Bloomberg Law
March 23, 2023, 3:00 PM

ANALYSIS: Three Takeaways from McDonald’s Toxic Culture Debacle

Kate Azevedo
Kate Azevedo
Legal Analyst

In 2018, McDonald’s Corp. faced a crisis in governance after allegations of a widespread culture of sexual harassment and employee misconduct surfaced. McDonald’s implemented several initiatives to remedy its workplace culture. Specifically, in 2019, the board took severe action by terminating CEO Steve Easterbrook and Chief People Officer David Fairhurst for their misconduct toward female subordinate employees.

But two significant developments in January—one judicial and one regulatory—show that repercussions from the matter are still ongoing. These rulings have redefined precedent for a corporate officer’s duty of oversight and heightened requirements for a company’s proper SEC corporate disclosure.

The McDonald’s story shall serve as a critical case study for corporate governance. My deeper analysis uncovers three takeaways from these latest developments that a corporate board should now consider when evaluating its governance practices relating to harassment and employee misconduct.

1. Officers Have Oversight Duty in Context

McDonald’s shareholders in 2021 sued the company in Delaware Chancery Court (In re McDonald’s Corporation Stockholder Derivative Litigation), asserting that its board of directors, and officers Easterbrook and Fairhurst, breached their duty of oversight under the Caremark doctrine. In its 1996 ruling, In re Caremark Int’l Derivative Litigation, the court determined that a board is obligated to implement an effective “reporting or information system” and to monitor the systems to address “red flags” of potential employee misconduct.

In January’s In re McDonald’s case, the court made a novel ruling by denying Fairhurst’s motion to dismiss. Fairhurst’s motion argued that the oversight duty described in Caremark applied to only directors and not corporate officers. The court disagreed, and explicitly ruled that a company’s corporate officers have a comparable—or even stricter—duty of oversight relative to its directors.

The ruling was an issue of first impression in Delaware law. Specifically, the judge ruled the duty of oversight is context-driven, based on an officer’s or director’s duties. The context of the “red flag” is also significant when evaluating the oversight duty. The court found that a “particularly egregious red flag” may trigger a corporate officer’s duty even if it fell outside of their scope of responsibility.

As a result of this ruling, a company must now evaluate its corporate officers’ oversight roles, and in doing so, it should consider each officer’s title and responsibilities. For example, a CEO may have company-wide oversight, while other officers may oversee specific areas within the company. A human resources executive, such as Fairhurst, is closer to the daily operations of a workplace and is therefore likely to be responsible for implementing a monitoring system and reporting misconduct to the board.

Although the shareholder claim against Fairhurst is headed for trial, the court granted the motion to dismiss filed by the McDonald’s board of directors. The court’s decision to grant the board’s motion rested on the context of the board’s response to the misconduct. The court also granted Easterbrook’s motion, but merely as a procedural matter; his prior settlement with McDonald’s waived any related future claims.

Below is a chart comparing how the court handled the motions to dismiss filed by Fairhurst and by the board, and why.

As this chart shows, even though the court found that both the board and the officer failed to have a reporting system in place, it still granted a motion of dismissal to the party that made an effort to address the red flags and misconduct, rather than to the party that “consciously ignored” them.

2. Oversight Claims Face Legal Hurdles

After the In re McDonald’s ruling, one might predict that companies are more vulnerable to Caremark claims due to the newly expanded definition of duty of oversight. Shareholders will likely feel more emboldened to pursue derivative suits, now that the court has established that a corporate officer does indeed have an oversight duty. But that fact might not necessarily result in shareholders winning more Caremark oversight claims in the Delaware courthouse, because significant procedural hurdles for derivative suits still remain.

A shareholder derivative suit contains inherent procedural hurdles that must be cleared before allowing a shareholder plaintiff to go forth with litigation against the company.

First, a derivative suit has a “demand requirement” that gives the board the first opportunity to address the specific wrongdoing the shareholders are claiming against the company. The derivative suit will terminate if the board decides to bring its own litigation on the matter or if it “fairly considered” the demand, but decided not to pursue it.

Second, shareholders pursuing a Caremark claim must demonstrate that the board and/or officers failed to make a good faith effort to oversee the company’s operations. A board has protection from liability under the business judgment rule; therefore, the board defendant shall often file a motion to dismiss for failure to state a claim upon which relief can be granted. It follows that many shareholders may not be pursuing this legal route in the Delaware Chancery Court due to these hurdles. A company should consider whether these procedural hurdles would apply when assessing its vulnerability to derivative litigation.

3. Boards Must Disclose Their Use of Discretion

McDonald’s experienced regulatory scrutiny from the Securities and Exchange Commission, which investigated whether the company properly disclosed CEO Easterbrook’s termination on its 2020 proxy statement to shareholders.

The SEC found McDonald’s violated Section 14(a) of the Securities Exchange Act and corresponding SEC Rule 14a-3 by failing to disclose that its board used “discretion” in terminating the corporate offer without cause and approving his $125 million severance package when his known misconduct violated the company’s code of conduct.

Despite the SEC’s finding, the company narrowly escaped a monetary penalty for its proxy filing violation due to its “substantial cooperation” and remedial measures—namely its successful litigation to claw back $105 million of Easterbrook’s compensation. McDonald’s has maintained it was unaware of Easterbrook’s large-scale misconduct prior to approving the severance package. Also, it chose to negotiate a “termination without cause” with Easterbrook to ensure an easy leadership transition and avoid expensive, protracted legal action, which is a common business practice.

Although McDonald’s did not face penalties or fines for its infraction, a company making a similar error of proxy disclosure in the future may not enjoy the same fate. Now that the SEC has set the order, a proxy statement without full disclosure could be a costly mistake for a company.

However, it is important to note that the commission very rarely charges entities with a violation of Section 14(a). Based on a Bloomberg Law search of more than 1,000 SEC orders over the past five years, the SEC charged a total of only 25 violations of improper disclosure under Section 14(a).

Furthermore, this rare SEC order was not well-received and resulted in negative pushback, being labeled as an aggressive use of the disclosure requirements in the media. Two SEC commissioners dissented to the order, calling it a “novel interpretation” of the executive compensation disclosure required by Item 402(b) of Regulation S-K. Companies should consider this balance when evaluating their SEC disclosures.

How a Strategic Board Should Move Forward

McDonald’s has faced legal and regulatory orders directed toward its board of directors and specific officers. The company managed to avoid monetary penalty in either action, but that does not mean other companies shall have the same outcomes when faced with this challenge. Going forward, companies, their boards of directors, and their senior officers should consider the following tips to account for these recent developments regarding their duty of oversight and the extent of corporate disclosure:

  • Design an effective monitoring system, specifically in human resources, to identify the appropriate red flags of harassment and misconduct in order to ensure a safe work environment. Establish a protocol for reporting red flags upward.
  • Continually assess the monitoring system for effectiveness as a good faith effort to identify red flags of harassment and misconduct. It may be a joint effort with compliance or ethics officers.
  • Seek legal advisement on the likely success rate of shareholder derivative litigation based on the applicable procedural and substantive requirements. The board should review its legal protocol to pursue its own legal action on the issue, which would effectively terminate the derivative litigation.
  • Review the company’s coverage of director and officer liability insurance. A corporation may need to include certain corporate officers, or increase coverage, within its insurance policy.

Bloomberg Law subscribers can find a variety of Practical Guidance documents, workflow tools, and reference materials for corporate counsel on our Corporate Governance practice page.

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