Form 10-Q

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(MARK ONE)

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2010

OR

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number: 001-09318

 

 

FRANKLIN RESOURCES, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   13-2670991

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Franklin Parkway, San Mateo, CA   94403
(Address of principal executive offices)   (Zip Code)

(650) 312-2000

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  YES    ¨  NO

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    x  YES    ¨  NO

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer     x

  

Accelerated filer        ¨

Non-accelerated filer  ¨  (Do not check if a smaller  reporting company)

  

Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  YES    x  NO

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

    Outstanding: 223,065,236 shares of common stock, par value $0.10 per share, of Franklin Resources, Inc. as of January 31, 2011.

 

 

 


PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.

FRANKLIN RESOURCES, INC.

Condensed Consolidated Statements of Income

Unaudited

 

       Three Months Ended
December 31,
 
(in thousands, except per share data)              2010                      2009          

Operating Revenues

       

Investment management fees

     $ 1,040,878       $ 806,664   

Sales and distribution fees

       577,832         488,053   

Shareholder servicing fees

       72,055         69,543   

Other, net

       9,548         13,151   
                   

Total operating revenues

       1,700,313         1,377,411   
                   

Operating Expenses

       

Sales, distribution and marketing

       647,153         535,593   

Compensation and benefits

       292,394         254,312   

Information systems and technology

       40,367         38,003   

Occupancy

       30,868         30,607   

General, administrative and other

       30,297         51,919   
                   

Total operating expenses

       1,041,079         910,434   
                   

Operating Income

       659,234         466,977   
                   

Other Income (Expenses)

       

Consolidated sponsored investment products gains (losses), net

       (738      15,072   

Investment and other income, net

       47,066         32,978   

Interest expense

       (7,895      (742
                   

Other income, net

       38,433         47,308   
                   

Income before taxes

       697,667         514,285   

Taxes on income

       207,550         156,736   
                   

Net income

       490,117         357,549   

Less: net income (loss) attributable to

       

Nonredeemable noncontrolling interests

       (11,877      216   

Redeemable noncontrolling interests

       837         1,730   
                   

Net Income Attributable to Franklin Resources, Inc.

     $ 501,157       $ 355,603   
                   

Earnings per Share

       

Basic

     $ 2.24       $ 1.55   

Diluted

     $ 2.23       $ 1.54   

Dividends per Share

     $ 0.25       $ 3.22   

See Notes to Condensed Consolidated Financial Statements.

 

2


FRANKLIN RESOURCES, INC.

Condensed Consolidated Balance Sheets

Unaudited

 

(in thousands)      December 31,
        2010         
       September 30,
        2010         
 

Assets

         

Current Assets

         

Cash and cash equivalents

     $ 4,101,724         $ 3,985,312   

Cash and cash equivalents of consolidated variable interest entities

       73,236           0   

Receivables

       810,236           684,223   

Investment securities, trading

       541,118           361,396   

Investment securities, available-for-sale

       1,017,398           1,114,637   

Investments of consolidated variable interest entities, at fair value

       44,395           0   

Investments in equity method investees and other

       89,367           91,866   

Deferred taxes

       96,114           89,242   

Prepaid expenses and other

       34,911           36,117   
                     

Total current assets

       6,808,499           6,362,793   
                     

Banking/Finance Assets

         

Cash and cash equivalents

       146,070           138,404   

Investment securities, trading

       0           23,362   

Investment securities, available-for-sale

       393,891           408,239   

Loans receivable, net

       401,944           374,886   

Loans receivable of consolidated variable interest entities, net

       265,881           0   

Other

       47,777           16,303   
                     

Total banking/finance assets

       1,255,563           961,194   
                     

Non-Current Assets

         

Investments of consolidated variable interest entities, at fair value

       943,727           0   

Investments in equity method investees and other

       687,571           702,634   

Property and equipment, net

       566,672           548,956   

Goodwill

       1,447,065           1,444,269   

Other intangible assets, net

       560,336           562,360   

Other

       122,522           125,882   
                     

Total non-current assets

       4,327,893           3,384,101   
                     

Total Assets

     $ 12,391,955         $ 10,708,088   
                     

[Table continued on next page]

See Notes to Condensed Consolidated Financial Statements.

 

3


FRANKLIN RESOURCES, INC.

Condensed Consolidated Balance Sheets

 

Unaudited

[Table continued from previous page]

 

(dollars in thousands, except per share data)      December 31,
         2010        
       September 30,
        2010         
 

Liabilities and Stockholders’ Equity

         

Current Liabilities

         

Compensation and benefits

     $ 196,137         $ 330,879   

Commercial paper

       27,248           29,997   

Current maturities of long-term debt of consolidated variable interest entities, at fair value

       55,735           0   

Accounts payable, accrued expenses and other

       291,012           244,203   

Commissions

       328,643           302,366   

Income taxes

       209,554           99,197   
                     

Total current liabilities

       1,108,329           1,006,642   
                     

Banking/Finance Liabilities

         

Deposits

       677,358           655,748   

Long-term debt of consolidated variable interest entities

       286,962           0   

Federal Home Loan Bank advances

       51,000           51,000   

Other

       1,843           16,745   
                     

Total banking/finance liabilities

       1,017,163           723,493   
                     

Non-Current Liabilities

         

Long-term debt

       898,971           898,903   

Long-term debt of consolidated variable interest entities, at fair value

       886,160           0   

Deferred taxes

       241,306           237,810   

Other

       86,503           91,261   
                     

Total non-current liabilities

       2,112,940           1,227,974   
                     

Total liabilities

       4,238,432           2,958,109   
                     

Commitments and Contingencies (Note 10)

         

Redeemable Noncontrolling Interests

       20,957           19,533   

Stockholders’ Equity

         

Preferred stock, $1.00 par value, 1,000,000 shares authorized; none issued

       0           0   

Common stock, $0.10 par value, 1,000,000,000 shares authorized; 223,293,744 and 224,007,674 shares issued and outstanding, at December 31, 2010 and September 30, 2010

       22,329           22,401   

Retained earnings

       7,827,026           7,530,877   

Appropriated retained earnings of consolidated variable interest entities

       93,836           0   

Accumulated other comprehensive income

       186,537           173,716   
                     

Total Franklin Resources, Inc. stockholders’ equity

       8,129,728           7,726,994   

Nonredeemable noncontrolling interests

       2,838           3,452   
                     

Total stockholders’ equity

       8,132,566           7,730,446   
                     

Total Liabilities and Stockholders’ Equity

     $ 12,391,955         $ 10,708,088   
                     

See Notes to Condensed Consolidated Financial Statements.

 

4


FRANKLIN RESOURCES, INC.

Condensed Consolidated Statements of Cash Flows

Unaudited

 

       Three Months Ended
December 31,
 
(in thousands)              2010                      2009          

Net Income

     $ 490,117       $ 357,549   

Adjustments to reconcile net income to net cash provided by operating activities:

       

Depreciation and amortization

       62,478         66,001   

Stock-based compensation

       21,775         19,619   

Excess tax benefit from stock-based compensation

       (12,047      (9,502

Net gains on sale of assets

       (26,968      (1,715

Equity in net income of affiliated companies

       (23,892      (4,150

Provision for loan losses

       2,845         1,053   

Other-than-temporary impairment of investments

       13,156         1,462   

Net losses of consolidated variable interest entities

       11,458         0   

Deferred income taxes

       5,957         (106

Changes in operating assets and liabilities:

       

Increase in receivables, prepaid expenses and other

       (135,780      (101,979

Increase in trading securities, net

       (182,115      (74,237

Increase in income taxes payable

       118,828         114,691   

Increase in commissions payable

       26,277         21,425   

Increase (decrease) in other liabilities

       9,130         (19,528

Decrease in accrued compensation and benefits

       (135,443      (53,508
                   

Net cash provided by operating activities

       245,776         317,075   
                   

Purchase of investments

       (43,512      (166,982

Purchase of investments by consolidated variable interest entities

       (176,137      0   

Liquidation of investments

       190,477         231,096   

Liquidation of investments by consolidated variable interest entities

       251,815         0   

Liquidation of banking/finance investments

       13,690         67,119   

Increase in loans receivable, net

       (28,049      (52,494

Decrease in loans receivable held by consolidated variable interest entities, net

       43,980         0   

Additions of property and equipment, net

       (54,003      (9,590

Cash and cash equivalents recognized due to adoption of new consolidation guidance

       45,841         0   
                   

Net cash provided by investing activities

       244,102         69,149   
                   

Increase in deposits

       21,610         24,665   

Issuance of common stock

       13,061         8,303   

Dividends paid on common stock

       (49,763      (732,970

Repurchase of common stock

       (198,536      (173,996

Excess tax benefit from stock-based compensation

       12,047         9,502   

(Decrease) increase in commercial paper, net

       (2,767      192,451   

Proceeds from issuance of debt

       0         9,000   

Payments on debt by consolidated variable interest entities

       (89,721      0   

Noncontrolling interests

       1,357         22,454   
                   

Net cash used in financing activities

       (292,712      (640,591
                   

Effect of exchange rate changes on cash and cash equivalents

       148         224   
                   

Increase (decrease) in cash and cash equivalents

       197,314         (254,143

Cash and cash equivalents, beginning of period

       4,123,716         3,104,451   
                   

Cash and Cash Equivalents, End of Period

     $ 4,321,030       $ 2,850,308   
                   

[Table continued on next page]

See Notes to Condensed Consolidated Financial Statements.

 

5


FRANKLIN RESOURCES, INC.

Condensed Consolidated Statements of Cash Flows

 

Unaudited

[Table continued from previous page]

 

       Three Months Ended
December 31,
 
(in thousands)              2010                      2009          

Components of Cash and Cash Equivalents

       

Cash and cash equivalents, beginning of period:

       

Current assets

     $ 3,985,312       $ 2,982,539   

Banking/finance assets

       138,404         121,912   
                   

Total

     $ 4,123,716       $ 3,104,451   
                   

Cash and cash equivalents, end of period

       

Current assets

     $ 4,101,724       $ 2,753,253   

Current assets of consolidated variable interest entities

       73,236         0   

Banking/finance assets

       146,070         97,055   
                   

Total

     $ 4,321,030       $ 2,850,308   
                   

Supplemental Disclosure of Non-Cash Information

       

Decrease in noncontrolling interests due to net deconsolidation of certain sponsored investment products

     $ (1,503    $ (55,449

Increase in assets, net of liabilities, related to consolidation of variable interest entities

       60,760         0   

Supplemental Disclosure of Cash Flow Information

       

Cash paid for income taxes

     $ 82,917       $ 40,476   

Cash paid for interest

       16,935         1,707   

Cash paid for interest by consolidated variable interest entities

       9,679         0   

See Notes to Condensed Consolidated Financial Statements.

 

6


FRANKLIN RESOURCES, INC.

Notes to Condensed Consolidated Financial Statements

December 31, 2010

(Unaudited)

Note 1 - Basis of Presentation

The unaudited interim financial statements of Franklin Resources, Inc. (“Franklin”) and its consolidated subsidiaries (collectively, the “Company”) included herein have been prepared by the Company in accordance with the instructions to Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). Under these rules and regulations, some information and footnote disclosures normally included in financial statements prepared under accounting principles generally accepted in the United States of America have been shortened or omitted. Management believes that all adjustments necessary for a fair statement of the financial position and the results of operations for the periods shown have been made. All adjustments are normal and recurring. These financial statements should be read together with the Company’s audited financial statements included in its Form 10-K for the fiscal year ended September 30, 2010. Certain amounts for the comparative prior fiscal year period have been reclassified to conform to the financial statement presentation as of and for the period ended December 31, 2010.

In the quarter ended December 31, 2010 the Company changed the presentation of its condensed consolidated statements of income. The primary changes consist of the classification of amortization of deferred sales commissions, previously presented as a separate line, and marketing support payments, previously included in advertising and promotion expenses, with related sales and distribution expenses previously reported as underwriting and distribution. The line was renamed sales, distribution and marketing to reflect the broader nature of the underlying expenses. Occupancy expenses previously included in information systems, technology and occupancy are now presented as a separate line to enhance transparency of each of the expense categories. Advertising and promotion expenses unrelated to marketing support payments are now classified with expenses previously reported as other, and the line was renamed general, administrative and other. No changes were made to the classification of revenues, however the line previously reported as underwriting and distribution fees was renamed sales and distribution fees.

Management believes that the revised presentation is more useful to readers of its financial statements and provides enhanced disclosure of its total sales, distribution and marketing expenses. The nature of the amortization of deferred sales commissions is consistent with the sales commission expenses recognized at the time of sale, therefore they are presented together. Similarly, marketing support payments, which are incurred in the Company’s U.S. business, are comparable in nature to a component of non-U.S. distribution expenses. Because of the growth in the Company’s international business and corresponding increase in distribution expenses, presenting them together with marketing support provides a more complete view of these distribution-related, asset-based expenses. Amounts for the comparative prior fiscal year period have been reclassified to conform to the current year presentation. These reclassifications had no impact on previously reported net income or financial position and do not represent a restatement of any previously published financial results.

The following table presents the effects of the changes in the presentation of operating expenses to the Company’s previously-reported condensed consolidated statement of income:

 

(in thousands)      Three Months Ended
December 31, 2009
 
         As Reported                Adjustments              As Amended      

Operating Expenses

            

Underwriting and distribution

     $ 467,027         $ (467,027    $ 0   

Sales, distribution and marketing

       0           535,593         535,593   

Compensation and benefits

       254,312           0         254,312   

Information systems, technology and occupancy

       68,610           (68,610      0   

Information systems and technology

       0           38,003         38,003   

Occupancy

       0           30,607         30,607   

Advertising and promotion

       34,848           (34,848      0   

Amortization of deferred sales commissions

       46,546           (46,546      0   

Other

       39,091           (39,091      0   

General, administrative and other

       0           51,919         51,919   
                              

Total operating expenses

     $ 910,434         $ 0       $ 910,434   
                              

Note 2 - New Accounting Guidance

On October 1, 2010, the Company adopted new Financial Accounting Standards Board (“FASB”) guidance related to transfers of financial assets. The guidance revises sale accounting criteria for transfers of financial assets and eliminates the concept of a

 

7


qualifying special-purpose entity (“QSPE”). The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

On October 1, 2010, the Company adopted new FASB guidance related to the consolidation of variable interest entities (“VIEs”). The guidance changes the model used to identify the primary beneficiary of VIEs other than entities that have the attributes of an investment company. The new model requires a qualitative analysis to determine whether a company’s variable interests give it a controlling financial interest in a VIE. The guidance also requires an ongoing reassessment of whether a company is the primary beneficiary of a VIE. The adoption of the guidance resulted in the consolidation of automobile loan securitization trusts and collateralized loan obligations (“CLOs”) that were not previously consolidated. The consolidation of these entities resulted in increases to total assets, long-term debt and total stockholders’ equity of $1,384.7 million, $1,278.1 million and $106.6 million as of October 1, 2010. See Note 5 – Variable Interest Entities.

Note 3 - Stockholders’ Equity and Comprehensive Income

The changes in total stockholders’ equity and redeemable noncontrolling interests for the three months ended December 31, 2010 and 2009 were as follows:

 

(in thousands)   Franklin
Resources,  Inc.

Stockholders’
Equity
    Nonredeemable
Noncontrolling
Interests
    Total
Stockholders’
Equity
    Redeemable
Noncontrolling
Interests
 

Balance at October 1, 2010

  $     7,726,994      $       3,452      $     7,730,446      $   19,533   

Adjustment for adoption of new consolidation guidance

    106,601          106,601     

Net income (loss)

    501,157        (11,877     489,280        837   

Net loss reclassified to appropriated retained earnings

    (11,996     11,996        0     

Other comprehensive income

       

Net unrealized gains on investments, net of tax

    849          849     

Currency translation adjustments

    12,667          12,667     

Net unrealized gains on defined benefit plans, net of tax

    13          13     

Cash dividends on common stock

    (56,012       (56,012  

Repurchase of common stock

    (198,536       (198,536  

Noncontrolling interests

       

Net deconsolidations of certain sponsored investment products

      0        0        (1,503

Net subscriptions (redemptions)

      (733     (733     2,090   

Other

    47,991          47,991     
                               

Balance at December 31, 2010

  $ 8,129,728      $ 2,838      $ 8,132,566      $ 20,957   
                               
(in thousands)   Franklin
Resources, Inc.
Stockholders’
Equity
    Nonredeemable
Noncontrolling
Interests
    Total
Stockholders’
Equity
    Redeemable
Noncontrolling
Interests
 

Balance at October 1, 2009

  $ 7,632,173      $ 2,262      $ 7,634,435      $ 65,126   

Net income

    355,603        216        355,819        1,730   

Other comprehensive income

       

Net unrealized gains on investments, net of tax

    12,438          12,438     

Currency translation adjustments

    9,447          9,447     

Net unrealized gains on defined benefit plans, net of tax

    163          163     

Cash dividends on common stock

    (736,926       (736,926  

Repurchase of common stock

    (173,996       (173,996  

Noncontrolling interests

       

Net deconsolidations of certain sponsored investment products

      0        0        (55,449

Net subscriptions (redemptions)

      (452     (452     22,906   

Other

    36,149          36,149     
                               

Balance at December 31, 2009

  $ 7,135,051      $ 2,026      $ 7,137,077      $ 34,313   
                               

 

 

8


The components of comprehensive income, including amounts attributable to noncontrolling interests, were as follows:

 

(in thousands)      Three Months Ended
December 31,
 
             2010                      2009          

Net income

     $ 490,117       $ 357,549   

Net unrealized gains on investments, net of tax

       849         12,438   

Currency translation adjustments

       12,667         9,447   

Net unrealized gains on defined benefit plans, net of tax

       13         163   
                   

Total comprehensive income

       503,646         379,597   

Less: comprehensive income (loss) attributable to

       

Nonredeemable noncontrolling interests

       (11,877      216   

Redeemable noncontrolling interests

       837         1,730   
                   

Total Comprehensive Income Attributable to Franklin Resources, Inc.

