What Constitutes a Commercially Reasonable Procedure in a Close-Out Scenario?

Concept

A commercially reasonable procedure in a close-out scenario represents the operationalization of fairness and objectivity in the face of counterparty default. It is a system designed to produce a valuation that reflects the economic reality of the terminated transactions at a specific moment in time. The International Swaps and Derivatives Association (ISDA) Master Agreement, particularly the 2002 version, provides the foundational architecture for this process.

The core of this architecture is the principle of objective reasonableness, a departure from the more subjective standards of earlier agreements. This principle dictates that the process of determining the final settlement amount, the Close-out Amount, must be transparent, defensible, and grounded in verifiable market data.

The system is designed to prevent the non-defaulting party from taking advantage of the situation by imposing a punitive valuation. Instead, the focus is on achieving a result that is fair and equitable to both parties, even in an adversarial context. This is achieved through a set of prescribed, yet flexible, procedures that guide the non-defaulting party in their calculation.

The procedures allow for the use of a variety of inputs, including quotations from third-party dealers, relevant market data, and even internal valuations, provided they are used in the regular course of business. The key is that the chosen methodology must be commercially reasonable and applied in good faith to produce a commercially reasonable result.

The transition from a ‘rationality’ standard to an ‘objective reasonableness’ standard in the 2002 ISDA Master Agreement marked a significant evolution in the architecture of derivatives close-outs.

What Is the Core Principle of Commercial Reasonableness?

The core principle of commercial reasonableness is the application of objective standards to a subjective process. It is about creating a framework that can be independently verified and assessed against prevailing market conditions. This principle is a cornerstone of the 2002 ISDA Master Agreement and has been reinforced by numerous court decisions.

The courts have consistently held that the process of determining the Close-out Amount is not a matter of discretion for the non-defaulting party. It is a matter of applying a set of objective criteria to the available information to arrive at a fair and accurate valuation.

This principle has significant implications for the non-defaulting party. It means that they must be able to demonstrate that their chosen methodology was reasonable and that they followed it in a consistent and transparent manner. This requires a robust internal process for managing close-outs, including clear documentation of all steps taken and the rationale for all decisions made. The non-defaulting party must be prepared to defend their calculation in court, if necessary, and to provide evidence that their actions were consistent with the principle of commercial reasonableness.

The Role of Good Faith

Good faith is an essential element of the commercially reasonable procedure. It is the thread that runs through the entire process, from the selection of the valuation methodology to the final calculation of the Close-out Amount. The non-defaulting party must act honestly and fairly in all their dealings with the defaulting party. This means that they must not seek to take advantage of the situation by manipulating the valuation process or by withholding relevant information.

The requirement of good faith is a subjective one, but it is assessed in the context of the objective standard of commercial reasonableness. This means that a court will look at the actions of the non-defaulting party and ask whether a reasonable person in their position would have acted in the same way.

• Transparency in the selection of valuation inputs is a key indicator of good faith. The non-defaulting party should be able to explain why they chose to use certain data points and not others.
• Consistency in the application of the chosen methodology is also important. The non-defaulting party should not change their approach mid-way through the process without a valid reason.
• Documentation of the entire process is critical. The non-defaulting party should maintain a detailed record of all their actions, including all communications with third parties and all internal deliberations.

How Does the ISDA Master Agreement Define the Process?

The ISDA Master Agreement provides a detailed framework for the close-out process. The 2002 version of the agreement introduced the concept of the “Close-out Amount,” which replaced the earlier “Market Quotation” and “Loss” methods. The Close-out Amount is a single, all-encompassing figure that represents the net value of all terminated transactions.

The agreement sets out a non-exhaustive list of factors that the non-defaulting party may consider when calculating the Close-out Amount. These factors include:

1. Quotations for replacement transactions from third-party dealers.
2. Relevant market data, such as interest rates, foreign exchange rates, and commodity prices.
3. Information from internal sources, provided it is used in the regular course of business for valuing similar transactions.

