This article has been written by Nikunj Arora of Amity Law School, Noida. This article provides a detailed overview of the methods of redemption of debentures, along with the meaning and characteristics of debentures, which is a long-term funding option for a company, as defined under the provisions of the Companies Act, 2013 and the associated rules.  

This article has been published by Sneha Mahawar.

Introduction

A company’s primary source of financing is its share capital. It is possible to raise capital by issuing shares. Shareholders of a company are the people who own the company’s shares. As such, they are the owners of the company and are its owners. It is possible that the company will require additional funds for a prolonged period of time. There is no way it can issue shares every time. Each organization, regardless of size, needs funds for a variety of business activities. To ensure smooth operation, capital must be sufficient, depending on the company’s appetite. Some companies issue debentures when raising capital, especially if they need long-term capital. Companies use various methods to raise capital, but debentures are one of the most popular.

Having depleted its equity, the company will need to seek financing from external sources through the use of External Commercial Borrowings (ECB), debentures, bank loans, and public fixed deposits. The Memorandum of Association of a company shall also include the provisions for borrowing powers of the company. The company would not be able to meet its long-term financial needs with the funds just by issuing shares. Debentures are, therefore, a popular means of raising long-term capital by companies. Hence, the company can raise loans from the public, and there is the possibility of dividing the loan amount into units of small denominations that can be sold to the public by the company.

Essentially, each unit is referred to as a debenture, and the holder of the unit is referred to as a debenture holder. Consequently, the company receives a loan for the amount raised. Debentures are one of the main instruments and methods used by companies to raise loan capital. Debentures are similar to a certificate of loan or a loan bond proving the company’s obligation to repay a specified amount with interest. Debentures do not become share capital for a company, but they become part of its capital structure. This article discusses the meaning of debentures and the methods of redemption of debentures.

Overview of debentures

Meaning of debentures

A debenture is a debt obligation that originates from the Latin word “debere”, which means to borrow. Debentures are written documents that acknowledge debts on behalf of a company under the common seal of the company. In this contract, the company agrees to repay the principal after a specified period or at intervals at its option and to pay an interest rate that will be fixed for a particular period. A bond is another term used in the same context in companies. Bonds are instruments for acknowledging debt. Bonds were traditionally issued by the government, but today non-governmental and semi-governmental organizations are also issuing bonds. It is now common practice to use the words debentures and bonds interchangeably.

In addition to specifying the redemption date, the debenture also specifies the interest rate and the method of payment. Recent technological advances and new instruments have accelerated the development of the Indian capital market, and the current economic climate enables debentures to contribute significantly to corporate finance. When compared with the issuance of preferred shares, bonus shares, equity shares, and rights issues, debentures are one of the most popular ways of raising capital. Section 2(30) of the Companies Act, 2013 (hereinafter referred to as Act), provides the authority for companies to issue bonds or debentures. Debentures are considered to be debt instruments that can be secured as well as unsecured by establishing a fee against the assets of the company. Companies may issue debentures as long-term unsecured bonds if they agree to repay them at a later date. In the event that the company cannot pay either the interest or the principal at maturity, the creditors of the company can request a liquidation of the company in order to recover their money by selling its assets.

A company may issue debentures that can be converted into shares completely or partially at redemption under Section 71 of the Act. At a general meeting, a special resolution must be passed to approve the issuance of debentures with an option to convert them into shares, wholly or partially. A debenture that carries a right to vote is prohibited under this Section.

Characteristics of debentures

The following are the characteristics of the debentures:

• The company issues it in the form of a certificate of indebtedness. The charge is generally attached to the assets or undertakings of the company. The redemption date is usually set in advance.
• The holders of debentures are creditors of the company and have no claim to the company’s ownership.
• Due to the fact that debenture holders are not the owners of the company, they do not have any rights over the company’s administration and management.
• A debenture holder does not have to worry about the company’s profits or losses because they get a fixed rate of interest every year regardless of the company’s financial position.
• As debentures typically attach to the assets of the company, in the event of liquidation and the company’s inability to repay the debt, the debenture holders might also be able to sell the company’s property via the legal process to recover their money.
• A commitment is given to debenture holders that the company will repay their principal amount along with the interest.
• No debenture holder has the right to vote at the company’s meetings.
• There is no risk for debenture holders to lose their money when a company is in wind-up since the company begins by repaying its debentures as required by law.

