DEBT CAPITAL BORROWING BY COMPANIES

Introduction

Most Companies like individuals require to borrow from time to time for the requirement of their business.

All companies registered under the Companies Act 2015 have an implied power to borrow for purposes incidental to their trade or business. A company formed under the earlier Act would have an implied power to borrow if its object is to carry on a trade or business. In delegating the company’s power to borrow to the directors, it is usual, and essential in the case of a company whose shares are quoted on the stock exchange, to impose a maximum limit on the borrowing arranged by directors.

The power of a company to borrow is exercised by the directors subject to the restrictions which may be placed by its articles of association or by the Companies Act. Sometimes the Articles of Association limits the powers of directors to a specific amount or a sum not exceeding a paid up capital.

Borrowing by a company may be 

• Intra-vires the company and directors
• A borrowing which is ultra-vires the company, or
• A borrowing which is intra-vires the company but ultra-vires the directors (beyond the scope of their authority)

Ultra-vires Borrowing

If a company borrows money beyond its express or implied powers, the borrowing is ultra -vires the company and is void. No debt is created and the securities given in respect thereof are inoperative and void and no ratification can render the debt valid.

A Company is said to resort to ultra vires borrowing if it exceeds the authority given to it in this respect by the Companies Act, and the Articles of the company.

Consequences of ultra-vires borrowing:

• Such loan is null and void and
• The loan does not create an actionable debt.
• No ratification can render the debt valid.
• The securities given in respect thereof are inoperative

Introductions Ltd. V. National Provincial bank Ltd

A company was formed with the main object of providing information and facilities to overseas visitors to the festival of Britain in 1951. The company later engaged in pig- breeding as its sole activity. For this purpose, it borrowed money from a bank which took debentures as security. The bank was given a copy of the memorandum of association and it knew that the only business being carried on by the company was pig- breeding.

It was held that the loan was for a purpose known to be ultra-vires and, therefore, the debentures were void.

Remedies available to lender

However, if the lender has acted in good faith that is without any knowledge that the company borrowed the money beyond its powers, he may have the following remedies:

 

• Injunction- If the company has not spent the money so borrowed; the lender may obtain an injunction order against the company restraining it from spending the amount and recover the same.
• Subrogation- If the money has been applied in paying off some debts of the company, he is entitled to step into the shoes of the creditors so paid off and can rank as a creditor of the company to the extent of the money so applied.

Neath Building Society. V. Luce

A building society borrowed money to pay off principle and interest due on a mortgage. The borrowing was ultra-vires.

It was held that the lenders were subrogated to the rights of the creditors who were paid off and could recover the amount from the company.

• Restitution– If the money has been invested in some particular asset, he may claim that asset, or if such asset cannot be ascertained he may claim that any increase in the assets as a result of such borrowing be restored to him in the event of a winding up.
• Suit for breach of warranty of authority– The lender may sue the directors personally for breach of implied warranty of authority and claim damages for the same.

If the fact that the borrowing was ultra-vires could have been discovered from the public documents of the company’s the lender cannot recover. He is deemed to know the contents of these documents public documents and thus cannot take the plea that he was misled by the warranty of the directors.

• Identification and tracking: – if the render can identify his money (this will be in the case where the money is still in the hands of the company in its original form), or any property purchased with it, he can claim the money or property purchased with it.

Borrowing ultr-vires the directors (inra-vires the company)

This occurs the borrowing is ultra-vires the directors but not the company. In such a case the borrowing can be ratified and thus be validated by the company. If the company ratifies the borrowing, then the loan binds both the lender and the company as if it had been made with the company’s authority in the first place. If the company refuses to ratify then the normal principles of agency and the rule of indoor management will apply as long as the lender proves that he lent the money in good faith and without notice.

When articles of association of company prescribes a particular procedure for doing a thing, the duty of carrying out the provision s lies on the person in charge of the management of the company. Outsiders are entitled to assume that the rules have been complied with. This is known as the Doctrine of indoor management or the Turquad Rule.

Debentures

The word debenture is derived from the Latin word “debere’’ meaning to owe.

