This article has been published by Pragnya Adarshi, a fourth-year law student pursuing Ballb (Hons.) at Xim university.

INTRODUCTION

A debenture is indeed a type of bond or promissory note that a company issues to raise funds. It is a financial instrument that reflects the company’s commitment to pay back the borrowed money plus interest at a predetermined later time. Debentures lack a specified collateral guarantee, as contrast to secured bonds. The general creditworthiness of the issuing company provides backing for debentures, even though they are not guaranteed by any particular assets. Investors generally rely on the company’s ability to generate sufficient cash flows and meet its financial obligations.

 An indenture is a legal and binding agreement between the issuer (the company or government entity) and the bondholders. It is a formal document that outlines the terms and conditions of the debt securities, such as bonds or debentures. The indenture serves as a contract that governs the relationship between the issuer and the bondholders. While it’s true that historically debentures were often issued as bearer instruments, modern debentures are more commonly issued in registered form.

 In registered form, ownership information is recorded, and interest payments and principal repayment are made to the registered holder. These coupons are detachable and can be presented for payment at specific intervals, usually every six months or annually. The redemption of the debenture refers to the repayment of the principal amount at the maturity date. In this date, the issuer is obligated to return the borrowed funds to the bondholders. If a debenture is in bearer form, the person holding the physical document at the time of payment will receive the money.

 In the case of registered debentures, the ownership transfer is facilitated through proper channels. It’s essential to note that financial instruments and market practices may evolve, and the specifics can vary based on jurisdiction, the terms of the individual debenture, and prevailing market conditions. Always refer to the specific terms and conditions outlined in the indenture and prospectus for accurate information.

 As mentioned under Section 2(30) of the Companies Act, 2013, defines “debenture” as any instrument, including bonds, debenture stock, or other securities of a company, whether constituting a charge on the assets of the company or not, and debenture stock is also defined accordingly. This means that an instrument can be classified as a debenture even if it does not create a charge on the company’s asset.

TYPES OF DEBENTURES

They come in a variety of forms, and each has unique attributes. It includes the following

• Debentures that are security-based
• Debentures according to tenure
• Conversion-based debentures
• Debt instruments based on enrolment

In the context of debentures, there are two broad categories of debentures that are security based i.e, secured and unsecured.

• Secured Debentures: A charge or mortgage on the company’s assets is used to finance secured debentures, which are issued by companies. In case of default, the debenture holders have a claim on the specified assets that were pledged as security.
• Unsecured Debentures: On the other hand, as you mentioned, when a company issues unsecured debentures, there is no specific charge placed on any of the company’s assets. These are not backed by specific collateral. In the event of default, the debenture holders do not have a direct claim on specific assets but are considered general creditors of the company.

Debentures with a Tenure Component:

• Debentures that are redeemable have a designated maturity date, and the issuing business agrees to reimburse the principal and interest to the holders of the debentures on that date. The company “redeems” or buys back the debentures at the end of the predetermined period. Most debentures fall into this category.
• Perpetual or irredeemable debentures are also referred to as irredeemable debentures since they lack a set maturity date. The principal amount is not owed by the issuing corporation. Conversely, holders of debentures receive ongoing periodic interest payments. However, the company may have the option to buy back or redeem irredeemable debentures under certain conditions specified in the terms of issuance.

Debenture Redemption Reserve (DRR): In some jurisdictions, companies may be required to create a Debenture Redemption Reserve to ensure that funds are set aside specifically for the redemption of debentures when they mature. It was implemented under Section 117C of the Indian Companies Act of 1956 to protect holders of debentures against the possibility of the issuing company defaulting. This mandate forces businesses to set aside a predetermined portion of the cash proceeds from the debenture issue in a special fund, which will only be used in an emergency to settle debt instead of defaulting on the debenture. 

As per the Companies (Share Capital and Debentures) Rules released by the Ministry of Corporate Affairs (MCA) in March 2014, companies are required to set up a DRR that is equivalent to no less than 50% of the total amount raised via the debenture issue.

