What Are the Key Differences between the 1992 and 2002 Isda Close out Provisions?

Concept

The architecture of over-the-counter derivatives markets rests upon a foundational legal technology the ISDA Master Agreement. Within this system, the close-out netting mechanism functions as the ultimate load-bearing wall, the protocol that prevents the failure of a single counterparty from initiating a catastrophic, systemic collapse. Understanding the evolution of this mechanism from the 1992 to the 2002 iteration is to understand a critical shift in the market’s own conception of risk, fairness, and operational resilience. The 2002 Agreement represents a direct architectural response to the lessons learned from market dislocations in the late 1990s, where the ambiguities and subjective elements of the 1992 framework were revealed under stress.

The core of this evolution is a deliberate migration from a subjective, relationship-based model of calculating termination payments to an objective, evidence-based framework. This was a move to re-engineer the system’s core fail-safe, making it more robust, transparent, and capable of withstanding severe market turbulence by codifying commercial reasonableness as the governing principle of its operation.

The transition from the 1992 to the 2002 ISDA Master Agreement marks a fundamental redesign of the close-out process, moving from a subjective standard of rationality to an objective standard of commercial reasonableness.

At the heart of the 1992 Agreement’s close-out provision was a significant degree of deference to the non-defaulting party. The calculation of the final settlement amount, whether through the “Loss” or “Market Quotation” method, was ultimately governed by a standard of good faith and reasonableness. In practice, legal interpretations of this standard, particularly under English law, coalesced around a test of rationality. This meant a court would not intervene unless the non-defaulting party’s calculation was so irrational that no reasonable party in its position could have arrived at it.

This high threshold provided flexibility. It also created uncertainty and the potential for dispute, as the defaulting party had a steep hill to climb to challenge a calculation, even one that might seem commercially suspect. The system relied heavily on the presumed integrity and rational behavior of the calculating party, an assumption that proved fragile during periods of acute market stress when incentives could become distorted.

The 2002 ISDA Master Agreement fundamentally alters this dynamic by re-architecting the calculation process around the concept of the “Close-Out Amount.” This new methodology discards the elective framework of its predecessor and institutes a single, unified standard. The defining feature of this new standard is its explicit two-part requirement the non-defaulting party must use “commercially reasonable procedures” to produce a “commercially reasonable result.” This is a profound systemic change. It shifts the fulcrum of the evaluation from the internal, subjective state of the calculating party (what they “reasonably determine”) to an external, objective benchmark of prevailing market practice. The calculation is no longer a matter of what the party itself deemed rational.

It becomes a matter of what an objective, informed third party would consider commercially reasonable under the circumstances. This architectural enhancement was designed to increase transparency, reduce the scope for valuation disputes, and provide greater certainty of outcome for all market participants, thereby strengthening the entire OTC derivatives ecosystem.

Strategy

The strategic redesign embodied in the 2002 ISDA Master Agreement’s close-out provisions reflects a sophisticated evolution in risk management philosophy. It was a direct response to the market’s demand for a more resilient and predictable framework following the financial crises of the late 1990s, such as the collapse of Long-Term Capital Management (LTCM). The core strategic thrust was to de-risk the close-out process itself by replacing ambiguity with objectivity and elective complexity with standardized procedure. This section explores the key strategic shifts that define the 2002 Agreement’s superiority as a risk management architecture.

The Mandate for Objective Commercial Reasonableness

The most significant strategic change is the move from the 1992 Agreement’s “rationality” standard to the 2002 Agreement’s explicit mandate for objective commercial reasonableness. The 1992 standard, which required the non-defaulting party to determine its “Loss” in a manner it “reasonably determines in good faith,” was interpreted by courts as a test of rationality. A defaulting party challenging a calculation had to prove that the outcome was one that no reasonable non-defaulting party could have reached. This provided a wide margin of discretion to the calculating party.

