What Evidence Is Required to Prove a Close-Out Calculation Was Commercially Reasonable?

Concept

The question of what evidence is required to prove a close-out calculation was commercially reasonable is a direct inquiry into the structural integrity of your risk management architecture. When a counterparty defaults, the close-out process is not merely a legal or administrative task. It is a critical stress test of your firm’s operational systems, valuation methodologies, and internal controls.

The evidence required is the verifiable output of a pre-engineered, robust, and impartial system designed for exactly this contingency. It is the data-driven proof that your actions were governed by objective process, not by opportunistic discretion.

At its core, the legal standard of “commercial reasonableness” demands a demonstration of objective fairness and good faith. Courts, particularly within influential jurisdictions like Delaware, have consistently established that this standard is objective. This means your firm’s actions will be measured against the standard of what a rational, similarly situated market participant would do under comparable circumstances.

The burden of proof rests on demonstrating that the close-out valuation was a product of a disciplined, consistent, and well-documented procedure. A failure to provide this evidence exposes the firm to litigation, reputational damage, and the potential for a court to substitute its own, less favorable, calculation.

The integrity of a close-out calculation is a direct reflection of the integrity of the underlying operational and risk systems that produced it.

The case of Skyview Fin. Co. LLC v. Kearsarge Trading, LLC provides a powerful illustration of this principle in action. In this dispute, a demand for collateral was deemed commercially unreasonable because it was vastly disproportionate to the actual risk of loss.

The court determined that a demand nearly 15 times the maximum potential loss was punitive. This establishes a foundational concept ▴ proportionality. Any close-out calculation must be demonstrably linked to the actual, quantifiable damages incurred. This linkage is impossible to prove without a clear, auditable trail of data showing how the replacement cost or loss was determined. The evidence, therefore, begins with the system’s ability to accurately quantify risk exposure in real-time.

This moves the challenge from the legal department to the system architect’s domain. Proving commercial reasonableness becomes a function of system design. The necessary evidence is not something to be assembled after a dispute arises; it is generated automatically and immutably by the systems that govern trading, risk, and settlement.

It includes time-stamped price feeds, records of all internal and external communications, minutes from valuation committee meetings, and the specific parameters of the valuation models used. Without this systemic foundation, any defense becomes a subjective narrative, vulnerable to challenge and reinterpretation.

Strategy

A defensible strategy for ensuring a commercially reasonable close-out is built on a proactive framework of defined procedures, objective benchmarks, and rigorous documentation. This framework is designed to remove ambiguity and subjectivity from the process, replacing them with a clear, auditable, and systematic methodology. The strategic objective is to construct a system where the evidence of reasonableness is an inherent byproduct of the close-out action itself.

Establishing Objective Valuation Benchmarks

The foundation of a defensible close-out calculation is the use of objective, verifiable benchmarks for valuation. Courts evaluating the reasonableness of an action look for evidence that the party’s efforts align with established industry practices. A comprehensive strategy incorporates multiple types of benchmarks.

• External Benchmarks These involve comparing the firm’s actions and valuation sources to those of the broader industry. For a standard interest rate swap, this would mean polling prices from recognized inter-dealer brokers or using established, liquid market data feeds. For a less liquid or more exotic instrument, it means demonstrating a process of soliciting quotes from a pre-approved list of other major market makers in that specific asset class. The strategy here is to pre-define what constitutes a “similarly situated company” and what qualifies as a “comparable objective” to avoid ambiguity during a crisis.
• Internal Benchmarks These benchmarks compare the actions taken during a specific close-out to the firm’s own established, written policies for similar events. This demonstrates consistency and procedural fairness. If the firm’s policy dictates that three quotes must be obtained for any off-market valuation, the evidence must show that three quotes were indeed solicited. This internal consistency is a powerful argument against claims of arbitrary or punitive action.
• Blended Benchmarks The most robust strategy utilizes a blended approach. It aligns the firm’s specific, documented internal procedures with accepted external industry standards. This creates a multi-layered defense. The firm can demonstrate that it followed its own playbook, and that this playbook is itself aligned with the best practices of the broader market.

The Proportionality Doctrine as a Guiding Principle

The principle of proportionality, as highlighted in the Skyview case, is a critical strategic pillar. A close-out calculation that appears punitive or disconnected from actual damages is immediately suspect. The strategy, therefore, must be to build a direct, unbreakable link between the counterparty’s default and the calculated damages.

This involves a clear methodology for calculating the firm’s replacement cost. The system must be able to document the following with precision:

1. The Exact Position The size, maturity, and specific terms of the defaulted transaction.
2. The Market Conditions at the Time of Default Verifiable data on market volatility, liquidity, and pricing for the relevant asset class at the precise moment the close-out was initiated.
3. The Cost of Replacement The actual or reasonably estimated cost of entering into an equivalent transaction with another counterparty. This is where the price discovery mechanism becomes paramount.