     $ 514,686       $ 377,651   
                   

During the three months ended December 31, 2010 and 2009, the Company repurchased 1.7 million and 1.6 million shares of its common stock at a cost of $198.5 million and $174.0 million under its stock repurchase program. In December 2010, the Company’s Board of Directors authorized the repurchase of up to 10.0 million additional shares of its common stock under the stock repurchase program. At December 31, 2010, approximately 11.3 million shares of common stock remained available for repurchase under the stock repurchase program. The stock repurchase program is not subject to an expiration date.

Note 4 - Earnings per Share

The components of basic and diluted earnings per share were as follows:

 

(in thousands, except per share data)      Three Months Ended
December 31,
 
             2010                      2009          

Net Income Attributable to Franklin Resources, Inc.

     $ 501,157       $ 355,603   

Less: Allocation of earnings to participating nonvested stock and stock unit awards

       2,126         3,265   
                   

Net Income Available to Common Stockholders

     $ 499,031       $ 352,338   
                   

Weighted-average shares outstanding – basic

       223,169         227,892   

Effect of dilutive common stock options and non-participating nonvested stock unit awards

       1,084         1,359   
                   

Weighted-Average Shares Outstanding – Diluted

       224,253         229,251   
                   

Earnings per Share

       

Basic

     $ 2.24       $ 1.55   

Diluted

       2.23         1.54   

For the three months ended December 31, 2010, the Company excluded approximately 0.2 million shares of non-participating nonvested stock unit awards from the calculation of diluted earnings per share because their effect would have been anti-dilutive. There were no anti-dilutive potential common shares outstanding during the three months ended December 31, 2009.

Note 5 - Variable Interest Entities

The Company consolidates VIEs for which it is considered the primary beneficiary. A VIE is an entity in which the equity investment holders have not contributed sufficient capital to finance its activities or the equity investment holders do not have defined rights and obligations normally associated with an equity investment.

The Company uses two different models for determining whether it is the primary beneficiary of VIEs. For all investment entities with the exception of CLOs, the Company is considered to be the primary beneficiary if it has the majority of the risks and rewards of ownership. For all other VIEs, including CLOs, the Company is considered to be the primary beneficiary if it has the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses of or right to receive benefits from the VIE that could potentially be significant to the VIE.

Under both models, the key estimates and assumptions used in the analyses may include the amount of assets under management, investment management and related service fee rates, the life of the investment product, prepayment rates, and the discount rate.

 

9


Collateralized Loan Obligations

The Company provides collateral management services to CLOs, which are considered VIEs. These CLOs are asset-backed financing entities collateralized by a pool of assets, primarily corporate loans and, to a lesser extent, high-yield bonds. Multiple tranches of debt securities are issued by the CLOs, offering investors various maturity and credit risk characteristics. The debt holders of the CLOs have recourse only to the corresponding collateralized assets, which cannot be used by the Company for any other purpose. Scheduled debt payments are based on the performance of the CLOs collateral pool. The Company generally earns management fees in the form of senior and subordinated management fees from the CLOs based on the par value of outstanding investments and, in certain instances, may also receive performance-based fees. In addition, the Company holds equity interests in certain of these investment vehicles. The Company determined that it is the primary beneficiary of the CLOs as it has the power to direct the activities that most significantly impact the CLOs’ economic performance in its role as collateral manager and holds a variable interest for which the Company has the right to receive benefits that could potentially be significant to the CLOs.

The Company elected the fair value option for the financial assets and liabilities of the consolidated CLOs as this option better matches the changes in fair value of the assets and liabilities. During the three months ended December 31, 2010, the changes in fair value of the underlying assets and liabilities of the consolidated CLOs resulted in a $34.2 million net gain and $43.3 million net loss, for a combined net loss of $9.1 million. This net loss includes interest income and expense and is recognized in investment and other income, net in the condensed consolidated statements of income. The net loss attributable to third-party investors is reflected as net income (loss) attributable to nonredeemable noncontrolling interests on the condensed consolidated statements of income and appropriated retained earnings on the condensed consolidated balance sheets.

The following table presents the unpaid principal balance and fair value of investments, including investments 90 days or more past due, and long-term debt of the consolidated CLOs:

 

(in thousands)

 

as of December 31, 2010

         Total Investments          Investments
     90 Days or More    
Past Due
         Long-term Debt      

Unpaid principal balance

     $ 1,015,785       $ 12,658       $ 1,151,716   

Excess unpaid principal over fair value

       (27,663      (6,306      (209,821
                            

Fair value

     $ 988,122       $ 6,352       $ 941,895   
                            

Automobile Loan Securitization Trusts

In previous years, the Company entered into automobile loan securitization transactions with securitization trusts, which then issued asset-backed securities to private investors. The securitization transactions were comprised of prime, non-prime and sub-prime contracts for retail installment sales that were secured by new and used automobiles purchased from motor vehicle dealers. The Company purchased the sale contracts in the ordinary course of business.

The Company retained certain interests as part of the securitization transactions. The interests, which consist of interest-only strips receivable and cash on deposit, represent the Company’s contractual right to receive excess interest and cash from the pool of securitized loans after the payment of required amounts to holders of the asset-backed securities and certain other costs associated with the securitization. Prior to October 1, 2010, retained interests were recorded at fair value estimated using discounted cash flow analyses and recognized as banking/finance trading securities in the condensed consolidated balance sheets.

The Company also retained servicing responsibilities for the securitization trusts and receives annual servicing fees ranging from 1% to 2% of the loans securitized. The services provided primarily consist of the management, service and administration of the loans, collection and posting of payments, and maintenance of accounts for the benefit of, and making distributions to, the holders of the asset-backed securities. The Company determined that it is the primary beneficiary of the securitization trusts as it has the power to

 

10


direct the activities that most significantly impact the securitization trusts’ economic performance in its role as servicer and holds a variable interest for which the Company has the right to receive benefits or the obligation to absorb losses that could potentially be significant to the securitization trusts. Prior to October 1, 2010, all of the securitization trusts met the definition of a QSPE and were not subject to consolidation under the previous accounting guidance.

The assets and liabilities of the securitization trusts are consolidated at their carrying values (the amounts at which they would have been carried in the Company’s condensed consolidated financial statements if the Company had always consolidated the securitization trusts). The holders of the asset-backed securities have recourse only to the collateralized assets of the securitization trusts, which cannot be used by the Company for any other purpose.

The following table shows further details of the loans serviced by the Company that were held by the securitization trusts and the loans that were managed together with them:

 

(in thousands)      December 31,
         2010        
       September 30,
         2010        
 

Principal amount of loans

         

Loans receivable of consolidated VIEs1

     $ 270,187         $ 319,976   

Loans receivable

       78,758           73,602   

Loans held for sale

       7,564           8,011   
                     

Total

     $ 356,509         $ 401,589   
                     

Principal amount of loans 30 days or more past due

         

Loans receivable of consolidated VIEs

     $ 7,090         $ 12,080   

Loans receivable

       3,249           2,825   
                     

Total

     $ 10,339         $ 14,905   
                     

 

1   Disclosed as securitized loans prior to the adoption of new consolidation guidance.

       

The Company provides guarantees to cover shortfalls for the securitization trusts in amounts due to the holders of the asset-backed securities if the shortfall exceeds cash on deposit. At December 31, 2010 and September 30, 2010, the maximum potential amounts of future payments related to these guarantees were $3.8 million and $6.2 million. During the three months ended December 31, 2010 and 2009, the Company did not provide any additional financial or other support to the securitization trusts or the holders of the asset-backed securities.

The original amount of loans serviced for the securitization trusts that were still in existence at December 31, 2010 and September 30, 2010 totaled $1.5 billion and $1.8 billion. At December 31, 2010 and September 30, 2010, the securitization trusts had approximately 28,100 and 31,600 loans outstanding, with weighted-average annualized interest rates of 10.52% and 10.51%.

Other Investment Products

The Company’s VIEs also include certain sponsored investment products other than CLOs and certain other investment products (collectively “other investment products”). These VIEs include limited partnerships, limited liability companies, and joint ventures. The Company’s variable interests generally consist of its equity ownership in and its investment management and related services fees earned from the VIEs. Based on its evaluations, the Company determined it was not the primary beneficiary of these VIEs and, as a result, did not consolidate these entities as of and for the periods ended December 31, 2010 and 2009.

 

11


The carrying values of the Company’s equity ownership interest in and investment management and related service fees receivable from the other investment products as recorded in the Company’s condensed consolidated balance sheets at December 31, 2010 and September 30, 2010 are set forth below. These amounts represent the Company’s maximum exposure to loss from these investment products.

 

(in thousands)      December 31,
        2010         
       September 30,
        2010         
 

Current Assets

         

Receivables

     $ 56,350         $ 63,813   

Investment securities, available-for-sale

       171,434           164,994   

Investments in equity method investees and other

       5,015           5,401   
                     

Total Current

       232,799           234,208   
                     

Non-Current Assets

         

Investment securities, available-for-sale

       0           845   

Investments in equity method investees and other

       621,097           636,548   
                     

Total Non-Current

       621,097           637,393   
                     

Total

     $ 853,896         $ 871,601   
                     

Total assets under management of the other investment products in which the Company held a variable interest but was not the primary beneficiary were $49.0 billion at December 31, 2010 and $48.1 billion at September 30, 2010.

While the Company has no contractual obligation to do so, it routinely makes cash investments in the course of launching sponsored investment products. The Company also may voluntarily elect to provide its sponsored investment products with additional direct or indirect financial support based on its business objectives. The Company did not provide financial or other support to its investment products during the three months ended December 31, 2010 and 2009.

 

12


Note 6 - Investments

Investments consisted of the following:

 

(in thousands)      December 31,
2010
       September 30,
2010
 

Current

         

Investment securities, trading

     $ 541,118         $ 361,396   

Investment securities, available-for-sale

         

Sponsored investment products

       950,584           1,032,602   

Securities of U.S. states and political subdivisions

       52,404           64,654   

Securities of the U.S. Treasury and federal agencies

       604           601   

Other equity securities

       13,806           16,780   
                     

Total investment securities, available-for-sale

       1,017,398           1,114,637   

Investments of consolidated VIEs, at fair value1

       44,395           0   

Investments in equity method investees and other

       89,367           91,866   
                     

Total Current

     $     1,692,278         $     1,567,899   
                     

Banking/Finance

         

Investment securities, trading

     $ 0         $ 23,362   

Investment securities, available-for-sale

         

Securities of U.S. states and political subdivisions

       830           835   

Securities of the U.S. Treasury and federal agencies2

       52,481           53,099   

Corporate debt securities3

       122,563           123,108   

Mortgage-backed securities – agency residential2

       217,897           231,046   

Other equity securities

       120           151   
                     

Total investment securities, available-for-sale

       393,891           408,239   
                     

Total Banking/Finance

     $ 393,891         $ 431,601   
                     

Non-Current

         

Investments of consolidated VIEs, at fair value1

     $ 943,727         $ 0   

Investments in equity method investees and other

       687,571           702,634   
                     

Total Non-Current

     $ 1,631,298         $ 702,634   
                     

 

1

See Note 5 – Variable Interest Entities.

2

Includes total U.S. government-sponsored enterprise obligations with fair values of $268.0 million and $281.7 million at December 31, 2010 and September 30, 2010.

3

Corporate debt securities are insured by the Federal Deposit Insurance Corporation or non-U.S. government agencies.

At December 31, 2010 and September 30, 2010, current investment securities, trading included $214.4 million and $86.3 million of investments held by sponsored investment products that were consolidated in the Company’s condensed consolidated financial statements.

At December 31, 2010 and September 30, 2010, banking/finance segment investment securities with aggregate carrying amounts of $188.4 million and $196.7 million were pledged as collateral for the ability to borrow from the Federal Reserve Bank, $71.7 million and $76.7 million were pledged as collateral for outstanding Federal Home Loan Bank (“FHLB”) borrowings and amounts available in secured FHLB short-term borrowing capacity, and $2.7 million and $3.5 million were pledged as collateral as required by federal and state regulators (see Note 9 – Debt). In addition, investment management and related services segment securities with aggregate carrying values of $6.5 million and $8.0 million were pledged as collateral at December 31, 2010 and September 30, 2010.

 

13


A summary of the gross unrealized gains and losses relating to investment securities, available-for-sale is as follows:

 

(in thousands)

 

as of December 31, 2010

              Gross Unrealized         
         Cost Basis                    Gains                        Losses                  Fair Value      

Sponsored investment products

     $ 821,681         $ 130,284         $ (1,381    $ 950,584   

Securities of U.S. states and political subdivisions

       51,567           1,667           0         53,234   

Securities of the U.S. Treasury and federal agencies

       52,961           124           0         53,085   

Corporate debt securities

       120,129           2,434           0         122,563   

Mortgage-backed securities – agency residential

       211,750           6,147           0         217,897   

Other equity securities

       13,609           651           (334      13,926   
                                         

Total

     $ 1,271,697         $ 141,307         $ (1,715    $ 1,411,289   
                                         

(in thousands)

 

as of September 30, 2010

              Gross Unrealized         
     Cost Basis        Gains        Losses      Fair Value  

Sponsored investment products

     $ 901,923         $ 138,105         $ (7,426    $ 1,032,602   

Securities of U.S. states and political subdivisions

       62,674           2,815           0         65,489   

Securities of the U.S. Treasury and federal agencies

       52,909           791           0         53,700   

Corporate debt securities

       120,159           2,949           0         123,108   

Mortgage-backed securities – agency residential

       225,443           5,603           0         231,046   

Other equity securities

       16,393           649           (111      16,931   
                                         

Total

     $ 1,379,501         $ 150,912         $ (7,537    $ 1,522,876   
                                         

The net unrealized holding gains on investment securities, available-for-sale included in accumulated other comprehensive income were $15.3 million and $14.2 million for the three months ended December 31, 2010 and 2009.

The following tables show the gross unrealized losses and fair values of investment securities, available-for-sale with unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:

 

(in thousands)

 

as of December 31, 2010

     Less Than 12 Months      12 Months or Greater      Total  
     Fair Value        Gross
Unrealized
Losses
     Fair Value        Gross
Unrealized
Losses
     Fair Value        Gross
Unrealized
Losses
 

Current

                         

Investment securities, available-for-sale

                         

Sponsored investment products

     $ 133,698         $ (1,066    $ 8,828         $ (315    $ 142,526         $ (1,381

Other equity securities

       4,065           (331      16           (3      4,081           (334
                                                             

Total Current

     $ 137,763         $ (1,397    $ 8,844         $ (318    $ 146,607         $ (1,715
                                                             

(in thousands)

 

as of September 30, 2010

     Less Than 12 Months      12 Months or Greater      Total  
     Fair Value        Gross
Unrealized
Losses
     Fair Value        Gross
Unrealized
Losses
     Fair Value        Gross
Unrealized
Losses
 

Current

                         

Investment securities, available-for-sale

                         

Sponsored investment products

     $ 66,816         $ (5,506    $ 23,394         $ (1,920    $ 90,210         $ (7,426

Other equity securities

       4,174           (108      26           (3      4,200           (111
                                                             

Total Current

     $ 70,990         $ (5,614    $ 23,420         $ (1,923    $ 94,410         $ (7,537
                                                             

 

14


For the three months ended December 31, 2010 and 2009, the Company recognized $13.2 million and $1.5 million of other-than-temporary impairment of investments, of which $7.3 million and $1.5 million related to available-for-sale equity securities. The Company did not recognize any other-than-temporary impairment of available-for-sale debt securities during the three months ended December 31, 2010 and 2009.

At December 31, 2010, maturities of available-for-sale debt securities were as follows:

 

(in thousands)        Cost Basis              Fair Value      

Securities of U.S. states and political subdivisions

         

Due in one year or less

     $ 5,586         $     5,718   

Due after one year through five years

       37,929           39,122   

Due after five years through ten years

       8,052           8,394   
                     

Total

     $ 51,567         $ 53,234   
                     

Securities of the U.S. Treasury and federal agencies

         

Due in one year or less

     $ 50,587         $ 50,693   

Due after ten years

       2,374           2,392   
                     

Total

     $ 52,961         $ 53,085   
                     

Corporate debt securities

         

Due after one year through five years

     $ 120,129         $ 122,563   

Mortgage-backed securities – agency residential

         

Due after five years through ten years

     $ 8,569         $ 9,215   

Due after ten years

       203,181           208,682   
                     

Total

     $     211,750         $ 217,897   
                     

Note 7 - Fair Value Measurements

The Company records substantially all of its investments at fair value or amounts that approximate fair value. There were no significant transfers between Level 1 and Level 2 for the three months ended December 31, 2010.

