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Debentures A brief on the Alternate source of Capital

legal method notes (Christ Academy Institute of Law)

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DEBENTURES: A BRIEF ON THE

ALTERNATIVE SOURCE OF CAPITAL

INDEX
S.N PAGE
TOPIC
O NO.

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1 ABSTRACT 3
2 INTRODUCTION 3
3 DEFINITION 4
DEFINITION ACCORDING TO
4 5
COMPANIES ACT, 2013
5 TYPES OF DEBENTURES 5
ISSUING AND REDEEMING
6 8
DEBENTURES
7 CONCLUSION 12
8 BIBLIOGRAPHY 13

ABSTRACT

This paper gives a brief about debentures, an alternate source of capital. It emphasizes on
how debentures are becoming a popular and flexible source of capital for companies and a
secured way for investors to invest their money on. This paper tries to define debentures in an
easy way and tries to simplify the definitions given under the Companies Act,2013 and lays
emphasis on as well as tries to clarify the procedures and the requirements a company has to
follow while issuing and redeeming a debenture, and also focuses on the types of debentures
that have developed over a period of time to attract various types of investors which have
emerged due to the growth and expansion in Indian business.

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INTRODUCTION

With the opening of the various doors by the globalization of the market, every business
house, whether it is a new venture or an established business house, needs funding from third
parties for research and development in order to gain a market advantage over its competitors

The corporate world offers several sources from which such business houses can raise funds
from the market. A significant number of companies raise capital by issuing public shares.
However, it is not viable for all companies as they are not equipped to go public. Particularly
companies that have only recently been founded. All of these modes have their own pros and
cons, as well as legal and procedural requirements, which is why these business houses prefer
to appoint professional consultants to understand the implications of each individual mode.
Depending on different scenarios, a business house and professional consultants come up
with the best feasible mode for raising funds.

For example, a business house wishing to retain its control would prefer floating debentures
to equity or preference shares given that it’ll result in dilution of ownership through the
issuance of equity and preference shares. Therefore as the cost of issuing debt is less than the
cost of issuing equity, debt financing is one of the most lucrative ways to raise funds for the
progress and expansion of business.

DEFINITION

A debenture is a tradable security that companies can issue to acquire long-term financing
without posting guarantees or diluting their capital. 1

A debt security is a type of long-term commercial debt instrument that may or may not be
secured by collateral. Governments or corporations use them to raise capital by borrowing
money from the public. It is a financing option for companies with solid finances that want to
avoid issuing shares and diluting their wealth. Debentures are also significant for companies

1 RYAN JOB, WHAT IS A DEBENTURE? BDC.ca (2019), https://www.bdc.ca/en/articles-tools/entrepreneur-

toolkit/templates-business-guides/glossary/debenture (last visited Jul 6, 2022).

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that do not want to tie up assets or that lack collateral for a classic loan. The word debenture
derives from the Latin word "debere" which means "to borrow" or "to lend".

A debenture is therefore a legal document that specifies how much money the investor
(principal) has given, the rate of interest to be paid, and the payment schedule. Investors
typically receive their capital when the debenture matures (at the end of its term). This means
that the company generally only pays the interest (a percentage of the face value of the
certificate or the loan amount) over the loan term and then settles the full principal (the loan
amount) when the certificate matures.

They are like unsecured loans in which the investor has no entitlement to the company's
assets if a default occurs. The reimbursement depends solely on the legal capacity of the
issuing company. However, before stock dividends are paid to its shareholders, the issuing
company will schedule interest payments on the debt. Sometimes companies issue them as
well, i.e. they have an asset like a mortgage. In liquidation, the company must primarily pay
the creditors by liquidating their assets.

Therefore, investors can check the credit ratings of these instruments before investing in
them.

When companies have otherwise pledged all of their assets as collateral, they can use bonds
to raise capital. This is because they have longer holding periods and lower interest rates. As
such, they can be more attractive than other types of long-term financing.

DEFINITION ACCORDING TO THE COMPANIES ACT, 2013

As per Section 2(30) of the Companies Act, 2013 “debenture” includes debenture stock,
bonds, or any other instrument of a company evidencing a debt, whether constituting a
charge on the assets of the company or not;2

provided that –

a) Instruments referred to in Chapter III-D of the Reserve Bank of India Act, 1934; and

2 COMPANIES ACT,2013, § 2(30), https://www.mca.gov.in/Ministry/pdf/CompaniesAct2013.pdf

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b) Any other instrument issued by a corporation prescribed by the central government in

consultation with the Reserve Bank of India shall not be treated as a debenture;

Debentures and bonds are in a way similar. Both propose businesses means to raise money
through debt.

