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TABLE OF CONTENTS
Abstract
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Classification of Debentures. 8 Advantages and Disadvantages 11 Legal Compliances 16 Issue in private companies 24 Debentures and Debt Market: Indian Context 27 Conclusion.. 30
Abstract:
Any informed borrower is simply less vulnerable to fraud and abuse -Alan Greenspan
Being a qualified Company Secretary, it was an interesting task to take up topics from corporate world. Having worked under various circumstances, one thing was clear that a project shall be based on some real time experiences that author has faced during her professional tenure. The concept of debenture struck in mind of author because she has seen that there is a lack of organized debt market in India and also, during her work experience, she has faced some challenges in legal compliance in issuing and listing of long term debt instruments: Debentures.
Introduction:
Finance is the lifeblood of every business. It is perhaps the most crucial factor in deciding fate of any business enterprise. Finance is required in day-to-day transactions of business as well as for carrying out capital (long term) investments of the business. Keeping this in view, it is the most important function of a financial manager that is to arrange funds for the business from different sources. This becomes necessary under the fact that pre determined goals of business could only be achieved when a business does not suffer from lack of finance. It is evident in daily lives too that a person cannot carry on his daily tasks without having financial support. Other than this, just like daily lives, a business cannot run smoothly in absence of finance. This therefore is the most crucial decision that a financial manager needs to take up- composition of capital structure of an organization. Following diagram shows capital structure and its various components:
Equity Capital
Preference Capital: Preferred stock, also called preferred shares or preference shares, is
typically a 'higher ranking' stock than voting shares, and its terms are negotiated between the corporation and the investor. Preferred stock usually carries no voting rights, but may carry superior priority over common stock in the payment of dividends and upon liquidation. Preferred stock may carry a dividend that is paid out prior to any dividends being paid to common stock holders. Preferred stock may have a convertibility feature into common stock. Preferred stockholders will be paid out in assets before common stockholders and after debt holders in bankruptcy. Terms of the preferred stock are stated in a "Certificate of Designation".
Debt Capital: Debt capital is the capital that a business raises by taking out a loan. It is a loan
made to a company that is normally repaid at some future date. Debt capital differs from equity or share capital because subscribers to debt capital do not become part owners of the business, but are merely creditors, and the suppliers of debt capital usually receive a contractually fixed annual percentage return on their loan, and this is known as the coupon rate. Debt capital ranks higher than equity capital for the repayment of annual returns. This means that legally, the interest on debt capital must be repaid in full before any dividends are paid to any suppliers of equity.
Our analysis will be based on long-term sources of funds: most specifically debt finds. In India, it is important to understand that, there is no bond market. Companies and government most often come up with issue of a long-term debt instrument known as debenture. Let us move forward and understand meaning of term debenture, especially in context of Indian financial markets.
Following are the basic features of debentures that differentiate them from other sources of finance. After understanding meaning of different capital structures, we need to understand peculiar characteristics of debentures that make them different from commonly used finance sources: Investors who invest in the debentures of the company are not the owners of the company. They are the creditors of the company or in other words, the company borrows the money from them. Funds raised by the company by way of debentures are required to be repaid during the life time of the company at the time stipulated by the company. As such, debenture is not a source of permanent capital. It can be considered as a long-term source. In practical circumstances, debentures are generally secured i.e. the company offers some of the assets as security to the investors in debentures. Return paid by the company is in the form of interest. Rate of interest is predetermined, but the company can freely decide the same. The interest on debenture is payable even if the company does not earn the profits In financial terms, debentures prove to be a cheap source of funds from the companys point of view So this thing needs to be kept in mind by a company that an investor is expected to invest in debentures only when liquidity and financial position of company is very sound. An investor is always careful before investing in any company, especially in debt instruments where there is hardly any chance of capital appreciation. So, a company that is very much sure about it financial well-being could very well come up with issue of debentures. Debentures are also ideal for
companies, which do not want any kind of dilution in control of management. That means, organizations, which do not want to issue shares, could come up with issue of debentures. Apart from that, financial manager must make sure that company is in sound enough position to make periodic interest payments and also, repayment of principal amount at the right time.
