Procurement Fraud: Schemes That Bilk Governments and Corporations

Procurement Fraud: Schemes That Bilk Governments and Corporations

Procurement fraud is a big problem that costs governments and companies billions of dollars every year. It involves manipulating the procurement process to unfairly award contracts or purchase goods and services at inflated prices. Understanding how these schemes work is the first step to preventing fraud and abuse.

Bid Rigging

One common type of procurement fraud is bid rigging. This involves collusion between bidders to manipulate the competitive bidding process. For example, competitors may agree to take turns being the low bidder, or decide who will win the contract beforehand. This eliminates true competition, resulting in higher prices for governments or companies. According to a Department of Justice report, bid rigging accounts for over $150 billion in costs to taxpayers and consumers each year.

To prevent bid rigging, procurement officials should be on the lookout for suspicious patterns like the same bidders taking turns winning contracts, or certain companies always submitting much higher bids than the winner. Splitting large contracts into smaller ones can also increase competition. And requiring open and sealed bidding makes it harder for bidders to collude.

Bribery and Kickbacks

Bribing procurement officials is another common fraud tactic. A vendor may offer cash, gifts, vacations, or other benefits to influence the officer’s decision. In return, the crooked official steers contracts to the vendor, even if they aren’t the most qualified or have the best price. The FBI reports that over 10% of public procurement spending is lost to corruption like bribery and kickbacks.

To reduce bribery, governments can increase oversight of procurement departments, especially for high-value contracts. Officials who review bids and award contracts should be rotated periodically. And robust whistleblower policies encourage employees to report suspected fraud. Vendors should also have clear ethics policies barring bribery of officials.

Overbilling and Overpayments

Vendors also commit fraud by overbilling governments and companies for goods or services. This may involve charging for work that was never done, hours that were not worked, or materials that were not used. Contractors may also bill multiple times for the same item or service. Without proper oversight, these inflated invoices easily slip through the cracks.

Preventing overbilling requires careful auditing of invoices and expenses before payment. Accounts payable staff should verify that billed items match work completed and contract terms. Automated systems can help detect duplicate charges or invoices that exceed pre-approved amounts. Conducting periodic audits of vendor records also helps identify overpayments.

Product Substitution

Instead of delivering the products specified in a contract, fraudulent vendors may substitute inferior or cheaper alternatives. But they still bill for the higher-priced goods in the contract. For example, a food supplier might ship lower-grade meat than the premium cuts ordered. Without adequate inspections, substitutions like this are hard to catch.

Organizations can protect against substitution fraud by writing detailed product specifications into contracts, and thoroughly inspecting shipments. Random sampling and testing of delivered goods acts as a deterrent too. For services contracts, requiring time sheets, progress reports, and site visits helps verify the work being billed was actually completed per contract terms.

Change Order Abuse

Change orders are used to modify a contract for additional work or expenses. Corrupt contractors take advantage of the change order process to increase their payments beyond the original agreed amount. They may claim that a change was necessary even if it clearly falls under the original scope. Vendors may also artificially break up the project into smaller pieces to request multiple change orders. This change order abuse ends up inflating the total cost to the government or company.

To prevent excessive change orders, procurement departments should closely review each request and supporting documentation. Change orders exceeding a set percentage of the original contract value may need additional approval and auditing. Having clear contract terms and scope of work makes it easier to reject invalid change order requests.

Split Purchases

When making a large purchase, some organizations require soliciting competitive bids or getting additional approval. Unethical employees try to bypass these safeguards by splitting the total purchase into smaller ones below the threshold. So instead of a single $20,000 contract requiring oversight, they approve ten separate $2,000 ones.

Organizations can reduce split purchases through strong policies and auditing. Lowering bid and approval thresholds closes loopholes. Accounts payable staff should watch for multiple smaller purchases with the same vendor. Data analytics helps identify suspicious patterns like spikes in purchases at certain times or from certain vendors.

Shell Companies

Some fraudsters create shell or pass-through companies to hide their involvement and inflate costs. They use the shell company to bid on contracts or purchase goods, then pass the work and invoices through to the main company. This creates a fake middleman allowing them to mark up costs. Shell companies also conceal conflicts of interest between vendors and procurement officials.

Thoroughly vetting new vendors can uncover shell companies with no real operating history or capabilities. Procurement staff should ask for details on a company’s operations, assets, previous contracts, and key personnel. Checking for connections with other vendors or employees helps detect hidden relationships.

Fake Invoices and Purchase Orders

Procurement scams often involve submitting fake invoices for goods and services that were never ordered or received. Criminals may create counterfeit invoices from real vendors, or completely fictional vendors, and submit them for payment. Individuals with access to ordering systems can also create fake purchase orders to generate fraudulent invoices. This results in governments and companies paying for items that don’t exist.

Fake invoices are harder to detect than inflated ones, but internal controls can help. Requiring secondary approval for payments over a certain amount limits a single person’s ability to create and approve bogus invoices. Accounts payable staff should verify that invoices match actual purchase orders and receiving documents. And audits should confirm that claimed goods and services were truly received.

