OCTAVE SPECIALTY GROUP INC 10-Q

Item 1A. Risk Factors You should carefully consider the risk factors set forth in the “Risk Factors” section, Item 1A to Part I in our Annual Report on Form 10-K for the year ended December 31, 2020, which are hereby incorporated by reference. These important factors may cause our actual results to differ materially from those indicated by our forward-looking statements, including those contained in this report. Please also see the section entitled “Cautionary Statement Pursuant to the Private Securities Litigation Reform Act of 1995” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this quarterly report on Form 10-Q. There have been no material changes to the risk factors we have disclosed in the “Risk Factors” section of our aforementioned Annual Report on Form 10-K, except as noted below. | Ambac Financial Group, Inc. 72 2021 Second Quarter FORM 10-Q | References to the "Secured Notes" and the "Ambac Note" in the "Risk Factors” section, Item 1A to Part I in our Annual Report on Form 10-K for the year ended December 31, 2020 should be understood to refer to the LSNI Secured Notes and LSNI Ambac Note, respectively, for all times prior to the issuance of the Sitka Senior Secured Notes and Sitka AAC Note, respectively, on July 6, 2021 (as described in Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements included in this Form 10-Q), and should be understood to refer to the Sitka Senior Secured Notes and Sitka AAC Note, respectively, for all times after the issuance of the Sitka Senior Secured Notes and Sitka AAC Note, respectively, on July 6, 2021. Our inability to realize the expected recoveries included in our financial statements could adversely impact our liquidity, financial condition and results of operations and the value of our securities, including the Sitka Senior Secured Notes and Tier 2 Notes. AAC is pursuing claims in litigation with respect to certain RMBS transactions that it insured. These claims are based on, among other things, representations with respect to the characteristics of the securitized loans, the absence of borrower fraud in the underlying loan pools or other misconduct in the origination process, the compliance of loans with the prevailing underwriting policies, and compliance of the RMBS transaction counterparties with policies and procedures related to loan origination and securitization. In such cases, where contract claims are being pursued, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral for any loan that breaches the representations and warranties. However, generally the sponsors have not honored those obligations and have vigorously defended claims brought against them. As of June 30, 2021, we have estimated RMBS R&W subrogation recoveries of $1,715 (net of reinsurance) included in our financial statements. These estimated recoveries are based on the contractual claims brought in the aforementioned litigations and represent a probability-weighted estimate of amounts we expect to recover under various possible scenarios. The estimated recoveries we have recorded do not represent the best or the worst possible outcomes with respect to any particular transaction or group of transactions. There can be no assurance that AAC will be successful in prosecuting its claims in the RMBS litigations. The outcome of any litigation, including the RMBS litigations, is inherently unpredictable, including because of risks intrinsic in the adversarial nature of litigation. Motions made to the court, rulings and appeals - in the cases being prosecuted by AAC or in other relevant cases - could delay or otherwise impact any recovery by AAC. Moreover, rulings that may be adverse to AAC (in any of its RMBS litigations, as well as in other RMBS cases in which it is not a party, including an unrelated RMBS case with an appeal currently pending at the New York Court of Appeals involving issues relevant to AAC’s breach of contract claims) could adversely affect AAC’s ability to pursue its claims or the amount or timing of any recovery, or negatively alter settlement dynamics with RMBS litigation defendants. Any litigation award or settlement may be for an amount less than the amount necessary (even when combined with other pledged collateral) to pay the Sitka Senior Secured Notes or the Tier 2 Notes, which could have a material adverse effect on our financial condition or results of operations and make it more difficult for AAC to repay the Sitka AAC Note (and therefore make it more difficult for the issuer of the Sitka Senior Secured Notes to repay the Sitka Senior Secured Notes) and/or the Tier 2 Notes and/or AAC’s outstanding surplus notes, on