There is no legal definition of a debenture. However, under sec 3 of the Companies Act: “Debenture”, in relation to a company, includes debenture stock, bonds and any other securities of a company (whether or not constituting a charge on the assets of the company);

 

In the words of Chitty J in Levy v Abercolis State and Slab (1887) 

“… I cannot find any precise legal definition of the term. It is neither in law or commerce and is a strictly technical term.”

 

In Edmonds v. Blaina Furnaces Co. Chitty J. said: “The term itself imports a debt – an acknowledgement of a debt – and generally, if not always, the instrument imports an obligation or covenant to pay. This obligation or covenant is in most cases at the present day accompanied by some charge or security.”

It can be said to be an acknowledgment in writing of a debt by a company to some person or persons by way of prospectus in much the same way as shares.

Any document which contains an acknowledgement of indebtness on the part of the company is a debenture for the purpose of the Act.

In modern commercial usage, the term debenture denotes the instruments issued by the company acknowledging indebtedness. However the term is generally used with reference to the instrument creating the transaction, the debt itself and an acknowledgement of indebtedness.

Debenture are therefore a form of security which may be bought and sold in much the same way as shares. In order to give the lenders security in case of non-payment of their loan, a charge is often made against the asset of the company.

Characteristics of debentures

 

• It is an instrument in writing. An oral promise in acknowledgement of a debt is not a debenture.
• It is an acknowledgement of the indebtedness of the company to its holder for the amount stated in it.
• It is one of a series of like debentures issued to a number of lenders. But a single debenture may be issued to a single individual. Thus a mortgage of a company’s property to a single individual as security is a debenture.
• It provides for the payment of a fixed sum with interest of a specified rate within a specified time. But this is not essential because a company may issue perpetual debentures.
• It is generally secured by a charge, fixed or floating on any part of the company’s property or undertaking. But this is, however, not an essential condition because debentures may or may not constitute a charge on the assets of the company.
• A debenture holder does not have any right to vote in the company’s meetings

 

Contents of a debenture

• Names of parties
• Statement of consideration
• Terms of repayment
• Rate of interest
• Obligations of the borrower e.g. to insure property and to provide accounts at stated intervals etc
• Events of default
• Powers of the lender following an event of default Types / classification of debentures

Debentures may be classified according to the following characteristics:- ▪ Negotiability

• Security
• Permanence
• Convertible
• Priority

Classification according to Negotiability

• Bearer debenture: This is a debenture issued to the holder. It vests upon the bearer. It is a negotiable instrument transferrable by the parties.
• Registered debentures: These are debentures issued to the registered holders. Such a debenture vests upon such person. It is transferable by the execution of an instrument of transfer by the parties

Classification according to Security

• Secured debentures: – Are debentures which contain a charge on the company’s assets which is enforceable by the lender in the event of default. Secured debentures may be secured by a fixed charge, floating charge or both fixed and floating charge.
• Unsecured or naked debentures:-These are debentures that have no securities. They do not create any charge on the assets of the company. The holders of such debenture are just like ordinary unsecured creditors of the company.

Classification according Permanence

• Redeemable debentures: – are the debentures which the company issues on condition that they shall be redeemed within the stipulated time in accordance with the terms of issue.
• Irredeemable debentures: – when debentures are irredeemable, they are called perpetual debentures. A debenture will be treated as irredeemable where either there is no fixed period for repayment of the principle amount or repayment of it is made conditional on the happening of an event which may not happen for an indefinite period or may happen only in certain specified events, e.g. winding up of the company

Classification according to Convertible

• Convertible debenture: This is a debenture which contains an option entitling the holder to convert his debt within a stipulated time into ordinary or preference shares of the company at the stated rates of exchange but not below the par value. These debentures are a hybrid between debentures and shares.

Issue of Debentures

Debentures are usually issued by a resolution of the board of directors under powers conferred by the company’s articles of association.

Such authority is however not required in the case of a trading company which has implied power to borrow money for the purposes of its business, and to give security for the loan by creating a mortgage or charge over its property.

