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Published: Fri, 02 Feb 2018
Debenture From Legal Aspects
Companies generally raise funds by issuing as share capital or through borrowing from lenders. A debenture is one of ways of company borrowing where the company agrees to repay the debt where may also be a charge over the company’s assets to ensure the repayment of this debt. Debenture is an alternative form of investment in a company that is more secured than investment in shares because company must pay interest and it will be paid before the dividend payment. Debenture holders also get privilege, if the company which issued the debentures becomes bankrupt. A disadvantage is that debenture holders have no share in the company and therefore have no control over it.
If a company borrows money from general, it will give its creditor a document ensuring the terms and existence of the loan, which is called a debenture and the amount written on the document is repayable at a future date.
The company must pay interest to the creditor during the period of the loan. In order to improve the chances of recovering the debt from the company if it becomes bankrupt, a creditor may take a charge over some or all of the assets of the company as collateral. So it means that the creditor has a legal interest in that asset and the company cannot sell it without either paying off the debt or getting the permission of the creditor which increases the creditor’s chance of being repaid on the bankruptcy of the company as it has a privileged claim on money from the bankruptcy.
Definition of Debenture from legal aspects:
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.
In commercial practice the term “debenture” typically refers to the document that evidences a secured debt, although in law the definition may also cover unsecured debts (like any “IOU”). The legal definition is relevant for certain tax statutes, so for instance in British India Steam Navigation Co v IRC Lindley J held that a simple “acknowledgement of indebtedness” was a debenture, which meant that a paper on which directors promised to pay the holder £100 in 1882 and 5% interest each half year was enough, and as a result subject to pay duty under the Stamp Act 1870. The definition depends on the purpose of the statutory provision for which it is used, as it also matters because debenture holders have the right to company accounts and the director’s report, because debenture holders must be recorded on a company register which other debenture holders may inspect, and when issued by a company, debentures are not subject to the rule against “clogs on the equity of redemption”. This old equitable rule held that one could not contract lose their right to pay off and be free from debt after the debt had been created, with the consequence that two parties could not convert a mortgage into a sale and that one could not contract for a perpetual period for interest repayments. However given this rule was designed as a limit on contractual freedom where one party was vulnerable to the bargaining strength of another, it was thought that the rule was inappropriate for companies. In Kreglinger v New Patagonia Meat & Cold Storage Co Ltd the House of Lords held that an agreement by New Patagonia to sell sheepskins exclusively to Kreglinger in return for a £10,000 loan secured by a floating charge would persist for five years even after the principal sum was repaid. The contract to keep buying exclusively was construed to not be a clog on redeeming autonomy from the loan because the rule’s purpose was to preclude unconscionable bargains. For companies the rule as a whole was abolished in what is now section 739 of the Companies Act 2006. In Knightsbridge Estates Trust Ltd v Byrne the House of Lords applied this so that when Knightsbridge took a secured loan of £310,000 from Mr Byrne and contracted to repay interest over 40 years, Knightsbridge could not then argue that the contract should be void, because the deal constituted a debenture under the Act, and so avoided this rule of equity.
In India the company act 1956, Section 2 (12) defines debentures as “Debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge on the Company’s assets or not. Debenture means a document, which either creates a debt or acknowledges it, and any document which fulfills either of these two conditions is a debenture.”
Debentures were rewritten by the Corporate Law Economic Reform Program Act (CLERP) 1999 in order to update them to reflect commercial practice. The Corporations Act chapter 2L s 283AA ff defines debenture as, “a chose in action that includes an undertaking by the body to repay as a debt moneys deposited or lent to the body. The chose in action may (but need not) include a charge over property of the body to secure repayment of the money”
This definition focuses on the legal right to repayment of the debt. A chose in action means a right that is enforceable by legal action.
In summary a “debenture” has the following characteristics:
The repayment of all moneys is secured by a charge in favour of the trustee over the whole or any part of the tangible property of the borrower or of any of the guarantors and
The tangible property that constitutes the security for the charge is sufficient to meet the liability for the repayment of all such money and all other liabilities that have been incurred and rank in priority to or equally with that liability.
Types of Debenture:
A company may issue different types of debentures which can be classified as follows:
From the Point of view of Security
Secured Debentures: Secured debentures refer to those debentures where a charge is created on the assets of the issuer company to pay its creditors in case of default. The charge may be fixed or floating. A fixed charge is created on a specific asset whereas a floating charge is on the general assets of the company. The fixed charge is created against those assets which are held by a company for use in operations not meant for sale whereas floating charge involves all assets excluding those assigned to the secured creditors.
