What Specific Documentation Should a Firm Prepare to Defend a Close-Out Amount Calculation under the 2002 Isda?

Concept

A firm’s defense of a close-out amount calculation under the 2002 ISDA Master Agreement rests upon a single, foundational principle ▴ the assembly of a meticulously curated and contemporaneous documentary record that substantiates every step of the valuation process. The core challenge is not merely to perform a calculation, but to construct an evidentiary trail demonstrating that the entire exercise was conducted through “commerically reasonable procedures in order to produce a commercially reasonable result.” This standard, a deliberate evolution from the more subjective “rationality” test of the 1992 ISDA Agreement, imposes a higher, objective burden on the determining party. Consequently, the documentation prepared must serve as a complete, self-contained narrative capable of withstanding intense scrutiny from the counterparty, and potentially, a court or arbitral tribunal.

The central nervous system of this defensive posture is the “Close-out Amount” itself, a concept that replaced the bifurcated “Market Quotation” and “Loss” methodologies of its predecessor. The 2002 ISDA framework provides significant flexibility, allowing the determining party to consider a wide array of information. This includes, but is not limited to, quotations for replacement transactions from third parties, relevant market data from information vendors, and even data from the determining party’s own internal sources and valuation models. This flexibility is a powerful tool.

It is also a significant source of potential dispute. The strength of a close-out calculation is therefore directly proportional to the quality and comprehensiveness of the documentation supporting the chosen valuation inputs and methodologies.

A successful defense hinges on proving the objective commercial reasonableness of both the process followed and the final calculated amount.

Preparing the necessary documentation is an exercise in building a fortress of evidence. Each document is a stone in the wall, and its integrity depends on its timeliness, its specificity, and its direct relevance to the terminated transactions. The process begins long before an early termination event is triggered, with the establishment of clear, documented internal policies and procedures for derivatives valuation and close-outs. It culminates in the delivery of the calculation statement required under Section 6(d)(i) of the agreement, which must be supported by a detailed dossier containing every piece of data, every communication, and every internal analysis that contributed to the final figure.

Judicial interpretation, particularly in cases like Lehman Brothers Special Financing Inc. v National Power Corporation, has underscored that courts will rigorously apply this objective standard. A failure to provide a robust documentary record leaves a firm exposed, turning what should be a straightforward contractual process into a protracted and costly dispute.

Strategy

The strategic framework for preparing a defensible close-out documentation package under the 2002 ISDA is built on a dual-pillar approach. The first pillar is procedural integrity, focusing on documenting that the methods used were commercially reasonable. The second pillar is substantive validity, focused on proving the outcome ▴ the final Close-out Amount ▴ is itself commercially reasonable. Every document collected and generated should be strategically aligned with reinforcing one or both of these pillars.

A proactive documentation strategy begins with establishing a clear, auditable internal framework before any counterparty distress emerges. This involves creating and maintaining a comprehensive policy document that outlines the firm’s standard operating procedures for handling an early termination. This policy should specify the hierarchy of valuation sources the firm will use, the criteria for determining when a market is illiquid enough to justify the use of internal models, and the approved list of third-party dealers from whom quotations will be sought. This foundational document demonstrates a pre-meditated, consistent, and reasonable approach, which is invaluable in defending the procedures followed during a specific close-out event.

What Is the Hierarchy of Valuation Inputs?

The 2002 ISDA provides a non-exhaustive list of information types that a determining party can use, creating a strategic imperative to select and document the most appropriate inputs for the specific market conditions at the time of termination. The strategy is to build a “best evidence” case for the valuation.

• Third-Party Quotations This is often considered the gold standard for defensibility, as it provides an external, market-based validation of the replacement cost. The strategy here involves documenting a rigorous and unbiased solicitation process. This includes recording all dealers contacted (both those who provided quotes and those who declined), the precise time of the requests, and the exact parameters of the replacement transaction for which quotes were sought.
• Relevant Market Data In the absence of sufficient, or commercially reasonable, quotations, the next strategic layer is the use of observable market data. This could include data from information vendors like Bloomberg or Reuters, such as interest rate curves, volatility surfaces, and credit spreads. The documentation strategy requires capturing not just the data itself, but also its source, the specific instrument or page identifier, and a precise timestamp.
• Internal Sources and Models The use of internal information is permitted, particularly when external data is not readily available or would not produce a commercially reasonable result. This is often the most scrutinized method. The defensive strategy is one of radical transparency. The firm must document why external sources were insufficient, the specific version of the internal model used, all inputs into the model with their sources and timestamps, the complete model output, and any post-model adjustments made. Validation reports for the model, prepared by an independent internal or external group, are a critical component of this documentation package.

Comparative Documentation Requirements

The strategic assembly of the documentation dossier requires a tailored approach depending on the primary valuation methodology employed. The following table illustrates the distinct documentary evidence required for each input type, forming a strategic checklist for the determining party.

Ultimately, the documentation strategy is about pre-empting challenges. By systematically recording every decision, every piece of data, and every communication, the determining party transforms the close-out calculation from an opinion into a verifiable, evidence-based conclusion. This disciplined approach is the most effective strategy for ensuring compliance with the 2002 ISDA’s demanding standard of commercial reasonableness.

Execution

The execution phase of defending a close-out calculation is a matter of disciplined, procedural execution. It involves the systematic assembly of a comprehensive documentation dossier that chronicles the entire close-out process from the moment of the trigger event to the final payment. This dossier is the primary defensive asset and must be constructed with the assumption that it will be subjected to adversarial review. The objective is to leave no part of the process undocumented and no aspect of the calculation unsubstantiated.

