Chapter 1: Introduction to Securities

Learning Objectives

After studying this chapter, you should understand:

• Concept, legal framework, and economic role of Securities in the financial system.
• Distinction between Owned Capital (Equity) and Borrowed Capital (Debt).
• Core features, returns, and investor benefits of Equity Capital.
• Characteristics, structural components, and investor protections in Debt Capital.
• Hybrid financial instruments: Convertible Debentures and Preference Shares.
• Comparative matrix of Equity, Debt, and Hybrid instruments.

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1.1 Introduction to Securities & Sources of Capital

A business enterprise requires capital to establish operations, invest in productive assets, meet working capital needs, and fund expansion. Business capital is fundamentally classified into two categories:

                            SOURCES OF BUSINESS CAPITAL
                                         │
                 ┌───────────────────────┴───────────────────────┐
                 ▼                                               ▼
           OWNED CAPITAL                                  BORROWED CAPITAL
          (Equity Capital)                                  (Debt Capital)
   Contributed by promoters and                   Borrowed from financial lenders,
   shareholders; risk capital                     banks, or debt security holders;
   held in perpetuity.                            contractual repayment obligation.

Statutory Definition of "Securities"

In India, securities are legally defined under Section 2(h) of the Securities Contracts (Regulation) Act, 1956 [SC(R)A]. Under this statutory definition, securities include:

1. Shares, scrips, stocks, bonds, debentures, debenture stock, or other marketable securities of a like nature in or of any incorporated company or body corporate;
2. Derivative instruments;
3. Units or any other instrument issued by any collective investment scheme (CIS) or Mutual Fund scheme to investors;
4. Security receipts defined under the SARFAESI Act, 2002;
5. Government securities (G-Secs, Treasury Bills, State Development Loans);
6. Rights or interest in securities.

Classification Criteria for Capital

Capital employed by a company is evaluated across four core dimensions:

1. Contributors of Funds: Promoters/founders vs. external retail and institutional public investors (equity shareholders) vs. financial creditors/lenders (debenture holders, banks).
2. Time Horizon / Tenor: Equity capital is perpetual (cannot be redeemed except via court-approved capital reduction or buybacks). Debt capital has a predetermined maturity period ranging from short-term (< 1 year) to long-term (up to 10–30 years).
3. Cost of Capital: Debt imposes a mandatory contractual cost (coupon/interest) payable irrespective of business profitability. Equity has no fixed payout obligation; returns depend on discretionary dividends and market capital appreciation.
4. Governance and Managerial Rights: Equity shareholders possess voting rights to elect directors and approve major corporate resolutions. Debt holders have no voting rights in corporate management, but retain restrictive covenants and priority claims over assets.

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1.2 Features of Equity Capital and Benefits to Investors

Equity capital represents the permanent risk capital of an incorporated company.

Key Characteristics of Equity Capital

1. Ownership Stake: Equity shares divide the total equity capital into units of equal face value (e.g., ₹1, ₹2, ₹5, or ₹10). Holding equity shares confers fractional ownership of the corporation.
2. Limited Liability: Under company law, the liability of an equity shareholder is strictly limited to the unpaid amount, if any, on the shares subscribed. Personal assets of shareholders cannot be attached to settle corporate debts or bankruptcy liabilities.
3. Perpetual Existence: Equity capital is contributed for perpetuity. The company has no obligation to repay or return capital to shareholders during its normal operating life. Investors seeking liquidity must sell their shares in the secondary market (stock exchange).
4. Voting Rights and Corporate Democracy: Each ordinary equity share carries one vote on a poll. Shareholders exercise control through general meetings (Annual General Meetings - AGMs and Extraordinary General Meetings - EGMs). Major corporate decisions require ordinary or special resolutions.
5. Residual Claim on Earnings and Assets:
   • Residual Profit: Equity shareholders are entitled to corporate profits only after operating expenses, depreciation, debt interest, and corporate income taxes are fully deducted. The remaining earnings (Profit After Tax - PAT) belong to shareholders.
   • Residual Liquidation Priority: In the event of corporate winding up, proceeds from the liquidation of corporate assets are utilized first to settle statutory government dues, secured lenders, unsecured creditors, and preference shareholders. Equity shareholders rank last.

