What Legal Challenges Can Arise When Determining a Commercially Reasonable Close out Amount?

Concept

Determining a commercially reasonable close-out amount in the context of derivatives is an exercise in precision under pressure, governed by a complex interplay of contractual obligations and legal precedents. The process is anchored in the ISDA Master Agreement, a cornerstone of the over-the-counter derivatives market. The specific version of this agreement, whether the 1992 or the 2002 iteration, fundamentally alters the legal landscape and the challenges that can arise.

The core of the issue lies in the standard of conduct imposed on the non-defaulting party when calculating the final amount owed upon the early termination of a contract. This calculation is not a mere accounting formality; it is a critical step that can have significant financial consequences and is often a focal point for legal disputes, particularly in times of market stress or when a major counterparty defaults.

The core challenge in establishing a commercially reasonable close-out amount is navigating the shift from a subjective standard of rationality to an objective standard of commercial reasonableness.

The Evolution of a Standard

The 1992 ISDA Master Agreement established a standard of “reasonableness” that was largely interpreted by the courts as a test of rationality. This meant that a party’s calculation of its losses would be upheld as long as it was not so irrational that no reasonable party could have arrived at that figure. This subjective standard offered a degree of deference to the non-defaulting party’s judgment. However, the 2002 ISDA Master Agreement introduced a more stringent, objective standard.

It requires the determining party to use “commercially reasonable procedures in order to produce a commercially reasonable result.” This shift from a subjective to an objective test is the source of many of the legal challenges in this area. It opens the door for a more rigorous judicial review of the entire process, from the solicitation of quotes to the final calculation.

The Objective Test in Practice

Under the 2002 ISDA Master Agreement, the determining party’s actions are measured against an objective benchmark ▴ what a reasonable party in the same market, under the same circumstances, would have done. This standard applies to both the process and the outcome. The procedures used to arrive at the close-out amount must be sound, and the final number must be justifiable.

This dual requirement for procedural and substantive reasonableness creates a higher bar for the determining party and, consequently, more avenues for the other party to challenge the calculation. The Lehman Brothers insolvency was a watershed moment that tested these provisions on an unprecedented scale, generating years of litigation and providing crucial judicial guidance on their interpretation.

Strategy

A strategic approach to determining a commercially reasonable close-out amount requires a deep understanding of the governing legal framework and a meticulous, defensible process. The overarching goal is to arrive at a figure that is not only accurate but also resilient to legal challenges. This involves a proactive stance on documentation, a clear methodology for valuation, and an awareness of the potential pitfalls that can lead to disputes.

A robust strategy for determining the close-out amount hinges on a transparent, well-documented process that can withstand judicial scrutiny.

Methodologies for Valuation

The choice of valuation methodology is a critical strategic decision. The determining party can use a variety of methods, including:

• Replacement Transaction ▴ Obtaining a quote from a third party for a transaction that replaces the terminated one. This is often considered the most reliable method, as it provides a clear, market-based measure of the loss.
• Market Quotations ▴ Gathering quotes from multiple dealers for the value of the terminated transaction. The number and type of quotes (indicative vs. firm) can be a point of contention.
• Internal Models ▴ Using internal pricing models to determine the value of the transaction. This method is more likely to be scrutinized and requires the determining party to demonstrate the model’s robustness and consistency with market practices.

The table below compares these valuation methodologies:

The Finality of Determination

A crucial aspect of the strategy is recognizing the finality of the close-out amount determination. Once a Section 6(d) notice under the ISDA Master Agreement is served, it is generally considered a “significant contractual event” and is binding. A party cannot unilaterally withdraw and resubmit a calculation, even if a clear error has been made. Any correction must be by mutual agreement or, failing that, by a court.

This underscores the need for a meticulous and thorough process from the outset. Attempting to reserve the right to amend the calculation in the notice itself is a practice that has been cast into doubt by the courts.

Execution

The execution of a close-out determination is a procedural minefield where even minor missteps can have significant legal and financial consequences. A flawless execution requires a detailed operational playbook that covers every stage of the process, from the initial default to the final notification.

Operational Playbook for Close-Out Determination

A comprehensive playbook for determining the close-out amount should include the following steps:

1. Immediate Actions Upon Default ▴
   • Verification ▴ Independently verify the occurrence of the event of default.
   • Internal Notification ▴ Immediately notify all relevant internal stakeholders, including the legal, risk, and trading departments.
   • Documentation ▴ Secure all relevant documentation, including the master agreement, confirmations, and any related correspondence.
2. Issuing the Termination Notice ▴
   • Drafting ▴ Draft the termination notice in strict accordance with the terms of the ISDA Master Agreement, specifying the event of default and the designated early termination date.
   • Delivery ▴ Ensure that the notice is delivered to the counterparty in accordance with the notice provisions of the agreement. Proper delivery is a critical, and sometimes overlooked, step.
3. The Valuation Process ▴
   • Methodology Selection ▴ Choose the valuation methodology that is most appropriate for the transaction and the prevailing market conditions. This decision should be documented and justified.
   • Gathering Evidence ▴ Meticulously document every step of the valuation process. If obtaining quotes, record the names of the dealers contacted, the time of the calls, the quotes received, and whether they were indicative or firm.
   • Consistency ▴ Ensure that the valuation is performed consistently with past practices and with how similar transactions are valued internally.
4. Calculating and Notifying the Close-Out Amount ▴
   • Calculation ▴ Calculate the final close-out amount, ensuring that all components of the calculation are accurate and justifiable. This includes accounting for any unpaid amounts and the value of any collateral.
   • Review ▴ Have the calculation reviewed and signed off by at least two senior individuals before it is finalized.
   • Notification ▴ Serve the Section 6(d) notice with the final close-out amount, recognizing that this is a binding determination.

Case Law Spotlight

The following table highlights key legal cases and their impact on the determination of close-out amounts:

The distinction between the 1992 and 2002 ISDA Master Agreements is not merely academic; it has a direct and significant impact on the execution and potential litigation of a close-out.

Reflection

The legal challenges inherent in determining a commercially reasonable close-out amount underscore the importance of a robust and well-defined operational framework. The shift from a subjective to an objective standard of conduct has transformed the landscape, demanding a higher level of diligence and precision from market participants. The principles established through years of litigation serve as a guide, but each close-out is unique, shaped by the specifics of the transaction, the prevailing market conditions, and the conduct of the parties involved. Ultimately, the ability to navigate these challenges successfully is a testament to the strength of an institution’s internal processes and its commitment to best practices in risk management.