This article is written by Gautam Chaudhary, a law student at Chanderprabhu Jain College of Higher Studies & School of Law, GGSIPU. The present article talks about the concept of debentures and meaning of redeemable debentures, followed by their types. Further, an exhaustive explanation of the nature and features of the same and redeemable debenture reserve is also given.
It has been published by Rachit Garg.
Every now and then, a company feels the need for funds and capital to stay as good and smooth as ever in the corporate market. The funds produced are utilised in various essential and crucial operations of the company. For example, the funds can be utilised for issuing shares since share capital is the principal source of income for every company, or they can be used for expanding the business, conducting research and development activities, etc. The point is that sometimes a company needs capital or funds for operations in the long run or for an immediate need. Due to their vibrant nature, debentures are also issued by the government for their required operations as well. It issues debentures, which are the most secured ones since its motive is to generate capital without driving people towards losses. This article discusses the source or way of generating the necessary funds and capital a company must generate to meet its needs.
Section 2(30) of the Companies Act, 2013, defines ‘debenture’; it states that debentures include the debenture stock, bonds or any other financial instrument promising to pay the amount taken by the company. For easy comprehension, debenture can be related to the concept of debt because debenture acts the same as debt for a company. For example, if A wants to buy a car whose value is 70 lakh INR and he has 20 lakh rupees, he would apply for a loan to purchase the desired car. The same is the case with companies. Let us say, a company wants to expand its research and development programme for enhanced intellectual property commercialization. The company’s steps have proved to be effective in the long term and are of enormous value. So, the company would reach out to take loans from the public. Basically, debentures refer to the document that showcases the formal acknowledgement of the debt by the company, admitting that the company has taken a loan from the public, wherein it also states the interest amount of the loan to be paid to the public at the specified time for the sum borrowed until the debenture is relieved. In simple terms, it can be said to be the company’s liability. The investors who purchase issued shares of the company become debenture holders.
Section 2(30) of the Companies Act, 2013, also talks about a charge over the assets of the company. Here the word ‘charge’ would mean the authority or power given to the public after issuing the share to them. The significance and need of the charge over the assets of the company are of paramount importance because, in common parlance, a charge would mean the freedom given to the debenture holders, which would come into play when the company fails in repayment of the borrowed amount along with interest. In this case, the debenture holders would have the utmost freedom to sell the assets of the company and recover their given principal amount and debt interest.
Types of debentures on different basis
Debentures issued to the common public are further classified into various types based on their security, convertibility, priority, record, performance, and coupon rate. These different types of debentures are explained below:
On the basis of security
Secured debentures are the same as collateral loans, which means these debentures operate only on collateral security that the company gives to the investors. In simple terms, some collateral must be kept for such debentures, and that collateral would be assets of the company. If the company fails to repay the principal amount with interest, the debenture holders can recover their money through the sale of the assets.
For example, a company XYZ needs capital for its business operation; to do so, it issues secured debentures to attract investors. Now here when the company issues a debenture of secured nature it shall keep let’s say any tangible asset of great value as collateral, say the company’s alternative power plant. Just in case, in the future, the company goes insolvent, it would clear the debt of the debenture holders by selling off the power plant. When the company becomes insolvent, then debenture holders acquire an absolute right over its property and can recover their money by selling the same.
Secured debentures are further categorised into two categories. They are as follows:
Fixed charge assets
Fixed charge assets are the particular assets the company gives against the borrowed debt. It is a fixed asset against which the debt would be recovered through a sale if the company fails to fulfil its end of the promise.
At last, it is obvious that these assets cannot be sold by the company without the consent of the debenture holders. For example, the company issued a debenture putting its heavy machinery of all types. This is a fixed charge.
Floating charge asset
Floating charge assets are general in nature; they are not specific, like fixed charge assets. The company issues debentures by giving general assets as security.
In the case of floating charge assets, the company is at full discretion in regards to what is kept as collateral, and for this reason, they are general in nature. For example, It may keep plants, machinery, or its official office building as collateral.
These debentures are called ‘unsecured’ because there is no collateral present to back the surety of repayment of the borrowed debt. Debenture holders give out loans to the company as per its market image, credibility, and value. In the case of such debentures, debenture holders do not possess the power to sell off the company’s assets.
On the basis of convertibility
These types of debentures can be eventually changed into equity shares of the company after a specified period of time. Equity shares are normal or ordinary shares, wherein, part ownership is obtained upon purchase.
For example, company XYZ issues debentures for a certain period, and during the said period the shareholders of the company decide to convert those debentures into equity shares. After the conversion, all the debenture holders would now enjoy the status of equity shareholders, where they would now have the right to vote in the company’s decisions and operations.
