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Payment Abuse or Payment Fraud?

Unfortunately, fraud and construction have gone hand in hand since the beginning of the industry.

One of the world’s oldest deciphered writings is the Code of Hammurabi, a 1772 B.C. set of laws regulating the construction industry, among other things. Among the regulations, builders who “do not construct [a building] properly” could be put to death. Problems with construction quality and a general distrust of builders, in other words, has a history.

General contractors and subcontractors grumble about their respective financial risk on a project. Each allege abuse of the payment flow and try to “stay ahead” of the other. This is not a discussion of traditional fraud categories like corruption, asset misappropriation and undisguised theft. This is a fraud gray area.

Most would agree that the gamesmanship sometimes crosses the line to fraud, and others would argue that it is almost always fraud. There are tools to prevent payment abuses and payment fraud.

What Is Payment Fraud?

With its layers of parties and hyper complexity, the construction project is a perfect breeding ground for fraud of all types, and especially payment flow abuse fraud.

The Association of Certified Fraud Examiners’ (ACFE) survey of members revealed that organizations lose an average of 5 percent in annual revenue to fraud. According to the survey, the number one fraud scheme in the construction industry is related to billing (36.2 percent). This is in line with Construction Business Owner’s list of the Most Common Types of Construction Fraud, which includes falsifying payment applications, billing for unperformed work and manipulating the schedule of values and contingency accounts.

The fraud measured by these reports is perhaps more sinister than “gray hat” fraud. “Gray hat” fraud can comes in all shapes and sizes, and the victims can be at the top or bottom of chain.

 Examples and Tools to Combat Fraud

The tools (and the fraud) may be slightly different depending on the party’s role in the project (i.e., “top of chain” or “bottom of chain” parties). Top of chain parties include general contractors, developers and lenders. Bottom of chain parties include subcontractors, sub-subcontractors, suppliers and laborers.

Misappropriation of funds occurs when a project participant is paid for work, but does not pay the laborers, subcontractors and suppliers down the chain, spending the money elsewhere.

This activity is definitely fraud. In fact, most states have criminal statutes on the books making this a misdemeanor or felony offense. It is extraordinarily hard to get these cases prosecuted, however, as they are riddled with civil dispute components.

This fraud is commonly committed by both bottom of chain and top of chain (i.e. general contractors) participants. The victim of this fraud includes all of the participants below the perpetrator in the contracting chain. Further, since a mechanics lien or bond claim can be filed, those above the perpetrator can also be affected by being required to pay for certain work twice.

The following tools are available to combat misappropriation of funds for top of the chain parties.

  • Lien waivers—Demand lien waivers from payees and their subs, laborers and/or suppliers before payment is made.
  • Payment bonds—Require subcontractors to post a payment bond to insulate the company in the event labors, sub-subs or suppliers go unpaid.
  • Criminal reporting—If there is a good and clean enough case, report it to the state attorney general’s office.

The following tools are available to combat misappropriation of funds for bottom of the chain parties:

  • Preliminary notice—Some states require preliminary notice, but it is a good idea to send these notices in every state to alert top of chain parties that the company is on the project. This will drastically reduce the chances of going unpaid and falling victim to misappropriation.
  • File lien/bond claim—If the company does fall victim to misappropriation, it may still be able to collect from other parties by filing a mechanics lien or bond claim.
  • Criminal reporting—Just like top of chain parties, the company may benefit from a reporting of the action to the attorney general’s office. Unfortunately, these accusations are rarely prosecuted.
  • Civil penalties—Most states allow a company to seek and recover civil penalties from anyone misappropriating funds. Learn the rule applicable to the project and leverage it.

False Payment Applications

Project participants are in a constant cat-and-mouse to “stay ahead” of the other on the project. This manifests itself in the battle over payment application content. A formal and defined payment application is an asset to any construction project, but formalities can only take the parties so far. There’s no way around the fact that payment application figures (i.e., the work completion percentages) are in the eye of the beholder.

False payment applications occurs when those down the chain inflate the percentage of work they have completed, and those up the chain deflate the same figure. The top and bottom of the chain parties, in other words, are simultaneously fudging the numbers to put more cash in their pocket with each application.

The following tools combat false payment applications for top of the chain and bottom of the chain parties.

  • Independent third party review—Having an independent contract administrator that everyone trusts is important and can go a long way to resolve this problem. There is a lot of concern about the allegiances of architects, the traditional contract administrator and all parties are well served to address those concerns.

The following tools combat false payment applications for top of the chain parties.

  • They have the purse—Top of chain parties hold the purse, and accordingly, they can assert some leverage in this game.
  • Be aware of project status—The purse is meaningless if the top of chain party doesn’t stay advised about the status of all parties on the project. Be in tune with the project in order to recognize false or borderline-false payment applications.

The following tools combat false payment applications for bottom of the chain parties.

  • Lien and bond claim right—Bottom of chain parties are in a bad position with payment applications. They frequently feel like they are being short-changed, and they frequently actually are. The power of the purse, however, means bottom of chain parties are likely required to keep moving on the project despite the payment application argument. Preserving lien and bond claim rights is critical to make certain that being behind doesn’t turn into getting stiffed.
  • Stop work—This is a very touchy remedy so proceed with great caution. Depending on the contract terms and situation, stopping work can put a bottom of chain party into a really bad position.

Payment abuse is a very convoluted and touchy subject. Bottom of the chain parties feel jaded and have a great argument. Top of the chain parties get burned frequently and argue they need to be insulated from risk, and they too have a great argument.

The problem for the construction industry is that these two arguments manifest themselves in “gray hat” fraud behavior, whereby each side works to “stay ahead” of the other. Staying ahead, however, necessarily requires one side to have an unfair advantage over the other.

Does the construction industry have a payment fraud or payment abuse problem? The answer is probably yes; but at the same time, both sides of the table have adequate tools that can be employed to protect themselves … and get ahead.

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