a timely basis or at all. In the event that AAC is unable to satisfy its obligations with respect to the Sitka AAC Note (and therefore make it more difficult for the issuer of the Sitka Senior Secured Notes to satisfy its obligations in respect of the Sitka Senior Secured Notes) or the Tier 2 Notes, holders will have the right to foreclose on any available collateral and to sue AAC for failure to make required payments; however, there can be no assurance that the sale of collateral will produce proceeds in an amount sufficient to pay any or all amounts due on the Sitka Senior Secured Notes or the Tier 2 Notes, as the case may be, or that holders will be successful in any litigation seeking payments from AAC. Additionally, while AAC may pursue settlement negotiations, there can be no assurance that any settlement negotiations will materialize or that any settlement agreement can be reached on terms acceptable to AAC, or at all. Depending on the length of time required to resolve these litigations, either through settlement or at trial, AAC could incur greater litigation expenses than currently projected. If a case is brought to trial, AAC’s ultimate recovery would be subject to the additional risks inherent in any trial, including adverse findings or determinations by the trier of fact or the court, which could adversely impact the value of our securities, including the Sitka Senior Secured Notes and the Tier 2 Notes. Any litigation award is subject to risks of recovery, including that a defendant is unable to pay a judgment that AAC may obtain in litigation. In some instances, AAC also has claims against a parent or an acquirer of the counterparty. However, AAC may not be successful in enforcing its claims against any successor entity. The RMBS litigations could also be adversely affected if AAC does not have sufficient resources to actively prosecute its claims or becomes subject to rehabilitation, liquidation, conservation or dissolution, or otherwise impaired by actions of OCI. Our ability to realize the estimated RMBS R&W subrogation recoveries included in our financial statements and the time of the recoveries, if any, is subject to significant uncertainty, including the risks described above and uncertainties inherent in the assumptions used in estimating such recoveries. The amount of these subrogation recoveries is significant and if we were unable to recover all such amounts, our stockholders’ equity as of June 30, 2021 would decrease from $ 1,123 to $(592). We expect to recover material amounts of claims payments through remediation measures including the litigation described above as well as through cash flows in the securitization structures of transactions that AAC insures. Realization of such expected recoveries is subject to various risks and uncertainties, including the rights and defenses of other parties with interests that conflict with AAC’s interests, the performance of the collateral and assets backing the obligations that AAC insures, and the performance of servicers involved in securitizations in which AAC participates as insurer. Additionally, our ability to | Ambac Financial Group, Inc. 73 2021 Second Quarter FORM 10-Q | realize recoveries in insured transactions may be impaired if the continuing orders of the Rehabilitation Court are not effective. Adverse developments with respect to any of the factors described above may cause our recoveries to fall below expectations, which could have a material adverse effect on our financial condition, including our capital and liquidity, and may result in adverse consequences such as impairing the ability of AAC to honor its financial obligations; the initiation of rehabilitation proceedings against AAC; decreased likelihood of AAC delivering value to AFG, through dividends or otherwise; diminished business prospects due to third party concerns about our ability to recover losses; and a significant drop in the value of securities issued or insured by AFG or AAC, including the Sitka Senior Secured Notes and the Tier 2 Notes. There may not be sufficient collateral to pay any or all of the Sitka Senior Secured Notes or Tier 2 Notes, and the pledge by AAC of its ownership interest in Ambac UK that secures the Sitka Senior Secured Notes may permit holders of the Sitka Senior Secured Notes to obtain value from the ownership interest in Ambac UK that is not available to other creditors of claimants of AAC. The Sitka Senior Secured Notes are secured by all assets of Sitka Holdings, LLC ("Sitka"). As a practical matter, the only material asset of Sitka is the note issued by AAC to Sitka (the "Sitka AAC Note"); therefore, the collateral