New York prosecutors sued Ernst & Young, accusing the accounting firm of helping to hide Lehman Brothers Holdings Inc's financial problems, the first major government legal action stemming from the Wall Street bank's 2008 downfall.

The civil fraud case seeks more than $150 million in fees that Ernst & Young received from 2001 to 2008 as Lehman's outside auditor, plus other unspecified

damages.

It contends that one of the largest U.S. auditing firms stood by for years while Lehman used accounting gimmickry to create a false impression about its financial health.

Ernst & Young is the only defendant in the case. New York did not file charges against the Lehman executives who ran the firm when it filed the largest bankruptcy in history in September 2008, helping spark the global financial crisis.

The accounting firm was not available for comment. New York Attorney General Andrew Cuomo filed the lawsuit days before he leaves office and becomes governor of the state in January.

Ernst & Young has said that it believes its work as Lehman auditor met all applicable professional standards and that accounting issues were not to blame for the bankruptcy.

Cuomo said that for more than seven years leading up to Lehman's bankruptcy, Lehman engaged in fraudulent accounting transactions that were not properly disclosed and that the auditor explicitly approved.

The case focuses on an accounting technique known as Repo 105, which temporarily removed as much as $50 billion in assets from the balance sheet in 2008.

This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed, Cuomo said in a statement.

The case, filed in New York state Supreme Court, is one of the biggest legal cases involving an accounting firm since Arthur Andersen was criminally indicted in 2002 over the Enron scandal.

The Ernst & Young case is a civil lawsuit, while Andersen was charged criminally and later convicted of obstruction of justice for its role in Enron's collapse.

The U.S. Supreme Court reversed the Arthur Andersen conviction in 2005, but the firm was virtually out of business by then -- and its reputation was shattered.

Andersen's demise reduced the number of big accounting firms that audit most large companies globally to just four, including Ernst & Young. Since then, prosecutors have been wary of charging entire firms with fraud because of worries that another audit firm could collapse, endangering the financial system.

In one major settlement, KPMG agreed in 2005 to pay $456 million to settle a federal investigation into questionable tax shelters, avoiding a potentially crippling criminal indictment. The firm agreed to make internal changes and to be overseen by an outside monitor temporarily as part of the pact.

In 1999, Ernst & Young agreed to pay $335 million to shareholders of Cendant Corp to settle a case stemming from an accounting scandal at the travel and real estate service company. Ernst & Young said at the time that it was misled by Cendant and had done nothing wrong.

London-based Ernst & Young employs about 140,000 people. It had revenue of $21.3 billion in the fiscal year ended June 30. About $9.6 billion came from Europe, the Middle East, India and Africa. Another $8.4 billion came from the Americas.

REPO 105

The Repo 105 transaction at the heart of Tuesday's lawsuit was exposed in a March report by Lehman bankruptcy examiner Anton Valukas. Lehman used Repo 105, which dates to 2001, without telling investors or regulators. the report said.

Cuomo's lawsuit said that E&Y, as an independent auditor, was obligated to ensure that Lehman's financial statements disclosed the Repo 105 transactions.

But instead, the financial statements said not a word about Repo 105, falsely represented that Lehman was treating all repo transactions as financings, and E&Y accordingly must be held accountable for the consequences of this fraud, the lawsuit said.

The March examiner's report said that Lehman could also have claims against former Lehman Chief Executive Richard Fuld and former Chief Financial Officers Chris O'Meara, Erin Callan and Ian Lowitt for negligence or breach of fiduciary duty related to the use of Repo 105 transactions.

(Reporting by Martha Graybow and Grant McCool. Editing by John Wallace, Gerald E. McCormick and Robert MacMillan)

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