The Delaware Court of Chancery ruled for the first time that corporate officers owe a fiduciary duty of oversight. The Court held that an officer’s duty of oversight generally applies only to matters within the officer’s areas of responsibility.
Delaware courts have consistently held that officers owe the same fiduciary duties as directors. This decision clarifies that those duties include the duty of oversight. The Court further held that sexual harassment by an officer is bad faith conduct that breaches the duty of loyalty to the corporation.
Corporations should take note and ensure they have the proper systems in place to promptly detect, report, and appropriately remedy misconduct.
The Case
This was a claim filed by the company’s stockholders alleging harm to the company against McDonald’s directors and officers, including the company’s former executive vice president and global chief people officer. The plaintiffs said he allowed a toxic culture to develop at the Company that turned a blind eye to sexual harassment and misconduct by ignoring red flags, acting in bad faith, and breaching his duty of loyalty. The plaintiffs asserted similar allegations against nine directors, claiming they were aware of a problem with sexual harassment and misconduct at the company, which they consciously ignored.
Officers Have a Duty of Oversight
The duty of oversight requires directors (and now officers) to (i) make a good-faith effort to ensure corporations have proper reporting systems, and (ii) appropriately address red flags suggestive of corporate wrongdoing. Oversight liability arises from the duty of good faith and requires a showing of bad faith by the officer or director.
The stockholders cited a lengthy list of red flags Fairhurst ignored, including numerous complaints about sexual harassment and misconduct filed by employees with the EEOC, coordinated walkouts and strikes by employees in multiple cities protesting the company’s culture relating to sexual harassment, and an inquiry by U.S. senators about sexual harassment and workplace safety.
The Court said the duty of oversight applies to officers and directors BUT only to the officer’s areas of responsibility. Officers must make a good-faith effort to establish information systems only in the areas of their responsibility and generally only will be responsible for addressing or reporting red flags within those same areas.
The Court noted an exception to this limitation for sufficiently prominent or particularly egregious red flags, which might require an officer to say something even if it fell outside the officer’s domain. The court cautioned that an officer who receives credible information indicating that the corporation is violating the law cannot turn a blind eye and dismiss the issue.
Fairhurst argued plaintiffs had not alleged sufficient facts to support an inference that he acted in bad faith. The Court rejected this argument, finding that the plaintiffs’ allegations supported a reasonable inference that Fairhurst was aware of potential issues with sexual harassment and misconduct and acted in bad faith by consciously ignoring them. The Court also pointed to Fairhurst’s own alleged sexual harassment in reaching its decision, finding that when a corporate officer himself engages in sexual harassment, it is reasonable to infer that the officer consciously ignored red flags about similar behavior by others.
The Court reached a different decision on a subsequent motion to dismiss the oversight claim against the company’s nine directors. The Court found that while the directors were aware of the company’s problem with sexual harassment, they took sufficient action to address it and therefore did not act in bad faith and breach their duty of oversight. Working with company management, the directors hired outside consultants, revised company policies, implemented new training programs, provided new levels of support to franchisees, and took other steps to establish a renewed commitment to a safe and respectful workplace.
Sexual Harassment as a Breach of the Duty of Loyalty
In the decision on Fairhurst, the Court found that plaintiffs put forth sufficient allegations to support a claim that Fairhurst breached his fiduciary duty of loyalty by allegedly engaging in sexual harassment. Fairhurst allegedly did so on three occasions, ultimately resulting in his termination in November 2019. The Court held that, when engaging in sexual harassment, the harasser engages in reprehensible conduct for selfish reasons, which harms the company by violating company policy, violating positive law, and subjecting the Company to liability. By doing so, the fiduciary acts in bad faith and breaches the duty of loyalty. In other words, selfish conduct that harms the corporation, such as sexual harassment, is bad faith conduct that breaches the duty of loyalty.
Conclusion
This decision should persuade corporations to ensure they are adequately prepared for such suits from a risk management, reporting, and compliance perspective by:
Ensuring directors, officers, and others in supervisory roles are informed of and trained on the company’s reporting systems and protocol - including how and when to report to the board.
Considering creating a policy on officer oversight obligations, including how officers should document their knowledge of and responses to red flags.
Considering how officers’ areas of responsibility and duties are defined and documented, given that oversight liability will be confined to those areas, except for egregious red flags.
Ensuring appropriate anti-harassment and anti-discrimination policies, practices, training and reporting, investigation, and compliance policies and systems are in place.
Considering revising certificates of incorporation to add clauses exculpating senior officers from personal liability for monetary damages in connection with breaches of their fiduciary duty of care, understanding they will not protect from oversight or sexual harassment fiduciary duty claims because officers cannot be indemnified for breaches of the duty of loyalty or bad faith conduct and they may not be exculpated in connection with derivative proceedings.
Confirmong, given relevant law regarding a company’s legal ability to indemnify for derivative settlements, that the company’s D&O insurance program has adequate coverage.
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