When I reported on Pegasus Communications (NASDAQ:PGTV) back in March, I closed with this: "The parental rating for Pegasus remains 'ES' -- extremely speculative." Well, it's time to downgrade to "Chapter 11."

The company has been locked in a contractual dispute with DirecTV, which is controlled by Fox Entertainment (NYSE:FOX), a subsidiary of News Corp. (NYSE:NWS) -- whew! In question are: (1) the length of the contract between the two, (2) the right to renew that contract under substantially the same terms, (3) premium service fees, and (4) launch fees.

In short, Pegasus, which provides direct broadcast satellite (DBS) TV service to rural areas, has the heart and soul of its operations tied up in a contractual dispute. Chase Carey, CEO of former DirecTV owner Hughes Electronics (now part of News Corp.), put it this way:

We believe that Pegasus has an unrealistic view of its contractual position and, therefore, of its resulting business prospects and fundamental valuation. With every day that passes, both Pegasus' significance to DirecTV and its value as a standalone enterprise diminish.

Ouch! Things got even worse in April when a federal jury awarded DirecTV $52 million in a billing case.

On Wednesday, DirecTV notified Pegasus that it was terminating its contract and offered the company $675 in cash for each of its 1.1 million subscribers if transferred to DirecTV by Aug. 31. Pegasus claimed DirecTV had no right to terminate the contract and sought court protection for its DBS assets through Chapter 11.

Pegasus is clearly trapped and in dire straits. It has $82 million in cash and total debt of $1.5 billion. You don't need a bar napkin to compute that the DirecTV offer of $742.5 million will not cover the bills. And not surprisingly, the stock opened this morning down 32%, a new 52-week low. If shareholders are yelling "Surprise, surprise, surprise" a la Gomer Pile, it's because the stock has bounced and, at noon, is down only 16%.

I can only imagine that buyers are thinking that News Corp. will raise its offer. After all, competitor EchoStar (NASDAQ:DISH), or a cable company like Comcast (NASDAQ:CMCSA), won't likely be much interested in a Chapter 11 outfit that, in its last quarter, reported falling sales and rising losses.

If you have an inkling to try to catch a falling knife, at least consider this: Pegasus traded at just $0.60 share -- not today's $13 a share -- as recently as the end of June 2002. Clearly, there is plenty of room for the stock to fall. And just as clearly, this horse is in a life-and-death struggle.

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Fool contributor W.D. Crotty owns stock in News Corp.