McDonald’s Part Two: Delaware Court of Chancery Dismisses Caremark Claims Against Directors Arising From Sexual Harassment Issues

Overview

On March 1, 2023, in In re McDonald’s Corporation Stockholder Derivative Litigation, Vice Chancellor Travis Laster of Delaware’s Court of Chancery granted a motion to dismiss derivative claims against McDonald’s directors relating to their alleged failure to address sexual harassment issues at the company. The decision follows a prior ruling in the same derivative lawsuit on January 25, 2023, which represented the first Delaware decision expressly holding that corporate oversight duties under In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), apply to not just directors but also officers. While the court’s prior ruling denied a motion to dismiss filed by McDonald’s Global Chief People Officer, this time the court dismissed claims against McDonald’s directors based on the same underlying facts. The court emphasized how hard it is to plead Caremark claims, while also observing that directors have an obligation to monitor not just “mission critical” issues but all “central compliance risks.” Because there were no allegations undermining the presumption that McDonald’s Board acted properly in addressing issues of sexual harassment facing the company, the plaintiffs’ claims failed.

Background

As described in our prior alert, the derivative lawsuit relates to various sexual harassment issues that faced McDonald’s after 2015, the year it hired Stephen J. Easterbrook as CEO and David Fairhurst as Global Chief People Officer. These issues included multiple EEOC complaints and a congressional investigation related to alleged sexual harassment at McDonald’s restaurants, as well as allegations of a “party atmosphere” at McDonald’s corporate headquarters and improper conduct by Easterbrook and Fairhurst individually. In December 2018, Fairhurst was disciplined—but not fired—for an incident of sexual harassment he committed.

Throughout 2019, McDonald’s Board, led by its Public Policy & Strategy Committee (the “Strategy Committee”), oversaw a series of actions to address sexual harassment issues at the company. The Board received multiple written and oral reports from the General Counsel outlining both the sexual harassment allegations and the steps McDonald’s was taking in response, which included the engagement of two consultants to help advise the company on training and education programs, the establishment of a hotline so employees could report misconduct, and a cultural assessment.

In November 2019, McDonald’s learned that Easterbrook had engaged in a relationship with a McDonald’s employee that, while consensual, violated company policy. The Board launched an investigation through outside counsel, who interviewed both Easterbrook and the employee. During the investigation, Easterbrook denied having intimate relationships with any other employees. The Board decided to terminate Easterbrook without cause—a decision that permitted him to receive a substantial severance package of cash and equity awards—but also required him (1) to write an apology letter to McDonald’s employees and (2) to sign a one-sided release (i.e., Easterbrook released his claims against McDonald’s, but McDonald’s did not release its claims against him). The Board also decided to terminate Fairhurst for cause.

In July 2020, McDonald’s learned that Easterbrook, contrary to his statements during the investigation, had relationships with several additional employees. Easterbrook allegedly misused company resources in connection with these relationships, granting his paramours hundreds of thousands of dollars in equity awards and taking trips with them on the company’s private jet. In August 2020, McDonald’s sued Easterbrook for breach of fiduciary duty and fraudulent inducement. In December 2021, the parties reached a settlement in which Easterbrook agreed to return $105 million in cash and equity compensation.

In April 2021, stockholders filed this derivative suit in the Delaware Court of Chancery. One of the claims was against Fairhurst, and the court addressed that claim in its January 2023 opinion. The plaintiffs also asserted claims against McDonald’s directors, alleging among other things that the directors (i) had ignored “red flags” related to sexual harassment issues; (ii) should not have hired Easterbrook as CEO in the first place in 2015; and (iii) acted improperly by not firing Fairhurst in December 2018 and by terminating Easterbrook without cause in November 2019. In its most recent decision on March 1, the court dismissed all these claims against McDonald’s directors.

Caremark Duties Extend Beyond “Mission Critical” Risks

On the way to dismissing the plaintiffs’ claims against McDonald’s directors, the court took the opportunity to address the recent line of Delaware cases involving Caremark oversight claims. Under Caremark, directors have (i) a duty to ensure effective information and reporting systems exist within a company such that the management and board can “reach informed judgments concerning both the corporation’s compliance with law and its business performance”; and (ii) a duty not to ignore red flags indicating wrongdoing. In Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), the Delaware Supreme Court permitted a Caremark claim to proceed against directors of an ice cream company that allegedly had no specific reporting system to address food safety issues, an “essential and mission critical” compliance area. Soon after Marchand, the Delaware Court of Chancery declined to dismiss a Caremark claim alleging that a pharmaceutical company’s board ignored “red flags” warning that the company was not complying with the trial protocol for its “mission critical” drug and that the company’s public disclosure was inaccurate.

