How Does the 2002 Isda Standard of Commercial Reasonableness Differ from the 1992 Standard?

Concept

The architecture of over-the-counter (OTC) derivatives markets relies on a foundational document ▴ the ISDA Master Agreement. Its primary function is to create a single, binding contract that governs all transactions between two parties, providing a standardized framework for mitigating counterparty credit risk. At the heart of this framework lies the critical mechanism for calculating payments upon the early termination of transactions, typically triggered by a default. The evolution from the 1992 ISDA Master Agreement to the 2002 version reflects a significant upgrade in the system’s logic for determining these close-out payments, a shift driven by the market’s need for greater certainty and defensibility in times of financial stress.

Understanding this evolution requires a focus on the core challenge ▴ valuing a portfolio of complex, often illiquid, derivatives at a specific moment of market disruption. The 1992 Agreement approached this with a bifurcated system, offering parties a choice between two valuation methodologies, “Market Quotation” and “Loss.” Each carried a distinct operational logic and a different, often subjective, standard of reasonableness. The 2002 Agreement streamlined this process into a single, unified concept ▴ the “Close-out Amount.” This was a direct response to the ambiguities and potential for disputes inherent in the earlier framework. The change represents a fundamental redesign of the close-out calculation, moving toward a more objective and robust standard of commercial reasonableness that has profound implications for how financial institutions manage risk and enforce their contractual rights.

Strategy

The strategic divergence between the 1992 and 2002 ISDA Master Agreements is most apparent in the architecture of their respective close-out valuation methodologies. The 1992 Agreement presented a choice between two distinct systems, each with its own operational philosophy and standard for conduct. The 2002 Agreement superseded this dual-track system with a single, consolidated approach designed to enhance objectivity and reduce disputes. This redesign reflects a strategic shift in market practice toward a more unified and defensible standard for valuing terminated derivatives.

The 1992 ISDA Agreement a Dual-Method Framework

Under the 1992 ISDA Master Agreement, parties selected either “Market Quotation” or “Loss” as their primary method for calculating payments upon an early termination. This choice, made in the Schedule to the Agreement, had significant strategic consequences.

• Market Quotation This method was designed to be the more objective of the two. It required the non-defaulting party to seek quotes from at least three leading dealers in the relevant market for a replacement transaction. The calculation was based on the average of these quotes. The underlying principle was to establish a fair market value through a defined, procedural polling of the market. The standard of reasonableness here was largely procedural; if the party followed the steps of obtaining quotes, the result was generally deemed reasonable. However, this method proved problematic in stressed or illiquid markets where obtaining firm quotes was difficult or impossible.
• Loss This method was more subjective. It allowed the non-defaulting party to determine, in its reasonable and good faith opinion, its total losses and costs resulting from the early termination. This could include the cost of a replacement transaction, but it could also encompass funding costs and other less tangible losses. The standard of reasonableness for “Loss” was based on the English legal concept of “Wednesbury unreasonableness,” a test of rationality which dictates that a decision can only be overturned if it is so unreasonable that no reasonable party would have come to it. This gave the calculating party considerable discretion.

The 1992 Agreement’s dual-method system created potential for subjectivity and disputes, particularly when market conditions made objective valuations difficult.

Comparative Analysis of 1992 Valuation Methods

The choice between Market Quotation and Loss involved a trade-off between procedural objectivity and discretionary flexibility. The following table illustrates the key distinctions:

The 2002 ISDA Agreement a Unified Close-Out Amount

The 2002 ISDA Master Agreement eliminated the dual-method choice and introduced a single, harmonized concept ▴ the “Close-out Amount.” This approach was engineered to synthesize the better elements of the previous methods while imposing a more rigorous and balanced standard of conduct. The definition of Close-out Amount gives the determining party significant flexibility in the types of information it can use for its calculation. This can include quotes from third parties, relevant market data, and information from internal pricing models.

Crucially, this flexibility is constrained by a new, more demanding standard of reasonableness. Section 6(e) of the 2002 Agreement requires the determining party to act in good faith and “use commercially reasonable procedures in order to produce a commercially reasonable result.” This creates a two-part test:

1. Commercially Reasonable Procedures The process used to arrive at the valuation must be sound and appropriate. This is an objective test of the methodology itself.
2. Commercially Reasonable Result The final calculated amount must be fair and reasonable from a commercial standpoint. This is an objective test of the outcome.

