Oct. 10 (Bloomberg) -- Movie Gallery Inc., the second- biggest U.S. movie-rental chain, may file for bankruptcy in the next two weeks under an agreement that leaves shareholders with a 5 percent stake, two people with direct knowledge of company's plans said.

Bondholders will get 95 percent of Dothan, Alabama-based Movie Gallery's shares, said the people, who declined to be identified because details of the plan weren't public yet. The chain and its creditors haven't reached a final agreement yet, they said.

Movie Gallery's pursuit of Chapter 11 protection follows its 2005 purchase of Hollywood Entertainment Corp. for $862 million, which left the company saddled with more than $1 billion in debt just as industry sales began to wane. The video chain lost money for two years as Blockbuster Inc. and Netflix Inc. took market share by selling movies over the Internet.

``These guys had blinders on,'' said Michael Pachter, an analyst at Wedbush Morgan Securities in Los Angeles. ``They really didn't think that Blockbuster and Netflix could grow this fast and take customers from them.''

Movie Gallery spokeswoman Meaghan Repko declined to comment.

The company had $1.2 billion in debt as of July, comprising about $325 million in bonds; $725 million in first-lien loans, which have first claim to the assets; and $175 million in second-lien loans.

The bondholders will get the right to buy $50 million in stock, with Sopris Capital Advisors LLC, the holder of about half the company's bonds, agreeing to buy any shares that aren't purchased, the people said. They wouldn't say how much equity would be in the company following its reorganization.

Nikos Hecht, a managing member at Sopris, declined to comment.

$400 Million

The company may come out of bankruptcy by early next year, with the debt reduced by about $400 million after some is converted to equity, the people said.

Creditors have proposed swapping half of the second lien into equity. The balance that is left would be renegotiated at an increased interest rate, the people said. Sopris owns less than half of the second lien, which ranks behind the first lien in repayment priority.

The company would still have $725 million in first-lien loans, and creditors are discussing the possibility of raising the interest Movie Gallery pays, the people said.

As of July 1, the rental chain was paying 10.9 percent on the first-lien loan and 11.9 percent on the second-lien loan.

Shrinking Value

Movie Gallery, with almost 4,500 video stores, was little changed at 27 cents 4:30 p.m. in Nasdaq Stock Market trading, giving the company a market value of about $8.8 million. The shares have plunged 92 percent this year. The chain was valued at as much as $604 million at the end of 2004.

In July, Movie Gallery defaulted on $725 million in loans and hired Lazard Ltd. as a financial adviser and turnaround specialists Alvarez & Marsal to help reorganize the company.

The chain said in August that it may not have enough cash to continue operating, and that it tapped its entire credit line.

Lazard spokeswoman Judi Mackey declined to comment.

The company's 11 percent notes due in 2012 rose 1 cent on the dollar to 33 cents, according to Trace, the NASD's bond- price reporting service. The yield fell to 49 percent.

The video-rental chain's bonds are rated C by Moody's Investors Service and D by Standard & Poor's, both below investment grade.

To contact the reporter on this story: Josh Fineman in New York at jfineman@bloomberg.net

Last Updated: October 10, 2007 17:01 EDT