What Are the Consequences If a Court Finds a Close-Out Calculation Was Not Commercially Reasonable?

Concept

The failure of a counterparty in a derivatives contract is a moment of systemic stress. It represents a fracture in the complex architecture of financial agreements that underpins institutional markets. In this critical moment, the governing operational protocol is the close-out calculation, a procedure designed to terminate all outstanding obligations and crystallize a final, net payment. The core of this protocol, particularly under the 2002 ISDA Master Agreement, is the mandate that this calculation be performed using “commercially reasonable procedures in order to produce a commercially reasonable result”.

This standard is not a vague guideline; it is a precise and objective design specification for the termination process. It functions as the market’s primary defense against arbitrary or punitive valuations in the chaotic aftermath of a default.

Understanding the consequences of failing to meet this standard requires viewing the ISDA Master Agreement as an operating system for the over-the-counter derivatives market. When a court finds a close-out calculation was not commercially reasonable, it is akin to finding a critical system bug in a party’s execution of that operating system. The system’s response is not to allow the user to patch the error and rerun the program. Instead, the system’s ultimate arbiter, the court, takes control of the process to restore integrity.

The court will impose its own calculation, effectively rewriting the financial outcome based on an objective assessment of what should have occurred. This judicial intervention is the primary and most severe consequence, transforming a contractual dispute into a public examination of a firm’s valuation and risk management capabilities.

A court’s rejection of a close-out calculation transfers valuation authority from the determining party to the judiciary itself.

The Objective Standard of the 2002 ISDA Master Agreement

The framework governing derivatives close-outs has evolved. The 1992 ISDA Master Agreement utilized a “Loss” calculation standard. This standard required the determining party to calculate its losses and costs in good faith, a test that courts often interpreted as a standard of rationality. A rational decision, in this context, is one that is not arbitrary or perverse.

The 2002 ISDA Master Agreement deliberately implemented a more rigorous protocol. It introduced the concept of the “Close-out Amount,” which must be determined through commercially reasonable procedures to achieve a commercially reasonable result.

This shift in language establishes a higher, purely objective standard. The focus moves from the determining party’s subjective state of mind to the external, verifiable reasonableness of its actions and outcomes. The inquiry becomes what a reasonable market participant, in the same position, would have done.

This objective test gives courts a greater capacity to scrutinize and, if necessary, substitute their own judgment for that of the calculating party. The procedures used and the final amount are measured against prevailing market practices and available data at the time of the termination.

What Constitutes Commercial Reasonableness in Practice

Commercial reasonableness is a function of process and substance. The ISDA framework provides flexibility, recognizing that a single, rigid valuation method would be unworkable across the vast spectrum of derivative products and market conditions. The determining party may use a variety of information sources to construct the Close-out Amount. These sources form the evidentiary basis upon which the reasonableness of the calculation will be judged.

The primary sources of information include:

• Quotations from Third Parties ▴ Obtaining quotes for a replacement transaction from major dealers in the relevant market is a cornerstone of a commercially reasonable process. This provides a direct, market-based measure of the cost to replace the terminated transaction.
• Relevant Market Data ▴ This is a broad category that encompasses any data a firm would reasonably use to value similar transactions. It includes information from electronic trading platforms, consensus pricing services, and other verifiable market data sources.
• Information from Internal Sources ▴ A firm may use its own internal models and valuation data. This is permissible provided the information is of the same type the firm uses in the regular course of its business for valuing similar transactions and is consistent with accepted market practice. The use of internal models without external verification can, however, attract greater scrutiny.

The overarching principle is that the chosen procedures must be logically designed to produce a result that reflects the economic reality of replacing the terminated transactions as of the Early Termination Date. A failure in this regard, whether through the use of flawed procedures or the reliance on unreasonable data, opens the door for a successful legal challenge.

Strategy

A finding of commercial unreasonableness is not merely a legal defeat; it represents a failure of a firm’s internal risk and valuation architecture. Therefore, the strategy for any institution acting as a Determining Party is one of pre-emptive compliance and rigorous documentation. The goal is to construct a close-out calculation that is not only accurate but also legally defensible.

This requires building a robust, transparent, and repeatable process that can withstand judicial scrutiny. The strategic objective is to create an evidentiary record so clear and compelling that it deters a challenge from ever being mounted, or ensures a successful defense if one occurs.

The architecture of a defensible close-out strategy rests on several key pillars. These pillars are designed to demonstrate that the firm’s actions were aligned with objective, external market standards at every stage of the calculation process. This approach transforms the legal requirement of “commercial reasonableness” into a concrete set of internal operational mandates.

A Framework for Defensible Calculation

A firm’s strategy should be built around creating a detailed and contemporaneous record of its decision-making process. This framework ensures that the procedures are, and can be proven to be, commercially reasonable.

Pillar One Procedural Integrity

The first pillar is the establishment of a clear, documented, and consistently applied internal procedure for handling early terminations. This procedure should be activated the moment a termination event occurs and should guide every subsequent action. A court will examine the logic and consistency of the procedures used. Ad-hoc or chaotic processes are inherently suspect.

