Borrowing as a commercial activity

Borrowing is a very common commercial activity and there are various ways and instruments existing in today’s world to facilitate this activity. Though it started as a transaction between two individuals, it has evolved with time. The definition of Debt has become wide and so has the terms of Creditor and Debtor. In Latin lexis there exist a term de bere which means “to borrow" and from it derives the term ‘Debenture’. This term debenture is one of the debt instrument used by Companies to borrow. So, in common parlance it is an instrument of borrowing. Now this article, with a brief introduction of debenture, emphasizes on the preliminary process involved in issuing of debentures, a method of borrowing, by Public and Private Company.

Concept of Debenture

Share capital is the main source of finance of a company. Such capital is raised by issuing shares. Those who hold the shares of the company are called the shareholders and are owners of the company. But company may need additional amount of money for a long period and it cannot issue shares every time. But it can raise loan from the public. The amount of loan is divided into units of small denominations and the company sells them to the public. Each unit is called a ‘debenture’ and holder of such units is called Debenture holder. The amount so raised is loan for the company.

Definition of Debenture

The Companies Act, 1956 (the legislation governing Companies in India and henceforth referred as Act) has defined the term under section 2(12) as, ‘debenture’ includes debenture stock bonds and any other securities of a company, whether constituting a charge on the assets of the company or not. But the meaning is not very clear. It was defined as a document which either creates a debt or acknowledges it. [1] Therefore one might comprehend it as a document, which companies use, to borrow and creates a charge generally in order to make the creditor secure of his money. According to Topham : “debenture is a document given by company as evidence of a debt to the holder usually arising out of a loan and most commonly secured by charge". [2] 

Kinds of Debenture

Basically Debentures can be classified into two categories and that is:

Secured debentures- when the debenture creates a charge over the assets of the company;

Unsecured debentures- when it does not create a charge on the assets of the company.

These secured/unsecured debentures can be further classified on the basis of conversion :

Convertible debentures- when it can be converted into equity or preference shares as agreed in the Prospectus issuing that debenture or as provided in the Article/Memorandum of association of the company, it is called convertible debentures. It can be further subdivided into :

Fully convertible Debentures (FCD); or

Partly convertible Debentures (PCD); or

Optionally Convertible Debenture (OCD).

Non-Convertible debentures – When the debenture is not convertible but is redeemed as debenture then it is called Non-convertible Debentures.

One more basis of classifying debenture is redemption or repayment and they are two types:

Redeemable debentures- when the debentures are issued on the condition that they shall be redeemed/repaid after a certain period, they are called redeemable debentures. Generally all the debentures are redeemable in nature. [3] 

Irredeemable or Perpetual Debenture – when a debenture is issued with no fixed time period of payment or which contains a clause that the principle amount shall be paid back only on the happening of some contingent event, e.g., Winding up, these are called irredeemable debenture. Section 120 of the Act provides for Perpetual Debentures.

Lastly debentures can be classified on the basis of negotiability into:

Bearer debentures- they are negotiable instrument and the bearer can redeem it as it carries no registered holder.

Registered debentures- these are debentures payable to the registered holders [4] only and these are not negotiable instrument.

Who can issue debentures?

A debenture is an instrument of debt executed by the company by issue of debentures. Now if we look into the Act, the Board of Directors empowered by the Article has been vested with the power to issue debentures [5] . The Act has envisages two kinds of companies in detail viz Public and Private Company. Both has the power to issue debentures but with a difference in the procedure. The definition of Private Company itself marks the most important distinction in the procedure by restricting the class of persons to whom debentures can be issued. [6] Debentures can be issued at par, at premium or at discount.

Issue of Debentures by Public Company

A Public company means a company which is not a private company, has a minimum paid up capital of Rs. 5 lakh or such higher paid up capital, as may be prescribed and is a private company which is subsidiary of a company which is not a private company. [7] A Public company can be Listed [8] or Unlisted [9] . The steps to be followed while issuing debentures:

The Board of Directors passes a resolution to issue debentures under the power vested in them by the Articles of the Company.

A company which issues debentures is under an obligation to create security thereof pursuant to section 117A of the Act by executing a trust deed.

Debenture Trustees are appointed for this purpose. SEBI (Debenture Trustee) Regulations, 1993 prescribe that no person shall be entitled to act as Debenture Trustee unless he is either a scheduled bank carrying on commercial activity or a public financial institution within the meaning of section 4A of the Act or an insurance company or a body corporate. It is also necessary that such an entity should have capital adequacy of net worth of one crore of rupees and have been licensed by SEBI to act as a Debenture Trustee.

A Prospectus or Draft Letter is prepared which provides disclosures relating to company’s affair and the purpose for which Debentures are being issued, the nature of debenture, the details relating to it and such other disclosures which the company has to make according to the Act and SEBI Guidelines in case of listed company.

That prospectus is registered, Forms are filled [10] , debenture is issued and the applications are invited from people.

