DEBT CAPITAL

BORROWING BY COMPANIES

Introduction
Most Companies like individuals require to borrow from time to time for the
requirement of their business.

All companies registered under the Companies Act 2015 have an implied power to
borrow for purposes incidental to their trade or business. A company formed under
the earlier Act would have an implied power to borrow if its object is to carry on a
trade or business. In delegating the company's power to borrow to the directors, it is
usual, and essential in the case of a company whose shares are quoted on the stock
exchange, to impose a maximum limit on the borrowing arranged by directors.

The power of a company to borrow is exercised by the directors subject to the

restrictions which may be placed by its memorandum or articles of association or by
the Companies Act. Sometimes the memorandum limits the powers of directors to a
specific amount or a sum not exceeding a paid up capital.

Borrowing by a company may be

 A borrowing which is ultra-vires the company, or
 A borrowing which is intra-vires the company but ultra-vires the directors
(beyond the scope of their authority)
Ultra-vires Borrowing
If a company borrows money beyond its express or implied powers, the borrowing
is ultra -vires the company and is void. No debt is created and the securities given
in respect thereof are inoperative and void and no ratification can render the debt
valid.
A Company is said to resort to ultra vires borrowing if it exceeds the authority
given to it in this respect by the Companies Act, and the Articles of the company.
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Consequences of ultra-vires borrowing:
a. Such loan is null and void and
b. The loan does not create an actionable debt.
c. No ratification can render the debt valid.
d. The securities given in respect thereof are inoperative
Introductions Ltd. V. National Provincial bank Ltd
A company was formed with the main object of providing information and
facilities to overseas visitors to the festival of Britain in 1951. The company later
engaged in pig- breeding as its sole activity. For this purpose, it borrowed money
from a bank which took debentures as security. The bank was given a copy of the
memorandum of association and it knew that the only business being carried on by
the company was pig- breeding.
It was held that the loan was for a purpose known to be ultra-vires and, therefore,
the debentures were void.

However, if the lender has acted in good faith that is without any knowledge that
the company borrowed the money beyond its powers, he may have the following
remedies:

1) Injunction- If the company has not spent the money so borrowed; the lender
may obtain an injunction order against the company restraining it from
spending the amount and recover the same.
2) Subrogation- If the money has been applied in paying off some debts of the
company, he is entitled to step into the shoes of the creditors so paid off and
can rank as a creditor of the company to the extent of the money so applied.
Neath Building Society. V. Luce
A building society borrowed money to pay off principle and interest due on
a mortgage. The borrowing was ultra-vires.
It was held that the lenders were subrogated to the rights of the creditors
who were paid off and could recover the amount from the company.
3) Restitution- If the money has been invested in some particular asset, he may
claim that asset, or if such asset cannot be ascertained he may claim that any
increase in the assets as a result of such borrowing be restored to him in the
event of a winding up.
4) Suit for breach of warranty of authority- The lender may sue the directors
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 personally for breach of implied warranty of authority and claim damages
for the same.
If the fact that the borrowing was ultra-vires could have been discovered
from the public documents of the company’s the lender cannot recover. He
is deemed to know the contents of these documents public documents and
thus cannot take the plea that he was misled by the warranty of the directors.
5) Identification and tracing: - if the render can identify his money (this will
be in the case where the money is still in the hands of the company in its
original form), or any property purchased with it, he can claim the money or
property purchased with it.

Borrowing ultr-vires the directors (inra-vires the company)

This occurs the borrowing is ultra-vires the directors but not the company. In such
a case the borrowing can be ratified and thus be validated by the company. If the
company ratifies the borrowing, then the loan binds both the lender and the
company as if it had been made with the company’s authority in the first place. If
the company refuses to ratify then the normal principles of agency and the rule of
indoor management will apply as long as the lender proves that he lent the money
in good faith and without notice.
When articles of association of company prescribes a particular procedure for
doing a thing, the duty of carrying out the provision s lies on the person in charge
of the management of the company. Outsiders are entitled to assume that the rules
have been complied with. This is known as the Doctrine of indoor management
or the Turquad Rule.

Debentures
The word debenture is derived from the Latin word “debere’’ meaning to owe.

