Debenture: Legal Definition, Types of Debenture and Raising Capital
What is a Debenture?
A debenture is a type of long-term debt instrument issued by a company that is not secured by physical assets or collateral, but rather backed by the issuer’s general creditworthiness.
Debenture Legal Definition
In the complex world of corporate finance, the term “debenture” is frequently encountered, yet its legal meaning is often misunderstood or oversimplified.
Legally, a Debenture (“DB”) refers to a type of debt instrument that is not secured by physical assets or collateral.
It represents a medium- to long-term investment in a company, where the company promises to pay the debenture holder interest and to repay the principal at a future date.
Essentially, it’s an unsecured loan certificate issued by a company, backed only by the general creditworthiness and reputation of the issuer.
Legal Framework
The legal framework governing DBs is intricate, often varying from one jurisdiction to another. Generally, it is governed by the company’s act or corporate law in a given country. These laws regulate the issuance, administration, and redemption of DBs.
Types of Debentures
- Convertible Debentures: These are debentures that can be converted into equity shares of the issuing company after a certain period.
- Non-Convertible Debentures (NCDs): These instruments cannot be converted into shares or equities. They are used as tools to raise long-term funds by companies through a public issue.
- Secured and Unsecured Debentures: While typically DBs are unsecured, some may be secured by a charge on the company’s assets.
- Registered and Bearer Debentures: Registered debentures are recorded in the company’s register of DB holders. Bearer debentures are transferable by mere delivery.
Legal Implications of Debentures
Rights of Debenture Holders
Debenture holders generally have the right to receive their interest payments and the return of their principal. However, they do not hold any ownership rights in the company.
Remedies for Default
In case of default, debenture holders can take legal action to recover their investment. The course of action depends on whether the DB is secured or unsecured.
Conversion and Redemption
For convertible debentures, the terms of conversion are critical. These terms must be clearly outlined in the DB agreement. Redemption of debentures refers to the repayment of the principal amount to the debenture holders.
What is the Difference between a Debenture and a Loan?
A debenture is a type of debt instrument issued by companies to raise capital, typically unsecured and backed by the issuer’s creditworthiness. A loan is a sum of money borrowed from a lender like a bank, usually secured by collateral, and requires repayment with interest over a specified period.
Loans offer more flexibility in terms and conditions, while debentures are governed by their issuance terms and are tradable. Debentures often involves regular interest payments and a fixed repayment date.
What Happens to Debentures in case of a Company’s Bankruptcy?
In the event of a company’s bankruptcy, debenture holders are treated as creditors. The repayment priority for debentures depends on their type. Secured debentures, backed by company assets, are prioritised and repaid from the sale of those assets.
Unsecured debentures, however, rank lower in repayment hierarchy, below secured creditors and above equity shareholders. They are repaid only after fulfilling secured debts.
The exact recovery for debenture holders depends on the remaining assets and the company’s debt structure.
In many cases, unsecured debenture holders may receive only a fraction of their investment or, in worst-case scenarios, nothing at all.
What is a Subordinated Debenture?
A subordinated debenture is a type of unsecured debt that ranks below other, more senior debts in terms of repayment priority in the event of a company’s bankruptcy or liquidation.
In such scenarios, holders of subordinated debentures are paid only after the claims of secured creditors and other higher-ranking debts are satisfied.
This increased risk typically results in a higher interest rate for subordinated debenture holders compared to senior debt holders.
What is a zero-coupon debenture?
A zero-coupon debenture is a debt security that does not pay periodic interest. Instead, it is issued at a significant discount to its face value and matures at par (or face value).
The investor’s return is the difference between the purchase price and the amount received at maturity.
This type of debenture appeals to investors seeking a long-term investment without the need for regular interest income, but who anticipate a lump sum at the end of the term.
Tax Implications
The issuance and transfer of DBs have tax implications both for the issuer and the holder. Interest payments on debentures are typically tax-deductible for the company.
Read article: The Spartan Capital Securities Lawsuit (re: Lowry and Monchik): A Legal Commentary
Regulatory Compliance
Issuing DBs requires compliance with various regulatory requirements, including securities laws and corporate laws. Companies must adhere to these regulations to avoid legal repercussions.
Conclusion
DBs play a vital role in corporate finance as a tool for raising capital. Understanding their legal meaning is crucial for investors, legal practitioners, and corporate managers.
While offering a flexible financing option for companies, DBs bring along a set of legal rights and obligations that must be carefully navigated.
In summary, DBs, while simple in concept, are complex in their legal and financial implications. As the corporate world evolves, so does the role and nature of DBs, making it an ever-relevant topic for legal and financial professionals.
