Lord Chancellor warned strategy at Claims Direct was flawed before IPO

The Government's most senior law officer warned the founders of Claims Direct that their business model was seriously flawed a year before they floated it on the Stock Exchange, netting personal fortunes between them of more than £50m.

A letter from the Lord Chancellor's Department cautioned that it was "extremely unlikely" legislation would be backdated to allow Claims Direct's clients to recover the cost of insurance policies taken out in connection with personal injury claims.

The letter, from a senior official in the department, was sent to Tony Sullman, the co-founder and chairman of Claims Direct, in July 1999 – 12 months before the company was floated at 180p a share, valuing it at £368m.

Since then the company, which specialises in no-win, no-fee personal injury cases, has seen its share price collapse and earlier this week the founders, Mr Sullman and Colin Poole, succeeded in buying the business back at a 10p a share – a 95 per cent discount to its flotation price.

The Claims Direct prospectus stated that insurance premiums had been recovered in "a number" of cases that had been settled out of court but no insured case had gone to court so there was no judicial award of the premium itself as well as damages for the accident.

Claims Direct hoped that the Access to Justice Act, which came into force in April 2000, would make premiums recoverable for the 20,000 cases it already had on its books. But the letter from the Lord Chancellor's Department said this was "extremely unlikely".

The founders received this letter almost a year before Claims Direct floated on 13 July 2000. But there is no mention in the company's prospectus under potential risks of the problem of back-dating insurance claims.

Mr Poole refused to comment yesterday on why the company did not address the issue in the prospectus, or why it went ahead with introducing the premiums eight months before the change in the law would mean that defendant insurers had to foot the bill rather than Claims Direct's own customers. Mr Poole said: "I will not be drawn on this at the moment."

Claims Direct introduced the premiums in August 1999. The premiums, which must be taken out by all Claims Direct customers, cover unsuccessful customers so that they do not have to pay any of the costs relating to their cases.

However, an investigation by the BBC's Watchdog programme revealed the premiums were not being recovered in many cases. This left many successful claimants with negligible compensation payouts because they had to pay for the hefty insurance policy out of their winnings.

The development attracted a barrage of bad publicity for the company and led to its subsequent problems of a dramatic drop in new business and the need to issue three profits warnings this year.

Knowledge of the official letter comes in the same week that it emerged that Mr Sullman and Mr Poole face a legal case being organised by Class Law, brought by franchisees who allege that certain executives knew about this flaw in Claim Direct's business model.

Meanwhile, Mr Sullman and Mr Poole continued their discussions with Simon Ware-Lane, the private investor who is seeking to buy their 55.4 per cent stake in Claims Direct. Mr Ware-Lane has been on the boards of companies in which Charles Church, the property tycoon who died in a Spitfire crash in 1989, invested.