There is no legal definition of a debenture. However, under sec 3 of the Companies

Act:
"Debenture", in relation to a company, includes debenture stock, bonds and any
other securities of a company (whether or not constituting a charge on the assets of
the company);

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In the words of Chitty J in Levy v Abercolis State and Slab (1887)
“… I cannot find any precise legal definition of the term. It is neither in law
or commerce and is a strictly technical term.”

In Edmonds v. Blaina Furnaces Co. Chitty J. said: “The term itself imports a debt
– an acknowledgement of a debt – and generally, if not always, the instrument
imports an obligation or covenant to pay. This obligation or covenant is in most
cases at the present day accompanied by some charge or security.”

It can be said to be an acknowledgment in writing of a debt by a company to some

person or persons by way of prospectus in much the same way as shares.

Any document which contains an acknowledgement of indebtness on the part of

the company is a debenture for the purpose of the Act.

In modern commercial usage, the term debenture denotes the instruments issued by
the company acknowledging indebtedness. However the term is generally used
with reference to the instrument creating the transaction, the debt itself and an
acknowledgement of indebtedness.

Debenture are therefore a form of security which may be bought and sold in much
the same way as shares. In order to give the lenders security in case of non-
payment of their loan, a charge is often made against the asset of the company.

Characteristics of debentures

1) It is an instrument in writing. An oral promise in acknowledgement of a debt

is not a debenture.
2) It is an acknowledgement of the indebtedness of the company to its holder
for the amount stated in it.
3) It is one of a series of like debentures issued to a number of lenders. But a
single debenture may be issued to a single individual. Thus a mortgage of a
company’s property to a single individual as security is a debenture.
4) It provides for the payment fixed sum with interest of a specified rate by a

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 specified time. But this is not essential because a company may issue
perpetual debentures.
5) It is generally secured by a charge, fixed or floating on any part of the
company’s property or undertaking. But this is, however, not an essential
condition because debentures may or may not constitute a charge on the
assets of the company.
6) A debenture holder does not have any right to vote in the company’s
meetings
Contents of a debenture
 Names of parties
 Statement of consideration
 Terms of repayment
 Rate of interest
 Obligations of the borrower e.g. to insure property and to provide accounts
at stated intervals etc
 Events of default
 Powers of the lender following an event of default
Types / classification of debentures
Debentures may be classified according to the following characteristics:-
 Negotiability
 Security
 Permanence
 Convertible
 Priority
Classification according to Negotiability
 Bearer debenture: This is a debenture issued to the holder. It vests upon the
bearer. It is a negotiable instrument transferrable by the parties.
 Registered debentures: These are debentures issued to the registered
holders. Such a debenture vests upon such person. It is transferable by the
execution of an instrument of transfer by the parties

Classification according to Security

 Secured debentures: - Are debentures which contain a charge on the
company’s assets which is enforceable by the lender in the event of default.

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 Secured debentures may be secured by a fixed charge, floating charge or
both fixed and floating charge.
 Unsecured or naked debentures:-These are debentures that have no
securities. They do not create any charge on the assets of the company. The
holders of such debenture are just like ordinary unsecured creditors of the
company.
Classification according Permanence
 Redeemable debentures: - are the debentures which the company issues on
condition that they shall be redeemed within the stipulated time in
accordance with the terms of issue.
 Irredeemable debentures: - when debentures are irredeemable, they are
called perpetual dentures. A debenture will be treated as irredeemable where
either there is no fixed period for repayment of the principle amount or
repayment of it is made conditional on the happening of an event which may
not happen for an indefinite period or may happen only in certain specified
events, e.g. winding up of the company
Classification according to Convertible
 Convertible debenture: This is a debenture which contains an option
entitling the holder to convert his debt within a stipulated time into ordinary
or preference shares of the company at the stated rates of exchange but not
below the par value. These debentures are a hybrid between debentures and
shares.
Issue of Debentures

Debentures are usually issued by a resolution of the board of directors under

powers conferred by the company's articles of association.
Such authority is however not required in the case of a trading company which has
implied power to borrow money for the purposes of its business, and to give
security for the loan by creating a mortgage or charge over its property.

