What Constitutes a Commercially Reasonable Procedure for Calculating a Close-Out Amount?

Concept

The calculation of a close-out amount is the definitive financial procedure that crystallizes the economic value of terminated derivatives contracts following a default or other termination event. It represents a system designed to replace the future cash flows and economic equivalents of a transaction portfolio, thereby reducing a complex web of future obligations to a single, net present value payment. The core of this mechanism is the principle of commercial reasonableness, an objective standard that governs the entire process.

This standard requires the calculating party, known as the Determining Party, to employ procedures that are verifiable, grounded in prevailing market conditions, and systematically designed to produce a result that is fair and defensible. The procedure is an exercise in financial reconstruction, demanding a methodical approach to valuation that reflects the true economic cost of replacing the terminated trades at a specific moment in time.

At its heart, the process is governed by the International Swaps and Derivatives Association (ISDA) Master Agreement, which provides the contractual architecture for the over-the-counter derivatives market. The 2002 ISDA Master Agreement, in particular, established a significant shift in the standard required for this calculation. It moved the benchmark from a subjective test of rationality to a higher, objective standard of commercial reasonableness. This evolution reflects a systemic push towards greater transparency and discipline in the close-out process.

The Determining Party is obligated not only to act in good faith but to use procedures that are demonstrably reasonable and to arrive at a result that is also, in itself, commercially reasonable. This dual requirement of procedural and substantive reasonableness forms the bedrock of the modern close-out calculation.

A commercially reasonable procedure for a close-out amount is an objective, evidence-based valuation method used to determine the economic equivalent of terminated derivatives contracts.

The Architecture of Commercial Reasonableness

The architecture of a commercially reasonable procedure is built on several foundational pillars. The primary objective is to determine the amount of losses or costs that would be incurred, or gains that would be realized, in replacing the material terms and economic benefits of the terminated transactions. This involves a comprehensive assessment of all aspects of the trades, including future payment obligations, delivery requirements, and any embedded optionality.

The calculation must be performed as of the designated Early Termination Date, unless doing so is not commercially reasonable, in which case the valuation is performed as soon as practicable thereafter. This temporal element is critical, as market conditions can shift rapidly, and the valuation must be anchored to a specific, contractually defined point in time.

To achieve this, the Determining Party is permitted to use a variety of inputs and methodologies. These can include, but are not limited to:

• Market Data Sourcing and applying relevant market data, such as interest rates, foreign exchange rates, commodity prices, and volatility surfaces, from recognized and reliable sources.
• Replacement Quotes Obtaining firm or indicative quotations from third-party dealers for a replacement transaction that mirrors the economic profile of the terminated trade. This is a common and highly defensible method.
• Internal Models Utilizing internal, proprietary valuation models, provided these models are consistent with industry practice, are regularly validated, and use verifiable market inputs.
• Hedging Costs Considering the costs or gains associated with terminating, liquidating, or re-establishing any hedges related to the terminated transactions. This ensures that the full economic impact on the Determining Party’s portfolio is captured.

The selection and application of these inputs must be done in a manner that is systematic and defensible. A procedure is unlikely to be deemed commercially reasonable if it selectively uses inputs that benefit the calculating party or ignores readily available information that would lead to a more accurate valuation. The entire process is subject to scrutiny and potential challenge, making robust documentation and methodological consistency paramount.

What Is the Objective Standard in Practice?

The objective standard of commercial reasonableness means that the actions of the Determining Party are measured against the hypothetical actions of a reasonable market participant in the same circumstances. A court reviewing a close-out calculation will assess whether the procedures used were objectively fair and appropriate, independent of the Determining Party’s subjective beliefs. This differs significantly from the earlier “rationality” standard under the 1992 ISDA Master Agreement, which only required that the calculation not be so unreasonable that no rational party could have arrived at it.

In practice, this means a Determining Party must be prepared to justify its methodology. For instance, if it relies on a single replacement quote, it may need to demonstrate why seeking additional quotes was not commercially reasonable. If it deviates from using observable market data, it must have a sound basis for doing so, such as market illiquidity or dislocation. The ability to produce a detailed record of the data sourced, the models used, and the rationale for the chosen methodology is a core component of executing a commercially reasonable procedure.

