A debenture redemption reserve (DRR) is a provision stating that any Indian corporation that issues debentures must create a debenture redemption service in an effort to protect investors from the possibility of a company defaulting. This provision was added to the Indian Companies Act of 1956 in an amendment introduced in the year 2000.
The provision has since been updated over the years by India’s Ministry of Corporate Affairs to reflect new DRR requirements. While the reserve requirements started at 50% in March 2014, they were quickly lowered to 25% in April 2014. Beginning in 2019, they were lowered to 10% of the value of the outstanding debentures.
A DRR requires the corporation to create a debenture redemption service to protect investors from the possibility of a company defaulting.
This rule offers investors a measure of protection because debentures are not backed by an asset, a lien, or any other form of collateral.
The reserve must represent at least 10% of the face value of debentures issued.
A company may only use the funds deposited in the DRR for the purpose of the redemption of debentures.
A debenture is a debt security that lets investors borrow money at a fixed interest rate. This instrument is considered unsecured because it is not backed by an asset, lien, or any other form of collateral.
Therefore, to protect debenture holders from the risk of default by the issuing company, Section 117C of the Indian Companies Act of 1956 implemented the debenture redemption reserve (DRR) mandate. This mandate requires companies to set aside in cash a certain percentage of the amount raised through the debenture issue in a special fund only to be used in extreme cases to repay their debt obligation rather than defaulting on the debenture.
In March 2014, the Ministry of Corporate Affairs (MCA) issued the Companies (Share Capital and Debentures) Rules requiring companies to establish a DRR equal to at least 50% of the amount raised through the debenture issue. This was quickly changed in April 2014 to 25%, an amount that would make it easier for companies to raise capital and still safeguard the interests of investors.
This capital reserve, which is to be funded by profits issuers generate every year until the debentures are redeemed, was lowered again in 2019, and must now represent at least 10% of the debenture’s face value.
Let’s assume a company issued $10 million in debentures on Jan. 10, 2021, with a maturity date of Dec. 31, 2025. In this case, a $1 million (10% x $10 million) debenture redemption reserve must be created before the debenture’s date of maturity.
Companies that fail to create such reserves within 12 months of issuing the debentures will be required to pay 2% interest, in penalties, to debenture holders. But companies don’t have to immediately fund the reserve account with one large deposit. Rather, they have the option of crediting the account by an adequate amount every year to satisfy the 10% requirement.
Before April 30 of each year, companies are also required to reserve or deposit at least 15% of the amount of its debentures that are due to mature on March 31 of the following year. These funds, which may either be deposited in a scheduled bank or invested in corporate or government bonds, are to be used to settle interest or principal payments on debentures maturing during the year and cannot be used for any other purpose.
Reasons for reducing the redemption reserve requirements from 25% to 10% include the need to make it easier for companies to raise capital and to help expand India’s bond market.
The debenture redemption service only applies to debentures that were issued after the 2000 amendment to Indian Companies Act of 1956. And companies falling under the following four categories are altogether exempt from DRR requirements:
All India Financial Institutions (AIFIs) regulated by Reserve Bank of India (RBI)
Other financial institutions regulated by RBI
Banking companies for both public and privately-placed debentures
Housing finance companies registered with the National Housing Bank
With partially convertible debentures, debenture redemption reserves must only be created for the non-convertible portion–the only redeemable portion. A company may not use funds allocated to the DRR for any purpose other than the redemption of debentures.