securing the Sitka Senior Secured Notes (the "Secured Notes Collateral") is effectively limited to the Sitka AAC Note and the collateral securing the Sitka AAC Note. In addition to AAC’s right to representation and warranty recoveries in respect of certain RMBS litigations, which is inherently uncertain, the Sitka AAC Note is also secured by the capital stock of Ambac UK. However, there can be no assurance that the fair market value of the capital stock of Ambac UK will not decrease, including significantly. The Tier 2 Notes are secured by AAC’s right to representation and warranty recoveries in respect of certain RMBS litigations above a threshold of $1.6 billion (the "Tier 2 Notes Collateral"), which is inherently uncertain. The value of the Secured Notes Collateral and the value of the Tier 2 Notes Collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. Consequently, liquidating the Secured Notes Collateral or the Tier 2 Notes Collateral may not produce proceeds in an amount sufficient to pay any or all amounts due on the Sitka Senior Secured Notes or Tier 2 Notes, respectively. The estimated fair market value of the Secured Notes Collateral and the estimated fair market value of the Tier 2 Notes Collateral are subject to fluctuations based on factors that include, among others, the ability to sell the collateral in an orderly sale, general economic conditions, the availability of buyers and other factors, including, in the case of the Secured Notes Collateral, the performance of Ambac UK’s portfolio of insured credits and the performance of its investment portfolio. The amount to be received upon a sale of the Secured Notes Collateral (including a sale of the collateral securing the Sitka AAC Note) or Tier 2 Notes Collateral would be dependent on numerous factors, including, but not limited to, the actual fair market value of the collateral at such time and the timing and the manner of the sale, and the amount that either the collateral agent or AAC receives may not equal or exceed the expected fair market value. Accordingly, there can be no assurance that the Secured Notes Collateral (including the collateral securing the Sitka AAC Note) or the Tier 2 Notes Collateral can be sold in a short period of time or at all or at acceptable prices to the applicable collateral agent or AAC. Further, AAC and the Sitka Senior Secured Notes collateral agent’s right to foreclose on the Secured Notes Collateral will be subject to local law, including, with respect to the capital stock of Ambac UK, a requirement to receive the prior approval of the UK insurance regulator for any change in control, and AAC or the collateral agent for the Sitka Senior Secured Notes may not be able to realize or foreclose on such collateral due to foreign law restrictions. Foreclosing on the Secured Notes Collateral may be difficult due to the laws of certain jurisdictions. We cannot assure investors that the jurisdiction applicable to the Secured Notes Collateral will have effective or favorable foreclosure procedures and lien priorities. Any foreclosure proceedings could be subject to lengthy delays, resulting in increased custodial costs, deterioration in the condition of the Secured Notes Collateral and substantial reduction of the value of such collateral. In the event of rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding, AAC cannot assure holders that the proceeds from any sale or liquidation of the Secured Notes Collateral will be sufficient to pay any or all of AAC’s obligations under the Sitka AAC Note, or that the sale of the Tier 2 Notes Collateral will be sufficient to pay any or all of AAC’s obligations under the Tier 2 Notes. In addition, in the event of any such proceeding, it is possible that the rehabilitator, trustee, or competing creditors will assert that the value of the collateral with respect to the Sitka AAC Note or the Tier 2 Notes, including AAC’s rights to recoveries in respect of RMBS litigations, is less than the then-current principal amount outstanding under the Sitka AAC Note and the Sitka Senior Secured Notes or the Tier 2 Notes (as the case may be) on the date of the rehabilitation filing. Upon a finding by the court overseeing the rehabilitation that the Sitka AAC Note and the Sitka Senior Secured Notes or the Tier 2 Notes (as the case may be) are under-collateralized, the claims in the rehabilitation proceeding with respect to the Sitka AAC Note or the Sitka Senior Secured Notes or the Tier 2 Notes (as the case may be) may be bifurcated between a secured claim up to the value of the collateral and an unsecured claim for any deficiency. As a result, the claims of the holders of the Sitka