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DEBENTURES AND CHARGES, BORROWING POWER
QUESTION BANK
1. Define debenture. What are the kinds of debentures?
2. Define debenture. Distinguish between debenture holders and shareholders.
3. Define debenture, its meaning, fixed and floating charges and kinds of debentures.
4. Debentures, meaning, kinds of debentures-discuss.
5. Define debentures. What are the rights of a debenture holder?
6. Explain the borrowing power of the company. What is consequences of unauthorised borrowing?
SHORT NOTES
1. Floating Charge
2. Fixed Charge
3. Debenture
4. Borrowing power/ effect of unauthorised borrowing.
5. Charge, mortgage, debentures, kinds of debentures, Distinguish between
shareholders and debentures holders.
6. charge - fixed – Floating
SYNOPSIS
[A] DEBENTURES
I. Introduction
II. Meaning and Legal Position
1. Payment of Interest and Redemption
2. Specific Performance:
III. Statutory Definitions
1. Section 2(30) of the Companies Act, 2013
2. According to Topham
IV. Characteristics of a Debenture
1. Acknowledgement of Debt:
2. Fixed Repayment Date:
3. Payment of Interest:
4. Company Seal:
V. Kinds of Debentures-
1. On the Basis of Registration & Transferability
a. Registered Debentures:
b. Bearer Debentures:
2. On the Basis of Redemption
a. Redeemable Debentures:
b. Perpetual / Irredeemable Debentures:
3. On the Basis of Security
a. Secured (or Mortgage) Debentures:
b. Unsecured (or Naked) Debentures:
4. On the Basis of Convertibility (Section 71(1))
a. Convertible Debentures:
b. Non-Convertible Debentures (NCDs
VI. Rights of Debenture Holders
1. Right to Receive Interest & Principal:
2. Right to Sue:
3. Right to Appoint a Receiver:
4. Right to Inspect Documents:
5. Representative Suits:
6. Petition for Winding Up:
VII. Debenture Redemption Reserve (DRR) Account (Section 71(4))
VIII. Debenture Trustees
1. Appointment (Section 71(5))
2. Duties (Section 71(6))
3. Liability (Section 71(7))
4. Power to File a Petition (Section 71(9))
IX. Distinction between Debenture Holders and Shareholders
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[B] CHARGES
I. Statutory Definition of "Charge" (Section 2(16))-
II. Kinds of Charges
1. Fixed Charge (or Specific Charge)
2. Floating Charge
A. Core Characteristics of a Floating Charge
B. Crystallization of a Floating Charge
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[C] BORROWING POWER
I. Principles Governing Corporate Borrowing
1. Implied Power to Borrow
2. Board of Directors' Authority (Section 179(3)(b))
3. Statutory Restrictions on Borrowing (Section 180(1)(c))
4. Exceptions to the Borrowing Limit
a. Temporary Loans:
b. Banking Companies:
II. Modes of Corporate Borrowing
III. Unauthorized (Ultra Vires) Borrowing
1. Borrowing Beyond the Authority of Directors (Section 180(5))
Judicial Precedent:
2. Borrowing Ultra Vires the Company
3. Equitable Remedies Available to an Ultra Vires Lender
a. Injunction:
b. Subrogation:
c. Identification and Tracing:
d. Damages for Breach of Warranty of Authority:
Comprehensive Guide to Debentures, Charges, and Borrowing Powers under the Companies Act, 2013
[A] DEBENTURES
I. Introduction
Whenever a company requires long-term funds but does not wish to dilute its equity share capital, it may opt to borrow money. When a company takes a loan, it issues a formal document acknowledging its indebtedness to the lender. Such a certificate or instrument is termed a ‘Debenture’.
A debenture holder is a creditor of the company and not a member. Consequently, they do not possess any voting rights in general meetings. Section 71 of the Companies Act, 2013, read along with the Companies (Share Capital and Debentures) Rules, 2014, governs the issuance and regulation of debentures.
II. Meaning and Legal Position
In commercial parlance, a debenture is a written acknowledgement of a debt issued by a company, usually containing provisions regarding the payment of interest at a fixed rate and the ultimate repayment of the principal amount.
1. Payment of Interest and Redemption: Under Section 71(8), a company is bound to pay interest and redeem the debentures strictly in accordance with the terms and conditions of their issue.
2. Specific Performance: Under Section 71(12), a contract with a company to take up and pay for any debentures may be enforced by a decree for specific performance.
