In March, after a brisk investigation, the law firm probing the massive false reporting of oil reserves at $160 billion (€130 billion) Royal Dutch/Shell Group concluded that a key problem was that CFOs of the four business units reported directly to the local managing directors, and not to the group CFO back in London. The lawyers recommended that the four unit CFOs report to the group CFO in future. Shell’s senior management duly complied.
However, some Shell insiders felt that the hurried investigation produced a “lawyers’ report” that was too concerned with obvious compliance issues and not enough with the subtle realities of how finance actually operates within a business. “It’s all about relationships,” says one executive who is close to Shell’s senior finance management. “You’ve got to be part of intersecting circles. If you’re a finance guy, you’ve got to be part of the finance circle, and everybody knows that. But if you formally become part of the finance organisation — sitting as a ‘spy in the camp’ in a division [and reporting to a group CFO] — you’ll find it very hard to create the right sort of relationships … that you want to have with the management team of the division.”
It is a fine balance, and one that all large companies continually have to grapple with. Reporting lines are especially vexed for the finance function, with its dual role as financial overseer and business facilitator. Often, in the wake of a major scandal, the blame is put on a lack of financial oversight and control, especially if a company is decentralised — as a number of global companies are these days. The reaction in many cases is to then centralise reporting. But no two scandals are the same, and while some, such as that at Dutch retailer Ahold, were about a rogue foreign division too loosely controlled from the centre, others, like Enron and Tyco, are scandals that were directed by CFOs at the centre. There is no obvious best practice model for companies to follow.
The Root of Their Woes
But if there is no consensus about how the reporting lines should run, there is broad agreement on the need for clarity of responsibility. In 2002, Allied Irish Bank, Ireland’s biggest bank with €81 billion of assets, discovered that a rogue currency trader, John Rusnak, had covered up a loss of €860m ($1.045 billion) at Allfirst, its American subsidiary. AIB immediately hired Eugene Ludwig, a former comptroller of the currency at the U.S. Treasury, to carry out a “root and branch” investigation.
“Ludwig found a whole number of deficiencies in management, all the way back through the organisation,” says Paul Quigley, deputy head of risk management, and the manager charged with implementing changes in the wake of the scandal.
Interestingly, a key problem Ludwig identified stemmed from the “spy in the camp” syndrome. After dissecting the history of the problem, Ludwig said that when AIB took over Allfirst in 1989 it reckoned previous European takeovers of American banks had failed because the American unit wasn’t given enough freedom. So AIB let Allfirst run itself, except in the area of treasury, where the Irish bank reckoned it had more expertise. AIB put in its own experienced treasurer at Allfirst, David Cronin, to build up trading operations.
In a report, Ludwig recounts how Cronin “was viewed as a ‘home-office spy’ and was largely excluded from senior management meetings and interactions.” Though he theoretically reported directly to Allfirst’s CEO, and sometimes the CFO, in practice Cronin took directions on policy and strategy from Patrick Ryan, AIB’s group treasurer in Dublin. In 2000, a new Allfirst CEO, Susan Keating, requested that Cronin report directly to Allfirst’s CFO, but group senior management wanted to retain direct control and a compromise followed, whereby Cronin had “dual reporting” to both Keating and Ryan.
Ludwig concluded, “This dual reporting structure obscured accountability of the business line. Dublin thought Baltimore was looking after the Allfirst treasurer, Mr. Cronin, and vice versa. The Allfirst treasurer turned out to be a key weak link in the control process.” But in its recommendations, the report added that it “doesn’t make a big difference” whether treasury and other key finance functions report directly to Allfirst’s CEO or to Dublin, “but it is enormously important that there is unambiguous clarity.”
To implement change, AIB hired another former US comptroller of the currency, John Heimann, who worked with Quigley on the new management architecture. “What we needed was something that would get us consistent controls across the group,” Quigley says.
AIB put in place a “classic matrix management” system, with four business units whose CFOs report directly to their divisional managing directors. But it added an independent risk management operation, with a chief risk officer — currently Shom Bhattacharya — sitting on the group executive board and reporting directly to the group CEO. Each unit has a risk team whose head reports directly to Bhattacharya, with a “strong dotted line” to the unit managing director. Where it all comes together is on the group executive committee, chaired by the group CEO and including the group financial director, Gary Kennedy, CRO Bhattacharya and the four divisional managing directors. It is a system of “checks and balances,” Quigley says.
The “spies” in the AIB system are clearly identified — the risk managers — whereas the CFOs are allowed to be clearly in support of their units, working with and reporting directly to their managing directors. (Has the system proved to be failsafe? See “DÉjÀ vu all over again” below.)
The AIB system may be suited to a bank, but the approach is echoed at €2 billion Danfoss, Denmark’s largest industrial group, which makes a wide range of components for products such as refrigerators and heating systems. Danfoss has three main divisions, each with presidents and CFOs — refrigeration and air conditioning; heating and water; and motion controls.
CFO Ole Steen Andersen has the unit CFOs (soon to be called vice presidents of finance, to reflect their wider roles, he says) report directly to the division president. But there is a control process in place, in which the corporate vice president of accounting and his team make regular visits to their counterparts in the units.
