Can a Determining Party Still Face Legal Challenges over Its Close out Amount Calculation under the 2002 ISDA?

Concept

The operational framework of the 2002 ISDA Master Agreement presents a critical shift in the calculus of risk for a Determining Party. A party’s calculation of a close-out amount is absolutely subject to legal challenge. This vulnerability stems directly from the architectural redesign of the termination payment mechanism, which moved from the 1992 Agreement’s standard of “rationality” to the 2002 Agreement’s more exacting requirement to use “commercially reasonable procedures in order to produce a commercially reasonable result”. This evolution introduces a higher, objective benchmark against which the Determining Party’s actions are measured.

The core of the issue resides in the fact that objective standards, by their nature, invite external scrutiny and judicial review. A court can, and will, substitute its own judgment for the Determining Party’s if the established process or the resulting figure fails to meet this elevated threshold of commercial reasonableness.

The 2002 ISDA Master Agreement’s requirement for “commercially reasonable” procedures elevates the standard for calculating close-out amounts, opening the door to greater judicial scrutiny and legal challenges.

The English Commercial Court’s decision in Lehman Brothers Special Financing Inc. v National Power Corporation provides a clear and authoritative analysis of this principle. In that case, the court established that the language of the 2002 ISDA was deliberately chosen to increase objectivity and flexibility in the close-out process. The ruling confirmed that the Determining Party’s process is not a matter of its own discretion, but a procedural obligation that can be rigorously assessed.

A party cannot simply assert that its calculation is correct; it must be able to demonstrate, with evidence, that the methodology employed was objectively sound and the outcome was commercially reasonable within the context of the prevailing market conditions. This creates a system where the integrity of the process is as significant as the final number itself.

What Is the Core Shift from the 1992 ISDA Agreement?

The fundamental change between the 1992 and 2002 ISDA Master Agreements lies in the standard of conduct demanded of the Determining Party. The 1992 Agreement required a “rational” determination, a standard that is deferential to the decision-maker. A challenge under the 1992 Agreement would have to prove that the calculation was one that no reasonable party could have reached. The 2002 Agreement, conversely, establishes a more stringent, two-part test:

• Commercially Reasonable Procedures ▴ This initial requirement focuses on the process of the calculation. The Determining Party must use methods that are recognized and accepted within the financial markets for valuing similar terminated transactions.
• Commercially Reasonable Result ▴ The second requirement assesses the outcome of the calculation. The final close-out amount must be a figure that is fair and rational given the market conditions at the time of termination.

This dual requirement means a court can find fault with either the methodology or the final amount. The result is a substantial increase in the potential for a successful legal challenge, compelling the Determining Party to adopt a more rigorous and transparent approach to the close-out calculation process.

Strategy

A strategic approach to calculating the close-out amount under the 2002 ISDA Master Agreement requires a fundamental focus on procedural integrity and evidentiary support. Given that the standard is one of objective commercial reasonableness, the Determining Party must construct a process that is both defensible and transparent. The primary strategic objective is to create a comprehensive audit trail that substantiates the decisions made and the data relied upon during the calculation process.

This involves a systematic approach to gathering and evaluating market information, ensuring that the chosen methodology aligns with accepted industry practices. A key consideration is the potential for future legal challenges, meaning every step should be taken with the assumption that it will be scrutinized in a court of law.

The strategy for a Determining Party is to build a defensible and transparent process for calculating the close-out amount, focusing on procedural integrity and strong evidentiary support.

Building a Defensible Calculation Framework

The architecture of a sound close-out calculation process should be built on a foundation of recognized market data and established valuation techniques. The 2002 ISDA Master Agreement itself provides a non-exhaustive list of information sources that a Determining Party may consider, including:

• Quotations from Third Parties ▴ Obtaining quotes for replacement transactions from one or more independent financial institutions is a primary method for establishing a commercially reasonable value. The selection of these institutions and the documentation of the requests for quotes are critical components of a defensible process.
• Market Data ▴ Utilizing relevant market data, such as interest rates, currency exchange rates, and commodity prices from reputable third-party providers, adds a layer of objectivity to the calculation. The source and timing of this data should be meticulously recorded.
• Internal Valuations ▴ The agreement permits the use of internal data and models, but this is subject to the condition that such sources are used in the regular course of business for valuing similar transactions. Relying solely on internal valuations, especially when external data is available, may increase the risk of a successful challenge.

