A loan where a company borrow money from the general public and the private institutions. Individuals/Institutions receive interest and the principal amount on maturity or defined intervals. The debenture redemption reserve (DRR) is a provision which is a mandate by RBI for protecting the investors in case Payment Defaults.
All the businesses require funds for growth and sustainability in the market. There are many options for the companies for raising funds. Apart from owner’s capital companies could raise funds from debt and by share issuance. Fund raising through debt involves debentures or borrowing the money in forms of loans.
Companies in India which issue debentures are required to set a particular fund known as the Debenture Redemption Reserve (DRR). The purpose of this is ensuring that the company repays the debentures as promised while lowering the risk of not being able to pay back. The Debenture Redemption Reserve ensures that there’s enough money to payback the debt holders.
What is Debenture Redemption Reserve (DRR)?
Companies Act, 1956 was amended in year 2000 for adding the provision of DRR (Debenture Redemption Reserve) for protecting the interests of the debenture holders. It maintains a reserve which is a mandate requirement for all companies which issue debentures.
A company is required to have a pool of funds for each issued debenture. Incase of liquidation of the company the debenture investors could be paid from funds which are available in DRR. Even after the collateral backs the debenture, the investors need not to wait for the collateral needs to be liquidated. As, its a long and time consuming process. In difficult situations, DRR funds are the saviours for the investors.
Many changes in the DRR have been made in past years. DRR has been made mandatory for all the companies. In August 2019, Ministry of Corporate Affairs amended this Provision. This amendment provides exemption to companies which are listed on the Indian Exchange to maintain a debenture redemption reserve.
As of March 2014, Ministry of Corporate Affairs mandates that companies are required to maintain a fund which is 50% of the value of funds raised in the DRR issue. Howsoever, this limit was later revised to 25%. Right now, this DRR fund requirement is 10% of issued debentures.
Its a vital financial tool for corporates for raising funds and financing their working capital and expansion plans. The Debenture Redemption Reserve is an important metric for attracting investors. This adds to the safety and reduce the risk for the debenture holders.
How Does a Debenture Redemption Reserve Work?
Companies which issue debenture have to maintain a DRR of 10% of the amount gathered from debenture issuance, the debenture holder are to be paid from DRR (Debenture Redemption Reserve). The DRR is to be funded by the profits which are earned by the company in the financial year.
Classification of Debentures
Debentures are issued in many methods and are classified based on its nature:-
:- On Basis of Security: These are protected by particular corporate assets. The Holder can claim this in the event of defaults.
:- Unsecured/ Naked Debentures: No asset is used to secure them.
:- On basis of Convertibility: These debentures have a fix conversion time after which they get convert into equity shares. As there are convertible debentures there are also Non-convertible Debentures which are not convertible into equity shares.
:- On basis of Tenure: Redeemable debenture are to be paid back after a certain amount of time. Perpetual Debentures are those which do not have a date for maturity.
:- On basis of Redemption: Callable Debentures are debentures which the corporation can call before its maturity. Puttable debentures are those which can be repurchased from the company before its maturity.
:- On the basis of Status or Position: First Debentures are those which have to be paid firstly at the time of liquidation. Second Debentures are paid after settling the first debentures
:- On basis of Registration: These debentures are listed in company’s registrar of holders of the debentures. Bearer Debenture are those in which no registration is necessary and the ownership is with the holder.
:- On basis of Interest Rate: These debentures carry a fixed interest rate during their tenure. Floating rate debentures are that in which interest rate differentiates on basis of some benchmark or market indicator.
Methods of Redemption of Debentures
While redeeming its debt instruments a firm pays back the debt instruments principal. Different ways to redeem debentures are:-
Redemption by Open Market Purchase:
Companies have option for purchasing and then cancel out their own debentures in the open market. By using this strategy all businesses could benefit from market circumstances and redeem debentures at profit.
Conversion-Based Redemption:
Redeeming convertible debentures by converting them into business equity shares. While at the time of issuance, the conditions for conversion are specified. Converting the holders of debentures into shareholder lowers the liabilities of the company.
Capital Redemption:
It involves redeeming debentures at the end of a specified period which arises out from capital, this effectively means that the money is paid from the capital and not from the earning. This is generally used for redeeming irredeemable bonds.
Profit Redemption:
Businesses could use revenues for funding a DRR. This reserve has a yearly transfer of specific amount of Profit, this is used for repaying debentures. Redeemable debentures are redeemed through this procedure.
Using Sinking Funds:
A business which is forms a sinking fund in which it deposits a fixed sum on a regular basis. These debentures are redeemed through this fund and accrue interest by buying them in the open market through direct repayment.
Call and Put Alternatives:
Some of the debentures have call or put options. Which allows for early redemption before the maturity date. Call options are company’s right for purchasing debentures, whereas the put option are for debenture holder’s right to sell debentures back to company.
Is Debenture Redemption Reserve Applicable to All Issuers?
The Debenture Redemption Reserve provision applies to the debentures which are issued after the amendment of Companies Act, 1956. However there are exemptions to this:-
- The DRR does not apply to Public Financial Institutions(PFI). PFI are those entities which are owned by the central government with having a majority of 51% stake.
- DRR is not needed for All India Financial Institutions for public and private debentures. These operate under the RBIs purview, e.g.NABARD, SIDBI,etc.
- All housing finance companies registered with National Housing Bank are exempted from DRR.
- DRR also does not applies to Non-Banking Finance Companies registered with the RBI.
- All Scheduled banks are exempted from having a DRR.
- Any company which is listed on NSE or BSE does not require to maintain a DRR.
If there is an unlisted HFC or NBFC which is making a public debenture issue in that case it must maintain a debenture redemption reserve. When any company issues a partially convertible debenture DRR is required only for the non convertible amount of the debenture issued. The ministry of Corporate Affairs allows it for companies to raise funds easily without any impediments.
Conclusion
A debenture is a much safer debt investment which provides a fixed return for the investor. An investor shall look for a better credit rating before investing in a debenture. Risks are also inherent in a debenture investment, like default risk cause of bankruptcy or any other financial concerns. The DRR is dealt with Section 117C of Comanies Act, 1956 for protecting the debenture holder interest. Its an exclusive reserve which is maintained only for debenture repayment purposes.
