UPDATE 2-UK's Co-op to cede control of bank to bondholders
* Bondholders to take majority stake in Co-op Bank
* Original plan saw Co-op retaining control of bank
* New proposals to protect retail investors - sources
* Co-op says committed to preserving ethical focus
* Some customers threaten to move to other lenders
By Matt Scuffham
LONDON, Oct 21 (Reuters) - Britain's mutually-owned Co-operative Group will hand control of its banking arm to creditors including U.S. hedge funds in order to seal a 1.5 billion pound ($2.4 billion) rescue of the country's seventh-biggest bank.
The Co-op Group, which currently owns the Co-operative Bank outright, has bowed to the demands of a group of bondholders, including U.S. hedge funds Aurelius Capital and Silver Point Capital, and agreed to a restructuring which will leave it with a 30 percent stake in the bank.
The move risks alienating the bank's 4.7 million customers, many of whom were drawn to it because of its perceived ethical focus, and some using social networking site Twitter threatened to leave if the change of ownership went ahead.
"We're planning to move away from Co-op Bank. Anyone know any ethical bank business current accounts?" said one.
Another suggested an action group or petition be set up to "let hedge funders know if they take control of Co-op Bank all signed up will go to other banks".
Co-op Group chief executive Euan Sutherland said on Monday he had reached an agreement in principle to save the bank.
The group, which also runs supermarkets, a travel agency and funeral services, added it remained committed to preserving the bank's ethical focus.
One source with knowledge of the discussions said the bank would continue to be called "Co-op" after bondholders take control and would retain its existing management.
The Co-op Bank hit trouble after racking up big losses on commercial property. Many of the bad loans were acquired through its takeover of the Britannia Building Society in 2009.
In June, the Co-op Group unveiled a plan to raise money from asset sales, bank loans and slicing the value of bonds in a bid to plug a 1.5 billion pound capital shortfall at the bank. That would have left the group with a controlling stake.
But rebel bondholders last month submitted an alternative proposal that would give them majority ownership of the bank.
Both plans use a so-called "bail-in" model where bondholders will swap their debt for new bonds and equity in the bank, which will be listed on the London Stock Exchange.
The proposals meet new European directives which force bondholders and depositors, rather than taxpayers, to bear the cost of failed banks. Policymakers are keen to prevent a repeat of the 2008 financial crisis when billions of dollars of taxpayers' money was used to rescue banks.
"This is the first bank to be rescued and to survive as a standalone entity without taxpayer money," Sutherland said.
The new plan for the Co-op Bank represents a climb-down by Sutherland, who had previously insisted there was "no plan B" and that the only alternative to his rescue plan for the bank was a formal resolution process which would have seen its assets seized by the Bank of England.
The bondholder group, which is advised by investment bank Moelis, represents institutions owning about 43 percent of the bank's lower Tier 2 bonds. It built up large enough positions on tranches of Co-op Bank's debt to block the deal proposed by the Co-op Group, Britain's biggest customer-owned business.
Sources with knowledge of the matter said the new proposals would protect the Co-op Bank's 15,000 retail bondholders, many of whom are pensioners who had relied on coupons from their investments. They are likely to receive a new income bearing bond rather than having their debt converted into shares.
Mark Taber, who has campaigned on behalf of retail investors, welcomed that development, but said he needed to see more details of the new plan.
"If they are being offered a bond, the terms will be important. They will need to consider how it's going to be structured and approached and the mechanics of it and make sure people aren't treated unfairly within it or left out," he said.
The Co-op Group said constructive engagement with bondholders was continuing and it was confident a proposal to recapitalise the bank could be agreed and put to all of them.
Co-op Bank's bonds rallied on Monday before being suspended from trading on the London Stock Exchange at the bank's request. The bank said it would request the suspension be lifted when the full details of the plan are announced.
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