Contract Risks

Presentation to the GFOA Annual
Conference on Contract Risks
May 11, 2016
Ron Steinkamp, CPA, CIA, CFE, CRMA, CGMA
rsteinkamp@bswllc.com | 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.

• Prepare solicitation document (RFI, RFQ,
RFP, etc.).
• Provide notice of solicitation.
• Issue solicitation document.
• Receive bids and proposals.
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Solicitation Phase

• Evaluates bids/proposals.
• May conduct discussions/negotiations.
• May provide opportunity to revise
bids/proposals.
• Select winning bid/proposal.
• Execute contract and terms.
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Bid Evaluation and Award Phase

• 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.
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Post Award and Administration Phase

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.
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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.

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.
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Collusion Between Contractors and Employees

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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• 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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• 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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• 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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• 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 Performance
Schemes and Red Flags
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• Non-conforming goods or services.
• Change order abuse.
• Cost mischarging.
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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

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.
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Change Order Abuse

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.
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Change Order Abuse

• 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.
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Change Order Abuse

• 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.
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Cost Mischarging

• 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.
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Cost Mischarging (Continued)

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.
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Cost Mischarging Abuse

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
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Elements of Fraud Prevention

Organizations should:
• Educate employees about procurement
fraud.
• Focus education efforts on employees in
best position to identify vulnerabilities or
red flags.
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Employee Education

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.
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Internal Controls

Implement programs to measure the
performance of procurement activities:
• Continuous monitoring using data
analytics.
• Regular internal audits.
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Monitoring Activities

A vendor due diligence program should include:
• Vendor background checks.
• Controls for vendor master file
management.
• Vendor monitoring.
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Vendor Due Diligence

Detecting Contract
Performance 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.
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Non-Conforming Goods or Services (Continued)

• 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.
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Change Order Abuse

• 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.
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Cost Mischarging

• 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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Connect
I
Ron Steinkamp
rsteinkamp@bswllc.com
314-983-1238
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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