How Can a Determining Party Defend Its Close out Calculation in Court?

Concept

The moment a counterparty’s default triggers an early termination under an International Swaps and Derivatives Association (ISDA) Master Agreement, the role of the Determining Party transforms. Your function shifts from a participant in a fluid market to the architect of a static, final valuation that must withstand the exacting scrutiny of a court. The defense of your close-out calculation begins years before any default occurs; it is embedded in the very architecture of your valuation and risk management systems. The question is what constitutes a structure that is not only operationally sound but judicially resilient.

At the core of this challenge is the definition of the “Close-Out Amount” as articulated in the 2002 ISDA Master Agreement. This is the governing standard for the majority of derivatives contracts currently active. The Close-Out Amount represents the gains or losses, and costs, associated with replacing or obtaining the economic equivalent of the terminated transactions.

It is a single figure that must encapsulate the financial reality of the default at a specific moment in time. The entire process hinges on a standard of objective commercial reasonableness, a departure from the more subjective standards of the preceding 1992 agreement.

A successful defense rests on demonstrating that both the procedures followed and the resulting calculation were objectively and commercially reasonable.

The critical evolution from the 1992 ISDA Master Agreement to the 2002 version marks a fundamental shift in legal expectation. The 1992 agreement utilized concepts of “Loss” and “Market Quotation,” which were interpreted by courts as requiring the Determining Party to act rationally and in good faith. This was a standard that afforded the non-defaulting party a degree of discretion. The 2002 agreement replaces this framework.

It explicitly requires the Determining Party to use “commercially reasonable procedures in order to produce a commercially reasonable result.” This linguistic change was deliberate and profound. It elevated the standard from a test of the party’s subjective rationale to an objective assessment of its actions and their outcome. A court will examine the process and the final figure against prevailing market practices and data.

The Objective Standard in Practice

The defense of a close-out amount is a defense of your methodology. The dual requirements of the 2002 ISDA framework create two distinct pillars for judicial review. First, the court will dissect the procedures undertaken. This involves a granular examination of how the Determining Party went about sourcing information and calculating the amount.

Were quotes for replacement transactions solicited? Were they from credible market participants? Was the timing of the valuation appropriate? Every step is an auditable event.

Second, the court will analyze the result itself. A perfectly executed, reasonable procedure that produces an outcome wildly divergent from the prevailing market reality may still fail. The final Close-Out Amount must be justifiable on its own terms, supported by market data and evidence. This means the internal models, data feeds, and analytical tools used to arrive at the number become subject to discovery and cross-examination.

Their integrity is as much on trial as the final calculation. The case law, particularly from disputes arising after the 2008 financial crisis, confirms that courts will substitute their own judgment for the Determining Party’s if the calculation is found wanting. The discretion of the Determining Party is constrained by the objective reality of the market.

Strategy

A defensible close-out calculation is the output of a pre-defined, rigorously institutionalized strategy. It is a system designed to operate under stress and produce an output that is inherently auditable and justifiable. The strategy is not about reacting to a default; it is about having a standing operational protocol that ensures every action taken contributes to a coherent and defensible evidentiary record. The architecture of this strategy rests on two foundational pillars ▴ procedural integrity and substantive reasonableness.

Procedural Integrity the First Line of Defense

Procedural integrity is the meticulous documentation of a commercially reasonable process. It is the narrative that explains how you arrived at your valuation. A court will look for evidence of a thoughtful, fair, and recognized methodology. This involves building a system that codifies best practices for derivatives valuation in a termination scenario.

What does this system look like in practice? It is a series of well-defined protocols that activate the moment an event of default is identified. These protocols must address several key areas:

• Sourcing Quotations ▴ The system must outline the process for obtaining quotations for replacement transactions. This includes identifying a list of appropriate market makers, specifying whether quotes should be firm or indicative, and documenting all communications. The 2002 ISDA Agreement explicitly permits the use of quotations, and leveraging them from multiple, diverse, and credible third parties is a primary method of demonstrating reasonableness. Relying on a single data point, especially an indicative one, exposes the calculation to challenge.
• Record Keeping ▴ Every action, decision, and piece of data must be recorded. This includes emails, phone call logs, screenshots of market data screens, and internal meeting minutes where the calculation is discussed. This creates an evidentiary trail that allows you to reconstruct the entire process for a judge or tribunal, showing not just what you did, but why you did it.
• Internal Models and Data ▴ If the calculation relies on internal valuation models instead of or in addition to third-party quotes, these models must be robust and well-documented. The strategy must include provisions for the regular validation of these models, including their inputs and assumptions. The data used, whether from sources like Bloomberg or internal systems, must be clean, time-stamped, and archived.
• Timing ▴ The 2002 Agreement requires the calculation to be performed “as of” the Early Termination Date, or if that is not reasonably practicable, as soon as possible thereafter. A defensible strategy includes a clear policy on how this timing is determined and justified, especially in volatile market conditions where delays may be unavoidable but must be explained.

Achieving a Commercially Reasonable Result

While a sound procedure is necessary, it is not sufficient. The final Close-Out Amount must align with the economic reality of the market at the time of termination. The strategy here is one of substantiation. The final number must be anchored to verifiable market data.

This involves more than simply averaging a few quotes. It requires a holistic assessment of all available information.

