Inquiry asks if HBOS misled over rights issue

A Financial Services Authority investigation into whether HBOS's former board may have misled investors at the time of the bank's abortive £4bn rights issue last year could "open the floodgates" to hundreds of civil court actions against Lloyds Banking Group, which acquired HBOS in January, according to senior legal sources.

The FSA is conducting a "supervisory review": scrutinising disclosures made by HBOS's board at the time of the Edinburgh-based bank's 2008 capital raising which flopped with a £3.8bn "stick" of stock being left with the underwriters, Morgan Stanley and Dresdner Kleinwort.

It is not clear whether HBOS's chairman, Lord Stevenson, its chief executive, Andy Hornby, now boss of Alliance Boots, or Peter Cummings, the former head of corporate lending, have been interviewed by the FSA. But it is understood that the former finance director, Mike Ellis, has been questioned.

Lloyds revealed the investigation was under way in a prospectus published last week to launch its own far more ambitious £13.5bn rights issue on Tuesday. It said that the FSA investigation is focused on the "accuracy and completeness" of HBOS's disclosures in particular on "the corporate impairments disclosed in the circulars and/or prospectuses." Lloyds said it was fully co-operating with the inquiry.

The inquiry centres on the June 2008 circular sent to HBOS investors which said the board was "optimistic about the fundamental prospects of the company's core business", adding it was "well placed to deliver long-term sustainable growth". Within four months, the bank was bust, with £215bn of toxic assets and a serious funding shortfall. Most of the "toxic" loans on HBOS's £600bn balance sheet were part of the lending authorised by Mr Cummings, who took control of the bank's corporate division in 2005. Billions of pounds of dubious loans were lent to property and retail tycoons. Banking sources claim the HBOS board was unwise to allow Mr Cummings to chair his own credit committee – which meant he was, in effect, signing off his loans.

Lawyers warned that directors who engage in any behaviour likely to give the market a false or misleading impression as to the price or value of an investment could face unlimited financial penalty. One said: "That could arise in cases where a board conducted inadequate due diligence or omitted material information when putting together a prospectus." Other experts warned that ex-HBOS directors could be struck off as directors.

In the new prospectus, Lloyds warns that the FSA's review "may result in enforcement actions and public sanction, which could expose the group to an increased risk of litigation."