Here we have another in a string of McDonald’s cases—all of them arising out of workplace misconduct at McDonald’s, none even dipping its toe into employment law. First, you’ll remember, there were settled charges brought by the SEC against McDonald’s and its former CEO, Stephen Easterbrook, arising out of disclosure about the termination of Easterbrook on account of workplace misconduct. Then there was the derivative Caremark litigation for breach of fiduciary duty against David Fairhurst, who formerly served as Executive Vice President and Global Chief People Officer of McDonald’s, for consciously ignoring red flags about workplace misconduct and engaging in some pretty extensive workplace misconduct himself. Now, we have a new decision out of Delaware regarding the derivative Caremark litigation against the company’s directors alleging that they ignored red flags about the company’s culture that condoned workplace misconduct. But this case turned out to be different—VC Laster of the Delaware Chancery Court dismissed the complaint against the directors. The Court held that, in this case, the directors did not ignore the numerous red flags: the facts cited in the pleadings did “not support a reasonably conceivable claim against them for breach of the duty of oversight.” Once again, the case reinforces that high bar described by former Chief Justice Leo Strine for Caremark claims: “Caremark claims are difficult to plead and ultimately to prove out,” and constitute “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” (See this PubCo post.)
In this case, plaintiff stockholders sued McDonald’s directors, alleging that, from 2015 until 2020, they “ignored red flags about a corporate culture that condoned sexual harassment and misconduct,” causing harm to the company. To state a claim, the plaintiffs had to allege facts supporting an inference that the directors consciously ignored red flags to an extent so egregious that it would indicate “a serious failure of oversight sufficient to support an inference of bad faith.” Although the directors argued otherwise, the Court held that the facts alleged did support the contention that the directors were on notice of the problem—there were vibrant red flags—but the Court agreed with the directors that what the complaint did “not support is an inference that the Director Defendants failed to respond.”
Background
The facts, as described by the Court, were based on the complaint, assuming the truth of the allegations and giving the plaintiffs the benefit of all reasonable inferences at this stage of the litigation. Over 2,200,000 employees (direct and through franchises) work at McDonald’s, 55% of whom are women. The company’s Standards of Business Conduct and its Human Rights Policy endorse the cultivation of “respectful workplaces.” In 2015, the company appointed Stephen Easterbrook as CEO, the board having accepted that he had an intimate relationship with an outside consultant to the company (provided she was removed from the account, which the Board failed to confirm). Easterbrook then promoted his colleague and personal friend, David Fairhurst, to the position of Global Chief People Officer.
According to the opinion, these two executives promoted a frat-boy-like “party atmosphere” at headquarters, at which male employees (including senior executives) “engaged in inappropriate behavior,…routinely making female employees feel uncomfortable.” A lot of alcohol was consumed and “Easterbrook and Fairhurst developed reputations for flirting with female employees, including their executive assistants. The Company grew to resemble a boys’ club. Recruiters were encouraged to hire ‘young, pretty females’ from high-end stores to work in administrative roles at the Chicago headquarters…. Easterbrook became known as a ‘player’ who pursued intimate relationships with staff.” But HR “failed to address complaints adequately,” it was alleged, with some employees who reported the problem fearing retaliation.
In 2016 and 2018, the opinion states, the company faced numerous complaints filed with the EEOC, followed by walkouts and strikes organized to protest the misconduct and the company’s failure to address it. Media coverage and Senate inquiries ensued. Around the same time, the company’s Compliance Department received specific reports about Fairhurst’s having “grabbed [an] employee and forced her onto his lap” (in front of over 30 employee witnesses), and concluded that his behavior was inconsistent with the Standards of Business Conduct. The matter was taken up by the Audit Committee and, notwithstanding the company’s purported zero-tolerance policy for sexual harassment, the Committee followed Easterbrook’s recommendation and simply cut Fairhurst’s bonus and required him to sign a “last chance” letter reciting his prior violations and misconduct.
