A group of Lionsgate bondholders who were recently excluded from a debt exchange are weighing potential litigation against the company, arguing that the exchange stripped all covenants and violated the holders’ “sacred rights” under the bond indenture, said two sources familiar with the situation.

For its part, bondholder Sycale Advisors hired legal counsel Selendy Gay to consider potential litigation against Lionsgate ahead of the studio’s separation of its film division from the STARZ streaming service. Other bondholders are also in talks to join the group, one of the sources noted.

“Participating holders went to the company and cut a preferential deal and the company went with it,” the first source said. “But there is no reason that some holders are in the “good” group, and some are in the “bad” group.” Selendy Gay is a litigation boutique that frequently represents allegedly jilted creditors as plaintiffs, including recent actions against TriMark, TPC Group, Mitel and Robertshaw.

The company launched the exchange at the beginning of the month seeking to swap USD 383m, or roughly half of the USD 715m 5.5% senior unsecured notes due 2029 issued at the STARZ business into new notes that would be guaranteed by the more profitable Studio business. The new notes will facilitate the full separation of the STARZ business from the Studio business which is expected to be completed by the end of the year. Upon separation, the new notes sitting at the Studio business will bear a slightly higher coupon of 6% and will mature in 2030, one year before the roughly USD 332m notes left out at the STARZ business.

Liberty 77 Capital LP, a private equity firm founded by former US Treasury Secretary Steve Mnuchin, was among the funds that participated in the private exchange which settled on 8 May, according to SEC filings. The firm is also a shareholder of Lionsgate after it bought a roughly 5.5% stake in the company last year.

Wachtell, Lipton, Rosen & Katz served as legal advisor to Lionsgate while Perella Weinberg Partners LP acted as financial advisor. White & Case served as legal advisor to the noteholders who took part in the exchange, according to a press release.

“The exchange is egregious,” said the first source familiar. “The bondholders left behind woke up one morning and were told sorry, you are not participating,” the source continued, noting that the excluded holders were left behind at the “BadCo” with all covenants and guarantees stripped away. Left-out holders were perplexed by the issuer’s move given that there wasn’t any urgency to complete the private exchange to avoid bankruptcy or prevent the company from falling into “distress,” said the source.

A trading dichotomy also emerged after the exchange was announced. The bonds that participated in the exchange began trading with a roughly 20-point premium to the excluded notes.

The USD 389m 5.5% senior unsecured notes that participated in the exchange and are issued at Lions Gate Capital Holdings 1 (LGCH1) last traded at 91.5 to yield 7.6%, while the USD 332m 5.5% notes left at the STARZ business traded recently at 72.2 to yield 13.3%, according to MarketAxess. The 5.5% notes traded down almost 4 points after the exchange was announced from 76.62 to yield 11.8% on 1 May, according to MarketAxess.

Holders left at the STARZ business are also concerned they could be primed with senior debt given the lack of covenants. However, the priming risk existed even before the exchange took place because the notes were unsecured, said a third source familiar.

“They gutted the indenture as part of the exchange,” said the first source familiar. The original indenture had many rights that prevented non pro rata exchanges, non pro rata redemption of notes, removing guarantees and subordinating debt, the source continued.

While the exchange was possible given that more than 50% of the holders agreed to participate, the transaction violates the “sacred rights” of all the bondholders since it modified guarantees and reduced the principal amount of the notes without the consent of all the holders, alleges the first source familiar.

“The transaction was permitted under the indenture and did not reduce the bondholder’s principal,” said the third source familiar, noting that the bondholders at STARZ are benefiting from having less pari passu debt at Lions Gate Capital Holdings. “The amendments were designed to facilitate the spin which is beneficial for everyone,” said the third source familiar.

Lionsgate, Selendy Gay and Sycale Advisors did not reply to a request for comment.