UNIT-2 LAW OF CORPORATE FINANCE

UNIT-2

Table of Contents

QUESTION-1-What do You mean by Debenture? Describe the nature, issue and clasS of debenture.

What is a Debenture?

A debenture is a type of long-term debt instrument issued by a company or government entity to raise capital. Debentures are essentially loan agreements where the issuer borrows money from the investor and promises to pay back the principal amount along with interest over a specified period. The repayment terms and interest rates are typically outlined in the debenture agreement. Unlike shares, debentures do not confer ownership rights but represent a creditor relationship between the investor and the issuer.

Debentures are commonly used by companies to raise funds for expansion, operational needs, or refinancing existing debts. They can be secured or unsecured, depending on the terms of issuance.

Corporate Finance

Nature of Debenture

The key characteristics of a debenture include:

  1. Debt Instrument: A debenture represents a debt owed by the issuing company to the debenture holders. The company is required to repay the principal amount on maturity and pay interest periodically (usually annually or semi-annually).
  2. Fixed Income Security: Debenture holders receive fixed interest payments over the term of the debenture. This makes it similar to bonds, which also provide fixed returns.
  3. Secured or Unsecured:
    • Secured Debenture: These are backed by the company’s assets as collateral. In case of default, the debenture holders can claim the company’s assets to recover their investments.
    • Unsecured Debenture: These are not backed by specific assets. In the event of default, debenture holders have to rely on the company’s general assets.
  4. No Ownership Rights: Holding a debenture does not give the holder any ownership rights or voting power in the company. Debenture holders are creditors and not shareholders.
  5. Tradability: Debentures can be traded in secondary markets, though the liquidity may depend on the issuing company’s creditworthiness.

Issue of Debenture

Issuing debentures is a common method used by companies to raise capital. The process of issuing debentures typically involves:

  1. Approval: The company’s board of directors or shareholders (in some cases) must approve the issuance of debentures.
  2. Terms and Conditions: The company defines the terms, such as the interest rate, maturity period, security (if any), and any special clauses. These terms are laid out in a debenture trust deed, which is a legal document.
  3. Debenture Prospectus: A prospectus is issued to potential investors, detailing the debenture’s features, including the issuer’s financial health, repayment terms, and risk factors.
  4. Public or Private Issue: Debentures can be issued to the public (public issue) or to a specific group of investors (private placement). A public issue may require the company to adhere to regulatory requirements such as filing with the Securities and Exchange Board of India (SEBI) for Indian companies.
  5. Subscription and Allotment: Investors subscribe to the debentures by purchasing them through a stockbroker or directly from the issuer, and the debentures are allotted to them. The company then uses the funds raised for its intended purposes.

Classes of Debentures

Debentures can be classified into several categories based on their features and characteristics:

  1. On the Basis of Security:
    • Secured Debentures: These debentures are backed by the company’s assets as collateral. The security could be in the form of real estate, equipment, or other assets that the company owns. If the company defaults on payment, the debenture holders can claim these assets.
    • Unsecured Debentures: These are not backed by any specific assets. If the company defaults, the debenture holders have to rely on the company’s general assets and liquidation procedures for recovery.
  2. On the Basis of Convertibility:
    • Convertible Debentures: These can be converted into equity shares of the company at a later date, usually after a specific period. The conversion ratio and terms are defined at the time of issuance.
    • Non-Convertible Debentures (NCDs): These debentures cannot be converted into shares and are typically repaid at maturity. They generally offer higher interest rates than convertible debentures due to the lack of equity conversion potential.
  3. On the Basis of Tenure:
    • Short-Term Debentures: These have a maturity period of less than 3 years.
    • Long-Term Debentures: These are issued for a period longer than 3 years, typically ranging from 5 to 30 years.
  4. On the Basis of Payment of Interest:
    • Fixed-Rate Debentures: These pay a fixed interest rate over the term of the debenture.
    • Floating-Rate Debentures: These pay interest that is linked to a market benchmark rate (such as LIBOR or the RBI’s repo rate) and fluctuates with market conditions.
  5. On the Basis of Redemption:
    • Redeemable Debentures: These debentures are issued with a specified redemption period. The company repays the principal amount to the debenture holders on maturity or as per the terms agreed upon.
    • Perpetual Debentures: These debentures do not have a fixed maturity date. The company is not required to redeem them but may do so at its discretion.
  6. On the Basis of Registration:
    • Registered Debentures: These debentures are issued in the name of the holder, and the ownership is recorded in the company’s register. Only the registered holder can transfer them.
    • Bearer Debentures: These debentures are not registered, meaning the holder is treated as the owner. They can be transferred easily by mere delivery.
  7. On the Basis of Voting Rights:
    • Debentures with Voting Rights: Some debentures provide the holder with limited voting rights, typically in cases of default or restructuring.
    • Debentures without Voting Rights: The majority of debentures do not grant voting rights, as the debenture holder is a creditor, not an owner.

