Construction fraud — it happens in owner-contractor and contractor-subcontractor relationships, and it's committed by employees of any type or size of contracting firm. Last year’s Kroll Annual Global Fraud and Risk Report showed that 70% of construction companies experienced at least one incidence of fraud in 2016. The number was 75% in 2015, so a 5% reduction of such a high percentage isn't much to celebrate.
Most instances of fraud go undetected, according to Frances Haynes, attorney at law firm Lewis Roca Rothgerber Christie’s Phoenix office, and only are detected when there are money problems or a dispute toward the end of a construction project. “That’s typically when you find out something’s gone wrong,” she said. “Problems become more magnified.”
Plus, said attorney Kevin Kolton, deputy group leader of the construction practice at Schiff Hardin in Chicago, “In good times, money hides a lot of problems.”
Kenneth Roberts, Schiff Hardin’s construction group practice leader, said that nine times out of 10, contractors that commit fraud think there’s a basis in the contract for what they’re doing and that they’re just stretching those boundaries.
But despite the acknowledgment that fraud happens too frequently, it’s difficult proving intent, which needs to be established to pursue a successful legal case. According to Kolton and Roberts, several elements have to exist to prove an act is fraudulent. In such a criminal case, and using a contractor’s payment application as an example, those would be:
- A false statement of material fact (i.e. a payment application that includes amounts for work not yet performed);
- The defendant’s knowledge that the statement was false (the contractor knew the payment application included amounts for work not yet completed);
- The defendant’s intent that the statement induce the plaintiff to act (the contractor submitted an incorrect payment application so that the owner would pay those unearned amounts);
- The plaintiff’s reliance on the statement (the owner used the payment application as the basis for determining payment to the contractor); and
- The plaintiff’s damages resulting from reliance on the statement (the owner paid for work that was not provided).
Some instances of wrongdoing, Haynes said, constitute fraud at the outset, but a company could argue that it didn’t know what it was doing was fraudulent. Again, she said, intent is hard to prove.
As in the example above, some companies will bill the owner for work that has not yet been performed or for materials that have not yet been delivered to the project site. Sometimes this is because the work is underway at the time of the application and the contractor or subcontractor is jumping the gun a bit.
It could also happen when the company is short on funds and views over-billing as an advance of sorts, allowing it to catch up on bills and meet payroll obligations, but intending to catch up with the work. But other fims intend to cheat the owner. For example, Kolton cited the case of an electrical contractor running short on cash who billed for the installation of electrical outlets, but installed nonfunctioning outlet wall plates instead with no wiring.
Many times, along with pay applications — both from contractors and subcontractors — come statements, also called waivers of lien, from subcontractors, sub-subcontractors and suppliers stating they’ve been paid up to date by the company submitting the application. Haynes said contractors behind on payments might be tempted to forge signatures to make it appear all bills on a certain project have been paid. This has become more commonplace, Haynes said, in the wake of electronic submissions via email or fax, where an altered form is not as easily detectable.
One way to safeguard the payment application process, Haynes said, is to require notarized signatures on lien waivers. Although a headache, a notarized original is harder to alter.
Some contractors and subcontractors, Kolton said, also substitute inferior materials for those originally specified, but don't give the appropriate credit on invoices to their customers.
As far as change orders, he said, when the contract calls for direct costs only to be used in billings for extra work, some contractors try to pad the numbers by altering their labor rates to include profits. Some contractors, he noted, are bold enough to enter into a lump-sum contract, and then try to convince the owner that some of the work covered should be billed on a time and material basis.
Roberts and Kolton said there are several controls that an owner or contractor can institute to make it harder to perpetrate fraud, including:
- Establishing strict project controls and adherence to the contract and maintaining adequate oversight throughout the construction process.
- Understanding what the scope of work is for each contract and requiring that the contractor break down the scope into a trackable schedule of values.
- Understanding what the audit rights in the contract are.
Have someone capable of doing so review pay applications to ensure waivers are legitimate, and to determine if there are anomalies in order to detect billings that represent undelivered or substandard materials and incomplete work.
Wrongdoing and theft can also be perpetrated by trusted employees, either on their own or with the help of a related outside party, like a vendor.
In one scenario, said attorney Jonathan Bondy of Chiesa Shahinian & Giantomasi in New York, a trusted employee, who is in charge of both accounts receivable and accounts payable, could set up himself as a fake vendor and start issuing checks that are low enough in dollar amounts not to raise suspicion. However, he said over time those small, illicit payments can add up to significant amounts.
There are also instances, Bondy said, where a legitimate vendor will make an agreement with an employee to over bill and then the two will split the difference.
No matter how small, construction companies should try to have some third-party oversight, the attorney said — even if that means having someone outside of the bookkeeping department reconcile the bank statements every month or requiring two signatures on checks that are more than a certain dollar amount. In addition, a steady eye on the project budget will reveal overages if more materials are being ordered than should be.
The bottom line is that an organized system of paperwork and cross-checking can reduce the chances of undetected fraud. Best practices, Roberts said, are sufficient project controls, as well “trust through verification.”