Debentures are debt instruments that companies use to raise funds. They acknowledge a sum borrowed from investors that the company promises to repay with interest at a future date.
Under Section 2(30) of the Companies Act, 2013, a debenture includes debenture stock, bonds, or any instrument acknowledging a company’s debt, whether secured or unsecured. Section 71 governs how companies issue and manage debentures. It covers conversion rights, security, redemption reserves, and trustee protections.
Unlike shareholders, debenture holders do not get ownership in the company. They act as creditors and receive fixed interest, but they do not have voting rights or a share in profits.
Key Takeaways
- Debentures can be secured or unsecured. There is no rule making one form more typical than the other. Section 71(3) explicitly permits secured debentures.
- Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014 caps secured debenture redemption at a maximum of 10 years. It is not a typical minimum tenure. Unsecured debentures have no prescribed redemption timeframe.
- Section 71 mandates a Debenture Redemption Reserve (DRR). It also requires the company to appoint a debenture trustee when it offers debentures to more than 500 persons.
- Debentures may be convertible or non-convertible. Convertible debentures can be fully or partly converted into equity shares. They may also be redeemable or, rarely, perpetual.
- Debenture holders are creditors, not owners. They receive fixed interest but have no voting rights or claim on profits.
- Interest on debentures is tax-deductible for the company, unlike dividends paid to shareholders.
What are the Key Features Under Section 71?
A company uses a debenture to acknowledge the debt it owes to the holder. The holder remains a creditor, not an owner, throughout the debenture’s term.
- Convertible Option: A company may issue debentures with an option to convert them into shares, wholly or partly, at redemption. This requires shareholder approval through a special resolution.
- No Voting Rights: Companies cannot issue debentures that carry voting rights.
- Secured Debentures: Companies can issue secured debentures, subject to the prescribed terms and conditions.
- Debenture Redemption Reserve (DRR): Companies must create a DRR out of profits available for dividends. The reserve can only be used to redeem debentures.
- Debenture Trustee: A company must appoint a debenture trustee when it offers debentures to more than 500 persons. The trustee must protect the interests of debenture holders.
- Fixed Interest: Debentures generally carry a fixed coupon rate. Interest may be paid monthly, quarterly, half-yearly, or annually, depending on the issue terms.
- Interest as a Business Expense: Interest is paid as a company expense before dividend distribution. It is tax-deductible and reduces taxable income.
- Conversion into Equity: Convertible debentures can convert into equity shares after a specified period. This gives investors eventual ownership and can allow issuers to borrow at a lower rate than non-convertible debentures typically command.
- Repayment: Companies can structure repayment through annual instalments or a lump sum at maturity. The repayment may be supported by the DRR.
- Tradability: Investors can trade listed debentures on the stock market. This gives them reasonable liquidity if they do not want to hold them until maturity.
Types of Debentures Under Company Law
Companies can classify debentures based on security, registration, conversion, and tenure. The main types are:
1. Based on Security
- Secured Debentures: These are backed by a charge on the company’s assets. The charge may be fixed or floating. In case of default, debenture holders have a legal right to recover their dues from the secured assets.
- Unsecured Debentures (Naked Debentures): These are not backed by any security or charge on assets. Investors rely solely on the company’s creditworthiness and reputation. This makes them inherently riskier than secured debentures.
2. Based on Registration
- Registered Debentures: The company records the names and details of debenture holders in its register. Transfer requires execution of a proper transfer deed and company approval.
- Bearer Debentures: These can be transferred by mere delivery. The holder is entitled to interest and repayment. These are rare in India due to regulatory restrictions and transparency requirements.
3. Based on Conversion
- Convertible Debentures: These can be converted into equity shares, fully or partially, after a specified period. The conversion takes place according to the terms of issue. They include Fully Convertible Debentures (FCDs) and Partly Convertible Debentures (PCDs).
- Non-Convertible Debentures (NCDs): These cannot be converted into equity shares. They remain purely debt instruments and offer fixed interest returns throughout their term.
4. Based on Tenure
- Redeemable Debentures: These are repayable after a specified period or in instalments during the company’s lifetime. Most debentures issued in India fall under this category.
- Irredeemable (Perpetual) Debentures: These are not repayable during the company’s lifetime. The company repays them only when it winds up. The Companies Act, 2013, generally does not permit them, making them practically obsolete in India.
