Difference between Shares and Debentures and its Advantages and Disadvantages


Introduction

A debenture (roughly) is a document given by a company as evidence of a charge created by the company in return for a loan. The word has been used to cover many things, but it generally means “a security for money, called on the face of it a debenture, and providing for the payment of a specified sum at a fixed date with interest half-yearly, and is usually one of a series”1

Debenture stock is a debt, generally secured by a trust deed; it is sub-divisible, but otherwise is much the same as a debt secured by debentures. The difference between a debt secured by debentures and debenture stock is very like the difference between shares and stock.

The liability of the company is regarded as a liability to pay an annuity rather than as a liability to repay a loan. “The issue of debenture stock is not borrowing at all; it is the sale in consideration of a sum of money of the right to receive a perpetual annuity” (which may be redeemable) 2

The phrase “mortgage debentures” is only another name fur debenture creating a charge on the property of the company; but the stock Exchange objects to an instrument being called a mortgage debenture unless it is secured by a trust deed.

A ‘debenture’ is a document which either evidences or acknowledges the creation of a debt3 or makes provision for the repayment of a loan to be made in the future.4

A definition such as this has a very wide application and definitions in the company codes in England and Australia became inclusive in an attempt to refine the definition. For example, in the previous English companies legislation a ‘debenture’ included ‘debenture stock, bonds, notes and any other securities of a corporation.’ It has been argued5 that past definition hindered rather than eased the process of determining the scope of ‘debenture’ as it was used in that statutes.6

1. Palmer’s Company Law, p. 278.

2. Rigby, L.J., [1899] 1 Q. B., p. 138

3. Levy v Abercorris Slate & Slab Co (1887) 37 Ch  D 260

4. In HandLevel Pty Ltd v  Comptroller of Stamps  (1985) 10 ACLR 207

5. JK Armitage, The Debenture Trust Deed, chapter 10 of Austin & Vann. The Law of Public  Company Finance (1986) Law Book Company at 259

6. The  cases of Knightsbridge Estates Trust Ltd vs Byrne (1940)

Essentially, a debenture is defined as a document that either acknowledges or creates the indebtedness of the issuer, for money lent or deposited with it. This acknowledgment may entail some form of security over property7 and may also take the form of debenture stock.

The debenture holders would rank after depositors in the event of liquidation. The Banking Act8 imposes a duty on the Reserve Bank to protect depositors9 and allows the Reserve Bank to call for information from a bank in order to aid them.10 A bank is required to notify the Reserve Bank where it considers it is unlikely to be able to meet its obligations. As a result the Reserve Bank may investigate the affairs of the bank, take control of it and any on its business until depositors have been repaid.11

The wide definition of debentures in s 9 directs attention to three possible types of interests which may underlie a debenture:

i)  Legal choses in action,

ii)  Equitable choses in action, and

iii) Negotiable instruments.

(i) Legal Chose in Action

A legal chose in action is an ‘incorporeal bundle of rights enforceable by action for debt in the courts of common law.’ 12 By this we mean that the property is intangible and incapable of being held physically. The owner has an intangible right of action to recover the debt owed.13 A legal chose in action can be assigned even though it is not tangible. It may be assigned either at law or in equity however, to assign at law, it must be a present existing proprietary right which is either vested or contingent.14

7. The word ‘charge’ is used and is defined widely as a charge created ‘in any way including a mortgage’: s 9.

8. 1959  (Cth) Div 2

9. Ibid s 12

10. Ibid s 13

11. Reserve Bank may act on advice of Attorney General as well.

12. Everett D,  ‘Security over Bank Deposits’(1988)  Aust Bus L Rev at 352.

13. Everett & McCracken, Financial Institutional Laws, (199O).p. 125-131.

14. Per Windeyer J  in Norman  v FCT (1963) 109 CLR 9 at 26.

(ii)  Equitable Chose in Action

The obligation created by the debenture may be an equitable chose in action. Debenture stock arose from the need to simplify the relationship between the debtor corporation and the debenture holders.15 Instead of issuing separate debentures each for a definite amount; corporation would treat a total amount borrowed from a number of lenders as a single stock. Certificates are then issued declaring each holder to be entitled to a definite amount, part of the stock.

Debenture stocks are not instruments evidencing debt but equitable interests under an instrument (usually a trust deed) which evidences a collective debt divided into units. They are treated as debentures for the purposes of the Corporations   Law. Regardless of whether there is consideration or not for a valid equitable assignment there need only be evidence of a clear intention to assign16 coupled with writing.

(iii)  Negotiable Instrument

The debenture may be a chose in action as discussed above but in the form of a negotiable instrument. The essential difference between the two is that a negotiable instrument has a different method and consequence of assignment. A chose in action may be classified as a negotiable instrument either by statute or by commercial custom and usage. The test of negotiability stems from ‘the law merchant’.

