CFPB Issues Proposed Libor Transition Rules

The Consumer Financial Protection Bureau (the Bureau) has issued proposed regulations (Proposed Regulations) to facilitate the transition away from Libor (the London Interbank Offered Rate) in the consumer credit market, and to address concerns and reduce uncertainty regarding the impact of the anticipated discontinuation of Libor at the end of 2021. The Proposed Regulations amend a number of provisions of Regulation Z (12 CFR Part 1026, which implements the Truth in Lending Act), providing specific guidance and relief with respect to the transition from Libor to other identified reference rates in both open-end and closed-end credit products. The Proposed Regulations are open for public comment until Aug. 4, 2020.

Simultaneously with the release of the Proposed Regulations, the Bureau has published 1) a set of Frequently Asked Questions (FAQ) on topics related to the transition away from Libor but which do not require amendment of Regulation Z and 2) an updated Consumer Handbook on Adjustable-Rate Mortgages (CHARM), which, among other changes, removes references to Libor.

The FAQ provides guidance with respect to the implications of Libor discontinuation on existing accounts and new originations under current regulations. It includes general information for creditors and consumers and a nonexclusive list of various regulatory provisions likely to be triggered by the transition. The FAQ also answers a series of specific questions, providing guidance with respect to notice, disclosure and other topics for adjustable-rate mortgage (ARM) products and home equity lines of credit (HELOCs).

The CHARM booklet is published by the Bureau to help consumers understand the terms and risks of ARMs and was last updated in 2014. According to the Bureau's release, the new revisions are intended to "align with the Bureau's educational efforts, to be more concise, and to improve readability and usability." In addition to the elimination of references to Libor in anticipation of Libor's discontinuation, the new version includes "a comparison table that describes adjustable rate mortgages and their differences in relation to fixed-rate loan products; an explanation of how an adjustable rate mortgage works; a tutorial on how to review an ARM Loan Estimate and a lender's ARM program disclosure; a comparison table for the various adjustable and fixed-rate loan offers that reader has received or will receive; and a description of the risks that come with different types of adjustable rate mortgages." The revised booklet (or a "suitable substitute") may be used by creditors immediately to comply with requirements under Regulation Z, although creditors are also permitted to use earlier versions of the booklet until existing supplies are exhausted.

Background

Libor, one of the most widely used interest rate benchmarks in the world, underlies an estimated $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years. In 2013, against a backdrop of scandals regarding manipulation of Libor and decreased liquidity in interbank lending, the Financial Stability Board (FSB), a global body that monitors the world's financial systems, established the Official Sector Steering Group (OSSG), consisting of senior officials from central banks and regulatory authorities, to coordinate the review and reform of global interest rate benchmarks. In 2016, the OSSG launched a new initiative, focusing on the improvement of contract robustness to address concerns regarding discontinuation of certain key interest rate benchmarks. The OSSG invited the International Swaps and Derivatives Association Inc. (ISDA) to lead the initiative with respect to discontinuation and fallbacks in the derivatives market.

In 2014, the Federal Reserve System and the Federal Reserve Bank of New York jointly created the Alternative Reference Rates Committee (ARRC), consisting of a wide variety of market participants, trade organizations and ex officio regulators. One of the ARRC's initial objectives was to identify a "risk-free alternative" rate for U.S. Dollar Libor (USD Libor) and to develop a plan to implement the voluntary adoption of the alternative rate. In 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the replacement for USD Libor. SOFR, published daily and administered by the Federal Reserve Bank of New York, is based on more than $700 billion in overnight repurchase transactions secured by U.S. treasuries. ISDA subsequently agreed that SOFR would be the "risk-free" alternative to USD Libor for derivatives purpose as well.

In 2017, the United Kingdom's Financial Conduct Authority (FCA), the regulator of Libor, announced that it would no longer compel participating banks to provide submissions beyond 2021. Since that time, regulators around the world have issued continuous warnings, urging financial market participants to transition, across all product classes, to the risk-free rates in anticipation of the near-certain discontinuation of Libor.