Conclusion

Debentures are a critical instrument in corporate finance, allowing companies to raise large sums of capital without diluting ownership. They offer a structured and flexible way to manage debt while providing investors with a predictable income stream. The various classes of debentures cater to different investor preferences and company needs, ensuring that this financial tool can be tailored to suit different business strategies and market conditions. Understanding the nature, issue, and classification of debentures is essential for both investors and companies looking to raise or invest capital in the financial markets.

QUESTION-2- Explain the effect of non-disclosure of certain information in the prospectus on creation of charges.

Effect of Non-Disclosure of Certain Information in the Prospectus on Creation of Charges

A prospectus is a formal legal document issued by companies inviting the public to subscribe to its shares or debentures. It provides essential information about the company, its financial condition, management, objectives, and terms of the offering. Under Indian law, the Companies Act, 2013, mandates that certain information be disclosed in the prospectus, including details about charges or encumbrances on the company’s assets. Failure to disclose material information, especially regarding charges, can have serious legal consequences, including the creation of liabilities or adverse implications for the company and its shareholders.

Here’s a detailed explanation of the impact of non-disclosure of information, particularly concerning the creation of charges:

What is a Charge?

A charge is a form of security interest granted by a company over its assets (both tangible and intangible) to secure repayment of a loan or debt. It is a way for a company to pledge its property, such as land, buildings, plant, machinery, or other assets, to secure financial obligations like debentures or loans.

Charges can either be fixed or floating:

  • Fixed Charge: Attached to specific assets (e.g., a building or piece of equipment).
  • Floating Charge: Covers a class of assets that may change over time (e.g., stock-in-trade, inventory).

Under Section 77 of the Companies Act, 2013, a company is required to disclose all charges created on its assets in its prospectus. The company must also file a charge creation with the Registrar of Companies (RoC) within 30 days of creating a charge. The charges must be duly recorded in the company’s records, and any non-disclosure can lead to severe consequences.

Key provisions related to charges:

  • Section 77: The company must register any charge created on its property with the RoC.
  • Section 78: The company must disclose any charges in the prospectus or other documents provided to investors.
  • Section 79: The charge must be recorded in the company’s register of charges.

Impact of Non-Disclosure of Charges in the Prospectus

If a company fails to disclose certain charges in its prospectus, it could face the following effects:

  • Liability for Misrepresentation: Non-disclosure of material information like charges can be considered misrepresentation. This can expose the company to legal action from investors or creditors who were not aware of the company’s encumbrances before investing.
  • Civil and Criminal Liability: Under Section 34 of the Companies Act, 2013, the company, its officers, and directors can be held liable for any omission or misstatement in the prospectus. This could lead to civil penalties or criminal action.
  • Voidable Transactions: If the charge was not disclosed, it could render the transaction or contract related to the charge voidable. This can complicate the company’s financial position and may require it to compensate the affected parties.

2. Impact on Creditors and Debenture Holders

  • Priority of Claims: A charge gives creditors the right to recover their dues by selling the company’s assets if the company defaults. If charges are not disclosed, it may lead to disputes over the priority of claims, especially when other creditors step in with competing claims over assets.
  • Uncertainty and Risk: Non-disclosure increases the risk for creditors and investors. If creditors are not made aware of existing charges, they may unknowingly lend to the company with a false understanding of the security of their loan. This can increase the potential for legal disputes or claims on the company’s assets.