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis.

 

(in thousands)

 

as of December 31, 2010

        Level 1                 Level 2                 Level 3                   Total          

Current Assets

       

Cash and cash equivalents of consolidated VIEs

  $ 13,085      $ 60,151      $ 0      $ 73,236   

Investment securities, trading

    351,495        184,687        4,936        541,118   

Investment securities, available-for-sale

       

Sponsored investment products

    950,584        0        0        950,584   

Securities of U.S. states and political subdivisions

    0        52,404        0        52,404   

Securities of the U.S. Treasury and federal agencies

    0        604        0        604   

Other equity securities

    9,752        4,054        0        13,806   

Investments of consolidated VIEs

    0        44,395        0        44,395   

Banking/Finance Assets

       

Investment securities, available-for-sale

       

Securities of U.S. states and political subdivisions

    0        830        0        830   

Securities of the U.S. Treasury and federal agencies

    0        52,481        0        52,481   

Corporate debt securities

    0        122,563        0        122,563   

Mortgage-backed securities – agency residential

    0        217,897        0        217,897   

Other equity securities

    0        0        120        120   

Non-Current Assets

       

Investments of consolidated VIEs

    546        941,250        1,931        943,727   

Life settlement contracts

    0        0        9,426        9,426   
                               

Total Assets Measured at Fair Value

  $     1,325,462      $     1,681,316      $ 16,413      $ 3,023,191   
                               

Current Liabilities

       

Current maturities of long-term debt of consolidated VIEs

  $ 0      $ 0      $ 55,735      $ 55,735   

Non-Current Liabilities

       

Long-term debt of consolidated VIEs

    0        856,642        29,518        886,160   
                               

Total Liabilities Measured at Fair Value

  $ 0      $ 856,642      $ 85,253      $ 941,895   
                               

 

15


(in thousands)

 

as of September 30, 2010

        Level 1                 Level 2                 Level 3                   Total          

Current Assets

       

Investment securities, trading

  $ 263,444      $ 94,622      $ 3,330      $ 361,396   

Investment securities, available-for-sale

       

Sponsored investment products

    1,032,602        0        0        1,032,602   

Securities of U.S. states and political subdivisions

    0        64,654        0        64,654   

Securities of the U.S. Treasury and federal agencies

    0        601        0        601   

Other equity securities

    12,610        4,170        0        16,780   

Banking/Finance Assets

       

Investment securities, trading

    0        0        23,362        23,362   

Investment securities, available-for-sale

       

Securities of U.S. states and political subdivisions

    0        835        0        835   

Securities of the U.S. Treasury and federal agencies

    0        53,099        0        53,099   

Corporate debt securities

    0        123,108        0        123,108   

Mortgage-backed securities – agency residential

    0        231,046        0        231,046   

Other equity securities

    0        0        151        151   

Non-Current Assets

       

Life settlement contracts

    0        0        9,214        9,214   
                               

Total Assets Measured at Fair Value

  $     1,308,656      $     572,135      $     36,057      $     1,916,848   
                               

The fair values of trading and available-for-sale securities are determined based on valuation techniques using the best information available, and may include quoted market prices, published net asset values of sponsored investment products, independent third-party broker or dealer price quotes, and discounted cash flows or other valuation methods as appropriate for each security type. For further discussion of the Company’s valuation techniques, see Note 1 – Significant Accounting Policies in the Company’s Form 10-K for fiscal year 2010.

Cash and cash equivalents of consolidated VIEs primarily consist of short-term money market instruments which are not traded on an active market. The fair value of these instruments is based on market observable inputs and they are classified as Level 2.

Investments and long-term debt of consolidated VIEs. The fair values of investments and debt held by consolidated VIEs are primarily obtained from independent third-party broker or dealer price quotes and classified as Level 2. The VIEs also issued debt that is classified as Level 3 because its fair value is determined using unobservable inputs. In these instances, the Company employs a market-based approach, which uses prices of recent transactions, various market multiples, book values and other relevant information for the instrument or related or other comparable debt instruments to determine the fair value. If the market-based approach is not available, the Company utilizes an income-based valuation approach, which considers the net present value of anticipated future cash flows of the instrument. A discount may also be applied due to the nature or duration of any restrictions on the disposition of the instrument.

 

16


The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the three months ended December 31, 2010 and 2009 were as follows:

 

(in thousands)    Securities
Held by
Consolidated
Sponsored
Investment
Products
    Residual
Interests
from
Securitization
Transactions
    Investments of
Consolidated
VIEs
    Other1     Total Level 3
Assets
    Long-term
Debt of
Consolidated
VIEs
 

Balance at October 1, 2010

   $         3,330      $       23,362      $ 0      $       9,365      $       36,057      $ 0   

Adjustment for adoption of new consolidation guidance

     0        (23,362     1,738        0        (21,624     71,382   

Total realized and unrealized
gains (losses):

            

Included in consolidated sponsored investment
products gains (losses), net

     154        0        0        0        154        0   

Included in investment and
other income, net

     0        0        193        703        896        14,899   

Purchases, sales and settlements, net

     1,417        0        0        (522     895        0   

Transfers into Level 3

     35        0        0        0        35        0   

Effect of exchange rate changes

     0        0        0        0        0        (1,028
                                                

Balance at December 31, 2010

   $ 4,936      $ 0      $ 1,931      $ 9,546      $ 16,413      $ 85,253   
                                                

Change in unrealized gains included in net income relating to assets and liabilities held at December 31, 2010

   $ 401 2    $ 0      $ 193 3   $ 314 3    $ 908      $ 14,899 3 
                                                

 

 

1   Other primarily consists of life settlement contracts.
2   Included in consolidated sponsored investment products gains (losses), net.
3   Included in investment and other income, net.

 
(in thousands)      Securities
Held by
Consolidated
Sponsored
Investment
Products
    Residual
Interests
from
Securitization
Transactions
     Other1        Total Level 3
Assets
 

Balance at October 1, 2009

     $         2,053      $       28,714       $       11,228         $       41,995   

Total realized and unrealized gains (losses):

              

Included in other, net revenue

       0        205         0           205   

Included in consolidated sponsored investment products gains (losses), net

       (289     0         0           (289

Included in investment and other income, net

       0        0         121           121   

Included in accumulated other comprehensive income

       0        0         209           209   

Purchases, sales and settlements, net

       4        1,586         283           1,873   
                                      

Balance at December 31, 2009

     $ 1,768      $ 30,505       $ 11,841         $ 44,114   
                                      

Change in unrealized gains (losses) included in net income relating to assets held at December 31, 2009

     $ (1 ) 2    $ 205 3     $ 0        $ 204   
                                      

 

1

Other primarily consists of equity securities and life settlement contracts.

2

Included in consolidated sponsored investment products gains (losses), net.

3

Included in other, net revenue.

 

17


The Company’s financial instruments that were not measured at fair value were as follows:

 

(in thousands)      December 31, 2010        September 30, 2010  
     Carrying
Value
       Estimated
Fair Value
       Carrying
Value
       Estimated
Fair Value
 

Financial Assets

                   

Cash and cash equivalents

     $ 4,247,794         $ 4,247,794         $ 4,123,716         $ 4,123,716   

Other investments

       50,327           53,069           53,081           48,366   

Loans receivable, net

       401,944           406,627           374,886           381,046   

Loans receivable of consolidated VIEs, net

       265,881           273,526           0           0   

Financial Liabilities

                   

Commercial paper

     $ 27,248         $ 27,248         $ 29,997         $ 29,997   

Deposits

       677,358           679,647           655,748           660,371   

FHLB advances

       51,000           51,765           51,000           53,731   

Long-term debt

       898,971           923,502           898,903           955,080   

Long-term debt of consolidated VIEs

       286,962           290,155           0           0   

Loans receivable of consolidated VIEs, net. The fair value is estimated using discounted cash flow models with interest rates that consider the current credit and interest rate risks inherent in the loans and the current economic and lending conditions.

Long-term debt of consolidated VIEs. The fair value is estimated using discounted cash flow models with interest rates that consider current interest rate risks, the credit quality of the underlying debt and current economic conditions.

Note 8 - Loans and Allowance for Loan Losses

The following table summarizes the banking/finance segment loans receivable by major category:

 

(in thousands)      December 31,
2010
     September 30,
2010
 

Commercial loans

     $      36,667       $      36,471   

Real estate mortgage loans

       66,931         61,688   

Installment loans1

       530,996         257,460   

Other

       48,860         24,716   
                   

Loans receivable

       683,454         380,335   

Less: allowance for loan losses

       (15,629      (5,449
                   

Total

     $ 667,825       $ 374,886   
                   

 

1

Includes loans receivable of consolidated VIEs at December 31, 2010.

Installment loans include automobile receivables and secured private banking loans to individuals. Other loans include credit card receivables and overdraft receivables. No loan loss allowance is provided on the secured private banking loans. For further discussion of the Company’s policy for Allowance for Loan Losses, see Note 1 – Significant Accounting Policies in the Company’s Form 10-K for fiscal year 2010. At December 31, 2010 and September 30, 2010, loans receivable with aggregate carrying values of $50.2 million and $45.9 million were pledged as collateral for the ability to obtain FHLB advances.

 

18


Maturities of loans receivable at December 31, 2010 were as follows:

 

(in thousands)         One Year   
or Less
       After One
Through  Five
Years
       After
  Five Years   
       Total  

Commercial loans

     $ 27,403         $ 4,296         $ 4,968         $ 36,667   

Real estate mortgage loans

       6,965           1,747           58,219           66,931   

Installment loans1

       218,888           240,800           71,308           530,996   

Other

       47,699           346           815           48,860   
                                           

Total

     $      300,955         $ 247,189         $ 135,310         $     683,454   
                                           

 

1

Includes loans receivable of consolidated VIEs.

The following table summarizes contractual maturities of loans receivable due after one year by repricing characteristic at December 31, 2010:

 

(in thousands)      Carrying
Value
 

Loans at fixed interest rates

     $ 308,727   

Loans at floating or adjustable interest rates

       73,772   
          

Total

     $     382,499   
          

Changes in the allowance for loan losses were as follows:

 

(in thousands)

 

for the three months ended December 31,

     2010     2009  

Balance, beginning of period

     $ 5,449      $ 7,026   

Adjustment for adoption of new consolidation guidance

       14,255        0   

Provision for loan losses

       2,845        1,053   

Charge-offs

       (8,914     (1,907

Recoveries

       1,994        477   
                  

Balance, End of Period

     $      15,629      $         6,649   
                  

Total loan charge-offs, net of recoveries, as a percentage of simple monthly average loans receivable

       1.01     0.41

Allowance for loan losses as a percentage of loans receivable

       2.29     1.80

The following table summarizes the loans receivable by impairment methodology:

 

(in thousands)      December 31, 2010      December 31, 2009  
        Collectively   
Evaluated
       Individually  
Evaluated
       Collectively  
Evaluated
      Individually 
Evaluated
 

Loans receivable

     $ 661,529       $ 21,925       $ 356,570       $ 12,472   

Less: allowance for loan losses

       (12,830      (2,799      (5,336      (1,313
                                     

Total

     $ 648,699       $ 19,126       $     351,234       $ 11,159   
                                     

The following is a summary of non-accrual, past due and restructured loans:

 

(in thousands)        December 31,  
2010
       September 30,
2010
 

Non-accrual loans

     $ 16,152         $ 5,305   

Loans delinquent for 90 days or more

       105           411   

Loans modified in troubled debt restructurings

       12,288           10,690   

Interest income recognized for loans modified in troubled debt restructurings was not significant for the three months ended December 31, 2010 and 2009.

 

19


Note 9 - Debt

Outstanding debt consisted of the following:

 

(in thousands)         December 31,   
2010
       Effective
  Interest  Rate  
     September 30, 
2010
       Effective
    Interest Rate   
 

Current

                

Commercial paper

     $ 27,248           0.23   $ 29,997           0.27

Current maturities of long-term debt of consolidated VIEs, at fair value, due fiscal year 2012

       55,735           7.01     0           N/A   
                            

Total Current

       82,983             29,997        
                            

Banking/Finance

                

FHLB advances

       51,000           3.62     51,000           3.62

Long-term debt of consolidated VIEs, due fiscal years 2013-2016

       286,962           5.65     0           N/A   
                            

Total Banking/Finance

       337,962             51,000        
                            

Non-Current

                

$300 million 2.000% notes due fiscal year 2013

       299,577           2.28     299,533           2.28

$250 million 3.125% notes due fiscal year 2015

       249,759           3.32     249,745           3.32

$350 million 4.625% notes due fiscal year 2020

       349,635           4.75     349,625           4.75

Long-term debt of consolidated VIEs, at fair value, due fiscal years 2012-2019

       886,160           2.60     0           N/A   
                            

Total Non-Current

       1,785,131             898,903        
                            

Total Debt

     $       2,206,076           $ 979,900        
                            

The current and non-current long-term debt of consolidated VIEs consists of debt of the consolidated CLOs and has both fixed and floating interest rates ranging from 0.29% to 11.18%. The banking/finance long-term debt of consolidated VIEs consists of debt of the consolidated securitization trusts and has both fixed and floating interest rates ranging from 1.84% to 8.18%. See Note 5 – Variable Interest Entities.

The banking/finance segment secures advances from the FHLB to fund its retail banking and consumer lending services. The outstanding advances are subject to collateralization requirements.

The Company’s senior unsecured and unsubordinated notes have an aggregate face value of $900.0 million and contain an optional redemption feature that allows the Company to redeem each series of notes prior to maturity in whole or in part at any time, at a make-whole redemption price. The indenture governing the notes contains limitations on the Company’s ability and the ability of its subsidiaries to pledge voting stock or profit participating equity interests in its subsidiaries to secure other debt without similarly securing the notes equally and ratably. The indenture also includes requirements that must be met if the Company consolidates or merges with, or sells all or substantially all of its assets to, another entity. As of December 31, 2010, the Company was in compliance with the covenants of the notes.

At December 31, 2010, contractual maturities for FHLB advances, long-term debt, and long-term debt of consolidated VIEs were as follows:

 

(in thousands)

 

For the fiscal years ending September 30,

     FHLB Advances
and  Long-term
Debt
       Long-term Debt of Consolidated VIEs        Total  
                  CLOs                Securitization
Trusts
      

2011 (remaining nine months)

     $ 2,000         $ 0         $ 0         $ 2,000   

2012

       0           59,182           0           59,182   

2013

       318,077           0           13,716           331,793   

2014

       0           0           40,609           40,609   

2015

       260,259           135,680           65,245           461,184   

Thereafter

       369,635           747,033           167,392           1,284,060   
                                           

Total

     $ 949,971         $ 941,895         $          286,962         $     2,178,828   
                                           

The consolidated VIEs may prepay their debt obligations prior to contractual maturity dates as a result of collateral asset repayments.

 

20


At December 31, 2010, the Company had $472.8 million of short-term commercial paper available for issuance under an uncommitted private placement program, and $15.0 million available in uncommitted short-term bank lines of credit. The banking/finance segment had $270.0 million available in uncommitted short-term bank lines of credit under the Federal Reserve system, $184.5 million available through the secured Federal Reserve Bank short-term discount window and $55.1 million available in secured FHLB short-term borrowing capacity.

Note 10 - Commitments and Contingencies

Guarantees

The Company is obligated to cover shortfalls for the automobile loan securitization trusts in amounts due to the holders of the asset-backed securities up to certain levels (see Note 5 – Variable Interest Entities).

At December 31, 2010, the banking/finance segment had issued financial standby letters of credit totaling $9.2 million on which beneficiaries would be able to draw in the event of non-performance by its customers, primarily in relation to lease and lien obligations of these banking customers. These standby letters of credit were fully collateralized by marketable securities as of December 31, 2010.

Legal Proceedings

As previously reported, between 2003 and 2006, following industry-wide market timing and late trading investigations by U.S. and Canadian regulators, and U.S. state government offices, Franklin and certain related parties were named in civil lawsuits in the U.S. and one of Franklin’s adviser subsidiaries was named in civil lawsuits in Canada.