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.
From the Point of view of Tenure
Redeemable Debentures: Redeemable debentures are those which are payable on the end of the specific period either in lump sum or in Instalments during the life time of the issuer company. Debentures can be redeemed either at par or at premium.
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.
From the Point of view of Convertibility
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.
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.
From Coupon Rate Point of view
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 interest rate is usually tagged with the bank rate.
Zero Coupon Rate Debentures: 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.
From the view Point of Registration
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 can be transferred only by executing a regular transfer deed.
Bearer Debentures: Bearer debentures are the debentures which can be transferred by way of delivery and the company does not keep any record of the debenture holders. Interest on debentures is paid to a person who produces the interest coupon attached to such debentures.
Some typical terms in debenture:
Listed below are some of the typical terms found in a debenture.
The amount that the company borrows must be repaid at some future date. Debenture is a fixed loan and for this type of loan, repayment is due on a particular future date or a loan repayable on demand and it will be mentioned in the loan document.
As debenture is a kind of loan, the company must pay the interest to its creditors according to the frequency and rate of the interest mentioned in the debenture document. The rate can either be fixed or it can be varies with 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.
The receiver’s job is to take possession of the assets that are subject to the charge. After making provision for payment of any prior creditors of the company, the receiver can sell enough of the charged assets to pay what is due to the debenture holder, together with interest and costs.
When this is achieved, the receiver retires from office and the company is allowed to carry on its business again. Frequently, however, the appointment of a receiver and the sale of its assets will force the company into liquidation.
Power of sale
In order to recover the sum due to the debenture holder, 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.
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.
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 permission of the charge holder.
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.
Usually, debentures containing a floating charge also impose a prohibition on the company granting any fixed charges over the assets that are the subject of the floating charge. This is because fixed charges that are created after the floating charge would rank before the floating charge for payment in the event of insolvency of the company. In other words, despite the fact a fixed charge is registered after a floating charge, it would be paid in preference to the floating charge.
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 chargee (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.
If a fixed charge is taken over land, it should be registered at the Land Registry. Details of any charge created by the company should also be kept in the company’s own register of charges at its registered office.
Advantages of Debenture:
The main advantages offered by the debentures are:
A sound option for long-term financing;
Provide the capture of large volumes of capital;
Have attractive cost of funds as a single operation, issuing debentures generates lower costs than the costs of various operations of mutual banks;
Reduce the complexity of administering a loan portfolio;
Institutional financial capacity for investors;
Adequacy of cash flows for the issuer;
Management freedom in the conditions of issue;
Provides funding in preparation for future resources which is derived from sales of goods and services through a firm’s own receivables;
Publicize the company’s image, making it widely known, opening doors for new shares in the capital market;
In the case of convertible debentures: lower interest payment in respect of debentures since the conversion can be considered a form of extra gains;
The issuance of debentures does not involve the change of control of the company, as may occur with the issuance of new shares.
Provide to the issuer, the opportunity to trade their shares at prices higher than they would get by releasing shares;
If a company achieves a profitable outcome, this may influence the majority of its bondholders to convert their debentures into shares, which not only eliminate the occurrence of redemption but also provide greater capitalization of the issuer.
Lower cost than other equity financing options obtained from investment banks;
Basic value is properly updated, according to several indices;
Decentralization of liabilities from one financial institution, sparing the company and the possible need for reciprocity.
Interest and premiums paid are deductible as expenses.
In Bangladesh debenture investors enjoy some tax exemption. Interest on debentures: Any interest not exceeding Tk. 20,000/- received by an assessee other than a company on debentures approved by the Securities and. Exchange Commission for the purpose of this paragraphs. The exemption together with any exemption available in respect of interest on securities shall not exceed Tk. 20,000/-.Investment by an assessee other than a company in the purchase of approved debentures or debentures-stocks subject to the conditions that –
i. The assessee is the first allottee of such debentures or debenture-stocks.
ii. Exemption is allowable on the amount which is in excess of the sale proceeds received during the year and in the preceding two years in the aggregate or of the cost price of debenture-stocks purchased in the year and the preceding two years whichever is greater, out of disposal of debentures or debenture-stocks purchased during the year and the preceding two years.
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