1. Why Valuation Disputes Are Inevitable

Unlike equity, there is no exchange price for an OTC derivative. Valuation is a model, not a market price.

Dispute triggers:

1. Asymmetric Information: Bank has full trading desk curve, volatility surface. Client has only bank's statement.
2. Model Risk: Two models, same product, 30% difference is normal for exotic options.
3. Close-out on Default: When ISDA is terminated early, how do you calculate final payment? This is the single largest source of litigation globally.

2. The Two ISDA Valuation Regimes - You Must Know This

A. 1992 ISDA Master Agreement - Market Quotation / Loss

• Market Quotation: Non-defaulting party asks 3-4 market makers: "What would you charge to replace this transaction today?" Average is Close-out Amount.
• Problem: During 2008 crisis, no one gave quotes. Dealers refused to quote for CDS on Lehman. This failed.

B. 2002 ISDA Master Agreement - Close-out Amount [Current Standard]

Section 14 defines: Determining party must act in good faith and use "commercially reasonable procedures in order to produce a commercially reasonable result."

It can use:

1. Quotes from third parties
2. Relevant market data - yield curves, FX spot, vol surface
3. Internal models - but must be same model used for its own books, not a special model to inflate claim.

This change was directly because 1992 mechanism broke in crisis.

3. Independent Pricing Models - What Regulators Mandate

RBI and SEBI now require Independent Valuation because bank's valuation is conflicted.

RBI Requirement for OTC:
As per Risk Management Master Direction, market-maker must provide to user:

• Daily MTM if asked, mandatory monthly independent MTM
• Methodology note - curve source (FBIL MIBOR, FEDAI, Bloomberg)
• The valuation cannot include Credit Valuation Adjustment (CVA) markup unless disclosed.

SEBI Requirement for Structured Products (MLDs):
This is most strict in India:

Valuation of MLDs shall be carried out by an agency appointed by AMFI... It shall be mandatory for issuer to appoint a third party valuation agency which shall be an AMFI appointed valuation agency.

Today AMFI appointed agencies are CRISIL and ICRA / CARE. They publish daily valuation of all Market Linked Debentures. Issuer like Edelweiss, JM Financial cannot use own model. This was after Karvy and DHFL crisis where issuers inflated MLD NAV.

Hierarchy of Independent Models:

Level 1 - Plain Vanilla: No model dispute.

• IRS: Discounted Cash Flow using OIS curve. PV = Sum(CF / (1+OIS)^t)
• FX Forward: Covered Interest Parity

Level 2 - Vanilla Options:
Black-Scholes / Black-76 for FX options. Inputs must be independent:

• Spot: FBIL Reference Rate, not bank's own
• Vol: ATM vol from Bloomberg BFIX, not internal trader mark
• Rates: FBIL MIBOR OIS

Level 3 - Exotics & Structured:
This is where disputes arise.

• Interest Rate Exotics: Hull-White 1-factor, LMM (Libor Market Model)
• FX Exotics (TARF, KIKO, Range Accrual): Stochastic Volatility - Heston Model + Monte Carlo with 50k paths
• MLDs linked to Nifty: Monte Carlo with local volatility + credit spread of issuer
• Adjustments: Now mandatory: CVA (counterparty risk), DVA, FVA (funding). Bank often includes FVA to inflate loss to client.

4. Landmark Case Laws on Valuation

A. Global Cases - The Law on "Commercially Reasonable"

1. Lehman Brothers Special Financing Inc. vs National Power Corporation (NPC) EWHC 487 (Comm) - THE leading case[2018]

Facts: LBSF (Lehman US) defaulted. NPC (Philippines) calculated Close-out Amount. NPC omitted accrued unpaid amounts owed to LBSF in calculation.
Held:

• Standard for Close-out Amount is objective, not subjective honesty. Court will check if procedures were commercially reasonable.
• Omission of accrued amounts was not a "manifest error" that required redoing calculation, but it showed need for detailed statement.
• Compliance Lesson: Your close-out statement must show line-by-line: quotes obtained, market data used, model used, time of valuation. A single number email is invalid.

