Duty of Observation Extended to Corporate Officers

by Tanner Dowdy, Notes and Comments Editor, University of Cincinnati Law Review Vol. 91

I. Introduction

Since In re Caremark Int’l Inc. Derivative Litigation was decided in 1996, the duty of observation under Delaware General Corporate Law (“DGCL”) has only been applied to corporate directors—not corporate officers.¹ The duty of observation requires directors to make a good faith effort to establish functional company information systems and respond to red flags that are reported.² As of January 2023, directors are not the only ones that carry this duty: In In re McDonald’s Corporation Stockholder Derivative Litigation, the Delaware Chancery Court extended the duty of observation to corporate officers.³ This article will review the Caremark case, summarize the holding in McDonald’s, and offer a few thoughts on what McDonald’s could mean for corporate officers in the future.

II. Caremark

At issue in Caremark was whether (and if so, to what extent) directors must ensure the corporation installs and supervises systems of internal controls to monitor compliance with applicable laws.⁴ Caremark arranged for alternative health care services for patients.⁵ As a healthcare manager, the company was subject to the Anti-Referral Payments Law (“ARPL”), which prevents health care providers from paying for referrals of patients covered by Medicare and Medicaid.⁶ As it turned out, Caremark routinely entered contracts with and paid physicians who recommended Caremark services and products to patients on Medicare and Medicaid.⁷ Though at the time there was some legal ambiguity surrounding what constituted an illegal payment under the ARPL, authorities began investigating the practices of Caremark in 1991.⁸

After years of investigations, guilty pleadings, and public scrutiny, stockholders of Caremark International, Inc. brought a derivative suit against the directors of the company for breach of the duty of care.⁹ The plaintiffs asserted that the directors breached their duty by, among other failures, “improperly monitoring, and failing to correct, illegal activity by Caremark employees that ultimately exposed Caremark to financial liability.”¹⁰ Eventually, the derivative suit was settled; the terms of which required approval from the Chancery Court.¹¹ The settlement’s terms were dominated by concessions to improve Caremark’s compliance program.¹²

In his decision evaluating the settlement for fairness, Chancellor Allen examined the legal underpins of the duty of care, giving particular consideration to how far directors must go in monitoring corporate affairs for legal compliance.¹³ He considered whether directors, in fulfilling the duty of care, must “assure that appropriate information and reporting systems are established by management.”¹⁴ Holding that such a duty does exist, Chancellor Allen went on to state that the reporting system’s level of detail must be tailored according to business judgment.¹⁵ In other words, boards do have a duty to ensure their reporting systems function appropriately, but the nature and scope of such functionality is afforded deference to a good faith business judgment.¹⁶

III. McDonald’s

McDonald’s concerned the tenure of two former McDonald’s executives—ex CEO Steve Easterbrook (“Easterbrook”) and ex Chief People Officer David Fairhurst (“Fairhurst”).¹⁷ The plaintiff-shareholders asserted that during Fairhurst’s term, the company began to foster a party culture, and that the human resources department – overseen by Fairhurst – systematically overlooked and ignored sexual harassment claims generated from the culture he encouraged.¹⁸ To bolster their claim, the complaint pointed to inappropriate conduct from Easterbrook and Fairhurst at company parties; Fairhurst’s willingness to ignore various complaints from co-workers; repeated complaints filed with the Equal Employment Opportunity Commission; a well-publicized 2018 employee walkout; Congressional attention on the matter; as well as a handful of instances of alleged sexual harassment on the part of Fairhurst himself.¹⁹ To the shareholders, the totality of this conduct constituted evidence that Fairhurst had breached the duty of observation—despite the fact that the duty had never been used against officers before.²⁰ Additionally, the complaint alleged that Fairhurst’s repeated inappropriate actions and relationships towards female coworkers constituted a breach of loyalty.²¹

The Chancellor sided with the shareholders, ruling that their complaint plead a claim for breach of the duty of oversight.²² Importantly, the Chancellor did not point to any failure to make an effort to implement information systems in finding Fairhurst liable.²³ Rather, it was his failure to respond to “red flags” raised by subordinates and coworkers that got him into trouble.²⁴ And with regards to the duty of loyalty, the court agreed with the shareholders again; noting that “when Fairhurst engaged in sexual harassment, he was not acting subjectively to further the best interests of the Company.”²⁵

IV. Implications

At first blush, this holding appears to hold what has long been an obvious practice: corporate officers must exercise oversight to ensure that company operating systems are robust and prompt in responding to issues. But, although officers have long exercised powers requiring oversight skills analogous to what the duty of observation asks, the legal implications of the McDonald’s decision could spur important changes. A few points on the implication of McDonalds are offered below.

