What Are the Legal Consequences of Failing to Use a Commercially Reasonable Procedure during a Close Out?

Concept

The mandate to employ a “commercially reasonable” procedure during a contract close-out is the very bedrock of predictable, enforceable agreements in institutional finance. This principle ensures that in moments of distress or default, the resolution process adheres to established market practices, preserving a measure of fairness and preventing the exploitation of a counterparty’s weakened position. The consequences of its breach are severe, extending beyond immediate financial penalties to reputational damage and the erosion of trust, which is the ultimate currency in our markets. A failure to act in a commercially reasonable manner transforms a standard procedural step into a significant legal and financial liability.

At its core, commercial reasonableness is a standard of conduct defined by the Uniform Commercial Code (UCC) and refined through extensive case law. It dictates that every aspect of a disposition of collateral ▴ including the method, manner, time, and place ▴ must be conducted in good faith and in accordance with accepted commercial practices. This is a flexible standard, designed to adapt to the specific circumstances of the transaction and the nature of the assets involved.

The ambiguity, however, is a double-edged sword. It allows for context-specific application, but it also creates a fertile ground for disputes when one party believes the other has acted in a self-serving or punitive manner.

The failure to adhere to commercially reasonable standards during a close-out can invalidate the process, exposing the non-compliant party to significant legal and financial repercussions.

The legal framework underpinning this concept is primarily found in Article 9 of the UCC, which governs secured transactions. When a debtor defaults on a secured loan, the creditor has the right to repossess and sell the collateral to recover the outstanding debt. The requirement of commercial reasonableness acts as a crucial check on the creditor’s power, ensuring that the sale process is designed to maximize the proceeds and, consequently, minimize any deficiency owed by the debtor. A failure to meet this standard can result in the reduction or complete elimination of the debtor’s liability for any shortfall.

What Defines a Commercially Reasonable Close Out?

Determining whether a close-out procedure was commercially reasonable is a fact-intensive inquiry that courts undertake with a high degree of scrutiny. Several key factors are consistently examined:

• Adequacy of Notice The secured party must provide reasonable and authenticated notice of the sale to the debtor and any other lienholders. This notice must be timely, allowing the debtor a sufficient opportunity to find alternative financing, redeem the collateral, or otherwise protect their interests. The content of the notice is also critical; it must accurately describe the debtor, the secured party, and the collateral, and it must state the method of disposition and the time and place of the sale.
• Method of Sale The secured party can choose to dispose of the collateral through a public or private sale. The choice of method must itself be commercially reasonable. A public auction might be appropriate for standardized assets with a ready market, while a private sale to a targeted group of potential buyers might be more suitable for specialized or illiquid assets. Courts will often scrutinize private sales more closely to ensure that the process was fair and the price obtained was reasonable.
• Marketing and Advertising The efforts made to market the collateral are a key indicator of commercial reasonableness. The secured party is expected to take steps that are consistent with the practices of a dealer in that type of property. This could include advertising in relevant trade journals, contacting known potential buyers, or engaging a professional auctioneer or broker. The goal is to generate interest and competition to achieve the best possible price.
• Timing of the Sale The sale must be conducted in a timely manner. An unreasonable delay could be viewed as an attempt to manipulate the market or take advantage of a depreciating asset. Conversely, a sale that is rushed without adequate preparation or marketing could also be deemed unreasonable.
• Price Obtained While a low price alone is not sufficient to establish that a sale was commercially unreasonable, it will certainly invite closer scrutiny. The court will look at the entire process to determine if the low price was the result of a flawed procedure. A significant discrepancy between the price obtained and the fair market value of the collateral is strong evidence of a commercially unreasonable sale.

The Proportionality Principle

A crucial aspect of commercial reasonableness is the principle of proportionality. A contractual demand or action taken during a close-out must be proportional to the harm it is intended to prevent. For example, if a party has reasonable grounds to believe its counterparty’s creditworthiness has deteriorated, it may demand adequate assurance of performance.

