Background and Business Description

9 Months Ended

Sep. 30, 2018

1. BACKGROUND AND BUSINESS DESCRIPTION

Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a financial services holding company incorporated in the state of Delaware on April 29, 1991.

Ambac provides financial guarantee insurance policies through its principal operating subsidiary, Ambac Assurance Corporation (“Ambac Assurance" or "AAC") and its wholly owned subsidiary, Ambac Assurance UK Limited (“Ambac UK”). Insurance policies issued by Ambac Assurance and Ambac UK generally guarantee payment when due of the principal and interest on the obligations guaranteed. The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio since 2007 has prevented Ambac Assurance and Ambac UK from being able to write new business. The inability to write new business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends and, as a result, Ambac’s liquidity, have been significantly restricted by the deterioration of Ambac Assurance’s financial condition and by the terms of the Settlement Agreement, dated as of June 7, 2010, as amended (the "Settlement Agreement"), by and among Ambac Assurance, Ambac Credit Products LLC (“ACP”), Ambac and certain counterparties to credit default swaps with ACP that were guaranteed by Ambac Assurance. Ambac Assurance is also restricted in its ability to pay dividends pursuant to regulatory restrictions, the Stipulation and Order (as described in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017) and the terms of its Auction Market Preferred Shares ("AMPS"). It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future.

Ambac also provides other financial products through subsidiaries of Ambac Assurance. These products include interest rate swaps, funding conduits, and investment agreements (until the first quarter of 2017) that were provided principally to clients that were also provided financial guarantee policies. These financial products have been in active run-off since 2007.

There are substantial restrictions on the ability to transfer Ambac’s common stock set forth in Article XII of Ambac’s Amended and Restated Certificate of Incorporation. In order to preserve certain tax benefits, subject to limited exceptions, any attempted transfer of common stock shall be prohibited and void to the extent that, as a result of such transfer (or any series of transfers of which such transfer is a part), either (i) any person or group of persons shall become a holder of 5% or more of the Company’s common stock or (ii) the percentage stock ownership interest in Ambac of any holder of 5% or more of the Company’s common stock shall be increased (a “Prohibited Transfer”). These restrictions shall not apply to an attempted transfer if the transferor or the transferee obtains the written approval of Ambac’s Board of Directors to such transfer. A purported transferee of a Prohibited Transfer shall not be recognized as a stockholder of Ambac for any purpose whatsoever in respect of the securities which are the subject of the Prohibited Transfer (the “Excess Securities”). Until the Excess Securities are acquired by another person in a transfer that is not a Prohibited Transfer, the purported transferee of a Prohibited Transfer shall not be entitled with respect to such Excess Securities to any rights of stockholders of Ambac, including, without limitation, the right to vote such Excess Securities and to receive dividends or distributions, whether liquidating or otherwise, in respect thereof, if any. Once the Excess Securities have been acquired in a transfer that is not a Prohibited Transfer, the securities shall cease to be Excess Securities. If the Board determines that a transfer of securities constitutes a Prohibited Transfer then, upon written demand by Ambac, the purported transferee shall transfer or cause to be transferred any certificate or other evidence of ownership of the Excess Securities within the purported transferee’s possession or control, together with any distributions paid by Ambac with respect to such Excess Securities, to an agent designated by Ambac. Such agent shall thereafter sell such Excess Securities and the proceeds of such sale shall be distributed as set forth in the Amended and Restated Certificate of Incorporation. If the purported transferee of a Prohibited Transfer has resold the Excess Securities before receiving such demand, such person shall be deemed to have sold the Excess Securities for Ambac’s agent and shall be required to transfer to such agent the proceeds of such sale, which shall be distributed as set forth in the Amended and Restated Certificate of Incorporation.

On October 11, 2018, Ambac received a Private Letter Ruling (“PLR”) from the U.S. Internal Revenue Service (“IRS”) with regard to certain aspects of Section 382 of the Internal Revenue Code of 1986, as amended. Section 382 generally limits the use of a corporation’s net operating loss carryforwards when an ownership change occurs. An ownership change results if there is a cumulative increase of more than 50 percentage points in the amount of stock held by one or more “5% shareholders” of the corporation during a three-year testing period. A group of persons who have a formal or informal understanding to make a coordinated acquisition of stock is treated as a single entity for these purposes.

