UPDATE 1-Ambac gets court's OK on plan to exit bankruptcy

* Plan includes proposed $102 mln settlement with IRS

* IRS must accept settlement for plan to become effective

* Noteholders would get some recovery; equity wiped out

By Nick Brown

March 14 (Reuters) - Ambac Financial Group Inc gained court approval on Wednesday on a plan to emerge from bankruptcy by restructuring nearly $1.7 billion in notes and settling a tax dispute with the Internal Revenue Service.

Judge Shelley Chapman backed the plan at a hearing in U.S. Bankruptcy Court in Manhattan, saying it represented "Herculean efforts" by the company, its creditors and regulators, and that her decision to approve it was "not a close call."

But while the plan affords some recovery for noteholders, it wipes out equity holders, a group for which Chapman expressed sympathy.

"The court regrets that it must approve a plan that provides no recovery for equity holders," Chapman said. "The losses suffered by equity holders are staggering. They must, unfortunately, join the ranks of the victims of the global financial crisis."

The restructuring is not a done deal. It hinges on resolving a dispute with the IRS, which had challenged Ambac's tax accounting practices related to credit default swap contracts.

Ambac has proposed a $101.9 million settlement with the IRS, which had initially demanded the return of more than $800 million from the company. The settlement is incorporated into the plan approved by Chapman on Wednesday, but the IRS has yet to accept it.

Once the second-largest U.S. bond insurer, Ambac filed for Chapter 11 protection in November 2010, burdened by large losses after it strayed in the prior decade from insuring municipal bonds and began guaranteeing bonds backed by risky mortgages.

Its restructuring plan allows for recoveries of between 11.4 and 17.6 cents on the dollar for holders of $1.25 billion in senior notes, and between 8.5 and 13.2 cents on the dollar for general unsecured claimholders, according to court papers.

Those groups, along with holders of $444.2 million in subordinated notes, could also stand to receive stock and warrants.

Exact recoveries depend in part on the value of the bankrupt entity's estate, which its financial adviser, the Blackstone Group, pegged at between $145 million and $225 million, an Ambac spokesman told Reuters on Tuesday.

Under the IRS settlement, Ambac would also allocate about $3.65 billion in so-called net operating losses, or NOLs, to its Ambac Assurance operating unit. The NOLs - tax benefits from losses on credit default swap contracts - were a contentious issue and were at the heart of the company's dispute with the IRS.

The restructuring plan met with objections from equity holders.

An attorney for the equity group sought to discredit Blackstone's valuation analysis, arguing that Blackstone Managing Director C.J. Brown, in nearly three hours of testimony on Tuesday, relied too heavily on third party data rather than his own expertise.

Judge Chapman overruled those objections.

The bankruptcy is In re Ambac Financial Group Inc, U.S. Bankruptcy Court, Southern District of New York, No. 10-15973.