Senior Secured Notes or Tier 2 Notes could be unsecured in whole or in part. The ability of the holders of the Sitka Senior Secured Notes or Tier 2 Notes to realize upon any of the collateral securing the Sitka AAC Note and the Sitka Senior Secured Notes or Tier 2 Notes, as the case may be, may also be subject to bankruptcy and insolvency law limitations or similar limitations applicable in insurance company rehabilitation or liquidation proceedings. In the event of rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding of AAC, creditors and claimants of AAC other than holders of Sitka Senior Secured Notes will not be entitled to recoveries based on the value of Ambac UK to the extent the security interest of the holders of Sitka Senior Secured Notes in the capital stock of Ambac UK is | Ambac Financial Group, Inc. 74 2021 Second Quarter FORM 10-Q | respected and any recoveries based on the value of Ambac UK are fully applied for the benefit of the holders of Sitka Senior Secured Notes. As a result, creditors and claimants of AAC other than holders of Sitka Senior Secured Notes may suffer greater losses in a rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding of AAC than they would have suffered in such a proceeding had the capital stock of Ambac UK not been pledged for the benefit of the holders of Sitka Senior Secured Notes. AAC insures obligations of the Commonwealth of Puerto Rico, including certain of its authorities and public corporations that are either subject to a Title III bankruptcy protection proceeding under the Puerto Rico Oversight, Management and Stability Act ("PROMESA") or have otherwise suspended debt service payments. AAC has made and may continue to be required to make significant amounts of policy payments over the next several years, the recoverability of which is subject to great uncertainty, which may lead to material permanent losses. While we believe our reserves are adequate to cover losses on Puerto Rico insured bonds, there can be no assurance that AAC may not incur additional losses in the future, particularly given the uncertainty related to the ongoing Title III proceedings and the developing economic, political and legal circumstances in Puerto Rico. Such losses may have a material adverse effect on AAC’s results of operation and financial condition. AAC has exposure to the Commonwealth of Puerto Rico (the "Commonwealth"), including its authorities and public corporations. Each has its own credit risk profile attributable to, as applicable, discrete revenue sources, direct general obligation pledges and/or general obligation guarantees. AAC had approximately $ 1,067 of net par exposure to the Commonwealth and these instrumentalities at June 30, 2021. Components of the overall Puerto Rico net par outstanding include capital appreciation bonds that are reported at the par amount at the time of issuance of the related insurance policy as opposed to the current accreted value of the bonds. The outstanding net insured amount including accretion on capital appreciation bonds is approximately $1,287 at June 30, 2021. Total net insured debt service outstanding (net par and interest) to the Commonwealth and its instrumentalities was approximately $2,486 at June 30, 2021. As a result of the developments described in this Risk Factor and elsewhere in this Quarterly Report on Form 10-Q (see Part I, Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Guarantees in Force, and Note 6. Financial Guarantee Insurance Contracts to the Unaudited Consolidated Financial Statements included in Part I, Item 1 in this Quarterly Report on Form 10-Q), the Commonwealth and certain of its instrumentalities are continuing to default on debt service payments, including payments owed on bonds insured by AAC. AAC has made, and may continue to be required to make, significant amounts of policy payments over the next several years, the recoverability of which is subject to great uncertainty, which may lead to material permanent losses. Our exposure to Puerto Rico is impacted by the amount of monies available for debt service, which is in turn affected by a number of factors including variability in economic growth and demographic trends, tax revenues, changes in law or the effects thereof, essential services expense, federal funding of Commonwealth needs as well as interpretation of legislation, legal documents, and updated financial information (when available). Substantial uncertainty also exists with respect to the ultimate outcome for creditors in Puerto Rico due to the July 30, 2021, Seventh Amended Title III Joint Plan of Adjustment of the Commonwealth ("Seventh Amended POA") or