Key procedural steps include:

1. Immediate Assembly of a Valuation Team ▴ Designate a specific team or individuals responsible for managing the close-out process. This ensures accountability and consistent application of procedures.
2. Selection of Reference Market-makers ▴ Identify a pool of credible, independent dealers from whom to request quotations. The selection process for these dealers should be documented and based on their active participation in the relevant market.
3. Structured Communication Protocol ▴ All requests for quotes, whether indicative or firm, should be made in a consistent manner. The timing and content of these communications must be logged.
4. Contemporaneous Record-Keeping ▴ Every decision, every piece of data received, and every internal discussion should be documented as it happens. This creates a reliable audit trail that is far more credible than recollections made months or years later during litigation.

Pillar Two Valuation Input and Data Selection

The second pillar concerns the quality and appropriateness of the data used in the calculation. The strategy is to base the valuation on the most objective and verifiable information available. While the 2002 ISDA allows for the use of internal models, reliance on external, third-party data provides a stronger defense against claims of self-interest.

A close-out calculation’s defensibility is directly proportional to the objectivity of its underlying data inputs.

The following table outlines a hierarchy of valuation inputs, ranked by their general level of defensibility:

How Does Market Disruption Affect the Valuation Strategy?

A critical strategic consideration is how to proceed during a period of significant market disruption, such as the conditions following the 2008 financial crisis. The 2002 ISDA provides a safety valve ▴ the calculation should be performed as of the Early Termination Date, or, if that is not commercially reasonable, as soon as practicable thereafter. A strategic delay may be justified if the market is so illiquid or volatile that any price obtained on the termination date would be distorted and unrepresentative.

However, the decision to delay must itself be commercially reasonable and thoroughly documented. The determining party must be prepared to justify why obtaining a valuation on the specified date was not feasible and why the chosen later date was appropriate.

Execution

When a dispute over a close-out calculation reaches a courtroom, the execution phase of the initial strategy is over, and the consequences become tangible. The court’s process is not one of negotiation or refinement of the original calculation. It is a process of substitution.

If the determining party’s calculation is found to have been produced by commercially unreasonable procedures or to have yielded a commercially unreasonable result, that calculation is set aside. The court then undertakes its own objective analysis to determine what the Close-out Amount should have been.

The Court as the Ultimate Calculating Agent

The most profound consequence of a non-compliant calculation is this ceding of control. The determining party loses its contractual right to perform the valuation. The court steps into the role of the calculating agent, using the evidence presented by both parties, including expert testimony and market data, to arrive at a de novo figure.

The original, flawed calculation may be considered as one piece of evidence among many, but it holds no special status. This judicial takeover of the valuation process represents a complete failure of the determining party’s execution.

This process has several critical operational implications:

• Finality of Judicial Determination ▴ The amount determined by the court is final and binding, subject only to appeal on legal grounds. The contractual machinery is superseded by the judicial machinery.
• Inability to Unilaterally Correct Errors ▴ A determining party cannot retract its initial calculation and submit a revised one upon discovering an error or omission. Once a calculation statement is delivered, it creates a debt obligation. Any correction from that point forward must be by mutual agreement of the parties or by order of the court. This prevents a party from having a “second bite at the apple” and underscores the need to get the execution right the first time.

The Spectrum of Financial Consequences

The direct financial consequences extend beyond the recalculation of the principal amount. The finding of a commercially unreasonable calculation triggers a cascade of potential financial liabilities.

What Is the Evidentiary Burden in Court?

The execution of a legal defense hinges on the quality of the evidence compiled during the calculation phase. The party that performed the calculation must demonstrate to the court, on the balance of probabilities, that its procedures and result were objectively reasonable. This involves presenting the detailed, contemporaneous records created as part of the valuation process. This includes logs of communications, copies of all quotes received, analysis of market data, and minutes of any internal meetings where valuation decisions were made.

The court’s judgment on commercial reasonableness will be based on the documented evidence of the actions taken at the time, not on post-hoc justifications.

Conversely, the party challenging the calculation will present its own evidence, which may include alternative quotes it solicited, expert analysis of why the determining party’s chosen methodology was flawed, or evidence of more representative market data that was ignored. The court weighs this competing evidence to reach its conclusion. The entire process underscores that the execution of a defensible close-out is an exercise in evidence creation. Without a robust and credible evidentiary trail, a firm’s ability to defend its actions is severely compromised.

Reflection

The principles governing a close-out calculation extend beyond a single contract or a single counterparty failure. They are a reflection of a firm’s entire risk management and valuation apparatus. Viewing the “commercially reasonable” standard not as a legal constraint, but as a design specification for this apparatus, shifts the perspective from reactive compliance to proactive system design.

How does your own operational framework measure up to this specification? Is the process for valuation under stress a robust, repeatable, and evidence-generating protocol, or is it an ad-hoc reaction to an unexpected event?

The knowledge of these consequences should prompt an internal audit of the systems that would be called upon in a crisis. The strength of a financial institution is ultimately tested at its weakest point. A failure in the close-out process is a failure at the most critical juncture. Building a framework that is transparent, disciplined, and grounded in objective market reality is the only way to ensure that when the system is tested, control over the outcome is not ceded to an external arbiter.