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A Project on
Borrowings by a Company:
Powers and Avenues
Company Law - II
(Towards partial fulfilment of the evaluation of the subject)
SUBMITTED BY: SUBMITTED TO:
KARAN SINGH and ANIRUDH SINGH MR. ANINDHYA TIWARI
Roll No. – 977 & 973 Faculty of Law
Sem. – VI, Sec. – ‘B’ NLU, Jodhpur
(B.Sc. LL.B.(Hons.))
NATIONAL LAW UNIVERSITY JODHPUR
10 th^ April, 2015
TABLE OF CONTENTS
- INTRODUCTION
- Chapter- I – Powers of Borrowing
- 1.1 POWERS OF BORROWING:.......................................................................................................
- 1.2 ULTRA VIRES BORROWING:
- Chapter – II – Overview of Debt Financing
- 2.3 ADVANTAGES AND DISADVANTAGES:
- Chapter – III – Private Debt
- 3.1 SMALL AND MEDIUM ENTERPRISES:
- 3.2 BUSINESS LOAN CATEGORIES:
- 3.3 ADVANTAGES
- 3.4 OTHER FEATURES:
- Chapter IV- Public Debt: Debt Securities
- 4.1 COMMERCIAL PAPERS:.........................................................................................................
- 4.2 CORPORATE BONDS:
- Advantages:
- Problems which plague Bond market in India:
- Chapter V – Overseas Borrowing - Advantages: - Downside of ECB: - Other Sources of Funding:
- Chapter VI - Conclusions..............................................................................................................
INTRODUCTION
India as a country faces a situation where its needs influx of funds to sustain its rapid GDP growth. Recently we have seen Indian Companies making forays into the foreign markets Eg: Bharti Airtel, Tata Motors. Therefore the need arises to fund such ventures. Internal funding may have been relied upon in the past decade but the sheer magnitude of the projects undertaken as well as new companies, which do not have pre existing cash flow, has compelled companies to rely on external financing. Therefore capital is needed for payment to suppliers, payment of wages or bills; project finance or undertaking mergers and acquisitions to simulate inorganic growth. Most companies rely on combination of equity finance and debt finance apart from internal financing. The nature and size of the business is directly proportional to the funds required by the Company. Ones understanding of the basic types of financing that one may avail from the market helps to choose an option tailored to the Companies needs.
Research Problem:
This project will mainly deal with debt financing and its advantage and disadvantages compared to the equity and as a general source of financing. There exists many ways by which a company can fund its requirement with respect to working capital, expansion, merger and acquisition – debt and equity are the two methods that are in vogue. Also the problems faced by the public debt market in the country have been highlighted. The general powers enjoyed by the company and the exercise of the powers have been highlighted in the initial chapters.
Objectives:
The various avenues by which an Indian Company can borrow, borrowing in case of a large company and what may be suitable for a small and medium sized enterprises and an overview of the advantages and disadvantages of these methods. Apart from the commonly used sources of debt – such as syndicate loans, debt securities the paper seek to brief like highlight the sources such as venture capital and crowd funding. The research paper also delves into the causes for under developed bond market and the need to improve upon the same.
Research Question:
This Research project explores the questions:
(I) What are the borrowing powers enjoyed by the company?
(II) What are the ways by which a company can borrow? What are the pros and cons of the methods undertaken?
Research Methodology:
The research methodology adopted for this topic is doctrinal in nature. As this analysing the various avenues undertaken by a company to raise funds, so a doctrinal method proves to be a more perceptible option. Research for this project has been conducted mainly by utilizing books- primary and secondary sources available in the NLU Delhi Law library. Also many articles from the internet and legal databases like Manupatra, Heinonline, Jstor etc.
The Board of Directors may borrow moneys by passing a resolution passed at the meetings of the Board. The board may delegate its borrowing powers to a Committee of Directors. Such a resolution should specifically mention the aggregate amount up to which the Committee, the Managing Director, Manager or any other principal officer of the company is authorized to borrow - on conditions as it may prescribe.^3
The total amount of money borrowed by the company (excluding loans obtained from banks to meet working capital requirements) shall not exceed the aggregate of the paid up capital and the free reserves.^4 The earlier provision relating to borrowing was under Section 293. Section 293 of the Companies Act, 1956 was applicable only to public companies i.e. private limited companies were exempted from this requirement and therefore they could borrow any sums of money upto any limit without the need of seeking any approval from the members of the company.^5 Now Section 180 is applicable to all companies i.e. public as well as private. So now, even private companies have to seek the approval of their members if they are intending to borrow monies in excess of their paid up share capital and free reserves.^6 It may be noted that a company may borrow in excess of its paid up capital and free reserves if it is so consented and authorized by the shareholders at a general meeting.
