NEW YORK -- It has been an active period for Bally Total Fitness since the company announced on May 31, plans to restructure under Chapter 11 protection. Liberation Investment Group, Bally’s second largest shareholder, threatened to sue the company in a letter sent Wednesday to Bally’s board of directors. In the letter, Liberation says that Bally’s pre-packaged bankruptcy plan was “draconian” because it cancels all existing equity. The company is expected to file for bankruptcy next month.

Liberation, which also claims shareholders are getting a raw deal in the agreement, holds 11.2 percent (4.62 million shares) of Bally’s depressed stock. Pardus Capital Management LP, Bally’s largest shareholder, holds 14.8 percent, or 6.1 million shares.

Bally’s plan involves a reduction in the principal outstanding on the company’s existing senior subordinated notes by $150 million by exchanging all existing senior subordinated notes for a new class of notes, common equity and the right to participate in a $77.5 million rights offering.

“By approving this restructuring, the board, management and those interests who now clearly control the company have abandoned their fiduciary duties to shareholders. The board’s flawed process led to this regrettable result,” according to the letter written by Liberation Investment Group attorney Andrew K. Glenn.

The letter was released in a Securities and Exchange Commission (SEC) filing by Bally on Wednesday. A Bally spokesman declined to comment.

“We also understand that the proposed pre-packaged plan would deliver all of the reorganized equity to the company’s bondholders,” the letter says, arguing the board ignored viable alternatives, including sales of the company’s assets on a market-by-market basis.

“My clients believe that there is significant value for shareholders that the board has decided to [give] to creditors in the pre-packaged plan,” the letter says.

Liberation demanded that its executives, Manny Pearlman and Gregg Frankel, be appointed to a seat on the board. Pearlman led the fight at the January 2006 shareholder meeting to have Bally's CEO at the time, Paul Toback, removed. That effort failed. At that same shareholder meeting, Pardus Capital Management fought to get Don Kornstein on the board and succeeded in doing so. Kornstein is now chairman of the board and interim chief restructuring officer of the company.

Liberation also warned that it is “prepared to vindicate their rights both in and out of bankruptcy court” and is willing to negotiate a “consensual resolution.”

In other news, Mark J. Wattles’ hedge fund Wattles Capital Management LLC announced in an SEC filing Thursday that it had sold all but 400,000 shares of its Bally stock this month. Wattles previously was Bally’s third-largest shareholder with 3.8 million shares, or 9.3 percent. Now, Wattles’ stake in Bally is less than 1 percent after selling 2.5 million shares on June 1 and 956,300 shares on June 4.

Also within the past week, Bally announced that Michael Feder, a managing director at financial advisory firm AlixPartners, joined the company as its new chief operating officer and “will assume broad leadership responsibilities for all operations.” Feder replaces former COO John Wildman, who becomes Bally’s interim chief marketing officer and senior vice president for sales. Bally also says it is continuing its search for a permanent chief executive.

Bally’s stock closed at 73 cents Friday on the Pink Sheets exchange.