DEBENTURES – A SUSTAINABLE FINANCIAL SOURCE OF A COMPANY

INTRODUCTION

Meaning of Debenture

The word ‘debenture’ has been derived from the Latin word ‘debere’ which means to borrow. A debenture is a written instrument acknowledging a debt under the common seal of the company. It contains a contract for repayment of principal after a specified period or at intervals or the option of the company and for payment of interest at a fixed rate payable usually either half-yearly or yearly on fixed dates.

According to section 2(12) of The Companies Act,1956 ‘Debenture’ includes Debenture Inventory, Bonds, and any other securities of a company whether constituting a charge on the assets of the company or not.

Concept and Provision of Debentures

When a company needs additional amount of money for a long period, it cannot issue shares every time. It can raise loans from the public. The amount of loan can be divided into units of small denominations and the company can sell them to the public. Each unit is called a ‘debenture’ and the holder of such units is called a Debenture holder.

A debenture is the most important instrument and method of raising the loan capital by the company. It is like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest to the debenture holder who becomes the creditor/ charge holder of the company and although the money raised by the debentures becomes a part of the company’s capital structure, it does not become share capital.

Debentures are proving to be a valuable contributor to the corporate sector’s financial needs in the current situation. In comparison to other ways of raising capital from the market, such as preferred shares, bonus shares, equity shares, and rights issues, the issuance of debentures is a major means of raising capital from the market.

The Companies Act provides an expansive definition of debentures rather than an exhaustive definition.?According to Section 2(30) of the?Companies Act 2013, the company has the authority to issue bonds or debentures, which are debt instruments that can be both secured and unsecured by establishing a fee on the company’s assets. The company normally pays interest to debenture holders at the end of each year before maturity, but if it is unable to pay either the interest or the principal amount of the loan, the creditors of the company have the right to request the competent authority that the company be liquidated to recover their money by selling the company’s properties.

Characteristics of Debentures

1. It is in the form of a certificate of indebtedness of the company and issued by the company itself.?It generally creates a charge on the assets/undertaking of the company. There is usually a specific date of redemption.

2. The debenture holders are creditors to the company and they do not have any claim of ownership of the company, unlike shareholders.

3. As the debenture holders are not the owner of the company so they are not entitled to the administration and management of the company.

4. The debenture holder need not be concerned with the profits or loss of the company, they have a fixed rate of interest on the principal amount which they get every year irrespective of the financial condition of the company.

5. Debentures usually have a charge on the assets of the company, which means that if the company goes into liquidation and is not able to repay the amount, the debenture holders can also sell the property of the company through the legal process under the applicable law to recover the money of the debenture holders.

6. There is an undertaking given by the company to repay debenture holders the principal amount along with the interest at the stated time.

7. The debenture holders cannot claim the privilege to vote in any meeting of the company.

8. When the company is in winding up, the priority of the company is to repay the debenture holders of the company as per the applicable law hence, there is no risk involved of loss of money of the debenture holders.

?A DETAILED STUDY ON DEBENTURES

Kinds of Debenture

1. On the basis of convertibility, Debentures are classified into the following categories:

(A) Non-Convertible Debentures

(B) Partly Convertible Debentures

(C) Fully Convertible Debentures

(D) Optionally Convertible Debentures

2. On the basis of security, Debentures are classified into the following categories:

(A) Secured Debentures

(B) Unsecured Debentures

3. On the basis of Redeem ability, Debentures are classified into the following categories:

(A) Redeemable Debentures

(B) Perpetual or Irredeemable Debentures

4. On the basis of Registration, Debentures are classified into the following categories:

(A) Registered Debentures

(B) Bearer Debentures

Rules and Guidelines on Debentures

SEBI issue of capital and disclosure requirement (ICDR) Regulations 2009

“Specified securities” are defined as equity shares and convertible securities under the SEBI Regulation 2009. The term “convertible securities” refers to a bond that can be exchanged for or converted into equity shares of a company after its maturity date, with or without the debenture holder’s consent, which also includes convertible preference shares and convertible debt instruments. As a result, the conditions to be addressed below apply not only to equity securities but also to public issues of convertible debt instruments. The issuer of such convertible debt instruments must meet the following requirements:

i. To get a ranking from one or more credit agencies.

