Law and You > Corporate Laws > Companies Act, 2013 > Debentures: Meaning and Types
Debenture is an instrument issued by company acknowledging its debts to the holder under its seal. Debentures carry interest at certain percent. According to Section 2(3) of the Companies Act 2013 ‘debenture” includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not.
Debentures are issued by the company in order to raise funds from the market. Such funds are then used by the company for research and development and growth in the market. Debentures or debt financing is preferred over the issue of equity shares for two major reasons i.e., issue of debentures does not lead to dilution of the ownership in the company and the cost of raising funds through debt is cheaper as compared to cost of raising equity.
Types of Debentures:
Classification on the Basis of Negotiability:
Registered Debentures:
The debenture which is issued under the Companies Act and is recorded in the register of debenture holders of the company is called registered debenture. The names of the debenture holders of these debentures appear both on the debenture certificate and in the company’s register of debenture holders.
Bearer or Unregistered Debentures:
Debentures which are payable to the bearer are called bearer debentures. The names of the debenture holders are not recorded in the register of debenture holders. They are treated as negotiable instruments and as such they are transferable by mere delivery.
Classification on the Basis of Security:
Secured Debentures:
Those debentures which are secured by a charge on the fixed or floating assets of the company are called secured or mortgaged debentures. In India all issued debentures should be secured compulsorily. This type of Debentures create some charge on the property of the company. There are two kind of charges-(a) fixed and (b) floating charge.
Unsecured Debenture:
Unsecured debentures are those which are not secured fully or partially by a charge on asset. At present it is neither popular nor issued in India. These are also called naked debenture or simple debenture. This type of debentures does not have any charge on the assets of the company. The holder of such debentures like unsecured creditors may sue the company on debentures for the recovery of debt. These will be treated as ‘deposit’ and the companies (Acceptance of deposits) Rules, 2014 will be applicable.
Classification on the Basis of Priority:
First Mortgage Debenture:
First mortgage debentures are those which are paid in priority to other debentures.
Second Mortgage Debenture:
Second mortgage debentures are those which are paid after the redemption of first mortgage debentures.
Classification on the Basis of Permanence
Redeemable Debentures:
The Debentures are said to be redeemable when the company reserves the rights to redeem them on or after a particular date. Generally, debentures are redeemable unless otherwise stated.
Irredeemable or perpetual Debentures:
When debentures are irredeemable, they are called perpetual debentures. A debenture is treated as irredeemable where there is no period fixed for repayment of the principal amount. They are not repayable during the life time of the company. The company may repay the money at the time of winding up of the company. Interest is paid on it regularly by company.
Classification on the Basis of Convertibility:
Convertible Debentures:
These debentures gives an option to the holders to convertible them into preference or equity shares at stated rates of exchange after a certain period. If the holders exercise the right of conversion, they cease to be lender to the company and become members. They may be fully convertible or partly convertible.
Non-convertible Debentures:
Such debentures are paid in cash as per the terms and are not converted into shares.
Specific Coupon Rate Debentures:
Debentures are usually issued with a specified rate of interest .This specified rate is called coupon rate .It may be either fixed or floating .The floating interest is usually linked with the bank rate and yields on treasury bond plus a reward for risk.
Zero Coupon rate Debentures:
A zero-coupon bond is one which does not carry a specified rate of interest. In order to compensate the investors such bonds are issued at a substantial discount. The difference between the face value and issue price is the total amount of interest related to the duration of the bond.
Advantages and Disadvantages of Debentures:
Advantages of Debentures:
- It enables a company to raise funds for a specific period.
- No dilution of control as debenture holders don’t possess voting rights
- Debenture (debt) enables the company to Trade on equity. It can pay dividend to equity shareholders at a rate higher than overall ROI.
- Debenture holders entitled to a fixed rate of interest.
- They enjoy priority over other unsecured creditors with respect to debt repayment.
- Suitable for conservative investors who seek steady ROI with little or no risk.
- Interest on debentures is treated as expense and is tax deductible.
- Company can adjust its gearing in accordance to its financial plan.
Disadvantages of Debentures:
- They have a fixed maturity; hence provision has to be made for repayment.
- There is a limit to which funds can be raised through debentures.
- It is risky if the company fails to pay interest or principal installment on time, as debenture holders can file petition for winding up the company.
- It is not suitable for a company with fluctuating earnings as it may also lead to fluctuations in payment of dividend payable to equity shareholders.