Shares and Debentures

Differences between a share and a debenture

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Shares Debentures
A holder of a share is a member of a A debenture holder is not a member of
company and is entitled to voting rights the company and is not entitled to
interfere in the company’s affairs
Shares may not be issued at a discount Debentures may be issued at discount
A company may not purchase its own A company may purchase its own
shares as it amounts to a reduction of debentures
capital
A share-holder is part owner of a A debenture holder is a creditor of the
company. company
Income on shares (dividend) is uncertain Income on debentures is fixed and
and depends on the director’s discretion certain whether or not a company has
made profits or not.
In case of winding up shareholders can In case of winding up debenture holders
only obtain payment after all the outside rank first for repayment
creditors have been paid

Similarities between a share and a debenture

a) A debenture is usually one of a “series” or “class” which is similar to a
“class” of shares.
b) Debentures as well, as shares are long-term investments in the company and
are transferable in the same manner.
c) Debentures and shares may be issued in the same way through a prospectus
issue.
d) Debentures just like shares can be issued at par or at a premium or at a
discount in exceptional circumstances
e) Both shares and debentures may be redeemable if stated to be so
redeemable.
Debenture stock
This means the borrowed capital consolidated into one mass. Instead of each lender
having a separate bond, he is issued a certificate entitling him to a certain sum,
being a portion of one large loan.
Advantages of debentures
a) They have a lower cost to the company when compared to the cost of equity
funds
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 b) Debenture holders do not participate in sharing of extra ordinary income of
the company since their earnings are restricted to fixed interest
c) Debenture holders do not have voting rights. Therefore, the issue of
debentures does not dilute the ownership and control of the company
d) During periods of inflation, debentures issues benefit the company because
its obligation of paying fixed interest and principal declines to real terms.
e) Debenture interest is deductible when computing taxableprofits whereas
dividends are not
f) Normally the interest rate is fixed and does not fluctuate with earnings.
g) A debenture is easily traded and as the company issuing it is a public
company, the trading will take place in the stock exchange
h) The Companies Act requirements that affect debentures are more relaxed in
a number of ways than those that affect shares. For instance there are no
restrictions on a company purchasing its own debentures and debentures can
be issued at a discount unlike shares
i) Its terms are set out in the trust deed and are thus clear and specific so that a
company can be certain of its obligations
Disadvantages of debentures
a) Debenture issue results in a legal obligation of paying interest and principal
which if not paid can result in liquidation
b) The debenture issue increases the firms gearing/leverage position. This
therefore reduces the firm’s ability to borrow future funds, that is, there is a
limit on the extent to which debt funds can be raised.
c) Debentures must be repaid at maturity and therefore at some point in time
the company will incur a substantial cash outflow which may affect its
liquidity position
d) Debenture holders may put very restrictive provisions or covenants to the
debt contract.
e) Crystallization of floating charges can mean that the security is swiftly
enforced. Given that the security will often be over the trading assets,
enforcement can cause major problems for the company
f) Payment of debenture interest is mandatory and not discretionary as it is
with shares. The company must therefore consider whether this liability can
be met

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 g) Debenture holders’ remedies include the appointment of liquidator or
receiver, which may have disastrous consequences on the company.
Register of Index of Debenture Holders

Under Section 573. (1) A company that allots debentures shall establish and
maintain a register of debenture holders

If a company fails to comply with a requirement of this section, the company,

and each officer of the company who is in default, commit an offence and on
conviction are each liable to a fine not exceeding one million shillings.
Rules for the register
i) The register of the debenture will be kept at the company’s registered
office
ii) The register of debenture holders must contain the following particulars:
iii) The name, address and occupation if any of the debenture holder
iv) The debentures held by each holder distinguishing each debenture by its
numbers and the amount paid or agreed to be considered as paid on those
debentures
v) The date at which each holder ceased to be a debenture holder
N.B: If the number exceeds 50 debenture holders, a debenture holders’ register
index must also be prepared unless the register of debenture holders is in such a
form as itself to constitute an index.
Debenture Trust Deed
Debenture holders of a company, who are usually in large numbers, may not have
the time to look after their interests in the property mortgaged or charged. They
may, in order to protect their interests, appoint some persons (usually some from
among them as trustees.
A trust deed in such a case is executed, conveying the property of the company to
trustees. Under the terms of the deed, the company undertakes to pay to the
debenture holders their principle and interest and normally charges its property to
the trustees as security.
The trustees must act diligently in the discharge of their duties. Any clause in the
trust deed which exempts them from liability for breach of their duty as trustees is
void.

