Lawyers across the City have been sifting through traders' e-mails and listening to recordings of their phone conversations in an attempt to piece together thousands of financial transactions.

It is the first stage in preparation for a wave of lawsuits expected to be brought by hedge funds and other investors against investment banks over losses sustained because of the credit crunch.

Banks are bracing themselves for claims of misselling on the grounds that they failed to inform investors of the risks of the products they were buying or deliberately misled them. Lawyers have been called in at a cost of up to £1,000 an hour to try to determine what commitments were made to investors and whether they breached the terms of the underlying contracts.

Sue Millar, a partner at Stephenson Harwood, said: "Many claims will turn upon who said what to whom and when. Answering these questions requires a detailed forensic analysis."

Law firms get set to sue investment banks

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Several leading City lawyers believe that the legal fallout from the credit crunch will be worse than during any recent financial crisis, including the dot-com collapse and the Enron scandal. But it is proving so difficult to determine who would be liable in any legal action that the bulk of claims could take much longer to emerge than was first predicted. Lawyers are now warning that it could drag on for years.

The majority of claims are likely to relate to complex structures such as collateralised debt obligations, but even many so-called “vanilla” lending transactions appear to have been carelessly put together. According to one partner at a City law firm: "There was a definite element of the Emperor's New Clothes about all this. You look at some of these deals and think, 'Why would you have agreed to that?' But they were different times. There was so much money sloshing around."

Lawyers said that most disputes will be kept secret as financial institutions seek to avoid having their reputations tarnished in court. Ms Millar said: "There will be some very public litigation but the majority of disputes will be resolved behind closed doors. There are significant sums at stake and investment banks and hedge funds will not want to wash their dirty linen in public."

Banks are afraid of the negative headlines that court proceedings would generate, while hedge funds — whose businesses thrive on secrecy — do not want their dealings laid out in front of competitors. Instead, they are more likely to try to resolve disputes by negotiating settlements through a mediator or by entering arbitration, a binding legal process that, unlike court proceedings, takes place in private.

Only those with little to lose, such as insolvent funds, or those who want to publicly embarrass a bank, are likely to seek redress in the High Court.

Clare Canning, a partner at law firm Mayer Brown, said that banks were traditionally uncomfortable with litigation and had always relied on relationships to resolve disputes. "It remains to be seen whether in a downturn they will be willing to risk those relationships by going to court."

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