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

Concept

The concept of a commercially reasonable procedure in a derivatives close-out is the system’s answer to a critical question that arises at a moment of maximum financial distress ▴ how do we establish a fair, objective, and defensible value for a terminated contract when a counterparty fails? This is the protocol that governs the orderly disassembly of complex financial positions, ensuring that the resolution process is grounded in verifiable market realities. It represents a fundamental architectural pillar within the International Swaps and Derivatives Association (ISDA) Master Agreement, specifically the 2002 version, designed to replace ambiguity with a structured, evidence-based methodology.

At its core, the procedure is the mechanism for calculating the “Close-out Amount”. This amount quantifies the gains or losses that a non-defaulting party incurs in replacing the economic equivalent of the terminated transaction. The mandate to use “commercially reasonable procedures” is a direct instruction to the determining party to build this calculation on a foundation of objectivity.

The process must be transparent, repeatable, and capable of withstanding intense scrutiny, including judicial review. It is the framework that prevents the close-out from becoming an arbitrary or punitive exercise, instead anchoring it to the prevailing conditions of the financial markets at the time of termination.

A commercially reasonable procedure is the mandatory, objective process for valuing a terminated derivative to ensure a fair and defensible outcome.

The design of this standard acknowledges the inherent complexities of derivatives. These are not simple assets with a single, universally agreed-upon price. Their value is a function of multiple variables, including underlying asset prices, interest rates, volatility, and time. Consequently, a commercially reasonable procedure is not a single, rigid formula.

It is a flexible yet disciplined approach that allows the determining party to use a range of relevant information to construct a valuation. This can include direct quotes from other market participants, observable market data, and even validated internal models, all governed by the overarching principle of achieving a commercially reasonable result.

What Is the Core Mandate of the Determining Party?

The determining party, which is the non-defaulting party in most scenarios, operates under a dual mandate defined by the 2002 ISDA Master Agreement ▴ to act in good faith and to use commercially reasonable procedures. These two requirements are distinct yet interconnected. Acting in good faith pertains to the party’s intent; it is a subjective standard that prohibits malicious or dishonest actions. The requirement to use commercially reasonable procedures, conversely, imposes a higher, objective standard on the process itself.

This means the methodology used to calculate the Close-out Amount must be reasonable by market standards, irrespective of the party’s intent. The procedure must be sound, logical, and aligned with how a neutral, informed market participant would approach the same valuation challenge under similar circumstances.

This objective standard is the critical innovation of the 2002 ISDA Master Agreement. It shifts the focus from what the determining party “reasonably determines” (a more subjective test under the 1992 agreement’s “Loss” definition) to a standard that can be measured and validated externally. The procedure is not about what the determining party believes to be reasonable, but what is demonstrably reasonable based on established market practices and available data. This creates a system of accountability, where the calculation is not an opinion but a conclusion derived from a defensible process.

Strategy

The strategic framework for establishing a commercially reasonable procedure revolves around a pivotal evolution in market practice, codified in the transition from the 1992 ISDA Master Agreement to the 2002 version. This shift was a direct response to the market’s need for greater clarity, objectivity, and defensibility in the close-out process. Understanding this evolution is fundamental to grasping the strategic imperatives that drive the modern approach to derivatives termination.

The 1992 Agreement offered two primary methods for calculating the termination payment ▴ “Market Quotation” and “Loss”. Market Quotation was a prescriptive method requiring the soliciting of quotes for a replacement transaction from at least three leading dealers. While it aimed for objectivity, its rigidity could be problematic in illiquid or volatile markets where obtaining such quotes was impractical.

The “Loss” method was more flexible, allowing a party to calculate its total losses and costs. This flexibility, however, came at the cost of objectivity, as it was based on what the determining party “reasonably determines in good faith,” a standard that courts interpreted as one of rationality, meaning it could only be overturned if it was a decision no reasonable party could have reached.

The strategic shift from the 1992 to the 2002 ISDA agreement elevated the close-out standard from subjective rationality to objective reasonableness.

The 2002 ISDA Master Agreement unified these concepts into a single, more sophisticated methodology ▴ the “Close-out Amount”. This new standard strategically blends the flexibility of the Loss method with a heightened, objective standard of commercial reasonableness. The core strategy is to create a robust, evidence-based valuation that is fair and can be validated by a third party, such as a court or an arbitrator.

The Shift from Rationality to Objective Reasonableness

The most significant strategic change introduced by the 2002 ISDA framework is the elevation of the standard of conduct from rationality to objective reasonableness. This is a profound architectural change with direct implications for how a determining party must behave. A rational decision simply has to be logical and not perverse; an objectively reasonable decision must align with an external, measurable standard of market practice.

