18. VARIABLE INTEREST ENTITIES AND CONSOLIDATION OF INVESTMENT VEHICLES

Legg Mason is the investment manager for CDOs/CLOs that are considered VIEs under revised accounting guidance, since investors in these structures lack unilateral decision making authority. These investment vehicles were created for the sole purpose of issuing collateralized instruments that offer investors the opportunity for returns that vary with the risk level of their investment. Legg Mason's management fee structure for these investment vehicles typically includes a senior management fee, and may also include subordinated and incentive management fees. Legg Mason holds no equity interest in any of these investment vehicles and did not transfer or sell any assets to any of these investment vehicles. In accordance with the methodology described in Note 1 above, Legg Mason concluded that it had a variable interest in only two of these investment vehicles, which are CLOs, and is the primary beneficiary of one of the two CLOs, because although Legg Mason 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 March 31, 2012 and 2011, the balances related to this CLO were consolidated on the Company's consolidated financial statements. The collateral assets of this VIE are primarily comprised of investments in corporate loans, and to a lesser extent, bonds. The assets of the CLO cannot be used by Legg Mason and gains and losses related to these assets have no impact on Net Income Attributable to Legg Mason, Inc. The liabilities of this VIE are primarily comprised of debt and the CLO's debt holders have no recourse to the general credit or assets of Legg Mason.

In addition, Legg Mason was the primary beneficiary of one sponsored investment fund VIE, and also held a controlling financial interest in one sponsored investment fund VRE, both of which were consolidated as of March 31, 2012, 2011 and 2010. Effective December 31, 2011, a controlling financial interest of $20,814 in a second sponsored investment fund VRE, which was consolidated as of March 31, 2011, by Legg Mason, was redeemed. Accordingly, the fund was deconsolidated by Legg Mason and the fund's balance sheet amounts have been excluded from Legg Mason's consolidated balance sheet as of March 31, 2012, but income statement and cash flow amounts for the fund have been included in Legg Mason's consolidated income and cash flow statements for the year ended March 31, 2012. Legg Mason's investment in CIVs as of March 31, 2012 and 2011, was $38,919 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 March 31, 2012 and 2011, respectively, and the Consolidated Statements of Income for the years ended March 31, 2012, 2011 and 2010, respectively:

Consolidating Balance Sheets



	March 31, 2012									March 31, 2011
	Balance Before Consolidation of CIVs		CIVs		Eliminations			As Reported		Balance Before Consolidation of CIVs		CIVs		Eliminations			As Reported
Current assets	$	2,439,162	$	58,040	$	(39,408	)	$	2,457,794	$	2,378,226	$	122,963	$	(54,633	)	$	2,446,556
Non-current assets	5,801,680		296,273		—			6,097,953		5,946,737		314,463		—			6,261,200
Total assets	$	8,240,842	$	354,313	$	(39,408	)	$	8,555,747	$	8,324,963	$	437,426	$	(54,633	)	$	8,707,756
Current liabilities	$	971,804	$	4,467	$	(489	)	$	975,782	$	914,803	$	55,094	$	(925	)	$	968,972
Long-term debt of CIVs	—		271,707		—			271,707		—		278,320		—			278,320
Other non-current liabilities	1,603,064		3,872		—			1,606,936		1,649,815		3,553		—			1,653,368
Total liabilities	2,574,868		280,046		(489		)	2,854,425		2,564,618		336,967		(925		)	2,900,660
Redeemable non-controlling interests	996		—		23,035			24,031		976		—		35,736			36,712
Total stockholders’ equity	5,664,978		74,267		(61,954		)	5,677,291		5,759,369		100,459		(89,444		)	5,770,384
Total liabilities and equity	$	8,240,842	$	354,313	$	(39,408	)	$	8,555,747	$	8,324,963	$	437,426	$	(54,633	)	$	8,707,756