Convertible debentures are further divided into two classes, which are as follows:
Debentures that are converted to equity shares only in a specific proportion are called partially convertible debentures. The company decides the proportion for conversion after it issues the securities to the general public.
For example, a company issues 100 debentures at a value of Rs. 200 per debenture. After some time, the shareholders decided to convert 30 debentures into equity shares. Upon the conversion, the debenture holders of those 30 debentures would have the right to vote in the company’s operations and would be called the owner of the company since they are the shareholders now.
These debentures are fully converted into equity shares of the company. The company decides whether to convert the debentures into equity shares at the time of issuance.
For instance, a company XYZ issues 100 debentures and, after some time, decides to convert them into equity shares. In this case, the investors in all the debentures would now be converted into shareholders and therefore have the above mentioned rights.
On the basis of priority
First mortgaged debentures
First mortgage debentures are given first preference at the time of company liquidation, which means the holders of the first mortgaged debentures are paid up first when the company begins repaying its debts and other forms of liabilities. It is only after the repayment of these debentures that the other forms of debentures are paid.
Second mortgaged debentures
Second mortgaged debentures are only repaid by the company after repaying the first mortgaged debentures at the time of liquidation. They come second, after the first mortgaged debentures.
For example, out of 100 investors, around 50 invested in first mortgaged debentures, and another 50 invested in second mortgaged debentures. Now that the company has started generating capital and has begun paying its liabilities, it would first pay the mortgage debenture holders and then the second ones.
On the basis of record
The term ‘registered’ here means the filing of necessary information like names and addresses of the debenture holders in the register maintained by the company for keeping a record where transfers of debentures are registered by the company. The debentures in respect of which the said record is made are registered debentures.
These debentures are also known as bearer debentures. In plain language, unregistered debentures can be comprehended as ‘informal debentures’, because, unlike registered debentures, they do not include a formal and laid down procedure. The details, such as names and addresses of the debenture holders, are not registered in the register of debentures by the company. Unregistered debentures are also transferable upon the delivery of the instrument, so the person holding the instrument gets paid.
For example, if company XYZ issues the above-mentioned debentures, in the case of a registered one, the company would maintain a register to keep all the necessary information for paying the investors conveniently in the future. But in the case of an unregistered debenture, the company would not maintain an information record register; rather, it would informally issue an instrument to pay the investors.
On the basis of performance
Redeemable debentures are issued for a certain period of time by the company. The company, at the date of issuance of the debentures, provides the debenture certificate, wherein it mentions the date upon which the principal amount will be repaid. The company, after the issuance of such debentures and on and after the date of issuance, becomes bound by its promise. These types of debentures are considered the most secure form of investment because the repayment of the principal amount is assured and further interest is given to the holder in lump sum or in instalments. This is discussed in-depth in the forthcoming paragraphs.
Unlike redeemable debentures, these debentures do not have a specified time period for repayment. The company only pays the debenture holders when it goes into liquidation, i.e., when it starts to pay off its debts and liabilities.
For example, a company on 1st of January, 2022 issues 100 debentures of 50 Rs. per debenture for a period of 5 years and at the time of issuing issues a certificate mentioning the rate of interest of 5% and date of repayment as 1st of January of 2027. 5 investors invested equally, i.e., each investor invested in 20 debentures. Here, the company is bound to repay the debenture holders at any cost after the expiry of the specified period, i.e., 5 years on the 1st of January, 2027, the principal amount of 1000 Rs. along with the amount of interest, i.e., 250 Rs.
On the basis of coupon rate
Specific coupon rate debentures
The coupon rate on debentures is the rate of interest associated with them. It is the rate in accordance with which the holder will get the interest. In the case of a specific coupon rate, the debentures are circulated in the market with a fixed and specific rate of interest. Through this, the company attracts investors to generate funds. Like in the above given example, 5% interest is the specific coupon rate for the debenture, and accordingly, the interest amount for 20 debentures of 50 Rs. per value will be 250 Rs.
Zero-specific rate of debentures
These debentures do not come with a rate of interest. In other words, the debenture holders are not paid any interest along with the principal amount. But, the holders benefit indirectly through these debentures because they are issued by the company at a discounted amount, that is lower than the face value of the issued debenture. With this type of debenture, the debenture holder benefits from the difference between the discounted amount and the face value amount.
Now that we know what the different types of debentures are, let us dive deep into the basics of redeemable debentures. Let us begin with what redeemable debentures are, followed by how they are issued and their advantages and disadvantages, inter alia.
