Fraud in umbrella contracts

Top management at Quoteron Inc. thought it was increasing efficiency when, at the urging of one of its procurement officers, Ken, it gave its hardware supplier, Donlane Supplies, an "umbrella contract." However, Ken secretly owned Donlane and fraudulently reaped the profits of an illegal exclusive deal. Here's how to detect and deter fraud in the procurement process.

Ken, a procurement official for Quoteron Inc., had a conflict of interest. He secretly owned a company, Donlane Supplies, which sold hardware materials to his employer. Ken convinced Quoteron to bypass normal procurement procedures and enter into a monopoly agreement with Donlane. For several years, Quoteron followed this anti-competitive arrangement, while all the time believing it to be good practice! The company believed this because its internal auditors had encouraged Quoteron to implement a number of "umbrella contracts" to reduce fraud and increase efficiency. Although umbrella contracts can indeed be beneficial when implemented properly, their blanket use without regard to consequences can perversely facilitate fraud — something that companies often overlook.

Benefits of umbrella contracts

Umbrella contracts (a predominantly European term), known also as umbrella agreements or framework agreements, are overarching contracts that set out the terms of future business with a supplier, such as price of goods, quantities, delivery times, etc. They're typically used when there's an ongoing need for particular goods or services. If companies implement them properly, they can minimize the potential for procurement fraud because the supplier has already gone through an approval process. However, a poorly executed umbrella contract might have the opposite effect.

Umbrella agreements can be attractive to both the purchaser and the supplier. The advantages to the buyer include:

• The procurement department doesn't have to request multiple quotations or conduct a tender (bid) exercise for each purchase.
• Fewer administrative hurdles can mean reduced time between requisitioning and delivery.
• Pre-agreed conditions can enhance certainty and security in the supply chain, thus helping management planning.
• The prospect of being selected as a long-term provider can encourage suppliers to offer lower prices.
• Flexibility is retained because umbrella agreements don't usually bind a purchaser to buy from a particular vendor in all circumstances.

This last point is important. Umbrella agreements shouldn't create an obligation to use a designated vendor. Buyers might set up any number of agreements so they can have a choice between suppliers. The option should remain for the buyer to go elsewhere for individual purchases — umbrella agreements should be designed to facilitate business, not to dictate it.

These advantages provide sound reasons for establishing umbrella agreements. However, companies must be careful implementing them because they might incur unnecessary exposure to increased fraud risk when a buyer places undue reliance on a single vendor. Indeed, fraud risks tend to parallel those inherent in procurement processes generally.

Fraud or collusion at any stage

Unless there are real exigencies, the buyer should first properly evaluate a number of suppliers and preferably conduct a full tender evaluation process before awarding an umbrella contract. Negotiating with just one pre-selected supplier could be considered a red flag unless the overall value of transactions is expected to be small.

The main steps in awarding an umbrella contract are: a decision to proceed, a bid solicitation process and a selection procedure. Fraud or collusion can occur at any of these stages, and the red flags are similar to those inherent in any normal tender.

In addition, however, when evaluating the possibility of fraud, there are additional phases both before and after the formal selection process, and examining these might highlight further red flags. Below are five distinct stages, with corresponding red flags. (This isn't an exhaustive list of procurement fraud indicators.)

Prior history

The buying organization might already have a trading history with one or more suppliers it's considering for an umbrella agreement. Reviewing this history might reveal the existence of traditional procurement red flags, e.g. multiple contracts just below financial authorization thresholds, the repeated use of the same vendor despite poor performance or cost-effectiveness, etc.

The decision

Even routine purchases require a documented request-and-approval process, and umbrella agreements should be no different. Missing documentation might be a warning sign that the decision to engage an umbrella contractor lacks a solid business case and/or there are vested interests in the selection.

Bid solicitation

The same red flags associated with a normal request for quotation procedure or an invitation to bid apply to an umbrella contract. For example, an umbrella invitation is likely to request pricing information for goods or services, and these can be designed to favor one company's products. Equally, always question a bid solicitation that fails to: advertise widely, invite other reputable vendors to tender and/or gives excessively short deadlines for submission. Such deficiencies might be designed to favor a bidder who has inside information from internal employees. Also, any inconsistency between the actual business requirements and the products sought might be a red flag.

Selection process

Pay attention to the receipt, storage and opening of bids. Check that the evaluation was performed with an appropriate segregation of duties. Look for suspicious bidding patterns. The absence of properly documented justification for selection is a red flag, particularly when the lowest bidder isn't chosen.