Debentures with Convertible Terms:

• Convertible Debentures: After a predetermined amount of time, holders of these debentures have the opportunity to convert them into equity shares of the issuing corporation. The conversion is usually at the discretion of the debenture holder, and upon conversion, they become shareholders in the company. This means they transition from being creditors to becoming partial owners with ownership rights corresponding to the equity shares they receive. The terms for conversion, including the conversion ratio (the number of equity shares per debenture), conversion price, and the conversion period, are typically outlined in the terms of the debenture issuance. Convertible debentures provide an additional incentive for investors, as they have the potential to benefit from any future increase in the value of the company’s shares.
• Non-Convertible Debentures: These cannot be exchanged for equity shares of the company. They remain as debt instruments throughout their tenure and do not provide the debenture holder with ownership rights in the company. Non-convertible debentures are typically redeemable, meaning the issuing company commits to repaying the principal amount along with interest at the end of the specified period. Non-convertible debentures are considered more stable in terms of providing fixed interest income without the potential fluctuations associated with equity ownership.

Debenture based on Registration

• Registered Debentures: In fact, registration of debenture holders is required for any firm issuing debentures, as stipulated by Section 88 of the Companies Act, 2013. The company’s registry and the debenture certificate both list the names of the holders of debentures. Regulatory bodies and holders of debentures may view this register, which is kept up to date by the corporation.
• Unregistered Debentures: Although the Companies Act specifically refers to registered debentures, it is not necessary for debentures to be “unregistered” in the sense that the word might suggest. The focus is on the registration of debenture holders rather than categorizing debentures as registered or unregistered. In practice, most debentures are issued in registered form, meaning the ownership details are recorded.

WHY ARE DEBENTURES ISSUED?

• Debt Capital (Debentures)

Companies raise debt capital by issuing bonds or debentures, among other debt instruments. A type of borrowing known as debentures involves an agreement from the business to repay the principal amount borrowed plus interest over a predetermined time period. Debentures can be classified as either secured or unsecured based on whether or not they are backed by particular assets.

Advantages: Issuing debentures allows companies to raise funds without diluting ownership and control, and interest payments are tax-deductible.

• Retained Earnings

The total profits that a business keeps after paying all costs and paying dividends to shareholders is known as retained earnings. Retained earnings can be used by businesses for a number of things, such as debt repayment, project finance, business reinvestment, and cushioning cash flow.

Advantages: Utilizing retained earnings can be a cost-effective way of financing growth without incurring debt or diluting ownership.

• Equity Capital (Shares):

It is generally raised by issuing shares of the company to investors. Shareholders become partial owners of the company and have certain rights, such as voting and receiving dividends. Common shares and preferred shares are common forms of equity. Common shareholders have voting rights, while preferred shareholders often have priority in receiving dividends.

Advantages: Raising equity capital provides funds without incurring debt, and it can be attractive to investors seeking ownership and potential capital appreciation.

• Debt capital

It is a form of financing that involves borrowing funds, and it typically comes with an obligation to repay the principal amount along with interest. Here are some key points to further elaborate on debt capital. Companies obtain debt capital by borrowing money from various sources, such as banks, financial institutions, or through the issuance of debt securities like debentures and bonds. Lenders (creditors) get a predetermined rate of interest on the borrowed amount in the case of loans or debentures. This interest is an upfront expense that the business has to reimburse the lenders for. At the conclusion of the loan or debenture term, the corporation is required to repay the principle amount borrowed in addition to interest.

Types of Debt Capital:

i)Loans: Companies can secure loans from banks or other financial institutions. Loans are often structured with a fixed term, interest rate, and repayment schedule.

1. ii) Debentures and bonds are debt instruments that businesses issue in order to raise money. When investors buy bonds or debentures, they become creditors of the business, which guarantees that the principle will be repaid at maturity and that interest will be paid on a regular basis.

Advantages of Debt Capital

i)Fixed Obligations: The fixed nature of interest payments allows for predictable cash flow management, as the company knows the exact amount it needs to pay to creditors.

ii)No Dilution of Ownership: Unlike equity financing, taking on debt does not dilute ownership. The lenders do not acquire ownership stakes in the company.

HOW ARE DEBENTURES GENERALLY ISSUED?

• Guidelines for the issuance of debentures under the 2013 Companies Act

A corporation that wishes to issue debentures may also choose to convert them into shares, either fully or partially. A specific resolution must be approved at the company’s general meeting in order to convert debentures into shares. Section 71(2) forbids the issuing of debentures that include voting rights in any business activity. Section 71(3) permits a firm to issue secured debentures on the terms and conditions specified. Under Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014, several parameters are given for the issue of debentures. 

