contract risks

Presentation to the GFOA Annual Conference on Contract Risks

May 11, 2016

Ron Steinkamp, CPA, CIA, CFE, CRMA, [email protected] | 314.983.1238

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Table of Contents

© 2016 All Rights Reserved Brown Smith Wallace LLP

Elements of a Contract

Methods of Procurement

Procurement Phases

Contract Procurement Schemes and Red Flags

Contract Performance Schemes and Red Flags

Preventing Contract Fraud

Detecting Contract Performance Fraud

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A contract is a mutual oral or written agreement between two or more parties that must contain the following elements:

–Competent parties–Lawful subject matter or objective–Mutual consent–Legal consideration–Form permitted by law

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• Competitive bidding using sealed bids.• Contracting by negotiation:

– Competitive negotiation.– Sole-source contracting.

• Simplified acquisition procedures:– Charge accounts.– Purchase cards.– Purchase orders.– Petty cash funds.



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Procurement Phases


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Pre-solicitation Phase


• Identify needs.• Develop bid specifications.• Determine method of procurement.• Develop criteria to award the contract.

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• Prepare solicitation document (RFI, RFQ, RFP, etc.).

• Provide notice of solicitation.• Issue solicitation document.• Receive bids and proposals.

Solicitation Phase


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• Evaluates bids/proposals.• May conduct discussions/negotiations.• May provide opportunity to revise

bids/proposals.• Select winning bid/proposal.• Execute contract and terms.

Bid Evaluation and Award Phase


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• Performance of contractual obligations.• Contract modifications/change orders.• Review of completed portions and release of funds.• Assessment of deliverables for compliance with

contract’s terms and quality.

Post Award and Administration Phase


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Contract Procurement Schemes and Red Flags


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• Collusion among contractors to circumvent the competitive bidding process.

• Collusion between contractors and procurement employees.

Contract Procurement Fraud Categories


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Collusion Among Contractors


Schemes• Complimentary Bidding – competitors submit token

bids to influence contract price and award.• Bid Rotation – competitors conspire to alternate the

business between them on a rotating basis.• Bid Suppression – competitors enter into an illegal

agreement whereby at least one refrains from bidding or withdraws a previously submitted bid.

• Market Division – competitors enter into agreements to divide and allocate markets and agree not to compete in each others markets.

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Red Flags• Limited competition.• Winning bid appears too high.• All contractors submit consistently high bids. • Qualified contractors do not submit bids.• Winning bidder subcontracts to losing bidder or non-bidders.• Bids submitted by companies unqualified to do work.• Bids fail to conform to requirements of the solicitation.• Losing bids poorly prepared.• Fewer competitors than normal submit bids.



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Red Flags (continued)• Bid prices fall when new contractor enters the competition.• Rotational pattern to winning bidders.• Evidence of collusion in bids, for example:

Bidders make same mathematical or spelling errors. Bids prepared using same format or typeface. Bidders submit identical bids.

• Pattern where last party to bid wins the contract.• Patterns of conduct that suggest collusion, for example:

Subcontract with each other. Regularly socialize. Hold meetings or visit each others offices.



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Schemes• Need Recognition – employee convinces employer that

it needs excessive or unnecessary products or services.• Bid Tailoring – employee drafts bid specifications in a

way that gives unfair advantage to a certain contractor.• Bid Manipulation – employee manipulates the bidding

process to benefit a favored contractor.• Leaking Bid Data – employee leaks pre-bid information

or confidential information from competing bidders to a favored bidder.

Collusion Between Contractors and Employees


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Schemes (continued)• Bid Splitting – employee breaks up a large project into

several small projects that fall below the mandatory bidding level.

• Unjustified Sole Source Award or Other Noncompetitive Method of Procurement



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Red Flags • Need defined in a way that can only be met by a certain contractor.• Assessment of need is not adequately or accurately developed.• Services continually purchased from a single source.• Estimates not prepared or are prepared after solicitations

requested.• Employee displays sudden wealth or lives beyond means.• Employee has outside business.• Multiple purchases that fall below the threshold limit.• Weak controls over the bidding process.• Only one or a few bidders respond to bid requests.• Contract not re-bid even though fewer than minimum number of

bids received.



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Red Flags (continued)• Similarity between specs and winning contractor’s product/

service.• Bid specs tailored to fit products/capabilities of a single contractor.• Unusual or unreasonable narrow or broad specs for the type of

goods or services being procured.• Unexplained changes in contract specs from previous proposals.• Higher number of competitive awards to one supplier.• Socialization or personal contacts between contracting personnel

and bidders.• Specs developed by or in consultation with a contractor who is

permitted to compete in the procurement.• High number of change orders for contractor.