In the U.S., the lawsuits were filed against Franklin and certain of its adviser and distributor affiliates, individual Franklin officers and directors, a former Franklin employee, and trustees of certain Franklin Templeton Investments mutual funds (the “Funds”). In 2004, the lawsuits were consolidated for coordinated proceedings with similar lawsuits against numerous other mutual fund complexes in a multi-district litigation titled “In re Mutual Funds Investment Litigation,” pending in the U.S. District Court for the District of Maryland, Case No. 04-md-15862 (the “MDL”). Plaintiffs filed consolidated amended complaints in the MDL on September 29, 2004. The three consolidated lawsuits involving the Company include a class action (Sharkey IRO/IRA v. Franklin Resources, Inc., et al., Case No. 04-cv-01310), a derivative action on behalf of the Funds (McAlvey v. Franklin Resources, Inc., et al., Case No. 04-cv-01274), and a derivative action on behalf of Franklin (Hertz v. Burns, et al., Case No. 04-cv-01624) and seek, among other forms of relief, one or more of the following: unspecified monetary damages; punitive damages; removal of Fund trustees, directors, advisers, administrators, and distributors; rescission of management contracts and distribution plans under Rule 12b-1 promulgated under the Investment Company Act of 1940; and attorneys’ fees and costs. On February 25, 2005, the Company-related defendants filed motions to dismiss the consolidated amended class action and Fund derivative action complaints. On June 26, 2008, the court issued its order granting in part and denying in part the Company’s motion to dismiss the consolidated amended class action complaint. In its order, the court dismissed certain claims, while allowing others under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and under Sections 36(b) and 48(a) of the Investment Company Act of 1940 to remain, and dismissed all class action claims against the named Funds. In addition, all named individual defendants have since been dismissed without prejudice from the consolidated class action pursuant to stipulation. The Company-related defendants filed a motion for partial summary judgment in the consolidated class action as to non-arranged market timing on March 24, 2010, and lead plaintiff filed its opposition and cross-motion for partial summary judgment on June 4, 2010. On December 9, 2010, the court granted the Company-related defendants’ motion for partial summary judgment, finding that the record could not support a finding of liability against the Company-related defendants and denied lead plaintiff’s cross-motion for partial summary judgment. The parties reached settlement-in-principle on December 21, 2010, pursuant to which the Company will pay $2.75 million towards distribution of settlement amounts reached in lead plaintiff’s settlements entered into with other, non-Company defendants, and any unspent amounts will be distributed to relevant Funds. The settlement is subject to certain conditions including court approval. The Company-related defendants’ motion to dismiss the consolidated fund derivative action remains under submission with the court, and, pursuant to stipulation, that action is currently stayed. In addition, pursuant to stipulation, the derivative action brought on behalf of Franklin has been stayed since 2004.

In Canada, Franklin Templeton Investments Corp., a Franklin subsidiary and the manager of Franklin Templeton Investments’ Canadian mutual funds, was named (along with several other non-Franklin affiliated manager defendants) in two market timing lawsuits that are styled as class actions (Huneault v. AGF Funds, Inc., et al., Case No. 500-06-000256-046, filed in the Superior Court for the Province of Quebec, District of Montreal on October 25, 2004, and Fischer v. IG Investment Management Ltd., et al., Case No. 06-CV-307599CP, filed in the Ontario Superior Court of Justice on March 9, 2006). The lawsuits sought, among other forms of relief, one or more of the following: unspecified monetary damages, punitive damages, an order barring any increase in management fees for a period of two years following judgment, and attorneys’ fees and costs. Oral argument on petitioners’ motion for authorization to institute a class action in the Huneault lawsuit concluded on May 5, 2009, and the court then took the matter under submission. Separately, on January 12, 2010, the court in the Fischer lawsuit denied plaintiffs’ motion for class certification, and plaintiffs filed a notice of appeal of that ruling on February 22, 2010. On July 20, 2010, Franklin Templeton Investments Corp. and the plaintiffs reached an agreement-in-principle to resolve both the Huneault and Fischer actions for a total proposed payment of approximately $5.0 million, subject to certain conditions including certification of a class in each lawsuit on consent for settlement purposes and court approval of the settlement. Both courts certified the respective classes in September 2010 and approved the settlements on December 17, 2010.

 

21


In addition, Franklin/Templeton Distributors, Inc. (one of Franklin’s subsidiaries and the principal underwriter to the Funds), as well as the individual trustees to the Franklin Custodian Funds (the “Trust”), were named in a lawsuit brought derivatively on behalf of the Trust, concerning payment of asset-based compensation between July 22, 2005 and the present to broker-dealers that hold Fund shares in brokerage accounts and that are not registered as investment advisers. The lawsuit was captioned Smith v. Franklin/Templeton Distributors, Inc., et al., Case No. CV 09-4775, and was filed in the U.S. District Court for the Northern District of California on October 6, 2009. Specifically, plaintiff attempted to allege claims under Section 47(b) of the Investment Company Act of 1940, and for breach of fiduciary duty, breach of contract, and waste of Trust assets, and sought unspecified monetary damages, declaratory and injunctive relief enjoining further asset-based compensation to such broker-dealers, and attorneys’ fees and costs. Defendants filed a motion to dismiss the complaint on January 22, 2010. On June 8, 2010, the court granted defendants’ motion to dismiss the Section 47(b) claim (the lone federal claim), giving plaintiff limited leave to amend his complaint to cure the deficiency in that claim. Plaintiff filed an amended complaint on July 7, 2010, and defendants filed a motion to dismiss the amended complaint on August 20, 2010. On October 22, 2010, the court granted defendants’ motion, dismissing the lone federal claim with prejudice for failure to state a claim, and declining to exercise supplemental jurisdiction over plaintiff’s state law claims. Plaintiff filed a notice of appeal to the United States Court of Appeals for the Ninth Circuit on November 19, 2010 (Case No. 10-17648). Plaintiff has until February 28, 2011 to file an opening brief.

Management strongly believes that the claims made in each of the unresolved lawsuits identified above are without merit and the Company intends to defend against them vigorously. The Company cannot predict with certainty, however, the eventual outcome of those lawsuits, nor whether they will have a material negative impact on the Company.

The Company is from time to time involved in litigation relating to claims arising in the normal course of business. Management is of the opinion that the ultimate resolution of such claims will not materially affect the Company’s business, financial position or results of operations. In management’s opinion, an adequate accrual has been made as of December 31, 2010, to provide for any probable losses that may arise from these matters for which the Company could reasonably estimate an amount.

Other Commitments and Contingencies

At December 31, 2010, the banking/finance segment had commitments to extend credit in an aggregate amount of $140.7 million, primarily under credit card lines and secured credit lines.

The Company, in its role as agent or trustee, facilitates the settlement of investor share purchase, redemption and other transactions with affiliated mutual funds. The Company is appointed by the affiliated mutual funds as agent or trustee to manage, on behalf of the affiliated mutual funds, bank deposit accounts that contain only (i) cash remitted by investors to the affiliated mutual funds for the direct purchase of fund shares, or (ii) cash remitted by the affiliated mutual funds for direct delivery to the investors for either the proceeds of fund shares liquidated at the investors’ direction, or dividends and capital gains earned on fund shares. As of December 31, 2010 and September 30, 2010, the Company held cash of $170.2 million and $351.5 million off-balance sheet in agency or trust for investors and the affiliated mutual funds.

In conjunction with an insurance recovery for prior years’ losses, the Company has agreed to indemnify its insurance provider and hold it harmless against future payments that it may be required to make under the relevant policy or relating to claims under that policy. The Company is unable to develop a reasonable estimate of its potential exposure under this indemnification. Management believes that the chance of the Company having to make any payments as a result of this agreement is remote.

At December 31, 2010, there were no changes in other commitments and contingencies that would have a material effect on commitments and contingencies reported in the Company’s Form 10-K for fiscal year 2010.

Note 11 - Stock-Based Compensation

Stock awards generally entitle holders to the right to sell the underlying shares of the Company’s common stock once the awards vest. Stock unit awards generally entitle holders to receive the underlying shares of common stock once the awards vest. The Company has granted certain performance-based long-term stock and stock unit awards which generally vest based on the achievement of predetermined Company financial performance goals. In the event a performance measure is not achieved at or above a specified threshold level, the portion of the award tied to such performance measure is forfeited.

Total unrecognized compensation cost related to nonvested stock and stock unit awards, net of estimated forfeitures, was $144.3 million at December 31, 2010. This cost is expected to be recognized over a remaining weighted-average vesting period of two years.

 

22


The following table summarizes nonvested stock and stock unit award activity:

 

(shares in thousands)  

Shares

       

Weighted-Average

Grant- Date

Fair Value

Nonvested balance at September 30, 2010

      1,015        $   95.86  

Granted

      802          118.58  

Vested

      (149       109.43  

Forfeited/cancelled

      (6       102.05  
           

Nonvested Balance at December 31, 2010

                          1,662        $        105.58  
           

Note 12 - Segment Information

The Company has two operating segments, investment management and related services and banking/finance. The Company derives substantially all of its operating revenues from providing investment management and related services to its sponsored investment products and the sub-advised accounts that it manages. This is the Company’s primary business and operating segment. The Company’s investment management and related services are marketed to the public globally under six distinct brand names: Franklin, Templeton, Mutual Series, Bissett, Fiduciary and Darby.

The Company’s secondary business and operating segment is banking/finance. The banking/finance segment offers select retail banking, private banking and consumer lending services through its bank subsidiaries. Banking and consumer lending activities include consumer credit and debit cards, real estate equity lines, home equity/mortgage lending, and automobile lending related to the purchase and servicing of retail installment sales contracts originated by independent automobile dealerships.

Financial information for the Company’s two operating segments is presented in the table below. Inter-segment transactions are immaterial and excluded from segment income and assets. Operating revenues of the banking/finance segment are reported net of interest expense and the provision for loan losses.

 

(in thousands)  

Three Months Ended

December 31,

 
 

2010

       

2009

 

Operating Revenues

         

Investment management and related services

  $     1,693,721        $     1,366,764   

Banking/finance

      6,592            10,647   
             

Total

  $     1,700,313        $     1,377,411   
             

Income Before Taxes

         

Investment management and related services

  $     693,961        $     508,400   

Banking/finance

      3,706            5,885   
             

Total

  $                697,667        $           514,285   
             

Operating revenues of the banking/finance segment were as follows:

 

(in thousands)  

Three Months Ended

December 31,

 
 

2010

       

2009

 

Interest and fees on loans

  $                  10,889        $        4,581   

Interest and dividends on investment securities

      2,423               3,641   
             

Total interest income

      13,312               8,222   
             

Interest on deposits

      (1,136            (1,300

Interest on long-term debt

      (4,642            (458
             

Total interest expense

      (5,778            (1,758
             

Net interest income

      7,534               6,464  

Unrealized gains on trading investments, net

      0               205  

Other income

      1,903               5,031  

Provision for loan losses

      (2,845            (1,053
             

Total

  $     6,592        $               10,647   
             

 

23


Operating segment assets were as follows:

 

(in thousands)      December 31,
2010
       September 30,
2010
 

Investment management and related services

     $ 11,136,392         $ 9,746,894   

Banking/finance

       1,255,563           961,194   
                     

Total

     $     12,391,955         $     10,708,088   
                     

The investment management and related services segment incurs substantially all of the Company’s depreciation and amortization costs and expenditures on long-lived assets.

Note 13 - Other Income (Expenses)

Other income (expenses) consisted of the following:

 

       Three Months Ended
December 31,
 
(in thousands)      2010      2009  

Consolidated Sponsored Investment Products Gains (Losses), Net

       

Realized gains, net

     $ 1,858       $ 5,056   

Unrealized gains (losses), net

       (2,596      10,016   
                   

Total

       (738      15,072   
                   

Investment and Other Income, Net

       

Dividend income

       10,230         10,548   

Interest income

       2,860         3,581   

Capital gain distributions

       38         862   

Other-than-temporary impairment of investment securities, available-for-sale

       (7,293      (1,462

Other-than-temporary impairment of investments in equity method investees and other

       (5,863      0   

Realized gains on sale of investment securities, available-for-sale

       26,749         2,130   

Realized losses on sale of investment securities, available-for-sale

       (307      (487

Gains on trading investment securities, net

       1,555         12,389   

Income from investments in equity method investees, net of tax

       23,892         4,150   

Foreign currency exchange gains (losses), net

       904         (1,422

Losses on assets and liabilities of consolidated VIEs, net

       (9,070      0   

Other, net

       3,371         2,689   
                   

Total

       47,066         32,978   

Interest expense

       (7,895      (742
                   

Other Income, Net

     $        38,433       $        47,308   
                   

Substantially all of the Company’s dividend income, capital gain distributions, and realized gains and losses on sale of investment securities, available-for-sale were generated by investments in its sponsored investment products. Interest income was primarily generated by investments in debt securities of the U.S. Treasury and federal agencies and cash equivalents. Proceeds from the sale of investment securities, available-for-sale were $140.0 million and $105.6 million for the three months ended December 31, 2010 and 2009.

The Company recognized net gains on trading investment securities that were held at December 31, 2010 and 2009 of $0.6 million and $10.4 million during the three months ended December 31, 2010 and 2009.

Note 14 - Banking Regulatory Ratios

Franklin is a bank holding company and a financial holding company subject to various regulatory capital requirements administered by federal banking agencies, including the Federal Reserve Board. Failure to meet minimum capital requirements can result in certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s condensed consolidated financial statements. The Company must meet specific capital adequacy guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

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Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain a minimum Tier 1 capital and Tier 1 leverage ratio (as defined in the regulations), as well as minimum Tier 1 and Total risk-based capital ratios (as defined in the regulations). The Company’s calculation methodology follows the most conservative risk-weighting assumptions within the Federal Reserve Board guidelines. Based on the Company’s calculations as of December 31, 2010 and September 30, 2010, it exceeded the applicable capital adequacy requirements as listed below.

 

(dollar amounts in thousands)      December 31,
2010
       September 30,
2010
       Capital
Adequacy
Minimum
 

Tier 1 capital

     $     5,764,364         $     5,461,801           N/A   

Total risk-based capital

       5,779,994           5,467,250           N/A   

Tier 1 leverage ratio

       60%           65%           4%   

Tier 1 risk-based capital ratio

       56%           63%           4%   

Total risk-based capital ratio

       56%           63%           8%   

Note 15 - Subsequent Event

On January 18, 2011, the Company acquired all of the net assets of Rensburg Fund Management Limited (“Rensburg”) for a purchase consideration of approximately $72.0 million in cash. Rensburg is a specialist U.K. equity manager with approximately $1.5 billion in assets under management as of December 31, 2010 relating to various U.K. unit trusts.

 

25


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward-Looking Statements

In this section, we discuss and analyze the results of operations and financial condition of Franklin Resources, Inc. (“Franklin”) and its subsidiaries (collectively, the “Company”). In addition to historical information, we also make statements relating to the future, called “forward-looking” statements, which are provided under the “safe harbor” protection of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are generally written in the future tense and/or are preceded by words such as “will”, “may”, “could”, “expect”, “believe”, “anticipate”, “intend”, “plan”, “seek”, “estimate”, or other similar words. Moreover, statements that speculate about future events are forward-looking statements. These forward-looking statements involve a number of known and unknown risks, uncertainties and other important factors that could cause actual results and outcomes to differ materially from any future results or outcomes expressed or implied by such forward-looking statements. You should carefully review the “Risk Factors” section set forth below, which describe these risks, uncertainties and other important factors in more detail.

While forward-looking statements are our best prediction at the time that they are made, you should not rely on them. Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. We caution you therefore against relying on any of these forward-looking statements. They are neither statements of historical fact nor guarantees or assurances of future performance. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. If a circumstance occurs after the date of this Form 10-Q that causes any of our forward-looking statements to be inaccurate, whether as a result of new information, future developments or otherwise, we do not have an obligation, and we undertake no obligation, to announce publicly the change to our expectations, or to make any revisions to our forward-looking statements, unless required by law.

The following discussion should be read in conjunction with our Form 10-K for the fiscal year ended September 30, 2010 filed with the U.S. Securities and Exchange Commission (the “SEC”), and the condensed consolidated financial statements and notes thereto included elsewhere in this Form 10-Q.

Overview

We are a global investment management company and derive substantially all of our operating revenues and net income from providing investment management and related services to our retail and institutional mutual funds, unregistered funds, and institutional, high net-worth and separately-managed accounts and other investment products. Our services include fund administration, shareholder services, transfer agency, underwriting, distribution, custodial, trustee and other fiduciary services. Our sponsored investment products and investment management and related services are distributed or marketed to the public globally under six distinct brand names: Franklin, Templeton, Mutual Series, Bissett, Fiduciary and Darby. We offer a broad range of sponsored investment products under equity, hybrid, fixed-income and cash management categories that meet a wide variety of specific investment needs of individual and institutional investors.

The level of our revenues depends largely on the level and relative mix of assets under management. As noted in the “Risk Factors” section set forth below, the amount and mix of our assets under management are subject to significant fluctuations and can negatively impact our revenues and income. The level of our revenues also depends on mutual fund sales and the number of mutual fund shareholder accounts. The fees charged for our services are based on contracts with our sponsored investment products or our clients. These arrangements could change in the future.

Our secondary business is banking/finance. Our banking/finance group offers select retail banking, private banking and consumer lending services through our bank subsidiaries. Our banking and consumer lending activities include consumer credit and debit cards, real estate equity lines, home equity/mortgage lending, and automobile lending related to the purchase and servicing of retail installment sales contracts originated by independent automobile dealerships.

During the first quarter of fiscal year 2011, market returns improved as the global economy continued to move toward recovery, evidenced by increases of 9% and 11% in the MSCI World Index and the S&P 500 Index. The market improvement benefited our assets under management, fee revenues and operating income, all of which increased significantly from the first quarter of fiscal year 2010.

