Ambac Financial Group hurried into bankruptcy protection this week because it was worried the Internal Revenue Service (IRS) might gut the entire company — including its sacrosanct bond insurance subsidiary, according to court documents.

The New York-based holding company petitioned for Chapter 11 bankruptcy protection on Monday — three weeks earlier than it had to — in a bid to avoid a scenario in which an IRS collection could detonate $3 billion of termination payments.

Ambac missed a $5.9 million interest payment on its debt at the beginning of the month and was not generating enough cash to pay off interest or principal on its $1.62 billion in bonds and loans.

Yet the missed payment would not technically become a default until the end of the month. The company had three weeks to sell itself or work out a restructuring and avoid bankruptcy.

Though negotiations with potential buyers were going poorly, the company had some time at least to negotiate a prepackaged bankruptcy plan before the default became official Nov. 30.

Any reorganization would presumably leave the company’s bond insurance subsidiary, Ambac Assurance Corp. (AAC), untouched and capable of paying claims on defaulted municipal bonds.
A letter the company received from the IRS put Ambac Assurance’s unassailability in jeopardy.
In an affidavit submitted to the U.S. Bankruptcy Court in the Southern District of New York, chief executive David Wallis explained that a $700 million tax dispute with the IRS sent Ambac rushing into the shelter of bankruptcy court.

The IRS has a power other creditors do not have. If it feels Ambac is delinquent on its taxes, the government can obtain a lien on the liquid assets of the company and all its subsidiaries. That could prompt the Office of the Commissioner of Insurance in Wisconsin, which regulates Ambac Assurance, to “rehabilitate” the insurer — to essentially take control of it.

That is the one fate Ambac has to avoid. The bond insurance subsidiary indirectly backs billions of dollars of credit-default swaps, which are insurance contracts forcing Ambac Assurance to cover losses on debts should they default.

Until the CDS result in actual claims, their book value might look ugly, but they do not force Ambac Assurance to pay any cash to the counterparty. However, these contracts stipulate that a move by state regulators to rehabilitate the insurer would technically trigger default, forcing it to pay the mark-to-market value of those contracts to counterparties.

Ambac Assurance’s exposure to those contracts should it default: $3 billion.

While Wallis assumes the Wisconsin commissioner would try to block these termination payments, the state might not succeed.

“In the event that OCI fails to restrain the assertion of such damages, this $3 billion in additional policyholder claims would dilute all other policyholder claims significantly,” Wallis said. “If the IRS were to take such enforcement actions with respect to AAC, there is a real risk that OCI would quickly thereafter commence a rehabilitation of the general account, which would likely cause collateral damage [and] seriously jeopardize or completely destroy AFG’s reorganization prospects.”

The need for protection from the government stems from two tax refunds Ambac Financial collected that the IRS is now questioning.

In 2008, Ambac adopted a new accounting method for its CDS contracts. It had the effect of amplifying the company’s losses. The big losses in 2007 and 2008 entitled Ambac to refunds of previously paid taxes. The company collected $708.1 million in refunds, thanks to the change.
On Oct. 28, the IRS requested some documents from Ambac. It wanted to know how the company calculated the size of these tax refunds. It also questioned the accounting methods underlying the determination of losses used to offset taxable income. Those losses currently total $7.3 billion, and are one of the company’s most valuable assets ­­— they confer the right for Ambac not to pay taxes on some potential future income.

If the IRS sees fit, it could assess a “deficiency,” seizing the company’s assets without giving notice or a chance to object. That move could trigger default, forcing $3 billion in payments on CDS contracts.

Sean Dilweg, the Wisconsin commissioner, in March took control of Ambac Assurance’s most risky assets, placed them into a segregated account, and froze any owed claims. The move was intended to protect Ambac Assurance from hemorrhaging money before a viable plan could be put in force to serve all policyholders.

The segregated account includes 700 in-force policies covering a net par outstanding amount of about $50 billion. Dilweg is currently seeking approval of a rehabilitation plan he filed in October, in which policyholders of the segregated account would receive a quarter of their permitted claims in cash and 75% in notes backed by the company’s surplus.

The Wisconsin state judge who green-lighted the creation of the segregated account and is tasked with approving the proposed rehabilitation plan issued an injunction Monday preventing the IRS from placing a lien on Ambac’s assets.

“The temporary supplemental injunctive relief requested by the rehabilitator is reasonable and necessary to promote the equitable and ordinary rehabilitation of the segregated account,” Judge William D. Johnston determined.

Ambac also sued the U.S. government on Tuesday, seeking relief from IRS collections.
Wallis on Monday submitted a “non-binding term sheet” that provides a framework for a reorganization in bankruptcy court. The term sheet tries to address the potential tax liabilities by folding them into the segregated account.

The term sheet stipulates that “any liabilities in respect of any preference or fraudulent conveyance claims” and “the fees and expenses incurred by AFG in relation to any litigation in regard to the return of the tax refunds” would also go into the segregated account.

Dilweg said this would be in the best interest of Ambac Assurance policyholders.

“I am prepared to take independent action seeking the full rehabilitation of AAC,” he said. “Full rehabilitation will put AAC in a favorable position to subordinate the claims discussed above to policyholder claims in the event such liabilities ­materialize.”

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