What Recourse Does a Defaulting Party Have If It Believes the Close-Out Amount Is Not Commercially Reasonable?

Concept

When a party to a derivatives contract defaults, the non-defaulting party is typically entitled to terminate the contract and calculate a close-out amount. This amount represents the net value of the terminated transactions. The process for calculating this amount is governed by the underlying agreement, most commonly an ISDA Master Agreement.

The central tenet of this calculation is the principle of commercial reasonableness, a concept that is both fundamental and frequently the subject of disputes. A defaulting party that believes the close-out amount is not commercially reasonable has several avenues of recourse, but the path is complex and requires a deep understanding of the governing contractual provisions and legal precedents.

The concept of a commercially reasonable close-out is not a mere formality; it is a cornerstone of derivatives law, designed to ensure that the non-defaulting party is made whole without being unjustly enriched. The 2002 ISDA Master Agreement, for instance, explicitly requires the determining party to use “commercially reasonable procedures in order to produce a commercially reasonable result.” This is an objective standard, meaning that the actions of the determining party are measured against what a reasonable market participant would do in similar circumstances. The defaulting party’s recourse is therefore grounded in the ability to demonstrate that the determining party’s actions fell short of this objective standard.

A commercially reasonable close-out ensures the non-defaulting party is compensated for its losses without gaining an unfair advantage.

The challenge for a defaulting party lies in substantiating its claim that the close-out amount was not commercially reasonable. This requires a meticulous analysis of the market conditions at the time of the close-out, the valuation methodologies employed, and the procedures followed by the determining party. The defaulting party must be prepared to present a compelling case, supported by evidence and expert analysis, that a different, more commercially reasonable close-out amount should have been calculated. The recourse available to a defaulting party is thus a function of its ability to dissect the close-out process and identify any deviations from the standard of commercial reasonableness.

What Is the Standard of Commercial Reasonableness

The standard of commercial reasonableness is not a rigid formula but a flexible concept that adapts to the specific circumstances of each case. Courts have consistently held that the determining party has a degree of discretion in selecting a valuation methodology, particularly in illiquid or dislocated markets where obtaining reliable market quotations may be difficult or impossible. In such situations, a determining party may be justified in using alternative valuation methods, such as a discounted cash flow analysis or its own internal models, provided that these methods are themselves commercially reasonable and applied in good faith.

The burden of proof rests on the party challenging the close-out amount to demonstrate that the procedures used or the result achieved were commercially unreasonable. This is a high bar to clear, as courts are generally reluctant to second-guess the business judgment of the determining party, especially when the party has acted in good faith. However, a defaulting party can successfully challenge a close-out amount if it can show that the determining party, for example, cherry-picked quotes, used a valuation model that was not appropriate for the type of transaction, or failed to take into account relevant market information.

The Role of the ISDA Master Agreement

The ISDA Master Agreement is the foundational document that governs the rights and obligations of the parties in a derivatives transaction, including the process for calculating close-out amounts. The two most common versions of the agreement, the 1992 and 2002 versions, have different approaches to this calculation. The 1992 agreement provides for two methods ▴ “Market Quotation” and “Loss.” The “Market Quotation” method, as the name suggests, relies on obtaining quotes from market makers. The “Loss” method is more flexible and allows the determining party to calculate its total losses and costs in connection with the terminated transactions.

The 2002 agreement, on the other hand, introduced a single “Close-out Amount” methodology, which is intended to be a more objective and transparent standard. The “Close-out Amount” is defined as the amount of losses or costs that the determining party would incur in replacing the terminated transactions. The ISDA also published the Close-out Amount Protocol, which allows parties to amend their 1992 agreements to incorporate the “Close-out Amount” methodology. Understanding the specific version of the ISDA Master Agreement that governs the transaction is therefore a critical first step for a defaulting party considering a challenge to a close-out amount.

Strategy

A defaulting party that believes a close-out amount is commercially unreasonable must adopt a multi-pronged strategy that combines a thorough analysis of the facts with a clear understanding of the legal and procedural options available. The overarching goal is to build a credible case that the determining party’s calculation was flawed and to persuade the other party, or a third-party adjudicator, to accept a revised, more favorable calculation. This strategy can be broken down into three key phases ▴ investigation, negotiation, and, if necessary, formal dispute resolution.

The investigation phase is the bedrock of any successful challenge. It involves a deep dive into the details of the close-out calculation, including the market data used, the valuation models employed, and the procedures followed by the determining party. The defaulting party should seek to obtain all relevant documentation from the determining party, including any quotes received from market makers, internal valuation reports, and communications related to the close-out process. This information should then be subjected to a rigorous analysis, ideally with the assistance of independent valuation experts, to identify any potential weaknesses or inconsistencies in the determining party’s calculation.

A successful challenge to a close-out amount begins with a meticulous investigation of the determining party’s calculation.