changes thereto, including whether or not the plan is confirmed and implemented and as to the ultimate recovery value of the consideration made available to creditors under various plan support agreements underpinning the Seventh Amended POA, which include contingent value instruments or CVI, the value which is entirely dependent upon the outperformance of certain tax revenues versus projections in the Commonwealth fiscal plans. In addition, uncertainty exists as it relates to legislation enacted by the Commonwealth and the United States, including PROMESA, as well as actions taken in reliance on such laws, including Title III filings. Given the numerous uncertainties and risks existing with respect to the restructuring process, outcomes associated with the Seventh Amended POA, the July 27, 2021 PRIFA Related Plan Support Agreement (“PRIFA PSA”), the July 12, 2021, Amended and Restated Plan Support Agreement (“Amended and Restated GO/PBA PSA”), and the May 5, 2021, the PRHTA/CCDA Related Plan Support Agreement (“PRHTA/CCDA PSA”), no assurance can be given that ultimate debt service discounts will not be more severe than those implied by the Seventh Amended POA and cause AAC to experience losses materially exceeding current reserves. As of July 27, 2021, AAC had signed on to the PRIFA PSA, the Amended and Restated GO/PBA PSA and the PRHTA/CCDA PSA. It is possible that certain restructuring process solutions, together with associated legislation, budgetary, and/or public policy proposals could be adopted and could significantly further impair our exposures or impact the value of the creditor consideration, including new GO and PRHTA bonds and CVI, proposed in the Seventh Amended POA and various plan support agreements. In addition, there are possible final legal determinations that could result in losses exceeding our current reserves by a material amount and further increases to our loss reserves. In particular, in a Title III process, should court-approved plans of adjustment for the Commonwealth, the Puerto Rico Highways and Transportation Authority ("PRHTA"), the Puerto Rico Public Buildings Authority ("PBA") or any other issuers of AAC’s insured debt that may or may not file for Title III protection contemplate discounts to debt service implied by, or even worse than, the most recently certified Commonwealth fiscal plan (April 23, 2021) (the “Commonwealth Fiscal Plan”) or should AAC receive unfavorable judgments in the litigations to which it is a party (though most are currently stayed), AAC’s financial condition would be materially adversely affected. For example, under the PRIFA PSA that was signed on July 27, 2021, by the Oversight Board, as representative of the Commonwealth of Puerto Rico, AAC, FGIC, and other holders of | Ambac Financial Group, Inc. 75 2021 Second Quarter FORM 10-Q | PRIFA bonds, PRIFA creditors will receive, on account of approximately $1,900 of allowed claims arising from PRIFA bonds, consideration in the form of (a) $193.5 in cash and (ii) a CVI premised on outperformance of general fund rum tax collections relative to the certified 2021 Commonwealth Fiscal Plan's projection (the "Rum Tax CVI"). The Rum Tax CVI is subject to a lifetime nominal cap of about $1,300, and is also subject to various permitted rum tax waterfall deductions and caps on distributions. Both the cash consideration and the Rum Tax CVI will be deposited into a trust held for the benefit of PRIFA bondholders (the "PRIFA Trust"); the PRIFA Trust will also be funded with an approximately 27% share of the Clawback CVI (described below), which is tied to potential cash payments related to the outperformance of the Commonwealth's sales and use tax ("SUT") against the certified 2020 Commonwealth Fiscal Plan's projections. The lifetime sum of Rum Tax CVI and the Clawback CVI cannot exceed the $1,300 lifetime nominal cap. The value of the PRIFA Trust is highly uncertain given the contingent, outperformance-driven structure of the instrument coupled with the likely back-ended nature of most of the potential cash flows. In addition, the Amended and Restated GO/PBA PSA, dated July 12, 2021, between the Oversight Board, as representative of the Commonwealth of Puerto Rico, PBA, and the Employee Retirement System of the Government of Puerto Rico ("ERS"), Assured Guaranty Corp. and Assured Guaranty Municipal Corp. ("Assured"), National Public Finance Guarantee Corp. ("National"), Syncora Guarantee Inc., and certain holders of GO and PBA bonds, which AAC joined on July 27, 2021, provides for lower Commonwealth debt service payments per annum relative to the Plan Support Agreement signed in February 2020 (the "Amended