The 2002 Agreement’s framework is strategically superior because it imposes a higher, dual standard. The calculating party must satisfy two distinct obligations:

1. Commercially Reasonable Procedures This prong focuses on the process of valuation. The calculating party must be able to demonstrate that the steps it took to arrive at a value were consistent with standard market practices. This could include obtaining quotes from active dealers, using recognized valuation models, or consulting third-party valuation services. The focus is on the operational “how.”
2. Commercially Reasonable Result This prong focuses on the outcome of the valuation. The final calculated Close-Out Amount must itself be a fair representation of market value at the time of termination. This provides a crucial backstop, preventing a situation where a party could follow a technically sound procedure that nonetheless produces a skewed or punitive result.

This dual requirement provides a more robust and defensible valuation, reducing the likelihood of protracted legal battles over the close-out amount. It creates a clear audit trail and forces the calculating party to ground its actions in observable market data and practices.

Unification and Simplification of the Valuation Method

The 1992 Agreement presented parties with a choice between two different valuation methodologies upon termination “Loss” and “Market Quotation.” This created unnecessary complexity and potential for disagreement.

• Market Quotation This method required the non-defaulting party to obtain quotes from at least three leading dealers in the relevant market for a replacement transaction. While seemingly objective, it could be difficult to implement in illiquid or stressed markets where dealers might be unwilling or unable to provide firm quotes.
• Loss This was a broader, more flexible measure allowing the non-defaulting party to calculate its total losses and costs resulting from the termination. This flexibility came at the cost of certainty and objectivity, as it relied heavily on the internal calculations of the non-defaulting party.

The 2002 Agreement’s strategy was to eliminate this confusing bifurcation. It introduced a single, unified concept the “Close-Out Amount.” This measure is defined as the amount of losses or costs that are or would be incurred in replacing, or providing the economic equivalent of, the terminated transactions. While it is conceptually closer to the 1992 “Loss” definition, it is explicitly governed by the overarching duty of commercial reasonableness. This unified approach simplifies the process, removes a point of pre-dispute negotiation, and ensures a consistent valuation methodology is applied across all transactions under the agreement.

By replacing the elective and complex valuation methods of the 1992 version, the 2002 ISDA Agreement institutes a single, more objective “Close-Out Amount” standard.

What Are the Implications of Mandating Two Way Payments?

A significant strategic enhancement in the 2002 Agreement was the elimination of the “First Method” payment option. The 1992 Agreement allowed parties to choose between:

• First Method (One-Way Payments) Under this method, if the net value of the terminated transactions was positive for the non-defaulting party, it could claim that amount. However, if the net value was positive for the defaulting party, the non-defaulting party was not required to make any payment. This was a punitive “walk-away” clause.
• Second Method (Two-Way Payments) This method required a payment to be made to whichever party was “in the money” on a net basis, regardless of which party had defaulted.

The First Method was widely criticized as inequitable, as it could provide a windfall to the non-defaulting party and was out of step with the fundamental principle of contract law, which aims to compensate for loss rather than to punish. By the time the 2002 Agreement was drafted, the market had overwhelmingly rejected the First Method in practice. The 2002 Agreement simply codified this market consensus by providing only for two-way payments. This strategic move reinforced the integrity and fairness of the close-out process, ensuring that the mechanism serves as a tool for making the non-defaulting party whole, not for generating a profit from a counterparty’s misfortune.

Architectural Enhancements for Systemic Stability

The 2002 Agreement introduced several other strategic changes designed to create a more complete and resilient legal architecture.

One of the most important was the inclusion of a standardized Set-Off Provision. While parties often added a set-off clause to the 1992 Agreement’s schedule, its absence from the main body of the agreement was a recognized weakness. The 2002 Agreement includes a broad set-off right in Section 6(f), allowing the non-defaulting party to set off the final early termination amount against any other amounts owed between the parties. This provides an additional layer of credit risk mitigation and enhances the efficiency of the final settlement process.

Furthermore, the 2002 Agreement introduced a more sophisticated framework for handling Illegality and Force Majeure events. It provides clearer mechanics for suspending and ultimately terminating transactions affected by such events, with specific valuation rules designed to achieve a fair, mid-market valuation. This was a direct response to the increasing complexity of cross-border transactions and the potential for unforeseen legal or political events to disrupt performance.

