12. Variable Interest Entities and Consolidation of Investment Vehicles

In the normal course of its business, Legg Mason sponsors and is the manager of various types of investment vehicles. Certain of these investment vehicles are considered to be variable interest entities (“VIEs”) while others are considered to be voting rights entities (“VREs”) subject to traditional consolidation concepts based on ownership rights. Investment vehicles that are considered VREs are consolidated if Legg Mason has a controlling financial interest in the investment vehicle.

Financial Accounting Standards Board Interpretation No. 46(R) (Accounting Standards Update 2010-10, "Amendments to Statement 167 for Certain Investment Funds")

For most sponsored investment funds, including money market funds, Legg Mason determines it is the primary beneficiary of a VIE if it absorbs a majority of the VIE's expected losses, or receives a majority of the VIE's expected residual returns, if any. Legg Mason's determination of expected residual returns excludes gross fees paid to a decision maker if certain criteria are met. In determining whether it is the primary beneficiary of a VIE, Legg Mason considers both qualitative and quantitative factors such as the voting rights of the equity holders, economic participation of all parties, including how fees are earned and paid to Legg Mason, related party ownership, guarantees and implied relationships.

Legg Mason concluded it was the primary beneficiary of one sponsored investment fund VIE, and also held a controlling financial interest in two sponsored investment fund VREs, all of which were consolidated as of September 30, 2011, March 31, 2011, and September 30, 2010.

Statement of Financial Accounting Standards No. 167 (Accounting Standards Codification Topic 810, "Consolidation")

For other sponsored investment funds that do not meet certain criteria, if Legg Mason has a significant variable interest, it determines it is the primary beneficiary of the VIE if it has both the power to direct the activities of the VIE that most significantly impact the entity's economic performance and the obligation to absorb losses, or the right to receive benefits, that potentially could be significant to the VIE.

Legg Mason concluded that it was the primary beneficiary of one of two CLOs in which it has a variable interest. Although it holds no equity interest in either of these investment vehicles, it had both the power to control and had a significant variable interest in one CLO because of its expected subordinated fees. As of September 30, 2011, March 31, 2011, and September 30, 2010, the balances related to this CLO were consolidated on the Company's consolidated financial statements.

Legg Mason's investment in CIVs as of September 30, 2011, and March 31, 2011, was $49,979 and $53,708, respectively, which represents its maximum risk of loss, excluding uncollected advisory fees. The assets of these CIVs are primarily comprised of investment securities. Investors and creditors of these CIVs have no recourse to the general credit or assets of Legg Mason beyond its investment in these funds.

The following tables reflect the impact of CIVs on the Consolidated Balance Sheets as of September 30, 2011, and March 31, 2011, and the Consolidated Statements of Income for the three and six months ended September 30, 2011 and 2010, respectively:

Consolidating Balance Sheets



	September 30, 2011									March 31, 2011
	Balance Before Consolidation of CIVs		CIVs		Eliminations			As Reported		Balance Before Consolidation of CIVs		CIVs ⁽¹⁾		Eliminations			As Reported
Current assets	$	2,074,231	$	81,099	$	(50,407	)	$	2,104,923	$	2,378,226	$	122,963	$	(54,633	)	$	2,446,556
Non-current assets	5,852,817		301,409		—			6,154,226		5,946,737		314,463		—			6,261,200
Total assets	$	7,927,048	$	382,508	$	(50,407	)	$	8,259,149	$	8,324,963	$	437,426	$	(54,633	)	$	8,707,756
Current liabilities	$	810,193	$	10,607	$	(427	)	$	820,373	$	914,803	$	55,094	$	(925	)	$	968,972
Long-term debt of CIVs	—		267,714		—			267,714		—		278,320		—			278,320
Other non-current liabilities	1,565,412		4,285		—			1,569,697		1,649,815		3,553		—			1,653,368
Total liabilities	2,375,605		282,606		(427		)	2,657,784		2,564,618		336,967		(925		)	2,900,660
Redeemable non-controlling interests	917		—		44,711			45,628		976		—		35,736			36,712
Total stockholders’ equity	5,550,526		99,902		(94,691		)	5,555,737		5,759,369		100,459		(89,444		)	5,770,384
Total liabilities and equity	$	7,927,048	$	382,508	$	(50,407	)	$	8,259,149	$	8,324,963	$	437,426	$	(54,633	)	$	8,707,756

(1) Certain immaterial non-current liabilities of CIVs are included in Other liabilities on the Consolidated Balance Sheets.

