How Do Courts Interpret Commercial Reasonableness under the 2002 ISDA?

Concept

The interpretation of “commercial reasonableness” under the 2002 ISDA Master Agreement is a function of objective analysis, not subjective discretion. Your operational framework for calculating a close-out amount must be architected around the central principle that the 2002 Agreement deliberately moved the goalposts from the earlier 1992 standard. The language was changed to introduce a more stringent, externally verifiable benchmark for performance.

Courts now view the calculation as a two-part system requiring both a commercially reasonable process and the generation of a commercially reasonable result. This dual requirement acts as a critical control mechanism, ensuring that the determining party, even when possessing a conflict of interest, operates within a range of outcomes that a neutral, informed market participant would deem acceptable.

The foundational legal precedent shaping this understanding is the English High Court’s decision in Lehman Brothers Special Financing Inc v National Power Corporation EWHC 487 (Comm). This case established that the shift in wording from the 1992 ISDA Agreement’s “reasonably determines in good faith” standard to the 2002 Agreement’s “act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result” was a material change. It was designed to impose a higher degree of objectivity on the process of determining a close-out amount following an early termination. This interpretation effectively recalibrated the risk parameters for both defaulting and non-defaulting parties.

The judicial interpretation of the 2002 ISDA Master Agreement mandates that commercial reasonableness be assessed against an objective, market-facing standard.

The Objective Standard Defined

The core of the court’s interpretation is the concept of objectivity. This standard requires the determining party to benchmark its actions and results against prevailing market norms and available data at the time of the determination. The court in the Lehman v NPC case made it clear that this objective standard is more demanding than the previous test of rationality.

The rationality test, associated with the 1992 Agreement, only required that the determining party avoid a decision that was arbitrary, capricious, or one that no reasonable party in its position could have made. The 2002 standard, conversely, demands a proactive and demonstrable effort to achieve a result that is fair and grounded in market reality.

This objective analysis is applied to two distinct but interconnected elements:

1. Commercially Reasonable Procedures ▴ This pertains to the “how” of the calculation. It involves the specific, verifiable steps the determining party takes to gather information and arrive at a figure. This could include obtaining quotes from multiple dealers, considering relevant market data, and using valuation models that are standard within the industry. The process must be transparent and defensible.
2. A Commercially Reasonable Result ▴ This focuses on the “what” ▴ the final close-out amount itself. The result must fall within a range of outcomes that would be considered reasonable by impartial market participants. A result at the extreme edge of a plausible range, solely benefiting the determining party, is likely to fail this test.

Why Was the Standard Changed?

The evolution from the 1992 to the 2002 ISDA Master Agreement reflects a deliberate market-wide effort to enhance certainty and fairness in the derivatives close-out process. The accompanying guidance to the 2002 Agreement explicitly noted that the changes were intended to achieve “greater objectivity” because the 1992 standard was perceived as “lacking”. This shift was a direct response to the potential for the determining party, often the non-defaulting party, to leverage its position to produce a self-serving outcome. By embedding an objective standard into the contract, ISDA created a more robust and equitable mechanism, reducing the scope for disputes and promoting greater confidence in the enforceability of close-out netting provisions, which are fundamental to the stability of the global financial system.

Strategy

A strategic approach to navigating the “commercial reasonableness” standard under the 2002 ISDA Master Agreement requires a fundamental shift in mindset from the framework of the 1992 Agreement. The strategy is one of constructing a defensible and transparent process that aligns with an objective, market-based reality. The determining party must operate as if its every action will be scrutinized by a court or tribunal, with the burden of proof falling on it to demonstrate the reasonableness of both its procedures and its final calculation. This involves a proactive system of documentation and a conscious effort to mitigate any appearance of self-interest.

Contrasting the 1992 and 2002 Standards

The strategic difference between the two agreements is profound. The 1992 Agreement’s “rationality” test provided the determining party with a wide latitude of discretion. The 2002 Agreement constrains that discretion significantly, demanding a more rigorous, evidence-based approach. The legal and operational posture required under each agreement is distinct.

What Is the Role of Good Faith?

Under the 2002 Agreement, the duty to “act in good faith” coexists with the obligation to use commercially reasonable procedures. These are separate but related duties. Good faith typically relates to a party’s honesty, fairness in dealing, and adherence to the common purpose of the contract. However, courts have clarified that good faith alone is insufficient.

A determining party could act in good faith (i.e. without malice or a desire to injure the other party) yet still fail to use commercially reasonable procedures. For instance, relying on a single, friendly, indicative quote might not be a breach of good faith, but it would almost certainly be deemed a commercially unreasonable procedure if multiple firm quotes were obtainable.

A documented, objective process is the primary strategic defense against challenges to a close-out calculation.

Developing a Defensible Process

The strategy for compliance centers on the creation of a robust and auditable trail. This process should be designed to demonstrate a systematic and impartial approach to valuation.

