Red Flags Everywhere! – Ten Risks for Directors – Week 4

Each week for the next 10 weeks, we will publish an installment of our Red Flags Everywhere! series, highlighting key risk areas that public companies and their boards of directors should keep top of mind.

This series will serve as a lead up to MoFo’s upcoming Red Flags Everywhere Tabletop program taking place in our Palo Alto office on May 7. Members of our Securities Litigation, Employment and Labor, and Capital Markets Groups will guide attendees through a ripped-from-the-headlines fact pattern designed to spark interactive discussion and practical analysis that will be valuable to every board advisor.

This week, we focus on CEO oversight and the board’s role in monitoring and evaluating the company’s chief executive. Effective, independent oversight in key areas can strengthen governance and reduce litigation risk.

If you are interested in learning more about MoFo’s Red Flags Everywhere Tabletop event, please reach out to Deborah Argueta. See all the Red Flags client alerts.

Board Oversight of the CEO Should Be Active and Independent

Effective CEO oversight sits at the core of the director role: it is not a periodic “check-the-box” exercise, but an affirmative responsibility to put in place reasonable systems for board-level monitoring and use those systems in good faith—especially when the CEO’s influence, incentives, conduct, or potential departure can materially affect the company. This may sound simple in the abstract but can prove challenging, depending on the CEO and the company. For example, if you’re on the board of a company with a superstar CEO, a giant pay package, and accusations of questionable behavior, you have your work cut out for you. Fortunately, recent Delaware decisions provide a practical roadmap for what is expected of directors when it comes to CEO oversight—and the liability risk when boards fall short.

Oversight of CEO compensation is not a rubber stamp—especially for superstar CEOs

In 2024, the Delaware Court of Chancery issued an opinion finding that Tesla’s board of directors breached their fiduciary duties in approving Elon Musk’s 2018 compensation plan.[1] Although the Delaware Supreme Court went on to reverse the decision in part,[2] the case still provides both a strong process warning for boards and a helpful framework for thinking about the board’s oversight of CEO compensation.

The Chancery court cautioned that CEO compensation is a decision that normally gets substantial deference, but that deference can disappear when a powerful CEO effectively dominates the process.

The case teaches five practical lessons:

1. Independence has to be real, not just a label. The court focused on the directors’ personal, business, and economic ties to Musk and concluded that several key directors were not independent in substance. That meant the board could not rely on formal committee structure alone.
2. The board should run an arm’s-length negotiation. The compensation committee—not the CEO—should control the process, set the timetable, develop alternatives, make counterproposals, and negotiate the size and terms of the package. The opinion faulted Tesla’s board because Musk effectively set the framework and the committee behaved collaboratively rather than adversarially.
3. The board should test necessity, not just upside.  One of the opinion’s sharpest points was that Musk already held a very large equity stake and had said he was not leaving. So, the court said that the board should have squarely asked whether more compensation was actually needed for retention, engagement, or alignment. The lesson is that even a highly performance-based plan can be unfair if the board never asks whether the plan is necessary in the first place.
4. Benchmarking and alternatives matter. The court criticized the absence of meaningful benchmarking and the failure to consider other tools that might have addressed the board’s stated concerns, such as stronger time-commitment or clawback-style protections. A board overseeing CEO compensation needs a record showing it compared options and exercised judgment.
5. Disclosure is part of the fiduciary job. Stockholder approval only helps if stockholders are fully informed. The court found the proxy misleading because it understated conflicts and sanitized the actual process. The board should ensure that the proxy accurately describes who negotiated, how they negotiated, and what conflicts existed.

Bottom line: when the CEO is a founder, superstar, or controller-like figure, the board’s oversight demands get heavier, not lighter. The more powerful the CEO, the more the board needs disinterested directors, a disciplined process, and a clean disclosure record.

Overseeing the CEO in the face of misconduct accusations requires active monitoring and escalation when necessary

In a derivative lawsuit involving McDonald’s, stockholders alleged that the board breached their duty of oversight in connection with the board’s handling of misconduct allegations against the CEO.[3] The Delaware Court of Chancery dismissed the claims. Although the board was on notice of serious red flags about workplace misconduct—including EEOC complaints, worker protests, a senator’s inquiry, and misconduct by the chief people officer—the court found that the directors responded appropriately. Their response included policy changes, training, outside advisors, and risk-management escalation. The board’s active oversight insulated them from liability risk.

