What Constitutes a "Commercially Reasonable" Procedure under the 2002 ISDA Agreement? ▴ Question

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The Fulcrum of Good Faith in Derivatives

The 2002 ISDA Master Agreement operates as the foundational text for the global over-the-counter derivatives market. Within its architecture, the concept of a “commercially reasonable” procedure serves as a critical fulcrum, particularly when market conditions deteriorate and one party must calculate a close-out amount following a default. This is the process of determining the net amount owed between two parties when their derivatives contracts are terminated prematurely. The 2002 Agreement shifted from the more prescriptive “Market Quotation” and “Loss” methods of the 1992 version to a more flexible, principle-based standard called the “Close-out Amount.” This evolution places a significant responsibility on the determining party to act in good faith and utilize procedures that are, in themselves, commercially reasonable to produce a result that is also commercially reasonable.

The standard of “commercially reasonable” is not a mere suggestion; it is an enforceable obligation of objective reasonableness.

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An Objective Standard in a Subjective World

The term “commercially reasonable” is intentionally not defined with prescriptive rigidity in the 2002 ISDA Master Agreement. Instead, it establishes an objective standard of conduct against which a party’s actions can be measured. This means the determining party’s procedures are evaluated based on what a rational market participant would do in similar circumstances, irrespective of the determining party’s own internal models or preferences.

This objectivity is crucial for maintaining market confidence and ensuring that the close-out process is fair and transparent. The determining party must consider a range of relevant information, including third-party quotations, market data, and even its own internally generated information, provided it can be justified as part of a reasonable process.

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Strategy

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Navigating the Close-Out Amount Calculation

The strategic core of the “commercially reasonable” standard is most evident in the calculation of the Close-out Amount. The 2002 ISDA Master Agreement provides a framework, not a formula, for this process. The determining party has the discretion to choose the most appropriate valuation inputs and methodologies, but this discretion is bounded by the obligation of commercial reasonableness.

This requires a strategic approach to valuation that is both defensible and transparent. The determining party must be able to demonstrate that its procedures were designed to produce a fair market value for the terminated transactions as of the early termination date.

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Key Considerations in the Valuation Process

Market Data ▴ The use of third-party supplied market data and quotations is a primary indicator of a commercially reasonable procedure. The determining party should solicit quotes from multiple dealers or consult recognized pricing sources to establish a credible valuation.
Internal Models ▴ While internal models can be used, they must be consistent with industry standards and validated against external market data. A heavy reliance on proprietary models without external verification may be challenged as not being commercially reasonable.
Transparency ▴ The determining party should maintain a clear record of the steps taken to calculate the Close-out Amount, including the data sources, methodologies, and any assumptions made. This documentation is essential for defending the reasonableness of the procedure in the event of a dispute.
Consistency ▴ The procedures used should be consistent with the party’s normal course of business for valuing similar transactions. Any deviation from standard practices must be justified by the specific circumstances of the close-out.

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The Interplay of Good Faith and Commercial Reasonableness

The 2002 ISDA Master Agreement explicitly links the concept of “commercially reasonable procedures” with the obligation to act in “good faith.” This means that the determining party must not only follow a reasonable process but also act with an honest and fair intention. The two concepts are intertwined; a procedure that is not conducted in good faith is unlikely to be considered commercially reasonable, and vice versa. For example, “cherry-picking” low quotes to inflate a close-out amount would violate both the duty of good faith and the standard of commercial reasonableness.

Good faith is the ethical compass that guides the application of commercially reasonable procedures.

The strategic implication for market participants is that they must cultivate a culture of fairness and transparency in their derivatives operations. This includes establishing clear internal guidelines for close-out procedures, training staff on their obligations under the ISDA Master Agreement, and ensuring that all actions are documented and justifiable.

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Execution

A Practical Guide to Commercially Reasonable Procedures

Executing a commercially reasonable close-out procedure requires a systematic and well-documented approach. The following steps provide a practical framework for determining the Close-out Amount in a manner that is consistent with the principles of the 2002 ISDA Master Agreement.

Initial Assessment ▴ Upon the occurrence of an event of default or termination event, the determining party should immediately assess the portfolio of transactions to be terminated. This includes identifying the specific terms of each transaction and gathering all relevant documentation.
Market Sounding ▴ The next step is to obtain valuation data from the market. This can be done by requesting quotes from a panel of dealers, consulting independent pricing services, or accessing electronic trading platforms. The goal is to obtain a representative sample of market prices for similar transactions.
Valuation And Calculation ▴ Using the market data obtained, the determining party should calculate the replacement cost of each terminated transaction. This may involve using standard valuation models, but the inputs to these models should be derived from the market data. The individual transaction values are then aggregated to determine the overall Close-out Amount.
Documentation And Notification ▴ The entire process should be meticulously documented, including the names of the dealers contacted, the quotes received, the valuation methodologies used, and the final calculation of the Close-out Amount. The other party should then be notified of the Close-out Amount in a clear and timely manner.

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Illustrative Close-Out Calculation

The following table provides a simplified example of a Close-out Amount calculation for a portfolio of interest rate swaps.

Transaction ID	Notional Amount	Mark-to-Market Value	Source of Valuation
IRS-001	$100,000,000	$1,500,000	Average of 3 dealer quotes
IRS-002	$50,000,000	($750,000)	Independent pricing service
IRS-003	$25,000,000	$250,000	Internal model (validated)
Total Close-out Amount		$1,000,000

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Dispute Resolution and the Role of the Courts

Despite the best efforts of the determining party, disputes can still arise over the calculation of the Close-out Amount. In such cases, the courts will be called upon to determine whether the procedures used were commercially reasonable. The courts will typically consider a range of factors, including the prevailing market conditions at the time of the close-out, the availability of market data, and the practices of other market participants. The burden of proof will be on the party challenging the calculation to demonstrate that the determining party’s procedures were not commercially reasonable.

The ultimate arbiter of commercial reasonableness is the court, which will apply an objective standard of review.

To minimize the risk of a successful challenge, determining parties should ensure that their close-out procedures are robust, transparent, and consistent with market best practices. This includes having a clear and well-defined policy for close-outs, using a variety of valuation sources, and maintaining detailed records of all actions taken.

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References

Cont, Rama. “The ISDA Master Agreement and the valuation of bilateral derivative portfolios.” Banque de France Financial Stability Review 15 (2011) ▴ 81-91.
Fleming, Michael J. and Neel Krishnan. “The microstructure of the US Treasury market.” Handbook of Fixed Income Securities (2012) ▴ 1-34.
Gregory, Jon. The xVA Challenge ▴ Counterparty Credit Risk, Funding, Collateral, and Capital. John Wiley & Sons, 2015.
Hull, John C. Options, futures, and other derivatives. Pearson Education, 2022.
Kenyon, Chris, and Roland Stamm. Discounting, Libor, CVA and Funding. Springer, 2012.

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Beyond the Letter of the Law

The concept of “commercially reasonable” procedures under the 2002 ISDA Master Agreement transcends a mere legal or contractual obligation. It is a reflection of the market’s expectation that participants will act with integrity and professionalism, even in times of stress. The flexibility of the standard is both its strength and its challenge.

It allows for the use of sound judgment and market expertise, but it also requires a commitment to fairness and transparency. Ultimately, a firm’s ability to navigate the complexities of the close-out process is a testament to the strength of its internal controls, its understanding of market dynamics, and its commitment to ethical conduct.