Executive Summary

The client firm determined that a focused requirements driven process, supplemented by stakeholder working groups, was the most rational approach to address the ‘build versus buy’ decision and the subsequent design and selection considerations. In this case, the scope of the effort required for the integration of a centralized risk and compliance processing module into a trade order management system platform comprising several in-house and vendor OMSs. The existing data model was separated into distinct entities supporting reference data across this platform as required for position, index, pricing and security master (SMF) data. The client required expertise to address the following business functionality and integration challenges:

  • Integration of portfolio and pre-trade risk evaluation functionality into multiple OMS workflows
  • Centralized data process with the capability maturity required for complex risk management across all instruments traded
  • Addition of an issuer schema to supplement the existing data model and to support more robust regulatory and counterparty risk testing, including complex diversification rules
  • Integrated reporting to support investment management, client and regulatory inquiry at the firm, client, fund and issuer level

During the course of an investment management platform integration project, components of a firm’s order management systems (OMS), portfolio accounting systems (PAS) and data warehouse reporting tools (OLAP) are often within the scope of a business analysis effort focused upon workflow optimization and efficiency enhancements that address portfolio risk management protocols. IT project managers and stakeholders are tasked with evaluating requirements with input from legal and compliance subject matter experts, as well as portfolio management, operations and IT stakeholders, in order to implement complex regulatory and risk solutions. In this situation, there may be little understanding on the part of any one stakeholder or group as to the best approach to the business analysis and technical requirements presented by the regulatory framework. In addition, the complexity of the functionality required to provide this system logic for many lines of business demands not only sound legal opinion and well designed business rules, but an understanding of the appropriate data sources to be used in the solution data modeling effort.

There are many risk and compliance solutions that project stakeholders will be asked to advise on in an investment management environment, depending on the firm’s line of business and the domicile of its trading activity, or that of the issuers it trades. Some of the common implementations include testing required for:

  • Counterparty and credit risk driven by client and internal requirements
  • Investment Company Act of 1940 guidelines
  • Securities and Exchange Act of 1934 reporting
  • Investment Adviser Act of 1940 (client guidelines)
  • UCITS3 (for both alternative and traditional asset managers)
  • Substantial Acquisition Rules of sovereign entities
  • Internal Revenue Code reporting


  1. The client’s legal, risk, investment, operations and compliance stakeholders were engaged in order for the project team to fully understand the scope of the trading workflows and types of testing and reporting structure required by the business
  2. Tests were broken out and analyzed with respect respective sources – SEC, client guidelines, prospectus, SAI, internal counterparty risk, etc. so that the data requirements could be defined and vetted early in the discussion
  3. The applicable workflows, business and functional requirements were vetted with stakeholder working groups during the course of the requirements gathering process
  4. Design and/or solution selection was initiated with a functionally traceable RFP process after stakeholder sign-off is completed
  5. Solution implementation and functionality testing were completed in a phased approach by OMS segment before UAT was conducted and the solution was cutover to a production environment

When approaching the requirements effort, there will necessarily be an extensive regulatory review in order to understand the specific testing that applies to the client line of business. Legal definitions and an understanding of the legislative framework are helpful when working with the language of the SEC’s mandate.


  • Investment Adviser: the “adviser” to an investment company, or mutual fund, is specifically understood, in the legal sense, to be responsible for compliance to the Investment Company Act, as well as to the investment clients they represent. The adviser to an investment company is often also its sponsor, such as a financial Advisery firm, brokerage firm or insurance company. The structure of the investment companies covered under the act may be that of an exchange traded “closed-end” fund, an ETF (however, not all of these products are issued under the 40 Act) or that of an “open-end” fund.
  • Net Assets: Net assets can be defined as the “net worth” of the fund, and is expressed as a dollar amount at the fund level, as compared to “NAV” (net asset value), which is a per share price struck daily from the same data and quoted to the public. This value is usually provided by either the accounting system of the client firm or by data fed from an accounting services provider such as the fund’s custodian. The value generally includes: the sum of paid capital, undistributed net investment income, accumulated undistributed net realized gain, and net unrealized appreciation. It is commonly used in tests related to the Investment Company Act; most OMS data schemes incorporate this data point into the test design scheme for purposes of compliance to the act.
  • Total Assets: The value generally includes: the sum of securities investments, cash, receivables, unrealized appreciation, and securities held as collateral for loaned securities. It is expressed as a dollar amount at the fund level.
  • Total Market Value: As current prices are made available, this amount represents the market value of all positions. It is expressed as a dollar amount at the fund level.
  • Diversified Fund: or “Diversified [investment] company” means a management company which meets the following requirements: At least 75 per centum of the value of its total assets is represented by cash and cash items (including receivables), Government securities, securities of other investment companies, and other securities for the purposes of this calculation limited in respect of any one issuer to an amount not greater in value than 5 per centum of the value of the total assets of such management company and to not more than 10 per centum of the outstanding voting securities of such issuer.
  • Non-diversified Fund: or “Non-diversified [investment] company” means any management company other than a diversified company, as defined above, such as a “fund of funds”.
  • Senior Securities: prior to 1940, a significant number of investment companies were highly leveraged, issuing large amounts of “leveraged” securities such as debt and preferred stock called “senior” securities; securities are not considered “senior” if the positions are covered by the fund, such as with covered call writing strategies. The SEC essentially defines transactions such as short sales, or instruments such as: options, futures, forward contracts, swaps, dollar rolls, when-issued securities & reverse repos as being senior securities; any security or investment structure that creates an obligation to someone other than the fund’s shareholders.
  • Segregated Amount: Defined as the sum of the “segregated quantity amounts” for all positions in the account. It represents the amount of cash, cash equivalents, treasury or other liquid securities held by the custodian to cover the exposure incurred from the issuance of senior securities.
  • Total Issuer Voting Shares: this quantity represents the ownership or control of an issuer, and includes the underlying voting rights of convertible securities, options and warrants. “Shares of a class” would comprise one class of issuer voting shares only.
  • Issuer Debt Outstanding: represents the amount of capital invested by shareholders & owners that is owed and payable.
  • Test Basket: such as with Sec. 5(b)(1), when a specified threshold is reached with respect to a data point at the issuer level, the instance is tracked by “placing” it in a “basket” of such cases, and an exception triggered when the total basket member percentage exceeds a stated threshold with respect to a predefined value, such as the total assets of the fund tested.

