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The World Has Changed: McDonald’s and the Oversight Duty of Officers-Part 2

This week, we are exploring a shift in the duties of care owed by corporate officers to the corporation. It is coming through the Chancery Court of Delaware in the case of McDonald’s Corporation and its former Executive Vice President and Global Chief People Officer of McDonald’s Corporation, David Fairhurst and his part in the creation of an absolute toxic atmosphere of sexual harassment at the very highest levels of the organization. It is styled In re McDonald’s Corporation Stockholder Derivative Litigation, and the court formally recognizes the oversight duties of officers of Delaware corporations. Today we consider the legal reasoning in the opinion.

Yesterday we began a discussion on the legal reasoning. Most compliance practitioners point to the 1996 Caremark decision as the one which set a Board’s duty around compliance. However, there has long been a duty of oversight in Delaware law, for Boards of Directors since at least the 1960s but for officers as well. In 1963, the Delaware Supreme Court established a Board duty when red flags are brought to its attention in the case of Graham v. Allis-Chalmers Manufacturing Co., which held that directors have an obligation to respond if information reached them, but created no affirmative duty to set up an information system to learn about issues within the company. A limited duty of oversight arose only if the directors had already learned enough to suspect that there were issues that needed overseeing. This was termed a “Red-Flags Claim” or a “Red-Flags Theory” of liability. This is also known as “Prong-One” Board liability.

Caremark created that affirmative duty for Board’s to engage in oversight. The Caremark court formulated a “more functional terminology, that species of claim can be called an “Information-Systems Claim” or an “Information- Systems Theory” of Board liability, also known as “Prong-Two” Board liability. In this type of case, a plaintiff typically pleads a prong-two Caremark claim by alleging that the board’s information systems generated red flags indicating wrongdoing and that the directors failed to respond. In McDonald’s Corp we now see both Prong-One and Prong-Two liability expanded to officers.

The Court of Chancery listed three key sources for expanding this duty from Boards to officers.

  1. Management runs a company. While Board’s oversee management, “most corporations are managed ‘under the direction of’ the board.” Moreover, “In the typical corporation, it is the officers who are charged with, and responsible for, running the business of the corporation.” Finally, “Because of this reality, “[m]onitoring and strategy are not exclusively the dominion of the board. Actually, nondirector officers may have a greater capacity to make oversight and strategic decisions on a day-to-day basis.”
  2. Boards depend on information from management. Here the court noted that “For relevant and timely information to reach the board, the officers who serve as the day-to-day managers of the entity must make a good faith effort to ensure that information systems are in place so that the officers receive relevant and timely information that they can provide to the directors.” From this, “it follows that officers must have a duty to make a good faith effort to establish an information system as a predicate to fulfilling their obligation to provide information to the board.”
  3. Compliance systems required under the USSG. The US Sentencing Guidelines (USSG) mandate that “[h]igh- level personnel of the organization shall ensure that the organization has an effective compliance and ethics program, as described in this guideline.” This requirement includes that “Specific individual(s) within high-level personnel shall be assigned overall responsibility for the compliance and ethics program.” The USSG goes on to define an organization’s “high-level personnel” as “individuals who have substantial control over the organization or who have a substantial role in the making of policy within the organization,” which includes “a director; an executive officer; an individual in charge of a major business or functional unit of the organization, such as sales, administration, or finance; and an individual with a substantial ownership interest.” This has the added benefit of putting compliance professionals directly in the path of liability created in this decision.

Interestingly since the Delaware courts had not explicitly expanded the duty of oversight to offices, the court looked at some bankruptcy court decisions for guidance. Here the Delaware court found, there were both Prong-One Red Flag claims and Prong-Two Information Systems claims available against officers under certain circumstances. The Delaware court concluded this section with the following “All of the foregoing authorities start from the premise that officers owe the same duties as directors. Because directors owe a duty of oversight, these authorities reason that officers owe a duty of oversight. That logic is sound.”

In a section I found very interesting, the Delaware court noted that officers have fiduciary duties to the corporation akin to those duties agents owe their principals. Here the court pointed to a prior Delaware decision, which “recognized a standard of conduct at the officer level that included a duty to act carefully, loyally, and in good faith to gather and provide information, with the standard of liability for the care dimension of the duty measured by gross negligence. By recognizing the duty to provide information, Hampshire lays the foundation for an officer-level duty consistent with an Information-Systems Theory.” The Court also found there is officer accountability to the Board which supports this extension of the duty of oversight to officer.

With this legal underpinning in place, please join me tomorrow to explore how this decision will impact Chief Compliance Officers.