This dual requirement is a significant upgrade from the 1992 standard. The English courts have affirmed that this is a stricter test than the “rationality” standard applied to the “Loss” calculation in the 1992 Agreement. It demands that the calculating party’s actions stand up to scrutiny from the perspective of an objective, commercially-minded third party. The system no longer permits a party to arrive at a conclusion that, while perhaps rational from its own perspective, is commercially unreasonable to the broader market.

Execution

The operational execution of a close-out under the 2002 ISDA Master Agreement is a disciplined process governed by the dual mandate of procedural and substantive commercial reasonableness. This requires a systematic approach to information gathering, valuation, and documentation to ensure the final Close-out Amount is robust and defensible. A failure to adhere to this standard can expose a non-defaulting party to legal challenges and potential re-calculation of the termination payment.

Operational Protocol for Calculating the Close-Out Amount

A non-defaulting party executing a close-out must construct a process that is both transparent and grounded in objective data. The following steps outline an operational protocol consistent with the requirements of the 2002 ISDA Agreement.

• Step 1 Initial Assessment Immediately following an Early Termination Date, the determining party must assess the portfolio of terminated transactions. This involves identifying all affected trades and gathering the relevant contractual documentation and market data available as of the termination date.
• Step 2 Information Gathering The party must gather a wide array of valuation information. The 2002 Agreement permits the use of various sources, and a robust process would involve consulting several. This includes obtaining quotes from dealers, sourcing data from electronic platforms, consulting internal pricing models, and identifying the cost of any actual replacement transactions entered into.
• Step 3 Valuation Methodology Selection The determining party must select and apply one or more valuation methodologies. The choice of methodology must be commercially reasonable for the types of transactions being valued. For liquid, plain-vanilla swaps, market quotes might be sufficient. For exotic or illiquid derivatives, internal models may be necessary, but their inputs and assumptions must be justifiable.
• Step 4 Calculation and Documentation The party calculates the Close-out Amount based on the gathered information and chosen methodologies. Every step of this process must be meticulously documented. This includes records of all quotes sought and received, market data snapshots, model parameters, and the rationale for any judgments made.
• Step 5 Delivery of the Calculation Statement A statement must be delivered to the defaulting party showing in reasonable detail how the Close-out Amount was calculated. This statement is a critical piece of evidence demonstrating that a commercially reasonable process was followed.

Quantitative Analysis and Data Synthesis

The “commercially reasonable” standard necessitates a quantitative approach grounded in verifiable data. The determining party cannot simply assert a number; it must be able to show its work. The synthesis of different data points is a key part of this process, as a single source may not be sufficient to produce a commercially reasonable result.

A defensible Close-out Amount under the 2002 ISDA framework is the product of a rigorous, data-driven valuation process, not a subjective estimate.

Consider a hypothetical scenario where a non-defaulting party is closing out a portfolio of interest rate swaps. A robust data synthesis process would look like the following table:

In this example, the determining party uses a blend of external quotes and internal models for one transaction while relying on the actual cost of a replacement hedge for the other. This multi-faceted approach, when properly documented, provides strong evidence of a commercially reasonable procedure designed to produce a commercially reasonable result. The 2002 standard effectively compels firms to build and maintain a sophisticated and auditable valuation architecture for their derivatives portfolio.

Reflection

From Subjective Loss to Objective Valuation

The transition from the 1992 ISDA Agreement’s valuation framework to the 2002 standard marks a critical evolution in the market’s risk management infrastructure. It reflects a systemic acknowledgment that in moments of counterparty default, ambiguity is the enemy of stability. The 1992 framework, with its subjective “Loss” calculation and potentially unworkable “Market Quotation” mechanic, contained structural weaknesses that could be exploited or could simply fail under stress.

The 2002 “Close-out Amount” represents a significant architectural improvement. By mandating a dual standard of commercially reasonable procedures and a commercially reasonable result, the framework compels market participants to build and maintain a more robust, transparent, and ultimately more defensible valuation apparatus. This is an upgrade to the entire system’s integrity.

It forces an objective discipline upon what can be a chaotic and contentious process, ensuring that the resolution of a default is grounded in verifiable data and sound commercial logic. The ultimate benefit is a more resilient and predictable financial system, where contractual obligations are harder to dispute and the costs of default are allocated in a manner that the broader market can recognize as fair.