Can a Party Unilaterally Revise a Close out Calculation after It Has Been Made?

Concept

The Principle of Calculation Finality

A close-out calculation represents a critical point of financial finality in the lifecycle of a derivatives contract. It is the formal process of determining the net amount owed between two parties following an early termination of their transactions, typically triggered by an event of default, such as insolvency. The governing framework for this process is almost universally the ISDA Master Agreement, a standardized contract that provides the essential architecture for over-the-counter derivatives. The core question is whether a party, having performed this calculation and communicated it, can unilaterally decide to revise it.

The answer, rooted in both contract law and the systemic need for certainty in financial markets, is a firm no. Once a determining party serves a net termination statement, it crystallizes a debt obligation. That statement cannot be unilaterally withdrawn and re-served.

This prohibition is a foundational element of contractual integrity. The close-out process is not an informal estimate; it is a binding determination made according to a pre-agreed methodology. Allowing a party to unilaterally amend its calculation would introduce an unacceptable level of uncertainty, transforming a definitive statement of account into a mere opening bid. This would undermine the very purpose of the ISDA Master Agreement, which is to create a predictable and enforceable framework for managing counterparty risk.

The initial calculation establishes a legal and financial reality; any subsequent adjustments are matters for mutual agreement or, failing that, judicial review. The system is designed to prevent second thoughts from disrupting a settled claim, ensuring that the process of unwinding complex financial positions remains orderly and reliable.

A party cannot unilaterally withdraw and remake a close-out calculation statement after it has been delivered, as doing so would undermine the contractual certainty that underpins the ISDA Master Agreement.

ISDA Frameworks and Valuation Standards

The ISDA Master Agreement exists in several versions, with the 1992 and 2002 agreements being the most prevalent. The distinction between them is significant in the context of close-out calculations and potential disputes. The standards they impose on the party determining the close-out amount differ in a way that fundamentally alters the grounds for a challenge. Understanding this evolution is key to grasping the rigidity of the calculation process.

The 1992 ISDA Master Agreement and Rationality

Under the 1992 ISDA Master Agreement, the calculation methodology often revolves around the concept of “Loss”. This standard requires the determining party to calculate its total losses and costs “reasonably. in good faith”. Courts have interpreted this to mean that the determination must be rational.

A rational decision is one that is not arbitrary or perverse. This provides the calculating party with a degree of latitude, as long as the methodology is explainable and not fundamentally unsound.

The 2002 ISDA Master Agreement and Commercial Reasonableness

The 2002 ISDA Master Agreement introduced a more stringent and objective standard. It requires the determining party to calculate the “Close-out Amount” by acting “in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”. This shift from “rationality” to “commercial reasonableness” is a deliberate tightening of the requirements. A “commercially reasonable” outcome is judged against an objective, external standard of market practice.

It is a higher bar to clear, demanding that the process and the result align with what other market participants would consider fair and appropriate under the circumstances. This objectivity makes the calculation less about the determining party’s internal judgment and more about a verifiable market reality, thereby narrowing the scope for unilateral discretion.

Strategy

Challenging a Calculation the Grounds for Dispute

While a unilateral revision is prohibited, it does not mean the initial calculation is unchallengeable. A party that receives a close-out statement and believes it to be flawed is not without recourse. The strategy shifts from revision to dispute.

The grounds for such a dispute are not based on a simple disagreement with the outcome but must be rooted in a failure of the determining party to adhere to the contractual standards of the governing ISDA Master Agreement. The nature of the challenge depends critically on which version of the agreement is in force.

A primary basis for a dispute is a “manifest error” in the calculation. This refers to obvious mathematical or numerical mistakes that are plain to see. For example, if a currency conversion was applied incorrectly or a set of trades was mistakenly omitted from the portfolio. Correcting such an error is not considered a unilateral revision of the entire determination but rather a rectification of a clear and demonstrable mistake.

However, even in this scenario, the preferred route is mutual agreement between the parties. If agreement cannot be reached, the matter falls to a court or tribunal to adjudicate the specific error, not to open the door for a complete recalculation by the determining party.

The prohibition on unilateral revision forces any disagreements over a close-out amount into a formal dispute resolution process, centering on whether the calculation adhered to the objective standards of the contract.

The more substantive challenge relates to the methodology itself. Under the 2002 ISDA Master Agreement, the recipient of a close-out notice can argue that the determining party failed to use “commercially reasonable procedures” or that the result was not “commercially reasonable”. This could involve several arguments:

• Improper Valuation Inputs ▴ The determining party may have used stale or inappropriate market data. For instance, using indicative quotes when firm, executable quotes were available, or relying on an internal model that does not reflect current market volatility.
• Unreasonable Timing ▴ The valuation should be performed as of the Early Termination Date, or if not commercially reasonable to do so, as soon as reasonably practicable thereafter. A significant and unjustified delay could be grounds for a challenge if it materially affected the valuation.
• Failure to Survey the Market ▴ A commercially reasonable procedure often involves obtaining quotes from multiple third-party dealers to establish a fair market price for a replacement transaction. Relying on a single quote, especially from an affiliated entity, could be deemed unreasonable.

