What Constitutes a “Commercially Reasonable” Procedure for Valuing a Terminated Derivative?

Concept

The abrupt termination of a derivative contract, whether through counterparty default or another trigger event, creates an immediate and critical operational challenge. The central question is no longer about the future performance of the instrument but about its present value in a state of disruption. Determining what constitutes a “commercially reasonable” procedure for valuing this terminated derivative is a function of establishing a defensible, transparent, and market-grounded process to arrive at a fair close-out amount.

This standard is a procedural backstop, a system designed to ensure fairness and predictability when the ordinary course of business has failed. Its architecture is built upon a foundation of legal precedent and market convention, primarily codified within the International Swaps and Derivatives Association (ISDA) Master Agreement.

The evolution of market standards reveals the system’s logic. The 1992 ISDA Master Agreement presented two primary valuation pathways ▴ “Market Quotation” and “Loss.” Market Quotation was a rigid, formulaic approach requiring the solicitation of quotes for a replacement transaction from a pre-defined set of “Reference Market-makers.” Its strength was its objectivity, but its rigidity became a weakness in illiquid or stressed markets where obtaining sufficient quotes was impractical. The alternative, “Loss,” was a more flexible but subjective measure, allowing the non-defaulting party to calculate its total economic damages in good faith. This flexibility often led to disputes over the methods and inputs used.

A commercially reasonable valuation is defined by the integrity of its process, not solely by the final number it produces.

Recognizing these limitations, the 2002 ISDA Master Agreement introduced a unified, more sophisticated standard known as the “Close-out Amount.” This framework represents the current institutional benchmark. It requires the calculating party to act in good faith and use commercially reasonable procedures to determine the losses or costs associated with replacing the economic equivalent of the terminated transaction. This standard explicitly allows for the inclusion of related costs, such as the expense of unwinding or re-establishing hedges and the cost of funding.

The shift from the older methodologies to the Close-out Amount reflects a fundamental understanding ▴ in complex, often illiquid OTC markets, a single, rigid valuation formula is inadequate. A robust and adaptable process, one that can accommodate different market conditions and instrument types while adhering to clear principles of fairness and transparency, is the superior architecture.

This procedure is therefore a system of ordered, logical steps designed to withstand scrutiny. It operates on the principle that if the process is sound, the outcome is defensible. The core components of this system include the consistent application of valuation methodologies, diligent documentation of every decision and data point, and the use of inputs that are verifiable and rooted in observable market practice wherever possible.

In a bankruptcy context, this procedural rigor is even more critical, as legal frameworks like the U.S. Bankruptcy Code’s Section 562 place the burden of proof on the calculating party to justify its valuation timing and methodology. Ultimately, a commercially reasonable procedure is one that a disinterested third party, such as a court or an arbitrator, can examine and find to be a logical, fair, and well-documented effort to replicate the economic reality of the terminated derivative at a specific moment in time.

Strategy

Developing a strategy for valuing a terminated derivative centers on constructing a valuation process that is both methodologically sound and procedurally defensible. The overarching goal is to arrive at a “Close-out Amount” that accurately reflects the economic reality of the non-defaulting party’s position, as prescribed by the 2002 ISDA Master Agreement. This requires a clear strategy for selecting valuation inputs, applying appropriate methodologies, and navigating the linked duties of good faith and commercial reasonableness.

A Hierarchy of Valuation Inputs

A core strategic principle is the adoption of a valuation hierarchy, similar to the framework used in financial accounting standards like IFRS 13 or ASC 820. This hierarchy prioritizes observable, market-based inputs over unobservable, model-based ones, creating a cascade of preferred data sources.

• Level 1 Inputs ▴ These are the most reliable and constitute the primary strategic objective to obtain. They are quoted prices in active markets for identical assets or liabilities. For a terminated derivative, this would be a firm, executable quote from a reputable dealer to enter into a replacement transaction that is the precise economic equivalent of the terminated one. Sourcing multiple such quotes provides the strongest possible evidence of a fair value.
• Level 2 Inputs ▴ When direct quotes for an identical transaction are unavailable, the strategy shifts to using observable inputs for similar instruments. This could involve using the price of a more liquid, standard derivative and then applying adjustments for differences in tenor, optionality, or underlying reference. It might also include using interest rate curves, volatility surfaces, or credit default swap (CDS) spreads from active markets to feed into a valuation model. The key is that the inputs themselves are sourced from the market, even if the final value is a product of a calculation.
• Level 3 Inputs ▴ This is the recourse when observable market data is scarce or non-existent, a common situation for highly structured or long-dated derivatives, or during periods of extreme market dislocation. The strategy here relies on internal valuation models, such as a Discounted Cash Flow (DCF) analysis. Using Level 3 inputs requires the highest degree of transparency and justification. Every assumption, from future cash flow projections to the discount rate applied, must be documented and defended as commercially reasonable.

