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What are debentures?


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What are debentures?

  1. 1. QUESTION 2<br /><ul><li>What are the effect of pre incorporation contrast according to common law and the Malaysian Companies Act 1950? Explain the cases relevant to the aforesaid matter.</li></ul>Introduction<br />Often promoters of companies try to enter into contracts on behalf of proposed corporations in order to secure the contract before the time for incorporation or to confirm the contracts for the corporation before the expense of incorporation is incurred. Normally the promoter does not have any intention of being personally liable on the contracts. In some cases the promoter is aware that the corporation has not been incorporated but the person dealt with is not aware that the corporation has not been incorporated. In other cases neither the promoter nor the person the promoter deals with is aware that the corporation has not been incorporated. In some cases the corporation is never actually incorporated. In other cases the corporation in incorporated and purports to ratify contracts entered into on its behalf before it was incorporated. In some cases the corporation that is purporting to ratify the contract is insolvent. The third party may be left to bear a loss if the promoter is relieved of personal liability and the third party’s claim is solely against the insolvent corporation. The questions that typically arise are whether the promoter can be personally liable on the contract and whether the corporation can ratify the contract.<br />Pre-Incorporation<br />A pre incorporation contract is one which is purportedly made by or on behalf of a corporation at a time when the corporation has not yet been incorporated. Because the corporation named in the promoter's contract has not been formed at the time the contract is made, the corporation when formed is not bound by the contract. However, adoption of the contract is anticipated by the parties to the contract. If the corporation in fact adopts the contract, then it will assume those rights and liabilities set out in the contract.<br />When a promoter enters into a contract on behalf of a corporation to be formed, the promoter may be considered personally liable to meet the obligations of the corporation if for some reason the corporation is not formed or does not adopt the contract. When the pre-incorporation contract is made, the corporation is not in existence and therefore cannot be a party to the contract. The promoter thus must be a party to the contract, and, under agency law principles, the promoter will be personally bound as an agent acting on behalf of a non-existent principal.<br />Promoters<br />A promoter is ‘one who undertakes to form a company with reference to a given project and to set it going and who takes the necessary steps to accomplish that purpose’ per Cockburn CJ in Twycross v Grant (1877). Thus Mr. A and Mr. B who have taken relevant steps to form the company to be called XYZ may be regarded as the promoters of the company. Promoters are persons who are likely to influence or affect the future of the company after its incorporation. They are regarded as fiduciaries in relation to the company. They act in a position of trust and must at all times act honestly and for the benefit of the future company. Promoters must never take any secret profits from the promotion of the company unless they make adequate disclosure to an independent board of directors or to directors or to all the present and intended shareholders.<br />The Common Law Position<br />This part reviews several cases that set out the common law position on pre-incorporation contracts. Kelner v. Baxter (1866), L.R. 2 C.P. 174 (Common Pleas) In Kelner v. Baxter (1866), L.R. 2 C.P. 174 (Common Pleas) the plaintiff and the defendants were promoters of the Gravesend Royal Alexandra Hotel Company, Limited. The plaintiff was to be the manager of the hotel under the new company. Before the company was incorporated the plaintiff offered to sell a stock of wine to the proposed company for £900 which was accepted by the defendants on January 27th, 1866 on behalf of the Gravesend Royal Alexandra Hotel Company Limited. On February 1st the directors of the Gravesend Royal Alexandra Hotel Company Limited ratified the agreement. However, the promoters did not receive a certificate of incorporation for the Gravesend Royal Alexandra Hotel Company Limited until February 20, 1866. The directors then purported to ratify the agreement again on April 11, 1866 just days before the company made an assignment in bankruptcy. The court held that the ratification of February 1, 1866 was not a valid ratification because the company was not in existence at the time. The ratification on April 11 was also held not to be a valid ratification because of the requirement that a ratification can only be done by a principal having capacity to contract at the time the contract was entered into as well as at the time of the ratification. It was also not valid on the basis that the company was not in existence at the time of the promoters purported to act on its behalf. The court nonetheless still felt there was clearly an intended contract and the only way in which there could be a valid contract was if the defendants were the other contracting parties. They thus held that there was a valid contract in which the plaintiffwas one party and the defendants were the other parties. Kelner v. Baxter thus confirmed that a company cannot ratify a contract, or purported contract, entered into on its behalf if the company was not in existence at the time a person purported to enter into a contract on its behalf. Kelner v. Baxter also highlighted the potential for promoters to be liable on contracts they purport to enter into on behalf of an as yet unincorporated entity. What was not clear after Kelner v. Baxter was whether promoters were automatically liable in these situations (sometimes referred to as the “rule of law” approach) or whether the promoter’s liability depended on whether it was intended that the promoter be a party to the contract (sometimes referred to as the “rule of construction” approach).