How Do Courts Define Commercial Reasonableness in ISDA Loss Calculations?

Concept

In the architecture of financial markets, precision in contractual language is the primary defense against catastrophic ambiguity. When a derivative contract is terminated, the calculation of net loss is not a theoretical exercise; it is a critical procedure where the definition of “reasonableness” dictates the flow of capital. Courts have moved decisively to define commercial reasonableness within International Swaps and Derivatives Association (ISDA) agreements as a standard of objective, demonstrable conduct, rather than a test of subjective belief or mere rationality. This interpretation hinges on a pivotal evolution in the ISDA Master Agreement itself, specifically the transition from the 1992 version to the 2002 version.

The core of the judicial interpretation rests on the distinction between two standards of conduct. The 1992 ISDA Master Agreement, when “Loss” is the selected payment measure, requires the non-defaulting party to determine an amount it “reasonably determines in good faith to be its total losses and costs”. Courts, particularly in cases following the 2008 financial crisis, interpreted this as a test of rationality. This standard, often associated with the Wednesbury unreasonableness principle in UK public law, is a relatively low bar to clear.

It essentially requires the calculating party to avoid a determination that is arbitrary, capricious, or one that no reasonable party in its position could possibly have reached. It grants significant discretion to the calculating party, so long as its actions are not completely irrational.

The shift from the 1992 to the 2002 ISDA Master Agreement marks a fundamental change from a subjective rationality test to a stringent, objective standard of commercial reasonableness.

Conversely, the 2002 ISDA Master Agreement introduced a more demanding framework for its “Close-out Amount” calculation. It mandates that the determining party must act “in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”. English courts, in landmark rulings such as Lehman Brothers Special Financing Inc. v National Power Corporation, have dissected this phrase to establish a two-fold objective test. This means that both the process of the calculation (the “procedures”) and the final figure (the “result”) are subject to scrutiny against an objective benchmark of what would be considered commercially reasonable in the prevailing market conditions.

The determining party’s subjective belief that it acted reasonably is insufficient. It must be able to provide evidence that its methodology and outcome align with accepted market practices.

This judicial clarification elevates the standard significantly. It transforms the close-out calculation from a discretionary act protected by a wide margin of error into a fiduciary-like responsibility that demands transparency, diligence, and justification based on observable market data and practices. The court’s stance is that the specific change in wording between the two agreements was a deliberate act by ISDA to introduce greater objectivity and fairness, removing the potential for a non-defaulting party to exploit its position, even if it does so in good faith.

Strategy

The strategic implications of the judicial definition of “commercial reasonableness” are profound for any institution engaged in derivatives trading. The shift from a rationality test to an objective standard fundamentally alters risk management protocols, documentation requirements, and potential litigation exposure during the close-out process. A failure to internalize this distinction within an institution’s operational framework is a failure of risk architecture.

The Evolution of Contractual Standards

The strategic decision by ISDA to modify the close-out language between the 1992 and 2002 Master Agreements was a direct response to the market’s need for greater certainty and less discretion in times of stress. The 1992 “Loss” calculation method was perceived as granting too much latitude to the non-defaulting party. The strategy behind the 2002 “Close-out Amount” was to create a more balanced and transparent mechanism, thereby reducing disputes and promoting market stability. For market participants, the strategy must be to align their internal procedures with this stricter, objective standard, treating every close-out calculation as a potentially defensible event.

This requires a proactive, evidence-based approach. The non-defaulting party must operate under the assumption that its calculations will be challenged and must therefore construct a complete and contemporaneous record of its actions. This includes documenting the market data sourced, the valuation models used, any quotations sought from third parties, and the rationale for the final determination. The objective is to build a narrative that demonstrates a logical and diligent process consistent with industry norms.

Comparative Analysis of ISDA Standards

Understanding the strategic differences between the two ISDA agreement versions is critical for assessing contractual risk. The following table breaks down the core distinctions in the close-out calculation standards.

What Is the Role of Good Faith?