ii. Appointment of one or more trustees in accordance with Section 71(5) of the Companies Act, 2013 and certain other laws.

iii. Establishment of a Debenture Redemption Reserve in accordance with Section 71(4) of the Companies Act of 2013.

iv. If the company offers to establish a guarantee or fee on its assets in connection with the secured convertible debt instruments, it must ensure the following:

a) Those assets are sufficient to pay off the entire principal sum at any time.

b) Such properties must be protected from all forms of interruption.

c) If the convertible debt instruments are backed by a second or subsequent payment, the assets or security should come after the liabilities constituting the prior charge.

d) The issuer is responsible for redeeming the convertible debt securities in accordance with the terms and conditions of the offer contract. These rules apply to partially convertible debt instruments as well.

Provisions of Companies Act, 2013 (Share Capital and Debentures) Rules, 2014

As per section 71(2), the company is not entitled to issue debenture which carries the voting rights, Secured debentures must abide by the terms and conditions set out.

Secured debentures may be issued by a company if certain terms and conditions are met, according to Section 71(3).

Further Rule 18 of the?Companies (Share Capital and Debentures) Rules, 2014?(‘2014 Rules’) which prescribes certain conditions to be fulfilled by a company in order to issue secured debentures provides that:

The company shall not issue secured debentures, unless it complies with the following conditions, namely:-

(1) The company shall issue secured debentures, provided that the date of redemption does not exceed 10 years from the date of issue. The exception to this is companies involved in setting up infrastructure projects, which can exceed up to 30 years but not beyond that.

(2) The issuance of a debenture shall be protected by the establishment of a charge on the company’s assets and properties, the value of which shall be sufficient to ensure the timely repayment of the principal amount of the debentures, as well as the interest thereon.

(3) Prior to the issuance of a letter of offer or prospectus for the subscription of the company’s debentures, the company must nominate a debenture trustee. To avoid injustice and protect the interests of the debenture holders, the company must execute a trust deed within 60 days of the debenture being issued.

(4) When a company issues a debenture that is completely backed by a guarantee from the federal government, the state government, or both, there is no need to create a tax on the company’s properties.

Issue of Debentures

Debentures are normally issued in the same way as they issue shares like, through a prospectus accepting applications for debentures, with the money to be charged in instalments on application, allotment, and particular dates. There are three ways to issue a debenture.

At par:?It is said to have been issued at par when the sum received for it is equal to the nominal value of the debentures.

At Discount:?A debenture is said to have been given a discount when the amount received is less than the nominal value.

At Premium:?If the price paid for a debenture is higher than the nominal value, it is said to be issued at a premium.

The time limit for issue of debenture certificate

The allottee is entitled to receive the debenture certificate within six months of the date of allotment. It is provided for in Section 56(4) of the Companies Act of 2013. According to Section 56(6) of the Companies Act, 2013, if a company fails to grant the debenture certificate within the time limit, it will be fined a minimum of 25,000 rupees and a maximum of 5,00,000 rupees. A fine of at least 10,000 rupees and up to 10 lakh rupees will be imposed on the officer who is in default.

The conditions are as follows: Rule 18

The redemption date for secured debentures cannot be more than 10 years from the date of issue. There are a few types of companies that may issue protected debentures that are longer than 10 years but not longer than 30 years.

Companies that are active in the creation of infrastructure projects.

i. Infrastructure Finance Companies.

ii. Infrastructure Debt Fund Non-Banking Financial Companies.

Infrastructure Debt Fund Non-Banking Financial Companies:?The issuance of a debenture shall be protected by the establishment of a charge on the company’s assets and properties, the value of which shall be sufficient to cover the due repayment of the principal amount of the debentures, as well as the interest thereon.?Prior to the issuance of a letter of offer or prospectus for the subscription of the company’s debentures, the company must nominate a debenture trustee. To avoid injustice and protect the interests of the debenture holders, the company must execute a trust deed within 60 days of the debenture being issued.

A mortgage or charge shall be created as the security for debenture in favor of the debenture trustee acting for the benefit of the Debenture holders.

i. Any particular movable property of the company that is not in the form of a pledge or

ii. Any specific immovable property situated anywhere or any interest therein.