<br />Malaysian Position<br />The Malaysian position is governed by section 35(1) and (2) of the Companies Act 1965. By virtue of section 35(1) of the Companies Act 1965, any contract or other transaction purporting to be made by a company prior to its formation may be ratified by the company after its formation. After such ratification, the company shall become bound by and entitled to the benefit thereof as if it had been in existence at the date of the contract or other transaction,<br />and as if it had been a party thereto. By virtue of section 35(2) of the Companies Act 1965, prior to ratification by the company, the person or persons who purported to act on behalf of the company shall in the absence of express agreement to the contrary be personally bound by the contract or other transaction and entitled to the benefit thereof. Thus, in Malaysia, a pre-incorporation contract can be ratified by the company after its incorporation. Once ratified, either party can sue the other party for breach upon the contract asillustrated in Cosmic Insurance Co. Ltd. v Khoo Chiang Poh (1981).<br />Certificate of Incorporation<br />When the register is satisfied that all the necessary requirements under the Act have been fulfilled and upon the memorandum being registered, he shall certify under his hand and seal that the company is incorporated on and from the date specified in the certificate. The register must also certify in the certificate of incorporation the class to which the company belongs, whether it is.<br /><ul><li>A company limited by share
  2. 2. A company limited by guarantee
  3. 3. A company limited both by share and guarantee
  4. 4. An unlimited company</li></ul>Where applicable, the register shall also state whether it is a private company.<br />On and from the date of incorporation specified in the certificate of incorporation, the company shall be a body corporate by the name contained in the memorandum capable forthwith of exerting all the functions of an incorporation company. The subscribers to the memorandum shall be deemed to have agreed to become members and on the incorporation of the company the subscribers shall be entered as members in its register of members and every other person who agrees to become a member of the company and whose name is entered in its register of member shall be a member of the company.<br />Certificate of Incorporation of Private Company<br />There is English authority to the effect that the date of incorporation is conclusive as to the date on which a company is incorporation notwithstanding the fact that the register could only sign the certificate at a later date, in Juilee Cotton Mills Ltd v. Lewisthe memorandum and artivles of a company were accepted by the register on January 6 1920 and the certificate of incorporation was dated on that day. it Was reasonably clear that the certificate was notin fact signed by the register until January 8 1920. The house of Lord held an allotment of share on January 6 1920 by the company to be valid. It was explained by Lord Summer in that case.<br />Conclusive evidence as to compliance with the Act<br />The evidence value of a certificate of incorporation issued by the register is very significant. The rational for such a provision is regarded as a matter of public policy; otherwise as Lord Cairn in Re Barned Banking Companyobserved, it would be a most disastrous consequence if, after all that had been done, any person was allowed to go back and enter into examination .in the same vein, Lord Chelmsford L.C said Oakes v Turquand and Hardingthat:<br />I think that certificate prevents all recurrence to prior matters essential to registration, among which is the subscription of a memorandum of association by seven persons and that it is conclusive in this case, that all previous requisites have been complied.<br />Hence once the memorandum is register and the register has given his certificate of incorporation nothing may be inquired into as to the regularities of the prior proceeding. Commenting on the effect of section 361, SallehAbas (as his Lordship then was) in Tan Lai v Mohamed Bin Mahmud said this: <br />This provision makes it impossible for anyone to challenge the lawfulness and validity of the existence of the company although it does not go so far as to say that the company objects and powers contained in the memorandum are neither lawful nor lawfully exercisable. To put it another way, a certificate of incorporation prevents any doubt from being cast upon the legal existence and the person of the company but it does not validate its illegal object. Of course a company pursuing an illegal object should not be register and the registrars is entitle to refuse the registration of such company and his refusal is reviewable upon an application on mamdamus, but once the company is register the court has to accept and regencies its valid and lawful existence until it is wound up or until its registration is cancelled at the suit of the Attorney-General on account of its register for an illegal object. <br />QUESTION 2<br /><ul><li>A company may borrow funds in much the same ways as individuals. One of the ways is by issuing debentures. Discuss.</li></ul>Introduction<br />Basically, any business activities need lots of capital to running it fluently. As we had learned about the nature of company business, one of the ways to obtain the capital is by issuing shares of the company. In addition, funds are also available through the company’s capital loans made to individuals or institution. Capital loans may be made through several ways such as loans, mortgage, overdraft, floating charge and debenture. <br />Like a natural person, a company may raise financial by borrowing. The power to borrow is usually included among the objects of companies. This power is usually expressed in a clear and detailed in the company’s memorandum or articles unless there is any excluded or modified. In so far as accompany borrows from private individuals or financial institution, there are no special rules governing corporate borrowings apart from the general law of debt. However, companies may finance their operations by the issue of debt securities in the form of debentures. Public companies may borrow from the public; a means of financing that is generally not available to other forms of business organizations.