Battle for Bally's Heats Up

This column was originally published on RealMoney on Sept. 13 at 10:40 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

The activist battle against Bally's Fitness (BFT Quote) is going to another level as Pardus Capital Management appears to be joining Liberation's effort.

I first wrote about Liberation and Bally's on July 25 when the stock was at $3.25. Piggybacking on top of Liberation's efforts has proved successful, with the stock closing Monday at $4.06, a full 25% higher. Pardus revealed that it owned 12% of the company (4 million shares) in a Securities and Exchange Commission filing last week, with a block of 1 million shares being bought last week at $3.93 per share.

In Pardus's (PCM's) filing it stated:

"PCM has communicated with management of the Company, and expects to continue to communicate with management of the Company." Pardus also threw in the line that funds do when they want to start talking with the other activists: "Depending upon such factors that PCM may from time to time deem relevant, PCM may, among other things, (i) communicate with other shareholders of the Company..."

Pardus's confidence, and Liberation's bet, achieved a substantial boon in the past two weeks as Bally's reworked some of its debt agreements with its bondholders. Let me just state that when a company defaults on its bonds, that is often the best time to buy its stock. Why? Because the hedge funds that own the bonds will do anything they can to avoid reporting a writedown on that debt to their investors.

In Bally's case, the "writedown avoidance efforts" began on Aug. 5, when two bondholders sent notice that Bally's was in default of their bonds because of earnings restatements that Bally's was in the process of filing. Bondholders typically have covenants in their loan agreements which trigger a default if the company does not file financial statements on time. Bally's has been under an SEC investigation for its earnings and is restating from 2000 to 2004. Bally's was given 30 days to either get a waiver extending its deadline or to file the restatements. Once the company defaults, even if it's a default based on a financial reporting covenant, bankruptcy is often a short hop away.

On Aug. 31, Bally's announced that the bondholders who had previously notified them they were in default had sent the company a waiver extending the deadline of the Financial Reporting Covenant (the line item in the loan agreement that said the company was in default unless it filed financial statements on a regular basis) until Nov. 30, 2005.

For taking on this additional risk, the bondholders got paid handsomely. One group of bondholders received $15 cash for every $1,000 invested (effectively raising their already high interest rate of 9.875% by another 1.50% on the year) and the other group of bondholders got the choice between $20 or 9.2 shares of stock for every $1,000 invested. They also changed slightly the terms of the loan agreement, making it more difficult for Bally's to default.