Redemption of debentures

In the process of redemption of the debentures, the company pays back the debt raised in the form of debentures. The company has to fix a maturity period for the debentures. As a result, the holders of debentures are repaid their investment at a price either equal to or above their face value at maturity. When the debentures are issued, the company must adhere to all terms and conditions described in the prospectus.

Companies that issue debentures shall create a debenture redemption reserve account out of profits available for dividend payments and the amount credited to the account may not be used by the company except for the redemption of debentures. The company must establish a Debenture Redemption Reserve in accordance with the following conditions, as per the Companies (Share Capital and Debentures) Rules, 2014 (hereinafter referred to as Rules): 

1. To create a Debenture Redemption Reserve, the company must use its profits available for dividend payments;
2. Before debentures begin to be redeemed, the company shall establish a Debenture Redemption Reserve equal to at least 50% of the amount raised through the issuance of debentures. 
3. According to Rule 18(7)(c) of the Rules, each company that is required to establish a Debenture Redemption Reserve shall either invest or deposit, as appropriate, on or before the 30th day of April in each year, a sum not less than 15% of the number of its debentures maturing during the year ending on the 31st day of March of the following year, in any of the following methods:

• In a deposit account at a scheduled bank that is not subject to any charge or lien;
• The second option is to invest in unencumbered securities of the Central Government or a State Government;
• In unencumbered securities covered in the sub-clauses (a) to (d) and (ee) of Section 20 of the Indian Trusts Act, 1882;
• The last option is unencumbered bonds issued by any other company which has been notified under Section 20(f) of the Indian Trusts Act, 1882.

4. Investments or deposits made as above shall serve only to redeem debentures maturing at the end of the year described above. The amount remaining invested or deposited, shall not fall below 15% of the number of debentures maturing at the end of the year.
5. The Debenture Redemption Reserve must be established in respect of the non-convertible portion of the debenture issued in the case of partly convertible debentures.
6. Debenture Redemption Reserve funds may not be used for any purpose other than the redemption of debentures by the company.
7. If a company fails to redeem the debentures on the date of their maturity or, in any case, fails to pay interest on the debentures on its due date, then an application can be made by any or all of the debentures holders or debenture trustees to the Tribunal. The Tribunal may, after hearing the parties concerned, direct the company to redeem the debentures forthwith on payment of principal and interest due. A decree for specific performance may be used to enforce a contract with the company to purchase and pay for its debentures.  

Advantages of redemption of debentures

In addition to the many advantages of issuing debentures, one of them is that the cost of raising money through debentures is lower than that of raising money through equity, due to the cost of equity being higher. A company can also benefit greatly from the redemption of its debentures. The following are some of these advantages:

• The company has reduced its operating costs by a significant amount.
• Assuring that the solvency ratio remains at a satisfactory level
• Optimize the utilization of idle or excess resources within a company to achieve a maximum return on investment
• In a scenario when the interest rate on debentures is higher than the market interest rate, it may be advantageous for the company to rebalance its balance sheet by reducing its expensive external liability.

Sources for the redemption of debentures

Whenever a company issues debentures, it commits to redeeming them with respect to their terms. Any of the following resources can be used by the company to redeem its debentures upon maturity:

• Any sale proceeds received from the sale of fixed assets.
• As a result of taking advantage of the company’s profits.
• The company purchased its own debentures in order to finance its growth 
• Out of fresh issues of debentures or shares that were issued on a regular basis
• As a result of converting the debentures into shares or new debentures that may or may not have the same coupon rate as the old debentures.
• From the company’s part capital, which is a small share of the capital.

