Imagine you are a scam artist. You could spend years gaining credibility with each of your intended victims. But that’s expensive and slow. Or you could play it smart, and simply rent the credibility of registered investment advisers (RIAs) who have already earned the trust of hundreds of people.

Convince the RIA that the con is legitimate and he or she will do the heavy lifting. Because the RIA has earned clients’ trust through years of prudent advice, clients will follow the RIA into the scam.

When the scamster can’t repay his victims, who remains? The RIA who staked his or her hard won credibility on an investment that turned out to be a fraud. Hundreds of RIAs are now facing civil lawsuits arising from the scams revealed in the wake of the financial crisis. (See today’s story on how more advisors are signing up for errors and omissions insurance:

And why not? The investment adviser owes his or her clients a fiduciary duty. Sure, the RIA can point to the private placement memorandum (PPM) in which the risks were disclosed.

But that is a diversion at best; every credible scam produces an impressive PPM, and no PPM discloses the risk of fraud. In this age of fraud, “I was defrauded too,” from an RIA, rings hollow as a defense.

The relevant question is, “Could the RIA have uncovered the fraud risk?” The answer is always “yes,” with help. Industry standard due diligence suffers from an undiagnosed cognitive bias called the “congruence bias.”

Congruence bias

The congruence bias leads us to seek to confirm our first hypotheses for any given situation, and exclude consideration of alternative hypotheses. The congruence bias leads most due diligence investigators to seek to confirm the legitimacy of the investment they are considering, rather than seeking to uncover a cleverly disguised fraud.

The mental approach to the investigation makes all the difference. Every decent scam artist covers his or her tracks well enough that an industry standard due diligence investigation will reveal no red flags.

But, fraud prevention due diligence considers both the “legitimate investment” hypothesis and the “clever fraud” hypothesis. Because it does so, it will find facts that the investigator considering only the “legitimate investment” hypothesis will not find.

The congruence bias can lead not only to lawsuits, but also to enforcement action from the U.S. Securities and Exchange Commission (SEC). In April 2009, the SEC charged RIA Hennessee Group LLC with violation of the antifraud provisions of the Investment Adviser’s Act of 1940. According to the SEC, Hennessee represented to its clients that it conducted substantial due diligence on all funds that it recommended.

Yet, it still led 40 of its clients into investing $56 million in the Bayou Hedge Fund fraud. Among those clients was Depauw University, which lost $3.25 million. Depauw is suing Hennessee to recover that money.

Settled with the SEC

Hennessee settled with the SEC without admitting or denying the SEC’s allegations. Before the Bayou fraud came to light, Hennessee had $1.35 billion under management. Its latest Form ADV discloses $275 million under management, an 80% decline. Those numbers make the point about the cost of inadequate fraud prevention.

Effective due diligence requires experience, and not just experience in reviewing legitimate investments for profitability. Any scam artist worth the title will make his scam look profitable. RIAs need specific experience in spotting the warning signs of financial fraud.

The situation is particularly dangerous for fund of funds advisers. Every effective fraud prevention investigation begins with a thorough investigation on the hedge fund manager. When the number of managers multiplies, as it does with funds of funds, the investigative burden multiplies.

Advisers to funds of funds cannot afford to be wrong about even one of the fund managers. The RIA’s eventual liability for the losses caused by that one manager can wreck years of otherwise good work, not to mention the reputational damage to the RIA.

How to become a student of financial fraud

At the very least, RIAs need to become students of financial fraud. They can begin that education at investorswatchblog.com, where we cover news of breaking investment scams and take lessons from each of them. By seeding his or her brain with the facts of the hundreds of investment scams that come to light each year, an RIA can be better prepared to recognize the scam that knocks on his or her door.

RIAs can begin a due diligence investigation by searching public records available on-line. PACER (Public Access to Court Electronic Records), at www.pacer.gov, allows anyone to search for federal court actions — civil, criminal, and bankruptcy — involving an investment promoter. The National Student Clearinghouse, www.studentclearinghouse.org, can verify educational credentials. Both sites charge a small fee. But, what they provide might be enough to warn an RIA away from a career-ending mistake.

For every Hennessee that leads its institutional clients into a fraud, there are dozens of smaller RIAs who lead their individual clients into frauds that do not make the national headlines, but which nonetheless ruin their clients’ plans for a comfortable retirement. RIAs can no longer pretend that, “We didn’t know” will suffice. RIAs will be held liable for missing red flags that a fraud prevention due diligence investigation would have uncovered.

For another interesting column by Pat Huddleston, see:Shame has a role to play in ending reckless conduct by stockbrokers

Pat Huddleston was an enforcement branch chief in the SEC, leading a team of enforcement attorneys in nationwide investigations of cases involving insider trading, brokerage firm misconduct, and scams of every stripe. Since returning to private law practice he has represented investors in securities litigation and arbitration. He currently serves as court-appointed receiver in SEC fraud cases, cleaning up the mess left in the wake of the collapse of those scams and working to recover assets for defrauded investors. In 2006, Pat founded Investor’s Watchdog, LLC, a due diligence company. He blogs on investment scams and investor protection issues every weekday at investorswatchblog.com. You can also follow him on Twitter where his handle is @scamdemic.