This article is written by Vipul Kumar, pursuing a Diploma in Law Firm Practice: Research, Drafting, Briefing and Client Management from LawSikho. The article has been edited by Tanmaya Sharma (Associate, LawSikho) and Zigishu Singh (Associate, LawSikho).
Every company or firm, no matter how large or small they are, whether they are involved in business, manufacturing, or providing services, requires funds. To run various business activities effectively and successfully there is a need to have an adequate amount of capital.
How do we raise funds to run the activities involved in a business? Mainly, two processes are used by the companies to raise funds – that is, stocks or debt. Debentures are a type of debt instrument used by companies to raise funds from various sources.
Redemption of debentures is the process by which an organization settles its liability in the case of a debenture. A debenture redemption depends on the type of debenture and the terms of repayment. They can differ based on these factors.
What is debenture?
The debenture is a highly effective tool for raising capital for a company that has been defined under Section 2(30) of the Companies Act, 2013, “Debentures” include debenture stocks, bonds, and other instruments of a company regarding debts whether they constitute a charge over the company’s assets or not.
What is Debenture Redemption Reserve (DRR)?
Debenture Redemption Reserve (DRR) is a fund preserved by companies that have been used to make payments on debentures. So the company that issues the Debenture must create a Debenture Redemption Reserve (DRR) to protect their investors and minimize the risk in case of default in the payment. As per the notification of MCA dated 16th August 2019, a Debenture Redemption Reserve is not required for privately placed debentures by NBFCs registered with RBI under Section 45-IA of the Reserve Bank of India Act, 1934 and Housing Finance Companies registered with the National Housing Bank.
Rights and remedies available to the debenture holder
Rule 18 (1) (c) of the Companies (Share Capital and Debentures) Rules, 2014, specifies that a debenture trustee shall be appointed by the company before the issue also known as “SEBI SCDR, 2014” of a prospectus or a letter of offer for subscription of debentures and no later than sixty days after allotment.
Rule 18 (3) of the SEBI SCDR, 2014 defines the duty of the debenture trustee as follows :-.
(a) To ensure that the letter of offer contains no matter that is inconsistent with the terms of the issue of the debentures or the trust deed;
(b) Make sure that the trust deed’s covenants do not prejudicially affect debenture holders’ interests;
(c) Request periodic status or performance reports from the company;
(d) Inform the holders of the debentures promptly if there is a default in the payment of interest or redemption of the debentures and what action has been taken by the trustee;
(e) They can appoint a nominee director in the Board of the company in the event of—any default regarding the redemption of debentures or interest payments, as well as any action taken by the trustee himself.
- According to Section 71(8) of the Companies Act, 2013, debenture holders are entitled to interest and redemption on their debentures by the terms of their issue.
- As per Section 71(10) of the Companies Act, 2013 if the company fails to pay the interest due or redeem debentures on their maturity date, the Tribunal can, after hearing the parties involved and requesting relief from the debenture trustee, direct the company to redeem the debentures.
According to Section 71 Sub-section (12) of the Company Act, 2013 a decree for specific performance may be used to enforce a contract with a company to take up and pay for debentures of the company. The Central Government may prescribe the procedure for securing the issue of debentures, the form of the debenture trust deed, the procedure for debenture holders to inspect and obtain copies of the trust deed, quantum of debenture redemption reserve required to be created, and any other matters.
- Section 164(2) of the Companies Act, 2013 provides a rule for the disqualification of directors for a period of one year or more if they fail to redeem their debentures on the maturity date. The individual who is responsible for non-compliance shall be barred from serving as a director of that company or any other company for the next 5 years from the date on which the company fails to redeem the debentures.
- According to Section 186(8) of the Companies Act of 2013, companies who have not repaid deposits or made interest payments are prohibited from making loans or guaranteeing acquisitions until the default is resolved.
Purpose of Debenture Redemption Reserve (DRR)
To reduce the risk of default of the debts borrowed through debentures, the Indian Government introduced DRR in 2000. In some cases, companies that have borrowed money through debentures do not have sufficient funds to repay these debts on time. There are two of the main reasons for defaults on payment namely: insufficient profitability and insufficient liquidity. The concept of DRR provides two requirements to address these two issues:
- The company must contribute a portion of profits to the DRR every year and that amount cannot be used until the payment of debenture is made. Because of that, the dividend available to the shareholders is to be reduced. This has enabled the company to retain enough reserve that allows a future settlement to debenture holders. Because of this, the chances of default due to profitability related issues may be reduced.
- Each year, the company should invest money that can be used to purchase a share or equity at a price that is equal to how much is transferred to the DRR account. To do this, only securities approved by the government can be purchased and those investments cannot be used for anything other than paying the debt holders. The risk of default due to profitability-related issues may therefore be reduced.
Mode of redemption
Based on the redeemability of the debenture it may be classified into the following two categories:
Debentures that have a specified repayment date and may be redeemed at the end of the period either in a lump sum or in installments any time before winding up of the business. They can be redeemed either at par or at a premium by the debenture holder. It may help the company to attract more investors and they are more assorted regarding the repayments.
Irredeemable or perpetual debentures
A debenture that cannot be redeemed during the lifetime of the company is called an irredeemable debenture. In this debenture, the borrower has not had any set period to repay the principal. It may be redeemed when the company is willing to repay the borrowed amount but this happens rarely. If a company becomes bankrupt, then it is ensured that the company’s lenders are repaid first.
