Along with the financials, operations, product and service quality, and other obvious aspects of their targets, acquirers are scrutinizing corporate governance systems and practices of potential partners - public or private. Adding governance to an already long due diligence checklist sometimes extends the dealmaking process, and even has caused some transactions to fall apart. But the extra effort, dealmakers say, provides acquiring company boards with some comfort that the deal won't legally backfire after closing by putting them in violation of Sarbanes-Oxley (SOX).

"Corporate governance is an important element of risk assessment when boards are looking at change-of-control situations," says Nell Minnow, Chairman of governance research firm The Corporate Library.

While dealmakers tend to agree that buyers are focusing on the way target boards and executives reach decisions, there is debate over whether governance pressures are easing up. Those who see commitments waning point to the way in which independently generated fairness opinions still haven't gained total acceptance, proposals to modify parts of SOX to cut costs for small businesses, and the blocking of an SEC rule that would have made it easier for shareholders to nominate directors among indications that outrage over corporate scandals has decreased.

"We're getting more pushback now," Minow says about efforts by business interests to reduce the regulatory demands ordered by SOX and other corporate governance initiatives.

Others argue that the pressure is still on and say that with New York State Attorney General Elliot Spitzer's investigations into mutual fund trading and the insurance industry, regulators are meddling in areas where they don't belong.

Both sides think some clues to further developments may grow out of the expected appeal of the Delaware court decision that absolved directors of Walt Disney Co. of any breaches in awarding a $140 million severance package to former president Michael Ovitz when he was ousted nearly a decade ago. While Chancellor William Chandler ruled that the action passed legal muster, he was critical of the decisions on general grounds.

In the M&A arena, no one asserts that deals aren't being done because targets don't meet certain compliance requirements, such as having the right mix of inside and outside directors. But governance issues, dealmakers say, are affecting the process of evaluating whether a given acquisition makes sense.

"We're seeing the changed climate as a disciplining process. It doesn't stop good deals from getting done, but it does create a greater level of accountability and confidence," says Marshall Sonenshine, Chairman of investment bank Sonenshine Partners.

The issue of increased accountability is a common theme in Mergers & Acquisitions' discussions with dealmakers about the increased visibility of governance in the deals arena. Jeff Kaminski, Director of Corporate Development at AmeriGas, says that a major impact of the increased emphasis on governance in his company's acquisition program is that it has formalized deal due diligence by having more people look at aspects of the deal and using more documentation.

"It's not so much that we've changed our process, but we've added more boxes to check off to indicate who saw what and when and by creating a record that they have signed off on parts of the deal process," Kaminski says. "We're doing the same things but documenting the processes more."

Rich Walje, CIO at PacifiCorp, comments, "We're seeing a higher level of due diligence than previously on corporate governance issues." He says that reviews of business practices are being done with more rigor now.

Paul Lapides, Director of the Corporate Governance Center at Georgia's Kennesaw State University, says that buyers can no longer just rely on what accounting firms tell them about targets. "You need to use specialist teams to dig out information," he says.

One part of the increased vigilance acquirers must exhibit occurs when a public company buys a private firm. Because the public company must meet SOX hurdles, a vital part of its acquisition process can be making sure that private targets are fully SOX-compliant or close to it.

"You have to ask questions about the preparedness of either private or public companies to meet SOX standards," says Kay Koplovitz, founder of Koplovitz & Co., a media and investment advisory firm.

She says if it is only a case of a few issues that must be addressed to bring the target into compliance, it isn't a deal breaker. But if there are too many variations, the acquisition may not be worth the amount of work required to lift its corporate governance standards.

"It doesn't necessarily mean there is something wrong at the target, just that it has not been operated up to the standards that SOX compliance will require," she says.

Because private companies often don't have the personnel, time, or money to apply the same rigorous standards required of large, public companies, there can be some awkward fits in the acquisition process.

Sanjay Subhedar, a Principal at Storm Ventures, says that with the type of startup companies his firm works with, there rarely are enough resources to prepare them for integration with an acquirer. "People are doing multiple jobs and you don't have the internal controls that you would find in larger companies," he says.

Kaminski notes that at one of AmeriGas' private company targets, "The entrepreneur couldn't find his last three year's tax records." He says that the challenge with smaller acquisitions historically has been to get access to meaningful data to use in the valuation of the company.

The basic platform that all corporate governance concerns are based on, in change-of-control or other situations, is Sarbanes-Oxley, whose stated objective was "to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws." Section 404, with its mandates on internal financial controls, seems to cause the most concern.

One technique that savvy buyers are employing is the use of the target's SOX compliance documentation as a starting point for their due diligence.