Methods or modes of redemption of debentures

Value at the time of redemption 

To ensure the interests of debenture holders and the company are not at risk, the Companies Act, 2013 grants the issuing company multiple options for redeeming the debentures. When the company redeems its debentures, it can redeem them at a value that has been predetermined when the debentures were issued. Debentures can be redeemed at several different values, such as:

• At par: In this case, the debentures have a face value equal to their redemption value.
• At premium: In such a scenario, a higher redemption value is assigned to the debentures than their face value. The redemption value can, for example, be Rs. 110 or 120 per debenture if the face value is Rs. 100.
• At discount: Debentures are redeemable for less than their face value in this case. For example, debentures with a face value of Rs 100 can be redeemed for Rs. 90 or 80 per debenture, as agreed when the debentures were issued.

Methods of redemption of debentures

It is the issuing and redeeming of debentures that makes debentures functional in an organization. A debenture is a certificate acknowledging the debt that is issued under the seal of the organization. A debenture is redeemed by paying its principal back to its holder. Therefore, debt obligations for debentures are discharged when debentures are redeemed. The redemption of debentures can be accomplished in a variety of ways, each with its own accounting method. In general, they fall into the following categories:

Redemption by payment in lump sum

There are many options for redeeming debentures, including this type. In comparison to other redemption methods, this method is simpler. A lump sum redemption occurs when debenture holders receive their promised amount on a specific date. The lump sum is the total principal amount of all debentures whose redemption occurs without a premium or discount. Whenever debentures are issued and redeemed for a lump sum, a fixed date is given. A debenture agreement will indicate this date as the maturity date. However, the organizations have the option of paying the debentures before maturity as well. Before the payment is made, the organization has a clear idea of the amount and the date. Therefore, it is possible to manage the resources properly.

The holders of these debentures are paid their agreed value in a single one-time payment under this redemption method. Payment will be in accordance with the agreement at the time of issuance of the debentures. The company may be able to meet its commitments on time with funds set aside under the Debenture Redemption Reserve (DRR) by making appropriate investments and arranging its finances.

Redemption of debentures in instalments

The company also agrees to redeem its debentures through instalments, which must be paid in accordance with the agreement at the time of issuance. A regular schedule of payments may or may not be agreed to at the time of debenture issue. By redeeming debentures through such a mechanism, the company is relieved of the burden of raising ad hoc amounts at maturity.

Every year, a portion of the debentures is redeemed. In most cases, the drawings determine which debentures need to be paid in which year. This is accomplished by placing slips indicating the number of debentures to be redeemed, and then taking out at random the number of slips equal to the number of debentures to be redeemed. It is called ‘Redemption by Drawings’. Debentures are usually redeemed based on the number of years they have been issued divided by the total amount of debentures issued. In accordance with the terms of the issue, holders of debentures whose slips have been taken out are repaid at par or at a premium. The redemption under this method is subject to the requirement of creating a debenture redemption reserve equal to 50% of the total amount of the debentures.

Redemption by purchasing the debentures through open market

The redemption of debentures can also be accomplished through open market purchases. In this way, the company is able to redeem its shares at a discounted price, which would have a positive impact on its bottom line.  A company can redeem its own debentures by purchasing them in the open market if its articles of association enable it to do so. Purchase of the debentures serves the following purposes:

• In order to earn more profits at a later date, this can be used as an investment which can then be sold at a higher price at the time of sale
• The debenture liabilities will be cancelled if the debenture rate is higher than the current rate of interest in the market.

It is a special requirement for a company to redeem its shares by purchasing them on the open market. The Articles of Association authorize the company to purchase its own debentures on the open market. This procedure is followed by the company, especially when the debentures of its own company are available for sale at a discount on the stock market and they wish to purchase them. Furthermore, they may wish to purchase it in order to save the interest that would otherwise have been payable on these bonds. The company may either cancel or keep alive the debentures purchased from the stock market for future issuance. These debentures are held as an investment in the company’s own debentures. Unless the Board of Directors passes a resolution, the cancellation cannot occur.

