As Peabody Energy Corp. stumbled toward bankruptcy last year, its Wall Street adviser raised a red flag for management.

Two powerful and litigious distressed-debt hedge funds held Peabody bonds. “Both are bomb throwers and we should be very suspicious,” wrote Tyler Cowan, a restructuring expert at Lazard Ltd.

Six months later, in April, the world’s largest private-sector coal company was in bankruptcy. And, sure enough, the two New York hedge funds -- Paul Singer’s Elliott Management Corp. and Mark Brodsky’s Aurelius Capital Management -- soon became embroiled in a bitter $1 billion dispute as they sought to extract a bigger share of Peabody’s assets.

The showdown has pitted Elliott and Aurelius against a Citigroup-led pool of lenders, and it centers on an arcane accounting change that highlights how the two funds, coming off a bruising, decade-long debt battle with Argentina, relentlessly look to gain an edge in bankruptcy proceedings.

In court filings, including emails and handwritten notes by Peabody executives, Elliott and Aurelius are shown to have privately lobbied management to make the accounting change that would shift $1 billion in collateral to benefit themselves and other holders of around $4 billion in unsecured bonds.

‘Fictional Tale’

The lenders led by Citigroup Inc., an agent to $2.8 billion in secured debt, contend that those assets rightly belong to them. Peabody caved to the demands of the hedge funds in their effort to “drive up their own recovery at the expense” of the secured creditors, Citibank says in court filings. Franklin Resources Inc., with 21 percent of one tranche of the debt, is among the biggest secured lenders.

Peabody dismisses the assertions as “an elaborate -- and wholly fictional -- tale of conspiracy.” There’s no evidence, it says, that management was “co-opted” or “acting at the direction” of the hedge funds and other unsecured lenders.

Elliott and Aurelius say in filings that in fact it was the Citi-led lenders that used their clout to get a leg up in the bankruptcy. The two firms, which lead a group that includes AllianceBernstein and Capital Research & Management, aren’t alleged to have engaged in any wrongdoing.

Allocation Dispute