Ultimate Law Guide

Case study: National Rock

As aspiring lawyers, in order to secure a training contract you will be required to demonstrate
your commercial awareness at the application and interview stage. You will be asked to discuss a
recent transaction that has interested you. The issue that has occupied the legal and financial
arena the most during the last six months is the fall of Northern Rock, one of the country’s
largest mortgage lenders.

Background

As a mortgage bank and building society, Northern Rock has 1.8m customers and an estimated
180,000 small shareholders. The bank’s headquarters are in Newcastle, although its reach spans
across every corner of the UK.

When is a crisis, a crisis?

As a result of the collapse of the US sub-prime market last summer, the world’s financial markets
were in turmoil and panic engulfed the City and the rest of the UK. Cheap and easy credit was no
longer readily available to financial institutions. This particularly affected Northern Rock, because
the lender had become over-reliant on cheap and easy credit to finance its business model.1

Northern Rock made vast sums of money by borrowing cheaply from the three-month money
market and using the proceeds to offer extended competitively priced mortgages which yielded
higher returns. However, once the credit crunch began to bite, there was a credit constriction as
banks became extremely wary of lending to other banks. This had a significant effect on Northern
Rock’s business: it was suddenly unable to obtain cash on the favourable terms from other banks
that it had become accustomed to, as lending rates had risen sharply. Although there are much
fewer sub-prime mortgages in the UK, mortgage lenders2 (particularly Northern Rock) found it
difficult to raise the cash to pay for additional mortgage lending. As soon as the money markets
froze, they were no longer able to roll over their loans. The Rock’s liquidity crisis erupted, and the

1 If you wind back the clock 12 months, City analysts were lauding Northern Rock’s lending model for its simplicity and effectiveness. At its peak, the
company was valued at over £6bn and it was the country’s fifth largest mortgage lender.
2 Bradford & Bingley and Alliance & Leister have also been affected by the credit crunch.

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mortgage securitisation market was left virtually paralysed. It soon became apparent that
Northern Rock’s business model was in serious trouble.3

Intervention of the Bank of England

The decline of Northern Rock had been swift. The lender needed to be bailed out by other banks
or the authorities, or it would become insolvent. But banks no long trusted each other; they
didn't know who had the worst problems.

The Bank of England rescued Northern Rock by injecting some much needed liquidity into the
ailing bank. Mervyn King, the governor of the Bank of England, assisted Northern Rock by
extending an emergency unlimited credit line, effectively underwriting Northern Rock. This
signaled the Bank of England’s gradual takeover of Northern Rock’s assets – a ‘temporary
nationalisation’4 to prevent it from collapsing from a lack of liquidity.

On 17 September 2007, Chancellor Alistair Darling increased the mounting panic by announcing
that the savings of all Northern Rock customers would be guaranteed by the government over
the long-term.5 This announcement was made despite the concerns of the Bank of England.6
Faced with the prospect of a run on a major retail bank for the first time in 140 years and a fall in
the bank’s shares, direct state intervention appeared to be the government’s solution to the
crisis, in order to stop a worsening panic on the high street.7 Northern Rock’s cash was no longer

3 Northern Rock were unable to raise huge sums of deposits to sustain the mortgage growth its investors had expected. Northern Rock turned to
alternative funding options for recourse. The bank implemented a securitisation programme of wholesale funding, secured bonds and covered bonds
worth £46bn to plug the shortfall between deposits of £27bn and loans of more than £86bn. Northern Rock covered the £13bn deficit by utilising the
short-term money markets and constantly rolling over its loans. The three-month LIBOR (London Interbank Offered Rates) were high, and this made
it an impossible obstacle for the bank to overcome, forcing it to halt its ongoing aggressive securitisation programme. This was problematic for Adam
Applegarth, the bank’s chief executive, because investors were no longer interested in mortgage-backed securities, which meant Northern Rock could
not obtain the £2.6bn it required to refinance its outstanding debt.
4 This was not enough to cut the queues of customers taking out their savings and reinvesting their money with other banks. They had not lost their
confidence in the whole banking system, merely in Northern Rock.
5 Taxpayers were therefore made responsible for underwriting the £1.6trn ($3.2trn) held in UK deposit accounts, an entirely unprecedented move in
British economic history. The editorial in The Business on 22 September 2007 commented that this was a drastic measure designed to reduce the
pressure of mounting queues of customers outside the bank desperate to withdraw their life savings, and a share price which was rapidly falling, with
a market capitalisation slump in excess of £1bn.
6 ‘[Mervyn King, the governor of the Bank of England] rightly argued that these institutions should not be rewarded for their excessive risk-taking and
the best policy was to allow the market to work itself out. Capitalism only functions properly when the market punishes those who fail or take the
wrong decisions, for whatever reason, not merely rewards those who succeed. He rightly sees keeping this source of emergency funds open as the
key part of a central bank’s job; another is its role as a lender of last resort, where the central bank extends loans to financial institutions in crisis ...
and that any financial assistance must come at a penalty rate to punish management and shareholders for the business getting into financial trouble
and having to ask for help.’
7 It was clearly evident that there was a lack of public confidence in official assurances from the highest triumvirate consisting of the government, the
Bank of England and the Financial Services Authority. With implications for savers, borrowers and investors, scaremongers were drawing parallels with
events of the 1930s in America, where mass bank bankruptcies led to a collapse in the supply of money and credit, turning a recession into a
depression.