2. LBSF vs NPC - Remaking Determinations (Earlier part of same litigation)

Court held while NPC should have included accrued amounts in original statement, this omission was not manifest error. Therefore first/original calculation statement fulfilled obligation.
Principle: You get one chance to do valuation correctly. You cannot keep re-calculating if market moves against you.

3. Lehman Brothers International Europe (LBIE) vs Assured Guaranty - $500 Million CDS Valuation Dispute - New York Court

Facts: Assured and Lehman had CDS portfolio. On termination, parties elected Market Quotation method. Assured sought dealer quotes. Quotes differed by over $500 million during 2008 crisis.
Held: Court upheld alternative valuation method - where market quotes are not available or not for comparable transactions, determining party can use internal models. Quote must be for comparable transaction and obtained in same manner as market transactions. A distressed quote during crisis cannot be used.

4. ANZ vs Pioneer Freight Futures (Australia) - Freight derivatives
Valuation dispute on FFAs. Court rejected bank's model which used own volatility estimate vs independent Baltic Exchange data. Established principle: Independent source for inputs is mandatory.

B. Indian Cases - MTM and Tax Disputes

5. Enercon India vs CIT - MTM Loss Allowability
Assessee valued open derivative positions at MTM claiming loss. AO disallowed as notional/contingent loss citing CBDT Instruction 3/2010.
ITAT / High Court held: If import hedges are proven and consistent method accepted in other years, MTM loss is allowable. Method must be consistent, not changed year to year. This is key for Ind AS 109 hedge accounting documentation.

6. Rajshree Sugars Case Again - Valuation Disclosure Failure
Axis Bank had valued KIKO options using internal model with 25% volatility but spot was moving 40%. Court observed bank did not provide independent valuation or model assumptions to client. Led to RBI 2011 circular mandating monthly independent MTM with methodology note.

7. SEBI MLD Valuation Enforcement (2022-2024)
Multiple issuers (Reliance Capital, Piramal) penalized for not appointing AMFI valuation agency and using own model which inflated MLD value to show higher NAV. SEBI order: Recognizing challenge investors face in comprehending hybrids, SEBI mandates AMFI-appointed valuation agencies have solutions to conduct unbiased and independent valuations.
Compliance now: CRISIL/ICRA model is binding. Issuer's internal model is only for risk, not for client reporting.

8. Cadbury India - Minority Valuation Dispute
Few minority shareholders took exception to valuation price, Court directed fresh valuation by independent firm.
Principle extended to derivatives: If there is doubt about fair valuation, SEBI can get valuation done by independent merchant banker.

5. How to Make Your Valuation Dispute-Proof - Compliance Framework

For a bank / corporate treasury:

1. Tri-Model Framework:

• Trader Model: For day-to-day risk
• Risk Model: Independent Risk Management validation (Model Risk Policy under RBI)
• Client Model: Third-party or independent curve for client reporting. Never same as trader markup.

2. Documentation in ISDA Schedule:
Insert custom clause:

"For purposes of Section 6, Market Data source will be Bloomberg BFIX at 4pm IST, Volatility source FBIL, and Model validation by external auditor annually. Close-out Amount will be calculated using mid-market without CVA/FVA unless parties agree otherwise."

3. Independent Price Verification (IPV):
As per Basel III, mandatory monthly IPV by Product Control team independent of Front Office. RBI inspection asks for IPV report. Difference > 5% needs escalation.

4. Dispute Resolution Clause:
Add Valuation Dispute clause: If MTM difference > $100k or 10%, parties must refer to 4 independent dealers and take median. If still disputed, refer to independent expert like ISDA Determinations Committee.

5. For MLD / Structured Products in India:

• Appoint CRISIL/ICRA before issuance
• Daily file upload to agency
• Disclose in offer document: "Valuation by AMFI appointed agency does not guarantee redemption price, model risk exists"

Bottom line: Courts no longer accept "Bank's model says so". They ask: Was procedure commercially reasonable? Were inputs from independent sources? Was methodology disclosed beforehand?