Delaware Court Extends Fiduciary Duty of Oversight to Corporate Officers
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Delaware Court Extends Fiduciary Duty of Oversight to Corporate Officers

Brownstein Client Alert, Feb. 21, 2023

For companies incorporated in Delaware (and beyond), it may be time to reexamine a number of issues impacting senior leadership from a variety of perspectives, including corporate governance, indemnification provisions, executive employment agreements, anti-harassment and discrimination policies, and more.

This is because a Delaware Court of Chancery recently determined—for the first time—that the fiduciary duty of oversight previously only recognized as to corporate directors applies equally, if not to a greater degree in certain contexts, to officers

Previously, the duty of oversight generally encompassed two obligations for corporate directors: (1) to ensure adequate information and reporting systems exist within the organization, and (2) to suitably respond to “red flags indicating wrongdoing” within those information and reporting systems. 

However, in a recent opinion, a Delaware court extended those same oversight duties to corporate officers and explained that most corporations are not directly managed by the board of directors. Rather, officers run the day-to-day operations of the business and have a greater capacity to make oversight and strategic decisions. Additionally, the court reasoned officers are typically tasked with creating, maintaining, and overseeing the requisite internal policies and information reporting systems. Consequently, the court held officers “are far more able to spot problems than part-time directors who meet a handful of times a year.”

The court further clarified that the scope of an officer’s duty of oversight is context-driven and limited to the officer’s area of responsibility. For example, while “the CEO and Chief Compliance Officer likely will have company-wide oversight portfolios, other officers generally have a more constrained area of authority.” A chief financial officer’s oversight duties may be limited to financial systems; a chief legal officer’s oversight duties may be limited to legal oversight; and an executive marketing officer’s oversight duties would naturally encompass different fiduciary obligations. The court specifically noted that the board can “of course … tailor the officers’ obligations and responsibilities,” nevertheless, a “particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.” 

Although this represents an expansion of potential liability against corporate officers, it remains unclear how far it will reach. On one hand, the opinion explicitly states that all corporate officers owe a duty of oversight to the company, even if they do not serve on the board of directors. The court opined, however, that a “flood of new employment-style claims seems unlikely,” because a breach of oversight duty claim is derivative in nature and has “all of the protections associated with derivative claims”—namely, the demand futility requirement. A shareholder derivative claim is unique in that the claim is pursued by shareholders, not for harm they suffered, but harm suffered by the company that the company has failed or refused to remedy. To have standing to bring such a claim, the shareholders must allege that they have informed the board of directors of the alleged wrongdoing, and that the board has declined to act. Or, the shareholders must credibly allege that any demand on the board would be “futile.” Generally, a demand is futile where the board itself is alleged to have committed the wrongdoing. Where an officer, especially one that is not a member of the board, is accused of the wrongdoing, it may be more difficult to credibly allege a demand on the board for action would be futile. This may prove to be a difficult hurdle for shareholders to overcome.

Further, the court reiterated the high burden to establish oversight liability, which requires a “showing of bad faith,” meaning that an officer must “consciously fail to make a good faith effort to establish information systems, or the officer must consciously ignore red flags.”

While the long-term impact is not yet known, Delaware corporations should take note and reexamine internal policies and procedures from a variety of perspectives: 

Corporate Governance: As the court noted, companies can determine how they are organized and managed. Because an officer’s duty of oversight is context-driven, companies should consider which employees serve as “officers” and the full scope of those officers’ duties and areas of oversight. Boards and officers should periodically review the company’s information reporting systems and controls to ensure they are adequate and that proper procedures are followed. Additionally, officers should review their own documentation procedures in response to potential “red flag” issues and ensure they are making a good faith effort to address and report these issues upward within their area of responsibility.

Additionally, companies may want to consider whether and how they can limit officer liability within their governing documents. In August 2022, the Delaware General Corporation Law was amended to allow corporations to extend limitations of liability for officers and directors. Specifically, a company may include in its certificate of incorporation a provision that eliminates officer liability for breaches of the duty of care in direct shareholder claims. Such limitation would not impact the claims at issue (because a duty of oversight claim is premised on the duty of loyalty, not care, and it is derivative in nature), but could nevertheless protect officers and directors from other direct shareholder claims. Boards and officers should pay attention to see if Delaware legislators enact similar legislation to insulate corporate officers from these types of derivative suits in the future.