Consolidating Statements of Income



	Three Months Ended
	September 30, 2011												September 30, 2010
	Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported			Balance Before Consolidation of CIVs		CIVs			Eliminations			As Reported
Total operating revenues	$	670,522		$	—		$	(625	)	$	669,897		$	675,753	$	—		$	(959	)	$	674,794
Total operating expenses	562,785			885			(625		)	563,045			586,393		1,461			(959		)	586,895
Operating income (loss)	107,737			(885		)	—			106,852			89,360		(1,461		)	—			87,899
Total other non-operating income (expense)	(52,597		)	3,081			(1,559		)	(51,075		)	12,746		4,499			(1,836		)	15,409
Income (loss) before income tax provision	55,140			2,196			(1,559		)	55,777			102,106		3,038			(1,836		)	103,308
Income tax (benefit) provision	(1,606		)	—			—			(1,606		)	26,720		—			—			26,720
Net income (loss)	56,746			2,196			(1,559		)	57,383			75,386		3,038			(1,836		)	76,588
Less: Net income (loss) attributable to noncontrolling interests	82			—			637			719			51		—			1,202			1,253
Net income (loss) attributable to Legg Mason, Inc.	$	56,664		$	2,196		$	(2,196	)	$	56,664		$	75,335	$	3,038		$	(3,038	)	$	75,335



	Six Months Ended
	September 30, 2011												September 30, 2010
	Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported			Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported
Total operating revenues	$	1,388,682		$	—		$	(1,677	)	$	1,387,005		$	1,350,697		$	—		$	(1,738	)	$	1,348,959
Total operating expenses	1,179,417			2,047			(1,677		)	1,179,787			1,157,317			2,704			(1,738		)	1,158,283
Operating income (loss)	209,265			(2,047		)	—			207,218			193,380			(2,704		)	—			190,676
Total other non-operating income (expense)	(66,229		)	8,183			(3,830		)	(61,876		)	(16,225		)	2,106			(1,142		)	(15,261		)
Income (loss) before income tax provision	143,036			6,136			(3,830		)	145,342			177,155			(598		)	(1,142		)	175,415
Income tax provision	26,261			—			—			26,261			53,784			—			—			53,784
Net income (loss)	116,775			6,136			(3,830		)	119,081			123,371			(598		)	(1,142		)	121,631
Less: Net income (loss) attributable to noncontrolling interests	159			—			2,306			2,465			105			—			(1,740		)	(1,635		)
Net income (loss) attributable to Legg Mason, Inc.	$	116,616		$	6,136		$	(6,136	)	$	116,616		$	123,266		$	(598	)	$	598		$	123,266

Other non-operating income (expense) includes interest income, interest expense and net gains (losses) on investments and long-term debt determined on an accrual basis.

The consolidation of CIVs has no impact on Net Income Attributable to Legg Mason, Inc.

The fair value of the financial assets and (liabilities) of CIVs were determined using the following categories of inputs as of September 30, 2011, and March 31, 2011:



	As of September 30, 2011
	Quoted prices in active markets (Level 1)		Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Total
Assets:
Trading investments:
Hedge funds	$	1,026	$	13,884		$	33,327		$	48,237
Government and corporate securities	—		10,075			—			10,075
Total trading investment securities	1,026		23,959			33,327			58,312
Investments:
CLO loans	—		257,880			—			257,880
CLO bonds	—		11,402			—			11,402
Private equity funds	—		—			23,513			23,513
Total investments	—		269,282			23,513			292,795
Other assets	7,083		—			—			7,083
	$	8,109	$	293,241		$	56,840		$	358,190

Liabilities:
CLO debt	$	—	$	—		$	(267,714	)	$	(267,714	)
Derivative liabilities	—		(4,285		)	—			(4,285		)
	$	—	$	(4,285	)	$	(267,714	)	$	(271,999	)



	As of March 31, 2011
	Quoted prices in active markets (Level 1)			Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Total
Assets:
Trading investments:
Hedge funds	$	—		$	14,087		$	34,272		$	48,359
Government and corporate securities	—			22,139			—			22,139
Repurchase agreements	—			12,331			—			12,331
Total trading investment securities	—			48,557			34,272			82,829
Investments:
CLO loans	—			275,948			—			275,948
CLO bonds	—			18,813			—			18,813
Private equity funds	—			—			17,879			17,879
Total investments	—			294,761			17,879			312,640
Derivative assets	125			45			—			170
	$	125		$	343,363		$	52,151		$	395,639

Liabilities:
CLO debt	$	—		$	—		$	(278,320	)	$	(278,320	)
Reverse repurchase agreements	—			(18,310		)	—			(18,310		)
Derivative liabilities	(128		)	(14,169		)	—			(14,297		)
	$	(128	)	$	(32,479	)	$	(278,320	)	$	(310,927	)

