A group of Northern Rock's small shareholders, acting in cahoots with hedge fund SRM Global, yesterday sent a letter to the government in the first step of a legal action against compensation proposals for investors of the nationalised bank.

A group of Northern Rock's small shareholders, acting in cahoots with hedge fund SRM Global, yesterday sent a letter to the government in the first step of a legal action against compensation proposals for investors of the nationalised bank.

The Northern Rock Shareholders Action Group, which has been in contact with 7000 of the bank's 150,000 or so small shareholders, is working with David Greene of law firm Edwin Coe to seek a judicial review of the method of valuation of their holdings before the bank was taken into state ownership last month.

The group filed a "letter before action" yesterday, claiming the valuation process is flawed because it makes assumptions that the company was unable to continue as a going concern and that it was in administration. They claim this puts it in breach of the Human Rights Act.

Hedge fund SRM Global, whose case is likely to combine with that of the shareholders' group, is expected to send a similar letter.

Greene, who previously represented 50,000 Network Rail shareholders when they attempted to get compensation for the effective nationalisation of that company, said: "We say the government is not entitled to predetermine the valuation process by making some assumptions about it."

Roger Lawson of the UK Shareholders Association, which has formed the action group, said shareholders feared they might get as little as 5p a share and said a fairer level would be £5.

"You only have to look at Northern Rock executive chairman Ron Sandler's business plan and how much the government expects to get returned to see that this company can expect to recover very quickly," he said.

While the Northern Rock case cost the 50,000 shareholders involved £3m, Greene estimates the costs of the Northern Rock case in the "late hundreds of thousands or maybe more". So far the group has raised £30,000 and is seeking backing from other investors.

Donations of £25 are being asked from every Northern Rock shareholder and a larger proportional amount from those with more than 1000 shares.

The government has 21 days in which to respond to Edwin Coe's letter but the case itself could take as long as 18 months.

The move comes a day after Northern Rock announced plans to cut more than 2000 jobs from its 6000-strong workforce. Sandler proposes to halve the size of its mortgage book to around £50bn and pay back around £25bn in Bank of England loans.