* Sutherland says impossible to reform Co-op
* Co-op to report full-year earnings on March 26
* CFO Pennycook becomes interim CEO
By Paul Sandle and Brenda Goh
LONDON, March 11 (Reuters) - Euan Sutherland, the man tasked with rescuing Britain's 170-year old Co-operative Group , quit on Tuesday and warned it was impossible to reform the mutually owned company unless its directors adopted a more commercial approach.
The Co-op, which runs a bank, supermarkets, and funeral homes, suffered what Sutherland called the worst year in its history in 2013 when it discovered a 1.5 billion pound ($2.5 billion) capital hole in its banking business.
Problems at the group, which is owned by its 7.2 million members and extols an ethical approach to business, were compounded by a drugs scandal involving the bank's ex-chairman, Methodist minister Paul Flowers who had little financial experience.
Sutherland wanted to reform the group's unwieldy governance structure to bring a higher level of corporate experience to the group. It has a tangle of boards populated by members elected from regional units of the organisation.
But after 10 months in the job, he tendered his resignation on Monday in a letter saying the Manchester-based group was "ungovernable," a source said earlier.
Sutherland, a former boss of Kingfisher's home improvement chain B&Q, said in a statement on Tuesday that he "had given his all to the Co-op and had hoped to lead its revival.
"However, I now feel that until the group adopts professional and commercial governance it will be impossible to implement what my team and I believe are the necessary changes and reforms to renew the group and give it a relevant and sustainable future," he said.
Sutherland said the company needed to reduce its debt, which was about 1.2 billion pounds in August 2013, and drive major efficiencies and growth in all of its businesses. But that needed fundamental governance reform and a revitalised membership to happen.
He will be replaced on an interim basis by Richard Pennycook, the group's chief financial officer, the Co-op said.
Sutherland's fight with parts of the board had become increasingly public after they resisted his efforts to turn the group into a more conventionally run business, such as the retailer Tesco or department store John Lewis.
Sutherland wrote on the group's page on social network Facebook at the weekend that unidentified board members were seeking to undermine him by leaking details of his 3.7 million pound ($6.15 million) pay package - more than double his predecessor - to the media.
"We appear to have disaffected people who are determined to make life difficult and embarrassing for The Co-operative," he said.
The board of the Co-op, Britain's biggest mutual, is elected from regional boards and independent Co-operative Societies, and is entirely non-executive, meaning no director is involved in day-to-day operations. Sutherland did not sit on this board.
The businesses are managed by three subsidiary boards, which Sutherland was on, one each for food, banking and specialist businesses.
Sutherland's resignation triggered an emergency board meeting on Monday evening, the source said, during which directors agreed to put forward reforms including a new board led by an independent chairman.
Ursula Lidbetter, chair of The Co-operative Group, said in a statement on Tuesday: "Euan's resignation must now act as a catalyst for the real and necessary change which the group must go through."
Andre Spicer at the Cass Business School said he did not think Sutherland's resignation would break the group, but it showed that attempts to reform it into a more mainstream business were going to be difficult, if not impossible.
"It's also going to be a very, very tough position to attract someone of a similar kind of stature," he said.
Sutherland, a Scot who trained at Coca Cola, and who has almost two decades of retail experience, was due to announce changes to his executive team on March 17 ahead of the group's full-year results on March 26.
His interim replacement Pennycook spent nearly eight years as finance chief at Wm Morrison Supermarkets and was widely credited with steering the grocer back on track after a problematic integration of rival Safeway which it bought in 2004.
The Co-op is selling assets such as its farming business and is expected to report a record loss of over 2 billion pounds stemming from its banking unit.