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December 15, 2014

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Secured Debentures Is The New Company Law A Roadblock?


- Ashwin Mathew, [ ]

Ashwin-Mathew

A Strict Interpretation Of Rule 18(1)(b) of the Share Capital and Debenture Rules, 2014 May Render Secured Debentures Issued By A Company With Insufficient Assets To Secure The Debentures Void.

The Better Course Would Be To Construe Rule 18(1)(b) Harmoniously With Rule 18(1)(d) To Conclude That For Such A Company, Security Over Immoveable Property May Be Provided By Group Companies Or Third Parties And the Value of Such Security Would Be Included In Computing The Security Cover For Such Debentures

Debentures issued by a company may be secured or unsecured. Unsecured debentures may be considered "deposits" for which stringent rules apply. On the other hand, secured debentures are not considered as deposits if the value of the security for such debentures is equivalent to the principal and interest on the debentures. Therefore, issue of secured debentures is an important means for a company to raise finance. In many cases, particularly in real estate project funding, the issuer company may not directly undertake the project, but may do it through its subsidiary or associate company and, hence, may not have adequate unencumbered assets of its own to secure the debentures. In such cases, the debentures may be secured by assets owned by a Project SPV or other companies in the group or by a third party in addition to the assets of the issuer company.

The provisions of the Companies Act, 2013 ("CA 2013") have led to confusion on whether 'security' provided by group companies or third parties for an issue of secured debentures by another company, can be taken into account to determine the extent of security cover.

This article looks at the impact of the provisions of CA 2013 on the issue of debentures by a company where the value of the security cover is determined by taking into account the assets or properties of both the (i) issuer company and (ii) any third party or companies forming part of the group to which the issuer company belongs.

 

PROVISIONS OF THE CA 2013

  • Section 71(3) of CA 2013 provides that secured debentures may be issued by a company subject to such terms and conditions as may be prescribed.
  • The terms and conditions for issue of secured debentures are contained in Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014 ("Debenture Rules"). These Rules provides inter alia:

    "18. (1) The company shall not issue secured debentures, unless it complies with the following conditions, namely:

    (a) ...

    (b) such an issue of debentures shall be secured by the creation of a charge, on the properties and assets of the company, having a value which is sufficient for the due repayment of the amount of debentures and interest thereon;

    (c) ...

    (d) the security for the debentures by way of a charge or mortgage shall be created in favour of the debenture trustee on ----

    (i) any specific moveable property of the company (not being in the nature of a pledge); or

    (ii) any specific immoveable property wherever situated, or any interest therein."

 