Methodological Approaches to the Close out Amount

The strategy for calculating the Close-out Amount must be flexible enough to accommodate the available inputs. The 2002 ISDA framework is designed to support this flexibility, focusing on the economic outcome.

The primary method is determining the Replacement Cost. This involves actively soliciting bids from market-makers to enter into a new transaction that mirrors the material terms of the terminated one. A sound strategy involves contacting a representative sample of leading dealers in that specific market segment (e.g.

3-5 dealers) and documenting their responses, even if they decline to quote. Firm bids are superior to indicative quotes, as they represent an actual price at which a transaction could be executed.

When replacement is not feasible, a Model-Based Valuation becomes the core of the strategy. A DCF model, for instance, is often considered commercially reasonable for valuing income-producing assets like a portfolio of loans underlying a repurchase agreement. The strategy here is to ensure the model’s integrity. This means using industry-standard models, sourcing inputs from the highest available level in the valuation hierarchy, and having the model’s output independently verified by an internal risk or valuation control group.

The strategic shift from the 1992 ISDA’s rigid formulas to the 2002 ISDA’s process-oriented standard acknowledges that in derivatives valuation, the ‘how’ is as important as the ‘what’.

Comparing ISDA Valuation Methodologies

Understanding the evolution of the ISDA Master Agreement’s valuation standards clarifies the strategic intent behind the current “Close-out Amount” framework. The table below compares the key methodologies, highlighting the deliberate move towards a more flexible, process-driven approach.

What Is the Role of Good Faith?

A critical element of the strategy is understanding the interplay between “good faith” and “commercially reasonable procedures.” They are intertwined obligations. Good faith is a subjective standard, relating to the state of mind and intentions of the calculating party ▴ it is a duty to act honestly. Commercial reasonableness, conversely, is an objective standard. It assesses the actions taken against the norms and practices of participants in the relevant market.

A strategy cannot rely on good faith alone. A party could honestly believe its valuation is correct, but if the procedure used to arrive at that valuation deviates from standard market practices without justification, it would fail the commercial reasonableness test. The strategy must therefore be to ensure that every step of the process is not only performed honestly but is also aligned with what a reasonable market participant would do in similar circumstances.

Execution

The execution of a commercially reasonable valuation is a meticulous, time-sensitive operational procedure. It translates the strategic framework into a series of documented, verifiable actions. The objective is to produce a final Close-out Amount that is robust enough to withstand a potential legal or regulatory challenge. This requires a disciplined playbook, rigorous data management, and a clear understanding of how the process adapts to specific contexts like bankruptcy.

The Operational Playbook for Calculating the Close out Amount

Executing the valuation requires a step-by-step process where each stage is carefully documented. This playbook ensures consistency and creates an audit trail that serves as the primary evidence of a commercially reasonable procedure.