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readily available and the bank urgently required the Bank of England (via taxpayers’ money) to
bail it out and rescue its customers.8

Was the Rock’s crisis a result of the US sub-prime crisis?9

Unlike the American sub-prime mortgage collapse, the current crisis affecting Northern Rock was
not a consequence of bad debt, over-lending, the quality of its mortgages, the standard of
Northern Rock’s credit checks on its borrowers, or even the UK’s widespread culture of taking on
inordinate levels of credit. Much of the crisis was caused by Northern Rock’s own flawed business
model and reckless approach to borrowing from the money markets.10 It may have suffered more
than most as a result of the worldwide credit crunch, but Northern Rock is certainly no victim.
The only victims are the taxpayers; the bank’s employees who face the prospect of losing their
jobs; and perhaps the small shareholders who have invested their life savings in the bank.11 Any
solution for the bank must surely have the taxpayers’ best interests at its centre.

It is our contention that the crisis at Northern Rock was not a cause but a symptom of a much
wider malaise: the financial markets could no longer withstand the impact of the demand for
cheap and easy credit from consumers, borrowers, investors and financial institutions alike.
.According to the BBC Business Editor, Robert Preston on the BBC website, Northern Rock was
starved of vital sustenance last summer when those wholesale markets closed: its undoing was
the crisis of confidence in the financial community precipitated by the disclosure of just how
ineffectual international banks had been as lenders.12 This is why the Rock had to demand

8 However, central banks around the world intervened and made billions of dollars available to the big banks to keep borrowing costs from rising too
sharply. The crisis remained under control, and because the US economy is currently weakening, many economists expect the US to experience a
recession.
9 It is worth noting here that similarities between the UK and US economies do exist: both these countries have shared huge rises in house prices,
stock market volatility, easy access to credit, large current account deficits (with the UK’s recently even higher than that of the US, in relation to gross
domestic product) and upward pressure on inflation. In addition, our respective banking sectors are strongly affected by the credit squeeze.
10 Northern Rock’s largest shareholder, Scottish Widows, had to cut their losses in the bank. Bradford & Bingley and Alliance & Leister have also been
affected by the credit crunch.
11 The editorial comment in the Financial Times, ‘No resolution for Northern Rock – Time is running out to avoid nationalising the bank’ (16 January
2008,) highlighted that the only scenario that would be palatable to everyone is a recapitalisation by commercial investors. But with banks such as
Citigroup and Meryll Lynch also having to raise money, it looks like Northern Rock has missed the boat. The vista has gone, and the sale process must
end soon.
12 Prime Minister Gordon Brown gave the following speech to the world’s political and business leaders at the World Economic Forum on 22 January
2008:
‘Much of the recent global financial crisis was caused by a search for higher returns, investors under-priced the risks in a number of markets.
The recent turbulence was caused by loan risks being transferred to those least able to understand them, which has raised many questions and issues
for policy makers. Firstly, there needs to be a mechanism to respond to the under-pricing of risk, but some markets are not functioning and the
availability of credit has been restricted. If these problems were due to an under-pricing of risk, the source of many of the problems had been a lack
of transparency. The transparency deficit needs to be addressed by credit rating agencies. Secondly, as the world’s financial markets have become
increasingly interconnected, the government of each nation must ensure they have effective cross-border crisis management arrangements. Central
banks have already taken positive action to sort out such short-term troubles. There is a need for strengthened national regulatory frameworks
together with strengthened international co-operation. Whilst global companies have undertaken business which has transcended borders, their
supervisors and regulators are largely national. The world has no effective early warning system and an absence of a uniform approach to managing

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succour from the Bank of England13 – and why it survived by a £60bn lifeline provided by the
Treasury. But make no mistake; for a bank it is as much a travesty to take excessive risks as a
borrower as it is to do so as a lender. A drying-up of access to funding will starve a bank just as
surely as lending to those who can't repay. The government decided it was acceptable to provide
long-term state aid to prevent what was once Britain’s fifth largest mortgage lender going bust.
As a result, the entire liabilities of the banking system were contingent liabilities of the state.14

Did a credible solution exist?

Three key issues required addressing:

1. Were commercial investors willing to pay up and inject sufficient new capital to buy out
Northern Rock?
2. Could Northern Rock be put into administration without extensively damaging the
country’s banking system?
3. If administration did not present a credible solution, how much would the government pay
shareholders to nationalise the bank?

The government clearly faced a tough decision between finding a fully financed private-sector
saviour (which remained their preferred option) and facing full nationalisation. A ‘responsible
private sector solution was clearly the best way forward’.15 A move where Britain’s leading
commercial banks would assist the Bank of England, together with the government, by
demanding an injection of billions of pounds of capital and deposits into Northern Rock in
exchange for new shares, and for the sake of the reputation of the City of London. Such a move
would bring an end to the government’s several months of unnerving hesitancy and legal
prevarication, which had been symptomatic of the handling of the Northern Rock saga, when
determination and strong governmental leadership was needed. In times of economic

