The state of New York has filed a civil lawsuit charging Ernst & Young with helping Lehman Brothers commit accounting fraud by concealing the investment bank's liquidity crisis as it spiraled into collapse.

Attorney General Andrew Cuomo alleges the Big 4 firm approved Lehman's notorious “Repo 105” transactions to remove liquid, fixed-income securities off the balance sheet for the sole purpose of reducing leverage that would be reported to investors, analysts, lenders, and anyone else interested in Lehman's financial condition. Cuomo is seeking the return of $150 million in audit fees paid by Lehman to E&Y from 2001 to 2008, plus unspecified investor damages and other relief.

Cuomo filed the complaint in New York Supreme Court under the state's Martin Act, which gives the attorney general's office broad powers to investigate and file claims related to commodities and securities fraud. The suit claims that E&Y was fully aware of Lehman's fraudulent Repo 105 transactions, specifically approved of Lehman's use of them, and gave Lehman an unqualified audit opinion every year from 2001 to 2007, despite knowing that they concealed the Repo 105 transactions.

“This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed,” said Cuomo in a statement. “Just as troubling, a global accounting firm, tasked with auditing Lehman's financial statements, helped hide this crucial information from the investing public.”

The suit also alleges that as Lehman's leverage mounted, it rapidly increased its use of Repo 105 transactions to make short-term borrowings look like asset sales, removing up to $50 billion from the balance sheet each quarter without disclosing it—all with E&Y's blessing. Cuomo also says E&Y failed to raise any objection as Lehman misled analysts on quarterly earnings calls, nor did E&Y inform Lehman's audit committee about a seemingly credible whistleblower concern.

It's important to note the case New York filed against E&Y is a civil suit, much different than the criminal charges that led to the demise of Arthur Andersen, which was convicted of obstructing justice in 2002 for destroying Enron documents. 

The 32-page complaint provides a detailed account of how manager-level auditors at E&Y questioned Lehman's use of Repo 105 transactions, but dialogue died as it rose to the ranks of the engagement partner. Mid-level managers noted concerns, for example, but can't remember discussing them with their superiors, according to the suit.

Ernst & Young published a statement promising to mount a vigorous defense. “There is no factual or legal basis for a claim to be brought against an auditor in this context where the accounting for the underlying transaction is in accordance with Generally Accepted Accounting Principles,” the firm said. “Lehman's audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry.”

The audit firm says Lehman's bankruptcy was not caused by accounting issues. “We look forward to presenting the facts in a court of law,” the firm said.