Current Developments in Estate Planning and Business Law: March 2023

Mar 17, 2023 10:00:00 AM


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From the enforcement of federal tax liens against a trust found to be the taxpayer’s nominee to the United States Supreme Court’s ruling that highly compensated workers may be entitled to overtime pay, we have recently seen significant developments in estate planning and business law. To ensure that you stay abreast of these legal changes, we have highlighted some noteworthy developments and analyzed how they may impact your estate planning and business law practice.

Property Held in Trust That Was Merely a Nominee of Delinquent Taxpayer Subject to Tax Lien

United States v. Hovnanian, Civ. No. 18-15099, 2022 WL 17959583 (D.N.J. Dec. 27, 2022)

The US government (the Government) alleged that Shant Hovnanian (Shant) owed more than $16 million in federal taxes from engaging in illegal tax shelters. A default judgment was entered against Shant for the amounts assessed against him. In the Government’s efforts to collect the taxes, it sought to attribute two pieces of real property held in trust to Shant so that it could attach federal tax liens to those properties and foreclose on them. Shant’s sister, Nina, was the trustee of the Pachava Asset Trust, which held legal title to the property where Shant resided rent-free. Nina was also the trustee of the VSHPHH Trust, which held title to an office complex occupied by first-floor tenants who paid rent and by Shant, who paid no rent for his usage of space at the complex.

The Government filed an action in the Federal District Court of the District of New Jersey seeking an order that it had valid tax liens against the two properties held by the Pachava Asset Trust and VSHPHH Trust and that its liens could be foreclosed. Nina, as trustee, filed motions to dismiss on behalf of both trusts, which were denied. The Government sought motions for partial summary judgment against the Pachava Asset Trust and VSHPHH Trust, arguing that the trusts were merely Shant’s nominees and that the tax liens should attach to the properties.

The Government asserted that, although the trusts held title to the residence and the office complex, Shant actually controlled those properties. The court noted that under United States v. Patras, 544 F. App’x 137, 140 (3d Cir. 2013), a third party is a taxpayer’s nominee where “the taxpayer has engaged in a legal fiction by placing legal title to property in the hands of a third party while actually retaining some or all of the benefits of true ownership.” In Patras, the Third Circuit Court of Appeals established a test with six factors—which the court noted should not be applied rigidly—to determine whether a nominee relationship exists due to the taxpayer’s active or substantial control over the property:

  1. Whether the nominee paid adequate consideration for the property;
  2. Whether the property was placed in the nominee’s name in anticipation of a suit or other liabilities while the taxpayer continued to control . . . the property;
  3. The relationship between the taxpayer and the nominee;
  4. The failure to record the conveyance;
  5. Whether the property remained in the taxpayer’s possession; and
  6. The taxpayer’s continued enjoyment of the benefits of the property.

Patras, 544 F. App’x at 141–42.

In determining whether the residence held by the Pachava Asset Trust was subject to a tax lien, the court found that the undisputed facts in the record established that (1) the transfer was made for minimal consideration (the property had been transferred to the trust by Shant’s mother for one dollar), (2) the transfer was made subsequent to the judgment entered by the Tax Court against Shant, (3) Shant had a close relationship with the current trustee, who was his sister, and previous trustees, who were also family members, and (4) Shant possessed and enjoyed the property, which was his primary residence. The court determined that because factors one, two, three, five, and six were met, there was no genuine dispute of fact regarding whether Pachava Trust was Shant’s nominee. It granted the Government’s motion for partial summary judgment and subjected the property where Shant resided to the federal tax lien.

The court also used the Patras test in determining whether the VSHPHH Trust, which held the office complex, was merely Shant’s nominee. The record established that (1) Shant’s parents transferred the office complex to the trust for one dollar in 2015, (2) the transfer of the property to the trust occurred subsequent to the judgment against Shant, (3) Shant was closely related to the trust because he and his sister were co-trustees at the time of the transfer and their children were the sole beneficiaries, and after Shant resigned as co-trustee after losing his tax case, his sister was the sole trustee, and (4) Shant possessed and enjoyed the office complex, as he used the rent paid by the other tenants for his own benefit; used the second floor rent-free; the trust beneficiaries never received any distributions; and Shant paid real estate taxes and other expenses for the office complex from his personal business account. Because factors one, two, three, five, and six of the Patras test were satisfied, the court granted the Government’s motion for partial summary judgment, ruling that the VSHPHH Trust was Shant’s nominee and that an order of sale would be issued.

