In a win for corporate boards and vindication of directors at McDonald's Corporation, the Delaware Chancery Court in McDonald's II dismissed all shareholder claims that directors violated their oversight duties amid a toxic corporate culture. Four takeaways from Vice Chancellor Laster's opinion offer valuable guidance for corporate directors in today's volatile world.
Oversight duties:
- encompass all risks, not just "central" or "critical" ones, putting directors on high alert
- are unlikely to be exculpable by charter provision, exposing directors to personal liability in money damages for violations
- reach to protecting stakeholders that are important to long-term shareholder value, showing how Delaware law both requires shareholder primacy and accommodates other interests
- hinge on acting in good faith in the best interests of the corporation, and directors who put their personal values ahead of the corporate interest risk being guilty of bad faith
In the case against the officers (McDonald's I), the shareholders alleged and the court agreed that officers owed and violated their oversight duties. In the case against the directors (McDonalds II), however, the court found that the directors acted in good faith and therefore did not violate their oversight or other duties. Across the Board previously posted about McDonald's I; the following discusses McDonald's II.
In the case against the board, shareholders claimed the directors failed to respond to red flags warning of a toxic culture and mishandled the firing of two top officers —the CEO and HR chief. The court agreed with the shareholders that there were red flags but agreed with the directors that they responded in good faith and otherwise met their duties in dealing with the two executives.
Takeaway 1: Directors Risk Personal Liability
Board oversight duties come in two forms. The first is the red flag rule, which traces to the 1963 case of Allis-Chalmers. Directors are liable for wrongdoing at a company if red flags manifest, but they fail to respond. The second is the information systems rule, which traces to the 1996 case of Caremark. Directors must assure that an information control system exists to give officers and directors material internal operating information, including legal compliance.
While these duties are longstanding, a fighting issue remains whether their breach always exposes directors to personal liability for money damages or whether they may be exculpated by charter provision authorized by statute. This hinges on whether oversight obligations are part of the duty of care (breaches of which can be exculpated) or duty of loyalty (which cannot).
McDonald's II hints that Vice Chancellor Laster's view is that oversight obligations are part of the duty of loyalty and breaches always expose directors to personal liability for money damages. He makes the point by quoting Delaware's Supreme Court, in Stone v. Ritter, that "a necessary condition" of oversight liability is "breach of the duty of loyalty, such as action in bad faith."
While not the last word, the Vice Chancellor's further statement of what it takes to find such a violation makes it fair and logical to impose personal liability for transgressions. To constitute bad faith in response to red flags, McDonald's II reminds us, the allegations must support an inference that the failure to act was "sustained, systematic, or striking." To be liable, a board aware of problems must have "consciously disregard[ed] its duty to address" them.
Takeaway 2. Risk Oversight is Broad
Many litigants and some directors may think that oversight duties encompass only risks that are "mission critical" to a company or involve "central compliance" issues. McDonald's II counters such a belief. The Vice Chancellor attributes widespread misconceptions about this to some wording in the Delaware Supreme Court's 2019 opinion in the Blue Bell case, Marchand v. Barhill.
That case addressed a claim that a board failed to maintain the information system that oversight requires, resulting in the undiscovered contamination of the company's ice cream products. The court called food safety "mission critical" at the company, when faulting the board for not trying to install a related information system. It further stated that Caremark contemplates information systems "about the corporation's central compliance risks."
But Vice Chancellor Laster in McDonald's II says those statements do not limit oversight duties to "mission critical" or "central compliance" risks. True, boards may invest more in information systems over such risks than others and it would be easier to infer bad faith for failure to do so.
But the concept of risk types works differently for red flag claims. For one, if a board becomes aware of impending harm to the corporation from the manifestation of any risk from any source, it must act. As Vice Chancellor Laster colorfully puts it: "a red flag can come out of the blue."
On the other hand, responsive decisions are presumed covered by the business judgment rule. When challenging a director's good faith to overcome that presumption, the existence of different types of risk "can reenter the analysis." The Vice Chancellor explains:
"an inference of bad faith is more likely when a red flag concerns an essential or mission critical risk, but a Red-Flags Claim is not dependent on the signal relating to an essential or mission critical risk."
Takeaway 3: Shareholder Primacy Rules But Accommodates Other Interests
As the McDonald II's shareholder lawsuit is predicated on how employee mistreatment harms a corporation and its shareholders, it illustrates both Delaware law's abiding commitment to shareholder primacy and how that logically accommodates stakeholder interests. Directors of Delaware corporations owe their duties to the shareholders and the corporation—not to employees or other stakeholders. Yet employee interests can be central to shareholder interests and make protecting employees the directors' responsibility. Vice Chancellor Laster explained:
The fiduciary principle requires that directors and officers act prudently, loyally, and in good faith to maximize the value of the corporation over the long-term for the benefit of the holders of its . . . equity . . .. Employees perform the work that affects the value of the corporation. To remain true to the fiduciary principle and build value over the long term, corporate fiduciaries must take care of the corporation's workers.
. . . Sexual harassment and misconduct render the workplace unsafe. Acts of sexual harassment and misconduct can result in serious injury to the corporation. The acts obviously harm the affected employees. At the same time, the acts jeopardize the corporation's relationship with other employees, create a risk that customers and clients will defect to competitors, and subject the corporation to potential liability under state and federal law.
Vice Chancellor Laster's statement is a useful and centrist antidote to extremists on both sides of prevailing debates over shareholder primacy versus stakeholder capitalism.
Takeaway 4: Putting Personal Values First Constitutes Bad Faith
In discussing what evidence of bad faith supports overcoming the business judgment rule, as noted in Takeaway 1, Vice Chancellor Laster offers "intentional dereliction of duty." This may arise for any reason not directed to advancing the corporation's best interests. Drawing on a long line of cases, the opinion admonishes directors as follows (emphasis added):
Bad faith can be the result of "any emotion [that] may cause a director to [intentionally] place [their] own interests, preferences or appetites before the welfare of the corporation . . ."
McDonald's II quotes an oft-cited formulation by the Delaware Chancery Court:
The reason for the disloyalty (the faithlessness) is irrelevant, the underlying motive (be it venal, familial, collegial, or nihilistic) for conscious action not in the corporation's best interest does not make it faithful, as opposed to faithless.
Vice Chancellor Laster's admonitions in the current governance atmosphere are a reminder of an age-old truth: directors who put "personal values" above the best interests of the corporation act in bad faith, exposing them to personal liability in money damages. That might be the most critical takeaway from McDonald's II for directors today.
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