Classification of debentures
In India, debentures could be classified in basically two categories: on the basis of security and on the basis of convertibility. Following diagram shows details of classification of debentures in Indian context:
Classification Of Debentures
Secured Debentures
Let us now discuss each of the types of debentures, which are issues in market by companies to raise funds.
Fully convertible Debentures (FCD): These are fully convertible into Equity
shares at the issuer's notice. The issuer decides the ratio of conversion. Upon conversion the investors enjoy the same status as ordinary shareholders of the company.
Secured Debentures: These instruments are secured by a charge on the fixed assets
of the issuer company. So if the issuer fails on payment of either the principal or interest amount, his assets can be sold to repay the liability to the investors.
Unsecured Debentures: These instruments are unsecured in the sense that if the
issuer defaults on payment of the interest or principal amount, the investor has to be along with other unsecured creditors of the company.
Along the dimension of security, we have seen that debenntures have been classified into unsecured(Straight) and secured (mortgage) debentures. Unsecured debentures do not carry any 9
cahrge on specific assets of the company while secured debentures carry a fixed or floating charges on assets of company. The distinction between secured and unsecured debentures becomes relevant in case the issuer defaults in payment of interest and principal amount so taken from investors. Secured debenture holders are entitled to take possession of security given to them and realize their dues by selling these assets, which are most commonly- land, buildings, plant, machinery of business. This right is valuable to debenture holders provided security is valuable, easily saleable and has not been simultaneously given as security to other creditors as well. All these factors have to be examined while evaluating debenture. Unsecured debenture are not backed by any such security, but an investor needs not worry about that if he has a belief that company is doing financially and chances of default are very bleak.
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Advantages of Debentures
Continuing the classification of debentures, next step to be undertaken during course of our analysis is to look at fact as to how debentures have an advantage over other sources of longterm finance. In this section of our study, we shall look as to what are the pros and cons of debentures that make it one of the most reliable sources of long-term finance and also create a huge scope in Indian financial markets. Following are advantages of debentures that make them a reliable source of finance as compared to other long-term finance sources: Let us divide our analysis into three major points i.e., division of advantages of debentures by different prospective:
Advantages of Debentures
General Advantages
Advantages to Investors
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Let us now take a look at the description of above-mentioned topics in brief. During course of description, efforts will be made to make sure that a reader understands relative advantage of debentures and conclusions could be drawn out as to how under utilized this very source of finance has been in Indian context:
General Advantages:
These advantages are highly dependable on the success rate of the current interest rate and economic situation of society.
Success or Failure: You are taking a great risk when investing in a corporate
debenture because the success of the company will determine how valuable your debenture is. A company debenture is only valuable when the company is successful and profitable, but if it fails, then you will lose a great amount of money. Debentures and
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bonds hold greater risks because the company could eventually go out of business, so this type of investment should be done very carefully. Debentures can be a very attractive form of investment, but only should be taken advantage of with companies that have a very high probability of being successful. Large and already successful businesses are smart forms of investments when considering buying corporate debentures.
Advantages to investors:
They have the possibility to acquire shares at a lower price to that of the market- by way of investment in convertible debentures with embedded options of conversion into equity shares. They have the right for subscription of shares at a lower price to that of the market. They are less exposed to the risks of inflation. The price of conversion is always lower to that of the market so the effects of a possible inflation are mitigated. This inflation effects causes a rise on the stocks quotations. Investors get better returns as compared to bank deposits. Debentures are less volatile as compared to equity shares. At times, companies come up with offers like principal guarantee. Due to SEBI guidelines, chances of default by corporate are very less.
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The financial cost is lessening, because if the investor chooses for the conversion they dont have to obey the requisites from the debentures: to pay interests and to refund the capital. On the other side, the interests from the debentures or bonds are usually lower than that on the market, this way, in case of not converting, the company will finance itself with cheap debt.
The sooner the conversion is made, the greater are the discounts, so the lesser are the numbers of shares that you can obtain with each debenture.