Execution

The execution of close-out procedures under the ISDA Master Agreement is a precise operational sequence where the theoretical legal standards translate into tangible financial outcomes. The shift from the 1992 to the 2002 framework represents a significant change in the operational playbook for a non-defaulting party. The execution process under the 2002 Agreement demands a more rigorous, documented, and externally verifiable approach to valuation, reflecting the higher standard of objective commercial reasonableness. This section provides a granular analysis of the execution mechanics, comparing the operational steps and valuation inputs required under both agreements.

Procedural Walkthrough a Tale of Two Close Outs

To understand the practical differences in execution, consider the step-by-step process a non-defaulting party (Party A) would follow after a counterparty (Party B) defaults.

1. Declaration of an Early Termination Date The initial step is the same under both agreements. Party A must serve a notice to Party B, specifying the Event of Default and designating an Early Termination Date for all outstanding transactions.
2. Valuation The Operational Divergence This is where the execution paths diverge significantly.
   • Under the 1992 ISDA Agreement Party A must first consult the schedule to see if “Market Quotation” or “Loss” was elected.
     • If Market Quotation is chosen, Party A’s operational team must contact at least three, and preferably four or five, leading dealers in the relevant derivatives market. They must request quotes for the cost of entering into a replacement transaction for the entire portfolio of terminated trades. The team must document all requests and responses. The final “Settlement Amount” is based on the arithmetic mean of the quotes obtained, after discarding any outliers. This process can be operationally burdensome and time-sensitive, especially in volatile markets.
     • If Loss is chosen, Party A’s internal finance and risk teams must begin a comprehensive calculation. This involves not only marking the portfolio to market using internal models but also quantifying any associated costs, such as funding costs, hedging breakage costs, and legal expenses. This process requires robust internal modeling capabilities and is subject to the broad “rationality” standard.
   • Under the 2002 ISDA Agreement Party A’s task is to calculate a single “Close-Out Amount.” The operational focus is on creating a defensible record that the procedures and the result were commercially reasonable. The playbook would involve:
     • Gathering relevant market data as of the termination date. This includes end-of-day pricing data from recognized sources (e.g. Bloomberg, Reuters), consensus pricing services, and where appropriate, indicative quotes from market makers.
     • Using internal, industry-standard valuation models to price the terminated transactions.
     • Obtaining information on the cost of unwinding any related hedges.
     • Potentially engaging a third-party valuation agent to provide an independent assessment, especially for complex or illiquid portfolios.
     • Crucially, documenting every step of this process the data sources used, the models applied, the quotes received (even if indicative), and the rationale for the final determination. This documentation is the evidence that the “commercially reasonable procedures” test has been met.
3. Calculation of the Final Payment In both cases, the final step is to combine the determined valuation amount with any “Unpaid Amounts” (payments that were due but unpaid prior to termination) to arrive at the final figure owed by one party to the other.

Valuation Methodologies a Comparative Analysis

The table below breaks down the key operational components of the valuation methods under each agreement, highlighting the shift in execution focus.

How Do the Legal Standards Impact Execution?

The difference in the governing legal standard has profound consequences for the execution of a close-out and the management of potential disputes.

The execution of a close-out under the 2002 ISDA Agreement requires a disciplined and transparent process designed to produce a result that is defensible in an objective market context.

In practice, the execution under the 2002 Agreement forces the non-defaulting party to act as if it were preparing for litigation from the moment of termination. Every choice, from the data sources consulted to the valuation models used, must be justifiable by reference to standard industry practices. This disciplined approach, while operationally demanding, ultimately serves the interests of both parties and the market as a whole by promoting transparency, fairness, and predictability in the critical process of closing out derivatives exposures.

Reflection

The architectural evolution from the 1992 to the 2002 ISDA close-out mechanism is a testament to the market’s capacity for systemic learning. The framework you operate under is more than a legal document; it is a reflection of your institution’s risk philosophy. Does your operational playbook prioritize flexibility and internal discretion, or does it value objective, verifiable procedures that minimize the potential for dispute? The 2002 Agreement provides a robust, standardized architecture designed for resilience in periods of market stress.

As you evaluate your own counterparty risk frameworks, consider how the principles of objectivity, transparency, and commercial reasonableness are embedded not just in your legal documents, but in the day-to-day execution of your risk management protocols. The strength of the system lies in the integrity of its every component.