In corporate finance, a debenture is a medium- to long-term debt instrument used by large companies to borrow money, at a fixed rate of interest. The legal term “debenture” originally referred to a document that either creates a debt or acknowledges it, but in some countries the term is now used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company’s capital structure, it does not become share capital. Senior debentures get paid before subordinate debentures, and there are varying rates of risk and payoff for these categories.
Debentures are generally freely transferable by the debenture holder. Debenture holders have no rights to vote in the company’s general meetings of shareholders, but they may have separate meetings or votes e.g. on changes to the rights attached to the debentures. The interest paid to them is a charge against profit in the company’s financial statements.
The term “debenture” is more descriptive than definitive. An exact and all-encompassing definition for a debenture has proved elusive. The English commercial judge, Lord Lindley, notably remarked in one case: “Now, what the correct meaning of ‘debenture’ is I do not know. I do not find anywhere any precise definition of it. We know that there are various kinds of instruments commonly called debentures.”
Companies have frequently to borrow large sums of money. The loan requirement of a company may not, therefore, be met by a single lender. The loan may have to be split into several units. One very convenient method of doing so is to borrow by issuing debentures. As a matter of fact the term ‘debenture’ does not have any precise legal meaning. The term as used in the modern commercial parlance is of extremely elastic character. The most referred meaning of debenture indicates that it is a document which either creates a debt or acknowledges it and any document which fulfills either of these conditions is a debenture.
Company can collect money from outsiders by issuing debentures if permitted by article and memorandum of association. Company pays interest for debenture and during liquidation debenture-holder’s claim is to be satisfied at first.
Features of Debenture:
- Debenture is a kind of acknowledgement of company’s loan
- It contains in it the amount of loan and the rate of interest
- The time and procedure of payment of both principal and interest is mentioned in the debenture
- It has a number, company’s name and seal on it
- It is mostly secured by charge
Classification of Debenture:
- On the basis of security:
- a) Ordinary debenture
- b) Mortgage debenture
- a) Ordinary Debenture: When the company acknowledges the debt by debenture but no security is promised to the creditor, it is ordinary debenture. The ordinary debenture-holders have secondary right after the secured creditors.
- b) Mortgage Debenture: When the company takes loan in exchange of its property as mortgage, it is called mortgage or secured debenture. In case of default in payment by the company, the creditor will have the right to sell the property in mortgage and receive his money out of proceeds.
Mortgage debenture may be of two kinds—
- Mortgage debenture of fixed charge
- Mortgage debenture of floating charge
- Mortgage debenture of Fixed Charge: If the company mortgages a fixed property as security for the loan, it is called mortgage debenture of fixed charge. Company cannot use or alienate such property without the consent of the creditor.
- Mortgage debenture of floating charge: When the company mortgages all of its present and future property as security, the debenture is called mortgage debenture of floating charge. In such case, the creditor will have the right to sell any of the company’s property in order to take back his principal and interest. The company can alienate or use the property without the consent of the creditor.
- On the basis of payment:
- a) Redeemable Debenture
- b) Irredeemable debenture
- a) Redeemable Debenture: When the company issues debenture on the condition that, the loan shall be repaid gradually with the interest, it is called redeemable debenture. A Separate fund is maintained by the company for the purpose of redemption of its debenture. A redeemed debenture can be re-issued.
- b) Irredeemable debenture: When the Company issues debenture on the condition that the principal will be returned only at the time of liquidation, the debenture is irredeemable. It is also known as perpetual debenture.
- On the basis of Registration:
- a) Registered Debenture
- b) Unregistered Debenture
- a) Registered Debenture: If a Register book is maintained by the company to keep all the information about the debenture-holders, the debentures are called registered.
- b) Unregistered Debenture: When the debenture is like a negotiable instrument which may be easily transferable and no information about the holder is maintained by the company, it is called unregistered debenture.
- Convertible debenture:
Some debentures are issued on the condition that they will be converted into shares after a certain period of time; these debentures are called convertible debenture.
Distinction between Share & Debenture:
- Share is a part of capital but debenture is part of Company’s loan
- Shareholders are the members of the company but debenture-holders are not members, they are outsiders
- Shareholders receive dividend from the company whereas debenture-holders are entitled to interest.
- Shareholders bear the liability of the company but debenture holders do not
- Shareholders participate actively in the company’s management but debenture holders do not have such right
- Shareholders have voting right but debenture holders do not have such right
- No security is required for allotment of share but debenture is mostly secured by charge
- Shareholders claim is satisfied at last during liquidation but debenture holders claim is satisfied before shareholders
Issue of debenture:
- Public company limited by share can issue debenture by a resolution in the Board of meeting. They must issue a prospectus in this regard.
- private companies cannot issue debenture
Rights of a Debenture holder:
- According to section 175 (1) of the Companies Act 1994 the debenture holder can receive copies of all deeds creating mortgage or security for loan which are submitted to the Registrar for registration and inspect the register of mortgages.
- If he is not allowed his right under section 175(1) company will be liable for compensation. [Section 175 (2)]
- According to section 176, all register of debenture must be kept open for inspection, and they can receive copies by paying fees.
- Debenture holder can claim the copy of trust deed which ensures repayment. In case of default company will be liable for compensation.
Remedies of Debenture holders in case of non-payment:
- Unsecured creditors –
- a) Creditors can file a suit against company for loan and interest
- b) They can apply to the court for compulsory liquidation
- Secured creditors –
- a) Sell the mortgaged property and receive their principal and interest
- b) Apply for appointment of a receiver
- c) Claim liquidation
- d) Resist sale or redemption of mortgaged property.
If the company fails to pay interest on loan, then creditor can claim appointment of receiver who will protect the interest of the creditors. Receiver may be appointed—
- a) According to the trust deed or conditions of debenture
- b) By an order of court on application of creditors
Duties of receiver:
- Take possession of the mortgaged property and make arrangement of sale
- Manage the property until the creditors’ claim is satisfied
- Manage the company if required
- he is entitled to remuneration for his services
Advantages and Disadvantages of Debentures
Advantages of Debentures
- Investors who want fixed income at lesser risk prefer them.
- As a debenture does not carry voting rights, financing through them does not dilute control of equity shareholders on management.
- 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.
- The company does not involve its profits in a debenture.
- The issue of debentures is appropriate in the situation when the sales and earnings are relatively stable.
Disadvantages of Debentures
- Each company has certain borrowing capacity. With the issue of debentures, the capacity of a company to further borrow funds reduces.
- With redeemable debenture, the company has to make provisions for repayment on the specified date, even during periods of financial strain on the company.
- Debenture put a permanent burden on the earnings of a company. Therefore, there is a greater risk when the earnings of the company fluctuate.
Types of Debenture
1. Secured and Unsecured:
Secured debenture creates a charge on the assets of the company, thereby mortgaging the assets of the company. Unsecured debenture does not carry any charge or security on the assets of the company.
2. Registered and Bearer:
A registered debenture is recorded in the register of debenture holders of the company. A regular instrument of transfer is required for their transfer. In contrast, the debenture which is transferable by mere delivery is called bearer debenture.
3. Convertible and Non-Convertible:
Convertible debenture can be converted into equity shares after the expiry of a specified period. On the other hand, a non-convertible debenture is those which cannot be converted into equity shares.
4. First and Second:
A debenture which is repaid before the other debenture is known as the first debenture. The second debenture is that which is paid after the first debenture has been paid back.