GO/PBA PSA"), extends the tenor of new recovery bonds, increases the amount of cash distributed to creditors, and provides additional consideration in the form of a CVI, intended to provide creditors with additional returns tied to outperformance of the SUT against the certified 2020 Commonwealth Fiscal Plan's projections. Fixed consideration as part of the Amended and Restated GO/PBA PSA includes a combination of cash, new GO current interest bonds, and new GO capital appreciation bonds. Recovery derived from fixed consideration is estimated to vary between approximately 67% and 77% (as of the petition date) for GO creditors, and between approximately 75% and 80% (as of the petition date) for PBA creditors. The PRHTA/CCDA PSA, dated May 5, 2021, between the Oversight Board as representative of the Commonwealth of Puerto Rico and PRHTA, Assured, National, and certain holders of PRHTA and CCDA bonds, which AAC joined on July 15, 2021, provides consideration for holders of PRHTA and CCDA bonds on account of their claims against the Commonwealth consists of interests of approximately 69% and 4%, respectively, of a contingent value instrument tied to the outperformance of the SUT against the certified 2020 Commonwealth Fiscal Plan's projections (the "Clawback CVI"). The Clawback CVI outperformance measures are subject to a lifetime nominal cap of 75% of the allowed PRHTA and CCDA claims under the Commonwealth plan of adjustment. The value of the Clawback CVI is highly uncertain given the contingent, outperformance- driven structure of the instrument coupled with the likelihood that cash flows in later years (years 23 through 30) will significantly exceed those in earlier years. In addition, under the PRHTA/CCDA PSA, the PRHTA creditors will also receive new PRHTA bonds with a face amount of $1,245 and $389 of cash proceeds, including a $264 interim distribution, payable at the effective date of the Commonwealth plan of adjustment. Of the $264 interim cash distribution, $184.8 will be allocated to holders of PRHTA '68 bonds and $79.2 will be allocated to holders of PRHTA '98 bonds. Of the $1,245 in new PRHTA bonds, approximately $646.4 will be allocated to holders of PRHTA '68 bonds and approximately $598.6 will be allocated to holders of PRHTA '98 bonds. Claim recovery expectations for PRHTA creditors under the PRHTA/CCDA PSA agreement are uncertain and subject to interpretation due to the aforementioned uncertainty related to the value of the Clawback CVI. Under the PRHTA/CCDA PSA, CCDA creditors will receive $112 of cash, inclusive of up to $15 related to restriction fees and consummation costs, payable at the effective date of the Commonwealth plan of adjustment. It is unclear how details under the agreements and plans described above may change. If the Seventh Amended POA is not confirmed in its current or similar form or a PRHTA plan of adjustment or PRIFA or CCDA plans of adjustment or Title VI agreements differ substantially from existing plan support agreements or are not confirmed or approved, AAC’s financial condition could be materially adversely affected. Additionally, no assurances can be given as to the outcomes of litigations filed, or that may be filed, in connection with the status and priority of HTA bonds, the Seventh Amended POA, a PRHTA plan of adjustment, or PRIFA or CCDA plans of adjustment or Title VI agreements, including but not limited to litigations to which AAC is a party. As a result of such outcomes, consideration received by AAC or holders of AAC-insured bonds under such plans or agreements, and AAC's financial condition, may be materially and adversely affected. It is also possible that economic or demographic outcomes may be as, or worse than, forecasted in the Commonwealth Fiscal Plan or under proposals or plans promulgated by the Commonwealth or its instrumentalities in or in connection with a Title III process or otherwise, which could result in performance-dependent sources of recovery like the contingent value instruments described above to produce no value or less value than expected based on current circumstances and assumptions. While our reserving scenarios reflect a wide range of possible outcomes reflecting the significant uncertainty regarding future developments and outcomes, given our exposure to Puerto Rico and the economic, fiscal, legal and political uncertainties associated therewith, our loss reserves may ultimately prove to be insufficient to cover our losses, potentially by a material amount, and may be subject to material volatility. Changes to our loss reserves may have a material adverse impact on AAC’s results of operations and financial condition.