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Investment is a dog-eat-dog world and Northern Rock investors must accept responsibility for the risk they took on

by Andy Gadd

If a company fails, its shareholders are the last to receive proceeds from winding it up. For taking this risk they participate in the profits through dividend distributions and from potential increases in the value of the shares over time to reflect the success of the business. So, if the business fails, shareholders could lose all their money. Pretty straightforward one might think – unless you hold shares in Northern Rock.

The Northern Rock Shareholders’ Action Group (a group of Northern Rock’s small shareholders) has issued a ‘letter of intent’ to the government that they will take legal action if they are not ‘properly compensated’ for their shares – which were suspended at 90p when the company was nationalised, or ‘taken into temporary public ownership’ the government prefers to say.

Terms of reference

These small shareholders accept it will be difficult to put a specific figure on what may be regarded as ‘fair compensation’ but I have seen speculation ranging from £4 to £9 a share. The problem is that the terms of reference specified by the government to be used by any independent valuer will be based on the fact that Northern Rock was unable to continue as a going concern – after all, the government loans had been withdrawn and the company was in effect in administration. Based on these criteria the compensation payable could in theory be as little as 5p per share.

I sympathise with shareholders who may face financial hardship, but to me the facts are clear. The business model of Northern Rock had a small savings base and a big lending arm, so it funded the difference by borrowing in the wholesale money markets. As the problems associated with the US sub-prime mortgage market led to the effective freezing of these markets, the Bank of England (BoE) had to step in to plug the cash shortage. This led to a run on the bank as depositors rushed to withdraw funds, and the BoE had to provide

emergency funds. At this stage Northern Rock was basically bust – it was only for economic and other reasons that the BoE (or taxpayer) stepped in to save it.

Investing in shares is about risk and return. The management of Northern Rock took a risk and if that risk had paid off then the shareholders stood to benefit. But it failed and it is not for the taxpayer to mitigate this. We weaken the incentive to understand the potential risks any company takes, and the need to hold management to account, if we compensate those who lose out when a poorly managed company goes bust.

I have seen commentary that says any compensation should be based on the value of Northern Rock before the government stepped in and I don’t agree with this. Surely any valuation must be based on the situation had the government not stepped in and in effect a ‘fire sale’ had taken place.

So, do I think that the government could have handled the situation better? Yes, and lessons have been learned, which ought to lead to changes. Do I have sympathy for the thousands of Northern Rock shareholders who believed their investments were safe, but who have now potentially lost everything? Yes. Do I believe the taxpayer should pay what could be substantial compensation to these shareholders, and is the government right to say any compensation should be based on the fact that Northern Rock, without our support, was in effect bust? Again, yes. But an independent valuer must determine the level of any compensation and I believe the terms of reference are reasonable in the circumstances.

The unfortunate truth

Those shareholders who were heavily exposed to Northern Rock are unfortunately learning a truth of investing – the more risk you take, the greater the potential rewards but also the greater the potential downside. It is easy for me to say, in hindsight, that investors should not be too reliant on an individual share unless they are able to accept this risk but I would have said that to anyone who had asked me before the demise of Northern Rock and it is common sense. Historically we have seen the demise of Barings Bank, Polly Peck and Equitable Life and I am sure we will see other companies with similar problems. That is investment.