What Constitutes a Commercially Reasonable Procedure under the 2002 ISDA?

Concept

The 2002 ISDA Master Agreement represents a significant evolution in the architecture of derivatives documentation, particularly in its treatment of default and early termination. A central element of this evolution is the introduction of the “Close-out Amount” as the methodology for calculating the final payment between parties when a transaction is terminated prematurely. This mechanism is underpinned by a critical standard of conduct ▴ the obligation of the determining party to use “commercially reasonable procedures in order to produce a commercially reasonable result.” This standard is the bedrock upon which the integrity of the close-out process rests, and understanding its implications is fundamental for any party to an ISDA Master Agreement.

The shift from the 1992 ISDA Master Agreement’s “Loss” and “Market Quotation” methodologies to the 2002 Agreement’s “Close-out Amount” was a deliberate one, born out of the market’s experiences with contentious defaults and the desire for a more objective and transparent process. The 1992 Agreement’s standards were often perceived as being too subjective, potentially allowing the non-defaulting party a wide degree of discretion that could be difficult to challenge. The 2002 Agreement sought to rectify this by introducing a more rigorous, two-pronged test ▴ the procedures employed must be commercially reasonable, and the outcome of those procedures must also be commercially reasonable. This dual requirement ensures that the process is sound and the result is fair, as judged by an objective standard.

The 2002 ISDA Master Agreement establishes a higher, objective standard for close-out calculations, demanding both commercially reasonable procedures and a commercially reasonable result.

The concept of “commercially reasonable” is a deliberate move away from a mere test of rationality or good faith. It is an objective standard, meaning that the actions of the determining party are to be judged against what a reasonable market participant would do in similar circumstances. This has profound implications for the non-defaulting party, who is tasked with the calculation.

It is not enough to simply act honestly; the party must be able to demonstrate that its process was sound and that the resulting valuation is one that can be justified by reference to prevailing market conditions and practices. This objectivity provides a greater degree of protection for the defaulting party, who can be assured that the close-out amount will not be an arbitrary or punitive figure.

The introduction of this standard also reflects a deeper understanding of the complexities of modern financial markets. The 2002 Agreement recognizes that a single, rigid methodology for calculating close-out amounts is often impractical. Markets can be illiquid, replacement transactions may not be readily available, and different types of transactions may require different valuation approaches.

By focusing on the reasonableness of the procedures and the result, the ISDA drafters provided a flexible yet robust framework that can be adapted to a wide range of circumstances. This flexibility, however, comes with the responsibility of the determining party to exercise its discretion in a manner that is both diligent and defensible.

What Does Commercially Reasonable Mean in Practice?

In practical terms, a commercially reasonable procedure is one that a prudent and experienced market participant would employ to ascertain the value of a terminated transaction. This could involve a variety of actions, such as seeking quotes from dealers, consulting independent valuation services, or using internal pricing models that are regularly tested and used in the ordinary course of business. The key is that the chosen method must be appropriate for the specific transaction and the prevailing market conditions.

For example, in a highly liquid market for a standard interest rate swap, obtaining a series of quotes from reputable dealers would likely be considered a commercially reasonable procedure. In contrast, for a more exotic or illiquid derivative, a more bespoke valuation methodology might be required, and the determining party would need to be able to justify its choice of that methodology.

The requirement for a commercially reasonable result adds another layer of scrutiny. Even if the procedure followed is sound, the final close-out amount must also be defensible. This means that the valuation must be within a range that would be considered reasonable by the market.

A result that is a significant outlier from the prevailing market consensus would likely be challenged, even if the procedure used to arrive at it was ostensibly reasonable. This dual requirement of reasonable procedure and reasonable result creates a powerful incentive for the determining party to act with care and diligence, as a failure to meet either standard could result in the close-out amount being successfully challenged in court.

The Evolution from the 1992 ISDA Master Agreement

The distinction between the 1992 and 2002 ISDA Master Agreements is crucial for understanding the significance of the “commercially reasonable” standard. The 1992 Agreement offered two primary methods for calculating the close-out amount ▴ “Loss” and “Market Quotation.” The “Loss” method allowed the non-defaulting party to determine its total losses and costs in good faith, a standard that was largely subjective. The “Market Quotation” method, while more objective, was often criticized for its rigidity, requiring quotes from four leading dealers for a replacement transaction. This could be impractical in illiquid markets or for complex transactions.

