Legal Adviser


“A document which either creates a debt or acknowledges it and any document which fulfills either of these conditions is a debenture”…………………….Explain and Illustrate.

Introduction:

A company raises its capital by means of issue of shares. But the funds raised by the issue of shares are seldom adequate to meet their long-term financial needs of a company. Hence, most companies turn to raising long-term funds also through debentures which are issued either through the route of private placement or by offering the same to the public. The finances raised through debentures are also known as long-term debt.  This chapter deals with the accounting treatment of issue and redemption of debentures and other related aspects

Meaning of Debentures:

Debenture: The word ‘debenture’ has been derived from a Latin word ‘debere’ which means to borrow. Debenture is a written instrument acknowledging a debt under the common seal of the company. It bears the date of redemption[1]and rate and mode of payment of interest. A debenture is therefore, a certificate of loan issued by a company. It is a type of security and a debenture holder is the creditor[2] of the company. It contains a contract for repayment of principal after a specified period or at intervals or at 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 Stock, Bonds and any other securities of a company whether constituting a charge on the assets of the company or not.[3]

Some definitions are as follows:

E. Thomas:

“A debenture is a document under Company’s seal which provides for the repayment of a principal sum and interest thereon at regular intervals which is usually secured by a fixed or floating charge on the company’s property and which acknowledges loan of a company”.

Topham:

“Debenture is a document given by a company as evidence of debt to the holder usually arising out of a loan and most commonly secured by a charge.”[4]

Chitty J.:

“Debenture’ means a document which either creates a debt or acknowledges it and any document which fulfills either of these conditions.”

In law, a debenture is a document that either creates a debt or acknowledges it. In corporate finance, the term is used for a medium- to long-term debt instrument[5] used by large companies to borrow money. In some countries the term is used interchangeably with bond[6], loan stock[7] or note. Debentures are governed by a trust deed which sets out the rules of the fund and the rights of the debenture-holders. They are issued through a Product Disclosure Statement (PDS) or Prospectus which highlights the terms, conditions, features and costs of the investment. Issuers

Characteristics of Debentures:

A document given by the company which describes the debt and is a proof of debt is known as Debenture. It secures the repayment of loan by creating charge on the assets. It may or may not be under seal. It is an unsecured debt backed only by the company, not by any collateral[8].  Debentures are usually used by the governments and large companies. They can be a great tool to raise funds and still leave specific assets free to be used for financing in the future. It includes stock, bonds and any other company’s securities.

There are some characteristics of debentures. They are-

  • A debenture is always in written form. An oral promise to pay back the debt is not a valid debenture. It is a type of a certificate.[9]
  • Debenture is an acknowledgment of indebtedness.[10]
  • Debentures are always issued in series. But there is no restriction on issue of a single debenture.
  • It is not necessary that debenture must be under seal. A debenture signed by two directors without a company seal is valid.
  • Debentures are secured by either fixed or floating charge[11] on assets of the company.
  • A company can also issue irredeemable debentures[12] without any undertaking to repay.
  • Debenture holders have no right to vote in any meeting of the company.
  • Fixed rate of interest is paid on debentures at regular intervals of time

Distinction between Shares and Debentures:

Ownership: A shareholder is an owner of the company whereas a debenture holder is only a loan creditor.  A share is a part of the owned capital whereas a debenture is a part of borrowed capital.

Return: The return on shares is known as dividend while the return on debentures is called interest. The rate of return on shares may vary from year to year depending upon the profits of the company but the rate of interest on debentures is pre-fixed.

Repayment: Normally, the amount of shares is not returned during the life of the company, while the debentures are issued for a specified period and the amount of debentures is returned after that period. However, an amendment in 1998 to The Companies Act, 1956 has permitted the companies to buy back its own shares from the market, particularly, when the price of its share in the market is lower than the book value.

Voting Rights: Shareholders enjoy voting rights whereas debenture holders do not normally enjoy any voting right.

Issue on Discount: Both shares and debentures can be issued at a discount. However, shares can be issued at discount in accordance with the provisions of Section 79 of The Companies Act, 1956 which stipulates that the rate of discount must not exceed 10% of the face value.

Security: Shares are not secured by any charge whereas the debentures are generally secured and carry a fixed or floating charge over the assets of the company.