The company may follow these two options after purchasing debentures on the stock market:

• The company can purchase the debentures for cancellation in the first option. An order of cancellation can only be revoked by the Board of Directors.
• Secondly, the company keeps the debentures alive so they can be issued in the future, rather than cancelling them. These debentures are kept by the company as an investment in its own debentures.

There will be no premium payable on the redemption of the company’s own debentures when the company purchases them for immediate cancellation and such debentures are redeemable at a premium. In this way, the company will be able to realize a capital profit from these debentures. It is not always the case that the company cancels its debentures, but sometimes it keeps them as investments. Companies usually do this when they have surplus funds. Thus, they prefer to invest the funds in their own company rather than in another company. The following are the possible reasons which may explain this:

• Company debentures are listed on the market at a lower price than their nominal value (face).
• It allows them to save interest otherwise due on such debentures.
• For the purpose of keeping these debentures alive and reselling them in the future.

In terms of the redemption of debentures by this method, the Securities and Exchange Board of India (SEBI) provides two basic guidelines. The following are listed:

• The obligation to create the Debenture Redemption Reserve (DRR) applies only to non-convertible debentures and non-convertible portions of partly convertible debentures.
• There will be a DRR of at least 10% equal to the nominal value of the outstanding debentures in the unlisted company.

Redemption by conversion of debentures into shares or new debentures

Debentures are most commonly redeemed by converting them into equity shares or preference shares or even into new ones. There is no limit to the number of new debentures that are issued, and the coupon rate can either match or be higher or lower than that of the existing debentures. In order to provide adequate information to the shareholders of the company about the impending addition to their share capital or the new long-term liabilities of the company, the company must mention the term ‘convertible’ as a prefix to the debentures on their balance sheet. The following is the procedure of conversion:

• There should be an option for conversion in the articles of association of the company.
• The Board of Directors shall hold a meeting and pass the Board Resolution for the Conversion of Compulsory Convertible Debentures (CCDs) into Equity Shares, together with the notice of the General Meeting for approval by the shareholders of the company.
• A special resolution for converting CCDs into equity shares should be passed at the general meeting of the shareholders of the company. A special resolution must be accompanied by an explanation pursuant to Section 62 of the Companies Act, 2013. All necessary information regarding the conversion should be included in the statement.
• The Form-MGT-14 must be filed with the Registrar of Companies, within 30 days of passing a Special Resolution.
• The holders of compulsorily convertible debentures receive a letter of option. The Company Secretary is required to verify the consent of the debenture holders at the time of conversion.
• Following this, the company needs to receive a valuation report in order to proceed with the conversion process.
• In the event that a special resolution is passed, the allotment of a share should take place within twelve months of the date of the resolution. Based on the valuation report, the price of the share is determined.
• In accordance with Form SH-1, share certificates must be prepared and issued.
• Holders of shares are issued share certificates, and their names are entered in the Register of Members.
• In 30 days following an allotment of Form PAS-3, a return allotment of securities must be filed with the Registrar. Fees should be paid and a list of all holders should be provided according to the Companies (Registration Offices and Fees) Rules, 2014.
• The list of allottees, board resolution, special resolution, valuation report, and board resolution is required for the return of allotment of PAS-3.

Redemption of debentures by sinking funds

Debenture Redemption Funds, also known as Sinking Funds, are funds created by appropriating some profits for the redemption of debentures at maturity, then investing the amount appropriated in investments. Sinking funds, or Debenture Redemption Funds, are created to invest money set aside from profits every year outside the business. The company uses the fund to invest or buy insurance policies. It is reinvested in the fund again after the income is received from the said investments or policies. Upon redemption, investments are sold or policies are surrendered to obtain the funds needed to pay off the debenture holders. Sinking funds can be divided into two types:

• Cumulative sinking fund: Sinking funds of this type reinvest interest earned on investments into new sinking funds. In other words, the amount invested will be equal to the annual surplus appropriation plus interest earned on previous investments.
• Non-cumulative sinking fund: Sinking funds of this type do not reinvest the interest earned on their investments. Therefore, the number of investments will be equal to the annual budget only, and the interest earned on investing in sinking funds will be transferred to the P&L account.

