Debentures Under Section 71: Conversion, DRR, Trustees and Holder Remedies

Plain debentures (interest-bearing, redeemable, non-voting debt) are a common way for a founder-led company to borrow without giving up equity. Section 71 of the Companies Act, 2013 sets the issue rules, and rule 18 of the Companies (Share Capital and Debentures) Rules, 2014 fills in the detail on security, trustees and the redemption reserve. That rule was amended in 2019 and again in 2020, so the older text circulating in templates is out of date. Section 72 adds a nomination facility that every holder should use.

Legal basis: Companies Act, 2013, ss.71-72; rule 18, Companies (Share Capital and Debentures) Rules, 2014, as amended by the 2019 and 2020 amendment rules.

What to do now

• Next step: Decide whether the instrument has a conversion option. If it does, get a special resolution at a general meeting before the issue (proviso to s.71(1), Companies Act 2013). If any part of the issue is secured, check the security and redemption-period conditions in rule 18(1).
• Deadlines: If the issue is a debenture offer to more than 500 members, or a prospectus or public offer, appoint the debenture trustee before the issue or offer (s.71(5)). A trust deed in Form SH.12 must be executed within three months of closure of the issue or offer (rule 18(5), Share Capital and Debentures Rules 2014). Where the debenture redemption reserve (DRR, profits set aside to repay holders) applies, the investment or deposit of the prescribed sum is due on or before 30 April each year (rule 18(7)(b)(v), as amended in 2020).
• Consequence of missing them: Section 71(10) lets the Tribunal, on a holder's or trustee's application, direct the company to redeem forthwith with principal and interest if redemption or interest payment fails. Section 71(9) lets the trustee ask the Tribunal to restrict further liabilities when assets look insufficient.

Have a CA review your facts before you act or file.

Conversion needs a special resolution; voting rights are banned

A company may issue debentures that can convert into shares. The proviso to s.71(1) says the issue of debentures "with an option to convert such debentures into shares, wholly or partly, shall be approved by a special resolution passed at a general meeting". So if a conversion option is attached, in whole or in part, members must pass a special resolution before the issue. Settle this before you finalise the term sheet, because the resolution is a precondition of the issue and not something to ratify later. The Act does not say what follows if it is skipped, so treat the risk as a compliance failure on the issue itself.

Section 71(2) is absolute: "No company shall issue any debentures carrying any voting rights." No class of debenture can vote at general meetings, whatever the size of the holding. A lender who wants control has to look at equity or board arrangements. A debenture buys a claim to interest and repayment.

Secured debentures: rule 18(1)

Section 71(3) allows secured debentures "subject to such terms and conditions as may be prescribed". Rule 18(1) prescribes them. The company shall not issue secured debentures unless:

• the date of redemption does not exceed ten years from the date of issue (rule 18(1)(a)). The rule allows a longer period, up to thirty years, for specified classes of company: those setting up infrastructure projects, infrastructure finance companies, infrastructure debt fund NBFCs, and companies permitted by a Ministry, the Reserve Bank, the National Housing Bank or another statutory authority to issue debentures beyond ten years. An ordinary operating company is not in those classes; and
• the issue is secured by a charge on the properties or assets of the company, its subsidiaries, its holding company or its associate companies, having a value sufficient for the due repayment of the debentures and interest (rule 18(1)(b)).

Rule 18(1) as it stands applies to secured issues. If your instrument is unsecured, these two conditions do not apply.

The debenture redemption reserve

Section 71(4) says that where debentures are issued, the company "shall create a debenture redemption reserve account out of the profits of the company available for payment of dividend and the amount credited to such account shall not be utilised by the company except for the redemption of debentures." The quantum is left to the rules (s.71(13)).