The agreement also gives the non-defaulting party the flexibility to use a combination of these inputs, or even to use a single input, as long as the chosen approach is commercially reasonable. This flexibility is important, as it allows the non-defaulting party to tailor their approach to the specific circumstances of the case. For example, in a highly liquid market, it may be appropriate to rely heavily on third-party quotations. In a less liquid market, it may be necessary to use a wider range of inputs, including internal valuations.

Strategy

A robust strategy for managing derivatives close-outs is an essential component of any institution’s risk management framework. The goal of this strategy should be to ensure that the close-out process is conducted in a manner that is both commercially reasonable and consistent with the institution’s overall risk appetite. This requires a deep understanding of the legal and regulatory landscape, as well as a clear-eyed assessment of the institution’s own operational capabilities. A well-defined strategy will not only help to minimize the financial and reputational risks associated with a close-out, but it can also provide a competitive advantage by enabling the institution to act quickly and decisively in a crisis.

The starting point for any close-out strategy should be the ISDA Master Agreement. The agreement provides the legal framework for the close-out process, and it is essential that the institution’s strategy is fully compliant with its provisions. This means that the strategy must be based on the principle of commercial reasonableness, and it must be designed to produce a result that is fair and equitable to both parties. The strategy should also be flexible enough to adapt to the specific circumstances of each case, as the most appropriate course of action will vary depending on the nature of the terminated transactions and the prevailing market conditions.

A proactive and well-documented close-out strategy is a critical defense against legal challenges and regulatory scrutiny.

Developing a Defensible Close out Strategy

A defensible close-out strategy is one that is based on a clear and consistent methodology, and that is supported by robust documentation. The strategy should be designed to withstand legal and regulatory scrutiny, and it should be able to demonstrate that the institution has acted in a commercially reasonable manner at all times. The key elements of a defensible close-out strategy include:

• A clear and consistent methodology for calculating the Close-out Amount. This methodology should be based on the principles set out in the ISDA Master Agreement, and it should be applied consistently across all close-outs.
• Robust documentation of the entire close-out process. This documentation should include a detailed record of all steps taken, the rationale for all decisions made, and all supporting evidence.
• Independent validation of the close-out calculation. This validation should be performed by a qualified third party, such as an accounting firm or a specialist valuation provider.

By implementing a defensible close-out strategy, an institution can significantly reduce the risk of a successful legal challenge. It can also help to protect the institution’s reputation by demonstrating that it has acted in a fair and transparent manner.

Table Comparing 1992 and 2002 ISDA Master Agreements

The following table provides a high-level comparison of the close-out provisions in the 1992 and 2002 ISDA Master Agreements:

What Are the Strategic Considerations for a Non Defaulting Party?

The non-defaulting party in a close-out scenario faces a number of strategic considerations. The most important of these is the need to balance the desire to maximize recovery with the obligation to act in a commercially reasonable manner. The non-defaulting party must also be mindful of the potential for legal and regulatory challenges, and must take steps to mitigate these risks. Some of the key strategic considerations for a non-defaulting party include:

1. Timing of the Early Termination Date. The non-defaulting party has a 20-day window in which to designate the Early Termination Date. The timing of this designation can have a significant impact on the Close-out Amount, and the non-defaulting party should carefully consider all relevant factors before making a decision.
2. Selection of the valuation methodology. The non-defaulting party has a great deal of flexibility in selecting the valuation methodology. They should choose a methodology that is appropriate for the specific circumstances of the case, and that is likely to produce a result that is both commercially reasonable and defensible.
3. Management of the valuation process. The non-defaulting party is responsible for managing the valuation process. This includes obtaining quotations from third-party dealers, gathering relevant market data, and performing any necessary internal calculations. The non-defaulting party should ensure that the process is conducted in a fair and transparent manner.

Execution

The execution of a commercially reasonable close-out procedure is a complex and demanding process. It requires a high degree of technical expertise, as well as a deep understanding of the legal and regulatory framework. The non-defaulting party must be able to navigate a series of procedural steps, from the designation of the Early Termination Date to the final calculation of the Close-out Amount. Each of these steps must be executed with precision and care, as any misstep could jeopardize the entire process and expose the institution to significant financial and reputational risk.