The Documentation Dossier a Step by Step Assembly

Executing a defensible close-out requires a methodical approach to evidence gathering. The following steps outline the critical documentation that must be prepared and collated at each stage of the process.

1. Foundational Documents This is the bedrock of the defense, prepared in the normal course of business, demonstrating a pre-existing, robust control environment.
   • Internal Valuation Policies ▴ The firm’s official, board-approved policies and procedures for the valuation of derivatives and for handling early terminations.
   • Model Validation Reports ▴ Independent validation reports for any internal pricing models that could potentially be used to value terminated transactions, especially for less liquid products. These reports should detail the model’s methodology, assumptions, limitations, and performance testing.
   • Approved Dealer Lists ▴ A documented list of approved counterparties and dealers from whom quotations are typically sought for various asset classes.
2. The Early Termination Event Documentation at this stage focuses on the trigger and the formal initiation of the close-out process.
   • Evidence of the Event of Default ▴ This could be public news releases (in the case of bankruptcy), notices of failure to pay, or internal records of a breach of agreement.
   • Notice of Early Termination Date ▴ A copy of the formal notice sent to the defaulting party, as required by Section 6(a) of the ISDA Master Agreement, along with proof of delivery (e.g. courier receipt, email delivery confirmation). All communications with the counterparty regarding the termination should be preserved.
3. The Valuation Process Record This is the most critical and detailed part of the dossier, providing a granular, contemporaneous record of how the Close-out Amount was determined.
   • For Quotation-Based Valuations ▴
     • A detailed log of all quotation requests, including the name of the dealer, the individual contacted, the time of the request, and the method of communication (e.g. recorded phone line, email).
     • The precise parameters of the replacement transaction provided to each dealer to ensure quotes were for a like-for-like transaction.
     • Copies of all quotations received, whether firm or indicative, written or oral. If oral, they should be documented in a contemporaneous note by the person who received them.
     • Records of any dealers who were contacted but were unable or unwilling to provide a quotation, along with any reasons given. This helps to demonstrate the state of market liquidity.
   • For Market Data-Based Valuations ▴
     • Time-stamped evidence of all market data used. This can be in the form of screenshots from data providers (e.g. Bloomberg, Reuters), downloaded data files, or reports from pricing services.
     • The documentation must clearly identify the specific data points used (e.g. Reuters page LIBOR01, specific swap curves, volatility tickers).
     • A narrative explaining how the market data was used to arrive at the valuation, including any calculation spreadsheets.
   • For Internal Model-Based Valuations ▴
     • A formal justification for why internal models were used (e.g. a written assessment that the market was illiquid and that available quotations were not commercially reasonable).
     • The precise version of the internal model and the software used.
     • A complete, time-stamped record of all inputs to the model and their sources (which may include market data documented as above).
     • The full, unaltered output from the model.
     • A clear record and explanation of any manual overrides or adjustments made to the model’s output.
4. Hedging Adjustments If the determining party includes costs or gains from unwinding hedges, as permitted by the definition of Close-out Amount, these must be rigorously documented.
   • Copies of trade tickets or confirmations for the termination, liquidation, or re-establishment of any related hedges.
   • Market data demonstrating the market levels at the time the hedge adjustments were executed.
   • A clear calculation worksheet showing how the gain or loss on the hedges is attributable to the terminated transactions, ensuring no double-counting of risk.
5. The Calculation Statement The final piece of the execution is the preparation and delivery of the statement required by Section 6(d)(i).
   • The statement itself, showing the calculation in “reasonable detail.” This should break down the Close-out Amount by transaction or group of transactions and clearly show how Unpaid Amounts are incorporated.
   • The dossier containing all the supporting evidence described above should be finalized and archived alongside the calculation statement, ready for disclosure if the calculation is challenged.

Illustrative Documentation for a Terminated Swap

To illustrate the required granularity, consider the documentation needed for a single terminated 5-year interest rate swap. The following table provides a non-exhaustive list of the specific evidence a firm would need to compile.

The burden rests on the challenging party to show that the determining party failed to act in a commercially reasonable manner.

How Do Courts View the Documentation Process?

Courts, particularly following influential rulings like Lehman v. NPC, have moved to enforce a standard of objective reasonableness. This means a judge will not simply defer to the determining party’s judgment. Instead, they will examine the documentary evidence to see if the procedures used were those that a reasonable actor, in that specific market and under those specific circumstances, would have employed.

A determination will be deemed commercially reasonable if it is made in a manner consistent with recognized market practices. A well-organized, contemporaneous, and comprehensive documentation dossier is the most potent tool for persuading a court that this objective standard has been met. The absence of such a record can be interpreted as a failure to follow commercially reasonable procedures, potentially invalidating the entire calculation.

Reflection

The assembly of a documentation package to defend a close-out calculation is more than a procedural necessity; it is a reflection of a firm’s institutional risk architecture. The quality and completeness of this evidence reveal the depth of the firm’s commitment to transparent, defensible, and robust operational controls. Does your firm’s current framework treat this documentation process as a reactive, administrative task to be completed only when triggered? Or is it viewed as a proactive, strategic capability, continuously maintained and refined as a core component of counterparty risk management?

Consider the information flows within your own organization. Are valuation policies, model validation reports, and dealer communication logs siloed within different departments, only to be hastily assembled in a crisis? Or are they integrated into a centralized system, creating a single source of truth that can be deployed instantly? The transition from the 1992 to the 2002 ISDA was a shift from subjective belief to objective proof.

A firm’s internal processes must mirror that evolution. The ultimate question is not whether a firm can produce documents, but whether it has built a system that generates a complete, contemporaneous, and unassailable evidentiary record as a natural output of its daily operations.