Hedge funds and Northern Rock – gain or loss?

The fact that the 'credit crunch' has resulted in major financial woe for a significant number of financial institutions has been widely publicised, as has its dramatic impact on businesses reliant on the wholesale market for credit, such as Northern Rock, the UK bank.

Originally published in the April 2008 issue

The fact that the ‘credit crunch’ has resulted in major financial woe for a significant number of financial institutions has been widely publicised, as has its dramatic impact on businesses reliant on the wholesale market for credit, such as Northern Rock, the UK bank.

Rescuing the bank proved impossible and Northern Rock is now in public ownership. The form of public ownership, nationalisation, is not the first nationalisation of a UK bank. In 1984 the Bank of England rescued Johnson Matthey Bank, a small bank which the government of the time considered too important to allow it to fail because of its role in setting the price of gold. While nationalisation is, legally, a very simple process (involving passing a piece of legislation allowing the entity to be brought and placed in public control), it is an extremely rarely used legislative tool in modern Britain and has been a very contentious and much debated measure.

During the crisis that engulfed Northern Rock, attention also focused on organisations, typically hedge funds, seeking to profit from corporate casualties. It is often assumed that the hedge funds which bought heavily into its equity when the crisis broke in the hope of extracting value must now be facing significant losses running into tens of millions of pounds. This article examines the likelihood of this in light of what is achievable by stakeholders in a situation of corporate financial distress.

The players

The bank run on Northern Rock on 14 September 2007 was the first run on a British bank since the infamous Black Friday of 10 May 1866 and the collapse of the Victorian bank Overend & Gurney. The event sparked the classic volatility in asset prices beloved of the hedge fund community. Enter RAB Capital PLC, the hedge fund which last year had approximately US$7.2 billion of assets under management and SRM Global with approximately US$3 billion in assets under management.

Stake building – equity

According to reports, overall RAB paid around £69 million for an 8.18% stake in the ailing bank and SRM paid around £64 million for its 11.5% stake. Both SRM and RAB bought shares in Northern Rock in September and October 2007 when the bank’s woes became very public and both carried on acquiring shares as the price fell. SRM purchased a further 120,000 shares on 11 February 2008 at 96.19 pence per share and RAB purchased 180,000 shares on 14 February 2008 at a price of 96.34 pence per share, prices significantly below the post-crisis high of £2.97p paid per share on 10 October 2007.

Risky strategy

At first sight the acquisition of shares in Northern Rock by these two hedge funds would appear to be a risky strategy and the continued acquisition of shares at falling values appears to be an action which merely exacerbates the risk. Under English law the assets of an insolvent company are distributed in a waterfall arrangement with the shareholders of a company ranking last in right of payment from the assets.

In corporate insolvencies it is by definition very rare to see any return being given to shareholders. There is no special insolvency regime for financial institutions in the UK to buoy a share price so it was always theoretically possible that shares in the bank would become penny shares (though the UK government, clearly shocked by the Northern Rock situation, has proposed new legislation to introduce a ‘special resolution regime’).

We await the results of the valuation of the shares in Northern Rock and the government’s decision on the level of compensation to be awarded to shareholders. What appears likely is that the level of compensation will be below the prices paid by SRM and RAB for their equity stakes because the UK government has indicated that the value to be ascribed to the shares will be discounted by the value of government assistance – government assistance maintained the bank’s solvency.

Equity – the blocking stake

There is clearly more to the strategy of RAB and SRM than simply taking an equity stake in Northern Rock in anticipation that the share price would increase.

In the extraordinary general meeting called by the hedge funds on 15 January 2008, SRM and RAB proposed a number of changes to the articles of association of Northern Rock which would impact on the freedom of the board to issue or allot shares and prevent the board from taking any action to dispose of assets in a ‘fire sale’ scenario, without shareholder consent.

This type of action is not uncommon. Investors can buy a ‘sliver’ of equity in order to gain information on a distressed company and also to gain a ‘blocking stake’ in the equity and so gain leverage in any restructuring. In this instance the hedge funds were able to requisition a general meeting on the basis that they held more than 10% of the paid up share capital of the company.

These resolutions were ‘special resolutions’ requiring a majority of 75% of shareholder votes to be passed and failed to gain the required majority by a small margin. Nonetheless, this demonstrates quite clearly that SRM and RAB were flexing their muscles as shareholders in order to try to control any sale or restructuring of the group and perhaps to extract a value beyond the market price of the equity. In this way, the funds were attempting to leverage the economic value of the stakes beyond the market price.

This strategy is not new. A similar strategy was pursued by Polygon Investment Partners in the restructuring of British Energy in 2004. The hedge fund had planned to use an EGM to seek support from shareholders for a resolution barring British Energy’s board from seeking a de-listing and to alter the articles of association to prevent the board making disposals without shareholder approval. Ultimately, this strategy was unsuccessful.

Stake building – debt

While we can establish the price paid by SRM and RAB for their equity stake in Northern Rock, what is more difficult to establish is the extent of their investment in the debt of the stricken entity and the price paid for it.

Again, at first the acquisition of debt owed by a failing company by these two hedge funds would appear to be another risky strategy which merely exacerbates the risk already faced by the funds. However, like equity, debt may provide the holder of it with leverage to control any sale of restructuring.

The acquisition of debt for less than its face value provides the funds with the opportunity, depending on the prospects for repayment, for classic debt arbitrage. The funds would acquire the debt from existing creditors at less than its face value and receive payment for it in excess of the acquisition price.

In addition, when a company is or is about to become insolvent, the directors’ duties, which are normally owed to shareholders, are owed to the creditors of the company.

As a result, the board of a technically insolvent company must consider the interests of its creditors in order to avoid a breach of their duties. Moreover, if the equity strategy proved to be ultimately unsuccessful because, as happened, it was not possible to rescue the bank, the English insolvency law waterfall arrangement which requires creditors to be paid before shareholders would ensure the funds have a hedge against their equity losses.

Charles Shiramba is Partner at law firm McDermott Will & Emery