Announcing the ResX Construction Fraud/ Waste/Abuse Case Study Series!

We are excited to announce our first series of articles discussing construction fraud investigations and constructionaudits. This series presents the results of what we have learned during the past 30 years performing construction fraudinvestigations and construction audits. These case studies are presented to educate construction project owners aboutthe types of fraud/waste/abuse that can occur on a construction project.

This article, and each article to follow, will focus on one construction billing and/or construction cost area. We willdiscuss what went wrong, how it was discovered, the financial impact, and how to avoid this cost in the future.

CM Performing Sub-Subcontractor Work for One of its Subcontractors

Construction auditors and construction fraud investigators know to test for the possibility that a losing bidder maysubsequently become a subcontractor to the winning bidder. When this occurs it is a red flag telling the auditor orinvestigator, that there is a heightened risk of bidding fraud or corruption. Bidding fraud or corruption can occur duringany bidding process, including:

• The bidding processing conducted by the owner to select the construction manager ("CM") or general contractor.
• The bidding process conducted by the CM to select its subcontractors.

This case study describes a situation where the CM was allowed to bid self-performed trade-work (e.g., mechanical,electrical, concrete), in addition to acting as the CM. When the CM submitted a bid to perform the trade-work, it lost theaward because a third party bidder submitted a bid for a lower price. Rather than accepting this result, the CM decidedit could still do excavation work if it was a sub-subcontractor to the winning subcontractor.

Case Background:

A $50 million GMP project required significant excavation work. This included land balancing, foundations, and aparking lot. The CM was allowed to bid on self-performed work and the bidding process was monitored by theowner. The CM's bid to self-perform the work was higher than a third party bidder (referred to hereafter as "ExCo"), sothe work went to ExCo. After ExCo was selected as the winning bidder, the CM began negotiations with ExCo tofinalize scope and price. The owner did not actively monitor these negotiations between the CM and ExCo. At theconclusion of the negotiations, ExCo's scope was slightly modified and its contract price was $500,000 higher than itsoriginal bid.

Unbeknownst to the owner was the fact that during the negotiations, the CM had negotiated a sub-subcontract withExCo. In this arrangement the CM would self-perform the foundation excavation as a sub-sub to ExCo. ExCo wouldtherefore be the CM's subcontractor to perform land balancing and parking lot excavation, and the CM would selfperformthe foundation excavation as a sub-subcontractor to ExCo.Subsequently, throughout the project the CM, when acting as a sub-subcontractor, was actually preparing invoices thatwould eventually be submitted to ExCo. ExCo would then bury these charges in its lump sum invoices and submit theseinvoices to the CM for approval. Consequently, in this scheme the CM was actually approving an invoice that waspartially prepared by itself.

This scheme was discovered during a routine close-out audit of the project when the construction auditor studied theexcavation bidding process, bid negotiation process, and the subsequent invoices from ExCo to the CM. Theconstruction auditor identified the losing excavation bidders and then discovered that the winning bidder's invoicesincluded charges from one of the losing bidders. This check is routinely performed to identify possible collusion amongthe bidders bidding for the construction manager role. However, it is not routinely performed for subcontractors unlessthe winning subcontractor is a GMP sub or the subcontractor's contract gives the owner the right to check thesubcontractor's cost records. This is because auditors frequently do not have the contractual audit right that would allowthem to audit the cost records of a lump sum subcontractor. 

On this particular audit, the auditor realized that a losing bidder was acting as a sub-subcontractor, and that thisparticular sub-subcontractor was actually the CM. The auditor next studied the bid negotiation process and determinedthat the subcontract amount was $500,000 higher than ExCo's original bid. This information was presented to theowner with the recommendation that the owner inform its general counsel and that before the owner discussed asettlement with the parties for their actions, a full construction cost audit be performed to determine ExCo's actual cost,and the CM's actual cost, for the excavation work they performed.

Best Practices:

To mitigate the risk of this type of fraud occurring on your construction project, we recommend the following bestpractices:

1. Avoid allowing the CM to do self-performed work.
   
   
2. If the owner plans to allow the CM to do self-performed work, then:
   1. Require the CM to obtain written approval from the owner before bidding.
   2. Require the request for bids be distributed early enough to allow third party bidders enough time to evaluate the work scope risks and to prepare a comprehensive bid proposal.
   3. Require that all bid proposals for work in which the CM is also a bidder, be submitted directly to the owner.
   4. Always require the CM bidding on self-performed work to submit its bid in advance of the other bidders.
   5. Require the CM to convert its bid price to a GMP and to bill on a GMP basis for all self performed work.
      
      
3. In addition, for all subcontractor bids, whether the CM is bidding to self-perform or not, the owner should: a. Monitor the negotiation process between the CM and winning bidder. b. Require that the CM prepare a written explanation, and obtain written owner approval, for all adjustments to the bid price that exceed 5% of the bidder's original price. c. Require all subcontracts to contain audit rights language that allows the construction auditor access to the subcontractor's cost records so the auditor can determine the names of the sub-subcontractors and compare these names to the list of losing bidders.

Resolution Experts PC, "ResX, PC", provides independent forensic accounting services for construction auditing andconstruction contract compliance. ResX is based in Michigan and serves clients throughout the United States. For moreinformation and to learn about working with ResX, please visit our website: www.resxpc.com.

The preceding narrative presents concepts that are dependent on facts and circumstances. These concepts can change depending on the specific facts and circumstances of an individual matter.

Published on May 9, 2017
Jim Schmid CPA, CFE, CPA/ABV, CFF, CCA Managing Director of ResX, PC