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The trust deed contains the terms and conditions endorsed on the debentures and
define the rights of debenture holders and the company. This is a document issued
by a company as a security whenever a series of debentures or debenture stocks are
issued. It is an acknowledgement by the company that it is indebted to trustees on
behalf of the debentures holders.
Contents of the Deed
- A covenant by the company to pay the amount due for the debenture
holders.
- A legal mortgage over the company asset’s vested in the trustees.
- Type or nature of security given by the company.
- Methods of redemption.
- Circumstances in which the security is enforced.
- Meeting of debentures holders.
- Maintenance of the registers of debentures holders.
- Details of any sinking fund proposed by the company to provide for stock
redemption.
- Power of the trustee to:
o Take possession of the security.
o Regulate its use.
o Sell the security.
o Appoint a receiver or manager.

Advantages of a Trust Deed

1. It compels the company to extend a legal mortgage over its assets to trustees.
Persons who subsequently lend money to the company cannot gain priority
over the company.
2. It facilitates protection of security on behalf of all creditors. They can act
expeditiously and effectively in safeguarding the interest of the debenture
holders and enforcing the security on their behalf
3. The company makes an additional covenant to pay the amount due to its
creditors.
4. The trustees act as watchdogs in seeing and insisting that the company’s
obligations under the trust deed are carried out properly. they are for

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 example empowered to see that the property is kept insured and properly
maintained
5. The trustees have the power to appoint a receiver or take possession of the
property and carry on the business of the company in case of need
6. Events are specified on the happening of which the principle money and
interest shall be payable e.g. non-payment of interest or non-performance of
the covenants in the deed. The appointment of the trustees, who are usually
paid, ensures that there are definite persons whose duty is to take action on
the happening of these stated events
7. The company is given a number of powers over the property charged which
it can exercise with the consent of trustees. E.g power of sale or lease of the
property.
8. In case of difficulty or doubt the trustees can convene meetings of
debenture-holders to apprise them of the position and to enable them to
discuss it and authorise the trustees to peruse any course of action beneficial
to the debenture holders.
Liability of Trustees

Trustees for debenture holders owe the same duties to their beneficiaries as are owed
by trustees in general.
A trustee is liable for any breach of trust where he fails to show the degree of care
and diligence required of him as trustees, having regard to the provisions of the trust
deed conferring on him any powers, authorities or discretions
Right to a copy of the trust deed
A registered debenture holder is entitled to a copy of a printed trust deed on payment
one shilling per one hundred words or part thereof in other cases.
Charges Securing Debentures
Debentures may be issued either secured or unsecured by a charge on the property of
the company.
A charge on the assets of a company given by a debenture or a trust deed may be
either a specific (fixed) charge or a floating charge.

Fixed Charge
A charge is a "fixed charge" if it is a mortgage of ascertained or specific property

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such as plant and machinery, freehold or leasehold land, or uncalled capital. A fixed
charge passé legal title to certain specific assets and a company loses the right to
dispose of the said property. In other words, the company can transfer the property
charged only subject to the charge i.e. the charge holder must first be paid whatever
is due to him. In the event of winding up, of the company a debenture holder secured
by a specific charge is the highest ranking class of creditors that is, that of secured
creditors. The company cannot also dispose of it without the consent of the holders
of the charge.
Advantages of a Fixed Charge

a) The value of the security is known.

b) The charge is in a position to control usage of security. This enables him to
prevent its wastage.
c) The charge has the power to appoint a receiver or manager in the event of
default
d) In the event of default the charge is empowered to sell the security without
judicial intervention.
e) The lender or charge has absolute priority.

