Close-out netting is one of those mechanisms which, in ordinary times, operates almost invisibly. It is the machinery that gives the derivatives market its appetite for risk: the ability of a counterparty, upon the occurrence of a defined event, to terminate a portfolio of transactions and reduce them to a single net obligation in either direction. The market has built itself around the assumption that this machinery will function as expected.
In periods of stress, that assumption is tested. The past three years have produced a small but instructive cluster of South African disputes in which the question of whether a close-out occurred, when it occurred, and at what valuation, has had to be litigated rather than negotiated. The decisions are not yet many, but they are enough to identify points of judicial discomfort with the standard contractual machinery.
Three patterns are worth noting. The first concerns the characterisation of the notice that triggers an early termination, particularly where the notice is given in circumstances of factual uncertainty. The second concerns the valuation methodology adopted by the determining party, and the willingness of courts to scrutinise that methodology where the loss is significant. The third concerns the interaction between contractual close-out and statutory insolvency law, where the position of an in-the-money counterparty is more precarious than the unqualified protection often assumed.
For practitioners advising on derivatives documentation, the practical implication is that the standard ISDA architecture should not be treated as self-executing. Operational discipline at the point of close-out — the precise wording of notices, the contemporaneous record of valuation inputs, and the engagement with insolvency considerations — is what separates a clean unwind from contested litigation.