Construction Accounting and Taxation

July/August 2012

TIPS (TO ENSURE PROPER SERVICE?): THE NEED FOR INTERNAL CONTROLS OVER BID RIGGING ON CONTRACTS
TRACY REED, PENELOPE BAGLEY, AND RON MARDEN PENELOPE BAGLEY, Ph.D., CPA, is the Reznick Group Fellow and an Assistant Professor at Appalachian State University in Boone, North Carolina. She has taught auditing at both the undergraduate and graduate level, as well as worked as an external auditor prior to obtaining her Ph.D. RON MARDEN, Ph.D., CIA, CPA, is the Cherry Bekaert Holland Research Fellow in the Department of Accounting at Appalachian State University in Boone, North Carolina. He is a member of the Institute of Internal Auditors and has taught auditing, internal auditing, and fraud classes. TRACY REED, Ph.D., CPA (inactive) is the Dixon Hughes Goodman Research Fellow and an Assistant Professor at Appalachian State University. Her professional accounting experience was with Deloitte & Touche. Tracy currently teaches financial accounting and auditing. The authors present scenarios showing what can go wrong with the contracting and bidding process, then discuss some precautions a company can take to help avoid bid rigging. Joe was the owner of REM, a successful regional carpet cleaning company that contracted out to perform regularly scheduled carpet and furniture steam-cleaning to some of the largest companies in the southeast. The company had 30 offices and over 250 employees covering from Florida to North Carolina. REM also specialized in restoration work when carpet and furniture were damaged from smoke, fire, and/or water disasters. Because the timing of the restoration work was unpredictable, it was a common procedure to contract and sub-contract out much of the work to other carpet cleaning companies so REM wouldn't have to pull its regular employees from

routine maintenance work. In fact, there was so much work coming from the restoration side of the business that Joe decided to hire Sal to be REM's restoration contracting official. Joe knew Sal had once owned his own carpet cleaning company and had many years of experience in the business. He had retired before signing on with REM. Joe was an honest business man and respected in the industry, so to keep things fair he told Sal that REM should obtain at least three independent bids before selecting which company would get the restoration contract work. It wasn't long before Joe started to hear complaints, not only from a number of independent companies that felt they were being passed over unfairly for the contract work, but also complaints about sub-standard work from some of the firms having restoration work done. While many of these complaints were from identifiable sources, some were anonymous. Several of the anonymous tips advised Joe that Sal needed to be investigated. The further Joe looked into the situation, the more he realized something was wrong. Ultimately, Sal turned out to be somewhat of a fraudster and a clever one at that. He used a number of tricks and techniques to supplement his income by rigging the bidding process on the contract work. He accepted bribes, kickbacks, and cooked up several other schemes in order to influence which companies would get the work. Joe soon realized that he had mistakenly put complete trust in Sal and never had considered that he would become a victim of occupational fraud.

Occupational fraud
Occupational fraud can take place in a variety of forms. According to the Association of Certified Fraud Examiners (ACFE), the term occupational fraud has been defined as the use of one's occupation for personal enrichment through the deliberate misuse or misappropriation of the employing organization's resources or assets. In other words, an employee, such as Sal, abuses the trust placed in him by an employer for personal gain. The ACFE has classified occupational fraud into three categories: asset misappropriation, financial statement fraud, and corruption. The scenario described above dealt with bid rigging, which would fall under the corruption category. Corruption involves an employee who misuses his or her influence in a business transaction in a way that violates a duty to the employer in order to gain a direct or indirect benefit.

Corruption
Corruption can result from any one of a number of situations including conflicts of interest, bribery, kickbacks, illegal gratuities, and/or economic extortion. Conflicts of interest result from a situation where an employee, manager, or executive has an undisclosed economic or personal interest in a transaction that can adversely affect the company. The key word here is undisclosed. The victim organization is unaware that its employee has divided loyalties. Bribery is the offering, giving, receiving, or soliciting of something of value for the purpose of influencing a transaction or event. These offers are usually made before the transaction takes place, and the amount is usually known ahead of time. Kickbacks are similar to bribes in that they also involve the offering, giving, receiving, or soliciting of something of value for the purpose of influencing a transaction or event. However, these offers are usually given after the transaction or event with the amount usually known ahead of time. Illegal gratuities are similar to kickbacks in that they are also usually given after the transaction or event. They differ in that the amount of the offer is usually not agreed to before the act takes place. They are occasionally referred to as tips or thank you gifts and are not always expected. Economic extortion is the obtaining of property or other assets from another with the other party's consent having been induced by wrongful use of actual or threatened force or fear. This is basically the flip side of bribery, where instead of an outside organization trying to influence an employee, the employee demands or extorts payment from the outside organization before moving forward with the transaction or event.

