Most of our readers would be well aware that section 588G of the Corporations Act can make directors personally liable if their company incurs a debt when it was insolvent, and there were reasonable grounds to suspect that the company was insolvent at that time.

But what exactly is a “debt”, and, in relation to a lease of property when is that debt “incurred”?

Neither the meaning of “debt” nor “incurred” is defined in the legislation, however there are two cases which are of assistance. The cases are Russell Halpern Nominees Pty Ltd v Martin (1987) WAR 150; (1986) 10 ACLR 539 (Russell). Bans Pty Ltd v Ling and Others (1995) 16 ACSR 404

These rules which can be distilled from those cases:

1. In relation to a lease of property the debt is incurred when the lease is first entered into. To incur a debt there must be “a positive, voluntary act” by the company. The lease instalments may well become payable each month, but that happens involuntarily as a result of the earlier incurring of the lease commitment.
2. Section 588G is concerned with when the debt was incurred rather than when it becomes payable. So even if some time after the incurring of the debt the company becomes insolvent and lease instalments become payable those amounts will not form part of an insolvent trading claim.
3. Of course if the lease was entered into when the company was insolvent (and the director knew or should have known of the insolvency) section 588G will apply. In these circumstances the director becomes personally liable for the amount of the full lease commitment.
4. If the lease period comes to an end and the company remains in possession of the property on, say, a month to month tenancy a new debt will be incurred each month and the director is in jeopardy of personal liability if the company is insolvent.
5. Paradoxically the obligation to pay monthly lease instalments (and any arrears) will form part of the assessment process of deciding whether a company is insolvent, that is able to meet its debts when they fall due, although the instalments will not form part of the insolvent trading claim.

In a recent liquidation handled by the writer a director had elected to have his company take up an option to roll over a lease. The director knew that his company was insolvent but was hoping (or expecting) to sell the business of the company and in that way to improve the eventual return to stakeholders, and he judged it necessary to have a lease over the business premises for the business sale purposes. Unfortunately the sale fell through, the company failed, and the director became liable for the full amount of the rolled over lease.

Of course it is not just property leases that are subject to these rules. For example they could apply to chattel leases or equipment hire agreements.