Saturday, March 4, 2023

Much Ado About Nothing

After VC Laster held that officers have Caremark duties, and can be the subject of derivative suits for violating them, there was a flurry of commentary to the effect that this would radically expand legal liability, open corporate officers up to a host of new lawsuits, and generally represented a bold new direction in Delaware law.  Now, of course, he’s done what was the most predictable thing in the world: He dismissed the claims on grounds of demand futility.   Which demonstrates there was nothing radical – or even particularly new – about his opinion originally.

So, the backstory:

The McDonald’s plaintiffs alleged that the directors of the company, its CEO, and its “Chief People Officer,” David Fairhurst, created and/or ignored a culture of pervasive sex discrimination and sexual harassment.  Fairhurst in particular was alleged to have done nothing about employee reports of harassment, to have tolerated a culture where employees feared reporting harassment, to have cultivated a “party atmosphere” that encouraged harassment, and ultimately to have engaged in sexual harassment himself.  Matters were so bad that there were coordinated EEOC complaints, nationwide employee walkouts, and inquiries from U.S. Senators.

On January 26, VC Laster held that if the allegations were true as to Fairhurst, then Fairhurst had violated his fiduciary duties to the corporation under Caremark by failing to identify the problem, attempt to redress it, and report matters to the board.  Fairhurst also violated his duties by personally engaging in illegal conduct – harassment – for his own benefit.  

On March 1, VC Laster issued a second opinion dismissing all claims against the directors on grounds of demand futility, with an additional order that claims against Fairhurst were also dismissed on demand futility grounds (that order is available on the docket, but is not currently on the court’s public website).

So, when it comes to the claims against Fairhurst, which were the ones that inspired the handwringing, it’s important to distinguish two separate issues which were collapsed in some of the reporting.  One is, what were Fairhurst’s duties to his employer?  The other is, assuming he violated those duties, can shareholders bring lawsuits over it?

Starting with Fairhurst’s obligations, the main concern was about Caremark duties and whether VC Laster unduly expanded them.  Now, sure, there’s an ongoing larger debate about why we have Caremark duties and what their function is or should be – compare Stephen M. Bainbridge, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight with Elizabeth Pollman, Corporate Oversight and Disobedience – but in this case, I think the label “Caremark” obscured more than it illuminated.  Fairhurst was the human resources guy.  His literal function – his actual responsibilities, what he was hired to do – was to handle employee relationships.  The most basic aspects of his job were to ensure the company was complying with employment and labor laws, and generally to maintain a good or at least tolerable company culture.  And he, quite flagrantly, did not do his job.

Professor Bainbridge (no fan of Caremark liability in the first place), was particularly vexed that VC Laster’s opinion expanded Caremark duties to mere garden variety lawbreaking instead of “mission critical” lawbreaking.  I think that misapprehends the point of the “mission critical” label, and this is something that VC Laster elucidates in his March opinion dismissing claims against the director defendants.  “Mission critical” was intended to identify things that are important enough to the company that they deserve board-level attention, and, in particular, things where the board should be affirmatively setting up a reporting system even in the absence of notice of a problem.  I.e., “mission critical” is how we know whether it’s a Big Thing or a little thing, and we don’t expect board members to constantly monitor little things even before they become Big Things, because being a board member is only a part time gig.  “Mission critical,” in other words, is how we define the scope of the board’s non-delegable oversight duties at the outset.  It is how we define the board’s actual job.

But Fairhurst was an officer, not a board member, and he had a different job.  Even if I concede that avoiding sexual harassment would not have been “mission critical” for McDonald’s at the board level, it absolutely was “mission critical” for Fairhurst.  We can call it Caremark, but we can also call it Fairhurst’s job description.  When it came to Fairhurst’s sphere of authority, this was not a little thing, it was a Big Thing.  If Fairhurst had been charged with keeping the copiers supplied with toner, and he ignored that job, it also would have been “mission critical” for him.  Which is why, in the January opinion, VC Laster made clear that when it comes to officers, who (unlike board members) do not have responsibility for the whole company, Caremark duties are shaped by their particularized spheres of authority.  

