How Does the 2002 ISDA Master Agreement Change the Valuation Method in a Close Out?

Concept

The 2002 ISDA Master Agreement fundamentally recalibrated the mechanism for calculating termination payments in the derivatives market. It moved away from the bifurcated and often contentious valuation methods of its 1992 predecessor, introducing a unified standard known as the “Close-out Amount.” This was a deliberate architectural shift designed to inject greater objectivity and flexibility into the critical process of closing out transactions following a default or other termination event. The prior framework, which offered a choice between “Market Quotation” and “Loss,” had revealed significant limitations. Market Quotation, while theoretically objective, proved rigid and impractical in distressed or illiquid markets.

Conversely, the Loss method, while flexible, was often criticized for its subjectivity, granting the non-defaulting party considerable discretion that could lead to disputes. The 2002 Agreement sought to synthesize the strengths of both, creating a single, more robust methodology.

From a Dual System to a Unitary Standard

Under the 1992 ISDA Master Agreement, parties had to select their preferred measure of damages at the outset of their relationship. This choice was between two distinct approaches:

• Market Quotation ▴ This method required the determining party to obtain quotes from leading dealers in the relevant market for replacement transactions. The goal was to find a market-based price for replacing the economic exposure of the terminated trades. While this appeared to be a sound, objective approach, its efficacy crumbled during periods of market stress. In volatile or one-sided markets, obtaining multiple, firm quotes could become difficult or impossible, rendering the process unworkable.
• Loss ▴ This approach was far more encompassing. It allowed the non-defaulting party to determine, in good faith, its total losses and costs resulting from the early termination. This could include not only the cost of replacement trades but also funding costs and other ancillary expenses. The primary critique of this method was its inherent subjectivity. The standard was one of rationality; the determining party’s calculation would generally be upheld unless it was a figure that no reasonable party could have reached.

The Introduction of the Close-Out Amount

The 2002 ISDA Master Agreement did away with this choice, instituting the “Close-out Amount” as the sole method for calculating the termination payment. This new definition was crafted to be a hybrid, incorporating the market-based principles of Market Quotation with the flexibility of the Loss method. The Close-out Amount is defined as the losses or costs the determining party would incur, or the gains it would realize, in replacing the economic equivalent of the terminated transaction.

The 2002 ISDA Master Agreement replaced the dual valuation choices of the 1992 version with a single, more objective standard known as the Close-out Amount.

Crucially, the 2002 Agreement elevates the standard of conduct for the party making the calculation. The determining party must act in good faith and, most importantly, “use commercially reasonable procedures in order to produce a commercially reasonable result.” This shift from the 1992 Agreement’s standard of “reasonableness” (often interpreted as mere rationality) to “commercially reasonable” procedures and results represents the core of the change. It imposes a higher, objective standard, moving the assessment from the determining party’s subjective state of mind to an objective evaluation of its actions and the outcome.

Strategy

The strategic impetus behind the 2002 ISDA Master Agreement’s valuation changes was to create a more resilient and equitable framework for derivatives close-outs. The shift to a single “Close-out Amount” was a direct response to the practical failings of the 1992 Agreement’s dualistic system, particularly as exposed during market crises. The new strategy embeds principles of objectivity, flexibility, and commercial reasonableness directly into the valuation process, aiming to reduce disputes and produce outcomes that better reflect prevailing market conditions.

A Higher Standard of Conduct

The most significant strategic change lies in the redefined obligations of the determining party. The 1992 “Loss” calculation was governed by a standard of good faith and reasonableness, which English courts had interpreted as a test of rationality (the “Wednesbury” test). This meant a calculation could be upheld as long as it wasn’t so irrational that no reasonable party would have made it. This was a low bar that gave considerable latitude to the calculating party.

