A common play by insurers that have failed to perform their duty to defend is to challenge the defense costs their policyholders incur on the grounds that they were unreasonable. The suggestion is that had the carrier defended the costs would have been less because the carrier would have hired cheaper defense counsel, or it would have ridden tighter herd on the costs incurred, or it would have required that only a limited number of lawyers be involved, or any of several other grounds for second-guessing the costs incurred by the policyholder. In addition to advancing these arguments, insurers have fabricated a specialized mouthpiece for making these points: “legal fee auditors.” But both the legal premise and the “expert” testimony offered in support increasingly are being looked upon with the skepticism properly applied to the excuses of a breaching party that is seeking to reduce its obligation to pay damages – especially when that breaching party is an insurance company that was supposed to defend its insured in the first place.

The legal premise of a carrier’s argument is that it needs to reimburse the insured only for “reasonable” defense costs, even if the policyholder already has spent the money. But this misconceives the legal context and the nature of the carrier’s obligation. In these after-the-fact circumstances, the carrier’s obligation is measured by ordinary principles of contract damages – and the hoary rule of Hadley v. Baxendale. E.g., Hajoca Corp. v. Security Trust Co., 25 A.2d 378, 381 (Del. 1942). The key to properly understanding the issues is to hold fast to first principles: when a party breaches a contract, the non-breaching party proves its recoverable damages by showing what was factually caused by the breach. In the context of the duty to defend, the natural and probable consequences of a breach of a duty to defend is that the policyholder will hire lawyers and experts to defend the suit against it. These costs, therefore, are the presumptive amount of damages for breach of the duty to defend.
Because the policyholder had no certainty that it would obtain recovery from someone else (i.e., the insurer), the amounts it incurred are presumed in the first instance to have been “reasonable” and “foreseeable.” E.g., Aerojet-General Corp. v. Transport Indem. Co., 948 P.2d 990, 924-25 (Cal. 1997); Lanier v. Lovett, 213 P.2d 391, 394 (Ariz. 1923) (“The price agreed upon for labor or materials . . . is, prima facie, the reasonable value”); Smith v. Champaign Urbana City Lines, Inc., 252 N.E.2d 381, 382 (Ill. App. 1969) (paid invoice prima facie evidence). Once the policyholder establishes the amounts it paid (which therefore would be sufficient to support a jury verdict in its favor on damages), the burden shifts to the carrier to prove by competent evidence that some or all of the insured’s incurred costs are so unreasonable as to constitute “unforeseeable” damages. See Marc Mayerson, Insurance Recovery of Litigation Costs, 30 Tort & Ins. L. J. 997 (1995). The presumption that costs incurred are reasonable or recoverable, though not conclusive, is a strong one: as the Seventh Circuit held:

When [the insured] hired its lawyers, and indeed at all times since, [the insurer] was vigorously denying that it had any duty to defend – any duty, therefore, to reimburse [the insured]. Because of the resulting uncertainty about reimbursement, [the insured] had an incentive to minimize its legal expenses (for it might not be able to shift them); and where there are market incentives to economize, there is no occasion for a painstaking judicial review.

Taco Bell Corp. v. Continental Cas. Co. (7th Cir. Nov. 5, 2004). Cf. National American Ins. Co. v. Certain Underwriters at Lloyd’s, London, 93 F.3d 529, 539-40 (9th Cir. 1996); Laffey v. Northwest Airlines Inc., 746 F.2d 4, 17 & n.88, 24-25 (D.C. Cir. 1984). (It is also worth mentioning that lawyers have an independent professional obligation only to charge a reasonable fee. DR 1.5; Florida Bar v Herzog, 521 So.2d 1118 (Fla. 1988).)
So, an insurer bears a heavy burden in showing that costs are so unreasonable as to constitute unrecoverable contract damages (recognizing the costs actually were already incurred). The means for the insurers to make these arguments in recent years has been via “legal fee auditors.” These chaps – typically former lawyers for insurance companies and almost certainly not “auditors” – really are disguised advocates who lack professional training and opine with no professional standards guiding their work. The audit profession is a real one, of course, and audits require compliance with written standards, such as Generally Accepted Auditing Standards promulgated by the AICPA. See generally Cumis Ins. Society Inc. v. Tooke, 293 A.D. 2d 794, 797-98 (N.Y. App. Div. 2002). The “legal audit” firms are not part of such disinterested, professional organizations – instead, they are mouthpieces with a mission to flyspeck legal fees on an after-the-fact basis. Several courts have not welcomed the testimony offered by these auditors/advocates:

[The insurance company] submitted an affidavit by a firm that hires itself out to review lawyers’ bills and that opined that [the insured] had overpaid the lawyers who represented it [in the underlying] litigation. We are unimpressed, as was the district court. . . The affidavit of the firm that picked through [the insured's] legal bills is excruciatingly detailed. The amount of time and money that went into its preparation and would be incurred in adjudicating its accuracy probably would exceed the potential excesses that it identifies.

