The curious incident of the regulator in the night–time

The media is barking up the wrong tree. Instead of obsessing about bonuses, they should be focusing on the HBOS and RBS rights issues of April-June 2008

“The curious incident of the dog in the night time” is a phrase from the Sherlock Holmes detective story Silver Blaze.

The dog’s failure to bark wasn’t seen as a clue by many. But it was by Holmes. He realised that the dog’s very silence spoke volumes. In this instance, he deduced it meant the criminal must have been known to the dog — indeed he turned out to be its master — and that the crime was therefore an Inside Job.

There are strong parallels with the UK banks HBOS and Royal Bank of Scotand and their relationships with the FSA and with their institutional investors.

It strikes me as very strange that the dogs who one might expect to be barking the loudest right now — institutional shareholders, who have lost billions, and the Listing Authority (part of the Financial Services Authority), which is supposed to keep tabs on the veracity of the information in the prospectuses of listed companies — are so eerily silent.

Instead, we are having to listen the baying of a media pack incensed by bankers’ bonuses.

However, if there was a “crime” committed by either of these two banks it doesn’t relate to the payment of bonuses. It is more likely to be that in April 2008 (Royal Bank of Scotland) and June 2008 (HBOS), the banks produced rights issue prospectuses which suggest that their boards of directors were either:-

(1)  Incompetent (in that they did not know what was going in inside their banks),

or

(2) Fraudulent (in that they knew, but chose to hide the information from shareholders).

Whenever a listed company seeks to raise capital by selling new shares in a rights issue, it must put together a legally-binding document known as a prospectus. For an institution the size of RBS or HBOS, these documents cost millions of pounds to produce and can stretch to several hundred pages. The legal requirement is to provide investors an accurate picture of the company’s likely future strengths and weaknesses (and not to gloss over the truth).

As a result of the effort and care that normally goes into the compilation of these documents, including lawyers grilling the board on the veracity of every single claim, investors have generally assumed they can can be relied upon as dependable guides when deciding whether or not to subscribe to new issues.

The heart of any prospectus is the so-called “working capital” statement.

In their prospectuses, each of the two Scottish banks made such statements — which, elsewhere in the documents, were said to be “unqualified by risk factors”.

In the working capital statements, the directors of RBS and HBOS informed their investors who they were seeking to tap for £12bn and £4bn respectively and that, subject to their rights issues being successful, they would have sufficient working capital to see them through the next 12 months.

Both the banks used ‘Magic Circle’ law firms as advisers (Linklaters in the case of RBS and Allen & Overy in the case of HBOS) when putting together these working capital statements, and City practice is to ensure the statements are 100% reliable by “stress-testing” under a range of scenarios including one sometimes described as financial ‘Armageddon’.

However, within a few months of making these unqualified working capital statements, after the bankruptcy of Lehman Brothers created a hiatus in the wholesale capital markets, both the Scottish banks were bust and in need of billions of fresh capital from the UK taxpayer, as well as an even greater quantity of state-subsidized liquidity. Both banks remain on state-funded life support and both would expire immediately if this was switched off.

RBS published its rights issue prospectus on 30 April 2008, raising £12bn from investors on 9 June 2008. Yet by 6 October 2008 (less than five and a half months later), the bank was in need of a further £20bn capital injection from the government. Sir John Gieve, deputy governor of the Bank of England, has indicated that by 10 October, even though shareholders had pumped in £12bn in June 2008, RBS was bankrupt.

In HBOS’s case, the £4bn rights issue was announced on 29 April and the prospectus published on 19 June. The process had flopped by 21 July 2008 — though underwriters Morgan Stanley and Dresdner Kleinwort were still obliged to stump up the cash after investors ran for the hills. The investors were right to steer clear. By 18 September 2008 (less than three months later and despite the underwriters having injected £4bn of capital after the rights issue flopped) HBOS was bust and needed a government-brokered rescue takeover by Lloyds TSB. Less than four weeks later, it required an £11.5bn capital injection from the government.

So what should one to make of the directors’ assurances in their prospectuses that the banks would have sufficient working capital to see themselves through the next 12 months (conditional on the rights issue cash materialising)? As one of my lawyer friends puts it, they are on a bit of a sticky wicket here, as both their working capital statements have been “unequivocally disproved by the banks’ own subsequent actions.”

More importantly, what is the role of the two dogs who did not bark in all this? The institutional investors in both RBS and HBOS and the U.K. Listing Authority ought, by rights, to be barking rather loudly now.

Having lost billions, one also might have thought institutional investors would be emitting more than the occasional whimper and doing a bit more than feebly claiming that they once sought to oust Sir Fred Goodwin and Sir Tom McKillop from their positions at RBS.

Their silence is all the more deafening since, if the banks’ prospectuses did mis-state or omit the facts, investors who took up their shares have a statutory right to claim full compensation for losses accrued.

Did the U.K. Listing Authority and the FSA perhaps know the bank’s boards too well? (It is notable that Sir James Crosby, who resigned from the board of HBOS in July 2006 and is presumably still close to some of his former colleagues on the failed bank’s board, continues to serve as deputy chairman of the FSA, of which the Listing Authority forms part).

Tomorrow the “fallible four” sometimes also called the “unfab four” — Sir Tom McKillop, Sir Fred Goodwin, Lord Stevenson and Andy Hornby — appear before the Treasury Select Committee. I suspect that we’re going to witness a fair amount of grandstanding from the MPs on the committee. As on previous occasions I suspect these bankers are going to blame “unprecedented market turmoil” / “market disruption” rather than acknowledge any personal culpability for their banks’ collapses.

But isn’t is the equivalent of a sea captain blaming “unexpectedly bad weather” after his ship hits the rocks?

This blog post was published on 9 February 2009, with minor corrections 30 May 2013