Convertibility: Shares cannot be converted into debentures whereas debentures

Types of Debentures:

A company may issue different kinds of debentures which can be classified as under:

1. From the Point of view of Security

(a)    Secured or Mortgage Debentures: Secured debentures refer to those debentures where a charge is created on the assets of the company for the purpose of payment in case of default. The charge may be fixed or floating.[13].

(b)   Unsecured Debentures: Unsecured debentures do not have a specific a charge on the assets of the company. However, a floating charge may be created on these debentures by default. Normally, these kinds of debentures are not issued.

2. From the Point of view of Tenure

(a)    Redeemable Debentures: Redeemable debentures are those which are payable on the expiry of the specific period either in lump sum or in Installments during the life time of the company. Debentures can be redeemed either at par or at premium. To pay for this type of debentures, company maintains a “Debenture Payback fund”[14]

(b)   Irredeemable Debentures: Irredeemable debentures are also known as Perpetual Debentures because the company does not give any undertaking for the repayment of money borrowed by issuing such debentures.  These debentures are repayable on the on winding-up of a company or on the expiry of a long period.

2. From the Point of view of Convertibility

(a) Convertible Debentures: Debentures which are convertible into equity shares or in any other security either at the option of the company or the debenture holders are called convertible debentures. These debentures are either fully convertible or partly convertible.

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

4. From Coupon Rate Point of view

(a)    Specific Coupon Rate Debentures: These debentures are issued with a specified rate of interest, which is called the coupon rate. The specified rate may either be fixed or floating. The floating one is eventually tagged by the bank rate and a treasury bond as a reward to avoid risk. The floating interest rate is usually tagged with the bank rate.[15]

(b)   Zero Coupon Rate Debentures: Zero Coupon rate is just the opposite of Coupon Rate Debenture. It can be simplified as the debenture which does not contain any coupon rate. Accordingly we can say, these debentures do not carry a specific rate of interest. In order to compensate the investors, such debentures are issued at substantial discount and the difference between the nominal value and the issue price is treated as the amount of interest related to the duration of the debentures.[16]

4. From the view Point Registration

(a) Registered Debentures: Registered debentures are those debentures in respect of which all details including names, addresses and particulars of holding of the debenture holders are entered in a register kept by the company. Such debentures are fully transferable[17] only by executing a regular transfer deed.

(b) Bearer Debentures: Bearer Debentures[18] are those debentures which work as negotiable instruments. These debentures are fully transferable and payment is made only to the bearer of the debenture. No register of these debentures is maintained by the company.[19]

Debenture categories

Comparing debenture products can be difficult so gaining an understanding of the use of the funds will assist in comparing products. Debentures can be put into various categories according to how the funds are used. Common categories are listed below;

Finance – funds are lent for commercial and also for personal purposes such as leasing plant equipment or work vehicles.

Mortgage financing – mortgage loans for secured residential and commercial property ownership and/or improvement.

Structured real estate investments – loans for ownership of commercial and residential real estate as part of a wider ownership structure.[20]

Debt capital funding – funds used as working capital or transaction-specific purposes to further issuer’s or groups’ business operations.

Memberships – debentures issued to facilitate memberships of clubs, groups or franchise operations. Members can take part in these sections.

Integrated property – funding of property transactions and development within a group or with related parties.[21] Debenture holders are ranked ahead of ordinary share-holders in the event of the winding up of a company.

Typical Terms of Debenture:

Listed below are some of the typical terms found in a debenture.

Repayment date

The amount that the company borrows will have to be repaid at some future date. It can be a fixed loan where repayment is due on a particular date or a loan repayable on demand.

Interest

The debenture must specify both the frequency and rate of the interest to be paid. The rate can either be fixed or else fluctuate according to bank rates.

Power to appoint a receiver

If the company defaults under the terms of a debenture, the debenture holder’s right to recover the money owed to them is by the appointment of a receiver in accordance with the terms of the debenture. Thus, the power to appoint a receiver should be contained in the debenture.

Power of sale

In order to recover the sum due to the debenture holder,[22] a receiver appointed by the debenture holder will need the power to sell the assets, which are the subject of the charge. Thus, a power of sale should be included in the debenture. Apart from the power of sale, it is advisable to list out in the debenture some other powers of a receiver, e.g. the power to take legal proceedings.

Security

Although there is no need for a loan to be secured, the debenture holder’s position is improved if they do take a charge over the company’s assets. The security can be in the form of a fixed charge or a floating charge, or a combination of the two over the assets of the company.