1. Activation and Documentation Assembly ▴ The process begins the moment an Early Termination Date is designated. The first action is to secure and assemble all relevant documentation. This includes the signed ISDA Master Agreement, the trade confirmation for the terminated transaction(s), any collateral agreements, and a complete record of all related cash flows and communications.
2. Designation of Valuation Date and Time ▴ The ISDA Master Agreement specifies that the valuation should occur as of the Early Termination Date. If market conditions (e.g. extreme illiquidity, market closure) make a valuation on this date impossible or unreliable, a subsequent date may be used. The execution of this step requires a formal, documented decision explaining why the original date was not commercially reasonable.
3. Valuation Team Mobilization ▴ A cross-functional team should be formally assigned to the task. This team typically includes personnel from the trading desk with product expertise, the risk management or valuation control group for independent oversight, and the legal department to ensure compliance with the contractual terms. For highly complex valuations, engaging an independent third-party valuation expert may be a key part of the execution.
4. Execution of Primary Valuation Sourcing Market Quotes ▴ The team’s first attempt should be to source executable quotes for a replacement transaction. This involves a formal, documented Request for Quote (RFQ) process sent to a list of 3-5 leading dealers in the relevant derivative market. The RFQ must specify the precise economic terms of the required replacement trade. All responses, including declinations to quote, must be logged with timestamps.
5. Execution of Secondary Valuation Model Based Approach ▴ If an insufficient number of firm quotes is obtained, the playbook dictates a shift to a model-based valuation. The execution requires selecting an industry-standard valuation model (e.g. a proprietary DCF model, or a standard option pricing model like Black-Scholes). The model choice itself must be justifiable and documented.
6. Input Calibration and Justification ▴ This is the most data-intensive step. Every input into the model must be sourced, documented, and justified. This includes market data like yield curves and volatility surfaces, and credit data like counterparty credit spreads. The source for each input (e.g. Bloomberg, Reuters, Markit) should be recorded. For unobservable inputs (Level 3), a detailed narrative explaining their derivation is required.
7. Calculation of Adjustments and Ancillary Costs ▴ The execution must include the calculation of all permissible adjustments under the 2002 ISDA definition of Close-out Amount. This includes:
   • Credit Valuation Adjustment (CVA) ▴ To reflect the credit risk of the counterparty.
   • Funding Valuation Adjustment (FVA) ▴ To incorporate the cost of funding the replacement trade.
   • Hedging Costs ▴ The documented costs of terminating, liquidating, or re-establishing any hedges related to the terminated derivative.
8. Independent Review and Verification ▴ The completed valuation, including all methodologies, inputs, and adjustments, must be submitted to an independent internal function for review and approval. This could be a dedicated Price Verification (IPV) team or a senior risk committee. This step provides a critical layer of internal control and objectivity.
9. Final Report Generation ▴ The final output of the execution is a comprehensive valuation report. This report serves as the definitive record of the process. It should detail the final Close-out Amount, the methodology used, a log of all quotes solicited, a complete list of all model inputs and their sources, and the sign-off from the independent review team.

Quantitative Modeling and Data Analysis

The credibility of a model-based valuation rests entirely on the quality and transparency of its data. The following tables provide examples of the granular documentation required during the execution phase.

How Should Valuation Inputs Be Documented?

The following table illustrates a sample log for the inputs used to value a hypothetical 10-year US Dollar interest rate swap that has been terminated.

Why Is a Quote Solicitation Record Important?

This record demonstrates a good-faith effort to obtain market-based prices, which is a cornerstone of a commercially reasonable process.

The following table shows a hypothetical log of attempts to get a replacement quote.

What Is the Impact of a Bankruptcy Filing?

When a counterparty enters bankruptcy, the execution of the valuation process is subject to additional legal constraints and scrutiny, primarily under the U.S. Bankruptcy Code. Section 562 establishes the timing for measuring damages from a terminated swap agreement. Damages are to be measured as of the date of termination. However, the statute provides a critical exception ▴ if there are no “commercially reasonable determinants of value” on that date, damages are measured on the first subsequent date where such determinants exist.

This provision places an immense burden of proof on the party that performed the valuation. If a debtor or trustee challenges the valuation date, the non-defaulting party must be able to prove, using evidence like the quote solicitation record, that it was impossible to obtain a reliable value on the termination date. This makes the disciplined execution of the operational playbook and the meticulous documentation of every failed attempt to get a price absolutely critical for defending the valuation in court.

Reflection

The principles and procedures discussed form a robust system for valuing a terminated derivative. The framework, built on the foundation of the ISDA Master Agreement and reinforced by legal precedent, provides a clear path for navigating a complex and high-stakes event. Yet, the existence of this framework is only the first component.

The true test of an institution’s preparedness lies in its internal operational architecture. How is this system embedded within your own firm’s protocols?

Consider the state of your own valuation playbook. Is it a theoretical document, or is it a living procedure, pressure-tested through drills and understood by all relevant personnel across trading, risk, and legal? When a termination event occurs, the response must be automatic and precise. The time for designing the system is long past; the only variable should be its execution.

Reflect on the data infrastructure that supports your valuation process. Is your ability to capture, timestamp, and archive every quote, every model input, and every internal decision sufficient to construct an unassailable audit trail? A valuation’s defense in a dispute is built not on recollection, but on records.

Ultimately, mastering the valuation of terminated derivatives is a reflection of a firm’s overall operational mastery. It demonstrates a commitment to process, a respect for transparency, and an understanding that in moments of market stress, a defensible procedure is the ultimate strategic asset. The knowledge of what constitutes a “commercially reasonable” procedure is the blueprint; the strength of your internal systems determines the integrity of the final construction.