(Reuters) – If you’re a high-ranking executive at a company incorporated in Delaware, now would be a good time to check in with your D&O insurance provider.
That’s because a Chancery Court judge explicitly ruled on Wednesday, in a first-of-its-kind decision, that corporate officers owe a fiduciary duty of oversight to their company, just like the corporate board members whose oversight duties were articulated in the famous 1996 decision In re Caremark International Inc.
And like the corporate directors addressed in the Caremark decision, corporate officers who fail to fulfill their oversight duties can be sued derivatively by shareholders acting on behalf of the corporation, according to Wednesday’s decision by Vice Chancellor Travis Laster.
“Under Delaware law, corporate officers owe the same fiduciary duties as corporate directors,” Laster wrote in In re McDonald’s Corporate Shareholder Derivative Litigation. “Although no Delaware decision has stated the proposition in so many words,” the judge added, “This decision confirms that officers owe a duty of oversight.”
Laster, as Reuters reported on Wednesday, refused to dismiss a shareholders’ derivative claim against former McDonald’s chief human resources officer David Fairhurst, who allegedly breached his duty to the company by fostering a corporate culture that allowed sexual harassment and misconduct to flourish.
The Delaware judge said plaintiffs’ lawyers from Grant & Eisenhofer, Scott + Scott and Newman Ferrara adequately alleged that Fairhurst ignored multiple red flag warnings about the problem and breached his duty of loyalty by allegedly engaging in an act of sexual harassment that contributed to his termination from McDonald’s 2019.
Fairhurst’s lawyers from Smith Katzenstein & Jenkins did not respond to an email query. I also emailed Fairhurst but did not hear back.
Laster’s ruling opens a new avenue of liability for corporate officers – but it’s not clear how wide the opening is.
First, the good news for shareholders. The McDonald’s decision says unequivocally that officers such as CEOs, CFOs, general counsel and human resources bosses have a duty of loyalty to the company even if they are not on the board of directors. Delaware, as you probably know, recently tweaked its corporate code to allow companies to exculpate corporate officers from liability for breaching their duty of care. The Laster decision provides a different route to accountability via a Caremark claim for breach of the duty of loyalty.
Moreover, as Laster explained, corporate officers arguably have more responsibility than board members to police corporate conduct. Officers’ roles can be limited – CFOs oversee finances, general counsel patrol legal affairs – but as day-to-day managers of corporate affairs, Laster wrote, “the officers are optimally positioned to identify red flags and either address them or report upward to more senior officers or to the board.”
It might be easier for shareholders, in other words, to offer adequate allegations that corporate officers breached their oversight duties by disregarding warning flags than to assert similar claims against board members who meet only a few times a year.
In a worst-case reading of Laster’s ruling from the perspective of potential defendants, said Boris Feldman of Freshfields Bruckhaus Deringer, who is not involved in the McDonald’s case, the judge’s “attempt to extend Caremark from directors to officers, judicially rather than legislatively, will create even greater opportunity for abusive lawsuits.”
But for those lawsuits to succeed, shareholders must still get past the huge obstacle standing in the way of every derivative suit: They have to show that it would have been futile to expect the company’s directors to sue on the company’s behalf. (Otherwise, of course, there would be no reason for shareholders to step into the shoes of the company.)
One of the classic ways to show demand futility is to argue that board members are conflicted when they face personal liability from a suit alleging a breach of their oversight duty. Shareholders in derivative suits frequently argue that directors can’t be expected to authorize lawsuits against themselves.
That conflict argument, said plaintiffs’ lawyer Joel Fleming of Block & Leviton and professor Minor Myers of the University of Connecticut School of Law, won’t be as effective for derivative lawsuits alleging that corporate officers who are not board members breached their oversight duties. A judge might be skeptical that board members can’t be trusted to uphold the company’s interest in dealing with a disloyal corporate officer.
“It’s going to be a rare circumstance,” said Myers, “where you can say an officer is in collusion with the board.”
Fleming agreed: “How much the [McDonald’s] decision matters,” he said, “remains to be seen.”
One early indicator will come from the McDonald’s case itself. Laster’s ruling on Wednesday addressed only whether shareholders had adequately alleged that former HR chief Fairhurst had a duty of loyalty to the company and that he breached that duty.
Wednesday’s ruling did not answer the still-looming question of whether shareholders have established that it would have been futile to expect the board to sue its own members (and Fairhurst) for failing to avert the workplace scandals that roiled the company under former CEO Steve Easterbrook. (Easterbrook, who settled the company’s claw-back suit in 2021, was dismissed as a defendant in the derivative litigation.)
The nine members of McDonald’s board who are defendants in the derivative case moved last March to dismiss the suit on demand futility grounds, arguing that the directors were not conflicted because plaintiffs’ vague allegations could not have prompted board members to be concerned about their personal liability.
Shareholders retorted that board members acted in their own self-interest and breached their duties of loyalty by trying to cover up scandals. Their cover-up, according to shareholders, shows that it would have been futile to expect board members to act.
A McDonald’s spokesperson declined to provide a statement.
If Laster ends up dismissing the shareholders’ derivative suit on demand futility grounds, Wednesday’s 65-page opinion establishing that corporate officers can be liable for breaching Caremark oversight duties will be a strange bit of legal history – important precedent that didn’t decide the case.
In the meantime, said defense counsel Feldman, “The one certain result? Larger amounts of D&O coverage for officers, along with an increase in premiums.”
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