Judicial Precedent:
In Laxman Bharmaji v. Emperor (AIR 1946 Bom 18), the Bombay High Court observed that any document which represents an acknowledgement of debt by a company falls within the legal interpretation of a debenture.
III. Statutory Definitions
1. Section 2(30) 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."
2. According to Topham
"A debenture is a document given by a company as evidence of a debt to the holder, usually arising out of a loan and most commonly secured by a charge."
IV. Characteristics of a Debenture
1. Acknowledgement of Debt: It is a formal document issued by the company that creates or acknowledges a debt.
2. Fixed Repayment Date: It generally stipulates the repayment of a specified sum of money at a fixed, predetermined maturity date.
3. Payment of Interest: It carries a commitment to pay a fixed, periodic rate of interest until the principal is redeemed.
4. Company Seal: It is usually issued under the common seal of the company, though the absence of a common seal does not invalidate it if signed by authorized signatories.
British India Steam Navigation Co. v. Commissioners of Inland Revenue (1881) 7 QBD 156: In this case, a certificate was signed by two directors but lacked the company's official seal. The court held it to be a legally valid debenture anyway.
1. Series or Single: Debentures are typically issued in a numbered series, though a single debenture can legally be issued to a single lender.
2. No Voting Rights: Under Section 71(2), no company can issue debentures carrying voting rights.
3. Secured or Unsecured: A debenture may or may not create a charge on the underlying assets of the company.
V. Kinds of Debentures-
1. On the Basis of Registration & Transferability
a. Registered Debentures: These are payable to individuals whose names appear in the debenture certificate and the company’s official Register of Debenture Holders. Their transfer requires a formal transfer deed.
b. Bearer Debentures: These are payable to the bearer and are treated as negotiable instruments. They can be transferred by mere physical delivery, and no record is maintained in the company's register.
2. On the Basis of Redemption
a. Redeemable Debentures: These are issued with a specific clause stating that the company will repay the principal amount at the expiry of a designated period or upon demand.
b. Perpetual / Irredeemable Debentures: These do not contain any fixed timeline for repayment. The company is only liable to repay the principal amount upon winding up or on the occurrence of a catastrophic default/breach of conditions.
3. On the Basis of Security
a. Secured (or Mortgage) Debentures: These are secured by a fixed or floating charge over the company’s assets. Under Section 71(3), secured debentures must comply with prescribed terms, including full redemption within a maximum period of 10 years (or up to 30 years for specific infrastructure projects).
b. Unsecured (or Naked) Debentures: These are backed only by the general creditworthiness of the company. They carry no specific charge or security over any company property.
4. On the Basis of Convertibility (Section 71(1))
a. Convertible Debentures: These grant holders the option to convert their debt into equity shares after a specified period. The issuance of convertible debentures requires approval via a Special Resolution passed by shareholders in a General Meeting.
b. Non-Convertible Debentures (NCDs): These carry no conversion privileges; they are strictly debt instruments to be redeemed in cash at maturity.
VI. Rights of Debenture Holders
1. Right to Receive Interest & Principal: The primary right to receive scheduled interest payments and timely repayment of capital.
2. Right to Sue: If a company defaults on payment, a debenture holder can sue the company for the recovery of the principal and accrued interest, executing a decree against company property.
3. Right to Appoint a Receiver: If the debentures are secured, holders can move to appoint a receiver to take possession of the charged assets.
4. Right to Inspect Documents: The right to inspect the Debenture Trust Deed, the Register of Debenture Holders, and the index thereof, as well as request copies.
5. Representative Suits: Where a default occurs on secured debentures, a holder can sue on behalf of themselves and all other debenture holders of the same class.
6. Petition for Winding Up: As creditors, debenture holders have the legal standing to file a petition for the compulsory winding up of the company before the National Company Law Tribunal (NCLT) on grounds of insolvency.
VII. Debenture Redemption Reserve (DRR) Account (Section 71(4))
To protect investors, Section 71(4) dictates that a company issuing debentures must establish a Debenture Redemption Reserve (DRR) account out of profits that would otherwise be available for distribution as dividends. The funds credited to this account cannot be utilized for any purpose other than the redemption of those specific debentures.
Note: As per amendments to the Companies (Share Capital and Debentures) Rules, DRR requirements have been exempted for All India Financial Institutions (AIFIs), Banking Companies, Listed Companies (including listed NBFCs and HFCs). For unlisted NBFCs and HFCs, DRR is not required. For other unlisted companies, a DRR of 10% of the value of outstanding debentures must be maintained.
