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Movie Gallery (MOVI) has negotiated a deal with creditors that will end up in them seeking Chapter 11 bankruptcy protection, according to people close to the matter.

How it will work is the company will convert its bonds and a part of its second-lien debt to stock. As of July, Movie Gallery has $1.2 billion in debt; with $600 million in first-lien debt, $175 million in second-lien debt and $322 million in bonds.

Most of these problems are attributed to the acquisition of Hollywood video in 2005, where they paid $1 billion to get the company by outbidding Blockbuster (BBI). Since that time the company has struggled to pay it's debts.

In July of 2007, they weren't able to meet their obligations from a senior loan from Goldman Sachs Credit Partners.

They've also been trying to work out forbearance agreements with its lenders.

While not publicy admitting they're going to declare bankruptcy, insiders say it will happen this month, and are looking to emerge from the process in the early part of 2008.

The response by Movie Gallery to acquire Hollywood video is the typical response by the industry, thinking getting bigger and getting more scale will solve their problems. As they've found out, this isn't a scale issue, but a distribution issue, where Netflix (NFLX) and Internet downloads and streaming has changed the way people receive or consume their movies.

They used debt to finance something that couldn't pay for itself, because consumers were moving in the opposite direction.

They made the wrong move and investment, and now will pay for it for a long time.