Unsecured Convertible Debentures and DRR

We have frequently encountered questions like

-????? whether debentures issued under Companies Act, 2013 can be unsecured

-????? whether debenture redemption reserves (DRR) are mandatory

-????? whether it is mandatory to invest the amounts in DRR

This discussion answers all these questions.

Section 71 of the Companies Act, 2013 permits a company to issue debentures with an option to convert into shares at the time of redemption. Therefore, the debentures can be issued which are convertible at the option of the debenture-holder either wholly or partly. Where the debentures are convertible, the issue should be pre-approved by the shareholders by passing a special resolution.

This write-up discusses certain issues regarding unsecured debentures revolving around mandatory nature of creation of debenture redemption reserve (DRR), investment of sums lying under DRR and other ancillary issues.

Can debentures be unsecured?

While dealing exclusively with debentures, section 71 of the Companies Act, 2013 uses the word “secured” only in sub-section 3 and sub-section 7, while sub-section (1), (2) and other sub-sections do not use the word “secured”. Sub-section (3) provides that secured debentures may be issued by a company subject to such terms and conditions as may be prescribed. The terms and conditions for issue of secured debentures are prescribed in rule 18 of the Companies (Share Capital and Debentures) Rules, 2014. The rule also prescribes requirements when there is a debenture trust.

While sub-section (1) permits a company to issue debentures with an option to convert into shares at the time of redemption, sub-section (3) only provides that secured debentures may be issued subject to prescribed conditions. Therefore, there is no compulsion that debentures shall be secured only.

This has also been substantiated in the case of Narendra Kumar Maheshwari vs. Union of India by the Supreme Court in para 13.1 of its Order dated 03.05.1989. It was observed that a debenture need not be secured. It further observed that even a non-convertible debenture need not always be secured.

Whether DRR is required, if debentures are unsecured?

Sub-section (4) of section 71 of the Act requires every company issuing debentures to create a Debenture Redemption Reserve (hereinafter DRR). The amounts in DRR (DRR amount) shall be created only out of profits available for dividend. The relevant portion of the section is extracted below:

“(4) Where debentures are issued by a company under this section, the company shall create a debenture redemption reserve account out of the profits of the company available for payment of dividend and the amount credited to such account shall not be utilised by the company except for the redemption of debentures.”

It is noteworthy, particularly in the light of subsequent observations, that sub-section (4) is applicable to all kinds of issue of debentures whether secured or unsecured. Therefore, the requirement of creating DRR will be applicable to debentures though they may be unsecured, in case there are profits during the year.

Whether rule 18 is applicable to unsecured debentures?

Sub-section (3) of section 71 requires that secured debentures shall be issued subject to such terms and conditions as may be prescribed. The relevant excerpt is extracted below:

“(3) Secured debentures may be issued by a company subject to such terms and conditions as may be prescribed.”

The use of the expression “as may be prescribed” in the above sub-section (3) is to be particularly noted. Additional terms and conditions as envisaged by this sub-section, are prescribed in rule 18 of the Companies (Share Capital and Debentures) Rules, 2014 (hereinafter Rules).

Sub-rule (7) of rule (18) of the Rules provides for the requirements of DRR and investment or deposit of sum in respect of debentures maturing during the year ending on 31st day of March of next year.

It is worthwhile to note that the said expression “as may be prescribed”, is absent in sub-section (4). In the absence of the said expression, there is no need to look for additional prescriptions if the case falls only under sub-section (4) and not under sub-section (3). Therefore, the additional terms and conditions prescribed in the rules are applicable only if the debentures are secured, which will be the case of sub-section (3). The additional conditions are not applicable to unsecured debentures by virtue of absence of the expression “as may be prescribed” in sub-section (4).

Debentures if unsecured, are outside the ambit of sub-section (3) and therefore outside the ambit of compliance of provisions of the rule 18. Given this, the terms and conditions prescribed in the Rules are not applicable to the debentures if unsecured.

DRR required only for non-convertible portion of Debentures

Rule 18(7)(c) prescribes that in case of partly convertible debentures, DRR shall be created in respect of non-convertible portion of debentures. While applicable to secured debentures in view of the foregoing conclusion, even in case of such debentures, DRR is required only in respect of the portion of the debentures which are non-convertible. The said clause (c) is reproduced below:?????????????

“(c) in case of partly convertible debentures, Debenture Redemption Reserve shall be created in respect of non-convertible portion of debenture issue in accordance with this sub-rule.”

Meaning of “non-convertible”

Sub-section (1) of section 71 helps in understanding the meaning of non-convertible debentures. It provides that “a company may issue debentures with an option to convert such debentures into shares, either wholly or partly at the time of redemption.”

Therefore, a mere option to convert debentures into shares will render the debentures as convertible debenture as against non-convertible, irrespective of whether such option is exercised by the debenture-holder or not. In other words, both optionally convertible as well as compulsorily convertible debentures will fall within the meaning of convertible debentures and therefore will be outside the purview of the meaning of “non-convertible”.

Debentures being optionally convertible into shares are to be considered as convertible and not non-convertible. Therefore, even when assuming the debentures in question were secured, there being no non-convertible portion, the necessity of creating DRR is not there much less investment of that amount in the prescribed securities/deposits {ref. sub-clause (vi) of clause (b) of sub-rule (7) of rule (18)}.

?Creation of DRR by the Company

?In view of the rule 18(7)(c), creation of DRR is relaxed in cases of non-convertible portion of secured debentures. However, in view of foregoing discussions, the relaxation is not available when the debentures are unsecured due to operation of sub-section (4) of section 71.

Therefore, while a Company is bound to create DRR by virtue of section 71(4)(c) even though the debentures are unsecured, it is not bound to invest the sum in prescribed securities/deposits.

Krishna Sharan Mishra

Partner | KSM Associates | Company Secretaries

Mobile – 9884041418; [email protected]