Taco Bell, slip op. at 9. The District of Massachusetts recognized that the testimony of a legal auditor is not likely to pass muster under Fed. R. Evid. 702 and the Daubert rule. E.g., Liberty Mut. Ins. Co. v. Black & Decker Corp., 2004 WL 1941351 (D. Mass. Aug. 25, 2004), at *8 & n.8. In Black & Decker, the court indicated that a fee auditor from one of the national fee-auditing outfits lacked the “specialized knowledge” and methodology as to testify properly as an expert witness. Id. While the court sought to be generous in saying that the effort was still helpful to the court, helpfulness alone is not a sufficient basis for its admission into evidence.
But there is an insurance spin that is worth returning to in evaluating the admissibility of the testimony of legal auditors and consideration of their project: As the Seventh Circuit concluded, “the duty to defend would be significantly undermined if an insurance company could, by the facile expedient of hiring an audit firm to pick apart law firm’s billings, obtain an evidentiary hearing on how much of the insured’s defense costs it had to reimburse.” Taco Bell, slip op. at 10-11. To similar effect was the thinking of the District of Massachusetts:

Having declined to involve itself in the insured’s conduct of the litigation once notified, [the insurer] is in no position ex post to complain that the insured’s billing and litigation management policies do not meet its private criteria. The insurer that declines defense after notice cannot claim prejudice in the form of billing format or litigation practices that do not meet its standards, since it could have assumed the defense and imposed those standards.

Black & Decker, 2004 WL 1941351 at *8.
The context of breach of contract is different from the situations where an application for reimbursement of fees is submitted under a federal statute or in a bankruptcy proceeding. Just because the insured’s damages for breach of contract are in the form of attorneys’ fees does not mean that the standard of proof of damages is any different – a distinction insurers often seek to efface. Insurers thus often object to “block billing” or “inadequate descriptions” and argue that they are excused entirely from reimbursing such amounts, but this is simply wrong. The issue is whether a jury is provided with a non-speculative basis to determine the insured’s damages – and in the circumstance of block billing or the like so long as one can be reasonably certain that the business methods of the law firm yields an accurate statement of the time spent on the matter, the insured has established its right to those damages. E.g., Jowdy v. Guerin, 457 P.2d 745, 749 (Ct. App. 1969) (“Under Arizona law there is a distinction between the degree of proof necessary to establish the fact of damages and that necessary to fix the amount. Once the plaintiff has clearly established that he has suffered damages, his burden is relaxed and he need only show the amount with reasonable certainty, free from mere speculation or conjecture.”). Lawyers bill for their time, not for their time descriptions (as the old “for services rendered” billing format confirms).
Similarly, some carriers have objected to including as an element of damages the costs of computerized legal research and other expenses, arguing that these are more properly overhead expenses; while such costs could be wrapped into the hourly rate at particular law firms, there is no impediment to billing for them separately. E.g., ABA Comm. On Ethics and Prof’l Respo., Formal Op. 93-379 (Dec. 6, 1993). These are not per se unforeseeable costs and their being billed separately is not outside market practices.
None of this is to deny that clients should control the costs incurred by their counsel, and sophisticated corporate clients monitor the costs incurred and the manner of their billing – because they are paying for it! There are innumerable ways to structure the fees and expenses of lawyers, including increasing the lawyers’ billing rates so that expenses are no longer broken out (i.e., setting the rate so that the firm absorbs expenses rather than setting rates contemplating that expenses are separately billed); clients may impose standards for how law firms use outside vendors for copying and the like. Some clients want task-based billing and are willing to pay for it; others are satisfied with daily billing or what carriers like to call “block” billing. All of these may be appropriate business deals to work out with defense counsel. The point here, however, is in determining a carrier’s obligation to reimburse defense costs all of these quibbles are too late – in a breach of contract the insured shows what it spent and the breaching party bears a heavy burden of showing that costs that were spent and were caused by its breach should nonetheless not be awarded as an element of damages. Holding fast to these straightforward principles of contract law and damages jurisprudence simplifies coverage cases and streamlines the presentation of damages evidence at trial (to the considerable relief of jurors).
In one of my cases, the legal auditor purported to question 73 percent of all the defense costs incurred for a sophisticated client by a leading employment-liability defense firm, preparing a report of some 748 pages. This should be Exhibit A in showing that this entire project quite properly is a dead-end, as the Seventh Circuit and District of Massachusetts both found.