Controlling construction costs: school districts of all sizes and economic status are vulnerable to overcharges and outright fraud. Here's how to keep your team as honest as possible.

She had no financial expertise--in fact, Veronica Klinefelt was a stay-at-home morn with a high school diploma when she won her bid for a seat on the East Detroit School Board in January 1998. But it was enough background to uncover a $3 million construction fraud scheme in her district that sent two board members and two superintendents to jail.

A clerk at a Home Depot store unraveled a pattern of fraud stemming from the Roslyn School District superintendent's office in New York simply by picking up the phone to see why someone was using the district's official credit card to purchase tens of thousands of dollars in building materials to be shipped to a private residence. And while he was asking, why did they choose his store 35 miles away instead of the Home Depot in Roslyn? When law enforcement tallied the abuses they uncovered since this warning light in October 2002, the bill came to $11.2 million--and again, several people are sitting in prison today.

These incidents shouldn't shock educators. After all, the construction industry ranks among the top 10 percent of industries known for corruption and fraud, says Michael Kessler, president and CEO of the New York-based Kessler International, a corporate investigations and forensic accounting firm. And for school districts, the ramifications reach deeper than the monetary losses. Businesses in Camden, N.J., for instance, are disillusioned that statewide school construction came to a grinding halt when its oversight group ran through the $8 billion budget before the jobs were completed.

"There were a lot of high hopes that with new schools being built, it would improve the reputation of the town, the housing and the commercial environment. They were looking to spur economic development that brings community pride," notes Timothy Duggan, the chairman of eminent domain at Stark and Stark, a Princeton, N.J., law firm that represents several of the property owners whose land is now on hold for future projects.

Of course, not all over-billing problems rise to the level of fraud, cautions Judy Marks, associate director of the National Clearinghouse for Educational Facilities in Washington, D.C. Her database spits out numerous articles in the past two years that detail disputes between districts and contractors, poorly organized oversight systems, and pure waste that socked it to taxpayers. "But fraud isn't a rampant problem among schools," she says. "I'd use that word sparingly."

Ironically, so does Mary Jane Cooper, New Jersey's Inspector General who delved into the Schools Construction Corporation records to discover what went wrong with this public agency the state government created to disperse and oversee its school construction dollars. She found plenty of reasons to shake her finger at the SCC in the report she filed in April 2005, "but we've really just found situations of waste and mismanagement rather than fraud," Cooper says.

Spotting the difference, she admits, is difficult. "Sometimes when we saw an incidence that looked like there might be collusion, we referred it to the prosecutor's office," she says. "When someone might be gaining from the system as opposed to just failing to know or do their job."

Finding Problems

Certainly fraud wasn't Klinefelt's first instinct when she began peering into East Detroit School System's working budget that was passed out to board members every month. She and fellow newbie Larry Burton simply wanted to be good stewards of the $30 million bond the community had just voted for. Health services in particularly jumped out--at one point, the line item amounts came to nearly $1 million--a figure nearly six times the amount allotted there for basically school nurse salaries. "We later figured out it was a section of the budget that no particular administrator was assigned to oversee. That allowed the finance director to run things through there that wouldn't have a principal looking at it and saying, 'Wait a minute,' " she explains.

She and Burton then asked for the contracts and invoices so they could do the math themselves. That's all it took to rip the lid off of what Klinefelt says she believes inched toward $9 million in losses. Among the paperwork, they discovered that under the building trades program, East Detroit's contract agreed to pay $2,000 per student per year. The invoices were for $2,300 per student per semester. In another line item, the finance director paid almost six times the amount budgeted, claiming it was because insurance didn't cover the loss.

A quick call to the insurance company revealed it was covered, and they did write a check--reimbursement that eventually found its way into private pockets. It was that tidbit that eventually gave the FBI the proof it needed to storm in.