The PLR addresses the ownership of Ambac’s common stock by three separate groups of funds and accounts managed by three separate investment advisors. In the PLR the IRS ruled that, based on certain facts and representations, for purposes of Section 382 each investment advisor will not be treated as the owner of the shares which it holds on behalf of the funds and accounts it advises, and each group of funds and accounts will not be treated as a single entity. The conclusions in the PLR are based on the particular facts and circumstances set forth in Ambac’s request for the PLR, including those set forth in representations provided in writing by the investment advisors to Ambac, such as the current and expected future investment strategies of the funds and accounts managed by these investment advisors, the current and expected manner in which the funds and accounts, and the investment decisions regarding Ambac’s common stock, are managed by these investor advisors, and the current and expected tax classification of the funds managed by these investment advisors. The PLR does not address the application of Section 382 to any Ambac shareholder other than those specifically addressed in the PLR. Ambac reserves all rights under its Charter regarding transfers and

voting of its stock and other securities, including those unrelated to Section 382. Furthermore, receipt of the PLR does not affect any voting or ownership restrictions that may apply to holders of Ambac’s common stock pursuant to applicable law.

As a result of the PLR, neither the investment advisors specifically addressed therein nor the funds and accounts they advise will be treated by Ambac as 5% shareholders for purposes of Article XII of the Charter unless any representation provided to Ambac by an investment advisor ceases to be true, including that no individual fund or account owns 5% or more of Ambac’s common stock.

In February 2018, Ambac achieved one of its key strategic priorities, the exit from rehabilitation of the Segregated Account (as defined below). Having accomplished this milestone, Ambac continues to pursue and prioritize its remaining key strategic priorities, namely:


•	Active runoff of Ambac Assurance and its subsidiaries through transaction terminations, policy commutations, reinsurance, settlements and restructurings, with a focus on our watch list credits and known and potential future adversely classified credits, that we believe will improve our risk profile, and maximizing the risk-adjusted return on invested assets;


•	Ongoing rationalization of Ambac's and its subsidiaries' capital and liability structures;


•	Loss recovery through active litigation management and exercise of contractual and legal rights;


•	Ongoing review of organizational effectiveness and efficiency of the operating platform; and


•	Evaluation of opportunities in certain business sectors that meet acceptable criteria that will generate long-term stockholder value with attractive risk-adjusted returns.

With respect to our new business strategy, we have identified certain business sectors, adjacent to Ambac's core business, in which future opportunities will be evaluated. The evaluation will be conducted through a measured and disciplined approach to identify opportunities that are synergistic to Ambac, match Ambac's core competencies, are rapidly scalable or available through mergers and acquisitions and that may allow for the utilization of Ambac's net operating loss carry-forwards. Although we are exploring new business opportunities, no assurance can be given that we will be able to execute or obtain the financial and other resources that may be required to finance the acquisition or development of any new businesses or assets. The execution of Ambac’s objective to increase the value of its investment in Ambac Assurance is subject to the rights of OCI (as defined below) under the Stipulation and Order, which requires OCI to approve certain actions taken by or in respect of Ambac Assurance, as well as the restrictions in the Settlement Agreement. Opportunities for remediating losses on poorly performing insured transactions also depend on market conditions, including the perception of Ambac Assurance’s and its subsidiaries' creditworthiness, the structure of the underlying risk and associated policy as well as other counterparty specific factors. Decisions by OCI could impair Ambac’s ability to execute certain of its strategies. Ambac Assurance's ability to commute policies or purchase certain investments may also be limited by available liquidity. Due to these factors, as well as uncertainties relating to the ability of Ambac Assurance to deliver value to Ambac, the value of our securities remains speculative.

Management reviews financial information, allocates resources and measures financial performance on a consolidated basis. As a result, the Company has a single reportable segment.

The Segregated Account

In March 2010, Ambac Assurance established a Segregated Account pursuant to Wisc. Stat. §611.24 (2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities, and the Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which term shall be understood to refer to such office as regulator of Ambac Assurance and to refer to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) commenced rehabilitation proceedings in the Dane County, Wisconsin Circuit Court (the “Rehabilitation Court”) with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. On October 8, 2010, OCI filed a plan of rehabilitation for the Segregated Account (the “Segregated Account Rehabilitation Plan”) in the Rehabilitation Court, which was confirmed by the Rehabilitation Court on January 24, 2011. On June 11, 2014, the Rehabilitation Court approved amendments to the Segregated Account Rehabilitation Plan and the Segregated Account Rehabilitation Plan, as amended, became effective on June 12, 2014. Policy obligations not allocated to the Segregated Account remained in the General Account of Ambac Assurance, and such policies in the General Account were not subject to and, therefore, were not directly impacted by the Segregated Account Rehabilitation Plan.

