The London Stock Exchange yesterday signalled a crackdown on hedge funds and other speculators that break the rules by short-selling Nothern Rock shares without ensuring that they have the stock to sell in the first place.

The warning came as it emerged that, even if Northern Rock is rescued by an acquirer, the bank will still owe the Bank of England £5.9 billion by the end of 2010. The figure was disclosed in an internal memo, entitled Project Wing, sent to potential bidders ahead of a deadline for takeover proposals this Friday.

The memo outlines the most likely options, including selling Rock’s assets and leaving existing shareholders invested in a company that held the multibillion-pound loan from the Bank of England.

Northern Rock’s shares have been subject to intense short-selling and “naked” short-selling since the Newcastle-based bank nearly collapsed in September. Although the LSE yesterday stopped short of attacking the speculative investors, the exchange gave warning of the “significant number of unsettled shares” in Northern Rock and strongly urged investors to close their positions as quickly as possible.

The Stock Exchange said: “What we are doing today is publicly saying that that number has to come down.”

Its action comes after RAB Capital, the influential hedge fund and the largest shareholder in Northern Rock, berated regulators for failing to police the system properly. RAB Capital has acquired its Rock stake as a long-term investment.

Short-sellers, typically hedge funds, borrow stock in the market and sell it, taking a bet the stock will fall so that they can buy the shares back and pocket the difference in price.

Naked short-selling occurs when hedge funds sell shares without borrowing the stock in the first place. The problem has been exacerbated in Northern Rock’s case by the huge trading volumes in the bank’s shares in mid-September and the massive volumes on loan to short-sellers.

Yesterday, 12.4 per cent of Northern Rock’s stock was on loan, indicating that it was being used by hedge funds to short the company. As much as 30 per cent of the bank’s shares were being shorted at the height of its troubles. According to Data Explorers, which monitors stock lending, the average FTSE company has 3.7 per cent of its stock on loan at any time.

The 36-page sales memo was circulated by the bank’s advisers after it became clear that no bidder was able to fully refinance Northern Rock’s borrowings from the Bank of England, thought to stand at about £20 billion today.

Instead, the bank’s advisers set out methods by which the bank could be broken up, with the sale of the infrastructure alone, or the infrastructure plus packages of securitised mortgages. It is likely that some assets and liabilities will not be sold but will be run off over time. The memo notes that the bank’s profits would fall to £143 million next year but reach £643 million by 2010.

The document does not consider the possibility of Northern Rock continuing as a standalone business. None of the options is thought to have been agreed with the Treasury.

Northern Rock yesterday tried to halt reporting of the document, arguing that it damaged attempts to sell the stricken bank. At least 50 bidders had received the memo in an attempt to drum up interest in the bank. But Northern Rock was granted only a partial injunction by the High Court, preventing the publication of any further material that had not already been published widely.

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