NEW YORK (Reuters) - Video chain Blockbuster Inc filed for bankruptcy protection on Thursday, battered by online and mail-order services such as Netflix Inc that have transformed how customers rent movies.

A store closing sign sits outside a Blockbuster movie rental store recently closed in Superior, Colorado November 19, 2009. REUTERS/Rick Wilking

A group of bondholders led by billionaire Carl Icahn and hedge funds have signed off on a restructuring deal that gives them a controlling stake in the company, court documents show.

Blockbuster plans to reinvent itself as a leaner competitor with more digital video offerings, including offerings on mobile devices. It said business is continuing as usual with its roughly 3,000 U.S. stores still open.

The bankruptcy allows the company to break leases and analysts expect Blockbuster to close hundreds of stores.

“The company is in a race against time,” said David Pauker, a managing director at turnaround firm Goldin Associates. He said Blockbuster needs to find a new format to stop its business from shrinking.

The company, founded in 1985 when video cassette recorders were becoming a fixture in U.S. homes, has been closing stores as it grapples with competition from Netflix, Coinstar Inc unit Redbox and others. It follows in the footsteps of rental chain Movie Gallery Inc, which filed for bankruptcy in February.

Blockbuster, which employs about 25,000 people, filed its Chapter 11 petition with the U.S. bankruptcy court in Manhattan.

Under its plan, Blockbuster would cut its debt to about $100 million from nearly $1 billion.

Icahn and hedge funds that together hold 80 percent of Blockbuster’s senior notes agreed to support the plan and provide $125 million of debtor-in-possession (or DIP) financing to help it operate while in bankruptcy.

Icahn, who sat on the company’s board of directors until earlier this year, has input on three of the seven directors for the post-bankrupt company’s interim board. He holds about one-third of the senior debt, a source familiar with the matter told Reuters on Wednesday.

“I think he’ll reduce the debt and reduce the number of stores and make it profitable again and sell it to a capital group or take it public,” said Mark Freiman, senior retail consultant at Focus Management Group. “He’ll make a ton of money off of it.”

Freiman said the average U.S. specialty retailer has about 700 to 800 viable locations. “If they close half, they are down to 1,500. That’s still a real good-sized chain.”

Blockbuster has started offering more digital delivery and mail-order services as well as express vending kiosks, but has struggled to keep pace as it is burdened by debt.

The recapitalization “will afford Blockbuster access to new capital and liquidity,” and will address its “unsustainable financial leverage,” Jeffery Stegenga, Blockbuster’s chief restructuring officer, said in a court filing.

He said Blockbuster can differentiate itself from rivals as the only company to provide customers with multiple ways to rent movies, with access to 125,000 titles.

Investors have flocked to Netflix, whose shares were trading for $160.87 on Thursday afternoon on Nasdaq, up 2.4 percent.

Blockbuster’s stock has languished on the pink sheets and plummeted 26 percent to 4.1 cents on Thursday. Its unsecured 9 percent notes due in 2012 fell to 2.5 cents on the dollar from 5.5 cents on Wednesday, according to MarketAxess. Both would be wiped out in the bankruptcy.

Lindsay Berz, who analyzes distressed companies for Chapdelaine Credit Partners in New York, said Blockbuster could gain market share from its non-store rivals by promoting its kiosk and mail business. “Would I be surprised if the bricks and mortar went quietly into the night? No.”

The case is In re: 10-14997, U.S. Bankruptcy Court, Southern District of New York.