On February 12, 2018, Ambac successfully concluded the rehabilitation of the Segregated Account pursuant to an amendment of the Segregated Account Rehabilitation Plan (the "Second Amended Plan of Rehabilitation"). The conclusion of the rehabilitation followed the successful completion of Ambac's surplus note exchange offers and consent solicitation, which, together with the satisfaction of all conditions precedent to the effectiveness of the Second Amended Plan of Rehabilitation, including the discharge of all unpaid policy claims of the Segregated Account, including accretion amounts thereon ("Deferred Amounts"), completed the restructuring transactions (the "Rehabilitation Exit Transactions") announced on July 19, 2017, as more fully described in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

In exchange for an effective consideration package of 40% cash, 41% Secured Notes (as defined below) and 12.5% General Account Surplus Notes (as defined below), paid in respect of outstanding Deferred Amounts and General Account Surplus Notes. Ambac Assurance received the following benefits as a result of the completion of the Rehabilitation Exit Transactions:


•	Satisfaction and discharge of all outstanding Deferred Amounts (including accretion) of the Segregated Account, totaling $3,856,992;


•	Cancellation of $552,320 in principal amount outstanding, plus accrued and unpaid interest of $257,200 thereon, of AAC's 5.1% surplus notes due 2020 (the "General Account Surplus Notes"); and


•	An effective discount of 6.5% on Deferred Amounts (applied first against accretion) and the outstanding amount of principal and accrued and unpaid interest on tendered General Account Surplus Notes.

Ambac received $0.91 in principal amount of Secured Notes for each $1.00 of Deferred Amounts that it held, and provided a $0.09 discount in full satisfaction and discharge of its Deferred Amount claims. Ambac did not participate in the voluntary surplus note exchange offers.

A newly formed special purpose entity Ambac LSNI, LLC ("Ambac LSNI") issued $2,154,332 of new secured notes (the “Secured Notes”), secured by all assets of the special purpose entity, which include a note issued by Ambac Assurance to the special purpose entity (the "Ambac Note"), which is secured by a pledge of Ambac Assurance’s right, title and interest in up to the first $1,400,000 of proceeds (net of reinsurance) from certain litigations in which Ambac Assurance seeks redress for breaches of representations and warranties and/or fraud related to residential mortgage-backed securitizations (the “RMBS Litigations”). In addition, the Ambac Note is secured by cash and securities having a market value of $221,676 as of September 30, 2018. Ambac Assurance also pledged for the benefit of the holders of Secured Notes (other than Ambac Assurance) the proceeds of the Secured Notes held by Ambac Assurance from time to time, and issued a financial guaranty insurance policy to a trustee for the benefit of holders of Secured Notes irrevocably guarantying all principal and interest payments in respect of the Secured Notes as and when such payments become due and owing.

Prior to the Rehabilitation Exit Transactions, Ambac and Ambac Assurance owned securities that were insured by Ambac Assurance and allocated to the Segregated Account. As a result of the Rehabilitation Exit Transactions, Ambac and Ambac Assurance received $124,881 and $643,583, respectively, of par amount of Secured Notes issued by Ambac LSNI. Such secured notes are reported in Investments in the Consolidated Balance Sheets at their fair value.

Ambac Assurance also received $240,000 in cash proceeds from the issuance of notes secured by recoveries from RMBS Litigations in excess of $1,600,000 ("Tier 2 Notes").

Receipt of Requisite Consents for Bank Settlement Agreement Waiver and Amendment

Ambac received sufficient consents from holders of General Account Surplus Notes for a waiver and amendment (the "BSA Waiver and Amendment") of the Settlement Agreement. Among other provisions, the BSA Waiver and Amendment includes amendments to the Settlement Agreement that (i) eliminate the requirement for Ambac Assurance to have "unaffiliated qualified directors" on its Board of Directors; (ii) eliminate the prohibition on new business activities; (iii) modify the restrictions on the incurrence of indebtedness and other material obligations; (iv) modify the restrictions on liens securing permitted indebtedness; (v) modify restrictions applicable to junior surplus notes; and (vi) modify restrictions on mergers or similar transactions.

Regulatory Approval of the Rehabilitation Exit Transactions, including a partial interest payment on Surplus Notes

OCI provided all approvals necessary to consummate the Rehabilitation Exit Transactions, to give effect to the BSA Waiver and Amendment, and to make a $13,501 pro-rata interest payment, representing approximately six months of interest, on the outstanding principal and accrued and unpaid interest of surplus notes that remained outstanding (of which $2,618 was received by Ambac for surplus notes that it owned that were considered extinguished for accounting purposes) after the closing of the Rehabilitation Exit Transactions on February 12, 2018.

