2/26/08

Jane Jarnis Senior and Lead Attorney, Wolters Kluwer Financial Services

As part of its proposed amendments to the Truth-in-Lending rules issued last May, the Federal Reserve Board (FRB) requested comment on changes to the very definition of consumer open-end lending. If adopted as proposed, this definitional change will have a significant impact on the lending practices of many financial institutions.

As we all know, the Truth in Lending Act, as implemented by Regulation Z, differentiates between consumer open-end and consumer closed-end credit and the disclosure rules for the two types of credit differ dramatically. Consumer open-end credit is very specifically defined; consumer closed-end credit is simply defined as consumer credit that is not open-end.

In this article, we will review both the existing and proposed rules as well as some industry feedback. As we’ll see in a moment, this 2007 proposal is not the first time the FRB has sought to clarify the definition of open-end lending.

Background

The Federal Reserve Board has indicated that, over the years, it has received comments from state attorneys general and consumer groups that the definition of open-end credit needs to be further clarified in order to aid creditors in their determination of whether to classify credit as an open-end plan or a closed-end transaction. These parties have expressed concerns that creditors may be treating certain credit transactions as open-end when they are truly closed-end transactions and that, as a result of this misclassification, consumers are not receiving the proper Truth-in-Lending disclosures.

The Federal Reserve Board sought to address these issues a decade ago. However, in response to industry concerns raised about its 1997 proposal, the Board decided to withdraw most of its proposed revisions.

Current Rules

In general, the regulation defines open-end credit as consumer credit extended under a plan with the following three characteristics:

• The creditor expects consumers to make repeated transactions,
• A finance charge may be imposed on any outstanding unpaid balance, and
• The amount of credit available to the consumer is replenished as the outstanding balance is repaid. That is, the consumer may borrow, repay, and borrow again.

Let’s take a look at how the commentary, as it exists today, addresses certain key definitional components of open-end consumer credit.

A Plan with Repeated Transactions

The current commentary recognizes that some creditors may offer a number of different credit features under one open-end credit plan. The consumer may have one account with the creditor with a number of subaccounts under which the creditor offers different credit features and rate structures. In addition, some subaccounts may be used repeatedly and others rather infrequently. The key is that the plan as a whole (not each subaccount) meets the definition of open-end credit.

To qualify as an open-end plan, the creditor must contemplate that consumers will make repeated transactions under the plan as a whole. In other words, it is not necessary that the creditor expects the consumer to repeatedly use each separate subaccount under the plan.

Replenishing Credit Line

Another term often used to refer to open-end credit is revolving credit. It is contemplated that under an open-end plan, the consumer can borrow, repay, and borrow again. That is, the consumer may take an advance and as the consumer repays the advance, the available credit is replenished and the consumer can reuse the credit.

The commentary notes that this “unlimited” credit is a key differentiator between open-end credit and closed-end credit. However, this does not mean that the creditor cannot change the amount of credit available to the consumer under the plan. Throughout the life of the plan, the creditor may verify the consumer’s financial condition, such as employment status and income, and reduce the consumer’s credit limit or suspend credit advances as may be appropriate.

Proposed Rules

The Federal Reserve Board is not proposing any definitional changes to the regulation itself. Instead, by making changes to the commentary, the FRB seeks to provide further guidance to help creditors properly characterize consumer credit.

Under the proposal, the focus will shift from the plan as a whole to each subaccount. Thus, when determining if the credit is an open-end credit plan or a closed-end credit transaction, the creditor must evaluate each subaccount individually. Each individual subaccount must meet the open-end credit definition set forth at the beginning of this article. As demonstrated by the industry reaction discussed below, this shift may have a significant impact on banking practices.

The Federal Reserve Board has identified two specific issues of concern. The first concern is a creditor’s review of the consumer’s credit information before making each advance. The second concern is the failure of the line to replenish to the extent the consumer has made payments. And, as mentioned above, when considering these two issues, the focus will be on each subaccount, not the plan as a whole. Each subaccount must meet the criteria. Let’s take a closer look. 

A Plan with Repeated Transactions

The consumer must be able to take repeated advances without having to separately qualify for each advance. The proposed commentary clarifies that while a creditor may continue to verify a consumer’s credit information, it cannot evaluate the consumer’s credit information before each advance.

Replenishing Credit Line

As proposed, the commentary continues to recognize the concept of one open-end credit plan with different plan features or subaccounts. But, it clarifies that the credit available under each separate subaccount must be replenished as the consumer repays prior advances. That is, the consumer must be able to continue to take advances under each subaccount to the extent that the outstanding balance of the subaccount is repaid.

Some Industry Reaction

As might be expected, many of those commenting requested that the Federal Reserve Board reconsider the proposed shift in focus. They asked that the focus remain on the credit plan as a whole and that the FRB eliminate the requirement that each subaccount be replenishable in order for the plan to be classified as open-end. In addition, they asked that the creditor be able to review the consumer’s financial condition before making advances. Let’s look at a couple of the examples addressed in the comment letters.

As stated in numerous comment letters, many open-end plans today replenish at the account or plan level, not at the subaccount level. It is fairly common for credit card issuers to offer a promotional APR on a balance transfer. In addition, some card issuers might offer a promotional APR with respect to a specific purchase. The promotional APR will apply only to the actual balance transferred or to the special purchase, not to the plan as a whole. As payments are made against the subaccount with the promotional APR, that subaccount will not be replenished, but the overall credit line will.

Some commenters also expressed concern about the proposed limitation on the creditor’s ability to evaluate the consumer’s credit information before an advance. These letters cited the practice of performing a credit review as part of the transaction authorization process. Here’s how this practice might work. If a requested advance would exceed the plan credit limit, the creditor might, at the time of the transaction, use automated underwriting as part of the authorization process, then increase the credit limit and make the advance.

The FRB’s proposed changes to the definition of open-end credit raises unique issues for the many credit unions who offer a multi-featured open-end credit plan. As explained by many commenters, under such a multi-featured plan, a member will typically have multiple loans or subaccounts with the credit union and will typically make repeated transactions under the plan. While the credit plan as a whole is replenishable, some of the subaccounts are not. For example, a member may have both an overdraft line of credit and an automobile loan under the plan. While the line of credit is replenishable, the automobile loan typically is not. In addition, advances made under some subaccounts may be individually underwritten and approved.

What’s Next

It will be some months before we will know what changes the Federal Reserve Board will ultimately make to the definition of open-end lending. The comment period ended October 12, 2007. As indicated in the proposed rules, the FRB intends to conduct further consumer testing of the effectiveness of its proposed open-end disclosures. In addition, the FRB may seek further comment on a few targeted issues this spring. We don’t expect to see final rules until the end of 2008.