Understanding Debenture Redemption Reserve

Companies in India that issue debentures maintain a Debenture Redemption Reserve (DRR). By doing so, investors will be protected from the possibility of a default by the company. Furthermore, DRR ensures that sufficient funds are available for debenture holders to meet their obligations. The company’s DRR funds shall be used exclusively for debenture redemptions.  It is important to understand that a Debenture Redemption Reserve (DRR) consists of two components. Initially, a portion of the company’s profits should be set aside. As a next step, the profit will be allocated. This process is called the earmarking of funds when this process is carried out. As a result, sufficient profits are available to repay debentures. As a second component, the company must invest funds in order to maintain liquidity.

Below is a list of companies that are exempt from maintaining DRRs:

• Public Financial Institutions: 

An institution whose paid-up capital is at least 51% owned by the government is known as a public financial institution (PFI). For example, Life Insurance Corporation of India (LIC), Infrastructure Development Finance Company Limited (IDFC), Industrial Credit and Investment Corporation of India Limited (ICICI), etc.

• All India Financial Institutions: 

The Reserve Bank of India (RBI) supervises All India Financial Institutions (AIFI). For example, the  Export-Import Bank of India (Exim Bank), National Bank for Agriculture and Rural Development (NABARD), Small Industries Development Bank of India (SIDBI), etc.

• Housing Finance Companies: 

HFCs are those companies which are registered under National Housing Bank (NHB).

• Non-banking finance companies: 

There is no need for DRR to be maintained by non-banking finance companies (NBFCs) licensed under Section 45-IA of the Reserve Bank of India Act, 1934.

• Scheduled banks: 

The Reserve Bank of India Act, 1934 specifies a list of scheduled banks.

• Listing companies: 

Companies listed on one of the Indian stock exchanges, the BSE or NSE, are called Listed Companies.

• Exception: 

If an unlisted NBFC or HFC issues debentures publicly, a DRR should be created.

Conclusion

Debentures are one of the most important sources of funds for a company in the long term. Upon receiving money, the holder must return it to the holder within a specified time period. The redemption of a debenture refers to the process of returning the sum invested by the holder of the debenture. Thus, it is imperative that the company select the sources and method of redemption with great care. It is a large amount of money that has to be paid to the holders of debentures. It is therefore important for the company to plan the redemption at the time of issuance. Debentures are redeemed as part of normal business operations for companies and have to be redeemed in accordance with the Companies Act, 2013, and associated rules. Debentures are redeemed when the company pays their amount. In the event of redemption of debentures, the liability associated with them is discharged. It is necessary to provide sufficient funds to redeem debentures, so prudent companies reserve funds from profits and accumulate these funds. A company must fulfill the redemption of its debentures in order to avoid penalties.

FAQs

Is it possible for the company to invest in the DRR?

Yes, a company may invest debenture redemption reserves to earn interest or profit by investing them in notified securities. Debentures must be redeemed with the income generated from such investments.

After the debentures have been redeemed, how are excess DRR treated?

A company’s Capital Reserve must be credited with any excess DRR after redeemed debentures.

How else do companies redeem their debentures?

The company can redeem debentures in addition to the above methods by taking out an insurance policy or by creating a sinking fund.

What is the purpose of issuing debentures by companies?

A debenture is a long-term liability issued by a company to raise capital. Since equity is more expensive than debt, issuing debentures can reduce capital costs. Debentures are also redeemed over a long period of time, so the company has adequate time to meet its obligations.

Do debentures require interest payments?

Yes, every year, the company must pay interest on its debentures from its profits, which is considered to be an operating cost. The Companies Act, 2013 penalizes companies for failing to make timely interest payments to debenture holders.

References

• https://www.icsi.edu/media/portals/0/SHARE%20CAPITAL%20AND%20DEBENTURES.pdf
• https://scripbox.com/pf/debenture-redemption-reserve/
• https://www.caclubindia.com/articles/redemption-of-debentures-as-per-companies-act-2013-and-its-latest-amendments-43510.asp
• https://fisdom.com/redemption-of-debentures/

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