Concept
The calculation of a close-out amount following a counterparty default is a critical juncture in the lifecycle of any derivatives portfolio. At this moment, the abstract architecture of the ISDA Master Agreement materializes into a concrete financial outcome. The principle of “good faith” acts as a fundamental governor on the discretion afforded to the calculating party, the entity tasked with determining the final sum owed.
This is a procedural safeguard, a system parameter designed to ensure that the process of replacing or valuing terminated transactions adheres to a standard of commercial reasonableness. It transforms the calculation from a purely mechanical exercise into a governed process, subject to objective scrutiny.
In the context of the 2002 ISDA Master Agreement, the concept is explicitly codified. The determining party must act in good faith and use “commercially reasonable procedures in order to produce a commercially reasonable result”. This language establishes an objective standard. The focus shifts to the integrity of the valuation process itself.
The determining party is not granted unlimited latitude; its actions are measured against prevailing market practices and the observable data available at the time of the close-out. This requirement serves to protect the defaulting party from a punitive or self-serving valuation while allowing the non-defaulting party to be made whole for its economic losses.
The good faith standard ensures that the discretion used in a close-out calculation is tethered to objective, commercially defensible actions.
The Evolution from Rationality to Reasonableness
Understanding the impact of good faith requires acknowledging its evolution within the ISDA framework. The 1992 ISDA Master Agreement employed a different standard, often summarized as a test of rationality. Under that regime, the calculating party determined its “Loss,” an amount it “reasonably determines in good faith to be its total losses and costs”.
This created a more subjective threshold; a court might only intervene if the determination was so outside the bounds of plausibility that no rational party could have reached it. This placed a heavy burden of proof on the challenging party.
The 2002 ISDA framework deliberately elevated this standard. The shift to requiring “commercially reasonable procedures” and a “commercially reasonable result” imposes a duty that is externally verifiable. A firm’s internal models, choice of replacement quote, or timing of the valuation are all subject to analysis based on what a comparable market participant would have done under similar circumstances.
Good faith, in this system, is demonstrated through the diligent application of these objective procedures. It is the adherence to a defensible and transparent methodology that fulfills the obligation.
What Is the Systemic Function of Good Faith in Terminations?
From a systems architecture perspective, the good faith obligation functions as a critical control mechanism that promotes market stability and predictability. In the event of a systemic shock leading to multiple defaults, this standard prevents exacerbating market stress through arbitrary or punitive close-out valuations. It forces a degree of procedural discipline that ensures the liquidation of positions reflects genuine replacement costs, rather than fire-sale prices or opportunistic gains. This disciplined approach helps contain financial contagion by ensuring that close-out amounts are grounded in economic reality, thereby preserving the integrity of the broader derivatives market.
Strategy
Strategically, the obligation to act in good faith and use commercially reasonable procedures dictates the entire operational approach to a close-out event. For the non-defaulting party, the primary strategy is to construct a valuation process that is not only accurate but also robust enough to withstand legal and commercial scrutiny. This involves a proactive and documented methodology for gathering market data, soliciting quotes, and making valuation judgments. The objective is to create an evidentiary trail that demonstrates every step was taken to achieve a fair market replacement cost for the terminated transactions.
A core component of this strategy is the selection of valuation inputs. The ISDA framework provides a non-exhaustive list of potential sources, including third-party quotations and various forms of market data. A strategic approach involves diversifying these sources. Relying on a single dealer quote, especially if that dealer has a vested interest, may be perceived as a failure to use commercially reasonable procedures.
A more robust strategy involves obtaining multiple indicative and firm quotes from a range of credible market makers. It also means cross-referencing these quotes with internal models and observable market data points, such as closing prices on exchanges or data from consensus pricing services.
A robust close-out strategy prioritizes the creation of a defensible audit trail, documenting the commercial reasonableness of each valuation decision.