The core of this strategic pillar is the convergence of evidence. A calculation is most defensible when multiple sources of information point to a similar value. This could include:

• The actual cost of a replacement transaction entered into with a third party.
• Firm quotations received from several independent dealers.
• Valuations derived from internal, well-validated models using observable market inputs.
• Relevant market data from recognized providers that corroborates the inputs and outputs of the calculation.

The following table illustrates the strategic shift required by the 2002 ISDA Master Agreement, which forms the basis of any modern defense strategy.

What Is the Role of Good Faith?

Under the 2002 ISDA framework, the obligation to act in good faith remains, but its role has shifted. It is a foundational expectation that underpins the entire process. A party could, in theory, follow a set of commercially reasonable procedures yet do so with a malicious intent to injure the counterparty. However, the primary focus of a court’s analysis will be on the objective evidence.

The defense strategy must prioritize the creation of a clear, logical, and evidence-based record that demonstrates commercial reasonableness. Good faith is demonstrated through the transparent and fair application of these objective procedures.

Execution

The execution of a defensible close-out calculation is the translation of strategy into a series of precise, documented, and auditable actions. This is the operational reality of building a case for the reasonableness of your valuation. It requires a disciplined, systematic approach that can be clearly articulated and evidenced in a legal setting. The ultimate goal is to present a court with a complete, coherent record that validates both the process undertaken and the result achieved.

The Operational Playbook for a Defensible Close Out

A robust operational playbook is a step-by-step guide for the individuals tasked with managing a default and calculating the Close-Out Amount. It ensures consistency and completeness, removing ambiguity from a high-pressure situation.

1. Activation Protocol ▴ Upon confirmation of an Event of Default, the playbook is formally activated. This involves notifying key internal stakeholders (legal, risk, trading, operations) and assembling the team responsible for the close-out process. The first entry in the event log is made.
2. Designation of Early Termination Date ▴ The team formally designates the Early Termination Date in accordance with the terms of the ISDA Master Agreement. This decision, and its rationale, is documented. The notice is prepared and sent to the defaulting counterparty, and proof of delivery is retained.
3. Quotation Solicitation ▴ The team executes the pre-defined quotation sourcing protocol. This involves sending a standardized Request for Quote (RFQ) to a list of approved, independent market makers. The RFQ should specify the precise parameters of the terminated transactions and request firm bids for replacement trades. All communications must be logged.
4. Market Data Capture ▴ Simultaneously with the quotation process, the team captures a wide range of relevant market data as of the Early Termination Date. This includes interest rate curves, FX rates, volatility surfaces, and credit spreads from multiple, recognized data vendors. This data provides an independent benchmark against which quotes and internal models can be compared.
5. Calculation and Substantiation ▴ The team calculates the Close-Out Amount. This may involve averaging the quotes received, executing a replacement trade and using its cost, or running an internal valuation model. The key is to document the chosen methodology and the reason for its selection. The team prepares a detailed report that reconciles the final number with the collected quotes and market data.
6. Internal Review and Approval ▴ The draft calculation and supporting documentation are submitted for internal review and approval by a senior committee (e.g. a risk or valuation committee). This provides a crucial layer of governance and a second check on the reasonableness of the calculation. The committee’s approval is formally minuted.
7. Service of the Calculation Statement ▴ Once approved, the detailed calculation statement, as required by Section 6(d) of the ISDA Master Agreement, is prepared and served on the defaulting party. This statement should clearly show how the Close-Out Amount was determined. Proof of service is archived. It is critical to get this right, as courts have held that a Determining Party cannot simply withdraw and unilaterally resubmit a calculation statement if it later changes its mind or finds an error. Any correction is a matter for the court or mutual agreement.

Quantitative Modeling and Data Analysis

The defensibility of the calculation is cemented by the quality of the underlying data. The following tables provide a template for the types of evidence that should be compiled during the execution phase.

This first table demonstrates a hypothetical calculation for a close-out amount on a 5-year USD interest rate swap where the defaulting party was paying a fixed rate.

This second table provides a template for the procedural log, which serves as the primary evidentiary record of the process.

How Does a Court Assess What Constitutes a Commercially Reasonable Procedure?

A court assesses procedural reasonableness by comparing the actions of the Determining Party against the established practices of the financial markets. It is an objective test. The court will hear expert testimony on what a typical market participant would do in a similar situation. The procedural log, as detailed above, becomes the central piece of evidence in this assessment.

The court will look for evidence of diligence, fairness, and a logical process. Did the party contact a reasonable number of dealers? Did it provide them with sufficient information to give an accurate quote? Did it ignore quotes that were inconvenient?

Did it create a clear audit trail? The more systematic and well-documented the procedure, the more likely a court is to deem it commercially reasonable.

Reflection

The successful defense of a close-out calculation is the ultimate validation of an institution’s internal risk architecture. The principles of objective reasonableness and procedural integrity are not merely legal hurdles; they are benchmarks for a superior operational framework. The process forces a critical self-examination. Are your valuation methodologies, data management protocols, and communication records designed to function with clarity and precision under the most severe stress?

The ability to produce a defensible calculation is a reflection of the system’s resilience. It transforms a potential legal liability into a demonstration of institutional competence, proving that the firm’s framework is built not just for the calm of normal markets, but for the storm of a counterparty default.