In the United States, Libor is a common benchmark rate for a wide range of adjustable-rate consumer credit products, including mortgages, credit cards, HELOCs, reverse mortgages and student loans. Typically, the adjustable interest rate is reset periodically on the basis of the selected benchmark (which, in the case of Libor, is tied to a specific tenor such as one-month Libor) plus a margin. As of the end of 2016, the ARRC estimated that there was $1.2 trillion of mortgage debt (including adjustable-rate mortgages, HELOCs and reverse mortgages) and $100 billion of nonmortgage debt tied to Libor. Many financial institutions have begun the process of transitioning new open-end and closed-end credit products away from Libor, but a large volume of existing products will be impacted by the discontinuation. The Proposed Regulations are intended to ease the transition and provide clarity for creditors and consumers.

Description of Proposed Rules

The Bureau has focused on specific areas of Regulation Z that relate to the replacement of adjustable rates and the disclosures that accompany changes in terms. The Proposed Regulations are intended to create a roadmap for creditors to transition existing products away from Libor, while maintaining sufficient protection for consumers.

The key areas where the Proposed Regulations provide guidance are 1) clarification of existing regulations that allow creditors to replace rates for open-end and closed-end credit products, 2) introduction of new regulations allowing the specific replacement of Libor for HELOCs and credit cards on or after March 15, 2021, subject to certain conditions, 3) revisions to the notice and disclosure provisions regarding changes in terms for certain open-end credit products, and 4) revisions to the rate reevaluation provisions for credit card accounts. It is important to note that the Proposed Regulations do not override contractual limitations. As a result, creditors will need to comply with the Proposed Regulations in addition to, and not in lieu of, their contractual obligations to consumers.

Open-End Credit

The Proposed Regulations include a number of amendments to the provisions of Regulation Z that govern open-ended credit products. Under the applicable regulations, "open-end credit" is defined to include "consumer credit extended by a creditor under a plan in which: (i) The creditor reasonably contemplates repeated transactions; (ii) The creditor may impose a finance charge from time to time on an outstanding unpaid balance; and (iii) The amount of credit that may be extended to the consumer during the term of the plan (up to any limit set by the creditor) is generally made available to the extent that any outstanding balance is repaid." [Cite 12 CFR 1026.2(a)(20)]

Replacement Index and Margin

HELOCs

Existing Section 1026.40(f)(3)(ii) provides that a creditor in respect of a HELOC plan may "change the index and margin used under the plan if the original index is no longer available, the new index has an historical movement substantially similar to that of the original index, and the new index and margin would have resulted in an annual percentage rate substantially similar to the rate in effect at the time the original index became unavailable." Under the Proposed Regulations, this provision would become clause (3)(ii)(A) and be modified by 1) replacing the phrase "historical movement" with the phrase "historical fluctuations" and 2) adding a new sentence at the end thereof, consistent with existing commentary, specifying that if the replacement index is newly issued, it may be used if it and the replacement margin "will produce an annual percentage rate substantially similar to the rate in effect when the original index became unavailable."

While the clause described above would require creditors to wait until Libor is no longer available before replacing it, the Proposed Regulations would add a new Libor-specific Section 1026.40(f)(3)(ii)(B), which would allow creditors to replace a Libor index and margin on or after March 15, 2021, even if Libor is still available, subject to terms described below.

Pursuant to the proposed clause (3)(ii)(B), a creditor could change the Libor index and margin to a replacement index and replacement margin on or after March 15, 2021 as long as "historical fluctuations in the LIBOR index and replacement index were substantially similar, and as long as the replacement index value in effect on December 31, 2020, and replacement margin will produce an annual percentage rate substantially similar to the rate calculated using the LIBOR index value in effect on December 31, 2020, and the margin that applied to the variable rate immediately prior to the replacement of the LIBOR index used under the plan." The provision would further allow a creditor to use a newly established replacement index "if the replacement index value in effect on December 31, 2020, and the replacement margin will produce an annual percentage rate substantially similar to the rate calculated using the LIBOR index value in effect on December 31, 2020, and the margin that applied to the variable rate immediately prior to the replacement of the LIBOR index used under the plan."