3. Affecting the Company’s Financial Position

  • Financial Distress: Non-disclosure can create confusion about the company’s financial position, which can affect its ability to raise further capital. Potential investors or lenders may reconsider investing in or lending to a company if they realize that the company has not disclosed significant charges on its assets.
  • Impact on Valuation: Investors who are unaware of existing charges may overvalue the company, not realizing that the company’s assets are already encumbered. This can lead to financial instability if the company faces financial difficulties and its creditors enforce their charges.

4. Regulatory and Administrative Impact

  • Registrar’s Intervention: If the company fails to disclose charges in its prospectus, the RoC may require it to rectify the omissions. This could result in delays in the offering process, fines, or regulatory sanctions.
  • Investor Protection Issues: Non-disclosure of charges undermines investor protection and transparency. Regulatory authorities such as the Securities and Exchange Board of India (SEBI) may intervene, further complicating the situation for the company.

5. Effect on the Trust of the Public and Investors

  • Loss of Investor Confidence: Non-disclosure can severely damage the company’s reputation in the financial markets. When investors feel that the company is not transparent, it undermines trust, which could lead to a fall in stock prices, loss of business opportunities, and difficulties in raising future capital.

Case Law Reference

Case: Standard Chartered Bank v. The State of Maharashtra

In this case, the Supreme Court of India emphasized the importance of full and frank disclosure in the issuance of securities. The court held that non-disclosure of important facts, such as charges, in the prospectus amounts to fraudulent misrepresentation and violates investor rights. This case highlights the legal repercussions that may follow from failure to disclose material facts like charges in the prospectus.

Case: T. N. Iyer v. Indian Bank

In this case, the court held that failure to register charges under the Companies Act and the omission to disclose them in the prospectus can lead to disqualification of the transaction, potentially making the company’s financial position more precarious.

Conclusion

The non-disclosure of charges in a company’s prospectus is a serious matter that can result in legal consequences, financial instability, and damage to the company’s credibility. In the event of non-disclosure, investors and creditors may be misled, leading to lawsuits, claims, and financial penalties. To ensure transparency and protect the interests of all stakeholders, companies must comply with the disclosure requirements under the Companies Act, 2013, and provide all relevant information, including charges, in their prospectus.

QUESTION-3-What is Mortgage ? Explain briefly different kinds of mortgage.

What is Mortgage?

A mortgage is a legal agreement in which a borrower pledges an asset, usually real estate, to a lender as security for a loan. The borrower retains possession of the property, but the lender gains certain rights to it if the borrower defaults on the loan. Mortgages are typically used in the context of property loans, where the borrower agrees to repay the loan within a specified period, with interest.

If the borrower fails to repay, the lender has the right to sell the property (or seize it, depending on the jurisdiction) to recover the owed money. This makes the property a form of collateral for the loan.

Different Types of Mortgage

In India, under the Transfer of Property Act, 1882, various types of mortgages are recognized. Each type has different characteristics and the level of control the lender has over the property. Here’s a brief overview of the major kinds of mortgages:

1. Simple Mortgage

  • Definition: In a simple mortgage, the borrower transfers the property to the lender as security but retains possession of the property. The lender has the right to sell the property if the borrower defaults on the repayment of the loan.
  • Key Features:
    • The borrower does not hand over possession of the property.
    • In case of default, the lender can sell the property to recover the loan.
    • The borrower is personally liable for repayment.

2. Conditional Mortgage (or Mortgage by Conditional Sale)

  • Definition: A conditional mortgage involves a sale of the property that is subject to certain conditions. If the borrower repays the loan within the stipulated time, the sale is voided, and the borrower regains full ownership. If the borrower defaults, the sale becomes final.
  • Key Features:
    • The property is sold conditionally.
    • The borrower can redeem the property upon repayment of the loan.
    • If the borrower fails to repay, the lender becomes the owner of the property.

3. English Mortgage

  • Definition: In an English mortgage, the borrower transfers the property to the lender as security for the loan. However, the borrower retains the right to redeem the property (reclaim full ownership) after repaying the loan within a certain period.
  • Key Features:
    • The borrower transfers the property to the lender but retains the right to redeem the property.
    • It has a clear period for repayment (within the mortgage deed).
    • If the borrower defaults, the lender may foreclose on the property.