VIII. Debenture Trustees
1. Appointment (Section 71(5))
No company can issue a prospectus or make an offer/invitation to the public or to its members exceeding 500 persons for the subscription of its debentures unless it has appointed one or more Debenture Trustees prior to making the offer.
2. Duties (Section 71(6))
The primary statutory responsibility of a debenture trustee is to protect the financial interests of the debenture holders, monitor the company’s asset security, and proactively redress investors' grievances.
3. Liability (Section 71(7))
Debenture trustees are legally liable for any loss caused to the debenture holders due to a failure to exercise reasonable care and due diligence. Any clause in a trust deed exempting a trustee from liability for negligence or breach of trust is strictly void. However, a liability exemption can be granted if agreed upon by a majority of debenture holders holding not less than three-fourths (75%) in value of the total outstanding debentures.
4. Power to File a Petition (Section 71(9))
If a debenture trustee concludes that the assets of the company are insufficient or are likely to become insufficient to discharge the principal amount when due, they may file a petition before the Tribunal (NCLT). The Tribunal, after hearing the case, may issue an order restricting the company from incurring any further liabilities.
IX. Distinction between Debenture Holders and Shareholders
Parameter | Debenture Holder | Shareholder |
Status | A creditor of the company. | A member/owner of the company. |
Voting Rights | Strictly no voting rights (Sec. 71(2)). | Enjoys full voting rights in general meetings. |
Return on Investment | Receives a fixed rate of interest, payable even if the company makes a loss. | Receives dividends, paid only out of distributable corporate profits. |
Charge on Assets | Debentures are usually secured by a fixed or floating charge. | Shares never carry any charge on the company's assets. |
Priority in Winding Up | Paid with priority over shareholders as a secured/unsecured creditor. | Paid last, receiving remaining residual capital after all creditors are cleared. |
Control | No right to interfere in the internal management of the business. | Exercises control through voting and electing the Board of Directors. |
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[B] CHARGES
I. Statutory Definition of "Charge" (Section 2(16))-
Under Section 2(16) of the Act:
“Charge means an interest or lien created on the property or assets of a company or any of its undertakings or both, as security, and includes a mortgage.”
Every company creating a charge within or outside India on its property, assets, or undertakings must register the details of the charge with the Registrar of Companies (ROC) within 30 days of creation (Section 77). Furthermore, under Section 82, the company must notify the Registrar of the full payment or satisfaction of any registered charge.
II. Kinds of Charges
Charges created to secure corporate debt generally fall into two categories:
1. Fixed Charge (or Specific Charge)
A fixed charge is created over specific, identifiable, and definite property of the company (e.g., land, buildings, heavy plant and machinery).
Restriction: The company cannot sell, transfer, or dispose of assets subject to a fixed charge without obtaining the prior explicit consent of the charge-holder.
2. Floating Charge
A floating charge is an equitable charge created over a class of assets that are dynamic and constantly changing in the ordinary course of business (e.g., raw materials, book debts, stock-in-trade).
Judicial Precedent:
In Government Stock and Other Securities Investment Co. Ltd. v. Manila Railway Co. Ltd. [1897] AC 81, Lord Macnaghten lucidly defined its nature:
"A floating security is an equitable charge on the assets for the time being of a going concern. It attaches to the subject charged in the varying condition in which it happens to be from time to time."
A. Core Characteristics of a Floating Charge
As established in Illingworth v. Houldsworth [1904] AC 355, a floating charge has three essential traits:
- It is a charge on a class of corporate assets, both present and future.
- The underlying class of assets changes continuously in the ordinary course of business.
- Until specific enforcement steps are taken by the lender, the company retains the full right to use, manage, sell, or dispose of the assets within its normal business operations.
B. Crystallization of a Floating Charge
A floating charge remains dynamic until an event occurs that causes it to "freeze" and convert into a fixed charge over the assets owned by the company at that exact moment. This transformation is called crystallization, and it occurs when:
1. The company goes into liquidation (winding up).
2. The company ceases to carry on its business activities.
3. The debenture holder or trustee intervenes and appoints a receiver because the company has defaulted on interest or principal payments.
4. Any event explicitly stipulated in the trust deed occurs to trigger automatic crystallization.
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[C] BORROWING POWER
Corporate capital consists of both equity and debt. The Companies Act, 2013, establishes rules for borrowing, striking a balance between business flexibility and protecting the interests of shareholders and creditors.
