Using the Duty of Loyalty as a Vehicle for Change in Sexual Misconduct Cases

Monday, November 27th, 2017 at 3:46 pm, by Elliott Grund

Beginning with the New York Times publication on October 5th, 2017 that detailed a pattern of sexual abuse by the well-known film producer Harvey Weinstein, the last month and a half has seen a maelstrom of allegations against many prominent individuals in both media and the political sphere. The list includes the likes of James Toback, Jeremy Piven, Mark Halperin, Kevin Spacey, Dustin Hoffman, Brett Ratner, Louis C.K., Roy Moore, and former President George H.W. Bush. Whether or not all of the allegations turn out to be valid, the publicity generated by the Times Oct. 5th piece has brought much-needed attention to an issue that has been continually swept under the rug for a very long time. While this attention should provide impetus for positive change in this area going forward, two questions remain: (1) how can we organize legal incentives to successfully establish a better system of protection in the future, and (2) what remedial avenues are available for past victims?

One interesting, and certainly non-conventional, answer to both of these queries is the use of corporations’ law. Both directors and officers of a corporation owe fiduciary duties to the corporation and its shareholders in their respective capacities. At the broadest level, these duties are separated into two forks: the duty of care and the duty of loyalty. Assuming that the corporation at issue is incorporated in Delaware, plaintiffs generally prefer to bring claims under the duty of loyalty since these claims are not insulated from the deferential business judgment rule.

Though the duty of loyalty encompasses a variety of potential fiduciary issues, the subset most pertinent in this scenario would be a director’s or officer’s obligation to act in good faith. Particularly, this obligation leads to various duties of oversight, (usually referred to as Caremark claims) which could create liability within the context of sexual misconduct.[1] As first promulgated in In re Walt Disney Co. Derivative Litigation, a failure to comply with the obligation to act in good faith is reflected in a director’s “[I]ntentional dereliction of duty, [and] a conscious disregard for one’s responsibilities.”[2] The decision laid out a standard of “[D]eliberate indifference and inaction in the face of a [known] duty to act…”[3] Thus, the essential question becomes: does such a duty to act attach when establishing adequate procedures for the prevention and potential ex post rectification of sexual misconduct that may occur within a corporation?

Caremark itself implicated this idea within the context of reporting –  stating that the “[S]ustained or systematic failure of the board of directors to exercise oversight – such as an utter failure to attempt to assure reasonable information and reporting systems exist – will establish the lack of good faith that is a necessary condition to liability.”[4] Though Caremark itself was a duty of care claim, Delaware courts have since repurposed under the branch of the duty of loyalty.[5] Specifically, in Stone v. Ritter, the Delaware Supreme Court articulated that directors may be liable for a breach of the obligation of good faith and thus a duty of loyalty violation, if directors “[F]ailed to implement any reporting or information system or controls; or (b) having implemented such a system of controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.”[6] Thus, it is clear from Stone and other subsequent decisions that this standard applies in the context of reporting or audit committees.[7]

However, it is less obvious if this standard would continue to hold up in the context of directors failing to set in place adequate procedures to prevent or address claims of sexual misconduct and harassment. Even if it did, what would such a standard look like? From some of the opinions of Delaware courts it appears that directors must adequately inform themselves about certain internal matters within the company.[8] With the whirlpool of allegations currently in the public eye, directors and officers of corporations should be on notice that this is an issue that needs to be addressed. Particularly, the interconnection with employment law and EEOC regulation[9] gives plaintiffs a strong argument that the installation of adequate procedures to guard against sexual misconduct in the workplace are a part of corporate officers’ and directors’ oversight duties. Even if this were not to be the case, potential claimants would still have a case if directors or officers had ignored potential red flags.[10] While this may be a particularly pertinent route in the Weinstein case (as his predilections appeared to be an open secret in Hollywood), it may be less applicable more generally.

The more important question then becomes what are adequate procedures and where is the line drawn – how far must adequate procedures go? New technology, for example, has recently been developed that allow people to confidentially submit the name of an abuser or assaulter to an information escrow. The information is held until at least one other person submits the name of the same abuser. At that point, the technology then lets both victims know that there appears to be a pattern with this particular person and gives them the option of coming forward together, avoiding many of the traditional pitfalls involved with bringing forward allegations of sexual crimes and misconduct. These “whisper networks” or information escrows are already being employed at college campuses, and developers are exploring the possibility of expanding the technology to professional settings. Would oversight liability extend to a failure to implement such rigorous standards? At this point, the answer clearly appears to be no, but could this duty be expanded into the future to reach such a high bar?

The standard present in the case law is one that seems to approach the criminal mens rea or mental state of recklessness. A “conscious disregard” to act in the face of a known duty to do so means that directors must be informed that they had a duty to establish certain procedures and failed to do so.[11] While this likely could create liability when management either ignores red flags or fails to install procedures against sexual misconduct and harassment generally, it would very likely fail to establish liability for the lack of an information escrow system (as long as some other system had been put in place). This generally seems to be the case – it does not matter exactly what procedures were put into place as long as some procedures were established (and were not completely inadequate).[12] Despite this, putative plaintiffs may have a stronger argument than it initially seems should they be able to prove that allegations of sexual harassment within a corporation instigated an effect on the bottom line. Fiduciary duty claims are rooted in directorial actions that damage shareholder value. If plaintiffs can convincingly show that sexual harassment claims within a corporation consistently diminish shareholder value, management may be held to meaningfully higher standards going forward.

[1] In re Caremark Intern. Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).

[2] In re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 61 (Del. 2006).

[3] Id.

[4] In re Caremark Intern. Inc. Derivative Litigation, 698 A.2d 959, 971 (Del. Ch. 1996).

[5] Stone v. Ritter, 911 A.2d 362 (Del. 2006).

[6] Id. at 370.

[7] Id.; In Re China Agritech, Inc. Shareholder Derivative Litigation 2013 WL 2181514, 18 (Del. Ch.) (articulating that a successful Caremark allegation “might take the form of facts that show the company entirely lacked an audit committee or other important supervisory structures or that a formally constituted audit committee failed to meet.”)

[8] Stone v. Ritter, 911 A.2d 362 (Del. 2006).

[9] Title VII of the Civil Rights Act of 1964, 42 U.S. Code § 2000e-2.

[10] Stone v. Ritter, 911 A.2d 362, 372 (Del. 2006).

[11] In re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 61 (Del. 2006).

[12] Stone v. Ritter, 911 A.2d 362 (Del. 2006).