Can a Determining Party Revise Its Close out Calculation after It Has Been Issued?

Concept

The question of whether a Determining Party can revise its close-out calculation after issuance cuts to the core of contractual certainty in the global derivatives market. The answer, established through significant legal precedent, is a firm and resounding no. Once a close-out amount is calculated and the corresponding statement is served under the ISDA Master Agreement, it cannot be unilaterally withdrawn or revised. This principle is a foundational element of the market’s architecture, designed to create a fixed and irreversible point of obligation following a termination event.

The issuance of the notice under Section 6(d) of the ISDA Master Agreement is treated as a “significant contractual event” that crystallizes the debt obligation between the two parties. It transforms a fluid set of future obligations into a single, final net payment amount. To allow a party to retract this statement would be to undermine the very finality the mechanism is designed to achieve, potentially re-opening risk calculations that the close-out process is meant to resolve permanently.

At its heart, the close-out mechanism is the market’s primary defense against systemic risk. When a counterparty defaults, the surviving party must terminate all outstanding transactions and calculate the net replacement cost. This calculation, the Close-Out Amount, represents the economic equivalent of the terminated trades. The “Determining Party” is the entity tasked with performing this calculation.

The inability to revise this figure is a feature, a structural safeguard that prevents a party from attempting to re-calculate its position based on favorable market movements that occur after the initial calculation has been made. The legal framework surrounding the ISDA Master Agreement treats the delivery of the close-out statement as an act that fundamentally alters the relationship between the counterparties, moving it from an ongoing concern to one of liquidation and final settlement. This finality is paramount for providing certainty to the non-defaulting party and to the market as a whole, ensuring that the financial fallout from a default is contained and quantified swiftly.

The finality of a close-out calculation is a cornerstone of derivatives contract law, preventing unilateral revisions after issuance to ensure market stability.

The governing legal interpretation, most notably clarified in the case of Lehman Brothers Special Financing Inc. v National Power Corporation, underscores this principle. In that case, the court ruled decisively that a Determining Party cannot simply withdraw a calculation and submit a new one, even if the original contained errors. The court established that any correction of an erroneous calculation is a matter to be resolved either by mutual agreement between the parties or, failing that, by the court itself. A revised calculation submitted by the Determining Party may be considered as evidence by a court, but it does not replace the original binding statement.

This judicial stance reinforces the integrity of the close-out process, placing a high burden on the Determining Party to ensure its initial calculation is performed with diligence and accuracy according to the standards set forth in the governing ISDA Master Agreement. The system is architected to prevent second thoughts, ensuring that the moment of calculation is definitive.

The Role of the Determining Party

The Determining Party operates as the central agent in the close-out process following an Early Termination Date. This role is typically assumed by the non-defaulting party or the non-affected party in the case of a termination event. Its primary function is to calculate the Close-Out Amount, a single figure that represents the aggregate gains or losses resulting from the termination of all transactions under the ISDA Master Agreement. This calculation is a complex undertaking, requiring the Determining Party to assess the replacement cost or economic equivalent of each terminated trade in the prevailing market conditions.

The process involves sourcing market data, obtaining quotes for replacement trades, or using internal valuation models to arrive at a figure that is both fair and representative of the market at the time of termination. The authority granted to the Determining Party is substantial, but it is constrained by a critical obligation to act in good faith and adhere to specific procedural standards defined within the agreement.

Understanding the Close out Calculation

The Close-Out Amount itself is a meticulously defined concept under the 2002 ISDA Master Agreement. It is the sum of the losses or costs that the Determining Party would incur, or the gains it would realize, in replacing the economic equivalent of the terminated transactions. This includes not only the stream of payments and deliveries that would have occurred but also the value of any optionality embedded within the trades. The calculation can be based on a variety of inputs, including:

• Quotations from Third Parties ▴ Obtaining indicative or firm quotes from other market makers for replacement transactions.
• Relevant Market Data ▴ Using observable market data such as interest rate curves, foreign exchange rates, and volatility surfaces to feed into valuation models.
• Internal Models ▴ Employing the Determining Party’s own proprietary models, provided they are the same type used in the regular course of its business for valuing similar transactions.

