How Can a Firm Prove Its Close-Out Valuation Was Commercially Reasonable?

Concept

A firm’s ability to prove its close-out valuation was commercially reasonable is the ultimate test of its internal systems architecture. It is an exercise in demonstrating procedural integrity and analytical rigor under conditions of material stress, such as a counterparty default. The core of this challenge resides in translating a contractual obligation into a series of verifiable, objective, and defensible actions.

The entire process is predicated on the understanding that the valuation is not a single number, but the output of a meticulously documented and robustly designed system. The burden of proof rests entirely on the non-defaulting party, which must operate as a disciplined executor of a pre-defined protocol, particularly under the stringent framework of the 2002 ISDA Master Agreement.

The evolution from the 1992 ISDA Master Agreement to the 2002 version marks a critical shift in the required standard of conduct. The 1992 agreement required the determining party to calculate its “Loss” by making a determination that was reasonable and in good faith. This was largely interpreted by courts as a test of rationality, meaning the valuation would stand unless no reasonable party could have reached that conclusion. The 2002 ISDA Master Agreement elevates this standard significantly.

It introduces the concept of a “Close-out Amount” and explicitly requires the determining party to “act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result.” This introduces a dual mandate ▴ the procedure itself must be objectively sound, and the final valuation figure must also be justifiable on its own merits. This is a profound architectural change, moving from a subjective belief to an objective, evidence-based demonstration.

The core challenge of a close-out valuation lies in systematically demonstrating that both the process followed and the result achieved were objectively reasonable.

What Defines the Modern Standard of Reasonableness?

The modern standard, particularly as clarified by legal precedents like Lehman Brothers Special Financing Inc v National Power Corporation, hinges on objectivity. A firm must construct a valuation process that a disinterested third party can examine and validate. This means every step, from the selection of dealers for quotations to the choice of a valuation model when market data is scarce, must be rooted in established market practice and supported by a clear, contemporaneous audit trail.

The concept of “reasonableness” is therefore stripped of personal judgment and rebuilt upon a foundation of procedural evidence. It is a system designed to function under duress and produce a result that is insulated from challenges of bias or self-interest.

The architecture of a defensible valuation system must account for the realities of market conditions at the time of the close-out. A commercially reasonable procedure during a stable market might be insufficient during a period of systemic disruption. Consequently, the system must be flexible enough to adapt its valuation methodology based on the availability and quality of market data. The 2002 ISDA framework anticipates this by allowing the determining party to move away from third-party quotations if it believes in good faith that they are not readily available or would not produce a commercially reasonable result.

This grants discretion, yet that discretion itself must be exercised reasonably and its justification thoroughly documented. The system’s design must therefore include clear triggers and protocols for escalating from direct market-based valuation to model-based approaches.

Strategy

The strategy for proving a close-out valuation is commercially reasonable is one of proactive architectural design. It involves building and maintaining a robust, transparent, and consistent valuation framework long before a counterparty default ever occurs. This framework serves as the firm’s primary defense, transforming the close-out process from a reactive scramble into the deliberate execution of a well-defined protocol. The strategy rests on three pillars ▴ methodological hierarchy, procedural integrity, and comprehensive documentation.

A Hierarchy of Valuation Methodologies

A successful strategy begins with a clearly defined hierarchy for valuation methodologies. This hierarchy dictates the sequence of approaches a firm will take, ensuring that the most objective methods are prioritized and that any deviation is justified. This is not a rigid set of rules, but a decision-making framework that guides the valuation team under pressure.

1. Primary Method Market Quotations The default and most defensible strategy is to rely on external, verifiable market data. This involves polling a sufficient number of active, independent dealers in the relevant market to obtain firm, executable quotations for a replacement transaction. The strategy here is to cast a wide net to establish a clear consensus price. The number and choice of dealers should be defensible and representative of the market for the terminated transaction.
2. Secondary Method Model-Based Valuation When market quotations are unavailable, unreliable, or would not produce a commercially reasonable result, the strategy must pivot to a model-based approach. This is a critical decision point that must be justified. The models used, whether they are discounted cash flow (DCF) analyses or more complex contingent claim models, should be consistent with those the firm uses in its regular course of business for risk management and financial reporting. Using a novel or reverse-engineered model specifically for the close-out introduces significant vulnerability to legal challenges.
3. Tertiary Method Indicative Data and Proxies In highly illiquid or disrupted markets, even robust models may lack reliable inputs. The strategy must then incorporate the use of indicative quotes, matrix pricing, or valuations of similar, more liquid instruments as proxies. Each of these inputs is less defensible than a firm quote, so their use must be accompanied by extensive documentation explaining the rationale for their selection and any adjustments made.

A sound valuation strategy prioritizes objective market data and dictates a clear, justifiable path for using model-based approaches when necessary.

Procedural Integrity as a Strategic Defense

The process itself is a critical component of the defense. Demonstrating that the firm followed “commercially reasonable procedures” is a separate requirement of the 2002 ISDA agreement. The strategy must therefore focus on making this process transparent, consistent, and immune to claims of bias.