Embezzlement

Procurement employees may abuse their access to steal or misuse funds through embezzlement schemes. They may establish fake vendors in the payment system and write checks to themselves. Or collude with real vendors to overpay on invoices and split the excess. Procurement cards can also be used to make unauthorized purchases for personal gain. The Association of Certified Fraud Examiners estimates that organizations lose 5% of revenues to employee embezzlement and theft.

To prevent embezzlement, organizations should segregate duties so no single employee controls the entire payment process. Mandating employee leave periods allows others to review their work for irregularities. Audits of vendor master files and payment histories identify suspicious patterns. And procurement card purchases should be monitored for compliance with policies.

Phantom Vendors

Payments made to fake, non-existent vendors represent another procurement fraud technique. Scammers create phantom vendors in the vendor master file or financial system to receive payments for goods never delivered or services never rendered. They may assume the identity of real companies, or invent completely fake ones. The fraudster then pockets the checks or wires paid to the phantom.

Preventing phantom vendors requires keeping vendor master files up to date, and promptly removing inactive ones. Accounts payable should verify all new vendors and watch for suspicious changes like altered bank accounts. Regular audits by multiple individuals help detect fake vendors not tied to any real business activity.

Conflicts of Interest

Procurement officials awarding contracts to companies they have undisclosed ties to is an ethics breach, even if not outright fraudulent. They may prioritize bids from vendors owned by friends or family members. Or award contracts to businesses they have a financial stake in. These conflicts of interest undermine fair, competitive bidding and often lead to higher costs.

Organizations should require procurement decision makers to fully disclose any potential conflicts of interest. Vendor bids and payments involving connected companies undergo additional scrutiny. Strict ethics and anti-nepotism policies are enforced, with violations resulting in termination. Removing or rotating employees out of procurement roles periodically also helps limit conflicts of interest.

Fraudulent Certifications

Certain government contracts require certification as a minority-owned, woman-owned, or other category of disadvantaged business to qualify. Vendors may falsify these certifications to win set-aside contracts they aren’t entitled to. They pretend to be owned by someone meeting the criteria when the real owners don’t. Or established companies create shell companies just to improperly gain certification and federal contracts.

Agencies must thoroughly vet and verify all certification applications through document reviews and site visits. They should check for ownership ties with other companies to detect sham affiliates. Monitoring contract performance and spend helps identify vendors not actually meeting disadvantaged business requirements. And violators should be prosecuted and barred from future contracts.

Contract Non-Compliance

Intentionally failing to comply with contract requirements is a form of fraud, even without billing issues. A vendor might use inferior materials or inadequately trained staff than outlined in the contract. They cut corners to reduce their costs, while still collecting full payment. This failure to deliver contracted goods or services amounts to fraud. But it often goes undetected without proper oversight.

Building robust compliance monitoring into contracts lets purchasers verify services meet requirements. This includes detailed performance metrics, progress reports, and on-site inspections. Penalties for non-compliance give vendors incentive to fulfill contract terms. And recurring non-compliance should result in termination with damages recovered.

Cyber Fraud

Procurement fraud is moving online as purchasing and payments shift to digital systems. Criminals hack into networks to steal payment or order information, create fake vendors, and route payments to themselves. Bogus websites impersonate real suppliers to submit false invoices. And compromised email accounts allow fraudsters to intercept legitimate purchases. A 2018 survey found that 78% of organizations experienced attempted payment fraud through electronic means.

Cybersecurity measures like intrusion prevention, multi-factor authentication, encryption, and access controls help secure procurement systems. Monitoring account activity and payments for anomalies detects fraud. Employee training raises awareness of risks like invoice and vendor spoofing. And digitally signing and validating invoices electronically reduces manipulation.

Money Laundering

Criminals often need to launder illicit funds, so they may use sham procurement contracts to clean dirty money. They overpay invoices from shell companies they control, mixing illegal cash with legitimate payments. Or submit inflated invoices from real vendors who return the excess funds as “refunds” now appearing legitimate. Non-existent services and ghost vendors provide cover for transferring and integrating dirty money.

Anti-money laundering efforts include scrutinizing payments that seem excessive for the goods or services described. Reviewing vendor ownership identifies those controlled by suspicious entities or individuals. Confirming services were truly delivered reduces payments for non-existent items. And reporting requirements deter vendors from participating in money laundering schemes.

Tax Evasion

By hiding income, procurement fraud is often tied to tax evasion as well. Vendors underreport their earnings with fake expenses to lower taxable income. They may route payments through shell companies in tax havens to avoid reporting the income. Some schemes involve overpaying taxes upfront, then submitting inflated procurement invoices to recoup the excess taxes. These techniques let vendors reduce tax obligations while overcharging governments or companies.

Verifying vendor financial documents helps identify unreported income and expenses not tied to legitimate business activities.