<br />According to the third schedule, the Companies Act 1965, including the powers:<br />13.To borrow or raise or secure the payment of money in such manner as the company may think fit and to secure the same or the repayment or performance of any debt, liability, contract, guarantee or other engagement incurred or to be entered into by the company in any way and in particular by the issue of debentures perpetual or otherwise, charged upon all or any of the company's property (both present and future), including its uncalled capital; and to purchase, redeem, or pay off any such securities.<br />Companies Act 1965 has specific provisions in respect of debentures, in order to protect the interests of the public who deal with the company and was involved with the debenture and the mortgage-security. To discuss the issue of debenture, we will look at the definition, types of debenture, appointment of trustees for debenture holders and tasks and duties. Discussion also will touch on the advantages and others of debenture itself.<br />Debentures<br />Debentures refer to a long term debt instrument which is used by large companies as well as government to obtain funds. It is similar to normal bonds except for the securitization conditions as it is usually unsecure because there are no liens or pledges on specific assets. In case of bankruptcy, the holders of debentures are considered as general creditors. As roughly view, debenture is a document given by a company as evidence of a charge created by the company in return for a loan. The word has been used to cover many things, but it generally means “a security for money, called on the face of it a debenture, and providing for the payment of a specified sum at a fixed date with interest half-yearly, and is usually one of a series”. <br />Debenture stock is a debt, generally secured by a trust deed; it is sub-divisible, but otherwise is much the same as a debt secured by debentures. The difference between a debt secured by debentures and debenture stock is very like the difference between share and stock.<br />The liability of the company is regarded as a liability to pay an annuity rather than as a liability to repay a loan. The issue of debenture stock is not borrowing at all; it is the sale in consideration of a sum of money of the right to receive a perpetual annuity which it maybe redeemable. We can say that a ‘debenture’ is a document which either evidences or acknowledges the creation of a debt or makes provision for the repayment of a loan to be made in the future.<br />Definition<br />A debenture is defined as a certificate of agreement of loans which is given under the company's stamp and carries an undertaking that the debenture holder will get a fixed return (fixed on the basis of interest rates) and the principal amount whenever the debenture matures.In finance, a debenture is a long-term debt instrument used by governments and large companies to obtain funds. It is defined as "a debt secured only by the debtor’s earning power, not by a lien on any specific asset." It is similar to a bond except the securitization conditions are different. A debenture is usually unsecured in the sense that there are no liens or pledges on specific assets. It is, however, secured by all properties not otherwise pledged. In the case of bankruptcy, debenture holders are considered general creditors. The advantage of debentures to the issuer is they leave specific assets burden free, and thereby leave them open for subsequent financing. Debentures are generally freely transferable by the debenture holder. Debenture holders have no voting rights and the interest given to them is a charge against profit.<br />In fact, there is no precise legal meaning attached to the word debenture. However, it van be understood as a document provided by a company that saw the show or loans made by the company, whether the debt is secured by a charge on the assets of the company or do not have any guarantee. Company and the debenture holders will have a binding contract which was agreed by both parties.<br />As Chitty J said in Levy v Abercorris Slate and Slab Co (High Court, England):<br />In my opinion a debenture means a document which either creates a debt or acknowledges it, and any document which fulfills either of these conditions is a ‘debenture’. I cannot find any precise legal definition of the term, it is nit either in law or commerce a strictly technical term, or what is called a term of art.<br />In Bensa Sdn Bhd v Malayan Banking Bhd, James Foong J (High Court, Malaysia) said:<br />To my mind, this nineteenth century definition of Chitty J above, where at first he cannot give any precise legal definition ought to be given a more liberal outlook to meet the modern day needs where the sphere of business has increased substantially due to modern technology and communication. In the present day, a wide range of forms and instruments are introduced to meet the ever changing needs of modern day commerce and for this, the term ‘debenture’ should also , include ‘debt’, any obligation, covenant, undertaking or guarantee to pay or any acknowledgement thereof.<br />According to the provisions of the above, we can deduce that the definition of debenture is referring to a fixed loan or long term. If the company invites the public to deposit money into the company or give loans to companies, this means that the company has offered debentures.<br />Types of Debenture<br />There are two important types of debentures:<br /><ul><li>Single Debenture
  5. 5. Is a document that ensure loan which made between bank or financial institution with company. That loan usually guaranteed with fixed charge or float charge on company’s assets. Condition on loan repayment should be made through an agreement that agree by both parties. Usually repayment may be requested automatically in the event of dissolution of company or other events which caused company fail to explain company debts.
