Corporate Watchdogs or Just Well-Connected? The Case for Reputable Inside Directors

By Prof. Byron Y SONG

As famed investor Warren BUFFETT once said, “It takes 20 years to build a reputation and five minutes to ruin it.” Indeed, the importance of a good reputation is evident in the number of high-profile executives appointed to corporate boards, such as Sheryl SANDBERG, who was both a director and Chief Operating Officer (COO) of Facebook while also serving on the board of The Walt Disney Company, or Ruth PORAT, the CFO of Alphabet (Google) who sits on the board of Blackstone, one of the world’s largest alternative asset managers. But does appointing reputable inside directors (“RIDs”)—defined as non-CEO inside directors holding at least one outside directorship—actually lead to stronger internal controls and better corporate governance? A new study[1] suggests that it just might—especially for firms in need of tighter oversight.

Boards of directors are pivotal in corporate governance, overseeing management and steering company strategy. While independent, outside directors are valued for their impartiality, concerns about independence and expertise arise when they are handpicked by CEOs—especially in the wake of accounting scandals like Enron and WorldCom. This brings RIDs into focus. With external board exposure, deep operational knowledge, and incentives to maintain their professional standing—if only to secure more high-paying and prestigious board appointments–they should be uniquely positioned to enhance governance.

Analysing data from 1,439 S&P 500 companies that reported internal control weaknesses (ICWs) under the Sarbanes—Oxley Act between 2004 and 2012, the findings are clear: appointing reputable inside directors (RIDs) does enhance the effectiveness of internal controls. RIDs support board committee oversight by providing outside directors with comprehensive information and mitigating CEO entrenchment. Holding significant operational roles—such as president, CFO, or COO—RIDs' daily responsibilities are closely tied to control and monitoring, allowing them to play a more meaningful role in board oversight. Finally, CEOs in firms with RIDs face increased monitoring and replacement pressures, incentivising them to strengthen internal controls.

Findings suggest that firms with RIDs are less likely to report or face potential ICWs, particularly when strong monitoring is needed—such as in firms with complex operations or operating in high-risk environments—or when misreporting carries steep regulatory or reputational costs. The impact of RIDs is more pronounced when they have significant reputational concerns, as they seek to protect their public image, and when they are not closely aligned with the CEO. Notably, RIDs who are CFOs are more likely to flag ICWs, while the mere act of bringing in new RIDs also increases the likelihood of fixing control issues.

Since RIDs play a clear role in strengthening corporate governance and enhancing financial integrity, regulators may want to take note. As for aspiring directors, they’d do well to remember Stephen KING’s words: "A good reputation must be earned—it can never be bought."

Reference:

[1]  Lin, Z., Song, B. Y., & Tian, Z. (2024). Reputable inside directors and internal control effectiveness. European Accounting Review, 33(4), 1197-1226. https://doi.org/10.1080/09638180.2022.2156573