After talking about advantages of debentures, lets take a look on various demerits this source of finance suffers from. No doubt that there are few cons from which debentures suffer, but these demerits are small enough to overlook and advantages always override the disadvantages:
General Disadvantages:
By issuing the debentures, the company accepts the risk of two types. These are payment of the interest at a fixed rate, irrespective of the non-availability of profits and repayment of principal amount at the pre-decided time. If earnings of the company are not stable or if the demand for the products of the company is highly elastic, debentures prove to be a very risky proposition for the company. Any adverse change in the earnings or demand may prove to be fatal for the company. Debentures are usually a secured source for raising the long-term requirement of funds and usually the security offered to the investors is the fixed assets of the company. A company, which requires less investment in fixed assets, such as a trading company, may find debentures as a wrong source for raising the long-term requirement of funds, as it does not have sufficient fixed assets to offer as security.
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For managing whole issue of debentures, a company is required to appoint a merchant banker. As per the SEBI guidelines, a company is required to file a draft prospectus with the SEBI though an eligible merchant banker, at least 21 days prior to filing of the same with the registrar of companies. Any offer of securities to public shall be in DEMAT mode. for this purpose, company shall enter into an agreement with a depository before public issue is made.
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debentures which is secured by charge, benefit of which will be available to all debenture holders pari passu, the company shall file the prescribed particulars in Form 10 and 13 with the Registrar of Companies for registration of charge. These forms shall be filed within 30 days after the execution of the deed.
The Debenture Trustees shall not: a) Beneficially hold shares in a company. b) Be beneficially entitled to monies, which are to be paid by the company to the debenture trustees. c) Enter into any guarantee in respect of principal debt secured by the debentures or interest thereon. This section also lists the functions that shall be performed by the Trustees. These include: I. II. Protecting the interests of the debenture holders by addressing their grievances. Ensuring that the assets of the company issuing debentures are sufficient to discharge the principal amount.
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III.
To ensure that the offer document does not contain any clause which is inconsistent with the terms of the debentures or the Trust Deed.
IV.
To ensure that the company does not commit any breach of the provisions of the Trust Deed.
V.
To take reasonable steps as may be necessary to undertake remedy in the event of breach of any covenant in the Trust Deed.
VI. VII.
To convene a meeting of the debenture holders as and when required. If the debenture trustees are of the opinion that the assets of the company are insufficient to discharge the principal amount, they shall file a petition before the Central Government and the latter may after hearing the parties pass such orders as is necessary in the interests of the debenture holders. As per the SEBI (Debenture Trustees) Regulations, 1993, a Debenture Trustee can be a scheduled bank, an insurance company, a body corporate or a public financial institution.
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e) Register of Debenture holders, meeting of all debenture holders and other administrative matters may be included in the Deed. In addition thereto, the SEBI regulations have laid format of the Trust Deed in Schedule IV to the regulations. Some of the important provisions would include f) Time limit of creation of security for issue of debentures. g) Obligations of the body corporate towards the debenture holders. h) Obligations towards the debenture holders - equity ratio and debt service coverage ratio. i) Procedure for the inspection of charged assets by the Trustees.
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Assurances. If however, a note or letter is made then it will attract stamp duty. It is pertinent to mention that once a mortgage is created by registration then no further stamp duty is payable on registration.
Issue of Partly Convertible Debentures or Fully Convertible Debentures requires other approval
In this case approval of shareholders by special resolution and of the central government pursuant to the provisions in Section 81 (3) (b) is required.
A public financial institution or scheduled bank either underwrites the above issue or subscribes to the issue of debentures, either wholly or in part or sanctions the whole or part of the debenture; and
The right of conversion may be at par or at a premium not exceeding 25% of the nominal value of the shares.
Default
In the event of failure on the part of the company to redeem the debentures on the date of maturity, the Company Law Tribunal may, on the application of any debenture holder, direct redemption of debentures forthwith by payment of principal and interest due thereon. If a default is made in complying with the orders of the Tribunal, every officer of the company who is in default shall be punishable with imprisonment for a term, which may extend to three years and shall also be liable to fine of not less than Rs.500/- for every day during which the default continues. (Section 117C) Further this offence is not compoundable under section 621A of the Act. There are contradictions between the Companies Act and the SEBI regulations on issues relating to: a) Utilisation of Debenture Redemption Reserves. The Act provides that the Debenture Redemption Reserve will be used towards redemption of debentures only whereas the SEBI regulation states that these will be a part of the General Reserves, which can be utilised for the purpose of bonus issues. b) Any debentures issued with a maturity period of 18 months or less is exempted from the creation of Debenture Redemption Reserve Account, whereas no such exemption is provided under the Companies Act.