Takeaways: Although the Hovnanian decision is unpublished, and thus, may have limited precedential value, it provides a reminder that even where a trust includes spendthrift provisions, those provisions will not limit the Internal Revenue Service’s (IRS’s) ability to enforce a federal tax lien against trust property if the trust is the delinquent taxpayer’s nominee. However, a court must first find that the taxpayer has a right to the property under state law before enforcing the tax lien under federal law. Holman v. United States, 505 F.3d 1060, 1068 (10th Cir. 2007) (“To enforce the tax lien on [the] property, the IRS must establish that [the taxpayer] has such an interest. If the IRS makes that showing under state law, the district court should then determine as a matter of federal law whether the nominee lien should be enforced, in light of the factors set forth in federal case law.”). Estate planning attorneys should advise clients to avoid actions that would result in a finding that a trust is merely the taxpayer’s nominee to the greatest extent possible.

Grantor’s Subsequent Writing Was Valid Amendment to Trust Rather than Memorandum for Disposition of Personal Property

In re Storto, No. 360134, 2023 WL 176669 (Mich. App. Jan. 12, 2023)

Pasquale Storto Jr. (Pasquale) created a trust October 17, 2005, and served as trustee until his death in May 2020. Pasquale’s sister Linda became the successor trustee upon his death. The trust document, which named Pasquale’s sister, grandchildren, and his ex-wife as beneficiaries of the residue of the trust, stated: “I reserve the right to amend or revoke this Agreement, wholly or partly, by a writing signed by me or on my behalf and delivered to Trustee during my life.” In addition, the trust provided: 

[T]he Settlor may desire to prepare a written statement or list, either entirely in his handwriting or just signed by him, to dispose of tangible personal property to a certain person or person[s] in the future. . . . If the list does not qualify as an amendment, I nevertheless hope those entitled to my estate will respect it.

In re Storto, No. 360134, 2023 WL 176669, at *1 (Mich. App. Jan. 12, 2023). The trust defined tangible personal property as property not primarily used in a business and provided a list that included boats, books, china, clothing, furnishings, and many other items. It further stated “Trustee shall determine which items are within this definition, and the determination shall bind all persons.” Id. 

Pasquale amended the trust twice in 2008, but a document that Pasquale’s partner, Priscilla Parness (Priscilla), asserted was a subsequent amendment was the subject of dispute. After Pasquale died, Priscilla claimed to have provided estate documents to his sister Linda that included a document entitled “Memorandum Regarding Desire [sic] Distribution of Personal Property” (Memo). Priscilla and Linda disagreed about the timing of delivery and whether the original version of the Memo was provided; the original Memo was not produced during the probate proceedings. Priscilla signed an affidavit stating that she had given Linda a binder of Storto’s estate planning documents that included the original Memo.

The Memo was partially typewritten and partially in Pasquale’s handwriting. In typewriting, the Memo stated “Certain of my personal effects have special meaning; I desire that upon my death, these items be given to those herein indicated.” Beneath this statement, the Memo included two headings, “Description of personal property” and “desired recipient and relationship,” with spaces below them for information to be included. Those spaces were filled in by Pasquale in his own handwriting and listed “my personal vehicle,” “home, 4880 Westland,” and “$50,000 – cash minimum” as personal property to be distributed to Priscilla. Pasquale signed the Memo on November 21, 2011. Below his signature, Pasquale handwrote another entry, “Pinestead Reef vacation time share,” as personal property to be distributed to Priscilla, dated June 24, 2017. Linda asserted that she did not have any knowledge of the Memo or the disposition of the property included in it.

Priscilla filed a petition with the probate court to determine whether the Memo was a valid amendment of the trust, asserting that Linda had refused to honor it. The probate court determined that Linda had not refuted Priscilla’s affidavit, which asserted that Priscilla had given Linda the original Memo. In addition, Linda’s testimony that Priscilla had provided her either an original or a copy of the Memo that she later returned to Priscilla did not contradict Priscilla’s evidence. The probate court granted Priscilla’s motion for summary disposition, holding that the Memo substantially complied with the trust’s method for amendment as required by Michigan law and was not merely an attempt to distribute personal property.