Companies (Share Capital and Debentures) Rules, 2014
The Companies (Share Capital and Debentures) Rules, 2014 regulate the issue, management, and transfer of share capital and debentures under the Companies Act, 2013. They promote transparency, investor protection, and corporate governance.
Key Areas Covered Under the Rules:
- Share Capital: Covers shares, voting rights, sweat equity, ESOPs, bonus shares, rights issues, and private placement.
- Types of Share Capital: Includes Authorized, Issued, Subscribed, and Paid-up capital.
- Issue of Shares at Discount (Section 53): Companies cannot issue shares at a discount, except sweat equity shares issued to employees or directors. Other discounted issues are void.
- Sweat Equity Shares (Rule 8): Requires special resolution approval and at least 1 year since business commencement. The annual limit is 15% of paid-up equity capital or ₹5 crore, whichever is higher, subject to an overall 25% cap.
- ESOP (Rule 12): Requires a special resolution and includes a minimum 1-year vesting period. It applies to eligible employees and directors, excluding independent directors.
- Bonus Shares (Section 63): Companies can issue bonus shares from free reserves, securities premium, or capital redemption reserve, subject to prescribed conditions.
- Rights Issue (Section 62): Existing shareholders get the first right to subscribe. The offer remains open for 15–30 days and is generally renounceable.
- Private Placement (Section 42): Shares or debentures are offered to identified persons, with a limit of 200 in a year. It requires a special resolution, PAS-4 filing, and allotment within 60 days.
Advantages of Debentures Under Company Law
Debentures offer companies a way to raise funds without giving up ownership or control. They can also provide investors with a structured return and repayment priority.
- Higher Repayment Priority: Debenture holders sit higher in the repayment “pecking order” than unsecured creditors generally. This improves their odds of recovery compared with parties near the bottom of the payment hierarchy.
- Protection for Directors: Directors get financial protection and reassurance regarding their own personal funds. Debenture obligations belong to the company, not to the directors personally.
- Long-Term Funding: Debentures support long-term funding for business growth. They are often more cost-effective than other forms of lending.
- Fixed Interest: Debentures typically carry a fixed interest rate. The company must pay this interest before issuing any dividends to shareholders.
- Retention of Control: Existing shareholders retain full control and profit-sharing proportion. Debenture holders have no equity claim.
Disadvantages of Debentures Under Company Law
Despite these benefits, debentures also create financial obligations and certain restrictions for companies.
- Fixed Interest Obligation: The company has no flexibility in its obligation to make interest payments. During financial difficulties, this can compromise growth or even force insolvency.
- Restrictions on Secured Assets: Restrictions imposed by securing a debenture against an asset limit management’s freedom to control or use that asset freely.
- No Voting or Profit Rights: Debenture holders have no voting rights or share of the company’s profits. This remains the case regardless of how well the business performs.
Difference Between Shares and Debentures Under Company Law
Shares and debentures are two common ways for a company to raise funds. However, shares represent ownership, while debentures represent debt owed by the company.
The key differences between them are given below:
| Basis | Shares | Debentures |
|---|---|---|
| Meaning | Represent ownership, making the holder a shareholder | Represent a loan to the company, making the holder a creditor |
| Nature | Ownership instrument | Debt instrument |
| Status of Holder | Shareholder (owner) | Debenture holder (creditor) |
| Return | Dividend (not fixed; depends on profits) | Interest (fixed and payable regardless of profits) |
| Voting Rights | Shareholders usually have voting rights | Debenture holders generally do not |
| Risk Level | Higher risk (returns not guaranteed) | Lower risk (fixed interest obligation) |
| Security | Usually unsecured (except certain preference shares) | Can be secured or unsecured |
| Repayment | No repayment during lifetime (except buyback or liquidation) | Repayable after a fixed period or on maturity |
| Priority in Liquidation | Paid after creditors | Paid before shareholders |
| Convertibility | Not convertible into debt | May be convertible into shares |
| Control | Shareholders have ownership and control | No control over management |
| Issue Purpose | To raise ownership capital | To raise borrowed funds |
| Tax Treatment | Dividend is not a deductible expense | Interest is a tax-deductible expense |
| Legal Provision | Companies Act, 2013 (e.g., Sections 43, 44) | Companies Act, 2013 (Section 71) |