“I see the divisional CFOs as more part of the business team, advising the president on economic matters,” says Andersen. “They are also responsible for the accounting in that group, but I feel comfortable that with the controllers from central office travelling all around the Danfoss world, if something was wrong they would pick it up.” As with AIB, the control function is kept at arm’s length from the divisional finance chiefs. As an added control mechanism, none of the divisions is allowed to hold cash (other than petty cash) and Danfoss is in the process of strengthening its cash pooling arrangements. Divisions also are not allowed to do any hedging, which is carried out on “net” basis at group level only.
Andersen departs from the AIB approach in eschewing any of the “dotted line” arrangements of a matrix structure. “The CFOs do not have dotted lines to me; I do not like dotted lines. I like clear, full lines of responsibility,” he says. “The CFO reporting to the president makes the president feel more responsible, and one of his responsibilities is that the business unit should follow the accounting rules of Danfoss.”
Divide and Rule
But while the “clear lines” philosophy may be one that suits a stable, profitable enterprise like Danfoss, it may not be appropriate for a struggling company. Consider Lycos, an €85m internet portal based in the Netherlands, which reported cumulative losses in 2002 and 2003 of €235m. According to Ralf Struthoff, who has been group finance chief since late 2002, the company once had a localised reporting structure but found it divisive and unworkable.
The company was managed on a country basis, with nine separate organisations. By the end of 2003, Struthoff says, “I began to feel increasingly uncomfortable with this setup. We developed the feeling that loyalty was too strong to the local organisation and not strong enough to group interests. We had difficulty implementing policy and it always took extra effort, as local CEOs felt very strongly about how to set up their finance functions. It was a source of conflict.”
He put in a new structure that has four pan-European business units, whose CFOs report directly to Struthoff, with a dotted line to their CEOs. The CEOs are given more freedom to make decisions on areas such as R&D spending, which previously was centralised. “In order to compensate for the business freedom they received, we tightened the screws on the financial reporting and control side,” says Struthoff.
At smaller struggling companies, it is often not so much the reporting lines as an over-complex organisation that causes problems. As at Lycos, CFO PÉter Lengyel found in 2001 when he arrived at RÁba, a HUF31.7 billion (€149.4m) loss-making Hungarian auto-parts maker, that it had far too many fiefdoms — 15 different business units with CEOs and CFOs. He pared that down to three, and while the local CFOs’ straight reporting lines are to their CEOs and the dotted lines to Lengyel, he says the important thing is a system of monthly meetings for key finance managers (20 in total) to share information.
The culture within an organisation and in the wider business world also determines how the management structure evolves. Novartis, the $25 billion (€21 billion) Swiss pharmaceuticals concern, was swept up in the post-Enron environment like most companies; this created a “mindshift” in the way the company thought about finance, says Matthias Weber, CFO for European operations of the Novartis Animal Health unit.
“The company felt that finance should get out of its technical role and become more of a business partner,” Weber explains. About three years ago, the finance function across the group was split into two functional lines—financial reporting and accounting (FRA) and business planning analysis (BPA), the latter mainly involved in capital allocation evaluation and other business analyses. In the wake of Enron, Weber says, “the image of FRA changed from the boring and neglected technical accounting group to the ‘compliance gatekeeper,’ the group that always gets the last word.”
In the structure at Novartis, both FRA and BPA have solid reporting lines to the unit CEO and dotted lines to the group CFO, Raymund Breu, in Basel. But now, “there are initiatives to build solid lines within the FRA group.” At the firm’s animal health unit, “they appreciate that finance has a certain independence … There is the ‘organigramme’ and then there’s reality. It’s up to the finance function itself to make the dotted lines strong, to create a community,” says Weber.
The People Effect
While there are many models to choose from, it ultimately comes down to people. In companies in trouble, the system of control has usually broken down and people lack a sense of order. In bringing centralised control, “maybe people will see finance as a ‘spy in the camp,’ but maybe that’s a good thing,” says Michael Adlem, U.K. managing director of Protiviti, a risk consultancy that specialises in troubled companies. “I often find that internal audit has been seen as a cost and cut to the bone. People there are unmotivated.”
That was the situation at Allfirst, Ludwig found. Rusnak’s direct supervisors had a strong personal relationship with him, which meant they were too trusting. But more importantly, Ludwig said, Rusnak and his supervisors allowed an atmosphere of bullying and intimidation that meant that back-office staff that should have spotted Rusnak’s false trades and alerted senior finance management were afraid to do so.
In Shell’s case, while lax reporting by divisional CFOs to group CFO Judy Boynton may have been one problem, another may have been that Boynton was too close to her boss, Philip Watts, the former chairman of Royal Dutch/Shell, who allegedly was the principle architect of the false reporting. Says the Shell insider, “What you’ll hear in ‘the City’ is ‘Judy had to go but we don’t necessarily think that she’s terribly at fault. But it happened while she was in charge.’ Also, that she was too close to Watts. I think that’s true—she may have been told by Watts not to stir things up too much. She would probably have done what she was told.”
So the advice for CFOs? No matter where your straight and dotted lines go to, keeping a wary eye on your colleagues will always be a tough part of the job.