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Managing Fraud Risk: Identifying and Preventing Corruption Schemes in Construction Companies

Fraud in the Construction IndustryAttributed to ACFE – Association of Certified Fraud Examiners – 2008 Report to the Nation

About the ACFE Survey 

  • Report done every 2 years, initially done in 1996.
  • Based on surveys of CFE’s on cases investigated and resolved.
  • 2008 report based on 959 cases across the country.
  • Most authoritative survey of its type

CFMA – Fraud in Construction: Occupational Fraud

Definition: "The use of one's occupation for personal enrichment through the deliberate misuse or application of the employing organization's resources or assets"

Association of Certified Fraud Examiners – 2006 Report on Occupational Fraud and Abuse

Summary of Findings 

  • Occupational fraud schemes frequently continue for years before they are detected.
  • Corruption is most common form of occupational fraud (27%), fraudulent billing schemes (24%) second.
  • Data shows that fraud is more likely to be detected by a tip than by audits, controls, or any other means.
  • Implementing major controls appears to reduce the median loss.
  • Industries most vulnerable - Banking and Financial Services (15%), government (12%) and healthcare (8%).
  • Small businesses are especially vulnerable to occupational fraud. Same for 2006 survey. Check tampering and fraudulent billing were the most common small business fraud schemes.
  • Lack of adequate internal controls was most commonly cited
  • Most victim companies modified their internal controls AFTER discovering they have been defrauded.
  • Occupational frauds were most often committed by the accounting department or upper management.
  • Fraudsters are generally first-time offenders. Triangle of Opportunity, Incentive, Rationalization.


 

CFMA – Fraud in Construction
Occupational Fraud
 
Corruption Asset Misappropriation Fraudulent Statements
Conflicts of Interest
• Purchasing Schemes
• Sales Schemes
Bribery
• Invoice Kickbacks
• Bid Rigging
Illegal Gratuities
Economic Extortion
Cash
• Larceny
• Fraudulent
    Disbursements
• Skimming
Non Cash
• Misuse
• Asset Requisitions / Transfers
• False Sales / Shipping
• Purchases / Receiving
Financial
• Asset / Revenue
    overstatement / understatement
• Timing differences
• Fictitious Revenues
• Concealed liabilities and expenses
• Improper Disclosures
• Improper Asset Valuations
Non Financial
• Employment
    Credentials
• Internal and External
    Documents






Detection of Fraud Schemes

 

  • TIP or COMPLAINT - Nearly half of cases in 2008 study were uncovered by a tip or a complaint from an employee, customer, vendor, or other source.
  • INTERNAL CONTROLS AND INTERNAL AUDITS
    • Most helpful in government and public companies
     
  • DISCOVERY BY ACCIDENT
    • Most common in private companies
     
  • EXTERNAL AUDIT
    • Most helpful for private companies
     





TIPS
Greatest source of tips is from other employees

  • Employees should be trained to understand fraud and how it harms the organization
  • Encourage employees to report illegal or suspicious behavior
  • Reassure employees that reports may be made confidentially and the organization prohibits retaliation against whistleblowers

30% of Tips came from external sources – encourage customers / vendors / stakeholders to report improper conduct

Small Businesses 

  • Business with less than 100 employees generally have fewer or weaker controls in place, primarily due to lack of personnel
  • Small business frauds are more likely to be detected by tip or accident
  • Room for improvement in their proactive detection efforts.


















CFMA – Fraud in Construction

Occupational Fraud


Definition: "The use of one's occupation for personal enrichment through the deliberate misuse or application of the employing organization's resources or assets"  

Association of Certified Fraud Examiners – 2006 Report on Occupational Fraud and Abuse

Possible perpetrators 

 

 

  • Clerks
  • Managers
  • Executives
  • Owners/Principals

Conclusion: Anyone in the company

Categories 

  • Misappropriating assets
  • Corruption
  • Falsifying financial statements

Is it fraud or abuse?

 

  • Clandestine
  • Fiduciary violation
  • Committed to obtain financial benefit
  • Costs company assets, revenues, or reserves

Why do employees commit fraud?

Cressy’s Fraud Triangle:

 


Opportunity
  1. Ability to commit fraud
  2. Get away with it
Incentive
  1. Greed/desir
  2. Pressure/need
Rationalization
  1. Crucial element
  2. Justifies act

Observations

 

  • Opportunity – Area where the employer has the most control
  • Incentive – Employer cannot control but may be observable
  • Rationalization – Grayest area; hardest for employer to discern


Categories

 

  • Misappropriating assets
  • Corruption
  • Falsifying financial statements


Frequency of Fraud Schemes:



Occupational Fraud - Median Loss:



Corruption

Definition: Employee wrongfully influences a business transaction in order to procure some benefit for themselves or another person.

Categories

 

  • Bribes 
  • Economic extortion 
  • Illegal gratuities 
  • Conflict of interest 

Corruption - Bribes

Definition of Commercial Bribery: A business transaction where something of value is offered to influence a business decision. 

