Editor's Note: Following is a continuation of last month's article in which a case study was presented of potential contract and procurement fraud. This month we learn how to effectively manage fraud and develop a solution for West Coast Construction (West Coast), a mythical construction company. To read the previous article, click here. To read the next article in the series, click here.
The best remedy against fraud, other illegal acts and ethics violations is a strong system of anti-fraud programs and controls supported by a positive “tone at the top” from an organization’s senior management.
As always, an ounce of prevention is worth a pound of cure.
In the case study of West Coast Construction (West Coast), a mythical construction company, West Coast has found itself in a situation that could have been either prevented or detected earlier if an appropriate fraud risk management structure had been in place. But now, West Coast must formulate a response to a potential fraud problem.
A Little Background…
West Coast had assigned Joe PM (Joe), one of its experienced project managers, to run a project for Technology, Inc. (Technology), an owner who wanted to build an office building. Joe immediately began working with West Coast’s contract administrator, Contract Admin, to assemble bid packages. The situation became problematic when Smith Mechanical was awarded the mechanical bid package. Almost immediately after receiving notice to proceed, Smith Mechanical began submitting change order requests that Joe approved, but Joe wasn’t obtaining Technology’s required approval. Technology started raising questions and voicing concerns about the excessive cost increases to the mechanical work when the contract value reached $1.9 million. The original subcontract was a fixed-price agreement for $1.4 million.
In addition, Contract Admin later learned that the CEO of Smith Mechanical was Joe’s brother-in-law and that Joe had awarded mechanical work to Smith Mechanical on each of his projects since he had been hired. However, Technology has no procedures that prohibit dealing with family members or relatives. Also, West Coast doesn’t perform background checks on its employees during the hiring process, and it doesn’t require employees to sign annual corporate compliance affidavits. These events and issues lead to the conclusion that all is not well at West Coast and that it may be prudent to conduct an internal inquiry or investigation. Before creating a solution for West Coast, it’s important to first understand the effective framework for managing the risks of fraud and financial abuse.
Lack of Fraud Prevention
From this case study, we can discern that there were very few, if any, preventative controls in place at West Coast with respect to fraud. While management at West Coast may be very concerned with the issues raised by Contract Admin and generally have very firm and decisive views regarding the tolerance of fraud in their organization, there do not appear to be any systems or policies in place which would make these attitudes about fraud known to the general employee population. This complicates matters because the lack of policies and procedures fails to mitigate potential inappropriate behavior, and it also makes it harder to take action against employees who have not acted in the best interests of the company but who also haven’t violated any particular policy.
There does not appear to be a code of conduct nor a corporate ethics and compliance program. [See this month’s article, “Your Code of Conduct (You Do Have One Don’t You?)” .] Additionally, the control structure as it currently exists seems to allow for activities that could increase West Coast’s potential exposure to fraudulent activities. The apparent lack of fraud prevention controls is further exacerbated by the limited number of programs in place with respect to the detection of fraudulent activities and the mechanisms to report them.
When considering Joe’s behavior in addition to the allegations, there are a number of red flags that jump out (refer to last month’s article). It is against this background that we need to formulate an appropriate response to address the issues of potential fraud and conflicts of interest which are in question.
The Investigation
Before commencing any investigation, it is wise to consider whether or not it should be conducted at the direction of counsel (internal or external) so that the work conducted, reports prepared and the conclusions reached are covered by the attorney-client work product privilege. There are investigations where this would be very beneficial and others where it might be unnecessary.
Additionally, prior to commencing the investigation, the investigator typically attempts to clarify the following: To whom is the investigator reporting, and what are the reporting guidelines (i.e., is a written or oral report to be issued)? What is the nature of the allegation, and what is an appropriate scope for the investigation? Is the investigation subject to any restrictions, and if so, what might be the effect on the completeness and integrity of the investigation?
Generally speaking, investigation work plans consider a broad range of activities, which may include:
- Gathering information, including hard copy and electronically-stored information
- Analyzing information that is gathered and determining its relevancy to the investigation
- Interviewing individuals that may possess knowledge or information relevant to the investigation
- Re-interviewing individuals based on information obtained during the initial interview process
- Performing other analysis as deemed appropriate
- Evaluating information obtained throughout the investigation and formulating investigative conclusions, including culpability
- Applying appropriate remedial actions
Having set the stage, there are several ways to conduct an investigation into allegations of fraud. Each may have risks associated with them. Inappropriate methods of investigations or mis-management of inquiries and investigations may leave an organization and its management team open to risks, which may be larger than the potential fraud being investigated. Just read the newspaper to observe the impact of an improperly conducted or mis-managed investigation, including the use of inappropriate investigative techniques. Also, in fairness to the subject of the investigation, an investigator needs to remember that even though an allegation of improper conduct may have been received, the mere allegation does not mean the individual has actually violated any policies or committed a fraudulent act.
