The most widely used index for adjustable-rate consumer contracts, the LIBOR, will soon cease to exist. This article explains new legal requirements that will apply when creditors are forced to change the index and margin on $1.4 trillion of adjustable-rate consumer contracts—millions of home mortgages, home equity lines of credit (HELOCs), credit cards, and private student loans. March 15 federal legislation and an amendment to Truth in Lending Act (TILA) regulations, effective April 1, specify how the transition to a new index must be made and clarifies creditor and servicer exposure to consumer class and individual litigation.
The $200 Trillion Problem Affecting Variable-Rate Consumer Credit, Other Financial Transactions
$200 trillion in financial transactions in the United States are tied to what has been referred as the world’s most important number—the LIBOR or London Interbank Offered Rate. The LIBOR is also the index used to compute the interest rate for approximately $1.4 trillion of adjustable-rate consumer contracts. The consumer’s interest rate is the sum of the LIBOR rate and a fixed margin. The interest rate is periodically reset on a schedule determined by the contract. Consumer contracts use either the one-month, three-month, six-month, or twelve-month LIBOR rate.
The LIBOR is currently on its death bed and, as of June 30, 2023, will no longer be published, largely because it has been shown to be vulnerable to bank manipulation. A criminal rate-setting conspiracy implicated large international banks and undermined public confidence in the LIBOR index. Because LIBOR rates will no longer be available as of June 30, 2023, creditors and servicers will soon have to replace the index for the millions of adjustable-rate consumer credit contracts based on the LIBOR.
This will lead to creditor and servicer exposure to consumer litigation and will raise many questions. Is there authority to replace the index and create a new margin? Has a reasonable alternative index been chosen? Was the new margin correctly computed? Have the new rates been properly integrated into creditor and servicer software or does this all lead to mistakes in payment amounts that are costly for the consumer? Has the creditor properly disclosed the change as required by the Truth in Lending Act (TILA)? Have any resulting changes in the rate complied with other TILA requirements? Since anything improper will be done on a widespread basis, there will be considerable exposure to consumer class actions.
On an individual basis, if there is a concern that a creditor or servicer miscalculates the interest rate on a mortgage loan based on a replacement index and margin, consumers can send their servicer a qualified written request and use the Real Estate Settlement Procedures Act error resolution process. See NCLC’s Mortgage Servicing and Loan Modifications § 3.3. Consumers with affected credit cards and HELOCs can follow the error correction procedures in the Fair Credit Billing Act. See NCLC’s Truth in Lending § 7.9.
Beware of Creditors Switching to a New Index Other Than a Spread-Adjusted SOFR
Consumer contracts using a LIBOR index invariably include terms allowing the note holder to replace the index if it becomes unavailable, but the language is often vague and one-sided, making the transition to a new index subject to challenge. No one alternative index behaves the same as the LIBOR, so changing the index even with a reasonable choice can prejudice consumers. Industry is concerned about an avalanche of litigation as it changes indices and margins and, for this reason, virtually no one in the industry has yet changed indices. But they will soon be forced to do so.
A committee of federal bank regulators and finance industry participants has recommended the spread adjusted SOFR (Secured Overnight Financing Rate) as the best replacement for consumer contracts. The SOFR reflects what banks pay each other for overnight loans secured by Treasury bonds. The SOFR is a daily index, but compound averages are used to produce one-month, three-month, six-month, and twelve-month SOFR term rates.
Because the SOFR is consistently lower than the LIBOR, a spread adjusted version of each SOFR term rate will also be available. It is computed by adding a fixed margin to the SOFR rate to approximate that difference. The Federal Reserve recommends using the spread adjusted index as a replacement for the same term LIBOR rates. This eliminates the need to change the contractual margin in existing credit agreements.
The official spread-adjusted SOFR will be computed on June 30, 2023, by comparing the current SOFR and LIBOR, but in the meantime, an approximate value can be calculated using the SOFR and LIBOR values for the same period and term. The official SOFR values will eventually be published on a freely accessible website. For now, SOFR rates can be found here. More information about the SOFR is available here and at 86 Fed. Reg. 69,716, 69,730 (Dec. 8, 2021).