Our total assets under management at December 31, 2010 were $670.7 billion, 4% higher than the balance at September 30, 2010, and 21% higher than the balance at December 31, 2009. Simple monthly average assets under management for the three months ended December 31, 2010 increased 8% from the previous quarter and 23% from the same period in the prior fiscal year, driven by both market appreciation and net new flows. Net new flows were $3.2 billion for the three months ended December 31, 2010. Long-term sales of $54.9 billion for the first quarter were an all-time high in both the U.S. and internationally, but redemption activity also increased, including $12.0 billion from one institutional advisory account. Sales increased for all investment objectives and remained strong in our global/international taxable fixed-income products.

 

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Although the financial markets continued to improve during the three months ended December 31, 2010, the business and regulatory environments in which we operate remain uncertain and subject to change. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Reform Act”), which was signed into law in July 2010, is expected to impose additional restrictions and limitations on our business. We will continue to review and evaluate the Reform Act and the extent of its impact on our business as the various rules and regulations required for implementation are adopted. The impact of the Reform Act on our financial position and results of operations, if any, is not known at this time.

Uncertainties regarding the economic recovery remain in the foreseeable future. As we continue to confront the challenges of this economic environment, we remain focused on the investment performance of our sponsored investment products and on providing high quality customer service to our clients. While we are focused on expense management, we will also seek to attract, retain and develop employees and invest strategically in systems and technology that will provide a secure and stable environment. We will continue to protect and further our brand recognition while developing and maintaining broker/dealer and client relationships. The success of these and other strategies may be influenced by the factors discussed in the “Risk Factors” section set forth below.

RESULTS OF OPERATIONS

 

       Three Months Ended
December 31,
             Percent      
Change
 
(dollar amounts in millions, except per share data)              2010                        2009               

Operating Income

     $ 659.2         $ 467.0           41%   

Net Income Attributable to Franklin Resources, Inc.

       501.2           355.6           41%   

Earnings per Share

              

Basic

     $ 2.24         $ 1.55           45%   

Diluted

       2.23           1.54           45%   

Operating Margin1

       38.8%           33.9%        

 

1

Defined as operating income divided by total operating revenues.

Operating income and net income attributable to Franklin Resources, Inc. increased for the three months ended December 31, 2010 as compared to the same period in the prior fiscal year. The increases were primarily due to a 29% increase in investment management fee revenues, which was driven by a 23% increase in simple monthly average assets under management and a higher effective management fee rate during the current period. A reduction to operating expenses from an insurance recovery for prior years’ losses also contributed to the higher income.

Diluted earnings per share increased consistent with the increase in net income and a 2% decrease in diluted average common shares outstanding primarily resulting from the repurchase of shares of our common stock.

 

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Assets Under Management

Assets under management by investment objective were as follows:

 

(dollar amounts in billions)      December 31,
        2010         
       December 31,
        2009         
       Percent
      Change      
 

Equity

              

Global/international

     $ 219.1         $ 189.5           16%   

United States

       77.0           66.3           16%   
                                

Total equity

       296.1           255.8           16%   
                                

Hybrid

       106.1           104.0           2%   

Fixed-Income

              

Tax-free

       71.4           69.7           2%   

Taxable

              

Global/international

       144.7           77.5           87%   

United States

       45.9           40.4           14%   
                                

Total fixed-income

       262.0           187.6           40%   

Cash Management

       6.5           6.1           7%   
                                

Total

     $ 670.7         $ 553.5           21%   
                                

Simple Monthly Average for the Three-Month Period1

     $ 655.6         $ 534.9           23%   
                                

 

1

Investment management fees from approximately 59% of our assets under management at December 31, 2010 were calculated using daily average assets under management.

Assets under management at December 31, 2010 were 21% higher than they were at December 31, 2009, primarily due to market appreciation of $61.8 billion and net new flows of $58.8 billion during the twelve-month period. The market appreciation related to products in all investment objectives as improved market conditions led to significant valuation increases, while the net new flows were primarily due to higher sales of fixed-income products. Simple monthly average assets under management, which are generally more indicative of trends in revenue for providing investment management and fund administration services than the year-over-year change in ending assets under management, increased 23% during the three months ended December 31, 2010, as compared to the same period in the prior fiscal year.

The simple monthly average mix of assets under management is shown below. The change in mix for the three months ended December 31, 2010, as compared to the same period in the prior fiscal year, reflects an investor shift to lower risk investments during the past twelve months.

 

       Three Months Ended
December 31,
 
               2010                        2009          

Equity

       44%           46%   

Hybrid

       16%           19%   

Fixed-income

       39%           34%   

Cash management

       1%           1%   
                     

Total

       100%           100%   
                     

 

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Assets under management by sales region were as follows:

 

(dollar amounts in billions)      December 31,
      2010      
           Percent    
of Total
       December 31,
      2009      
           Percent    
of Total
 

United States1

     $ 461.4           69%         $ 407.9           74%   

Europe2

       102.0           15%           60.8           11%   

Asia-Pacific3

       73.7           11%           52.5           9%   

Canada

       33.6           5%           32.3           6%   
                                           

Total

     $ 670.7           100%         $ 553.5           100%   
                                           

 

1

Approximately 65% and 67% of our operating revenues originated from United States operations in the three months ended December 31, 2010 and 2009.

2

Europe sales region includes Middle East and Africa.

3

Asia-Pacific sales region includes Latin America and Australia.

Due to the global nature of our business operations, investment management and related services may be performed in locations unrelated to the sales region.

Components of the change in our assets under management were as follows:

 

(dollar amounts in billions)      Three Months Ended
December 31,
         Percent    
Change
 
           2010                  2009           

Beginning assets under management

     $ 644.9       $ 523.4         23%   

Long-term sales

       54.9         42.2         30%   

Long-term redemptions

       (52.8      (28.2      87%   

Net cash management

       1.1         0.3         267%   
                            

Net new flows

       3.2         14.3         (78)%   

Reinvested distributions

       5.8         3.7         57%   
                            

Net flows

       9.0         18.0         (50)%   

Distributions

       (7.3      (4.5      62%   

Appreciation and other

       24.1         16.6         45%   
                            

Ending Assets Under Management

     $ 670.7       $ 553.5         21%   
                            

Investment Management Fee Rate

Our effective investment management fee rate (investment management fees divided by simple monthly average assets under management) increased to 0.635% for the three months ended December 31, 2010 from 0.603% for the same period in the prior fiscal year. The increase was primarily due to higher levels of global/international assets under management and performance fees earned in the current year. Generally, investment management fees earned on international products are higher than fees earned on United States products as they include fees to offset higher distribution costs.

Operating Revenues

The table below presents the percentage change in each revenue category.

 

(dollar amounts in millions)      Three Months Ended
December 31,
           Percent    
Change
 
           2010                    2009             

Investment management fees

     $ 1,040.9         $ 806.7           29%   

Sales and distribution fees

       577.8           488.1           18%   

Shareholder servicing fees

       72.1           69.5           4%   

Other, net

       9.5           13.1           (27)%   
                                

Total Operating Revenues

     $ 1,700.3         $ 1,377.4           23%   
                                

 

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Investment Management Fees

Investment management fees are generally calculated under contractual arrangements with our sponsored investment products and sub-advised accounts as a percentage of the market value of assets under management. Annual rates vary by investment objective and type of services provided.

Investment management fees increased for the three months ended December 31, 2010 primarily due to a 23% increase in simple monthly average assets under management and a higher effective management fee rate.

Sales and Distribution Fees

We earn fees from the sale of certain classes of sponsored investment products on which investors pay a commission at the time of purchase. Sales commissions are reduced or eliminated on some share classes and for some sale transactions depending upon the amount invested and the type of investor. Therefore, sales fees will change with the overall level of gross sales, the size of individual transactions, and the relative mix of sales between different share classes and types of investors.

Globally, our mutual funds and certain other products generally pay us distribution fees in return for sales, marketing and distribution efforts on their behalf. Specifically, the majority of U.S.-registered mutual funds, with the exception of certain of our money market mutual funds, have adopted distribution plans under Rule 12b-1 promulgated under the Investment Company Act of 1940 (the “Rule 12b-1 Plans”). The Rule 12b-1 Plans permit the mutual funds to bear certain expenses relating to the distribution of their shares, such as expenses for marketing, advertising, printing and sales promotion, subject to the Rule 12b-1 Plans’ limitations on amounts. The individual Rule 12b-1 Plans set a percentage limit for Rule 12b-1 expenses based on average daily net assets under management of the mutual fund. Similar arrangements exist for the distribution of our non-U.S. funds where, generally, the distributor of the funds in the local market arranges for and pays commissions.

We pay a significant portion of sales and distribution fees to the financial advisers and other intermediaries who sell our sponsored investment products to the public on our behalf. See the description of sales, distribution and marketing expenses below.

Overall, sales and distribution fees increased for the three months ended December 31, 2010. Sales fees increased 5% primarily due to a 5% increase in gross commissionable sales. Distribution fees increased 26% primarily due to a 23% increase in simple monthly average assets under management.

Shareholder Servicing Fees

We receive shareholder servicing fees as compensation for providing transfer agency services, which include providing customer statements, transaction processing, customer service, and tax reporting. These fees are generally fixed charges per shareholder account that vary with the particular type of fund and the service being rendered. In some instances, we charge sponsored investment products these fees based on the level of assets under management. In the United States, transfer agency service agreements provide that accounts closed in a calendar year generally remain billable at a reduced rate through the second quarter of the following calendar year. In Canada, such agreements provide that accounts closed in the calendar year remain billable for four months after the end of the calendar year. Accordingly, the level of fees will vary with the change in open accounts and the level of closed accounts that remain billable.

Shareholder servicing fees increased for the three months ended December 31, 2010 primarily due to an increase in simple monthly average billable shareholder accounts in Europe and the United States.

Other, Net

Other, net revenue primarily consists of revenues from the banking/finance segment as well as income from custody services. Banking/finance revenues include interest income on loans and servicing income and are reduced by interest expense and the provision for loan losses. We have consistently followed our methodology in determining our allowance for loan losses, which incorporates current economic factors. Other, net revenue also includes the net investment income of our consolidated sponsored investment products, which is primarily comprised of dividend and interest income.

Other, net revenue decreased for the three months ended December 31, 2010 primarily due to a $1.8 million increase in provision for loan losses, mainly resulting from the consolidation of securitization trusts during the current year, and a $1.5 million realized gain on the sale of retained interests from securitizations in the prior year.

Operating Expenses

In the first quarter of fiscal year 2011, we changed the presentation of our condensed consolidated statements of income. See Note 1 – Basis of Presentation in the notes to condensed consolidated financial statements in Item 1 of Part I of this Form 10-Q.

 

30


Amounts for the comparative prior fiscal year period have been reclassified to conform to the current year presentation. The table below presents the percentage change in each operating expense category.

 

       Three Months Ended
December 31,
           Percent    
Change
 
(dollar amounts in millions)            2010                    2009             

Sales, distribution and marketing

     $ 647.1         $ 535.6           21%   

Compensation and benefits

       292.4           254.3           15%   

Information systems and technology

       40.4           38.0           6%   

Occupancy

       30.9           30.6           1%   

General, administrative and other

       30.3           51.9           (42)%   
                                

Total Operating Expenses

     $ 1,041.1         $ 910.4           14%   
                                

Sales, Distribution and Marketing

Sales, distribution and marketing expenses primarily consist of payments to financial advisers, broker/dealers and other third parties for providing services to investors in our sponsored investment products, including marketing support services. These payments are generally determined as percentages of either assets under management or sales. Also included is the amortization of deferred sales commissions related to up-front commissions on shares sold without a front-end sales charge to shareholders. The deferred sales commissions are amortized over the periods in which commissions are generally recovered from distribution fee revenues and contingent sales charges received from shareholders of the funds upon redemption of their shares.

Sales, distribution and marketing expenses by cost driver are presented below:

 

       Three Months Ended
December 31,
           Percent    
Change
 
(dollar amounts in millions)            2010                    2009             

Asset-based expenses

     $ 433.5         $ 325.3           33%   

Sales-based expenses

       171.4           163.8           5%   

Amortization of deferred sales commissions

       42.2           46.5           (9)%   
                                

Sales, Distribution and Marketing

     $ 647.1         $ 535.6           21%   
                                

Asset-based expenses increased for the three months ended December 31, 2010 primarily due to a 23% increase in simple monthly average assets under management and higher levels of international products which have higher distribution costs. Sales-based expenses increased due to a 5% increase in commissionable sales. Amortization of deferred sales commissions decreased primarily due to runoff of deferred commissions related to U.S. Class B shares, partially offset by higher sales of U.S. Class A and C shares with up-front commissions.

Compensation and Benefits

Compensation and benefit expenses increased for the three months ended December 31, 2010 primarily due to increases in variable compensation and salaries, wages and benefits. Variable compensation increased $24.3 million, mainly due to higher bonus expense based on our performance. Salaries, wages and benefits increased $16.4 million primarily due to higher 401(k) plan matching contributions, health insurance costs and staffing levels, as well as annual merit salary adjustments that were effective December 1, 2010. At December 31, 2010, our global workforce had increased to approximately 8,000 employees from approximately 7,800 employees at December 31, 2009.

We continue to place a high emphasis on our pay for performance philosophy. As such, any changes in the underlying performance of our sponsored investment products or changes in the composition of our incentive compensation offerings could have an impact on compensation and benefit expenses going forward. However, in order to attract and retain talented individuals, our level of compensation and benefit expenses may increase more quickly or decrease more slowly than our revenue.

Information Systems and Technology

Information systems and technology costs increased for the three months ended December 31, 2010 primarily due to higher technology costs related to certain strategic projects.

 

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Details of capitalized information systems and technology costs are shown below.

 

       Three Months Ended
December 31,
 
(in millions)            2010                  2009        

Net carrying value at beginning of period

     $ 63.9       $ 65.2   

Additions during period, net of disposals

       5.0         3.9   

Amortization during period

       (9.4      (8.3
                   

Net Carrying Value at End of Period

     $ 59.5       $ 60.8   
                   

Occupancy

The Company conducts its worldwide operations using a combination of leased and owned facilities. Occupancy costs include rent and other facilities-related costs including depreciation and utilities.

Occupancy costs for the three months ended December 31, 2010 were comparable to the same period in the prior fiscal year.

General, Administrative and Other

General, administrative and other operating expenses primarily consist of fund administration services and shareholder servicing fees payable to external parties, advertising and promotion costs, professional fees, corporate travel and entertainment, and other miscellaneous expenses. General, administrative and other operating expenses decreased for the three months ended December 31, 2010 primarily due to $26.5 million of net insurance recoveries for losses incurred in prior years, partially offset by an increase in fund administration services and shareholder servicing fees resulting from higher average assets under management.

We are committed to investing in advertising and promotion in response to changing business conditions, and to advance our products where we see continued or potential new growth opportunities. As a result of potential changes in our strategic marketing campaigns, the level of advertising and promotion expenditures may increase more rapidly, or decrease more slowly, than our revenues.

Other Income (Expenses)

 

       Three Months Ended
December 31,
 
(in millions)            2010                  2009        

Consolidated sponsored investment products gains (losses), net

     $ (0.7    $ 15.1   

Investment and other income, net

       47.0         33.0   

Interest expense

       (7.9      (0.8
                   

Other Income, Net

     $ 38.4       $ 47.3   
                   

Other income (expenses) includes net realized and unrealized investment gains (losses) on consolidated sponsored investment products, investment and other income, net and interest expense from our investment management and related services business. Investment and other income, net is comprised primarily of income related to our investments, including interest and dividends, realized gains (losses) on sale of available-for-sale investment securities, gains (losses) from trading investments, other-than-temporary impairments, income (losses) from equity method investees, gains (losses) of assets and liabilities of consolidated VIEs, and foreign currency exchange gains (losses).

Total other income (expenses) decreased for the three months ended December 31, 2010 primarily due to $7.9 million of interest expense related to $900.0 million of long-term debt issued in May 2010. Impacts from market volatility and the implementation of new accounting guidance related to consolidation of VIEs resulted in offsetting gains and losses in the other components. Higher market valuations resulted in a $24.8 million increase in net realized gains on sale of available-for-sale investment securities and a $19.7 million increase in income from equity method investees. Fewer funds consolidated in the current quarter and lower market valuations resulted in a $15.8 million decrease in net gains from securities held by our consolidated sponsored investment products. Lower valuations also resulted in an $11.7 million increase in other-than-temporary impairments on available-for-sale and other equity investments. Net gains on trading investment securities decreased by $10.8 million, of which $9.3 million related to prior year gains on residual interests from securitization transactions, which were recognized as trading securities prior to the implementation of the new accounting guidance. The new accounting guidance also resulted in recognition of $9.1 million of net losses in the current quarter from the changes in fair value of the assets and liabilities of consolidated collateralized loan obligations (“CLOs”).

 

32


Our investments in sponsored investment products primarily consist of the initial cash investments made in the course of launching mutual fund and other investment product offerings; however we may also invest in our products for other business reasons. The market conditions that impact our assets under management similarly affect the investment income earned or losses incurred on our sponsored investment product investments.