major disruptions in the global financial markets. Many of the problems were identified in advance but not acted upon. We need a clearer, more
authoritative watchdog. Regulators must overcome national boundaries with common principles, shared analyses and collaborative handling of
financial crises. We can also do much more to boost confidence in global markets over the long-term by taking action to reform the international
financial institutions. The International Monetary Fund should be central to such reform. It must be reformed to reflect global economics. To be
effective in the modern era, the IMF must start to act with the same independence as a central bank and develop responsibilities for financial stability
to be made clearer, for the surveillance of the world economy, for informing and educating markets, and for enforcing transparency through the
system . . . to create an early warning system against the threat of a future global financial crises.’
13 It is worth noting that each private bidder has promised swift repayment to the Bank of England of a sizeable chunk of its lending. The money
must be borrowed to fulfil that promise, and the financial credit crisis has left banks both short of liquidity and weary of risk, especially as the
mortgage market and the economy continues to turn down.
14 Martin Wolf, ‘The Bank must keep its nerve’, Financial Times, 25 January 2008, p 10.
15 Alex Brummer, ‘the credit squeeze , Daily Mail, 16 January 2008, p 8.
’
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uncertainty, the banks viewed preserving their liquidity and finding new investors as the main
priority. Bailing out Northern Rock was someone else’s crisis.16

What were the government’s options?

Did a way forward to this Northern wreck exist? The government’s options were a subsidised sale
to the private sector, putting the lender into administration or nationalisation.

A private sector sale

The government had been confident of a private sector buyout. There were three contenders:
• A commercial consortium led by Sir Richard Branson's Virgin Group,17 which would take a
controlling interest in the bank
• Olivant, a private-investment firm headed by Luqman Arnold, the former Abbey National
bank head
• Northern Rock’s own in-house management team, led by Paul Thompson
The government was under intense pressure to deliver the best deal for the taxpayer as
taxpayers had to foot so much of the bill in this crisis, and therefore deserved nothing less.

The proposals

Virgin’s proposal was based on a three-way split between the interests of the bank’s
shareholders, Virgin and the taxpayer. Virgin would invest £1.25bn, which consisted of £500m
created through a rights issue18 priced at 25 pence per share. The £750m residual consisted of
£250m from the Virgin Group and a £500m cash injection from the commercial consortium.

Olivant proposed taking a minority interest in Northern Rock and turning the bank around
through improved management. Both Olivant and the Virgin Group made assurances to involve
Northern Rock and preserve most of the bank’s 6,000 jobs.

The management proposal, meanwhile, suggested a simple split between the Rock and the
taxpayer. It would involve a smaller cash injection upfront, which would have provided room to
negotiate further down the line, because unlike Virgin the proposal from the in-house
management team did not have a distinct brand and commercial interests to consider (Virgin

16 We believe Northern Rock became a failure as a result of the government’s inability to reform before such a banking disaster struck, and this is
now costing the government. In these dire circumstances the banks see conversion of capital and funding from new investors as the main priority, but
reforms must be implemented to avoid such a banking crisis in the future.
17 The consortium also included global insurance heavyweights AIG, Hong Kong-based First Eastern Investment Group and the hedge fund
Toscafund.
18 Essentially, companies make rights issues to shareholders to raise finance for investment or to reduce the burden of a company debt. A rights
issue offer increases new shares to the public, which will dilute the shareholding of the existing shareholders in the business.

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proposed to change Northern Rock’s name to Virgin Money if it won the bidding process, which
would have required the approval of regulators). However, the government appreciated that
choosing their own management presented them with more options – from selling the Rock in the
next couple of years, or aggressively running down its mortgage book should it not be viable.

The bids were on the rocks

The bidders were unable to obtain access to sufficient capital to repay the £26bn loan from the
Bank of England and the £30bn guarantee of depositors.19 This became the main negotiating
point for the interested parties, and they attempted to wrangle with the government over
protecting the taxpayers' loans, which had been underpinning the bank. The reticence of
commercial banks to lending created a financial landscape which weakened the government’s
ability to find a private buyer.20

On the 4 February 2008, the day of the government deadline for interested parties to submit
their proposal to buy the Rock, Olivant pulled out of the bidding process ‘due to the government’s
inflexible demands and terms offered’, compounding the government’s problems.

Are there any other options for private-sector rescue?

Goldman Sachs advised the government on its handling of the Northern Rock affair and explored
whether it could have raised the necessary private finance where private bidders had failed. They
suggested wrapping up the government's £30bn loan to Northern Rock into bonds. The bonds would
be sold to investors, which would be a way for the government to receive a much quicker
repayment.

While this was a credible solution, the move would have proved unworkable in practice, due to
the complexities over the bank’s repayment hierarchy to its outstanding creditors. If the bonds
were secured against the bank’s assets, where would the bonds rank in the Rock’s extensive
queue of creditors?21 The bonds required underwriting by insurers, in order to adopt the credit
rating of the insurer. However, the insurers were unlikely to be prepared to give these ‘credit
wraps’ because of the economic uncertainty in the global economy and their unwillingness to buy

19 The Bank of England should have responded more swiftly and orchestrated a rescue by Britain's top banks. However, unfortunately it dithered. In
today's more open and competitive financial environment, a new way of dealing with banking emergencies is required. Britain is the only country out
of the leading European economies that lacks a special public mechanism for grabbing control of a failing bank and ensuring that depositors get their
money without delay. Germany, for example, has invoked its mechanism and the larger leading banks have bailed out the smaller ailing banks.
20 Prevarication and mismanagement by the government of the Northern Rock crisis could have been avoided when the matter first came to the
government’s attention on 9 August 2007. Lloyd’s TSB, one of Britain’s most respected retail banks, made a sound offer to buy Northern Rock at a fair
and reasonable price of £2 a share, providing the Bank of England would guarantee up to £30bn of commercial loans, an offer they could only dream
of now. Instead of showing the decisive leadership required, the government and Bank of England procrastinated and the deal disappeared. This set in
motion the dramatic chain of events which has led to the demise of ‘Northern wreck’.
21 In addition, under European competition law governments are free to invest in companies, but they have to act as rational investors, which means
the bonds would have to be issued on commercial terms.