Bid rigging on contracts

In the competitive bidding process all bidders are supposed to be placed on the same level, bidding on the same terms and conditions based on the specifications of the contract. Unfortunately, this can be a very cutthroat environment and ripe for all types of corruption. The way the bidding process can be rigged will depend largely on the level of influence of the corrupt employee. The more power the employee has over the bidding process, the more likely that person can influence or be influenced in the selection of the bidder and/or the terms of the contract. In the case of REM, Sal had complete control over the bidding process, which allowed for the corruption to easily occur. Corruption in the bidding process can be complex and difficult to detect because there are so many ways the process can be manipulated. As discussed earlier, bad business decisions may be made on behalf of the organization because of conflicts of interest, bribes, kickbacks, illegal gratuities, and/or economic extortion.

Corruption, bid rigging, and internal controls

In their 2012 Report to the Nations on Occupational Fraud and Abuse, the ACFE present some interesting statistics compiled from their survey of 1,388 individual fraud cases. 1 While asset misappropriation frauds were certainly the most common, over a third of the cases reported involved some form of corruption scheme with median losses reaching $250,000. In addition, while there is a great benefit to detecting any type of fraud scheme as quickly as possible, the reported median amount of time it took from the point at which the corrupting scheme occurred to when it was discovered was about a year and a half. Although the cases reported to the ACFE do not represent an exhaustive list of every fraudulent act over the past two years, they plainly highlight the critical need for effective internal controls over occupational fraud and, as in the REM case, over corruption in the bidding on contracts. Interestingly, the ACFE's report indicated that the method most effective for detecting corruption was tips (followed by management review and internal audit). While over half of the tips originated from employees, a third of the remaining detected schemes were discovered from customer tips or reported anonymously through phone or web-based hotlines. The report found that organizations with some form of hotline in place have a much higher likelihood of detecting fraud through a tip than an organization without a hotline. A hotline is just one of many types of internal control that companies can put in place to help deter corruption and bid rigging. Surprisingly, the ACFE found that the control weakness that contributes most to fraud is the absence of internal controls, followed closely by the override of existing internal controls and lack of management review. Another interesting discovery from the report was where the fraud was found. The report categorized an organization into six areas, including accounting, operations, sales, upper management, customer service, and purchasing. The various fraud schemes that were carried out in these areas included corruption, billing schemes, skimming, non-cash schemes, cash larceny, check tampering, payroll, expense reimbursement, as well as several other schemes. Out of all these possibilities, corruption schemes were the highest in each of the six areas of the organization, with the exception of the accounting area. Not surprisingly, the highest rates of corruption were found in the purchasing and upper management areas (over 50% of their cases involved corruption). This highlights the problem of bid rigging, as these areas are likely involved in contract bidding.

Red flags of contract fraud

There are several resources available to help companies identify the occurrence of bid rigging. The red flags we have identified are based on three recent articles. In an article titled: Finding the Bid Riggers: The 12 Red Flags of Contract and Procurement Fraud, Charles Piper discusses a dozen situations to look for to avoid problems when collecting bids on contracts. 2 For each scenario Piper illustrates what can go wrong and, based on his personal experiences with bid rigging cases, a number of internal control procedures to prevent, detect, or correct the schemes. Keep in mind that in some cases more than one red flag may be present at a time. The Organisation for Economic Co-operation and Development (OECD) is an intergovernmental organization that develops global standards, international conventions, agreements, and recommendations to promote rules in the areas of governance and the fight against bribery and corruption. They have issued a report highlighting seven signs to identify bid rigging. 3 Another article by Kathryn Kerkhoff, who is a Special Agent of the United States Department of Transportation Office of Inspector General, details ways to detect and prevent fraud schemes related to transportation projects. 4 Specifically, she discusses ways to detect bid rigging, price fixing, product substitution, quality-control testing fraud, bribery, kickbacks, conflicts of interest, false claims, overbilling, and disadvantaged business enterprise fraud. Bid rigging may occur through collusion of an employee with external contractors, but it may also occur when external contractors collude with each other to fix prices at a higher amount than competitive bidding would normally result.