4. Usufructuary Mortgage

  • Definition: Under a usufructuary mortgage, the borrower transfers possession of the property to the lender, who can enjoy the income or benefits (usufruct) from the property. The lender can retain possession until the debt is repaid but does not have the right to sell the property.
  • Key Features:
    • The lender receives income from the property (e.g., rent).
    • No personal liability for the borrower if the income from the property is insufficient to repay the debt.
    • The lender holds the property until the loan is repaid, but cannot sell it.

5. Equitable Mortgage

  • Definition: An equitable mortgage is created by deposit of title deeds without a formal deed of mortgage. In this case, the borrower deposits the title deed (legal documents) of the property with the lender, creating an agreement of mortgage.
  • Key Features:
    • No physical transfer of property.
    • The title deed serves as security for the loan.
    • It is commonly used in India when the borrower cannot go through the legal formalities of a registered mortgage.

6. Reverse Mortgage

  • Definition: A reverse mortgage allows a borrower, typically an elderly homeowner, to receive payments based on the equity of their home. The homeowner continues to live in the home, and the loan is repaid when the borrower passes away or moves out of the house.
  • Key Features:
    • Generally available to senior citizens.
    • The borrower receives periodic payments from the lender.
    • The loan is repaid when the borrower dies, sells the property, or moves out permanently.

7. Tangible Mortgage

  • Definition: A tangible mortgage involves the borrower physically handing over the property or a tangible asset as security for the loan.
  • Key Features:
    • The property itself is handed over to the lender.
    • Used in cases involving tangible assets (real estate, jewelry, etc.).

8. Anomalous Mortgage

  • Definition: An anomalous mortgage is one that does not fall under any of the above categories but has characteristics of several types of mortgages. It could involve a mix of features from different mortgage types.
  • Key Features:
    • It is a hybrid of different mortgage types.
    • Its terms and conditions are specifically crafted to suit the requirements of the parties involved.

Conclusion

In essence, a mortgage serves as a form of security for a loan, allowing lenders to recover their funds by selling the mortgaged property if the borrower defaults. The different types of mortgages allow both lenders and borrowers to choose arrangements that best suit their needs, based on the level of risk and control desired. Each type has its unique characteristics and legal implications, making it important for individuals and businesses to understand which type of mortgage suits their specific financial situation.

QUESTION-4- Write a critical note on Inter Corporate Loans and Investments.

Critical Note on Inter-Corporate Loans and Investments

Introduction

Inter-corporate loans and investments refer to financial transactions between two or more companies, where one company lends funds to another or invests in its shares or debentures. These transactions are common in the corporate world, where business groups, parent companies, subsidiaries, or affiliated companies engage in lending and investing activities to strengthen their financial position, promote growth, and optimize resources.

However, while inter-corporate loans and investments can offer significant benefits, they also raise concerns, especially in terms of financial transparency, governance, and legal compliance. In this note, we will critically examine the concept, its significance, regulatory framework, and potential challenges associated with inter-corporate loans and investments.

Concept and Significance

  1. Inter-Corporate Loans: These refer to loans provided by one company to another, typically within the same group or among related parties. These loans may be short-term or long-term and can be unsecured or secured by assets.
  2. Inter-Corporate Investments: These involve the purchase of shares, debentures, or other financial instruments issued by another company. Companies engage in investments as a means of expanding their business portfolio, earning returns, or securing influence over other companies.

Significance:

  • Liquidity Management: Inter-corporate loans help companies with liquidity issues by providing short-term financial support.
  • Strategic Control: Investments allow a company to gain a controlling stake or influence over another company, which could be valuable for long-term strategic purposes.
  • Profit Generation: Companies can earn interest from loans or dividends and capital gains from their investments.
  • Diversification: Inter-corporate investments enable companies to diversify their operations and spread business risks across different industries or sectors.