This strategic shift is best understood by comparing the valuation methodologies side-by-side.

Information Sourcing and the Hierarchy of Evidence

A core part of the strategy is the intelligent use of information. The 2002 ISDA Agreement provides a non-exhaustive list of information sources that can be used to calculate the Close-out Amount, creating a flexible hierarchy of evidence. The determining party is expected to use the best available information to produce a commercially reasonable result.

• Third-Party Quotations ▴ These are quotes for replacement transactions from other market participants. The 2002 ISDA is more flexible than the old Market Quotation method; it does not require a minimum number of quotes, and they can be indicative. A single quote may be sufficient if relying on it is commercially reasonable.
• Relevant Market Data ▴ This includes observable, third-party data such as interest rate curves, foreign exchange rates, commodity prices, and volatility surfaces. Using such data allows for a valuation grounded in transparent market indicators.
• Internal Sources ▴ A party can use its own internal models and data to perform the valuation. This is permissible only if these sources are of the same type used by the party in the regular course of its business for valuing similar transactions. This provision adds practicality but comes with a critical check ▴ the internal methodology must be consistent and not created ad-hoc for the close-out.

The strategy dictates that a determining party should prioritize external, objective data where available. It may only disregard such information if it reasonably believes in good faith that the data is not readily available or would produce a result that is not commercially reasonable. This creates a clear preference for market-facing evidence over internal calculations, reinforcing the principle of objectivity.

Execution

Executing a derivatives close-out under the “commercially reasonable” standard is a meticulous process that demands procedural discipline, rigorous documentation, and a clear-headed approach to data analysis. The objective is to construct a valuation that is not only accurate but also fully defensible. The execution phase translates the strategic principles of objectivity and fairness into a series of concrete, auditable actions.

The first step in the execution is to establish a clear timeline. The Close-out Amount should be determined as of the Early Termination Date. However, the ISDA framework provides a crucial exception ▴ if determining the value on that specific date is not commercially reasonable ▴ perhaps due to extreme market dislocation or illiquidity ▴ the valuation can be performed on the next commercially reasonable day or days. This decision to delay must itself be reasonable and well-documented, as it is a key procedural choice that could be scrutinized later.

How Should a Firm Document the Close out Process?

Documentation is the bedrock of a defensible close-out. Every step taken, every piece of data considered, and every decision made must be recorded. This creates a clear audit trail that demonstrates the commercial reasonableness of the procedure. A failure in documentation can undermine an otherwise sound valuation.

1. Record the Rationale ▴ Document the overarching methodology chosen for the valuation. If a combination of methods is used (e.g. blending an indicative quote with market data), the logic for this approach must be explained.
2. Log All Communications ▴ Keep detailed records of all attempts to obtain quotes from third parties, including who was contacted, when they were contacted, and the content of their responses (or lack thereof). This is evidence of a diligent effort to survey the market.
3. Archive Market Data ▴ Save all market data used in the calculation. This includes screenshots of pricing screens, downloaded data for yield curves, and any other quantitative inputs. The data should be timestamped to the exact time of the valuation.
4. Detail Internal Model Inputs ▴ If internal models are used, the inputs, assumptions, and the model version must be documented. It is also wise to include evidence that the model is used for similar valuations in the normal course of business, as required by the ISDA protocol.

A Framework for Assembling the Close out Amount

The practical assembly of the Close-out Amount involves gathering and synthesizing information from various sources. The determining party must demonstrate that it has considered relevant information and has not “cherry-picked” data to arrive at a self-serving result. The following table illustrates how different pieces of information might be gathered and assessed in a hypothetical interest rate swap close-out.

Based on this assembled evidence, the determining party could confidently calculate a final Close-out Amount. For instance, it might primarily rely on the firm quote from Bank A and adjust for the hedging costs, resulting in a net amount of -$5,150,000. The other data points serve as crucial evidence that this result is commercially reasonable. This multi-faceted approach, drawing from different but corroborating sources, is the hallmark of a robust and defensible execution.

Reflection

The framework of commercial reasonableness is more than a legal defense; it is a reflection of a firm’s operational discipline and market intelligence. The principles embedded within the ISDA protocol offer a blueprint for managing counterparty risk in a systematic and defensible manner. The true test of this system lies not in its application during a crisis, but in the preparatory work done beforehand. How robust are your internal valuation models?

Are your data archiving and documentation processes sufficient to withstand scrutiny? Answering these questions proactively is what separates firms that are merely compliant from those that possess a true structural advantage in navigating market instability.