Fraud and Abuse in the Construction Industry Auditing Construction Contracts and Projects Presenter: William Consolie – Global Practice Leader, Construction Services

Objective / Introduction Construction Project Audits Objective / Introduction Share construction audit knowledge and experiences regarding different types of construction contracts and risks, and identify the appropriate controls to help mitigate the risks. First Level of Control: Contract Selection/Contracting Strategy Second Level of Control: Contract Administration The Secret Weapon: Construction Audit Skills

Agenda Contract Selection/Contract Strategy Contract Administration Construction Project Audits Agenda Contract Selection/Contract Strategy What types of Contracts are used for construction projects and what are the risks? Contract Administration How do I know what to look for? Discussion Will solid financial controls and compliance testing destroy the relationship between the Owner and Contractor? Can you rely on the architect to ensure cost control and quality? Questions?

Contract Selection/Strategy

What are the Types of Contracts Used for Construction Projects? Construction Project Audits What are the Types of Contracts Used for Construction Projects? Lump Sum, Fixed Cost, Stipulated Sum Cost Reimbursable or Cost Plus Cost Plus with Fixed or Percentage Fee Cost Plus with Guaranteed Max (GMAX or GMP) Cost Plus with GMAX & Shared Savings Unit Price Time & Material

Construction Project Audits

When do I use Lump Sum Contracts for Construction? Construction Project Audits When do I use Lump Sum Contracts for Construction? Specifications and Bid Packages Detailed Design Substantially Complete Work Breakdown Packages Realistic Schedule/Timeline Delivery Dates Milestones Adequate Bid/Price Competition Unit Price – Units of Measurement

What are the Risks Associated with Lump Sum Contracts? Construction Project Audits What are the Risks Associated with Lump Sum Contracts? Bid Rigging Material Quality Switch Subcontractor Switch Front-end Loading Scope Not Performed Work Not Complete Insurance Not Purchased Original Scope Presented As Change Order Insufficient Testing Contractor Low-balling Contingency/Allowance Not Returned Prevailing Wage Rate Requirements Workmanship Issues Fitness For Purpose

When do I use Cost Plus Contracts for Construction? Fast Track Projects State of the Art Construction Large Dollar Contract Completion Date in Flux Lack of Competition

What are the Risks Associated with Cost Plus Contracts? Construction Project Audits What are the Risks Associated with Cost Plus Contracts? Labor Rates & Fringes (multiplier) Uncompensated overtime Excess reported hours Travel & reimbursable Union rates Ghosts Self-Performed work Materials Trade discounts Excessive material Scrap (attic stock) & returns Rework Subcontractors Over billing

What are the Risks Associated with Cost Plus Contracts? (continued) Construction Project Audits What are the Risks Associated with Cost Plus Contracts? (continued) Equipment Rent to own Charge exceeds purchase price or FMV Excess repair costs Sweetheart deals Rates Equipment not on job Rental rebates not credited Change orders – Pricing, OHP Insurance – CCIP assessment Bonds – Subguard / Payment and Performance Home office charges - IT, check charges, infrastructure Charging for non-reimbursable costs Fines Mathematical errors – Fee, CCIP, Subguard; Forecast billing

What Are the Risks of a Unit Price Contract? Construction Project Audits What Are the Risks of a Unit Price Contract? Erroneous estimates Mobilization/demobilization Improper measuring/quantity verification Re-calculation clause omitted Quantities not delivered

What Are the Risks of a Time & Material Contract? Construction Project Audits What Are the Risks of a Time & Material Contract? Use of incorrect labor rates Overstated time sheets Use of incorrect material mark ups See Cost Plus

What is the Life Cycle of a Construction Project? Construction Project Audits What is the Life Cycle of a Construction Project? Contract Negotiations Construction Retention Pay Out Pre-Award Contract Finalized Contract Compliance Close-Out Cost Avoidance Protective Contract Language Process Improvement Maintain Controls Overcharge Identification Establish if obligations to Subs & Suppliers have been met Accuracy of final billing Review back charges & buy outs Confirm receipt of deliverables Tax cost segregation –Tax Practice Ensure owner favorable contract Evaluate GC bid Ensure adequate control structure Tax cost segregation planning –Tax Practice Review payment applications Analytic review and support Test and evaluate change orders On-site inspections Assess and monitor internal controls Identify potential overcharges prior to final payment Cost Recovery Protective contract language recommendations Process improvements recommendations Tax savings (accelerated depreciation) 25% 50% 75% 100% 0% Benefits

Contract Administration

Construction Project Audits What are the most critical Cost Plus Contract terms in typical Construction Projects? Right to Audit Clause Cost of the Work Allowance Funds Salaried Professional Labor Rates Contractor’s Contingency Fund Change Orders Bonding / Insurance Schedule of Key Personnel Contractor’s Fee Retainage Shared Savings Clause / Early Completion Bonus Conflicts

Contract Terms Right to Audit Clause Construction Project Audits Contract Terms Right to Audit Clause Maintains the Owner’s right to validate costs at a later date

Contract Terms Cost of the Work Construction Project Audits Contract Terms Cost of the Work Establishes terms and conditions for Contractor’s reimbursable costs Trade Costs General Conditions (Actual costs!)