1.2 ULTRA VIRES BORROWING: If a company exceeds its authority to borrow as provided under the Companies Act or the Memorandum of Association or Articles of Association of company then it can be said that the company has resorted to ultra vires borrowing.
When a company borrows ultra vires such loan is treated as null and void and does not go on to create a actionable debt. Any securities given as a part of such loan stands inoperative. This puts the lenders under the obligation to return back the securities. Also the lender impeded from suing the company for the return of the loan.
The remedies like injunctions, restitution, subrogation and suit for breach of warranty available only if the lender has acted in good faith and was unaware that the company borrowed the money
(^3) Section 179 (3) (d), THE COMPANIES ACT, 2013. (^4) Section 180(1)(c), THE COMPANIES ACT, 2013. (^5) Section 293, THE COMPANIES ACT, 1956. (^6) Section 180, THE COMPANIES ACT, 2013.
beyond its powers. In the event of the money going into company’s pocket, the company would be liable to repay, even in case of unauthorized borrowings.^7
Chapter – II – Overview of Debt Financing
Most Companies require access to capital markets in order to facilitate inorganic growth. Capital infusion is required for investment in acquiring land, setting up factories, buying and upgrading machinery and for Mergers and Acquisitions. Internal cash flows are grossly inadequate to meet the total capital needs of most of the Companies. 8 There are various ways available to a company for raising capital.
2.1 USE OF INTERNAL CAPITAL:
The decision that a company has to take is whether to utilize the limited internal capital from earnings or raise external funds by borrowing or from the capital markets. This decision is dependent on several factors like tax incentives and capital market conditions. For example external borrowing is more costly in environments where creditor rights are weak and locally available external debt is scarce. Other factors such as desire to hedge political risks and inflationary environment also play a role.^9 Also business group subsidiaries make use of internal debt, which more often has important cost advantage over external debt sources. Internal is debt is provided by owner (the parent company). The advantages associated with this are as – efficient allocation of resources, flexibility and provided opportunity for renegotiation as very low or zero cost. Then again a company may be forced to borrow externally if it or its parent company is financially weak. The placing of external debt on a subsidiary limits the risk of propagation of financial risk throughout the group.^10
(^7) Lakshmi Ratan Cotton Mills Co. Ltd v. J K Jute Mills Co; Ltd, (1957) 27 Comp. Cas. 660 (All). (^8) Stephen G Cecchetti and Enisse Kharroub, Reassessing the impact of finance on growth , (January 2012) http://sirc.rbi.org.in/downloads/4Cecchetti.pdf 9 Mihir A. Desai, C. Fritz Foley, James R. Hines Jr., A Multinational Perspective on Capital Structure Choice and Internal Capital Markets 10 , p. 3, http://www.bus.umich.edu/otpr/wp2003-4.pdf Nico Dewaelheyns, Cynthia Van Hulle, Internal capital markets and capital structure: bank versus internal debt , p 7, https://lirias.kuleuven.be/bitstream/123456789/183225/2/Internal+capital+markets+and+capital+structure+- +bank+versus+internal+debt.pdf.
Ownership: The reason why debt financing is appealing to many is that one is able to hold on to the ownership of the company. It is ensured that full fledged control remains with the promoter as the Banks and lenders while forwarding a loan is not looking for a stake in the company. Investor appeasement is no longer a worry. Acquisition proceeds: In case of acquisition of the company it wouldn’t be necessary to pay out a hefty sum to the investor as is required in case of venture capital. Proceeds go straight to the bank and may be re invested in the company for future growth. Tax Deductions: Interest paid on the business debt are considered “business expenses” and are tax deductible while cash flows on equity (like dividends) are not.^16 Also debt is said to add discipline to management. This is on an assumption that the management of company which has higher cash flows left over each year are more likely to be complacent each year.^17
The disadvantages associated with borrowing rather debt financing are as follows:
Repayment: Repayment of debt poses financial risk. Regular payment of interest puts pressure on cash flow. Makes the company less profitable and less lucrative to investors in the secondary market and therefore effect stock prices. Also if the company is undergoing a torrid time with respect to its business and returns, necessary cash for repayment can put the company in financial difficulty and may even lead to bankruptcy. Credit Rating: Heavily leveraged companies have lower credit ratings. This effects financing of future project with debt. Cash & Collateral: Collateral forms an important part of any loans and Banks and lenders inevitable would ask for collateral of equal value to the loan as a security in case you default on your payments. Hence default risks are always associated with debt financing.^18
Other factor like size of the company, business cycle and sector also has an impact on what method a company would choose to raise funds. Heavy reliance on debt funding is not
(^16) Debt vs. Equity Financing: Which Is the Best Way for Your Business to Access Capital? Available at http://www.nfib.com/business-resources/business-resources-item?cmsid=50036>. 17 Aswath Damodaran, The Debt-Equity Trade Off: The Capital Structure Decision , http://people.stern.nyu.edu/adamodar/pdfiles/ovhds/ch7.pdf 18 NSE paper on Debt Market, available at http://www.nseindia.com/content/us/ismr2011ch5.pdf
favourable as it may reflect negatively on the company and by lending institutions or potential investors tend to stay away from such companies. Therefore it is important to maintain a favourable debt-to-equity ratio.
