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. For its services, Legg Mason is entitled to receive management fees and may be eligible, under certain circumstances, to receive additional subordinate management fees or other incentive fees. Legg Mason's exposure to risk in these entities is generally limited to any equity investment it has made or is required to make and any earned but uncollected management fees. Investment vehicles that are considered VREs are consolidated if Legg Mason has a controlling financial interest in the investment vehicle, absent substantive kick-out rights.

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 one sponsored investment fund VRE, both of which were consolidated as of June 30, 2012, March 31, 2012 and June 30, 2011. Effective December 31, 2011, a controlling financial interest of $20,814 in a second sponsored investment fund VRE previously consolidated 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 three months ended June 30, 2011.

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 the level of its expected subordinated fees. As of June 30, 2012, March 31, 2012 and June 30, 2011, the balances related to this CLO were consolidated on the Company's consolidated financial statements. The other CLO is not consolidated as its level of expected subordinated fees is insignificant.

Legg Mason's investment in CIVs as of June 30, 2012 and March 31, 2012, was $37,164 and $38,919, 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 June 30, 2012 and March 31, 2012, respectively, and the Consolidated Statements of Income for the three months ended June 30, 2012 and 2011, respectively:

Consolidating Balance Sheets



	June 30, 2012									March 31, 2012
	Balance Before Consolidation of CIVs		CIVs		Eliminations			As Reported		Balance Before Consolidation of CIVs		CIVs		Eliminations			As Reported
Current assets	$	1,658,681	$	57,902	$	(37,577	)	$	1,679,006	$	2,439,162	$	57,714	$	(39,408	)	$	2,457,468
Non-current assets	5,821,363		298,638		—			6,120,001		5,801,680		296,599		—			6,098,279
Total assets	$	7,480,044	$	356,540	$	(37,577	)	$	7,799,007	$	8,240,842	$	354,313	$	(39,408	)	$	8,555,747
Current liabilities	$	495,045	$	12,582	$	(413	)	$	507,214	$	971,804	$	4,467	$	(489	)	$	975,782
Long-term debt of CIVs	—		273,560		—			273,560		—		271,707		—			271,707
Other non-current liabilities	1,536,721		3,620		—			1,540,341		1,603,064		3,872		—			1,606,936
Total liabilities	2,031,766		289,762		(413		)	2,321,115		2,574,868		280,046		(489		)	2,854,425
Redeemable non-controlling interests	1,335		—		20,167			21,502		996		—		23,035			24,031
Total stockholders’ equity	5,446,943		66,778		(57,331		)	5,456,390		5,664,978		74,267		(61,954		)	5,677,291
Total liabilities and equity	$	7,480,044	$	356,540	$	(37,577	)	$	7,799,007	$	8,240,842	$	354,313	$	(39,408	)	$	8,555,747

Consolidating Statements of Income (Loss)



	Three Months Ended
	June 30, 2012												June 30, 2011
	Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported			Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported
Total operating revenues	$	631,277		$	—		$	(585	)	$	630,692		$	718,160		$	—		$	(1,052	)	$	717,108
Total operating expenses	554,523			677			(585		)	554,615			616,632			1,163			(1,053		)	616,742
Operating income (loss)	76,754			(677		)	—			76,077			101,528			(1,163		)	1			100,366
Total other non-operating income (expense)	(91,029		)	(4,134		)	1,105			(94,058		)	(13,632		)	5,102			(2,271		)	(10,801		)
Income (loss) before income tax provision (benefit)	(14,275		)	(4,811		)	1,105			(17,981		)	87,896			3,939			(2,270		)	89,565
Income tax provision (benefit)	(4,997		)	—			—			(4,997		)	27,867			—			—			27,867
Net income (loss)	(9,278		)	(4,811		)	1,105			(12,984		)	60,029			3,939			(2,270		)	61,698
Less: Net income (loss) attributable to noncontrolling interests	180			—			(3,706		)	(3,526		)	77			—			1,669			1,746
Net income (loss) attributable to Legg Mason, Inc.	$	(9,458	)	$	(4,811	)	$	4,811		$	(9,458	)	$	59,952		$	3,939		$	(3,939	)	$	59,952

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 (Loss) 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 June 30, 2012
	Quoted prices in active markets (Level 1)		Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Total
Assets:
Trading investments:
Hedge funds	$	1,441	$	5,791		$	22,207		$	29,439
Investments:
CLO loans	—		262,804			—			262,804
CLO bonds	—		10,137			—			10,137
Private equity funds	—		—			24,188			24,188
Total investments	—		272,941			24,188			297,129
	$	1,441	$	278,732		$	46,395		$	326,568

Liabilities:
CLO debt	$	—	$	—		$	(273,560	)	$	(273,560	)
Derivative liabilities	—		(3,620		)	—			(3,620		)
	$	—	$	(3,620	)	$	(273,560	)	$	(277,180	)



	As of March 31, 2012
	Quoted prices in active markets (Level 1)		Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Total
Assets:
Trading investments:
Hedge funds	$	1,016	$	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 June 30, 2012			Valuation technique	Unobservable input	Range (weighted average)
$	(273,560	)	Discounted cash flow	Discount rate	1.5	%	-	22.3%	(3.4%)
				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 changes in assets and (liabilities) of CIVs measured at fair value using significant unobservable inputs (Level 3) are presented in the tables below:



