Open Mic: The industry talks back

Northern Rock is the highest profile victim of the sub-prime meltdown and subsequent credit crunch in the UK, so far. However, at present it appears that there are unlikely to be serious repercussions in terms of criminal charges or civil proceedings against the company and its directors and officers.

This is a prime example of the differing approaches taken by the UK’s investing public and our American cousins in holding decision-makers responsible and a willingness to litigate.

It is also an opportunity to contrast the risks associated in writing US and UK liability insurance, such as directors’ and officers’ (D&O), financial institutions and pension trustees. It also provides food for thought in the present risk-averse attitude to US domiciled or exposed corporations, and the continuing perception that UK D&O currently shows no signs of generating the claims examples needed to influence premium rates in the short to medium term.

Had Northern Rock’s directors and officers been domiciled in the US rather than the UK, we could look to the recent failure of US-based securities firm Bear Stearns, to predict their likely fate.

Northern Rock’s liquidity strategy has been blamed for its fall from grace. The first signs of a sub-prime crisis emerged in the US in June 2007 when (ironically) two Bear Stearns hedge funds collapsed.

Northern Rock was still issuing a positive outlook in its July 2007 interim results with no mention of the worldwide credit problems, or its need to refinance large chunks of mortgage-securities in September. In August, a worldwide strike on intra-bank lending, in particular collateralised mortgage securities, meant that Northern Rock could no longer fund its business. Within a matter of days Northern Rock approached the Bank of England for a bail out.

When this approach was made public Northern Rock’s share value fell more than 32% overnight. And when it was nationalised in February 2008, its shares stood at 90p – more than 85% down from the £6.50 value before the bail out.

An investors’ compensation scheme is currently under review, but those who held shares in Northern Rock at the date of nationalisation are unlikely to recover more than 90p per share, and some analysts suggest that the government offer may be as low as 5p per share. Investors are likely to incur significant losses regardless.

In contrast, the problems at Bear Stearns were probably set long before the first cracks in global liquidity. Bear Stearns’ stock price began to tumble in June 2007 due to investigations into the failures of two of its hedge funds, and the banks first ever quarterly loss was announced. Despite this, as late as 12 March 2008, Bear Stearns’ chief executive announced categorically that the firm had ample liquidity.

On 14 March, investment bank JPMorgan and the Federal Reserve had to bail out Bear Stearns as its liquidity position had deteriorated. On 16 March, an offer by JP Morgan to purchase the firm was accepted at $2 per share – representing a fall of $157 per share to just over 1% of the share value before the first hedge fund collapsed less than a year earlier. JP Morgan has since increased its offer to $10 per share.

“Had Northern Rocks directors and officers been domiciled in the US rather than the UK, we could look to the recent failure of Bear Stearns to predict their likely fate.

While Northern Rock failed in September 2007 and Bear Stearns only in March 2008, the extent of the fall-out has been dramatically different.

Shortly after government intervention and the possibility of a takeover emerged, a UK shareholder group was established to prevent the sale of Northern Rock at undervalue, but not to litigate against the directors and officers or the company itself, despite crystallised losses in market capital in the region of £2.5bn.

Some hedge funds with large stakes in Northern Rock and a 6,000 strong private investor group have recently announced that they are considering taking proceedings against the government, the FSA and individuals such as the Chancellor and the chairman of the Bank of England.

In stark contrast to the UK, several shareholder lawsuits were filed in US courts under federal securities laws against the directors and officers of Bear Stearns on 17 March 2008 – just one day after the announced sale to JP Morgan. The class actions allege that the defendants issued false and misleading statements regarding the company’s business and financial results. The damages sought are likely to be in the billions, with significant insurance-related losses.

Northern Rock’s pension scheme has a reported £100m deficit. It remains unclear at this stage whether the government will make this good or whether the scheme will be bought out by a third party, or transferred to the Pensions Protection Fund.

Members can bring actions against trustees in the courts under common law negligence, or they might be able to complain to the Pensions Ombudsman, who could make a finding of maladministration on behalf of all members. At present there is no indication of proceedings by members against the Northern Rock fund trustees, at least one of whom sat on the board of Northern Rock as the group’s finance director.

Over the pond, Bear Stearns’ pension fund was exposed due to the fund’s significant holdings of Bear Stearns’ stocks – which plummeted over 98% prior to the offer from JP Morgan. In contrast to Northern Rock’s trustees, Bear Stearns’ pension fund trustees have already been named in a raft of lawsuits alleging, primarily, that they failed in their fiduciary duties by imprudently continuing to invest in Bear Stearns’ stocks. The lawsuits are brought under the Employment Retirement Income Security Act 1974, a federal statute enacted to regulate a corporation’s sponsored pension plan.

While the FSA has accepted a degree of blame in the way the Northern Rock crisis played out, it has generally sought to blame Northern Rock’s management for the company’s failure and the losses sustained by the investing public.

Under the Financial Services and Markets Act 2000 the FSA could seek to prosecute individuals, if they had made misstatements to the investing public. However, despite the public condemnation of the former management’s actions, the FSA has not stated an intention to prosecute Northern Rock’s directors and officers.

In contrast, the directors and officers of Bear Stearns are already participants in an investigation by the Securities & Exchange Commission, the US financial markets regulator. Indeed, the directors and officers of Bear Stearns could face jail and significant fines if found guilty of an offence under US securities laws.

“The damages sought [against Bear Stearns directors and officers] are likely to be in the billions, with significant insurance-related losses.

There are a number of key drivers for litigation in the US which are not present in the UK. Examples include:

• The legality of contingency fee agreements (class action litigation is generally funded this way).

• The general lack of adverse costs orders.

• Class actions on behalf of unidentified individuals and on an opt-out basis as compared to the UK’s, sort-of, equivalent – a group litigation order, which requires claimants to opt in.

• Codified securities laws giving individuals the right to pursue directors and officers directly.

• Cultural distinction, the impact of which cannot be underestimated.

While key differences such as these exist, the approach to litigation and D&O liability in the UK and the US, and in turn their insurers, are likely to remain distinctly different.

However, it is not clear, especially in light of the European Commission’s vote in favour of a so-called European Collective Redress Mechanism, and last year’s class action settlement of European shareholders in the Netherlands relating to Royal Dutch Shell, if the litigious environments in the two continents will continue to differ so dramatically in the future.