Fraud is pretty common in the construction industry. That’s not to say that the industry is full of bad people – rather, it’s just an industry where the few bad apples that are determined to commit fraud might have an easier time getting away with it. This is largely because of the very nature of the work: the average construction project is a study of controlled chaos. Read on as we take a closer look at construction fraud, and how to combat common types.
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Understanding the Most Common Types of Construction Fraud
Fraud seems to happen more often in construction than in other industries, and it’s easy to see why. A typical project will often have a number of different project participants with tons of moving parts. Construction financing and the current system of payment are both a mess. And communication and transparency on many construction sites are practically non-existent. On top of all this, there are an unlimited number of ways fraud can occur at any point during a construction project.
Read more: 6 Financial Controls to Prevent Fraud
But it’s impossible to detect fraud or develop effective means of avoiding it without understanding the most common types of fraud and how to identify them before it’s too late. Let’s look at some common forms of construction fraud.
Unsurprisingly, bid-rigging occurs during the bidding process. It involves any type of price fixing or collusion amongst the prospective contractors and subs. This form of construction fraud occurs whenever contracts are awarded by soliciting competitive bids.
When bidders coordinate beforehand, or when the bidding is somehow tainted, it undermines the whole process (and it’s also illegal). If you keep up with current events, then you know that it’s common for bid-rigging schemes to involve public authorities.
There are four main bid-rigging tactics that may be employed:
1. Bid Suppression
Bid suppression is pretty self-explanatory – it’s when bidders are threatened, bribed, or otherwise convinced not to bid on a particular job. It could be through lucrative payouts, mutual agreement, or even by threat of violence or some other action.
2. Complementary Bidding
Similar to bid suppression, but with complementary bidding, competitors predetermine who will win the bid. The other bidders will submit unreasonably high bids or bids with unacceptable additional terms to enhance the illusion that there is genuine competitive bidding.
Honestly, it can be seen as a creative version of bid suppression.
3. Bid Rotation
Each participating competitor will take agree to take turns to be the winning/lowest bid on a project. They will know each others’ pricing to guarantee the desired outcome.
4. Promising Subcontracts in Exchange for Coordinating Bids
Another potential way bids might be fraudulently rigged is for one party to convince other bidders to intentionally lose their bids or withdraw in exchange for large subcontracts on the job.
So, where there’s only one winner to the contract at hand, whoever wins that contract might promise their contemporaries large subcontracts under that agreement.
How to Identify and Combat Bid Rigging
When soliciting bids, include non-collusion affidavits as a bid document requirement. These documents should be clear and standardized to help with evaluation.
You should also reserve the right to reject any and all bids if you feel there is unfair competition. Sure, this safeguard might be ignored, but it will provide extra ammunition in the event fraud is discovered on the project – and it might make a bidder think twice if they’re participating in a fraudulent scheme!
There are a few red flags to look for when accepting bids. Be sure that it isn’t the same contractor that is consistently winning bids. Or, look out for contractors that bid and never win (due to unusually high bids or questionable proposed terms).
Other practices may cause concern after the bid is accepted – like when the losing subcontractors are hired for other roles on the project.
Some of these issues can be avoided by having a solid pre-qualification procedure for all potential bidders. Prequalifying contractors and subs can help weed out potential problems early on.
Be sure that all of your request and selection documents are clear, simple, and standardized to help in the evaluation process. Any red flags should be avoided.
Falsifying Payment Applications and Invoices
The most common type of fraud in the construction industry is the falsification of payment applications and invoices. This accounts for over half of all fraud in the industry, and it can occur at any level of the payment chain.
The following are the four most common methods of manipulating payment applications.
1. Inflating Labor or Material Costs
This can occur anywhere along the payment chain. Those on the bottom of the chain may inflate costs or percentage of work completed. By doing so, they’ll boost their profit margin on the job.
Plus, a party may try to hide or exaggerate what’s being paid to their subs and suppliers – pocketing the difference once payment is made. In a worst-case scenario, by the time these payment apps reach the top level, it’s possible that the labor or materials costs might fluctuate multiple times.
2. Payment Applications That Fall Outside the Scope of Work
No matter the size of the project, the top of chain parties will be receiving any number of payment applications, processing them as they come in. But this is where attention to detail can protect you from fraud.
Parties might manipulate payment apps by completely make them up, or by adding additional work to their original scope.
3. Improper Wage Rates or Categories
Many times, a sub will try to charge a journeyman rate for work that was performed by an apprentice. Or they may charge you equipment rental fees for equipment that they already own.
4. Billing for Unperformed Work
This type of fraud is pretty self-explanatory, and hopefully easier to keep in check with proper oversight. Contractors and subs can overstate the units of production, labor, or equipment actually used on the project.
A Note about Federal Projects and the False Claims Act
Ok. This isn’t a type of construction fraud – it’s an additional warning! When fraud occurs on a federal project (or even just a project utilizing federal funds), construction fraud takes on a lot more risk. What’s more, if your subcontractor commits fraud when submitting a pay app or invoice, but you pass along their fraudulent documentation up the chain, you could even get caught up in the mess despite being totally innocent. The False Claims Act means business.
How to Combat Falsified Pay Apps
Again, a clearly defined scope of work can help reduce any misunderstandings or misrepresentations when it comes to payment applications. The project manager should always keep a payment app checklist and request any receipts or invoices associated with the labor or materials that are claimed.
