Collusion and covert payments, not always monetary, take investigation in the construction industry far beyond the books and records, says Haymarket Risk Management Ltd.
Versions of these articles previously appeared in the RICS journal and on Fraud Intelligence.
“Fraud in construction” are words we hear all the time, be it the Office of Fair Trading investigating cartels, black holes in company accounts, or senior managers suspended whilst a probe takes place. My favourite example, though, is when major public construction contracts are massively overspent and a member of the House of Lords is appointed to investigate. His or her report will inevitably include phrases like “mistakes were made”, “no-one was really to blame”, “new controls have been put in place” and “it won’t happen again” – until it does.
How many people, I wonder, fully appreciate the diversity of fraud in construction - not only that it is endemic, but how it affects just about any business, including major public works; how it can be perpetrated by people at all levels in all sorts of organisations and in so many ways.
There is one common element in all construction fraud - the main victim is usually the principal or, in public works contracts, the taxpayer. The only way to combat this blight on the industry is to understand the frauds - how committed, and how they can be prevented.
It is a mistake to rely on internal and/or external audit as they invariably check only what is on record, and most construction-related fraud is either disguised or off-record; it is almost impossible for routine audit to detect.
I will present a series of scenarios that illustrate the diversity of construction fraud, why routine audit fails to detect it and how the forensic Quantity Surveyor has a major part to play in its prevention and detection.
Case study 1
A large supermarket chain invited three construction companies to bid to build a new store. The three formed a cartel and agreed that company B would submit the lowest, albeit inflated, bid. The supermarket chain vetted the bids but did not have them properly cost-quantified and the contract was duly awarded to B. Companies A and C later invoiced and were paid by B for non-existent consultancy services.
After the store was built, the client’s internal audit department performed a review of major contracts, including the one in question. It found nothing untoward, which was unsurprising as there was nothing in the supermarket chain’s records to indicate what had happened.
The fraud only came to light after a senior manager of company B was dismissed (for unconnected reasons) and subsequently wrote to the CEO of the supermarket chain, attaching copies of the “kickback” invoices.
Following a covert investigation, all the parties to the fraud were confronted with evidence in simultaneous, unannounced interviews. Having initially denied any business relationships, each was confronted with the copy ’kickback’ invoices and full admissions were made.
The supermarket chain revised its pre-vendor vetting procedures and, crucially, ensured major construction contract bids were cost-analysed by an independent forensic Quantity Surveyor to identify intentional overcharging before the award of contract.
Case study 2
The Contracts Manager of the client company was befriended by a construction company director. The relationship developed to the point where they agreed that the Contracts Manager would share confidential information to help his ‘friend’ in a contract bid, in return for a kickback if the construction company won the tender... which it did.
The kickback was an extension to the Contracts Manager’s house. To distance themselves from any suspicion and frustrate any audit review, the main contractor instructed a subcontractor to supply the materials and perform the work. He invoiced the cost to the main contractor, which subsequently passed the cost on to the client. The Contracts Manager simply signed off the payment for the cost of the extension work done, which had been, by then, disguised within a series of stage payments.
From an audit viewpoint, the client’s records contained nothing untoward and, again, the fraud only came to light during an investigative review of past contracts. The lack of a Quantity Surveyor and the unhelpful attitude of the Contracts Manager, fuelled suspicions and a covert investigation was initiated. A visit to the local Planning Department revealed the application for the extension and a stroll past the Contracts Manager’s house confirmed the recent work. In response to a casual remark about the excellent extension, and a question as to whether she could recommend who did it, the Contracts Manager’s wife unwittingly provided the name of the subcontractor that had carried out the work.
The client introduced a policy whereby all contracts above £500,000 be reviewed by an independent Quantity Surveyor before contract award and as a part of the contract management.
Case study 3
The Managing Director of a large construction engineering group subsidiary agreed a £25m fixed price to undertake a major and complex contract. Questions from colleagues about the wisdom of this decision were met with a mixture of indignation and bullying by the subsidiary MD. While his colleagues remained sceptical, they lacked the technical knowledge to challenge his decision.
The contract went ahead but the subsidiary had to be bailed out by the Group when costs escalated: in the event, the subsidiary was closed and the Group nearly collapsed.
An investigation revealed that the soon-to-retire subsidiary MD was paid a substantial kickback to agree the £25m price, which he knew was unachievable (all the more so because he used a favoured subcontractor to provide labour at inflated costs and excess vehicles and plant).
Recovery was made from the supplier of labour and materials but this was too little and too late to save the subsidiary.
The Group introduced new procedures whereby contracts above a certain monetary level had to be agreed at Group rather than subsidiary level. They also introduced stringent pre-vendor vetting procedures under which no new supplier could be introduced without being checked to ensure they were independent of anyone in the Group and had a track record in the area for which they were bidding.
Case studies 1 and 2 highlight the risks of relying on normal audit functions to identify construction fraud. Audit has to go beyond its normal procedures and become more proactive in searching for clues to fraudulent activity. Further, detection tests should form part of the procurement process, ie, before contract award and before there is a chance that fraud might occur.
In case study 1, an independent Quantity Surveyor cost-analysing the projected work in advance of contract award would have identified the inflated bids.
Case study 2 highlights the fact that the principal should demand to know the identity of the intended subcontractors from the outset, and audit should become more proactive in applying off-record tests as a matter of course.
In case study 3, the lesson is that if you have doubts, do not be fobbed off. Press for detailed answers until you are satisfied and, if necessary, employ someone technically qualified to help.
Contractors often maintain buildings they have constructed. In cases where controls are lax, eg, no segregation of duties and no independent needs assessment, this can introduce risk, particularly when there is a close relationship between the contractor and the principal’s Contracts Manager, who can invent maintenance work in return for a share of the spoils.
The first step in detecting fraud in maintenance contracts is prevention, which should begin when contractors are invited to bid for a maintenance contract, and should continue through the bidding and contract award process, and for as long as the contract exists, specifically:
- pre-vendor vetting of potential contractors (before being invited to bid);
- an independent Quantity Surveyor to analyse bids to identify value for money/quality issues;
- segregation of duties to ensure no one person has control of a transaction;
- maintenance and repair work (above a pre-determined value) not to be ordered by the Contracts Manager without prior independent assessment;
- Quantity Surveyor checks on the value of works above a certain value;
- quality checks to be performed through random tests;
- all staff/suppliers to be informed that it is policy for these tests to be made.
In conclusion, good preventive controls are essential to reduce risk and it is always better to prevent a fraud than to have to recover from it. However, successful detection is a key part of prevention and it therefore falls to audit to review their processes, look beyond what is on record and to apply innovative detection tests rather than simply engage in a futile audit of what is on record.
In part 2, the author looks at trends in construction fraud and how to defend against it.