Bonds are non-convertible short-term or long-term debts that can be secured or unsecured
whereas debenture stock are unsecured, convertible, and generally long-term debts. 3

Some of the salient features of debentures are as follows:

1. It is an acknowledgment of debt;
2. It is issued by the establishments under their common seal;
3. It can be secured or unsecured;
4. Interest rate and payment date are stated;
5. The debentures issued are freely transferable by the holders;
6. Debenture holders have no voting rights in the company;
7. Interest payable to debenture holders is charged against the Company's profits.

TYPES OF DEBENTURES4

1. BASED ON PERFORMANCE

Redeemable Debentures

Redeemable Debentures are debentures where the redemption date of the debentures is
expressly stated in the issued debenture statement, the company is legally obliged to repay
the principal amount to the debenture holder on the specified date.

Irredeemable Debentures

3 8 KEY FEATURES OF BONDS AND DEBENTURES, https://www.tomorrowmakers.com/other-investments/8-key-

differences-between-bonds-and-debentures-article
4 Khushnum Motafram,,DIFFERENT TYPES OF DEBENTURES AND THEIR USE , https://blog.ipleaders.in/different-
types-of-debentures-use/

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Irredeemable Debentures are perpetual and, unlike redeemable debt, there is no set date by
which the company must pay the debenture holders. It can only be redeemed when the
company goes into liquidation.

2. BASED ON SECURITY

Secured Debentures

When the debentures are issued by encumbering the assets of the Company, such debentures
are referred to as Collateralized debentures or secured debentures. The fee incurred on the
debentures may be fixed or variable. In accordance with the provisions of the Companies Act
2013, any position so created must be registered with the Registrar within 30 days of its
creation.

Unsecured Debentures

Unlike secured debentures, unsecured debentures are issued by the company without
encumbering the company's assets. In other words, these debentures offer no protection to the
debenture holder in the event that the company is unable to pay the principal on the due date.

3. BASED ON PRIORITY

First mortgaged debentures

In principle, the distinction of debentures by priority can be described as a subcategory of

secured debentures. The first mortgaged debentures are those debentures which rank senior to
all other debentures issued by the Company. This preference is asserted at the time of the
liquidation of the company, when the company's assets are distributed among the creditors.

Second Mortgaged Debentures

Second Mortgaged Debentures, rank second only to First Mortgage Obligations in relation to
the Company's assets at the time of liquidation. Only after the first creditors of debentures
are satisfied can the creditors of the second mortgaged debenture claim their principal on the
deal upon liquidation.

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4. BASED ON CONVERTIBILITY

Fully Convertible Debentures

Fully convertible debentures have the right, at the option of the debenture holders, to convert
their debentures into shares in the company's capital at a future date. The conversion ratio, the
post-conversion rights of the debenture holders, and the time at which the conversion is
triggered will be determined at the time these debentures are issued.

Partially Convertible Debentures

Partially Convertible debentures may be divided into two parts. The first part is the
debentures that are convertible into the company's share capital and the second part are the
non-convertible debentures that are repaid at the end of their mandate. The debenture holder
will be given an option to convert part of their debt into shares in the company. Partially
convertible debentures are also considered optional convertible debentures.

Non-convertible Debentures

Debentures that are not convertible into company equity are referred to as non-convertible
bonds. These debentures will be redeemed at maturity.

5. BASED ON RECORD

Registered Debenture

In the case of registered debentures, the company's name, address, number of debentures and
other information relating to holding are entered in the register of debentures. In such cases,
the transfer of debentures from one debenture holder to another will be recorded in both the
Register of dentures and the Register of transfer.

Unregistered Debentures

Unregistered Debentures are also known as Bearer debentures. Unlike registered debentures,
the company does not keep a record of such debentures and the principal and interest are paid
to the holder of the instrument in exchange for the name written on the instrument. These
debentures are readily transferable in the market.

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ISSUING AND REDEEMING DEBENTURES

Section 71 of the Companies Act 2013 and Rule 18 of Companies (Share Capital And
Debentures) Rules, 2014 lay down certain conditions for the issue and redemption of
debentures.

