Our bi-monthly newsletter highlights important developments related to US civil and criminal securities law.
In what seems destined to be a landmark Delaware Court of Chancery decision, Vice Chancellor J. Travis Laster denied former McDonald’s Executive Vice President and Global Chief People Officer David Fairhurst’s motion to dismiss claims that he had breached his fiduciary duties on the grounds that, unlike directors, corporate officers owe no fiduciary duty of oversight under Delaware law. Fairhurst was accused of promoting a “party atmosphere” at McDonald’s corporate headquarters, turning a blind eye to repeated instances of sexual harassment of female employees, and sexually harassing female employees on at least two occasions himself. When the company’s “toxic” corporate culture became publicly known, it led to regulatory investigations, investor lawsuits, and even a U.S. Senate probe. In the context of these allegations, the court explicitly stated for the first time that corporate officers owe a duty of oversight similar to that imposed upon directors, reasoning that the same logic that underpinned the Caremark decision’s creation of the duty of oversight for directors also applies to officers.
The oversight duties recognized in the Delaware Court of Chancery’s well-known Caremark decision require directors to make a good faith effort to ensure that effective information and reporting systems exist within a company and not to ignore red flags signaling misconduct. Subsequent case law has stated broadly that “the fiduciary duties of officers are the same as those of directors,” without defining the specific duties with that “same” category. Here, in In re McDonald’s Corp., the court clarified that the duty of oversight equally applies to officers. In supporting this determination, the court noted that nondirector officers often have greater input in day-to-day operations within a company, including the management of its information and reporting systems, and play an essential role in ensuring that directors receive timely notice of relevant information regarding the company. Conversely, the court reasoned that if officers do not have the duty of oversight already imposed on directors, it would “create a gap in the ability of directors to hold officers accountable.”
The court’s opinion places potentially important limitations on the oversight duties applicable to officers, with the scope of officer oversight duties being tied directly to officers’ “particular areas of responsibility.” It is unclear, however, whether officers accused of breaching Caremark-type oversight obligations will be able to effectively defend the claims as exceeding the scope of their duties. One can readily envision boilerplate allegations, for example, that ensuring corporate integrity and honest reporting of problematic facts falls within the scope of every corporate officer. The court itself cast doubt on the efficacy of “beyond the scope” defenses to the claim it was recognizing, allowing for the possibility that “a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.” However, similar to the standard applied to directors, Vice Chancellor Laster held that “oversight liability for officers requires a showing of bad faith,” and officers therefore cannot be liable for “failure of oversight caused by a breach of the duty of care” if they were acting in good faith.
The McDonald’s decision broke more new ground by sustaining a fiduciary duty of loyalty against Fairhurst based on acts of sexual harassment he personally was alleged to have perpetrated. The court allowed the fiduciary duty claim to proceed on this ground as well, stating that “[w]hen engaging in sexual harassment, the harasser engages in reprehensible conduct for selfish reasons. By doing so, the fiduciary acts in bad faith and breaches the duty of loyalty.”
This case marks a potentially dramatic expansion of an officer’s fiduciary duties, both in terms of oversight and otherwise, including the potential to recast as a fiduciary duty claim what traditionally has been treated as ordinary course employment tort liability—i.e., issues that may unquestionably be serious but previously were not the basis to impose broad fiduciary liability for sexual harassment against the individual tortfeasor or other officers and directors. It remains to be seen whether this potential expansion will be limited to the egregious factual situation alleged in In re McDonald’s Corp. in the same way that the impact of Caremark has rarely been applied outside the original extreme factual circumstances in which the oversight duty was first recognized. Only one thing is clear in the McDonald’s decision: much is unknown about these newly defined officer fiduciary duties. For a more thorough discussion of the McDonald’s decision, please see Delaware Court of Chancery Finds for the First Time That Officers’ Fiduciary Duties Include Caremark Duty of Oversight, and That Sexual Harassment Is a Breach of the Duty of Loyalty.