For more information about the Segregated Account rehabilitation and the Rehabilitation Exit Transactions and related matters, please refer to Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

Final Decree and Order

On June 22, 2018, the Rehabilitation Court entered the Final Decree and Order discharging the Rehabilitator and the Special Deputy Commissioner for the Segregated Account and formally closing the case that was commenced by OCI in the Rehabilitation Court in 2010.

August 2018 AMPS Exchange

At June 30, 2018, Ambac Assurance had 26,411 shares of issued and outstanding AMPS with a liquidation preference of $660,275 (reported as noncontrolling interest of $264,110 on Ambac's balance sheet).

On July 3, 2018, Ambac and Ambac Assurance commenced an offer to exchange (the “AMPS Exchange”) all of Ambac Assurance’s outstanding AMPS for surplus notes and, from Ambac, cash and warrants to purchase Ambac's common stock. Concurrently with the AMPS Exchange, Ambac Assurance solicited proxies (each a “Proxy” and together the “Proxies”) from the holders of the AMPS to vote in favor of a resolution

to be passed at a special meeting (“Special Meeting”) of Ambac Assurance’s shareholders (the “Proxy Solicitation”). The surplus notes offered in the AMPS Exchange have the same terms as other outstanding surplus notes of Ambac Assurance (other than junior surplus notes). The offering period for the AMPS Exchange expired on August 1, 2018 and the transaction closed on August 3, 2018 (the "Settlement Date").

In exchange for each $25 of liquidation preference (i.e., per share), AMPS, holders received from Ambac Assurance, surplus notes with a total outstanding amount (including accrued and unpaid interest thereon through on June 22, 2018 (the "Signing Date")) equal to $13.875 (the “Repurchase”). AMPS holders who tendered on or before July 17, 2018, representing 22,096 of the AMPS, also received from Ambac $0.500 in cash and 37.3076 warrants (rounded down to the nearest whole warrant) to purchase an equivalent number of shares of common stock of Ambac at an exercise price of $16.67 per share (the “AFG Purchase” and, together with the Repurchase, the “Purchases”).

As a result of the completion of the Purchases, Ambac:


1.	Repurchased 84.4% or 22,296 AMPS with an aggregate liquidation preference of $557,400, including $34,650 in aggregate liquidation preference in the AFG Purchase;


2.	Captured a nominal discount of approximately $227,000 (a discount of approximately $253,000 on a fair market value basis) on $557,400 of the total outstanding liquidation preference of AMPS; and


3.	Issued, in aggregate, $212,740 in current principal amount of surplus notes with accrued interest thereon on Settlement Date of $98,366, issued 824,307 warrants and paid $11,048 in cash.

Prior to the Purchases, the AMPS were reported on the balance sheet within non-controlling interests and were carried at their fair value at the date Ambac emerged from bankruptcy, which is lower than the fair value of the total consideration provided to the AMPS holders in the Purchases. The difference between the fair value of consideration provided to AMPS holders and the carrying amount of the AMPS has been reflected as a reduction to Net income attributable to common stockholders in the third quarter of 2018 for approximately $81,686.

Concurrently with the offering of the AMPS Exchange, Ambac Assurance launched the Proxy Solicitation to approve (i) for the holders of AMPS only, the Purchases and (ii) an amendment to Ambac Assurance’s Restated Articles of Incorporation to delete Section 7(c) of the Fifth Article, which provided for the purported right of holders of AMPS to elect Ambac Assurance directors in certain circumstances (the “Charter Amendment” and together with the Purchases, the “Transactions”). The affirmative vote of the holders of at least two-thirds in aggregate liquidation preference of AMPS was required for the Purchases and the Charter Amendment to be operative. Additionally, the affirmative vote of at least two-thirds of the outstanding shares of Ambac Assurance common stock entitled to vote at the Special Meeting was required for the Charter Amendment to be operative. The Special Meeting was held on July 18, 2018, at which the Transactions were duly approved. The Charter Amendment became effective on the Settlement Date.

Certain holders of AMPS agreed to support the Transactions and signed and became parties to a Preferred Stock Repurchase and Support Agreement, dated as of June 22, 2018 (the “Preferred Stock Repurchase and Support Agreement”), by and among certain holders of AMPS party thereto (each, a “Supporting Holder” and together, the “Supporting Holders”), Ambac and Ambac Assurance. The Supporting Holders, who represented approximately 89% in liquidation preference of outstanding AMPS as of the Signing Date, agreed under the Preferred Stock Repurchase and Support Agreement to vote in favor of the Transactions and also committed to tender at least 80% of the aggregate liquidation preference of outstanding AMPS.