• Sourcing Valuations ▴ The system must prioritize obtaining multiple, independent, and, where possible, firm quotations for a replacement transaction. Relying on internal models or indicative quotes should be a secondary option, used only when the primary market is illiquid or unavailable, and this rationale must be documented.
• Market Selection ▴ The choice of the relevant market for obtaining valuations is a critical strategic decision. The determining party should consider all relevant available markets and be prepared to justify why one was chosen over another. The goal is to identify the most liquid and appropriate market for a transaction of the relevant size and type.
• Documentation and Record-Keeping ▴ Every step of the process must be meticulously recorded. This includes who was contacted for quotes, when they were contacted, the exact terms of the quotes received, and the reasoning behind the final selected valuation. This documentation is the primary evidence in any subsequent dispute.
• Avoiding Conflicts of Interest ▴ While courts recognize that the determining party is inherently in a position of conflict, that party must demonstrate it did not allow its own commercial interests to override the objective standard. Choosing a valuation at the extreme end of a reasonable range simply because it is the most advantageous is a strategic error that courts will correct.

Ultimately, the strategy is to internalize the objective standard and embed it within the firm’s operational protocols for derivatives close-outs. This transforms the legal requirement from a potential litigation risk into a systematic business process that ensures compliance and enhances the certainty of outcomes.

Execution

Executing a close-out calculation under the 2002 ISDA Master Agreement is an exercise in procedural discipline and objective valuation. The determining party must construct a process that is not only compliant in theory but also robust in practice. This means translating the legal standard of “commercial reasonableness” into a concrete set of operational steps, data points, and decision-making criteria. The entire execution must be predicated on the assumption that it will be subjected to intense scrutiny and must be justifiable to an external arbiter.

Operational Playbook for a Commercially Reasonable Close Out

The execution of a close-out requires a systematic approach. The following steps provide a high-level operational playbook for a determining party, designed to satisfy the dual requirements of reasonable procedures and a reasonable result.

1. Immediate Market Assessment ▴ Upon an early termination event, the first step is to conduct a thorough assessment of all available markets for a replacement transaction. This includes identifying key market makers, inter-dealer brokers, and other potential sources of liquidity. The assessment should be documented, noting the characteristics of each potential market.
2. Systematic Quote Solicitation ▴ The core of the procedure is the solicitation of quotes. This must be done systematically. Contact a pre-defined list of independent, arm’s-length market participants. The number should be sufficient to provide a representative sample of the market, typically three to five. All communications, including the specific parameters of the transaction for which a quote is sought, must be recorded.
3. Prioritization of Quote Types ▴ The process must prioritize quote types based on their reliability.
   • Firm Quotes ▴ These are actionable bids or offers for a replacement transaction and represent the highest quality valuation data.
   • Indicative Quotes ▴ These are non-binding estimates of value. They are less reliable and should only be used when firm quotes are unavailable. The reliance on indicative quotes must be justified by market conditions.
   • Internal Models ▴ Valuation models should be used as a fallback or a cross-check, particularly in illiquid markets. The model’s inputs, methodology, and calibration must be fully documented and consistent with industry standards.
4. Analysis and Selection ▴ The collected quotes must be analyzed. Outliers should be investigated. The final selected valuation should be the one that is most representative of the market at that specific time. If a range of reasonable values exists, selecting a value purely based on self-interest is impermissible. The rationale for selecting one quote over others must be clearly articulated and recorded.
5. Comprehensive Record Creation ▴ A complete file should be compiled contemporaneously with the process. This record is the definitive evidence of the procedures followed and the basis for the result.

Executing the Calculation What Is a Reasonable Range?

Courts have acknowledged that there is typically a range of commercially reasonable outcomes, not a single correct number. The execution challenge is to ensure the final determination falls comfortably within this range and is not at an aggressive extreme. The table below illustrates how different procedural choices can lead to outcomes that may or may not withstand judicial scrutiny.

The execution of the close-out amount is therefore a function of disciplined process management. The goal is to create an objective, evidence-based valuation that is resilient to legal challenges. By focusing on transparent procedures, high-quality data, and justifiable decision-making, a determining party can effectively navigate the stringent requirements of the 2002 ISDA Master Agreement and ensure the finality and enforceability of the close-out calculation.

Reflection

The judicial framework surrounding the 2002 ISDA Master Agreement provides a clear mandate for objectivity. The principles established by the courts are not merely legal constraints; they are architectural specifications for building a robust and defensible operational system for managing counterparty default. Reflect on your own firm’s protocols. Are they designed merely to produce a number, or are they engineered to produce a verifiably reasonable result through a transparent process?

The distinction is the difference between legacy risk and institutional resilience. The knowledge of this legal standard is a component, but its integration into a firm’s core operational fabric is what creates a lasting strategic advantage.