On June 14, 2010, the Federal Reserve Board amended its Regulation Z to implement certain provisions of last year’s Credit Card Accountability, Responsibility, and Disclosure Act (the “CARD Act”). The Board has been periodically adopting regulations to implement various provisions of the CARD Act.1 This most recent action affects penalty fees (such as late payment fees and over-limit fees) and interest rates.

As to penalty fees, the new rule requires that any penalty fee imposed by a credit card issuer be reasonable and proportional to the violation of the cardholder agreement.

As to interest rates, it requires that (1) credit card issuers reevaluate every six months annual percentage rates (“APRs”) that were increased on or after January 1, 2009 and (2) notices of rate increases disclose the principal reasons for the increase.

Except for compliance with amendments to penalty fee disclosures (which are effective December 1, 2010), compliance is mandatory August 22, 2010. The Board proposed these rules March 15, 2010 and received more than 22,000 public comments on them.

Penalty Fees

The statute required the Board in issuing these rules to consider (1) costs incurred by the creditor from a violation, (2) deterrence of violations, and (3) cardholder conduct.

The final rule lets an issuer charge a penalty fee if it has determined that the amount of the fee represents a reasonable proportion of the costs it incurs as a result of the type of violation. Thus, in the case of a late payment, collection costs, such as the cost of notification of the customer and the cost of establishing workout and temporary hardship arrangements, may be considered in justifying the penalty fee. However, higher loss rates and associated reserves must be excluded from the analysis. Because costs change, costs are to be re-evaluated annually.

The Board had considered that, instead of basing a penalty fee on cost, an issuer might be allowed to base such fee on a determination that the amount was necessary to deter violations. However, the Board decided, in the final analysis, that “would not effectuate the purposes of the Credit Card Act”. However, the Board did decide to permit, as an alternative to a cost analysis, a “safe harbor” of a $252 penalty fee for a first violation and a $353 fee for any additional violation of the same type during the next six billing cycles4.

The Board, in considering consumer conduct, adopted two prohibitions. First, an issuer is prohibited from imposing penalty fees greater than the dollar amount “associated” with the violation, and, thus, a consumer who exceeds a credit limit by $10 may not be charged an over-limit fee of more than $10; and a consumer who is late making a $10 minimum payment cannot be charged a late fee of more than $10. The safe harbor penalty fees mentioned in the preceding paragraph would be subject to this cap. Second, an issuer may not impose multiple penalty fees based on one event, and, thus, if a payment is late and the check representing the payment is returned unpaid, only one penalty fee may be charged, not both a late payment fee and a returned item fee.

Reevaluation of Rate Increases

The CARD Act requires that a card issuer that has increased an APR on an account, based on credit risk or market conditions or other factors, must, at least every six months, consider changes in such factors and determine whether to reduce the APR, maintaining reasonable methodologies for doing so.

The Board’s final rule requires that any reduction occur within 45 days after completion of the evaluation.

The issuer may review using either the same factors originally considered or those the issuer currently considers in acting on new account applications. However, for rate increases between January 1, 2009 and February 21, 2010, an issuer’s first two reviews are to be based on factors the issuer currently considers in the case of new accounts unless the rate increase was based solely on consumer-specific reasons, such as the consumer’s delinquency.

The final rule terminates the obligation to review once the rate is reduced to the rate in effect prior to the increase. Otherwise, the rule requires reevaluations every six months indefinitely.

Practical Considerations

In light of the expense associated with justifying penalty fees by computing costs of violations and reevaluating those costs annually, issuers are strongly incented to use option of the safe harbor penalty fees of $25 for a first violation and $35 for the next six billing cycles.

Similarly, to the extent that the expense of reevaluating rate increases every six months, issuers would also seem to be strongly incented to avoid rate increases and even to roll back any existing post-January 1, 2009 rate increases, offsetting that expense with higher rates on new accounts.