  • Differs from traditional bribery only in relation to what is being influenced.


Categories

 

  • Kickbacks – Undisclosed payments made by vendors to employees of purchasing companies
  • Bid rigging – Employee fraudulently assists a vendor in winning a contract


Kickback scheme commonalities 

  • Involve collusion between an employee and an outside party (vendor)
  • Normally attack the purchasing function
  • Consequently, purchasing employees are usually involved


Kickback scheme examples

Diverting additional business to a vendor

  • Market pricing (where’s the harm?)
    • No market incentive re: price and quality
    • Incentive to recoup kickback
    • Usually turn into overbilling scheme
     

Overbilling

 

  • Vendor submits inflated invoice
    • Higher than market pricing
    • Shipped less product or lower quality product
    • Fictitious invoice
     
  • Employee may or may not have approval authority

Kickback payments

 

  • Always a two-sided transaction
  • Cash for kickbacks usually diverted to "slush fund"
    • Non-company account
    • Company checks to fictitious entity
    • Paying false invoices
    • Payments often charged as “fees” for consulting or other services
     


Bid rigging — In the context of bribes, bid rigging involves and illegal payment to an employee to assist a vendor in winning a contract.

  • Employee fraudulently assists a vendor in winning a contract
  • Subverts the bidding process
  • Victim company’s employee tends to have influence in or access to bidding process
  • High stakes in construction market (particularly in bad economic times)


Bid rigging categories:

Presolicitation phase

  • Needs recognition schemes
  • Specification schemes
    • Tailoring/narrowing
    • Prequalification requirements
    • Vague specifications
    • Bid splitting
    • Advance look
     

Solicitation phase

  • Bid rotation
  • Fictitious suppliers
  • Restricted bid period

Submission phase

  • Abuse of sealed bid process
  • Advance or inside information

Corruption – Economic Extortion 

  • Flip side of bribery scheme
  • Employee demands payment to select vendor
  • Pay up or else
  • Transactionally the same as a bribe


Corruption — Illegal Gratuity — A gift given by a party who benefitted from a decision to the person who made the decision.

  • Similar to bribe, but usually occurs after decision
  • Often morph into bribery schemes
  • May be a way to determine openness to a bribe

Generally follow a pattern

  • Gifts, travel & entertainment
    • Construction work, new windows, finished basement
     
  • Cash
  • Checks/financial instruments
  • Hidden interests
  • Loans
  • Asset leases/sales below market
  • Promises of favorable treatment


Corruption — Conflicts of Interest — Situations where an employee, manager, executive or partial owner has an undisclosed economic or personal interest in a transaction that adversely affects the company.

  • May violate employee’s fiduciary duty owed to employer
  • May violate terms of partnership, ownership or joint venture agreement terms
  • Not all conflicts are economic
  • Conflict vs bribery
    • Approving fraudulent invoice for:
      • Kickback, then its is bribery
      • Fraudster’s company, then conflict of interest
       
    • Transaction mechanics are the same
     

Schemes

  • Purchase schemes
    • Inflated prices
    • Rig bids
    • False invoices
     
  • Sales schemes
    • Under-market pricing
    • Write-off A/R
     
  • Compete with employer
    • Divert employer’s clients to employee’s company
     
  • Unique assets transactions
    • Usually involves land, buildings or large equipment
    • Fraudster owns an interest in the asset
    • Fraudster impacts negotiations in his favor
     
  • Land flips
  • Resource diversions
    • Fraudster uses employer’s materials, equipment, or labor to assist his own company
     

Corruption — Detection

Most corruption schemes detected through:

  • Tips from honest employees
  • Tips from disgruntled co-workers
  • Tips from disgruntled outsiders
  • Tips from disgruntled co-conspirators

Tip allegations need to be validated through investigation

Red flags

  • People
  • Transactions

Red flags related to fraudsters

  • Bribe takers/embezzlers
    • Big spender
    • Gift taker
    • Odd couple
    • Rule breaker
    • Complainer
    • Genuine need
     
  • Bribe givers
    • Gift bearer
    • Sleaze factor
    • Too-successful bidder
    • Poor products or services
    • One person operation
     

Red flags related to transactions

Purchasing

  • Material reorder points routinely missed
  • Use of same vendor(s)
  • Purchasing policies not followed or consistently bent
  • Analytics
    • Pricing trends year to year or project to project
    • Trends relative to market pricing
     

Bidding

  • False statements in bid docs
  • Sign-offs by unauthorized individuals
  • Shortcutting or bypassing review proceduresv
  • Bidders involved in developing bid docs
  • Unusual variations in specification or contracts
  • Short bid periods
  • Vague terms in solicitation package
  • Improper contact (business or social) with a bidder
  • Acceptance of late bids/back dating of bids
  • Changes to bid after all bids received (intentional errors)
  • Patterns in bid awards

