Editor's Note: The following is the first in a short series of articles dedicated to preventing business fraud. To read the next article in the series, click here.
How would you react if someone at your company said, “Last year we lost 5 percent of our revenue due to fraud, and we’re not sure how it happened!”
The 2006 Association of Certified Fraud Examiners (ACFE) Report to the Nation on Occupational Fraud & Abuse estimated that U.S. companies lose 5 percent of their annual revenues to fraud. When applied to U.S. construction expenditures of $1.14 trillion dollars in 2005, that's $57 billion in construction industry losses, according to the U.S. Census Bureau, Construction Spending. While these figures are only approximations, they point to the magnitude of real corporate losses and highlight how important it is for the construction business owner to address the issue of construction fraud.
What Is Fraud?
Preventing and detecting fraud requires an understanding of the basic elements of fraud and why people commit fraud. The concept of fraud covers an array of irregularities and illegal acts characterized by intentional deception. There are five basic elements which are required for something to be termed fraudulent:
- A representation about a material fact...
- That is false or misleading...
- Made intentionally, knowingly or recklessly...
- Which is believed and acted upon by the victim...
- To the victim's damage.
While the above helps define what fraud is, it does not explain why it occurs. To better understand the root causes of fraud, many fraud investigators turn to Professor Steve Albrecht's "Fraud Triangle." The Fraud Triangle theorizes that people commit fraud because they: a) face a personal pressure, b) perceive an opportunity to relieve that pressure without getting caught and c) can rationalize or justify their fraudulent activities.
It is important to note that the area where an organization can do the most to prevent fraud is in the sphere of opportunity. This area is where a strong control structure and effective tone at the top will provide an organization with the most benefits.
Contract and Procurement Fraud
There are many common fraud schemes within the construction industry. Contract and procurement fraud presents a particularly high profile and negative impact on the construction industry. A majority of contract and procurement fraud schemes fall under the fraud category of "bribery and corruption." According to the 2006 ACFE Report to the Nation, corruption represents 37.1 percent of all construction fraud cases reported to the ACFE.
In cases of bribery and corruption, fraudsters wrongfully use their influence in a business transaction to procure some benefit for themselves, or another person, contrary to their duty to their employer or the rights of another. Common examples include accepting kickbacks and engaging in conflicts of interest. The following fictional case study illustrates several construction contract and procurement fraud schemes. The case study shows how contract and procurement fraud can take place in all phases of a construction contract and identifies several red flags that can be used to detect fraud when it occurs. Please note: The case study is fictional-any relationship or resemblance of the parties in the case study to actual individuals or companies is purely coincidental.
West Coast Construction (West Coast) is a medium-sized general contractor with operations in Arizona and New Mexico. West Coast was recently contacted by Technology, Inc. (Technology), an owner who wanted to build a 60,000 square foot office building in an existing Phoenix area business park. The building program included open plan office space, conference rooms, a small cafeteria and facilities for high-end IT/data and security equipment.
Technology had one part-time project manager supporting the project. The construction schedule was compressed to ten months, and Technology intended to sign an "at risk" cost-plus-fixed-fee type of contract with either a general contractor (GC) or a construction management (CM) firm because of the need to control user changes due to the personalities of the stakeholders involved. Technology conducted a brief due diligence review of regional GC's and CM's and selected West Coast based on references obtained by Technology's part-time project manager. Upon execution of its agreement with Technology, West Coast assumed responsibility for delivering the project under the terms of the agreement.
West Coast assigned one of its more experienced project managers, Joe PM, to run the project. Joe immediately began working with West Coast's contract administrator, Contract Admin, to assemble subcontractor bid packages, so that early work packages could be started as soon as possible. The bid packages for site preparation, excavation, foundations, and structure went together without any problems. The mechanical bid package, however, was a different story. Joe insisted on making a considerable number of changes to West Coast's standard contract language, as well as to the mechanical specifications. Knowing how important it is that bid specifications be clear and concise to avoid unnecessary change orders, Contract Admin thought that Joe's changes might be problematic.
Contract Admin held the bid opening for the mechanical subcontracting package, which was attended by Joe and the project engineer. Expecting at least five qualified bid proposals, Contract Admin was surprised to find that West Coast received only two proposals. Contract Admin knew that Joe had worked previously with several mechanical subcontractors that had declined to bid, and Contract Admin wondered why Joe could not have given them enough advance notice about the project to encourage them to submit additional bids. Of the two bids received, one bid was from Smith Mechanical and the other bid was from a mechanical subcontractor that West Coast used often from a neighboring state but which Contract Admin knew to be extremely busy on other work. Contract Admin determined that this subcontractor's bid was provided to West Coast as a courtesy only; they had no intent of or desire to win the bid.
During the bid opening, Contract Admin read off the submitted bids, and Smith Mechanical was the apparent low bidder. Once the bid opening was complete, Contract Admin completed a bid analysis and normalization and confirmed that Smith Mechanical would be awarded the contract. The bid normalization took much longer than expected due to the large number of exclusions and assumptions included in Smith Mechanical's bid. Contract Admin thought that many of the items should have been included in the original bid, and it was difficult to make an accurate comparison of the two mechanical bids. Joe explained to Contract Admin that this was to be expected due to the complexity of the work. Joe reassured Contract Admin that once the contract was awarded, there would be no further issues. During the negotiations with Smith, Contract Admin encountered additional push-back on some of West Coast's standard subcontracting provisions. Contract Admin believed Smith should have addressed these concerns in Smith's original bid.