On appeal, in an unreported decision, the Michigan Court of Appeals disagreed with Linda’s contention that the probate court had erred in granting Priscilla’s motion for summary disposition, noting that Michigan courts have acknowledged that, in resolving disputes regarding the meaning of a trust, “a court’s sole objective is to ascertain and give effect to the intent of the settlor.” Id. at *3. Nevertheless, under Michigan law regarding the construction of wills and trusts, when only a copy and not the original document is available after the grantor or testator’s death, there is a rebuttable presumption that the testator or grantor destroyed it with the intent to revoke it.

The court found that there was no genuine issue of material fact regarding whether the Memo existed at the time of Pasquale’s death because Linda had offered no evidence of the falsity of Priscilla’s sworn affidavit that the Memo was in the binder when she gave it to Linda. The court found that Linda’s admission that she had seen and copied the Memo after Pasquale’s death and her failure to provide evidence that the version she had seen was only a copy was of greater importance in determining the lack of a genuine issue of material fact regarding whether Pasquale had revoked it prior to his death.

Linda argued that because the rules of construction for wills also apply to trusts, the gift of $50,000 cash made in the Memo was invalid under Mich. Comp. Law § 700.2513, which states “[A] will may refer to a written statement or list to dispose of items of tangible personal property not otherwise specifically disposed of by the will, other than money” (emphasis added). However, the Michigan Trust Code also provides that a settlor may revoke or amend a revocable trust by “ . . . substantially complying with a method provided in the terms of the trust.” Mich. Comp. Law § 700.7602(3)(a). 

The court determined that Pasquale ensured that the Memo would be delivered to the successor trustee—Linda—upon his death, by writing and signing the Memo and keeping it with his estate documents in a location that he had disclosed to Linda and Priscilla. In addition, although the Memo was not labeled as an amendment, Pasquale had fully complied with the trust’s terms applicable to amendments by executing the Memo, which changed the terms of the trust, signing it, and delivering it to himself as trustee. Because the Memo was a valid amendment of the trust rather than merely a list disposing of personal property, the prohibition of cash gifts in Mich. Comp. Law § 700.2513 was inapplicable. As a result, the probate court’s grant of Priscilla’s motion for summary judgment was affirmed.

Takeaways: A grantor may amend a trust by executing a subsequent writing as specified by the terms of the trust or state law, but this may not be the best practice to ensure that the grantor’s wishes are achieved. Informal writings may be misplaced or lead to family disputes regarding their meaning as in In re Storto, and they provide opportunities for unscrupulous individuals to take advantage of a vulnerable grantor. The most protective practice is for the grantor to restate the entire trust with an attorney’s help to include carefully drafted amendments.

Where Trust Permitted Trustee to “Dispose of” Ranch, Trustee Was Permitted to Sell It and Proceeds Allocated to Trust Principal

In re John O. Yates Trust, No. 04-21-00365-CV, 2022 WL 17970586 (Tex. Ct. App. Dec. 28, 2022)

John Yates executed a will in 1953 providing for his residuary estate to be placed in trust for his siblings and their issue per stirpes. Upon his death in 1964, his residuary estate, including real property in Bexar County that was described in John’s will as “my ranch home in Bexar County, Texas,” was placed in trust, where it remained for over five decades. The ranch and some mineral interests were part of the trust principal, and the trust beneficiaries received trust income.

In 2020, Frost Bank, the trustee, filed a petition asking the court to determine if John’s will authorized the sale of the ranch and if the proceeds of such a sale should be allocated to the trust’s principal account. One of the trust’s beneficiaries, Robert Yates, argued that the will prohibited the sale of the ranch, or if it allowed the sale, the proceeds should be considered income rather than principal. The trial court determined that the will authorized the sale of the ranch and that the proceeds must be allocated to the trust’s principal account.

