Preventing Construction Loan Fraud

Contract Simply is now Rabbet. We’re the same company – just with a new name – building the only intelligent construction finance platform. The content of this post has been preserved with the Contract Simply name.

Fraud is a concern in almost any industry, but the area of construction seems to be particularly susceptible to this malady. As a fairly recent study has shown, the amount of losses caused by fraud in the construction industry is almost double the overall industry average. With a large number of moving pieces, both physical and financial, construction projects that aren’t closely monitored leave a lot of room for attempts at manipulation.

Construction loans further increase the already high number of factors to juggle simultaneously, making it difficult to keep close track of every aspect of the loan and the construction project itself. Unmonitored funds and expenditures are a popular playing ground of the ill-intentioned. Even when dealing with highly reputable parties with a track record of clean and honest work, it is never a bad idea to install mechanisms that can detect and prevent fraudulent activity.

Let’s examine the most common types of construction loan fraud and what you can do to recognize and prevent it.

Types of Construction Loan Fraud

Lending institutions tend to monitor their funds closely to minimize the risk of fraud. It is in their best interest that the project is completed successfully without any major modifications to the budget but, generally, the lender will protect the borrower’s interests only as far as they align with their own. In other words, borrowers cannot rely solely on the lending institutions to ensure a clean and transparent construction process. They are still vulnerable to fraud from the construction side of the project.

Opportunities for fraud are seemingly limitless in an industry with multiple parties and processes, but we can generally boil it down to three most common types:

●        False Payments: The most common type of construction fraud, this group includes any sort of unjustified due payment, whether through inflated prices of materials or labor, false invoices, excessive purchases, etc.

●        Inventory Mismanagement: This is any type of mishandling of stored materials, whether its purchase of cheaper and lower-quality materials than agreed upon, use of inventory for personal needs, or plain theft.

●        False Representation: Any unreported deviations from the agreed upon amount and quality of work, including charging for work outside of the predefined scope, charging for work that hasn’t been done, charging the full price for inferior work, disregard for pre-agreed and paid safety standards, worker permits, and so on fall under this fraud category.

How to Detect and Prevent Construction Loan Fraud

The only definitive way to keep your loan-funded construction project safe from fraud is to closely track all of its aspects. However, that’s easier said than done. Constant supervision of all current expenses and their relation to the overall budget, as well as first-hand accounts of the project’s progress and the status of stored materials, is a time consuming and often complicated process.

A number of risks can potentially be avoided before construction work has even begun, through a transparent and precise contract agreement and pursuit of additional guarantees regarding the amount and quality of work. Still, even the finest word on paper can only go so far, and skilled and experienced fraudsters always find creative ways to work around regulations. Therefore, the borrower must always keep close track of ongoing costs and the actual work being done.

Possible red flags related to fraud are frequent change order requests and line items that go over budget. They are not necessarily proof of any wrongdoing, but they certainly require close scrutiny.

Implementation of contemporary technologies in construction loan management can go a long way in detecting warning signs and preventing fraud altogether, particularly when it comes to financial transactions. For instance, Contract Simply’s construction loan software enables a transparent process from start to finish by automating a number of processes that reduce manual entries, maintain tidy documentation of receipts and invoices, and allow 24-7 access to all project finance details. Additionally, and most importantly in this context, the software is also equipped with automatic checks that immediately detect any warning signs of improper activity. These warning signs may include:

●        Missing or duplicate source documents

●        Payees on checks that do not match general ledger entries

●        Receipts or invoices that lack professional quality

●        Overdrawn budget line items

Once a potential problem is detected, it is easier to focus on it and review all of the details to determine whether there was indeed any fraud attempted.

Every project with significant funding is at risk of fraudulent activity. It is imperative for any party at risk to keep a watchful eye on the project’s progress in all its minute details. With the number of factors to monitor, embracing modern technologies that can relieve you of some aspects of the comprehensive supervision effort will save you time and help minimize the risk of losing money due to fraud.