Employment Agreements, Policies, and Investigations: Companies should also consider amending any employment agreements, executive compensation agreements, and/or indemnification agreements with officers/directors. Officers when negotiating these agreements may also be more focused on the D&O coverage provided by the company and having a clear description of the officer’s area of responsibility. Qualified officers may be discouraged from taking positions with Delaware companies without having assurances of adequate protections and indemnification provisions in place.

Further, this opinion reiterated the requirement that corporations maintain robust anti-discrimination, anti-harassment, and other related policies; that corporations have an adequate oversight and reporting mechanism for such policies; and that such policies are actually enforced at all levels of the organization. Companies should periodically reexamine their policies and enforcement structure, including legal review of written policies and an audit as to reporting and enforcement procedures.

Finally, if the company receives any complaints or accusations of executive misconduct, companies should tread carefully with respect to any resulting investigations or disciplinary action. The opinion explicitly concluded that an executive’s own acts of harassment constitute a breach of the duty of loyalty. Accordingly, if handled improperly, a complaint of sexual harassment could not only give rise to a direct claim under state and/or federal employment laws by the alleged victim but could also give rise to shareholder derivative claims for breach of fiduciary duty. 

D&O Insurance: Similarly, corporations should reassess all insurance policies and indemnification policies and continue monitoring any changes in D&O insurance coverage following this opinion. This decision may also result in increased D&O insurance premiums, which could negatively impact the affordability of adequate coverage.

Environmental, Social, and Governance (ESG): ESG is an increasingly prevalent force impacting corporate investment and governance strategy. Broadly, the concept takes into account a more expansive view of long-term company risks and opportunities, such as governance standards, a company’s impact on its stakeholders and employees (including diversity efforts, anti-harassment policies, gender equality), impacts on customers and the communities in which the company operates, and environmental impacts. It of course follows that this broader set of risks and related management implications impacts potential fiduciary obligations of a company’s leaders. In recent years, shareholder derivative lawsuits have been filed alleging that, despite companies’ promotion of ESG efforts on their public website or internal policies, in practice, they are lacking. While the opinion does not expressly mention the concept of ESG, the opinion highlights certain allegations that implicate ESG concerns. 

Whether styled as an ESG violation or a duty of oversight violation, the opinion highlights the importance that companies seriously consider their workplace culture, their compliance with and effectiveness of their published values and policies, and that leadership actually “walks the walk” with respect to those values and policies. For example, many corporations have recently added employment titles such as “Chief Culture Officer” or “Chief Diversity Officer.” These types of employment arrangements raise many questions as to potential claims under the duty of oversight and/or ESG framework. Is such position an “officer” level position? If so, will non-compliance and/or ineffectiveness in achieving improvements in diversity, gender, or corporate “culture” give rise to claims against the company? Corporations in Delaware and beyond should be cognizant of these developments and act proactively.

Securities: Parallel to the Delaware civil action, the U.S. Securities and Exchange Commission has also charged corporate executives and companies with violations of the anti-fraud provisions of the Securities Act of 1933 for failing to disclose violations of company policy in connection with executive compensation reporting. Accordingly, in responding to complaints or allegations of executive misfeasance, companies should be thoughtful in their approach to the investigation and publication of such actions, so as not to run afoul of SEC disclosure requirements.

Litigation and Books and Records Demands: As mentioned, it is unclear whether this opinion will “open the floodgates” with respect to new claims against corporate officers. Regardless, corporations can take steps to protect against potential litigation. One possible result is increased books and records demands from shareholders seeking information about the directors’ and officers’ duties, compliance with such duties, and existence of any “red flags.” Companies should consider strategies as to how to maintain such records and/or respond to such forthcoming requests. Additionally, if confronted with a demand related to an officer’s misconduct, a company should consult counsel to formulate an appropriate response.

Non-Delaware Companies: Many jurisdictions follow Delaware for guidance and, over time, adopt tenets from Delaware case law. Non-Delaware companies should stay alert to similar changes in their own jurisdictions. 

To learn more about the impact of this opinion and how to protect your company’s practices, please contact a member of the Brownstein team. Our Corporate & Business, Litigation, ESG, and Labor and Employment teams are prepared to assist.

This document is intended to provide you with general information regarding a Delaware Court of Chancery ruling that applies the fiduciary duty of oversight to corporate officers. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions. The information in this article is accurate as of the publication date. Because the law in this area is changing rapidly, and insights are not automatically updated, continued accuracy cannot be guaranteed.

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