The Corporations Law also appears to contemplate that negotiable instrument can be debentures as it allows the use of ‘other forms of transfer permitted by law’ other than by execution and delivery of a proper instrument of transfer.

Types of Debentures

A company may issue different types of debentures which can be classified by different types:

Þ     On the basis of Security: There are two types of debentures as per the basis of security.

1. Simple naked or unsecured debentures: These debentures are not given any security on assets. They have no priority as compared to other creditors.

15. Pennington RR, Company Law, 5thEd 1985 at p 475.

16. Per Windeyer J Norman v FCT (1963) 109 CLR  9

2. Secured or mortgage debentures: these debentures are given a security on assets of the debentures company. In case of default in the payment of interest or principle amount, debenture holders can sell the assets in order to satisfy their claims.

Þ     On the basis of Registration: In this section, there are two types of debentures.

3. Bearer debentures: These debentures are easily transferable. They are just like negotiable instruments. The debenture is handed over to the purchaser without any registration deed.

4. Registered debentures: as compared to bearer debenture which is transferred by mere delivery, registered debenture require a procedure to be followed for the transfer.

Þ     On The basis of payment:

5. Redeemable debenture: these debentures are to be redeemed on the expiry of ascertain period. The interest on the debenture is paid periodically but the principle amount is returned after a fixed period.

6. Irredeemable debentures: such debentures are not redeemable during the life time of the company. There are payable either on the winding up of the company or at the time of any default on the part of the company.

Þ     On the basis of convertibility:

7. Convertible debenture: – sometimes convertible debenture is issued by a company and the debenture holders are given an option to exchange the debenture into enquiry shared after the lapse of a specified periods.

8. Non-Convertible Debentures: The debentures which cannot be converted into shares or in any other securities are called nonconvertible debentures. Most debentures issued by companies fell in this category.

Difference between Shares and Debentures

There are major differences between share and debenture which made them distinguished from one another.17

17. http://www.universalteacher4u.com/cbse/xii/acctheory/ch7/page1.htm [Accessed March 14, 2011]

1. Capital

ü      A share is a part of equity or preference share capital of a company. The holders of the shares may be described as part owner of the company.

Whereas, a debenture is a part of loan capital of the company. The holder of a debenture is the creditor of the company.

2. Return

ü      Return on share is known as dividend. A company declares dividend only when there are profits and its rate may vary from year to year.

Whereas, return on a debenture is known as interest and the company compulsorily pays it at a fixed rate whether there are profits or losses.

3. Appropriation

ü      In case of share, dividend is an appropriation of profit and is therefore debited in Profit & Loss Appropriation Account.

Whereas, interest on debenture is a charge against profits and is therefore debited in Profit & Loss Account.

4. Charge on Property

ü      Shares do not create any charge on the assets of the company.

Debentures create a charge on the asset of the company.

5. Redemption

ü      Normally the share capital is not returned during the lifetime of the company.

Whereas, the amount of debentures has to be returned after a stipulated period of time as per the conditions of issue.

6. Discount on Issue

ü      Shares can be issued at discount only when the conditions lay down in Section 79 of the Companies Act 1956 are fulfilled.

There are no restrictions on issue of debentures at a discount.

7. Premium on Issue

ü      The premium received on issue of shares can be utilized by the company subject to the conditions given in Section 78 of the Companies Act 1956.

Premium received on issue of debentures can be utilized by company in any manner it likes.

8. Purchase

ü      A company cannot purchase its own shares

However, A company can purchase own debentures from the open market.

9. Convertibility

ü      Shares cannot be converted into debentures.

But, debentures can be converted into shares according to the conditions of issue of debentures.

10. Control

ü      A shareholder has the right to control the affairs of the company by exercising his right to attend the general meeting of the company and by exercising his voting right.

A debenture holder does not have any right to control the affairs of the company.

11. Winding up

ü      At the time of winding up the shareholders are paid their capital at the end.

Debenture holders have a priority as to return of amount received from them in the event of winding up of the company.There are advantages as well as disadvantages of debentures.18

Advantages

1. Control of company is not surrendered to debenture holders because they do not have any voting rights.

2. Trading on equity is possible as debenture holders get a lower rate of return than the earnings of the company.

3. Interest on debenture is an allowable expenditure under income tax act; hence incidence of tax on the company is decreased.

4. Debenture can be redeemed when company has surplus funds.

18. http://www.indiastudychannel.com/resources/92713-Types-advantages-disadvantages-debentures.aspx [Accessed March 15, 2011]

Disadvantages

1. Cost of raising capital through debentures is high of high stamps duty.

2. Common people cannot buy debenture as they are of high denominations.

3. They are not meant for companies earning greater than the rate of interest which they are paying on the debentures.

Rights of Debenture Holders

Holders of the Debentures have the following rights:

ü      To receive interest/redemption in due time.