These revisions would be further clarified and supplemented by commentary and examples provided by the Bureau pursuant to the Proposed Regulations. In particular, the Bureau has determined that effective on a date to be specified, both the prime rate and certain ARRC-endorsed SOFR rates have "historical fluctuations that are substantially similar" to the replaced Libor rates. This determination satisfies one of the key requirements in both clauses (3)(ii)(A) and (3)(ii)(B) regarding the replacement index and will simplify the process of determining compliance with those provisions.

The revisions to clause (3)(ii)(A) and the addition of clause (3)(ii)(B) would give creditors the option to replace Libor under either provision, as long as the relevant conditions are satisfied. One important distinction between the two provisions relates to the timing of the determination of whether the new rate is "substantially similar" to the old rate. Under clause (3)(ii)(A), the timing is based on the date on which Libor becomes unavailable. Under clause (3)(ii)(B), the timing is based on rates in effect as of Dec. 31, 2020, and the margin in effect immediately prior to replacement, which will allow creditors to transition to replacement rates sooner than if they had to wait for Libor to become unavailable. The Dec. 31, 2020, comparison date should provide creditors with adequate time to provide all necessary notices ahead of the earliest permitted replacement date, March 15, 2021.

The Bureau is soliciting comments with respect to the determination of whether rates are "substantially similar," including whether the Bureau should provide factors that creditors must consider in reaching that determination and if so, what those factors should be. In addition, the Bureau is soliciting comments on whether the final rule, if adopted, should provide that the rate using the SOFR-based spread-adjusted index is "substantially similar" to the rate calculated using the Libor index, so long as the creditor uses as the replacement margin the same margin in effect on the day that the Libor index becomes unavailable (in the case of (3)(ii)(A)) or the same margin that applied to the variable rate immediately prior to the replacement of the Libor index (in the case of (3)(ii)(B)).

As noted above, the Bureau makes clear that these provisions do not excuse creditors from satisfying the contractual requirements governing their HELOC plans. Creditors would remain subject to any contractual restrictions on the timing or selection of any replacement of Libor as the relevant index. The proposed examples provide some commentary on the interaction between the regulations and hypothetical contract terms.

Credit Cards

Existing Section 1026.55(b)(2) permits a credit card issuer to increase an annual percentage rate (APR) when "(i) The annual percentage rate varies according to an index that is not under the card issuer's control and is available to the general public; and (ii) The increase in the annual percentage rate is due to an increase in the index." This provision is supplemented by Comment 55(b)(2)-6, which provides that a card issuer may change the index and margin used to determine the APR "if the original index becomes unavailable, as long as historical fluctuations in the original and replacement indices were substantially similar, and as long as the replacement index and margin will produce a rate similar to the rate that was in effect at the time the original index became unavailable. If the replacement index is newly established and therefore does not have any rate history, it may be used if it produces a rate substantially similar to the rate in effect when the original index became unavailable."

The Proposed Regulations would move the comment set forth above to a new Section 1026.55(b)(7)(i) and add a new clause (b)(7)(ii). Similar to the changes described above with respect to HELOCs, the new clause (b)(7)(ii) would create a new Libor-specific replacement right for card issuers, allowing issuers to convert from Libor and increase an APR on or after March 15, 2021 "as long as historical fluctuations in the LIBOR index and replacement index were substantially similar, and as long as the replacement index value in effect on December 31, 2020, and replacement margin will produce an annual percentage rate substantially similar to the rate calculated using the LIBOR index value in effect on December 31, 2020, and the margin that applied to the variable rate immediately prior to the replacement of the LIBOR index used under the plan." As with the HELOC terms, a newly established index may be used if "the replacement index value in effect on December 31, 2020, and the replacement margin will produce an annual percentage rate substantially similar to the rate calculated using the LIBOR index value in effect on December 31, 2020, and the margin that applied to the variable rate immediately prior to the replacement of the LIBOR index used under the plan."

