Power to Borrow and Issue Debentures by a Company

This article discusses in detail the provisions providing power to the companies to burrow. This also discusses the procedure of issuing debentures by a Company.
Estimated Reading Time: 12 minutes

Introduction

To run a business effectively/successfully, adequate amount of capital is necessary. In some cases, capital arranged through internal resources is not adequate and the organization is resorted to external resources of arranging capital i.e., External Commercial borrowing (ECB), Debentures, Bank Loan, and Public Fixed Deposits etc.  Thus, borrowing is a mechanism used whereby the money is arranged through external resources with an implied or expressed intention of returning money. This article will discuss the power of a company to borrow and issue debentures.

Power of Company to Borrow

The power of the company to borrow is exercised by its directors, who cannot borrow more than the sum authorized.  The power to borrow money and issue debentures can only be exercised by the Directors at a duly convened meeting. Pursuant to Section 179(3)(c) & (d) directors have to pass resolution at a duly convened Board Meeting to borrow money. The power to issue debentures cannot be delegated by the Board of directors. However, the power to borrow monies can, be delegated by a resolution passed at a duly convened meeting of the directors to a committee of directors, managing director, manager, or any other principal officer of the company.

The resolution must specify the total amount up to which the moneys may be borrowed by the delegates. Often the power of the company to borrow is unrestricted, but the authority of the directors acting as its agents is limited to a certain extent. For example, Section 180 (1)(c) of the Act prohibits the Board of directors of a company from borrowing a sum which together with the monies already borrowed exceeds the aggregate of the paid-up share capital of the company and its free reserves apart from temporary loans obtained from the company’s bankers in the ordinary course of business unless they have received the prior sanction of the company by a special resolution in general meeting.

Temporary loans

Explanation to section 180(1)(c) provides that the expression “temporary loans” means loans repayable on demand or within six months from the date of the loan such as short-term, cash credit arrangements, the discounting of bills and the issue of other short-term loans of a seasonal character but does not include loans raised for financial expenditure of a capital nature. [1]

It is further provided in proviso to Section 180(1)(c) that the acceptance by a banking company, in the ordinary course of its business, of deposits of money from the public, repayable on demand or otherwise, and withdraw able by cheques, draft, order or otherwise, shall not be deemed to be borrowing of monies by the banking company within the meaning of clause (c) of Sub-section (1) of Section 180. It is important at this stage to distinguish between, borrowing which is ultra vires the company and borrowing which is intra vires the company but outside the scope of the director’s authority.

The provisions of Sub-section (5) of Section 180 lay down that debts incurred more than the limit fixed by clause (c) of Sub-section (1) shall not be valid unless the lender proves that he lent his money in good faith and without knowledge of the limit imposed by Sub-section (1) being exceeded. 

Exemption to private companies

With recent exemption notification no. 464 (E) private companies have been exempted in the entire provisions of Section 180 of the Companies Act 2013, resultantly special resolution is not required to exercise powers under section 180 for private companies.

Unauthorized Borrowing

Where a company borrows without the authority conferred on it by the articles or beyond the amount set out in the Articles, it is an ultra vires borrowing. Any act which is ultra vires the company is void. In such a case the contract is void and the lender cannot sue the company for the return of the loan. The securities given for such ultra-vires borrowing are also void and inoperative. Ultra vires borrowings cannot even be ratified by a resolution passed by the company in general meeting.

However, equity assists the lender where the common law fails to do so. If the lender has parted with his money to the company under an ultra vires borrowing, and is, therefore, unable to sue for its return, or enforce any security granted to him, he nevertheless has, in equity, the following remedies:

  • Injunction and Recovery: Under the equitable doctrine of restitution, he can obtain an injunction provided he can trace and identify the money lent, and any property which the company has bought with it. Even if the monies advanced by the lender cannot be traced, the lender can claim repayment if it can be proved that the company has been benefited thereby.
  • Subrogation: Where the money of an ultra vires borrowing has been used to pay off lawful debts of the company, he would be subrogated to the position of the creditor paid off and to that extent would have the right to recover his loan from the company. Subrogation is allowed for the simple reason that when a lawful debt has been paid off with an ultra vires loan, the total indebtedness of the company remains the same. By subrogating the ultra vires lender, the Court can protect him from loss, while debt burden of the company is in no way increased.
  • Suit against Directors: In case of ultra vires borrowing, the lender may be able to sue the directors for breach of warranty of authority, especially if the directors deliberately misrepresented their authority.[2]

Outside the Scope of Agents’ Authority

A distinction should always be made between a company’s borrowing powers and the authority of the directors to borrow. Where the directors borrowed money beyond their authority and the borrowing is not ultra vires the company, such borrowing is called Intra vires borrowing but outside the Scope of Agents’ Authority. The company will be liable to such borrowing if the borrowing is within the directors’ ostensible authority and the lender acted in good faith or if the transaction was ratified by the company.  

