Different Types of Debentures and Their Use

Introduction

With the opening of doors to market globalization, every business house, whether a startup or
a well-established business house needs funds from a third party for research and development
to acquire a market edge over its competitors. These age of competitive business spares no one
who struggles coming up with an innovative idea to capture the market share. Such business
houses tend to fall even before they get started. The situation is worse for the startup businesses
which along with the cut-throat competition also has restraint on financial stability to their
despair. For a business house to acquire the market innovation which would work in their favor
needs funds for research and development, innovation, implementation and what not. Now the
question arises, where do these funds come from? In the corporate world, there are various
sources from which such business houses can acquire funds from the market. Business houses
can acquire funding by way of floating shares of the company in the form of equity and
preference or can procure a loan from banks and financial institutions upon mortgage of
company’s asset or can sale some of their shares to third party or can even float and issue bonds
and debentures to third parties in accordance with the provisions of applicable laws. Since all
these modes have their own advantages and disadvantages along with the procedural and legal
requirements, business houses prefer to appoint professional advisors for understanding the
implication of each and every mode.

Depending upon various scenarios, a business house and the professional advisor comes up
with the best mode feasible to such houses. A business house which would want to retain
control over itself would prefer floating of debentures as against the equity or preference shares
given the dilution of ownership caused upon the issue of equity and preference shares. Sine,
the cost of issuing debt is less than the cost of issuing equity, debt financing is one of the most
lucrative ways of raising funds for business growth and development.

Debentures

As discussed above, a debenture is one of the capital market instrument which helps business
houses to raise funds from the market for the development of the business. The word debenture
has been derived from the Latin word “debere” which means borrowing or taking a loan. In
layman’s language, debenture can be defined as an acknowledgement of debt issued by the

1
company to the third parties under the common seal of the company. In accordance with
Section 2(30) of the Companies Act, 2013, debentures include debenture stock issued by the
company as an evidence of debt taken by such company, either by creation or non-creation of
the charge over the assets of the company.

Salient Features of Debentures

Some of the salient features of debentures are as follow:

1. It is an acknowledgement of the debt;

2. It is issued by the company under its common seal;

3. Debentures can be both secured or unsecured;

4. The rate of interest and the date of payment is pre-determined;

5. Debentures issued are freely transferrable by debenture holders;

6. Debenture holders do not get any voting right in the company;

7. Interest payable to the debenture holders are charged against the profits of the
company.

Provisions Governing Debentures

Following provisions of the Companies Act, 2013 governs the floatation, issue and allotment
with regards to the debentures:

1. Section 2(30) – Definition;

2. Section 44 – Nature of debentures;

3. Section 71 – Provisions relating to issue and allotment of debentures;

4. Rule 18 of the Companies (Share Capital and Debenture) Rules, 2014 – Rules
pertaining to issue and allotment of debentures.

2
Types of Debentures

There are various forms of debentures which a company can issue depending upon its
requirement. Debentures can be issued based on various factors i.e. performance, security,
priority, convertibility and record.

1. Based on Performance

Based on the performance, there are two types of debentures which are issued i.e.

o Redeemable Debentures

Redeemable debentures are the debentures where the date of redemption of the debentures are
specifically mentioned in the debenture certificate issued, where on such date, the company is
legally bound to return the principal amount to the debenture holder.

o Irredeemable Debentures

Irredeemable debentures continue for perpetuity and unlike redeemable debentures, there is no
fixed date on which the company needs to pay the debenture holders. It becomes redeemable
only when the company goes into liquidation.

2. Based on security

o Secured Debentures

When the debentures are issued by way of creation of charge over the assets of the company,
then such debentures are called as secured debentures. The charge created over the debentures
may be fixed or maybe floating. In accordance with the provisions of the Companies Act, 2013,
such charge created has to be registered with the Registrar within 30 days of such creation.

o Unsecured Debentures

Unlike secured debentures, unsecured debentures are issued by the company without creation
of charge over the assets of the company. In other words, these debentures do not offer any

3
protection to the debenture holder in case the company is unable to pay the principal amount
on the due date.