1) A corporation with approval by a special resolution at the general meeting may issue
debentures with an option to convert all or part of those debentures into shares at the
time of redemption
2) The redemption period for secured debentures is limited to ten years from the date of
issue. However, the following types of organisations can issue Debentures for a period
of more than ten years but not more than thirty years:5
 Companies engaged in the development of infrastructure projects;
 Infrastructure Finance Companies’ as defined in clause (viia) of sub direction (1)
of direction 2 of Non-Banking Financial (Non-deposit accepting or holding)
Companies Prudential Norms (Reserve Bank) Directions, 2007
 Infrastructure Debt Fund Non-Banking Financial Companies' as defined in clause
(b) of Direction 3 of the Infrastructure Debt Fund Non-Banking Financial
Companies (Reserve Bank) Directions, 2011;
 Companies authorised to issue debentures for a period of more than ten years by a
Ministry or Department of the Central Government, the Reserve Bank of India,
the National Housing Bank, or any other statutory authority.

The issuing and redemption of Debentures can be done at par, at premium and at discount.

At Par

The case of 'Issue of Debentures at Par' occurs when the payment received and the nominal
value of the debentures are equivalent or equal. In other words, it occurs when the issue price
is comparable to the debenture's face value.

For example, issuing Rs.1,000 Debentures for Rs.1,000.

At Premium
5 Rule 18, COMPANIES (SHARE CAPITAL AND DEBENTURES) RULES, 2014,
https://www.sebi.gov.in/sebi_data/attachdocs/apr-2017/1492085873402.pdf

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The 'Issue of Securities at Premium' occurs when a corporation issues securities at a price
higher than the nominal value. As a result, the Securities Premium Reserve is the excess issue
price over the face price.

For example, issuing Rs. 100 debentures for Rs. 110. The Rs. 10 is the premium6

At Discount

Debentures are said to be issued at discount when they are sold for less than their nominal
value (face value).

For example, if Rs. 100 debenture is offered to the public at Rs. 90, it is issued at a discount.
The corporation suffers a loss of Rs. 10 on each debenture. As a matter of equity, it is
preferable to deduct this loss.

The same is applicable while redeeming the debentures.

3) No company can issue debentures with voting rights and the company has to follow
the prescribed terms when issuing secured debentures.
4) A Debenture Redemption Reserve Account for the redemption of debentures shall be
established by the company out of the profits of the corporation available for payment
of dividends when debentures are issued by a corporation under this Section, and this
amount can be used by the company only for the repayment of bonds.

A Debenture Redemption Reserve (DRR) is a fund requisite retained by companies issuing

debentures in India. These efforts are designed to protect investors from the probability of the
company defaulting on payments. In addition, DRR ensures that sufficient funds are available
to meet the obligations of the debenture holders. In addition, the Company will only use the
funds available in DRR to redeem debentures.

5) A company has to appoint one or more debenture trustees in accordance with the
prescribed conditions governing their appointment to issue a prospectus or make an
offer or invitation to the public or to its members exceeding five hundred for the
subscription of its debentures.
6) A debenture trustee takes action to protect the interests of debenture holders and
resolve their complaints in accordance with prescribed rules.

6 K.Aggarwal, ISSUE OF DEBENTURE: AT PAR, PREMIUM AND DISCOUNT,

https://www.yourarticlelibrary.com/accounting/debentures/issue-of-debenture-at-par-premium-and-
discount/46934

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7) Any provision in a trust deed for securing the issue of debentures, or in any contract
with debenture-holders secured by a trust deed, shall be void insofar as it would have
the effect of exempting or indemnifying a trustee thereof from liability for breach of
trust, where he fails to demonstrate the standard of care and due diligence expected of
him as a trustee, pertaining to the provisions of the trust deed conferring on him any
authority
8) However, the debenture trustee's responsibility shall be subject to immunities as
agreed upon by a majority of debenture-holders holding not less than three-fourths of
the overall debentures at a meeting conducted for that purpose.
9) A corporation is required to pay interest and redeem debentures in accordance with
the terms and circumstances of their issuance.
10) If the debenture trustee determines that the company's assets are insufficient or are
possible to become insufficient to discharge the principal amount as and when it
becomes due, the debenture trustee may file an application before the Tribunal, and
the Tribunal may, by order, impose such constraints on the company incurring any
further debts as the Tribunal deems appropriate.
11) On the application of any or all of the debenture-holders or debenture trustees, the
Tribunal by order can direct the company to redeem the debentures immediately for
the payment of principal and interest due when a company fails to redeem the
debentures on the maturity date or fails to pay interest on the debentures when it is
due, thereon.
12) If any officer of the company fails to comply with the Tribunal's order under this
section, he or she must be punished with imprisonment for a term not less than three
years or with a fine not less than two lakh rupees but not less than five lakh rupees or
both.
13) An order for specific performance may be used to enforce a contract with the
company to take up and pay for any debentures of the corporation.
14) The Central Government may establish the procedure for securing
 the issuance of debentures,
 the type of debenture trust deed,
 the procedure for debenture-holders to inspect and get copies of the trust deed,
 the amount of debenture redemption reserve required to be formed,
 and other considerations.

