March 2023 in Brief: Corporations, LLCs & Partnerships

Court of Chancery Dismisses Caremark “Red-Flags Claim” Against the Directors of McDonald’s Corporation Relating to Pervasive Sexual Harassment; Holds Directors’ Termination of McDonald’s CEO Without Cause Was Governed by the Business Judgment Rule

In re McDonald’s Corporation Stockholder Derivative Litigation, C.A. No. 2021-0324-JTL (Del. Ch. March 1, 2023) (Laster, V.C.)

By Pamela Millard, Potter Anderson & Corroon LLP

On the heels of a January 2023 opinion denying defendant officer’s motion to dismiss plaintiffs’ derivative claims after determining that corporate officers of a Delaware corporation owe a fiduciary duty of oversight under In re Caremark Int’l Inc. Derivative Litig. (“Caremark”), the Court dismissed similar claims brought against the director defendants (the “Directors”) of McDonald’s Corporation (the “Company”), citing plaintiffs’ failure to plead a bad faith “Red-Flags Claim.” In addition, the Court dismissed claims alleging that the Directors erred in terminating the Company’s CEO in 2019 without cause after learning that the CEO had engaged in an inappropriate relationship with a Company employee, finding that the Directors’ determination was entitled to deferential business judgment review.

To reprise the facts leading to the Court’s January 2023 opinion (“McDonald’s I”), the derivative lawsuit stemmed from ongoing claims of pervasive sexual harassment at the Company, beginning in 2015 when Stephen Easterbrook was hired as CEO and David Fairhurst became Global Chief People Officer. Beginning in 2016, the Company faced increased public scrutiny regarding sexual harassment and misconduct, and dozens of employees filed complaints with the Equal Employment Opportunity Commission (“EEOC”) alleging sexual harassment in the Company’s restaurants. In 2018, after receiving additional EEOC complaints, the Company’s alleged “party atmosphere” and environment of sexual misconduct prompted a December 2018 Senate inquiry.

In 2019, as the Company developed its response to the Senate inquiry, the board received a report outlining the Company’s sexual harassment and misconduct issues and its remedial efforts. The board also terminated Easterbrook in October 2019 without cause and fired Fairhurst for cause one month later. In 2021, plaintiffs filed the present lawsuit alleging claims against Fairhurst, who was the subject of McDonald’s I, as well as Caremark claims against the Directors.

In dismissing plaintiffs’ claims, the Court first reviewed the history of Caremark duty of oversight claims under Delaware law, distinguishing between a claim that directors (1) utterly failed to implement any reporting or information system or controls (an “Information-Systems Claim”); or (2) having implemented such a system or controls, consciously failed to monitor or oversee its operations, negating the board’s ability to be informed of risks or problems requiring board oversight (a “Red-Flags Claim”).

The Court then noted that plaintiffs’ claims involved the Directors’ awareness of sexual harassment and misconduct at the Company and allegations that the Directors acted in bad faith by failing to address them: “In other words, the plaintiffs have asserted a Red-Flags Claim. They have not asserted an Information-Systems Claim.” To state a Red-Flags Claim, plaintiffs must plead facts supporting an inference that the directors were aware of pervasive sexual harassment at the Company— “a proverbial red flag”—but consciously ignored it. Plaintiffs were also required to prove a “serious failure of oversight” sufficient to support an inference that the Directors acted in bad faith.

Characterizing Fairhurst’s behavior as the head of the Company’s human resources division as “the most vibrant of red flags regarding a potential problem with sexual harassment and misconduct,” the Court nonetheless determined that plaintiffs failed to allege facts supporting an inference that the Directors failed to act. Rather, in 2019, the board worked with management to craft a comprehensive Company-wide response, including (1) hiring outside consultants, (2) revising Company policies, (3) implementing new training programs, (4) providing additional support to the Company’s franchise owners, and (5) taking other steps to improve the Company’s work environment.

Based on the remedial actions taken by the Company, the Court concluded that it could not draw a pleading-stage inference that the Directors acted in bad faith in responding to pervasive sexual harassment and misconduct at the Company, and dismissed plaintiffs’ Red-Flags Caremark claim.

Turning to allegations that the Directors breached their fiduciary duties by terminating Easterbrook without cause versus with cause, the Court reaffirmed prior case law holding that the business judgment rule protects a board’s decision to terminate an executive without cause, even if a with-cause termination was supportable. The Court also held that it was not reasonably conceivable that the Directors’ decision was based on self-interest, or that the board acted hastily in evaluating the terms of the CEO’s departure. Finally, the Court determined that the terms of Easterbrook’s separation agreement with the Company, including a severance package payable to the former CEO, did not support a separate claim for waste.

Recent Delaware Court of Chancery Decision Highlights Importance of Avoiding Conflicts and Full Disclosure in Take-Private Deals

By Mark D. Hobson

A recent decision of the Delaware Court of Chancery involved the taking-private of a public company, Mindbody, Inc. (“Mindbody”), by a private equity firm, Vista Equity Partners Management, LLC (“Vista”), and serves as an important reminder of the need in take-private deals to avoid conflicts in the sell-side process and to ensure that all material facts are properly disclosed to the target’s board and stockholders. See In re Mindbody, Inc. Stockholder Litigation, C.A. No. 2019-0442-KSJM, memo. op. (Del. Ch. Mar. 15, 2023).