What's more, the "uninsured" water-damaged gym floor at an elementary school was originally bid at $5,000. When the truth came out, the construction manager told the successful bidder to give him some blank stationery, which he used to doctor up a bid in the $70,000 range to present to the school board. The company owner received $5,000 for the job and $5,000 for the use of his paper; the finance manager and construction manager split the remaining $60,000.

"In our situation, any lay person actually going through the papers and looking at the lines would have seen something was wrong," says Klinefelt, now an Eastpointe (Michigan) city council member and mayor pro tem. "The two key areas are tight control of your finance department and your maintenance department. Because if those two guys are in collusion with each other, an audit will not pick up half of what they do."

Cooper's investigation honed in on a host of vulnerabilities for school districts:

* State-of-the-art promises--run-of-the-mill deliveries. In several cases, New Jersey schools were to receive top-notch roof and upgraded windows with weatherproofing features and didn't get what they ordered, she says.

* Bid-rigging--In New Jersey's case, this often meant bidders got together and agreed not to compete. It boiled down to "You bid on this and I'll bid on that" divvying of the pie.

* Front-loading--In this game, the prime builder puts in bills for work that hasn't been completed yet. "That can result in problems down the line," Cooper explains. "The school may not be paying more than they are entitled to, but then the contractors may not deliver as promised on schedule." The situation is also ripe to use change orders as a sneaky way to compensate for the early payments, since that front money has already been spent.

* Union missteps--From Kessler's files come tales of union contracts that billed everyone at master wages, when in fact they didn't put master workers on that particular job.

Incorporate Checks and Balances

When Kessler addresses school administrators, he stresses "fraud begins from Day One. There can be bidding irregularities, theft on the job sites, questionable change orders, non-authorized transactions--you name them and they exist.

"We've seen luxury offices set up by construction managers with top-notch equipment that should have been turned over to the school district but wasn't," he adds. As his general rule, with hard bids, fraud will exist in change orders. GNP contracts foster general condition problems, where general conditions that don't belong to the school district are being included.

On the other hand, Cooper hasn't found any pattern in whether fraud lies more with the prime contractors or subcontractors.

And don't forget perhaps the most damaging weakness of all: human nature. Kessler currently is monitoring a fraud case in the Southeast where school officials could lay the blame on laziness. The contract required the contractors to produce itemized bills for every expense, but administrators requested they hold all that until the end of the job. "Meanwhile, the construction managers were just raking this district over the coals," he says.

Indeed, Cooper condenses New Jersey's problems to two fundamental areas: weak internal management, financial controls and questionable personnel practices; and lax and/or non-existent oversight and accountability. Klinefelt sums up the problem in just one word: cronyism.

"Before I understood what was really going on, I understood that there were unusually close relationships in this district," she says. The construction manager, for instance, was traveling with board members and the superintendent. The finance director had a picture in his office of a rafting trip he took in Colorado with the construction manager's sons. The construction manager himself confessed in testimony that he regularly dined with a superintendent and a retired county sheriff inspector at Paul's Chop House. "The more we drank, the more we negotiated," he reportedly said.

Certainly tales like that prompted Cooper's office to recommend New Jersey school scene enforce a code of ethics that requires board members to sign off that they have no relationships to either the company selling the land, any management companies hired to represent the board, or the prime contractor. Vendors, too, must put their John Hancocks to that no-conflict-of-interest agreement.

Stopping Fraud Before It Starts

Many districts set up a system where multiple people must sign off on a project, assuming these approval layers protect them from fraud. That's a myth, says Kessler. He once worked a case where six individuals were required to give permission and the district still fell victim. "Everybody thinks everybody else is doing their job, and therefore they just sign their name," he notes.

It comes as no surprise his solution is for school districts to bring in forensic accountants to manage the project. After all, construction is such a specialized field with so many key things to watch for that a CPA who incorporates construction oversight as part of his job doesn't really have time to do it justice. And with school building costs anywhere from $30 million to $50 million, he argues, it's certainly worth some money to make sure you're not getting ripped off.

