What Are the Key Differences between the 1992 and 2002 ISDA Close-Out Provisions?

Concept

The transition from the 1992 to the 2002 ISDA Master Agreement represents a critical system upgrade in the architecture of over-the-counter (OTC) derivatives markets. This evolution was not an academic exercise; it was a direct response to systemic failures and costly ambiguities observed during the market crises of the late 1990s. For any principal operating within these markets, understanding the precise differences in the close-out provisions is fundamental to appreciating the stability and predictability of the current operational framework. The core of the matter lies in how the system manages its most vulnerable moment ▴ the termination of a contract following a default.

The 1992 framework provided a set of tools that, while functional, contained latent design flaws. The 2002 framework is a direct architectural revision intended to correct those flaws by standardizing the damage calculation methodology and elevating the required standard of conduct for the performing party.

At the heart of this architectural shift is the replacement of a bifurcated, and often contentious, valuation system with a unified, more objective standard. The 1992 ISDA forced parties to choose between two distinct methods for calculating termination payments ▴ “Market Quotation” and “Loss.” Market Quotation was a procedurally rigid mechanism requiring the solicitation of quotes from reference market-makers. This process proved cumbersome and often failed entirely in distressed or illiquid markets where such quotes were unavailable. The alternative, “Loss,” was a more flexible standard, allowing the non-defaulting party to calculate its total losses and costs.

This flexibility, however, introduced a high degree of subjectivity, which frequently led to disputes over the self-interested nature of the calculations. The system was prone to breaking down under the very conditions it was designed to manage.

The 2002 ISDA addresses this central vulnerability by introducing a single, unified methodology known as the “Close-out Amount.” This consolidated approach was engineered to synthesize the positive attributes of its predecessors while mitigating their weaknesses. It provides the determining party with the flexibility to use various information sources ▴ including internal models and replacement transaction costs ▴ while simultaneously imposing a stricter, externally verifiable standard of behavior. This is the shift from a subjective test of rationality to an objective test of commercial reasonableness.

The 2002 framework mandates that the entire process, from the procedures followed to the final calculated amount, must be commercially reasonable. This systemic upgrade provides a more robust and defensible mechanism for resolving defaults, directly impacting counterparty risk assessment and the overall stability of the derivatives ecosystem.

Strategy

The strategic decision by the International Swaps and Derivatives Association to overhaul the 1992 Master Agreement was driven by a clear mandate ▴ to forge a more resilient and transparent architecture for managing counterparty default. The market turmoil of the late 1990s, particularly the Russian financial crisis and the collapse of Long-Term Capital Management (LTCM), exposed critical weaknesses in the 1992 framework. These events demonstrated that in times of severe market stress, the existing close-out mechanisms could exacerbate uncertainty and lead to protracted, costly legal battles. The strategy behind the 2002 ISDA was therefore preemptive and structural, aimed at redesigning the core risk-management engine of the OTC markets.

From Ambiguous Options to a Unified Mandate

The primary strategic failure of the 1992 ISDA was its presentation of “Market Quotation” and “Loss” as equivalent choices. This created an immediate point of negotiation and potential disagreement. A sophisticated counterparty would strategically elect the method that it believed would favor it in a potential default scenario. This introduced an element of game theory into the documentation process that distracted from the goal of creating a neutral, efficient resolution mechanism.

The 2002 ISDA’s strategy was to eliminate this choice entirely. By implementing the single “Close-out Amount” standard, the framers removed a significant source of pre-dispute friction and post-default litigation. This unified approach forces all parties onto a level playing field, where the focus shifts from exploiting definitional loopholes to achieving a commercially justifiable outcome.

The introduction of a single “Close-out Amount” in the 2002 ISDA strategically eliminated the contentious choice between “Market Quotation” and “Loss,” fostering a more objective and less litigious termination process.

What Is the Strategic Impact of a Higher Evidentiary Standard?

A pivotal strategic change was the elevation of the standard of conduct for the party determining the close-out payment. The 1992 “Loss” calculation was governed by a good faith standard and a test of rationality, often interpreted by English courts as the “Wednesbury unreasonableness” test. This standard is relatively low, requiring only that the determining party’s calculation is not so irrational that no reasonable party could have arrived at it. This subjectivity was a strategic liability for the market, as it provided a wide latitude for the non-defaulting party to act in its own interest, potentially at the expense of the defaulting party’s creditors.

The 2002 ISDA implements a strategically superior system by imposing a dual-pronged requirement of objective reasonableness. Section 6(e) requires the determining party to use “commercially reasonable procedures in order to produce a commercially reasonable result.” This is a significant strategic upgrade. It means the process itself must be sound, transparent, and justifiable to an objective observer.

The outcome must also fall within a range of what the broader market would consider reasonable. This higher standard acts as a powerful deterrent to aggressive or self-serving calculations, thereby increasing confidence in the fairness of the close-out process and reducing the likelihood of legal challenges.