What are redeemable debentures
First of all, in order to understand the meaning of redeemable debentures, it is necessary to throw some light on the meaning of redemption. Let us understand what redemption is. Redemption means repayment of the amount borrowed at the expiration of the time period for which it was taken in the first place. Hence, redeemable debentures are debentures that are repaid by the company upon the expiry of a specific time period. In the certificate given by the company, it is clearly specified when the debenture will be repaid, and whether the amount will be repaid in whole or in instalments.
Redeemable debentures bring a sense of certainty along with them because the company is bound to repay this type of debenture, mandatorily, to all the debenture holders. Due to the presence of redeemable debentures, companies attract more investors or give out loans simply because they are secured, wherein the possibility of getting paid is undeniable. For example, company X issued debentures on the 23rd of December 2021 and issued a certificate stating that the debenture would be repaid on the 23rd of December 2022. In this case, the debenture shall be repaid after the expiration of the stated period of time.
Redeemable at par
Repayment of a debenture as per the same face value of the debenture is called redeemable at par. Just like bonds, debentures also have a face value. It is a value that a company sets on a debenture at the time of issuance. For example, suppose a company issued a debenture for Rs. 100 (face value) for a minimum period of five years. The debenture holders will buy it at Rs. 100 only. Then, after five years, the company repays the debenture holders the same amount, i.e., Rs. 100.
Redeemable at a premium
In cases of redemption at a premium or redeemable at a discount, the company issues the debentures at a certain face value but repays the amount to the debenture holders at a higher amount than the initial issued amount. For example, the company issued a debenture at Rs. 90 (face value), and after five years it repaid the debenture holders the amount of Rs. 110 to remove the liability. It can be seen here that the company’s repaid amount is higher than the initial face value amount.
Issue of redeemable debentures
Under the Indian Company Act, 2013, debentures come under the category of securities. Therefore, for issuing the debentures, the same legal provisions as those of securities are followed as provided by the code. Section 23 of the Companies Act deals with the issue of securities and classifies such issues by public and private companies. The same has already been discussed below.
Section 23 states that a public company may issue securities via a public offer by issuing a prospectus specifying all the necessary details. Whereas Subsection 1 (b) also provides that securities may be issued through private placement following the provision given under Section 42 of the Companies Act, Part (c) further provides that they can also be issued through a rights issue or a bonus issue, by a listed company, or also through a company that wants to get its securities listed. In this case, the intending company shall follow the rules and provisions provided by the Securities Exchange Board of India Act, 1992.
Section 23 deals with the issue of securities by private companies, wherein it says that it may issue securities through the right issue or bonus issue following the necessary provisions provided by the Act. It also provides that it can issue security through private placement following the provisions given under Section 42 of the Act.
Features of redeemable debentures
As stated above, redeemable debentures are conclusively written promises with the assurance of paying back the lent money with interest.
The foremost feature of redeemable debentures is the repayment of the sum borrowed. By issuing redeemable debentures, a company also issues a surety to repay the holders after the expiry of a particular time, say 5 years, because the company becomes bound by the certificate of debenture stating the date of repayment.
Value of redeemable debentures
Upon the expiry of the fixed time period, the company repays the amount either in the whole sum or in instalments. This is the second feature of redeemable debentures. The amount can be repaid either at par, i.e., the same as the face value at the time of issuance, or at a premium, i.e., a higher amount than the actual amount that was at the time of the issuance.
For example, one company, XYZ, issued redeemable debentures with a face value of Rs. 20 lakhs at par, and another company, i.e., DYC, issued redeemable debentures with a face value of Rs. 20 lakhs but issued it at 2% premium rate. Here, XYZ company will repay the amount of Rs. 20 lakhs only to its debenture holders since it was issued at par, i.e., the same face value, whereas the company DYC will repay the amount of 20 lakh with a rate of 2%, i.e., 20 thousand, since it was issued at premium.
Debenture Redemption Reserve (DRR)
Section 71(4) of the Indian Companies Act, 2013 makes it mandatory for companies operating in India to set up a Debenture Redemption Reserve (DRR) after issuing debentures to investors. The motive of the same is to provide protection and a sense of security to the investors for their invested money. The said reserve is made and maintained by the company by keeping aside a certain percentage of the cash amount raised through the issue of debentures. This allows the company to use the cash as a backup plan to remove its debt obligation if, in the future, the company fails for any reason. The said provision has been mandated by the Ministry of Corporate Affairs to protect the interests of investors since such debentures are not backed by the surety of assets and lien.
Advantages of redeemable debentures
Redeemable debentures provide the debenture holders with a great number of advantages which are proven to be a good source of income, and beneficial to the investors. The following are mentioned below.
