The Federal Reserve Board issued a final rule last week that establishes default rules for benchmark replacements in certain contracts that use the London Interbank Offered Rate (LIBOR) as a reference rate.  LIBOR will be discontinued in June 2023.  The rule implements the Adjustable Interest Rate (LIBOR) Act, which was enacted in March 2022.  The final rule will be effective 30 days after the date it is published in the Federal Register.

In response to the discontinuation of LIBOR, Congress enacted the LIBOR Act to provide a uniform, nationwide solution for replacing references to LIBOR in existing contracts with no or inadequate fallback provisions, meaning no or inadequate contract provisions for determining an alternative reference rate.  For these contracts, the final rule replaces references to LIBOR in the contracts with the applicable Board-selected replacement rate after June 30, 2023.  The rule identifies five separate Fed-selected replacement reference rates for different types of contracts, including consumer credit transactions.  As required by the LIBOR Act, each replacement reference rate is based on the Secured Overnight Financing Rate (SOFR).

The CFPB addressed the discontinuation of LIBOR through Regulation Z and Official Staff Commentary amendments issued in December 2021.  The final rule became effective on April 1, 2022, with the exception of certain changes to two post-consummation disclosure forms that become effective on October 1, 2023.  The mandatory compliance date for revisions to Regulation Z change-in-terms notice requirements was October 1, 2022 and the mandatory compliance date for all other provisions of the final rule was April 1, 2022.

Before the amendments, Regulation Z’s open-end credit provisions only allowed HELOC creditors and card issuers to change an index and margin used to set the APR on a variable-rate account when the original index “becomes unavailable” or “is no longer available” and certain other conditions are met.  Having determined that all parties would benefit if creditors and issuers could replace a LIBOR-based index before LIBOR becomes unavailable, the CFPB’s final rule added a new provision that allows HELOC creditors and card issuers (subject to contractual limitations) to replace a LIBOR-based index with a replacement index and margin on or after April 1, 2021, including an index based on the SOFR.  However, in connection with the final Regulation Z rule, the CFPB reserved judgment on whether it would identify a SOFR-based index as comparable to the 1-year LIBOR index, indicating that it would consider whether to issue a supplemental final rule on replacements to the 1-year LIBOR index after reviewing the Alternative Reference Rates Committee’s recommendations for a replacement rate.  In May 2022, the ARRC recommended the use of the 12-month SOFR term rate to replace 12-month LIBOR rates.

For closed-end credit, Regulation Z provides that a refinancing subject to new disclosures results if a creditor adds a variable-rate feature to a closed-end credit product but that a variable-rate feature is not added when a creditor changes the index to one that is “comparable.”  The CFPB’s final rule added new commentary that provides examples of the types of factors to be considered in determining whether a replacement index is a “comparable” index to a particular LIBOR-based index.

For consumer loans subject to Regulation Z that give the creditor or card issuer authority to replace a LIBOR-based index with a new index that is not based on LIBOR, the LIBOR Act would not require the creditor or card issuer to use a SOFR-based replacement index.  However, pursuant to the LIBOR Act and the Fed’s final rule, the Fed-selected SOFR-based index will automatically replace a LIBOR-based index if the creditor or card issuer has not selected a replacement index by the earlier of the date LIBOR is discontinued or the latest date for selecting a replacement index under the terms of the credit contract.

The LIBOR Act provides a number of  safe harbor provisions that protect a creditor that selects the SOFR-based rates designated in the Fed’s final rule as a replacement for a LIBOR-based index.  In response to comments on its proposed rule, the Fed added a new section to the final rule that expressly states that the LIBOR Act’s safe harbor protections apply to any LIBOR contract for which a Fed-selected replacement rate becomes the replacement rate pursuant to the provisions of the final rule.  Also in response to comments, the Fed affirmed in its discussion of the final rule that, consistent with the LIBOR Act, the final rule does not affect any requirements imposed by any provision of Federal consumer financial law.

For more recent closed-end adjustable-rate notes that use a LIBOR-based index, Fannie Mae and Freddie Mac have adopted fallback language that would require the noteholder to replace a LIBOR-based index with the SOFR-based index designated in the Fed’s final rule.  Even if not required by the LIBOR Act, Regulation Z, or contract to replace a LIBOR-based index with a SOFR-based index, HELOC lenders and card issuers should consider whether to take advantage of the LIBOR Act’s safe harbor provisions when selecting a replacement index.  In addition, the safe harbor provisions should also be considered by noteholders or other creditors before selecting a  replacement index for closed-end adjustable-rate mortgages or other closed-end variable-rate credit products that do not contractually require use of a SOFR-based replacement index.