17. 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, 2013 and 2012, 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 (Loss) 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. The other CLO is not consolidated, as its level of expected subordinated fees is insignificant.

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, 2013, 2012 and 2011. Effective December 31, 2011, a controlling financial interest of $20,814 in a second sponsored investment fund VRE, which was consolidated by Legg Mason as of March 31, 2011 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 and later, but partial 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, 2013 and 2012, was $39,056 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 March 31, 2013 and 2012, respectively, and the Consolidated Statements of Income (Loss) for the years ended March 31, 2013, 2012 and 2011 respectively:

Consolidating Balance Sheets



	March 31, 2013									March 31, 2012
	Balance Before Consolidation of CIVs		CIVs		Eliminations			Consolidated Totals		Balance Before Consolidation of CIVs		CIVs		Eliminations			Consolidated Totals
Current assets	$	1,908,932	$	73,320	$	(39,390	)	$	1,942,862	$	2,439,161	$	58,040	$	(39,407	)	$	2,457,794
Non-current assets	5,115,181		211,617		—			5,326,798		5,801,681		296,272		—			6,097,953
Total assets	$	7,024,113	$	284,937	$	(39,390	)	$	7,269,660	$	8,240,842	$	354,312	$	(39,407	)	$	8,555,747
Current liabilities	$	692,261	$	10,539	$	(334	)	$	702,466	$	971,803	$	4,467	$	(488	)	$	975,782
Long-term debt of CIVs	—		207,835		—			207,835		—		271,707		—			271,707
Other non-current liabilities	1,517,069		2,930		—			1,519,999		1,603,064		3,872		—			1,606,936
Total liabilities	2,209,330		221,304		(334		)	2,430,300		2,574,867		280,046		(488		)	2,854,425
Redeemable non-controlling interests	1,355		—		19,654			21,009		996		—		23,035			24,031
Total stockholders’ equity	4,813,428		63,633		(58,710		)	4,818,351		5,664,979		74,266		(61,954		)	5,677,291
Total liabilities and equity	$	7,024,113	$	284,937	$	(39,390	)	$	7,269,660	$	8,240,842	$	354,312	$	(39,407	)	$	8,555,747

Consolidating Statements of Income (Loss)



	Fiscal Year Ended
	March 31, 2013
	Balance Before Consolidation of CIVs			CIVs			Eliminations			As Reported
Total operating revenues	$	2,615,047		$	—		$	(2,397	)	$	2,612,650
Total operating expenses	3,046,587			2,965			(2,403		)	3,047,149
Operating income (loss)	(431,540		)	(2,965		)	6			(434,499		)
Total other non-operating income (expense)	(72,177		)	(2,864		)	(1,067		)	(76,108		)
Income (loss) before income tax provision (benefit)	(503,717		)	(5,829		)	(1,061		)	(510,607		)
Income tax provision (benefit)	(150,859		)	—			—			(150,859		)
Net income (loss)	(352,858		)	(5,829		)	(1,061		)	(359,748		)
Less: Net income (loss) attributable to noncontrolling interests	469			—			(6,890		)	(6,421		)
Net income (loss) attributable to Legg Mason, Inc.	$	(353,327	)	$	(5,829	)	$	5,829		$	(353,327	)



	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 (benefit)	293,219			14,627			(4,763		)	303,083
Income tax provision (benefit)	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 (benefit)	373,581			(3,000		)	(5,384		)	365,197
Income tax provision (benefit)	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

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 March 31, 2013:



	Quoted prices in active markets (Level 1)		Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Value as of March 31, 2013
Assets:
Trading investments:
Hedge funds	$	2,076	$	3,268		$	19,448		$	24,792
Investments:
CLO loans	—		172,519			—			172,519
CLO bonds	—		11,052			—			11,052
Private equity funds	—		—			26,982			26,982
Total investments	—		183,571			26,982			210,553
	$	2,076	$	186,839		$	46,430		$	235,345

Liabilities:
CLO debt	$	—	$	—		$	(207,835	)	$	(207,835	)
Derivative liabilities	—		(2,930		)	—			(2,930		)
	$	—	$	(2,930	)	$	(207,835	)	$	(210,765	)



