Authorities from the American state of Massachusetts sued Merrill Lynch & Co on Thursday, charging the Wall Street firm with fraud over its dealings in the troubled auction-rate securities market.

Auction-rate securities are preferred shares or debt instruments with rates that reset regularly, usually every week, in auctions overseen by the brokerage firms that originally sold them. But the $300-billion market for these instruments collapsed in February, trapping investors who had been told that they were safe and the instruments were easy to liquidate.

February's meltdown began in July 2007, when MBIA Inc. and Ambac Financial Group Inc., the two largest insurers of auction- rate debt, reported lower profits because of losses on securities backed by sub-prime mortgages. Losses at the insurers prompted auctions for $1.8 billion of their own securities to fail, according to Fitch Ratings.

The complaint, filed by Secretary of State William F Galvin's office, cites e-mails from Merrill Lynch management urging research staff to write positive reviews of the securities - which brokers at many firms were selling as safe alternatives to money market funds, right up until the collapse of the market.

''Research analysts routinely soft-pedaled significant negative events affecting liquidity in the auction markets,'' he said in the complaint. At the same time, managers knew ''the auction markets were not functioning properly and were in fact in significant danger of collapsing,'' he said.

Merrill is the second Wall Street firm Galvin has targeted in his auction-rate probe. In June he filed fraud charges against UBS Financial Services Inc., alleging the brokerage misled customers about the auction-rate market. The Swiss investment bank also faces charges in New York and Texas. (See: New York attorney general charges UBS with securities fraud)

In a separate settlement with Massachusetts Attorney General Martha Coakley, UBS agreed to pay $40 million in restitution and fines for auction-rate securities illegally sold to Massachusetts towns and cities.

Galvin is also investigating Bank of America Corp.'s handling of auction-rate investments.

The state said Merrill sold about $95 million in auction-rate securities to 165 Commonwealth investors in January and February, even as executives knew the market could fail. "We now find out that research was corrupted and investors were disadvantaged. That's really troubling," Galvin said in an interview.

Merrill defended its research practices and denied wrongdoing. "Our research reflected the honest belief that [auction-rate securities offered higher returns in exchange for less liquidity and noted that market changes had begun to occur," the firm said in a statement. Analysts, the firm added, called the market "as they saw it, not the way anyone else did."

The firm called its analysts as ''men of integrity and intellectual honesty'' and insisted that ''nothing the sales desk could do or couldn't do affected how much these analysts earned or their standing in our research department.''

But last August, as problems in the sub-prime market were bubbling over to the auction market, a managing director in charge of Merrill's auction desk, Frances Constable, directly e-mailed a fixed-income analyst to say, "Any renewed research focusing on the high quality of [auction-rate securities] . . . would be extremely helpful."

''Reports of the imminent demise of the auction market seem to be greatly exaggerated, again,'' analyst Kevin Conery wrote in an 8 February research note. ''We continue to be impressed by the auction market's resiliency.''

In another instance, the complaint said, Constable objected to a research report pointing out that auction-rate securities could be harder to cash out of than other securities, and asked that it be retracted and rewritten.

In an e-mail, she complained that the piece could "single-handedly undermine the auction market." The research department acquiesced, according to the complaint, declaring the securities a "buying opportunity" in a revised report.

Merrill denied any material changes to the report. Constable, the firm said, "was entitled to voice her views, just as the analysts were entitled to ignore them. And her opinions did not change the views of our analysts."

Analysts provide research to brokerage clients and to the brokers themselves, who often rely on that information when they sell stocks, bonds, and other products to investors.

Conflicts in research have been a problem on Wall Street before. Merrill and other firms paid combined fines of more than $1 billion after investigations in 2002 revealed analysts hyped dot-com stocks to help their investment-banking business and pump up share prices. Galvin said he was dismayed to find new research problems at Merrill.

At the same time, Massachusetts Representative Barney Frank, chairman of the House Financial Services Committee, said he would hold hearings on auction-rate securities starting on 18 September "to examine the continuing crisis."

Former New York Attorney General Eliot Spitzer in 2003 won $1.4 billion in settlements from 10 firms including Merrill he accused of misusing analyst research to win investment-banking deals. The probe uncovered e-mails showing former Merrill analyst Henry Blodget touted stocks to clients while deriding them to colleagues, referring to one as a ''piece of junk.''

That settlement barred contacts between investment bankers and equity analysts, and doesn't prohibit a sales employee from calling a fixed-income analyst to express opinions, Herr said. (See: Citigroup faces securities fraud charges)