Scope of Corporate Officer Liability Broadens Under Delaware Law

Though it’s the second smallest state in the country, Delaware has long had outsized influence in the realm of corporate law. Long deemed one of the premier states for the formation of business entities, Delaware now boasts that more than one million businesses have made it their legal home. That volume of companies inevitably contributes to a wealth of corporate litigation. Moreover, state corporate law cases in Delaware are tried exclusively by judges, not juries, a fact thought to have created more predictability in litigation outcomes.  However, despite the broad sweep of Delaware’s statutory framework and the depth of its body of corporate case law, there was until last week, surprising uncertainty with respect to a pretty fundamental question: do corporate officers have legal duties of oversight that are as extensive as the oversight obligations of corporate directors? The Delaware Court of Chancery took a substantial step last week towards resolving that uncertainty, ruling that a McDonald's Corp. officer had oversight obligations on par with directors. That decision will likely have far-reaching implications.

In a shareholder derivative suit against former McDonald's executive David Fairhurst, the Delaware Court of Chancery adjudicated Fairhurst’s motion to dismiss a claim asserted against him for breach of an alleged duty of oversight. Fairhurst served as Executive Vice President and Global Chief People Officer of McDonald’s from 2015 until he was terminated for cause in 2019. The court’s opinion noted as background that Fairhurst was the executive officer with day-to-day responsibility for ensuring that the company “provided its employees with a safe and respectful workplace.”

Suing on the Company’s behalf, shareholders allege in this ongoing suit that during Fairhurst’s tenure as the head of human resources, he breached his fiduciary duties by allowing a corporate culture to develop that condoned sexual harassment and misconduct. They assert that Fairhurst’s fiduciary duties included a duty of oversight, which required that he take various identified concrete steps that would put him in position to be able to, among other things, report to top company executives any red flags regarding sexual harassment and misconduct at the Company.

The plaintiffs argue that Fairhurst breached his duty of oversight by consciously ignoring red flags. Fairhurst moved to dismiss the oversight claim for failing to state a claim on which relief can be granted. Fairhurst asserted that Delaware law does not impose on officers any obligations comparable to the duty of oversight articulated by the Court of Chancery in a seminal decision on director duties and liabilities, In re Caremark International Inc. Derivative Litigation.

The Court of Chancery rejected Fairhurst’s argument, denying his motion to dismiss the “duty of oversight” claim. Its written opinion expressly “clarifies that corporate officers owe a duty of oversight. The same policies that motivated [the court in Caremark] to recognize the duty of oversight for directors apply equally, if not to a greater degree, to officers. The Delaware Supreme Court has held that under Delaware law, corporate officers owe the same fiduciary duties as corporate directors, which logically includes a duty of oversight.” The court further explained that, “[j]ust as a junior manager with supervisory duties can report to a senior manager with supervisory duties, so too can an officer with a duty of oversight report to a board of directors with a duty of oversight. And 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.”

The court acknowledged that the scope of different officers’ duty of oversight would differ based on the subject matter areas for which they bear responsibility within the responsibility. “Some officers, like the CEO, have a company-wide remit. Other officers have particular areas of responsibility, and the officer’s duty to make a good faith effort  . . . only applies within that area. An officer’s duty to address and report upward about red flags also generally applies within the officer’s area, although a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain. As with the 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.”

That “bad faith” reference may, at first glance, seem like a potential limitation on the array of instances in which officers could be held to be in breach of the duty of oversight. But the Court of Chancery stated in denying Fairhurst’s motion to dismiss that “an officer cannot act in good faith while violating company policy, breaking the law, and exposing the company to liability.” That statement underscores how sweeping and profound the implications of this ruling could be. It can reasonably be assumed that companies will seek to modify policies and bylaws in ways intended to exculpate officers from certain bases of liability. Indeed, authority to do so has already been established: on August 1, 2022, a new amendment to the Delaware General Corporation Law (DGCL) became effective that expanded Section 102(b)(7) of the DGCL to allow for exculpation of not only directors, but also officers of a Delaware corporation, so as to eliminate or limit their personal liability to the corporation or its stockholders for monetary damages for breaches of fiduciary duties as a director or officer. Whether shareholder backlash against any such attempts at advance exculpation will derail those attempts will be among the many interesting things to monitor in the wake of this new precedent. Though this case may justifiably be read as, in many ways, a common-sense extension of principles already applicable to directors, that should not be understood to mean it is of modest practical impact.