SEC Regulatory Overview for Mutual Funds

Securities Act of 1933
The first of four major securities acts that would come to shape and solidify the securities industry over the coming decades, the Securities Act of 1933 addressed the issuance of securities throughout the industry, including the shares of open-end and closed-end investment companies. It required that any person wishing to offer securities to the public register those securities and provide prospective investors with adequate disclosure in the form of an investment prospectus. (2)

Because mutual funds issue shares that constitute publicly traded stock in the investment company itself, they fall under the provisions of the ‘33 Act and its subsequent rules. The prospectus delivered to investors under the ‘33 Act defines the objective of the fund. The Investment Company Act of 1940 described below, under section 35(d) of the ‘40 Act, states that a fund may not use a name that is misleading with respect to the investments selected by the adviser. Common practice in the industry is to review all fund prospectuses and develop a monitoring system in the trade and portfolio management workflow to test for adherence to this rule (which is further described in the test analysis portion below).

Securities Exchange Act of 1934
The ‘34 Act broadly addresses rules related to the exchange of securities, as opposed to the issuance of instruments. This act also created the SEC and gave it enforcement powers with respect to federal securities laws. Specifically related to mutual fund investment management, the act requires disclosure of institutional investment manager holdings, as well as provides a framework for transfer agent registration and rules of conduct. (3)

Investment Company Act of 1940
After the stock market declines that occurred in late 1929, the mutual fund industry sustained losses that were severely compounded by the issuance of “senior securities”, used to fund the acquisition activity of the adviser, and which had put the investment company in a heavily leveraged financial position. Investor losses resulting from this financial structure, and the general market decline prompted a SEC study which determined that the governance provided by the Securities Act of 1933 was insufficient to provide the risk management that both investors and the capital markets as a whole required.

The findings of this study led Congress to conclude that the activities of persons operating mutual funds should be regulated under a new and more specifically crafted set of guidelines, which became known as the Investment Company Act of 1940, deeming it necessary given the aggregate risk undertaken by the investing public. The U.S. Congress observed in section one of the Investment Company Act, “[investment] companies are the media for the investment in the national economy of a substantial part of the national savings, and may have a vital effect upon the flow of such savings into the capital markets…”

The act “establishes a comprehensive regulatory framework for investment companies”, “designed to:

  • Prevent insiders from managing the companies to their benefit and to the detriment of public investors
  • Prevent issuance of securities having inequitable or discriminatory provisions
  • Prevent the management of investment companies by irresponsible persons
  • Prevent the use of unsound or misleading methods of computing earnings and asset value
  • Prevent changes in the character of investment companies without the consent of investors
  • Prevent investment companies from engaging in excessive leverage
  • Ensure the disclosure of full and accurate information about the companies and their sponsors.

