UPDATE 2-Blockbuster video chain headed for sale

* Agreement saves company from Chapter 7 liquidation

* Sale to proceed with first bid from hedge fund group

* Blockbuster proposes April 4 sale auction (Adds details on sale and auction dates throughout)

By Caroline Humer

NEW YORK, March 10 Blockbuster Inc BLOAQ.PK will proceed to a sale auction in April after the bankrupt video rental chain negotiated an agreement with creditors who had called for an immediate Chapter 7 liquidation.

A group of hedge funds led by Monarch Capital reached an agreement with creditors including Hollywood studios over the terms of the sale auction.

The studios including Disney Co (DIS.N) had said the original sale plan shortchanged them. Together they are owed more $100 million.

They and other creditors including the U.S. Trustee, a Department of Justice official, had asked the judge to convert the bankruptcy to a Chapter 7 liquidation, which essentially is a going out of business sale.

The judge, Burton Lifland, said he was "going to greenlight" the proposed sale plan and ruled against converting the bankruptcy to a Chapter 7 liquidation.

Lifland helped prompt the talks by making it clear he had concerns about the original sale proposal, which could have left many creditors with nothing.

The agreement sets up an auction which the company proposed for April 4 followed by a court hearing to approve the sale on April 7.

The sale could preserve Blockbuster's ongoing business, although the buyer may have the option to shut down all or parts of it.

Blockbuster, which has 2,500 locations, filed for bankruptcy in September after years of struggling to keep up with competition from Netflix Inc (NFLX.O) and online offerings.

The Monarch group submitted an initial bid for $290 million. The company listed assets of around $1 billion in its most recent disclosure, for Jan. 30.

The judge told lawyers for billionaire investor Carl Icahn their client could bid at the auction. A bondholder wanted to prevent Icahn from bidding, arguing he was an insider because he served on the company's board last year.

"If you've got a deep pocket, empty it out at the auction," the judge said during the hearing, which was delayed for hours for the negotiations over the sale proposal.

The judge still has to approve the agreement in writing as well as the sale and auction dates.

The case is In re: Blockbuster Inc, U.S. Bankruptcy Court, Southern District of New York, No. 10-14997. (Reporting by Caroline Humer; Writing by Tom Hals; Editing by Phil Berlowitz)