The Seventh Circuit recently had occasion to consider several novel arguments by an insurer seeking to avoid application of the Taco Bell doctrine—i.e., the rule that, where an insurer breaches its duty to defend, the policyholder is entitled to a presumption that its defense costs are reasonable and necessary. Taco Bell Corp. v. Continental Casualty Co., 388 F.3d 1069, 1075-76 (7th Cir. 2004). The Seventh Circuit’s opinion both strengthened the foundations of Taco Bell and further clarified some of its contours, a result beneficial to policyholders facing wrongful denials of duty to defend coverage. USA Gymnastics v. Liberty Insurance Underwriters, Inc., No. 21-2914, 2022 U.S. App. LEXIS 22702 (7th Cir. Aug 16, 2022).
November 30, 2022 Practice Points
Seventh Circuit Clarifies Contours of Taco Bell Doctrine
The court clarified the contours of the rule that, when an insurer breaches its duty to defend, the policyholder is entitled to a presumption that its defense costs are reasonable and necessary.
By Drew Barrios
The underlying litigation involved hundreds of lawsuits against USA Gymnastics (USAG) alleging that Dr. Larry Nassar, the team doctor of USAG, sexually abused. USAG filed for Chapter 11 bankruptcy in the Southern District of Indiana as a result of the Nassar lawsuits, and in the bankruptcy, it filed an adversary proceeding against its insurers seeking coverage for the Nassar lawsuits and several other related legal proceedings, including investigations by Congress, the Indiana Attorney General, and the U.S. Olympic Committee, as well as a proceeding in which the Olympic committee sought to decertify USAG as the national governing body of gymnastics (collectively with the Nassar lawsuits, the “Nassar legal proceedings”). In that adversary proceeding, USAG sought partial summary judgment that one of its insurers, Liberty Insurance Underwriters, Inc., breached its duty to defend USAG in the Nassar legal proceedings. Adopting the bankruptcy court’s opinion recommending that USAG’s motion be granted as to the Nassar Legal Proceedings, but denied as to three criminal proceedings, the district court granted the motion and held Liberty had a duty to defend USAG in the Nassar legal proceedings.
Liberty nevertheless refused to reimburse USAG’s defense costs on the basis that some of them were neither reasonable nor necessary. USAG thus filed a motion to enforce the prior order, and the bankruptcy court’s recommended that the district court award USAG basically all of its requested fees. The district court once again agreed with the bankruptcy court’s recommendation and entered judgment for USAG, and Liberty appealed the ruling to the Seventh Circuit.
In reliance on an opinion from the Indiana Court of Appeals that adopted the Taco Bell doctrine—Thomson Inc. v. Ins. Co. of N. Am., 11 N.E.3d 982, 1023–24, 1031 (Ind. Ct. App. 2014)—Liberty made two novel arguments as to why Taco Bell did not apply under the circumstances: (1) USAG “failed to adequately supervise the outside counsel it engaged” because it “never requested write-offs from outside counsel and rarely followed up with them to ask questions about invoices they submitted”; and (2) USAG had not paid the fees it was seeking in full. The court was not persuaded by either argument.
As to the first argument, Liberty relied on another Seventh Circuit opinion addressing the reasonableness of attorneys’ fees (Metavante Corp. v. Emigrant Savings Bank, 619 F.3d 748, 774 (7th Cir. 2010)) to argue that a party has a duty to scrutinize legal bills before paying them. The Seventh Circuit rejected this argument and held that the duty to scrutinize does “not require a party to either request write-offs from outside attorneys or ask them questions about invoices.” The Seventh Circuit therefore held that an insured “may supervise its outside counsel without refusing to pay portions of legal bills or engaging in hairsplitting about those bills.”
In rejecting Liberty’s second argument that Taco Bell did not apply because USAG had not paid its fees in full, the court reiterated that the Taco Bell doctrine applies where the insured has “uncertainty about reimbursement” and, as a result, “market incentives to economize.” None of the Seventh Circuit’s prior cases addressing Taco Bell, however, held that an insured’s payment of fees in full was a precondition of the doctrine’s application; the court therefore held that “payment in full is not a requirement for the presumption of reasonableness to apply.” Instead, the only requirement is that a policyholder has “supervised and incurred legal fees without any expectation of payment,” because “the policyholder may lack sufficient funds to pay fees that are reasonable and necessary to its defense.” The Seventh Circuit also noted that “if the policyholder does pay a significant percentage of its fees—particularly when it has difficulty covering its day-to-day operating expenses—that is strong evidence of market incentives to economize, rendering the presumption applicable.”