Bad Faith is the Red Flags Liability Standard. In the future, plaintiffs wishing to hold officers liable for a red flags claim must (1) “plead facts supporting an inference that the fiduciary knew of evidence of corporate misconduct;” (2) demonstrate “that the fiduciary consciously failed to take action in response”; and (3) “support an inference that the failure to take action was sufficiently sustained, systematic, or striking to constitute action in bad faith.”²⁶ Though the duty of observation is new for officers, officers can take solace that the court went with the bad faith standard and not a lesser standard of liability such as gross negligence.

But, on the other hand, the court noted that in determining whether a “defendant consciously ignored red flags regarding a culture of sexual harassment and misconduct, it is reasonable to give weight to the fact that the defendant himself committed multiple acts of sexual harassment.”²⁷ This has implications for directors and shareholders who receive knowledge that officers have engaged in sexual harassment. That is, if a shareholder or director becomes aware that an individual officer is investigated for a claim sexual harassment, it may increase the likelihood that books and records requests or derivative litigation ensues.

The Uncertain Scope of Officer Observation. There was a cursory discussion in McDonald’s that dealt with the scope of an officer’s observation duties. The Chancellor noted that the scope of an officer’s duty will depend in large part on what function they perform for the company.²⁸ That is, the CEO’s observational requirements may extend throughout the company, while the Chief Legal Officer (“CLO”) would only “be responsible for legal oversight and for making a good faith effort to establish reasonable information.”²⁹ This admission is important: it hints that “officers generally only will be responsible for addressing or reporting red flags within their areas of responsibility.”³⁰ That said, the court noted that “one can imagine exceptions.”³¹ The nature and breadth of these exceptions are certainly open for future litigation. Though it makes sense that a CLO should not be required to oversee financial matters like a Chief Financial Officer, questions arise for other positions. For example, what about a Chief Information Officer or Chief Compliance Officer? Each of these positions deal with company reporting systems, compliance concerns, and information collection. Should the observational duties of these positions extend throughout the company? Or should their oversight be tailored narrowly? It is this author’s opinion that such officers should be especially wary about how McDonald’s extends their oversight duties.

V. Conclusion

McDonald’s is a wakeup call. Observational duties used to be an esoteric discussion on the nature of being a corporate director. The issue has now morphed into a discussion about what it means to be a corporate officer. It is realistic to think that because officers perform more oversight functions on a day-to-day basis than directors (who may meet twice a year), the potential for shareholder litigation against officers will increase. This is particularly true given that officers tend to be more public facing, well known within the company, and subjected to more media scrutiny. Though the difficulty of bringing a successful derivative suit remains, it is important that compliance teams understand the importance of McDonalds and the threat it poses. Delaware companies should carefully consider how their officers practice oversight in their roles. And, where gaps exist, internal company documents and reporting system duties may need revision to protect against liability.

Cover Photo by Muhammad Haikal Sjukri on Unsplash

Tanner Dowdy

Tanner Dowdy is a Kentuckian born and raised. Before law school, Tanner attended the University of Kentucky where he majored in Finance and Political Science. It was at UK, fusing together these majors, where Tanner became passionate about the interplay between law and capital markets. His contributions to the law review reflect that passion. After law school, Tanner plans to practice in the securities law space. In his free time, you can find Tanner outdoors, collecting vintage records, running, lifting, or visiting new coffeeshops and breweries with friends!

References

1
Lindsay Faccenda, et al., Delaware Court of Chancery Concludes That Duty of Oversight Applies to Officers, JD Supra (Feb. 1, 2023), https://www.jdsupra.com/legalnews/delaware-court-of-chancery-concludes-1626533/.
2
In re McDonald’s Corp. S’holder Derivative Litig., No. 2021-0324-JTL, 2023 WL 387292, 9 (Del. Ch. Jan. 26, 2023).
3
Id. at 30.
4
Stephen F. Funk, In Re Caremark International Inc. Derivative Litigation: Director Behavior, Shareholder Protection, and Corporate Legal Compliance, 22 Del. J. Corp. L. 311 (1997).
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Id. at 314.
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Id. at 315.
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Id.
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Id.
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Id. at 317-18.
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Id. at 312.
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Id. at 318.
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Id.
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Id. at 319.
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Id. at 319-20.
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Id.
17
In re McDonald’s Corp. S’holder Derivative Litig., No. 2021-0324-JTL, 2023 WL 387292, 9 (Del. Ch. Jan. 26, 2023).
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Id. at 26.
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Id. at 26-28.
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Id. at 28.
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Id. at 27.
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Id. at 18-19.
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