• Guidelines relating to the Redemption Reserve (DRR) for debentures 

According to Section 71(4), the money deposited into such a reserve account can only be used to redeem debentures. In the unlikely event that the business defaults on its repayment commitments, a Debenture Redemption Reserve (DRR) is meant to reduce the risk to the holder of the debenture. The debenture redemption reserve is a fixed annual percentage of the company’s profit. DRR is only increased by these gains that are eligible for dividend payments.

Exceptions: i) The requirement to maintain a debenture redemption reserve was lifted as of August 16, 2019, for companies listed on the National Stock Exchange (NSE), the Calcutta Stock Exchange (CSE), or the Bombay Stock Exchange (BSE).

1. ii) The Reserve Bank of India (RBI) and the Central Government are the only organizations not required to maintain the DRR. This includes publicly traded financial firms in which the RBI owns at least 51% of the paid-up shares.

iii) All banks are subject to a schedule specified in the Reserve Bank of India Act, 1934’s second schedule.

• Guidelines pertaining to debenture trustees

I)Appointment of Debenture Trustee:

• Companies cannot invite subscriptions for debentures without designating one or more debenture trustees.
• SEBI (Debenture Trustee) Regulations, 1993, govern the nomination of debenture trustees.

II)Responsibilities of Debenture Trustee:

• Debenture trustees are responsible for safeguarding the interests of debenture holders.
• They must address any complaints from debenture holders.
• SEBI regulations and Companies Act impose specific duties on debenture trustees.

III)SEBI (Debenture Trustee) Regulations, 1993:

• SEBI has established regulations to govern the role and conduct of debenture trustees.
• Clause on Liability:Any clause releasing the debenture trustee from liability for breach of trust is void if it excuses failure to exercise due care and diligence.

IV)Powers of Debenture Trustee:

If a debenture trustee believes that the company’s assets are insufficient to cover debenture payments, they may petition the National Company Law Tribunal (NCLT).

V)Rule 18 (3) of Companies (Share Capital and Debentures) Rules, 2014:

• Debenture trustees are responsible for ensuring that the letter of offer aligns with the debenture deed.
• They should request periodic updates on the company’s performance.
• They must notify debenture holders in the event of a default.

 

• Other guidelines pertaining to issue debentures

I)Creation of Charge: It is a common practice that when a company issues debentures, it creates a charge on its assets or properties. This charge serves as security for the debenture holders, especially in the case of secured debentures. This means that certain assets of the company are pledged to secure the repayment of the debentures.

1. II) In the event that a corporation neglects to pay the interest due or redeem the debentures by the maturity date, legal ramifications may ensue. The Tribunal (or regulatory bodies) may receive remedy requests from debenture holders or the debenture trustee. The Tribunal might mandate that the business redeem the debentures.

III) Regulatory Oversight: The Central Government is able to establish guidelines for protecting the rights of holders of debentures. The objective of this regulatory supervision is to guarantee equity, openness, and defence of debenture holders’ rights.

IV)The format of the Debenture Trust Deed may also be specified by the Central Government. The legal document known as the debenture trust deed describes the terms and conditions of the issue of debentures as well as the debenture trustee’s responsibilities.

PROCEDURE FOR ISSUING DEBENTURES

I)Convene a General Meeting:

• Organize a general meeting by giving a notice to all directors at least seven days in advance.
• Attach the draft resolution, agenda notes, and notice to the meeting invitation.

II)Pass a Special Resolution:

• During the general meeting, pass a special resolution approving the issuance of debentures.

III)File Form MGT-14 with ROC:

• Within 30 days of passing the special resolution, file Form MGT-14 with the Registrar of Companies (ROC).

• • Pay the required fee as per the Companies (Registration Offices and Fees) Rules, 2014.

• Attach a statement of explanation, records of the general meeting, and certified true copies of the resolution with the form.

IV)Record Names of Debenture Allottees:

• Record the names of individuals to whom the debentures will be offered, as per Section 42 of the Companies Act, 2013.
• Prepare a private placement offer letter using PAS-4 forms.

V)Send Offer Letters:

• Within 30 days of recording names, send offer letters to the individuals either in writing or electronically.

• Maintain a record, using form PAS-5, of individuals to whom the offer letters were made available.

VI)Open a Separate Bank Account:

• Open a separate bank account in a bank listed in Schedule II of the Reserve Bank of India Act, 1934, to retain the funds received on the application.

VII)Issue Debenture Certificates:

• If debentures are allocated to holders, issue debenture certificates within six months from the allocation date.