ü      To receive a copy of the trust deed on request.

ü      To apply for winding up of the company if the company fails to pay its debt.

ü      To approach the Debenture Trustee with your grievance.

Re-issue and Redemption of Debentures

Repayment or discharge of liability on account of debentures is called redemption of debentures. The method of debenture redemption adopted determines to a very large extent, the actual accounting for redemption as well as the marshalling of resources for the same.

Corporation Law allows a corporation to re-issue debentures after they have been redeemed. The section does not specifically provide for redemption of debentures19 but rather it is necessarily implied by the operation.There are broadly four methods for the redemption of debentures which are as follows: 20

19. Compare with s 193 of the Corporations Law which allows corporations to issue redeemable preference shares.

20. http://www.universalteacher4u.com/cbse/xii/acctheory/ch8/page1.htm [Accessed March 10, 2011]

i.         Lump-sum payment method: In this method, redemption of debentures is done by repayment in one lump sum after the expiry of a stipulated period. The total amount payable to debenture holders is decided at the time of issue of debentures (i.e. debentures will be redeemed at par or at premium). Usually a company creates sinking fund or an insurance policy fund for the redemption of debentures.

ii.         Drawings of Lots method: In order to reduce the liability of debentures, company may repay the debentures in some installments. A certain amount of debentures is redeemed at regular interval of time during the lifetime of the debentures by drawings of lots.

iii.         Purchase in the Open Market: The Company from the open market can purchase its own Debentures. Debentures so purchased may be cancelled immediately or may be kept as an investment, which will be cancelled later. It may beneficial for the company if it purchases its own debentures at a discount from the open market.

iv.         Conversion Method: Usually debentures are redeemed in cash but sometimes debenture holders are given an option to get their debentures converted either in shares or for new debentures of the company. The redemption of debentures by means of shares or new debentures is known as redemption by conversion. Debentures, which carry such right, are called ‘Convertible Debentures’.

Conclusion

In the words of Chitty J., the word ‘debenture’ refers to a document that has the capability and tendency to do two things: either it could establish and constitute a loan or a debt or acknowledge it.21 As for the general features of a debenture, they are as follows:

On a usual basis, a debenture is in the form of a certificate that is issued under the seal of a company or on behalf of it. Furthermore as mentioned before a debenture is a clarion acknowledgement and recognition about the fact that a loan has been taken and needs to be paid back. A debenture also signifies very clearly as to what amount of the loan would be paid back on which particular date leaving no qualms behind. Moreover a debenture ensures the payment of interest until the principal sum is completely paid back. Lastly, a debenture also creates a charge on the prospect of the undertaking of the company or sometimes on any class of its assets. Debentures may have a term of 30 years or more.

21. In Levy vs. Abercorris Slate & Slab Co., (1987) 37 Ch. D. 260, 264.

Frequently, debentures will have an indenture, which is a contract protecting the rights of the debenture holders.22 It will define what acts constitute default by the corporation as well as stipulate the rights of the holder on default.A Debenture is basically a way of giving loan to the Company. In encyclopedia Britannica, debenture is defined in this way, a debenture is a bond not secured by specific assets but accepted by investors because the firm has a high credit standing or obligates itself to follow policies that ensure a high rate of earnings.23 The word has been used to cover many things, but it generally means ” a security for money, called on the face of it a debenture, and providing for the payment of a specified sum at a fixed date with interest half-yearly, and is usually one of a series”.24

22. A. James Barness, Law for Business, p. 507, para 3

23. debenture. (2011). In Encyclopædia Britannica. Retrieved from http://www.britannica.com/EBchecked/topic/154718/debenture

24. Palmer’s Company Law, p. 278.

Bibliography

1. Rigby, L.J., [1899] 1 Q. B., p. 138

2. JK Armitage, The Debenture Trust Deed, chapter 10 of Austin & Vann. The Law of Public Company Finance (1986) Law Book Company at 259

3. Everett D, ‘Security over Bank Deposits’(1988)

4. Everett & McCracken, Financial Institutional Laws, (199O)

5. Per Windeyer J in Norman v FCT (1963)

6. Pennington RR, Company Law, 5thEd 1985

7.http://www.universalteacher4u.com/cbse/xii/acctheory/ch7/page1.htm [Accessed March 14, 2011]

8. http://www.indiastudychannel.com/resources/92713-Types-advantages-disadvantages-debentures.aspx [Accessed March 15, 2011]

9. http://www.universalteacher4u.com/cbse/xii/acctheory/ch8/page1.htm [Accessed March 10, 2011]

10. debenture. (2011). In Encyclopædia Britannica. Retrieved from http://www.britannica.com/EBchecked/topic/154718/debenture

11. Barness, A.,Dworkin, T., Richards, E. Law for Business (7th ed.)Craig S. Beytien