Chapter – III – Private Debt
As we have discussed earlier Companies can raise debt by issuing securities directly into the capital market (public debt) or by borrowing from the banks and other lenders (private debt). The size of the company as well as its capital requirement plays an important role in its decision of funding choices.
3.1 SMALL AND MEDIUM ENTERPRISES: Plenty of opportunities exist today for SMEs to obtain funding. Banks loans are a viable option for SMEs to raise money. Banks have extended their credit options to SMEs by regularly updating their product lines, services and even opening special counters.^19 Companies may take recourse to business loans for a variety of requirements such as:
Starting new ventures, Expansions, New purchase, Working capital requirement, Vendor and dealer financing, Bill discounting etc.^20
Bank finance is the primary source capital for MSMEs. Credit extended to this sector by the banks has increased over the years. As at the end of March 2011, the total outstanding credit provided by all Scheduled Commercial Banks (SCBs) to the MSE sector stood at Rs.4785. billion as against Rs. 3622.90 billion in March 2010 registering an increase of 32%.^21 Banks
(^19) Need a money for your business? Check out new loans schemes for SMEs , (Oct 24, 2013) http://economictimes.indiatimes.com/news/emerging-businesses/sme-policy-trends/need-a-money-for-yourbusiness- check-out-new-loans-schemes-for-smes/articleshow/24649220.cms 20 21 Id. Dr. K. C. Chakrabarty, Deputy Governor, Reserve Bank of India Empowering MSMEs for Financial Inclusion and Growth- Role of Banks and Industry Associations , available at http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?id=.
letter of credit is seen in international finance where buyer and seller do not know each other, the business transaction will be facilitated using the bank's credit worthiness.^26
3.2.1 Syndicated Loans: Debt often constitutes a major source of financing for large corporations. Syndicate loans and corporate bonds have become chief source for large debt financing. Syndicated loans generally involve a loan issued to a single borrower jointly by a group of lenders (who are usually banks but can be other financial institutions). The lead bank issues a memorandum containing borrower specific information to other prospective lenders. The types of facilities offered through a syndicated loan are term loan facility, revolving loan facility or a hybrid of both of them.^27
3.3 ADVANTAGES^28 :
[i] It is practical to use this financing route is the borrower requires large and sophisticated facilities or multiple type of facilities, as this simplifies the process of borrowing to a lot extent. The borrower uses one agreement to borrow from the whole group, contrary to entering into a series of bilateral agreement each with different terms and conditions.
[ii] It can be argued that the syndicated loan market is the most powerful substitute of the bond market in terms of its size, maturity and nature of loans provided. The extensive use of public debt (Bonds) entails issuance cost. Also relatively small issuance of bond would not be cost effective.
[iii] The renegotiation problem: Renegotiation of the terms and conditions of debt agreement is on the face of it difficult with a large number of bond holders than with a single bank or with a small group of lenders.
[iv] There exists information asymmetry in the public debt market. A bond holder may not be informed about the viability of a particular project that the company is undertaking and therefore debt contracts may contain harsh covenants which may result in premature liquidation of
(^26) Ibid. (^27) Guide to Syndicated Loans, Loan market Association , available at http://www.lma.eu.com/uploads/files/Guide_to_Par_Syndicated_Loans.pdf 28 Yener Altunbaş, Alper Kara and David Marqués-IbáñezLarge Debt Financing, Syndicated Loans vs corporate Bonds , Working Paper Series no 1028 , (March 2009) available at http://www.ecb.europa.eu
profitable projects. Also the lenders would demand higher return for risk generated by information asymmetry.