	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 March 31, 2013			Valuation technique	Unobservable input	Range (weighted-average)
$	(207,835	)	Discounted cash flow	Discount rate	1.1	%	-	11.0	%	(2.3%)
				Default rate	3.0	%	-	4.0	%	(3.5%)
				Constant prepayment rate				25.0	%



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 changes in assets and (liabilities) of CIVs measured at fair value using significant unobservable inputs (Level 3) for the years ended March 31, 2013 and 2012 are presented in the table below:



	Value as of March 31, 2012			Purchases		Sales			Settlements / Other		Transfers		Realized and unrealized gains/(losses), net			Value as of March 31, 2013
Assets:
Hedge funds	$	24,116		$	1,980	$	(6,602	)	$	—	$	—	$	(46	)	$	19,448
Private equity funds	25,071			2,622		(2,030		)	—		—		1,319			26,982
	$	49,187		$	4,602	$	(8,632	)	$	—	$	—	$	1,273		$	46,430
Liabilities:
CLO debt	$	(271,707	)	$	—	$	—		$	75,798	$	—	$	(11,926	)	$	(207,835	)
Total realized and unrealized gains (losses), net													$	(10,653	)



	Value as of March 31, 2011			Purchases		Sales			Transfers In		Transfers Out			Realized and unrealized gains, 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, net														$	14,576

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 (Loss). 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 $(11,842) and $7,297 for the years ended March 31, 2013 and 2012, respectively.

There were no transfers between Level 1 and Level 2 during either of the years ended March 31, 2013 and 2012.

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 respective reporting dates. The following table summarizes, as of March 31, 2013 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 March 31, 2013
Category of Investment	Investment Strategy	March 31, 2013			March 31, 2012			Unfunded Commitments		Remaining Term
Hedge funds	Global macro, fixed income, long/short equity, systematic, emerging market, U.S. and European hedge	$	24,792	(1)	$	31,575	(2)	n/a		n/a
Private equity funds	Long/short equity	26,982		(3)	25,071		(3)	$	5,549	6 years
Total		$	51,774		$	56,646		$	5,549

n/a – not applicable


(1)	11% daily redemption; 8% monthly redemption; 2% quarterly redemption; and 79% 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 March 31, 2013.

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, 2013 and March 31, 2012:



	March 31, 2013			March 31, 2012
CLO loans and bonds
Unpaid principal balance	$	186,839		$	277,156
Unpaid principal balance in excess of fair value	(3,268		)	(7,374		)
Fair value	$	183,571		$	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	$	225,161		$	300,959
Excess unpaid principal over fair value	(17,326		)	(29,252		)
Fair value	$	207,835		$	271,707

During the years ended March 31, 2013 and 2012, total net gains (losses) of $(8,455) and $2,054, respectively, were recognized in Other non-operating income (loss) 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 years ended March 31, 2013 and 2012, 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. The CLO commenced its wind-down in July 2012, such that proceeds from securities cannot be reinvested and are applied to reduce the debt outstanding in the quarter subsequent to receipt, after other required payments.

Total derivative liabilities of CIVs of $2,930 and $3,872 as of March 31, 2013 and 2012, respectively, are recorded in Other liabilities of CIVs. Gains and (losses) of $942 and $(1,223), respectively, for the fiscal year ended March 31, 2013, and $54,603 and $(47,697), respectively, for the fiscal year ended March 31, 2012, related to derivative liabilities of CIVs are included in Other non-operating income (loss) 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, 2013 and 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 and maximum risk of loss were as follows:



	As of March 31, 2013
	Equity Interests on the Consolidated Balance Sheet		Maximum Risk of Loss ⁽¹⁾
CLOs	$	—	$	496
Real Estate Investment Trust	989		2,644
Other sponsored investment funds	43,104		87,121
Total	$	44,093	$	90,261



	As of March 31, 2012
	Equity Interests on the Consolidated Balance Sheet		Maximum Risk of Loss ⁽¹⁾
CLO	$	—	$	442
Public-Private Investment Program ⁽²⁾	282		282
Other sponsored investment funds	54,161		93,521
Total	$	54,443	$	94,245


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


(2)	Upon liquidation of the fund, Legg Mason's investment was fully redeemed in the quarter ended December 31, 2012.

The Company's total AUM of unconsolidated VIEs was $17,090,267 and $17,534,840 as of March 31, 2013 and 2012, respectively.

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.