  6. 6. Public Debenture or Debenture Series
  7. 7. Is debenture that published to public. According to Section 38(1) and (2), company that invite public to buy debenture or accept money deposit or loan from people required to issued a document that witness that debt within two months from money accession date from the public. Section 38(5) on the other hand stipulated that the document could only be stated as debenture if company prospectus includes statement that company loan repayment guaranteed with charge on company asset. If company issue debenture to public, company compelled appoint trustee to that debenture holders.</li></ul>Trustee for Debentures Holders<br />Appointment<br />Every company which offers debentures to the public for subscription or purchase in Malaysia must appoint a trustee corporation as trustee for the debenture holders. The appointment may be set out in the debenture itself or in a trust deed relating to those debentures. The borrowing company must not allot of those debentures until a trustee corporation has been appointed and has consented to act trustee.<br />Both the terms “borrowing corporation” and “Trustee Corporation” are defined by section 4(1). A “borrowing corporation” is defined as:<br />Corporation that is or will be under a liability (whether or not such liability is present or future) to repay any money received or to be received by it n response to an invitation to the public to subscribe for or purchase debentures of the corporation in accordance with the provisions of Division 4 of Part IV.<br />On the other hand, for the purpose of the Act, a “trustee corporation” means:<br /><ul><li>a company registered as a trust company under the Trust Companies Act 1949; or
  8. 8. a corporation that is a public company under this Act or under the laws of any other country, which has been declared by the Minister to be a trustee corporation for the purposes of this Act.</li></ul>Qualifications of Trustee Corporation<br />A trustee corporation must not be appointed to hold office or act as trustee for the debenture holders of a borrowing corporation without leave of the High Court if that trustee corporation is:<br /><ul><li>a beneficial shareholder of the borrowing corporation;
  9. 9. beneficially entitled to moneys owned by the borrowing corporation to it;
  10. 10. a corporation that has entered into a guarantee in respect of the principal debt secured by those debentures or in respect of interest thereon; or
  11. 11. a corporation that is by virtue of section 6 deemed to be related to:
  12. 12. any corporation of a kind referred to in terms (1) to (3) above; or
  13. 13. the borrowing corporation.</li></ul>Where the borrowing corporation awes money to the trustee corporation, the trustee corporation is not prevented from being appointed, holding office or acting as a trustee for the debentures holders so long as such moneys owned:<br /><ul><li>do not, at the time of the appointment or at any time within a period of three months after the debentures are first offered to the public, exceed 10% of the amount of the debentures proposed to be offered to the public within that period and do not, at any time after the expiration of that period, exceed 10% of the amount owned by the borrowing corporation to the debenture holders;
  14. 14. are secured by a first mortgage over land of the borrowing corporation or by any debentures issued by the borrowing corporation to the public or any debenture to which the trustee corporation, or its related corporation, is not beneficially entitled; or
  15. 15. are moneys to which the trustee corporation, or its related corporation, is entitled as trustee for the debenture holders of the borrowing company in accordance with the term of the debentures or of the relevant trust deed.</li></ul>The trustee corporation is also not prevented from being appointed, holding office or acting as trustee if it, or its related corporation, is a shareholder of the borrowing corporation in respect of shares held beneficially by it and if the shares do not give the trustee corporation and all its related corporations, more than 5% of the voting power at any general meeting of the borrowing corporation.<br />If there is default in complying with section 74, the corporation and every officer of the corporation who is in default shall be guilty of an offence under the Act.<br />Retirement of Trustees<br />Where a change of a trustee for the debentures is envisaged, the following conditions must be observed:<br /><ul><li>a trustee corporation must not cease to be the trustee until another qualified corporation has been appointed as trustee and has taken office as such;
  16. 16. if the debentures or trust deed makes provision for the appointment of a successor to a retiring trustee, the appointment may subject to section 74 be made in accordance with that provision;
  17. 17. where no provision has been made in the debentures or a trust deed for the appointment of a successor to a retiring trustee, the borrowing corporation has the power to appoint a successor who is qualified for appointment pursuant to section 74.