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even the safest investments in the current market conditions. If the bonds were unsecured, it
may be even more difficult to attract investors to buy them.22

Administration
The option of putting Northern Rock into administration was based on standard business practice.
Any other troubled company would have faced going bust if it had been faced with such financial
troubles – what made Northern Rock different?

Putting Northern Rock into administration would have enabled the competing interests of equity
and debt holders to be resolved in a fair and transparent manner in accordance with the law.
However, administration appeared impossible without causing chaos for Northern Rock’s retail
depositors if deposits were frozen, despite the Treasury's guarantees.

The real question was – at what price would this solution be? An independent valuer could have
estimated what cash flows Northern Rock might produce in the future, but any number would
have been arbitrary. Given that most of the remaining value of the equity had been the
government’s own loans and guarantees, the Treasury faced the comical prospect of paying up
for its own financial support.

Nationalisation
That left nationalisation as a remedy. Many commentators viewed taking the bank into public
ownership as the least palatable option, because it meant the taxpayer would have to continue
sustaining Northern Rock’s liabilities. The government would take charge of Northern Rock if it
was nationalised.23

An outright nationalisation of the beleaguered bank offered the advantage of clearly determining
the demarcation of financial responsibility, and aligning power and potential profits in a balanced
way. But the prospect of nationalising Northern Rock opened up a litany of questions that would
be difficult for the government to answer: a full nationalisation of Northern Rock would attract
opposition, and the government would receive a great deal of criticism. If the government
continued to provide state aid to Northern Rock beyond the 17 March deadline, it would also
require prior approval from the European Commission in order to continue providing state aid in

22 Goldman Sachs aimed to add further investors to join the consortium of banks which could have provided a loan of up to £15bn to a bidder. Some
parties involved with Northern Rock remained insistent that a commercial deal was not completely dead. But the signs from Citigroup, Deutsche and
Royal Bank of Scotland (the banks which might put up the loan to a bidder) are not positive. On 15 January 2008, Citigroup, the world’s largest bank,
sacked more than 4,200 people worldwide and slashed its dividend to shareholders by a huge 40 per cent.
23 However, it must be noted that taking the bank into public hands would nonetheless be politically embarrassing for Mr Brown, who has been as
keen as Tony Blair for Labour to shed its reputation as the party of state ownership. And it would probably mean breaking one of his self-imposed
fiscal rules, as at least half the bank's liabilities would move onto the public books. But where Northern Rock is concerned, a dose of realism is long
overdue.

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accordance with the EC six months rule.24 This would create a potential disagreement between
the government and EC over rules banning state subsidies, with the government facing criticism
for disregarding the rights of shareholders.25

The shareholders opposed any move to nationalise Northern Rock and were prepared for a hard
fight to protect their rights. The most vociferous of the dissenting shareholders were Philip
Richards, chief executive of RAB Capital, and SRM Global's Jon Wood – the two hedge fund
investors who together own 18 per cent of the bank and aimed to maximise the value of
shareholders’ legal interest in the company. Their preferred option was a private sector
acquisition as it offered the only real hope of a commercial return on the sale of their
shareholding.26 On 15 January, Richards and Wood convened an extraordinary general meeting in
an attempt to assert shareholders' interests and restrict the board's ability to issue new shares or
sell the bank’s assets without shareholder approval in order to resolve Northern Rock's
difficulties. However, only one of their four resolutions was adopted, ensuring that the board
consulted the shareholders before deciding the bank’s fate.

The bank, after all, still remained solvent and under private ownership, despite being sustained
by public money. However, the commercial reality was clear: any decisions about the future of
Northern Rock were going to be taken by the government.27 Notwithstanding, the shareholders
should not have expected the government to pay more than it was legally expected to do.

Nationalisation of Northern Rock

After much deliberation, on 17 February 2008 the government brought Northern Rock into public
ownership. This heralded a move that put an end to the six months of turmoil over the fate of the
stricken bank, and its efforts to find a buyer from the private sector. Chancellor Alistair Darling
said nationalisation would be a ‘temporary measure’ and would be a prelude to a future private
sale. However, he would not put a timetable on the period of state ownership and say how long
this would be for.

