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Delaware Court of Chancery Dismisses Caremark Claims Against Directors for Failure to Allege Bad Faith Conduct

March 9, 2023 Download PDF

On March 1, 2023, the Delaware Court of Chancery dismissed Caremark oversight claims brought against the directors of McDonald’s Corporation for their alleged failure to address “red flags” suggesting widespread sexual harassment and workplace misconduct at the company. In re McDonald’s Corp. S’holder Derivative Litig., 2023 WL 2293575 (Del. Ch. Mar. 1, 2023). The court found that the plaintiffs’ allegations criticizing the directors’ efforts to address such red flags failed to plead that the directors acted in bad faith. McDonald’s reaffirms the vitality of Delaware’s strict Caremark pleading standard and should help allay recent concerns that it had been diluted.

Background on Caremark Claims

Delaware law has long recognized that directors’ fiduciary duty of loyalty requires that they supervise a corporation’s affairs by both establishing a system of internal controls and responding to “red flags” suggesting corporate misconduct. Claims that directors breached their oversight responsibilities are described as “among the hardest to plead and prove” because such claims require a showing of bad faith conduct.[1] Lawsuits asserting such claims had historically and routinely been dismissed at the pleadings stage under this strict standard.

The Delaware Supreme Court’s 2019 decision in Marchand v. Barnhill was perceived as a turning point and potential dilution of the historically strict standard.[2] (Discussed here.) In Marchand, the Supreme Court reversed the Court of Chancery’s dismissal of Caremark claims against the directors of an ice cream company, Blue Bell Creameries USA, Inc., stemming from a widespread listeria outbreak. The Supreme Court reasoned that the allegations that the directors failed to implement any “board-level compliance monitoring and reporting” concerning the “intrinsically critical” issue of food safety were sufficient to plead that the directors acted in bad faith. Marchand and a series of subsequent decisions declining to dismiss Caremark claims at the pleadings stage have led to a perception that Caremark claims have become easier to plead.[3]

The Court of Chancery’s Opinion

Certain McDonald’s stockholders filed a consolidated complaint alleging that, under the watch of the CEO and CPO, the company cultivated and promoted a culture of sexual harassment and workplace misconduct. The stockholders alleged that McDonald’s directors were put on notice of this misconduct by employee complaints, strikes and even an inquiry from a U.S. senator. The plaintiffs’ complaint also detailed the actions the directors had taken in response, including “(i) hiring outside consultants, (ii) revising the Company’s policies, (iii) implementing new training programs, (iv) providing new levels of support to franchisees, and (v) taking other steps to establish a renewed commitment to a safe and respectful workplace.”[4] The stockholders criticized the directors’ response as ineffective and alleged that the directors violated their fiduciary duties under Caremark because they “did not fix the problem.”[5]

In addition, the stockholders alleged that the directors breached their fiduciary duties by entering into a without-cause separation agreement with McDonald’s CEO. The stockholders alleged the directors acted out of self-interest, purportedly fearing that a for-cause termination would invite a litigation challenge by the CEO and publicize the company’s pervasive culture problems that the directors had allegedly failed to remedy in bad faith.[6] 

The Court of Chancery dismissed the stockholders’ claims against the directors as insufficient to plead a claim. The court reasoned that the stockholders’ own allegations and documents incorporated into the complaint demonstrated that the directors acted in good faith to remedy the alleged misconduct brought to their attention. The court further reasoned that the allegations the directors’ responses were ineffective did not demonstrate bad faith, explaining that fiduciaries “cannot guarantee success . . . What they have to do is make a good faith effort.”[7] 

The court also dismissed the stockholders’ claims that the directors breached their fiduciary duties by agreeing to a without-cause separation agreement. In addition to finding no allegations suggesting bad faith conduct by the directors, the court reasoned the stockholders failed to allege that the directors were interested or lacked independence in reaching that decision. The court thus explained that the directors’ decision “was a classic business judgment” entitled to deference.[8]

Implications

Dispelling the perception that Delaware courts have lowered the Caremark pleading bar, McDonald’s highlights that directors fulfill their duty of loyalty by making a good faith effort to respond to reports of misconduct. In addition, the good-faith decisions of disinterested and independent directors to part ways with members of management alleged to have been involved in reported misconduct will continue to be protected by business judgment deference. Accordingly, complaints charging only that the directors’ actions were ineffective or even grossly negligent should still be expected to fail at the pleadings stage. And, the same is true with good-faith business judgments made by a majority of unconflicted directors.

McDonald’s also highlights the importance of sound formal corporate recordkeeping. The directors’ good-faith efforts to address the alleged red flags were documented in board meeting minutes and materials that were provided to the court in support of their motion to dismiss. Although noting that director defendants’ overreliance on such documents in their motions to dismiss can sometimes lead to the court converting a pleadings-stage motion to one for summary judgment, the court found that conversion in this instance was not warranted.

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[1]       See In re Clovis Oncology, Inc. Derivative Litig., 2019 WL 4850188, at *12 (Del. Ch. Oct. 1, 2019).

[2]       Marchand v. Barnhill, 212 A.3d 805 (Del. 2019).

[3]       See, e.g., Clovis Oncology, 2019 WL 4850188; Inter-Mktg. Grp. USA, Inc. on Behalf of Plains All Am. Pipeline, L.P. v. Armstrong, 2020 WL 756965 (Del. Ch. Jan. 31, 2020); Hughes v. Xiaoming Hu, 2020 WL 1987029 (Del. Ch. Apr. 27, 2020); Teamsters Loc. 443 Health Servs. & Ins. Plan v. Chou, 2020 WL 5028065 (Del. Ch. Aug. 24, 2020); In re Boeing Co. Derivative Litig., 2021 WL 4059934 (Del. Ch. Sept. 7, 2021).

[4]       McDonald’s, 2023 WL 2293575, at *1.

[5]       Id. at *12, 21.

[6]       Id. at *28.

[7]       Id. at *21.

[8]       Id. at *28.  

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