Rights/Remedies of Debenture Holder

According to Rule 18, it is the duty of the debenture trustee to communicate any debenture holder defaults, if any, with respect to the redemption of debentures or payment of interest, as well as any action was taken by the trustee himself. Furthermore, if the company fails to pay interest to the debenture holder for two consecutive years or fails to redeem the debentures, the debenture trustee appoints a nominee director to the board of directors.

i. A debenture holder is entitled to interest and redemption of debentures in accordance with the terms of their issue, according to section 71(8) of the Companies Act, 2013.

ii. Section 71(10) of the Companies Act, 2013 provides that if the company fails to pay the interest due or redeem debentures on their maturity date, the Tribunal may, on the application of the debenture trustee or any or all of the debentures and after hearing the parties involved, direct the company to redeem the debentures by an order.

Furthermore, if the company fails to comply with the tribunal’s order, section 71(11) of the Companies Act, 2013 provides that the tribunal may punish the officers in default with imprisonment for up to three years or a fine of at least 2,00,000 rupees and up to 5,00,000 rupees, or both. Both secured and unsecured debenture holders are covered by this provision. The holder of a debenture will ask the Tribunal to issue a payment order for the company that has defaulted. Before reaching a decision, the Tribunal considers the circumstances surrounding the company’s payment default.

i. Section 164(2) (b) provides for the disqualification of directors of a company who have failed to redeem debentures on the maturity date for a period of one year or more. For the next 5 years following the date on which the company fails to redeem the debentures, that individual will be barred from serving as a director of that company or any other company.

ii. Under Section 186(8) of the Companies Act of 2013, any company that has failed to repay any deposits or make any interest payments is prohibited from making any loan, guaranteeing any acquisition, or providing any protection until the default has been resolved.

Redemption of Debenture

The word “redemption of debentures” refers to the company repaying the entire sum of the debentures in compliance with the terms and conditions of the debentures. The company is not discharged or absolved of its responsibility on behalf of the debentures until they are repaid. The debentures can be exchanged in four different forms.

There are the following:

1)?Payment in a lump sum – At the end of the specified time period, the company redeems the debenture by making a lump sum payment in accordance with the terms of issue.”

2)?Payment in instalments – In this case, the payment for debenture redemption is made in instalments on particular dates during the debenture’s term. The company’s gross liability is split into the number of years.

3)?Purchase on the open market – Redemption of debentures by purchase in the open market occurs when a company purchases its own debentures for the purpose of cancellation.

4)?By conversion into shares or new debentures -?In this case, the company redeems its debentures by converting them into shares or establishing a new debenture class. If the debenture holder believes the offer is advantageous, he may exercise his right to convert the debentures.

Debenture Redemption Reserve Account

According to Section 71(4) of the Companies Act, 2013. When a company issues debentures, it is required to set up a debenture redemption reserve account with income available for dividends, and the money put into the account can only be used to redeem debentures.

Under Rule 18(7) of the Companies (Share Capital and Debentures) Rules, 2014, such requirements must be met. It is required for the company to maintain a Debenture Redemption Reserve for the purpose of redeeming debentures, as per the following conditions:-

(a) The Debenture Redemption Reserve shall be established from the company’s income available for dividend payment.

(b) Before debenture redemption begins, the company must establish a Debenture Redemption Reserve equal to at least 50% of the money raised from the debenture issue.

(c) Not later than the 30th of April of each year, create a Debenture Redemption Reserve by depositing or investing a sum equal to not less than 15% of the number of debentures maturing during the year until the 31st of March of the following year, in one or more of the following ways:

i. In free-of-charge or lien deposits with any scheduled bank.

ii. In unencumbered Central?or state government securities

iii. In unencumbered securities

iv. In unencumbered bonds issued by the company.

v. The funds deposited or invested as mentioned above are only to be used for the redemption of debentures maturing during the year in question, given that the amount remaining invested or deposited, as the case may be, does not fall below 15% of the number of debentures maturing during the year ending on March 31st of the year in question.

(d) In the case of partially convertible debentures, a Debenture Redemption Reserve shall be established in accordance with this sub-rule for the non-convertible portion of the debenture matter

(e) The amount added to such an account is only available for redemption of debentures.