Collusion of an employee
Some red flags indicating bid rigging through collusion of an employee with external contractors might include: Repeated awards to the same entity. If the same supplier is often the selected bidder, it is important to discover the reasons they are awarded the contract and if those reasons are justified. A contracting official (CO) may have preselected the winning vendor and engineered supporting documentation to support this selection through post-dating of quotes and other documents. 5 This can be discovered through review of the pre-award contract documentation to

ensure that the contract was advertised and other quotes or bids were obtained at the proper time. Competitive bidder complaints and protests. This may occur when certain companies submit bids but either rarely or never win. When bidders complain, their protests should be evaluated by someone other than the CO periodically to determine if they have merit. 6 Piper discovered an instance of bribery of a CO, who was prematurely opening bids and providing that information to a friend. Complaints about quality and quantity or awarding contracts to contractors with low performance records. Repeated complaints of this type may indicate that the contracting company is supplying defective products, or committing fraud such as product substitution, short quantity shipments, 'ghost' shipments (submitting invoices for payment but never shipping the items), double-billing, etc. 7 While this may occur accidentally, repeated complaints may indicate this is purposeful and has allowed the vendor to underbid, since they had no intention to fulfill their contract in its entirety. Awarding contracts to contractors with low performance records may be an indication that the CO is receiving kickbacks from the contractor. 8 Multiple contracts awarded below competitive threshold. If a CO splits a single job into multiple contracts that are below the dollar value that requires obtaining competitive bids, they can then award the contracts to a single vendor without competition. Piper 9 discusses an instance where a CO split a single job into several orders to keep the price per order under $2,500, the threshold that required obtaining competitive bids. This CO also obtained phone bids for contracts between $2,500 and $25,000, but always called their preferred bidder last, providing them the competing bids prior to obtaining a bid from them. Contract scope changes and post-award contract change orders. This occurs when a CO adds work to the contract after it is awarded that is unrelated to what was advertised, or adds a significant amount of similar work, which changes the total dollar amount of the contract significantly. These are both instances where the competitive bids provided might have been significantly different if the bidders were aware of the extra work related to the entire project. It favors the bidder who is aware of the extra work when placing the bid. 10

Urgent need or sole source. If a need is deemed to be urgent or the terms of the contract are such that there is only one possible supplier, then a contract may be awarded without obtaining competitive bids. It is important in these instances to determine if, in fact, this is the appropriate action. For urgent need, it is important to determine if the need is in fact urgent, and if it occurred because of poor planning. In that case, a selected vendor may have been favored or the price paid for the contract may be higher than necessary. For sole source contracts, it is important to determine if in fact the supplier is the only source. It is possible that no-value-added technical specifications may have been added to the contract to favor a specific vendor. A simple internet search including only value-added specifications may locate other sources. 11 Lifestyle beyond means. If a CO is living a lifestyle that is clearly beyond their means, then it is possible that they are receiving payoffs, bribes, and kickbacks. A company may note an employee buying a new, very expensive car and/or home, taking expensive and frequent vacations, or other unrealistic spending patterns unsustainable given their current financial situation. 12 Award to non-lowest bidder. A CO may be allowed to award the bid to the non-lowest bidder based on best-value, such as reputation or prior working relationship. This allows the CO to favor bidders due to payoffs, kickbacks, bribes, or relationships. 13

Collusion among bidders

Some red flags indicating that collusion among bidders is occurring and that the company may be paying prices that are higher than those resulting from competitive bidding might include: Bidders take turns being the lowest bidder. In these cases, the bidders take turns winning the contracts, but all bids submitted are higher than they would have been if the process were truly competitive. However, because all the prices were inflated, including the winning bid, the CO assumes that all prices are reasonable. 14 Winning bidder subcontracts work to unsuccessful bidders. Especially in situations where the bidders involved also take turns being the lowest bidder. This may indicate that the bidders are in collusion and are also price-fixing at an elevated price. 15