24 The government may rely on the EU's ‘one time, last time’ rule, which requires the private sector to stump up 50 per cent of the cash and for state
aid to be as little as possible, so that the business cannot price in a predatory way.
25 Time is running out for the government. They have set a deadline of 16th February for any private-sector solution; until then they will need
European Union approval for the current package of state support, which lasts for only six months.
26 If Northern Rock issues further shares to a private buyer and dis-applies pre-emption rights (shareholders’ rights to buy additional shares if the
company offers/issues new shares to the general public) then the existing shareholding would be diluted. A basic example: if X has 25 per cent shares
in Northern Rock and there are 100 shares, X has a 25 per cent shareholding in the company. If a private-sector buyer acquired Northern Rock and
100 more shares were issued, the total number of shares would therefore be 200. X would then hold 12.25 per cent shareholding in the company.
27 The editorial comment in the Financial Times, ‘No resolution for Northern Rock – Time is running out to avoid nationalising the bank’ (16 January
2008,) points out that shareholders would have no interest had the Bank of England not lent Northern Rock more than £20bn, and had the Treasury
not guaranteed the bank’s deposits. They did so to prevent catastrophic damage to the financial system. That leaves shareholders with legal rights,
but no moral right to expect a commercial return.

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The government ruled out two rescue bids put forward by Virgin and the bank's in-house
management team because they would not provide best value for money for the British taxpayer.
The chancellor insisted the decision would protect the banking sector and the public would gain
over the long term if the government held on to Northern Rock until market conditions improved.
Once the value of Northern Rock grows, the taxpayer will gain from any commercial return
resulting from a future private sector buyout.

What did nationalisation spell for the Northern Rock shareholders?

The key question will be whether the proceeds from the re-privatisation of Northern Rock belong
to the government or the original shareholders. The government does not intend to compensate
the shareholders at anywhere near the book value of the bank’s capital since 30 June 2007, when
the last full balance sheet showed that shareholders' funds stood at £2.35bn and the net asset
value (NAV)28 weighed in at over £5.50 per share. But much has happened since then, as the
Rock's market capitalisation (the value at the current market price of all the ordinary shares of a
company) plunged to £380m at the 90 pence suspension price. And even this valuation included
the residual hope of a private rescue.

Despite government assurances that the bank's mortgage book is ‘good’, without forensic
analysis of these loans it's impossible to make a proper stab at the lender's NAV. It is highly
likely that the lender’s accumulated net worth has been significantly reduced by asset write-
downs and trading losses. The bottom line is, without government support, the Rock would be
worthless.

The proceeds from a sale of the bank presumably in the next few years may belong to the
government. The government’s actions appear to be legally valid as the shareholders have had
sufficient time to dispose of their shares. Where does this leave shareholders? The shareholders
have expressed dismay at the government’s decision to nationalise the bank, as it is likely to
leave them with little or no compensation for their shares. They are invariably disappointed at
having the value of their shares significantly reduced from £12, when the business was at an all-
time high, to 90 pence at the close of business on 15 February 2008, when the shares were
suspended. The shareholders are likely to argue that the government’s action in expropriating the
bank was wholly unfair. A credible package led by the management and backed up by
shareholders had been presented to the government. The government rejected the private bid,

28 The Net Asset Value (NAV) is the total of all the company’s assets (which are due to the ordinary shareholders) less the borrowings and other prior
charges. If the market price is less than the NAV per share, it can be ‘at a discount’. If it is over the NAV per share, it is described as being ‘at a
premium’. The NAV can be found by dividing the net value of the assets by the number of shares in issue.

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bypassing the shareholders’ interests, which it argues were morally outrageous and legally
invalid.

An independent arbiter panel will be appointed to determine how much the shareholders will be
compensated. The value of the bank will be based on the assumption that no government help
was available. So the shares must be considered worthless, which is clearly the reason why the
shareholders believe the government’s method of valuing the shares is flawed. The shareholders’
claim rests on the assumption that they are owed an unlimited government guarantee. Without
public backing from the government, Northern Rock’s ‘book value’ was worthless. Shareholders
should see any compensation as a bonus.

Most shareholders are naturally disappointed at seeing their investment dissipated. Commencing
legal action against the government remains an option and many are receiving legal advice. RAB
Capital and SRM Global will almost certainly bring a legal action against the government, as they
stand to lose their entire investment (£70m each). However, it is worth pointing out that
nationalising Northern Rock depended on the Bank of England’s loan to preserve the value of its
assets and solvency. If the government had not intervened then the assets would have been sold
at far less than their normal value, and the bank would have gone bust. The shareholders should
therefore be amenable to a reasonable and fair offer from the panel that provides a positive value
for their shares.29

Taxpayers’ cash should only protect depositors, not City profits at an undisclosed price. If that
price is low, legal action is likely, but legal costs will clearly be a barrier for many shareholders.
The lender’s hedge fund investors could finance a legal challenge, but the UK’s unsuccessful
party-pays system puts the unsuccessful party on the hook of huge legal charges in the event of
losing a claim. Investors may posture to stir up enough political pressure to embarrass the
government into paying them a bit more compensation. However, the investors have had ample
time to cut their losses, and at the end of the day, those who live by the market must sometimes
lose by it30 because one of the risks of buying stocks is that you can lose all your cash if your
investment fails to yield a return.31

29 It is worth noting that most of the smaller shareholders got their shares free when Northern Rock became a bank, and institutions knew it was a
risk. Why should shareholders be rewarded (i.e. compensated) for failure?
30 If Northern Rock does repay its loan from the state in full but its shareholders receive nothing, the British government’s actions may amount to
robbery under the law.
31 Shares are otherwise called equities; they're the first part of the funding side of the balance sheet to take the hit if a company racks up losses.