Fixed charge

“A fixed charge is taken over specific property, e.g. land, buildings, fixed plant and machinery. Upon the giving of a fixed charge, the company, though still is the legal owner of the charged asset, cannot sell or deal with the asset without the consent of the charge holder”.[23]

Floating charge

Unlike a fixed charge, a floating charge does not attach to a specific asset. It ‘floats’ over a class of assets, while the component parts of that class of assets may be changing as the company still has the power to deal with any of the assets within that class without the need to consult the charge holder. A debenture can provide that the floating charge can ‘crystallize’ in specific circumstances. For example, when the company ceases to carry on business or goes into liquidation, or when the debenture holder appoints a receiver to enforce their security.

When a floating charge crystallizes, it no longer hovers over a class of assets which are subject to the charge, but becomes equivalent to a fixed charge because from the time of crystallization, the company cannot deal with any item within the class of assets without the consent of the charge holder.

Rights and Remedies of Debenture Holders:

If the Company fails to pay the interest or principal on the due date or fails to comply with any of the terms and conditions under, which the debenture was issued, the debenture holder can adopt any of tile following remedial measures:

1.      He may file a suit for the recovery of, money by sale of the assets which were charged for the payment of the money.

2.      He may file an application for the appointment of a receiver by the court.

3.      He may himself appoint a receiver if the terms of the debenture entitled him to do so.

4.      The trustees may sell the properties charged, if such a power is given to them, tinder the terms of the debenture.[24]

5.      He may apply to the court for the foreclosure of the company’s right to redeem the properties charged for the payment of the money.

6.      He may present petition for the winding up of the company.

The above mentioned rights may not necessarily be absolute. For example, the right to transfer debentures (in physical mode) is subject to the company’s right to refuse transfer as per statutory provisions. [25]

Registration

Once the company has formally entered into a debenture, it is the company’s responsibility to register prescribed particulars of any charge contained in the debenture at Companies House within 21 days of creation of that charge. If the debenture contains a floating charge and a prohibition on the creation of later fixed charges taking priority, the prohibition should be noted on the prescribed particulars as well.  Although it is primarily the responsibility of the company to register particulars of any charge, it is the charge (i.e. the debenture holder) who suffers if the charge is not registered or is registered late.

So, in practice, the debenture holder normally registers the charge. If the charge is not registered at Companies House, it is void against an administrator or liquidator of the company and against any person who acquires an interest in the charged asset. Any debts owed by the company to the debenture holder still remain outstanding but are treated as unsecured debt in the event of the company’s insolvency and will be added to all the other debts which the company owes to be paid right at the end of the insolvency process.

Redemption of debentures:

Redemption of debentures refers to extinguishing or discharging the liability on account of debentures in accordance with the terms of issue. In other words redemption of debentures means repayment of the amount of debentures by the company.[26] There are four ways by which the debentures can be redeemed:

1. Payment in lump sum

2. Payment in installments

3. Purchase in the open market

4. by conversion into shares or new debentures.

I.   Payment in lump sum: The Company redeems the debentures by paying the whole amount in one lump sum to the debentures holders at the expiry of the agreed time or earlier at the option of the company. In this case, the time of repayment is known in advance and the company can plan its financial resources accordingly.

II.   Payment in installments: Under this method, redemption of debentures is made in installments at the end of each year during the tenure of the debentures. The total amount of debenture liability is divided by the number of years it is to last and the actual debentures redeemable are identified by means of drawing the requisite number of lots from out of the debentures outstanding for payment.

III.   Purchase in open market: When a company purchases its own debentures through stock exchanges for the purposes of cancellation, such an act of purchasing and cancelling the debentures constitutes redemption of debentures by purchase in the open market.

IV.   Conversion into shares or new debentures: A company can redeem its debentures by converting them into new class of debentures or shares. If debenture holders find that the offer is beneficial to them, they can exercise their right of converting their debentures into new class of debentures or shares. These new shares or debentures can be issued at par, at a discount or at a premium.

Conclusion:

So, lastly we can say that debenture is a document which either creates a debt or acknowledges it, and any document which fulfills either of these conditions is a debenture. It is an acknowledgment of the loan received by the company equal to the nominal value of the debenture. It bears the date of redemption and rate and mode of payment of interest. It is a certificate of loan issued by a company. It is a type of security and a debenture holder is the creditor of the company. If a company borrows money, it will give its creditor a document confirming the existence and terms of the loan. This document is called a debenture. Under the debenture, the amount borrowed is repayable at a future date.

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