Regulatory Framework in India

The Companies Act, 2013, provides the legal framework for regulating inter-corporate loans and investments in India. The following provisions are relevant in this context:

  1. Section 185 – Loans to Directors, etc.
    • Under Section 185, a company is prohibited from providing loans or advances to its directors or to entities in which the director has an interest, except in certain prescribed conditions.
    • This provision ensures that the use of company funds is not misused for personal gains of directors and prevents conflicts of interest.
  2. Section 186 – Loans and Investments by Companies
    • Section 186 regulates loans, guarantees, and investments made by companies in other entities.
    • It requires approval from the board of directors and, in some cases, from shareholders through a special resolution.
    • The section also limits the amount a company can invest in other entities, ensuring the company does not overexpose itself to financial risks.
  3. Section 188 – Related Party Transactions
    • This section regulates transactions between related parties, including loans and investments. Related party transactions require approval from the board and, in some cases, from shareholders.
    • It aims to prevent the misuse of company funds for the benefit of related parties at the expense of the company and its shareholders.
  4. Reserve Bank of India (RBI) Guidelines
    • RBI also issues guidelines on inter-corporate loans and investments in the context of non-banking financial companies (NBFCs) and banks, especially on the limits and disclosures that need to be followed.
    • The regulations seek to minimize risks arising from loans and investments made to unrelated entities or entities with poor credit ratings.

Advantages of Inter-Corporate Loans and Investments

  1. Capital Efficiency: By providing loans to affiliated companies or related entities, a company can generate interest income while helping these entities meet their funding needs without requiring external borrowing.
  2. Strategic Alliances: Investments in other companies may help strengthen relationships within business groups or industries. Strategic investments can allow for better control over key industry players, which could be crucial in a competitive market.
  3. Risk Diversification: Inter-corporate investments in different sectors or industries provide a mechanism for diversification, reducing the impact of downturns in any single industry.
  4. Tax Benefits: Depending on the structure of the loans and investments, companies may benefit from favorable tax treatment on interest income, dividends, or capital gains.
  5. Improved Market Position: Loans and investments can help companies gain market share and influence, either by supporting a struggling subsidiary or gaining control over another company.

Challenges and Risks

  1. Misuse of Funds: A major concern with inter-corporate loans and investments is the potential misuse of funds, especially when transactions occur between related parties. This can result in the diversion of resources for non-business purposes, harming the financial health of the lending company.
  2. Conflict of Interest: Loans and investments between related companies or affiliates could lead to conflicts of interest. If not properly regulated, it may lead to situations where a company prioritizes the interests of related parties over those of its shareholders or creditors.
  3. Overexposure to Financial Risk: Excessive lending to or investment in a single entity or group of companies can increase a company’s financial risk. This becomes particularly problematic if the borrowing company is struggling financially or if there is a market downturn that affects the value of investments.
  4. Transparency Issues: Inter-corporate loans and investments, especially those involving related parties, can sometimes lack transparency. If the terms of these transactions are not properly disclosed, it can mislead investors and other stakeholders, impacting the company’s reputation and trust.
  5. Regulatory Non-Compliance: Failure to comply with the regulatory provisions of the Companies Act, 2013, and other relevant laws can lead to legal repercussions, penalties, and reputational damage. Many companies may overlook regulatory compliance, either due to ignorance or a desire to expedite the transactions.
  6. Liquidity Concerns: While inter-corporate loans can improve liquidity for subsidiaries or affiliated companies, they could strain the liquidity position of the lending company if the loans are not repaid on time. This can lead to a chain of liquidity issues for the parent company, especially if there are multiple unpaid loans.

Case Law Analysis and Examples

  1. Sterlite Industries (India) Ltd. v. SEBI (2011):
    • In this case, the Securities and Exchange Board of India (SEBI) investigated the inter-corporate loans made by Sterlite Industries and other group companies, emphasizing the need for full disclosure and adherence to regulations. SEBI held that failing to disclose such transactions could mislead investors about the financial position of the companies involved.
  2. Sahara India Real Estate Corporation Ltd. v. SEBI (2012):
    • The Supreme Court dealt with issues related to unauthorized issuance of bonds and investments made by Sahara India to its subsidiaries. The case highlighted the risk of misuse in inter-corporate transactions and stressed the importance of strict compliance with the regulatory framework governing such transactions.

Conclusion

Inter-corporate loans and investments are critical for fostering growth, capital efficiency, and strategic development in the corporate world. However, without proper governance, transparency, and regulatory oversight, these transactions can lead to significant financial risks, conflicts of interest, and legal complications. Companies must ensure that their inter-corporate loans and investments are made with due diligence, comply with all applicable regulations, and are subject to proper internal controls to safeguard shareholder interests and ensure long-term financial stability.