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Critics round up on the government’s decision to nationalise

Many commentators believe the government’s decision for a ‘temporary’ period of public
ownership was a desperate attempt to minimise the political fallout and chorus of disapproval
that surrounded its decision to nationalise Northern Rock. Bankers, shareholders, taxpayer
groups and opposition politicians32 criticised the government’s decision after five months’ delay,
and ministers who ‘dithered their way to disaster’,33 leading to taxpayers incurring unnecessary
costs and risks.

Other commentators attacked the government’s move to nationalise the bank. They said the
nationalisation heralded an end of the government’s reputation for economic competence which
had previously been the bedrock of its success, as they were now taking the country back to the
1970s when the then Labour Government’s nationalisation policies were ineffective.34 Shadow
Chancellor George Osborne said nationalisation would harm Britain’s reputation for financial
services.

Many rival banks have raised concerns that placing Northern Rock under public ownership could
put them at a competitive disadvantage. Senior banking executives believe the lender should be
subject to tough guidelines spelling out exactly how it can operate and compete with commercial
banks in the mortgage and savings markets, to prevent the competitive landscape becoming
distorted and rival banks being unfairly disadvantaged.35 On the BBC’s Working Lunch
programme, the presenter Adam Shaw interviewed Adrian Coles, the director general of the
Building Societies Association. Mr Coles said, ‘We are very concerned that taxpayer-funded
compensation for an institution that has failed would lead to pressure being put on organisations
which have not failed and do not need taxpayer support.’

Rival bankers believe the government’s objective should be focused on running down the
Northern Rock’s business in order to ensure that taxpayers do not lose out. Further questions
were raised as to the fairness of the government-backed lender operating in the banking sector.
Northern Rock can borrow and lend in more consumer-friendly way than its rivals because of
government backing. Robert Preston, the BBC’s business editor, commented on the BBC’s
website that the UK taxpayers are now subsidising the bank in loans and guarantees to other

32 Even the Liberal Democrats, who supported the decision to nationalise Northern Rock, were critical of the timing, as it could have a destabilising
impact on the market.
33 George Osborne, the shadow chancellor, speaking in the House of Commons on 18 February 2008.
34 Labour part-nationalised British Leyland in 1975 while the Conservatives took Rolls-Royce under government control in 1971.
35 Rival banks are pushing for Northern Rock to operate under a series of stringent guidelines similar to those laid out for National Savings &
Investments, the government-sponsored savings vehicle.

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lenders to the tune of about £55bn. The Treasury now feels that nationalisation offers the most
certainty of securing these guarantees.

It is thought that the business model the government proposes will be similar to those put
forward by the Virgin Group and the in-house management consortium. These were likely to see
a downsizing of the bank to a ‘more sustainable size’, which may mean possible job cuts for some
of the 4,300 employees of the bank. Ron Sandler, ‘the company doctor’, was appointed as chief
executive36 to keep most of the employees in jobs. Mr Sandler aims to reinvent Northern Rock as
a ‘profitable, vibrant and sustainable business’. The bank has already confirmed they will protect
savers' deposits. However, critics have warned that it is vitally important that Northern Rock
should not be allowed to distort the savings market.

The government believed it had explored all the possibilities, and after a full evaluation adopted a
commercial (not political) and legitimate decision in the best interests of the taxpayer. The
biggest issue for the government was the safeguarding of taxpayers' money, and nationalisation
would be the correct step in the long term. The government did not intervene earlier, as it
believed it was prudent to allow the bank’s board of directors and shareholders sufficient time to
weigh up a private-sector solution.

The reality is that the search for a viable private-sector rescuer was likely to prove fruitless. The
government took on the bank’s risks when it underwrote its debt book last September. At that
point Northern Rock stopped being a properly run private business. Any public–private answer
would have left taxpayers with the risk and the City with all the benefit (profit); an unpalatable
option that could have left the taxpayer losing even more money.

The government had a contingency plan for how it would approach nationalisation should it arise,
and it opted to do so through emergency legislation. However, the House of Lords voted against
key parts of the necessary Bill. The House prevented the government from pushing legislation
through that would have exempted the bank from the Freedom of Information Act, and voted for
an amendment which demanded an audit be carried out on the ailing bank within three months of
it being nationalised, to benefit taxpayers. The Office of Fair Trading will also carry out annual
reviews of Northern Rock.

36 Stephen Hester, the chief executive of British Land and a former finance director of Abbey National bank, has been appointed to the team
overseeing Northern Rock.

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What happened to the private sector proposals?

The negotiations with the consortium led by Sir Richard Branson's Virgin Group failed simply
because the numbers did not add up, and the government had been left with no alternative but
to nationalise Northern Rock. The chancellor said the proposals put forward by the Virgin Group
would have forced the government to wait too long before it received taxpayers’ money back,
while the in-house management team had not been able to invest sufficient equity to sustain the
bank. However, Sir Richard Branson criticised the government's decision to nationalise the bank.
He believed his commercial solution represented a strong proposal, and that an experienced team
and one of the country’s most recognised brands would have been the best way forward.

Was the government right to nationalise Northern Rock?