The case teaches at least four practical points:

1. CEO oversight includes culture and legal-compliance risk, not just financial performance. The opinion treats sexual harassment and workplace safety as risks that can threaten enterprise value and create fiduciary problems for directors. A board cannot dismiss those issues as mere HR problems.
2. Red flags are especially important when they point to misconduct at the top. Once the board learned that the head of HR had engaged in harassment, and later that the CEO had engaged in a prohibited relationship, the board had to act. The case makes clear that when senior leadership is implicated, board-level oversight should become even more active and visible.
3. Liability turns on bad-faith inaction, not imperfect action. The court emphasized that directors are not liable just because their response was weak, debatable, or unsuccessful. The question is whether they consciously ignored the problem. Because McDonald’s directors could show a real response, the court would not infer bad faith.
4. How the board handles the CEO’s separation is usually still protected by business judgment. The court said the board’s choice to terminate the CEO without cause, after a limited investigation, could be criticized in hindsight, but criticism alone did not establish bad faith. Delaware law still gives boards room to choose among imperfect options when dealing with a compromised CEO, so long as the choice is rational and made in good faith.

Bottom line: a board’s duty to oversee the CEO is a duty to recognize red flags, elevate them to the board level, and respond in good faith. Fiduciary duty does not require directors to guarantee a perfect outcome or choose the best response in hindsight. Instead, liability turns on whether the board consciously ignored serious warning signs. When the board engages, investigates, and responds, even if the response later looks incomplete or mistaken, the court is unlikely to infer bad faith.

CEO succession planning is a core oversight function and should be handled with a disciplined, board-led process

The board’s oversight of the CEO also includes succession planning, which should be approached with the same rigor as other high-stakes board decisions. Although most successors still come from inside the company, average CEO tenure has shortened, and boards more frequently consider external candidates. As a result, the risk of a flawed succession process has grown. Like a sale-of-the-company process, CEO succession can attract intense market scrutiny, and an informal or poorly documented process can create legal, operational, and reputational risk. Boards should therefore plan for both orderly succession and contingency scenarios, including sudden incapacity, death, misconduct, or business underperformance that may require an accelerated transition.

Critically, that planning should be tied to strategy. A board cannot sensibly evaluate successor candidates unless it has a clear view of the company's strategy today and over the next three-to-five years, as well as of the leadership capabilities that strategy will demand. Many boards find it useful to maintain a CEO skills matrix, much like a board skills matrix, and to revisit it at least annually—or more often when age, tenure, performance, or changing business conditions make transition risk more acute. Succession oversight should extend beyond the CEO to the broader C-suite. A change in the CEO role can disrupt the rest of the leadership team if the board has not thoughtfully assessed the ripple effects across the organization. This is also where truly disinterested directors are especially important, particularly when long tenure or close personal relationships may impair objective judgment.

Here are five practical tips for succession oversight:

1. Plan for both orderly and emergency succession. The board should maintain a long-range plan for an expected transition and a separate contingency plan addressing sudden death, incapacity, misconduct, or business underperformance, including interim leadership arrangements.
2. Use a current CEO profile tied to strategy. The board should identify the experience, judgment, operational skills, market credibility, and culture leadership the company will need over the next three-to-five years, and update that profile as strategy changes.
3. Test the internal slate against the market. Even if the board expects to select an insider, considering external candidates—and, in many cases, retaining a search firm—can sharpen the board’s assessment, create a better record, and reduce the risk of insular decision-making.
4. Keep the process independent, but pragmatic. A board or designated committee should discuss succession at least annually, including in executive session without the CEO present and, where appropriate, with input from the chief human resources officer. In an orderly transition, the board will often need the incumbent CEO’s cooperation to make the handoff successful.
5. Document the process and prepare the messaging. The minutes should reflect the skills matrix used, the reasons for selecting an internal or external candidate, organizational effects, and the board’s consideration of timing, SEC disclosure, and PR/IR planning.

Bottom line: CEO succession is a recurring board-level risk-management exercise that demands independence, market testing, documentation, and coordinated disclosure and communications.

Key Takeaways

1. Treat CEO oversight and succession as an ongoing board responsibility with a predictable cadence—not a once-a-year evaluation event.
2. Make independence operational: structure CEO pay, performance, and succession planning so independent directors have real authority and access to independent advice.
3. In conflicted situations (pay, related-party matters, M&A timing, or leadership transitions), re-center board control and supervision—and document the board’s deliberative approach.
4. Escalate, investigate, remediate, and follow up: repeated red flags require board-level visibility and closure tracking.
5. For leadership changes, plan the announcement as carefully as the decision itself: timing, SEC disclosure, and PR/IR coordination can shape how a transition is received.

The prior Red Flags alerts are available here:

• Week 1: Director Oversight of AI Requires Strong Processes and Good-Faith Engagement
• Week 2: Board Engagement with Political and Social Issues Should Be Tied to Stockholder Value
• Week 3: Board Refreshment and Director Risk: Navigating Investor Demands and Delaware Constraints

[1] See Tornetta v. Musk, 326 A.3d 1203 (Del. Ch. 2024).

[2] In re Tesla, Inc. Deriv. Litig., No. 534, 2024 (Del. Dec. 19, 2025).

[3] In re McDonald’s Corporation Stockholder Derivative Litigation, 291 A.3d 652 (Del. Ch. 2023).