Can an Institution Be Found to Have Acted in Good Faith Even If the Close out Results in a Large Financial Loss for the Counterparty?

Concept

An institution can absolutely be found to have acted in good faith even when a contract close-out precipitates a substantial financial loss for its counterparty. The determinative factor in such a legal and operational analysis is the integrity of the process employed during the close-out, rather than the ultimate financial outcome. The architecture of sophisticated financial contracts, such as the ISDA Master Agreement, anticipates the potential for significant market volatility and defaults.

These agreements grant discretionary power to the non-defaulting party specifically to protect its own commercial interests in a turbulent environment. The exercise of this discretion is governed by contractually defined standards, most commonly the dual requirements to act “in good faith” and to use “commercially reasonable procedures.”

The concept of “good faith” in this context is precise. It functions as a core obligation of honesty in fact and fidelity to the purpose of the contract. It requires the institution to execute the close-out for its intended purpose ▴ the mitigation of risk following a default ▴ and to avoid acting with an ulterior motive. This principle is coupled with the more procedural mandate for commercial reasonableness.

The institution must follow a valuation process that is rational, transparent, and grounded in observable market data where available. The resulting calculation, the Close-out Amount, is a product of this machinery. A large loss for the counterparty may simply be a reflection of severe market dislocation or the illiquidity of the underlying assets at the time of default, conditions that are outside the institution’s control.

A finding of good faith hinges on the procedural integrity of the close-out, not the financial loss experienced by the counterparty.

The Mechanics of Contractual Discretion

In wholesale financial agreements, one party is often granted discretion to value assets or positions under specific circumstances, like an event of default. This is a critical system component designed to ensure a swift and decisive mechanism for terminating exposure and crystallizing a claim. The legal inquiry into whether this discretion was exercised properly focuses on the constraints the contract places upon that power.

The standard is one of process, not result. The institution performing the close-out is entitled to protect itself from risk and may value the position with its own interests in mind, provided the valuation is rational and the procedure is fair.

The framework of the 2002 ISDA Master Agreement provides a clear operational blueprint for this. It specifies that the determining party must “act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”. This language creates a standard that can be audited and defended. The focus shifts from the pain of the loss to the methodology of the calculation.

Was the process documented? Were multiple quotes sought where practical? Were recognized valuation models used? These are the questions that determine compliance.

What Is the Scope of the Good Faith Duty?

The duty of good faith must be interpreted within the specific context of the governing agreement and jurisdiction. Under English law, which governs a vast number of international financial contracts, the principle of freedom of contract is paramount. Courts are therefore cautious about implying broad, undefined duties of good faith that could undermine the explicit terms negotiated by sophisticated commercial parties. The duty is typically narrow and does not obligate a party to subordinate its own commercial interests to those of its counterparty.

An institution can prioritize its own financial safety during a close-out, as that is the primary purpose of the contractual provision. The duty of good faith acts as a boundary, ensuring this self-protection does not become commercially unreasonable or dishonest.

Strategy

The strategic framework for an institution executing a close-out under duress is one of disciplined risk management operating within defined legal boundaries. The primary objective is to terminate risk exposure efficiently and arrive at a defensible valuation that will withstand legal scrutiny. A large financial loss for the counterparty is a potential and foreseeable consequence of this process, especially in volatile or illiquid markets.

The strategy, therefore, is built around procedural robustness, creating an evidentiary trail that substantiates the “good faith” and “commercial reasonableness” of the actions taken. This transforms the close-out from a purely financial event into a structured, auditable protocol.

An institution’s strategy must acknowledge that its discretion is not absolute. It is a power granted for a specific purpose ▴ to calculate a termination value that reflects the economic reality at the moment of close-out. The ability to act in one’s own commercial interest is a key component of this power. For example, when valuing an illiquid asset, the institution is entitled to consider the costs and risks it would incur to liquidate or hedge that position.

A “mid-market” valuation might appear equitable, but it fails to account for the actual, one-sided costs of unwinding the trade in the real world. A strategy grounded in commercial reality incorporates these costs into the valuation, which is a legitimate exercise of discretion. The resulting figure may be disadvantageous to the defaulting party, yet it is a commercially reasonable reflection of the non-defaulting party’s economic loss.

Constructing a Defensible Close out Protocol

A successful strategy relies on a pre-defined and consistently applied close-out protocol. This operational plan should be activated the moment an event of default occurs, ensuring that all actions are deliberate and documented. The goal is to create a clear narrative demonstrating that the institution acted rationally and honestly. This involves a multi-pronged approach to valuation, seeking external data points to corroborate internal calculations.

The choice of valuation methodology should be appropriate for the type of assets involved and the prevailing market conditions. For instance, using a broker-dealer poll is a classic method for valuing derivatives, but the selection of dealers and the questions asked must be fair and unbiased.

The following table outlines the strategic components of a defensible close-out process versus a process that invites challenge.

How Does Market Context Influence Strategy?

