Can Internal Models Be Challenged during a Close-Out Amount Determination? ▴ Question

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The Mandate for Commercial Reasonableness

Yes, internal models can be challenged during a close-out amount determination. The entire framework for derivatives close-outs, particularly under the widely adopted International Swaps and Derivatives Association (ISDA) Master Agreements, is built upon a foundational principle of commercial reasonableness. This principle acts as a crucial check on the power of the determining party (typically the non-defaulting party) to calculate the final settlement amount. A close-out amount is not an arbitrary figure; it represents the economic value of the terminated transactions, essentially the cost of replacing the derivative’s future cash flows in the prevailing market at the time of termination.

When external market data is scarce or deemed unreliable, parties often turn to internal valuation models. These proprietary models, while sophisticated, are not unassailable. Their inputs, methodologies, and ultimate outputs are subject to scrutiny and can be disputed if they fail to produce a result that is objectively and commercially reasonable.

The core of any potential dispute rests on whether the internal model’s valuation reflects a fair market replacement cost under the principle of “commercially reasonable procedures.”

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Deconstructing the Close-Out Amount

Upon an early termination event, such as a default, the ISDA Master Agreement requires the calculation of a single net figure to be paid by one party to the other. Under the 2002 ISDA Master Agreement, this figure is known as the “Close-out Amount.” The determining party is tasked with calculating the losses or gains resulting from the termination of all relevant transactions. This calculation can incorporate various information sources, including quotations from third-party dealers, relevant market data, and, significantly, data from the determining party’s own internal sources. The use of internal models is explicitly permitted, especially for bespoke or illiquid derivatives where public price points are unavailable.

However, this permission is not a blank check. The overarching requirement is that the entire process ▴ from the selection of data to the application of the model ▴ must be conducted using “commercially reasonable procedures in order to produce a commercially reasonable result.” This standard is the primary lever for a challenge.

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The Nature of an Internal Model Challenge

A challenge to an internal model is fundamentally an argument about valuation. The disputing party is not necessarily claiming that the model is inherently flawed in its mathematical construction, although that is possible. More commonly, the challenge focuses on how the model was applied or the data it used. Key questions that form the basis of a dispute include:

Model Inputs ▴ Were the inputs used in the model (e.g. volatility surfaces, interest rate curves, correlation matrices) reflective of the actual market conditions at the time of termination?
Methodology Application ▴ Was the valuation methodology consistent with standard market practice for similar instruments? Or did the determining party apply a methodology that was self-serving?
Availability of Market Data ▴ Did the determining party justifiably resort to an internal model when reliable third-party quotations or market data were, in fact, available?
Result Reasonableness ▴ Does the final Close-out Amount significantly deviate from what other market participants would have calculated using their own standard models and data?

The Lehman Brothers bankruptcy proceedings provided a decade-long series of test cases for these very issues, demonstrating how contentious and complex disputes over proprietary valuation models can become, especially in times of market stress. Ultimately, the validity of a close-out amount derived from an internal model is not determined by its proprietary complexity but by its objective fairness and adherence to market standards.

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Strategy

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Frameworks for Valuation Scrutiny

Strategically approaching a challenge to an internal model requires a multi-faceted analysis that extends beyond a simple disagreement over the final number. It involves a systematic deconstruction of the determining party’s valuation process and the construction of a robust, evidence-based alternative. The core strategic objective is to demonstrate that the determining party’s procedures or resulting valuation failed the test of commercial reasonableness prescribed by the ISDA Master Agreement. This involves scrutinizing the inputs, the model’s logic, and the context in which the valuation was performed.

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Grounds for a Formal Challenge

A successful challenge is built upon specific, identifiable flaws in the determination process. Parties contemplating a dispute should focus their strategy on several key areas of vulnerability. The proprietary nature of internal models means the non-determining party is at an information disadvantage, making focused discovery and expert analysis critical.