  18. 18. a borrowing corporation may with the consent of an existing trustee appoint as successor to the existing trustee any corporation which is qualified for appointment pursuant to section 74. Such as power may be exercised by the borrowing corporation notwithstanding anything in the Act or in any debentures or trust deed; and
  19. 19. where the trustee has ceased to exist or to be qualified under section 74 or fails or refuses to act or is disqualified under section 74, the High Court may appoint any corporation qualified pursuant to section 74 to be the trustee in place of the trustee which has ceased to exist or to be qualified or which has failed or refused to act as trustee or is disqualified as such. The application to the High Court may be made by the borrowing company or the Minister.</li></ul>The successor trustee must within one month after the appointment lodge with the Registrar the notice of the appointment. In default, it may commit an offence under the Act.<br />Duties of trustees<br />The duties of a trustee for debenture holders are set out in section 78 of the Act. The trustee must, inter alia:<br /><ul><li>exercise reasonable diligence to ascertain whether or not the assets of the borrowing corporation and any of its “Guarantor Corporation”, in relation to a borrowing corporation, means a corporation that has guaranteed or has agreed to guarantee the repayment of any money received or to be received by the borrowing corporation in response to an invitation to the public to subscribe for or purchase debentures of the borrowing corporation: s. 4(1) are likely to be or become sufficient to discharge the principal debt as and when it becomes due;
  20. 20. satisfy itself that the contents of the prospectus offering the debentures are consistent with the terms of the debentures or with the relevant trust deed;
  21. 21. ensure that the borrowing corporation complies with the registration requirements in respect of the charges created in relation to the debentures;
  22. 22. exercise reasonable diligence to ascertain whether the borrowing corporation and any of its guarantor corporations have committed any breach of the covenants, terms and provisions of the debentures or trust deed;
  23. 23. take all steps to have the breach remedied by the borrowing corporation and any of its guarantor corporations if the breach will materially prejudice the security, if any, for the debentures or the interests of the debenture holders;
  24. 24. devise proposals for the protection of the investment of the debenture holders where the borrowing corporation or any of its guarantor corporations fail when so required by the trustee to remedy any breach of the covenants, terms and provisions of debentures or the trust deed; and
  25. 25. give to the debenture holders a statement explaining the effects and recommend to them an appropriate course of action to be taken when the borrowing corporation proposes a compromise or arrangement.</li></ul>Advantages of Debentures <br />There is an improvement in the financial structure of the company, because the extra resources (debentures) are transformed into own resources (shares). It transforms debt into capital.<br />The financial cost is lessening, because if the investor chooses for the conversion they don’t have to obey the requisites from the debentures: to pay interests and to refund the capital. On the other side, the interests from the debentures or bonds are usually lower than that on the market, this way, in case of not converting, the company will finance itself with cheap debt.<br />The sooner the conversion is made, the greater are the discounts, so the lesser are the numbers of shares that you can obtain with each debenture.<br />The holders of the debentures are entitled to a fixed rate of interest. It can be presented as "5% Debenture".<br />Debentures are for those who want a safe and secure income as they are guaranteed payments with high interest rates.<br />They have priority over other unsecured creditors when it comes to debt repayment.<br />Conclusion <br />On a usual basis, a debenture is in the form of a certificate that is issued under the seal of a company or on behalf of it. Furthermore as mentioned before a debenture is a clarion acknowledgement and recognition about the fact that a loan has been taken and needs to be paid back. A debenture also signifies very clearly as to what amount of the loan would be paid back on which particular date leaving no qualms behind. Moreover a debenture ensures the payment of interest until the principal sum is completely paid back. A debenture also creates a charge on the prospect of the undertaking of the company or sometimes on any class of its assets. Debenture may have a term of 30 years or more.<br />Frequently, debentures will have an indenture which is a contract protecting the rights of the debenture holders. It will define what acts constitute default by the corporation as well as stipulate the rights of the holder default. <br />A debenture is basically a way of giving loan to the Company. When companies issue debentures to the public, companies are required to appoint a trustee to the debenture holders. Qualifications and duties and obligations have been determined by the trustee Companies Act 1965. Therefore, company must comply with these regulations because they are made to safeguard the interests of holders of debentures of the company.<br />