When Does an Officer’s Sexual Harassment of Employees Constitute a Fiduciary Breach?

Background. The Plaintiff (Alex Brola) and the Defendant (Christopher Lundgren) were the co-founders, and the two sole shareholders and directors, of Credit Glory Inc. (the “Company”), a private Delaware corporation based in New York. Brola was the Company’s President; Lundgren was the Vice President and Secretary. Lundgren allegedly sexually harassed two employees, using racial slurs when communicating with them, excluding them from meetings, and threatening them with termination if they did not submit to his desires. The two employees resigned due to the harassment and then successfully brought claims before the EEOC and in New York state court. Those actions led to judgments totaling $1.35 million against the Company and Lundgren jointly, and $235,000 against each of them individually.

Brola brought suit in the Court of Chancery, seeking to hold Lundgren personally liable to the Company for those judgments and other losses resulting from the harassment. Relying on the McDonald’s decision, Brola asserted that Lundgren breached his duty of loyalty to the Company by using his position for his own selfish reasons. Vice Chancellor Lori W. Will dismissed the case, holding that demand on the board to bring the litigation was not excused, as the underlying claim of breach of fiduciary duties was not viable because Lundgren’s harassment of employees was personal misconduct and not a breach of his fiduciary duties.

Discussion

In McDonald’s, the court had held that a corporate officer’s sexual harassment of employees constituted a breach of fiduciary duties. In McDonald’s, the company’s Head of Human Resources allegedly sexually harassed and assaulted company employees. Vice Chancellor J. Travis Laster held in that case that the officer breached his fiduciary duty of loyalty and acted in bad faith by committing these acts. Vice Chancellor Laster reasoned that the duty of loyalty requires that officers not act based on their personal, selfish interests but the interests of the corporation, and that the McDonald’s officer had engaged in “reprehensible conduct for selfish reasons.” (The court also, separately, ruled in McDonald’s that the officer, given his position as the Head of Human Resources, had breached his duty of loyalty, under the Caremark doctrine, by failing to prevent widespread sexual harassment of employees by others at McDonald’s. The Caremark ruling was not relevant in Brola—indeed, the court never even mentions Caremark in the decision—as there were no allegations of harassment of employees by others that invoked a duty of oversight).

The court distinguished McDonald’s on the basis that the officer’s direct corporate duties in that case included  ensuring a safe workplace. Vice Chancellor Will stressed that the McDonald’s defendant, as the Head of Human Resources, was “a senior officer charged with maintaining a safe and respectful workplace at the enterprise level.” By himself engaging in sexual harassment, Vice Chancellor Will reasoned, he had “subverted” his corporate office. “His personal misdeeds were framed by the corruption of the corporate mission he was entrusted to lead.” But, the Vice Chancellor wrote, “fiduciary liability is not a catch-all for every wrong committed in the workplace simply because the perpetrator happens to hold a title.” The difference between Brola and McDonald’s, she stated, is that, in Brola, “Lundgren is not alleged to have abused the specific delegated authority of his corporate office. None of the factual allegations in the complaint concern fiduciary conduct taken in Lundgren’s capacity as a director or the Company’s Secretary. Instead, his wrongdoing relied on his general authority as a supervisor” (emphases added). Thus, his “[e]gregious interpersonal misconduct, even [though] violative of employment law and company policy, [fell] outside the scope of Delaware corporate law.”

The court stressed that Delaware law governs a corporation’s “internal affairs,” not “external relationships.” Vice Chancellor Will emphasized in Brola that Delaware law governs a corporation’s internal affairs—that is, its corporate governance, oversight of enterprise-level risk (i.e., Caremark duties), and “fulfillment of the fiduciary promise.” The purpose of Delaware corporate law is to “police[] the integrity of the corporate decision-making process,… [by] guard[ing] against self-dealing, conflicted transactions, and bad faith conduct.” Delaware law does not govern “external relationships” between managers and employees—these are governed instead by employment statutes (and other applicable statutes such as civil rights statutes) and the substantive law of the jurisdiction where the alleged injury took place. Vice Chancellor Will observed that, in this case, “[t]he legal system worked as intended.” “Victims sued in New York to vindicate their interests and obtained substantial judgments against a New York resident and a New York-based company. Those proceedings confirm that the remedy for Lundgren’s behavior lies in tort and employment law, not corporate doctrine. To sustain Brola’s claim would impose a precarious layer of fiduciary liability onto comprehensive legal frameworks and convert this court of equity into a general workplace disciplinary forum, adjudicating matters well beyond its purview.” Further, a claim that Lundgren acted in “bad faith” in the performance of his duties “distort[ed] bad faith beyond recognition, seeking to transform it into a general morality code,” the Vice Chancellor wrote.

