POOR LIVVY,” FANS OF OLIVIA NEWTON-JOHN sighed when they heard that her Los Angeles-based Koala Blue company had filed for bankruptcy protection in February. For the past eight years, Olivia, 42, had put her singing and acting career in third place behind her family—actor husband Matt Lattanzi, 32, and daughter Chloe, 5—and her company, Koala Blue, which she created in 1982 to market her line of Australian-style sportswear. This spring, after the business started to falter, Olivia suggested that Koala Blue was just one more victim of tough economic times. “We expanded too fast,” she said, “and when the recession hit, we really got hurt.”

But now a far different story is emerging, one that threatens to tarnish Newton-John’s sweeter-than-sugar image. According to many of those who invested in Koala Blue shops and lost their life savings, the venture was plagued by disputes between licensees and the home office, shoddy merchandise and late deliveries—problems that the star of Grease and her business partners never solved. “We’ve lost everything we had,” says Karen Snow, 35, who, with her husband, Steve, 40, ran two Koala Blue operations in Colorado that recently collapsed. “We lost our house, our real estate, our cash. We now have a car, some furnishings and a brand-new baby, and that’s all.”

But most of the 20-plus Koala Blue licensees see the Chapter 11 filing as more than just a business failure. They charge that by seeking bankruptcy protection, Newton-John and her management partners will be able to avoid sales agreements—some of them exclusive—with the shop owners. That will likely leave the company free to arrange more lucrative, less risky deals to sell merchandise through such department-store chains as Saks Fifth Avenue and Nordstrom—a move that managers say may be the only way to salvage the company. In retaliation, two shop owners have filed lawsuits seeking millions in damages from Koala Blue—and others are considering taking action.

Olivia has refused further comment on the subject of her company’s near demise. Koala Blue executives disparage the lawsuits, charging sour grapes on the part of the people who bought into the company. “By and large, [the investors] had no experience in fashion or business, and they were undercapitalized,” says Dan Zuckerman, who was Koala Blue’s director of licensing until he lost his job during a round of layoffs in May. “I think they were just greedy,” says David Brown, the company’s former chief financial adviser. “The idea of going into business with Olivia Newton-John had them star-struck.”

Indeed, it was Newton-John’s perky Aussie allure that made the Koala Blue clothes so popular early on. The first shop opened in 1983 on trendy Melrose Avenue in Hollywood to huge success. Naturally, Olivia and Co. started looking to expand the business. Investors interested in a Koala Blue license had to make an initial investment of $200,000. “It seemed like a good idea to find individuals willing to put up their own money to become part of our family,” says Brown.

The company wooed prospective investors with brochures that talked of Olivia’s magic, billing her as “a strong glamorous lady who has many dreams and the ability to make those dreams come true.” The appeal worked. With Olivia providing the glitz at shop openings, the business expanded by 1990 to 13 corporate-owned stores—financed by Olivia and her friend and partner Pat Farrar—and 49 licensed stores in the U.S., Japan, Canada, France and Australia. By 1989, sales totaled more than $14 million annually. Olivia was having a ball. “When I shop now,” she said, “I call it research.”

But for the licensees, the dream quickly turned into a ghastly nightmare. This year alone at least 17 licensed stores worldwide have folded. Of the 13 corporate-owned stores, only the flagship in Hollywood remains open.

Among the casualties are Jim and Joanne Karis. A business consultant with a master’s degree in economics, Karis, 42, and his wife, 39, were bowled over by what he considered “shockingly good” profits Olivia and her company projected. In 1988 the Karises opened the first of three Koala Blue shops in the Chicago area. Both say they saw themselves as clear-headed capitalists—but concede that Olivia’s star power swayed their business judgment. “Here is someone who is so famous that if you could connect yourself with her there’s no way you can get hurt,” explains Karis. “She’ll surround herself only with people who know what they’re doing.”

From the beginning, the Karises—and others—say, there were problems with late shipments and inferior merchandise. Jade-green garments the Karises ordered, for instance, were misdyed kelly. Patchwork items would arrive with bare white spots and no patches. One season’s knits were spattered with grease spots. Texas licensees Jeb Bashaw, 28, and Mark DeWalch, 29, say that the elastic in one shipment of pants and shorts was of such poor quality that the garments lost their stretch after a single washing. Bashaw and DeWalch say that when they called to complain about a shipment of tie-dyed clothes that arrived dyed in solid colors, sans “tie,” the company recommended they tell customers to take the clothes home and bleach the patterns in. “For a $100 T-shirt, you’re supposed to dye it yourself?” says Bashaw, a former stockbroker. Concludes New York licensee Paul Martin, a 25-year retail veteran who has closed two of his three Long Island shops: “[Olivia and her partners] were supposed to have the expertise, but this group of people had the highest level of incompetence—beyond our wildest imagination.”

The bad times got worse, say several Koala Blue shop owners, when the company hired a new chief operating officer, Gloria Teague, in 1990. According to licensees, Teague, who was let go in the June corporate crunch, instituted unreasonably rigid corporate policies that they suspect were aimed at severing the company’s obligations to their boutiques—even if it meant forcing them to close shop. “There was never any doubt in our minds what they were trying to do,” says Paul Martin. “They lied, they were deceitful, they didn’t care what the outcome was.”

For starters, some licensees claim, Koala Blue betrayed its exclusivity pact with several shops by selling to local department stores, nudging boutiques in Minnesota and Illinois closer to their end. Then there was the demand that the licensees provide letters of credit—bank guarantees that bills would be paid. Until Teague arrived, Koala Blue did not regularly require the documents from the shop owners. Suddenly, Teague insisted on always having them in hand before headquarters would ship any new clothes. The unexpected credit demand turned out to be the last straw for many owners. Bashaw and DeWalch had already sunk $650,000 into their four Texas stores, but at that point, says Bashaw, “We finally decided to just hang it up.”

What has most incensed licensee Martin, however, is Olivia’s latest legal maneuver. Together with partner Farrar, she wants to buy the Koala Blue trademark from the company for $355,500. If they do manage to purchase the Koala Blue label, the partners will gain permanent control over the company name and be able to cut whatever deals they like with manufacturers and stores.

In hopes of blocking his nemesis, Paul Martin, along with five other Koala Blue licensees, has filed an objection with the U.S. Bankruptcy Court in Los Angeles. Judge Kathleen March will not rule on the sale until Aug. 20, but in an initial hearing on the matter in July, she sternly warned Olivia’s counsel that she is unlikely to approve the trademark deal.

In court documents, Koala Blue managers have defended their actions, saying, for instance, that the high-volume, high-profit sales to department stores may be the only way to salvage the company. But at what cost? The Karises have lost more than $600,000—”our children’s college money,” says Joanne. Laurie McCray, 37, a single mother of two, plowed $1 million borrowed from her father plus her own savings into two stores in San Diego, and is gasping for air. “I started out two years ago with $360,000, two cars and money for my daughter’s college,” she says. “Now I have nothing. My father cosigned my loans and is about to have a heart attack over this. Olivia’s big thing is ‘Save the Earth,’ ‘Save all the little animals.’ I just wish she’d start worrying about some of the people who are being destroyed.”