QUESTION-5-What si debenture? What are the different kinds of debentures that may be issued by a company?

Debenture: Definition and Types

Definition of a Debenture

A debenture is a debt instrument issued by a company to raise long-term capital. It represents a loan taken by the company from the public or institutional investors. The company promises to repay the principal amount at a specified maturity date along with periodic interest payments, which are usually fixed. Debentures are governed by the provisions of the Companies Act, 2013, and are considered a critical component of a company’s capital structure.

A debenture is typically documented through a debenture certificate, and it may or may not have security attached to it. Unlike shares, debenture holders do not have ownership rights in the company but are creditors entitled to fixed returns.

Key Features of a Debenture

  1. Debt Instrument: Debentures represent borrowed funds and must be repaid.
  2. Fixed Interest: Interest is paid periodically, often at a fixed rate.
  3. No Ownership Rights: Debenture holders are creditors, not shareholders.
  4. Transferability: Debentures are transferable instruments and can be traded on secondary markets.
  5. Tenure: They have a fixed maturity period.

Types of Debentures

The types of debentures a company can issue are classified based on security, tenure, convertibility, registration, and priority.

1. Based on Security

  1. Secured Debentures:
    • These are backed by specific assets of the company as collateral. If the company defaults, the debenture holders can claim the secured assets.
    • Example: Mortgage debentures where land or building is pledged.
  2. Unsecured Debentures:
    • These are not backed by any collateral. The repayment relies solely on the creditworthiness and financial stability of the issuing company.

2. Based on Tenure

  1. Redeemable Debentures:
    • These are repayable by the company at the end of a specified period or earlier, as per the terms.
    • Most companies issue redeemable debentures to ensure that debt is cleared over time.
  2. Irredeemable (Perpetual) Debentures:
    • These have no fixed maturity period and are not repayable during the lifetime of the company. The repayment occurs only upon the company’s liquidation.
    • These are rare due to potential regulatory and financial implications.

3. Based on Convertibility

  1. Convertible Debentures:
    • Holders have the option to convert their debentures into equity shares of the company after a specified period.
    • Fully Convertible Debentures (FCDs): Entire debenture amount is converted into equity shares.
    • Partly Convertible Debentures (PCDs): A part of the debenture is converted into equity, while the remaining continues as debt.
  2. Non-Convertible Debentures (NCDs):
    • These cannot be converted into equity shares and remain as debt instruments until maturity. They typically offer higher interest rates than convertible debentures.

4. Based on Registration

  1. Registered Debentures:
    • The details of the debenture holders are registered with the company. Transfer of ownership requires informing the company.
    • Ensures better security but limits liquidity due to procedural transfer requirements.
  2. Bearer Debentures:
    • These are transferable by mere delivery without the need for registration. The holder is considered the owner.
    • These debentures offer higher liquidity but pose risks such as loss or theft.

5. Based on Priority

  1. First Mortgage Debentures:
    • Holders have the first charge on the assets pledged as security.
  2. Second Mortgage Debentures:
    • Holders have a secondary charge on the assets, meaning they are repaid only after the claims of the first mortgage debenture holders are satisfied.

6. Other Types

  1. Zero-Coupon Debentures (ZCDs):
    • These do not carry any periodic interest. Instead, they are issued at a discount and redeemed at face value upon maturity.
    • Example: A debenture issued for ₹900 but redeemed for ₹1,000 after 5 years.
  2. Callable Debentures:
    • These can be redeemed by the company before their maturity date. It provides flexibility to the company to reduce debt when conditions are favorable.
  3. Puttable Debentures:
    • Holders have the right to demand early redemption before maturity under certain conditions.
  4. Subordinated Debentures:
    • These rank lower in priority than other debts. In the event of liquidation, these are repaid after senior debts are cleared.

Provisions Under Companies Act, 2013

  1. Section 71:
    • Governs the issuance of debentures, including the appointment of debenture trustees for secured debentures.
    • Requires companies to create a debenture redemption reserve (DRR) to ensure repayment.
  2. SEBI Guidelines:
    • Publicly listed companies must comply with additional SEBI regulations, including disclosures in the prospectus.