Deciding whether the right decision was taken is ultimately dependent on where your interest
lies.37 Northern Rock only survived because it was nationalised in all but name last September,
when the government guaranteed its liabilities. To underwrite a private sale now would have
meant the government retaining all of the risks while privatising potential profits. The
government’s responsibility lay with the taxpayer, and the interests of the taxpayer should
supersede any other competing commercial interests. It seems the government adopted this line
of thinking, though hesitantly, in making its decision over this intractable problem.38 Should the
government have walked away from the prospect of a private takeover some time ago? It was
their protracted delay over facing up to the unavoidable, however, that has caused more political
damage than the act of nationalisation itself.

The two bidders were not the right suitors for Northern Rock because they were only interested in
buying cheap and making a huge commercial return. Their takeover offers were not positive
enough to repay the emergency Bank of England loans. Northern Rock is currently worthless but
at least nationalisation protects more people than administration. Had the bidders been prepared
to repay the government debt (guarantees that had prevented the bank from becoming
insolvent) then we may have seen a largely different outcome.

The important thing now is for the government to immediately establish what the bank’s
problems are and how it can restore customer confidence and grow its deposit base. The first

37 The Conservatives’ alternative plan was to put Northern Rock into public administration managed by the Bank of England. Administration would
have provided a clear exit strategy, with no pretence of ‘business as usual’ and therefore no concerns about unfair competition with other rival banks
and building societies. It would also mean the taxpayer would not be responsible for such massive risks. However, the Tories’ solution was criticised
as ‘cynical opportunism’ and ‘vacuous . . . political point scoring’ by the Liberal Democrat party.
38 A Reputation Cracks confirmed, ‘The Chancellor’s search for a third way between nationalisation and receivership was an unworkable attempt to
triangulate corporate collapse. A braver government would have reached this point long before.’ (Guardian Online, 18 February 2008).

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priority must be to work out the seriousness of the problems at the bank with an independent
audit of its loan book. Northern Rock’s debt will be confirmed as official public debt. Secondly, the
bank must cease its irresponsible lending and aggressive deposit-taking, by drastically reducing
its mode of extensive borrowing in order to successfully change its approach to its mortgage
lending and funding. If Northern Rock can remain a viable business, it must reduce its
dependence on the wholesale money markets used to finance its mortgages. Thirdly, it is likely
that Northern Rock will operate on a much smaller scale, so there will be challenging times ahead
for the employees because the bank’s business will probably be downsized.

At least the bank still has a future, with the prospect of a private sale in the next few years when
the market improves. If any profit eventually emerges from this debacle, it should surely benefit
the British taxpayer, who has been inadvertently footing the shortfall from the beginning. One
thing is certain: the fate of Northern Rock will surely have a significant knock-on effect on the UK
mortgage market.

Despite the government’s ambitions to revive the bank, it is likely that Ron Sandler will adopt
elements of the business plan developed by Northern Rock’s management team. This envisaged
reducing the bank’s £110bn balance sheet in half. The European Commission is likely to insist it
reduces in size to avoid breaching EU rules. The emergency legislation will grant the government
the power to take control of failing banks and building societies for a year.

So who is responsible for the Northern Rock debacle?

It seems a more measured approach could have been taken to the Northern Rock crisis.
Following several months of inquiries, MPs prepared a report on the handling of the run on
Northern Rock, and provided a comprehensive assessment of the lessons to be learnt from the
near collapse of the bank. The MPs outlined a hierarchy of blame: the bank’s directors were most
culpable, for their reckless business model and failure to prepare for a banking bust in a rapidly
altering global financial landscape; then the City watchdog, the Financial Services Authority
(FSA), for not addressing the flawed business strategy until it was too late nor advising the bank
to diversify its sources of funding;39 then the Bank of England, for not being innovative and
flexible enough in it decisions and the way it injected liquidity into the banking system after the
markets froze.

39 Vincent Cable, the Liberal Democrat Treasury spokesperson, said: ‘The FSA has failed in every test since it was set up.’ These are harsh criticisms
in light of the fact that the clear mandate of the FSA had been responsibility to ensure the Bank of England would not grant support to an ailing
financial institution too easily and require reigning in by the Treasury. In the Northern Rock case, it was the chancellor who felt he lacked the
authority to push through support for the stricken lender.

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The proposals for reform addressed the failings of the triumvirate – the Treasury, the Bank of
England and the FSA – and their inability to manage a financial institution that ran into a financial
crisis. The report called for large-scale reform to the way the tripartite regulatory system
operated. It pointed out that complacency, lack of communication and ineffectual decision-
making and mismanagement between the three authorities had turned a difficult situation into a
national crisis.40

The main proposals for reform were:

Intervention in failing banks in the future and the authority to take over the running of a
bank on the verge of financial difficulties

Increased authority to instruct the offending bank to change its business model

New powers to seize and protect depositors’ cash when a bank gets into serious difficulty,
and then to oversee its recovery

The committee proposed the creation of a new, semi-independent financial-stability body. This
body would sit within the Bank of England and be managed by a reconfigured deputy governor of
the Bank of England, who would not be under any direct reporting line to the governor on
banking remedial work. The MPs expressed preference for the Bank of England to gain greater
powers and develop a greater role in ensuring financial stability because of its closer proximity to
the markets.41

Were there any winners in the Northern Rock saga?

