Early this year, on January 25, 2023, the Delaware Court of Chancery extended the duty of oversight required of a corporation’s directors to its corporate officers, in In re McDonald’s Corp. Stockholder Derivative Litigation, No. 2021-0324-JT, 2023 Del. Ch. LEXIS 23 (Jan. 25, 2023). Before McDonald’s, the Delaware standard had been governed by the 1996 decision in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). Caremark held that corporate directors breach their duty of oversight if they:
- Fail to ensure effective information and reporting systems exist; or
- Ignore the red flags indicating wrongdoing, when the director (i) knows of the red flags, (ii) consciously fails to take action, and (iii) the failure to take action was sufficiently sustained, systematic, or striking as to constitute bad faith.
The reasoning in Caremark was adopted by the Delaware Supreme Court, again only recognizing the oversight duties for directors. See Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006).
In McDonald’s, the Chancery Court focused on the second, “red flag” prong of the Caremark decision. The defendant officer, David Fairhurst, served as McDonald’s Executive Vice President and Global Chief People Officer—in other words, head of human resources. Shareholders of McDonald’s Corporation brought a derivative action against Fairhurst and others, alleging that Fairhurst “breached his fiduciary duties by allowing a corporate culture to develop that condoned sexual harassment and misconduct.” In re McDonald’s Corp. Stockholder Derivative Litig., 2023 Del. Ch. LEXIS 23, at *2.
Specifically, between 2015 and 2019, McDonald’s faced complaints from the U.S. Equal Employment Opportunity Commission and a congressional investigation related to alleged sexual harassment at numerous McDonald’s restaurants, as well as allegations of a “party atmosphere” at McDonald’s headquarters and improper conduct by then-CEO Stephen J. Easterbrook and Fairhurst. Easterbrook was terminated by the board after it became known that he engaged in an inappropriate relationship with a subordinate employee. Fairhurst was aware of that relationship, yet he took no action. Additionally, Fairhurst himself committed several acts of sexual harassment against subordinate employees. As a result of this misconduct, McDonald’s terminated him. In the derivative action, the stockholders alleged that Fairhurst was aware of Easterbrook’s inappropriate relationship with a subordinate yet ignored it, turned a blind eye to pervasive allegations of sexual harassment at the company, engaged in three acts of sexual harassment against subordinate employees, ignored complaints about the conduct of other coworkers, and never reported red flags to the Board (i.e., the proverbial “fox guarding the henhouse”).
The court first acknowledged that while Delaware has not expressly extended the duty of oversight to officers, the Delaware Supreme Court has noted that the duties of officers are the same as the duties of directors. Extending that reasoning, the court noted that unlike directors, who have broad duties of oversight, “officers generally will only be responsible for addressing or reporting red flags within their areas of responsibility, although one can imagine possible exceptions.” Id. at *55. However, a “particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.” Id. at *5. The court held that the shareholders adequately pleaded a Red Flag Claim, showing “an inference that the fiduciary knew of evidence of corporate misconduct.” Id. at 67.
The court further held that the shareholders sufficiently stated a claim against Fairhurst for breaching his duty of loyalty by harassing subordinate employees. The court noted that a “corporate officer who uses a position of power to harass, intimidate, or assault employees clearly acts for a purpose other than that of advancing the company’s interests.” Id. at *77. When Fairhurst was engaging in sexual harassment, he was acting in bad faith and not in the best interest of the corporation, breaching his duty of loyalty.
The McDonald’s decision implicates directors and officers liability (“D&O”+) coverage, which is designed to cover corporate directors and officers for claims alleging breaches of duties to shareholders. Although McDonald’s decision expands the breadth of the Caremark duty of oversight to officers, D&O policies already encompass potential officer liability in their coverage. Both directors and officers are covered under Side A (for non-indemnifiable amounts) and Side B (which covers the company for amounts paid as indemnification). A monetary judgment or settlement in a shareholder derivative action like McDonald’s is not indemnifiable by the company because the company is the plaintiff. Thus, the defendant directors and officers should be covered directly under Side A, with no retention, for any monetary settlement or judgment. Defense costs in a derivative action are typically indemnifiable and thus should be covered under Side B coverage, subject to retention. However, the Chancery Court’s holding in the McDonald’s case may further implicate Side A coverage because directors and officers may not be able to be indemnified if they are determined to have acted in bad faith and against the interest of the company.
Lastly, given the expansion of officer liability in Delaware, D&O insurance underwriters may request more detailed information on the number of officers, the process for electing or appointing officers, and how a corporation defines the officer role. Policyholders should consult with their insurance broker professionals and outside insurance coverage counsel each year when seeking or renewing their D&O coverage.