The 2002 Agreement’s “Close-out Amount” replaces both of these with a single, more flexible standard. The determining party is no longer bound by the rigid requirements of the “Market Quotation” method, but it is also held to a higher standard than the subjective “good faith” of the “Loss” method. The shift to an objective standard of commercial reasonableness represents a significant step forward in the evolution of derivatives documentation, providing a more balanced and equitable framework for the close-out process. This evolution reflects the maturation of the derivatives market and the recognition that a more sophisticated and nuanced approach is needed to address the complexities of modern financial instruments.

Strategy

The strategic framework for determining a Close-out Amount under the 2002 ISDA Master Agreement is a multi-faceted process that requires a deep understanding of the legal standard, the specific transaction at issue, and the prevailing market conditions. The non-defaulting party, as the determining party, must navigate a complex landscape of choices, each with its own set of risks and rewards. The overarching goal is to arrive at a valuation that is not only accurate but also defensible, as a poorly executed close-out process can lead to protracted legal disputes and significant financial losses.

A core element of the strategy is the selection of the valuation methodology. The 2002 Agreement provides a non-exhaustive list of information that can be used, including quotes from third parties, relevant market data, and information from internal sources. The determining party has the discretion to choose the most appropriate method, but this discretion must be exercised in a commercially reasonable manner. This means that the choice of methodology must be justifiable in the context of the specific transaction and the market environment.

For example, relying solely on internal models for a highly liquid, standardized product for which external quotes are readily available could be seen as commercially unreasonable. Conversely, for a bespoke, illiquid derivative, internal models may be the only reliable source of valuation, and their use would likely be considered reasonable, provided the models are sound and used in the ordinary course of business.

The strategic selection of a valuation methodology under the 2002 ISDA Master Agreement must be a justifiable and commercially reasonable choice, tailored to the specific transaction and market conditions.

The timing of the valuation is another critical strategic consideration. The 2002 Agreement specifies that the Close-out Amount should be determined as of the Early Termination Date, or if that is not commercially reasonable, as soon as practicable thereafter. This provides the determining party with a degree of flexibility, which can be particularly important in times of market stress. For example, in the immediate aftermath of a major credit event, markets may be dislocated and illiquid, making it difficult to obtain reliable valuations.

In such a scenario, a determining party might reasonably decide to wait a short period for markets to stabilize before calculating the Close-out Amount. However, any such delay must be justifiable, and the determining party must be prepared to explain why a valuation on the Early Termination Date would not have been commercially reasonable.

How to Select a Valuation Methodology?

The selection of a valuation methodology is a critical decision that should be guided by a careful assessment of the specific circumstances. The following table outlines some of the key factors to consider when choosing a valuation approach:

The choice of methodology is not an either/or proposition. In many cases, a combination of approaches will be the most commercially reasonable. For example, a determining party might use its internal models to generate an initial valuation and then seek to corroborate that valuation with indicative quotes from dealers. This multi-pronged approach can provide a more robust and defensible valuation, particularly for complex or illiquid transactions.

The Role of Good Faith

While the 2002 ISDA Master Agreement imposes an objective standard of commercial reasonableness, the duty to act in good faith remains a fundamental obligation of the determining party. This means that the determining party must act honestly and fairly, and must not seek to take advantage of its position to the detriment of the defaulting party. The duty of good faith is a separate and distinct obligation from the duty to act in a commercially reasonable manner. A determining party could, in theory, follow a commercially reasonable procedure but still be found to have acted in bad faith if its motives were improper.

In practice, the two obligations are closely intertwined. A procedure that is not commercially reasonable is unlikely to be considered to have been undertaken in good faith. Conversely, a party that is acting in good faith is more likely to adopt a procedure that is commercially reasonable. The key takeaway for the determining party is that it must be guided by a genuine desire to arrive at a fair and accurate valuation, and must not be influenced by any ulterior motives, such as a desire to punish the defaulting party or to generate a windfall profit.

• Documentation ▴ The determining party should maintain a detailed record of the steps it took to calculate the Close-out Amount. This should include a record of all quotes sought and received, the details of any models used, and the rationale for any judgments made.
• Consistency ▴ The determining party should be consistent in its approach to calculating Close-out Amounts. A party that uses different methodologies for different counterparties in similar circumstances may have difficulty justifying its approach.
• Transparency ▴ While there is no general obligation to disclose the details of the calculation to the defaulting party, a willingness to provide a reasonable level of transparency can help to avoid disputes.

