How Sarbanes-Oxley affects merger considerations: two attorneys analyze the ways in which the law could impact companies' merger activity--inciuding internal control issues and public company deals for private firms.

• Author: Falis, Neil D.
• Position: M & A Strategy

For the better part of two years, financial executives have been inundated with analyses of the corporate governance and public reporting requirements of The Sarbanes-Oxley Act of 2002 and related corporate governance reforms. More recently, financial executives have been flooded with information on the internal control requirements of Sarbanes-Oxley Section 404, which, for larger companies, become effective beginning with their annual reports for fiscal 2004.

However, as much energy as financial managers may have exhausted on these issues, many have not yet considered the effect of Sarbanes-Oxley on their company's merger and acquisition activity.

The level of concern is not the same in all transactions. A target that already is publicly traded presumably is in compliance with Sarbanes-Oxley and stock market rules. And if the target, whether public or private, is immaterial in size relative to the acquirer, the likelihood of the transaction causing the acquirer any significant Sarbanes-Oxley issues is diminished. However, a public company can face real challenges when it acquires a significantly sized target that was privately held, and therefore historically not subject to Sarbanes-Oxley.

Public company acquirers should address these and related concerns by conducting more comprehensive due diligence of a target's Sarbanes-Oxley compliance and financial disclosure and systems before effecting a transaction. This diligence should include: 1) an assessment of the target's management team to take their corporate governance and ethical "temperature"; 2) a review of internal controls and any significant deficiencies in their design or operation that could impair disclosure of financial information; 3) an evaluation of the level of aggressiveness of the target's accounting policies; and 4) meetings with persons involved in the target's compilation of financial data. Acquirers also should require targets to make representations and warranties concerning internal controls, disclosure controls and procedures and other financial disclosure issues.

A discussion of several specific issues that public company management should examine in conducting a Sarbanes-Oxley "audit" of an M & A target follows.

Controls and Procedures

Public-company internal control standards have long been in existence, and therefore, at least theoretically, an acquired company's controls always have been an appropriate subject for due diligence. However, Sarbanes-Oxley Section...