In accordance with new accounting guidance adopted during the June 2011 quarter, the changes in assets and (liabilities) of CIVs measured at fair value using significant unobservable inputs (Level 3) for the three and six months ended September 30, 2011, are now prepared on a gross basis in the tables below:



	Value as of June 30, 2011			Purchases		Sales			Transfers			Realized and unrealized gains/(losses), net		Value as of September 30, 2011
Assets:
Hedge funds	$	35,718		$	1,647	$	(3,871	)	$	(1,057	)	$	890	$	33,327
Private equity funds	19,792			3,396		—			—			325		23,513
	$	55,510		$	5,043	$	(3,871	)	$	(1,057	)	$	1,215	$	56,840
Liabilities:
CLO debt	$	(278,195	)	$	—	$	—		$	—		$	10,481	$	(267,714	)
Total realized and unrealized gains (losses), net												$	11,696



	Value as of June 30, 2010			Purchases, sales, issuances and settlements, net		Transfers		Realized and unrealized gains/(losses), net			Value as of September 30, 2010
Assets:
Hedge funds	$	13,934		$	2,189	$	2,627	$	962		$	19,712
Private equity funds	14,812			1,011		—		(21		)	15,802
	$	28,746		$	3,200	$	2,627	$	941		$	35,514
Liabilities:
CLO debt	$	(252,444	)	$	—	$	—	$	(378	)	$	(252,822	)
Total realized and unrealized gains (losses), net								$	563



	Value as of March 31, 2011			Purchases		Sales			Transfers		Realized and unrealized gains/(losses), net		Value as of September 30, 2011
Assets:
Hedge funds	$	34,272		$	10,699	$	(15,507	)	$	—	$	3,863	$	33,327
Private equity funds	17,879			3,974		—			—		1,660		23,513
	$	52,151		$	14,673	$	(15,507	)	$	—	$	5,523	$	56,840
Liabilities:
CLO debt	$	(278,320	)	$	—	$	—		$	—	$	10,606	$	(267,714	)
Total realized and unrealized gains (losses), net											$	16,129



	Value as of March 31, 2010		Purchases, sales, issuances and settlements, net		Transfers ⁽¹⁾			Realized and unrealized gains/(losses), net			Value as of September 30, 2010
Assets:
Hedge funds	$	12,374	$	3,389	$	2,627		$	1,322		$	19,712
Private equity funds	13,692		2,654		—			(544		)	15,802
	$	26,066	$	6,043	$	2,627		$	778		$	35,514
Liabilities:
CLO debt	$	—	$	—	$	(249,668	)	$	(3,154	)	$	(252,822	)
Total realized and unrealized gains (losses), net								$	(2,376	)


(1)	Transfers into Level 3 for the six months ended September 30, 2010, primarily represent liabilities recorded upon the initial consolidation of investment vehicles.

Realized and unrealized gains and losses recorded for Level 3 assets and liabilities of CIVs are included in Other non-operating income of CIVs on the Consolidated Statements of Income. Total unrealized gains for Level 3 investments and liabilities of CIVs relating only to those assets and liabilities still held at the reporting date were $9,990 and $854 for the three months ended September 30, 2011 and 2010, respectively. Total unrealized gains (losses) for Level 3 investments and liabilities of CIVs relating only to those assets and liabilities still held at the reporting date were $10,935 and $(2,084) for the six months ended September 30, 2011 and 2010, respectively.

There were no significant transfers between Levels 1 and 2 during the six months ended September 30, 2011 and 2010.

The NAV values used as a practical expedient by CIVs have been provided by the investees and have been derived from the fair values of the underlying investments as of the reporting date. The following table summarizes, as of September 30, 2011, the nature of these investments and any related liquidation restrictions or other factors which may impact the ultimate value realized.

Category of Investment

Investment Strategy

Fair Value Determined Using NAV

Unfunded Commitments

Remaining Term

Hedge funds

Global, fixed income, macro, long/short equity, systematic, emerging market, U.S. and European hedge

48,237

⁽¹⁾

n/a

Private equity funds

Long/short equity

23,513

⁽²⁾

10,449

8 years

Total

71,750

10,449

n/a – not applicable


(1)	3% daily redemption; 5% monthly redemption; 27% quarterly redemption; 1% annual redemption; and 64% subject to three to five year lock-up or side pocket provisions.


(2)	Liquidations are expected over the remaining term.

There are no current plans to sell any of these investments.

Legg Mason has elected the fair value option for certain eligible assets and liabilities, including corporate loans and debt, of the consolidated CLO. Management believes that the use of the fair value option eliminates certain timing differences and better matches the changes in fair value of assets and liabilities related to the CLO.