On appeal, the Texas Court of Appeals determined that John’s will was unambiguous and that the court would construe it as a matter of law. Noting that identical rules of construction apply to wills and trusts, the court stated that they would focus “on the testator’s intent, which we ascertain by looking to [the trust’s] provisions as a whole, as set forth within its four corners” and on the meaning of the words the testator actually wrote, rather than what he intended to write. In re John O. Yates Trust, No. 04-21-00365-CV, 2022 WL 17970586, at *2 (Tex. Ct. App. Dec. 28, 2022).

In support of his assertion that the ranch could not be sold, Robert relied on article IX(c) of John’s will, which stated: “Except as may otherwise be provided herein, my Trustee or its successor shall not have or exercise the right, power, privilege or authority to sell, convey or dispose of any of the trust property or any part thereof.” Id. However, article IX(m) stated: 

I direct my Executor and Trustee to pay all taxes, insurance and normal repairs and other expenses in connection with the maintenance of my ranch home in Bexar County, Texas[,] and my ranch in Duval County, but the cost of same shall be chargeable in equal proportions to such one or more of my brothers and sisters or nieces and nephews that shall desire to use the same. Otherwise, my Executor and/or Trustee shall, with the consent and approval of the Advisory Committee, lease or otherwise dispose of said properties and the rentals or proceeds shall become part of the income or principal of the trusts created under my Will in equal parts or by stirpes as the case may be. 

Id. at *3 (emphasis added). In determining John’s intention for the will’s language when he executed it, the court rejected Robert’s argument that the failure to use the word “sale” to describe the types of dispositions permitted by the will precluded the trustee from selling the ranch. Several dictionary definitions and cases illustrated that the “plain and usual meaning of the term ‘dispose of’ encompasses the sale of property.” The court also disagreed with Robert’s argument that the sale of the ranch was prohibited by provisions in the will expressing a general intention to preserve the trust property. The court found that such an intent was expressed in the will, but it was not absolute. To the contrary, the will included exceptions to the general rule that the trust property should not be sold that were applicable to certain assets, including the ranch. As a result, the court upheld the trial court’s ruling that the trustee was authorized with the consent and approval of the advisory committee to sell the ranch property. 

Robert also argued that the proceeds of a sale of the ranch must be considered income and not principal based on a provision in John’s will stating “[a]lthough my estate consists primarily of mineral interests which should not be sacrificed by sale or otherwise, all receipts of money shall, as far as possible, be considered income . . . .” The court disagreed, holding that the language in article IX(m), which specifically addressed a disposition of the ranch, did not contain language creating an exception to the general rule set forth in article IX(a) that the trust should be administered “in accordance with and governed by the terms and conditions of the Texas Trust Act.” The current version of that law, Texas Prop. Code § 116.161(2), requires that money received from the sale of a principal asset be allocated to the principal of the trust. In addition, article IX(m) of the will stated that rentals or proceeds from the lease or disposition of the ranch “shall become income or principal” of the trusts (emphasis added). Therefore, the court determined that the trial court did not err in ruling that the proceeds of the sale of the ranch must be allocated to the trust’s principal account.

Takeaways: The In re John O. Yates Trust case emphasizes the importance of clearly drafted provisions in wills and trusts regarding whether trust property may be sold, particularly in circumstances involving trusts holding farms, ranches, or similar properties that have remained within a family for generations and to which family members may have strong emotional ties. Poor drafting, resulting in lack of clarity, increases the likelihood of litigation and damage to family relationships.

US Supreme Court Finds Highly Compensated Employee Paid Daily Rate Entitled to Overtime Pay

Helix Energy Sols. Grp., Inc. v. Hewitt, No. 21-984, 2023 WL 2144441 (S. Ct. Feb. 22, 2023) 

From 2014 to 2017, Michael Hewitt worked as a toolpusher on an offshore oil rig for Helix Energy Solutions Group, Inc. (Helix). His job involved overseeing some of the oil rig’s operations and supervising twelve to fourteen other workers. During each twenty-eight-day stretch that Hewitt spent on the oil rig, he often worked twelve hours per day, seven days a week, or eighty-four hours a week. Between each stint of work, he had twenty-eight days off. Helix paid Hewitt on a daily-rate basis, and he did not receive overtime pay. He earned more than $200,000 annually based on this compensation scheme.