Incorporating New Systemic Risks Force Majeure

The 1992 ISDA was largely silent on events that were outside the control of either party but made performance impossible, such as natural disasters, terrorist attacks, or government actions. The 2002 ISDA strategically introduced a “Force Majeure” Termination Event to address this gap. This was a direct lesson from events like 9/11, which highlighted the need for an orderly unwind mechanism when performance becomes impossible for reasons unrelated to a party’s creditworthiness.

The inclusion of this provision is a key strategic enhancement, providing a clear, predictable protocol for terminating transactions under extraordinary circumstances. It prevents such events from automatically triggering a more punitive Event of Default and specifies a fair, mid-market valuation method for the close-out calculation, further stabilizing the system during periods of widespread disruption.

Execution

The execution of close-out provisions under the ISDA Master Agreements is a precise, high-stakes procedure where the theoretical differences between the 1992 and 2002 versions manifest as tangible financial outcomes. For a non-defaulting party, the operational mechanics and legal standards governing the calculation of the termination payment are profoundly different. The shift from the 1992 framework to the 2002 framework is a move from a system with optional, divergent paths to a single, more rigorous protocol. This requires a higher level of diligence, documentation, and adherence to objective market standards.

Executing the Calculation a Procedural Breakdown

Executing a close-out requires a methodical approach. The non-defaulting party, now the “Determining Party” under the 2002 ISDA, must navigate a series of steps where the differences between the two agreements are critical.

1. Selection of Method (1992 ISDA Only) The first operational step under a 1992 Agreement is to consult the Schedule to see if “Market Quotation” or “Loss” applies. If Market Quotation is selected, the party must attempt to obtain quotes from at least three reference market-makers for terminating or replacing the transaction. This process is operationally intensive and requires formal communication and tracking. If quotes cannot be obtained, the agreement may fall back to the Loss method, introducing procedural complexity. The 2002 ISDA eliminates this step entirely; the “Close-out Amount” is the mandatory method.
2. Information Gathering and Valuation This is where the execution diverges most significantly.
   • Under 1992 “Loss” The Determining Party gathers information to support its good faith determination of its total losses and costs. This can include internal valuations, but the evidentiary burden is primarily to show that the final number was arrived at rationally.
   • Under 2002 “Close-out Amount” The Determining Party must execute a far more robust and externally-focused process. It is expected to consider a wider range of information, including quotes from third parties, relevant market data, and information from internal models. The key is that these sources must be commercially reasonable inputs to a commercially reasonable process. The Determining Party must be prepared to defend its choice of data and methodology to an objective third party.
3. Documentation and Justification The burden of proof in execution is substantially higher under the 2002 Agreement. A party calculating a Close-out Amount should meticulously document every step of its process ▴ the market data it consulted, the models it used, any quotes it solicited (even if not formally required), and the rationale for its final determination. This documentation is the primary evidence that the party followed “commercially reasonable procedures.” Under the 1992 “Loss” standard, while documentation is prudent, the legal defense rests more on the rationality of the outcome than the rigor of the process.

Executing a close-out under the 2002 ISDA demands a more rigorous, documented, and externally verifiable process compared to the more subjective standards of the 1992 version.

How Do Grace Periods Differ in Execution?

The 2002 ISDA tightens the operational timelines for curing defaults. For a “Breach of Agreement” Event of Default, the 1992 version provides a 30-day grace period after notice is given. The 2002 version reduces this to 14 days under certain circumstances, reflecting a market preference for faster resolution of defaults. This compressed timeframe requires firms to have more efficient internal monitoring and communication protocols to identify and address potential breaches before they escalate into a full-blown Event of Default.

The Set-Off Provision a New Execution Tool

The 2002 ISDA introduced an explicit set-off provision in Section 6(f). In the 1992 version, the right to set off a close-out payment against other amounts owed between the two parties was reliant on the provisions of the governing law or specific language added to the Schedule. The inclusion of a contractual set-off right in the 2002 version is a powerful execution tool.

It provides the non-defaulting party with a clear, unambiguous right to net the final termination payment against any other collateral, margin, or amounts due outside of the Master Agreement itself. This streamlines the final settlement process and strengthens the credit protection for the non-defaulting party, reducing the risk that it will have to pay out a large termination sum while separately litigating to recover other debts from the defaulting counterparty.

Reflection

The evolution from the 1992 to the 2002 ISDA framework is a lesson in systemic integrity. The enhancements were not cosmetic; they were deep, architectural changes designed to bolster the resilience of the entire OTC derivatives market. As you evaluate your own operational framework for counterparty risk management, consider the standard to which you hold your own internal processes. The 2002 ISDA’s mandate for objective, commercially reasonable procedures is more than a legal requirement; it is a best practice for sound risk governance.

Does your firm’s protocol for valuing positions and managing defaults meet this higher, more defensible standard? The knowledge of these agreements is one component, but its true power is realized when integrated into a comprehensive operational system built on principles of transparency, objectivity, and preparedness.