The McDonald’s court observed that, following Marchand, parties often took the position that oversight duties under Caremark apply only to “mission critical” risks facing the company. The court disagreed with that position:

• With respect to Caremark claims about ensuring effective information and reporting systems, the court noted that directors have a duty to establish reporting systems addressing any “central compliance risks”—whether “mission critical” or not. The court also suggested that directors have a duty to address risks beyond “central compliance risks,” but noted that plaintiffs “will have difficulty rebutting the business judgment rule where officers or directors have made a good faith decision regarding the level of monitoring resources, if any, to assign to a risk.”
• With respect to Caremark claims about responding to “red flags,” the court noted that “[t]he concept of central compliance risks, including essential or mission critical risks, does not play a similar role for a Red-Flags Claim. If an officer or director learns of evidence indicating that the corporation is suffering or will suffer harm, then the officer or director has an obligation to respond. To mix metaphors, a red flag can come out of the blue.” That is, according to the court, Caremark claims can rest on any red flags suggesting wrongdoing of any kind if it could cause harm to the company, regardless of the type of risk involved (whether “central compliance risks,” “mission critical” risks, or something else).

The Business Judgment Rule Continues to Protect Directors From Caremark Claims

Even as it applied Caremark duties beyond mission-critical risks, the court reinforced Caremark’s high hurdle and rejected the plaintiffs’ Caremark claims. In McDonald’s, the plaintiffs did not allege deficient reporting systems, only that directors ignored red flags. The court readily found red flags, namely the intensification of the sexual harassment issues that occurred in 2018. The court also found that the plaintiffs’ allegations supported an inference “that until the end of 2018, the Director Defendants were operating in business-as-usual-mode.” However, that “business-as-usual attitude changed at the end of 2018.” From that point onward, the Board and its Strategy Committee received regular reports from management and held meetings concerning sexual harassment issues, and the company took a number of affirmative steps to address them. On that record, the plaintiffs could not rebut the presumption that the Board acted in good faith to address the “red flags” that directors had observed.

The court also rejected the idea that the Board could face liability simply because lawsuits continued to be filed and sexual harassment problems may have continued to persist. It observed: “Whether the response fixed the problem is not the test. Fiduciaries cannot guarantee success, particularly in fixing a sadly recurring issue like sexual harassment. What they have to do is make a good faith effort.”

The court similarly relied on the business judgment rule in dismissing the plaintiffs’ challenges to the Board’s hiring and firing decisions.

The plaintiffs alleged that, before his promotion to CEO, Easterbrook was having a relationship with a third-party consultant who worked for McDonald’s, and that this relationship violated McDonald’s policies, but the Board nonetheless named Easterbrook CEO after he promised that the third-party consultant would no longer work on McDonald’s account. The plaintiffs criticized this hiring decision and further claimed the Board never followed up on Easterbrook’s promise. The court found that whether to promote Easterbrook was committed to the Board’s judgment, even if doing so required an exception to company’s nonfraternization policy. The Board was also entitled to rely on Easterbrook’s assurance that the consultant would be removed from McDonald’s account.

The plaintiffs fared no better in challenging the Board’s termination decisions regarding Fairhurst and Easterbrook. The plaintiffs challenged the decision to discipline, but not fire, Fairhurst in December 2018, as well as the decision to terminate Easterbrook without cause in November 2019. Despite taking a swipe at the Board’s decision to terminate Easterbrook without cause—the court noted that the directors’ “judgment that they had sufficient information to reach a decision” was a “poor one” in light of the later revelations about Easterbrook’s conduct—the court found no allegations sufficient to rebut the presumption that the Board had acted on an informed basis and in good faith. The plaintiffs argued that the Board terminated Easterbrook without cause to avoid litigation that could have uncovered the Board’s own misconduct and exposed it to liability, but that argument failed because the directors had not violated their Caremark duties and thus did not face any threat of liability.

Takeaways for Companies and Their Directors

In light of the latest decision in McDonald’s, boards should continue to assess risks facing the company—“mission critical” or not—by considering the following potential steps:

• Identify all “central compliance” risks facing the business, not just risks that might be considered “mission critical.”
• Conduct a holistic assessment of all other risks facing the business, deciding which require ongoing oversight.
• Have a robust compliance system in place, including policies keyed to mission-critical risks, “central compliance risks,” and any other risks that, in the board’s judgment, warrant attention.
• Ensure that officers understand their responsibilities (and, in light of McDonald’s, their fiduciary duties) to manage these risks and to make regular reports to the board.
• Timely address red flags, regardless of whether they relate to “central” or “mission critical” risks, and take reports of noncompliance or other risk-generating behavior seriously.
• Have minutes and board materials that explicitly refer to the board’s oversight of these risks.

At the same time, the second McDonald’s decision highlights the substantial deference that boards enjoy in carrying out their oversight duties under Caremark, even where the red flags are particularly bright. Boards do not have to tackle oversight issues on their own, and are entitled to rely on the company’s officers to help identify risks, report risks to the board, and propose solutions—particularly now that officers themselves have oversight duties based on the prior McDonald’s decision from January of this year. If directors can show that they took action to address corporate risks on a disinterested and informed basis, they generally will be entitled to the benefit of the business judgment rule.