Conclusion

Debentures are a vital source of corporate financing, providing flexibility and options for both companies and investors. The type of debenture issued depends on the company’s financial needs, market conditions, and investor preferences. While debentures offer stable returns for investors, they also come with risks, especially in the case of unsecured or subordinated debentures. Companies must ensure compliance with legal provisions to maintain transparency and trust among stakeholders.

Question-6- What is Creation of Charge ? Explain Fixed and Floating charge with the help of decided cases.

Creation of Charge: Definition and Overview

The term “creation of charge” refers to the process by which a company secures its financial obligations by providing its assets as collateral. A charge is a form of security interest created on the company’s property or assets, enabling lenders to recover their dues in case of default. The creation of a charge is governed under the Companies Act, 2013, particularly Section 77 and related provisions.

A charge can be created voluntarily by the company, often for securing loans or other credit facilities, and must be registered with the Registrar of Companies (RoC) within a prescribed timeline to ensure enforceability against third parties.

Key Provisions of the Companies Act, 2013

  1. Section 77:
    • A company must register charges (other than charges on its own property) with the RoC within 30 days of creation.
    • The registration protects the lender’s rights in the event of liquidation or insolvency.
  2. Section 78:
    • If the company fails to register a charge, the lender (chargeholder) can independently apply for registration.
  3. Section 79:
    • Provides a timeline extension for charge registration with additional fees if there are delays.
  4. Section 84:
    • Covers the requirement to maintain a register of charges.

Types of Charges

Charges are broadly categorized as fixed charges and floating charges, depending on their nature and the type of asset they secure.

1. Fixed Charge

A fixed charge is created on specific, identifiable, and immovable assets such as land, buildings, or machinery. Once a fixed charge is created, the company cannot sell, transfer, or dispose of the asset without the lender’s consent unless the loan is repaid.

Key Characteristics of a Fixed Charge
  • It applies to specific assets only.
  • The asset under a fixed charge is static and not consumed or replaced during business operations.
  • Provides a high degree of security to creditors.
Example of a Fixed Charge

If a company takes a loan from a bank and pledges its office building as collateral, the bank holds a fixed charge on that building.

Case Law Example

Illingworth v. Houldsworth (1904)

  • A fixed charge was defined as a security attached to a specific property from the time the charge is created.
  • The court emphasized that the asset remains under the control of the lender, preventing its sale without consent.

2. Floating Charge

A floating charge is created over a class of assets, usually current or fluctuating assets such as inventory, receivables, and stock. Unlike a fixed charge, the company is free to deal with the assets in the ordinary course of business until an event of default or crystallization occurs.

Key Characteristics of a Floating Charge
  • It covers a pool of changing assets.
  • The charge “floats” over the assets until it crystallizes (e.g., on default, liquidation, or a specific event).
  • Allows operational flexibility for the company.
Example of a Floating Charge

A bank may create a floating charge on a company’s inventory and receivables, which fluctuate as the company conducts its operations.

Crystallization of Floating Charge

The floating charge becomes fixed in specific circumstances, such as:

  • Non-repayment of loans.
  • Appointment of a liquidator or receiver.
  • Insolvency proceedings.
Case Law Example

Re Yorkshire Woolcombers Association (1903)

  • The court defined a floating charge as one that hovers over a class of assets and remains dormant until a specific triggering event occurs.
  • It also emphasized that such a charge allows the company to use the assets in its day-to-day operations until crystallization.

Key Differences Between Fixed and Floating Charges

AspectFixed ChargeFloating Charge
Asset TypeSpecific, identifiable assets.Fluctuating pool of assets.
Control Over AssetsCompany cannot sell or dispose of assets.Company can deal with assets until default.
Security LevelHigh security for creditors.Lower security until crystallization.
ExamplesLand, buildings, machinery.Stock, receivables, inventory.

Significance of Registration of Charges

The registration of charges is crucial to:

  1. Ensure transparency in a company’s financial dealings.
  2. Provide legal protection to creditors.
  3. Prioritize claims in case of insolvency or liquidation.

Failure to register a charge may render it invalid against other creditors or a liquidator.

Importance in the Corporate World

  1. For Companies:
    • Enables borrowing against assets while retaining ownership.
    • Facilitates flexible credit arrangements with floating charges.
  2. For Creditors:
    • Provides assurance of repayment.
    • Establishes priority in claim settlement during insolvency.