The primary strategic pillars for a challenge include:

Inappropriate Model Inputs ▴ This is often the most fertile ground for a dispute. The argument centers on whether the data fed into the model was appropriate for the market conditions at the time of the close-out. For example, using stale volatility data or an interest rate curve that does not reflect prevailing credit conditions could be grounds for a challenge.
Methodological Deviation ▴ The strategy here is to show that the valuation model used deviates from accepted industry practice for that type of derivative. While models are proprietary, their fundamental principles (e.g. Black-Scholes for simple options, Monte Carlo simulations for exotics) are well-established. A departure from these norms without clear justification can be challenged.
Ignoring Available Market Data ▴ The 2002 ISDA Master Agreement allows the use of internal models, but not necessarily as a first resort. A strong strategic angle is to prove that the determining party ignored reasonably available and reliable third-party quotations or market data that would have produced a different, more reasonable result.
Lack of Good Faith ▴ This is a higher bar to clear, but it involves demonstrating that the determining party did not act in good faith. This could involve evidence of manipulating inputs or selecting a valuation methodology known to produce a self-serving outcome. The standard under the 2002 ISDA is objective reasonableness, which is a more stringent requirement than the “rational” standard of the 1992 agreement.

A challenge’s success hinges on transitioning the argument from a subjective disagreement on price to an objective demonstration of procedural or methodological failure.

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Comparative Valuation Methodologies

To substantiate a challenge, it is insufficient to simply claim the Close-out Amount is wrong. A counter-valuation must be presented. The table below outlines the primary valuation methodologies and their strategic implications in a dispute.

Valuation Methodology	Description	Strategic Application in a Challenge
Market Quotation	Sourcing firm quotes for a replacement transaction from several independent, leading dealers in the relevant market.	This is the strongest form of evidence. Presenting multiple, credible dealer quotes that diverge significantly from the internal model’s output provides a powerful argument that the model’s result is not commercially reasonable.
Internal Model Replication	Using a separate, industry-standard internal model to re-value the terminated transactions using independently sourced market data.	This strategy directly confronts the “black box” of the determining party’s model. It aims to show that even with a sound model, the original result was flawed due to biased inputs or faulty calibration.
Indicative Mid-Market Valuations	Gathering indicative, non-binding quotes or using consensus data services to establish a fair mid-market value for the derivatives.	While less powerful than firm quotes, this data can establish a “zone of reasonableness.” A valuation that falls far outside this zone can be presented as evidence of a commercially unreasonable result.
Back-to-Back Hedging Cost	Demonstrating the actual cost incurred to enter into an offsetting or replicating transaction with a third party to neutralize the risk of the terminated trade.	This provides a real-world, realized cost that can be compared against the hypothetical loss calculated by the internal model. It is a practical measure of the replacement cost.

Ultimately, the strategy is to build a compelling narrative, supported by expert analysis and hard market data, that the determining party’s calculation was not a good-faith effort to determine its true loss but rather an outcome skewed by its choice of procedures, models, or data.

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Execution

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The Procedural Mechanics of a Valuation Dispute

Executing a challenge against an internal model’s close-out calculation is a structured process governed by the terms of the ISDA Master Agreement and applicable law. It moves from initial disagreement to a formal dispute, requiring meticulous documentation and expert evidence at each stage. The objective is to compel a recalculation or to secure a favorable judgment in a formal dispute resolution forum. The entire process is predicated on the obligation of the determining party to justify its calculation under the “commercially reasonable” standard.

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Step-By-Step Dispute Escalation

The process of challenging a Close-out Amount follows a logical progression. While specific timelines and notice requirements are detailed in the ISDA Master Agreement, the general flow is consistent.

Receipt and Initial Analysis ▴ Upon receiving the close-out statement from the determining party, the recipient has a limited window to review the calculation. This initial analysis involves an internal valuation to identify any material discrepancy.
Notice of Disagreement ▴ If a significant difference exists, the challenging party must formally issue a Notice of Disagreement. This notice should be timely and clearly state that the calculated Close-out Amount is being disputed. While not always required, outlining the general basis for the disagreement at this stage can be beneficial.
Information Request and Discovery ▴ The challenging party should request detailed information about the basis of the calculation. This includes the valuation methodology used, the key inputs (e.g. curves, volatilities), and the source of the market data. The determining party’s willingness to provide this information can be a factor in subsequent proceedings.
Expert Valuation and Negotiation ▴ The challenging party will typically engage a third-party valuation expert to prepare an independent report. This report forms the basis for negotiation with the determining party. The goal is to reach a commercial settlement based on a revised, mutually agreeable valuation.
Formal Dispute Resolution ▴ If negotiations fail, the dispute proceeds to the forum specified in the ISDA Master Agreement, which could be litigation in a specified court (e.g. English Commercial Court, New York Supreme Court) or arbitration.

