A former Seattle Public Utilities employee has been arrested after an investigation found he stole more than $1 million over five years by diverting money for water-main extension projects into a private bank account.

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As a project engineer for Seattle Public Utilities (SPU), Joseph Phan met with developers and customers to estimate the cost of extending or installing city-water mains and meters.

He also collected deposits and payments for the work, typically checks made out to the city of Seattle.

Police say that in 2006, Phan opened a bank account in his name and that of the city and began depositing those customer payments. By January 2011, the checks totaled almost $1.1 million.

Police say Phan, 44, bought a rental house, a car, other property and paid off credit cards with some of the money. Police seized $220,000 from the bank account, but about $500,000 is unaccounted for, said John Carver, King County senior deputy prosecuting attorney, at a Friday court hearing after Phan’s Thursday arrest on suspicion of first-degree theft.

A judge set bail at $750,000 after agreeing that Phan, who in 1993 changed his name from Chau Phan, was a flight risk.

Phan’s wife and two cousins attended the court hearing, but said they knew nothing of the allegations. Phan waived his right to appear at the hearing.

“He is a very loving father, a good husband. He has had no problems in the past,” said Philip Dovinh, a cousin. “We ourselves don’t know what’s going on.”

The charges come after a year of critical audits of the utility’s financial controls and the firing of five employees, including Phan, for improperly accessing and in some cases crediting their own utility accounts.

“It’s a fundamental rule of financial management that you don’t want the guy saying ‘here’s your invoice’ to be the guy collecting the money,” said Seattle City Auditor David Jones, who speculated that in Phan’s case, the segregation of financial duties had broken down.

The city auditor has performed audits on five of SPU’s lines of business since 2007, including water, wastewater, drainage, transfer stations and commercial solid waste, but none examined the activities of engineers, Jones said.

A state audit released in June said the utility lacked adequate internal controls to ensure that adjustments to customer accounts were legitimate, but that audit did not look at the Project Engineering and Management Division for which Phan worked.

SPU was created out of several separate city departments in 1997 including water, garbage and wastewater, all of which had their own accounting procedures. Jones said that Ray Hoffman, who took over as SPU director in 2010, has taken an aggressive stance toward financial accountability and misconduct.

In a statement released Friday, Hoffman said, “The legal process still needs to determine the guilt or innocence of this individual, but obviously this kind of alleged misconduct is unacceptable and reprehensible.”

Mayor Mike McGinn said that in fall 2010, Hoffman informed him of potential fraud by SPU employees.

“I instructed him to aggressively investigate the extent of the fraud and put in place controls to prevent its repetition,” the mayor said in a statement Friday.

City council members also reacted with concern.

“To say that I’m outraged is an understatement,” said Jean Godden, chair of the committee that oversees the utility. “Immediate steps must be taken to recover the funds and to ensure that there are safeguards in place to protect the public’s money.”

SPU spokesman Andy Ryan said the utility has a $6 million insurance policy, which it will pursue to collect any losses in the Phan case.

Since the concerns about employees accessing their own accounts were raised, the utility has created its own division of Risk and Quality Assurance. It has increased the review and monitoring of account transactions, limited the number of people with access to customer accounts, and required employees to sign a confidentiality agreement that includes an ethics statement.

Hoffman said Friday that he had hired an independent consultant to work on issues identified during the Phan probe and to review all financial practices.

City records show Phan earned $77,488 in 2010 as a civil engineer. He had worked for the city since 1995 and was promoted to associate engineer in 2000. As part of his job, Phan had access to customer-service accounts so he could research and issue water-availability certifications to property owners and developers, according to the utility.

In 2010, Phan accessed his own residential account and that of a rental property to show payment when none had actually been made.

Hoffman notified Phan in February 2011 that he was being fired.

After Phan was fired, a developer contacted Phan’s manager to ask about the crediting of a previous deposit and provided a copy of the check. Phan’s manager could find no record of the check ever being deposited with the city.

SPU investigators eventually found copies of dozens of checks in Phan’s project files, and police ultimately established that all the checks had been deposited in Phan’s account and not the city of Seattle’s bank account, according to a probable-cause document filed in court.

Phan had been working since last summer for the city of Bothell as a project inspector in the utilities department, but was fired Thursday after Seattle police arrested him there. Steve Anderson, Bothell’s deputy city manager, said Bothell officials did not know about Phan’s problems in Seattle.

“We do comprehensive reference checks, and there was no red flag on Mr. Phan,” Anderson said. The Seattle Times wrote in December that Phan had agreed to a $1,500 fine from the Seattle Ethics and Election Commission for fixing his own account.

Seattle Times reporter Steve Miletich contributed to this report. Lynn Thompson: 206-464-8305 or lthompson@seattletimes.com. On Twitter @lthompsontimes.