Strategy

The strategic framework for calculating a close-out amount under the 2002 ISDA Master Agreement is a disciplined, multi-layered process designed to ensure fairness and objectivity. The overarching strategy is to construct a valuation that is resistant to challenge by adhering to a clear hierarchy of valuation inputs and maintaining meticulous records. This approach mitigates legal and financial risk for the Determining Party. The strategy is predicated on the understanding that the calculation is not a punitive measure but a contractual mechanism to restore the non-defaulting party to the economic position it would have occupied had the transactions not been terminated.

A central strategic decision is the choice of valuation methodology. While the 2002 ISDA Master Agreement provides flexibility, the most defensible strategies prioritize observable, external market inputs over internal, model-based calculations. The gold standard is often considered to be the cost of entering into a replacement transaction with a third-party dealer. This method provides a clear, auditable, and market-based measure of the terminated transaction’s value.

Where a direct replacement is not possible due to market illiquidity or the bespoke nature of the trade, a strategy might involve decomposing the transaction into its constituent parts and valuing them using observable market data. The key is to build a valuation from the ground up using the most reliable information available.

Evolving Standards from 1992 to 2002 ISDA

Understanding the strategic shift from the 1992 ISDA Master Agreement to the 2002 version is fundamental. The 1992 Agreement used the concepts of “Market Quotation” and “Loss,” with Loss being the more commonly applied measure. The “Loss” standard required a party to reasonably determine its total losses and costs in good faith.

Courts interpreted this as a test of rationality, affording the Determining Party significant discretion. The 2002 Agreement replaced these concepts with the single “Close-out Amount” and its explicit requirement for “commercially reasonable procedures” to produce a “commercially reasonable result.” This change imposes a much higher burden on the Determining Party.

The strategic implications of this are profound. Under the 2002 framework, a party must actively demonstrate the reasonableness of its actions. It cannot simply assert a loss; it must show its work. This has led to the adoption of more rigorous internal governance procedures around close-outs, including multi-level sign-offs, independent valuation checks, and comprehensive record-keeping policies.

The strategic imperative is to create a transparent and methodologically sound valuation that aligns with objective market realities, thereby minimizing dispute risk.

The following table contrasts the strategic approaches dictated by the two agreements:

How Does a Firm Build a Defensible Calculation Strategy?

A defensible strategy involves a pre-defined and consistently applied internal policy for handling termination events. This policy should outline the hierarchy of valuation methods to be used. A typical hierarchy would be:

1. Obtain Replacement Quotes The first step should always be to attempt to obtain firm, executable quotes for a replacement transaction from several independent, reputable dealers in the relevant market. The number of quotes sought (e.g. three to five) should be sufficient to establish a fair market price.
2. Use Observable Market Data If replacement quotes are unavailable, the next step is to value the transaction using a model that is predominantly fed by observable, third-party market data. This includes interest rate curves, FX spot and forward rates, and liquid volatility surfaces.
3. Rely on Internal Models with Verifiable Inputs For highly illiquid or bespoke transactions where direct market data is sparse, the use of sophisticated internal models may be necessary. To be considered commercially reasonable, these models must be well-documented, theoretically sound, and calibrated to the extent possible with any available market information. The unobservable inputs should be carefully justified.
4. Document Everything Regardless of the method used, every step of the process must be documented. This includes who was contacted for quotes, the quotes received, the sources of all market data, the model methodologies and assumptions, and the rationale for any judgments made. This documentation is the primary defense in any subsequent dispute.

Execution

The execution of a commercially reasonable close-out calculation is a precise operational procedure. It translates the strategic framework into a series of concrete, auditable actions. The execution phase begins the moment an Early Termination Date is designated and requires a dedicated team, often comprising personnel from trading, risk management, and legal departments, to work in concert.

The primary objective during execution is to generate a valuation that is not only accurate but can also be fully substantiated with a clear evidence trail. This requires a systematic approach to data gathering, valuation, and communication.