Where the borrowing is intra vires the company but outside the authority of the directors e.g., where the articles provide that the directors shall have the power only up to Rs. 100 lakhs and prior approval of the shareholders would be required to borrow beyond Rs. 100 lakhs; any borrowing beyond Rs.100 lakhs without shareholders’ approval i.e., intra vires borrowing by the company but outside the authority of directors can be ratified by the company and become binding on the company. The company would be liable, particularly if the money has been used for the benefit of the company. Here the legal position is quite clear.

The company has power or capacity to borrow, but the authority of the directors is restricted either by the articles of the company or by the statute, and they have exceeded it. The company may, if it wishes, ratify the agent’s act in which case the loan binds the company and the lender as if it had been made with company’s authority in the first place.

On the other hand, the company may refuse to ratify the agent’s act. Here the normal principles of agency apply. The doctrine of Indoor Management also known as rule in Royal British Bank v. Turquand[3]  shall protect the lender, provided he can establish that he advanced the money in good faith. [4]

Case Laws

Relating to borrowing power of a company

  • Sinclain v. Brougham (1914)[5]

The behavior of the directors, as the company’s agents, can have no effect whatsoever on the validity of the loan for no agent can have more capacity than his principal. No agent can have a power which is not with the principal. If, therefore, the borrowing is ultra vires the company so that the company has no capacity to undertake it, the lender can have no rights at common law. No debt is created and any security which may have been created in respect of the borrowing is also void.

The lender cannot sue the company for the repayment of the loan. If the borrowing by the directors is ultra vires their powers, the directors may, in certain circumstances, be personally liable for damages to the lender, on the ground of the implied warranty given by them that they had power to borrow. Sometimes it happens that a power to borrow exists but is restricted to a stated amount, in such a case if by a single transaction an amount in excess is borrowed; only the excess would be ultra vires and not the whole transaction[6]

  • V.K.R.S.T Firm v. Oriental Investment Trust Ltd.[7]

In this case, under the authority of the company, its managing director borrowed large sums of money and misappropriated it. The company was held liable stating that where the borrowing is within the powers of the company, the lender will not be prejudiced simply because its officer has applied the loan to unauthorized activities provided the lender did not know about the intended misuse.

  • T.R. Pratt. Ltd. v. E.D. Sassoon and Co. Ltd.[8]

In this case, there was no limit on the borrowing for business in the memorandum of the company. But the directors could not borrow beyond the limit of the issued share capital of the company without the sanction of the general meeting. The directors borrowed money from the plaintiff beyond their powers. It was held that the money having been borrowed and used for the benefit of the principal either in paying its debts, or for its debts, or for its legitimate business, the company cannot repudiate its liability on the ground that the agent had no authority from the company to borrow. When these facts are established a claim on the footing of money had been received would be maintainable.

It was also held that under the general principle of law when an agent borrows money for a principal without the authority of the principal, but if the principal takes benefit of the money so borrowed or when the money so borrowed have gone into the coffers of the principal, the law implies a promise to repay. In that connection it was observed that there appears to be nothing in law which makes this principle inapplicable to the case of a joint stock company and even in cases where the directors or the managing agent had borrowed money without there being authorization for the company, if it has been used for the benefit of the company, the company cannot repudiate its liability to pay.

  • Krishnan Kumar Rohatgi and Others v. State Bank of India and Others[9]

Here, the company borrowed an amount of Rs. 5 lakhs from the Bank under a Promissory Note. The repayment was guaranteed by a person by executing a guarantee in favor of the company. The company used to make payments towards loan and the promissory note used to be renewed from time to time. In the suit for recovery, the company contended that the pro-note was executed by the Chairman without there being a resolution of the Board of directors authorizing the Chairman to execute the pro-note as required under Section 292(1)(c) of the Act,1956 [Corresponds to section 179(1)(d) of the Companies Act, 2013].

Rejecting these contentions, the Patna High Court held that in cases where the directors borrow funds without their having authorization from the company and if the money has been used for the benefit of the company, the company cannot repudiate its liability to repay. Under the general principles of law, when an agent borrows money for a principal without the authority of the principal, but the principal takes the benefit of the money so borrowed or when the money so borrowed has gone into the coffers of the principal, the law implies a promise to be paid by the principal.