The current rule is rule 18(7), which the 2019 amendment rules substituted. Its main points for an unlisted company that is not a bank, an All India Financial Institution, an NBFC or a housing finance company:

• DRR is created out of profits available for payment of dividend (rule 18(7)(a)).
• For "other unlisted companies, the adequacy of Debenture Redemption Reserve shall be ten percent. of the value of the outstanding debentures" (rule 18(7)(b)(iv)(B)).
• Such a company must, on or before 30 April each year, invest or deposit a sum of not less than fifteen per cent of the amount of its debentures maturing during the year ending 31 March of the next year (rule 18(7)(b)(v), as substituted in 2020). The amount remaining invested must not fall below fifteen per cent at any time in that year.
• The permitted methods are a deposit with a scheduled bank free of charge or lien, unencumbered Central or State Government securities, unencumbered securities of the kind listed in section 20 of the Indian Trusts Act, 1882, and certain unencumbered bonds of other notified companies (rule 18(7)(b)(vi)). The amount so invested cannot be used for any purpose other than redeeming the debentures maturing that year.
• For partly convertible debentures, DRR is created only on the non-convertible portion (rule 18(7)(c)).
• The amount credited to DRR cannot be used except for redemption of debentures (rule 18(7)(d)).

Different percentages or exemptions apply to banks, All India Financial Institutions, NBFCs, housing finance companies and listed companies (rule 18(7)(b)(i) to (iii)). Check which category you fall in before relying on the ten per cent figure. A company with no profits available for dividend has nothing from which to create the reserve, which is something to work through with lenders before the issue.

When a debenture trustee is mandatory

Section 71(5): "No company shall issue a prospectus or make an offer or invitation to the public or to its members exceeding five hundred for the subscription of its debentures, unless the company has, before such issue or offer, appointed one or more debenture trustees". The sentence has two limbs. A prospectus, or an offer or invitation to the public, needs a trustee. An offer or invitation to members exceeding five hundred also needs one. The 500 figure belongs to the members limb. The trustee must be appointed before the issue or offer, not after allotment.

Rule 18(2) sets the conditions for appointment:

• the trustees' names must appear in the letter of offer and in all later notices to holders (rule 18(2)(a));
• written consent must be obtained from each proposed trustee before appointment, and the letter of offer must say so (rule 18(2)(b));
• a person cannot be appointed if he beneficially holds shares in the company, or is a promoter, director, key managerial personnel, other officer or employee of the company or its holding, subsidiary or associate company (rule 18(2)(c)(i) and (ii)); the rule lists further disqualifications, so read it in full; and
• a trustee may be removed before the end of the term only if holders of not less than three-fourths in value of the outstanding debentures approve at their meeting (rule 18(2)(e)).

Rule 18(6) provides that sub-rules (2) to (5) of rule 18 do not apply to a public offer of debentures. That is a matter for the public-issue regime, which is outside this article.

What the trustee must do

Section 71(6) requires the trustee to "take steps to protect the interests of the debenture-holders and redress their grievances". Rule 18(3) lists the trustee's duties. They include calling for periodical status or performance reports from the company, promptly telling holders of defaults, ensuring that the security and the DRR are in place, checking that the company's assets are sufficient to meet interest and principal, and taking steps to convene a holders' meeting when one is required.

One duty has teeth: the trustee must appoint a nominee director on the company's Board on two consecutive defaults in paying interest, a default in creating the security, or a default in redemption (rule 18(3)(e)). Rule 18(4) requires the trustee to convene a holders' meeting on a written requisition from holders of at least one-tenth in value of the debentures outstanding, or on any breach or default event.

Section 71(7) makes void any term of a trust deed that would exempt the trustee from liability for breach of trust, or indemnify the trustee, where he fails to show the degree of care and due diligence required of him. The proviso allows exemptions "agreed upon by a majority of debenture-holders holding not less than three-fourths in value of the total debentures at a meeting held for the purpose".

The trust deed

Rule 18(5) requires a trust deed in Form SH.12, or as near thereto as possible, to be executed in favour of the trustees within three months of closure of the issue or offer. Rule 18(8) gives members and debenture holders the right to inspect the trust deed on the same footing as the register of members, and to receive a copy within seven days of a request, on payment of the fee.

