Section 117 of Companies Act, 1956

Issue of convertible debentures

The 1956 Act did not empower a company to issue partly or fully convertible debentures. However, sub-section (1) of s. 71 of the 2013 Act is a new provision empowering the companies to issue partly or fully convertible debentures, provided the issuance is made pursuant to approval of the members by means of special resolution passed at a general meeting.

Issue of debenture with voting rights prohibited

Section 117 of the 1956 Act barred issuance of debentures with voting rights and the same is provided under s. 71(2) of the 2013 Act, which also bars issuance of debentures carrying voting rights.

Reason for not allowing debenture with voting rights

debentures

Section 117 of the 1956 Act gave effect to the following recommendations of the Company Law Committee (in respect of the 1956 Act): “Complaints were made to us that in some companies debentures were issued with voting rights, thereby placing the debenture holders in a much more advantageous position than the holders of equity. In view of the secured position of the former, under the usual terms of debenture trust-deeds, we consider it wrong in principle that their position should be further strengthened by giving them the right to vote on the same basis as the shareholders of the company. If debenture holders possess voting rights, they may be in a position to influence the policy of the company in a manner, which may be detrimental to the interests of the general body of shareholders. Apart from other abuses to which this practice is liable and on which we need not dilate in this context, we see no good reason for conferring voting rights on debenture holders. A suitable provision should, therefore, be made at an appropriate place in the Act prohibiting this practice.”  Section 117 of the 1956 only applied to debentures issued after the commencement of the 1956 Act. Voting rights as regards debentures existing on the date of such commencement of the 1956 Act, were not affected.

Debentures as method of raising loan capital

In addition to raising capital by means of shares, companies have frequently to go into the capital market for floating loans by issuing debentures. A debenture issue is therefore an equally important part of project financing along with share capital. A company can raise loans in various ways, e.g., by an ordinary unsecured credit, by a mortgage on property, by making bills of exchange or promissory notes or by the issue of debentures. In all these cases one should first see whether the company has borrowing powers; secondly, whether the directors have authority to exercise that power without a resolution of the company; thirdly, whether there is any limit on the amount that may be borrowed and fourthly, whether the company or directors have powers to secure repayment by charging or by mortgaging the assets of the company. The power to borrow is an inherent power the company has the power to borrow. As per s. 179 of the 2013 Act, the power of the company is conferred on the board, subject to the limits of s. 180 of the 2013 Act.

In an Australian case the appellant company and others were parties to a trust deed executed as part of an arrangement whereby a number of public companies subscribed for cumulative redeemable preference shares in another company. Under the share issue agreement with each preference shareholder, the appellant company agreed to purchase the preference shares on the happening of certain contingent events, and this obligation was secured by charges on the land. It was held that the charge given by the appellant was security for its undertaking to buy the preference shares on certain contingencies and was not security for the performance of the company’s obligations to redeem the shares issued. It was, therefore, not a mortgage in the true sense. The charge was not a debenture since this, in its ordinary sense, did not include a promise in writing by a company to purchase shares at a future date nor a specific mortgage of land to secure a future obligation to purchase property.

Borrowing on debentures

The term “debenture” may be construed in a wide sense as including any acknowledgement of a debt, or in the narrow sense of a transferable capital market instrument. In its wider sense, debenture is the one of the most common method of borrowing by companies. A debenture is like a certificate of loan or a loan bond given under the seal of the company and evidencing the fact that the company is liable to pay specified amount with interest, usually charging the company’s assets for repayment of the loan. They may be offered privately without issuing a prospectus, something which can also be done by the private company or they may be offered to the public by means of a prospectus, which, however, cannot be done by a private company. The money raised by debentures becomes a part of the company’s capital structure, but it does not become a share capital. It is a loan and therefore a debt due from the company and interest is payable whether there are profits or not. Although debentures are a well-known instrument of loan in the mercantile world and quite a few provisions of the Companies Act deal with them, there is no complete definition of the term debenture. Debentures may be either a bare promise to pay the money or a promise secured by a mortgage or a charge. According to s. 124 of the 1956 Act [now, s. 2(16) of the 2013 Act] the word charge includes a mortgage. A lender of money to a company must take care to see what kind of security he wants. He must also carefully see that the property covered by the charge is precisely described so that he can be sure of his security. It was pointed out in Quset Cae Ltd., Re, 1985 BCLC 266 that even a widely drafted charge covering all moneys would not cover unsecured loan stock issued to a third party and subsequently acquired by the debenture-holder. A bank to whom the company applied for loans on debentures, undertook investigation by its accountant into the borrowing company’s financial position. It was held that the borrower was not liable for the costs of such investigation. The mortgage or charge may be created by words to that effect in the debenture certificate itself or by a separate deed to the benefit of all the debenture-holders.

