Battling construction fraud in a fragile economy

Schemes that victimize owners and contractors

Financial fraud affecting project owners

A project owner is anyone that is paying for or benefitting from a construction project. Owners are corporate clients, real estate developers, government bodies, or investors that ultimately want to receive their project in exchange for a competitive and transparent price that is based on the governing construction contract. The owner’s “fair price” objective is undermined by a sham contractor procurement process or when the project’s price is inappropriately increased by change orders after construction starts.

Procurement fraud occurs at the start of a project and is commonly defined as (a) bid rigging: when multiple contractors work together to inflate the price submitted to the owner, or (b) collusion: when an insider at the owner (e.g., procurement officer or project executive) works with a predetermined contractor to funnel the contract their way. “Both types of procurement fraud ultimately mean the owner pays more for construction,” said Tim Lynch, Manager in Grant Thornton’s Construction Advisory practice. “That extra money often results in a slush fund that is used to pay off regulators, union officials, or is kicked back to the owner’s representative. Unsurprisingly, this type of behavior opens up the project to not only financial fraud but also attention from law enforcement and regulators.”

Change orders are often necessary to modify the project’s price due to a new scope of the work or unforeseen field conditions (e.g., permit revisions). However, change orders are also a common source of fraud, waste, and abuse as contractors take advantage of owners by overstating the price based on duplicative scopes or excessive costs, Koltsov said. “Change orders are the number-one way that owners overpay on their project,” he said. “Contractors recognize that change orders are effectively sole sourced and that the owner does not have leverage to hold long negotiations due to schedule pressures. This creates the opportunity for contractors to inflate pricing.”

Financial fraud impacting contractors

First, the procurement and change order fraud schemes described in the prior section indirectly affect the contractors not benefiting from the inappropriate behavior. Those contractors don’t get a fair shot at getting hired and could be negatively affected by cash flow issues if the project funds are drained. However, there is another group of fraud schemes that are perpetuated by employees or third parties that directly defraud the contractor. 

Labor and wage compliance violations are typically not top-down mandates from a contractor’s CEO or CFO. Rather, the complexity of paying construction workers proper prevailing wages, changing union rates, or in accordance with project labor agreements is typically delegated to project managers and accountants. These project-level individuals are often incentivized to keep costs down, increase the project’s profit margin, and ultimately benefit with a profitability bonus. “Direct financial incentives provide a clear motivation for someone to commit fraud, which is why companies need proper oversight to monitor those risks” Koltsov said.

Construction fraud in the news

The above schemes were allegedly brought to real life earlier this year in a $5 million indictment of 50 defendants announced by the Manhattan District Attorney’s Office. Although the case has yet to be adjudicated, the indictment alleges a coordinated effort that touches upon many of the common fraud schemes that plague the industry and described above: bid rigging, kickbacks, inflated change orders, and pressure from organized crime. More information related this case can be found here.

1. Incorporate detailed cost estimates throughout the construction lifecycle

One of the best ways to stop construction fraud is to stop the slush fund, which could be used for corrupt or improper behavior, from filling up. To combat fraud during a procurement process or with the submission of inflated change orders, owners should engage qualified cost estimators and/or quantity surveyors. These specialized skillsets will deter fraud by providing an independent line of sight regarding market-reasonable pricing, instead of simply trusting that the contractor is providing a “fair price.” Findings related to considerable price gaps should be investigated to assess if there is a misunderstanding in scope or an indicator of inflated costs. Ultimately, project owners gain confidence that they are paying market value for goods and services they typically do not have a first-hand benchmark to compare against.

2. Perform risk-based vendor due diligence

As evidenced by the ACFE data related to the increase in construction fraud, the construction industry continues to be prone to bad behavior and bad actors. To counter this risk, strategic due diligence procedures should be performed to:

• Identify potential conflicts of interest across seemingly separate entities.
• Assess performance risk due to a history of liens, safety violations, or litigation.
• Understand likelihood of regulatory risk due to hiring companies or individuals with a track record of inviting attention from law enforcement.

These proactive due diligence steps should be supported by regular site visits during construction to validate that the entities actually at the job site have been vetted.

3. Implement enhanced oversight of high-value assets

Companies that are already experiencing unacceptable levels of inventory shrink or those that regularly hold high-value items should aggressively minimize the opportunity for theft. Specifically, this should include a coordinated approach to:

• Ensure proper video monitoring and physical access controls (e.g., ID card swipes) at warehouses/storage locations.
• Rotate the individuals that are involved in the physical supply chain and logistics process.
• Implement regular inventory cycle counts to quickly identify discrepancies between physical and system records.
• Confirm that allegations are properly investigated, remediated, and communicated throughout the organization.

These steps should deter theft and reduce the financial impact by increasing the likelihood that theft is uncovered quickly.

4. Incorporate centralized oversight for labor compliance

One of the most manipulated costs on a construction project is the cost of labor. To mitigate contractual and/or regulatory violations, companies should institute a centralized or regional function to identify unexpected anomalies in labor rates and costs. The identified variances should be analyzed against relevant requirements and any findings proactively addressed with management, the project’s owner, and potentially, government-funding bodies. Companies that manage numerous projects in various jurisdictions should be proactive in this pursuit by developing a standardized and automated process to collect, process, analyze, and identify labor costs insights that require investigation.

5. Set expectations of a project cost audit

Owners and general contractors should include strong audit rights in their construction contracts to deter inappropriate behavior. Furthermore, companies should message to their third parties that an objective and fact-finding audit at key project milestones or upon completion is simply good vendor hygiene and not an allegation of fault. While there may be numerous red flags and circumstantial fraud risk indicators that companies can identify throughout a course of a project, a third-party audit can trace which companies received payment and how much they were paid. A comprehensive and objective third-party cost audit is often the most efficient way for a company to validate overbillings or unacceptable behavior.

Although challenging economic conditions might increase the motivation for fraud, these solutions and techniques can help protect businesses. The controls are just as necessary in a booming economy as they are in a recession, but the potential for fraud at this time should cause business owners to pause and make sure their protections are sound.