North Carolina Business Litigation Report

Sanctions For Derivative Action Plaintiff And His Lawyers

Egelhof v. Szulik, 2008 NCBC 2 (N.C. Super. Ct. Feb. 4, 2008)(Tennille)

It’s hard to imagine a more inadequate plaintiff than Egelhof to undertake the fiduciary responsibility of being a plaintiff in a derivative action against Red Hat, a publicly traded company. Egelhof was only 24 years old, and held only a few hundred dollars of Red Hat's stock. He had become a plaintiff in response to a solicitation on the internet. As the Court described Egelhof, "[h]e had little investing experience, no experience in litigation, no prior connection with the [his] law firm, no personal knowledge of [the corporation] and its operations, and a minor criminal record."

The Court concluded that this plaintiff "lacked any credentials to act as a fiduciary for a company in multi-million dollar litigation." Noting Egelhof’s paltry stake in Red Hat, the Court held that "[w]hile the size of ownership is not determinative of standing, a potential plaintiff's lack of a real financial stake in the litigation is a warning sign that he or she may not be willing or able to devote the time necessary to fulfill the fiduciary obligations imposed by law on a shareholder derivative plaintiff."

These factors alone would probably not have warranted sanctions, but Egelhof was completely uninvolved in his case. He relocated, more than once, and never gave his lawyers a forwarding address. He sold his stock during the course of the lawsuit, creating a significant standing issue, but never mentioned this to his lawyers. He had never even met his lawyers until the night before his deposition and had spent a total of five hours on the case by the time he was deposed.

The Court's sanction to Egelhof was to prohibit him from being a plaintiff in a class action or derivative action in North Carolina for the next five years. The lawyers came in for an equally harsh sanction.

The Court found that they had violated Rule 1.4 of the Rules of Professional Conduct by failing to properly inform their client. The Court also found that the firm had failed in its "duty to know its client" and to "have confidence in the client's knowledge and ability to fulfill his or her fiduciary duties." Instead, the firm had "borrowed" the plaintiff's name, "treated the lawsuit as its own," and made all litigation decisions without input from their supposed client. In a final faux pas, the lawyers had failed to obtain pro hac admission from the Business Court before arguing the motion for sanctions.

The lawyers and their firm were barred from being admitted pro hac in any court in North Carolina for a period of five years. The only lawyer for plaintiff who escaped sanctions was Egelhof's local counsel, but the Court sent a clear warning to lawyers acting as local counsel in shareholder lawsuits. It said that they would be “well advised” to consider the following factors before putting their signature on these types of lawsuits:
  • Is there a real plaintiff capable of fulfilling his or her fiduciary duties?
  • Is the complaint being filed in a race to the courthouse?
  • Are the allegations based on known facts or media stories?
  • Has there been any effort to review the books and records of the company to support demand futility claims?
  • Are the claims meritorious, and are there allegations that would support a finding that red flags existed to warrant board action in a derivative case?
  • Is there clear precedent supporting or contrary to the positions taken?

Both sides have appealed (the defendants on the denial of their motion for an award of attorneys' fees).


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Mack Sperling
Brooks Pierce, LLP
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