Because federal regulators and industry have determined that a spread-adjusted SOFR is the best approximation for a LIBOR index, practitioners should view with suspicion a creditor that replaces the LIBOR with any other index—does this index initially produce a substantially similar rate, and does it sufficiently approximate the way the LIBOR changes over time to continue to produce substantially similar rates in the future? The Consumer Financial Protection Bureau has also determined that the prime rate published in the Wall Street Journal has historical fluctuations substantially similar to the LIBOR. As described below, use of a different index than the SOFR or prime rate may result in TILA violations and may lose the protection provided by recent federal legislation.
March 15 Congressional Legislation Regulates the LIBOR Replacement
On March 15, 2022, the President signed the Adjustable Interest Rate (LIBOR) Act into law, as part of the 2022 Consolidated Appropriations Act. See Division U of Public Law No. 117-103 (Mar. 15, 2022). Division U § 105 provides a safe harbor from liability for creditors and servicers that, as a replacement index, adopt a spread-adjusted SOFR, as set out by the Federal Reserve Board, but use of SOFR as a replacement index is voluntary. The legislation also clarifies the limits of the safe harbor.
The legislation provides that a creditor will be immune from liability for use of a spread-adjusted SOFR instead of a LIBOR index. If the creditor uses another index and margin, it risks being sued if that replacement is not clearly authorized by the contract and prejudices consumers. Even using the spread-adjusted SOFR, a creditor or servicer can be subject to suit for miscalculating the index or for actions other than the strict choice of the SOFR replacement index.
Section 105(b)(2) specifically provides that a credit agreement is still enforceable even though a replacement index is utilized. Of course, the consumer may have a cause of action if the replacement index is improperly chosen.
A safe harbor is also provided if a creditor or servicer makes so-called “conforming changes,” which are other contract changes needed to make the SOFR fit into a contract. For consumer contracts, the Federal Reserve Board will issue rules setting forth what conforming changes will be covered by the safe harbor. An example of what might be permitted is changing the contractually designated day of the month on which the current index value is identified, if the SOFR is not available on the date originally specified in the contract.
Note holders are not permitted to change a consumer’s rights or the cost of a contract under the guise of making “conforming changes” or by picking an inappropriate replacement index. Other than the safe harbor, section 104(f)(6) broadly preserves the right to sue if harmed by those actions for corrections and damages needed when a servicer makes mistakes. Section 104(f)(5) preserves federal consumer financial laws requiring creditors to send change-in-terms notices to borrowers and regarding the re-evaluation of credit card rate increases.
Section 104(f)(4) states that change of the index does not affect “any cap, floor, modifier, or spread adjustment to which LIBOR had been subject” under existing contract language. The listed contract terms cannot be changed when implementing the alternative index unless changes are specifically authorized elsewhere—such as by the contract at issue, another law or regulation, or the pending definition of “conforming changes” to be issued by the Board.
The CFPB LIBOR Transition Rule, Effective April 1, Amends TILA Regulation Z
On December 8, 2021, the CFPB issued a final rule, effective April 1, 2022, amending Regulation Z to account for the end of the LIBOR, often called the “LIBOR Transition Rule.” The rule treats separately closed-end variable rate credit (primarily home mortgages and private student loans) and open-end credit (primarily HELOCs and credit cards).
NCLC’s Truth in Lending Appendix B has been updated to include the LIBOR Transition Rule changes to Regulation Z and NCLC’s Truth in Lending Appendix C has been updated with the respective changes to Regulation Z’s Official Staff Interpretations. The changes will soon be incorporated into the treatise’s text. Useful materials explaining the rule are also found on the CFPB website.
LIBOR Transition Requirements for Variable-Rate Mortgages and Private Student Loans
Other than replacing the word LIBOR throughout Regulation Z with the term SOFR, the LIBOR Transition Rule for closed-end credit focuses on whether a replacement index is comparable. The existing interpretation regarding post-consummation disclosures states that replacing an index with a comparable index is not considered refinancing a transaction and does not require the creditor to re-issue disclosures required when consummating a refinancing. Reg. Z Official Interpretations § 20(a)(3)(ii)(B). New disclosures are required if a replacement index is not comparable; the failure to make new disclosures would be a TILA violation. See Reg. Z Official Interpretations § 20(a)-3(ii)(B). See also NCLC’s Truth in Lending § 5.15.3.
