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Corporate oversight responsibility, supersized — what Canadian directors and officers should know

Earlier this year, in In re McDonald’s Corporation Stockholder Derivative Litigation,[1] the Delaware Court of Chancery held, for the first time, that officers of Delaware corporations — not just directors — owe a “duty of oversight”.

Delaware courts have routinely held that corporate officers owe the same fiduciary duties as directors. The duty of oversight is often described as a subset of the duty of loyalty owed by directors under Delaware law. McDonald’s is notable, however, in underscoring the critical role corporate officers play in recognizing and reporting allegations of impropriety within the company — and the personal liability they may face for failing to do so.

Canadian law has yet to recognize a duty of oversight, but decisions of the Court of Chancery are often persuasive. McDonald’s is thus an important point of reference — and a timely reminder — for Canadian corporations, as well as for officers, directors, and stakeholders who are concerned about good corporate citizenship and broader ESG principles. Identifying and responding to misconduct within an organization remains imperative. McDonald’s warns of the potential consequences of failing to do so.

Background

McDonald’s followed the firing of David Fairhurst, the former Executive Vice President and Global Chief People Officer at McDonald’s Corporation. Mr. Fairhurst’s employment had been terminated in 2019 in the wake of public scrutiny over the company’s allegedly toxic workplace environment and allegations of misconduct against Mr. Fairhurst himself.

Certain of the company’s shareholders commenced a derivative action against several of the company’s directors and officers, including Mr. Fairhurst. The plaintiffs specifically alleged that Mr. Fairhurst had breached his duty of oversight by “allowing a corporate culture to develop that condoned sexual harassment and misconduct” and by consciously ignoring “red flags regarding sexual harassment and misconduct at the Company”.[2]

Mr. Fairhurst moved to dismiss the oversight claim, contending that Delaware law imposed no obligations on officers comparable to the duty of oversight owed by corporate directors.

Court of Chancery’s analysis

The Delaware court’s analysis centred on the so-called “Caremark duty”, named after the Court of Chancery’s seminal decision on director oversight claims, In re Caremark Inc. Derivative Litigation.[3]

Under Delaware law, directors (and now, officers) have a duty to exercise oversight and to monitor the corporation’s operational viability, legal compliance, and risk management protocols. In practice, Caremark and subsequent decisions of the Delaware courts[4] have recognized two species of oversight claims:

(i) “information-systems” claims are allegations that the board failed to make a good faith effort to establish information and reporting systems about the corporation’s central compliance risks designed to provide to senior management and the board with timely, accurate information to facilitate board oversight;[5] and

(ii) “red-flags” claims are allegations that directors were aware of “red flags” indicating wrongdoing/non-compliance and consciously chose not respond.[6]

In McDonald’s, the plaintiffs’ claim was of the second variety, alleging that Mr. Fairhurst “turned a blind eye to complaints about sexual harassment”. The claim referred to a laundry list of red flags that Mr. Fairhurst allegedly ignored, including numerous complaints filed with the United States Equal Employment Opportunity Commission, a ten-city strike by McDonald’s workers across the United States, and an inquiry from a U.S. Senator seeking to investigate issues of sexual harassment and misconduct at the company.[7]

In a detailed opinion, Vice Chancellor Laster denied Mr. Fairhurst’s motion to dismiss, holding affirmatively that corporate officers owe a duty of oversight under Delaware law. Vice Chancellor Laster supported his decision on several bases:

(i) The rationale for the duty of oversight. The “foundational premises” for recognizing a duty of oversight “apply equally, if not to a greater degree, to officers”.[8] Since, in a typical corporation, it is corporate officers rather than directors who are charged with running the corporation, it is those officers who have the greatest capacity to make oversight decisions and identify red flags.

(ii) Equality of fiduciary duties. Declining to recognize that officers owe a fiduciary duty of oversight would mean that, contrary to established Delaware precedent, the fiduciary duties of officers would not be the same as those of directors.

(iii) The officer’s duty as agent. As a corporate agent, officers have a duty to provide material information to the board that the officer knows, or should know. A “red flag” constitutes information material to the officer’s duties, or that the board would wish to have.

(iv) Accountability to the board. “The oversight duties of officers are an essential link in the corporate oversight structure”.[9]It follows that a corporate board should be empowered to assert and control a derivative claim for breach of fiduciary duty against an officer where that officer’s failure to exercise an oversight function has caused the corporation harm. If the board has “relied on the officer in good faith”, then “the directors would be in a position to hold the officer accountable” for failure to provide adequate oversight “without facing oversight liability themselves”.[10]

Having concluded that a duty of oversight applies to officers, the Delaware court made two notable observations.

First, the scope of a specific officer’s duty is context-driven and related to the officer’s role within the organization. An officer’s duty to make good faith efforts to establish an information system only applies within the officer’s area of responsibility (though some officers, like the CEO, are likely to have a company-wide remit). Similarly, an officer’s duty to address and report upward on red flags also generally applies within the officer’s area (though the court left open the possibility that any officer might be responsible for reporting a red flag which was “sufficiently prominent”).

Second, oversight liability requires a showing of bad faith. The officer must consciously fail to make a good faith effort to establish information systems, or the officer must consciously ignore red flags. The bad faith requirement has made success on Caremark-style claims exceedingly difficult in practice, with most claims defeated at the pleadings stage.

