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Construction fraud schemes — Prevention and detection

RFP

Construction costs are a significant and often unpredictable expenditure for colleges and universities, whether you are building or renovating academic, research, residential or other facilities. If your institution doesn’t have effective controls in place to identify risks and manage project expenditures, you may experience unexpected growth in project costs.

Moreover, the current economic slowdown and expected future economic uncertainty have increased billing abuse and fraud in the construction industry. While the majority of contractors operate with a high degree of integrity, you should be prepared to identify the common red flags that could signal when abuse and/or fraud are most likely to occur on your construction project.

The potential exposure related to construction initiatives is great, beginning with huge capital expenditures that have high visibility on financial statements, as well as growing scrutiny of institutional accountability and transparency. Therefore, preventing and detecting construction fraud or billing abuse is a necessity for your higher education institution. Following are 10 possible fraud scenarios and a few ways to prevent or detect them.

1. False application for payment

One of the most common types of construction fraud is false or erroneous applications for payment. In fact, false pay applications constitute more than half of all construction fraud incidents. Since many higher education construction projects use guaranteed maximum price contracts — rather than lump-sum — in order to allow their institutions to realize potential construction cost savings, contractor payment applications need to be monitored and scrutinized closely for errors or irregularities to protect project savings for your institution.

Pay applications can be erroneous in a number of ways, such as errors or miscalculations in line items or totals, inaccuracies in “rolling-forward” construction costs from prior periods, false invoices or other supporting documentation, or inflated rates in supporting invoices that do not reflect the actual costs incurred. Other areas within payment applications that are at risk for fraud include wage rates and categories (e.g., billing for a journeyman when an apprentice did the work), overhead and equipment rates, and contractor profit or markup formulas and fee calculations.

What you can do: Ensure that your contract includes a “right to audit” clause, and contractor payment applications and supporting documentation are closely reviewed and audited throughout the duration of the construction project. Each payment application should be reviewed in detail, including recalculation of subtotals, totals and other calculated fields (e.g., contractor markup and fees), and verification that costs from previous periods are accurately reflected. It is much easier to correct fraud or erroneous billing if the problem is identified when it occurs, rather than after the contractor is paid and time has passed.

2. Billing for work not performed

Make sure your contractor is not front-loading their payment applications with work not yet performed. For projects partially funded by federal government funds, front-loading is considered a false claim under the False Claims Act. Another related fraudulent activity is overstating units consumed, or equipment or labor usage.

What you can do: Be sure field records are kept to track the usage of unit-based items such as labor or equipment. The construction contract should stipulate that the contractor will provide time sheets or other supporting documentation for labor expenses and require that the contractor prepare a daily report that lists equipment being used, identify the operators of that equipment and note the purpose for which the equipment is being used. This will simplify auditing labor expenses and equipment rental costs. Scrutinize labor usage and equipment rental expenses monthly, and confirm that these items are actually being used and the claimed usage ties to the appropriate field records.

3. Collusion, related parties and conflicts of interest

Closely monitor the subcontractor bidding, evaluation and selection process in order to identify fraud such as bid rigging and price fixing, which can substantially increase construction costs. Schemes that fall under this category include bid rotation, bribes and kickbacks; use of related-party subcontractors without appropriate disclosures and approvals; false or inflated change orders; undervalued deductive change orders; and phantom subcontractors that consume buyout savings.

What you can do: To avoid bid manipulation, document and incorporate appropriate policies and procedures into the contract to guide the subcontractor selection process. As the project owner, prequalify and preapprove all subcontractors, making sure they bid on the full scope of work and then pick the lowest-priced, most qualified and responsive subcontractor. 

4. Change order manipulation

Change orders can be problematic if not monitored closely. Project owners and contractors often argue about whether work is “in contract” or if it requires a change order. Sometimes contractors will submit a change order for work they have not yet done without subtracting the amount for the original, displaced work. Or they may submit a change order for the cost of a new material without deducting the cost of the originally selected material.

