A recurring issue under private company D&O insurance policies is the scope of the preclusive effect of the professional services exclusion. This question is particularly important for companies in professional services industries, as just about everything these kinds of companies do arises in some way out of their delivery professional services. In a June 4, 2018 decision in a case presenting these issues, the Ninth Circuit affirmed the district court’s holding that the professional services exclusion in an educational services company’s D&O insurance policy precluded coverage for a False Claims Act claim. As discussed below, the case raises questions about the purposes of the professional services exclusion and the way it operates to restrict available coverage. The Ninth Circuit’s June 4, 2018 opinion can be found here.
The insurance coverage dispute arises out of a False Claims Act lawsuit that was filed in April 2014 against HotChalk Inc. by certain of its former employees. HotChalk is in the business of helping universities create or expand their online degree programs. Their services include promoting and administering those programs, including recruiting students. The plaintiffs in the False Claims Act suit alleged that the HotChalk provided forms of incentive payments to its employees responsible for recruiting student in violation of Department of Education regulations prohibiting companies involved in federal student grant and loan programs from paying commissions or incentive compensation. HotChalk ultimately settled the underlying lawsuit.
HotChalk submitted the False Claims Act lawsuit to its D&O insurer, which denied coverage for the lawsuit on the grounds that the lawsuit arose out of the company’s professional services rendered to its customer universities and were therefore excluded from coverage under the policy’s professional services exclusion. HotChalk filed a coverage lawsuit against the insurer. The insurer filed a motion for judgment on the pleadings.
In a November 15, 2016 order (here), Northern District of California Judge Claudia Wilken entered an order granting the D&O insurer’s motion. Judge Wilken rejected HotChalk’s argument that the underlying lawsuit arose out of its alleged employee compensation practices, which, the company argued, strictly involved an internal aspect of the way it ran its business and therefore was unrelated to its delivery of professional services.
Judge Wilken concluded that HotChalk’s incentive compensation scheme “could only have been improper because of the professional services that HotChalk provided.” The statutory scheme that prohibited the incentive compensations was intended to “protect the government’s own financial interests and its interest in protecting student borrowers.” Absent HotChalk’s provision of professional services, Judge Wilken said, the company would not have been subject to the law that it was alleged to have violated in the underlying lawsuit. Therefore, she concluded, the False Claim Act lawsuit arose out of HotChalk’s professional services and could not potentially fall outside the professional services exclusion. HotChalk filed an appeal to the Ninth Circuit.
The professional services exclusion in HotChalk’s D&O insurance policy provides that the
Insurer shall not be liable for Loss under this Coverage Section on account of any Claim alleging, based upon, arising out of, attributable to, directly or indirectly arising from, in consequence of, or in any way involving the rendering or failing to render professional services, provided, however, this exclusion shall not apply to any Claim(s) brought by any securities holder of the Company in their capacity as such.
The June 4, 2018 Decision
In a June 4, 2018 per curiam decision designated as not for publication, a three-judge panel of the Ninth Circuit, applying California law, affirmed the district court’s decision, holding that the policy’s professional services exclusion precluded coverage for the underlying claim.
In reaching its decision, the appellate court emphasized a factual aspect of the underlying claim that was not highlighted in the district court decision. The appellate court stressed not only that the underlying lawsuit alleged that HotChalk had paid improper compensation but also that the company had caused both students and the universities with whom HotChalk partnered to submit false claims to the federal government.
On the insurance coverage question, the appellate court said that underlying lawsuit “clearly arose out of HotChalk’s professional services,” emphasizing that the claims against HotChalk “alleged that it caused false claims to be submitted to the federal government, thereby defrauding the government.” HotChalk’s liability was not, as the company argued, merely a matter of employee compensation; rather, the court said, HotChalk’s alleged liability “derived from the fact that its professional services caused ineligible students and ineligible universities to submit claims for federal federal financial aid.”
As a result, the court concluded, “the liability arose out of HotChalk’s rendering of professional services and was therefore excluded from coverage.” In a footnote, the court also observed that “the relationship between HotChalk’s professional services and its alleged liability was direct and well within the plain language of the professional services exclusion at issue in this case.”
