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