Consolidating Statements of Income



	Fiscal Year Ended
	March 31, 2012
	Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported
Total operating revenues	$	2,665,668		$	—		$	(3,094	)	$	2,662,574
Total operating expenses	2,323,213			3,709			(3,101		)	2,323,821
Operating income (loss)	342,455			(3,709		)	7			338,753
Total other non-operating income (expense)	(49,236		)	18,336			(4,770		)	(35,670		)
Income (loss) before income tax provision	293,219			14,627			(4,763		)	303,083
Income tax provision	72,052			—			—			72,052
Net income (loss)	221,167			14,627			(4,763		)	231,031
Less: Net income (loss) attributable to noncontrolling interests	350			—			9,864			10,214
Net income (loss) attributable to Legg Mason, Inc.	$	220,817		$	14,627		$	(14,627	)	$	220,817



	Fiscal Year Ended
	March 31, 2011
	Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported
Total operating revenues	$	2,788,450		$	—		$	(4,133	)	$	2,784,317
Total operating expenses	2,396,938			4,704			(4,133		)	2,397,509
Operating income (loss)	391,512			(4,704		)	—			386,808
Total other non-operating income (expense)	(17,931		)	1,704			(5,384		)	(21,611		)
Income (loss) before income tax provision	373,581			(3,000		)	(5,384		)	365,197
Income tax provision	119,434			—			—			119,434
Net income (loss)	254,147			(3,000		)	(5,384		)	245,763
Less: Net income (loss) attributable to noncontrolling interests	224			—			(8,384		)	(8,160		)
Net income (loss) attributable to Legg Mason, Inc.	$	253,923		$	(3,000	)	$	3,000		$	253,923



	Fiscal Year Ended
	March 31, 2010
	Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported
Total operating revenues	$	2,637,658		$	—		$	(2,779	)	$	2,634,879
Total operating expenses	2,314,376			2,263			(2,943		)	2,313,696
Operating income (loss)	323,282			(2,263		)	164			321,183
Total other non-operating income (expense)	(47		)	17,329			(8,809		)	8,473
Income (loss) before income tax provision	323,235			15,066			(8,645		)	329,656
Income tax provision	118,676			—			—			118,676
Net income (loss)	204,559			15,066			(8,645		)	210,980
Less: Net income (loss) attributable to noncontrolling interests	202			—			6,421			6,623
Net income (loss) attributable to Legg Mason, Inc.	$	204,357		$	15,066		$	(15,066	)	$	204,357

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 defined in Note 1) as of March 31, 2012:



	Quoted prices in active markets (Level 1)		Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Value as of March 31, 2012
Assets:
Trading investments:
Hedge funds	$	1,016	$	6,443		$	24,116		$	31,575
Investments:
CLO loans	—		260,690			—			260,690
CLO bonds	—		9,092			—			9,092
Private equity funds	—		—			25,071			25,071
Total investments	—		269,782			25,071			294,853
	$	1,016	$	276,225		$	49,187		$	326,428

Liabilities:
CLO debt	$	—	$	—		$	(271,707	)	$	(271,707	)
Derivative liabilities	—		(3,872		)	—			(3,872		)
	$	—	$	(3,872	)	$	(271,707	)	$	(275,579	)

Except for the CLO debt, substantially all of the above financial instruments where valuation methods rely on other than observable market inputs as a significant input utilize the NAV practical expedient, such that measurement uncertainty has little relevance. The following table provides a summary of qualitative information relating to the valuation of CLO debt.



Value as of March 31, 2012			Valuation technique	Unobservable input	Range (weighted average)
$	(271,707	)	Discounted cash flow	Discount rate	1.7	%	-	24.5%	(3.8%)
				Default rate	2.5	%	-	4.0%	(3.4%)
				Constant prepayment rate				15.0%

Significant increases (decreases) in any of these inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, both the constant rate of prepayment and default rate are driven by market conditions related to interest rates, credit ratings, and other factors. Each of the inputs noted could move independently depending on specific market conditions, making it possible for varying market conditions to drive changes in these inputs with a positive, negative, or zero correlation.