[v] Moreover syndicated loans provide assured capital and also diversify their funding source. It provides much needed immunity from market volatility and also provide easy pitch for new banks to start their business.^29
Private debt i.e one obtained by means of syndicated loans have special covenants for monitoring the activities of the borrower, which are not present in standard public issue.
Lately it has been observed that syndicated loans have been finding favour with some already heavily leveraged Indian companies which are unable to raise money through equities. India’s half of investment banking revenues come from Syndicated Loans. RBI Master Circular- Loans and Advances – Statutory and Other Restrictions govern syndicated loans in India.^30
Examples of Syndicated Loans: Reliance Industries Ltd raised $ 1.5 billion from a group of 18 International and Indian Banks to finance its capital expenditure in India and new projects in its refining and petrochemical business.^31
3.4 OTHER FEATURES:
Interest Rates:
Loan agreements invariably make express provisions for interest charges. The rate of interest may be fixed for the term of the loan or may be variable (or floating) over the life of the loan. The interest rate for most loans in India is linked to lender’s base rate which is decided by the bank based on RBI guidelines. These rates are subjected to be reviewed atleast once every
(^29) Malvika Joshi, Syndicated Loans Offer Lucrative Business To Investment Banks , Livemint (Wed, Apr 10 2013) http://www.livemint.com/Industry/d7fEDjmOKBQYIb2Qu3kftN/Syndicated-loans-offer-lucrative-business-to- investment-bank.html. 30 Master Circular Loan and Advances: Statutory and other Restrictions, (July 2, 2002) http://rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=7380 31 RIL To Raise $1.75-Bn Syndicated Term Loan , (August 22, 2013) http://www.business- standard.com/article/companies/ril-to-raise-1-75-bn-syndicated-term-loan-113082100994_1.html
India is characterized by reliance on internal financing, surprisingly large role of Banks and miniscule and barely perceptible bond market. 80% of corporate bonds comprise of privately placed debt by public financial institutions. 35
A recent surge in financing through the bond market has renewed hope in the public debt market. “Fund-raising by Indian companies through private placement of debt securities or bonds surged more than eight-fold to over Rs 17,700 crore in September. According to market regulator Securities and Exchange Board of India (SEBI), Indian firms garnered a total of Rs 17,763 crore in September from the debt on a private placement basis route after hitting a seven-year low of Rs 2,089 crore in the preceding month”.^36
Let us look at few of the debt securities that companies use to raise funds:
4.1 COMMERCIAL PAPERS:
Commercial papers are unsecured money market instruments issued as a promissory note. It is a short term funding tool that highly rated companies, primary dealers and all India Financial
(^35) Stephen Wells and Lotte Schou-Zibell, India’s Bond Market— Developments and Challenges Ahead , Working Paper Series On Regional Economic Integration No. 22, December 2008. 36 Fund raising via debt placement rises over eight-fold in September , New Delhi, (Tue Oct 22 2013) http://www.indianexpress.com/news/fund-raising-via-debt-placement-rises-over-eightfold-in-september/1185722/.
institutions can use typically to meet their short term funding. Reserve Bank of India guidelines govern the issuance of CPs.^37
4.2 CORPORATE BONDS: Bonds are tradable fixed-income securities. Bonds can be differentiated on the basis of: covenants, option features, cash flow pattern (via coupon and principal schedule), maturity, price, and ratings. 38
Features:
Bond Covenants: The rules or legally binding terms between the bond issuer and its holder, specifying the rights of the lender and restrictions on the borrower. Four major kinds of bond covenants: asset covenants, dividend covenants, financing covenants, and bonding covenants. The type of covenants included in bond varies. Options: Bond often comes with features that allow both buyers and sellers to terminate the bond agreement, often requiring the party exercising the option to make certain payments or take on different risks. The most important embedded options are callability, convertibility, and putability. Cash Flow Pattern: Very important aspect of a bond. This feature helps to determine its value. It is generally specified by the annual interest payments, also called coupon rate. A fixed rate bond entails a payment of half the stated coupon every six months. Floating- rate bonds are characterized by the interest rates tied to some benchmark rate plus a fixed or a variable spread. Ratings: Every bond is rated by rating agencies (CRISIL, ICRA in India) that specifies the creditworthiness of the bonds.