Contract award, performance and renewal

Even after the company makes its selection, additional red flags can appear. In particular, be concerned about a lack of due diligence prior to the formal signing of any agreement even with longstanding suppliers. Not only does due diligence address fraud risk but also other business risks such as supply chain and reputational risk (e.g. using a vendor known for poor workforce conditions). Beware of a higher volume of business than originally anticipated, which could indicate an attempt to attract a lower level of scrutiny than would otherwise have been needed in the initial bid solicitation.

Since individual purchases will be easier to make under an umbrella agreement, it becomes more important to ensure that the company only uses the vendor for purchases of the type specified in the umbrella agreement; question any deviations. Fraud examiners should also be alert to any contractor's attempts to change the terms of the agreement. Ensure that procurement staff members are familiar with selection guidance to assist them in choosing the correct vendor when multiple umbrella contractors exist. Rotating purchasing staff will reduce the risk of overly familiar relations with one supplier.

Staff should continually review the performance of umbrella contractors and grant contract extensions only after a documented review and authorization process (and ideally repeated due diligence). 
 

Anonymous tip-off begins investigation

Let's return to the true case of Quoteron, a large corporation with a regional office that conducts its own procurement. (I've changed names and some details.) Someone sent an anonymous tip-off to Quoteron's internal investigation unit alleging corrupt activity between the regional office and one of its umbrella contractors, Donlane Supplies.

Background

Quoteron started purchasing hardware materials from Donlane eight years prior (soon after Ken started work in the procurement office), the last five had transactions of approximately $75,000 per year. Individual transactions were frequent, but of low value, so the procurement supervisor was receptive to Ken's suggestion to establish an umbrella contract for domestic hardware supplies. The supervisor asked another colleague, Judy, to solicit bids accordingly. She contacted four suppliers directly (including Donlane Supplies) and invited them to tender for the umbrella agreement.

Judy took the bids to the procurement supervisor and finance manager for review. Donlane was considered the cheapest supplier overall, and Quoteron awarded them a 12-month umbrella contract, thus making them the default supplier for all hardware materials. The procurement supervisor subsequently extended the agreement for two more years. The company's management felt this was fine and were pleased at the agreement's flexibility. However, management was unaware of some additional information later unearthed by the investigation team.

The investigation

Ken's managers were unaware that Ken also owned Donlane Supplies. Donlane had begun trading with Quoteron soon after Ken started work in the procurement office and had declared an annual turnover of a little more than $75,000 for the previous five years. Investigators cross-referenced public company records with Ken's personnel records and found that Ken's wife was Donlane's sole director, and his stepson was the manager and public face of the company, which allowed Ken to stay behind the scenes.

After investigators examined procurement files and internal correspondence and subsequently interviewed procurement personnel, they found that prior to the umbrella agreement, Ken was sometimes able to administer hardware material purchases by himself. However, he wasn't always able to do this because the company rotated purchase requests among procurement staff. So, Ken kept an eye open to see when others were dealing with requests for products that Donlane could supply. He would then suggest to the procurement official that they use Donlane. This strategy only worked on low-value purchases in which the company could seek quotes from a single supplier. Although Ken wasn't the most senior staff member within the department, his tenure and forceful personality ensured that other employees were reluctant to antagonize him, so he was able to direct most hardware purchases to Donlane.

Ken was also on good terms with the office handyman, whom he instructed to submit supply requests piecemeal, which ensured that purchases would normally be below the financial threshold when procurement staff would need to solicit bids from at least three separate vendors.

However, as Quoteron's business expanded over time, so did the volume of purchases, which made it harder for Ken to keep track of orders, resulting in the company making occasional purchases from other vendors. To ensure that Donlane remained the sole supplier, Ken argued that Quoteron could save time and money by establishing an umbrella contract for domestic goods. The procurement supervisor saw an opportunity to reduce his own workload, so he quickly agreed and asked Judy to begin the process.

Ken persuaded Judy to let him help with the exercise. They drew up a list of items that they estimated Quoteron would require on a regular basis. They then selected four hardware suppliers, including Donlane, and invited each of them to submit bids for an umbrella agreement.