Hewitt filed suit against Helix in federal district court, asserting that he was entitled to overtime pay under the Fair Labor Standards Act of 1938 (FLSA) (29 U.S.C. §§ 201 to 219). The FLSA requires overtime pay for covered employees who work more than forty hours per week. Helix asserted that it was not required to pay Hewitt overtime compensation because he was a “bona fide executive” within section 213, which sets forth several exemptions from the FLSA’s overtime requirements—a determination that the court found turned upon whether he was paid on a salary basis under the applicable regulation. The district court ruled that Hewitt was paid on a salary basis and that he was not entitled to overtime pay, but the Fifth Circuit Court of Appeals reversed.

On appeal, the Supreme Court upheld the Fifth Circuit’s decision, ruling that daily-rate workers are not paid on a salary basis as defined by 29 C.F.R. § 541.602(a), which states: 

An employee will be considered to be paid on a ‘salary basis’ . . . if the employee regularly receives each pay period on a weekly, or less frequent basis, a predetermined amount constituting all or part of the employee’s compensation, which amount is not subject to reduction because of variations in the quality or quantity of the work performed. Subject to [certain exceptions], an exempt employee must receive the full salary for any week in which the employee performs any work without regard to the number of days or hours worked.

Payment on a salary basis requires an employee to be paid their full salary for the week, that is, a predetermined amount “without regard to the number of days or hours worked,” that “is not subject to reduction” if the employee works less than a full week. As a result, the court determined that “nothing in that description fits a daily-rate worker, who by definition is paid for each day he works and no others.”

The court noted that its conclusion was confirmed by 29 C.F.R. § 541.604(b), which provides that the salary-basis requirement is still satisfied if an employee’s earnings are computed using daily, hourly, or shift rates, as long as the employer also guarantees a weekly payment approximating the employee’s usual earnings. However, Helix acknowledged that Hewitt’s compensation scheme did not guarantee that he would receive an amount bearing a reasonable relationship to the amount he typically earned each week.

The court rejected Helix’s assertion that a ruling that the salary basis test does not capture daily-rate workers would result in “windfalls” for high earners: rather, it held that “[w]orkers are not deprived of the benefits of the [FLSA] simply because they are well paid.” (quoting Jewell Ridge Coal Corp. v. Mine Workers, 325 U.S. 161, 167 (1945)). The court noted that the FLSA reflects “the statutory choice not to set a simple income level as the test for exemption. Some might have made a different choice, but that cannot affect what this Court decides.” Helix Energy Sols. Grp., Inc. v. Hewitt, No. 21-984, 2023 WL 2144441, at *690 (S. Ct. Feb. 22, 2023). As a result, the court ruled that Hewitt, a highly compensated daily-rate worker who did not fall within the statutory exemptions, was eligible for overtime pay under the FLSA.

Takeaways: The Supreme Court’s decision in Helix Energy Solutions Group reaffirms that eligibility for overtime pay is not limited to workers who receive lower rates of compensation. To avoid liability for overtime pay, employers should adjust their compensation scheme to ensure their employees fall within one of the FLSA’s exemptions.

Ninth Circuit Court of Appeals Rules that Federal Arbitration Act Preempts California Law Prohibiting Employers from Requiring Arbitration of Employee Claims

Chamber of Com. of the U.S. of Am. v. Bonta, No. 20-15291, 2023 WL 2013326 (9th Cir. Feb. 5, 2023)

California Assembly Bill 51, effective January 1, 2020, added Cal. Lab. Code § 432.6 to California’s labor code. Section 432.6(a) prohibits employers from requiring employees to waive as a condition of employment the right to litigate certain claims. Under section 432.6(c), “a condition of employment” includes “an agreement that requires an employee to opt out of a waiver or take any affirmative action in order to preserve their rights.” In addition, an employer may not retaliate against an employee for refusing to waive these rights under section 432.6(b). The statute provides that an employer that violates its provisions is “guilty of a misdemeanor.” Cal. Lab. Code § 433.

