Debt is an obligation that one party owes to another party, to pay back a borrowed sum.

Debt financing is when a firm raises money, by selling debt securities to lending institutions, individuals and investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid.1 In finance, debt is a means of using anticipated income and future purchasing power in the present before it has actually been earned. Some companies use debt as a part of their overall corporate finance strategy.2 Companies can raise debt finance by issuing debt securities directly into the capital markets or by borrowing from banks and other lenders. UNSECURED DEBT In finance, unsecured debt refers to any type of debt that is not collateralized by a lien on specific assets of the borrower in the case of liquidation or failure to meet the terms for repayment. In the event of the bankruptcy of the borrower, the unsecured creditors will have a general claim on the assets of the borrower after the specific pledged assets have been assigned to the secured creditors, although the unsecured creditors will usually realize a smaller proportion of their claims than the secured creditors.3 OVERDRAFTS An overdraft is a form of debt financing provided to a customer by his bank, through his current account. An overdraft arises when a company draws on its current account to such an extent that a negative balance is produced. Usually, an arrangement to overdraw up to a certain limit is made in advance between a company and its bank, for the purpose of which the company might be required to pay a commitment fee. If a company makes an unauthorized drawing, it can be viewed conceptually as

http://www.investopedia.com/terms/d/debtfinancing.asp http://en.wikipedia.org/wiki/Debt 3 http://en.wikipedia.org/wiki/Unsecured_debt

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an offer by the company 4 and if the bank meets the drawing, it constitutes an acceptance, resulting in formation of a contract between the two parties, regarding the overdraft. 5 An overdraft is generally repayable on demand.6 In Rouse v Bradford Banking Co, it was explained that no party contemplates a bank to sue for recovery of money granted as overdraft immediately, without giving notice. Even though there is no legal obligation to abstain from doing so, if a bank that agrees to give an overdraft acts in such a manner, it would cause serious damage to the business.7 However, a bank is only required to give sufficient time to the company to effect the mechanics of payment. A bank is not under any obligation to give time to a company to raise funds that it does not have, in order to repay the overdraft and in such cases, the bank can rightly sue the company for not repaying immediately.8 TERM LOANS These are loans which are given for a specified period of time. The term loan agreement specifies the principal amount of the loan, the currency in which it is denominated and the way in which it will be made available to the borrower. The agreement can provide for the borrower to draw all the loan amount of the loan at once or draw the amount at specific intervals of time. Similarly, the agreement also provides whether the repayment is to be made at once or in installments over a period of time. The borrower can be given the option of early repayment. A provision should be included in the agreement, enabling the lender to demand early repayment in case a number of specified of defaults occur. The loan agreements contain representations and warranties, which perform an investigative function.9 Some matters and warranties that are covered by the representation and warranties are: (i) The capacity of the company to enter into the loan agreement and the authority of its directors and officers to do so
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Barclays Bank Ltd. V WJ Simms Son & Cooke [1980] 1 QBD 699 Id. 6 Williams and Glyns Bank v Barnes [1981] Com LR 205 7 [1894] AC 586, HL, 596 per Lord Hershell LC 8 Cripps (Pharmaceutical) Ltd v Wickenden [1973] 1 WLR 944 9 nd PR Wood, International Loans, Bonds, Guarantees, Legal Opinions (Sweet & Maxwell, 2 Edn, 2007) ch 4

(ii) (iii)

The financial position of the borrower Any pending litigations or claims against the borrower which may adversely effect his capability to perform obligations under the loan agreement

Covenants under a loan agreement Covenants in a loan agreement serve the purpose of restricting the borrower in carrying out his business and give the lender certain control over the way in which the borrowers business is conducted. Their primary purpose is to ensure that the borrowers credit rating does not decline while the debt remains pending. Covenants are divided into two kinds. Positive covenants include acts that the borrower promises to do, while negative covenants contain acts which the borrower promises to refrain from doing. A few types of covenants are: (i) (ii) (iii) (iv) (v) Reporting covenant Financial covenant Disposal of assets covenant Change of business covenant Negative pledge covenant

Apart from these, there are some implied covenants which are to be followed. These covenants are presumed to be implied but are not included in the loan agreement due to their obviousness. SECURED DEBT A debt is a secured debt when a lender has control over the assets of the borrowing company, which are the security and can enforce his claims against those assets, in the event of default of the lender to repay the debt. When a Companys assets are not sufficient to pay off all the debts at the time of insolvency, the pari passu rule applies to the unsecured creditors, implying that each unsecured creditor gets repaid out of the companys assets, in the size proportionate to their claim. This rule does not apply to the secured creditors and they get priority of payment in case of insolvency over the unsecured creditors. This puts the secured creditors in a position which is much stronger than unsecured creditors, in case the lender becomes insolvent.