A critical component of execution is the establishment of a clear timeline. The 2002 ISDA Master Agreement requires the calculation to be performed as of the Early Termination Date, or as soon as commercially reasonable thereafter. In practice, this means the valuation team must act swiftly to capture market data and obtain quotes that are relevant to that specific date.

Delays can call the reasonableness of the procedure into question, especially in volatile markets. Therefore, a pre-established “close-out playbook” that assigns roles and responsibilities is an invaluable tool for efficient execution.

A Procedural Playbook for Calculating the Close-Out Amount

Executing the calculation requires a step-by-step process. The following playbook outlines a robust procedure consistent with the objective standard of commercial reasonableness under the 2002 ISDA Master Agreement.

1. Transaction Identification and Grouping Immediately identify all transactions governed by the relevant ISDA Master Agreement that are subject to termination. The Determining Party has the discretion to calculate a single Close-out Amount for the entire portfolio or for groups of related transactions. Grouping transactions (e.g. all interest rate swaps in a particular currency) can be a reasonable procedure if it facilitates a more accurate or efficient valuation.
2. Market Data Snapshot Capture a comprehensive snapshot of all relevant market data as of the close of business on the Early Termination Date. This should be sourced from multiple, independent, and reputable providers (e.g. Bloomberg, Reuters). The data set should be archived and timestamped.
3. Initiate Quotation Process The valuation team should formally request quotes for replacement transactions from a pre-approved list of market makers. The request should specify the precise economic terms of the terminated transactions. All communications, both verbal and written, must be logged.
4. Valuation and Synthesis As quotes are received, they must be analyzed for consistency and reasonableness. If a replacement transaction is executed, its cost provides a very strong basis for the Close-out Amount. If quotes are used as the basis, the Determining Party might, for instance, use the arithmetic mean of the quotes received. If a model-based approach is used, the model must be run using the captured market data.
5. Inclusion of Hedging Costs and Gains The team must perform a parallel analysis to identify, quantify, and document any costs incurred or gains realized from unwinding or re-establishing hedges directly related to the terminated transactions. This requires clear attribution of hedges to the specific transactions being closed out.
6. Final Calculation and Review The valuation from the primary method (quotes or model) is combined with the hedging costs/gains to arrive at the final Close-out Amount. This calculation must be reviewed and signed off by senior management outside of the initial calculation team to provide an independent check.
7. Preparation of the Section 6(d) Statement A formal statement detailing the Close-out Amount, along with any Unpaid Amounts, is prepared and delivered to the counterparty. While the underlying calculations do not have to be provided at this stage, they must be maintained and ready for disclosure should a dispute arise.

The execution of a close-out calculation is an operational discipline focused on creating a verifiable and methodologically sound valuation dossier.

Hypothetical Close-Out Calculation an Example

To illustrate the execution process, consider the close-out of a 5-year USD Interest Rate Swap where the Determining Party was receiving a fixed rate of 2.50% and paying floating SOFR on a notional principal of $100 million. The Early Termination Date is set for August 3, 2025.

The following table demonstrates a simplified execution dossier for this close-out:

This detailed, evidence-based approach demonstrates a commercially reasonable procedure. It relies on objective, external data (dealer quotes), uses a clear and simple methodology (averaging), incorporates associated costs (hedge unwind), and creates a clear audit trail. This level of diligence is the hallmark of a properly executed close-out calculation and provides the strongest possible position should the valuation be challenged.

Reflection

Calibrating Your Internal Systems

The principles of commercial reasonableness extend beyond a single calculation. They offer a lens through which to examine your entire operational framework for counterparty risk management. The rigor demanded by the ISDA close-out process should be reflected in all adjacent systems. How does your firm’s collateral management protocol align with this standard of objectivity?

Are your valuation dispute resolution mechanisms designed with the same level of procedural clarity? The integrity of a close-out calculation is a direct reflection of the integrity of the systems that produce it. Viewing this process as a systemic capability, rather than a standalone task, is the first step toward building a truly resilient operational architecture.