The Strategic Implications of a Flawed Calculation

For the party making the determination, the inability to unilaterally revise a calculation places immense pressure on getting it right the first time. Submitting a flawed or poorly substantiated calculation can lead to significant strategic disadvantages. It opens the door to a protracted and costly dispute process. During this period, the net payment is held in abeyance, creating liquidity and credit risk for both parties.

Furthermore, if a court ultimately finds that the initial calculation was not commercially reasonable, it has the authority to substitute its own calculation for the flawed one. This represents a complete loss of control over the process for the determining party.

The table below outlines the strategic considerations and potential risks associated with the close-out calculation process under the 2002 ISDA Master Agreement.

Execution

The Procedural Mechanics of Close out and Dispute

The execution of a close-out calculation is a regimented process dictated by the ISDA Master Agreement. A failure to adhere to these procedural steps can invalidate the calculation and shift the strategic advantage in any subsequent dispute. The process begins with the designation of an Early Termination Date, which is the specific date on which the transactions are valued.

The Determining Party, which is typically the non-defaulting party, is then tasked with calculating the Close-out Amount. Under the 2002 ISDA, this involves determining the losses, costs, or gains of replacing the economic equivalent of the terminated transactions. The framework provides a non-exhaustive list of information that can be used:

1. Market Quotations ▴ Obtaining quotes from leading dealers in the relevant market for replacement transactions. This is often considered the most reliable and objective source.
2. Relevant Market Data ▴ Using information from sources such as electronic trading platforms, brokers, and information vendors to inform a valuation model.
3. Internal Methodologies ▴ In the absence of robust external data, a party may use its own internal models, provided they are consistent with practices used for other similar transactions and can be demonstrated to be commercially reasonable.

Once the calculation is complete, the Determining Party must deliver a statement to the other party showing the Close-out Amount and detailing the Unpaid Amounts that are also due. This statement crystallizes the payment obligation. If the recipient disputes the calculation, they must typically notify the Determining Party in writing, specifying the grounds for their disagreement. This initiates the formal dispute resolution process, which may involve negotiation, mediation, or ultimately, litigation.

A Case Study in Calculation and Challenge

To illustrate the mechanics, consider a scenario where Party A (a bank) has terminated its interest rate swaps with Party B (a corporation) following a default by Party B. Party A is the Determining Party under a 2002 ISDA Master Agreement.

Party A’s process for calculating the Close-out Amount might look as follows:

• Step 1 ▴ Identify all 15 outstanding interest rate swaps with Party B.
• Step 2 ▴ On the Early Termination Date, Party A’s trading desk requests mid-market quotes for equivalent replacement swaps from four other leading banks (Bank W, Bank X, Bank Y, Bank Z).
• Step 3 ▴ Party A also runs its internal valuation model, which uses a standard discounted cash flow methodology calibrated to the current interest rate curve.
• Step 4 ▴ The firm quotes and internal model results are compiled and analyzed. Party A’s policy is to use the average of the two most competitive third-party quotes as the primary basis for the Close-out Amount, using its internal model as a check for reasonableness.
• Step 5 ▴ A final Close-out Amount is calculated, representing the cost to Party A of entering into these replacement swaps. This amount is communicated to Party B in a formal statement.

The table below shows the data Party A might have gathered.

Party A calculates the Close-out Amount as the average of the quotes from Bank X and Bank W, resulting in $15.05 million. Now, suppose Party B disputes this. Its grounds for challenge could be that Party A should have included Party B’s own valuation model, or that the quote from Bank Z was an outlier that Party A should have investigated further. However, given that Party A used multiple firm quotes from leading dealers, its procedure is likely to be deemed commercially reasonable, and Party B’s challenge would face significant hurdles.

The key is the robustness and objectivity of the process. A unilateral desire by Party A to later change this calculation to $15.5 million because it found a different replacement transaction would be impermissible.

The procedural integrity of a close-out calculation, from gathering market data to the final communication, is the bedrock of its enforceability and defense against disputes.

Reflection

The Systemic Importance of Finality

The prohibition on the unilateral revision of a close-out calculation is a cornerstone of stability within the vast architecture of global derivatives markets. This principle ensures that the unwinding of contractual obligations, especially during times of market stress or counterparty failure, follows a predictable and orderly path. It transforms a potentially chaotic process into a structured procedure, reinforcing the integrity of the system as a whole. The finality of a served notice provides a fixed point of reference from which all subsequent actions, whether payment or dispute, can proceed with clarity.

Considering this framework, market participants are prompted to evaluate the robustness of their own internal procedures for both calculating and validating close-out amounts. The strength of a claim or a defense rests not on subjective assessments of fairness but on the documented, objective, and commercially reasonable nature of the actions taken. The ISDA Master Agreement does not merely provide a set of rules; it demands a disciplined operational approach. The capacity to execute this process with precision is a critical component of effective counterparty risk management, safeguarding not just the interests of a single firm but the stability of the interconnected financial network.