Commentators say that if the target is public, acquirer investigators can examine some of its 404 paperwork to get an idea of the worth of its financial systems. While targets rarely offer total access to their compliance information before deal closing, they sometimes will show enough for the buyer to see if the two companies' financial controls will mesh. If the transaction closes, the post-merger comparison of SOX filings by both companies can be reconciled more easily.

Another SOX-generated challenge in the dealmaking process is that since late 2004, all acquisitions have to be squeaky-clean to ensure that the targets' corporate governance standards don't taint the acquirers, according to Subhedar. "We have been telling our companies than anybody they buy has to be clean and crisp in such potential trouble areas as revenue recognition," he says.

Revenue recognition describes the circumstances in which intake from sales and other income may be included at the top line and thus impact an entity's profit-and-loss account. Manipulating the point at which incoming funds hit a company's books has been a longstanding problem area for a number of companies, including, of course, acquirers conducting due diligence on targets.

Subhedar says that at the early-stage technology companies he works with it is not uncommon for the owners to overlook instituting the kind of checks and balances in their internal controls to track when the money comes in and from what sources. This can happen, in part, because some of the tech companies don't have much revenue to show.

Sonenshine also says that revenue recognition issues can be a potential indicator of sloppy controls. "We will not advise our clients to acquire a company if we're not comfortable with their revenue recognition procedures," he says.

Sonenshine also points to the increased degree of concern over the issue of whether minority shareholder rights are being respected as a new metric for gauging a deal's viability.

Another consideration for would-be acquirers is the possibility that the target is using techniques such as a staggered board and a poison pill to resist change and allow current management to remain entrenched.

Ironically, according to Richard Ferlauto, Director of Pension and Benefit Policy at the American Federation of State, County and Municipal Employees (AFSCME), both of these tools were originally intended to protect shareholders' interests, but they have evolved into devices that can sometimes be used to hinder improved levels of corporate governance.

"The public markets are demanding transparent governance from the start of any transaction," he says. Ferlauto adds that it is clear that in IPOs and mergers, it is no longer acceptable to include anti-shareholder provisions. In the past, companies were able to include dramatic anti-shareholder provisions and count on them going unnoticed in change-of-control transactions, he says.

But, even as SOX compliance brings advantages for shareholders, executives point out some of the drawbacks of the increased regulatory workload.

"Even when people factor in the cost of SOX compliance, they often don't count the distraction factor that the act causes," Kaminski says. He notes that companies have to realize that the time they spend ensuring compliance is time they aren't spending running the business itself.

But he also notes that once a company gets its compliance procedures up and running, there are some practical benefits for the business that go beyond meeting compliance responsibilities.

"Everybody perceives it as a pain in the neck, but once it is in place, it helps management," says Kaminiski. "It can also help shareholders because it allows them to make judgments on their investment more knowledgably."

While justifiable compensation is a moving target, it has increasingly been the focus of attention for corporate governance crusaders and, as such, will be a factor in the determination of the solidity of governance standards at both targets and acquirers.

"If bad corporate governance is a disease, excessive compensation is how you take the patient's temperature," Minow says.

She says she expects increased pressure from the insurance industry as it adjusts directors' and officers' insurance packages to protect against shareholder suits based on allegations that boards have approved excessive compensation packages.

For his part, Lapides says it is the responsibility of directors of both companies in a combination to stay on top of the golden parachutes that result from the deal. "Some of these payouts will attract the attention of Congress, and it should be on all directors' and officers' minds that they be able to justify them," he says.

Another part of the compensation puzzle that executives must pay attention to, according to Subhedar, is how they treat options when companies are being sold. Most states require them to be re-registered after deal closing.

"Whether it's employees' options or whether you sold stock to shareholders or gave some to friends of the company, if you don't have the proper permissions from the state, you won't be able to close the acquisition," Subhedar says.

Lapides notes that in the current environment of increased scrutiny, sellers must be able to justify their decisionmaking processes in the event of shareholder suits challenging transactions. "Board members will find that they will have a harder time hiding behind the business judgment rule," he says.

This rule, often invoked in rulings on takeover issues, states that a court should not substitute its judgment for the judgment of company directors as long as they represent informed decisions and are not clear examples of improper actions.

Sonenshine says that if there is any possibility of the appearance of a conflict of interest in any decisions, boards should quickly appoint a special committee to deal with any potential trouble spots. "If board members or the CEO don't know what they're doing with regard to an acquisition, now is not the time to wing it," he asserts.

Kaminski says the best guarantee for making clean acquisitions is "faith in the integrity of the management team." He encourages dealmakers to scrutinize the track record of a target and get comfortable with whether or not it is the kind of organization the acquirer wants bring into the family.

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