Conclusion

The creation of charges, particularly fixed and floating charges, plays a critical role in securing corporate borrowings. While fixed charges ensure strong security over static assets, floating charges provide flexibility to companies over dynamic assets. Compliance with legal requirements, including registration, is essential to safeguard the rights of all stakeholders.

Question- 7- Loan and Investment are the important functions of a corporate body. Discuss the various provisions regard.

Loan and Investment: Key Functions of a Corporate Body

Loans and investments are critical functions of a corporate body, enabling efficient utilization of funds, strategic growth, and expansion. Under Indian corporate law, these activities are regulated to ensure transparency, accountability, and financial stability. The Companies Act, 2013 provides a comprehensive framework for governing loans and investments made by companies.

Provisions Regarding Loans and Investments under the Companies Act, 2013

1. Section 179: Powers of the Board

The board of directors has the authority to:

  • Approve loans and investments.
  • Borrow funds within the limits prescribed by the company’s Articles of Association (AOA).

Decisions related to loans and investments must be made in board meetings, ensuring due diligence.

2. Section 186: Loans, Investments, and Guarantees

This section outlines the provisions related to loans, guarantees, and investments made by a company.

Limits on Loans and Investments
  • A company cannot provide loans, guarantees, or make investments exceeding 60% of its paid-up share capital, free reserves, and securities premium, or 100% of its free reserves and securities premium, whichever is higher.
  • Any loan or investment exceeding these limits requires approval through a special resolution passed in a general meeting.
Disclosures and Approvals
  • The company must disclose the purpose of the loan or investment.
  • Prior approval of the public financial institution (if applicable) is required.
Exemptions

The restrictions under Section 186 do not apply to:

  • Banking and insurance companies.
  • Loans or guarantees provided by companies to wholly-owned subsidiaries.
Register of Loans

A company must maintain a register of loans, guarantees, and investments in the prescribed form. This register should be kept at the company’s registered office and must be available for inspection.

Key Provisions
  • A company cannot directly or indirectly advance loans to its directors or provide guarantees or securities for loans taken by its directors or relatives.
  • However, loans to managing or whole-time directors are allowed if:
    • The loan is part of a service scheme approved by the members.
    • The loan is given by a company whose principal business is lending.
Penalties for Non-Compliance
  • The company and the director may be fined heavily for non-compliance.
  • The fine for the company ranges between ₹5 lakhs and ₹25 lakhs. Directors may face a fine or imprisonment.

Loans and investments made with related parties must comply with the provisions of Section 188. This ensures that transactions are conducted fairly and at arm’s length to prevent misuse of corporate funds.

Purpose and Benefits of Loans and Investments

Loans and investments serve as tools for achieving strategic objectives. Their significance lies in:

1. Supporting Business Expansion

Corporate loans help fund new projects, mergers, or acquisitions, thereby expanding the company’s market presence.

2. Enhancing Liquidity

Short-term loans or investments in liquid assets improve the company’s cash flow and operational efficiency.

3. Generating Returns

Investing surplus funds in profitable ventures or securities provides an additional source of income.

4. Strengthening Business Relationships

Inter-corporate loans and investments can foster alliances, enabling mutual growth among businesses.

Case Studies and Judicial Interpretations

  1. Tata Motors Limited v. Registrar of Companies (2019)
    • The court ruled on the compliance of Tata Motors’ investments with Section 186, emphasizing the importance of maintaining a proper register and obtaining prior approvals.
  2. Reliance Industries Limited v. SEBI (2020)
    • SEBI investigated loans given by Reliance to its subsidiaries, reinforcing that all loans and investments must align with corporate governance norms.

Penalties for Non-Compliance

Failure to comply with the provisions of the Companies Act regarding loans and investments attracts penalties, including:

  • Monetary fines for the company and its officers.
  • Disqualification of directors in case of repeated violations.
  • Reputational damage to the company.

Conclusion

Loans and investments are vital for a company’s growth and financial health, enabling efficient utilization of resources and fostering strategic expansion. However, these functions must be carried out in strict compliance with the provisions of the Companies Act, 2013. Companies must exercise due diligence, seek necessary approvals, and maintain transparency to avoid legal and financial consequences.

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