Liberty also argued Taco Bell did not apply based on what is known as the “special circumstances” exception from the Metavante opinion, an exception that arises when the court has reason to doubt whether market considerations alone ensure fees are reasonable. Metavante, 619 F.3d at 775. If the district court has such doubts it may, “as a matter of its sound discretion,” request additional information from the insured. Liberty claimed three special circumstances existed that raised doubts about whether USAG’s fees were adequately market tested.
The first special circumstance Liberty raised was a conflict of interest arising out of the fact that USAG’s chief legal officer was also an attorney at Miller Johnson, one of many law firms USAG engaged as outside counsel. Liberty argued USAG was unable to provide “disinterested and meaningful” oversight of Miller Johnson’s fees due to this situation. The court rejected this argument, again noting that no case law stood for the proposition that Taco Bell does not apply where an apparent conflict of interest exists. The court reasoned further that Liberty’s conflict of interest argument was unpersuasive because, having breached its duty to defend, it was not entitled to the “benefit of hindsight” to identify “purported conflict[s] of interest” in order to avoid Taco Bell.
The second special circumstance Liberty pointed out was that Gibson Dunn, another of the law firm’s USAG engaged, had agreed with USAG at one point during its representation that it would only seek reimbursement of fees from USAG’s insurers going forward. Liberty maintained that any fees subsequent to that agreement were not market tested. The court agreed with Liberty on this point, holding that once “the deal was reached, USAG knew it would not be responsible for paying Gibson Dunn’s fees, so USAG lacked an adequate incentive to keep those bills low.” Despite this holding, USAG was nevertheless held to be entitled to reimbursement of Gibson Dunn’s fees because the Seventh Circuit deferred to the bankruptcy court’s factual finding that Gibson Dunn’s fees were reasonable and necessary.
The third and last special circumstance Liberty noted pertained to grants of funds USAG received from the National Gymnastics Foundation. According to Liberty, this “pipeline of third-party support removed the incentive for USAG to drive down costs,” rendering the Taco Bell presumption inapplicable. In response, USAG maintained the funds (1) were used to pay legal bills for which USAG was not seeking coverage from Liberty, and (2) merely allowed USAG to stay afloat and did not generate a surplus that removed its market incentives to economize. The Seventh Circuit sided with USAG and adopted the bankruptcy court’s finding USAG’s acceptance of funds from third parties for the very purpose of paying fees when it had insufficient resources itself” was not a special circumstance sufficient to overcome the Taco Bell presumption. The Seventh Circuit emphasized that it was undisputed “USAG was bankrupt and lacked money to spare,” and so the record did not support “any finding that USAG stockpiled vast sums of money for legal expenses, which would have removed any need to economize” and rendered Taco Bell inapplicable.
All told, the Seventh Circuit’s opinion was an unequivocal win for the policyholder bar. The court flatly rejected Liberty’s attempt to avoid application of Taco Bell on the grounds that USAG failed to adequately supervise counsel because it did not request write-offs or ask questions about invoices, and had not paid its fees in full. These were novel arguments not yet addressed in Taco Bell or its progeny. Where an insurer disputes fees because the insured failed to seek write-offs or question invoices, USAG provides policyholders strong counterarguments. Likewise, where a policyholder is struggling financially and unable to pay fees incurred in defense of costly litigation that its insurer has wrongfully refused to defend, the policyholder can now be confident that it will nevertheless be entitled to the Taco Bell presumption. Lastly, the Seventh Circuit significantly limited the ability of insurers to utilize Metavante’s “special circumstances” exception by confirming the exception’s narrowness and the fact that its application is within the sound discretion of trial courts. Moreover, the court’s treatment of Liberty’s various “special circumstances” arguments places boundaries on the exception, which had scarcely been addressed until now.
Drew Barrios is an associate with Reed Smith, Chicago.
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