According to the opinion, the events of 2018 catalyzed management and the Board to engage with the issue of sexual harassment and misconduct, which included revised policies, training and outside experts. The GC reported on these actions and the EEOC charges to the Board Strategy Committee in January 2019 and to the full Board in May 2019. For a special meeting of the Strategy Committee devoted to harassment in June 2019, the GC, Fairhurst and the Chief Communications Officer prepared a memo describing the issues and the steps the company had taken, including a full policy review; engagement of the Rape, Abuse & Incest National Network to advise the company; implementation of training programs on maintaining a safe and respectful workplace and on harassment, unconscious bias and workplace safety; establishment of a new, third-party-managed hotline for employee complaints; and termination of the company’s mandatory arbitration policy for harassment claims; among other things. The Committee Chair concluded that the company had developed a comprehensive plan, would continue to be proactive and evaluate “how best to execute its strategy and be a leader on this issue.” In September, the Board also heard from its Enterprise Risk Management group, which had identified “respectful workplace” as a new Tier 2 risk (essentially, a risk with potential for sustained adverse impact). That same month, the GC and the Chief Communications Officer, along with, ironically, Easterbrook and Fairhurst, reported to a special meeting of the Strategy Committee on “a strategy to improve the Company’s reputation as an employer,” that involved striving “for a leadership position by moving beyond compliance.” (Hmmm, the foxes guarding the henhouse are reporting to the Board on how to better protect the hens. Did the participation of the GC and the Chief Communications Officer salvage that one?)
Then, in October 2019, the Board learned that Easterbrook was engaging in a prohibited relationship with an employee and asked outside counsel to conduct an investigation. That investigation, however, was limited to interviews of the employee and Easterbrook, who denied that he had engaged in other relationships with employees. To avoid disruption and potential litigation, the Board agreed to a negotiated termination of Easterbrook without cause, allowing him to retain all prior comp and severance, amounting to almost $48 million, with about $44 million of equity awards. The press release said only that Easterbrook had “violated company policy and demonstrated poor judgment” as a result of a “consensual” relationship with an employee. At the same time, the Board also terminated Fairhurst for cause.
The plaintiffs objected that the company did not seek to recover comp received during his tenure as CEO and valued the comp and severance package at about $126 million. The plaintiffs were also suspicious of the absence of formal minutes for certain of these meetings.
Following Easterbrook’s termination, a coalition of union pension funds raised objections to the “without cause” aspect of the termination, and, in April 2020, sought to vote out two directors. In addition, employees filed two class actions alleging toxic work culture compounded by a lack of sexual harassment training and help from HR. One of the complaints alleged that “three out of every four female non-managerial McDonald’s employees have personally experienced sexual harassment at McDonald’s, ranging from unwelcome sexual comments to unwanted touching, groping, or fondling, to rape and assault,” with large proportions experiencing retaliation and loss of income. A 2019 survey was consistent with those claims.
When the Board was tipped off about another Easterbrook affair, it ordered a more thorough investigation, which revealed at least three additional workplace affairs. The investigation found that he had used his company email account “to transmit dozens of nude, partially nude, or sexually explicit photographs and videos, including photographs of the three Company employees.” He also granted restricted stock units worth hundreds of thousands to at least two of the employees and used the company aircraft for transporting them. The Board resolved to sue Easterbrook, claiming that he lied during the original investigation. He claimed waiver, asserting that Board knew or should have known. The company settled for return of comp worth about $105 million.
This litigation was filed in April 2020. Count I of the complaint asserts that the directors breached their fiduciary duties by terminating Easterbrook without cause and not addressing the misconduct of Easterbrook and Fairhurst earlier (i.e., promoting Easterbrook to CEO when he was known to be having an affair with the consultant). Count II asserts a Caremark claim that the directors breached their duty of oversight by failing to remedy severe, widespread sexual harassment at the company, and Count IV is a claim for waste (entering into the original Easterbrook agreement, which “no rational person would support.”) Count III presented claims against each of Easterbrook and Fairhurst, the first of which was dismissed because the company released those claims in the Easterbrook settlement and the second of which was determined to state a claim and allowed to go forward in a separate decision. (See this PubCo post.) The directors moved to dismiss for failure to state a claim.