However, the amount of assurance demanded must be commercially reasonable and proportional to the potential loss. An excessive demand could be seen as a breach of the obligation to act with commercially reasonable discretion.

This principle was central to the case of Skyview Finance Co. LLC v. Kearsarge Trading, LLC, where Kearsarge’s demand for collateral was found to be disproportionate to the actual risk of loss. The court determined that this constituted a breach of its obligation to act within its commercially reasonable discretion, resulting in a judgment against Kearsarge. This case underscores the importance of a carefully calibrated response to a counterparty’s perceived financial distress.

Strategy

Navigating the complexities of a contract close-out requires a strategic approach that is grounded in a deep understanding of the legal and commercial landscape. The overarching goal is to mitigate risk, preserve value, and ensure that all actions taken will withstand legal scrutiny. A well-defined strategy for a commercially reasonable close-out is not merely a defensive posture; it is a proactive framework for managing distressed situations effectively and professionally.

Developing a Robust Close out Protocol

The foundation of a successful close-out strategy is a comprehensive, documented protocol that is consistently applied. This protocol should be an integral part of an institution’s risk management framework and should be regularly reviewed and updated to reflect changes in market practices and legal precedent. The key components of such a protocol include:

• Clear Default Triggers The protocol should clearly define the events that constitute a default and trigger the close-out process. This eliminates ambiguity and reduces the potential for disputes over whether a close-out was justified in the first place.
• A Pre-Defined Communication Plan A structured communication plan is essential for ensuring that all required notices are sent in a timely and effective manner. The plan should specify the content of the notices, the method of delivery, and the parties who must be notified.
• Asset Valuation Procedures The protocol should outline the procedures for valuing the collateral. This may involve obtaining independent appraisals, consulting with industry experts, or using recognized market data sources. A transparent and well-documented valuation process is crucial for defending the commercial reasonableness of the close-out.
• A Decision Matrix for Method of Sale The protocol should provide a framework for selecting the most appropriate method of sale for different types of assets. This decision matrix should consider factors such as the nature of the collateral, the state of the market, and the likely pool of potential buyers.
• Record-Keeping Requirements Meticulous record-keeping is paramount. The protocol should mandate the documentation of every step in the close-out process, from the initial default notice to the final application of the sale proceeds. This documentation will be invaluable in the event of a legal challenge.

The Role of Expert Consultation

In many close-out situations, particularly those involving complex or illiquid assets, seeking expert advice is a critical strategic move. Engaging with professionals who have specialized knowledge and experience can significantly enhance the commercial reasonableness of the process. These experts may include:

• Legal Counsel Experienced legal counsel can provide invaluable guidance on the requirements of the UCC and other relevant laws. They can help to ensure that the close-out protocol is legally sound and that all actions taken are compliant with applicable regulations.
• Financial Advisors Financial advisors with expertise in distressed asset sales can assist with valuation, marketing, and the execution of the sale. Their involvement can provide a strong defense against claims that the process was not conducted in a commercially reasonable manner.
• Industry Specialists For highly specialized assets, such as intellectual property or unique pieces of equipment, consulting with industry specialists can be essential for accurately assessing value and identifying potential buyers.

The strategic engagement of these experts should be documented as part of the close-out record. This demonstrates a commitment to a professional and diligent process, which will be viewed favorably by a court in the event of a dispute.

How Does the Market Environment Impact Strategy?

The prevailing market conditions at the time of the close-out can have a significant impact on the strategic decisions that must be made. A volatile or declining market can make it more challenging to achieve a favorable price for the collateral. In such an environment, the secured party must be particularly diligent in its marketing efforts and may need to consider a wider range of disposition options. The case of The Williams Companies, Inc. v.

Energy Equity, L.P. illustrates this point. A decline in the energy market significantly impacted the value of the assets in question, leading to a dispute over whether the acquirer had used commercially reasonable efforts to complete the transaction. This case highlights the importance of being able to demonstrate that the close-out strategy was adapted to the realities of the market.