Difference between Shares and Debentures:

OWNERSHIP

A share is a part of the owned capital. So, a shareholder is an owner of the company.

A debenture is a part of the borrowed capital. So, a debenture holder is only a creditor.?

RETURN

The return on shares is known as a dividend, (which is part of the profits of the company)

The return on debentures is known as interest, which is fixed from the day of the issue of debentures

CHARGE Vs. APPROPRIATION

The payment of a dividend is an appropriation out of profits

The payment of interest is a charge and is to be paid even if there is no profit

REPAYMENT

The amount of share is not returned during the life of the company although it can be transferred to another person

Debentures are issued for a fixed period and the amount is returned after that period

SECURITY

Shares are not secured by any charge on the assets of the company.

Debentures are generally secured and carry a fixed or floating charge over the assets of the company

?CONVERTIBILITY

Shares cannot be converted into debentures

Debentures can be converted into shares of the company

?VOTING RIGHTS

Voting rights are available to the Shareholders

Debenture holders do not normally enjoy any voting right.

CONCLUSION

Whether debentures are a sustainable financial source of a Company - In business, issuing debentures is one way to raise money for the working of the company. It is very different from equity shares or other kinds of shares (both preference and equity). The basic distinction being, when one buys the shares of the company he becomes the part-owner of the company, but when one buys debentures issued by the company he becomes a creditor to the company. We can conclude that debenture is a kind of formal loan given to the company by another individual. The company is under obligation to repay the loan within a specified period of time with interest.

The advantages of Debentures can be thus summed up as follows:

1.?????Investors who want fixed income at lesser risk prefer them.

2.?????As a debenture does not carry voting rights, financing through them does not dilute control of equity shareholders on?management.

3.?????Financing through them is less costly as compared to the cost of preference or equity capital as the interest payment on debentures is?tax?deductible.

4.?????The company does not involve its profits in a debenture.

5.?????The issue of debentures is appropriate in the situation when the sales and earnings are relatively stable.

On the other hand the disadvantages of Debentures can be summed up as follows:

1.?????Each company has certain borrowing capacity. With the issue of debentures, the capacity of a?company?to further borrow funds reduces.

2.?????With redeemable debenture, the company has to make provisions for repayment on the specified date, even during periods of financial strain on the company.

3.?????Debenture put a permanent burden on the earnings of a company. Therefore, there is a greater risk when the earnings of the company fluctuate.

Introducing debt into the business creates financial obligations for a company, due to its high interest rates and needs for preferential payment. It is a very crucial decision and the company needs to think through all the consequences before making a decision. The debt capital affects the dividend rates of the existing shares. Also, the company before making such a decision should ensure that it would be able to handle the baggage of the financial distress that comes along with their issuance. These days companies are not preferring the issue of debentures for raising capital and look for other alternatives to do the same. In some cases, the companies might choose to issue redeemable debentures to their shareholders, instead of declaring dividend or issuing bonus shares. This can be done by the company for two major reasons- in order to raise debt capital, or when the company is unable to pay dividends or cannot accommodate a reduced share price.

Usually, whenever a company issues debentures, the risk perception of the equity shareholders increases, as debenture holders have to be paid interest, before paying any amount to the other stakeholders of the company. As a result, the company has to increase the dividend payout ratio, in order to create a balance and retain its existing shareholders and keep them satisfied, even after the issue of debentures. Investors have the perspective of getting maximum return possible and debentures as a whole don’t seem to be something that gives a lot of returns; but there are investors who do not have the risk appetite as that of a younger person and hence want to invest in something with a good fixed income and these are the people that actually put their money in debentures. Different industries have different ways in which they perceive, view, act and react to market situations. Debenture issue decreases the Net Profit percentage as compared to the Gross profit percentage, but as debentures are a form of loan, the Company is in an advantageous position to issue them because for a prestigious company, the sale of debentures can be made by focusing only on its goodwill. Moreover, contrary to shares, issuing of debentures does not create a burden on the profits of the company and also helps retain the ownership of the company in its own hands.

Thus, to sum it up, debentures can be considered as a sustainable source of finance for the company only if the company has a high profit earning capacity, where it is in a position to pay interest to the debenture holders and thereby retain its net profit income.