Sarbanes Jitters Force Buyers To Intensify Due Diligence: Wary of Regulatory Backlash, Acquirers Dig Deeper Into Target Numbers and Controls

Buyers have raised the negotiating stakes in direct response to the nation’s newly stiffened corporate governance rules. Aggravating traditional worries about whether a transaction will pan out strategically and financially are fears that the deal also can get the buyer into regulatory hot water after closing. As a result, jittery acquirers are intensifying pre-closing investigations of targets, particularly publicly traded firms, and demanding in writing that the target’s financials are not only accurate but have been crunched in the proper manner. The harder-nosed attitudes further leverage the advantages that buyers enjoy in the difficult m&a market that has tilted in their direction for the last two years, and prolong the transactional process at a time when deal flow has been the weakest in more than a decade. “What they (buyers) don’t want to do is inherit an investigation or a hassle or anything like that,” says Eric Simonson, an m&a attorney at Kaye Scholer. Increasingly aggressive efforts by acquirers to protect themselves and gain “comfort” in executing deals stem from the 2002 Sarbanes-Oxley law and subsequent SEC rules mandating tighter standards for financial disclosures by publicly traded companies. Reactions to the law, hatched amid a string of accounting scandals and corporate collapses, have taken these forms: Deeper Due Diligence – Buyers and their advisers are not only spending more time checking out the components of the balance sheet and profit-and-loss statement but probing into the ways the numbers have been calculated and the viability of the target’s internal systems and controls that created them. Purchase Contract Terms – New protective language regarding the financials is showing up in acquisition agreements, principally in the representations and warranties sections, to increase the buyer’s comfort levels. For example, buyers may require public targets to attest that figures certified to the SEC by CEOs and CFOs are indeed accurate and sometimes to, in effect, re-certify the numbers specifically for the deal. For an added dimension of armor plating, the buyer may even want to know whether a disclosure committee of the board has cleared the figures, even though Sarbanes-Oxley only suggests, and does not require, establishment of such units. “We’re seeing more Sarbanes-Oxley-type of representations on disclosure committees and certification of financials because the buyer’s financials are going to be on the hook post-closing,” says William G. Lawlor, a transactions lawyer at Dechert. “And we’re seeing more due diligence because of that,” he adds. Joseph L. Johnson 3d, who heads the m&a practice at Goodwin Procter, estimates that the “amount of due diligence that people are doing in public deals has about doubled on the financial accounting side” in the last 18 months. “The amount of time has significantly lengthened,” he says. “Billion-dollar deals used to be done quickly if the (target) company had a long track record. But when you see big companies fail and when you see the events that have happened over the past few years, there is now a whole new level of due diligence. People are very nervous. For a CEO, a deal that gets the company in trouble could be a career-ending move.” Stephen W. Rubin of Proskauer Rose says that he hasn’t pushed for expanded reps and warranties in the sale of a public company in the new regulatory environment but agrees that there is no substitute for expanded due diligence. Unlike a private company that has only a few shareholders, there is no recourse in going after a dispersed shareholder base or managers with modest ownership. “With a public company, after the deal is done, the seller is off the hook,” he says. “There’s nobody in a public company to stand behind the reps and warranties.” However, that reality should strengthen the buyer’s resolve for intense due diligence. “Part of the cost of doing a public deal is accepting the fact that if the reps and warranties are wrong, that’s our problem,” Rubin says. “Historically, we used to rely on the fact that those companies were reporting companies (to the SEC). Until a year-and-a-half ago, we got significant comfort from that fact. Now, because of all of the things that have happened, people are not taking these certifications lightly.” Charles M. Elson, head of the Center for Corporate Governance at the University of Delaware, likens the contract language to a “belt and suspenders” approach that won’t work without the right due diligence. Unless the investigation is thorough, he says, “If a deal is going to go bad, it’s going to go bad no matter how many reps and warranties you have.” “I think that instead of simple reliance on the numbers, you are going to have to demonstrate a heightened inquiry into whether reliance on public numbers is justified to protect yourself in a transaction,” Elson adds. “In other words, did the procedure by which the numbers were created comply with Sarbanes-Oxley? In the past, if you had audited numbers, you relied on the auditor’s opinion. I think you are going to have to go a bit further now.” This has led buy-side advisers to comb the target’s internal controls in finite detail. “People really care when the CEO and CFO sign a certification that the chain of command on the information going up to them was functioning correctly,” Simonson notes. Historically, unless something terribly wrong was discovered, the assumption was that the internal controls were okay, but that has changed. And it’s led to specific assertions in purchase contracts. While the right due diligence is most critical, Simonson notes, buyers are “much more worried about controls” and they want reps in writing because they “are not leaving this to chance.” Lawlor says that in some deals that he has worked on, the buyers insisted on a special re-certification and breakdown of results that already had been certified to the SEC as a condition of closing. “That’s not typical but the buyers said, “We’re inheriting these results going forward and they are under our watch, so we just want to make sure we have an up-to-date certification,” he reports. In all cases, he says, the buyers were prepared to do extensive due diligence but wanted additional comfort that they were going in the right direction. At minimum, the heavier investigations and negotiations over new contract language have lengthened the time between agreement and closing. But they also have been deal breakers. The investigation can run to 45 days, says Johnson in noting the shift in buyer caution. “If I would have suggested that a year ago, they would have gotten a new lawyer,” he says. “They are doing a lot more due diligence than they ever did and when in doubt they are walking away. In public m&a, there’s no one to talk to if something goes wrong. The seller’s people just fade into the sunset.” Commenting about the impact on deal flow, Simonson says, “It certainly slows things down. Anything that slows things down means that it is more difficult and fewer acquirers are going to start the process.” Moreover, the issues are new to the m&a negotiating table and it will take a while to establish some standardized rules or processes that can telescope the pre-deal machinations and provide some universally accepted protections. “There are no best practices yet,” states Simonson. Copyright 2003 Thomson Media Inc. All Rights Reserved. (http://www.thomsonmedia.com)