Precedents of issue of debentures in India

The requirement of creation of a Debenture Redemption Reserve is unique to India and is globally unheard of. This was inserted in India around the year 1998 in pursuance of recommendation of Committee formed under the chairmanship of Justice D.R. Dhanuka. Apparently, the very motivation for having a Debenture Redemption Reserve (“DRR”) seems difficult to understand and among the various problems which have inhibited the growth of the Indian bond market over the past many years, the requirement of creation of a DRR has also been one amongst them. The state of bond market in India is quite in its nascent stage, that is to say, in India the bond market is much under developed as compared to countries having same level of economic development as our country. If one may compare the penetration in bond market in India with certain other countries like Malaysia, Thailand or China, the facts state that the Indian bond market is in great degree of infancy as its penetration as such is extremely low. Therefore, in pursuance to promote the bond market in India the finance minister made a Budget pronouncement to relax the requirement of DRR whereas this actually being one of the factors which is impeding the bond markets in the country should have been completely eliminated.

MCA’s amendment

Based on the intent of the Union Budget of 2019-20 which proposed to scrap off the requirement of creation of DRR, the MCA came out with notification to amend the Companies (Share Capital and Debentures) Rules, 2014 dated August 16, 2019. The amendments have brought in a relaxation to reduce the requirement of DRR from 25% to 10%.  Further, the provisions have exempted NBFCs registered with RBI and HFCs registered with National Housing Bank from creation of DRR in case of public issue of debentures. Also, the requirement of listed companies to create DRR has been done away with.

It may be noted that the amended Rules have also reduced the quantum of funds to be transferred to DRR by unlisted companies. However, in a completely unexpected move, the MCA probably has unsettled an otherwise settled matter on creation of debenture redemption fund as per Rule 18(7), which entails that the requirement for parking liquid funds, in form of a debenture redemption fund (DRF) has been extended to all bond issuers, irrespective of whether they are covered by the requirement of DRR or not.

Ambiguity of the amendments

In India, it’s a well known fact that among the leading issuers of bonds in the country, the finance and infrastructure companies dominate the corporate bond market. An important fact that one may note is that most of the bond issuance in the country are by private placement and public offers in case of bonds may notably be fewer in number. Having said all of this, that the very logic for a company to have a DRR more so to have it funded by DRF seems to be based on the presumption that the company is making a public offer and therefore in order to serve public interest and serve the interest of debenture holders, the company must continue to park a part of its profits towards DRR so as to conserve money to redeem the debentures.

Whereas, if the debenture issuance itself happens to be on a private placement basis, one shall appreciate that it is a bond issuance where the debenture investors are mostly fewer and it is issued on a very limited offer basis where the investor wants to invest upon analyzing the strength of the issuer and hence the question of any debenture holder’s interest being served by making any DRR seems completely misplaced. In fact, in such cases the issuance of debentures is more like a privately placed security where the investor itself takes the credit call on the issuer based on a mutual negotiation or a one to one informed decision making of the investor to take stake on the issuer. Now, while the DRR requirement is itself therefore misplaced, expecting companies to actually be funded by creating a DRF does not carry any further sense as such. This is because, if a company has itself issued debentures and his credibility has been evaluated by the investor himself, then it is completely upto the treasury management of the issuer to make arrangement for the redemption of the debenture when it falls due.

Now, turning eyes on the financial sector entities issuing such debentures or as we mentioned, the sector overwhelmingly forming large part of the Indian bond market For a financial sector entity there are several issues as to why the requirement of DRR and more so the requirement of DRF seems completely illogical. Firstly, most of the financial sector entities are covered by asset liability mis-match requirements. Therefore, as and when the debenture redemption falls due, it becomes a case of a short term liability for the company and the AL Management in the company itself must be taking care of the impending redemption of the bonds and it may not be required to fall back on the requirement of any such DRF.

There also seems to be a lack of clarity in extending the requirement of DRF to financial sector entities particularly in case of privately placed bonds. This may be said as a completely illogical extension here where listed NBFCs are required to create DRF whereas the unlisted NBFCs are not. From the point of view of involvement of public interest there is far greater public interest involved in case of listed NBFCs and much lesser in case of unlisted NBFCs, so, exempting unlisted NBFCs from the requirement of DRF but exposing listed NBFCs to such requirement where there is no requirement of DRR itself, there must have been something amiss and have escaped attention while drafting the rules.

Conclusion

On going through the language of the law and the intent which had been behind the same, considering the MCA notification, the requirement of DRR itself has substantially been relaxed and is virtually made inapplicable to financial sector entities. Now, it may be thought that making an exception there and saying, while the DRR itself i.e. the conservation of profits itself is not required but at the same time creating a funded reserve is required, seemingly gives rise to a great degree of confusion. This is because, when DRR itself is merely an accounting entry then moving to the next step of making it funded is a questionable fact and that when the DRR itself is not required, the requirement of funding it seems completely misplaced more so when the intent behind the same was to promote the exploration of the bond market which has turned out to be confusing it with the existing framework of debenture issuance in the country, little realizing the ongoing liquidity crisis which the entire financial system is going through making the implications of this requirement will be completely inopportune.

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