While the 2002 agreement emphasizes objective reasonableness, the requirement to act “in good faith” remains. Strategically, parties should view this not as a separate, lesser standard, but as an overarching principle that informs the entire process. A procedure could, in theory, be commercially reasonable on its face but be applied in bad faith to achieve a punitive outcome. For instance, deliberately choosing a valuation time when markets were temporarily dislocated to maximize the counterparty’s loss could be seen as a breach of good faith, even if the valuation source itself was “reasonable.” The strategic imperative is to ensure that the entire close-out process is conducted with honesty of purpose, which in turn reinforces the commercial reasonableness of the actions taken.

Execution

Executing a close-out calculation under the 2002 ISDA Master Agreement’s objective standard requires a rigorous, methodical, and defensible operational playbook. The focus must shift from arriving at a number to architecting a process that can withstand judicial scrutiny. Every step must be deliberate and documented, creating an auditable trail that validates the commercial reasonableness of the final determination.

The Operational Playbook for a Defensible Calculation

A non-defaulting party must implement a clear, repeatable process for calculating the Close-out Amount. This process serves as the primary evidence that “commercially reasonable procedures” were employed.

1. Immediate Convening of a Valuation Team As soon as an Early Termination Date is declared, a dedicated team comprising trading, risk management, and legal personnel should be convened. This establishes a formal, controlled process from the outset.
2. Systematic Sourcing of Market Data The team must gather valuation data from multiple, credible sources. This is a critical step in demonstrating objective analysis.
   • Dealer Quotations Solicit firm or indicative quotes from several active market makers in the relevant derivative. All responses, including refusals to quote, should be logged.
   • Electronic Platform Data Capture data from relevant trading platforms and benchmarks, noting the time of collection.
   • Internal Model Valuation If internal models are used, their inputs, methodology, and assumptions must be documented. The model should be one that is regularly used in the ordinary course of business for valuing similar transactions.
3. Selection of a Valuation Methodology The determining party must choose a valuation method and justify its selection. If, for example, dealer quotes are disregarded in favor of an internal model, the rationale must be compelling, such as evidence that the quotes were not representative of the market at the time of the close-out.
4. Creation of a Calculation File A comprehensive file should be created that contains all collected data, correspondence, internal notes on decisions made, the final calculation worksheet, and a narrative summary of the process. This file is the primary artifact for defending the calculation.
5. Issuance of the Close-out Statement The final statement detailing the Close-out Amount should be issued with care. As courts have cast doubt on the ability to unilaterally withdraw and reissue a statement, accuracy is paramount. The statement should be reviewed by legal and compliance before being sent.

Quantitative Modeling and Data Analysis

The reasonableness of a result is often tied to the quality of the data used. Consider a hypothetical close-out of a 5-year interest rate swap. The determining party must calculate its loss by assessing the cost of entering into a replacement trade.

A defensible close-out calculation is the output of a rigorous and transparent process, not merely a subjective assessment of loss.

The table below illustrates a simplified data analysis that a valuation team might undertake to demonstrate the commercial reasonableness of its final determination.

How Can a Calculation Be Challenged?

A counterparty wishing to challenge a Close-out Amount must attack the objective reasonableness of either the procedures or the result. A challenge might argue that the determining party failed to survey a representative portion of the market, relied on stale data, used an inappropriate valuation model, or ignored readily available and more favorable quotations. The success of such a challenge depends on the challenger’s ability to present evidence of what a commercially reasonable process would have looked like and the different result it would have produced. This is why the determining party’s execution and documentation are so critical; they form the first and most important line of defense.

Reflection

Fortifying Your Institutional Framework

The judicial interpretation of “commercial reasonableness” is more than a legal footnote; it is a systemic pressure test for an institution’s internal risk controls. The principles laid down by the courts compel a move away from reliance on individual discretion towards a framework of procedural integrity. This requires an honest assessment of your own operational architecture. Are your close-out procedures formalized and consistently applied?

Is your documentation sufficient to construct a complete and defensible narrative of your actions under stress? Is your team trained to understand that their actions will be measured against an objective, market-wide standard?

Viewing this not as a compliance burden but as a component of a superior operational system is key. A robust, evidence-based close-out protocol is a strategic asset. It minimizes legal and financial risk, enhances counterparty confidence, and ultimately reinforces the stability and integrity of the institution’s market-facing operations. The ultimate advantage lies not just in understanding the rules, but in building a system that executes them with precision and foresight.