SEC Settles Claims with McDonald’s and its Former CEO for Misstatements Regarding Former CEO’s Termination for Poor Judgment and Inappropriate Personal Relationship in Order Sharply Criticized by Two Commissioners as Unprecedented and Improper Rulemaking-by-Enforcement
On January 9, 2023, the SEC (U.S. Securities and Exchange Commission) announced settlements with McDonald’s Corporation and its former CEO Stephen J. Easterbrook related to misstatements relating to the circumstances of Easterbrook’s termination. The McDonald’s settlement is the latest example of the SEC attempting to base disclosure claims on allegations of internal mismanagement of the sort that may be unquestionably serious but historically not viewed as disclosure violations. In this case, a slim majority of three SEC commissioners concluded that Rule 402 of Regulation S-K required a disclosure of the reasons why McDonald’s terminated a CEO—with two other commissioners harshly criticizing the SEC for expanding “settled” law.
Specifically, in November 2019, McDonald’s terminated Easterbrook for exercising poor judgment and engaging in an inappropriate personal relationship with a subordinate in violation of corporate policy. At the same time, McDonald’s entered into a settlement agreement whereby Easterbrook’s termination was deemed “without cause” such that he was allowed to retain equity compensation that he would have forfeited if fired “for cause.” Following the termination, McDonald’s discovered during an internal investigation that Easterbrook engaged in other “improper relationships” that he allegedly failed to disclose.
The SEC charged McDonald’s with violating a laundry list of securities laws by failing to disclose all the factors that went into the CEO termination decision, including Sections 10(b) and 14(a) of the Exchange Act and Rules 10b-5 and 14a-3 thereunder, Section 17(a) of the Securities Act, and Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-11. In particular, the SEC charged that McDonald’s violated Items 402(b) and (j)(5) of Regulation S-K for not telling shareholders that the company had “exercised its discretion” to treat the termination as “without cause” and thus allowed him to retain then-unvested equity compensation. As part of the negotiated settlement, McDonald’s agreed to the imposition of a cease-and-desist order, with the SEC waiving any request for a civil penalty on the grounds that McDonald’s cooperated with the SEC’s investigation and undertook remedial steps that included suing Easterbrook and recovering substantial equity compensation that it previously agreed he could receive under the now-repudiated settlement agreement. Easterbrook settled by consenting to the imposition of a cease-and-desist order, a five-year officer and director bar, and a $400,000 civil penalty. Easterbrook also consented to the payment of more than $52 million in combined disgorgement and prejudgment interest, which the SEC deemed already satisfied by the compensation Easterbrook repaid to McDonald’s in resolution of disputes over his termination from the company.
Two of the five commissioners pointedly criticized the three-commissioner majority of engaging in “regulatory expansion through enforcement”—a familiar criticism when the SEC imposes some new and different (and, almost always, a higher) legal compliance standard by announcing negotiated settlement (i.e., charges) without undertaking to impose the new standard through traditional regulatory rulemaking whereby the public is entitled to participate in the process. Here, the dissenting commissioners noted that the order was an expansion of the already “expansive executive compensation disclosure requirements,” and that the SEC had not previously applied Item 402 in any way to suggest that an issuer needs to disclose its rationale for terminating an officer, with or without cause. Ultimately, the two commissioners warned that the SEC is on a “slippery slope that may expand Item 402’s disclosure requirements into unintended areas.” For this reason, the two commissioners rebuked the decision, stating that if “the Commission intended to expand a settled disclosure requirement,” the SEC “should publicly articulate its views through rulemaking or formal guidance so that companies understand the requirement before the Commission starts enforcing it.”
DraftKings Securities Lawsuit Dismissed for ‘Threadbare’ and ‘Conclusory’ Allegations
On January 10, 2023, federal Judge Paul A. Engelmayer of the U.S. District Court for the Southern District of New York dismissed with prejudice a securities class action lawsuit against online sports betting company DraftKings, Inc. (“DraftKings”). Judge Engelmayer found that the report on which the complaint “essentially entirely relies”—a report by known short seller Hindenburg Research (the “Hindenburg Report”)—was unable to adequately support plaintiffs’ allegations because of the likely bias inherent in its authorship and its reliance on unidentified and unspecified “confidential” sources.