Section 432.6(f) was designed to avoid Federal Arbitration Act (FAA) preemption, stating: “Nothing in this section is intended to invalidate a written arbitration agreement that is otherwise enforceable under the Federal Arbitration Act (9 U.S.C. Sec. 1 et seq.).” It also includes a severability clause: “The provisions of this section are severable. If any provision of this section or its application is held invalid, that invalidity shall not affect other provisions or applications that can be given effect without the invalid provision or application.” 

In Chamber of Commerce v. Bonta, the Chamber of Commerce and other business groups and trade associations sought a declaratory judgment that Assembly Bill 51 was preempted by the FAA, an injunction prohibiting California officials from enforcing it, and a temporary restraining order in federal district court. The federal district court ruled in favor of the Chamber of Commerce, finding that Assembly Bill 51 “conflicts with the purposes and objectives of the FAA.” California officials appealed to the Ninth Circuit Court of Appeals, challenging the district court’s ruling that the FAA preempted Assembly Bill 51.

The Ninth Circuit affirmed the district court’s judgment. Noting that the purpose of the FAA is to promote a national policy favoring arbitration, the court thoroughly discussed Supreme Court cases addressing preemption of state laws and rules by the FAA. Although many of the Supreme Court cases addressed state laws affecting the enforceability of arbitration agreements, the Supreme Court established that “the FAA’s preemptive scope is not limited to state rules affecting the enforceability of arbitration agreements, but also extends to state rules that discriminate against the formation of arbitration agreements.” Chamber of Com. of the U.S. of Am. v. Bonta, No. 20-15291, 2023 WL 2013326 at *7 (9th Cir. Feb. 5, 2023). Relying on Kindred Nursing Ctrs. Ltd. P’ship v. Clark, 137 S. Ct. 1421, 1428–29 (2017) and Doctor’s Assocs., Inc. v. Casarotto, 116 S. Ct. 1652 (1996), the court held 

Although the plaintiffs in Casarotto and Kindred Nursing were attempting to enforce an executed arbitration agreement, the Court's rationale for invalidating state rules burdening the formation of arbitration agreements is equally applicable to a state rule like AB 51, which discriminates against the formation of an arbitration agreement but does not make an improperly formed arbitration agreement unenforceable. Given the evidence that AB 51’s unusual structure (criminalizing the act of entering into an agreement, while allowing the parties to enforce it once executed) was for the purpose of “navigating around” Supreme Court precedent, it is hardly surprising that there is no Supreme Court precedent on point. Still, nothing in Casarotto or Kindred Nursing suggests that a state rule targeting only the formation of an arbitration agreement falls outside of the FAA’s preemptive scope. As the Supreme Court has indicated, if a state could criminalize the conduct of entering into an arbitration agreement, it could entirely defeat the FAA’s purpose.

Id. The court went on to examine whether Assembly Bill 51 presented an “unacceptable obstacle” to the achievement of the “full purposes and objectives of Congress” in enacting the FAA. The court concluded that Assembly Bill 51 placed a severe burden on the formation of arbitration agreements by imposing civil and criminal penalties on employers that form them, which is “antithetical” to the federal policy favoring arbitration embodied by the FAA. As a result, the court held that the FAA preempted Assembly Bill 51.

Takeaways:  In a 2021 decision that included a dissenting opinion saying the ruling would likely be reversed by the Supreme Court, the Ninth Circuit Court of Appeals terminated the district court’s injunction prohibiting enforcement of Assembly Bill 51 (13 F.4th 766 (9th Cir. 2021)). On August 22, 2022, it withdrew the 2021 decision (45 F.4th 1113 (9th Cir. 2022)) and granted a rehearing. Based on the Ninth Circuit’s February 15, 2023, decision that Assembly Bill 51 is wholly preempted by the FAA, California employers may now require employees to enter into arbitration agreements as a condition of employment. Although the state of California could appeal the case to the Supreme Court, no appeal had been filed at the time of writing.