Analysis
Count II: The Claim For Breach Of The Duty Of Oversight. In Count II, the plaintiffs asserted a Caremark claim, contending that the directors “breached their duty of oversight by failing to take action to address a toxic corporate culture that condoned sexual harassment and misconduct.” The Court concluded that there were certainly red flags, but the plaintiffs had “not alleged facts supporting a reasonable inference that the Director Defendants acted in bad faith in response to those red flags.”
Under Caremark, the Court explained, “a board’s fiduciary duties encompass the need to make a good faith effort to ensure that ‘information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance.’…In other words, the directors had a basic duty to attempt to obtain information about what was happening within the corporation.” Subsequent cases held that a “breach of the duty of loyalty, such as action in bad faith, was a ‘necessary condition to liability.’” As framed by the Delaware Supreme Court, to survive a motion to dismiss an oversight claim, “a plaintiff must allege particularized facts supporting a reasonable inference that either ‘(a) the directors utterly failed to implement any reporting or information system or controls [an “Information-Systems Claim”]; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention [a “Red-Flags Claim”].’”
In this case, the Court said, the plaintiffs asserted a “Red Flags Claim,” which would require the plaintiffs to “plead facts supporting an inference that the red flags came to the attention of the Director Defendants, as well as facts supporting an inference that the Director Defendants consciously failed to take action in response to the red flags. The pled facts must support an inference that the failure to take action was sufficiently sustained, systematic, or striking to constitute action in bad faith.”
In a lengthy effort to correct what the Court perceived as a popular misinterpretation, the Court rejected the idea that a Red-Flags Claim must relate to “mission critical” risks, as suggested by discussions of Marchand v. Barnhill, where the phrase seemed to have “acquired talismanic importance.” (See this PubCo post.) Rather, the Court maintained, quoting Marchand, the rule enunciated was that a board must “’make a good faith effort to put in place a reasonable system of monitoring and reporting about the corporation’s central compliance risks.’” [Emphasis added.] Applying that rule, the Marchand court characterized the particular risk at issue in that case as “mission critical.” “Although,” the Court here said, “it is fair to infer that all ‘essential and mission critical risks’ qualify as ‘central compliance risks,’ it is also possible that some ‘central compliance risks’ may not reach the level of ‘essential and mission critical.’”
But, that aside, this case involved a Red-Flags Claim, the Court said, where the concept of central compliance risks plays a different role—it speaks to the question of bad faith. In the context of 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.” The decision about how to respond is generally protected by the business judgment rule unless one of the presumptions of loyalty, good faith and informed basis is rebutted. Accordingly, the Court said, in the context of a Red-Flags Claim, to survive a motion to dismiss, the plaintiff must allege facts supporting an inference of bad faith; if a red flag is related to a central compliance risk, that inference of bad faith arising out of a failure to respond is “easier to draw.” According to the Court, “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.” While the risk in this case did not have to amount to a mission critical risk, the Court concluded, it was “easy to draw a pleading-stage inference that maintaining employee safety is both essential and mission critical.” Compliance with labor and employment law is essential, and sexual harassment and misconduct make the workplace unsafe and harm the company, subjecting it to potential liability and reputational harm. All of that was all reflected in Board minutes: “The court does not have to infer that sexual harassment and misconduct constituted a mission critical risk. The Company said it.”
The complaint identified a long list of red flags “from lawmakers, regulators, civil rights groups, and—perhaps most glaringly—McDonald’s own employees,” all of which the directors contested as not red-flag-level events. While that may be arguable as to some of the events, the Court said, when “the head of human resources has engaged in multiple acts of sexual harassment, that is enough to put directors on notice of problems in the human resources area.” The Court concluded that the facts of the complaint supported an inference that, by the end of 2018, the directors were on notice of sexual harassment problems at the company.