A strategically sound close-out process transforms documentation from a reactive legal necessity into a proactive operational asset.

How Does a Firm Codify Its Close out Strategy?

A codified strategy is essential for ensuring consistent and defensible execution. This is typically achieved through a formal, board-approved policy document that is integrated into the firm’s operational systems. The table below contrasts a weak, ad-hoc approach with a strong, system-driven strategy.

By implementing a strong, proactive strategy, the firm builds a fortress of evidence. The focus shifts from defending a decision to presenting the output of a pre-approved, impartial machine. This approach respects the court’s need for objectivity and provides the clearest possible evidence that the firm acted in good faith and in a commercially reasonable manner.

Execution

The execution of a commercially reasonable close-out is the final, tangible expression of the firm’s underlying concepts and strategies. It is a high-stakes operational procedure where every action must be precise, deliberate, and, most importantly, recorded. The quality of the execution directly determines the quality of the evidence produced.

A flawed execution, even with a sound strategy, can undermine the entire process and create legal vulnerabilities. This section details the specific operational playbook, quantitative methods, and technological architecture required for a defensible execution.

The Operational Playbook

A detailed operational playbook is the central nervous system of the close-out process. It provides a step-by-step procedure that ensures no critical action is missed and that all decisions are made within a controlled framework. This playbook must be a living document, regularly reviewed and integrated into the firm’s risk management systems.

1. Step 1 Initial Default Confirmation and Notification Upon an event of default, the system should automatically flag the counterparty’s status. The first human action is to verify the default event according to the terms of the governing agreement (e.g. ISDA Master Agreement). An immediate, formal notification, using a pre-approved template, is sent to the counterparty, citing the specific default provision and stating the firm’s intent to close-out all outstanding positions.
2. Step 2 Valuation Committee Activation The default event must trigger an automated alert to the members of the firm’s pre-designated Valuation Committee. This committee, typically comprising senior personnel from Risk, Trading, and Legal, is responsible for overseeing the entire close-out process. The first meeting should be convened within a contractually specified timeframe (e.g. two hours) to review the exposure and approve the valuation methodology.
3. Step 3 Price Discovery Protocol This is the most critical phase for evidence generation. The committee, guided by the firm’s policies, will execute a price discovery protocol. For liquid instruments, this may be as simple as taking a snapshot of the mid-price from multiple, independent data feeds (e.g. Bloomberg, Refinitiv) at a specific time. For illiquid instruments, a more complex Request for Quote (RFQ) process is initiated. The system must log which dealers were contacted, the exact time of the request, and the full content of all responses, including any refusals to quote.
4. Step 4 Execution of Hedging or Replacement Trades Based on the price discovery, the firm will execute trades to neutralize the risk from the defaulted positions. The execution methodology itself must be commercially reasonable. For example, liquidating a massive position in an illiquid asset in a single block trade could be deemed unreasonable if it drastically moves the market price. A more defensible approach might be a phased liquidation over a defined period, with all execution prices meticulously recorded.
5. Step 5 Final Calculation and Documentation Package Once the positions are closed or hedged, the final close-out amount is calculated. This is the sum of all liquidated gains and losses, replacement transaction costs, and any other specified damages. The system then automatically compiles a complete documentation package. This package is the ultimate evidentiary output and should include the default notice, all market data snapshots, RFQ logs, trade confirmations, and a summary report from the Valuation Committee detailing every decision made.

Quantitative Modeling and Data Analysis

The quantitative rigor of the valuation is the bedrock of a defensible calculation. Simply picking a single price is insufficient. A robust process uses a weighted average or other statistical method to arrive at a fair market value, with the methodology being both pre-defined and transparent. The goal is to create a calculation that is objective and repeatable.

Objective quantitative analysis provides the verifiable data that transforms a subjective valuation into a defensible calculation.

Consider the close-out of an illiquid corporate bond. The following table demonstrates a data-driven approach to valuation, as would be recorded by the firm’s risk system.

In this model, the wide bid-ask spread from Dealer C might lead the Valuation Committee to assign it a zero weighting, a decision that must be documented in the committee’s minutes. The internal model price, based on the last known trade adjusted for market drift, is given a smaller weighting than the live quotes from active dealers. The final close-out price of 99.00 is not a single, arbitrary number; it is the calculated output of a transparent, multi-source quantitative process. This data table, along with the minutes explaining the weighting choices, forms an exceptionally strong piece of evidence.