Another way to reduce the possibility of fraudulent payment applications is to schedule them out in advance and reconcile each request with the issued work orders and job cost reports. You should always pair each payment app with a work order, never authorize a payment just because an application is received.
Manipulating Change Orders or the Schedule of Values
Change orders are usually given less scrutiny than the initial bidding and contract award process. This makes change orders very dangerous and susceptible to fraud if not properly monitored.
Change orders can be issued for a base contract’s work scope or not include a proper scope of work at all. They can include excess charges or improper price reductions for substituted work or materials. Change orders can stack up fast, and fraud can breed quickly in the chaos.
This can even occur before actual construction even begins. Consider a contractor who is acting in collusion with the contracting party. They could submit an extremely low bid, then once awarded the contract, the official will approve multiple change orders to increase the contract price, allowing the contractor to recover a profit quickly and continue to line the pockets of project officials. Seriously, it happens!
The schedule of values is another aspect of a project that could be manipulated. Failing to regularly update your schedule of values, can lead to problems down the line. When changes or buyouts are made, this can increase the likelihood of cover-up or fraud.
How to Combat the Change Order / SOV Fraud
Any time a change order is issued, be sure to track and document any changes. The schedule of values is the financial backbone of a construction project.
When change orders are issued, the effect on both the schedule of values and the contingency accounts should be taken into consideration. Another useful tactic is to compare the change order signatures with the actual date of completion, to be sure you are not being over-invoiced for labor hours.
Diverting Lump-Sum Costs to Costs for Material and Time
This may happen when a project’s budget includes an item (like a piece of equipment) in its lump sum calculation, but then that item is also billed later on by a contractor or sub on a time and material basis. Since this work was already accounted for in the budget, then billed again later on, it results in double-dipping.
How to Combat Lump-Sum Cost Diversion
The best way to protect yourself against this type of fraud is close monitoring and oversight on the project. Before sending out payments, be sure to compare the actual costs to the budget on a line item basis. Always refer to your schedule of values!
Substitution or Removal of Materials or Equipment
Another common form of construction fraud is through the substitution, removal, or simple exaggeration of materials being used on the project. For one, it’s possible that a contractor or subcontractor promises to use a certain grade or brand of material, or a certain piece of equipment, then substitutes it with a cheaper one – pocketing the difference.
Sometimes this can be an honest mistake on the part of a subcontractor who didn’t read the specifications or who thinks they’re making a better decision than the architect. This type of fraud is a simple one for subcontractors to avoid; simply make a substitution request.
Another way to take advantage might be to over-order materials or equipment, then move the excess from the project site for use on another job – causing the customer to pay for materials they won’t even benefit from.
Finally, contractors and subs might simply exaggerate what materials or equipment have been ordered or delivered to the job site in order to be reimbursed, then pocket the excess over what was actually purchased.
How to Combat the Materials / Equipment Fraud
Anytime material or equipment is delivered to the job site, not only should you request receipts from your subs, but it’s also a good idea to get confirmation of the quality (or brand) and quantity directly from the supplier.
Trust, but verify. That way you know when and which materials were delivered. Also, keep track of any and all equipment needed for the project. Whether it be equipment already owned, purchased, or leased – keep an accurate, running inventory to keep track.
A false representation is sort of a catch-all category of contractor or construction fraud. This occurs anytime you receive something different from what you paid for. This is achieved in a number of different ways.
Contractors or subs could be charging for more laborers than the job actually took. They might claim that they were using a team of skilled workers, and may have been using undocumented workers for cheaper labor.
This could even be silence when failing to comply with any building or environmental regulations.
How to Combat the False Representations Fraud
A simple way to combat any general false representations is through audits. Having a right to audit clause not only helps control the bottom line, but keeps your subcontractors aware of your presence on the project. The audit clause should include the right to conduct surprise onsite audits and access to your subcontractor’s books in case you smell trouble.
Simple, Effective Ways to Protect Against Any Type of Construction Fraud
The best way to combat fraud on a construction project is careful oversight by both the owner and the management team. Here are a few easy ways to protect your team from fraud.
Do your due diligence when hiring anyone to a project. Try to hire local and established contractors to reduce the possibility of fraud. Perform background checks on everyone, get references, or at the very least do a quick Google search. Inform yourself about the local market conditions, availability of competition, and bid pricing of comparable projects in the area. It’s also a good idea to familiarize yourself with their business structure. Many times contractors will be subsidiary companies that may be trying to conceal who the principal is. Know who you are working with!
Designating a Chief Compliance Officer
Performing your due diligence on everyone is a lot to ask. Many construction companies elect to designate a Chief Compliance Officer, to act as a communication point between contractors on the project and the owner/management team. Your compliance officer should not only conduct initial investigations but also conduct regular ongoing reviews as well. Continuous monitoring is a simple way to decrease the likelihood of fraud. Your Chief Compliance Officer should have the power to conduct periodic audits and be able to review payrolls, invoices, and contracts.
Fraud occurs when people stop paying attention. Implementing some of these measures early on will help in the long run, but as a baseline action, staying alert will help ward off construction fraud. Litigation costs money, violations can lead to lawsuits, and a history of fraud can destroy your company’s reputation. Always be vigilant!