The Red-Flags Claim fell short, however, in arguing that the directors failed to respond. Until the end of 2018, the Court observed, the facts supported an inference that the directors “were operating in business-as-usual mode,” despite hearing about various EEOC claims. But, at the end of 2018, management “began taking action,” and the directors “began focusing on the issue,” with reports to the Strategy Committee in January and June 2019 and to the full Board in May 2019, advising about the issues and the numerous steps the company was taking, as described above. The directors also “elevated the importance of addressing sexual harassment and misconduct as an enterprise risk.” In November, after learning about their misconduct, the Board terminated Easterbrook and Fairhurst. Even if the Board’s efforts were not entirely successful, the Court reasoned, that was “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.” According to the Court, the record showed that the directors “responded to the red flags regarding the toxic culture that was developing at the Company.” Because of their effort, it was “not possible” to infer that they acted in bad faith. As a result, the Caremark claim for breach of the duty of oversight failed to state a claim on which relief could be granted.
Count I: The Decisions To Promote Easterbrook To CEO, Discipline Fairhurst, And Terminate Easterbrook Without Cause. In Count I, the plaintiffs challenged decisions by the directors to (i) promote Easterbrook to CEO, (ii) discipline Fairhurst by having him enter into the last chance letter, and (iii) terminate Easterbrook without cause. The Court concluded that each decision was protected under the business judgment rule.
Under the business judgment rule, the court simply looks to see whether the decision was “rational in the sense of being one logical approach to advancing the corporation’s objectives.” To rebut the application of the business judgment rule, the plaintiffs could allege “facts that call into question whether the director acted in good faith,” which encompasses both “an intent to harm [and] also intentional dereliction of duty.” The court concluded that neither the “enhanced scrutiny” standard or the “entire fairness” standard was applicable.
With regard to the three Board decisions—to promote Easterbrook with knowledge that he was involved in an intimate relationship with a consultant, to discipline Fairhurst rather than terminate him (an exception to the company’s zero-tolerance policy) in reliance on the advice of his crony Easterbrook, and to terminate Easterbrook without cause after only a brief investigation—the Court concluded that all three cases were illustrations of “classic business judgment.” The plaintiffs did not plead “facts sufficient to rebut any of the business judgment rule’s presumptions. ” Even if, in hindsight, the decisions appeared to be poor ones, the Court maintained, that doesn’t mean that they breached their fiduciary duties: the “business judgment rule recognizes that people can make mistakes, even when acting diligently, loyally, and in good faith.”
For example, the plaintiffs contended that, in their decision to terminate Easterbrook without cause after a perfunctory investigation, the directors were acting in self interest because they feared that a legal challenge to a for-cause termination would reveal their tolerance of pervasive workplace misconduct at the company and their failure to end it. The plaintiffs were trying “to conjure an inference of bad faith” from the idea that the directors were trying to protect themselves from liability, but the Court didn’t buy it—that allegation was not enough to overcome the presumption of good faith. Rather, the Court concluded, “the defendants could have rationally believed in subjective good faith that an amicable termination without cause was in the best interests of the Company.”
Ultimately, the Court decided that it was “not reasonably conceivable” that these decisions were made in bad faith. In all three cases, the Court said, the directors’ conduct may have implicated the duty of care, but their conduct hardly amounted to even gross negligence and, in any event, directors were exculpated for breaches of the duty of care at that level. In the case of the inadequate initial investigation of Easterbrook, the decision that the information was adequate for making a decision was itself a kind of business judgment; while “that judgment appears to have been a poor one, it is not an actionable one.” And while the failure to keep minutes of all meetings could be a “cause for suspicion,” it was “not sufficient to support an inference of bad faith.”
Count IV: The Claim For Waste. The Court also made short work of the claim that the decision to allow Easterbrook to receive severance and other separation benefits under his termination without cause constituted waste. According to the Court, a “transaction constitutes waste when it is so one-sided that no rational person acting in good faith could approve it.” Under more recent Delaware decisions, “waste” has been reconceived under the business judgment rule “as a means of pleading that the directors acted in bad faith.” The Court concluded that the separation agreement did not support a claim for waste: there were a number of benefits to the company from the agreement, and the decision to enter the agreement did not “suggest a decision so extreme as to be inexplicable on any basis other than bad faith.”
Conclusion: The Court concluded that the plaintiffs failed to state any claims and dismissed all of the claims against the directors under Rule 12(b)(6).