Almost immediately after receiving West Coast's notice to proceed, Smith Mechanical began submitting change order requests for different piping specifications, equipment upgrades and differing site conditions. Each of these changes was expeditiously reviewed and approved by Joe. While it appeared that Joe was obtaining Technology's approval on the change orders, Contract Admin could not be sure that Technology was reviewing and approving the changes before the work was actually started.
The original Smith Mechanical subcontract was a fixed-price agreement for $1.4 million. When the contract value reached $1.9 million, Technology started raising questions and voicing concerns about the excessive cost increases to the mechanical work. In several instances, Technology refused to pay change order requests submitted by Smith, which Joe had already approved on behalf of West Coast. Technology stated repeatedly that there was no justification for over three-quarters of Smith's change order requests, all of which were submitted after the work in the field was either started or completed. When Technology's Internal Audit Department performed a contract compliance audit, it found the following deficiencies regarding the Smith Mechanical subcontract:
- The specified quality of materials/equipment was not used and the substituted materials/equipment did not meet the specification requirements.
- The required bonds and insurance certificates were not provided.
- Smith's change order requests were not priced according to the subcontract's unit price schedule for labor.
- Change order requests lacked adequate support for supervisory and administrative mark-ups and/or approvals.
- Back charges and deductive changes were not properly accounted for.
- Smith had incorporated reworked parts/equipment into the project.
- Smith claimed costs for unauthorized overtime and premium time.
- The rates submitted for equipment owned by Smith exceeded market rental rates and the maximum rates allowed by contract.
- Smith incorrectly included costs for major equipment repairs that should be covered in the base rental rate.
As pressure from Technology intensified, Contract Admin routinely found herself trying to explain the increasingly vague and confusing justifications for these increases to West Coast's management. It was at this time that Corporate Accountant contacted Contract Admin and asked her to explain the situation. Contract Admin did not have a reasonable explanation and was unable to provide acceptable answers. Consequently, Corporate Accountant asked Contract Admin to review the project records and determine what was causing the mechanical subcontract cost overruns. The next day during lunch with her good friend Schedule Guru, Contract Admin explained her situation. After listening to the specifics of the situation, Schedule Guru gave Contract Admin some information that took her by surprise. Schedule Guru explained that the CEO of Smith Mechanical was Joe PM's brother-in-law.
After researching the situation further, Contract Admin learned that over the past four years since Joe was hired by West Coast, Joe awarded the mechanical work to Smith Mechanical on each of Joe's three projects. On one occasion, Smith Mechanical was not the original low bidder but was determined to be the low bidder after Joe made some suspicious bid normalization adjustments.
On each of Joe's previous three projects, the value of the mechanical subcontract increased over 50 percent from the original contract value. This is in contrast to the average increases on the other subcontracts, which averaged from 5 to 10 percent. On Joe's previous projects, there had been no serious concerns because his projects were profitable and all subcontractor change order requests had been passed on to the owner. When Contract Admin reviewed the files for the Technology project she was able to find support for all of the Internal Audit Department's findings. What was even more disturbing was that Joe's actions, in retrospect, appeared to be orchestrated. This raised several questions:
- Did Joe intentionally modify the bid specifications so they were vague and confusing?
- Did other subcontractors decline to bid because of the known relationship between Joe and Smith Mechanical? Or even worse, did Joe or Smith Mechanical inform them of their intentions?
- Did Joe knowingly allow Smith Mechanical to substitute poor quality materials and equipment without informing the client?
- Did Joe knowingly pass through change order requests for supervision, administration and unauthorized overtime and premium time?
- Did Joe receive any direct or indirect compensation from Smith Mechanical?
This was a lot for Contract Admin to digest at once, especially given Joe's track record at the company. Contract Admin also knew that this current project was different because Technology had refused to pay and was threatening to stop all payments.
Contract Admin reviewed Technology's internal policies and procedures for procurement and found that there were no specific policies or procedures that prohibited dealing with family members or relatives. A colleague explained that the issue had never come up before, and no one had found it necessary to memorialize such policies and procedures. In addition, Contract Admin also discovered that a lot of trust had been put on Joe, as he had unlimited authority to approve and sign change orders. Joe was also responsible for coding all project expenses to the accounting system and had authorized several vendors, which were not qualified by anyone else at West Coast.
Contract Admin knew that West Coast did not perform background checks on its employees during the hiring process. Contract Admin also learned that West Coast did not require its employees to sign annual corporate compliance affidavits. It started to look like Joe had the perfect opportunity to commit procurement fraud.
Armed with all the facts gathered from her review, Contract Admin set up a meeting with Corporate Accountant to explain what she had found.
In next month's issue, we'll tell you how to deal with fraud once you've discovered it has occurred.
Clay Gilge and Erika Alvord are both directors within KPMG's Forensic Real Estate & Construction Advisory Practice. KPMG Forensic Real Estate and Construction Advisory professionals support clients by providing industry knowledge, multidisciplinary teams and experience in managing both the financial and technical aspects of major capital projects and programs. In addition to performing forensic investigations on construction projects, they assess the adequacy of project controls, determine compliance with contractual and regulatory requirements, and provide management oversight on complex and troubled projects. Gilge can be reached by phone at 206.913.4670. Alvord can be reached by phone at 503.820.6603.