Shares and Debentures

Differences between a share and a debenture

Shares	Debentures
A holder of a share is a member of a company and is entitled to voting rights	A debenture holder is not a member of the company and is not entitled to interfere in the company’s affairs
Shares may not be issued at  a discount	Debentures may be issued at  discount
A company may not purchase its own shares as it amounts to a reduction of capital	A company may purchase its own debentures
A share-holder is part owner of a company.	A debenture holder is a creditor of the company
Income on shares (dividend) is uncertain and depends on the director’s discretion	Income on debentures is fixed and certain whether or not a company has made profits or not.
In case of winding up shareholders can only obtain payment after all the outside creditors have been paid	In case of winding up debenture holders rank first for repayment

 

Similarities between a share and a debenture

• A debenture is usually one of a “series” or “class” which is similar to a “class” of shares.
• Debentures as well, as shares are long-term investments in the company and are transferable in the same manner.
• Debentures and shares may be issued in the same way through a prospectus issue.
• Debentures just like shares can be issued at par or at a premium or at a discount in exceptional circumstances
• Both shares and debentures may be redeemable if stated to be so redeemable.

Debenture stock

This means the borrowed capital consolidated into one mass. Instead of each lender having a separate bond, he is issued a certificate entitling him to a certain sum, being a portion of one large loan.

Advantages of debentures

• They have a lower cost to the company when compared to the cost of equity funds
• Debenture holders do not participate in sharing of extra ordinary income of the company since their earnings are restricted to fixed interest
• Debenture holders do not have voting rights. Therefore, the issue of debentures does not dilute the ownership and control of the company
• During periods of inflation, debentures issues benefit the company because its obligation of paying fixed interest and principal declines to real terms.
• Debenture interest is deductible when computing taxable profits whereas dividends are not
• Normally the interest rate is fixed and does not fluctuate with earnings.
• A debenture is easily traded and as the company issuing it is a public company, the trading will take place in the stock exchange
• The Companies Act requirements that affect debentures are more relaxed in a number of ways than those that affect shares. For instance there are no restrictions on a company purchasing its own debentures and debentures can be issued at a discount unlike shares
• Its terms are set out in the trust deed and are thus clear and specific so that a company can be certain of its obligations

Disadvantages of debentures

• Debenture issue results in a legal obligation of paying interest and principal which if not paid can result in liquidation
• The debenture issue increases the firms gearing/leverage position. This therefore reduces the firm’s ability to borrow future funds, that is, there is a limit on the extent to which debt funds can be raised.
• Debentures must be repaid at maturity and therefore at some point in time the company will incur a substantial cash outflow which may affect its liquidity position
• Debenture holders may put very restrictive provisions or covenants to the debt contract.
• Crystallization of floating charges can mean that the security is swiftly enforced. Given that the security will often be over the trading assets, enforcement can cause major problems for the company
• Payment of debenture interest is mandatory and not discretionary as it is with shares. The company must therefore consider whether this liability can be met
• Debenture holders’ remedies include the appointment of liquidator or receiver, which may have disastrous consequences on the company.

Register of Index of Debenture Holders

Under Section 573. (1) A company that allots debentures shall establish and maintain a register of debenture holders

If a company fails to comply with a requirement of this section, the company, and each officer of the company who is in default, commit an offence and on conviction are each liable to a fine not exceeding one million shillings.

Rules for the register

The register of the debenture will be kept at the company’s registered office ii) The register of debenture holders must contain the following particulars:

• The name, address and occupation if any of the debenture holder
• The debentures held by each holder distinguishing each debenture by its numbers and
• The amount paid or agreed to be considered as paid on those debentures

The date at which each holder ceased to be a debenture holder

N.B: If the number exceeds 50 debenture holders, a debenture holders’ register index must also be prepared unless the register of debenture holders is in such a form as itself to constitute an index.

Debenture Trust Deed

Debenture holders of a company, who are usually in large numbers, may not have the time to look after their interests in the property mortgaged or charged. They may, in order to protect their interests, appoint some persons (usually some from among them as trustees.