Delaware Chancery Court Holds Corporate Officers Can Be Liable for Breach of Fiduciary Duty of Oversight

In re McDonald’s Corp. Stockholder Derivative Litigation, C.A. No. 2021-0324-JTL, 2023 WL 387292 (Del. Ch. Ct. Jan. 26, 2023)

From 2015 to 2019, David Fairhurst was executive vice president and global chief people officer of McDonald’s Corporation (McDonald’s). He was responsible for ensuring a safe and respectful workplace for McDonald’s employees until his termination for cause in 2019. McDonald’s stockholders filed a derivative action against Fairhurst alleging that he had breached his fiduciary duties, including a fiduciary duty of oversight, by permitting the development of a corporate culture that condoned sexual harassment and misconduct. The shareholders alleged that Fairhurst’s duty of oversight required him to create an information system capable of managing McDonald’s human resources functions. In addition, they asserted that he had a duty to use the information generated by the system to perform his job and report to the chief executive officer and board of directors on his areas of responsibility, including red flags regarding incidents of sexual harassment and misconduct at McDonald’s. The shareholders did not assert that Fairhurst had failed to establish an information system, but rather that he had ignored red flags indicating that McDonald’s would suffer harm due to sexual harassment occurring at the company. In addition, Fairhurst himself had engaged in and been disciplined for sexual harassment.

The Court of Chancery of Delaware previously determined in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996) that corporate directors have a duty of oversight. Fairhurst filed a motion to dismiss on the basis that corporate officers did not owe a fiduciary duty of oversight under Delaware law. 

The Court of Chancery of Delaware disagreed with Fairhurst, holding that corporate officers, who run a business on a full-time basis, owe a duty of oversight; in fact, “the officers are far more able to spot problems than part-time directors who meet a handful of times a year.” In re McDonald’s Corp. Stockholder Derivative Litigation, C.A. No. 2021-0324-JTL, 2023 WL 387292, at *12 (Del. Ch. Ct. Jan. 26, 2023). Further, the court explained that the duty flowed from multiple sources, including the Caremark decision; the Delaware Supreme Court’s equating of officer duties with director duties in Gantier v. Stephens, 965 A.2d 695, 709 (Del. 2009) (“the fiduciary duties of officers are the same as those of directors.”); agency principles; and the accountability structure existing between officers and the board of directors. 

The court further explained that an officer’s duty of oversight varies depending upon the context. For example, a chief executive officer may have a broader area of responsibility, while other officers may have particular responsibilities, and thus their duty to establish an information system would apply exclusively to that area. Their duty to address and report red flags generally applies to their particular area, although they may have an obligation to report issues even if the issues do not fall within their purview if the red flags are “particularly egregious.” Id. at *1. 

The court found that Fairhurst owed a duty of oversight and thus had an obligation to make a good faith effort to establish information systems that would enable him to have the information necessary to do his job and report to the chief executive officer and the board and not to consciously ignore red flags. Because the shareholders identified red flags that sexual harassment had occurred at McDonald’s, the court analyzed whether Fairhurst had acted in bad faith by deliberately ignoring the red flags. Although there is a presumption under Delaware law that directors and officers act in good faith, the court determined that the stockholders’ complaint pleaded facts sufficient to support an inference of bad faith: “When a corporate officer himself engages in acts of sexual harassment, it is reasonable to infer that the officer consciously ignored red flags about similar behavior by others.” Id. at *2. The court further determined that it was reasonable to infer that Fairhurst knew about and facilitated the creation of McDonald’s problems with sexual harassment and misconduct, which included Equal Employment Opportunity Commission (EEOC) complaints, a class-action lawsuit, a ten-city strike aimed at drawing attention to the EEOC complaints, and increased public scrutiny. As a result, the court ruled that the stockholders had sufficiently pleaded a claim for breach of the fiduciary duty of oversight against Fairhurst and that his motion to dismiss was denied.

Takeaways: As a result of the court’s decision in In re McDonald’s Corp. Stockholder Derivative Litigation, corporate officers of Delaware corporations are more likely to be defendants in derivative actions alleging breach of the fiduciary duty of oversight. In accordance with the court’s holding, to avoid liability, corporate officers should take steps to ensure they are well-informed about their scope of duties and responsibilities and about the information systems needed to monitor their areas of responsibility. In addition, they should take sufficient steps to implement those systems. Further, any red flags of possible noncompliance with the legal or regulatory mandates within their areas of responsibility should be reported to their supervisors and corrective actions should be taken. The officers should document the implementation of the necessary systems and any actions taken to report and address red flag issues.

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