	Value as of March 31, 2012			Purchases		Sales			Transfers In		Transfers Out		Realized and unrealized gains/(losses), net			Value as of June 30, 2012
Assets:
Hedge funds	$	24,116		$	434	$	(830	)	$	—	$	—	$	(1,513	)	$	22,207
Private equity funds	25,071			—		(878		)	—		—		(5		)	24,188
	$	49,187		$	434	$	(1,708	)	$	—	$	—	$	(1,518	)	$	46,395
Liabilities:
CLO debt	$	(271,707	)	$	—	$	—		$	—	$	—	$	(1,853	)	$	(273,560	)
Total realized and unrealized gains (losses), net													$	(3,371	)



	Value as of March 31, 2011			Purchases		Sales			Transfers In		Transfers Out		Realized and unrealized gains/(losses), net		Value as of June 30, 2011
Assets:
Hedge funds	$	34,272		$	9,052	$	(11,636	)	$	1,057	$	—	$	2,973	$	35,718
Private equity funds	17,879			578		—			—		—		1,335		19,792
	$	52,151		$	9,630	$	(11,636	)	$	1,057	$	—	$	4,308	$	55,510
Liabilities:
CLO debt	$	(278,320	)	$	—	$	—		$	—	$	—	$	125	$	(278,195	)
Total realized and unrealized gains (losses), net													$	4,433

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 $(3,492) and $945 for the three months ended June 30, 2012 and 2011, respectively.

There were no transfers between Level 1 and Level 2 during the three months ended June 30, 2012 and 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 June 30, 2012 and March 31, 2012, the nature of these investments and any related liquidation restrictions or other factors which may impact the ultimate value realized:



		Fair Value Determined Using NAV						As of June 30, 2012
Category of Investment	Investment Strategy	June 30, 2012			March 31, 2012			Unfunded Commitments		Remaining Term
Hedge funds	Global macro, fixed income, long/short equity, systematic, emerging market, U.S. and European hedge	$	29,439	⁽¹⁾	$	31,575	⁽²⁾	n/a		n/a
Private equity funds	Long/short equity	24,188		⁽³⁾	25,071		⁽³⁾	$	7,444	7 years
Total		$	53,627		$	56,646		$	7,444

n/a – not applicable


(1)	7% daily redemption; 7% monthly redemption; 3% quarterly redemption; and 83% are subject to three to five year lock-up or side pocket provisions.


(2)	5% daily redemption; 6% monthly redemption; 5% quarterly redemption; and 84% are subject to three to five year lock-up or side pocket provisions.


(3)	Liquidations are expected over the remaining term.

There are no current plans to sell any of these investments held as of June 30, 2012.

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 June 30, 2012 and March 31, 2012:



	June 30, 2012			March 31, 2012
CLO loans and bonds
Unpaid principal balance	$	280,928		$	277,156
Unpaid principal balance in excess of fair value	(7,987		)	(7,374		)
Fair value	$	272,941		$	269,782

Unpaid principal balance of loans that are more than 90 days past due and also in nonaccrual status	$	—		$	2,963
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		)
Fair value of loans more than 90 days past due and in nonaccrual status	$	—		$	1,940

CLO debt
Principal amounts outstanding	$	300,959		$	300,959
Excess unpaid principal over fair value	(27,399		)	(29,252		)
Fair value	$	273,560		$	271,707

During the three months ended June 30, 2012 and 2011, total losses of $3,264 and $1,504, respectively, were recognized in Other non-operating income of CIVs in the Consolidated Statements of Income (Loss) related to assets and liabilities for which the fair value option was elected. CLO loans and CLO debt measured at fair value have floating interest rates, therefore, substantially all of the estimated gains and losses included in earnings for the three months ended June 30, 2012 and 2011, were attributable to instrument specific credit risk.

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 $3,620 and $3,872 as of June 30, 2012 and March 31, 2012, respectively, are primarily recorded in Other liabilities of CIVs. Gains and (losses) of $252 and $(299), respectively, for the three months ended June 30, 2012, related to derivative assets and liabilities of CIVs are included in Other non-operating income (loss) of CIVs. Gains and (losses) of $12,090 and $(11,811), respectively, for the three months ended June 30, 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 June 30, 2012 and March 31, 2012, for VIEs in which Legg Mason holds a 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 June 30, 2012
	VIE Assets Not Consolidated		VIE Liabilities Not Consolidated		Equity Interests on the Consolidated Balance Sheet		Maximum Risk of Loss ⁽¹⁾
CLO	$	394,118	$	366,118	$	—	$	440
Public-Private Investment Program	672,403		3,279		281		420
Other sponsored investment funds	16,280,421		60,517		51,645		85,685
Total	$	17,346,942	$	429,914	$	51,926	$	86,545



	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


(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. These VIEs are not consolidated because Legg Mason does not absorb a majority of each VIE's expected losses or does not receive a majority of each VIE's expected residual returns.