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Red Flags (continued)• Evidence of changes to bids after received.• Winning bid voided for errors and job re-bid or awarded to

another bidder.• An otherwise qualified bidder is disqualified for seemingly

arbitrary, false, frivolous, or personal reasons.• Employee accepts late bids.• Contract awarded to non-responsive bidder.• Bids of competing contractors are lost.• Bid deadlines are changed.• Invitations for bids are sent to unqualified contractors or those

who previously declined to bid.



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Red Flags (continued)• Winning bid is just under the next lowest bid.• Winning bid is unusually close to the procuring entity’s estimate.• Last party to bid wins the contract.• Contractor submits false documentation to get late bid accepted.• Contracting personnel provides information or advice about

contracts to a contractor on a preferential basis.• Unjustified split purchases under competitive bidding limits.• Sequential purchases just under the upper-level review or

competitive bidding limits. • Frequent use of sole source procurement contracts.• High number of sole source awards to one contractor.



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Red Flags (continued)• Requests for sole source when there is an available pool of

contractors.• Procuring entity did not maintain accurate minutes of pre-bid

meetings.• False statements made to justify noncompetitive method of

procurement.• Justifications for noncompetitive method signed/approved by

employees without authority.• Fail to obtain required review for sole source justification.



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Contract PerformanceSchemes and Red Flags


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• Non-conforming goods or services.• Change order abuse.• Cost mischarging.

Performance Fraud Schemes


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Non-Conforming Goods or Services


• Contractor knowingly delivers goods or services that do not conform to the underlying contract specifications and bills and receives payment without informing purchaser of the deficiency.

• Examples: Delivering/using products/materials of lesser quality than specified in

contract. Substituting products/items different than what is specified in the contract. Delivering/using lower quality staff than specified in the contract. Delivering/using counterfeit, defective, reworked, or used parts. Delivering/using materials that have not been tested. Falsifying the test results of materials, products, or goods. Making false certifications for example:

New materials Domestically manufactured. Meet contract specifications concerning quality or quantity Company minority owned

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Red Flags • High percentage of returns for noncompliance with specifications.• Product compliance certificate missing or appears altered or modified.• Compliance certificates signed by low-level employee with no quality

assurance responsibilities.• Materials testing done by supplier.• Evidence that tests or inspection results were falsified.• Discrepancy between product description and appearance.• Offers by contractors to select the sample and prepare it for testing.• Delivery of look-alike goods.• Unusually high number of early replacements.• Contractor restricts or avoids inspections of goods or services upon

delivery.



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• Contractor submits a low bid to ensure they win the contract, but increases the price with subsequent change orders.

–OR- • Contractor uses change order process to improperly extend or

expand contracts and avoid rebidding.

• Usually involves collusion with employee.

• Change orders receive less scrutiny than the original bid selection process, making them a popular way to fraudulently access funds or generate funds for kickbacks.

Change Order Abuse


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Red Flags • Poor contractor internal controls over determining the need for change

orders.• Procurement employee acts outside normal scope of duties.• Numerous change orders justified on a variety of grounds, for

example: Change in prices. Inflation. Unavailability of specific materials/equipment. Need to substitute more expensive alternatives.

• Employee approves numerous unexplained or unjustified change orders for same contractor.

• Repeated pattern of change orders that increases price, scope, or period of agreement.

Change Order Abuse


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Red Flags (continued)• Questionable, undocumented, or frequent change orders awarded to

a particular contractor.• After contract award, bid specifications that lack detail are clarified

through change order.• Poorly drafted requests for change orders.• Pattern of change orders just below threshold limit.• Employee involved in both determining requirements and procuring

the item.• Period of agreement extended by change order instead of re-

bidding.

Change Order Abuse


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• Contractor charges the procuring entity for costs (material and labor) that are not allowable, not reasonable, or cannot be allocated to the contract.

• Three types: Accounting Mischarge: Contractor knowingly charges unallowable

costs to the buyer, concealing or misrepresenting them as allowable costs, or hiding them in accounts that are not closely monitored/audited.

Material Mischarge: Contractor charges higher price for materials than agreed or substitutes inferior materials.

Labor Mischarge: Contractor charges for work that was not actually performed or overcharges for labor.

Cost Mischarging


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• Examples: Charging the same cost to more than one contract. Charging non-existent costs or costs at inflated amounts. Charging unallowable costs (e.g., entertainment, advertising,

etc.) to the contract. Charging costs to the wrong cost category or contract. Failing to disclose discounts and credits. Using outdated standard costs. Colluding with contractors directly to charge high prices and

rebating part of the price increase without disclosure. Using phantom suppliers to inflate costs. Falsifying support documentation.

