UPDATE 3-Portugal Telecom may sue BES over unpaid family co's debt -sources

Thu Jul 17, 2014 5:34pm EDT

* S&P cuts BES rating to B-, warns on solvency risks

* Moody's cuts ESFG to Ca, cites default fears

* Portugal Telecom itself faces potential lawsuit

* BES-linked Rioforte holding company failed to repay $1 bln debt (Adds Portugal Telecom also likely to be sued)

By Sergio Goncalves and Andrei Khalip

LISBON, July 17 (Reuters) - Banco Espirito Santo (BES) could be sued over a loan that one of its founding family's holding companies failed to repay to Portugal Telecom, sources said on Thursday, as credit rating agencies downgraded the bank and its key shareholder.

Still, Finance Minister Maria Luis Albuquerque said the problems faced by BES, Portugal's largest listed bank, and the family's Espirito Santo Group did not pose an imminent danger to the country's financial system and reiterated the government did not plan to use public funds to help the bank.

But other risks loomed for BES following Tuesday's failure by the family's Rioforte company to repay 847 million euros ($1.15 billion) in debt to Portugal Telecom, which forced the telecom firm to take a cut in its stake of a merger with Brazil's Oi.

Sources close to the process told Reuters that Portugal Telecom was considering taking BES to court due to the non-payment as the commercial paper was bought with funds deposited at BES bank accounts, and was considered risk-free by the telecom firm.

A BES spokesman pointed to the bank's July 10 statement in which it said institutional clients "are considered qualified investors, in accordance with applicable legal criteria, hence with more capacity to assess risk".

Portugal Telecom declined to comment.

The company also faces a possible lawsuit by several minority shareholders, according to Diario Economico newspaper. It cited Octavio Viana, the head of ATM investor association, as saying they sought legal action against PT's board over the Rioforte investment that cut their stake in the merged company.

A lawsuit against BES could potentially open the door to other companies and investors suing it for selling them debts issued by the family's companies that were seen as being safe.

BES's shares have been hammered by fears in the past few weeks that its capital base could be undermined by the large debts of its founding family, which controlled and managed the bank until just a few weeks ago.

Ratings agencies warned of a potential impact on BES solvency from the Espirito Santo family's financial problems.

Standard & Poor's cut two notches from its long-term rating - to high-risk "B-" - for BES, saying its action reflected "our assessment that BES' capital position has weakened as a result of the higher losses that, according to our expectations, it is likely to face given its direct exposure to the Espirito Santo Financial Group (ESFG), to its subsidiaries, and to Rioforte."

The rating could be downgraded again, S&P said.

Sources have told Reuters that Rioforte is preparing to file for creditor protection in Luxembourg, where it is registered, to avoid a disorderly cut-price sale of its assets.

Moody's rating agency - which last week cut BES by three notches to "B3" - downgraded ESFG by two notches to "Ca", citing "the heightened risk of default for the group, combined with the potential for significant losses for bondholders".

ESFG is still the largest single shareholder in BES, with a 20 percent stake.

BES shares fell 7.9 percent to close at 0.419 euros, but still above the all-time low of 0.36 euros it hit on Tuesday.

"The rating cut is another blow in what has been a very negative news flow about the group, which stokes the uncertainty in the market, not allowing BES to have two straight sessions of gains," said Jose Novo, a trader at Orey iTrade brokers.

Shares in Portugal Telecom fell 6.8 percent to new all-time lows after another rater, Fitch, downgraded its and Oi's credit ratings by one notch to junk-level "BB+" due to the nonpayment by Rioforte, adding that "the recovery value is highly uncertain". Oi was down 5.5 percent in Sao Paulo.

"SERIOUS SITUATION"

Concerns surrounding the Espirito Santo banking clan, which founded BES more than a century ago, were sparked when an audit of a family holding company that owns Rioforte found what it called a "serious financial situation".

Those jitters spread last week to Europe and beyond, raising broader concerns about Portugal itself, just two months after it exited an international bailout deal, but have subsided somewhat after the government said the bank had enough capital to face its risks and it would not use public funds to help it.

"We are not preparing any recapitalisation of BES, and there are no indications that it may become necessary," Albuquerque told a parliament committee.

"The situation in the financial system has improved significantly with the reinforcement of capital ratios. Let's not confuse the whole financial system with one bank; it is important not to spread unjustified alarm."

The problems at BES initially pushed Portugal's bond yields higher, but in the past few days the yields have fallen again - to 3.73 percent on Thursday from Wednesday's 3.76 percent.

S&P said potential new impairments associated with BES's exposure ESFG and Rioforte "could be of a magnitude at least offsetting the benefit" from BES's recent capital increase.

BES raised 1.04 billion euros in a capital increase in May-June. It first reported unspecified "material irregularities" at Rioforte's parent company Espirito Santo International in the capital hike prospectus in late May.

BES's problems have wiped out 57 percent of its value in the past month, despite a 20 percent surge on Wednesday that analysts attributed to bargain-hunting and reports the bank's new CEO may bring in new shareholders to reinforce capital.

Bank of Portugal chief Carlos Costa has also said that although he sees no need for a capital increase at BES, there were shareholders interested in taking part in a BES capital increase if any additional capital were needed. ($1 = 0.7394 Euros) (Additional reporting by Filipa Lima; Editing by Sophie Walker and Will Waterman)