The LIBOR Transition Rule sets out factors for determining whether a replacement index is not comparable, for determining if the change is to be considered a refinancing, requiring new disclosures. An index is comparable if it is publicly available, outside the creditor’s control, moves in a manner comparable to the LIBOR over time, and will have a comparable impact on consumer payments. See new Reg. Z Official Interpretations § 20(a)-3(iv). The LIBOR Transition Rule identifies the spread adjusted one-month, three-month, and six-month SOFR indices as comparable to replace the one-month, three-month, and six-month LIBOR indices. The CFPB has not yet decided if the twelve-month SOFR is comparable to the twelve-month LIBOR. See new Reg. Z Official Interpretations § 20(a)-3(ii)(B).
LIBOR Transition Requirements for Variable-Rate HELOCs and Credit Cards
The LIBOR Transition Rule provides, for HELOCs (including reverse mortgage HELOCs) and credit cards, that the creditor can replace the LIBOR with a new index and margin on or after April 1, 2022—that is, it can do so even before the June 30, 2023, discontinuation of the LIBOR. The replacement index and replacement margin must result in an APR substantially similar to the APR calculated using the LIBOR index values on a specified date and the account’s existing margin. See new Reg. Z §§ 1026.40(f)(3)(ii)(B) (HELOCs), 1026.55(b)(7)(i) (credit cards).
A replacement index also must have historical fluctuations substantially similar to those of the LIBOR being replaced, unless the replacement index is newly established. The LIBOR Transition Rule identifies as meeting the historical fluctuation requirement a spread-adjusted SOFR to replace a one-month, three-month, or six-month LIBOR, as will be computed by June 30, 2023. Also meeting the historical fluctuation requirement is the prime rate published in the Wall Street Journal with respect to a one-month and three-month LIBOR. See new Reg. Z §§ 1026.40(f)(3)(ii)(B) (HELOCs) and 1026.55(b)(7)(ii) (credit cards).
Existing Regulation Z requires for HELOCs and credit cards a change-in-terms notice disclosing a new index and, if the margin increases, then the new margin. See NCLC’s Truth in Lending §§ 6.8.4, 8.5.3. The LIBOR Transition Rule adds to this by requiring disclosure of a new margin even if the margin decreases. Compliance is not mandatory until October 1, 2022, but creditors can comply beginning April 1, 2022. See new Reg. Z §§1026.9(c)(1)(ii) (HELOCs) and 1026.9(c)(2)(v)(A) (credit cards).
Additionally, the LIBOR Transition Rule details how a creditor may disclose information about the periodic rate and APR in a change-in-terms notice for HELOCs and credit cards if the creditor will use a spread-adjusted SOFR to replace the one-month, three-month, or six-month LIBOR, since precise SOFR rates will not be released until June 30, 2023. If the change-in-terms notice is sent before June 30, 2023, the creditor may state that information about the rate is not yet available, but that the creditor estimates that, at the time the index is replaced, the rate will be substantially similar to what it would be if the index did not have to be replaced, and that the rate will vary with the market based on a SOFR index. See new Reg. Z Official Interpretation § 1026.9(c)(1)-4.
The LIBOR Transition Rule provides an exception to the normal requirement that a card issuer increasing a consumer’s interest rate (because of a perceived increase in the consumer’s risk) must re-evaluate the increase after six months and continue doing so every six months until the rate is reduced to the same rate as before. See NCLC’s Truth in Lending § 7.2.5.
Effective April 1, 2022 (and not applicable to rate changes prior to that date), if the transition from the LIBOR to a new index meets the substantially similar and historical fluctuation requirements described above, the card issuer is exempted from the rate re-evaluation requirement for a rate increase that occurs solely because of the LIBOR transition. See new Reg. Z § 1026.59(h)(3). (Note that any rate increase will be minor, or the index transition would not meet the substantially similar requirement.) This exception does not apply to changes in the APR not required by the LIBOR transition.
The LIBOR Transition Rule also explains, for situations where this exception does not apply, how to calculate the same rate as before, such as where the rate increase occurred prior to the card’s issuer’s transition from the LIBOR and the re-evaluation occurs using a new index. See new Reg. Z §1026.59(f)(3).