The court noted additional reasons—beyond “the risk of doctrinal sprawl”—to reject placing “workplace misconduct under the banner of fiduciary duty.” First, the court stated, employment disputes are regulated by comprehensive state and Federal laws “that reflect careful legislative choices.” Federal and state laws provide “robust remedies for victims of harassment but impose[] strict procedural guardrails….” Thus, “[p]ermitting derivative claims for the same conduct would authorize an end-run around these statutory frameworks….” Second, the internal affairs doctrine holds that Delaware law governs the relationships between corporate owners and managers, and does not reach interpersonal matters occurring within other states’ borders. Third, treating sexual harassment claims as corporate assets creates perverse incentives. “It risks commodifying personal trauma, forcing it into public derivative litigation that lacks the privacy protections of employment statutes.” And, “[e]quity must not sanction collateral litigation that exposes victims to unwanted scrutiny in the service of a corporate recovery and attorneys’ fees.” In a footnote, the court noted that a derivative claim is not necessary for a company to recover its losses from an officer’s sexually harassing employees “since there are insurance and contribution structures designed for such employment-related risk.”

Practice Points

• The distinction between an officer’s areas of specific authority versus general supervision will be important in determining whether sexual harassment by the officer may constitute a breach of fiduciary duties. Brola establishes that sexual harassment by an officer may constitute a fiduciary breach only where the officer has “abused the specific delegated authority of his corporate office.” In such cases, the sexual harassment extends beyond mere “interpersonal conduct,” as it subverts the corporate office. Thus, sexual harassment by a corporate Secretary, in Brola, was not a fiduciary breach, while sexual harassment by a Head of Human Resources, in McDonald’s, was a fiduciary breach. Companies, and corporate officers, may wish to review and consider the company’s descriptions of officers’ specific authority and responsibilities, keeping the Brola ruling in mind. Closely held corporations, with a small group constituting the sole shareholders, directors and officers of the company, may wish to consider broadening the specific delegated authority of each of the officers to include specifically matters such as workplace safety.
• Officers should keep in mind that, post-Brola, there are still circumstances under which they may have personal liability to the corporation for their sexual harassment of employees. Personal liability may arise if: the officer’s sphere of specific responsibility included preventing sexual harassment or ensuring a safe and respectful workplace; the officer engaged in the harassment for the purpose of harming the corporation (which would be highly unusual); or, arguably, although not addressed in Brola, the harassment was closely and/or substantially linked to use of the corporate apparatus (for example, the harassment involved the improper use of corporate funds or leaking of the corporation’s confidential information).
• Sexual harassment by a director should not constitute a fiduciary breach. Based on Brola, a director—having general supervision responsibilities rather than any specific charge to prevent sexual harassment—should not have personal liability for his or her sexual harassment of company employees, except under the unusual kinds of circumstances described just above with respect to officers (i.e., intent to harm the corporation or, potentially, use of the corporate apparatus).
• Directors and officers still have potential liability under Caremark for failing to oversee the risk of sexual harassment by others. Under Caremark (which, as noted, was not relevant in Brola), directors may be personally liable for a board-level failure to oversee the risk of sexual harassment at the company. The Caremark ruling in McDonald’s (left undisturbed in Brola) established that an officer also may have Caremark liability for a failure to oversee sexual harassment by others—if  preventing the misconduct fell within the sphere of the officer’s responsibilities, or if the misconduct was so egregious that the officer should have reported it up the chain of authority even though the misconduct was outside the officer’s sphere of responsibilities. Notably, Caremark claims are still among the most difficult claims on which a plaintiff can hope to win a judgment, as the defendant officer or director must have acted in bad faith (i.e., with an actual intent to harm the corporation or a knowing disregard of duties).
• Companies should review their sexual harassment policies and risk protections. A company should seek to ensure that: its code of conduct, other corporate policies, trainings, reporting methods, grievance procedures, and corporate communications are state of the art with respect to sexual harassment prevention; the company fosters a corporate culture in which employees feel free to report concerns; the company takes appropriate and timely action in response to complaints; and the company’s insurance policies, indemnification and contribution provisions, and employment agreements appropriately protect the company in the event of claims relating to sexual harassment.