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Evidentiary Requirements for a Successful Challenge

In any formal dispute, the burden of proof is on the challenging party to demonstrate that the determining party’s calculation was not commercially reasonable. This requires a portfolio of concrete evidence. The table below details the critical evidence types and their purpose in a dispute.

Evidence Category	Specific Examples	Purpose in the Dispute
Market Data	Third-party dealer quotations for replacement trades; data from consensus pricing services (e.g. Bloomberg, Refinitiv); historical market data (volatility, rates) from the termination date.	To establish an objective, market-based valuation and demonstrate that the internal model’s output is an outlier.
Expert Witness Reports	A detailed report from a qualified derivatives valuation expert analyzing the determining party’s methodology, inputs, and result, and providing an independent calculation.	To provide an authoritative, independent assessment that critiques the original calculation and substantiates the challenging party’s proposed valuation.
Internal Communications	Emails, internal memos, and trading records from the determining party (obtained through discovery) that may reveal a disregard for market data or an intent to produce a self-serving number.	To challenge the “good faith” component of the determination process and show a potential bias in the calculation.
Procedural Documentation	Records of all communications, notices of disagreement, and information requests sent between the parties.	To prove that all procedural requirements under the ISDA Master Agreement were met and that the challenge was initiated in a timely and proper manner.
Precedent and Market Practice	Evidence of how similar close-outs have been handled in the market; academic literature and industry white papers on standard valuation practices.	To demonstrate that the determining party’s actions deviated from established industry norms and best practices.

Executing a challenge requires transforming a valuation disagreement into a rigorously documented procedural and quantitative argument.

Ultimately, the execution of a challenge is a high-stakes process that combines financial analysis, legal procedure, and strategic negotiation. A successful outcome depends on the ability to build a compelling, evidence-based case that systematically dismantles the commercial reasonableness of the original Close-out Amount calculation, forcing a re-evaluation that more accurately reflects the fair market value of the terminated derivatives.

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References

Allen & Overy. “Close-out netting and the ISDA Master Agreement.” A&O Shearman, 2022.
Choudhry, Moorad. The REPO Handbook. Butterworth-Heinemann, 2010.
Flavell, Richard. Swaps and Other Derivatives. John Wiley & Sons, 2010.
Gregory, Jon. The xVA Challenge ▴ Counterparty Credit Risk, Funding, Collateral, and Capital. John Wiley & Sons, 2015.
Hull, John C. Options, Futures, and Other Derivatives. Pearson, 2022.
International Swaps and Derivatives Association. “2002 ISDA Master Agreement.” ISDA, 2002.
McGuire, Randall. The Rutter Group California Practice Guide ▴ Federal Civil Procedure Before Trial. Thomson Reuters, 2023.
O’Connor, J. “Valuation in the context of derivatives litigation.” P.R.I.M.E. Finance, 2013.
Squire Patton Boggs. “Close-Out Amount Calculations Under 2002 ISDA.” The National Law Review, 2018.
The Law Society Gazette. “How to handle derivatives close-out disputes.” The Law Society Gazette, 2021.

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Valuation as a System of Justification

The ability to challenge a close-out amount is a fundamental component of market integrity. It transforms the valuation process from a unilateral declaration into a bilateral system of justification. The knowledge that any calculation, particularly one derived from a proprietary internal model, is subject to rigorous, evidence-based scrutiny imposes a powerful discipline on the determining party. It forces a continuous alignment of internal methodologies with external market realities.

This framework encourages transparency and reinforces the principle that even in bespoke, over-the-counter markets, there exists a gravitational pull toward fair value. The critical question for any market participant is therefore not whether their models are complex, but whether their outputs can be defended as a commercially reasonable reflection of reality.