The Government was last night accused of riding roughshod over Northern Rock investors after it appeared to wipe out the repayment rights of £400 million of preference shareholders in the stricken mortgage bank.

The Treasury, which took Northern Rock into public ownership in February, has been under pressure to clarify the terms of compensation for these special shareholders, who argue that they have greater rights than ordinary equity investors.

The shareholders, whose holdings were used to back bonds issued by a special purpose vehicle, Saphir Finance, are understood to include some of the biggest and most powerful "long-only" shareholders in the City.

The Association of British Insurers, the lobby group for the fund management industry, has thrown its weight behind their claim, lobbying the Treasury to compensate preference shareholders in full for their loss.

Peter Montagnon, director of investment affairs at the ABI, has argued that the Government risks damaging the City's reputation if it refuses to acknowledge the repayment rights of all company owners, not just those of Northern Rock.

However, the Government sidestepped the repayment issue earlier this week as it converted the preference holdings into ordinary shares. The conversion formed part of a debt-for-equity swap with Rock that made available a further £3 billion of debt to the bank.

Some observers had argued that the payment of just 1p in the pound in compensation to any investor in the bank would have triggered the repayment of the £400 million in full.

Converting the preference shares to ordinary shares appears to cancel the Government’s obligation.

Mr Montagnon said: "In our opinion, the proposed conversion of the preference shares does not exempt the Government from the need to respect the hierarchy of the capital structure as it was at the time of nationalisation.

"We have been trying for some time to impress on the Government the importance of respecting the capital hierarchy. This is a matter of principle, which affects confidence more broadly, as it is fundamental to the way financial markets operate."

The holders of about £400 million of Northern Rock bonds are also affected. A missed interest payment on the Saphir bonds in July led to a downgrade by Moody's, the credit rating agency, and led to a sharp drop in their value.

Northern Rock ran into difficulties last September after it was shut out of the wholesale markets. The Government is poised to appoint an independent valuer to assess terms of a compensation payment to shareholders, which include hedge funds SRM Global and Rab Capital.

It is understood that Houlihan Lokey, the restructuring expert, is among a shortlist of candidates.

A Treasury spokesman said: "The independent valuer will consider the value of the shares at the point of their transfer to Treasury in February. The Treasury's decision to convert the preference shares we now hold to ordinary shares will therefore have no impact on the eventual compensation that may be payable to former shareholders."

It is understood that SRM Global, Northern Rock's largest former shareholder, is preparing to publish a response to the Government's £3 billion debt injection today that will question whether it was necessary and suggest that Rock remains a viable bank.

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