Fraud charges loom over Ernst & Young in the US

Prosecutors consider civil action relating to firm's auditing of Lehman Brothers

Ernst & Young, the accountancy giant, could face fraud charges in the US over the 2008 collapse of Lehman Brothers, it has emerged.

Prosecutors in New York are considering launching civil charges against the firm relating to an accounting practice which allowed the investment bank to hide tens of billions of dollars in debts from investors.

Ernst & Young was Lehman's auditor and was sharply criticised this year in a court examiner's report on the bankruptcy, for failing to raise red flags over a practice called "Repo 105". The practice helped the bank reduce its leverage for a few days around the end of each quarter – when it had to report the number to shareholders.

Andrew Cuomo, the New York state attorney-general, could file charges this week and it was reported yesterday that Ernst & Young could simultaneously agree a settlement. Neither Mr Cuomo's office, nor the accounting firm would comment yesterday. Ernst & Young repeated its statement on the Repo 105 controversy. "Throughout our period as the auditor of Lehman, we firmly believe our work met all applicable professional standards, applying the rules that existed at the time," it said.

If they are brought, the charges would be the first directly relating to the collapse of Lehman, which was the central event of the credit crisis and a shock that almost brought the global financial system to a standstill. They would also raise echoes of the Enron bankruptcy in 2001, after which that company's auditor, Arthur Andersen, was found guilty of negligence in a criminal trial. Those charges against Arthur Andersen were so serious – and involved accusations its officers shredded evidence – that the firm ultimately went out of business.

Lehman's reliance on Repo 105 was discovered by Anton Valukas, an examiner appointed by the bankruptcy court to examine whether the bank's creditors might have legal claims against Lehman executives or advisers. Mr Valukas's report said that Ernst & Young could be pursued for negligence. "Repo 105 did not cause the collapse of Lehman Brothers – that was due to an over-reliance on short-term finance to cover long-term liabilities and bad property investments," he wrote in March. "But it did conceal the bank's parlous state for a long time."

Under the practice, which London-based law firm Linklaters certified was legal under UK law, Lehman reduced the apparent scale of its short-term borrowings for a few days around the end of each quarter. It began using the practice in 2001, but the scale of its use ballooned. Bart McDade, its head of equities, described Repo 105 as "another drug we are on", in an internal email.

By 2008, as the credit crisis escalated and shareholders were paying increasing attention to banks' short-term borrowings and demanding that Lehman reduce its borrowings sharply, the bank was hiding $50bn of debt from its investors.

Ernst & Young was criticised by Mr Valukas for giving Repo 105 a clean bill of health even after one employee tried to bring the issue to the attention of Lehman's board of directors. Matt Lee was a mid-level employee at Lehman's New York office, a 14-year veteran of the firm, when he wrote to senior managers in May 2008 alleging poor accounting practices. His claims were investigated by Ernst & Young, who failed to pass Mr Lee's allegations up for consideration by the Lehman board. The accounting firm said in March that it did not find any material issues in its investigation.

Within weeks of the incident, Mr Lee was fired, a casualty of lay-offs carried out by Lehman in June 2008. More than 8,000 staff were let go in the months before the bank filed for bankruptcy in September 2008.

Until now, US prosecutors looking into wrongdoing during the credit crisis have concentrated on non-Lehman matters. Civil charges have been brought against Goldman Sachs for failings in their mortgage derivatives business and against former executives of Countrywide, the largest US sub-prime mortgage lender.