Rights of debenture holders

debentures

The following are the rights of debenture holders:

  • Right to receive repayment of principal when due,
  •  Right to receive interest on principal, as and when due,
  • Right to enforce security.
  • Right to inspection of registers and returns without payment of fees [under the 2013 Act this is covered under s. 94(2)]
  • Right to vote in matters in which the debenture-holders have an interest. In the context of the 2013 Act, Rule 18(4) of the Companies (Share Capital and Debentures) Rules, 2014 mandate the debenture trustee to convene a meeting of debenture holders in certain circumstances.
  • Right to make a complaint to the Tribunal under s. 221 of the 2013 Act on having a reasonable ground to believe that the removal, transfer or disposal of funds, assets, properties of the company is likely to take place in a manner that is prejudicial to the interests of the company or its shareholders or creditors or in public interest, for freezing the assets of the company.

 For the purpose of filing petition to the Tribunal under s. 272(1) of the 2013 Act for the winding up of the company, debenture holders are deemed to be creditors under s. 272(2) of the 2013 Act. In case of Gramercy Emerging Market Fund versus Essar Steel Limited, 2002 111 CompCas l Guj the Gujarat High Court held that the debenture holders were the creditors of the company and held that the petition for winding up by the debenture holders were maintainable as the debenture trustees were party to such petition. However the court held that the trustees were necessary party to the winding up petition; in the absence of trustee being party to the petition, the petition could be dismissed.

As regards right to proceed against the debenture trustee, the beneficiary has the right to compel the trustee to perform any particular act of his duty and restrained from committing any contemplated or probable breach of trust (s. 61 of the Indian Trust Act). Where there is a breach of trust the trustee shall be required to make good such loss sustained by the trust property/beneficiary (s. 23 of the Indian Trust Act). In light of the above, the debenture holders have the right to proceed against the trustees where it can be established that the trustees have acted in a manner adversely affecting the interest of the beneficiary or the trust property.

Interest on debentures

Interest is payable on debentures in accordance with the agreed terms and not otherwise. The debenture must therefore contain an agreement to pay interest. They should also provide that if the principal amount is not paid back at the due date, the interest shall continue to be payable at the agreed rate. The interest on debentures is a debt. It is payable whether there are or are no profits, and, although such interest is usually to be charged against income account before arriving at the profit for the year, interest paid on capital borrowed for constructing works may during the period of construction properly be added to the capital and treated as part of the cost of construction.  It has also been held that where interest on debentures has been paid out of capital, there being no profits, the company need not make good the capital expended before paying dividends. Debentures usually provide that if default takes place in the payment of interest and continues up to a specified period, the principal shall become immediately payable. The debenture-holders may then recover judgments for principal and interest. Where interest is made payable only out of profits, the debentures are known as income bonds and all available profit has to be used towards this end until the interest is paid in full. When a receiver is appointed the moneys available are applied, first in paying interest due, and the balance in repaying the capital, although, if the debenture-holders so require, they may have the moneys received applied in repaying capital in the first instance, which will be to their advantage if there is a deficiency, for these payments do not bear income-tax. Further, if the arrears of interest are not the same in all cases, each debenture-holder proves for the aggregate amount due to him for principal and interest.

Interest on call money

When the allottees of debentures were called upon to pay the call money by a certain date and the date was subsequently extended, it was held that the allottees that had paid the amount according to the first date were entitled to interest from the date of payment up to the time of the extended date. The company had also agreed to pay 14% interest as ordered by the Court. The Court did not allow any claim for interest over the interest amount by reason of the provisions in s. 3 of the Interest Act, 1978.