The Proposed Regulations provide additional commentary and examples to further clarify and supplement the proposed changes to the regulations. In particular, the Bureau has determined that effective on a date to be specified, both the prime rate and certain ARRC-endorsed SOFR rates have "historical fluctuations that are substantially similar" to the replaced Libor rates. This determination satisfies one of the key requirements in both clauses (b)(7)(i) and (b)(7)(ii) regarding the replacement index and will simplify the process of determining compliance with those provisions.

The proposed regulations in clauses (b)(7)(i) and (b)(7)(ii) would give card issuers the option to replace Libor under either provision, as long as the relevant conditions are satisfied. As with the HELOC regulations, an important distinction between the two provisions relates to the timing of the determination of whether the new rate is "substantially similar" to the old rate. Under clause (b)(7)(i), the timing is based on the date on which Libor becomes unavailable. Under clause (b)(7)(ii), the timing is based on rates in effect as of Dec. 31, 2020, and the margin in effect immediately prior to replacement, which will allow card issuers to transition to replacement rates sooner than if they had to wait for Libor to become unavailable. The Dec. 31, 2020, comparison date should provide creditors with adequate time to provide all necessary notices ahead of the earliest permitted replacement date, March 15, 2021.

The Bureau is soliciting comments with respect to the determination of whether rates are "substantially similar," including whether the Bureau should provide factors that card issuers must consider in reaching that determination and if so, what those factors should be. In addition, the Bureau is soliciting comments on whether the final rule, if adopted, should provide that the rate using the SOFR-based spread-adjusted index is "substantially similar" to the rate calculated using the Libor index, so long as the card issuer uses as the replacement margin the same margin in effect on the day that the Libor index becomes unavailable (in the case of (b)(7)(i)) or the same margin that applied to the variable rate immediately prior to the replacement of the Libor index (in the case of (b)(7)(ii)).

As noted above, the Bureau makes clear that these provisions do not excuse creditors from satisfying the contractual requirements governing their credit card plans. Card issuers would remain subject to any contractual restrictions on the timing or selection of any replacement of Libor as the relevant index. The proposed examples provide some commentary on the interaction between the regulations and hypothetical contract terms.

Disclosure Requirements

HELOCs

Pursuant to existing Section 1026.9(c)(1), HELOC creditors are required to provide notice of any change in certain specified terms, including the replacement of the index or change in the components of the adjustable rate, at least 15 days prior to the effective date of the change (unless such change in consented to by the consumer). Section 1026.9(c)(1)(ii) provides an exception to such notice for changes involving a reduction of any component of a finance or other charge – creditors are ordinarily not required to notify customers of reductions to the components of the adjustable rate. Under the Proposed Regulation, this exception would not apply to a reduction of the margin that occurs on or after Oct. 1, 2021, where a Libor index is replaced pursuant to proposed Section 1026.40(f)(3)(ii)(A) or 1026.40(f)(3)(ii)(B) (each as described above). As a result, creditors replacing a Libor rate on or after Oct. 1, 2021, pursuant to proposed Section 1026.40(f)(3)(ii)(A) or 1026.40(f)(3)(ii)(B) will be required to provide notice not only of the index replacement, but also any change in the margin, even if the margin is decreased. With respect to replacements that occur prior to Oct. 1, 2021, creditors have the option to provide notice of the reduction of the margin, but are not obligated to do so. The Bureau believes that this proposed change would provide additional transparency for customers with respect to the determination of the adjustable rate going forward, while only marginally increasing the burden on the creditor. In addition, creditors are likely to want to provide this information to avoid confusion and because it is beneficial to the customers.