A critical strategic decision involves the selection and weighting of these different information sources. A well-documented rationale for the choices made will be invaluable in defending the final calculation. For instance, if quotes from third parties vary significantly, the Determining Party should have a clear and commercially reasonable basis for the one it ultimately chooses.

Navigating Illiquid Markets

Calculating a close-out amount in an illiquid market presents a unique set of challenges. The absence of readily available price information and the potential for wide bid-offer spreads can make it difficult to establish a single, objectively reasonable price. In such scenarios, the emphasis on a commercially reasonable procedure becomes even more important. A Determining Party should:

1. Document the Lack of Liquidity ▴ The first step is to create a clear record of the market conditions, noting the absence of active trading or reliable price sources.
2. Expand the Scope of Inquiry ▴ The party should make a reasonable effort to obtain any available indications of value, even if they are not firm quotes. This could include indicative pricing from dealers, matrix pricing models, or other valuation techniques recognized in the industry for illiquid assets.
3. Provide a Clear Rationale ▴ The final calculation should be accompanied by a detailed explanation of the methodology used and why it was commercially reasonable given the prevailing market circumstances. This transparency can be a powerful defense against claims of unreasonableness.

The following table illustrates the strategic shift in approach required by the 2002 ISDA Master Agreement compared to its predecessor:

Execution

The execution of a close-out amount calculation under the 2002 ISDA Master Agreement is a procedural exercise that demands precision and foresight. A Determining Party must operate under the assumption that its every action may be subject to judicial review. The objective is to produce a result that is not only commercially reasonable but is also the product of a demonstrably sound and impartial process.

This requires a granular focus on documentation, data integrity, and adherence to established market conventions. The operational goal is to construct a record that can withstand a legal challenge by providing a clear, contemporaneous account of the steps taken and the rationale behind them.

Executing a close-out calculation requires meticulous documentation and adherence to a process that can be independently verified and justified as commercially reasonable.

How Should a Determining Party Procedurally Act?

A systematic, step-by-step approach is essential to ensure compliance with the “commercially reasonable” standard. The following protocol provides a framework for a robust and defensible calculation process:

1. Establish a Record-Keeping System ▴ From the moment an early termination event occurs, the Determining Party should create a dedicated file for all documents, communications, and data related to the close-out calculation. This includes emails, telephone notes, and screenshots of market data.
2. Identify Potential Valuation Sources ▴ The party should identify a list of potential sources for quotations and market data. This may include a pre-approved list of counterparties for obtaining quotes and subscriptions to recognized data providers.
3. Issue Requests for Quotations (RFQs) ▴ RFQs for replacement transactions should be sent to a reasonable number of independent third parties. The RFQs should be consistent in their terms and should accurately reflect the economic characteristics of the terminated transaction.
4. Gather and Analyze Market Data ▴ Concurrently with the RFQ process, the Determining Party should gather relevant market data for the time of the termination. This data should be time-stamped to demonstrate its relevance to the valuation date.
5. Evaluate the Information Received ▴ The party must carefully assess all the information gathered, including the third-party quotes and market data. Any significant discrepancies should be investigated and documented.
6. Select a Valuation and Document the Rationale ▴ The final valuation should be based on a reasoned and consistent application of the gathered information. The rationale for selecting a particular quote or valuation methodology should be clearly articulated in writing.
7. Prepare a Detailed Calculation Statement ▴ The final close-out amount statement should be accompanied by a summary of the procedures followed and the information relied upon. This transparency can deter challenges and will be invaluable if a challenge does arise.

This procedural rigor is the most effective way to mitigate the legal risks inherent in the 2002 ISDA Master Agreement’s close-out mechanism.

What Are Potential Grounds for a Legal Challenge?

A party seeking to challenge a close-out amount calculation will typically focus on demonstrating that either the procedures used or the resulting amount were not commercially reasonable. The following table outlines potential arguments a challenging party might raise and the corresponding defensive measures for the Determining Party:

Reflection

The transition to an objective standard of commercial reasonableness within the 2002 ISDA Master Agreement framework should prompt a deeper evaluation of your institution’s internal risk control systems. The principles discussed here extend beyond the immediate context of a derivatives close-out. They speak to a broader operational philosophy. The capacity to construct and document a robust, evidence-based process is a core component of institutional resilience.

Reflect on how your current protocols for valuation, risk assessment, and dispute resolution align with this principle of objective defensibility. A truly superior operational edge is achieved when these systems are so well-architected that they function with precision and transparency, even under the most adverse market conditions.