The CEO of Mindbody at the time of the take-private transaction, the “main protagonist” in this case, had not only an interest in a near-term liquidity of Mindbody, coupled with a desire to sell the company fast—the CEO had grown frustrated at his inability to monetize his Mindbody stock and concerns about the public markets—but also an expectation that he would receive post-merger employment as an officer of Vista, accompanied by significant equity-based incentives. Consequently, plaintiffs argued that the CEO took actions to strategically drive down the stock price of Mindbody pre-merger, and provided Vista with informational and timing advantages during the due-diligence and go-shop periods (e.g., the CEO tipped Vista that a formal sale process was beginning for Mindbody). These actions of the CEO complemented Vista’s modus operandi in its approach to deal work, which was to gain a competitive advantage over competing bidders by moving quickly in presenting a firm offer.

Consequently, before the merger closed, some Mindbody stockholders (collectively the “plaintiffs”) filed federal securities class actions in California and Delaware, including the filing of a suit in April 2019 in the Court of Chancery under Section 225 of the Delaware General Corporation Law (“DGCL”) to challenge the validity of the stockholder vote (the “Section 225 Action”) and an enforcement action in the Court of Chancery under Section 220 of the DGCL to obtain books and records concerning the merger (the “Section 220 Action”). Following the closing of the merger, the Section 220 Action was voluntarily dismissed, but the Section 225 Action moved forward, with discovery concluding in April 2019, the same month that the plaintiffs filed an appraisal petition (the “Appraisal Action”). A couple months later, in June 2019, the plaintiffs filed a class action lawsuit (the “Luxor Action”) alleging breach of fiduciary duty claims against the CEO, the CFO, and Eric Liaw, who was the director representative of Mindbody’s largest stockholder prior to the merger (“IVP”). The Section 225 Action, the Appraisal Action, and the Luxor Action were consolidated in October 2019 into this case before the Delaware Court of Chancery. Thereafter, on December 15, 2020, the parties settled, with the court’s approval, the Section 225 claim, followed by a dismissal without prejudice of the claims against Liaw. Finally, after fact discovery had closed, the plaintiffs further amended their complaint on July 27, 2021, by dropping the CFO as a defendant, reasserting claims against Liaw, and adding aiding-and-abetting claims against IVP and Vista.

In essence, the plaintiffs advanced two main theories of breach: 1) that the CEO breached his fiduciary duties by tilting the sale process in favor of Vista; and 2) that the CEO committed disclosure violations by failing to disclose facts about the sale process and omitting information about the actual revenue results of Mindbody. The remedy sought by the plaintiffs was the lost transaction price that Vista would have paid if the process had not been tilted in its favor, which Luxor argued was $40 per share—the price actually paid in the merger was $36.50 per share. Liaw and IVP settled with the plaintiffs, leaving only the CEO and Vista as defendants in this case.

Based on the facts at hand, Chancellor McCormick concluded that the plaintiffs’ claim was a “paradigmatic Revlon claim” because the case involved a conflicted fiduciary whom the Mindbody Board of Directors failed to adequately oversee and who consequently tilted the sale process to further his own personal interests contrary to the best interests of the stockholders of Mindbody. The Chancellor noted that disabling conflicts of interest can include a fiduciary’s “desire to gain liquidity” and “prospect of future employment”, depending of course on “the subjective intent of the fiduciary.” The court determined that the facts presented supported that the CEO (i) “was subjectively motived [in the take-private transaction] in large part by his need for liquidity”, (ii) had become “uniquely smitten with Vista before the formal sale process began”, and (iii) “had a relatively limited window for effectuating” the take-private to the benefit of the CEO. Further, the CEO repeatedly took independent steps, without the knowledge of the Mindbody Board, to assist Vista in giving it a competitive advantage in the Mindbody sale process. “In short, the Board was in the dark” about how the CEO was manipulating the sale process. 

Chancellor McCormick also determined that “the stockholders [of Mindbody] were as in the dark as the Board”; as a consequence, the applicable standard of review was enhanced scrutiny under Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986). The defendant fiduciaries were not able to lower the standard of review to the business judgment rule, in reliance on Corwin v. KKR Fin. Hldgs. LLC, 125 A.3d 304 (Del. 2015), because the take-private action with Vista was not “approved by a fully informed, uncoerced majority of the disinterested stockholders” of Mindbody. The CEO had kept hidden his actions with Vista, so the stockholder vote was based on deficient disclosures of all material information. Therefore, Corwin did not apply. The court found that the CEO had “breached his fiduciary duties in the process-based disclosures.” 

Regarding Vista, Chancellor McCormick, addressing the plaintiffs’ two theories of liability for aiding and abetting against Vista, found that the first theory—that Vista had aided and abetted the CEO’s sale-process breaches—was procedurally improper because the plaintiffs never asserted this theory until a post-trial briefing and to hold otherwise “would impose substantial prejudice to Vista.” As a consequence, the court found that the plaintiffs failed to timely assert its claim under the first theory. On the other hand, the court did find Vista to be liable for aiding and abetting in the CEO’s process-based disclosure breaches because the plaintiffs had proven, among others, that Vista was a knowing participant in such breaches.