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c) No Public Issue/Rights Issue of Debentures shall be made by a company unless it has appointed one or more Debenture Trustees for such debentures whereas under SEBI guidelines, appointment of Debenture Trustees is compulsory only in case of debentures with maturity of 18 months or more. A listed company though subjected to SEBI regulations must comply with stringent norms between the two legislations / regulations made there under.
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relatives. Hence, the Private Company must issue Debentures only as a Secured Debenture.
2) Approvals to be taken before proceeding for the issue: The following approvals are
required to be obtained by the Company: Board for issue of Debentures under Section 292(1)(b). Board Creation / Declaration of Trust: Board Appointment of Debenture Trustees (Section 117B) Board Approval of Draft Trust Deed Board Approval of the Form of Debenture Certificate. Letter from Trustees Consent from the Debenture Trustees to act as Trustees. No approvals are required to be obtained under Section 293(1)(a) and (d) since, the Section does not apply to Private Limited Companies, unless it is a Subsidiary of a Public Company.
3) Allotment: Since, the Company proposes to place the Debenture privately, it is suggested
that a Letter of Offer is also made which would be circulated amongst the target buyers. The draft letter of offer is also required to be approved by the Board. The conditions relating to the payment for subscription, the Security, the rate of interest on the Debentures and the period by which the Debentures would be redeemed would have to be specified.
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6) Time Limit For Issue Of Debenture Certificate: The time limit for the issue of
Debenture Certificate is 3 months from the date of allotment. If the Company is of the opinion that it might not be able to issue the Debenture Certificate within 3 months, then it is suggested that an application is made to the CLB requesting for extending the time- limit for issue of Debenture Certificate.
10) Payment of stamp duty on the debentures: The stamp duty as prescribed under the
Stamp Act, as in force in state, required to be affixed to the Debenture Certificate on the face of the same or in the form of attaching a separate sheet of paper and affixing the stamps on the same. The fact that the stamps so affixed forms part of the Certificate with the Certificate Number should be mentioned on the sheet so attached.
Alternative method:
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Instead of affixing stamps on the debenture certificate or by attaching a separate sheet, there is also a provision to pay consolidated stamp duty. For this purpose, intimation is needed to be given to concerned authorities by writing them official letters.
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basis. Most often, there is a lack of liquidity in Indian stock markets that lead to a disinterest by investors in debt instruments. This difference in Indian scenario with that of advanced economy (USA) will become more clear by way of following case analysis. In this case illustration, we will take two companies from each nation: Reliance Industries Limited from India and Wal-Mart Inc. from USA. We will see that both the companies have significant effect on their respective economies and in a way they reflect financial structure and pattern followed by investors in that nation. We will take into account respective contribution of debt- bonds and debentures in total capital as well as total liabilities of these companies. After this analysis, we will be in a position to draw conclusions of illustration as well as make our recommendations on project and debentures scenario in Indian market.
Wal-Mart Inc. USA: Long term Debt: $ 27,799 millions Shareholders Equity: $64,608 millions Total assets of continuing operations: $163,514 millions
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It is shown by way of above pie chart that Wal-Mart uses about 30% of debt in total sources of finance raised by various methods. It means that bond markets in USA are much more liquid and organized as compared to Indian markets whose condition will be clear with help of following illustration:
Reliance Industries Limited: India Shareholders Funds: Rs. 81,448.60 crores Debentures: Rs. 4118.12 Crores
5%
95%
(Reliance Industries Limited: Sources of Long Term Finance) This very illustration shows that debentures and bonds have not been able to win confidence of investors in context of Indian Financial Market.
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Conclusion of Analysis
It is not just about a single company, whole debt market of India needs reorganization and that too at a rapid rate. In todays context when due to recession, equity markets have fallen drastically in India, debentures could just help in saving day for all troubled financial markets of India. Apart from that, government should take account of SEBIs advices when the authority has constantly urged them to work for organization of debt market in India. This is necessary because in an emerging economy, it is important that there is an active participation of public in corporate world activities. Role of a Company Secretary is important because in this condition hes the one who has to maintain equilibrium between interest of investors, company and government of India. This is perhaps real challenge that a Company Secretary will have to face in some years to come.
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