Taxes on Income

As a multi-national corporation, we provide investment management and related services to a wide range of international sponsored investment products, often managed from locations outside the United States. Some of these jurisdictions have lower tax rates than the United States. The mix of pre-tax income (primarily from our investment management and related services business) subject to these lower rates, when aggregated with income originating in the United States, produces a lower overall effective income tax rate than existing U.S. federal and state income tax rates.

Our effective income tax rate was 29.75% for the three months ended December 31, 2010, as compared to 30.48% for the same period in the prior fiscal year. The decrease was primarily due to a favorable international tax ruling and a reduction to our tax reserves due to a state audit settlement.

The effective income tax rate for future reporting periods will continue to reflect the relative contributions of non-U.S. earnings that are subject to reduced tax rates and that are not currently included in U.S. taxable income.

LIQUIDITY AND CAPITAL RESOURCES

The following table summarizes certain key financial data relating to our cash flows and uses of capital.

 

       Three Months Ended
December 31,
 
(in millions)            2010                  2009        

Cash Flow Data

       

Operating cash flows

     $ 245.8       $ 317.1   

Investing cash flows

       244.1         69.1   

Financing cash flows

       (292.7      (640.6

Net cash provided by operating activities decreased during the three months ended December 31, 2010 as compared to the same period in the prior fiscal year, despite an increase in income, due to higher purchases of trading securities and payments of accrued compensation and benefits. Net cash provided by investing activities increased mainly due to higher liquidations of investments, net of purchases. Net cash used in financing activities decreased primarily due to lower dividends paid on common stock, partially offset by a decrease in commercial paper issuances and repayment of debt by consolidated VIEs.

The assets and liabilities of our consolidated VIEs, which consist of CLOs and automobile loan securitization trusts, do not impact our liquidity and capital resources. The collateral assets of the VIEs are held solely to satisfy the obligations of the VIEs. We have no right to the assets of the VIEs, beyond our direct investment in, and management fees generated from, these entities, which are eliminated upon consolidation. The debt holders of the VIEs have recourse only to the corresponding collateralized assets. Accordingly, the assets and liabilities of our consolidated VIEs are excluded from the discussion below.

The following table summarizes certain key financial data relating to our liquidity and debt.

 

(in millions)      December 31,
       2010      
       September 30,
       2010      
 

Balance Sheet Data

         

Assets

         

Cash and cash equivalents

     $ 4,247.8         $ 4,123.7   

Receivables

       810.2           684.2   

Investments

       2,041.8           1,876.2   
                     

Total liquid assets

     $ 7,099.8         $ 6,684.1   
                     

Liabilities

         

Debt

         

Commercial paper

     $ 27.2         $ 30.0   

Federal Home Loan Bank advances

       51.0           51.0   

Long-term debt

       899.0           898.9   
                     

Total debt

     $ 977.2         $ 979.9   
                     

 

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Liquidity

Liquid assets consist of cash and cash equivalents, current receivables, and current and certain other investments (trading, available-for-sale, investments in equity method investees consisting of mutual fund sponsored investment products, and other). Cash and cash equivalents include cash on hand, non-interest-bearing and interest-bearing deposits with financial institutions, federal funds sold, time deposits, U.S. government-sponsored enterprise obligations, securities of the U.S. Treasury and federal agencies, debt instruments with original maturities of three months or less at the purchase date and other highly liquid investments, including money market funds, which are readily convertible into cash. Cash and cash equivalents at December 31, 2010 increased primarily due to net cash provided by operating and investing activities, partially offset by net cash used in financing activities. At December 31, 2010, the percentages of cash and cash equivalents held by our U.S. and non-U.S. operations were approximately 47% and 53%, as compared to approximately 49% and 51% at September 30, 2010.

Capital Resources

We believe that we can meet our present and reasonably foreseeable operating cash needs and future commitments through existing liquid assets, continuing cash flows from operations, borrowing capacity under current credit facilities and the ability to issue debt or equity securities.

In March 2008, we filed an automatic shelf registration statement with the SEC as a “well-known seasoned issuer”. Using the shelf registration statement, we may sell, at any time and from time to time, in one or more offerings, our shares of common stock, shares of preferred stock, debt securities, convertible securities, warrants or units.

In May 2010, we issued senior unsecured and unsubordinated notes with a face value of $900.0 million. Of the notes, $300.0 million was issued at a fixed interest rate of 2.000% per annum and matures in 2013, $250.0 million was issued at a fixed interest rate of 3.125% per annum and matures in 2015 and $350.0 million was issued at a fixed interest rate of 4.625% and matures in 2020. The indenture governing the notes contains limitations on our ability and the ability of our subsidiaries to pledge voting stock or profit participating equity interests in our subsidiaries to secure other debt without similarly securing the notes equally and ratably. As of December 31, 2010, we were in compliance with the covenants of the notes.

The banking/finance segment secures advances from the FHLB to fund its retail banking and consumer lending services. At December 31, 2010, we had $51.0 million of FHLB advances outstanding. These advances had a weighted-average interest rate of 3.62% at December 31, 2010 and are subject to collateralization requirements.

At December 31, 2010, we had $472.8 million of short-term commercial paper available for issuance under an uncommitted private placement program and $15.0 million available in uncommitted short-term bank lines of credit. Our banking/finance segment had $270.0 million available in uncommitted short-term bank lines of credit under the Federal Reserve system, $184.5 million available through the secured Federal Reserve Bank short-term discount window and $55.1 million available in secured FHLB short-term borrowing capacity.

Our ability to access the capital markets in a timely manner depends on a number of factors, including our credit rating, the condition of the global economy, investors’ willingness to purchase our securities, interest rates, credit spreads and the valuation levels of equity markets. If we are unable to access capital markets in a timely manner, our business could be adversely impacted.

Uses of Capital

We expect that our main uses of cash will be to expand our core business, make strategic acquisitions, acquire shares of our common stock, fund property and equipment purchases, pay operating expenses of the business, enhance technology infrastructure and business processes, pay stockholder dividends and repay and service debt.

On December 16, 2010, our Board of Directors declared a regular quarterly cash dividend of $0.25 per share which was payable on January 7, 2011 to stockholders of record on December 31, 2010.

In December 2010, we purchased an office building in Fort Lauderdale, Florida for $29.7 million in cash to be used for business operations.

We maintain a stock repurchase program to manage our equity capital with the objective of maximizing shareholder value. Our stock repurchase program is affected through regular open-market purchases and private transactions in accordance with applicable laws and regulations. During the three months ended December 31, 2010 and 2009, we repurchased 1.7 million and 1.6 million shares of our common stock at a cost of $198.5 million and $174.0 million. The common stock repurchases made as of December 31, 2010 reduced our capital in excess of par value to nil and the excess amount was recognized as a reduction to retained earnings. In December 2010, our Board of Directors authorized the repurchase of up to 10.0 million additional shares of our common stock under our stock repurchase program. At December 31, 2010, approximately 11.3 million shares of our common stock remained available for repurchase under our stock repurchase program. Our stock repurchase program is not subject to an expiration date.

 

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The funds that we manage have their own resources available for purposes of providing liquidity to meet shareholder redemptions, including securities that can be sold or provided to investors as in-kind redemptions, and lines of credit. While we have no contractual obligation to do so, we may voluntarily elect to provide the funds with direct or indirect financial support based on our business objectives.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

Our contractual obligations and commercial commitments are summarized in our Form 10-K for the fiscal year ended September 30, 2010. At December 31, 2010, there were no material changes outside the ordinary course in our contractual obligations and commercial commitments from September 30, 2010, with the exception of the impact resulting from the adoption of new consolidation guidance. See Note 2 – New Accounting Guidance, Note 5 – Variable Interest Entities, and Note 9 – Debt, in the notes to the condensed consolidated financial statements in Item 1 of Part I of this Form 10-Q for further discussion.

OFF-BALANCE SHEET ARRANGEMENTS

In our role as agent or trustee, we facilitate the settlement of investor share purchase, redemption, and other transactions with affiliated mutual funds. We are appointed by the affiliated mutual funds as agent or trustee to manage, on behalf of the affiliated mutual funds, bank deposit accounts that contain only (i) cash remitted by investors to the affiliated mutual funds for the direct purchase of fund shares, or (ii) cash remitted by the affiliated mutual funds for direct delivery to the investors for either the proceeds of fund shares liquidated at the investors’ direction, or dividends and capital gains earned on fund shares. As of December 31, 2010 and September 30, 2010, we held cash of approximately $170.2 million and $351.5 million off-balance sheet in agency or trust for investors and the affiliated mutual funds.

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America, which require the use of estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results may differ from those estimates under different assumptions. Following are updates to our critical accounting policies disclosed in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K for the fiscal year ended September 30, 2010.

Fair Value Measurements

We record substantially all of our investments in the financial statements at fair value or amounts that approximate fair value. We use a three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value based on whether the inputs to those valuation techniques are observable or unobservable.

Level 3 assets and liabilities represented approximately 0.5% of total assets measured at fair value and 9.1% of total liabilities measured at fair value at December 31, 2010. There were immaterial transfers into and no transfers out of Level 3 during the three months ended December 31, 2010.

The following is a description of new significant assets and liabilities measured at fair value resulting from the adoption of new accounting guidance as of October 1, 2010, the fair values methodologies used, and the fair value hierarchy level.

Investments and long-term debt of consolidated VIEs. The fair values of investments and debt held by consolidated VIEs are primarily obtained from independent third-party broker or dealer price quotes and classified as Level 2. The VIEs also issued debt that is classified as Level 3 because its fair value is determined using unobservable inputs. In these instances, we employ a market-based approach, which uses prices of recent transactions, various market multiples, book values and other relevant information for the instrument or related or other comparable debt instruments to determine the fair value. If the market-based approach is not available, we utilize an income-based approach which considers the net present value of the instrument and converts those amounts into a net present value. A discount may also be applied due to the nature or duration of any restrictions on the disposition of the instrument.

Goodwill and Other Intangible Assets

We make significant estimates and assumptions when valuing goodwill and other intangible assets in connection with the initial purchase price allocation of an acquired entity, as well as when evaluating impairment of goodwill and other intangible assets on an ongoing basis.

 

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Subsequent to August 1, 2010, there were no impairments to goodwill or indefinite-lived intangible assets as we determined no events occurred or circumstances changed that would more likely than not reduce the fair value of the reporting unit below its carrying value, or indicate that our indefinite-lived intangible assets might be impaired.

We test definite-lived intangible assets for impairment quarterly. As of December 31, 2010, approximately 90% of our definite-lived intangible assets related to investment management contracts of Fiduciary Trust Company International (“FTCI”). The undiscounted future cash flow projections for FTCI institutional and high net-worth management contracts exceeded their carrying values by approximately 35% and 22%, respectively. The undiscounted future cash flow projections for the other definite-lived intangible assets exceeded their respective carrying values by more than 100%. We estimated the future undiscounted cash flows for all definite-lived intangible assets using assets under management growth rates ranging from -6.4% to 6.0% depending on the type of management contracts. The assumptions used in our impairment tests for definite-lived intangible assets were developed taking into consideration ongoing market conditions. As of December 31, 2010, a decline in the assets under management of over 1,000 basis points could cause us to evaluate whether the fair value of our definite-lived intangible assets is below the asset carrying value.

While we believe that our impairment tests and the assumptions used to estimate fair value are reasonable and appropriate, if the assumptions used in our estimates of fair value change in the future, we may be required to record impairment charges or otherwise accelerate amortization expense.

Income Taxes

We record deferred tax assets and liabilities for temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements using the statutory tax rates in effect for the year when the reported amount of the asset or liability is recovered or settled, respectively. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying values of deferred tax assets to the amount that is more likely than not to be realized. For each tax position taken or expected to be taken in a tax return, we determine whether it is more likely than not that the position will be sustained upon examination based on the technical merits of the position, including resolution of any related appeals or litigation. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize. The tax position is measured at the largest amount of benefit that is greater than 50% likely of being realized upon settlement. We recognize the accrual of interest on uncertain tax positions in interest expense and penalties in other operating expenses.

As a multi-national corporation, we operate in various locations outside the United States and generate earnings from our non-U.S. subsidiaries. We indefinitely reinvest the undistributed earnings of our non-U.S. subsidiaries, except for income previously taxed in the U.S., subject to regulatory or contractual repatriation restrictions or contractual repatriation requirements, and the excess net earnings after debt service payments and regulatory capital requirements of our Canadian and U.K. consolidated subsidiaries. Changes to our policy of reinvestment or repatriation of non-U.S. earnings may have a significant effect on our financial condition and results of operations.

Loss Contingencies

We are involved in various lawsuits and claims encountered in the normal course of business. When such a matter arises and periodically thereafter, we consult with our legal counsel and evaluate the merits of the claims based on the facts available at that time. In management’s opinion, an adequate accrual has been made as of December 31, 2010 to provide for probable losses that may arise from these matters for which we could reasonably estimate an amount. See also Note 10 – Commitments and Contingencies in the notes to condensed consolidated financial statements in Item 1 of Part I of this Form 10-Q.

 

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Consolidation of Variable Interest Entities

We consolidate VIEs for which we are considered the primary beneficiary. A VIE is an entity in which the equity investment holders have not contributed sufficient capital to finance its activities or the equity investment holders do not have defined rights and obligations normally associated with an equity investment. We provide investment management services to various investment entities that we sponsor in the normal course of business. We also invest in various entities in the normal course of business. Certain of these entities are considered to be VIEs.

We use two different models for determining whether we are the primary beneficiary of VIEs. For all investment entities with the exception of CLOs, we are considered to be the primary beneficiary if we have the majority of the risks and rewards of ownership. For all other VIEs, including CLOs, we are considered to be the primary beneficiary if we have the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and the obligation to absorb losses of or the right to receive benefits from the VIE that could potentially be significant to the VIE.

The variable interests that we have in investment entity VIEs, other than CLOs, generally consist of our equity ownership interest in and investment management and related service fees earned from these VIEs. We use expected cash flow scenarios to determine if our investment management and related service fees and/or equity ownership interests provide us with a majority of the VIE’s expected losses or residual returns. Based on our evaluation, we determined we were not the primary beneficiary of these VIEs and, as a result, did not consolidate these entities as of and for the three months ended December 31, 2010.

We provide collateral management services to CLOs which are considered VIEs. These CLOs are asset-backed financing entities collateralized by a pool of assets, primarily corporate loans and, to a lesser extent, high-yield bonds. We generally earn management fees in the form of senior and subordinated management fees from the CLOs based on the par value of outstanding investments and, in certain instances, may also receive performance-based fees. In addition, we hold equity interests in certain of these investment vehicles. We determined that we are the primary beneficiary of the CLOs as we have the power to direct the activities that most significantly impact the CLOs’ economic performance in our role as collateral manager and hold a variable interest for which we have the potential to receive significant benefits that could potentially be significant to the CLOs.

In previous years we entered into automobile loan securitization transactions with securitization trusts, which then issued asset-backed securities to private investors. We retained certain interests as part of the securitization transactions, which consist of interest-only strips receivable and cash on deposit. We also retained servicing responsibilities for the securitization trusts and receive annual servicing fees. Our services primarily consist of the management, service and administration of the loans, collection and posting of payments, and maintenance of accounts for the benefit of, and making distributions to, the holders of the asset-backed securities. We determined that we are the primary beneficiary of the securitization trusts as we have the power to direct the activities that most significantly impact the securitization trusts’ economic performance in our role as servicer and hold a variable interest for which we have the right to receive benefits or the obligation to absorb losses that could potentially be significant to the securitization trusts. The securitization trusts were not subject to consolidation under the accounting guidance in effect prior to October 1, 2010.

Our evaluation of whether we qualify as the primary beneficiary of VIEs is highly complex and involves significant judgments, estimates and assumptions. The key estimates and assumptions used in our analyses may include the amount of assets under management, investment management and related service fee rates, the life of the investment product, and the discount rate. These estimates and assumptions are subject to variability. For example, assets under management are impacted by market volatility and the level of sales, redemptions, contributions, withdrawals and dividend reinvestments of mutual fund shares that occur daily. In addition, third-party purchases and redemptions, which are outside of our control, can impact our evaluation. Collateralized assets of CLOs and securitization trusts are impacted by market volatility and prepayment rates. There is judgment involved in assessing whether we have the power to direct the activities that most significantly impact VIEs’ economic performance and the obligation to absorb losses of or the right to receive benefits from VIEs that could potentially be significant to the VIEs.

While we believe that our evaluation is appropriate, future changes in estimates, judgments, and assumptions may affect the determination of primary beneficiary status and the resulting consolidation of VIEs in our consolidated financial statements.

NEW ACCOUNTING GUIDANCE

See Note 2 – New Accounting Guidance in the notes to condensed consolidated financial statements in Item 1 of Part I of this Form 10-Q.

 

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RISK FACTORS

Volatility and disruption of the capital and credit markets, and adverse changes in the global economy, may significantly affect our results of operations and may put pressure on our financial results. The capital and credit markets continue to experience volatility and disruption. Although global market conditions have shown some stabilization and improvement, the decline in global market conditions has in the past resulted in significant decreases in our assets under management, revenues and income, and future declines may negatively impact our performance. Such declines have had and may in the future have an adverse impact on our results of operations. Even if legislative or regulatory initiatives or other efforts successfully stabilize and add liquidity to the financial markets, we may need to modify our business, strategies or operations, and we may be subject to additional constraints or costs in order to satisfy new regulatory requirements or to compete in a changed business environment.