Non-HELOC Credit

Existing Section 1026.9(c)(2)(i)(A) requires creditors (other than HELOC creditors) to provide notice of any "significant change in account terms," including the replacement of the index or change in the components of the adjustable rate, at least 45 days prior to the effective date of the change (unless such change in consented to by the consumer). Section 1026.9(c)(2)(v) provides an exception to such notice for changes involving a reduction of any component of a finance or other charge – creditors are ordinarily not required to notify customers of reductions to the components of the adjustable rate. Under the Proposed Regulation, this exception would not apply to a reduction of the margin which occurs on or after Oct. 1, 2021, where a Libor index is replaced pursuant to proposed Section 1026.55(b)(7)(i) or 1026.55(b)(7)(ii) (each as described above). As a result, creditors replacing a Libor rate on or after Oct. 1, 2021, pursuant to proposed Section 1026.55(b)(7)(i) or 1026.55(b)(7)(ii) will be required to provide notice not only of the index replacement, but also any change in the margin, even if the margin is decreased. With respect to replacements that occur prior to Oct. 1, 2021, creditors have the option to provide notice of the reduction of the margin, but are not obligated to do so. As with the similar proposal for HELOCs, the Bureau believes that this proposed change would provide additional transparency for customers with respect to the determination of the adjustable rate going forward, while only marginally increasing the burden on the creditor. In addition, creditors are likely to want to provide this information to avoid confusion and because it is beneficial to the customers.

Reevaluation Provisions

Under existing Section 1026.59(a)(1), if a credit card issuer "increases an annual percentage rate that applies to a credit card account under an open-end (not home-secured) consumer credit plan, based on the credit risk of the consumer, market conditions, or other factors, or increased such a rate on or after January 1, 2009, and 45 days' advance notice of the rate increase is required pursuant to § 1026.9(c)(2) or (g)," the card issuer is required to periodically reevaluate certain factors and, based on such review, reduce the annual percentage rate applicable to the customer's account, as appropriate.

In the release accompanying the Proposed Regulations (Facilitating the LIBOR Transition (Regulation Z), 85 FR 36938, June 18, 2020; see 36950), the Bureau indicates that the industry has raised concerns about the application of Section 1026.59(a)(1) to the transition away from Libor. The release suggests that the transition from a Libor index to a different index pursuant to proposed Section 1026.55(b)(7)(i) or Section 1026.55(b)(7)(ii) (each as described above) may constitute a rate increase that would subject an account to the reevaluation requirements. Existing Section 1026.59(h) provides two exceptions to the reevaluation requirement set forth in Section 1026.59(a)(1), but neither exception provides any relief from these concerns.

The Proposed Regulations would add a third exception as clause (3) under Section 1026.59(h). This exception would expressly state that the reevaluation requirements of Section 1026.59(a)(1) do not apply to an increase that occurs as a result of the transition from a Libor rate as long as the change occurs in accordance with Section 1026.55(b)(7)(i) or Section 1026.55(b)(7)(ii). This proposal is intended to clarify the obligations of credit card issuers and encourage issuers to transition away from Libor sooner than they might otherwise if it would trigger reevaluation obligations. A proposed comment to this new exception would clarify that the exception does not apply to rate increases already subject to Section 1026.59 prior to the transition from the Libor rate to another index in accordance with Section 1026.55(b)(7)(i) or Section 1026.55(b)(7)(ii).