Plaintiffs accused DraftKings of failing to disclose alleged “black market” operations by SBTech (Global) Limited (“SBTech”), the software company that DraftKings acquired in 2020 to provide the sports betting software platform on which DraftKings operates. According to plaintiffs, SBTech had been operating in jurisdictions where online gaming was illegal—so-called “black markets”—thereby exposing DraftKings to heightened regulatory and criminal risk and rendering some of its revenue “the fruit of illegal conduct.” When Hindenburg Research published its report revealing the alleged black-market operations, DraftKings’ share price fell 4.17%.
The court found that the complaint failed to adequately allege that SBTech in fact operated and derived revenue from these “black markets” due to its heavy reliance on the Hindenburg Report, which the court found to be unreliable for two overarching reasons. First, the Hindenburg Report was a report by an interested short seller, so any allegations it made “must be considered with caution.” Second, the Hindenburg Report was “largely based on unsourced or anonymously sourced allegations”—by unspecified “former employees”—that plaintiffs had been unable to confirm or fact-check. Accordingly, the court found that allegations derived from the Hindenburg Report were not sufficient to meet the heightened pleading standards of the Private Securities Litigation Reform Act.
While the decision also addressed (and dismissed) claims against individual defendants linked to their trades in DraftKings stock, the brunt of the court’s opinion emphasizes the unreliability of short-seller reports as the sole, or even principal, source upon which a securities complaint is founded. This opinion indicates that, without other markers of reliability, a short-seller report does not provide a persuasive basis for allegations of securities fraud.
Judge Cites ‘Public Deterrence’ in 10-Year Sentence in First Cryptocurrency Insider Trading Case
In what prosecutors described as the first insider trading case involving cryptocurrency, a federal judge sentenced Nikhil Wahi, a graduate student and brother of former Coinbase employee Ishan Wahi, to 10 months in prison and forfeiture of $892,500 in illicit profits. The sentence follows Wahi’s guilty plea to charges that he participated in a scheme alongside his brother and friend Sameer Ramani, to trade in cryptocurrency assets using illegal tips his brother learned via his job at Coinbase about when crypto assets would be listed on Coinbase’s trading platform, which often led to a significant appreciation in their value. These tips allowed Wahi and Ramani to purchase at least 25 crypto assets before announcement and then sell for a profit in a scheme that went on for almost a year and generated upwards of $1.1 million.
Wahi was indicted for wire fraud and conspiracy to commit wire fraud in July of 2022 and pled guilty to the charges in September. Notably, these wire fraud charges are not dependent on whether the crypto assets at issue constitute securities, with Assistant U.S. Attorney Noah Solowiejczyk stating at the time of Wahi’s plea that “the defendant’s decision to resolve this case with a wire fraud plea should not be understood as a statement about whether these crypto assets at issue were in fact securities or whether the defendant needed to know that they were securities.” Whether crypto assets qualify as securities has been the subject of significant recent debate, and the scheme is also the subject of a parallel civil enforcement proceeding brought by the SEC (U.S. Securities and Exchange Commission), which remains pending, premised on the SEC’s allegations that at least nine of the 25 crypto assets traded as part of the scheme qualified as “securities.”
Wahi’s sentence reflects what federal Judge Loretta A. Preska termed “a need  for public deterrence” as she weighed Wahi’s timely guilty plea and agreement to surrender his unlawful gain against the length of the trading scheme and the magnitude of his gains. In a press release issued after the sentencing, U.S. District Attorney Damian Williams stated that the sentence “makes clear that the cryptocurrency markets are not lawless. There are real consequences to illegal insider trading, wherever and whenever it occurs.”
Lawyers in Goodwin’s Securities and Shareholder Litigation and White Collar Defense practices have extensive experience before U.S. federal and state courts, legislative bodies and regulatory and enforcement agencies. We continually monitor notable developments in these venues to prepare the Securities Snapshot — a bi-weekly compilation of securities litigation news delivered to subscribers via email. This publication summarizes news from the civil and criminal securities law arenas in a succinct, digestible format. Topics covered include litigation and enforcement matters, legislation, rulemaking, and interpretive guidance from regulatory agencies.
Jennifer Burns LuzPartner