Nov. 10 (Bloomberg) -- Philadelphia Newspapers LLC, the bankrupt owner of the Philadelphia Inquirer and the Daily News, won reversal of a bankruptcy judge’s ruling allowing creditors to use their debt to bid at an auction later this month.

U.S. District Judge Eduardo Robreno in Philadelphia ruled today the company can bar creditors owed more than $300 million from bidding the amount of their claims to gain control. The decision reverses an earlier ruling that criticized the company for trying to manipulate the sale process. The bankruptcy court judge erred in his decision, Robreno said.

“The decision of the bankruptcy court will be reversed,” Robreno said in the ruling. “The right to credit bid by the senior lenders cannot be found to exist at this juncture.”

An auction slated for Nov. 18 is central to the company’s reorganization plan. The plan filed in August calls for a sale of the company to a local investor group led by Bruce E. Toll, vice chairman of homebuilder Toll Brothers Inc. The plan would pay creditors about $92 million to extinguish about $500 million in debt.

“We’re gratified by the decision and now the auction can proceed with all bidders being treated equally, which would lead to the maximum value for the assets,” Jay Devine, a spokesman for the company, said in a phone interview.

Market Test

Lawyers for the publisher said an auction would subject the agreement of sale to a market test to see if there was a better deal available. Lawyers for senior lenders including CIT Group Inc. argued that the sale was a guise to allow insiders to keep control of the company’s assets.

Robreno didn’t consider in his ruling whether the proposed sale constitutes an insider transaction. Neither did he consider any “alleged unscrupulous conduct engaged in by the respective parties,” according to the ruling.

Abid Qureshi and Fred Hodara, attorneys for the senior lenders, didn’t immediately return phone and e-mail messages seeking comment on the ruling.

A section of the Bankruptcy Code, which applies to this case, doesn’t entitle a secured creditor the right to credit bid at a public auction held as part of a reorganization, Robreno said in his ruling.

“The senior lenders retain the right to argue at confirmation, if appropriate, that the restriction on credit bidding failed to generate fair market value at the auction, thereby preventing them from receiving the indubitable equivalent of their claim,” Robreno said.

Initial Bids

Initial bids for the auction must be submitted by Nov. 16. A confirmation hearing to approve the winner and the company’s reorganization plan is set for Dec. 4. The offer from Toll’s group will serve as the initial bid.

In addition to Toll, the investor group includes the Carpenters Union pension fund and former Rohm & Haas Co. director David W. Haas. Toll and the pension fund were part of the initial group of investors that acquired the publisher from McClatchy Co. in June 2006 for $562 million.

The local investors have offered to pay creditors $30 million, plus any cash held by Philadelphia Newspapers. The proposal would repay lenders about $36 million of the roughly $318 million they are owed, according to court documents.

The lenders would also be given ownership of the building that houses the Inquirer in downtown Philadelphia. The deal requires the lenders to allow the newspaper to stay in the building rent-free for two years, according to court documents.

The cases are In Re Philadelphia Newspapers LLC, 09-178, U.S. District Court, Eastern District of Pennsylvania (Philadelphia) and In re Philadelphia Newspapers LLC, 09-11204, U.S. Bankruptcy Court, Eastern District of Pennsylvania (Philadelphia).

To contact the reporter on this story: Sophia Pearson in Wilmington, Delaware, at spearson3@bloomberg.net.

Last Updated: November 10, 2009 15:02 EST