Analytics and corruption indicators

  • Develop a body of historical data
    • For each bid received
    • For each bid awarded
    • Actual costs for each contract
    • By CIS number
    • Cost/SQFT (installed)
    • Unit prices
    • Material prices by purchase unit
     
  • Trend and compare historic data
    • Year to year
    • Project to project
    • By sub/vendor
    • By market
    • By work (new, rehab, repair)
    • By purchasing person
    • Against competitors or industry metric
    • Versus market pricing
     
  • Look for departures from trends and anomalies

Conflicts of Interest

  • Very difficult to uncover
  • Discovery methods
    • Tips
    • Observation
    • Analysis
     

Tips

  • Other vendor complaints
  • Employee complaints re: service or quality

Observation

  • Lifestyles
  • Financial problems
  • Personal problems (divorce, addictions, relationships)
  • Work habits (it takes time to run a side business)
  • Involvement in areas of company outside of job duties

Analysis

  • Periodic comparison of:
    • Vendor and employee addresses
    • Vendor TIN’s and employee SSN’s (including listed relatives
    • Vendor phone numbers to all employee phone numbers
     
  • Full investigation of vendor ownership done and filed with periodic reviews/updates
  • Periodically interview purchasing employees to identify vendors receiving favorable treatment
  • Credit and background checks
    • Must have signed employee permission form on hand
    • State laws vary, so review with counsel
     





Stimulus Monies — ARRA — American Recovery and Reinvestment Act of 2009

Purpose: Stimulate economy by accelerating "shovel ready" projects

Issues:

  • Applies FAR to Stimulus projects
  • Applies other Federal requirements to Stimulus projects
    • NEPA compliance
    • Buy American
    • Whistleblower
    • Federal fraud and false claims
    • Contractor reporting
    • Federal oversight
     

NEPA Compliance

  • National Environmental Policy Act
  • Required even if project has completed an environmental review
  • NEPA compliance issues could create delays to construction start
    • Adjust your schedules, budgets and/or estimates
     
  • ARRA requires reviews to be "completed on an expeditious basis"
    • Fed will likely use a streamlined process
    • Even so, delay impacts should be planned for
     

Buy American

  • Generally:
    • All steel, iron and manufactured goods produced or manufactured in U.S.
    • "Unmanufactured" construction material must be domestic (e.g. sand)
    • All components or subcomponents of manufactured construction materials can be foreign
      • Normally 50% must be domestic
       
    • Contracting Officer must mark-up non-compliant bids by 25%
    • Any waiver should (must) be obtained prior to submitting offer
     

Whistleblower Protection

  • Applies to all "non-Federal" employees
    • State & local governments, contractors and subs
     
  • Offenses expanded from fraud to also include:
    • Mismanagement, waste, abuse, substantial danger to public health, or violation of law or regulation
     
  • Whistleblower must have only "reasonable belief"
  • Employee has low burden to prove reprisal
  • Employer must show “clear and convincing evidence” that action against employee would have occurred regardless of whistleblower status
  • Economic times may cause employees blow whistle to avoid firing or layoff

Fraud and False Claims

  • Legislation
    • Passed into law
      • Fraud Enforcement and Recovery Act (5/09) ("FERA")
       
    • Pending
      • H.R. 1788 False Claims Correction Act
      • S. 458 False Claims Clarification Act
      • vH.R. 1667 War Profiteering Prevention Act
       
     
  • FERA
    • Protects TARP and other stimulus monies
    • Authorizes funding to hire fraud prosecutors and investigators
    • Extends False Claims Act to any false or fraudulent claim for government money or property whether or not:
      1. Claim is presented to government employee
      2. Government has physical custody of money
      3. Claimant intended to defraud the government
       
     
  • Pending House and Senate bills
    • Essentially apply FERA expansion of the FCA to all federal contracting
     
  • War Profiteering Prevention Act
    • Bill is still in Committee
    • Aimed at U.S. companies with government contracts to provide goods and services overseas
    • Establish criminal penalties for bid rigging, fraud, gross overcharging, delivery of faulty military parts, and environmental damage
     

Enhanced Quarterly Reporting

  • Stimulus contracts in general require more extensive reporting and extend reporting to subs and material suppliers
  • New FAR rule 52.204-11
    • Applicable to any contract fully or partially ARRA funded
    • Requires quarterly public on-line reporting of ARRA expenditures
    • If prime or 1st tier sub, disclose names and total compensation of five highest-paid officers
    • Reporting likely to be covered by FCA provisions
    • Allows competitors access to ongoing projects’ cost and status
     

Enhanced Oversight

  • Allows GAO access to prime and sub records
  • Permits GAO to interview officers and employees of prime and subs
  • IG powers expanded only to the prime contractor
  • Contractors should:
    • Increase internal and document controls
    • Follow FAR to the letter
    • Assure that consultants (CPA’s, attorneys and claims consultants) aware of changes to laws and regulations
    • These new powers combined with new reporting means project performance issues need to be dealt with proactively
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