duty of loyalty in connection with Fairhurst’s own alleged misconduct.

In denying Fairhurst’s dismissal motion, Vice Chancellor Laster expressly rejected Fairhurst’s contention that liability for breach of the duty of oversight does not extend to corporate officers. His decision, Laster said, “clarifies that corporate officers owe a duty of oversight,” citing extensive Delaware authority that corporate officers owe the same fiduciary duties as corporate directors, and adding that “the fact that corporate officers owe a duty of oversight does not foreclose officers from owing a similar duty.”

While recognizing that corporate officers have a duty of oversight, “its context-driven application will differ.” Some company officers – for example, the CEO – will have company-wide oversight responsibilities, while other officers’ oversight responsibilities will generally pertain to their “particular areas of responsibility.” However, officers can be liable for violations of the duty of oversight only “if a plaintiff can prove that they acted in bad faith and hence disloyally.”

As developed by the Delaware Courts, a breach of the duty of oversight claim can be either an “Information-Systems Claim” (that is, failing to have systems in place to facilitate necessary oversight) and a “Red-Flags Claim.” Vice Chancellor Laster determined that the plaintiffs’ claims against Fairhurst were of the red flags variety. In order for a red flags claim to survive a dismissal motion, Vice Chancellor Laster said, a plaintiff must plead facts sufficient to support an inference that the fiduciary knew of evidence of corporate misconduct; that the fiduciary consciously failed to take action; and that the failure was sufficiently sustained, systematic, or striking to constitute action in bad faith.

In concluding that the plaintiffs’ allegations satisfied these requirements, Vice Chancellor Laster first concluded that, in his HR role, Fairhurst owed a duty of oversight with respect to the company’s workforce. He concluded further that the plaintiffs had alleged facts sufficient to establish red flags indicating sexual harassment at the company, as well as to support a reasonable inference that Fairhurst knew about the red flags.

In concluding that Fairhurst had acted in bad faith by consciously ignoring the red flags, Vice Chancellor Laster put a great deal of weight on the allegations of Fairhurst’s own alleged misconduct, observing that “When a corporate officer himself engages in acts of sexual harassment, it is reasonable to infer that the officer consciously ignored red flags about similar behavior by others.”

In a short but nonetheless important final section of his opinion that could be overlooked given his other holdings on the duty of oversight issue, Vice Chancellor Laster addressed the plaintiffs’ further and analytically distinct allegation that Fairhurst had also violated his fiduciary duties by engaging personally in acts of sexual harassment.

In concluding that the plaintiffs had sufficiently stated a claim on this basis, Vice Chancellor Laster noted that “When Fairhurst engaged in sexual harassment, he was not acting subjectively to further the best interests of the Company. He was therefore acting in bad faith.” Laster added further that “It is not reasonable to infer that Fairhurst acted in good faith and remained loyal to the Company while committing acts of sexual harassment, violating company policy, violating positive law, and subjecting the Company to liability. It is reasonable to infer that Fairhurst acted disloyally and for an improper purpose, unrelated to the best interests of the Company.”

Discussion

Vice Chancellor’s opinion in the Fairhurst case will undoubtedly be the subject of extensive discussion and analysis in the weeks and months ahead. A great deal of the discussion will focus on the question of whether or not he was correct in holding that liability for breach of the duty of oversight, which had previously been extended by Delaware’s courts only to corporate directors, also extends to corporate officers. Vice Chancellor Laster obviously anticipated the possibility of controversy on this topic; much of his opinion consists of several verbal and analytic buttresses intended to allow his opinion to withstand any criticism.

Laster’s conclusion that liability for breach of the duty of oversight can extend to officers as well as to directors may be, in and of itself, unobjectionable. Laster is quite correct when he quotes extensively from prior Delaware Supreme Court decisions stating that “the fiduciary duties of officers are the same as those of directors.” This general proposition, supported by the reasoning of the Caremark decision, justify the conclusion that the duty extends to officers as well as to directors.

Where I start to part ways with Vice Chancellor’s analysis has to do with his analysis that follows after his conclusion that officers as well as directors can be liable for breaches of the duty of oversight.