Procedure in case of Unlisted Public Company

Debentures are issued in accordance with the provisions of the Articles .The power to issue debentures is vested in Board of directors. They pass a resolution to this effect. Once a decision is taken by the board of directors to issue debentures, in case of unlisted company, the next step will be to draft prospectus relating to the issue [11] , then applications are invited, and letters of allotment are issued. On rejection of applications, application money is refunded. In case of partial allotment, excess application money may be adjusted towards subsequent calls. A company which issues debentures is under an obligation to create security thereof pursuant to section 117A of the Act by executing a trust deed. The need for executing a trust deed will arise when a company wants to issue a prospectus or letter of offer to the public for securing subscription to its debentures and for this purpose appoint one or more Debenture Trustees. The trust deed should state that the Debenture Trustees have consented to be appointed as such as required by section 117B of the Act and they see that a Debenture Redemption Reserve has been created to insure payment of interest and redemption of debentures under section 117C.

Procedure in case of Listed Public Company

But a Listed company has to comply not just with Companies Act but with the SEBI guidelines and therefore the procedure becomes a lengthy one. When the resolution is passed, Debenture Trustees are appointed [12] and a Trust deed is executed. An Application to recognized stock exchange for listing as under (Issue & listing of debt securities) SEBI Guidelines, 2008 is made. An agreement with a Depositary for dematerialization of the debentures is made. [13] The issue proposed to be listed has to obtain credit ratings from Credit Rating Agencies and minimum one rating from registered Credit Rating Agencies is required to be obtained. [14] Then the company files a Prospectus or an offer letter with the Registrar of Companies (ROC) under section 56 of the Act stating the purpose of issue, ratings obtained, debenture trustees to the issue, details of charge created, experts analysis, the interest rates, premium, period of maturity, redemption conditions, etc, besides disclosure related to the Company. Once this essential filing is done and registered, applications are invited from Public, allotment is made, and certificates are issued and delivered accordingly.

Issue of Unsecured Debenture by a Public Company

With mandatory appointment of Debenture Trustee, execution of Trust Deed and creation of DRR [15] by Public companies under sections117B, 117A and 117C respectively, it is implied that a Public company cannot issue Non-Convertible Unsecured Debentures (In case of convertible unsecured debenture, the debentures will be converted into equity or preference shares at some time period and as such the conversion acts as security for debenture holders). In fact Non-convertible Unsecured Debentures are treated as “Public Deposit" [16] under section 58A of the Act, and is subject to procedure provided in Companies (Acceptance of Deposit) Rules, 1975. Under it an advertisement is issued instead of prospectus or offer letter and when the Deposit is accepted, instead of Register of Debenture Holder, a Register of Deposit is maintained and receipt is furnished instead of certificate. As such a procedure different as the one stated above is followed.

Hence, we observed the procedure involved in issue of Debentures by Public Company. Now let’s see the procedure for Private Company.

Issue of Debentures by Private Company

A Private company is normally called as ‘close corporation’. It means a company which has a minimum paid up capital of Rupees one lakh or such higher paid-up capital as may be prescribed, and by its Articles-

Restricts the right to transfer its shares;

Limits the number of its members to 50 not including its employees members (present or past);

Prohibits any invitation to the public to subscribe for any share in, or debenture of, the company;

Prohibits any invitation or acceptance of deposits from persons other than its members, Directors or their relatives. [17] 

The process involved in issuing of debentures hence become less lengthy than in Public company because the debenture has to be circulated on private placement basis as people other than member of the company, director of the company and relatives of those members and directors of that company are prohibited. Therefore, the procedure starts from the Article vesting with the Board of Directors, the power to issue debentures by passing a revolution to that effect. If there is no such provision then an alteration of the Article is done by passing of a special resolution as per section 31 of the Act. The Board of directors passes a resolution to issue debentures and offers it only to people mentioned in sub clause (iii)(d) of Section 3(1). All other provisions as applicable to a public company will apply in the case of a private company except that it may not be required to appoint Debenture Trustee and instead execute Deed of charge on its assets and register it with the Registrar. The requirement of having to create Debenture Redemption Reserve will have to be followed as it is a special provision in the Companies Act, 1956 and apply to both public and private companies.  As such the debentures are issued and certificates are delivered.

Unsecured Debentures

A private company can issue unsecured debentures as there issue is confined to private circulation which implies only those related to the company and having trust on it will be the lenders. As the risk is high with unsecured debenture so is the rate of interest earned. The apprehensions as to default or lapse of payment of interest regarding unsecured debentures have been curtailed with DRR being made compulsory compliance to every company under the Act.

The procedure followed is same as that of public company and even here the unsecured debentures are treated as “deposits". The director or member, as the case may be, from whom money is received, furnishes to the company at the time of giving the money, a declaration in writing to the effect that the amount is not being given out of funds acquired by him by borrowing or accepting from others. [18] The Register of Deposit is maintained and receipt is issued. Thus, private company also issues unsecured debentures.

Conclusion: A Method of Borrowing

Company as a legal person also borrows and it follows all the basic principles of taking a loan. The creation of charge is an act similar to how an individual mortgages his property as security to the borrowed money. The Appointment of Debenture trustees ensures a public vigilance as multitude interest is involved. The Creation of DRR is an addition to the security and enhances the credibility of the debtor. As such in a nutshell the procedure explained above is the method followed by companies in India to borrow.