THE Government's defence of its zero-return compensation scheme for former shareholders in the nationalised bank Northern Rock was attacked in court today as "unlawful, unfair and manifestly disproportionate".

Individual shareholders - including current and retired employees of the Newcastle-based bank - and representatives of two hedge funds which also stand to lose out, packed a London courtroom at the start of a renewed legal challenge to the scheme.

Lord Pannick QC, for major investor SRM Global, told the Court of Appeal that the Treasury's argument attempting to justify a scheme which would result in a nil valuation of Northern Rock shares was superficial and of no substance.

He urged three judges, headed by Master of the Rolls Sir Anthony Clarke, to rule that the scheme, introduced by statute when the bank was taken over by the Government in February last year, infringes the human rights principle that the taking of property by the state must be balanced by compensation reasonably related to its value.

In an earlier unsuccessful High Court action, shareholders alleged the Government deliberately set out to make a profit from its nationalisation of the bank at their expense.

They claimed that the compensation scheme was based on false criteria which would lead to shares being valued at zero so the Government would inevitably make a profit when the bank was eventually sold off - as early as this autumn, according to current City rumours.

The High Court upheld the Government's argument that, but for support from the Bank of England, Northern Rock would have been unable to pay its debts as they fell due and would have had to cease business. It was not unreasonable that shares should be valued on that basis.

The case was brought by two hedge funds, SRM Global and RAB Capital, and up to 200,000 private shareholders.

The private shareholders, including existing and former Northern Rock employees - many at risk of losing their retirement nest egg shares - are backed by the UK Shareholders Association.

The shareholders insist that their shares should be valued at more than £4 each.