Predictive Scenario Analysis

To fully grasp the execution process, consider a detailed case study. A mid-sized hedge fund, “AlphaGen,” has a significant derivatives portfolio with “BetaBank,” a regional investment bank. On a Monday morning, news breaks that BetaBank has suffered catastrophic losses from an unrelated event and is entering emergency receivership, triggering an immediate event of default under their ISDA Master Agreement. AlphaGen’s Chief Risk Officer, Maria, receives an automated system alert at 08:05 UTC.

AlphaGen’s system immediately freezes all pending settlements with BetaBank and flags their entire net exposure, calculated at a mark-to-market of +$42.7 million in AlphaGen’s favor. The system automatically sends a notification to the three members of the Valuation Committee ▴ Maria, the Head of Trading (David), and the General Counsel (Sarah). The committee convenes via a secure video call at 08:30 UTC, which is automatically recorded and transcribed by their compliance software.

The largest and most complex position is a $500 million, 5-year receive-fixed interest rate swap on a custom, non-standard benchmark. There is no direct, liquid market price for this instrument. Following their playbook, the committee authorizes the execution of their Illiquid Asset Price Discovery Protocol.

At 09:00 UTC, David uses their integrated RFQ system to send a request for a mid-market quote on the swap to four pre-approved Tier 1 banks. The RFQ system logs the exact time of the request and the identity of the recipients.

The responses arrive over the next 15 minutes:

• Bank 1 ▴ +$15.2 million
• Bank 2 ▴ +$14.8 million
• Bank 3 ▴ No quote, citing market volatility.
• Bank 4 ▴ +$15.1 million

All responses are automatically ingested and time-stamped in the system. The committee reconvenes at 09:20 UTC. They note the “no quote” from Bank 3, which is a critical piece of evidence demonstrating the illiquidity and difficulty of the market.

They decide to use the average of the three provided quotes as the basis for the close-out valuation of that specific swap ▴ ($15.2M + $14.8M + $15.1M) / 3 = +$15.03 million. Sarah, the General Counsel, formally records this decision and the rationale in the committee’s digital minutes.

Simultaneously, the system is calculating the close-out values for all other, more liquid positions using a weighted average of live data from Bloomberg and Refinitiv. By 10:00 UTC, the system has aggregated all values and calculated a total close-out amount of +$43.1 million due to AlphaGen. A full documentation package, including the default notice, the RFQ logs, the committee minutes, and a detailed breakdown of every single position and its valuation source, is automatically generated and sent to Sarah for final review.

At 10:30 UTC, this package is formally delivered to BetaBank’s receivers. AlphaGen has created a comprehensive, verifiable, and time-stamped body of evidence demonstrating that its calculation was the result of a rigorous, objective, and systematic process executed in a highly volatile market.

System Integration and Technological Architecture

The flawless execution of the playbook and quantitative analysis depends entirely on the underlying technological architecture. A defensible system is not a patchwork of spreadsheets and emails; it is an integrated platform designed for this specific purpose.

• Risk Management System (RMS) Core This is the central hub that maintains a real-time view of all counterparty exposures. It must be capable of complex calculations like CVA (Credit Valuation Adjustment) and PFE (Potential Future Exposure) and must be the system of record for all positions.
• Immutable Audit Trail The most critical technological component is a ledger that records every action. This could be a blockchain-based ledger or a traditional write-once-read-many (WORM) database. Every price tick received, every RFQ sent, every internal message, and every decision must be logged with a non-modifiable timestamp. This log is the ultimate source of truth.
• Integrated Communication Module The system must integrate with email, secure messaging, and video conferencing to automatically log all relevant communications related to the close-out. The RFQ process should be handled through an integrated module, not through personal email accounts.
• Automated Reporting Engine The ability to automatically generate the final, comprehensive evidence package is crucial. This engine pulls data from the RMS, the audit trail, and the communication logs to create a single, coherent document that can be presented to a counterparty, a regulator, or a court. This automation reduces the risk of human error and ensures all required evidence is included.

Ultimately, the execution phase demonstrates that the firm’s commitment to commercial reasonableness is not just a policy, but an ingrained, technologically enforced operational reality.

Reflection

The evidence required to prove a commercially reasonable close-out calculation is ultimately a reflection of your firm’s entire operational philosophy. It forces a fundamental question upon every principal and risk manager ▴ Is your operational framework an integrated system designed for resilience, or is it a collection of disparate processes that function only under normal market conditions? The data, the documentation, and the procedures are not artifacts to be collected in the aftermath of a crisis. They are the continuous, verifiable output of a well-architected system.

Viewing the challenge through this lens transforms the requirement from a potential legal liability into a strategic opportunity. It provides the impetus to build more robust risk systems, more transparent valuation methodologies, and more disciplined internal controls. The process of engineering a defensible close-out framework hardens the entire operational structure of the firm.

How would your current systems perform under the unblinking scrutiny of a counterparty default? Is the evidence of your reasonableness a product of deliberate design or a matter of operational chance?