In order to accomplish this, the Act mandates the safekeeping and proper valuation of fund assets, restricts transactions with affiliates, limits transactions that leverage the funds assets, and imposes governance regulations as a check on fund management(4). The authors of the Mutual Fund Law Handbook concluded that, “The 1940 Act’s main concern is the integrity, accuracy, and security of mutual fund investment portfolios and operations. One aspect of that concern is the Act’s attention to the financial and other records of funds and to their outside accountants.”. (5)

Investment Advisers Act of 1940
Another act requires the registration of anyone in the business of offering investment advice per se, such as the adviser to an investment company, as well as advisers to institutional and individual clients. The Investment Advisers Act of 1940 promulgates disclosure rules with respect to the adviser’s interests in all transactions it undertakes, and also contains anti-fraud provisions. More specifically, it requires that investment guidelines spelled out in the client agreement are adhered to, and prompts the SEC to inspect the operations of the adviser to ascertain that the adviser is in compliance with the act (hedge funds are currently not regulated as investment advisers or as mutual funds due to exemptions provided by federal law). (6)

Investment Company Act (40 Act) Tests Monitored in the Trading Workflow
The tests defined by the Act, which are applicable to the OMS environment, are generally related to these six categories:

  • Investments in other investment companies
  • Investments in securities-related businesses
  • Liquidity
  • Diversification requirements – industry and issuer
  • Leveraged investments
  • Names of investments companies with respect to portfolio holdings
  • Tests related specifically to money market fund credit quality and liquidity

The 40 Act has several sections that can be tested, and these are too numerous to be listed here in their entirety. Here is an example from one section:

Section 18 governs the capital structure of investment companies. Section 18(f) in particular, prohibits issuance by the investment company, of “senior securities” unless a fund offsets the obligation. The SEC defines “senior security” broadly based on the potential obligation to someone other than the shareholders. Prior to the act, excessive issuance of these securities had greatly increased the speculative nature both the common stock and the investment portfolios of investment companies.
However, two exemptions exist to this restriction, provided that either:

  • a segregated account is maintained, consisting of cash, government securities, or high grade debt securities, in an amount equal to the obligation;
  • by owning or having the right to acquire the asset that the fund is required to deliver, such as with a “covered-call” writing option strategy.

Bank borrowing is allowed, so long as the coverage for all borrowing is, at minimum, 300% of the amount borrowed. (7)

These tests can be simple to fairly complex to code in practice. For example test logic for a Section 18 borrowing rule may be structured in this way:
Test Name [field data in OMS]: “At least 300% asset coverage for borrowing.”
Test Description [field data in OMS]: “1940 Act Requirement for diversified funds – Sec 18(f). Open-end investment companies should not issue “senior securities”, but a fund may borrow from a bank provided it maintains at least 300% [net] asset coverage.”
Rule Analysis Logic: Net assets (NA) plus borrowing must be at least 300% of borrowing, so NA must be at least twice borrowing, so borrowing must be no more than 50% of NA.
Formula: [absolute value of borrowing at fund level] / [NA, where exception is triggered when 50% of NA is exceeded] The application of tests related to the above categories can be engineered to operate in a “pre-trade” mode or a “portfolio” mode. A pre-trade mode evaluation is best understood as a test that calculates the position related “bucket” (multiple concurrent trades may be evaluated at once, system-wide) combined with the settled portfolio position quantity prior to the order being placed.

A portfolio (holdings) mode test is a component calculation of this test that is evaluated when trades have settled and also to prepare the data for pre-trade evaluations in the following trade cycle. The application of any test and test mode varies with the requirements of the adviser and the specific fund types, instruments types and domicile of the custodied assets. If the fund adviser requires these tests in the pre-trade workflow, the data quality must be reliable in order to have the confidence required to configure and apply tests. Otherwise, trading performance impacts would result if the platform were designed to limit trader control over the order when a test fails.


Robust financial risk and compliance management is good business. Talented and effective leaders that understand the scope of the securities industry often manage operations that effectively manage risk and compliance controls. Additionally, risk management tools that focus on credit exposure, issue and issuer concentration and firm-wide leverage can save firms from realizing substantial trading losses and the consequences of inadequately managed client and firm related risk exposure.
These are the common results of a successful implementation:

Leveraged expertise

  • Prospectus, SAI, guidelines, foreign entity, and IRS business rules analysis
  • Portfolio management business rules, functional requirements and workflow analysis
  • Request for proposal, vendor evaluation and testing scenario analysis
  • System configuration, functional integration and user acceptance testing


  1. Securities and Exchange Commission, Division of Investment Management website (www.sec.gov). SME, legal & industry interpretations appended.
  2. “Protecting Investors: A Half Century of Investment Company Regulation”, United Sates Securities and Exchange Commission, Division of Investment Management, May 1992
  3. Ibid.
  4. Clifford E. Kirsch, Investment Adviser Regulation – Step by Step Guide to Compliance and Law, (New York, Practicing Law Institute, 2006 ).
  5. James M. Storey & James M. Clyde, Mutual Fund Law Handbook (Little Falls, NJ: Glasser LegalWorks, 1998)
  6. Alan R. Palmiter, Securities Regulation – Examples and Explanations [Cases], (Aspen, CO: Aspen Publishers, 2002).
  7. Ibid, p.5
Published On: September 15th, 2022 / Categories: Uncategorized /