Applicability of Debenture Redemption Reserve

Ashish M. Shaji

24 Apr, 2021

Debenture Redemption Reserve is a fund maintained by the companies that have issued debentures. It aims to minimize the risk of default on repayment of debentures. DRR ensures that the funds are available for meeting obligations towards debenture holders. Let’s discuss more about DRR.

Components of Debenture Redemption Reserve

There are two components of DRR. The first component is setting aside a portion of the profit. Profit allocation is done in a process called earmarking of funds. It ensures that adequate profits are accessible for repayment of debentures. The second component involves funds investment. It ensures that the company has adequate liquidity to make repayment.

Purpose and Uniqueness

Companies that have borrowed money through debentures might not have funds to make repayment. With a view to minimize the chances of default, the government introduced the DRR concept in 2000. The main reason for default includes lack of profitability and lack of liquidity.

In order to address these concerns, the concept of DRR provides for two requirements-

• Each year, a portion of the profit is earmarked for transfer to the Debenture Redemption Reserve. The earmarked amount can’t be used until repayment of debentures is made. The effect of this is that the dividend available to shareholders is reduced. When dividends is lowered, enough funds are retained in the company to allow a future settlement to debenture holders. Therefore the chance of default from the company due to profitability issues is reduced.
• Each year, investments are purchased for an amount equivalent to the transfer made to the DRR. Only securities approved by the government may be purchased for investments. The investments can’t be sold for any purpose apart from meeting liability towards the debenture holders. The effect of this is that a part of the assets of the company is reserved for repaying the debenture liability. Therefore the chance of default from the company due to profitability issues is reduced.

A DRR ensures that the company sets aside a profit portion for repayment of long-term Non-Convertible Debentures out of its current profit. When a company that issued Non-Convertible Debentures either goes bankrupt or faces liquidity crunch, it usually defaults on its repayments. Hence DRR here proves to be of utmost importance as it reduces the investment risk for the buyer of debentures. Although a few companies issue secured debentures, a DRR can help them also as dues recovery by liquidating assets can take some amount of time.

Debenture Redemption Reserve-Applicability

All companies are required to maintain DRR except for the following:

• Public Financial Institutions (These are companies whose paid-up share capital is held by the Central Government to more than 51%.  Some of the examples include LIC, Infrastructure Development Finance Company, Industrial Development Bank of India, etc.)
• All India Financial Institutions (These are companies whose business is done under the RBI supervisions. Some of the examples include Export, Import bank of India, Small Industries Development Bank of India, and National Housing Bank).
•  Housing Finance Companies (The need to maintain a DRR shall be waived in case the company is registered with the National Housing Bank).
• Non-Banking Financial Companies (The need to maintain DRR shall be waived in case where the company is registered under Section 45-IA of the RBI Act, 1934).
• All scheduled banks (Schedules banks are banks specified in the second schedule of the RBI Act, 1934^[1]).
• Listed Companies.

According to section 71(4) read with the Rule 18 (1) (c) of the Companies (Share Capital and Debentures) Rules, 2014 provides every company that issues debentures to create a Debenture Redemption Reserve of 10% of outstanding value of debentures for the redemption of such debentures.

Certain class of companies as provided has to either deposit, prior to 30^th April every year, in a scheduled bank account, a sum of minimum 15% of the amount of its debenture maturing during the year ending on 31^st March next year or invest in one or more securities laid in rule 18 (1) (c) of SHA (DRF).

By virtue of the present amendment, it is critical to ascertain the applicability of creation of Debenture Redemption Reserve and Debenture Redemption Fund in terms of Companies Act 2013. The exemption with respect to DRR and DRF was applicable to listed companies in case of private placement. While Non-Banking Financial Companies continue to enjoy exemption (also in case of unlisted companies) pursuant to the present amendment Non-NBFCs listing NCDs shall not be eligible to avail the benefit of the said exemption and would be required to maintain DRR and DRF.

One can contend over the fact that the securities are listed though the company isn’t, and therefore the exemption extended to listed companies should be available equally to unlisted companies with listed securities.

 Conclusion

As stated earlier, DRR ensures that the company sets aside a profit portion for repayment of long-term Non-Convertible Debentures out of its current profit. When a company that issued Non-Convertible Debentures either goes bankrupt or faces a liquidity crunch, it usually defaults on its repayments. Hence Debenture Redemption Reserve here proves to be of utmost importance as it reduces the investment risk for the buyer of debentures.

Also, Read: Non Convertible Debentures (NCD) Issued by NBFC: A Complete Overview