Method of redemption of debenture
Redemption of debentures refers to paying off the company’s debt when the company repays the full amount of the debentures according to the terms and conditions of the debentures. Until the debentures are repaid, the company is not discharged from its obligations. There are several methods used for the redemption of the debentures and each method has a unique accounting method. Those are classified as follows:
Payment in lump-sum on the maturity
At the end of the maturity period, the company can redeem the debenture according to the terms of the issue by making a one-time lump sum payment.
Payment in installments after the maturity date
This method of redemption of debentures involves repayment of the borrowed funds in installments at specific dates according to the debenture’s terms.
Redemption through purchase from the open market
In this method, the company is willing to purchase the debenture by purchase from the open market. They can cancel it as well to increase the date of maturity of the debenture. Another purpose of the purchase of debenture from the open market may be to get the discounted rate that can help to reduce the overall redemption payment and overall business revenue as well.
Redemption by conversion into shares
In this method, the company redeems its debenture by converting it into an equity share. At the time of issuance, the terms and conditions of the conversion must be addressed.
Applicability of Debenture Redemption Reserve (DRR)
All companies need to maintain a DRR except for the following: –
- All India financial institutions: – The companies which are doing business under the supervision of the RBI like Export, Import Bank of India, Small Industries Development Bank of India, and National Housing Bank etc.
- Housing finance companies: – No need to maintain the DRR for the company registered with the Housing Finance Companies.
- Non-banking financial companies: – No need to maintain the DRR for the registered under Section 45-IA of the RBI Act, 1934.
- All scheduled banks: – The scheduled bank mentioned in the second schedule of the Reserve Bank of India Act, 1934 shall waive to maintain the DRR.
- Listed companies: – A company listed on one of the two stock exchanges, either the NSE or the BSE.
The main purpose of these relaxations was introduced by the MCA for the reduction of the cost of borrowings incurred by companies.
Method of Investment to the Debenture Redemption Reserve (DRR) Funds
According to the new notification dated 19th of August 2019 by the MCA Companies (Share Capital and Debentures) Amendment Rules, 2019.
A Debenture Redemption Reserve is not required for privately placed debentures by NBFCs registered with RBI under section 45-IA of the Reserve Bank of India Act, 1934 and Housing Finance Companies registered with the National Housing Bank. A company that falls under this category must, on or before the 30th day of April in each year, invest or deposit, as the case may be, not less than fifteen percent of the number of its debentures maturing during the year and ending on the 31st day of March the following year. For debentures issued by the company, the amount of the Debenture Redemption Reserve shall be ten per cent of the outstanding debentures on or before the 30th day of April in each year. In this case, the amount invested should match the amount transferred to the DRR. Ledger balances of the DRR and the investment should be equal to each other. The amount transferred under DRR can be invested in the approved securities listed below:
- To deposits with any scheduled bank;
- To deposits in Central Government or any State Government treasury bills and commercial papers;
- Long term bonds that have been issued by the Government.
Provided that Invested or deposited amount shall not, at any time, fall below 15% of the amount of the debentures maturing during the year ending on the 31st day of March of that year. The amount invested as DRR shall only be used for the same purpose during the year referred to above.
What is a Debenture Redemption Reserve Account?
Under section 71(4) of the Company Act,2013, the company shall establish a debenture redemption reserve account out of the profits available for dividend payment. The amount credited to such an account shall not be used by the company except for the redemption of debentures.
According to Rule 18(7) of the Companies (Share Capital and Debentures) Rules, 2014, the company that issues the debenture must maintain the Debenture Redemption Reserve Account to redeem the debenture according to the following conditions:
- Dividend income available for dividend payments shall be used for establishing the Debenture Redemption Reserve.
- A Debenture Redemption Reserve must be established by the company before debenture redemption begins, equivalent to at least 50% of the money raised from the debenture issue.
- The company must accumulate a Debenture Redemption Reserve by depositing or investing a sum equal to at least 15% of the number of debentures maturing during the year until the 31st of March of the following year, in one or more of the following ways:
- In free-of-charge or lien deposits with any scheduled bank.
- In unencumbered Central or state government securities
- In unencumbered securities
- In unencumbered bonds issued by the company.
In addition, companies should also be aware that the Debenture Redemption Reserve (DRR) account must be opened with a financial institution authorized by the Reserve Bank of India.
Indian capital markets have expanded much faster over the last few years as a result of new instruments and technological advances. The current situation is proving that debentures are an important part of the corporate sector’s financial needs. Compared to other forms of raising capital from the market, such as preferred shares, bonus shares, equity shares, and rights issues, debentures are a major way to raise capital. Making provisions like DRR may reduce the potential for default on debentures. The DRR ensures that the funds are available with the company to meet the obligations towards debenture holders to make the payment. Thus, Debenture Redemption Reserve here is of utmost importance as it reduces the investment risk for the buyer of the debenture.
- The Companies (share capital and debenture) Rules, 2014
- THE COMPANIES ACT, 2013
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skills.
LawSikho has created a telegram group for exchanging legal knowledge, referrals, and various opportunities. You can click on this link and join: