In the latest development in the Delaware courts’ evolving elucidation of the standards surrounding claims for breach of the duty of oversight – sometimes referred to as Caremark claims — a Delaware Court has held that the board of McDonald’s cannot be held liable for an alleged oversight duty breach in connection with the alleged scandals at the company involving sexual harassment allegations. This ruling in the directors’ favor follows closely after the same court’s recent ruling in the same case that the plaintiffs had stated a claim against an officer defendant for breach of the duty of oversight. The court’s recent rulings in the case provide extensive additional insights with respect to what must be alleged to establish a Caremark claim. Vice Chancellor Laster’s March 1, 2023, opinion in the case, dismissing the claims against the McDonald’s directors, can be found here.
The background regarding this case is set out in detail in my recent discussion of Vice Chancellor Laster’s rulings with respect to the claims against the officer defendants. Suffice it to say here that before and during 2018, a series of events arose pertaining to alleged sexual harassment at the company, including a wave of complaints filed with the EEOC; a ten-city strike by employees across the U.S.; and an inquiry from a U.S. Senator seeking to investigate sexual harassment issues.
In December 2018, the directors learned that the company’s Global Chief People Officer, David Fairhurst, had allegedly engaged in an act of sexual harassment, the investigation of which uncovered that in 2016 the same individual had engaged in a prior incident of sexual harassment. In November 2019, the director defendants terminated company CEO Stephen Easterbrook after learning that he had engaged in an improper relationship with an employee. At the same time, the board terminated Fairhurst with cause based on a further allegation of misconduct. (There is more to Fairhurst’s and Easterbrook’s alleged misconduct; please refer to the prior post for further detail.)
The plaintiffs filed a shareholder derivative lawsuit against the company. They alleged that from 2015 until 2020, the company’s directors ignored red flags about a corporate culture that condoned sexual harassment and misconduct. The plaintiffs also alleged that the directors breached their fiduciary duties by terminating Easterbrook without cause, given the allegations against him. The plaintiffs also allege that the decision to hire Easterbrook in the first place and that the decision to give Fairhurst one Last Chance after the 2018 incident came to light breached their fiduciary duties. Finally, the plaintiffs alleged that in terminating Easterbrook without cause, allowing him to keep millions of dollars in compensation, the directors engaged in Waste. The defendant directors filed a motion to dismiss.
The March 1, 2023, Opinion
In a detailed 78-page opinion, Vice Chancellor Laster granted the defendant directors’ motion to dismiss. In granting the motion, he specifically held that the plaintiffs had not presented allegations sufficient to sustain a claim for breach of the duty of oversight.
Vice Chancellor Laster opened his analysis of the duty of oversight claims by observing that corporate fiduciaries “cannot act loyally” if “they consciously ignore evidence that the corporation is suffering or will suffer harm.” To support a claim under this theory, Laster said that plaintiffs “must allege facts supporting an inference that the directors knew about a problem – epitomized by the proverbial red flag – yet consciously ignored it.” To meet this test, plaintiffs must plead more that that the directors “responded in a weak, inadequate, or even grossly negligent manner.” The pled facts must “indicate a serious failure of oversight sufficient to support an inference of bad faith.”
Having stated these standards, Vice Chancellor Laster found that “the plaintiffs have pled facts supporting an inference that the Director defendants knew about a problem with the sexual harassment and misconduct at the Company.” Here, he cited the series of events at the company in 2018, which, Laster said, put the director defendants on “notice of a threat” to the company. In addition, he said, there is “one more brutal fact” – that is the fact that Fairhurst himself had engaged in sexual misconduct on more than one occasion. When the head of the human resources function has “repeatedly engaged in sexual harassment,” Laster said, “that is the most vibrant of red flags regarding a potential problem with sexual harassment and misconduct.”
That said, Laster still concluded that the plaintiffs had not stated a claim for breach of the duty of oversight against the director defendants. What the complaint does not do, Laster said, is to plead sufficient facts to support an inference that the director defendants failed to respond.
Throughout 2019, Laster said, the director defendants “engaged with the problem of sexual harassment at the company; the company hired outside consultants, revised company policies, implemented new training programs; and took other steps “to establish a renewed commitment to a safe and respectful workplace.” Given that response, Laster said, “it is not possible to draw a pleading-stage inference that the Director Defendants acted in bad faith.” The pleadings “do not support a reasonably conceivable claim against them for breach of the duty of oversight.”
With respect to the plaintiffs’ allegations that the director defendants breached their fiduciary duties by terminating Easterbrook without cause, Laster said that while “reasonable minds can disagree about whether the Director Defendants made the right decision by opting initially to terminate the CEO without cause,” and even if the director defendants “made an objectively wrong decision” in that regard, the business judgment rule “protects them from liability for a good faith error.” It is worth noting with respect to Laster’s ruling on this issue that he expressly referred to the presence of an exculpatory provision in the company’s corporate charter.
Judge Laster made the same ruling with respect to the plaintiffs’ allegations that the defendants breached their fiduciary duties in their initial decision to hire Easterbrook as CEO and their decision to give Fairhurst one Last Chance after the 2018 incident. These decisions, Laster said, are “similarly debatable.” The business judgement rule “protects those decisions as well.”