Issue of debentures at a discount

Section 79 of the 1956 Act barred issuing shares at a discount except in case of sweat equity shares. Section 53 of the 2013 Act on same lines prohibits issuance of shares at a discount other than sweat equity shares. However, there is no such restriction on issue of debentures. There is no restriction upon issue of debentures at a discount. The effect of a discount is that it amounts to an additional interest. Commission can also be paid to underwriters and others for placing or guaranteeing to taking up of debenture. But convertible debentures cannot be issued at a discount because it would amount to a colorable scheme for issue of shares at a discount. This was laid down in Moseley versus Koffyfontein Mines Ltd., where debentures issued at a discount entitled the holder to convert them into shares of the same nominal amount as the debentures and they were also immediately convertible. The whole thing was held to be a devise by issuing shares at a discount. This decision left open the question whether an option to convert is valid if it is not exercisable until sometime after the debentures are issued. Where any commission, allowance or discount is paid or made in respect of debentures the total amount must be stated in the company’s annual returns.

A statement of the amount or rate of commission, discount or allowance must also be included in the particulars lodged with the Registrar for registering particulars of debentures under s. 129 of the 1956 Act, but failure to comply with this provision would not affect the validity of the debentures. The amount or rate paid or payable, during the preceding two years, as commission, would also need to be stated in every prospectus, to which Schedule II of the Act is applicable under s. 56 of the 1956 Act.

Convertible debentures

A convertible debenture means which by the terms of its issue gives the holder the right to exchange debenture wholly or in part with fully paid shares. The privilege of issuing convertible debentures had to be conceded to companies because even otherwise there was no reason why a company should not issue shares by the extinguishment of a debt. The only care which has to be taken is that convertible debentures may not be issued at a discount by way of a colorable scheme to issue shares at a discount. It is for this reason that particulars which have to be filed with the Registrar when there is payment for shares in kind have also to be filed when shares are issued in lieu of convertible debentures. Where a bonus is payable on debentures only out of profits and there are no profits the bonus must not be satisfied by an issue of fully paid shares.  For rules applicable to issue of convertible debentures by exercise of an option, see the Public Companies (Terms of Issue of Debentures and Raising of Loans with options to convert such Debentures or Loans into Shares) Rules, 1977 reproduced in Annexure H) To revise the rules, MCA had circulated for comments Draft Public Companies (Terms of Issue of Debentures and Raising of Loans with options to convert such Debentures or Loans into Shares) Rules, 2011.

Conversion into preference shares

The company had converted its debentures into preference shares on Supreme Court orders. SEBI ordered the company to refund the amount to debenture-holders. This order was held to be not enforceable.  Issue of shares on conversion of preference shares/convertible debentures:

  • Where the conversion period is on or before a certain time, convene Board meeting to decide on the date of conversion and advise the stock exchanges where the instruments are listed or where the proposed issue of debenture is to be listed.
  •  Where conversion price is linked to market price of the underlying equity shares, work out the conversion price on the basis of the pricing formula stated in the offer document.
  • Advice the preference shareholders/debenture-holders about the conversion price as worked out on the basis of the above formula.
  • Where the preference shares/convertible debentures are optionally convertible, obtain consent of the holders for the conversion.
  •  Advise the stock exchanges about the record date fixed for the conversion so that trading in the convertible preference shares/debentures can stop before the said date.
  • Hold Board meeting and forfeit the preference shares/debentures which are partly paid after sending at least 3 notices, the last one by registered A/D.
  • Advice the stock exchanges about the shares/debentures forfeited.
  • Reissue the forfeited shares, if so decided by the Board and file return of allotment with ROC.
  • Process all transfers received till the record date for conversion.
  • Issue share certificates to the holders on conversion of the convertible preference shares/debentures into equity shares.
  • Where shares are issued in odd lots on conversion, organize the sale of odd lots by a Trust to be appointed and distribute the sale proceeds among the odd lot holders on pro rata basis by cheques/warrants.
  • File return of allotment with the ROC
  • Arrange for listing of the shares on the stock exchanges.
  • Update the register of members.

While the provisions of the 2013 Act have to be complied with for issue/transfer of securities; in case the issue or transfer of any security is made to or by a person resident outside India, the same shall abide by the regulations framed by RBI in this behalf: Purchase/Sale of Shares and/or convertible debentures by an NRI on a stock exchange in India on repatriation and/or non-repatriation basis under portfolio investment scheme [Regulation 5(3)(i) read with Sch. 3 of FEM]. For more clarification about Company Registration in Bangalore, kindly visit our website and feel free to contact us.. Thanks for reading!!!

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