A U.S. federal appeals court on Friday will hear arguments that Chrysler LLC's sale to a group including Italian carmaker Fiat SpA and the U.S. government violates long-standing bankruptcy law and should not be allowed to go forward.

The appeal, which has delayed Chrysler's sale, is likely to be closely watched by General Motors Corp, which filed its bankruptcy case this week in the same court and is pursuing a similar type of sale.

Investors, who fear it upends long-standing assumptions about the safety of secured debt, will also be eyeing the ruling.

U.S. Bankruptcy Judge Arthur Gonzalez ruled on Monday that the sale could become effective on Friday, saying that no one but the senior lenders was receiving a penny of value in the deal.

The deal would bring a New Chrysler out of bankruptcy, which will be owned by Fiat, the company's union, and the U.S. and Canadian governments, but that will now depend on the appeal.

A group of Indiana pension funds, which holds about $42 million of Chrysler's $6.9 billion in secured loans, and fought the sale in bankruptcy court, will argue before a three-judge panel for the U.S. 2nd Circuit Court of Appeals in New York on Friday at 2 p.m. EST.

Offering a preview of their arguments, lawyers for the Indiana pension funds, Chrysler, its unsecured creditors committee, union, Fiat, and several other groups filed briefs with the appeals court on Thursday.

CAN BE SAVED

The Indiana pension funds have objected to the sale saying it violates laws about the priority of repayment in bankruptcy by favoring more junior creditors over senior secured creditors. The funds argue that Chrysler's plan to distribute stock in the New Chrysler to the union and the government, while paying senior lenders only 29 cents on the dollar, is an illegal sub rosa reorganization plan, which ordinarily would not be permitted under the bankruptcy code. The funds also claim that the U.S. Treasury did not have authority to offer funds to the automakers under the Troubled Asset Relief Program (TARP).

Chrysler, however, can be saved without trampling the law and the rights of the first lien lenders, White & Case lawyers representing the Indiana pensioners wrote in their brief on Thursday. In any case, the issues on appeal call on the Court to maintain the rule of law, even set against cries from others that the economy as a whole will benefit from the sale.

OppenheimerFunds Inc, an asset management firm which originally opposed the deal through a larger group of secured lenders that later disbanded, filed an amicus brief with the court in support of the objectors arguing the sale should not be allowed.

The funds appeal to this court to set aside the sale order, which undermines well-established principles of United States bankruptcy law and threatens to destabilize American credit markets by subverting the equitable principles of creditors' rights, the Oppenheimer funds wrote in their brief, saying they hold $96 million of Chrysler's secured loans.

Chrysler's lawyers, from the Jones Day law firm, said in a brief filed to the court of appeals that the pensioners trying to block the sale were wrong in arguing that the terms of the deal violated bankruptcy rules by improperly distributing the debtor's assets.

In the end, the Fiat Sale is precisely that -- a sale of assets for a price that far exceeds liquidation value, to a purchaser who wants to use the assets in a productive enterprise, Chrysler's lawyers argued in court papers.

It also said that the pensioners did not have the standing to argue that the government improperly used TARP funds in the transaction.

Lawyers for United Auto Workers, the union representing Chrysler's workers, disputed the Indiana pensioners' contention that the timeframe for approving was too quick, saying they had had plenty of time to file objections in May.

The union called for the court to affirm the bankruptcy judge's rule that the sale is the only currently viable option for Chrysler.

The U.S. government, Chrysler Financial, Fiat and Chrysler's unsecured creditors' committee also filed briefs saying the deal should be closed. The government argued the Indiana's pension funds lacked standing.

Chrysler Financial, an affiliate that financed 62 percent of its dealers and about half of its customers, said its ability to collect money would be severely prejudiced if the sale is not closed, because those dealers will be put out of business if Chrysler does not survive as New Chrysler.

It's a real threat, if it (the appeals court) overturns the sale or finds it doesn't comply with bankruptcy code, said Stuart Hirshfield, Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. Whatever happens here will certainly help or create a problem for GM.

The appeal is: In re: Chrysler LLC, U.S. Court of Appeals for the Second Circuit, No. 09-2311. The bankruptcy case is In re: Chrysler LLC, U.S. Bankruptcy Court, Southern District of New York, No. 09-50002.

(Reporting by Emily Chasan and Caroline Humer; Additional reporting by Tom Hals, Phil Wahba and Grant McCool)

Chrysler Sale