Winning bidder does not accept job and is later found to be a subcontractor. In this case, due to collusion, the prices are already elevated. By rejecting the contract, the contract price paid will be even higher, as the contract will then be awarded to the next-lowest bidder. Therefore, the awarded contract will unfairly benefit both the lowest bidder (as a subcontractor) and the secondlowest bidder, who gets the contract. 16 Similar bid contracts are submitted. When bidders collude, they may use the same person to organize and write all of the bids. Companies should look for instances of similar terminology, misspellings, handwriting, and identical line item bids for nonstandard items. They may also note apparent connections between bidders, like common addresses, personnel, or telephone numbers. 17

Collusion of employee with external contractor or among contractors

Some red flags that may indicate either collusion of an employee with an external contractor or collusion among contractors might include: Abnormal bid patterns. This may include things such as: sudden and identical increases in prices that cannot be explained by corresponding cost increases, identical pricing from all vendors on all items, large price differences between the winning bid and all other bids, a supplier's bid on one contract is significantly different than their bid on a different but similar contract, and a significant reduction from past price levels after a bid from a new or infrequent bidder.

These types of abnormal bid patterns may indicate that a bidder will use substandard material and/or material that does not meet the specifications of the contract, potentially with the knowledge of the CO, who is receiving a payoff. They may also be a clear indicator of collusion in the current bidding, or collusion in prior contracts among bidders. 18

Agent fees. Any contract submitted that lists an agent fee should be carefully scrutinized. Piper notes that some agent fees were paid to a supposedly independent agent called a 10- percenter who would receive a 10% fee if the contract was awarded to the bidder. There have been instances when the 10-percenter was the same agent for multiple bidders on the same contract, indicating collusion among bidders. In other instances, the 10-percenter was facilitating bribes to the CO related to certain contracts. 19 Socializing and/or business relationships. If competitive bidders regularly socialize or hold meetings shortly before a tender deadline, this may indicate collusion among bidders. 20 It is also possible that a CO may socialize or have business relationships with a bidder or the bidder's family that may be an indication of collusion. 21 The red flags mentioned above can help a company identify when bid rigging is occurring, whether due to collusion of an employee with an external party or collusion among bidders. Bid rigging is always a detriment to the company and should be prevented or detected and corrected as quickly as possible. In order to do this, a company needs to develop a strong system of internal controls.

Internal controls to help prevent bid rigging

While the red flags discussed are not an exhaustive list of the things that can go wrong with the contracting and bidding process, there are some precautions a company can take to help avoid bid rigging. Below are easily implementable internal controls that can help a company to avoid bid rigging due to employee corruption, as in the case of REM, and collusion among bidders. Some internal controls that would help avoid bid rigging through collusion of an employee with external contractors would include: Be fair and equitableTreat all bidders the same. Share the selection criteria with all bidders and clearly define performance requirements. If a bidding extension is offered to one supplier, the same extension should be offered to all bidders. If one supplier asks a question, share the question (but not the asker's name) and the answer with all potential suppliers. Do not negotiate with one supplier without providing the same opportunity to any more favorable or lower-priced suppliers. 22

Watch yourselfMake sure the employees involved in the bidding process are following the company's protocol. The contract specifications should not be based on a single supplier's capabilities, and selection criteria should be established prior to soliciting bids. Don't share information with bidders about the bids of others. And most importantly, be sure no employees involved in the bidding process have any type of financial or personal interest with any of the bidders. 23