Execution

The execution of a close-out under the 2002 ISDA Master Agreement is a process that demands precision, diligence, and a keen awareness of the legal and commercial context. The determining party must not only choose a commercially reasonable procedure but must also execute that procedure in a manner that is beyond reproach. This requires a deep understanding of the practical steps involved in obtaining valuations, as well as the ability to navigate the complexities of different market environments. A flawed execution can undermine an otherwise sound strategy, leading to a valuation that is successfully challenged and a close-out process that is fraught with legal and financial risk.

A critical aspect of the execution is the process of obtaining quotes from third-party dealers. While the 2002 Agreement does not mandate a specific number of quotes, it is generally advisable to seek quotes from a range of reputable dealers in order to obtain a representative sample of the market. The request for quotes should be made in a clear and consistent manner, and should specify the precise terms of the transaction to be valued. It is also important to distinguish between indicative quotes and firm quotes.

Indicative quotes are non-binding and are provided for information purposes only, while firm quotes are binding and represent a price at which the dealer is willing to trade. While firm quotes provide a stronger basis for a valuation, they can be difficult to obtain, particularly in volatile or illiquid markets. In such cases, a determining party may need to rely on indicative quotes, but it should be prepared to justify its reliance on them.

The meticulous execution of a close-out, particularly the process of obtaining and evaluating quotes, is paramount to ensuring a defensible valuation under the 2002 ISDA Master Agreement.

The use of internal models is another key aspect of the execution process. The 2002 Agreement expressly permits the use of internal models, provided they are used in the regular course of business for the valuation of similar transactions. This is a critical safeguard, designed to prevent a party from developing a model specifically for a close-out in order to produce a self-serving valuation. When using an internal model, the determining party should be prepared to demonstrate the model’s validity and its consistent application.

This may involve providing evidence of back-testing, independent validation, and regular use in the ordinary course of business. The inputs to the model should also be commercially reasonable and should be based on reliable market data where available.

What Is the Process for Obtaining and Evaluating Quotes?

The process of obtaining and evaluating quotes is a critical part of the execution of a close-out. The following is a step-by-step guide to this process:

1. Identify a list of suitable dealers ▴ The dealers should be reputable and active in the relevant market. The list should be broad enough to provide a representative sample of the market, but not so broad as to be unwieldy.
2. Prepare a clear and consistent request for quotes ▴ The request should specify the precise terms of the transaction to be valued, including the notional amount, the maturity date, and any other relevant parameters. It should also specify whether the quote is to be indicative or firm.
3. Distribute the request for quotes to the selected dealers ▴ The request should be distributed to all dealers at the same time in order to ensure a level playing field.
4. Receive and record all quotes ▴ All quotes received should be recorded in a timely and accurate manner. The record should include the name of the dealer, the time the quote was received, the price quoted, and any other relevant information.
5. Evaluate the quotes ▴ The quotes should be evaluated for their reasonableness and consistency. Any outliers should be carefully examined and, if necessary, excluded from the calculation. The determining party should be prepared to justify the exclusion of any quotes.
6. Calculate the Close-out Amount ▴ The Close-out Amount should be calculated based on the evaluated quotes. The methodology for calculating the Close-out Amount from the quotes should be commercially reasonable and should be applied consistently.

The Importance of Documentation

Throughout the execution of the close-out process, it is essential to maintain a detailed and contemporaneous record of all steps taken. This documentation will be critical in the event of a dispute, as it will provide the evidence needed to demonstrate that the determining party acted in a commercially reasonable manner. The following table provides a checklist of the key items to be documented:

By following a rigorous and well-documented process, the determining party can significantly reduce the risk of a successful challenge to its Close-out Amount calculation. The key is to approach the process with a mindset of objectivity, transparency, and a commitment to arriving at a valuation that is both commercially reasonable and demonstrably fair.

Reflection

The “commercially reasonable” standard within the 2002 ISDA Master Agreement is more than just a legal term of art; it is a reflection of the market’s evolution towards a more mature and sophisticated understanding of risk and valuation. It challenges market participants to look beyond their own immediate interests and to consider what is fair and reasonable from an objective, market-wide perspective. As you integrate this understanding into your own operational framework, consider how the principles of objectivity, transparency, and diligence can be applied not just to the close-out process, but to all aspects of your derivatives trading activities. The pursuit of a commercially reasonable outcome is, in essence, the pursuit of a more stable and resilient financial system.