A trust deed in such a case is executed, conveying the property of the company to trustees. Under the terms of the deed, the company undertakes to pay to the debenture holders their principle and interest and normally charges its property to the trustees as security.

The trustees must act diligently in the discharge of their duties. Any clause in the trust deed which exempts them from liability for breach of their duty as trustees is void.

The trust deed contains the terms and conditions endorsed on the debentures and define the rights of debenture holders and the company.

This is a document issued by a company as a security whenever a series of debentures or debenture stocks are issued. It is an acknowledgement by the company that it is indebted to trustees on behalf of the debentures holders.

Contents of the Trust Deed

• A covenant by the company to pay the amount due for the debenture holders.
• A legal mortgage over the company asset’s vested in the trustees. – Type or nature of security given by the company.
• Methods of redemption.
• Circumstances in which the security is enforced.
• Meeting of debentures holders.
• Maintenance of the registers of debentures holders.
• Details of any sinking fund proposed by the company to provide for stock redemption.
• Power of the trustee to: o Take possession of the security. o Regulate its use. o Sell the security.

o Appoint a receiver or manager.

Advantages of a Trust Deed

• It compels the company to extend a legal mortgage over its assets to trustees. Persons who subsequently lend money to the company cannot gain priority over the company.
• It facilitates protection of security on behalf of all creditors. They can act expeditiously and effectively in safeguarding the interest of the debenture holders and enforcing the security on their behalf
• The company makes an additional covenant to pay the amount due to its creditors.
• The trustees act as watchdogs in seeing and insisting that the company’s obligations under the trust deed are carried out properly. they are for example empowered to see that the property is kept insured and properly maintained
• The trustees have the power to appoint a receiver or take possession of the property and carry on the business of the company in case of need
• Events are specified on the happening of which the principle money and interest shall be payable e.g. non-payment of interest or non-performance of the covenants in the deed. The appointment of the trustees, who are usually paid, ensures that there are definite persons whose duty is to take action on the happening of these stated events
• The company is given a number of powers over the property charged which it can exercise with the consent of trustees. E.g power of sale or lease of the property.
• In case of difficulty or doubt the trustees can convene meetings of debenture-holders to apprise them of the position and to enable them to discuss it and authorise the trustees to peruse any course of action beneficial to the debenture holders.

Liability of Trustees

Trustees for debenture holders owe the same duties to their beneficiaries as are owed by trustees in general.

A trustee is liable for any breach of trust where he fails to show the degree of care and diligence required of him as trustees, having regard to the provisions of the trust deed conferring on him any powers, authorities or discretions. Right to a copy of the trust deed

A registered debenture holder is entitled to a copy of a printed trust deed on payment of a prescribe amount.           

Charges Securing Debentures

Debentures may be issued either secured or unsecured by a charge on the property of the company.  A charge on the assets of a company given by a debenture or a trust deed may be either a specific (fixed) charge or a floating charge.

Fixed Charge

A charge is a “fixed charge” if it is a mortgage of ascertained or specific property such as plant and machinery, freehold or leasehold land, or uncalled capital. A fixed charge passé legal title to certain specific assets and a company loses the right to dispose of the said property. In other words, the company can transfer the property charged only subject to the charge i.e. the charge holder must first be paid whatever is due to him. In the event of winding up, of the company a debenture holder secured by a specific charge is the highest ranking class of creditors that is, that of secured creditors. The company cannot also dispose of it without the consent of the holders of the charge. Advantages of a Fixed Charge

• The value of the security is known.
• The chargee/lender is in a position to control usage of security. This enables him to prevent its wastage.
• The chargee has the power to appoint a receiver or manager in the event of default
• In the event of default the chargee is empowered to sell the security without judicial intervention.
• The lender or chargee has absolute priority.

Floating Charge

This is an equitable charge securing a debenture on the assets of a going concern. Its essence is that it remains dormant until the undertaking ceases to be going concern or some event occurs when it crystallizes.

