A New York state appeals court revived Ambac Financial Group Inc's $1 billion lawsuit against JPMorgan Chase & Co over an investment vehicle that in 2007 and 2008 suffered heavy losses from toxic subprime debt.

The court said Ambac has sufficiently alleged gross negligence by JPMorgan, whose Chief Executive Jamie Dimon was said to have concluded as early as October 2006 that subprime mortgages could go up in smoke.

Ambac accused JPMorgan of breach of contract over losses that its Ambac Assurance unit suffered on notes it guaranteed for Ballantyne, a special purpose vehicle established to reinsure term life insurance policies.

Thursday's decision by a New York state appeals court in Manhattan reversed a March 2010 ruling by Supreme Court Justice Barbara Kapnick, restoring Ambac's lawsuit in its entirety. Ambac had also sought punitive damages.

Kapnick is the same judge who will consider whether to approve Bank of America Corp's $8.5 billion settlement with investors who said they were misled before investing in what proved to be sour mortgage-backed securities.

A JPMorgan spokeswoman called Ambac's claims meritless, and said the second-largest U.S. bank will continue to defend itself vigorously. Michael Allen, a lawyer for Ambac, declined to comment.

Ambac was once the second-largest municipal bond insurer, but filed for bankruptcy last November after incurring big losses from insuring subprime debt. Wisconsin's insurance commissioner is overseeing the wind-down of Ambac Assurance.

OPPOSITE OF DISCRETION

Prior to being fired in October 2008, JPMorgan had been the investment adviser on $1.65 billion of accounts that Ballantyne had funded by selling notes that Ambac insured.

These accounts were supposed to provide reasonable income and a high level of safety.

But Ambac said JPMorgan stuffed them with securities backed by subprime mortgages and home equity lines of credit -- despite Dimon's warning and despite having reducing its own exposure by several billion dollars.

Writing for the appeals court, Justice James Catterson rejected JPMorgan's argument that there could be no breach of contract claim because the accounts were diversified in a manner allowed under the contract, despite their risks.

Adhering to the maximum contractually permitted percentages despite seismic changes to the economy, to world markets and JPMorgan's own internal conclusions about an impending financial meltdown in the housing market, suggests the very opposite of managing the accounts and exercising discretion as to whether the securities should be held at all, Catterson wrote.

JPMorgan and Ambac are based in New York.

The case is Ambac Assurance UK Ltd v. JPMorgan Investment Management Inc, New York State Supreme Court, Appellate Division, First Department, No. 5034.

(Reporting by Jonathan Stempel, editing by Gerald E. McCormick, Gary Hill)

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