I. Principles Governing Corporate Borrowing
1. Implied Power to Borrow
A company's capacity to borrow depends heavily on its nature:
a. Trading/Commercial Companies: Possess an implied power to borrow money as a necessary incident to conducting business.
b. Non-Trading Companies: Do not have an implied power to borrow; they must be explicitly authorized by their Memorandum of Association (MOA).
2. Board of Directors' Authority (Section 179(3)(b))
The power to borrow monies is vested in the Board of Directors. Under Section 179(3)(b), this power can only be exercised on behalf of the company by means of a formal resolution passed at a meeting of the Board.
3. Statutory Restrictions on Borrowing (Section 180(1)(c))
The Board of Directors cannot borrow unlimited sums of money. Under Section 180(1)(c), the Board must obtain approval from the shareholders via a Special Resolution in a General Meeting if:
The money to be borrowed (together with monies already borrowed by the company) will exceed the aggregate of its paid-up share capital, free reserves, and securities premium.
Any such resolution passed by shareholders must explicitly state the total maximum limit up to which the Board of Directors is authorized to borrow.
4. Exceptions to the Borrowing Limit
The following forms of financing are excluded when calculating the statutory borrowing limit under Section 180(1)(c):
a. Temporary Loans: Short-term loans obtained from the company’s bankers in the ordinary course of business that are repayable on demand or within six months (such as cash credit, overdrafts, or seasonal bills). This exception explicitly excludes loans raised to fund capital expenditures.
b. Banking Companies: The routine acceptance of money deposits from the public by a banking company does not constitute a "borrowing" within the meaning of this restrictive section.
II. Modes of Corporate Borrowing
A company with valid borrowing powers may raise funds using several legal structures:
1. Legal or equitable mortgages on specific real estate or property.
2. Floating charges over the entire undertaking of the company.
3. Issuing commercial bonds or promissory notes.
4. Issuing secured or unsecured debentures and debenture stock.
5. Securing short-term overdrafts, cash credits, or term loans from banks and financial institutions.
III. Unauthorized (Ultra Vires) Borrowing
Borrowing becomes unauthorized or ultra vires under two distinct circumstances:
1. Borrowing Beyond the Authority of Directors (Section 180(5))
If directors borrow money in excess of the limits imposed by the shareholders without a valid Special Resolution, the debt is unauthorized. However, under Section 180(5), such debt is not valid or effectual unless the lender can prove that they advanced the loan in good faith and without knowledge that the internal borrowing limits had been exceeded.
Judicial Precedent:
In In re National Provincial Bank of England [1970] Ch 99 (often cited alongside In re Introduce Ltd), it was established that where a lender advances money knowing that the transaction is for an unauthorized, ultra vires purpose, the loan contract is invalid, and any security (such as debentures) issued to protect that loan is void.
2. Borrowing Ultra Vires the Company
When a company borrows money beyond the structural capacity authorized by its Memorandum of Association (MOA), the transaction is ultra vires the company.
Legal Consequence: The borrowing contract is completely void ab initio (void from the beginning). It cannot be ratified by the shareholders, even by a unanimous vote. The transaction does not create a debtor-creditor relationship.
3. Equitable Remedies Available to an Ultra Vires Lender
Because an ultra vires loan does not create a valid debt at common law, the lender cannot sue the company for breach of contract. However, equity provides four remedies to protect an innocent lender who acted in good faith:
a. Injunction: If the company has not yet spent the money, the lender can obtain an injunction from the court to restrain the company from parting with or spending the funds.
b. Subrogation: If the ultra vires loan was used by the company to pay off its existing lawful debts, the lender steps into the shoes of those cleared creditors. Under the principle of subrogation, the lender can recover the amount to the extent that the company's valid liabilities were reduced.
c. Identification and Tracing: If the lender can distinctly trace their money or identify specific assets purchased with that money, the court can issue a tracing order to restore those assets to the lender.
d. Damages for Breach of Warranty of Authority: The lender can sue the individual directors personally for damages, on the grounds that the directors falsely warranted that they possessed the legal authority to borrow the funds.
Judicial Precedents:
Weeks v. Propert (1873) LR 8 CP 427: A railway company exhausted its legal borrowing limits. Despite this, the directors advertised for loans. Weeks lent £500 based on this representation. The court held that while the company was not liable, Weeks could successfully sue the directors personally for breach of their warranty of authority.
In re Madras Native Permanent Fund Ltd. (1931) 133 IC 605: The Madras High Court affirmed that an ultra vires loan is void and legally non-existent. It creates no enforceable relationship between the company and the lender, preventing the lender from claiming a share of assets alongside legitimate creditors during liquidation.
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