Advantages: General importance of bond markets and its advantages as a source of financing^39 –
(^37) Introduction to Commercial Paper , available at http://crisil.com/Ratings/Commentary/CommentaryDocs/CRISIL- ratings_intro-cp_nov09.pdf. 38 Mark Grinblatt, Sheridan Titman, FINANCIAL MARKET AND CORPORATE STRATEGY, 49 (McGrawHill, 2nd^ Edn,
- 39 Ramit nagpal, Bond Markets: Should India look for a Regional Solution? 39 Int'l Law. 697 2005, p 698,699.
Retail investors are almost absent from this market. The limited investor base can also be attributed to the investor preference in government securities. The huge quantum of government borrowings i.e. supply of Government-securities in addition to mandatory requirements in these various financial institutions leaves lesser amount of money in the market and draws away investment from the corporate debt segment.^42
Chapter V – Overseas Borrowing
As seen in the preceding chapters the Indian commercial banks and the capital markets form the chief source of credit for Indian companies. Also non-banking finance companies also provide loans especially in the areas where banking finance is prohibited restricted or scarce. Raising money through ways such as ECB and issuance of foreign currency convertible bonds are additional sources of funding.
FEMA and the rules and regulations there under govern any loan or credit facilities by a foreign lender to Indian companies. Foreign borrowing can be under taken by the following ways:
a) External Commercial Borrowings (ECB): Foreign currency facilities to Indian borrowers in the form of bank loans, buyers’ credit, suppliers’ credit, securitized instruments (e.g. floating rate notes and fixed rate bonds, non-convertible, optionally convertible or partially convertible preference shares) availed of from non-resident lenders are collectively termed as ECBs. They have a minimum average maturity of 3 years.^43
b) Foreign Currency Convertible Bonds (FCCBs): It refers to a bond issued by an Indian company expressed in foreign currency. Such bond also entails the payment of principal and interest in foreign currency.
c) Preference shares: (Types: non-convertible, optionally convertible or partially convertible). These instruments are considered as debt. They are denominated in Rupees and rupee interest rate derives its value from the swap equivalent of LIBOR plus spread.
(^42) DR Dogra, India’s emerging Corporate Bond Market: Potential and Challenges, http://www.careratings.com/Portals/0/CareAdmin/NewsFiles/ManagementSpeak/Mr%20Dogra's%20Article- %20FICCI%20-%20Financial%20Foresights%20-%20Aug%202013%20123-08-30-2013.pdf 43 Master circular on ECB and Trade Credits, Master Circular No. 07/2009-10, July 1, 2009.
d) Foreign Currency Exchangeable Bond (FCEB):- “FCEB is a bond expressed in foreign currency, the principal and interest in respect of which is payable in foreign currency, issued by an Issuing Company and subscribed to by a person who is a resident outside India, in foreign currency and exchangeable into equity share of another company, to be called the Offered Company, in any manner, either wholly, or partly or on the basis of any equity related warrants attached to debt instruments. The FCEB may be denominated in any freely convertible foreign currency”.^44
ECBs can be accessed under two routes – the automatic and approval route.^45 The ECB Guidelines also puts a cap on the amount of ECBs that can be raised, the amount of interest and fees in foreign exchange that can be paid on ECBs, prepayment of ECBs and assets that can be provided as security for an ECB.^46
Advantages: The natural inclination for businesses to raise loans through ECBs is justified by the fact that in a country like India, the Prime Lending Rate (PLR) in the domestic banking industry is distinctly higher than the oversea loan, and naturally companies would like to lower their interest burden.^47
Reasons that make ECB attractive:
For Investors
Time period of ECBs can be as short as three years, most of them are for a specified period. The rate of interest associated with an ECB is fixed. Repatriable nature of the interest and the borrowed amount. ECBs are devoid of owners risk as in case of Equity Investment.^48
(^44) External Commercial Borrowings and Trade credits , http://www.iibf.org.in/documents/ecb-and-trade-credit.pdf. (^45) India Cross Border banking and Finance, http://www.jsalaw.com/Admin/uplodedfiles/PublicationFiles/Lexis%20Nexis%20-%20India%20chapter%20- %20Cross%20Border%20Banking%20and%20Finance%20-%20July%202012.pdf 46 > 47 Master circular on ECB and Trade Credits, Master Circular No. 07/2009-10, July 1, 2009. A research report On External Commercial Borrowings By Indian Companies available at http://www.salvuscapital.com/ecb.pdf 48 K.V. Bhanu Murthy, Manoj Kumar Sinha, Phool Chand, Ashis Taru Deb, Trends and Determinants of External Commercial Borrowing in India, http://world-finance-conference.com/papers_wfc2/252.pdf.