With various parties interested in taking over Northern Rock and competing against each
other, the bank’s crisis created 16 separate legal instructions and provided a great number of
roles for the City’s heavyweight lawyers (mostly within the magic circle firms). Northern Rock
were advised by Freshfields Bruckhaus Deringer; Allen & Overy (on the borrowing facility from
the Bank of England); and now Linklaters are advising the newly appointed management
team. The government had been advised by investment bank Goldman Sachs for financial
advice, and Slaughter and May for legal advice. The Bank of England had initially been
advised by Freshfield’s until September 2007, but due to a conflict of interest in also
representing Northern Rock, the mandate went to Clifford Chance. The Virgin group were

40 Except for the bank’s board of directors, the strongest criticism was leveled at the FSA for its failure in its role as City watchdog to identify the
flaws in the Northern Rock business model.
41 BBC Business Editor Robert Preston stated in his article ‘Who is to blame for the Northern Rock debacle?’ that one committee recommendation for
the chancellor to adopt had been for the banks to ‘pre-fund’ a new deposit-protection scheme or make substantial cash injections into it. Although it is
vital that we all have total confidence in the robustness of such a scheme, right now none of our banks have a surplus of spare cash and this
recommendation is therefore unworkable. It may be better to take an IOU from the banks than to drain them of liquidity at a moment when they're
feeling the pinch from the credit squeeze and the economy is paying a price in the form of reduced availability of credit.

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advised by Allen & Overy. Olivant were advised by US firm Sullivan & Cromwell. With regard
to the other interested parties, JC Flowers were represented by Herbert Smith; Ashurst’s
advised Cerberus; Linklaters advised Lloyd’s TSB; and the two majority hedge fund
shareholders of Northern Rock, RAB Capital and SRM, were advised by Nabarro’s and White &
Case respectively.

Conclusion

The government’s prevarication and the prolonged will-they-won’t-they speculation about a

private sale caused significant political damage. The government gave itself no choice precisely
because of its own political motivations. Fears of losing jobs in Labour constituencies in the north-
east, of private equity firms generating ‘excess profit’ and of immediate financial losses have
influenced its decision. Public ownership provides the government with more control over events.
In this way, the true costs may not be known for years.42 If the government involves itself in
business then it should do so in a transparent and businesslike way. This is nationalisation of a
failed company, deliberately undertaken for political reasons but clouded in the pretence of
commercial pragmatism.

The financial and political knock-on effects of the Northern Rock debacle are immeasurable at the
moment. We will only know the real, true cost to taxpayers once the bank and its assets are sold.
In the meantime, taxpayers may have to fund billions in extra borrowing that could have been
put to more constructive use. We now have the situation where the government will be making
decisions on a chunk of Britain’s housing stock in a falling market and a housing slump looks
likely. How will the government cope with the prospect of effectively repossessing the homes of
families? Repossessing homes of families in mortgage arrears would seriously damage the
government’s reputation even further, which would weaken the bank’s power over borrowers who
could no longer afford to meet their mortgage payments. It would certainly look bad for the
government.

The government does not know the true cost of the housing slump and the level of compensation
to shareholders. The nationalisation of Northern Rock is likely to trigger shareholder litigation that
may drag on for years. Nationalisation of the bank also sets a dangerous precedent, as it leaves
open the possibility of the government having to nationalise any other bank that gets itself into

42 The Treasury’s mishandling of changes to capital gains tax and the government’s £30,000-a-year levy taxation of non-domiciles will make the UK a
far less attractive place to invest in. This, together with a weakening pound as a result of the economic slowdown, rising inflation and a budget deficit
that is widening, adds further weight to the problems the government is experiencing. The Northern Rock crisis has tarnished the City’s reputation as
a global financial centre.

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the same financial trouble as Northern Rock. What will happen if a big company like Barclays
finds itself with similar problems; will the government bail out the global bank?

Anything the government does will now be highly politicised, despite its claims that the bank will
be run as a commercial entity at arm’s length. It is now a priority for the government to come
out and explain exactly how it intends to run the bank. What will Northern Rock’s strategy be?
The answer has implications for the bank, and the wider banking sector. As with any state-
controlled bank it is largely expected that politics rather than economics will be the main driver of
how the future of National Rock is run. Basic operational issues will be politicised: what happens
to current borrowers who are refused mortgage refinancing as the bank pulls back on its lending?
If Northern Rock simply runs down its books (current mortgage deals), jobs will be cut and
morale will be lost. It is also difficult to attract experienced leaders with the requisite expertise to
manage the company.

The final judgement on whether public ownership is good business or a political disaster is
unlikely to be made until after the next general election in 2009 or 2010 – a politically frustrating
delay for the Conservative party. The political cost may be even higher: even if nationalisation
proves to be the correct decision, Gordon Brown will be blamed for inevitable job losses at the
ailing bank and taxpayers may become so disaffected that they will no longer have trust in the
Government’s economic competence, and as a result, Labour may lose the next general election.

Will the global economy become far too weak in the year ahead? To conclude, in light of the risks
associated with the credit squeeze and the necessary rebalancing of the global economy, the
turbulent conditions at least present an opportunity for reform. The global economy is facing its
biggest test in more than a decade. The latest round of challenges in the global financial markets
presents a chance to address key issues that, if tackled properly, will improve economic
management, the fight against inflation and banking regulation. All of this should help us to
prevent similar crises happening in the future.

Ultimate Law Guide team

Note to reader: The article above is intended for educational purposes only. Please note
that some of the PLC articles are pitched at practising lawyers, but they will help you to
build up your knowledge of specific aspects of legal practice.

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