The investigator should (now that an allegation of fraud has been made) obtain as much information as possible without alerting the subject of the inquiry. Furthermore, the number of people who are involved in the inquiry should be minimized to limit the potential for sensitive information being misused and to ensure the evidence is maintained in its current state. This does not mean the scope of the inquiry should be curtailed, rather this would merely have an impact on the timing of who should be involved and when.
An appropriate response to an allegation might be to conduct an investigation in a phased or scaled manner. Additionally, a decision should be made to determine how to conduct the investigation (i.e., from the outside (peripheral) working toward the subject of the investigation).
This approach may result in gathering as much information in a comprehensive and efficient manner without alerting the subject. In addition, it may optimize the quality of the subject’s interview by taking advantage of the most complete set of information. The investigator can also question the subject about specific documents. Of course, as the investigator moves closer to the subject, the likelihood of the subject becoming aware of the inquiry increases significantly. Alternatively, the specific circumstances may suggest that an initial interview be conducted with the subject of the investigation and then move toward gathering additional data. The approach selected should be the one that maximizes the integrity and objectivity of the investigation, ensures the preservation of information and opportunity to collect information and results in the subject being treated fairly and respectfully.
Case Study: West Coast’s Solution
Since there is no apparent requirement to disclose actual or potential conflicts of interest, there are some deficiencies with respect to hiring practices and there is no proactive review for potential fraudulent activities at West Coast, conducting an investigation in a phased or scaled manner might be the best solution. This would include the following:
- Commence an interview with Contract Admin obtaining as much information from her as possible.
- Take appropriate steps to secure information that may be relevant to the investigation, including restricting Joe access to such information.
- Gather as much information with respect to the bids that were handled by Joe, and then analyze this information to determine the level of changes and number of change orders. Evaluate the information obtained in the context of other projects that Joe has managed, as well those projects his peers have managed. Factors to be considered in such an evaluation might include the nature of the underlying change order; the completeness of supporting documentation and vendors and subcontractors involved; and evidence of review and approval of the changes.
- Conduct public records searches on Smith Mechanical to facilitate understanding of its owners and key employees, determine if any records contained adverse information, and identify any other information that may be relevant to the investigation.
- Gather information relating to Joe that may be relevant to the investigation, including:
- Company cell phone records to determine the level of contacts with key individuals
- Travel and entertainment reports (and supporting documentation) submitted by Joe to determine who he has entertained, as well as the timing and location of those meetings
- Copy of his personnel file to facilitate the identification of potential conflicts of interest or other information that may be relevant to the investigation
- Secure Joe’s company-issued computer, and make a forensic image of its contents. It is preferable to secure his company-issued computer in an unannounced manner. The contents of the computer can be analyzed to identify relevant electronic documents, including e-mails. Deleted information may be restored. The analysis of e-mails may identify people with whom he was corresponding and the subject matter of that correspondence. Joe might assert privacy issues with regards to the contents of his company-issued computer, but generally speaking, companies have a right to the information contained on computers owned by them, not withstanding who the custodian of the machine is. Legal counsel should be consulted on such questions.
- Consider making inquiries with Technology about the issues they raised regarding the billings and change orders, and obtain relevant information.
- Identify individuals who may have information or knowledge relevant to the investigation, and conduct interviews with these people.
- Conduct an interview with the subject of the inquiries presenting any relevant documentation gathered through the steps previously identified.
Throughout the investigation, the investigator assesses the information obtained with a view toward the weight of the information providing support for the investigator’s conclusions.
Investigation Closed
Because of the phased approach taken during the course of the investigation and as a result of the information gathered at each step, West Coast was able to gather enough relevant information that was shared with Joe during his interview. In light of this information, Joe admitted to the conflict of interest and to arranging the bidding in favor of Smith Mechanical for which he was paid both in cash and in kind. Joe’s employment was subsequently terminated; however, West Coast elected not to press charges. The conclusion of the investigation does not mean it’s the end of the story for West Coast. Now, they must turn their attention to developing a robust compliance program to help prevent these problems from arising in the future.
Construction Business Owner, June 2007