Navigating Valuation Methodologies
The choice of valuation methodology is a key strategic decision. The determining party must select a path that aligns with the “commercially reasonable” standard. The table below outlines common methodologies and assesses their alignment with the good faith requirement.
| Valuation Methodology | Description | Alignment with Good Faith & Reasonableness |
|---|---|---|
| Replacement Transaction | Entering into an actual, binding transaction with a third party to replace the material terms of the terminated trade. | High. This provides a definitive, market-tested price. The key is documenting that the chosen counterparty and price were commercially reasonable at the time of execution. |
| Multiple Dealer Quotes | Soliciting firm or indicative quotes from several independent market makers for a hypothetical replacement transaction. | High. Demonstrates a thorough survey of the available market. The process should be documented, including which quotes were deemed actionable and why. |
| Internal Model-Based Valuation | Using the firm’s own proprietary models to calculate the present value of the terminated transaction’s future cash flows. | Moderate to High. This is acceptable if the models are consistent with those used for internal reporting and risk management, and can be benchmarked against observable market inputs. Transparency is critical. |
| Market Data Consensus | Relying on prices from third-party consensus services or observable data from exchanges or clearing houses. | High. This method is grounded in objective, widely available data, making it inherently transparent and defensible as a commercially reasonable procedure. |
How Does Documentation Support a Good Faith Argument?
Comprehensive documentation is the shield that defends a close-out calculation. The strategic imperative is to record not just the final number, but the entire decision-making process that produced it. This documentation should function as a complete record of the actions taken by the determining party.
Every choice, from the selection of dealers for quotes to the justification for disregarding an outlier price, must be logged and explained. This creates a contemporaneous record that is invaluable in demonstrating that procedures were commercially reasonable and that the party acted in good faith.
- Quote Solicitation Log A detailed record of every market maker contacted. This should include timestamps, the specific parameters of the requested quote, the response received (or lack thereof), and the name of the individual contact at the dealer.
- Valuation Rationale Memo An internal document that explains the final methodology chosen. If multiple sources were used, it should detail how they were weighted or reconciled. If a specific quote was chosen as the basis for the calculation, the memo must justify why it was the most commercially reasonable option.
- Market Conditions Snapshot A collection of relevant market data from the time of the close-out. This can include screenshots of pricing screens, reports from data vendors, and commentary on market liquidity and volatility. This context is vital for justifying decisions made under prevailing circumstances.
Execution
The execution of a close-out calculation under the good faith standard is a procedural and data-intensive undertaking. It requires a systematic approach to asset valuation, data collection, and documentation. The objective is to produce a final Close-out Amount that is not only financially accurate but also procedurally unimpeachable. This process begins the moment an Early Termination Date is triggered and must be conducted with precision and diligence.
The first phase of execution involves identifying and cataloging all Terminated Transactions. For a complex portfolio, this requires a detailed inventory of every trade, its material terms, and any associated collateral. Once the portfolio is defined, the determining party must establish a clear timeline for the valuation.
The ISDA Master Agreement specifies that the valuation should occur as of the Early Termination Date, or a commercially reasonable date thereafter. If the valuation is delayed, the rationale for this delay must be thoroughly documented, citing factors such as market illiquidity or the complexity of the portfolio.
A Procedural Playbook for Close-Out Calculation
Executing a defensible close-out requires a structured operational plan. The following steps provide a framework for the determining party to follow, ensuring compliance with the dual obligations of good faith and commercial reasonableness.
- Portfolio Assembly and Verification Immediately upon the trigger of an Early Termination Date, assemble a complete and final list of all transactions with the defaulting counterparty. This list must be verified against internal records and, if possible, reconciled with the defaulting party’s records to prevent disputes over the scope of the close-out.
- Establishment of Valuation Hierarchy Define and document the firm’s preferred hierarchy of valuation sources before beginning the process. For example, a firm might decide to prioritize firm quotes from three independent dealers, falling back to a model-based valuation only if insufficient quotes are available. This pre-defined logic demonstrates a principled, non-opportunistic approach.
- Systematic Data Gathering Execute the data gathering process according to the established hierarchy. Contact dealers for quotes simultaneously, providing identical parameters for the hypothetical replacement trades. Capture all relevant market data, including interest rate curves, volatility surfaces, and credit spreads as of the valuation date.
