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Blockbuster, a long-established video rental company, indicated in a recent SEC filing that it may be close to filing for protection from its creditors under Chapter 11 of the U.S. Bankruptcy Code. The company’s indebtedness totals about $1 billion. As a result, one ratings agency has already downgraded Blockbuster’s creditworthiness.

Filing Chapter 11 would give Blockerbuster breathing room to restructure its debt. Meanwhile, in an effort to preserve liquidity, the company has already started closing unprofitable stores, which will allow it to cut expenditure by $200 million in 2010. To raise capital, it plans to sell its European unit.

Of course, the news of a potential bankruptcy did not sit well with investors, especially in light of the fourth-quarter loss of $2.24 a share. The stock price plunged some 30% to $0.32 a share at the close of trading on March 19, 2010, the day of the announcement.

In addition to its debt burden, Blockbuster faces strong competition. While it is setting up kiosks and other initiatives to draw customers, rivals such as Netflix and  Coinstar (Redbox) are making a business turnaround a difficult task.

Blockbuster has about 146,000 shares of Series A Cumulative Convertible Perpetual Preferred Stock (liquidation value $1,000) outstanding. This debt ranks below more senior debt, but ahead of the common stock. In the event of a bankruptcy filing, preferred shareholders will likely receive some value, while common stock holders may be left empty handed. Despite its financial crisis, quarterly dividend payments of $18.75 a share on each preferred are still intact, but could be interrupted if the company does file for bankruptcy. If there is a restructuring, convertible holders would receive cash, holdings in a “new” company, or a combination of both.

On the other hand, if the company does not survive bankruptcy and dissolves itself, things could turn profitable for holders of the company’s Series A 7 ½% Cumulative Convertible Perpetual Preferred Shares, if they bought them below liquidation value. According to the prospectus governing the convertible preferreds, under the Liquidation Preference clause, holders would be entitled to receive $1,000.00, plus accumulated and unpaid dividends up to the date fixed for liquidation, winding-up, or dissolution. If cash is unavailable for settlement, then preferred shareholders may receive company assets to the value of the liquidation value, plus accrued and unpaid dividends. Bear in mind that the settlement on this preferred stock comes after any distribution is made on more senior indebtedness and senior stocks.