Staff commentary buried deep within the recently issued final rules implementing provisions of the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the "CARD Act") briefly touches on interest rate floors. As a result of this staff commentary in the final rules, "floors" on variable rate credit card plans may soon be a thing of the past.
As mentioned in a previous Alert, the Board of Governors of the Federal Reserve (the "Board") has issued a "final rule" which amends various sections of Regulation Z ("Reg Z") and adds new sections to Reg. Z. Except for a few provisions, the majority of the final rule becomes effective February 22, 2010.
One provision of the final rule creates a new Section 226.55(a) in Reg. Z. This section prohibits credit card issuers from increasing rates on credit card charges and balances, unless the card issuer does so under a specific exception. One of the listed exceptions permits rates that "vary according to an index that is not under the card issue's control" to increase. 12 C.F.R. § 226.55(b)(2). In other words, rates that are tied to, for example, the prime rate published in the Wall Street Journal, are permitted to increase when that prime rate increases. This is because the rate published in the Wall Street Journal is not under the card issuer's control.
Unfortunately, the staff commentary for this section states that, for purposes of Section 226.55(b)(2), an index is considered to be under the card issuer's control if the "variable rate is subject to a fixed minimum rate or similar requirement that does not permit the variable rate to decrease consistent with reductions in the index." In other words, if the variable rate plan has an interest rate floor, the variable rate plan does not qualify under the above exception.
This leaves very few options for credit card issuers that have variable rate plans with "floors."
One option for issuers of variable rate plans may be to keep the floor. Under this option, the plan will not be eligible for the Section 226.55(b)(2) exception and, after February 22, 2010, the interest rate will never be allowed to increase unless it is permitted to do so under another exception. In essence, it will no longer be a variable rate plan because the rate can only stay stuck at the current floor rate or decrease. Since card issuers will not want to be saddled with a plan that can only decrease and never increase, it will be in their best interests to "fix" the rate by converting the plan to a non-variable rate plan. Thus, even though the issuer has kept the "floor" it no longer has a variable rate plan and the "floor" has become meaningless.
If the issuer under this option chooses to increase its rates in the future under the "45-day advance notice" exception in Section 226.55(b)(3), the new rate will apply only to new charges incurred more than 14 days after the 45-day notice has been given. The outstanding balance will be frozen at the then-current rate. The advantages of having the entire balance being charged a rate that moves with an index will have been lost.
A second option may be to give a 45-day notice to cardholders that their plans are being revised to remove the "floor." The immediate downside to this option is that most rates will fall dramatically once the "floor" is removed at the next reset date following the 45-day period. Neither will rates be allowed to increase until the notice period has elapsed. Because it is uncertain as to when interest rates will begin to rise, the issuer could be stuck with these low rates for an extended period of time. The benefit to this option, however, is that the issuer will have a "true" variable rate plan under which all balances will be charged at a rate that moves with an index.
A third option may be to remove the "floor" and increase the margins that are added to the index, in the hope that the increase in margins will make up any losses associated with losing the "floor." Because an increase in margins would likely constitute a "significant change in account terms" under Section 226.9(c)(2), an issuer that chooses this option will likely be required to provide 45-day advance notice.
Unfortunately, if the change in margins at the next reset date results in an increased rate above the current rate, then the rate increase is not as a result of a change in an index not under the issuer's control; i.e ., not a Section 226.55(b)(2) increase. As a result, the new rate may be applied only to transactions that occur more than 14 days after the notice is given and outstanding balances would be frozen at the current rate. Future rate increases will only be available by giving a 45-day notice and only new charges would be subject to the increased rate. The practical effect is that the plan will have converted to a non-variable rate plan under which increased rates can only be applied to new charges and only after giving a 45-day notice.
Not all hope is lost, however. If the increase in margins does not result in a rate increase at the next reset date, then the floor will have been removed and the new margins will be in place. Consider this scenario: the index on a variable rate plan is currently 2 percent, the margin is 3 percent but the floor is 9 percent. The required 45-day notice is given that at the next reset date the floor will be removed but the margin will increase to 6 percent. On the next reset date, assuming the index does not increase more than 1 percent, the new rate will be 9 percent or less, which means there has been no increase from the current rate.
Subsequently, if at the next reset date the index increases, the increased rate will be permitted under Section 226.55(b)(2) and will apply to the entire balance, not just the new charges. Going forward, the entire balance will be subject to the new rates at each reset date, irrespective of whether they increase or decrease. The plan remains a valid variable rate plan, albeit without a floor. Thus, although the issuer may have lost its "floor," it can keep its variable rate plan.