The prevailing market environment is a critical input into the close-out strategy. In a stable, liquid market, obtaining firm, executable quotes is straightforward. The range of reasonable valuations will be narrow. In a volatile, dislocated market ▴ often the very environment in which defaults occur ▴ the range of potential valuations can be extremely wide.

Bid-ask spreads widen dramatically, and liquidity can evaporate. In this scenario, a commercially reasonable procedure must account for this reality. The strategy must shift to one of preservation and prudence. The institution may need to use valuation models based on assumptions where market data is unavailable, or it may need to factor in the significant costs of liquidating a large, illiquid block of securities into a panicked market. Documenting the rationale for these decisions is the cornerstone of demonstrating good faith.

The strategy for a close-out is not to avoid a loss for the counterparty, but to ensure the valuation process is procedurally sound and commercially rational.

Execution

The execution of a contract close-out is the practical application of the institution’s risk management strategy and its adherence to the legal standard of good faith. This phase is entirely procedural. Every action taken, from the initial default notice to the final calculation of the termination payment, must be deliberate, documented, and aligned with the governing contract.

The objective is to build an unassailable record that proves the institution followed commercially reasonable procedures to produce a commercially reasonable result. The magnitude of the counterparty’s loss is irrelevant if the execution is flawless.

Proper execution begins with the assembly of a dedicated team, typically involving legal, compliance, risk, and trading personnel. This team must operate from a pre-established playbook that details the precise steps for a close-out under the relevant agreement, such as an ISDA Master Agreement. The first step is the formal delivery of all required notices, establishing a clear timeline. Subsequently, the core task is the valuation of the terminated transactions.

This is where the principle of commercial reasonableness is most rigorously tested. The institution must demonstrate that it sought to determine its true economic loss in a manner that is both fair and reflective of market conditions at the time.

A Procedural Playbook for Valuation

Executing a defensible valuation requires a systematic and evidence-based approach. The following steps represent an operational playbook for an institution tasked with determining a close-out amount.

1. Initial Assessment ▴ Immediately upon default, the team must identify all outstanding transactions covered by the agreement. The nature of these transactions (e.g. interest rate swaps, options, forwards) will dictate the appropriate valuation methodologies.
2. Market Data Snapshot ▴ The team must gather all relevant market data as of the designated early termination date. This includes interest rate curves, volatility surfaces, credit spreads, and foreign exchange rates from reliable sources like Bloomberg, Reuters, or exchange-traded instruments.
3. Solicitation of Quotes ▴ For many OTC derivatives, obtaining quotes from independent third-party dealers is a primary method for establishing fair value. The institution should:
   • Select Dealers ▴ Choose a panel of at least three to five reputable dealers active in the relevant market. The selection should be unbiased and not skewed towards dealers known for aggressive pricing.
   • Formulate the Request ▴ The request for quotation should be for the cost of entering into a replacement transaction that would precisely offset the terminated trade. All key economic terms must be specified.
   • Document Responses ▴ All quotes received, including any that are declined or non-responsive, should be recorded with the time and date of receipt.
4. Internal Model Valuation ▴ In parallel, the institution should run its own internal valuation models using the market data snapshot. These models should be well-documented, regularly validated, and consistent with industry practice. The results can be used to corroborate the external quotes.
5. Final Determination and Documentation ▴ The final close-out amount is determined by synthesizing the gathered information. If dealer quotes are used, the institution might average them or use the median. If a quote is an outlier, the reason for its exclusion must be documented. A final report should be compiled, detailing every step, all data used, the quotes received, the internal calculations, and the final determination. This report is the primary evidence of a commercially reasonable process.

Illustrative Close out Calculation

Consider the close-out of a single interest rate swap. The table below demonstrates how different components contribute to the final amount, showcasing the importance of accounting for actual replacement costs.

A meticulously executed and documented valuation process is the ultimate defense against allegations of bad faith.

This example shows how a “mark-to-market” gain of $5 million is reasonably reduced by $1 million to account for the real-world costs of replacing the trade. A counterparty might only see the $5 million figure and claim the $4 million settlement is unfair. However, the institution’s detailed execution record, showing the derivation of the funding and liquidation costs, provides the necessary justification and demonstrates that it acted in good faith to make itself whole, which is the entire purpose of the close-out mechanism.

Reflection

The principles governing contractual close-outs reveal a foundational element of market architecture ▴ the codification of trust and the mechanics of its dissolution. The focus on process over outcome underscores a system designed for resilience among sophisticated participants who understand that risk is ever-present. The question then moves from the abstract to the operational. Is your institution’s framework for exercising contractual discretion merely a set of guidelines, or is it a rigorously tested, evidence-based protocol?

Does the system for valuation and documentation function as an integrated defense mechanism, capable of demonstrating commercial reason and integrity under the pressure of a real-world default scenario? The strength of a contract is only realized in its enforcement, and the integrity of that enforcement is a direct reflection of the operational systems built to support it.