The 2002 Agreement deliberately imposes a more stringent, two-pronged test:

1. Commercially Reasonable Procedures ▴ The process used to arrive at the valuation must itself be objectively reasonable from a commercial standpoint. This involves an assessment of the steps taken by the determining party.
2. Commercially Reasonable Result ▴ The final calculated amount must also be commercially reasonable. This provides a check on the outcome, ensuring that even a sound procedure does not lead to an unjustifiable result.

This dual requirement for both process and outcome to be objectively commercially reasonable is a substantial elevation from the previous standard. It shifts the focus from what the determining party subjectively believed to what an objective third party would consider reasonable in the same circumstances.

The move to a “commercially reasonable” standard requires the determining party to justify both its valuation process and the final amount against an objective market benchmark.

Flexibility in Information Sources

To facilitate this new standard, the 2002 Agreement provides a non-exhaustive list of information sources that the determining party can use. This codifies the hybrid nature of the Close-out Amount, blending external market data with internal valuations when necessary.

This structure provides a clear hierarchy. The determining party should look to the external market first. However, it retains the flexibility to use its own internal, sophisticated modeling in situations where the market is illiquid, volatile, or otherwise unreliable. This prevents a party from being forced to rely on flawed market data while still holding it to an objective standard of commercial reasonableness in how it uses its internal models.

Execution

Executing a close-out under the 2002 ISDA Master Agreement requires a disciplined and well-documented process. The determining party must operate with the awareness that its procedures and the resulting calculation may be scrutinized against a rigorous, objective standard. The focus on “commercially reasonable” is not merely semantic; it has profound practical implications for how a non-defaulting party must conduct itself.

Operationalizing Commercial Reasonableness

A party tasked with determining a Close-out Amount must approach the task as a formal, evidence-based exercise. This means that ad-hoc or poorly documented calculations are vulnerable to legal challenges. The following steps outline a robust execution process:

1. Immediate Assessment of Market Conditions ▴ As of the Early Termination Date, the determining party should assess the state of the relevant market. Is it liquid and orderly, or is it dislocated and volatile? This initial assessment will guide the choice of valuation inputs.
2. Systematic Information Gathering ▴ The party should systematically attempt to gather information from the prescribed sources. This may involve formally requesting quotes from several market makers, polling pricing services, and running internal valuation models. All attempts, successful or not, should be logged.
3. Methodology Justification ▴ The determining party must decide which information sources to rely on. If it chooses to disregard available market quotations in favor of its internal models, it must have a defensible, good-faith reason for doing so ▴ for example, that the quotes are not firm, are at unrepresentative levels, or are for different transaction sizes.
4. Documentation and Record-Keeping ▴ Every step of the process must be meticulously documented. This includes who was contacted for quotes, the quotes received, the market data used, the parameters of any internal models, and the rationale for the final determination. This documentation is the primary evidence that the procedures were commercially reasonable.

A Comparative Analysis of Valuation Standards

The practical difference between the 1992 and 2002 standards becomes clear when examining how a court might review a determination.

The execution of a close-out under the 2002 Agreement is a procedural undertaking that demands robust documentation and a demonstrable adherence to objective commercial standards.

In essence, the execution of a close-out under the 2002 framework has become a more rigorous and defensible process. While it allows for a range of reasonable outcomes, it curtails the ability of the determining party to act as the sole arbiter of its own losses without reference to objective criteria. This heightened standard, while placing a greater burden on the determining party, ultimately serves to increase certainty and fairness in the market by ensuring that close-out valuations are grounded in commercial reality.

Reflection

The evolution from the 1992 to the 2002 ISDA Master Agreement reflects a maturation of the derivatives market. The codification of the Close-out Amount is more than a technical adjustment; it is a structural enhancement designed to bolster the integrity of the market’s foundational legal framework. For market participants, this change necessitates a critical examination of their internal procedures for handling defaults and terminations.

Is your firm’s process for calculating termination values sufficiently robust to withstand scrutiny under this higher, objective standard? The strength of a contractual agreement is truly tested only at its breaking point, and the 2002 ISDA provides a clearer, more defensible mechanism for navigating that critical juncture, reinforcing the stability of the entire financial network.