In the words of Lord MacNaughten in Lillingworth V Houndsworth,

“A floating charge on the other hand is shifting in its nature, hovering over and so to speak floating with the property which it is intended to affect until some event occurs or some act is done which causes it to settle and fasten on the subject of the charge within its reach and grasp.”

Characteristics of a floating charge

These were laid down by Romer J in Revorkshire Wool Combers Association:

• It is a charge on a class of assets of the company both present and in future.
• The class of assets must be one that keeps on changing from time to time in the ordinary course of business of the company.
• The charge remains dormant until crystallization. Until such a time, the company may use the assets charged in the ordinary course of its business

Rules relating to floating charges

• It attaches to the subject charged in varying conditions in which it happens to be from time to time
• When an item within the class charged is sold, the charge ceases to attach to it, when an item is acquired the charge immediately attaches to it
• It remains dormant until the undertaking charged ceases to be a going concern or until the person in whose favour the charge is created intervenes.
• It leaves the company free to deal with the property in the course of its business, and it may even sell its undertaking provided the company remains a going concern.
• The company may also create a mortgage over a specific property which will rank in priority to the floating charge.

Crystallization of floating charges

A floating charge is an equitable charge which does not fasten on any specific property but covers the whole of the company’s property. When it crystallises or become fixed, the assets comprised in the charge are subject to some restrictions and are affected in the same manner as under a specific (fixed charge).

Upon crystallization the floating charge fastens on the available Asset and thereby becomes a fixed charge.

A floating charge will crystallize in the following circumstances:

• When the company ceases to carry on business or ceases to be a going concern
• Default in payment of the principal or interest when due and payable provided the chargee takes some step to enforce the security.
• Upon the commencement of recovery proceedings against the company.
• When the company goes into liquidation, the floating charge automatically crystallises whether or not the company is in default.
• Upon the appointment of a receiver by a debenture holder or by the terms of the debenture causes crystallization.
• Whenever one floating charge crystallizes all others crystallize.

Advantages of a Floating Charge

• The charge covers the assets of a going concern both present and future.
• It enables companies with no fixed assets to borrow.
• It enhances the borrowing capacity of companies with fixed assets
• The charge does not prevent the company from disposing off and acquiring new stock.
• Upon crystallization, the charge settles on the floating assets within its reach and grasps thereby enabling the chargee to sell them.

Disadvantages of a floating charge

• The value of the security remains uncertain since the company continues to dispose of and acquire stock.
• A fixed charge created subsequent to the floating charge has priority in the satisfaction of claims.
• Other interests e.g. landlords distress for rent have priority in the satisfaction of claims.
• Under Sec 312 of the Act a floating charge created within 6 months before the commencement of winding up is deemed to be a fraudulent preference and is void
• A floating charge created within 12 months before the commencement of winding up is invalid unless it is proved that the company was solvent immediately after its creation. Distinction between fixed and floating charge

Floating charge	Fixed charge
• A floating charge is an equitable charge on all the assets of the company	• Fixed charge is a specific charge on a specific piece of property
• The company has freedom to deal with the property charged	• The company losses right to deal with the property till redemption
• Creates equitable rights on the assets of the company	• Passes legal title to the assets of the company

 

Priorities of a Fixed and Floating Charge

• Fixed charges rank according to the order of creation.
• A fixed charge takes priority of a floating charge notwithstanding that floating charge was created before the fixed charge.
• A floating charge created before a fixed charge can take priority if the legal charge (fixed charge) created had notice of the prior charge.
• A fixed charge created prior to a floating charge has priority.
• It is possible to vary the rules of priority by an agreement between the parties.
• If a floating and fixed charge relate to the same security, the fixed charge has priority. A floating charge will be postponed to a later fixed charge over the same property. This is so because the fixed charge attaches to the charged property at the time of its creation whereas the floating charge attaches at the time of crystallization.
• The floating charge would however have priority over the later fixed charge if—

▪ The floating charge contained a “negative pledge” clause which prohibited the company from later on creating fixed charges with priority over it, and ▪ the holder of the fixed charge actually knew of the prohibition.

• If two floating charges are created over the general assets of the company, they rank in order of creation.

