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Ninth Circuit Rejects Insured’s “Internal Business Practice” Argument and Enforces D&O Policy’s Broad Professional Services Exclusion

Directors and Officers Alert | June 8, 2018
By: Sean Mahoney, Maurice Pesso and Ciaran Way

Earlier this week, in HotChalk, Inc. v. Scottsdale Insurance Company, No. 16-17287, 2018 U.S. App. LEXIS 14884 (9th Cir. Jun. 4, 2018), the Ninth Circuit Court of Appeals affirmed a District Court’s determination that a broadly-worded professional services exclusion in a directors and officers liability insurance policy required dismissal of the insured’s coverage and bad faith claims at the pleadings stage. In particular, the Ninth Circuit explicitly rejected the insured’s argument that the exclusion did not apply because the underlying False Claims Act allegations only related to the insured’s internal business practices and not to its provision of educational services to others.

HotChalk lends strong support for rejecting an insured’s attempt to narrow the scope of broad form exclusions to apply only to those claims “for” the excluded conduct. Where an exclusion includes a broad form preamble like the “alleging, based upon, arising out of, attributable to, directly or indirectly arising from, in consequence of, or in any way involving” language at issue in Hotchalk, courts should assess whether the wrongful acts in the claim would have existed “but for” the excluded conduct — not simply whether the wrongful acts are “for” the excluded conduct. We expect that insurers will cite to Hotchalk for the proposition that broad form exclusion are in fact “very broad.”

HotChalk, Inc., the insured, provided technology and support services to universities to establish or expand their online degree programs, including marketing online programs and recruiting students and faculty. HotChalk’s employees filed a qui tam lawsuit against the company asserting violations of the False Claims Act, claiming that HotChalk had falsely certified to the US Department of Education that it had complied with the Higher Education Act. In particular, the qui tam plaintiff employees alleged, inter alia, that HotChalk violated the Higher Education Act by providing incentive-based payments to employees charged with recruiting students.

HotChalk tendered that lawsuit to its D&O insurer, Scottsdale. Scottsdale denied coverage based upon a professional services exclusion stating that the insurer “shall not be liable for Loss under [the Policy] 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 failure to render professional services….” HotChalk ultimately settled the underlying lawsuit and sued Scottsdale for breach of contract and bad faith, seeking reimbursement of its expended defense costs and the amount it paid to settle the underlying action. Scottsdale filed a motion for judgment on the pleadings, arguing that its professional services exclusion barred coverage for the underlying False Claims Act case. The District Court agreed and dismissed HotChalk’s complaint. HotChalk appealed.

HotChalk conceded in the District Court that its educational services constituted “professional services” within the meaning of the exclusion. In both the District Court and on appeal, however, HotChalk argued that its alleged practice of compensating employees based upon their success in enrolling students “related strictly to [its] employee compensation system, an internal aspect of the way it ran its business, and accordingly was unrelated to its professional services.”

Both the District Court and the Ninth Circuit rejected this argument. The District Court concluded that “HotChalk’s allegedly incentive-based compensation scheme could only have been improper because of the professional services that HotChalk provided.” After noting that prior Ninth Circuit precedent had interpreted the professional services exclusion as “very broad,” the District Court further determined that “HotChalk undisputedly provided professional services, and absent those professional services, HotChalk would not have been subject to the law that it was alleged to have violated in the underlying False Claims Act lawsuit.” The District Court accordingly dismissed both the contract claim and the bad faith claim against Scottsdale.

The Court of Appeals affirmed this conclusion on essentially the same grounds, holding that “the claims at issue in the [False Claims Act lawsuit] clearly arose out of HotChalk’s professional services.” HotChalk, 2018 U.S. App. LEXIS 14884 at *5. The Court of Appeals reasoned that “HotChalk’s liability [in the underlying False Claims lawsuit] was not merely a matter of employee compensation, as HotChalk argues…. [it] derived from the fact that its professional services caused ineligible students and ineligible universities to submit claims for federal financial aid to the [Department of Education].” In a footnote, the Court of Appeals distinguished another case, FoodPro International, Inc. v. Farmers Insurance Exchange, 169 Cal. App. 4th 976 (2008), explaining that “the relationship between HotChalk’s professional services and its alleged liability was not merely ‘incidental’” but was “direct and well within the plain language of the professional services exclusion at issue….” HotChalk, 2018 U.S. App. LEXIS 14884 at *5 n.2.

Notably, in another footnote, the Court of Appeals further rejected HotChalk’s argument that reading the professional services exclusion so broadly eviscerates all coverage under the policy. The Court of Appeals determined that this argument was an “overstatement” and specifically noted that, by its own terms, Scottsdale’s exclusion did not apply to claims by HotChalk’s “securities holders.” Id. at n.3.

If you have questions or would like additional information, please contact Sean Mahoney (mahoneys@whiteandwilliams.com; 215.864.6342), Maurice Pesso (mpessom@whiteandwilliams.com; 212.631.4405) or Ciaran Way (wayc@whiteandwilliams.com; 215.864.6815).

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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