Finally, Vice Chancellor Laster rejected the plaintiffs’ waste claims. The plaintiffs had argued that the directors’ decision to structure Easterbrook’s termination as without cause was so one-sided that no rational person would approve it. Laster said that “although reasonable minds could disagree with the Director Defendants’ course of action, the bargain was not so out of whack as to constitute waste.” While some might argue that a termination for cause “would have been more beneficial” to the company, that “is not the test.” The decision to terminate the CEO without cause “was not so extreme as to support a pleading stage inference of bad faith.”
There is much here that will hearten defense-side advocates and comfort directors concerned about their potential liability. Notwithstanding Laster’s earlier decision with respect to the applicability of the duty of oversight to corporate officers — a ruling that has engendered a great deal of discussion and controversy — his decision here with respect to the company’s directors seems to highlight just how difficult it is for plaintiffs to sustain liability claims with respect to corporate directors. Laster’s decision does seem to answer commentators and critics who had voiced concerns that a breach of duty of oversight claim might not, despite all of the representations about Caremark claims over the years, be one of the most difficult of all claims to sustain against directors.
While much of the discussion of this decision – let’s call it McDonalds II – will focus on his discussion of breach of the duty of oversight issues, his separate but related discussion of the applicability of the business judgment rule to the plaintiffs’ claim concerning the CEO’s termination should not be overlooked. His rulings demonstrate just how extensive the protection of the business judgement rule is for directors. His invocation of the exculpatory provision in the company’s charter is also noteworthy and should not be overlooked by those charged with taking steps to try to protect corporate directors from liability.
I am sure that many observers, reviewing the recent decisions of the Delaware courts with respect to breach of the duty of oversight claims, may wonder in the wake of this latest ruling where we are with respect to these kinds of claims.
This question seems particularly compelling given the egregiousness of the underlying allegations here. The fact is that the circumstances here are beyond appalling – it isn’t hard to extrapolate here that the reason a culture of tolerance of sexual misconduct existed at the company is that the company’s top executives themselves were engaging in repeated instance of misconduct. Indeed, let us not forget that in his prior ruling in this case (we’ll call it McDonald’s I), Laster expressly found that the plaintiff had stated sufficient allegations for a breach of the duty of oversight against Fairhurst to be sustained
On the one hand, Delaware’s courts have sustained claims with respect to breach of the duty of oversight by Boeing’s board with respect to the Max 737 air disasters, and with respect to Blue Bell Creamery’s board in connection with the listeria outbreak in its ice cream manufacturing facilities (in the Marchand v. Barnhill case).
On the other hand, allegations of breach of the duty of oversight have been found to be insufficient with respect to one of the largest ever cybersecurity breaches (in the Marriott case), and now with respect to allegations of an pervasive atmosphere of sexual harassment and misconduct at McDonald’s.
A cynic might say that the differentiating fact between the cases where the allegations were found to be sufficient versus the cases related to underlying circumstances involving human deaths, while the unsuccessful cases did not. As tempting as it might be to try to assert this analysis, it overlooks the fact that, in this case, the allegations against Fairhurst were found (in McDonalds I) to be sufficient to sustain oversight duty breach claim. So the cynical explanation is not helpful in trying to sort out the decisions.
A more reasoned analysis, particularly with respect to the McDonald’s case, would cite the difference in the allegations about what the respective boards of directors did with respect to the alleged red flags. In this case, as Vice Chancellor Laster found, the directors were able to show that they did not disregard the red flags, whereas in the Boeing case, Vice Chancellor Zurn found that the plaintiffs were able to present sufficient allegations that the directors did not respond to the red flags.
The various references in the Delaware courts’ decisions about the breach of the duty of oversight to “red flags” and to “mission critical” operations has been the source of a great deal of discussion and controversy. In that regard, in McDonalds II, Vice Chancellor Laster explained that a plaintiff may establish a Caremark claim by alleging either that (1) the directors utterly failed to implement a reporting or information system; or (2) having implemented such a system or controls, the directors consciously failed to monitor or oversee the operations. He refers to these two types of claims and prong-one and prong-two claims. Red flag type allegations are relevant to the prong-two type claims.
The McDonald’s claims, Laster said, is one of these prong-two claims, about which Laster emphasized it is not necessary to show that the red flags were with respect to “mission critical” operations. Allegations that a function or operation is “mission critical,” Laster said, is pertinent to a prong-one claim, about the failure to establish reporting systems. Allegations of a “mission critical” function does not play a similar role in prong-two red flag claims. However, if a red flag allegation involves a central compliance risk, then “it is easier to draw an inference that a failure to respond meaningfully resulted from bad faith.” I emphasize these aspects of Laster’s opinion here because the role of “red flag” and “mission critical” operations in pleading Caremark claims has been the source of a great deal of discussion, and, arguably, confusion. Laster’s comments on these issues may be helpful in sorting out some of this confusion.
The key to understanding Vice Chancellor Laster’s decision, and in particular in his dismissal of the claims against the director defendants, is that the directors were able to show that they had “engaged with the problem” that the evident red flags signaled. Given that response, the plaintiffs allegations of breach of the duty of oversight could not be sustained. The lesson for directors is to put themselves in a position to show that they responded to and engaged with “red flags” that come to their attention. Well-advised boards will put processes and structures in place to ensure that they are informed of identified risks and that the are taking steps to “engage with” identified risks.