Pay on time, or the Tribunal steps in

Section 71(8): "A company shall pay interest and redeem the debentures in accordance with the terms and conditions of their issue." Two Tribunal routes back this up.

Before default. If the trustee concludes that the company's assets are insufficient, or likely to become insufficient, to discharge the principal when due, the trustee may file a petition before the Tribunal. After hearing the company and any other interested person, the Tribunal may impose restrictions on the incurring of further liabilities as it considers necessary in the interests of holders (s.71(9)).

After default. Where the company fails to redeem on maturity or fails to pay interest when due, the Tribunal may, on the application of any or all of the holders, or the trustee, and after hearing the parties, direct the company to redeem the debentures forthwith on payment of principal and interest due (s.71(10)).

A contract with the company to take up and pay for debentures can be enforced by a decree for specific performance (s.71(12)).

Nomination: the holder's succession step

Section 72(1): "Every holder of securities of a company may, at any time, nominate, in the prescribed manner, any person to whom his securities shall vest in the event of his death." Joint holders may together nominate a person to whom all rights vest on the death of all of them (s.72(2)).

A valid nomination overrides other dispositions. Section 72(3) says that, notwithstanding any other law or any disposition, testamentary or otherwise, the nominee becomes entitled to all the rights in the securities on the holder's death "to the exclusion of all other persons, unless the nomination is varied or cancelled in the prescribed manner". Where the nominee is a minor, the holder may appoint, in the prescribed manner, a person to become entitled to the securities if the nominee dies during minority (s.72(4)). Holders of debentures, including friends and family who lend to a startup, should make the nomination when they subscribe and not leave it for later.

Issue checklist

• Conversion option attached? Special resolution at a general meeting before the issue (s.71(1) proviso).
• No voting rights on any debenture (s.71(2)).
• Secured? Redemption within ten years unless in a specified class, and a charge on assets of sufficient value (rule 18(1)).
• DRR: ten per cent of outstanding debentures for other unlisted companies, created out of dividend-available profits, with the 15 per cent investment or deposit by 30 April (rule 18(7)).
• Offer to more than 500 members, or a prospectus or public offer: trustee appointed before the issue, with written consent and no disqualification (s.71(5); rule 18(2)).
• Trust deed in Form SH.12 within three months of closure (rule 18(5)).
• Pay interest and redeem as per the terms (s.71(8)); know the two Tribunal routes (s.71(9) and (10)).
• Each holder files a nomination (s.72).

FAQ

When does issuing debentures need member approval?
When they carry an option to convert into shares, wholly or partly. The proviso to s.71(1) requires a special resolution passed at a general meeting.

Can debentures carry votes?
No. Section 71(2) says "No company shall issue any debentures carrying any voting rights."

How much redemption reserve does an unlisted company need?
For other unlisted companies, rule 18(7)(b)(iv)(B) fixes adequacy at ten per cent of the value of outstanding debentures. Banks, financial institutions, NBFCs, housing finance companies and listed companies are treated differently under rule 18(7).

When is a debenture trustee mandatory?
Before a prospectus or a public offer, or an offer to members exceeding five hundred (s.71(5)).

What can holders do on default?
Any holder or the trustee can apply to the Tribunal for an order to redeem forthwith with principal and interest (s.71(10)). The trustee can separately seek restrictions on further liabilities (s.71(9)).

Who gets a dead holder's debentures?
The nominee, to the exclusion of all other persons, unless the nomination was varied or cancelled (s.72(3)).

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See Also

• Allotting Shares After a Public Offer? Minimum Subscription, Listing Permission and Refunds Under Sections 39–40
• Buying back your own shares (s.68): the 25% ceiling, the board-vs-members route, and the solvency paper trail
• GST registration for a new company: who must register, by when, and how