The construction industry has suffered mightily as a result of the global recession. Private funding has dried up and large commercial projects are way down, so contractors are scrambling to compete for smaller jobs, subcontracts and consulting work. If history is a guide, shady dealings will ensue.

“During the downturn in the real estate market between 1989 and 1993, there was a tremendous increase in construction fraud across the board,” says Blake Coppotelli, head of the Real Estate Integrity Services practice at Kroll, a risk consultancy. “There was an increase in corruption cases, there was an increase in kickbacks, in bid rigging, fraud and cost-abuse cases, labor schemes, labor racketeering, organized crime–all as a result of the downturn.”

There’s no reason to think this recession–which is shaping up to be both longer and deeper than many in the past–will be any different, and it comes with a new wrinkle: a large spigot of funding for public projects and infrastructure improvements.

According to Kroll’s 2009 Global Fraud Report, the global pool of stimulus money stands at $5 trillion, and Kroll estimates as much as $500 billion will be lost to fraud. A lot of that fraud, Coppotelli says, will occur in the construction sector.

“As soon as there was even the hint of stimulus funds for construction projects, I can guarantee discussions began, amongst that group that has the propensity to commit illegal acts, on how to make sure they can secure contracts in the construction industry,” Coppotelli says. “I guarantee you that organized crime was talking amongst themselves, the contractors they control and the unions they control.”

The next three to five years will be a high-risk period for the industry, Coppotelli says, and in-house counsel must be vigilant. The motive and opportunity for corruption is profound, so internal compliance is critical. And stimulus-backed projects can open new fronts of liability for companies not used to government contracting.

Inside and Out

Given the risky outlook, the first step in-house counsel should take is to increase the frequency and scope of internal compliance audits, ethics programs and other training efforts. Even companies with robust programs should do a double take, experts say, because in the current environment, just one rogue agent can bring down the business.

Once they are minding their own shop, counsel also should turn an eye to the market.

“Companies have to be very cognizant of what their competitors are doing,” Coppotelli says. “If they feel that their competitors are engaging in any improper conduct, they have to alert the right authorities at the state level or federal level.”

Any business fighting for survival needs a fair playing field, and it’s hard to beat competitors that may be rigging bids or paying bribes and kickbacks. It’s not always hard to recognize–one example in the Kroll report cites a winning bid that came in one cent under a key competitor–but it can be difficult to prove, so getting legal involved early is essential.

In some cases, outing crooked competitors can actually pay dividends. Federal funding means federal laws apply, including the False Claims Act.

“If you’re subject to the False Claims Act, that’s going to make people who are not awarded the contracts look very carefully at the decisions that were made,” says Donald Nettles, a Baker Donelson shareholder who focuses on construction litigation. “If there’s been fraud, waste or abuse, they can get in on a qui tam suit.” (See “Perfect Storm,” from InsideCounsel‘s July issue, for more on False Claims Act litigation.)

Awaiting Rules

The bidding process is always the nexus of fraud in the construction industry, but with stimulus-related projects it’s even worse because the money is preceding the rules.

“There’s a lot of concern about how the contracts are going to be awarded,” says Peter Sullivan, a Hinshaw & Culbertson partner who focuses on real estate litigation. “There are not a lot of details out there about how this bidding process is going to take place. If you don’t know what the process is, how do you determine that pricing is competitive?”

The dilemma highlights a fundamental tension in the stimulus program: The impetus to get money into the economy quickly is at odds with fair and transparent disbursement. The sooner the projects get going, the better for the economy. But moving fast invites corruption, conspiracy and cronyism.

Funding that Congress made available as early as February was intended to get “shovel-ready” projects moving within 120 days. But there are caveats for early bidders.

“The problem is that the rules that are going to govern the competitive bids aren’t out there yet,” Nettles says. “People are scrambling today to get the contracts out, put in bids to get that work, and then be subject to regulations that are not in place yet.”

New Contractors

Stimulus-funded projects are sure to attract many construction companies new to government contracting and its inherent bureaucratic pitfalls.

“The larger companies are very well geared to dealing with state, local and federal government. That’s a big part of their business,” says Sullivan. “But when you start dealing with smaller contractors, they may not have that experience.”

For instance, hundreds of different state and federal agencies will be involved with bailout-backed projects, each with its own policies and procedures to navigate.

“If you want to deal with the U.S. Corps of Engineers, you’ve got to get approved by the U.S. Corps of Engineers. To do work with the Department of Defense is a completely different animal,” Nettles says. “To the extent that [construction companies] shift their business focus from the private sector, they’re going to find a lot of new red tape.”

The specialized nature of some projects also will draw in new players. Beyond the money dedicated to traditional roads and buildings projects, upgrades to the nation’s communications and energy framework are also moving forward thanks to stimulus funds. Any contractors retooling in an effort to win those contracts will find a lot of new paperwork.

“There is [about] $5 billion set aside for upgrading the electrical grid. That’s construction. And $6.95 billion for broadband deployment, that is absolutely construction,” Nettles says.

A lot of the contractors that will do that work, Nettles says, are not set up to deal directly with the government.

“They are going to have to do that though,” he says, “and very quickly.”