Floating Charge

This is an equitable charge securing a debenture on the assets of a going concern. Its
essence is that it remains dormant until the undertaking ceases to be going concern
or some event occurs when it crystallizes.
In the words of Lord MacNaughten in Lillingworth V Houndsworth,
“A floating charge on the other hand is shifting in its nature, hovering over and so to
speak floating with the property which it is intended to affect until some event
occurs or some act is done which causes it to settle and fasten on the subject of the
charge within its reach and grasp.”
Characteristics of a floating charge
These were laid down by Romer J in Revorkshire Wool Combers Association:
 It is a charge on a class of assets of the company both present and in future.
 The class of assets must be one that keeps on changing from time to time in
the ordinary course of business of the company.

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  The change remains dormant until crystallization. Until such a time, the
company may use the assets charged in the ordinary course of its business.

Rules relating to floating charges

1) It attaches to the subject charged in varying conditions in which it happens to
be from time to time
2) When an item within the class charged is sold, the charge ceases to attach to
it, when an item is acquired the charge immediately attaches to it
3) It remains dormant until the undertaking charged being a going concern or
until the person in whose favour the charge is created intervenes
4) It leaves the company free to deal with the property in the course of its
business, and it may even sell its undertaking provided the company remains
a going concern.
5) The company may also create a mortgage over a specific property which will
rank in priority to the floating charge.
Crystallization of floating charges
A floating charge is an equitable charge which does not fasten on any specific
property but covers the whole of the company’s property. When it crystallises or
become fixed, the assets comprised in the charge are subject to some restrictions and
are affected in the same manner as under a specific (fixed charge).
Upon crystallization the floating charge fastens on the available Asset and thereby
becomes a fixed charge.
A floating charge will crystallize in the following circumstances:
1) When the company ceases to carry on business or ceases to be a going
concern
2) Default in payment of the principal or interest when due and payable provided
the charge takes some step to enforce the security.
3) Upon the commencement of recovery proceedings against the company.
4) When the company goes into liquidation, the floating charge automatically
crystallises whether or not the company is in default.
5) Upon the appointment of a receiver by a debenture holder or by the terms of
the debenture causes crystallization.
6) Whenever one floating charge crystallizes all others crystallize.
Advantages of a Floating Charge

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  The charge covers the assets of a going concern both present and future.
 It enables companies with no fixed assets to borrow.
 It enhances the borrowing capacity of companies with fixed assets
 The charge does not prevent the company from disposing off and acquiring
new stock.
 Upon crystallization, the charge settles on the floating assets within its reach
and grasps thereby enabling the chargee to sell them.
Disadvantages of a floating charge
 The value of the security remains uncertain since the company continues to
dispose of and acquire stock.
 A fixed charge created subsequent to the floating charge has priority in the
satisfaction of claims.
 Other interests e.g. landlords distress for rent have priority in the satisfaction
of claims.
 Under Sec 312 of the Act a floating charge created within 6 months before the
commencement of winding up is deemed to be a fraudulent preference and is
void
 A floating charge created within 12 months before the commencement of
winding up is invalid unless it is proved that the company was solvent
immediately after its creation.
Distinction between fixed and floating charge
Floating charge Fixed charge
 A floating charge is an equitable  Fixed charge is a specific charge
charge on all the assets of the on a specific piece of property
company
 The company has freedom to deal  The company losses right to deal
with the property charged with the property till redemption
 Creates equitable rights on the  Passes legal title to the assets of
assets of the company the company

Priorities of a Fixed and Floating Charge

a) Fixed charges rank according to the order of creation.

