Northern Rock: The Rocky road to ruin
19 May 2008
The legal profession’s finest are warming up for a conflict between angry shareholders in Northern Rock and the Government in which the finer points of insolvency law will be the battleground
Former shareholders in the nationalised bank Northern Rock are taking no chances in their proposed judicial review, lining up the big guns of the bar to fight their case against the Government.
The crux of their argument is that the Government confiscated their shares in the ailing bank and made insufficient allowances to compensate them, effectively breaching their human rights.
As the shareholders’ grounds of claim states: “The statutory scheme established by the Treasury to compensate shareholders for the expropriation of their shares is in violation of Article 1 of the First Protocol of the European Convention on Human Rights.
“In short, the Treasury has wrongfully legislated to take ownership of a solvent business, on terms which ensure that it will make a profit in due course, at shareholders’ expense.”
The investors clearly believe they have a strong case - why launch a judicial review otherwise? Leading the fight under advice from White & Case partner John Reynolds is hedge fund SRM Capital, the bank’s largest shareholder at the time of nationalisation, which has called on David Pannick QC and Claire Weir of Blackstone Chambers, as well as Matthew Collings QC of Maitland Chambers, to represent it. A group of the bank’s smaller shareholders, represented by Edwin Coe partner David Greene, has called on George Bompass QC of 4 Stone Buildings, while hedge fund RAB Capital is using Michael Beloff QC and Iain Steele of Blackstone and David Wolfson of One Essex Court. They will all face the formidable force that is Lord Anthony Grabiner QC for the Treasury. Grabiner will work alongside Philip Sales QC, Clive Lewis QC and Paul Nicholls, all of 11KBW.
Yet despite the headline-grabbing spectacle the case will make if permission to launch the review is granted, some litigators remain sceptical about the grounds for the claim.
“It seems somewhat tenuous,” says one partner at a City firm. “The shareholders have raised concerns about the basis on which something the Government did was done, but at the end of the day it will be very difficult for them to find a remedy that’s effective from their point of view.”
Not so, according to Greene at Edwin Coe. “In the primary legislation and the secondary legislation for nationalisation, the Government set out certain criteria that have to be taken into account by the valuer during the valuation process,” he says. “Those criteria are likely to have the effect that the value of the shares and the compensation is either nil or very little. They’re intended to reduce the compensation payable for the expropriation of the assets.
“Article 1 of the First Protocol on the European Convention on Human Rights protects property rights against expropriation and that’s brought into effect domestically by the Human Rights Act. We say that the criteria they’re setting are in breach of shareholders’ rights under that.”
The main issue is that the Government has said any calculation of Northern Rock’s value for compensatory purposes must assume that the Bank of England’s lender of last resort assistance and the Treasury’s deposit guarantees are withdrawn, effectively leaving the bank in administration.
Prior to applying for the judicial review, the shareholders asked the Treasury to rethink that stance, arguing that Northern Rock is, and was, a going concern that faced illiquidity rather than insolvency issues.
Via Slaughter and May partner Elizabeth Barrett, the Government rejected the plea.
A letter from Barrett says: “A system of compensation which proceeds on the assumption that the public assistance has been withdrawn and that no further public assistance will be provided […] is reasonable and appropriate. Such a scheme reflects a fair balance between the interests of the individual shareholders and the wider public interest. It ensures that there is a reasonable relationship between the amount of any compensation payable and the value of the property at the time and in the circumstances in which the transfer occurred.
“Northern Rock, without public financial assistance, would have ceased to be a going concern and would have been made subject to an insolvency procedure such as administration. Those provisions therefore provide a reasonable and proportionate basis for determining any compensation payable to persons who held shares in Northern Rock immediately prior to their transfer.
“The Treasury consider that the action envisioned […] would be misconceived and without merit.”
Yet other institutions that had large shareholdings in the bank are preparing to enter the fray, also convinced that their assets have been appropriated wrongfully.
A 17 April letter from Legal & General solicitor Marianne Manning to Reynolds at White & Case reads: “Legal & General Investment Management, as fund manager for a number of clients, was a significant shareholder in Northern Rock plc. It therefore has a substantial interest in any judicial review process.”
Of course, the argument can be made that investing is a risk and everyone who makes an investment should know that just as they could make huge profits, they could also lose every penny.
Sophisticated investors, such as fund managers and hedge funds, should be more aware of this than most individual shareholders. As Philip Price, chief operating officer at SRM Advisers, admits in his witness statement: “The reason that we bought heavily into Northern Rock was because, after the unfortunate events which led to the run on Northern Rock and a loss of confidence in it, its shares were trading at a deep discount to their true book value.
“Northern Rock had the benefit of liquidity support from the tripartite authorities, which was provided in response to the turbulence in the financial markets. In our experience, such support is given (and expected to be given, and continued) in cases of illiquidity and insolvency […] Consequently we thought that its shares were a very good investment, but we regarded them as a medium to long-term investment and not a speculative one.”
Clearly, as would be expected, those running the hedge fund knew exactly what they were doing. But in a sense, that could give more credence to their claim: the issue is not the fact that they have lost money that is the problem (and with more than 48 million shares SRM has lost a lot), rather it is more the way in which that money was lost.
“It’s the unfairness of the terms of the compensation scheme and of the level of compensation which will be paid to former shareholders under the compensation scheme that’s the basis of the claim,” insists Price.
Greene also dismisses the argument that in this case investors knew what they were getting into and stood to lose as well as gain from their shareholdings.
“That’s not a relevant argument here,” he states. “It’s right that you take a risk when you invest in shares. The results of that risk might have been a sale of Northern Rock’s assets to a third party during the autumn and winter of 2007-08. That would have realised for many people a substantial loss, given that in January 2007 people were buying shares at about £11.50.
“But that hasn’t happened - there’s been a nationalisation. In certain circumstances a government is entitled to nationalise in the public interest, but it has to pay a reasonable price for the asset it’s taking.”
Of greatest annoyance to the shareholders is the fact that the Government has repeatedly said it wants to make a ’return’ for taxpayers on the money that was pumped into Northern Rock.
Shareholders will rely on evidence from economist Professor Timothy Congdon to rubbish this. He stresses that the Government did not make an investment, but a loan.
Congdon’s evidence runs thus: “The suggestion that the Government should seek ’a return’ or an ’adequate return’ on ’its money’ in circumstances of lender of last resort, or should somehow make a profit or achieve ’value’ (beyond the repayment of lender of last resort assistance in accordance with its terms), is unprecedented in my experience. It seems to arise from a misunderstanding of the nature of lender of last resort assistance and, specifically, from a confusion between a loan and a capital injection.”
The point being that you can only make a return when a capital investment is made while loans are simply repaid. The shareholders invested capital and should expect a return, while the Government made a loan and should expect the sum to be repaid with interest. Northern Rock has so far paid off £4bn of the loan it received, at a penal rate of interest, and expects to have the remaining £20bn or so paid off by 2010.
While the case seems strong, there are still plenty of sceptics. One such is Forsters litigation partner Andrew Head. “The Northern Rock shareholders should have been well aware of the risk that their shares would decline in value and were free to sell their shares at any time up to the date that Northern Rock was nationalised,” he says. “In these circumstances the Government’s compensation proposals appear to be both reasonable and defensible.”
In the meantime, Grabiner et al are standing by to let the shareholders have their day in court. It could be bloody.