One consideration entirely missing from his analysis and discussion is whether the oversight  being questioned here related to a corporate function that was “mission critical.” This “mission critical” element was a fundamental component of the Delaware Supreme Court’s analysis in the Marchand v. Barnhill decision and in the Boeing decision. Food safety, the court said in Marchand, was mission critical to the defendant company, an ice cream manufacturer. Airplane safety, the court said in Boeing, was mission critical for the airliner manufacturer. For mission critical functions, having monitoring systems and responding to red flags is indispensable. Failure to take these steps, the courts said, violated the oversight duties.

It seems to me the absence of discussion of this “mission critical” element is important. It would have been interesting to see what Vice Chancellor Laster would say on the question of whether or not employment practices activities – a basic corporate activity common to all companies — were mission critical to McDonald’s. It seems hard to say that the EPL activities at the heart of this case are the equivalent to, say, food safety in the Marchand case or airliner safety in the Boeing case.

As UCLA Law Professor Stephen Bainbridge, on his eponymous blog ProfessorBainbridge.com, puts it in his discussion of Vice Chancellor Laster’s opinion, to what sort of conduct does the duty of oversight belong? Does it, as Vice Chancellor Laster’s opinion inferentially seems to suggest, apply to all corporate functions?

I raise these objections because of a fundamental concern, which is whether or not the Delaware courts are going too far in sustaining breach of the duty of oversight claims. There was a time, not too long ago, when Delaware’s courts made a point of saying that claims for breach of the duty of oversight are among the most difficult under Delaware law to sustain; indeed, the restatement of this difficulty was virtually an obligatory part of the discussion by any Delaware court of oversight duty claims. Tellingly, Vice Chancellor Laster’s opinion omits this ritualistic restatement of how difficult it is for plaintiffs to sustain a breach of the duty of oversight claim.

None of this should be interpreted to suggest that the underlying allegations of misconduct are not serious; the question is not whether or not the underlying allegations are disturbing (which they undoubtedly are), the question is whether these kinds of allegations match up to the legal theory on which the plaintiffs are attempting to proceed.

Therein lies my concern: even if we can agree with Vice Chancellor Laster that there is no reason under Delaware law why liability for breach of the duty of oversight should not extend to officers as well as directors, are the plaintiffs’ allegations in this case sufficient to state such a claim? Should Vice Chancellor Laster have included a discussion of the “mission critical” function component of the analysis? My concern here is that in light of this decision, it may be easier for plaintiffs to sustain claims that both officers and directors have breached their duty of oversight. In that regard, I note that academic commentators had already raised the alarm that oversight duty breach claims are not in fact the most difficult kind of claim to sustain, and in fact they increasingly are being sustained with alarming frequency.

But that is not my biggest concern about Vice Chancellor Laster’s opinion. My biggest concern is his brief but nonetheless explosive conclusion that allegations of sexual harassment against a corporate officer can state a claim for breach of fiduciary duty. The possibilities for this conclusion to do mischief are incalculable – they raise the possibility that every sexual misconduct claim will become a Delaware Chancery Court D&O claim brought by shareholders in addition to an employment practices liability claim brought by the victim of the alleged misconduct.

Indeed, Vice Chancellor Laster recognizes in his opinion that his conclusion about the breach of fiduciary duty claim will raise these kinds of concerns. He expressly notes in his opinion that “Some might ask whether the Court of Chancery should be hearing sexual harassment claims and worry that recognizing such a claim will open the floodgates to employment-style litigation.” He is correct about this, a lot of people will indeed be asking this very question. In response, however, Laster notes only that because this type of claim would be a derivative lawsuit, it would be subject to all of the defenses associated with derivative claims, such as the demand requirement; he also adds that mere claims of misconduct will not suffice to support the fiduciary duty claim.

From my perspective, Vice Chancellor Laster’s conclusion about breach of fiduciary duty claims based on alleged sexual misconduct is most unfortunate. I could be proven wrong – and I hope I am – but there is a very real risk that the court’s recognition of the validity of this type of claim could indeed open the floodgates to these kinds of shareholder claims. One can only hope that on appeal, the Delaware Supreme Court cleans up this part of Laster’s opinion – and perhaps does the same for the rest of the opinion as well.

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