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 b) A fixed charge takes priority of a floating charge notwithstanding that floating
charge was created before the fixed charge.
c) A floating charge created before a fixed charge can take priority if the legal
charge (fixed charge) created had notice of the prior charge.
d) A fixed charge created prior to a floating charge has priority.
e) It is possible to vary the rules of priority by an agreement between the parties.
f) If a floating and fixed charge relate to the same security, the fixed charge has
priority. A floating charge will be postponed to a later fixed charge over the
same property. This is so because the fixed charge attaches to the charged
property at the time of its creation whereas the floating charge attaches at the
time of crystallization.
g) The floating charge would however have priority over the later fixed charge if
—
 The floating charge contained a "negative pledge" clause which
prohibited the company from later on creating fixed charges with
priority over it, and
 the holder of the fixed charge actually knew of the prohibition
h) If two floating charges are created over the general assets of the company,
they rank in order of creation.
Registration of Charges
Section 96(1) requires the prescribed particulars of specified charges on a company's
property or undertaking to be delivered to the registrar for registration within 42
days after the date on which the charge was created. The specified charges are:
 A charge to secure an issue of debentures;
 A charge on uncalled share capital;
 A charge created by an instrument, which, if executed by an individual, would
require registration as an instrument under the Chattels Transfer Act (e.g. a
Letter of hypothecation);
 A charge on land;
 A charge on book debts of the company;
 A floating charge;
 A charge on calls made but not paid;
 A charge on a ship or any share in a ship;
 A charge on goodwill, a patent, a copyright or a trademark.
The prescribed particulars
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The "prescribed particulars" of registered charges are enumerated in Form No 214
and are:
a) The date and description of the instrument creating or evidencing the
mortgage or charge;
b) The amount secured by the mortgage or charge;
c) Short particulars of the property charged;
d) Names, postal addresses and descriptions of the persons entitled to the charge;
e) Amount of rate per cent of commission, allowance or discount (if any) paid.
f) Particulars of the company
General Aim
The purpose of registering the aforesaid particulars is to enable a would-be creditor
to know the company's existing indebtedness and the assets available for their
settlement.
Certificate of Registration
The Companies Act requires the registrar to give a certificate, under his hand, of the
registration of any of the specified charges. The certificate shall be conclusive
evidence that the statutory requirements as to registration have been complied with.
Consequently, the charge would not be rendered void on the grounds that one of the
prescribed particulars, such as the date of the creation of the charge, is later found to
be incorrect.
Particulars of the register
i) The name, address, occupation of each debenture holder
ii) The debentures held by each holder distinguish each debenture by its number
iii) The amount paid or agreed to be paid on the debenture
iv) The date at which each person was entered in the register as a debenture
holder
v) The date at which any person ceased to be a debenture holder
vi) Every company to keep at its registered office a register of charges the
following particulars:
 A short description of the property charged
 The amount of the charge
 The names of the persons entitled to the charge

Effect of Non-Registration

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Registration of charge cures all defects characterising the charge. The charge is
deemed to have been made in due compliance with the provisions of the companies
Act.
If the prescribed particulars if any of the specified charges is not registered within
the prescribed period of 42 days
 The charge will be "void against the liquidator and any creditor of the
company".
 The money secured becomes immediately repayable. This means that the
lender is not bound by the terms of the charge and can take immediate steps to
recover his money; and
The court is empowered by the Companies Act to extend the time for registration of
the charge on being satisfied that the omission to register the charge within the
prescribed time was accidental or was due to negligence or other sufficient cause,
provided that neither creditors nor shareholders would be prejudiced by the
extension.
Remedies of Debenture Holders
1. Debentures holders’ action / Right to sue: This is the right of a creditor to
sue the company for the amount due inclusive of interest in the event of
default. This remedy is available to both secured and unsecured creditors.
2. Foreclosure/ Foreclosing order: This is a Court order which prevents the
company from redeeming its security. It denies the company the equitable
right to redeem and the security becomes rested in the tender who can sell it at
will.
3. Appointment of receiver: A receiver may be appointed by the debenture
holder in accordance with the terms of the debenture or by the Court on
application by a debenture holder. A receiver takes over possession of the
security and manages the same to facilitate payment of the amount due.
The following amount must be paid:
 All amounts outstanding prior to the mortgage or charge.
 Rates and taxes and other outgoings.
 The receiver’s commission.
 Payment of insurance and repairs as agreed.
 Principal or interest due.

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4. Petition for Winding Up: A company may be wound up by the Court upon
application if the Court is satisfied that it is unable to pay its debts, that is
insolvent. A creditor may petition for the winding up of a company on this
ground. A company is deemed unable to pay its debts:
 If a debt of KShs. 100,000 or more remain unpaid after 3 weeks of
demand.
 If execution of another Court processor order in favor of a creditor is
returned unsatisfied in whole or in part.
 It is proved to be satisfaction or the Court that the company is unable to
pay its debts. In determining whether it is so unable the Court must take
into action the contingent and prospective liabilities of the company.

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