The objective is to produce a figure that puts the non-defaulting party in the same economic position it would have been in had the transactions run their course. This requires a comprehensive assessment of all material terms and the prevailing market environment at the moment of termination.

Strategy

The strategic framework governing close-out calculations under the ISDA Master Agreement is predicated on the principle of objective reasonableness. The inability of a Determining Party to revise its calculation is a strategic design choice that enforces discipline and promotes certainty in the market. The 2002 ISDA Master Agreement introduced a pivotal change in this regard, moving away from the more subjective standards of the 1992 agreement.

Under the 2002 framework, the Determining Party must not only act in good faith but must also use “commercially reasonable procedures in order to produce a commercially reasonable result.” This language imposes a higher, objective standard that can be measured and, if necessary, challenged and replaced by a court’s calculation. The strategy is to remove ambiguity and prevent a situation where a Determining Party could use its discretion to arrive at a self-serving figure without objective justification.

This shift towards objectivity has profound strategic implications. It means that the entire calculation process must be transparent, well-documented, and defensible. A Determining Party must be prepared to demonstrate that its procedures ▴ whether based on third-party quotes or internal models ▴ were consistent with standard market practices and were applied in a way that was designed to achieve a fair market value. The prohibition on unilateral revision forces the Determining Party to treat its initial calculation with the utmost seriousness.

There is no opportunity to correct a hastily prepared figure later. This creates a powerful incentive to invest in robust valuation systems and clear internal protocols for handling default scenarios. The strategy of the ISDA framework is to front-load the diligence, ensuring that the calculation is performed correctly the first time, thereby minimizing the potential for protracted disputes after the fact.

The objective standard of “commercial reasonableness” in the 2002 ISDA Master Agreement is a strategic pillar designed to ensure fair and defensible close-out calculations.

From the perspective of the party receiving the close-out statement, the finality of the calculation provides a clear and stable basis for its own financial planning and risk management following a counterparty default. If the receiving party believes the calculation is erroneous or fails the test of commercial reasonableness, its recourse is not to wait for a potential revision from the Determining Party, but to formally dispute the amount. The legal framework provides a clear pathway for such challenges, with the courts acting as the ultimate arbiter.

This creates a balanced system where the Determining Party has the initial responsibility to calculate the amount, but the receiving party has the right to challenge it based on objective criteria. The inability to revise the calculation prevents the Determining Party from using the threat of revision as a negotiating tactic, further contributing to a more predictable and orderly resolution process.

How Does the Standard of Calculation Differ between Agreements?

The evolution from the 1992 ISDA Master Agreement to the 2002 version marked a significant tightening of the standards for close-out calculations. This change reflects a market-wide desire for greater objectivity and a reduction in the potential for disputes arising from subjective interpretations. The following table illustrates the key differences in the strategic approach between the two agreements.

Strategic Considerations for the Determining Party

Given the finality of the close-out calculation, a Determining Party must adopt a rigorous and defensible strategy for its determination process. Key strategic considerations include:

• Documentation ▴ Every step of the calculation process must be meticulously documented. This includes records of all market data used, communications with any third parties providing quotes, and detailed explanations of the methodologies applied by internal models.
• Procedural Consistency ▴ The procedures used must be consistent with the party’s normal business practices for valuing similar instruments. Using ad-hoc or unusual methods for a close-out calculation could be challenged as not being commercially reasonable.
• Market Sounding ▴ The party should gather a sufficient range of data points to support its final figure. Relying on a single quote or a narrow data set could expose the calculation to challenges that it does not reflect the broader market.
• Hedging Costs ▴ The definition of Close-Out Amount allows for the inclusion of costs associated with terminating or re-establishing hedges related to the terminated transactions. These costs must be real, quantifiable, and directly attributable to the close-out.