The following table outlines some strategic considerations for different market environments:

Execution

The execution of a commercially reasonable close-out is a matter of procedural precision and meticulous documentation. Every step must be taken with the understanding that it may be subject to intense scrutiny in a legal proceeding. The focus of the execution phase is to translate the strategic protocol into a series of concrete actions that are both effective and defensible.

A Step by Step Guide to a Defensible Close Out

The following is a detailed, step-by-step guide to executing a commercially reasonable close-out:

1. Verification of Default Before initiating any close-out procedures, it is essential to verify that a genuine event of default has occurred as defined in the underlying agreement. This step should be documented, including a reference to the specific contractual provision that has been breached.
2. Internal Review and Strategy Session Once a default has been verified, an internal review should be conducted to assess the situation and formulate a specific close-out strategy. This session should involve all relevant stakeholders, including risk management, legal, and the relevant business unit. The minutes of this meeting should be preserved.
3. Issuance of Formal Default Notice A formal notice of default should be sent to the debtor and all other required parties. This notice should be drafted by legal counsel and should comply with all contractual and statutory requirements. The method of delivery should be one that provides proof of receipt.
4. Repossession of Collateral If the collateral is physical, steps must be taken to repossess it in a lawful and peaceful manner. Any actions taken during the repossession process should be carefully documented.
5. Valuation of Collateral A thorough and independent valuation of the collateral should be conducted. This may involve multiple appraisals, especially for high-value or unique assets. All valuation reports and supporting data should be retained.
6. Marketing and Solicitation of Bids A comprehensive marketing plan should be implemented to solicit bids for the collateral. The specific actions taken will depend on the nature of the asset and the chosen method of sale. All marketing materials, correspondence with potential buyers, and records of bids received should be kept.
7. Execution of the Sale The sale should be conducted in a professional and transparent manner. If a public auction is held, the time, place, and all relevant terms should be publicly announced. If a private sale is conducted, the negotiations and final terms should be fully documented.
8. Application of Proceeds and Deficiency Calculation The proceeds of the sale should be applied in the manner prescribed by the UCC and the underlying agreement. A detailed accounting of the application of proceeds and the calculation of any deficiency should be prepared and sent to the debtor.

What Are the Most Common Execution Errors?

Even with a well-defined protocol, errors in execution can undermine the commercial reasonableness of a close-out. Some of the most common errors include:

• Insufficient Notice Providing notice that is too short or that lacks essential information is a frequent and often fatal flaw.
• Inadequate Marketing A failure to make a genuine effort to market the collateral to a reasonable pool of potential buyers is a red flag for courts.
• Self-Dealing Any transaction that suggests the secured party is attempting to purchase the collateral at a below-market price for its own benefit will be viewed with extreme suspicion.
• Poor Record-Keeping The inability to produce clear and contemporaneous records of the close-out process can make it very difficult to defend against a legal challenge.

Case Study Analysis of Execution Failures

The following table provides a hypothetical analysis of two close-out scenarios, one that is likely to be deemed commercially reasonable and one that is not:

This comparative analysis demonstrates how seemingly small differences in execution can have a profound impact on the legal defensibility of a close-out. The key takeaway is that a commitment to a fair and transparent process, supported by thorough documentation, is the best defense against a claim of commercial unreasonableness.

Reflection

The principles of commercial reasonableness are more than just a set of legal requirements; they are a reflection of the fundamental values of fairness and good faith that underpin our financial markets. A close-out procedure is a moment of truth, a test of an institution’s commitment to these values. As you review your own operational framework, consider not only whether your protocols are legally compliant, but also whether they are designed to achieve a just and equitable outcome, even in the most challenging of circumstances. The ultimate measure of a successful close-out is not simply the recovery of a debt, but the preservation of integrity and the reinforcement of trust in the system as a whole.