In Drosophila, a BMP-related ligand Decapentaplegic (Dpp) is essential for cell fate specification during embryogenesis and in imaginal disc development. Dpp signaling culminates in the phosphorylation and nuclear translocation of Mothers against dpp (Mad), a receptor-specific Smad that can bind DNA and regulate the transcription of Dpp-responsive genes. Genetic analysis has implicated Schnurri (Shn), a zinc finger protein that shares homology with mammalian transcription factors, in the Dpp signal transduction pathway. However, a direct role for Shn in regulating the transcriptional response to Dpp has not been demonstrated. In this study we show that Shn acts as a DNA-binding Mad cofactor in the nuclear response to Dpp. Shn can bind DNA in a sequence-specific manner and recognizes sites within a well-characterized Dpp-responsive promoter element, the B enhancer of the Ultrabithorax (Ubx) gene. The Shn-binding sites are relevant for in vivo expression, since mutations in these sites affect the ability of the enhancer to respond to Dpp. Furthermore we find that Shn and Mad can interact directly through discrete domains. To examine the relative contribution of the two proteins in the regulation of endogenous Dpp target genes we developed a cell culture assay and show that Shn and Mad act synergistically to induce transcription. Our results suggest that cooperative interactions between these two transcription factors could play an important role in the regulation of Dpp target genes. This is the first evidence that Dpp/BMP signaling in flies requires the direct interaction of Mad with a partner transcription factor.