Execution

The execution of a close-out calculation is a high-stakes, time-sensitive process that culminates in the issuance of a legally binding statement. The absolute prohibition on unilateral revision means that the operational execution must be flawless. Once an Early Termination Event occurs, the Determining Party must immediately begin the process of valuing all terminated transactions. This involves a coordinated effort between traders, risk managers, quantitative analysts, and legal counsel.

The first step is to establish the precise valuation time, as market data will be frozen at this point for the purpose of the calculation. The party will then execute its valuation procedures, which, as established, must be commercially reasonable.

If, after the Section 6(d) notice has been delivered, the Determining Party discovers a manifest error in its calculation ▴ for example, a simple mathematical mistake or a data input error ▴ it cannot simply issue a corrected notice. The binding nature of the original notice prevents this. The correct operational procedure is to promptly notify the other party of the discovered error. From there, two paths are available.

The first and most efficient path is for the parties to mutually agree on a corrected amount. This can be formalized through a bilateral amendment or a simple letter agreement acknowledging the error and the revised figure. The second path, which is taken if no agreement can be reached, is to submit the matter to a court or tribunal. In this scenario, the court will not simply accept the Determining Party’s revised figure.

Instead, the court will undertake its own analysis to determine what the Close-Out Amount should have been, using the objective standard of commercial reasonableness. The original calculation and the proposed revision will both be submitted as evidence for the court’s consideration.

A discovered error in a close-out calculation necessitates bilateral agreement or judicial intervention for correction; unilateral revision is contractually forbidden.

This process underscores the critical importance of having a robust and pre-defined operational playbook for handling terminations. Financial institutions must have systems and controls in place to ensure the accuracy of their calculations from the outset. This includes automated data feeds from reliable sources, pre-vetted valuation models that are regularly back-tested, and a clear, multi-level sign-off process before any close-out statement is issued.

The legal and financial consequences of an erroneous calculation are significant, not just in terms of the potential for litigation, but also in the operational resources that must be diverted to resolve the dispute. The entire execution framework is designed to compel accuracy and diligence upfront, reflecting the serious and irreversible nature of the close-out process.

What Is the Workflow for Correcting an Erroneous Calculation?

When an error is found in an issued close-out statement, a specific and disciplined workflow must be followed. A unilateral revision is not an option. The process is one of negotiation and, if necessary, litigation, where the burden of proof rests on demonstrating the correct, commercially reasonable amount.

Operationalizing Commercial Reasonableness

To ensure that a close-out calculation can withstand scrutiny, a financial institution’s execution process must be a direct operationalization of the “commercial reasonableness” standard. This involves several concrete steps:

• Pre-defined Data Sources ▴ The institution should maintain a list of approved, independent data sources for all relevant asset classes. Relying on a single, unverified source is a significant operational risk.
• Model Validation ▴ Any internal models used for valuation must be subject to a rigorous and independent model validation process. This includes back-testing, stress testing, and documentation of the model’s assumptions and limitations.
• Contemporaneous Records ▴ The creation of detailed, contemporaneous records is vital. This includes screenshots of market data, recordings of phone calls where quotes were obtained, and logs from valuation systems. These records become primary evidence in a dispute.
• Segregation of Duties ▴ The personnel responsible for executing the valuation should be separate from those who managed the relationship with the defaulted counterparty to avoid any appearance of bias. A final review by an independent risk management or legal function is a crucial control step.

By embedding these principles into the operational fabric of the institution, a Determining Party can execute its duties with a high degree of confidence that its calculation will be deemed final, binding, and, above all, commercially reasonable.

Reflection

The inability to revise a close-out calculation transforms it from a mere accounting entry into a foundational act of market stabilization. The knowledge that this figure is final compels a level of discipline and precision that ripples through an institution’s entire operational framework. It demands robust valuation systems, transparent procedures, and a culture of diligence. Reflecting on this principle invites a deeper question about your own operational architecture.

Is it designed merely to produce a number, or is it engineered to produce a final, defensible, and commercially reasonable result under pressure? The strength of the close-out mechanism lies in its rigidity. Its proper execution is a testament to the strength of the systems that support it.