The fair value of the financial assets and (liabilities) of CIVs were determined using the following categories of inputs (as defined in Note 1) as of March 31, 2011:



	Quoted prices in active markets (Level 1)			Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Value as of March 31, 2011
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 fiscal 2012, the changes in assets and (liabilities) of CIVs measured at fair value using significant unobservable inputs (Level 3) for the year ended March 31, 2012 are now presented on a gross basis in the table below:



	Value as of March 31, 2011			Purchases		Sales			Transfers In		Transfers Out			Realized and unrealized gains/(losses), net		Value as of March 31, 2012
Assets:
Hedge funds	$	34,272		$	17,018	$	(32,058	)	$	3,302	$	(3,316	)	$	4,898	$	24,116
Private equity funds	17,879			4,889		(762		)	—		—			3,065		25,071
	$	52,151		$	21,907	$	(32,820	)	$	3,302	$	(3,316	)	$	7,963	$	49,187
Liabilities:
CLO debt	$	(278,320	)	$	—	$	—		$	—	$	—		$	6,613	$	(271,707	)
Total realized and unrealized gains (losses), net														$	14,576



	Value as of March 31, 2010		Purchases, sales, issuances and settlements, net		Transfers ⁽¹⁾			Realized and unrealized gains/(losses), net			Value as of March 31, 2011
Assets:
Hedge funds	$	12,374	$	8,340	$	5,862		$	7,696		$	34,272
Private equity funds	13,692		4,906		—			(719		)	17,879
	$	26,066	$	13,246	$	5,862		$	6,977		$	52,151
Liabilities:
CLO debt	$	—	$	—	$	(249,668	)	$	(28,652	)	$	(278,320	)
Total realized and unrealized gains (losses), net								$	(21,675	)


(1)	Transfers into Level 3 for the year ended March 31, 2011, primarily represent assets and 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 (expense) of CIVs on the Consolidated Statements of Income. 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 $7,297 and $(21,668) for the fiscal year ended March 31, 2012 and 2011, respectively.

There were no significant transfers between Levels 1 and 2 during either of the years ended March 31, 2012 or 2011.

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 March 31, 2012, 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

31,575

⁽¹⁾

n/a

Private equity funds

Long/short equity

25,071

⁽²⁾

7,444

7 years

Total

56,646

7,444

n/a – not applicable


(1)	5% daily redemption; 6% monthly redemption; 5% quarterly redemption; and 84% 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 March 31, 2012 and 2011:



	March 31, 2012			March 31, 2011
CLO loans and bonds
Unpaid principal balance	$	277,156		$	299,044
Unpaid principal balance in excess of fair value	(7,374		)	(4,283		)
Fair value	$	269,782		$	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	(1,023		)	(2,837		)
Fair value of loans more than 90 days past due and in nonaccrual status	$	1,940		$	2,126

CLO debt
Principal amounts outstanding	$	300,959		$	300,959
Excess unpaid principal over fair value	(29,252		)	(22,639		)
Fair value	$	271,707		$	278,320

During the years ended March 31, 2012 and 2011, total net gains (losses) of $2,054 and $(14,686), 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 fiscal year ended March 31, 2012, were attributable to instrument specific credit risk, as overall credit spreads widened and the general credit curve steepened.

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 $3,872 as of March 31, 2012, 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 $54,603 and $(47,697), respectively, for the fiscal year ended March 31, 2012, related to derivative assets and liabilities of CIVs are included in Other non-operating income of CIVs. Gains and (losses) of $15,364 and $(18,022), respectively, for the fiscal year ended March 31, 2011, 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 March 31, 2012 and 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 March 31, 2012
	VIE Assets Not Consolidated		VIE Liabilities Not Consolidated		Equity Interests on the Consolidated Balance Sheet		Maximum Risk of Loss ⁽¹⁾
CLO	$	390,861	$	362,861	$	—	$	442
Public-Private Investment Program	674,520		3,213		282		282
Other sponsored investment funds	17,296,521		20,544		54,161		93,521
Total	$	18,361,902	$	386,618	$	54,443	$	94,245



	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	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.

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.