As a package, project auditors do bring some impressive skills--they examine a district's construction firm to determine its choice of building materials, its crew size and whether its cost projections are inflated or unrealistic. Firms like Kessler police change orders, double-check material quality and inspect workmanship.

Cooper backs his advice. "I have lawyers and accountants that make up most of my staff and they all agree it is better to spend the money upfront in prevention than in trying to detect that you've been defrauded afterwards. That can be tremendously expensive, difficult to prove and ends up in litigation," she points out.

But that still shouldn't allow school administrators to abdicate responsibility to this person, says Cooper. Her office recommends also having someone representing the district on site, on a daily basis when possible, to compare deliveries to invoices and contracts. New Jersey had one case where the construction firm was to be paid at completion milestones, but the management oversight firm didn't always trot out to the site to confirm.

Districts should also require a provision in the contract that states they have the right to audit vendors' books any time they suspect fraud. Next, add a provision stating that if the prime contractors don't pay the subs within a certain period, they must notify the district. "That alerts you to the fact that something may be going on," she says, explaining the red flag.

Nor should you dismiss the multiple signature set-up. Among the most glaring internal control deficiencies Cooper found in her report was an SCC official's ability to unilaterally sign off on the approval and award of large contracts without board approval. For instance, a COO or managing director title could give a nod to change orders as long as they didn't exceed $250,000, or the CEO could approve a construction contract that came in under $20 million. Such sums create very large windows of opportunity for anyone tempted to help himself.

"Single-signature authority can lead to huge problems," she says. "You need someone to open the bills, someone else to record the money going out. You need a lot of different levels so that if there is going to be collusion, it takes a number of people and that isn't as easy as having one or two people agree to defraud the system." The trick lies in not making it your only defense.

"Fraud can never be prevented totally," Kessler says, breaking the bad news. "But you can certainly put up enough checks and balances that it tells, people, 'Do this somewhere else.'"

NINE WAYS TO SPOT PROBLEMS

Veronica Klinefelt's discovery of fraud during her first year on the East Detroit school board certainly didn't make her life a bed of roses. "People thought we were crazy," she says. Rallied by the construction manager whom Klinefelt says she believed was financing the effort, individuals in the community tried to whip up a special election to remove her from office. The effort included newspaper ads and fliers handed out even to her children's friends as they walked home from school.

"It was intimidating, quite frankly. We knew we were dealing with millions of dollars, and if we disappeared off the face of the Earth, for them, it would all just go away," she adds.

She weathered the cold shoulders and veiled threats, however, to provide legal authorities with the documentation they needed to prosecute. From that experience, she shares this crash course for board members and administrators who would like to avoid the hot seat:

1. "Trust but verify." It is important to have a relationship of trust within a district, but board members and administrators should not be reluctant to ask for back-up information if they have concerns about any bills.

2. Notice unusually close relationships. Klinefelt and her colleague gave the FBI agent a list of who to investigate based solely on who had relationships with outside contractors--and almost everyone on the list was indicted.

3. Share responsibility. Have one person receive the bids and document the date and time of arrival while another person--preferably from another department--takes responsibility for their safekeeping until the bid opening.

4. Watch people's spending habits. "If your maintenance director makes $70,000 and lives in a $3 million home, make a mental note of it!" she says.

5. Check all revenue. Some revenue--such as summer school checks or insurance checks--might not be considered in an audit. Roslyn's finance director was found guilty of helping himself to both those pots.

6. Double-check contractor payments. Superintendents periodically should seek a report (vendor run) on contractors to determine what they have been paid on a bond project and compare that to the contract.

7. Create a separate construction fund. Bond project expenditures should never come out of the general fund.

8. Have the board approve any change orders. There should be no open-ended change orders that give the administration the authority to approve over expenditures.

9. See the contract. Board members should insist on having a physical contract for review before voting to hire any firms.

Julie Sturgeon is a contributing editor.