Each supplier delivered its bids to Quoteron, with Donlane the last. Judy collected the bids and stored them until the deadline. She opened the bids in front of her supervisors, but she immediately disposed of the bids' envelopes. An analysis of the bid documentation showed that Ken had cleverly influenced the purchase requirements to give undue weight to expensive items the company rarely ordered. While Donlane's bid was the cheapest overall, they were more expensive on goods that Quoteron ordered regularly. The bid evaluators missed this. Quoteron awarded Donlane the umbrella agreement, but no one conducted due diligence — the procurement supervisor's excuse was that Donlane was already a longstanding supplier. Although Quoteron already had a small number of umbrella agreements in place for other services such as vehicle repairs and plumbing/electrical services, this was the first agreement for goods.

After the initial 12 months, the procurement supervisor authorized a two-year extension of the agreement. However, rather than conducting a full performance review as required, he justified the extension solely on the basis that he had received no complaints about Donlane's performance.

The red flags

Apparently, none of Quoteron's staff — and in particular, the procurement supervisor and auditors — saw the red flags, even though they were abundant at each stage of the process:

Prior history

The persistent selection of Donlane Supplies before the umbrella contract should have been a concern, particularly given that the domestic hardware supplies weren't specialized, and other vendors were readily available.

Despite supplying goods worth $75,000 per annum, the overwhelming majority of purchase transactions with Donlane were of low individual value and below the financial threshold for soliciting multiple bids — a clear red flag.

Also, Ken's support of Donlane Supplies should have raised questions with colleagues and managers, especially because he wasn't advocating for individual companies in other areas of procurement. Ken's dominant personality played a part here, and while this wasn't necessarily a red flag in its own right, managers should be alert to the impact of forceful personalities.

The decision

Management should have questioned the sudden decision to instigate an umbrella agreement, especially after so many years of trading consistently without one. Demand for hardware supplies had remained stable over the preceding years, and there was no clear business or operational need for an umbrella contract and indeed no proper documentation justifying the decision. While the agreement did save time, the company didn't consider other goods or services similarly, and the special treatment of common domestic supplies should have raised questions.

Bid solicitation

Judy didn't prepare any documentation to justify why she had selected and approached the four companies for bids.  The lack of any wider public advertising was a further red flag. The supply of domestic hardware isn't a specialized market, and many vendors would likely have been competent to bid.

The selection process

Disposing of the bid envelopes was poor practice and constrained any subsequent review of the process to ensure the correct handling of bids. (Investigators suspected, but never proved, that Judy had opened the bids under pressure from Ken and re-sealed them before opening them for the evaluation committee).

Contract award, performance and renewal

Quoteron chose Donlane as the sole default supplier. There was no reason why the company couldn't have awarded umbrella contracts to multiple suppliers, which would have given Quoteron more choices.

No one performed due diligence prior to signing the umbrella agreement. Had they done so, this could have identified Ken as a shadow director of Donlane Supplies. It also would have also been clear from the company's annual accounts that its turnover of $75,000 closely matched the level of business conducted with Quoteron, thus suggesting that Donlane was completely reliant on this trading relationship for survival. Another red flag was that the procurement supervisor renewed the contract without reviewing it or evaluating Donlane's performance.

Outcome

Following the investigation,  Quoteron fired Ken and terminated Donlane as a supplier. While Ken had engaged in corrupt activity, poor management only facilitated the situation. The procurement supervisor retired just before the conclusion of the investigation, but had he acted more diligently, he could easily have spotted many of the irregularities at a much earlier stage. The internal auditors also overlooked this contract and automatically assumed that umbrella contracts reduced procurement risks.

Lessons learned

Umbrella agreements hold many potential advantages for the buyer, but the same basic care and attention required in any normal purchase tender should be applied in the selection of umbrella agreements. Don't assume that they automatically reduce the risk of fraud — they might, but only if implemented correctly. Poor execution might actually facilitate fraud. Fraud examiners and auditors should keep this in mind when reviewing such contracts or recommending their adoption. All umbrella agreements should be based on sound, documented business needs and retain the flexibility to conduct procurement with other suppliers where needed. While establishing an umbrella agreement provides the opportunity to identify red flags, don't overlook any prior trading history with possible suppliers. Conversely, post-award events can also provide clues as to potential irregularities.

Never neglect due diligence, even when an umbrella agreement is based on a long trading history. Not only is it good practice, but failure to conduct periodic due diligence might itself be indicative of a lack of professionalism, care or worse.

Paul Catchick, CFE, holds a doctorate in fraud and corruption in intergovernmental organizations and is the senior internal investigator at the Organization for Security and Cooperation in Europe (OSCE), based in Vienna, Austria. The OSCE is the world's largest regional security organization, with 57 participating states. 

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