• by Erik Sass  @eriksass1, March 22, 2010

Senior creditors will not be able to use money owed to them to bid for Philadelphia Newspapers, the Third Circuit Court of Appeals ruled Monday, setting the stage for a planned auction scheduled for April 27.

The decision, which upholds an earlier ruling, is a major setback for creditors who hoped to take ownership of the company without having to resort to more financing, simply by using the newspaper publisher's debts to them as refund bids.

The appeals court ruling confirms the lower court's judgment that the creditors are only legally entitled to receive such repayment as allowed by the proceeds from the auction -- which, given the distressed state of the newspaper industry in general, may well be substantially less than the amount they are owed.

The senior creditors hold about $300 million of debt assumed by the company during the $562 million buyout engineered by local Philadelphia ad mogul Brian Tierney in 2006. For comparison, one group (composed of old and new investors) has placed a bid of just $67 million.

The prolonged bankruptcy proceedings have pitted senior creditors against another group of investors including real estate developer Bruce Toll, a pension fund, and a new investor, David Haas, heir to the Rohm & Haas chemical fortune. The senior creditors have indicated they will oust Tierney as publisher if they gain control of the company, while the local investor group supports him.

The Philadelphia Newspapers bankruptcy proceedings have been marked by controversy since the company entered Chapter 11 bankruptcy protection in February 2009 -- including accusations of corporate espionage through computer hacking and illegal recording of conversations, as well as a reprimand to both sides from the bankruptcy court judge for failing to negotiate in good faith.

These bankruptcy proceedings are just one of a number of sagas involving newspaper companies that were acquired (or acquired other properties) in highly leveraged transactions at the peak of the credit bubble, before the economic downturn and a continuing decline in newspaper ad revenue pulled the rug out from under the industry.

Tribune Co. is still in the throes of a contested bankruptcy case which, like Philadelphia, has been slowed by disputes between different factions of investors and creditors. Last year also saw declarations of bankruptcy by Freedom Communications, the Sun-Times Media Group, the Journal Register Co., and Star Tribune Holdings; for the most part these cases have all been resolved.