A security interest is linked only with the debt for which it is given as security. A creditor cannot claim an interest over the security even when there is no outstanding debt. Also, a security interest arises in a property that the debtor owns. A debtor may also grant security in an asset which he is going to acquire in future. When an agreement is entered into, for providing a property as security over which the debtor will have ownership in the future, will not imply the creditor having security interest in the said property, at the time of the agreement being concluded. Forms of Security Security is divided into four types pledge, lien, mortgage and charge. Mortgages and charges are the more commonly used security due to their practicality. Because possession is required to be made over the subject matter by the creditor in pledge and lien, they have limited practical significance. Pledge and Lien Pledge involves the assets of the debtor being transferred to the creditor as security for the debt. If the debtor fails to repay the dent in due time, the creditor can sell the pledged asset to account for the amount of the debt and returning the surplus amount to the debtor.10 In lien, the debtor has the right to detain the property but not to sell it.11 The creditor may further sub-pledge the pledged asset. However, as soon as the debtor has repaid the debt, he is entitled to immediately hold possession of the pledged property. Mortgage Mortgage is a transfer of ownership as security for a debt which is to be retransferred once the debt has been discharged. A debtor may mortgage his own property or a third person may mortgage his property on behalf of the debtor but he does not require taking the liability of repaying the debt upon him. In a legal mortgage, the legal title to the mortgaged property needs to be transferred to the creditor. Charges
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Re Hardwick, ex p Hubbard (1886) 17 QBD 690, CA Donald v Suckling (1866) LR 1 QB 585

A charge gives its holder rights relating to the property which is given as security but does not require a transfer of the legal or beneficial ownership of the property. A charge is normally created by an agreement between parties along with a consideration or in the form of a deed. However, an equitable charge can also be created by the charger declaring himself a trustee of the relevant assets for the purpose of security.12 Under Section 124 of the Companies Act, 1956, charge includes mortgage. Charges are of two kinds, i.e. fixed charges and floating charges. These are described in brief below. Fixed Charges A charge is fixed when it is made specifically to cover definite and ascertained assets of permanent nature. In fixed charges, the holder of the secured property immediately has all the rights in relation with the secured property and the holder can restrict the company from disposing off or destroying the secured property. If the charger sells any security that is subject to fixed charge, the buyer obtains the property along with the charge, unless he proves that he is a bonafide purchaser not having knowledge of fixed charge. Floating Charges Floating charges are charges on a class of assets, which may be in the present, or future and changes from time to time in the ordinary course of business. Floating charges majorly differ from fixed charges in the sense that the charger can deal with the security and can transfer the assets even though they are the subject matter of security. 13 Floating charge normally extends to future as well as existing property of the company. A floating charge does not always need to remain floating. It can be converted into fixed charge, through a process called crystallization.

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Re Bond Worth Ltd. [1980] Ch 228 per Slade J Re Sectrum Plus Ltd [2005] 2 AC 680, HL per Lord Scott

In Re Yorkshire Woolcombers Ltd., characteristics to deteremine whether a charge is a floating charge were mentioned. According to Romer LJ, a charge is a floating charge if: (i) (ii) (iii) It is a charge on a class of assets of a company present and future The class will change from time to time in the ordinary course of business and It is contemplated by the charge that till the time some further actions are taken by the persons interested in the charge, the company can carry on its business ordinarily in such class of assets.14 The most important criteria to determine a floating charge is the extent the company will be free to deal with assets which form subject matter of the security. A floating charge crystallizes in the following situations: (i) (ii) (iii) (iv) When the company is liquidated When the company ceases to carry on its business When creditors take steps to enforce the security On happening of any event that has been specified in the deed

CORPORATE BONDS Corporate bonds are debt securities issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company's physical assets may be used as collateral for bonds.15 DEBENTURES Section 2(12) of the Companies Act, 1956 defines debenture as follows: Debenture includes debenture-stock, bonds and any other securities of a company whether constituting a charge on the companys assets or not.

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[1903] 2 Ch 284 CA http://www.investopedia.com/terms/c/corporatebond.asp

The definition so provided in the statute fails to explain the meaning of a debenture and its nature. Chitty J. explained the meaning of debenture as follows: Debenture means a document which either creates a debt or acknowledges it and any document which fulfills either of those conditions is a debenture.16 There are certain characteristic features that a debenture possesses which are as follows: (i) (ii) (iii) It is a movable property It is issued by the company in the form of a certificate of indebtedness It specifies the date of redemption and also provides for repayment of principal and interest at specified date o dates. (iv) It usually creates a charge on the undertakings of the company

There are different kinds of debentures that companies issue in order to raise finance. Following are the kinds of debentures: (i) Bearer debentures These are negotiable instruments transferrable by delivery. These give a bonafide title to the acquirer of the debenture and enable the bearer to sue the company in his own name. (ii) Registered debentures These debentures are payable to those persons whose name appears in the register of debenture holders. (iii) Irredeemable debentures These debentures do not contain any clause with regard to payment or contain a clause that they shall not be repaid. (iv) Redeemable Debentures These are issued for a specified period of time, on the expiry of which, the company has the right to pay back the debenture holders and have its assets released form charge or mortgage.
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Levy v Abercorris Co. [1888] 37 Ch. D. 260

(v)

Convertible Debentures An option is given to holders of these debentures to convert them into equity or preference shares at stated exchange rates after holding them for a certain period of time. Once converted into shares, they cannot be converted back to debentures. These are further classified into: (a) Fully Convertible Debentures These are converted into equity shares on the expiry of a specified period of time. (b) Partly Convertible Debentures These are partly convertible and partly non-convertible. The non-convertible part is redeemed after a specified period, while the convertible part is converted into equity shares at the expiry of such period of time.

ZERO COUPON BONDS These bonds are sold at discount on the nominal value and are redeemed at nominal value at the end of the maturity period.