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Issue of Debentures

1. Approved and authorised by AOA

2. Examine the borrowing limit to see whether it needs to be increased (can be done
separately before issue or can be approved at the same meeting)
3. Debenture valuation report for determining debenture price
4. Establishing a separate bank account for debt issuance and depositing funds there.
5. Call a Board of Directors meeting to ratify the following:
 Form PAS-4 and Application forms for offer letter approval Form PAS-5 approval
for registering private placement offer Debenture Trustee Appointment
of Debenture Trustee and create an agreement
 Confirmation of Debenture Subscription Agreement.
 To sanction the creation of a charge on the company's assets in the case of secured
debentures.
 To set the date and time for the shareholders' EGM/AGM.
 Send notification of the Extraordinary General Meeting/Annual General Meeting
to all shareholders.7
6. Provide shareholders notice of the EGM/AGM, together with an explanatory
statement that includes the specifics of the debenture issue, as well as the valuation
report, debenture agreements, and all other terms and conditions of such issue.
7. Submit Form MGT-14.
8. Issue an offer letter in PAS-4 to the selected debenture holders and record it in Form
PAS-5.
9. Once the allocation funds are received in the bank account, hold another board
meeting to allocate debentures, debenture certificates, create a debenture redemption
reserve, and execute the debenture deed (Form SH-12)
10. Submission of Form PAS-3 for allocation return
11. Debenture Certificate Issuance to Debenture Holders

Redemption of Debentures

1. Hold a Board meeting to discuss the redemption of debentures.

7 Prema Hunagund, ALL ABOUT DEBENTURES UNDER COMPANIES ACT,2013,
https://taxguru.in/author/csprernahunagund/

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2. Inform the debenture holders of the redemption.

3. Coordinate refunds with banks
4. Alterations to the debenture register
5. Changes in the charge register, if any debenture charges are established

Furthermore, in the event of Compulsory/Optionally Convertible Debentures, if shareholder

permission was not obtained at the time of issue for the conversion portion, then shareholder
approval is required for such conversion.

Also, if the debentures are redeemed from the company's profits, the shareholders' consent is
necessary.

CONCLUSION

A company issues debentures in order to raise capital from the market. This capital is then
subsequently used by the corporation for market research and development in order to remain
in the market and for its growth and expansion. Debentures or debt financing are favoured
over the issuance of equity shares for two key reasons: the issuance of debentures does not
result in dilution of ownership in the company, and the cost of obtaining funds through debt is
less expensive than the cost of raising money through equity.

Debentures are a risky investment for the investors as there is an absence of collateral and
security so the companies try to issue various forms of debentures to attract the different
types of investors in the market.

Debentures along with being advantageous to the company are also beneficial for the
debenture holders or investors as they provide a set interest rate on the due date and thus are
helpful during periods of inflation since they provide a fixed interest rate. Thus the Holders
face little risk because interest is paid even if the company fails. And when the corporation
has excess cash, it can swiftly redeem them. Making debentures a viable and accommodating
source of capital for emerging as well as established enterprises.

BIBLIOGRAPHY

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1) Khushnum Motafram, Different Types of Debentures and Their Use,(October 14,

2019) https://blog.ipleaders.in/different-types-of-debentures-use/

2) K. Agarwal, Issue of Debenture: at Par, Premium and Discount,

https://www.yourarticlelibrary.com/accounting/debentures/issue-of-debenture-at-par-
premium-and-discount/46934

3) Avatar Singh, Company Law, Paperback 17th Edition, 2018, Reprinted 2022

4) Prema Hunagund, All About Companies Act2013,

https://taxguru.in/author/csprernahunagund/
5) Companies Act,2013
6) Companies (Share Capital And Debentures) Rules, 2014

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