Contract Terms Allowance Funds Construction Project Audits Contract Terms Allowance Funds Establishes guidelines for in-scope items with unknown costs

Contract Terms Salaried Professional Labor Rates Construction Project Audits Contract Terms Salaried Professional Labor Rates Determines the cost and profit of Contractor’s resources

Contract Terms Salaried Professional Labor Rates Construction Project Audits Contract Terms Salaried Professional Labor Rates Issue: Contractor’s salaried employee labor rates (labor burden multiplier) Risk: Contractor’s hidden profit center – overstated costs typically passed on to Owner Solution: Cost Avoidance: Validate Contractor labor rates & burden multiplier at contract negotiation phase, maintaining right to audit throughout project Cost Recovery (Compliance): Validate CM labor rates & burden multiplier during construction

Examples of hourly labor rate overcharges: Construction Project Audits Examples of hourly labor rate overcharges: Classification Comment Deferred Compensation Contractor did not pay at rate used in multiplier Paid Time Off Sometimes not included in multiplier – charged directly to project in addition to multiplier 401K (Retirement Plan) Easily overstated (averaged) – new employees? Stock Option Plan Not all employees participate Employee Incentives Contractor did not pay at all or at rate used Safety/Education Component of overhead Small Tools Contractor did not provide / overhead FICA/SUTA/FUTA Statutory Limitations excluded Workers/Compensation Supervision rate lower then trade labor (OCIP /CCIP may be utilized)

Contract Terms Contractor’s Contingency Fund Construction Project Audits Contract Terms Contractor’s Contingency Fund Establishes guidelines for draw down of Contractor’s contingency

Contract Terms Change Orders Construction Project Audits Contract Terms Change Orders Specifies overhead and profit markups for Contractor and Subcontractors

Contract Terms Change Orders Construction Project Audits Contract Terms Change Orders Specifies overhead and profit markups for Contractor and Subcontractors

Contract Terms Change Orders Construction Project Audits Contract Terms Change Orders Issue: Change Orders are new scope and new billing opportunity for trades resulting in an increase to the GMP Risk: Change order costs are often overstated, with pricing that does not comply with the contract terms and conditions resulting in added costs to the Owner Solution: Cost Avoidance: Validate change order pricing at receipt of COR, maintaining right to audit throughout project Cost Recovery (Compliance): Validate change order pricing at a later date during the construction phase

Contract Terms Bonding / Insurance Construction Project Audits Contract Terms Bonding / Insurance Specifies the type and limits for required insurance coverages

Contract Terms Schedule of Key Personnel Construction Project Audits Contract Terms Schedule of Key Personnel Determines who the Contractor assigns to the construction project

Contract Terms Schedule of Key Personnel Construction Project Audits Contract Terms Schedule of Key Personnel Determines who the Contractor assigns to the construction project

Contract Terms Contractor’s Fee Construction Project Audits Contract Terms Contractor’s Fee Determines when and where the Contractor can charge fee

Contract Terms Contractor’s Fee Construction Project Audits Contract Terms Contractor’s Fee Determines when and where the Contractor can charge fee

Contract Terms Retainage Construction Project Audits Contract Terms Retainage Specifies when the Owner should withhold payments to the Contractor

Contract Terms Shared Savings Clause / Early Completion Bonus Construction Project Audits Contract Terms Shared Savings Clause / Early Completion Bonus Details incentives to Contractor for reducing cost or finishing early

Contract Terms Shared Savings Clause / Early Completion Bonus Construction Project Audits Contract Terms Shared Savings Clause / Early Completion Bonus Details incentives to Contractor for reducing cost or finishing early

Contract Terms Conflicts Construction Project Audits Contract Terms Conflicts Dictates order of preference in event of contract conflict

Fraud Case Studies

Hospital System Kickback Scheme A large hospital system called Experis in to investigate a recently discharged Sr. Project Manager. While reviewing the PM’s files they noticed unusual job cost activity. Experis uncovered $1 Million in fraudulent invoices billed and paid with over $600K going into fraudster controlled bank accounts via several contractors : Invoices for work not performed Ghost projects set up Cost shifting without proper authorization Lack of internal control Lack of proper supervision Documented policies not adhered to

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The Scam Unworked Labor Days Added Daily Labor Hours Added Unworked Labor Days Added Billing of Sick Days, Vacation, etc. Lump Sum Stipend Payments MBE Fraud

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Discussion

Construction Project Audits Will solid financial controls and compliance testing destroy the relationship between the Owner and Contractor? Trust but verify The financial controls and compliance testing should confirm the choice of contractor not destroy a relationship

Can you rely on the Architect to ensure cost control and quality? Construction Project Audits Can you rely on the Architect to ensure cost control and quality? The cost of that degree of service can be very high The A&E firm would incur additional liability which they may not want This is similar to relying on a Construction Manager or General Contractor to protect your interests. The architect has interests that compete with the owner and because they completed the design may incur liability. As one architect explained, “if we did what owners think we do, they couldn’t afford us”.

Questions? Presenter: Bill Consolie – Global Practice Leader, Construction Services william.consolie@experis.com (404) 697-5701