The amount and mix of our assets under management are subject to significant fluctuations. Fluctuations in the amount and mix of our assets under management may be attributable in part to market conditions outside of our control that have had, and in the future could have, a negative impact on our revenues and income. We derive the majority of our operating revenues and net income from providing investment management and related services. The level of our revenues depends largely on the level and mix of assets under management. Any decrease in the value or amount of our assets under management because of market volatility or other factors negatively impacts our revenues and income. We are subject to an increased risk of asset volatility from changes in the global financial and equity markets. Individual financial and equity markets may be adversely affected by economic, political, financial, or other instabilities that are particular to the country or regions in which a market is located, including without limitation local acts of terrorism, economic crises or other business, social or political crises. Declines in these markets have caused in the past, and may cause in the future, a decline in our revenues and income. Global economic conditions, exacerbated by war or terrorism or financial crises, changes in the equity market place, currency exchange rates, interest rates, inflation rates, the yield curve, defaults by derivative counterparties and other factors that are difficult to predict affect the mix, market values and levels of our assets under management. The funds we manage may be subject to an unanticipated large number of redemptions as a result of such events, causing the funds to sell securities they hold, possibly at a loss, or draw on any available lines of credit to obtain cash to settle these redemptions, or settle in-kind with securities held in the applicable fund. The Company, in its discretion, may also provide financial support to a fund to enable it to maintain sufficient liquidity in such event. Our investment management services revenues are derived primarily from fees based on a percentage of the value of assets under management and vary with the nature of the account or product managed. A decline in the price of stocks or bonds, or in particular market segments, or in the securities market generally, could cause the value and returns on our assets under management to decline, resulting in a decline in our revenues and income. Moreover, changing market conditions may cause a shift in our asset mix between international and U.S. assets, potentially resulting in a decline in our revenue and income depending upon the nature of our assets under management and the level of management fees we earn based on them. Additionally, changing market conditions may cause a shift in our asset mix towards fixed-income products and a related decline in our revenue and income, as we generally derive higher fee revenues and income from equity assets than from fixed-income products we manage. On the other hand, increases in interest rates, in particular if rapid, or high interest rates, as well as any uncertainty in the future direction of interest rates, may have a negative impact on our fixed-income products as rising interest rates or interest rate uncertainty typically decrease the total return on many bond investments due to lower market valuations of existing bonds. Any decrease in the level of our assets under management resulting from price declines, interest rate volatility or uncertainty, increased redemptions or other factors could negatively impact our revenues and income.

We are subject to extensive and complex, overlapping and frequently changing rules, regulations and legal interpretations. Our investment management and related services business and our banking/finance business are subject to extensive and complex, overlapping and frequently changing rules, regulations and legal interpretations in the countries in which we operate, including, among others, securities, banking, accounting and tax laws and regulations. On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Reform Act”). The Reform Act, as well as other legislative and regulatory changes, is expected to impose additional restrictions and limitations on us and will likely result in increased scrutiny and oversight of our financial services and products. Due to the complexity and broad scope of the Reform Act and time required for regulatory implementation, we are not able to predict at this time the specific requirements that will be adopted by regulatory agencies having authority over us pursuant to the Reform Act, or the impact that any changes in regulation would have on our business. We will continue to review and evaluate the Reform Act and the extent of its impact on our business as the various rules and regulations required for implementation are adopted.

Financial reporting requirements, and the processes, controls and procedures that have been put in place to address them, are often comprehensive and complex. While management has focused attention and resources on our compliance policies, procedures and practices, non-compliance with applicable laws or rules or regulations, conflicts of interest requirements or fiduciary principles, or our inability to keep up with, or adapt to, an ever changing, complex regulatory environment could result in sanctions against us, including fines and censures, injunctive relief, suspension or expulsion from a particular jurisdiction or market or the revocation of licenses, any of which could also adversely affect our reputation, prospects, revenues, and earnings.

We are subject to U.S. federal securities laws, state laws regarding securities fraud, other federal and state laws and rules and regulations of certain regulatory and self-regulatory organizations, including those rules and regulations promulgated by, among

 

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others, the SEC, the Financial Industry Regulatory Authority and the New York Stock Exchange. To the extent operations or trading in our securities take place outside the United States, we are subject to regulation by non-U.S. regulations and regulators, such as the U.K. Financial Services Authority, and U.S. regulations and regulators such as the Department of Justice and the SEC with respect to the Foreign Corrupt Practices Act of 1977. Certain of our subsidiaries are registered with the SEC under the Investment Advisers Act of 1940 and many of our funds are registered with the SEC under the Investment Company Act of 1940, both of which impose numerous obligations, as well as detailed operational requirements, on our subsidiaries which are investment advisers to registered investment companies. Our subsidiaries must comply with a myriad of complex and changing U.S. and/or non-U.S. rules and regulations, some of which may conflict, as well as complex tax regimes. Additionally, as we expand our operations, sometimes rapidly, into non-U.S. jurisdictions, the rules and regulations of these non-U.S. jurisdictions become applicable, sometimes with short compliance deadlines, and add further regulatory complexity to our ongoing compliance operations.

In addition, we are a bank holding company and a financial holding company subject to the supervision and regulation of the Federal Reserve Board (the “FRB”) and are subject to the restrictions, limitations, or prohibitions of the Bank Holding Company Act of 1956 and the Gramm-Leach-Bliley Act. The provisions of the Reform Act are expected to have an impact on our banking/finance business. Significant aspects of the Reform Act relate to changes in the regulation of banks, thrifts, holding companies and related institutions, including with respect to regulation and supervision in the banking industry and, the imposition of various restrictions and limitations on certain activities of such entities. The Reform Act includes a number of measures that will increase capital and liquidity requirements, impose limits on leverage, and enhance supervisory authority and regulatory oversight of non-banking entities which may apply to our business. The FRB may impose additional limitations or restrictions on our activities, including if the FRB believes that we do not have the appropriate financial and managerial resources to commence or conduct an activity or make an acquisition. Further, our subsidiary, Fiduciary Trust Company International, is subject to extensive regulation, supervision and examination by the Federal Deposit Insurance Corporation and New York State Banking Department, while other subsidiaries are subject to oversight by the Office of Thrift Supervision and various state regulators. The laws and regulations imposed by these regulators generally involve restrictions and requirements in connection with a variety of technical, specialized, and expanding matters and concerns. For example, compliance with anti-money laundering and Know-Your-Customer requirements, both domestically and internationally, and the Bank Secrecy Act has taken on heightened importance with regulators as a result of efforts to, among other things, limit terrorism. At the same time, there has been increased regulation with respect to the protection of customer privacy and the need to secure sensitive customer information. As we continue to address these requirements or focus on meeting new or expanded ones, we may expend a substantial amount of time and resources, even though our banking/finance business does not constitute our dominant business sector. Any inability to meet these requirements, within the timeframes set by regulators, may subject us to sanctions or other restrictions by the regulators that could impact our broader business. Moreover, being subject to banking regulation may put us at a disadvantage compared to our competitors which are not subject to such requirements.

Regulatory and legislative actions and reforms have made the regulatory environment in which we operate more costly and future actions and reforms could adversely impact our assets under management, increase costs and negatively impact our profitability and future financial results. Since 2001, the federal securities laws have been augmented substantially and made significantly more complex by, among other measures, the Sarbanes-Oxley Act of 2002, the USA Patriot Act of 2001 and the Reform Act. Moreover, the adoption of new laws or regulations and changes in the interpretation or enforcement of existing laws or regulations have directly affected, and may continue to affect, our business. With new laws and changes in interpretation and enforcement of existing requirements, the associated time we must dedicate to, and related costs we must incur in, meeting the regulatory complexities of our business have increased. In particular, many provisions of the Reform Act require the adoption of rules to implement the Reform Act and mandate multiple studies, which could result in additional legislative or regulatory action. We may be required to invest significant management time and resources to address the various provisions of the Reform Act and the numerous regulations that are required to be issued under it. In addition, the SEC has proposed changes to Rule 12b-1 promulgated under the Investment Company Act of 1940, which, if adopted, could limit our ability to recover expenses relating to the distribution of our funds. Outlays associated with meeting regulatory complexities have also increased as we expand our business into new jurisdictions. Compliance activities to meet these and other new legal requirements have required us to expend additional time and resources, and, consequently, we are incurring increased costs of doing business, which potentially negatively impacts our profitability and future financial results. Moreover, any potential accounting or reporting error, whether financial or otherwise, if material, could damage our reputation, adversely affect our ability to conduct business, and decrease revenue and net income. Finally, any regulatory and legislative actions and reforms affecting the mutual fund industry, including compliance initiatives, may negatively impact revenues by increasing our costs of accessing or dealing in the financial markets or by making certain investment offerings less favorable to our customers.

Changes in tax laws or exposure to additional income tax liabilities could have a material impact on our financial condition, results of operations and liquidity. We are subject to income taxes as well as non-income based taxes, in both the United States and various foreign jurisdictions and are subject to ongoing tax audits in various jurisdictions. Tax authorities may disagree with certain positions we have taken and assess additional taxes. We regularly assess the likely outcomes of these audits in order to determine the appropriateness of our tax provision. However, there can be no assurance that we will accurately predict the outcomes of these audits, and the actual outcomes of these audits could have a material impact on our net income or financial condition. Changes in tax laws or

 

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tax rulings could materially impact our effective tax rate. For example, certain proposals for fundamental U.S. international tax reform, if enacted, could increase the amount of taxes we are required to pay and have a significant adverse impact on our future results of operations and profitability.

Any significant limitation or failure of our software applications, technology or other systems that are critical to our operations could constrain our operations. We are highly dependent upon the use of various proprietary and third-party software applications and other technology systems to operate our business. We use our technology to, among other things, obtain securities pricing information, process client transactions, and provide reports and other customer services to the clients of the funds we manage. Any inaccuracies, delays, or systems failures in these and other processes could subject us to client dissatisfaction and losses. Although we take protective measures, including measures to effectively secure information through system security technology, our technology systems may still be vulnerable to unauthorized access, computer viruses or other events that have a security impact, such as an authorized employee or vendor inadvertently causing us to release confidential information, which could materially damage our operations or cause the disclosure or modification of sensitive or confidential information. Moreover, loss of confidential customer identification information could harm our reputation and subject us to liability under laws that protect confidential personal data, resulting in increased costs or loss of revenue.

Further, although we take precautions to password protect and encrypt our laptops and other mobile electronic hardware, if such hardware is stolen, misplaced or left unattended, it may become vulnerable to hacking or other unauthorized use, creating a possible security risk and resulting in potentially costly actions by us. Most of the software applications that we use in our business are licensed from, and supported, upgraded and maintained by, third-party vendors. A suspension or termination of certain of these licenses or the related support, upgrades and maintenance could cause temporary system delays or interruption. In addition, our failure to properly manage and operate our U.S. data centers could have an adverse impact on our business. Although we have in place certain disaster recovery plans, we may experience system delays and interruptions as a result of natural disasters, power failures, acts of war, and third-party failures. Technology is subject to rapid change and we cannot guarantee that our competitors may not implement more advanced Internet platforms for their products, which could affect our business. Potential system failures or breaches, or advancements in technology, and the cost necessary to address them, could result in material financial loss or costs, regulatory actions, breach of client contracts, reputational harm or legal claims and liability, which in turn could negatively impact our revenues and income.

Our investment management business operations are complex and a failure to properly perform operational tasks or the misrepresentation of our products and services could have an adverse effect on our revenues and income. Through our subsidiaries, we provide investment management and related services to investment funds and institutional, high net-worth and separately-managed accounts (collectively, our “sponsored investment products”). Our investment management and related services include fund administration, shareholder services, transfer agency, underwriting, distribution, custodial, trustee and other fiduciary services. In order to be competitive, we must properly perform our fund and portfolio administration and related responsibilities, including portfolio recordkeeping and accounting, security pricing, corporate actions, investment restrictions compliance, daily net asset value computations, account reconciliations, and required distributions to fund shareholders. In addition, the intentional or unintentional misrepresentation of our products and services in advertising materials, public relations information or other external communications could adversely affect our reputation and business prospects. Further, certain of our subsidiaries may act as general partner for various investment partnerships, which may subject them to liability for the partnerships’ liabilities. If we fail to properly perform and monitor our investment management operations, our business could suffer and our revenues and income could be adversely affected.

We face risks, and corresponding potential costs and expenses, associated with conducting operations and growing our business in numerous countries. We sell mutual funds and offer investment management and related services in many different regulatory jurisdictions around the world, and intend to continue to expand our operations internationally. As we do so, we will continue to face challenges to the adequacy of our resources, procedures and controls to consistently and effectively operate our business. In order to remain competitive, we must be proactive and prepared to implement necessary resources when growth opportunities present themselves, whether as a result of a business acquisition or rapidly increasing business activities in particular markets or regions. As we grow, we face a heightened risk that the necessary resources and/or personnel will be unavailable to take full advantage of strategic opportunities when they appear or that strategic decisions can be efficiently implemented. Local regulatory environments may vary widely, as may the adequacy and sophistication of each. Similarly, local distributors, and their policies and practices as well as financial viability, may be inconsistent or less developed or mature. Notwithstanding potential long-term cost savings by increasing certain operations, such as transfer agent and other back-office operations, in countries or regions of the world with lower operating costs, growth of our international operations may involve near-term increases in expenses as well as additional capital costs, such as information, systems and technology costs and costs related to compliance with particular regulatory or other local requirements or needs. Local requirements or needs may also place additional demands on sales and compliance personnel and resources, such as meeting local language requirements, while also integrating personnel into an organization with a single operating language. Finding and hiring additional, well-qualified personnel and crafting and adopting policies, procedures and controls to address local or regional requirements remain a challenge as we expand our operations internationally. Moreover, regulators in non-U.S. jurisdictions could also change their policies or laws in a manner that might restrict or otherwise impede our ability to distribute or register investment products in their respective markets. Any of these local requirements, activities, or needs could increase the

 

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costs and expenses we incur in a specific jurisdiction without any corresponding increase in revenues and income from operating in the jurisdiction. In addition, from time to time we enter into international joint ventures in which we may not have control. These investments in joint ventures may involve risks, including the risk that the controlling joint venture partner may have business interests, strategies or goals that are inconsistent with ours, and the risk that business decisions or other actions or omissions of the controlling joint venture partner or the joint venture company may result in harm to our reputation or adversely affect the value of our investment in the joint venture.

We depend on key personnel and our financial performance could be negatively affected by the loss of their services. The success of our business will continue to depend upon our key personnel, including our portfolio and fund managers, investment analysts, investment advisers, sales and management personnel and other professionals as well as our executive officers and business unit heads. Competition for qualified, motivated, and highly skilled executives, professionals and other key personnel in the asset management and banking/finance industries remains significant. Our success depends to a substantial degree upon our ability to attract, retain, and motivate qualified individuals, including through competitive compensation packages, and upon the continued contributions of these people. Regulations required to be adopted under the Reform Act as well as regulations under consideration outside the Reform Act, could impose restrictions on compensation paid by financial institutions, which could restrict our ability to compete effectively for qualified professionals. As our business grows, we are likely to need to increase correspondingly the overall number of individuals that we employ. Moreover, in order to retain certain key personnel, we may be required to increase compensation to such individuals, resulting in additional expense without a corresponding increase in potential revenue. We cannot assure you that we will be successful in attracting and retaining qualified individuals, and the departure of key investment personnel, in particular, if not replaced, could cause us to lose clients, which could have a material adverse effect on our financial condition, results of operations and business prospects.

Strong competition from numerous and sometimes larger companies with competing offerings and products could limit or reduce sales of our products, potentially resulting in a decline in our market share, revenues and net income. We compete with numerous asset management companies, mutual fund, stock brokerage, and investment banking firms, insurance companies, banks, savings and loan associations and other financial institutions. Our investment products also compete with products offered by these competitors as well as real estate investment trusts, hedge funds and others. The periodic establishment of new asset management companies and other competitors increases the competition that we face. At the same time, consolidation in the financial services industry has created stronger competitors with greater financial resources and broader distribution channels than our own. Competition is based on various factors, including, among others, business reputation, investment performance, product mix and offerings, service quality and innovation, distribution relationships, and fees charged. Additionally, competing securities broker/dealers whom we rely upon to distribute and sell our mutual funds may also sell their own proprietary funds and investment products, which could limit the distribution of our investment products. To the extent that existing or potential customers, including securities broker/dealers, decide to invest in or distribute the products of our competitors, the sales of our products as well as our market share, revenues and net income could decline. Our ability to attract and retain assets under our management is also dependent on the relative investment performance of our funds and other managed investment portfolios, offering a mix of sponsored investment products that meets investor demand and our ability to maintain our investment management services fees at competitive levels.