Some internal controls to help avoid collusion among bidders: Be an informed buyerAs the saying goes, knowledge is power. Know the market characteristics from which the purchase will be made, including recent industry trends, product offerings and prices, and potential suppliers. Ask questions about prices and bids that don't make sense. Not only can this increase your knowledge about the market, but it can also help raise the awareness of potential bidder collusion. 24 Solicit bids from as many suppliers as possibleDo not limit potential suppliers to a prequalified group, qualify the bidders during the process. Not only might this result in the best contract for you, increasing the number of bidders can also decrease the probability of collusion. 25 Some internal controls to help avoid collusion of an employee with an external contractor or collusion among bidders include: Encourage communication Establish a hotline or something similar where fellow bidders can convey competition concerns. Also, establish a similar program for internal employees to report suspicious activities of other employees or potential bidders. Conduct interviews with former bidders who are no longer bidding on your contracts to determine why they are no longer bidding. You might discover that the vendors are being treated unfairly. Most importantly, follow up on complaints and tips received to determine if there is a legitimate cause for concern. 26Open communication with bidders and employees can help identify employee corruption or collusion schemes. Don't let them talk among themselves Limit the communication between bidders as much as possible. Open communication and gatherings of bidders can enable signaling and provide opportunities for collusion. Allowing bids to be submitted in person can also be

troubling, as it provides an opportunity for last minute under the table negotiations (i.e., potential bribery situations). Bids submitted anonymously by telephone or mail, or better yet, through electronic bidding, can help avoid such situations. Further, requiring bidders to sign a non-collusion affidavit can help deter collusion and questionable bidding practices. 27 Be awareIt is critical that employees who are responsible for analyzing, reviewing, or overseeing the compliance of contract award procedures be aware of the risks of bid rigging, price fixing, and collusion. 28 Personnel should be mindful of red flags previously discussed in this article. Even if only one irregularity is identified, it should not be automatically dismissed as accidental or a coincidence. Additional research and analysis may identify underlying patterns of collusion, corruption, or conflicts of interest. Even with internal controls in place, collusion and corruptions, particularly in bid rigging, can still occur. Regrettably, a company cannot control the actions of their bidders, and even the most dedicated employee may compromise his or her integrity in contract-awarding decisions because of monetary incentives. Unfortunately, bribes, kickbacks and the other various forms of corruption may simply be perceived as tipsto ensure proper service.
1

Association of Certified Fraud Examiners, Report to the Nations on Occupational Fraud and Abuse (2012). http://www.acfe.com/rttn.aspx.
2

Piper, C. Finding the Bid Riggers: The 12 Red Flags of Contract and Procurement Fraud, Fraud Magazine (July/August 2012). Charles Piper, CFE, CRT, is a private investigator, consultant, and owner of Charles Piper's Professional Services in West Tennessee (www.piperpi.com).
3

Organisation for Economic Co-operation and Development (OECD), Detecting Bid Rigging in Public Procurement, www.oecd.org/competition/bidrigging (2009).
4

Kerkhoff, K. Detect and Prevent Fraud Schemes on Transportation Projects www.techtransfer.berkeley.edu/newsletter/11-1/fraud.php (2011).
5

Op. cit. Notes 24.

6

Op. cit. Notes 2 and 3.

7

Op. cit. Note 2.

8

Op. cit. Note 4.

9

Op. cit. Note 2.

10

Op. cit. Notes 2 and 4.

11

Ibid.
12

Op. cit. Notes 3 and 4.

13

Op. cit. Notes 2 and 4.

14

Op. cit. Notes 24.

15

Op. cit. Notes 2 and 4.

16

Ibid.
17

Op. cit. Notes 2 and 4.

18

Op. cit. Notes 24.

19

Op. cit. Note 2.

20

Op. cit. Note 3.

21

Op. cit. Note 4.

22

Dominick, C. 11 Signs of Ethical Competitive Bidding,' Organisation for Economic Co-operation and Development (OECD), http://www.nextlevelpurchasing.com/articles/ethical-competitivebidding.html (2004); Organisation for Economic Co-operation and Development (OECD), Guidelines for Fighting Bid Rigging in Public Procurement,' www.oecd.org/competition (2009).
23

Ibid, Dominick.
24

U.S. Department of Justice (USDOJ), Preventing and Detecting Bid Rigging, Price Fixing, and Market Allocation in Post-Disaster Building Projects,' www.justice.gov (2008); Op. cit. Note 22, OECD.
25

Ibid.
26

Op. cit. Note 22, OECD.

27

Op. cit. Notes 22 (OECD) and 24 (USDOJ).

28

Op. cit. Note 24 (USDOJ).

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