After that, we are in Agency 101 territory, or, more specifically, Restatement (Third) of Agency § 1.01 territory, namely, that agents are fiduciaries who consent to act under the principal’s control.  I can’t think of an agency principle in the world more fundamental than that agents should not flagrantly ignore their assigned responsibilities. 

So, yes, of course, the Chief People Officer violated his fiduciary duties to the company when he decided that he just wasn’t going to do his job, resulting in – I cannot emphasize this enough – nationwide employee walkouts.  The only surprising thing about the whole mess is that, in the Year of Our Lord 2022 (when this was briefed), Fairhurst even made the argument that, as Chief People Officer, he had no duty to prevent sexual harassment, and further, that he expected a court would accept that argument and write it down and publish it where other people could see it.

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But then there’s the next question, which is, if he did violate his duties, can shareholders be the ones to bring the lawsuit?  And on this, again, VC Laster got it exactly right, exactly the way I explain it to my students, and it surprises me that anyone could think otherwise. 

Namely, we all experience little torts every day.  Someone bumps into us on the street; a delivery is late, or wrong; the dry cleaner loses our clothes.  We (usually) make a decision not to sue over these things, because it would be expensive to do so, or time-consuming, or the tortfeasor is judgment proof, or a lawsuit would expose us to embarrassing discovery.  Instead, we handle matters other ways.  We lump it, or we complain to the manager, or we refuse to do business with the vendor again.  Companies are in the same boat – sure, they could sue every employee who makes a mistake or steals some petty cash, but sometimes, most of the time, it makes more sense to handle matters with a firing or some other form of internal discipline.  And boards are charged with making those decisions, just as they’re charged with other aspects of managing the company.

But occasionally, we don’t actually trust that boards can make that decision fairly.  When?  Well, most obviously, when the board members themselves were the tortfeasors.  But there might be other situations, such as when board members have close relationships with the tortfeasors.  In those scenarios, shareholders get to substitute their judgment for that of the board, and bring the lawsuit in the company’s name.  And that’s what a derivative lawsuit is.  Not every defendant in a derivative lawsuit is a board member, or even an officer – a while ago, for example, shareholders of HealthSouth brought a derivative lawsuit against the company’s auditor, on the ground that the auditor had breached its contract with the company by failing to catch all the accounting fraud.  See Ernst & Young, LLP v. Tucker ex rel. HealthSouth Corp., 940 So. 2d 269 (Ala. 2006).

The demand requirement of Rule 23.1 is how we sort out situations where we can and can’t trust the board to decide whether the company should bring a lawsuit – and that is how we ensure that imposing duties on corporate officers will not result in an explosion of liability, not by limiting their duties in the first place.  And that is exactly what happened in McDonald’s.  Fairhurst violated his duties to the company (and very possibly his employment contract).  That potentially triggered liability to the company, in the same way that any employee who abandons his responsibilities would be liable for damages caused.  But, ultimately, boards decide when a lawsuit is the most appropriate method of discipline, and VC Laster concluded that shareholders did not have a good reason to think that the board could not make that decision in this case.

That also takes care of another objection to VC Laster’s original ruling, namely, the part where he held Fairhurst violated his duties by engaging in sexual harassment personally.  Any agent violates their duties when they engage in misconduct; this is the kind of thing I teach in the beginning of a BizOrgs class.  The agent might also violate his employment agreement, behave negligently, or do any of a thousand other things that could trigger either contract or tort liability to his principal, just as Ernst & Young might have violated its contract with HealthSouth by conducting a negligent audit.  A finding that there is liability as between the employee (or the contractor) and the company is entirely unremarkable.  The rubber meets the road when it comes to what the principal decides to do about those things, and in particular, who makes that decision.  When that law changes, it’ll be notable.

Ann Lipton | Permalink


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