Changes in the third-party distribution and sales channels on which we depend could reduce our revenues and hinder our growth. We derive nearly all of our fund sales through third-party broker/dealers and other similar investment advisers. Increasing competition for these distribution channels and regulatory initiatives have caused our distribution costs to rise and could cause further increases in the future or could otherwise negatively impact the distribution of our products. Higher distribution costs lower our net revenues and earnings. Additionally, consolidations in the broker/dealer industry could adversely impact our revenues and earnings. Moreover, if several of the major financial advisers who distribute our products were to cease operations or limit or otherwise end the distribution of our products, it could have a significant adverse impact on our revenues and earnings. There is no assurance we will continue to have access to the third-party broker/dealers and similar investment advisers that currently distribute our products, or continue to have the opportunity to offer all or some of our existing products through them. A failure to maintain strong business relationships with the major investment advisers who currently distribute our products may also impair our distribution and sales operations. Because we use broker/dealers and other similar investment advisers to sell our products, we do not control the ultimate investment recommendations given to clients. Any inability to access and successfully sell our products to clients through third-party distribution channels could have a negative effect on our level of assets under management, related revenues and overall business and financial condition.

Our increasing focus on international markets as a source of investments and sales of investment products subjects us to increased exchange rate and other risks in connection with earnings and income generated overseas. While we operate primarily in the United States, we also provide services and earn revenues in The Bahamas, Asia, Canada, Europe, Latin America, Africa, and Australia. As a result, we are subject to foreign exchange risk through our non-U.S. operations. Fluctuations in the exchange rates to the U.S. dollar may affect our financial results from one period to the next. While we have taken steps to reduce our exposure to foreign exchange risk, for example, by denominating a significant amount of our transactions in U.S. dollars, the situation may change in the future as our business continues to grow outside the United States. Appreciation of the U.S. dollar could moderate revenues

 

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from managing investment products internationally or could affect relative investment performance of certain funds invested in non-U.S. securities. In addition, we have risk associated with the foreign exchange revaluation of U.S. dollar balances held by certain non-U.S. subsidiaries for which the local currency is the functional currency. Separately, management fees that we earn tend to be higher in connection with international assets under management than with U.S. assets under management. Consequently, a downturn in international markets could have a significant effect on our revenues and income. Moreover, as our business grows in non-U.S. markets, any business, economic, social or political unrest affecting these markets, in addition to any direct consequences such unrest may have on our personnel and facilities located in the affected area, may also have a more lasting impact on the long-term investment climate in these and other areas and, as a result, our assets under management and the corresponding revenues and income that we generate from them may be negatively affected.

Poor investment performance of our products could affect our sales or reduce the level of assets under management, potentially negatively impacting our revenues and income. Our investment performance, along with achieving and maintaining superior distribution and client services, is critical to the success of our investment management and related services business. Strong investment performance often stimulates sales of our investment products. Poor investment performance as compared to third-party benchmarks or competitive products could lead to a decrease in sales of investment products we manage and stimulate redemptions from existing products, generally lowering the overall level of assets under management and reducing the management fees we earn. We cannot assure you that past or present investment performance in the investment products we manage will be indicative of future performance. Any poor investment performance may negatively impact our revenues and income.

We could suffer losses in earnings or revenue if our reputation is harmed. Our reputation is important to the success of our business. We believe that our Franklin Templeton Investments brand has been, and continues to be, well received both in our industry and with our clients, reflecting the fact that our brand, like our business, is based in part on trust and confidence. If our reputation is harmed, existing clients may reduce amounts held in, or withdraw entirely from, funds that we advise or funds may terminate their management agreements with us, which could reduce the amount of assets under management and cause us to suffer a corresponding loss in earnings or revenue. Moreover, reputational harm may cause us to lose current employees and we may be unable to continue to attract new ones with similar qualifications, motivations, or skills. If we fail to address, or appear to fail to address, successfully and promptly the underlying causes of any reputational harm, we may be unsuccessful in repairing any existing harm to our reputation and our future business prospects would likely be affected.

Our future results are dependent upon maintaining an appropriate level of expenses, which is subject to fluctuation. The level of our expenses is subject to fluctuation and may increase for the following or other reasons: changes in the level and scope of our advertising expenses in response to market conditions; variations in the level of total compensation expense due to, among other things, bonuses, changes in our employee count and mix, and competitive factors; changes in expenses and capital costs, including costs incurred to maintain and enhance our administrative and operating services infrastructure or to cover uninsured losses and an increase in insurance expenses including through the assumption of higher deductibles and/or co-insurance liability.

Our ability to successfully integrate widely varied business lines can be impeded by systems and other technological limitations. Our continued success in effectively managing and growing our business depends on our ability to integrate the varied accounting, financial, information, and operational systems of our various businesses on a global basis. Moreover, adapting or developing our existing technology systems to meet our internal needs, as well as client needs, industry demands and new regulatory requirements, is also critical for our business. The constant introduction of new technologies presents new challenges to us. We have an ongoing need to continually upgrade and improve our various technology systems, including our data processing, financial, accounting, and trading systems. Further, we also must be proactive and prepared to implement technology systems when growth opportunities present themselves, whether as a result of a business acquisition or rapidly increasing business activities in particular markets or regions. These needs could present operational issues or require, from time to time, significant capital spending. It also may require us to reevaluate the current value and/or expected useful lives of our technology systems, which could negatively impact our results of operations.

Our inability to successfully recover should we experience a disaster or other business continuity problem could cause material financial loss, loss of human capital, regulatory actions, reputational harm, or legal liability. Should we experience a local or regional disaster or other business continuity problem, such as an earthquake, terrorist attack, pandemic or other natural or man-made disaster, our continued success will depend, in part, on the availability of our personnel, our office facilities, and the proper functioning of our computer, telecommunication and other related systems and operations. While our operational size, the diversity of locations from which we operate, and our redundant back-up systems provide us with a strong advantage should we experience a local or regional disaster or other business continuity event, we could still experience near-term operational challenges, in particular depending upon how a local or regional event may affect our human capital across our operations or with regard to particular segments of our operations, such as key executive officers or personnel in our technology group. Moreover, as we grow our operations in new geographic regions, the potential for particular types of natural or man-made disasters, political, economic or infrastructure instabilities, or other country- or region-specific business continuity risks increases. Past disaster recovery efforts have demonstrated that even seemingly localized events may require broader disaster recovery efforts throughout our operations and, consequently, we

 

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regularly assess and take steps to improve upon our existing business continuity plans and key management succession. However, a disaster on a significant scale or affecting certain of our key operating areas within or across regions, or our inability to successfully recover should we experience a disaster or other business continuity problem, could materially interrupt our business operations and cause material financial loss, loss of human capital, regulatory actions, reputational harm, or legal liability.

Certain of the portfolios we manage, including our emerging market portfolios, are vulnerable to significant market-specific political, economic, or other risks, any of which may negatively impact our revenues and income. Our emerging market portfolios and revenues derived from managing these portfolios are subject to significant risks of loss from political, economic, and diplomatic developments, currency fluctuations, social instability, changes in governmental policies, expropriation, nationalization, asset confiscation and changes in legislation related to foreign ownership. International trading markets, particularly in some emerging market countries, are often smaller, less liquid, less regulated and significantly more volatile than those in the U.S.

Our revenues, earnings, and income could be adversely affected if the terms of our management agreements are significantly altered or these agreements are terminated by the funds and other sponsored investment products we advise. Our revenues are dependent on fees earned under investment management and related services agreements that we have with the funds and other sponsored investment products we advise. These revenues could be adversely affected if these agreements are altered significantly or terminated. The decline in revenue that might result from alteration or termination of our investment management services agreements could have a material adverse impact on our earnings or income.

Regulatory and governmental examinations and/or investigations, civil litigation relating to previously-settled regulatory and governmental investigations, and the legal risks associated with our business, could adversely impact our assets under management, increase costs and negatively impact our profitability and/or our future financial results. From time to time we may receive requests for documents or other information from governmental authorities or regulatory bodies or we also may become the subject of governmental or regulatory investigations and/or examinations. Moreover, governmental or regulatory investigations or examinations that have been inactive could become active. We may be obligated, and under our certificate of incorporation and by-laws and our standard form of indemnification agreement with certain directors in some instances, we are obligated, or we may choose, to indemnify directors, officers, or employees against liabilities and expenses they may incur in connection with such matters to the extent permitted under applicable law. In addition, we have been named as a defendant in mutual fund shareholder class action and fund derivative lawsuits, as well as in a corporate derivative lawsuit, that relate to previously settled regulatory and governmental investigations. While management believes that the claims made in these lawsuits are without merit, and intends to defend against them vigorously, litigation typically is an expensive process. Risks associated with legal liability often are difficult to assess or quantify and their existence and magnitude can remain unknown for significant periods of time. Moreover, settlements or judgments against us have the potential of being substantial if we are unsuccessful in settling or otherwise resolving matters early in the process and/or on favorable terms. Eventual exposures from and expenses incurred relating to current and future litigation, investigations, examinations and settlements could adversely impact our assets under management, increase costs and negatively impact our profitability and/or our future financial results. Judgments or findings of wrongdoing by regulatory or governmental authorities or in civil litigation against us could affect our reputation, increase our costs of doing business and/or negatively impact our revenues, any of which could have a material negative impact on our financial results.

Our ability to meet cash needs depends upon certain factors, including the market value of our assets, operating cash flows and our perceived creditworthiness. Our ability to meet anticipated cash needs depends upon factors such as the market value of our assets, our operating cash flows and our creditworthiness as perceived by lenders. If we are unable to obtain funds and financing, we may be forced to incur unanticipated costs or revise our business plans. Further, our access to the capital markets depends significantly on our credit ratings. A reduction in our long- or short-term credit ratings could increase our borrowing costs and limit our access to the capital markets. Volatility in the global financing markets may also impact our ability to access the capital markets should we seek to do so, and have an adverse affect on investors’ willingness to purchase our securities, interest rates, credit spreads and the valuation levels of equity markets. If we are unable to obtain funds and financing, or access the capital markets in a timely manner, we may be forced to incur unanticipated costs or revise our business plans, and our business could be adversely impacted.

Diverse and strong competition limits the interest rates that we can charge on consumer loans. We compete with many types of institutions for consumer loans, certain of which can provide loans at significantly below-market interest rates or, in some cases, zero interest rates in connection with automobile sales. Our inability to compete effectively against these companies or to maintain our relationships with the various automobile dealers through whom we offer consumer loans could limit the growth of our consumer loan business. Economic and credit market downturns could reduce the ability of our customers to repay loans, which could cause losses to our consumer loan portfolio.

Our business could be negatively affected if we or our banking subsidiaries fail to remain well capitalized, and liquidity needs could affect our banking business. Our bank and thrift subsidiaries are subject to significant regulation and supervision, which includes minimum regulatory capital standards. Franklin is also subject to minimum regulatory capital standards because it is a bank holding company and financial holding company registered with the FRB under the Bank Holding Company Act of 1956. Franklin and its bank and thrift subsidiaries are currently well capitalized under applicable guidelines. However, our business could be

 

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negatively affected if Franklin or its bank or thrift subsidiaries failed to remain well capitalized. For example, because our bank and thrift subsidiaries are well capitalized and we otherwise qualify as a financial holding company, we are permitted to engage in a broader range of activities than are permitted to a bank holding company. Loss of financial holding company status would require that we either cease these broader activities or divest our bank subsidiaries if we desire to continue such activities. The banking regulators are authorized (and sometimes required) to impose a wide range of requirements, conditions, and restrictions on banks, thrifts, and bank holding companies that fail to maintain adequate capital levels. The Reform Act imposes more stringent capital, liquidity and leverage ratio requirements on bank holding companies. In addition, liquidity needs could affect our banking business, which may be subject to an unanticipated large number of withdrawals as a result of a number of factors, such as changed or unstable economic conditions, adverse trends or events, business closings and lay-offs, rates paid by competitors, general interest rate levels, and returns available to clients on alternative investments. Our banking subsidiaries may be required from time to time to rely on secondary sources of liquidity, such as the sale of investment securities, FHLB advances and federal funds lines to enable them to meet such withdrawal demands. These secondary sources may not be sufficient to meet liquidity needs.

We are dependent on the earnings of our subsidiaries. Substantially all of our operations are conducted through our subsidiaries. As a result, our cash flow and our ability to fund operations are dependent upon the earnings of our subsidiaries and the distribution of earnings, loans or other payments by our subsidiaries. Our subsidiaries are separate and distinct legal entities and have no obligation to provide us with funds for our payment obligations, whether by dividends, distributions, loans or other payments. Any payments to us by our subsidiaries could be subject to statutory or contractual restrictions and are contingent upon our subsidiaries’ earnings and business considerations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

In the normal course of business, our financial position is subject to market risk, including, but not limited to, potential loss due to changes in the value of financial instruments including those resulting from adverse changes in interest rates, foreign currency exchange rates and market valuation. Financial instruments include, but are not limited to, investment securities, loans, deposits and debt obligations. Management is responsible for managing market risk. Our Enterprise Risk Management Committee is responsible for providing a framework to assist management to identify, assess, and manage market and other risks.

We are exposed to changes in interest rates, primarily through our loans, investment in debt securities, and outstanding debt. We minimize the impact of changes in interest rates related to our investments in debt securities by managing the maturities of these securities, and through diversification. We minimize the impact of changes in interest rates related to our outstanding debt by entering into financing transactions that ensure an appropriate mix of debt at fixed and variable interest rates. In addition, our banking/finance segment monitors the net interest rate margin and the average maturity of interest earning assets, as well as funding sources. From time to time, we may enter into interest-rate swap agreements to mitigate interest rate exposure arising from the loans receivable portfolio.

As of December 31, 2010, we have considered the potential impact of a 200 basis point movement in market interest rates on our interest-earning assets, net of interest-bearing liabilities, total debt outstanding and our portfolio of debt securities. Based on our analysis, we do not expect that such a change would have a material impact on our operating revenues or results of operations in the next twelve months, for each of these categories or in the aggregate.

We are subject to foreign currency exchange risk through our international operations. While we operate primarily in the United States, we also provide services and earn revenues in The Bahamas, Asia-Pacific, Canada, Europe, Latin America and Africa. Our exposure to foreign currency exchange risk is minimized in relation to our results of operations since a significant portion of these revenues are denominated in U.S. dollars. This situation may change in the future as our business continues to grow outside the United States and expenses incurred denominated in foreign currencies increase. Our exposure to foreign currency exchange risk in relation to our condensed consolidated balance sheet mostly relates to cash and cash equivalents and investments that are denominated in foreign currencies, primarily in Euro, Pound Sterling, Indian Rupee, and Canadian Dollar. These assets accounted for approximately 11% of the total cash and cash equivalents and investments at December 31, 2010. We also have exposure to foreign exchange revaluation of U.S. dollar balances held by certain non-U.S. subsidiaries for which their local currency is the functional currency. These assets accounted for approximately 3% of the total cash and cash equivalents and investments at December 31, 2010. We generally do not use derivative financial instruments to manage foreign currency exchange risk exposure. As a result, both positive and negative currency fluctuations against the U.S. dollar may affect our results of operations and accumulated other comprehensive income.

We are exposed to market valuation risks related to securities we hold that are carried at fair value and securities held by sponsored investment products that we consolidate, which are also carried at fair value.

 

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The following is a summary of the effect of a 10% increase or decrease in the carrying values of our financial instruments subject to market valuation risks at December 31, 2010.

 

(in thousands)          Carrying    
Value
       Carrying Value
Assuming  a
10% Increase
       Carrying Value
Assuming  a
10% Decrease
 

Assets

              

Current Assets

              

Investment securities, trading

     $ 541,118         $ 595,230         $ 487,006   

Investment securities, available-for-sale

       1,017,398           1,119,138           915,658   

Investments of consolidated VIEs, at fair value

       44,395           48,834           39,956   
                                

Total current assets

     $ 1,602,911         $ 1,763,202         $ 1,442,620   
                                

Banking/Finance Assets

              

Investment securities, available-for-sale

     $ 393,891         $ 433,280         $ 354,502   
                                

Non-Current Assets

              

Investments of consolidated VIEs, at fair value

     $ 943,727         $ 1,038,100         $ 849,354   
                                

Total Assets

     $   2,940,529         $   3,234,582         $   2,646,476   
                                

Liabilities

              

Current Liabilities

              

Current maturities of long-term debt of consolidated VIEs, at fair value

     $ 55,735         $ 61,309         $ 50,162   

Non-Current Liabilities

              

Long-term debt of consolidated VIEs, at fair value

     $ 886,160         $ 974,776         $ 797,544   
                                

Total Liabilities

     $ 941,895         $ 1,036,085         $ 847,706   
                                

To mitigate the market valuation risks, we maintain a diversified investment portfolio and, from time to time, we may enter into derivative agreements. Our exposure to these risks is also minimized as we sponsor a broad range of investment products in various global jurisdictions, which allows us to mitigate the impact of changes in any particular market(s) or region(s).

Our cash, cash equivalents and investments portfolio by investment objective at December 31, 2010 was as follows:

 

(dollar amounts in thousands)    Total
       Portfolio      
     Percent
of Total
      Portfolio      
     Trading Securities
Included  in
Portfolio
     Percent
of  Total

Trading
      Securities      
 

Cash and Cash Equivalents

   $ 4,321,030         54%       $ 0         0%   

Investment Securities

     </