HOW TO BUY DEBENTURES?

There are basically two types of methods.

• Direct Approach:

Definition: In the direct approach, investors purchase debentures directly from the issuing company.

Process: This involves dealing directly with the company’s issuance process, often through their financial department or designated agents.

Advantages: Direct investment allows for a direct relationship between the investor and the issuing company. However, this approach may have limitations, such as the need for direct contact with the company and potentially higher minimum investment requirements.

• Indirect Approach:

Definition: The indirect approach involves purchasing debentures through a third party, such as a financial institution or broker.

Process: Investors can buy debentures indirectly through brokerage accounts, mutual funds, or other financial intermediaries that offer these instruments.

Advantages: Indirect investment provides flexibility and convenience. Investors can access a broader range of debentures and manage their investments through established financial platforms. It may also allow for smaller investment amounts and diversification.

REDEMPTION OF DEBENTURESs

The registration of debentures under the company’s registry is governed by Section 88. Debenture holders are privileged above other contributors to the company’s capital, including shareholders and unsecured creditors, due to their security and registration under the company’s registry. The sole purpose of debenture registration under the firm’s registry is to determine the order of debenture holders within a corporation. 

Procedure: There are several ways in which companies can decide to redeem their debentures. Throughout the redemption process, the company usually repays the cash raised from holders of debentures by issuing additional debentures.

BENEFITS OF DEBENTURES

These are distinguished into two types, as follows, and offer a number of benefits.

I)Debenture benefits to the business

• Secure financing option: When compared to stock or shares, debentures are among the most effective and secure alternatives for a company to raise money. It is safer to issue debentures because of the company’s capacity to repay the debt.
•  Less credible: Because debenture holders are not entitled to voting rights under Section 71(2) of the Companies Act, 2013, the company is not subject to as much authority and is allowed to operate with greater independence. 
• Lower dilution risk: Because the debenture holders do not receive any ownership, there is less chance that the corporation may dilute its shares
• Redeemable options: Since the corporation can repay the debentures whenever it has extra money, it is not restricted in its permanent duty to provide security to the holders of the debentures after they have settled their debt with them.

II)Benefits of debentures for the holder

• Low Risk Investment:

Debentures, especially those with fixed interest rates, are considered relatively safe investments.

The fixed-rate option provides a predictable income stream for debenture holders, irrespective of the company’s performance or financial condition.

• Possession Rights and Security:

Debenture holders often have a claim on the company’s assets or properties that are pledged as security for the amounts borrowed.

This provides a level of security for debenture holders, as they have a legal interest in specific assets that can be used to recover their investment.

• Protection in Company Failure:

In the event of a company’s failure or insolvency, debenture holders are typically considered secured creditors.

This means that even if the company faces financial difficulties, debenture holders have a higher likelihood of recovering their investment compared to unsecured creditors.

DRAWBACKS OF DEBENTURES

They also have certain drawbacks, which can be divided into two categories:

i)The company’s drawbacks with debentures

• Expensive during a downturn: Debentures may become pricey during a downturn in a firm’s business, but since the interest rate would remain the same, the corporation would incur additional costs.
• Burden of Interest Payment: Since the firm’s ability to pay interest to debenture holders is independent of both market trends and performance, when the company is not doing well, paying interest to interest holders typically puts a strain on it.
• Unbalanced debt-to-equity ratio: Although debentures have no effect on the company’s equity, they would force it to rely more heavily on debt, which would jeopardize the business’s ability to be financially viable.
• A substantial outflow of cash: When debenture holders receive a sizable amount of cash from the company during the redemption process, this might cause an imbalance in the company’s cash on hand.

ii)Debenture holders’ disadvantages in regard to debentures

• Lack of ownership by issuing debentures, holders of debentures assist a firm in raising funds, but they are not granted any ownership stake in the business. 
• Debentures have a fixed interest rate regardless of the firm’s performance, in contrast to shares where dividends might increase when the company is doing well. 
• Insecure at times: Even while shares are less safe than debentures, not all debentures are safe; in fact, unsecured debentures carry greater risk than secured debentures.

CONCLUSION

Debentures are one of the best and most tightly regulated ways for a company to raise capital. They have a few very unique features that set them apart from conventional money raising techniques. Both the business and the debenture holder can benefit from the safety and profitability provided by the debenture structure. A more secure strategy for investors and businesses looking to raise capital for expansion is required due to the private sector’s increasing influence.