Registration of Charges

Section 96(1) requires the prescribed particulars of specified charges on a company’s property or undertaking to be delivered to the registrar for registration within 42 days after the date on which the charge was created. The specified charges are:

• A charge to secure an issue of debentures;
• A charge on uncalled share capital;
• A charge created by an instrument, which, if executed by an individual, would require registration as an instrument under the Chattels Transfer Act (e.g. a Letter of hypothecation); ▪ A charge on land;
• A charge on book debts of the company;
• A floating charge;
• A charge on calls made but not paid;
• A charge on a ship or any share in a ship;
• A charge on goodwill, a patent, a copyright or a trademark.

The prescribed particulars

The “prescribed particulars” of registered charges are enumerated in Form No 214 and are:

• The date and description of the instrument creating or evidencing the mortgage or charge;
• The amount secured by the mortgage or charge;
• Short particulars of the property charged;
• Names, postal addresses and descriptions of the persons entitled to the charge;
• Amount of rate per cent of commission, allowance or discount (if any) paid.
• Particulars of the company

General Aim

The purpose of registering the aforesaid particulars is to enable a would-be creditor to know the company’s existing indebtedness and the assets available for their settlement.

Certificate of Registration

The Companies Act requires the registrar to give a certificate, under his hand, of the registration of any of the specified charges. The certificate shall be conclusive evidence that the statutory requirements as to registration have been complied with. Consequently, the charge would not be rendered void on the grounds that one of the prescribed particulars, such as the date of the creation of the charge, is later found to be incorrect.

Particulars of the register

• The name, address, occupation of each debenture holder
• The debentures held by each holder distinguish each debenture by its number

• The amount paid or agreed to be paid on the debenture

• The date at which each person was entered in the register as a debenture holder
• The date at which any person ceased to be a debenture holder
• Every company to keep at its registered office a register of charges the following particulars:
  • A short description of the property charged
  • The amount of the charge
  • The names of the persons entitled to the charge

 

Effect of Non-Registration

Registration of charge cures all defects characterising the charge.  The charge is deemed to have been made in due compliance with the provisions of the companies Act.

If the prescribed particulars if any of the specified charges is not registered within the prescribed period of 30 days

• The charge will be “void against the liquidator and any creditor of the company”.
• The money secured becomes immediately repayable. This means that the lender is not bound by the terms of the charge and can take immediate steps to recover his money; and

N.B: The court is empowered by the Companies Act to extend the time for registration of the charge on being satisfied that the omission to register the charge within the prescribed time was accidental or was due to negligence or other sufficient cause, provided that neither creditors nor shareholders would be prejudiced by the extension.

Remedies of Debenture Holders

• Debentures holders’ action / Right to sue: This is the right of a creditor to sue the company for the amount due inclusive of interest in the event of default. This remedy is available to both secured and unsecured creditors.
• Foreclosure/ Foreclosing order: This is a Court order which prevents the company from redeeming its security. It denies the company the equitable right to redeem and the security becomes rested in the tender who can sell it at will.
• Appointment of receiver: A receiver may be appointed by the debenture holder in accordance with the terms of the debenture or by the Court on application by a debenture holder. A receiver takes over possession of the security and manages the same to facilitate payment of the amount due.

The following amount must be paid:

• All amounts outstanding prior to the mortgage or charge.
• Rates and taxes and other outgoings.
• The receiver’s commission.
• Payment of insurance and repairs as agreed.
• Principal or interest due.

Petition for Winding Up: A company may be wound up by the Court upon application if the Court is satisfied that it is unable to pay its debts, that is insolvent. A creditor may petition for the winding up of a company on this ground. A company is deemed unable to pay its debts:

• • If a debt of KShs. 100,000 or more remain unpaid after 3 weeks of demand.
  • If execution of another Court processor order in favor of a creditor is returned unsatisfied in whole or in part.
  • It is proved to be satisfaction or the Court that the company is unable to pay its debts. In determining whether it is so unable the Court must take into action the contingent and prospective liabilities of the company.