In a far-reaching decision with significant implications, the Delaware Chancery Court recently issued a decision confirming that Caremark duty of oversight obligations extends to senior officers.  This will have an immediate impact on shareholder derivative risks and litigation.  Companies now will face duty of oversight breach claims that include or even just focus on senior officers who have breached their fiduciary duty of oversight. 

Vice Chancellor Laster denied a motion to dismiss In re McDonald’s Corp. S’holder Derivative Litig., No. 2021-0324, 2023 WL 387292 (Del. Ch. Jan. 25, 2023), finding that the former head of resources for McDonal’s food breached his fiduciary duties by: (1) ignoring red flags regarding sexual harassment and misconduct at the company and (2) personally engaging in sexual harassment. 

In his ruling, Vice Chancellor Laster stated his ruling “clarifies that corporate officers owe a duty of oversight,” and rejected the defendant’s claim  that Delware law does not impose the same obligations on corporate officers that apply to corporate directors in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).

The Court explained that the defendant owed the company a fiduciary duty of oversight to make a good faith effort to “put in place” reasonable information systems” to fulfill his obligations and responsibilities in order to report to the CEO and the board, and that he should not have ignored red flags that indicated the company was going to face serious harm.

Plaintiffs claimed that the defendant exercised inadequate oversight with regard to sexual harassment that occurred at McDonald’s franchises.  The Court explained that a Red-Flags Claim must be based on plead facts that support the inference that the officer knew of evidence of corporate misconduct and that the officer consciously failed to take action in response.  In the Court’s view, the plead facts must support a reasonable inference that the failure to act was systematic or striking and constituted bad faith.  In other words, the officer had notice of serious misconduct and brushed it off or failed to investigate.

In its ruling, the Court found that the plaintiffs identified a number of red flags, including coordinated complaints to the Equal Employment Opportunity Commission, employee walkouts and protects about sexual harassment, and specific Congressional inquiries.  The Court further noted that the defendant was the executive officer with day-to-day responsibilities for oversight of the human resources function and was supposed to have his “ear-to-the-ground” about the company’s employees.

The Court further ruled that the plaintiffs had plead sufficient facts from which a reasonable inference could be reached that the defendant acted in bad faith.  In support of this finding, the Court cited the allegation that the defendant himself engaged in multiple acts of sexual harassment, and was formally reprimanded for such conduct, as well as specific allegations that McDonald’s human resource department ignored complaints of sexual harassment and employees feared retaliation for reporting complaints.

The Court’s decision is likely to lead to an increase in derivative claims against senior officers at companies.  While this increase may occur, it is important to remember that such claims must meet a “bad faith” standard, requiring evidence of a conscious disregard of red flags as opposed to a finding of negligence.  Notwithstanding this higher standard of proof, the risk associated with senior management conduct will certainly multiply and greater attention to such risks will be required. 

Senior officers who fail to act or follow up in response to red flags will certainly fall to increased litigation.  It is important to note that a red flag is not an indication that misconduct has or will occur but can extend to situations where there are facts known to the actor that indicate a significant probability that misconduct has or will occur.  If anything, the new standard will require senior officers to follow up and to document exactly what steps they took to inquire and resolve the red flag.  A failure to act in these circumstances will create real and tangible risks of litigation.