3. Based on Priority

o First Mortgaged Debentures

Basically, the distinction of debentures based on priority can be called as a subcategory of the
secured debentures. First Mortgaged Debentures are those debentures which has first
preference over all the other debentures issued by the company. Such preference is claimed at
the time of liquidation of the company when the assets of the company are distributed among
the credit holders.

o Second Mortgaged Debentures

Second Mortgage Debenture, as the name suggests, has second preference over the assets of
the company at the time of liquidation after the first mortgaged debentures. Only after the first
mortgaged debenture holders are satisfied, will the second mortgaged debenture holders can
claim their principal amount from the company at the time of liquidation.

4. Based on Convertibility

o Fully Convertible Debentures

Fully convertible debenture holders have the right to convert their debentures into equity shares
of the company at a future date, at the option of the debenture holders. The conversion ratio,
the rights of the debenture holders post-conversion and the trigger date for conversion are
defined at the time of issue of these debentures.

o Partially Convertible Debentures

Partially convertible debentures can be divided into two parts. The first part being the
debentures which are convertible to equity shares of the company and the second part being
non-convertible debentures which shall redeem at the expiry of its tenure. An option is given

4
to the debenture holder to partially convert its debt into shares of the company. Partially
convertible debentures are also deemed as optionally convertible debentures.

o Non-Convertible Debentures

Debentures which do not have an option to get converted into equity shares of the company are
called non-convertible debentures. These debentures get redeemed at the end of the maturity
period.

5. Based on Record

o Registered Debenture

In case of registered debenture, the name, address, number of debentures and other details
pertaining to holding are entered by the company in the register of debentures. In such cases,
the transfer of debentures from one debenture holder to another debenture holder is recorded
in the register of debenture holders as well as register of transfer.

o Unregistered Debentures

Unregistered debentures are also called bearer debentures. Unlike registered debentures, the
company does not maintain the records of such debentures and the principal amount and the
interest is paid to the bearer of the instrument as against the name written over such instrument.
These debentures are easily transferrable in the market.

Use of Debentures

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.

Considering its various types, debentures are issued by the company as required by the investor
investing in the company. In case the investor insists on issuing first mortgaged debenture to

5
have an added protection over and above the secured debenture, the company may issue such
debenture to the investor, which again depends on the necessity of funds to the company. In
the usual course of business, registered non-convertible redeemable secured debentures are
issued by the company as it provides protection to the investors against the failure of the
company to repay the principal amount. Where the investor prefers to have a shareholding in
the company after a fixed period of time, the company may be required to issue fully or
optionally convertible debentures.

A fixed charge is a charge for finance against a tangible, physical asset such as property,
land and machinery. Said assets will be used as collateral should the business fail to repay
their debts when owed, or fail to agree on suitable repayment terms.

What is a fixed charge over assets?

A lender has full control of fixed assets used as security against a debt and if the business
needs to take back control of the asset to sell or remove, they will need to pay off the
remainder of their debt with the lender.

Examples of fixed charges

The most common examples of fixed charges are:

• Mortgages

• Standard bank loans

• Rentals and Leases

• Rent deposits

• Invoice Factoring

What is a floating charge?

A floating charge is a charge that is held over assets but ‘floats’, meaning that it can
change over time as the business changes and assets move. Certain assets and stock can
change periodically – this includes machinery and plant, for example.

6
What is a default of a floating charge?
This is when the business defaults on payments owed to the lender and the lender is able to
issue a demand for repayment.

Examples of floating charges

Floating charges can be held over numerous things, including:

• Stock

• Cash

• Debtors

• Inventory

• Furniture, fixtures and fittings

• Plant and machinery

What is the main difference between fixed and floating charges?

The main differences between fixed and floating charges are as follows:

• Fixed charges relate to physical, identifiable assets whereas floating charges are
flexible and apply to business assets as a whole.

• A fixed asset cannot be sold or disposed of without the lender’s authorisation, whereas
floating charges can be changed until they are ‘crystallised’ as fixed.

• Fixed charges are higher in the hierarchy than floating charges in cases of business
insolvency and creditor payment.

What happens if a company becomes insolvent?

