With shares plunging 98% in the past two years, Movie Gallery's (NASDAQ:MOVI) equity carcass is nearly picked clean.

Earlier this month, Movie Gallery announced that it had failed to satisfy certain liquidity covenants on its $900 million credit facility. Its default raised the specter of a bankruptcy filing, sending the shares into a tailspin. Movie Gallery's current low-low share price now reflects a substantial likelihood that the shares will be massively diluted, or perhaps even cancelled, if the company files Chapter 11.

The latest plunge in Movie Gallery shares followed weeks of steady descent. The sell-off was likely prompted by a Blockbuster (NYSE:BBI) presentation noting that company's own second-quarter in-store woes, which clued alert investors into a surprise industrywide decline.

Movie Gallery's default came just months after the company successfully refinanced its long-term debt. Even worse, Movie Gallery's breakup value remains pretty much nada, which doubtlessly allowed Goldman Sachs (NYSE:GS) to organize the debt restructuring in the first place. After all, the "property, plant, and equipment" figure on Movie Gallery's balance sheet is almost certainly overstated, given the past year's sharp decline in the resale value of used DVDs.

Here, an old banker's saying is apt: The borrower who owes $10 and cannot pay is in some trouble, but the lender who is owed $1,000,000 and cannot collect is in serious trouble. Movie Gallery's bondholders are, or at least ought to be, seriously committed to the success of its turnaround, either before or after a bankruptcy filing. Otherwise, they'll never get paid.

On the plus side, Movie Gallery seems finally to have caught on to the changing dynamics of the video-rental business. Over the past several months, Movie Gallery has finally taken steps to expand its distribution footprint. Most importantly, it plans to roll out a rental-by-mail service to rival Blockbuster and Netflix (NASDAQ:NFLX) later this summer. Movie Gallery has also been expanding its kiosk rental business, which rents new-release DVDs at ATM-like machines in supermarkets.

Movie Gallery also recently purchased MovieBeam, an Internet-based, set-top-box subscription service, originally created by Disney (NYSE:DIS) and Cisco (NASDAQ:CSCO), offering video-on-demand subscriptions. Along with the success of Movie Gallery's Game Crazy video game sales division, these developments create at least the hope of righting the ship. But first, the company must steer clear of the current liquidity-crunch iceberg currently in its path.

Unfortunately, a Chapter 11 filing will leave Movie Gallery's bondholders with only the most meager sliver of equity. The company's market cap is currently just less than $19 million, weighed against the guaranteed bankruptcy expenses and dramatic paper losses to bonds that follow a filing. While it's certainly possible that an agreement could only be reached under the compulsion of a court order to play nice -- indeed, shareholders already politely turned down management's request last year to expand the number of authorized shares -- at this point, I seriously doubt it.

In perhaps the most serious limitation for bondholders, one of Movie Gallery's best assets is the substantial collection of net operating losses (NOLs) it's racked up over the past couple of years. Fairly onerous government regulations cover the purchase and sale of NOLs, designed to discourage the establishment of flimsy tax shelters. In this case, these regulations would limit the amount of equity that bondholders could expect to receive without cancelling the tax assets.

Now that Movie Gallery's shares have been gutted, observers are left wondering how badly its bonds will suffer. As the vultures swoop down to pick at Movie Gallery's junk-rated debt in anticipation of a filing, it becomes increasingly unlikely that the company and its stakeholders will reach an out-of-court settlement, even thought that would probably be best for all concerned.  While bankruptcy courts were created to solve these kinds of thorny collective-action problems, I can't help thinking there are cheaper methods to do the same.

For more on the movie-rental madness, check out:

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Fool contributor R.C. Lim manages Avocado Capital, L.P., a value fund, and welcomes your feedback. He does not own shares of any of the companies mentioned. The Motley Fool's disclosure policy will never lose value.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.