Cost Mischarging (Continued)


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Red Flags • Contractor refuses, delays, or is unable to provide complete supporting data.• Contractor’s supporting data is missing or unavailable for review.• Contractor’s supporting documents are of poor quality.• Contractor provides different supporting documents for the same item and unit

prices vary widely.• Evidence of falsifications or alterations to supporting data.• Contractor fails to submit cost data that is current, accurate, and complete.• Contractor fails to disclose internal documents on vendor discounts.• Cost estimates are not consistent with contractor’s prices.• Repeated non-compliance with the contractor’s disclosed bidding or estimating

practices.• Old, outdated standards used to support proposals.• Contractor fails to disclose information regarding significant cost issues that will

reduce proposal costs.

Cost Mischarging Abuse


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Preventing Contract Fraud


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A program designed to prevent and detect contract procurement fraud should include the following elements:

• Employee Education

• Internal Controls

• Monitoring Activities

• Vendor Due Diligence

Elements of Fraud Prevention


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Organizations should:

• Educate employees about procurement fraud.

• Focus education efforts on employees in best position to identify vulnerabilities or red flags.

Employee Education


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Key internal controls include:• Audit Clause in every contract.• Documented policies and procedures.• Selection committees and criteria.• Segregation of duties.• Supervisory controls.• Receiving controls.• Authorization/approval controls.• Reconciliation controls.• Recording controls.

Internal Controls


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Implement programs to measure the performance of procurement activities:

• Continuous monitoring using data analytics.

• Regular internal audits.

Monitoring Activities


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A vendor due diligence program should include:

• Vendor background checks.

• Controls for vendor master file management.

• Vendor monitoring.

Vendor Due Diligence


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Detecting ContractPerformance Fraud


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• Examine the following documents for red flags: Contract or purchase order specifications. Contractor’s statements, claims, invoices and supporting documents. Received products. Test and inspection results.

• Review correspondence and contract files for indications of non-compliance.

• Request assistance from outside technical experts to conduct after the fact tests.

• Inspect or test questioned goods or materials.• Segregate and identify the source of suspect goods and materials.• Review inspection reports to determine whether the work performed

and materials used were inspected and considered acceptable.



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• Review the contractor’s books, payroll, and expense records to see if they incurred necessary costs to comply with contract specifications.

• Review the inspection and testing reports of questioned materials.• Conduct routine/unannounced inspections and tests of materials.• Examine the contractor’s books and manufacturing or purchase

records for discrepancies between claimed and actual costs.• Interview procurement personnel about the presence of any red flags

or other indications of noncompliance.• Search and review external records (e.g., court records, prior

complaints, audit reports, investigative reports, media sources, etc.) to determine if history of misconduct.

Non-Conforming Goods or Services (Continued)


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• Examine change orders that add new items.• Examine change orders that increase scope, quantity, or

price of contract.• Analyze change orders for red flags.• Interview complaining contractors, unsuccessful bidders,

and procurement personnel about the presence of red flags.

• Search and review external records (e.g., court records, prior complaints, audit reports, investigative reports, media sources, etc.) to determine if history of misconduct.

Change Order Abuse


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• Examine contract, material and labor cost files for red flags.• Review for unallowable costs.• Examine material cost transfers.• Examine contract charges to determine if materials properly

charged to the job.• Examine materials ordered and charged in excess of contract

requirements.• Compare material and labor costs over a specific period to

identify any unusual changes and determine reason for the change.

• Review standard vs. actual material and labor costs to determine any variances.

Cost Mischarging


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• Investigate contractor to determine ownership and search for signs of corruption.

• Scan the general ledger for unusual adjusting entries.• Review audit reports, reimbursement requests, construction

reports, etc.• Examine time cards and hours expended on the contract and

compare to hours billed.• Conduct site visits to verify labor.• Compare direct and indirect labor account totals between years

and investigate significant changes.• Analyze labor charges to determine any shifts in charging

patterns.



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• Prepare a schedule of salary/wage changes and compare to rates at contract award date.

• Look for terminated employees charged to contract.• Compare employee personnel records to contract position

qualification requirements.• Search and review external records (e.g., court records, prior

complaints, audit reports, investigative reports, media sources, etc.) to determine if history of misconduct.



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ConnectI


Ron [email protected]

6 CityPlace Drive, Suite 900│ St. Louis, Missouri 63141 │ 314.983.1200 1520 S. Fifth St., Suite 309 │ St. Charles, Missouri 63303 │ 636.255.3000

2220 S. State Route 157, Suite 300 │ Glen Carbon, Illinois 62034 │ 618.654.3100 1.888.279.2792 │ www.bswllc.com

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