* Decision could push healthcare system toward suitors - or bankruptcy
* Insurer seeks to block suitors, says West Penn breached deal
* Nearly $740 mln municipal debt at stake
NEW YORK, Oct 25 (Reuters) - The outcome of a court hearing set to begin on Thursday will determine whether a major regional healthcare system in Pennsylvania is driven into bankruptcy or will be allowed to seek other suitors after a $475 million merger deal with insurer Highmark Inc crumbled.
At stake is the fate of the nonprofit West Penn Allegheny Health System and nearly $740 million of municipal debt it issued in 2007. In an era of growing hospital consolidation across the country, West Penn's case is also an unusual one - a merger suddenly gone wrong.
The two initially announced their agreement in June, saying Highmark would take control of West Penn in exchange for a cash infusion that would allow West Penn, which had already shuttered some facilities, to avoid more layoffs and closures.
But the partnership imploded amid demands by Highmark that before it would consummate the transaction, West Penn must declare bankruptcy in order to reduce its burdensome debt load, according to court documents.
Allegheny County Judge Christine Ward will hear arguments on Thursday and Friday about whether she ought to grant a request from Highmark, filed Oct. 1, to block West Penn from talking to other potential buyers and investors.
``If they're not allowed to potentially align themselves with someone else, they're out on an island by themselves,'' said Tom Metzold, co-director of municipal investments at Eaton Vance Management. ``I don't see how they can survive otherwise.''
Some attribute the change of tenor to the April departure of former Highmark CEO Kenneth Melani, who had resisted ideas that West Penn file for bankruptcy. He was fired after a fight with his girlfriend's husband led to an assault charge.
New CEO William Winkenwerder appeared at a West Penn board meeting on Aug. 30 for the first time and said he wanted to renegotiate the terms of the agreement to include debt reduction, even bankruptcy, West Penn said in its countersuit.
POTENTIAL DOWNGRADES ON HORIZON
The heated dispute and the abrupt end to the planned alliance caused concern among all three major credit rating agencies. On Sept. 28, the same day the public learned of the collapsed deal, the agencies warned that they might downgrade West Penn.
``We view this agreement as providing a strong path forward for them,'' Martin Arrick, senior nonprofit healthcare analyst for Standard & Poor's Ratings Services, told Reuters. ``Without a Highmark merger, it's a much more difficult situation.''
S&P rates West Penn at Caa1, already a speculative grade. West Penn has about $1.2 billion in assets but $1.4 billion in liabilities.
The first nine months of West Penn's fiscal year were strained, with the system's expenses exceeding revenues by nearly $76 million, according to the most recent data.
Net patient revenue was down 2.2 percent, or $25 million, from the same period in 2011. The system is now run by interim CEO Keith Ghezzi of the turnaround firm Alvarez & Marsal.
Pittsburgh-based Highmark, one of the 10 largest health insurers in the United States, has already provided $225 million to West Penn under the terms of their agreement. How much of that money constitutes a loan, which must be repaid, rather than a grant is also likely to be a contentious issue as the court case unfolds.
SOME DEBT REDUCTION STILL LIKELY
West Penn has also lost some business to its main regional rival, University of Pittsburgh Medical Center, rated A-plus by S&P. In a continuing lawsuit, West Penn accuses UPMC of stifling competition.
West Penn has also suffered financially from regional demographic changes, including an aging population and increasing Medicare patients, Arrick said.
West Penn, which is highly leveraged, has been trying to find a way out of its difficult financial bind for several years. It has lost patients and has significant pension expenses, he said.
West Penn could still find other potential investors if the judge allows it, according to Alan Schankel, head of fixed income research at Janney Montgomery Scott LLC.
``There's always suitors,'' he said. ``There's always a chance that even somebody not from that area, looking to expand or grow, would come into the market.''
But the terms offered by another partner would likely still require some debt reduction, or bankruptcy. That could even push West Penn back into discussions with Highmark if West Penn sees that ``just about every road they could possibly go down leads to the same thing,'' Schankel said.
``I think West Penn's future is pretty dim,'' he said. ``I'm not sure how they can avoid some kind of bankruptcy.''
Some of West Penn's doctors on Wednesday wrote an open letter to Governor Tom Corbett, asking him to intervene and seeking to get negotiations with Highmark reopened.
The system's municipal bonds, which mature in November 2040, sold at about 70 cents on the dollar as of Oct. 19, according to Municipal Market Data, a unit of Thomson Reuters. On the day West Penn announced that the merger was off, they had been selling for as much as 86 cents on the dollar.
(Reporting by Hilary Russ; Edited by Tiziana Barghini and Lisa Shumaker)