• by Erik Sass  @eriksass1, September 15, 2010

The troubled Tribune bankruptcy case is disintegrating altogether, with a demand from one unsecured creditor that Tribune's management be removed in favor of a court-appointed trustee. This would effectively replace one side of the ongoing negotiations midstream, and could signal a major shake-up in the collapsing bankruptcy reorganization.

According to the filing by lawyers representing Aurelius Capital Management, which held Tribune bonds before the company was taken private in a highly leveraged buyout led by Sam Zell, the management team appointed by the real estate mogul has acted "dishonestly and fraudulently." They believe "this is a case that screams out for the appointment of a trustee."

Specifically, Aurelius' lawyers argue that Zell's management team, Tribune's former management, and various senior lenders all have a financial interest in not unearthing facts that might prove the entire transaction was doomed to insolvency from the beginning, and therefore a "fraudulent conveyance."

By proceeding with bankruptcy reorganization under the assumption that the deal was legitimate, Zell is protected from further losses on his investment and maintains control of the company. The senior lenders stand to recoup a much larger share of their investments -- perhaps even taking control of the company, as once planned.

This is the second legal move this week attacking the very basis of Tribune management's claim to control the company and its sputtering bankruptcy reorganization.

On Monday, a committee of unsecured creditors filed a petition with the Delaware bankruptcy court to ensure they have the right to sue Sam Zell if the current round of negotiations fail. The committee of eight unsecured creditors outlined a number of areas where they might find a legal basis to sue Sam Zell, Tribune's current and previous board of directors, and Valuation Research Corp., a financial consulting firm that gave the stamp of approval for the buyout deal in October 2007.

Two weeks ago, Tribune's current management team handed over responsibility for formulating a new bankruptcy reorganization plan to a four-person committee drawn from the company's board of directors. The Delaware bankruptcy court also appointed a mediator, U.S. Bankruptcy Judge Kevin Gross, to oversee Tribune's negotiations with its various creditors. However, Aurelius says this move is "too little, too late," as it leaves elements of the current management in control of the company.

Still, the handoff was essentially an admission of defeat by management, following the collapse of its proposed bankruptcy reorganization plan. Senior lenders, including JP Morgan Chase, withdrew their support for the plan after a court-appointed examiner found evidence that some of the key elements of the 2007 buyout may have been fraudulent.

By forcing management to negotiate a new bankruptcy reorganization, these senior lenders may be hoping to head off the kind of inquiry into the potential misdoings identified by independent examiner Kenneth Klee.

In August, Klee filed a report that was critical of some aspects of the initial undertaking. Klee was investigating allegations brought by some bondholders that Tribune was doomed to bankruptcy from the start. Although he found no evidence of wrongdoing on the part of the buyout team led by real-estate mogul Sam Zell, Klee's findings provided crucial ammunition for the unsecured creditors trying to stop the bankruptcy reorganization plan proposed by Tribune's management.

Specifically, he said certain information suggested that some individuals in the company's former management team may have known it was not financially viable, making it a "fraudulent conveyance." As a result, he warned that it was "somewhat likely that a court would conclude that the Step Two Transactions [when the company assumed $3.6 billion in debt] constituted intentional fraudulent transfers and fraudulently incurred obligation."