What you can do: Ensure the contract clearly outlines the change order process. Closely monitor change orders, both at the time of change order approval and at billing. Be particularly leery of:

  • Change orders for base contract work scope
  • Change orders with missing scope descriptions
  • Change orders with excess charges
  • Deliberate omission of design specifications in the original scope of work
  • Improper price reductions for work substitution


5. Manipulation of the schedule of values and contingency accounts

Failing to update schedule of values line items when buyouts (i.e., when subcontractors are selected and pricing is finalized) occur is another fraudulent practice that is often used to conceal buyout savings. Rather than these savings reverting to the project owner, they could be repurposed by a contractor for funding the cost of errors, excess charges or fraudulent charges. Buyout and other cost savings should be transferred to a buyout savings account as they are realized and should not be left in a direct cost line item — an opportunity for an unscrupulous contractor to bill that line item for unrelated work or overcharges such as:

  • Failing to associate subcontractors or vendors with specific schedule of values line items
  • Hiding cost overruns during the course of the project
  • Using buyout savings to pay for nonreimbursable costs


What you can do:
In the contract clearly document that all buyout savings will be moved to and accumulated in a separate line item account titled “savings and losses from subcontractor buyout” or to the contingency account. Monitor the movement of these buyout funds with a tracking system, and require that you, as the project owner, approve all changes to the schedule of values.

6. Substituting or removing material

A common construction fraud scheme is to utilize inferior or lower-grade material that requires subsequent change orders to repair/replace down the road or can lead to failure of a structure or system. Problems include ordering additional material for use on a contractor’s other, unrelated projects or personal use, or using residual inventory from a prior project.

What you can do: Review and monitor materials expenditures to confirm that purchased items are consistent with the project design specifications. Periodically perform site visits to confirm that the correct materials are being installed, particularly for big-ticket items and materials that will be hidden after installation is complete.

7. Diverting lump sum charges to time and material cost

Expenses such as cleaning or general conditions may be budgeted in a lump sum amount, but the contractor may attempt to bill for these services on a time and materials basis, resulting in additional costs. This often occurs for items such as equipment charges or cleaning expenses (e.g., billing for the actual rental cost of an electric sweeper, while a lump sum in the budget should already cover that sweeper).

What you can do: Carefully review project budgets and contract terms in order to verify whether line items were budgeted on a lump sum or time and materials basis, and confirm that billing — including supporting documentation — for these items is in a manner consistent with the project budget and contract.

 Sample of fraud red flags
• Atypical application for payment form
• Missing or disorganized billing backup
• Use of contingency funds without adequate/timely explanation
• Changes in the schedule of values without adequate/timely explanation
• Subcontractor complaints regarding delayed payment
• Missing subcontractor lien waivers
• Unusual bid patterns
• Unsuccessful bidders hired as subcontractors
• Unauthorized changes in time records or missing time records
• Missing weight tickets for debris removal or soil removal
• Use of related parties and subcontractors with common ownership
8. Diverting purchases and theft of equipment/tools

Make sure you are not paying for tools or equipment not being used on your actual job site, such as those used for other projects or personal use by the contractor.

What you can do: Watch out for items purchased and shipped to a different project site or project purchases in excess of project specifications.

9. Nonpayment of subcontractors and material suppliers

Nonpayment of subcontractors, suppliers and other vendors by your general contractor can result in project delays and additional costs. Fraudulent behavior can include the contractor’s delay in providing subcontractor lien waivers; falsifying subcontractor lien waivers, which could be an indication that subcontractors have not received payment from the general contractor; or using project cash receipts to pay bills of unrelated projects.

What you can do: Unscrupulous general contractors may not pay their subcontractors in a timely manner. Require a conditional lien waiver from all subcontractors and material suppliers with each current pay application. This waives their right to file a mechanics lien on the property as long as they receive payment for services rendered. Additionally, require a full and final lien waiver from all subcontractors and material suppliers with each following pay application to cover the payment received for the previous pay application. This is confirmation that the subcontractor has received payment for services rendered and waives their right to file a mechanics lien on the property. Keep a log of all lien waivers and tie the amounts in the log to the pay application to confirm that all subcontractors and material suppliers have submitted sufficient waivers to cover the work billed in their pay applications.

10. False representations

Finally, many contracts require specific terms about the contractor’s employees, insurance, purchases, etc. For example, a contract may require that the contractor utilize a specific percentage of minority workers or local residents. False representations might include using undocumented workers; violating “buy American” requirements; or falsifying minority content reports, test results or insurance certificates. False representations by contractors may also be related to noncompliance with environmental regulations or misrepresentation of small business status. 

What you can do: To minimize this risk, make sure your contract requires that the contractor provide adequate documentation to support and confirm the contractor’s representation. Make sure to collect, review and maintain copies of this documentation.