If your business becomes insolvent, there is a particular hierarchy that will be followed when
creditors are repaid with the sale of company assets.

It may depend on the type of formal insolvency process that a business takes, but the
priorities are typically the same. Take Liquidation for example; in this case, both fixed and
7
floating charges are secured, meaning that they will take priority over unsecured creditors and
will have to be paid first.

Difference Between Fixed Charge and Floating Charge

Charge refers to the collateral, given for securing the debt, by way of mortgage on the
company’s assets. There are two kinds of charge, fixed charge, and floating charge. The
former is a charge on the real asset of the company that is identifiable and ascertained when
the charge is created. Conversely, the latter is slightly different, which is created over the the
assets circulatory in nature, i.e. the charge is not attached to any definite property.

Companies borrow funds from banks, financial institutions and other companies in the form
of loans to fulfill their monetary requiements. The moneylender demands security against the
loan and so, the borrower creates a charge over the assets or lien on the property. In this
context fixed charge and floating charge are often discussed. Before understanding creation
of charge, one should know the difference between two types of charge.

Content: Fixed Charge Vs Floating Charge

1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart
BASIS FOR
FIXED CHARGE FLOATING CHARGE
COMPARISON

Meaning Fixed charge refers to a charge that Floating charge refers to a charge
can be ascertained with a specific that is created on the assets of
asset, while creating it. circulatory nature.

Nature Static Dynamic

8
 BASIS FOR
FIXED CHARGE FLOATING CHARGE
COMPARISON

Registration of Voluntary Compulsory

charge

What is it? A legal charge. An equitable charge.

Preference First Second

Asset type Non-Current Asset Current Asset

Dealing in asset The company has no right to deal The company can use or deal with
with the property, but subject to asset, until crystallization.
certain exceptions.

Definition of Fixed Charge

Fixed Charge is defined as a lien or mortgage created over specific and identifiable fixed
assets like land & building, plant & machinery, intangibles i.e. trademark, goodwill,
copyright, patent and so on against the loan. The charge covers all those assets that are not
sold by the company normally. It is created to secure the repayment of the debt.

In this type of arrangement, the unique feature is that after the creation of charge the lender
has full control over the collateral asset and the company (borrower) is left over with the
possession of the asset. Therefore, if the company wants to sell, transfer or dispose off the
asset, then either previous approval of the lender is to be taken, or it has to discharge all the
dues first.

Definition of Floating Charge

The lien or mortgage which is not particular to any asset of the company is known as Floating
Charge. The charge is dynamic in nature in which the quantity and value of asset changes
periodically. It is used as a mechanism to secure the repayment of a loan. It covers the assets
like stock, debtors, vehicles not covered under fixed charge and so on.

9
In this type of arrangement the company (borrower) has the right to sell, transfer or dispose
off the asset, in the ordinary course of business. Hence, no prior permission of the lender is
required and also there is no obligation to pay off the dues first.

The conversion of floating charge into fixed charge is known as crystallization, as a result of
it, the security is no more floating security. It occurs when:

• The company is about to wind up.

• The company ceases to exist in future.
• The court appoints the receiver.
• The company defaulted on payment, and the lender has taken action against it to
recover the debts.

Key Differences Between Fixed Charge and Floating Charge

The following are the major differences between fixed charge and floating charge:

1. The charge that can be easily identified with a certain asset is known as Fixed Charge.
The charge which is created on assets that changes periodically is Floating Charge.
2. Fixed Charge is specific in nature. Unlike floating charge which is dynamic.
3. Registration of movable assets is voluntary, in the case of fixed charge. Conversely,
when there is a floating charge, the registration is compulsory irrespective of the asset
type.
4. The fixed charge is a legal charge while the floating charge is an impartial one.
5. Fixed Charge is given preference over floating charge.
6. The fixed charge covers those assets that are specific, ascertainable and existing
during the creation of the charge. On the other hand floating charge, covers present or
future asset.
7. When the asset is covered under fixed charge, the company cannot deal with the asset
until and unless the charge holder agrees for so. However, in the case of floating
charge the company can deal with the asset until the charge is converted to fixed
charge.

10