* PT stake in merged company cut to 25.6 pct from 38 pct in old terms
* Portugal Telecom and Oi shares up in relief over tie-up
* PT to sue Espirito Santo company Rioforte to recover debt
* PT has option to buy back Oi shares if recovers money
* Still unclear on size of losses facing Banco Espirito Santo (Adds BES, PT closing prices, details on talks)
By Axel Bugge and Leila Abboud
LISBON, July 16 (Reuters) - Portugal Telecom has been forced to take a cut in its share of a merger with Brazil's Grupo Oi after a holding company of the Espirito Santo family failed to repay more than $1 billion it owed to the telecom company.
Portugal's largest telecoms provider said it would take legal action to try and recover the debt from the family company, Rioforte, which fell due on Tuesday.
The revision of the terms of the merger with Oi is the most high-profile consequence so far of the escalating troubles of the Espirito Santo clan, once one of Europe's premier business dynasties.
Senior representatives of key Oi shareholders, such as Brazil's development bank BNDES and construction firm Andrade Gutierrez, travelled to Lisbon and negotiated the deal with PT's board on Tuesday, sources in Brazil said.
The Espirito Santo family's business empire is in disarray since the emergence of accounting irregularities at another of its holding companies, putting Portugal and the family-founded bank Banco Espirito Santo (BES) under pressure as questions swirl about potentially destabilising losses.
"From the point of view of reputation, this is bad for Portugal's image as a whole, which was just beginning to improve as the country exited the (EU/IMF) bailout," said Filipe Garcia, head of Informacao de Mercados Financeiros consultants in Porto.
He said events raised question marks over management at BES and the standards of governance at Portugal Telecom and its failure to diversify risk.
The failure of Rioforte, which holds some of the family's major assets, including hotels and property, to repay 847 million euros ($1.15 billion) in short-term debt owed to Portugal Telecom by July 15 means the latter will now have a 25.6 percent stake in the merger with Oi instead of the 38 percent originally agreed.
The agreement also shifts the credit risk from the Rioforte loans, which total 897 million euros, back to Portugal Telecom and away from Oi, which has said it did not know about them.
The reworked deal reassured investors that the tie-up, designed to create a telecoms champion with 100 million subscribers and $19 billion in annual revenue, would go ahead.
It also shows that Oi will not go to war with its soon-to-be partner despite threats from some of its shareholders to sue the Portuguese carrier over the Rioforte loans. Brazil's state development bank said the loan was inconsistent with "minimum standards of good corporate governance".
"In our view, this deal is significantly positive for PT investors and modestly positive for Oi investors, with it very much in the interest of both parties to progress with the merger," said Mark Chapman from Credit Insights.
Although the new merged company is likely to see its debt downgraded to junk due to the unpaid loan, shares in Portugal Telecom rose 3.3 percent to 1.89 euros in relief that the merger will go through. They had slumped by more than a third to a historic low in the past few weeks on concerns it would unravel.
Shares in Oi jumped the most in six months, rising over 13 percent.
Shares in BES soared to close almost 20 percent higher from Tuesday's all-time lows on bargain-hunting and helped by reports that its new chief executive may bring in new shareholders.
Also, Bank of Portugal chief Carlos Costa told TVI television late on Tuesday that "if any additional capital were needed due to risks that at this moment we do not see, certainly there are shareholders interested in taking part in a BES capital increase". He reiterated that BES was well capitalised.
Portugal's largest listed bank has said it has more than enough reserves to deal with its exposure to the Espirito Santo empire, but investors are still waiting for it to put a figure on any losses.
Uncertainty over the eventual bill has triggered a plunge in the bank's shares and bonds over the past month.
Rioforte is the second Espirito Santo company not to honour its debts in as many weeks, but the failure to repay the Portugal Telecom loan cuts at the heart of the country's tight-knit business community.
The Espirito Santo family and Portugal Telecom have a long allegiance cemented by personal friendships and cross share holdings.
BES has a 10 percent stake in the telecoms group, and Portugal Telecom officials knew the Espirito Santo clan had some problems before they handed over the cash in April, people familiar with the matter have told Reuters.
Portugal Telecom has declined to say why it invested so much of its liquidity in one firm's commercial paper, and Oi has sharply criticised the Lisbon-based group for not disclosing the loan earlier. Oi's representatives had quit the Portugal Telecom board in protest when told of the Rioforte deal.
Wednesday's agreement is likely to be seen as good news for Zeinal Bava, Oi's CEO, who had headed Portugal Telecom's Portuguese business before moving to Oi in June 2013, months before the tie-up was announced.
Some investors had expressed concern that the Rioforte situation would put Bava - whose operational know-how is crucial to Oi - in a difficult position, since it remains unclear whether he knew about the loan.
The unpaid debt, which had been transferred to Oi in May, will now be shifted back to Portugal Telecom. Portugal Telecom has a call option to buy back more shares in Oi over a six-year period, potentially increasing its stake in the merged group if it can recover some of the Rio Forte money.
The next step in the saga is expected to be Rioforte filing for creditor protection, people close to the situation said on Tuesday. There is a seven-day grace period on the loan that was due on Tuesday before Rioforte is technically in default.
Portugal Telecom will then have to sue Rioforte to try to claw back some of the money. Credit analysts said it was hard to predict how long the process could take, but emphasized that PT faced a difficult road to get paid back. ($1 = 0.7376 Euros) (Additional reporting by Andrei Khalip, Guillermo Parra-Bernal,; Writing by Carmel Crimmins; Editing by Tom Pfeiffer, Will Waterman and Giles Elgood)