It reads like a story from the recent financial collapse when headlines exposed the corrupt practices of many of the Western nations' big financial companies. This time, however, some of those corporate giants are the ones getting fleeced -- by a construction company. Unfortunately, says Barry LePatner, the story of how a construction management company and its aligned subcontractors allegedly bilked millions of dollars from their clients is one that has become all too familiar in the construction industry.
"Lehr Construction is alleged to have over-invoiced its clients to the tune of more than $78 million," says LePatner, founder of LePatner & Associates LLP and author of Broken Buildings, Busted Budgets: How to Fix America's Trillion-Dollar Construction Industry (University of Chicago Press, 2007, www.BarryLePatner.com). "The company allegedly entered into agreements with subcontractors who submitted inflated purchase orders to clients, who then paid the inflated amount to the subcontractors. Lehr then, allegedly, pocketed a portion of the overbilling it had passed on to the owner."
The corruption at New York City-based Lehr Construction is no exception, notes LePatner. In fact, the New York Times has reported that over the past year, both the district attorney of New York County and state police investigators have called in over a hundred subcontractors in the latest roundup of indictments related to corruption on projects as prominent as the Goldman Sachs and Bank of America headquarters facilities. And only a month ago, another construction management firm, the Builders Group, and its top corporate officers pleaded guilty to a scheme to steal millions of dollars from clients in corporations and on condominium projects.
"These stories of corruption should warn every major construction project owner of the dangers of placing millions-and sometimes tens and hundreds of millions-into the hands of companies with very questionable business practices," says LePatner. "But the reality is project after project collapses because owners make the same mistakes."
LePatner pinpoints three of the most common mistakes, which, unfortunately, have been made by many developers and corporate and institutional owners.
"First, owners don't properly monitor operations to prevent corrupt practices," says LePatner. "All too frequently, they believe that merely sending out questionnaires about a company's finances or prior project successes will serve as appropriate due diligence. Second, they don't include provisions in their contracts that will compel transparency or serve as safeguards from cost-boosting corruption. And third, they don't properly do the necessary auditing work during and after a project to provide, for example, inventory controls and assurances that all payments to a construction manager have been made to suppliers, vendors, and subs.
"As long as corruption is allowed to continue, so will the cost overruns that repeatedly bust project budgets, adding between 25 to 50 per cent to project costs. And until owners are educated about the costly inefficiencies of the construction industry and take action to protect themselves from corruption, cost overruns will continue to sabotage projects-public and private alike."
LePatner has devoted his career to ending this corruption, and his law firm provides forensic analysis and due diligence for its clients through its wholly owned affiliate, Proactive Integrity Associates LLC. "We are a nation that loves to build," says LePatner. "But without taking the proper precautions, we do not know how to build well. These widespread reports of corruption don't affect only private owners. Because of the threat of cost overruns, state governments have become reluctant to take on much-needed infrastructure projects, decisions that could lead to future economic and security problems for the country. It's time for owners of all kinds to take back the building process."
LePatner offers the following advice for owners who want to avoid the losses and embarrassment that come with hiring contractors bent on committing fraud:
Stage One: The Planning Process
Don't assume hiring unions will protect you. Many owners hide behind the belief that if they retain union contractors, who are bound by so-called "project labour agreements," that there are rules to set in stone the costs for the work to be done. "Nothing could be further from the truth," says LePatner. "While a project labour agreement may establish the rates and benefits for every category of worker on a project, to avoid corruptions such as fictitious invoices and kickbacks, owners must employ greater steps to protect their project budgets."
Perform a background search on your construction team. For owners, the contract bidding process should include thorough questionnaires that require bidders to answer questions about their businesses, their ownership, and their history, including jobs worked, liens filed, criminal, civil, and administrative inquiries, and other similar information. At a minimum, owners should verify licenses and business registration of a bidder and conduct public records searches to uncover any history of litigation, criminal convictions, failure to pay taxes, undisclosed conflicts of interest among the project team, and other matters that would call into question the integrity or business practices of a bidder.
Owners may also want to do a search of news articles to see if past reports of wrongdoing by certain bidders exist. In addition to conducting the public record and open source research described above, more in-depth investigation may be warranted depending on the size of the project. A further layer of diligence includes in-depth interviews by investigators and/or project management staff of prior customers of a bidder, construction managers and design professionals who have previously worked with the bidder, opposing parties in litigation, former employees, and other industry and confidential sources of information regarding the bidder. These interviews can provide real-life perspective regarding how well the bidder performs its work and interacts with owners and other team members.
"This information provides the owner with a baseline of information from which to initiate verification of qualifications and background investigations of the bidders and their owners, principals, and employees," says LePatner. "For example, if Lehr's clients had properly researched the company, they would have discovered that Lehr Construction pleaded guilty to charges related to bid rigging in the late 1990s that resulted in overcharging clients tens of millions of dollars. One of Lehr's principals, Howard Lazar, reportedly pleaded guilty to attempting to bribe a city inspector in the 1970s."