Modes of Raising Finance

A company uses various kinds of borrowing to finance its operations. The various types of borrowings can generally be categorized as follows:

  1. Long Terms Borrowings – Funds borrowed for a period ranging for five years or more are termed as long-term borrowings. A long-term borrowing is made for getting a new project financed or for making big capital investment etc. Generally Long-term borrowing is made against charge on fixed Assets of the company. 
  2. Short Term Borrowings – Funds needed to be borrowed for a short period say for a period up to one year or so are termed as short-term borrowings. This is made to meet the working capital need of the company. Short term borrowing is generally made on hypothecation of stock and debtors. 
  3. Medium Term Borrowings – Where the funds to be borrowed are for a period ranging from two to five years, such borrowings are termed as medium-term borrowings. The commercial banks normally finance purchase of land, machinery, vehicles etc.
  4. Secured/unsecured borrowing – A debt obligation is considered secured if creditors have recourse to the assets of the company on a proprietary basis or otherwise ahead of general claims against the company. 
  5. Unsecured debts comprise financial obligations, where creditors do not have recourse to the assets of the company to satisfy their claims.
  6. Syndicated borrowing – if a borrower requires a large or sophisticated borrowing facility this is commonly provided by a group of lenders known as a syndicate under a syndicated loan agreement. The borrower uses one agreement covering the whole group of banks and different types of facility rather than entering into a series of separate loans, each with different terms and conditions.
  7. Bilateral borrowing – It refers to a borrowing made by a company from a particular bank/financial institution. In this type of borrowing, there is a single contract between the company and the borrower. 
  8. Private borrowing comprises bank-loan type obligations whereby the company takes loan from a bank/financial Institution.   
  9. Public borrowing is a general definition covering all financial instruments that are freely tradable on a public exchange or over the counter, with few if any restrictions i.e., Debentures, Bonds etc.

Debentures

According to Section 2(30) of Companies Act, 2013, “debenture” includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not.

Further it is provided that—

  • the instruments referred to in Chapter III-D of the Reserve Bank of India Act, 1934; and
  • Such other instrument, as may be prescribed by the Central Government in consultation with the Reserve Bank of India, issued by a company, shall not be treated as debenture. Different types of debentures can be classified on the basis of – Security, Tenure, Convertibility, Coupon rate and Registration.

Procedure to Issue Debentures under the Companies Act, 2013

  • Call and hold Board meeting and decide which types of the debenture will be issued by the Company.
  • If the Company decides to issue secured debenture the company has to comply with the condition prescribed in the Rule 18 of the Companies (Share Capital & Debentures) Rules, 2014.
  • In case appointment of Debenture Trustee, consent shall be obtained from a SEBI registered Debenture Trustee, who is proposed to be appointed. If debentures to be issued are Secured Debentures, a Debenture Trust Deed in Form No. SH – 12 or as near thereto as possible shall be executed by the Company in favor of Debenture Trustees within sixty days of allotment of Debentures.
  • In the Board meeting pass resolutions for i) Approval of Offer letter for private placement in Form No. PAS – 4 and Application Forms (In case of private placement of debentures); ii) Approval of Form No. PAS – 5 (In case of private placement of debentures); iii) Approval of Debenture Trustee Agreement and appointment of a Debenture Trustee (In case of Secured Debentures only); iv) Appointment of an expert for valuation (In case of private placement of debentures); v) Approval of increase of borrowing powers, if required; vi) To authorize for creation of charge on the assets of the company; vii) Approve the Debenture Subscription Agreement; viii) To fix day, date and time for the extraordinary general meeting of shareholders.
  • Prepare the draft of i) Debenture Subscription Agreement; ii) Offer Letter for private placement in Form No. PAS – 4 and Application Forms; iii) Records of a private placement offer in Form No. PAS – 5; iv) Debenture Trustee Agreement; v) Mortgage Agreement for creation of charge on assets of the company.
  • Issue notices of extraordinary general meeting along with the explanatory statement.
  • Hold extraordinary general meeting and pass special resolution to issue convertible secured debentures and increase borrowing powers of the company and to authorize the Board to create charge on the assets of the company.
  • File Form No. PAS – 4 and PAS – 5 in Form No. GNL – 2 with the Registrar of Companies.
  • File Offer Letter in Form No. MGT – 14 with the Registrar of the Companies.
  • File copy of Board resolutions, Special Resolution, Debenture Subscription Agreement, Debenture Trustee Agreement etc. in Form No. MGT – 14 with the Registrar of Companies.
  • File Form No. PAS – 3 (Return of allotment) with the Registrar of Companies after making allotment of debentures.
  • File Form No CHG – 9 for creation of charge on assets of the Company.[10]

Issue of Debentures, whether redeemable or convertible involves compliance with the substantive and procedural aspects of law, therefore, documentation becomes very important.

Conclusion

There is more than one way to fund a new business venture and fuel its growth. For almost all, it is going to require bringing in outside money at some point. The above monograph depicts about raising finance


[1] Corporate Law Commentary, LexisNexis

[2] WWW.ICSI.EDU/PORTALS

[3] (1856) CI & B 327)

[4] The Doctrine of Indoor Management

[5] [1914] Ac 398

[6] Deonarayan Prasad Bhadani V. Bank of Baroda, (1957) 27 Com Cases 223 (Bom)

[7] AIR 1944 Mad 532

[8] AIR 1936 Bom 62

[9] (1980) 50 Comp Cas 722

[10] LINKEDIN/CYRIL AMARCHAND COLUMNS

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