- Analysis and Selection of Inputs Review the collected data. Discard any quotes that are clear outliers, but document the reason for their exclusion (e.g. “Quote was 5 standard deviations from the mean and dealer admitted to having no active axe in the product”). Average the remaining actionable quotes or select the most representative one, providing a clear justification for the choice.
- Calculation and Internal Review Calculate the final Close-out Amount based on the selected inputs. This calculation should be independently reviewed and verified by a separate team or individual within the firm to check for mathematical errors and to provide a second opinion on the commercial reasonableness of the result. The entire review process must be documented.
Illustrative Valuation Scenario
Consider a portfolio of terminated interest rate swaps. The determining party must calculate the cost of replacing these positions in the prevailing market. The following table illustrates how different data sources might be synthesized to arrive at a commercially reasonable valuation for a single swap.
| Valuation Source | Mid-Market Mark (USD) | Replacement Offer (USD) | Justification Notes |
|---|---|---|---|
| Dealer A Quote | +1,050,000 | +975,000 | Firm, actionable quote from a major dealer. Represents a direct, executable replacement cost. |
| Dealer B Quote | +1,065,000 | +980,000 | Firm, actionable quote. Price is consistent with Dealer A, providing market consensus. |
| Dealer C Quote | +1,150,000 | +1,090,000 | Indicative quote only. Noted as an outlier and given less weight as it was not a firm offer. |
| Internal Model Price | +1,055,000 | N/A | Model price based on observable swap curves. Used as a verification tool to confirm that dealer quotes are aligned with internal, consistent valuation methods. |
| Final Determined Value | N/A | +977,500 | Calculated as the average of the two firm quotes (A and B). This is a highly defensible approach as it relies on executable prices from independent sources. |
The execution of a close-out calculation culminates in a single number derived from a multi-faceted, documented, and procedurally sound valuation process.
This detailed execution process, supported by robust documentation and transparent methodologies, is the ultimate expression of acting in good faith. It transforms a subjective legal standard into an objective operational discipline, ensuring that the final Close-out Amount is a true economic reflection of the terminated transactions.
References
- Lehman Brothers Special Financing Inc. v National Power Corporation & Anor EWHC 487 (Comm).
- Fondazione Enasarco v Lehman Brothers Finance SA EWHC 1307 (Ch).
- Lehman Brothers International (Europe) v Lehman Brothers Finance SA EWCA Civ 188.
- International Swaps and Derivatives Association. “2002 ISDA Master Agreement.” ISDA, 2002.
- International Swaps and Derivatives Association. “1992 ISDA Master Agreement.” ISDA, 1992.
- Henderson, Schuyler K. “Henderson on Derivatives.” LexisNexis, 2017.
- Gregory, Jon. “The xVA Challenge ▴ Counterparty Credit Risk, Funding, Collateral, and Capital.” Wiley Finance, 2015.
Reflection
Calibrating Your Operational Framework
The principles governing a close-out calculation extend beyond the immediate context of a counterparty default. They compel a deeper examination of a firm’s entire valuation and risk management architecture. The requirement for objective, commercially reasonable procedures serves as a benchmark against which all internal processes can be measured.
How does your firm’s daily portfolio valuation methodology stand up to this standard of external verifiability? Are the models and data sources used for risk reporting consistent with the procedures that would be deployed in a termination event?
Viewing the good faith standard not as a legal constraint but as a design principle for a robust operational system can yield significant advantages. It encourages the development of transparent, well-documented, and consistent valuation practices across the organization. This creates a more resilient infrastructure, one that is prepared to act decisively and defensibly in a crisis.
Ultimately, the integrity of a close-out calculation is a reflection of the integrity of the system that produces it. The true measure of preparedness lies in the coherence and transparency of that system long before any Early Termination Date is declared.
Glossary
Isda Master Agreement
Counterparty Default
Commercial Reasonableness
Terminated Transactions
Commercially Reasonable Procedures
2002 Isda Master Agreement
Determining Party
1992 Isda Master Agreement
Good Faith
Commercially Reasonable
2002 Isda
Reasonable Procedures
Market Data
Dealer Quote
Close-Out Calculation
Final Close-Out Amount
Early Termination Date
Early Termination
Master Agreement