ANALYSIS

  • In real estate projects, it is common for the company issuing debentures to be the holding company for land owning companies that are also involved in the development of the project. Since such transactions are underwritten by investors based on the project and project receivables, land owning companies provide security for the debentures issued by the holding company. Two relevant issues arise from the above provisions of CA 2013:
    • Can the security provided by a group company for an issue of debentures by another group company be taken into account to determine whether the secured assets or properties are sufficient to repay the principal and interest on the debentures?
    • If a company issues secured debentures without meeting the condition of Rule 18 (1) of the Rules, would the issue of secured debentures be void?
  • Security from a group company
    • Rule 18(1)(b) of the Debenture Rules provides that a company issuing secured debentures must create a charge on its properties or assets of a value that is sufficient to repay the principal and interest on the debentures ("Value Test"). However, Rule 18(1)(d) of the Debenture Rules provides that the charge or mortgage must be created in favour of the debenture trustee on any specific moveable property of the company (other than a pledge) or any specific immoveable property wherever situated. There appears to be a disconnect between Rule 18(1)(b) and Rule 18(1)(d) of the Debenture Rules since the former rule speaks of security over assets of the issuer company while the latter seems to envisage that the immoveable property of any party can be taken into account for the purpose of determining the security cover
    • In light of the above, can Rule 18(1)(b), read with Rule 18(1)(d) of the Debenture Rules, be interpreted to argue that for the purposes of Rule 18(1)(b), the immoveable property over which security is created need not belong to the company issuing the debentures? Consequently, can the value of such immoveable property be included to determine the value of security for meeting the Value Test?
    • A strict interpretation of Rule 18 of the Debenture Rules may not support the argument that the security provided by a group company or a third party over immoveable property can be reckoned for the Value Test. However, in the absence of clarity on the legislative intent for such a restrictive view, the more appropriate course would be to harmoniously construe Rule 18 of the Debenture Rules.
    • A harmonious interpretation of Rule 18(1)(b) with Rule 18(1)(d) of the Debenture Rules would support the conclusion that security provided for issue of debentures by a company may include security over moveable property of the company and immoveable property of the company and / or a group company(ies) or third parties. All such security would be considered to determine whether the Value Test has been met. This would make it possible for group holding companies to issue debentures that are secured by immoveable property held by land owning companies of the same group or third parties.
  • Does contravention of Rule 18 of the Debenture Rules render the issue of debentures void?
    • The next issue of relevance is the consequences for breach of Section 71 of CA 2013 read with the Debenture Rules. Section 71 of CA 2013 does not lay down a specific penalty for a breach of the conditions in the Debenture Rules. Therefore, the provisions of Section 450 of CA 2013, which lays down the general penalty for violation of provisions of CA 2013 for which no specific penalty is prescribed, would apply1. A related issue of significance is whether the issue of secured debentures would be void if the provisions of CA 2013 read with the Debenture Rules are not met.
    • A three judge bench of the Supreme Court in Mannalal Khetan v. Kedar Nath Khetan2 examined whether the provisions of Section 108 of the Companies Act, 1956 ("CA 1956") prohibited a registration of shares in contravention of the section or merely imposed a penalty for such non-compliance. The Court held that the provisions of Section 108 of CA 1956 were mandatory, rendering the underlying transaction void for non-compliance. The Court reasoned that:

      (a) a contract is void if prohibited by a statute under a penalty even without an express declaration that the contract is void because such a penalty implies a prohibition;

      (b) in every case where a statute inflicts a penalty for doing an act, such act is unlawful because no penalty would be imposed for a lawful act.
    • This decision of the Supreme Court was relied on by a division bench of the Bombay High Court in Shirish Finance and Investment (P) Limited v. M. Sreenivasulu Reddy3 to hold that the provisions of the Takeover Code were mandatory and any non-compliance would render the underlying transaction void.
  • Rule 18 of the Debenture Rules prohibits a company from issuing secured debentures unless the conditions stated therein are fulfilled. If the Courts strictly interpret the provisions of Rule 18 of the Rules, and do not take into account the assets or properties of third party / group company for the purpose of determining the extent of security cover, then, the issue of debentures could be deemed void and the money raised by the company from such issue would need to be returned to the debenture holders.

CONCLUSION

As noted above, a strict interpretation of Rule 18(1)(b) of the Debenture Rules may render an issue of secured debentures by a company whose assets are insufficient to secure the debentures 1:1 void by disregarding the security provided by group companies or third parties. Therefore, the better course would be to harmoniously construe Rule 18(1)(b) and Rule 18(1)(d) of the Debenture Rules to conclude that for an issue of secured debentures by a company, security over immoveable property may be provided by group companies or third parties and such security would be reckoned for determining whether the Value Test is met. Such an interpretation is in line with the position under the erstwhile Companies Act, 1956.

To lift the fog surrounding this issue, it may be worthwhile to get a clarification from the Ministry of Company Affairs to the effect that the Value Test can be met by aggregating the value of assets secured by the issuer company and the immoveable assets secured by a group company or third party.

 

Footnote:
1 Under Section 450 of CA 2013, if a company or any officer of a company or any other person contravenes any of the provisions of CA 2013 or the rules made there under and for which no penalty or punishment is provided elsewhere in CA 2013, the company and every officer of the company who is in default or such other person shall be punishable with fine which may extend to `10,000, and where the contravention is a continuing one, with a further fine which may extend to `1,000 for every day after the first during which the contravention continues.
2 (1977) 2 SCC 83; MANU/SC/0060/1976.
3 2002 (1) Bom CR 419; MANU/MH/0545/2001

 

Disclaimer - The views expressed in this article are the personal views of the author and are purely informative in nature.

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