What is Debenture Redemption Reserve (DRR)?
A Debenture Redemption Reserve (DRR) is a fund requirement maintained by the companies that issue debentures in India. This effort is to protect the investors from the possibility of the company defaulting on repayments. Also, DRR ensures that enough funds are available to meet the obligations of debenture holders. Furthermore, the funds available in DRR, the company shall use only to redeem debentures.
Scripbox Recommended Goals
Plans that will help you to achieve your life goals across multiple time frames.
There are two components in a Debenture Redemption Reserve (DRR). The first component is to set aside a portion of the company’s profit. Next is the process of allocating the profit. This process is known as ‘earmarking of funds. This ensures that adequate profits are available for the repayment of debentures. The second component is the investment of funds, ensuring that the company has enough liquidity for repayment.
The Ministry of Corporate Affairs (MCA) introduced the reserve requirements in March 2014, where the company had to maintain a 50% reserve of the debenture issue capital. This was immediately reduced to 25% in April 2014 to make it easier for companies to raise capital and safeguard the interest of investors. Further in the 2019 Budget, the MCA reduced it to 10% of outstanding debentures for unlisted companies. Also, the following companies need not maintain or create DRR –
- Companies listed with NSE and BSE
- Non-Banking Financial Companies (NBFCs) registered with RBI under Section 45-IA of the Reserve Bank of India Act, 1934
- Housing Finance Companies (HFCs) registered with National Housing Bank (NHB).
Thus, this notification was a relaxation for the companies to maintain DRR.
How Does a Debenture Redemption Reserve Work?
A debenture is a debt instrument that a company issues to raise capital and borrows money from the investors as a loan at a fixed interest rate. A debenture is an unsecured security because any asset or collateral does not back it. Therefore, to protect the debenture holders from the risk of default, the Indian Companies Act of 1956 under Section 117 introduced the Debenture Redemption Reserve mandate. As per this mandate, the company that issues debentures has to keep aside a percentage of the amount they raise through debentures in a special fund. The company will utilise this fund in extreme cases to repay the debt obligations rather than default the debenture payment.
Example
Let us assume that an unlisted company issues Rs.10 crore worth debentures in January 2020 with a maturity date of December 2025. In this case, the company has to create Rs.1 crore (10% of 10 crores) as a debenture redemption reserve before the maturity date.
The companies have to create the reserve within 12 months of issuing the debentures. If companies cannot create the DRR, they have to pay 2% interest as a penalty to debenture holders. The companies have to create the reserve within 12 months of issuing the debentures. However, these companies do not have a compulsion to create a reserve account with one large amount immediately. They can credit the account by an adequate amount every year to satisfy the 10% requirement.
The companies shall invest or deposit before 30th April of each year at least 15% of the amount of debentures that will mature on 31st March of the following year. The reserve account funds can be invested in corporate or government bonds approved by the government. Thus, the company can use these funds to settle the interest and principal payments on debentures maturing during that year. Also, the company cannot use or sell these funds for any other purpose other than meeting the liability towards debenture holders.
explore our article on Difference Between Shares and Debentures
Applicability of Debenture Redemption Reserve
The MCA introduced the relaxations for DRR to reduce the cost of borrowings for the companies. The following are the companies that are exempted from maintaining DRR –
- Public Financial Institutions (PFIs) – are companies where the central government holds more than 51% paid-up capital. Some examples of PFIs are Life Insurance Corporation of India (LIC), Infrastructure Development Finance Company Limited (IDFC), Industrial Credit and Investment Corporation of India Limited (ICICI), Industrial Finance Corporation of India (IFCI), and Industrial Development Bank of India (IDBI).
- All India Financial Institutions (AIFI) – are companies under the supervision of the Reserve Bank of India (RBI). Some of the examples of AIFI are Export-Import Bank of India (Exim Bank), National Bank for Agriculture and Rural Development (NABARD), Small Industries Development Bank of India (SIDBI), and National Housing Bank (NHB).
- Housing Finance Companies (HFCs) – companies registered under National Housing Bank (NHB) need not maintain DRR.
- Non-Banking Finance Companies (NBFCs) – companies registered under Section 45-IA of the Reserve Bank of India Act, 1934 need not maintain DRR.
- Scheduled Banks – all banks mentioned under the second section of the Reserve Bank of India Act, 1934.
- Listed Companies – A company listed under one of the two stock exchanges in India, either the BSE or the NSE.
Note – 1) In case of a public issue of debentures for unlisted NBFCs and HFCs, they should create DRR. 2) In the case of partially convertible debentures, the company shall create DRR only for the non-convertible portion (i.e. only the redeemable portion on maturity).
Explore: Redeemable Debentures
Utilisation of Debenture Redemption Reserve
The company can utilise the funds in DRR to invest in approved securities. The following are securities that the company can invest in –
- Deposits with scheduled banks
- Treasury bills (t-bills) and commercial papers
- Government long term bonds
All these investments shall be made before 30th April. The investment amount and the DRR amount should be the same. In simple words, the ledger balance of DRR and the ledger balance of investment should be the same.
When the debentures are maturing and due for repayment, the company should sell the investments and settle the liability. The company shall use the sale proceeds from investments for meeting the repayment obligation of debenture holders and not for any other purpose. Also, the profit or loss arising from the sale of investments, the company should not adjust towards the DRR. After settling the entire debt of debentures towards the investors, the company can transfer the balance of DRR to the general reserve account.