The following table presents the fair value and unpaid principal balance of CLO loans, bonds and debt carried at fair value under the fair value option as of September 30, 2011, and March 31, 2011:



	September 30, 2011			March 31, 2011
CLO loans and bonds
Unpaid principal balance	$	287,338		$	299,044
Unpaid principal balance in excess of fair value	(18,056		)	(4,283		)
Fair value	$	269,282		$	294,761

Unpaid principal balance of loans that are more than 90 days past due and also in nonaccrual status	$	2,963		$	4,963
Unpaid principal balance in excess of fair value for loans that are more than 90 days past due and also in nonaccrual status	(1,176		)	(2,837		)
Fair value of loans more than 90 days past due and in nonaccrual status	$	1,787		$	2,126

CLO debt
Principal amounts outstanding	$	300,959		$	300,959
Excess unpaid principal over fair value	(33,245		)	(22,639		)
Fair value	$	267,714		$	278,320

During the three and six months ended September 30, 2011, total losses of $3,048 and $4,551, respectively, were recognized in Other non-operating income of CIVs in the Consolidated Statements of Income related to assets and liabilities for which the fair value option was elected. During the three and six months ended September 30, 2010, total gains (losses) of $2,593 and $(1,586), respectively, were recognized in Other non-operating income of CIVs in the Consolidated Statements of Income related to assets and liabilities for which the fair value option was elected. For CLO loans and CLO debt measured at fair value, substantially all of the estimated gains and losses included in earnings for the three and six months ended September 30, 2011, were attributable to instrument specific credit risk due to the credit spreads for these instruments continuing to widen during the current periods. Specifically, overall credit spreads for the CLO debt across the entire capital structure widened due to a general credit curve steepening that occurred during the six months ended September 30, 2011.

The CLO debt bears interest at variable rates based on LIBOR plus a pre-defined spread, which ranges from 25 basis points to 400 basis points. All outstanding debt matures on July 15, 2018.

Total derivative liabilities of CIVs of $4,285 as of September 30, 2011, and total derivative assets and liabilities of CIVs of $170 and $14,297, respectively, as of March 31, 2011, are primarily recorded in Other liabilities of CIVs. Gains and (losses) of $41,896 and $(35,025), respectively, for the three months ended September 30, 2011, and $53,986 and $(46,836), respectively, for the six months ended September 30, 2011, related to derivative assets and liabilities of CIVs are included in Other non-operating income of CIVs. Gains and (losses) of $4,811 and $(5,387), respectively, for the three months ended September 30, 2010, and $6,174 and $(7,926), respectively, for the six months ended September 30, 2010, related to derivative assets and liabilities of CIVs are included in Other non-operating income (expense) of CIVs. There is no risk to Legg Mason in relation to the derivative assets and liabilities of the CIVs in excess of its investment in the funds, if any.

As of September 30, 2011, and March 31, 2011, for VIEs in which Legg Mason holds a significant variable interest or is the sponsor and holds a variable interest, but for which it was not the primary beneficiary, Legg Mason’s carrying value, the related VIE assets and liabilities and maximum risk of loss were as follows:



	As of September 30, 2011
	VIE Assets Not Consolidated		VIE Liabilities Not Consolidated		Equity Interests on the Consolidated Balance Sheet		Maximum Risk of Loss ⁽¹⁾
CLO	$	385,423	$	357,423	$	—	$	449
Public-Private Investment Program⁽²⁾	608,646		2,682		254		538
Other sponsored investment funds	17,602,559		11,469		73,360		107,410
Total	$	18,596,628	$	371,574	$	73,614	$	108,397



	As of March 31, 2011
	VIE Assets Not Consolidated		VIE Liabilities Not Consolidated		Equity Interests on the Consolidated Balance Sheet		Maximum Risk of Loss ⁽¹⁾
CLO	$	382,692	$	354,692	$	—	$	196
Public-Private Investment Program⁽²⁾	692,488		2,002		290		290
Other sponsored investment funds	20,241,752		16,771		83,480		121,899
Total	$	21,316,932	$	373,465	$	83,770	$	122,385


(1)	Includes equity investments the Company has made or is required to make and any earned but uncollected management fees.


(2)	The Company continues to manage funds under the Public-Private Investment Program. As a result of restructuring its investment during the three months ended June 30, 2010, the Company remains a sponsor but no longer has a variable interest in certain of the Public-Private Investment Program funds.

The assets of these VIEs are primarily comprised of cash and cash equivalents and investment securities, and the liabilities are primarily comprised of debt and various expense accruals.