Indeed, in a second McDonald’s ruling dismissing the shareholders’ claims against the company’s directors, the court held that the directors had responded to the red flags regarding the toxic culture that was developing. While there was some evidence that their interventions failed to fix the problem, the success of their intervention was not dispositive (and was protected by the business judgment rule).[11]

While McDonald’s may lead to an uptick in Caremark claims, it remains to be seen whether those claims will be successful and in what circumstances.

Potential Canadian implications

Canadian courts have yet to recognize an equivalent to the “Caremark duty”. Still, it is not difficult to situate such a duty within the existing Canadian corporate law framework.

Canadian and Delaware law both recognize the same two fundamental duties imposed on directors and officers: a “duty of loyalty” and a “duty of care”.[12] The Supreme Court of Canada, like the Delaware Supreme Court, has confirmed that these statutory duties are borne by both directors and officers.[13]

Delaware’s “Caremark duty” merely recognizes that the duty of care requires directors — and now also officers — to be “reasonably informed concerning the corporation”[14] (in officers’ case, within their sphere of responsibility, as noted above). That is because relevant and timely information is an essential predicate for satisfaction of directors’ supervisory and monitoring responsibility under corporate law.[15] Directors’ duties therefore “logically include” a duty to oversee corporate operations.[16] It is the conscious disregard of that responsibility that constitutes a breach of the duty of loyalty and which may result in personal liability.

As Chief Justice Strine of the Delaware Supreme Court has explained, “[i]f Caremark means anything, it is that a corporate board must make a good faith effort to exercise its duty of care. A failure to make that effort constitutes a breach of the duty of loyalty”.[17]

Canadian boards, like those of Delaware corporations, must manage, or supervise the management of, the business and affairs of a corporation.[18] In discharging this duty, directors (and the officers to whom managerial responsibilities are delegated) must act “on a reasonably informed basis”.[19] And they must do so in good faith, failing which they may be personally liable for breaching their duty of loyalty.[20]

This is the very matrix that led the Caremark court to recognize a duty of oversight in Delaware. It goes without saying that Canadian directors have the same need for information — most directly from corporate officers — as their Delaware counterparts. Without adequate information systems in place and reliable reporting of the red flags that those systems detect, the supervisory mandate of a Canadian board is necessarily impaired. And, as directors’ day-to-day managerial responsibilities are, like in Delaware, typically delegated to officers, Canadian officers also have the greatest capacity to make oversight decisions and identify red flags.

The foundational premises cited by the Caremark court for recognizing the duty of oversight and by the McDonald’s court for extending it officers therefore both appear to apply equally north of the border. Indeed, the Supreme Court of Canada has already recognized that the duty of care “imposes a legal obligation upon directors and officers to be diligent in supervising and managing the corporation’s affairs”.[21] Recognizing an express duty of oversight for both directors and officers would require only an incremental step from this position.

What now?

The Court of Chancery is often the birthplace of influential ideas in corporate law. It is possible that the concept of an express oversight duty could find favour with a Canadian court in the right case.

In light of these developing legal principles, and also the stakeholder expectations they may foster, Canadian directors and officers should ensure that operational risk management and compliance, including active monitoring and oversight of corporate operations, is top of mind. Specifically, directors and officers should:

  • stay informed on issues of significance to the company, particularly those involving material operational and compliance risks;
  • establish protocols to ensure that the board and senior management are apprised of practices and systems for ensuring the timely flow of accurate information and identifying “red flags”;
  • routinely audit whether established protocols are effective in practice and whether flagged issues are being reported up the chain to senior management and the board; and
  • delegate express responsibility for ensuring adequate board and management oversight of areas identified as high risk.

As McDonald’s illustrates, employee wellbeing is one such area of significant risk. In Vice Chancellor Laster’s words, “[t]o remain true to the fiduciary principle and build value over the long term, corporate fiduciaries must take care of the corporation’s workers”.[22] Canadian corporate fiduciaries — directors and officers alike — should take note.

 

[1] In re McDonald’s Corporation Stockholder Derivative Litigation, Del. Ch. Ca. No. 2021-0324-JTL (Del. Ch. Jan. 26, 2023) [McDonald’s].

[2] McDonald’s, at 1.

[3] In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996) [Caremark].

[4] See, e.g. Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006).

[5] McDonald’s, at 20-21.

[6] McDonald’s at 21-22, 27.

[7] McDonald’s, at 54-55.

[8] McDonald’s, at 2.

[9] McDonald’s, at 36.

[10] McDonald’s, at 37.

[11] In re McDonald’s Corporation Stockholder Derivative Litigation, Del. Ch. Ca. No. 2021-0324-JTL (Del. Ch. Mar. 1, 2023) at 45 [McDonald’s 2].

[12] See e.g. Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009) at 708-709; Canada Business Corporations Act, R.S.C. 1985, c. C-44, s. 122(1) [CBCA]; Peoples Department Stores Inc. (Trustee of) v. Wise, 2004 SCC 68, at para. 32 [Peoples].

[13] Peoples, at para. 32.

[14] Caremark, at 970.

[15] Caremark, at 970. Similar to Canadian corporate law (e.g. CBCA, s. 105), Section 141 of the Delaware General Corporation Law provides that “[t]he business and affairs of every corporation . . . shall be managed by or under the direction of a board of directors.”

[16] McDonald’s, at 2.

[17] Marchand v. Barnhill, 212 A.3d 805 (Del. 2019) at 37.

[18] See e.g. CBCA, at s. 105(1).

[19] Peoples, at para. 67; CBCA, at s. 122.

[20] See e.g. CBCA, at s. 122(a).

[21] Peoples, at para. 32.

[22] McDonald’s 2, at 38-39.

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