- With more risk, you get more return. Debentures being secure investments, returns are less.
- Like ordinary shares, debenture holders will not be regarded as owners of the company and have no voting rights.
- Debenture financing enhances the financial risk.
- Common people cannot buy debenture as they are of high denominations
Comparison Between Shares and Debentures:
| Shares | Debentures |
| Shares are a small fraction of a company’s capital. | Debentures are long term debt instruments that companies issue to borrow capital. |
| It is own capital of the company. | It is borrowed capital of company. |
| Shareholders are the company owners of the proportion of shares held by them. | Debenture holders are company creditors |
| The company pays dividends to shareholders out of its profits. | The debenture holders receive interest payments even if the company makes no profit. |
| Shares are risky investments as they are affected by market volatility. | They are less risky than shares. Also, If a company issues secured debentures which are backed by assets, the holders have an assurance of payment |
| Shares are highly liquid securities which can be bought and also sold on the stock exchange quickly. | They are less liquid in comparison to equity shares. |
| Shareholders have the voting rights. | Debenture holders do not have voting rights. |
| Shares cannot be converted into debentures. | If the company issues convertible debentures, they can be converted into company shares. |
| No credit rating is given. | The debentures are rated by the credit rating agencies. Companies with the highest rating are the safe. |
| Shareholders are given the last priority for payment in case of bankruptcy. | Debenture holders are paid first when the company goes bankrupt. |
| Dividends are declared out of the company’s net profit. | Interest on debentures is an expense to the company and is also deducted to arrive at net profit. |
| A trust deed is not required while issuing shares. | Since debentures are circulated to the public, a trust deed is required. |
Fixed Charge and Floating Charge:
Companies borrow funds from banks, financial institutions and other companies in the form of loans to fulfill their monetary requirements. The moneylender demands security against the loan and so, the borrower creates a charge over the assets or lien on the property.
Fixed Charge:
A fixed charge is a charge or mortgage secured on particular property, e.g. land and buildings, a ship, piece of machinery, shares, intellectual property such as copyrights, patents, trade marks, etc.
A business that borrows does not typically sell these fixed assets and therefore the fixed charge is applied to protect the repayment of the company debt. The simplest way to put it into perspective is to think of a mortgage, a company cannot sell their office without the lender’s permission, as the company will have not yet paid the debt off and therefore these assets must be retained as security for the loan.
With fixed charge debentures, the lender has full control of the company asset. Therefore, should the company want to sell that particular asset, they must have the lender’s approval to do so or pay off the debt.
The fixed charge in a debenture ranks before that of a floating charge in a debenture on company insolvency.
While a fixed charge in a debenture charges assets that can be easily identified, a floating charge debenture is a charge that floats above ever-changing assets.
Floating Charge:
A floating charge is a particular type of security, available only to companies. It is an equitable charge on (usually) all the company’s assets both present and future, on terms that the company may deal with the assets in the ordinary course of business. Very occasionally the charge is over just a class of the company’s assets, such as its stock.
The floating charge is useful for many companies, allowing them to borrow even though they have no specific assets, such as freehold premises, which they can use as security. A floating charge allows all the company’s assets, such as stock in trade, plant and machinery, vehicles, etc., to be charged.
The special nature of the floating charge is that the company can continue to use the assets and can buy and sell them in the ordinary course of business. It can thus trade with its stock and sell and replace plant and machinery, etc. without needing fresh consent from the mortgagee. The charge is said to float over the assets charged, rather than fixing on any of them specifically. This continues until the charge ‘crystallizes’, which occurs when the debenture specifies. This will include any failure to meet the terms of the loan (non-payment, etc.), or if the company goes into liquidation, ceases to trade, etc.
Distinguish Between Fixed Charge and Floating Charge:
| Fixed Charge | Floating Charge |
| Fixed charge refers to a charge that can be ascertained with a specific asset, while creating it. | Floating charge refers to a charge that is created on the assets of circulatory nature. |
| It is static in nature | It is dynamic in nature |
| Registration of charge is voluntary. | Registration of charge is compulsory. |
| It is a legal charge | It is an equitable charge |
| The fixed charge in a debenture ranks before that of a floating charge in a debenture on company insolvency. | The floating charge in a debenture ranks after that of a fixed charge in a debenture on company insolvency. |
| It is non-current asset | It is current asset |
| The company has no right to deal with the property, but subject to certain exceptions. | The company can use or deal with asset, until crystallization. |