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LEGAL ISSUES FRAUDHere’s how contractors can minimize fraud exposure.

By Scott Shaffer and Seth Snyder

Contractors face risks to their businesses – and risks even in simply completing a project – that are many and varied. Contractors are very familiar with the threat of damaged equipment, injuries, lending disputes, unexpected change orders, weather delays and jurisdictional interference, to name just a handful. Contractors survive and thrive in the construction industry because of their ability to navigate such challenges. However, there is another form of risk many tend to overlook — fraud.

Where Fraud Originates

The critical role that contractors play in the construction process makes them a target from multiple directions. Contractors can be victimized by vendors, subcontractors, employees and investment partners and even other contractors. Here are a few examples of fraud in construction.

The Fake Architect: Paul Newman was a respected New York architect. Throughout his career, he drafted dozens of architectural renderings and affixed hundreds of stamps to building plans and inspections. He designed senior centers and renovated commercial establishments. Municipalities, residential property owners and businesses alike relied on Newman to get the job done.     

There was only one issue: Newman was not actually an architect. In June, he pled guilty to six felony counts of fraud. “As we allege, for over seven years the defendant has pretended to be a registered architect, deceiving hundreds of New Yorkers —including families and senior citizens — with the sole goal of enriching himself,” said New York State Attorney General Eric Schneiderman.

Inflated Invoices: In 2013, a supplier in Georgia pled guilty to defrauding a St. Louis-based construction company to which he supplied materials. The supplier inflated the invoices to a co-conspirator who worked for the construction company and after payment was received for those invoices, the supplier provided a kickback to the co-conspirator. The two fraudsters were charged with multiple counts of mail fraud, wire fraud and money laundering.

Diversity Misrepresented: Fraudulent bidding does not necessarily require co-conspirators. Consider the case of a Chicago company whose owner falsely represented the company as a minority business enterprise to win public contracts. In reality, the company was just a shell company, designed to secure public contracts. As a result, legitimate minority contractors were cheated out of millions of dollar of work that this fraudulent minority contractor won. In connection with this fraud, the owners were charged with lying to the FBI and mail fraud.

Knowing The Risks

Contractors owe it to themselves to be cautious about fraud. Broadly speaking, such caution has two components. The first component is recognizing where fraud risk is emerging. Threats are both external and internal. Vendors and sub-contractors pose the most likely external risk. These groups will most commonly attempt to defraud contractors by overbilling for goods and services, falsifying payment applications, billing for unperformed work or ghost employees and billing improperly for overtime. Perhaps less obvious, but no less important, is being the “odd contractor out” in situations where bid rigging occurs. A contractor who enters a bidding scenario in good faith can be victimized by competitors in any of the following scenarios:

  • Complementary bidding: Some bidders agree to submit bids that are intended to be unsuccessful so that another conspirator can win the contract.
  • Bid rotation: Bidders take turns being the designated successful bidder.
  • Phantom bidding: Creating false bids for the purpose of tricking a legitimate bidder into bidding more than is needed.

Internal threats will emerge from contractors’ employees. These fraud risks can come in the form of over-reporting time, entering into kickback relationships with vendors, filing false travel and expense reports and diverting customer payments.

The second component in exercising caution regarding fraud is ensuring that a strong control environment is in place within your organization.

Contractors can protect themselves from external fraud by performing due diligence and background checks on vendors, subcontractors and employees. Additionally, construction agreements should include proper safeguards that protect your company. Contractual provisions such as access to books and records, detailed audit rights and the ability to interview individuals like the construction manager and subcontractors can help minimize these risks.

Implementing a system of internal controls is your best tool for preventing fraud carried out by employees. Contractors that are victims of internal fraud often fail to segregate duties. Segregation of duties involves reducing a single employee's control over a major business function and implementing multiple channels of review. In addition to minimizing the risk of fraud, segregation of duties minimizes the risk of unintended errors.

Other effective internal controls include creating a well-defined ethics policy, training employees, maintaining rigorous financial processes and establishing a hotline for employees and vendors for reporting fraud and abuse.

Responses to Suspected Fraud

If fraud is suspected there are a few steps to be taken. First, consult general counsel for guidance. A contractor may also want to retain an outside forensic consultant to investigate. Finally, be diligent about gathering and saving any relevant electronic or hard copy files, documents or other evidence that fraudsters may attempt to conceal or destroy.

Scott Shaffer is the co-leader of Grant Thornton’s construction advisory services practice. He has extensive experience in dealing with the complexities pertaining to revenue recognition under long-term construction accounting. He can be reached at 414-277-1560 or at [email protected]

Seth Snyder is an experienced manager in Grant Thornton’s forensic advisory services practice.  He has more than 13 years of experience providing solutions to clients including internal audit, business process consulting and remediation, contract compliance, forensic investigation and construction advisory services. He can be reached at 312-602-8338 or at [email protected]

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