The key to successful execution is a combination of preparation, process, and people. The institution must have a well-defined close-out plan in place before a default occurs. This plan should set out the roles and responsibilities of all key personnel, and it should provide a detailed roadmap for the entire process.

The institution must also have a robust set of internal controls to ensure that the process is conducted in a fair and transparent manner. Finally, the institution must have a team of experienced professionals who are capable of executing the plan effectively and efficiently.

A meticulously executed close-out process, supported by comprehensive documentation, is the ultimate expression of commercial reasonableness.

A Step by Step Guide to a Commercially Reasonable Close Out

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

1. Designate the Early Termination Date. The first step in the close-out process is to designate the Early Termination Date. The non-defaulting party has a 20-day window in which to do this. The timing of this designation is a critical strategic decision, and the non-defaulting party should carefully consider all relevant factors before making a choice.
2. Select the valuation methodology. The next step is to select the valuation methodology. The non-defaulting party has a great deal of flexibility in this regard, but the chosen methodology must be commercially reasonable. The non-defaulting party should document the rationale for their choice of methodology.
3. Gather valuation inputs. Once the valuation methodology has been selected, the non-defaulting party must gather the necessary valuation inputs. This may include obtaining quotations from third-party dealers, gathering relevant market data, and performing internal calculations.
4. Calculate the Close-out Amount. The next step is to calculate the Close-out Amount. This calculation should be performed in accordance with the chosen valuation methodology, and it should be supported by robust documentation.
5. Deliver the close-out statement. The final step is to deliver the close-out statement to the defaulting party. This statement should set out the Close-out Amount and provide a detailed breakdown of how it was calculated.

What Data Should Be Collected for a Defensible Valuation?

The following table provides a non-exhaustive list of the types of data that should be collected for a defensible valuation:

How Can a Non Defaulting Party Ensure Procedural Fairness?

A non-defaulting party can ensure procedural fairness by adhering to a set of core principles throughout the close-out process. These principles are designed to promote transparency, consistency, and objectivity, and they are essential for demonstrating that the institution has acted in a commercially reasonable manner. Some of the key principles of procedural fairness include:

• Independence. The valuation process should be conducted by a team that is independent of the trading desk that originated the terminated transactions. This will help to avoid any potential conflicts of interest.
• Objectivity. The valuation should be based on objective criteria, such as third-party quotations and market data. The non-defaulting party should avoid relying on subjective judgments or assumptions.
• Transparency. The entire valuation process should be transparent and well-documented. The non-defaulting party should be prepared to share all relevant information with the defaulting party and with any regulators or courts that may be involved.

Reflection

The architecture of a commercially reasonable close-out procedure is a testament to the financial system’s capacity for self-regulation and its commitment to fairness, even under duress. It is a system designed to bring order to chaos, to replace subjectivity with objectivity, and to ensure that the resolution of a default is a process of valuation, not of retribution. As you reflect on the principles and procedures outlined here, consider your own institution’s readiness to navigate this complex terrain. Is your close-out strategy a living document, one that is regularly reviewed and updated to reflect changes in the market and in the law?

Is your team equipped with the knowledge and the tools to execute this strategy effectively? The answers to these questions will determine your ability to protect your institution’s interests and to uphold the integrity of the financial system as a whole.

How Can We Improve Our Internal Close out Procedures?

Continuous improvement of internal close-out procedures is a hallmark of a mature and resilient financial institution. This process begins with a critical self-assessment of your existing framework. Are there any single points of failure in your current process? Are your documentation standards sufficiently robust to withstand legal scrutiny?

By asking these questions, and by stress-testing your procedures against a range of hypothetical scenarios, you can identify areas for improvement and take proactive steps to strengthen your defenses. This might involve investing in new technologies, providing additional training for your staff, or engaging external experts to review your processes. The goal is to create a close-out procedure that is not only compliant with the letter of the law, but that also embodies its spirit of commercial reasonableness.