• Systematic Solicitation The firm should maintain a pre-approved list of dealers for different asset classes. The solicitation process should be conducted systematically, contacting multiple dealers to avoid accusations of “cherry-picking” a favorable quote. All communications, including the exact time of the request and the response, must be logged.
• Contemporaneous Documentation The core of procedural integrity is documenting every decision in real time. This includes notes on why certain quotes were deemed non-representative, the rationale for choosing a specific valuation model, and the source of all inputs used in that model. This audit trail is the primary evidence that the firm acted methodically and in good faith.
• Internal Consistency The procedures used for the close-out should align with the firm’s established internal policies for valuation. Applying a different standard or methodology during a close-out raises immediate questions about the motive. Consistency demonstrates that the firm is operating according to a pre-determined system, not improvising to achieve a desired outcome.

Comparative Analysis of ISDA Close-Out Standards

Understanding the strategic implications of the governing ISDA Master Agreement is paramount. The shift from the 1992 to the 2002 version represents a fundamental change in the strategic burden of proof, as detailed in the table below.

Execution

The execution of a defensible close-out valuation is a disciplined, multi-stage process. It requires the seamless integration of legal, trading, and risk management functions, all operating under the pressure of a live market event. The objective is to create an unassailable record that demonstrates adherence to the principles of commercial reasonableness at every step. This is the operational manifestation of the firm’s valuation strategy.

The Operational Playbook for Close out Valuation

A firm must execute a pre-defined operational playbook the moment an Event of Default occurs and the decision to terminate is made. This playbook ensures that all necessary actions are taken in a logical sequence and that no critical step is missed.

1. Designate Early Termination Date Immediately upon an Event of Default, the non-defaulting party must designate an Early Termination Date (ETD) in accordance with the ISDA Master Agreement. This date is critical as it establishes the “as of” date for the valuation.
2. Assemble The Valuation Team A cross-functional team should be convened, typically including representatives from the trading desk responsible for the products, the risk management department, the legal/compliance department, and operations. This team will oversee the entire process.
3. Execute The Dealer Poll The team will initiate a systematic poll of pre-vetted, independent dealers to obtain quotes for a replacement transaction. This must be done promptly on the ETD. The requests should be for firm, executable quotes where possible. All requests and responses must be logged with precise timestamps.
4. Assess The Quality Of Market Data The valuation team must critically assess the received quotations. They need to determine if the quotes are from active market makers, if they are reasonably consistent, and if they reflect a liquid market. A wide dispersion in quotes may be evidence that market data is not reliable.
5. Document The Methodology Decision Based on the assessment of market data, the team makes a formal decision. If reliable quotes are available, the valuation will be based on their average. If not, the team must document precisely why the quotes are being disregarded and formally select the appropriate model-based valuation methodology.
6. Perform And Validate The Valuation The valuation is performed using the chosen methodology. All inputs into the model (e.g. yield curves, volatility surfaces) must be from verifiable, independent sources and their selection must be documented. The model’s output should be cross-checked or validated by a separate internal party where possible.
7. Prepare The Close-Out Statement A detailed statement is prepared outlining the calculation of the Close-out Amount. This statement should be clear enough for a third party to understand and replicate the calculation. It should be sent to the defaulting counterparty along with supporting evidence.

Quantitative Modeling and Data Analysis

The quantitative aspect of the execution must be transparent and reproducible. The following tables illustrate the type of data that must be captured and generated during the process.

Sample Dealer Poll Log for an Interest Rate Swap

This table documents the process of soliciting quotes for a hypothetical 5-year USD Interest Rate Swap with a notional of $100 million, where the firm was paying a fixed rate.

In this scenario, the firm would calculate the Close-out Amount based on the arithmetic mean of the three accepted quotes. The rejection of Bank D’s quote and the non-response from Bank E are critical pieces of evidence supporting the reasonableness of the procedure.

Contemporaneous and detailed documentation of the dealer poll is the primary evidence supporting the use of market-based valuation.

What Is the Protocol for Valuing Illiquid Assets?

Executing a valuation for illiquid or complex derivatives, where a reliable dealer poll is impossible, requires an even more rigorous adherence to process. The focus shifts from external validation via quotes to internal validation via model integrity and input sourcing.

• Model Validation The chosen valuation model must have been previously validated and approved by the firm’s independent model validation group. Its theoretical underpinnings and limitations should be well-documented.
• Input Sourcing Every input to the model must be sourced and justified. For example, if a DCF model is used, the source of the discount curve (e.g. OIS curve from a specific data provider) must be recorded. If a volatility input is required, the rationale for using a specific volatility surface must be explained.
• Valuation Adjustments (XVAs) For complex derivatives, various valuation adjustments (Credit Valuation Adjustment – CVA, Funding Valuation Adjustment – FVA) may be part of the firm’s standard valuation. The application of these adjustments in the close-out calculation must be consistent with how they are applied in the normal course of business.
• Third-Party Valuation Services Engaging a reputable, independent valuation service can provide a powerful piece of corroborating evidence. While the firm retains the ultimate responsibility, an external valuation that closely aligns with the internal calculation significantly strengthens the claim of commercial reasonableness.

Reflection

Ultimately, the ability to substantiate a close-out valuation is a direct reflection of a firm’s operational and risk management architecture. The process transcends a mere compliance exercise; it is a live stress test of the systems, controls, and protocols that define the institution’s character. The evidence produced ▴ the logs, the model documentation, the internal communications ▴ collectively forms a narrative of discipline and reason. Considering this, a firm should not ask, “What is the minimum we must do to defend this valuation?” Instead, the guiding question for designing its internal framework should be, “Does our system produce a result that is so transparently derived and methodologically sound that its commercial reasonableness is self-evident?” The answer to that question reveals the true strength of the firm’s operational core.