Armed with the findings of its investigation, the defaulting party can then enter into negotiations with the determining party. The objective of these negotiations is to present the defaulting party’s case in a clear and compelling manner and to persuade the other party to agree to a revised close-out amount. The defaulting party should be prepared to share its analysis and expert opinions with the determining party and to engage in a constructive dialogue about the areas of disagreement. It is often in the interest of both parties to resolve the dispute through negotiation, as this can be a more cost-effective and less adversarial process than formal dispute resolution.

Leveraging Expert Determination

If negotiations fail to produce a satisfactory outcome, the defaulting party may need to consider formal dispute resolution. One of the most effective and efficient options in this context is expert determination. Expert determination is a process in which an independent expert with specialized knowledge in derivatives valuation is appointed to resolve the dispute. The expert’s decision is typically binding on the parties, providing a final and enforceable resolution to the dispute.

Expert determination offers several advantages over traditional court litigation. It is generally a faster and less expensive process, as the expert can focus solely on the technical valuation issues at the heart of the dispute. The expert is also likely to have a deeper understanding of the complexities of derivatives valuation than a judge or jury, which can lead to a more informed and accurate decision. Furthermore, the process is private and confidential, which can be an important consideration for parties who wish to avoid the publicity of a court case.

Potential Legal Challenges and Defenses

In addition to expert determination, a defaulting party may also have the option of pursuing a legal challenge in court. This can be a more protracted and expensive process, but it may be necessary in cases where the dispute involves complex legal issues in addition to valuation questions. A defaulting party considering a legal challenge should be aware of the potential defenses that the determining party may raise. These can include arguments that the close-out calculation was conducted in good faith, that the chosen valuation methodology was commercially reasonable under the circumstances, and that the defaulting party has not met its burden of proof to show otherwise.

The following table outlines some of the potential legal challenges and defenses that may arise in a dispute over a close-out amount:

Execution

Executing a successful challenge to a commercially unreasonable close-out amount requires a disciplined and methodical approach. The defaulting party must be prepared to invest the time and resources necessary to build a robust case and to navigate the complexities of the dispute resolution process. The following is a step-by-step guide to executing a challenge, from the initial assessment of the close-out amount to the final resolution of the dispute.

The first step is to conduct a thorough and objective assessment of the close-out amount. This should involve a detailed review of the calculation statement provided by the determining party, as well as any supporting documentation. The defaulting party should pay close attention to the following:

• The valuation methodology used ▴ Was it consistent with the terms of the ISDA Master Agreement? Was it appropriate for the type of transaction and the prevailing market conditions?
• The market data used ▴ Was the data from a reliable source? Was it representative of the market at the time of the close-out?
• The procedures followed ▴ Did the determining party follow the procedures outlined in the ISDA Master Agreement? Did it act in a manner that was consistent with industry best practices?

If this initial assessment raises any red flags, the defaulting party should consider engaging an independent valuation expert to conduct a more in-depth analysis. The expert can provide an objective opinion on the commercial reasonableness of the close-out amount and can help to identify any flaws in the determining party’s calculation.

How to Initiate a Dispute?

Once the defaulting party has gathered sufficient evidence to support its claim, it should formally notify the determining party of its dispute. This notification should be in writing and should clearly state the reasons why the defaulting party believes the close-out amount is commercially unreasonable. The notification should also include a revised calculation of the close-out amount, prepared by the defaulting party or its expert, along with any supporting documentation.

The purpose of this notification is to put the determining party on notice of the dispute and to provide it with an opportunity to respond. The determining party may be willing to reconsider its calculation in light of the information provided by the defaulting party, or it may be willing to enter into negotiations to resolve the dispute. Even if the determining party is not immediately receptive, the notification serves as an important first step in the formal dispute resolution process.

The Expert Determination Process

If the parties are unable to resolve the dispute through negotiation, they may agree to submit the matter to expert determination. The process for initiating expert determination is typically outlined in the ISDA Master Agreement or can be agreed upon by the parties. The following table provides a general overview of the expert determination process:

The expert determination process is designed to be a flexible and efficient way to resolve valuation disputes. The parties can agree on the specific procedures to be followed, and the expert has the discretion to tailor the process to the specific needs of the case.

In conclusion, a defaulting party that believes a close-out amount is commercially unreasonable has a clear path to recourse. By following a disciplined and methodical approach, the defaulting party can build a strong case and can significantly increase its chances of achieving a more favorable outcome. The key to success lies in a thorough investigation of the facts, a clear understanding of the legal and procedural options, and a willingness to engage in a constructive dialogue with the other party.

Reflection

The framework for challenging a close-out amount in a derivatives transaction is a testament to the intricate balance between contractual certainty and equitable outcomes. It underscores the importance of a robust operational framework that is not only compliant with the letter of the law but is also resilient enough to withstand the scrutiny of a dispute. As you reflect on the information presented, consider how your own internal processes for valuation and dispute resolution align with the principles of commercial reasonableness.

Is your framework designed to simply meet the minimum requirements, or is it engineered to provide a strategic advantage in the event of a dispute? The answer to this question may reveal opportunities to enhance your operational resilience and to better protect your interests in the complex world of derivatives.