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1.3 Features of Debt Capital and Benefits to Investors

Debt capital represents borrowed funds that create a formal debtor-creditor legal relationship between the borrowing company and the lending investors.

Key Characteristics of Debt Capital

1. Contractual Payout Obligation: Debt securities (bonds, debentures) mandate periodic interest payments (known as the coupon rate) at predetermined frequencies (annual, semi-annual, quarterly, or monthly). The obligation to pay interest is absolute and independent of corporate profit or loss.
2. Defined Maturity & Redemption: Debt is borrowed for a fixed tenor. On the maturity date, the borrowing company is legally bound to redeem the instrument by repaying the principal borrowed.
3. Security and Collateralization:
   • Secured Debt: Backed by a specific charge (fixed charge or floating charge) on corporate assets. If the company defaults, the Debenture Trustee can enforce the charge and liquidate the pledged assets to recover investor dues.
   • Unsecured Debt: Backed only by the general creditworthiness of the issuing company (e.g., Commercial Papers, unsecured subordinated debentures).
4. Credit Rating Requirement: Under SEBI regulations, public issues and listed private placements of debt securities must obtain credit ratings from at least one SEBI-registered Credit Rating Agency (CRAs such as CRISIL, ICRA, CARE, India Ratings). Credit ratings evaluate default probability (e.g., AAA indicates highest safety; D indicates default).
5. Tax Deductibility of Interest: From the corporate issuer's perspective, interest paid on debt capital is a tax-deductible business expense. This reduces taxable income, creating an "interest tax shield" that lowers the effective cost of debt compared to equity dividends.

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1.4 Hybrid Financial Instruments

Hybrid instruments combine the structural characteristics of both debt and equity within a single financial contract:

┌─────────────────────────────────────────────────────────────────┐
│                   HYBRID CAPITAL STRUCTURES                     │
├────────────────────────────────┬────────────────────────────────┤
│      PREFERENCE SHARES         │     CONVERTIBLE DEBENTURES     │
├────────────────────────────────┼────────────────────────────────┤
│ • Fixed dividend rate          │ • Periodic interest coupon     │
│ • Priority over equity         │ • Converts into equity shares  │
│ • No management voting rights  │ • Avoids cash redemption drain │
│ • Maximum 20-year redemption   │ • Pre-agreed conversion ratio  │
└────────────────────────────────┴────────────────────────────────┘

1. Preference Shares

• Fixed Dividend Rate: Offers a predetermined dividend rate (e.g., 7% Cumulative Preference Shares).
• Dual Priority:
  1. Priority in dividend distribution before any dividend is paid to ordinary equity shareholders.
  2. Priority in repayment of capital in the event of corporate liquidation before equity shareholders.
• Voting Rights Limitation: Preference shareholders do not hold general voting rights. However, under Section 47 of the Companies Act, 2013, if dividends remain unpaid for a period of two consecutive years or more, preference shareholders gain the right to vote on all corporate resolutions.
• Statutory Tenor: Under Section 55 of the Companies Act, 2013, all preference shares must be redeemable within a maximum period of 20 years (or up to 30 years for specified infrastructure companies).

2. Convertible Debentures

• Debt instruments that carry an option or mandate allowing conversion into ordinary equity shares after a predetermined period at a pre-agreed conversion ratio.
• Eliminates the cash outflow required for principal repayment upon maturity for the issuing company.

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1.5 Comparative Analysis: Equity vs. Debt vs. Preference Capital

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Chapter Summary & Exam Cheat Sheet

• Securities Definition: Codified under Section 2(h) of SC(R)A, 1956; explicitly includes units of mutual fund schemes.
• Equity Capital: Perpetual risk capital with limited liability, residual claim, and democratic voting rights.
• Debt Capital: Borrowed funds with fixed coupon, mandatory repayment at maturity, priority charge on assets, and zero management control.
• Interest Tax Shield: Debt interest is tax-deductible; dividends are distributed from post-tax earnings.
• Preference Shares: Fixed dividend and priority in capital refund; maximum statutory tenor is 20 years (Section 55).
• Preference Voting Trigger: Preference shareholders obtain full voting rights if dividends remain unpaid for 2 consecutive years.