Delaware Court of Chancery Determines That the Duty of Oversight Applies to Corporate Officers

For almost 30 years, the Delaware courts have held that corporate directors are charged with a fiduciary duty of “oversight.” Directors must make sure that their corporations both (1) implement reasonable information and reporting systems and (2) monitor for and respond appropriately to any “red flags” that suggest that wrongdoing is taking place within the organization.^[1] But even though the issue has often been discussed, it has not been clear that corporate officers bear the same duty of oversight.

Recently, however, the Delaware Court of Chancery held for the first time that the fiduciary duty of oversight extends to corporate officers as to “matters within their areas of responsibility.”^[2] In In re McDonald’s Corp. Stockholder Litig., Vice Chancellor Travis Laster denied a motion to dismiss an oversight claim brought derivatively against the former chief people officer of McDonald’s for allegedly failing to address “red flags” indicating that sexual harassment was occurring within the company.

The Court’s Analysis

The court began by explaining that the same policies that underlie the duty of oversight for directors “apply equally, if not to a greater degree, to officers.” Officers are charged with running the day-to-day operations of the business, and thus they are “optimally positioned to identify red flags and either address them or report upward.” Officers also must gather timely and relevant information to share with the board and to help with their own decision-making.

The court also found support in other authorities. The Delaware Supreme Court has held that as a general matter, “the fiduciary duties of officers are the same as those of directors” — and those duties logically would include oversight duties.^[3] Analogizing officers and directors to agents and principals, the Vice Chancellor also found guidance in the law of agency, which imposes on agents the obligation to use reasonable efforts to provide their principals with all material information relating to the tasks entrusted to the agent. The court even cited the current federal sentencing guidelines, which give credit to organizations that require executive officers to undertake compliance and oversight obligations. And on a practical level, the court reasoned that “a contrary holding would create a gap in the ability of directors to hold officers accountable” for oversight failures.

Unlike directors, however, and apart from the chief executive officer and chief compliance officer, officers in most cases do not have “company-wide oversight portfolios.” Instead, their scope usually is limited to designated areas of responsibility. The chief financial officer, for example, is responsible for financial oversight, while the chief legal officer is responsible for legal oversight. There may be exceptions if a red flag is “sufficiently prominent,” in which case “any officer might have a duty to report upward about it.”

The court clarified that the oversight duty sounds in loyalty, and thus officers cannot be liable unless they are shown to have acted in bad faith. The court rejected a standard, such as gross negligence, that would be easier for plaintiffs to meet. The court noted that a less protective standard of this sort could expose officers to unjustified lawsuits and deter qualified candidates from serving altogether.

In the case at hand, plaintiffs based their claim on the second kind of oversight duty, which the court called a “Red-Flags Claim.” The claim survived because the pleading supported inferences that (a) the chief people officer knew of evidence of corporate misconduct and failed to take appropriate action in response to it and (b) his failure was “sufficiently sustained, systemic, or striking to constitute bad faith.” The court cited several facts supporting an inference of bad faith, including allegations regarding the chief people officer’s own participation in multiple acts of sexual harassment.

Key Takeaways

While the Delaware Court of Chancery has previously suggested that a claim of inadequate oversight is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment” (as discussed here), the McDonald’s decision signals a willingness to hold officers liable for failures to exercise proper corporate oversight. Decisions by the Delaware Court of Chancery do not carry the same weight as those from the Delaware Supreme Court, but until the Delaware Supreme Court addresses this issue directly, we can expect Vice Chancellor Laster’s decision in McDonald’s to be studied closely and cited widely. Thus, corporate officers should take an active role in both implementing reasonable information and reporting systems and monitoring and responding to critical risks within their areas of responsibility.

Still, the bad faith requirement adopted by the court affords a degree of protection to officers. For an oversight claim to survive a motion to dismiss, plaintiffs will need to allege specific facts showing that the officer’s failure to exercise oversight was “sufficiently sustained, systemic, or striking to constitute bad faith.”

^{[1] See In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996); Stone v. Ritter, 911 A.2d 362 (Del. 2006).}

^{[2] See In re McDonald’s Corp. Stockholder Litig., C.A. No. 2021-0324-JTL (Del. Ch. Jan. 26, 2023).}

^{[3] See Gantler v. Stephens, 65 A.2d 695, 709 (Del. 2009).}