The appellate court’s observation that the underlying lawsuit involved allegations that HotChalk had caused students and schools to submit false claims to the federal government puts this coverage dispute in a light not readily apparent from the district court’s opinion; these allegations suggest that the underlying case was about more than just HotChalk’s employment compensation practices (which, it could be argued, do not involve professional services as such), but rather did in fact “arise out of” HotChalk’s delivery of professional services. On that basis, the appellate court concluded that the exclusion applied.
The deeper question is whether the exclusion should operate this way given the purposes of the D&O insurance policy and the reason that buyers purchase the coverage.
In thinking about this question, it is important to keep in mind why the professional services exclusion is in the D&O policy in the first place. As I have previously noted when talking about this exclusion, the professional services exclusion is one of several standard D&O policy exclusions that are designed to keep claims in their proper lanes. For example, the standard Bodily Injury/Property Damage exclusion is designed to ensure that claims that properly are addressed by the policyholder’s GL policy are not picked up the D&O policy. The Professional Services Exclusion is there to ensure that claims alleging actual or alleged errors or omissions in the delivery of professional services — that is, E&O claims — are not picked up by the D&O insurance policy. Operating properly, the Professional Services Exclusion ought to exclude claims – and only exclude claims — that would fall under the policyholder’s E&O insurance.
The problem with the exclusion in this policy – and, in fairness, in the professional services exclusion found in many D&O insurance policies – is that it is built upon a very broad preamble; the exclusion precludes coverage for any Claim “alleging, based upon, arising out of, attributable to, directly or indirectly arising from, in consequence of, or in any way involving” the rendering or failing to render professional services. This wording sweeps so broadly that it could encompass ordinary business activities, particularly for a professional services company. It could involve, for example, the company’s payment of compensation to its employees whose activities involve delivering services.
It is true that the appellate court seized on factual allegations in the underlying complaint (that were in fact not even mentioned by the district court) to the effect that the company caused fraudulent claims to be submitted to the federal government. The court concluded that these allegations “clearly” arose out of HotChalk’s delivery of professional services.
I wonder, though, that if HotChalk’s policy had an exclusion that rather than the broad “based upon, arising out of” preamble had a narrower “for” preamble, whether the claim would have been excluded. This is of course a hypothetical that is hard to assess without more detailed information about the underlying allegations; the claimant may have alleged that HotChalk caused fraudulent submissions to the federal government, but it isn’t clear from the record whether or not the claim was “for” the services that caused the fraudulent submission. It is possible, depending on the specifics of the underlying lawsuit, that this claim would have been excluded even with the narrower “for” wording.
That said, in my view, the narrower wording comes closer to the true intended purpose of the professional services exclusion – that is, to keep claims in their proper lane. The broader “based upon” wording threatens to sweep too broadly and, particularly for companies in a professional services business, to preclude claims that properly should be covered and that indeed represent the very kind of claim for which the insurance is purchased.
The danger for any D&O policyholder, but particularly for D&O policyholders in professional services industries, is that much of the organization’s activities arise out of the delivery of services. The prospective reach of the exclusion sweeps so broadly that it could encompass virtually everything the organization does, effectively rendering the coverage illusory. An amicus to this appeal, United Policyholders, raised this very argument to the Ninth Circuit. The appellate court rejected this suggestion but reference to the carve-back in the exclusion for shareholder claims, which, the court said “demonstrates” that the illusory coverage argument is an “overstatement.”
Unfortunately, in my experience, carriers do regularly rely on a broadly worded professional services exclusion to try to preclude coverage in a way that very much does threaten to make the coverage illusory. As I have argued before, it is one of the things I think that carriers regularly get wrong. The insurer in this appeal may well have prevailed in this coverage dispute, but the question the industry should be asking is whether this is the way the policy is supposed to operate. Regardless of the outcome of this specific case, I continue to believe that the more general issue of the overly broad scope of the professional services exclusion is a problem for everyone involved, including the insurers.