Redeemable debentures are proven to be financially secure in nature. The foremost reason for the same is that these types of debentures are surely repaid because the company, at the date of issue, grants a certificate stating when and how in the future the borrowed amount and interest will be repaid. However, it is after a long and tiring period of time. But still, it is unlike all the other risky and unstable forms of the financial market, like cryptocurrency and stocks, etc.
Stable source of income
By investing, or in other words, lending money to the company, the person investing becomes a debenture holder. This debenture holder can now earn and have a stable source of income for a reasonable period of time. It is to be noted that a debenture holder only earns through the interest rate available on the debenture issued, and he can purchase an endless number of debentures as he likes. The more debentures issued, the more profits there will be.
Good source of funds
The main purpose of the issuance of debentures is to fulfil the business needs of a company. A company that decides to carry out huge operations like expanding business jurisdiction, research and development, and the purchase of plants and machinery does not purchase these out of its own pocket, the reason being the massive cost of the same. Therefore, the company generates financial power through these debentures only. They also help these companies generate funds through debentures, which are redeemable at a premium.
Disadvantages of redeemable debentures
Redeemable debentures come with a low rate of interest in comparison to other financial securities. Therefore, investors make a low amount of money out of these debentures as compared to other securities like bonds, shares, stocks, etc.
In the event that the issuer, i.e., the company, is not able to make a profit, then these debentures become a financial burden on the company because they are bound to pay the principal amount and ultimately pay it after the expiry of the specified date. In such cases, the company faces losses and pays the debenture holders from its own pocket.
No voting rights
Unlike convertible debentures, redeemable debentures do not create voting rights in the company’s management and decisions.
Difference between redeemable and non-redeemable debentures
The following are the key differences between redeemable debentures and non-redeemable debentures:
|Redeemable debentures||Non-Redeemable debentures|
|These debentures carry a fixed date of repayment.||Does not carry a fixed date of repayment.|
|The company issues a certificate specifying the specific date upon which repayment will be operated.||The company issues a certificate specifying no date of repayment.|
|The company is bound to repay after the expiry of the specified date.||The company is not bound to pay the sum.|
|The company will pay the sum only after the expiry of the specified time period. Not before and not far beyond the fixed date.||The company will only pay when it goes into liquidation or as per the terms stated by it.|
The company, in order to generate funds, may issue various forms of financial securities, like stocks and shares on stock exchanges, but it can also, in order to play it safe, issue debentures. Since stocks and shares carry with them their risk factors, unlike them, the company can make a pretty good amount of capital through debentures since it is secured and safe. They can also be said to be one of the cheapest ways to generate funds.
From an investor’s point of view, redeemable debentures are the safest form of investment with guaranteed repayment and interest. They are also given priority at the time of winding up the company.
Frequently Asked Questions (FAQs)
What does a debenture represent?
A debenture represents a loan taken from the public for the purpose of raising funds. For example, a company, say, in the name of XYZ, wants to expand its business horizon and add plants and machinery for the same. Here, the company, in order to generate funds for the purchase of machinery and business expansion, may issue debentures for the public. When investors (from the local public) buy these debentures, a relation of debt is created between the company and the investor(s). Thus, in this instance, the company is liable to pay the debenture holder(s) the principal amount invested along with the interest amount.
Why are secured debentures termed ‘secured’?
Secure debentures are termed ‘secured’ because of the presence of the concept of charge over assets. If in any case, the company is not able to repay the borrowed amount and interest, the debenture holder always has the right to sell off the assets of the company and get the principal amount with interest.
Can a debenture be termed a loan?
Primarily a debenture can be said to be a loan taken from the public, but it can further be said to be the deceleration and admission by the company of taking a loan. The declaration is made through the issue of debenture certificates.
What is a debenture certificate?
A debenture certificate is a document that is issued by the company under its official seal, it is known as a debenture deed. It is issued in favour of the debenture holder. The document consists of various essential details like how many units a debenture holder has invested in, the date upon which the company will repay the amount, the rate of interest, and the names and details of assets.
What is the purpose of debenture?
The company issues debentures for its development and enhancement through various methods like R & D (Research & Development), taking off big projects, purchasing machinery, etc.
Why are redeemable debentures considered to be a secured form of investment?
Redeemable debentures are considered to be a secured form of investment because, in these types of debentures, there exists a surety for the investors for repayment of the lent amount. Since the company issues a certificate specifying the date upon which the amount will be repaid, it becomes bound from the date of issuance until the date of expiry. There is no scope of loss in redeemable debentures.
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