The terms of existing Section 1026.59 raise one additional concern with respect to the transition away from Libor. Section 1026.59(f) provides conditions under which a card issuer's existing obligation to reevaluate the factors pursuant to Section 1026.59(a)(1) may be terminated. Under that Section, the issuer's obligation to reevaluate will cease if the issuer reduces the annual percentage rate "to the rate applicable immediately prior to the increase, or, if the rate applicable immediately prior to the increase was a variable rate, to a variable rate determined by the same formula (index and margin) that was used to calculate the rate applicable immediately prior to the increase." This provision, however, provides no guidance in the event that the index that was previously used to calculate the rate no longer exists. This situation would arise if an issuer was subject to Section 1026.59 prior to the conversion away from Libor – the subsequent unavailability of Libor would make it impossible for an issuer to satisfy the conditions to cease reevaluation.

Proposed Section 1026.59(f)(3) would create a new condition to allow the issuer to cease reevaluation. Under that proposal, an issuer could cease reevaluation if, "in the case where the rate applicable immediately prior to the increase was a variable rate with a formula based on a LIBOR index, the card issuer reduces the annual percentage rate to a rate determined by a replacement formula that is derived from a replacement index value on December 31, 2020, plus replacement margin that is equal to the LIBOR index value on December 31, 2020, plus the margin used to calculate the rate immediately prior to the increase (previous formula)." In addition, an issuer would be required to satisfy the conditions set forth in § 1026.55(b)(7)(ii) for selecting a replacement index. This new provision would be effective as of March 15, 2021. By providing a measurement against the Dec. 31, 2020, rates, the new condition provides issuers with a method to cease reevaluation even after Libor has been discontinued. The Bureau believes that the reference to Dec. 31, 2020 provides a "static and consistent reference point by which to determine the formula," and is also consistent with the index values used in the transition permitted under proposed Section 1026.55(b)(7)(ii).

Proposed additional comments to the rule would provide specific examples of the application of proposed Section 1026.59(f)(3).

Technical Edits

In addition to the changes described above, the Proposed Regulations include a number of technical edits to the open-end credit regulations. These revisions generally replace references to Libor with references to SOFR, and include corresponding and conforming changes.

Closed-End Credit

The Proposed Regulations also provide certain revisions specific to closed-end credit. Closed-end credit generally includes all forms of credit other than open-end credit.

Refinancings

Pursuant to existing Section 1026.20, a refinancing of closed-end credit triggers certain disclosure and other requirements. Section 1026.20(a) and its related commentary provide a number of clarifications and exceptions regarding specific types of actions that would or would not constitute a refinancing. In particular, Comment 20(a)-3.ii.B provides that a refinancing results if the creditor "adds a variable-rate feature to the obligation," but clarifies that "a creditor does not add a variable-rate feature by changing the index of a variable-rate transaction to a comparable index, whether the change replaces the existing index or substitutes an index for one that no longer exists."

The Bureau proposes to conclude that certain applicable ARRC-endorsed SOFR rates would constitute "comparable indexes" to the Libor rates being replaced. The Proposed Regulations would add to Comment 20(a)-3.ii.B an illustrative example that would specify that a creditor does not add a variable-rate feature (and, therefore, does not trigger a refinancing) by changing the index of a variable-rate transaction "from the 1-month, 3-month, 6-month, or 1-year USD LIBOR index to the spread-adjusted index based on SOFR recommended by the ARRC to replace the 1-month, 3-month, 6-month, or 1-year USD LIBOR index respectively because the replacement index is a comparable index to the corresponding USD LIBOR index." This determination would simplify the analysis for creditors, while maintaining the spirit of the regulation to protect consumers.

Technical Edits

In addition to the change above, the Proposed Regulations include a number of technical edits to the closed-end credit regulations. These revisions generally replace references to Libor with references to SOFR, and include corresponding and conforming changes.

Conclusion

The final rules set forth in the Proposed Regulations would take effect on March 15, 2021, except that the rules relating to the change-in-term disclosure requirements for HELOCs and credit cards would apply as of Oct. 1, 2021. The Bureau is soliciting comments on the Proposed Regulations through Aug. 4, 2020.

For more information on the Proposed Regulations and how they could impact your organization, please contact the authors.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.