Demand transparency. Transparency is the key to maintaining integrity in the construction process from bidding to billing to timely completion. Project owners should have the right to obtain and review all financial and accounting documentation relating to their project, including that of the subcontractors. If possible, direct electronic access with proprietary software that manages all aspects of the retention, performance, and payments to the contractors and subcontractors should be provided. This access not only will provide the owner with the information needed to detect overbilling, fraud, waste, and abuse, but it will set a tone with the project team that the owner is serious about preventing cost overruns and will be watching the team closely throughout the process.
Know who's doing your building. Through carefully tailored contracts, owners should be given the right to approve all subcontracts for their project. Doing so allows the owner to perform due diligence on the subcontractors and ferret out those who are unqualified or unscrupulous. "A requirement that all contractors and subcontractors use owner-approved contracts will ensure that the right to audit extends to the subs," says LePatner. "Control over the team members and contractual arrangements also helps to prevent unwarranted and surprise liens from being filed for unpaid subcontractor costs."
Stage Two: The Building Process
Perform surprise onsite inspections. Although due diligence and contract language can go a long way toward protecting the owner from corruption and cost overruns, they are not a substitute for ongoing monitoring of a project. One overt tool that can be used during the project is surprise onsite inspections. During these inspections, owners should verify the number of workers onsite and the types of work being performed. Equipment should be spot-checked to make sure those items for which the owner is paying are actually onsite and are actually being utilized. Not only will such onsite inspections help to identify potential issues not readily apparent from the accounting and project documentation, but they will further reinforce an atmosphere of transparency, owner oversight, and respect for the integrity of all team members.
Reviews should be conducted of general conditions charges and change orders to ensure that the owner is not being charged under general conditions for an item or cost that was to be included in the fixed-price contract. Unfortunately, this kind of double billing is fairly common and is often not detected by owners unfamiliar with construction industry practices. It also is helpful to monitor contract compliance of fees and charges based on a percentage, such as the construction management fee or mark-up, to make sure the fees are not inflated.
"Any work being performed on a time and materials basis should be subject to additional scrutiny," notes LePatner. "Owners should perform spot verification of contractor and subcontractor payrolls to ensure that the amounts charged to the owner were actually paid to the labourers, tax authorities, unions, or insurance carriers. Review of cancelled checks, on a sample basis, can provide much of the needed verification."
Beware of the hidden "costs" of insurance. Some contractors use insurance costs as a profit center at the expense of owners. During the project, periodic reviews should be conducted of insurance policies, riders, and endorsements to verify coverages, as well as to document payment (through cancelled checks) to insurance carriers. "Often, owners and their representatives are provided what is widely known as an ACORD form, which is a seemingly official-looking document provided by a contractor's insurance broker," says LePatner. "The ACORD form may list all insurance coverages, but this form is not evidence of the actual insurance policies and endorsements being issued by an insurance company. Some corrupt contractors may use these costs to collect the full value of insurance premiums from owners and then never actually buy the policies."
Stage Three: The Close-out Process
Look out for last-minute charges. At the end of the project, owners should require a confirmation from the contractor, subcontractors, and any other team members that no additional costs or fees exist. It is customary to obtain waivers of liens at the time final payments are made. Again, a great way to ensure there has been no wrongdoing is to review and verify cancelled checks to make sure all subcontractors were paid the amount the general contractor or construction manager charged to the owner. Any discrepancies should be considered red flags and investigated further.
"The forensic monitoring procedures conducted throughout the project should be completed on the final payment requisitions, with particular attention paid to any last-minute change orders or fees," says LePatner. "No retainage (the 10 per cent held back from all contractors on each requisition) should be released until the owner and its examiners are convinced that all charges are appropriate and properly authorized."
The above procedures may seem like overkill to some, but they shouldn't when you consider how contractors win projects. The reality is that construction companies are hired through "low ball" bidding, meaning they bid at or below cost to win a project. Then they use unnecessary claims and change orders to run up their profit. It's a practice that happens throughout the construction industry-on projects big and small-and one that will likely only increase as recession-starved construction contractors fight for business.
"Most companies, hospitals, school boards, local governments, and other real estate developers can ill afford to have it reported publically that corrupt contractors were employed on a large-scale project," says LePatner. "When this occurs, it is necessary to identify why preventive mechanisms, such as the ones discussed above, weren't put in place to avoid such wholesale theft of millions. When these protective procedures are in place, the reality is that unscrupulous contractors avoid bidding.
"Going forward, owners have a choice," he concludes. "They can continue to avoid challenging the construction industry that has long lived with a reputation tarnished by repeated corruption, or they can practice the kind of self-help that will provide peace of mind and cost savings worth millions-and sometimes tens of millions of dollars-to their bottom lines. The choice is obvious-but again, it is a choice that few owners, going forward, can afford to get wrong."