July 31 (Bloomberg) -- Merrill Lynch & Co. was accused by Massachusetts Secretary of State William Galvin of misleading investors about the stability of the auction-rate market at the same time the investment bank was marketing the securities.

New York-based Merrill ``co-opted'' its research department to help place the securities with customers, Galvin said in a statement from Boston today. The state's administrative claim asks the third-largest U.S. securities firm to ``make good'' on sales of now-frozen holdings, compensate investors who disposed of their bonds or shares at a loss and pay an unspecified fine.

``This company was aggressively selling'' the securities ``and its auction desk was censoring the research analysts to make sure they downplayed'' risks in the market, Galvin said in the statement. ``They knew the auction markets were in trouble, but the investors were the last to know.''

Merrill is the second bank sued by Galvin after Wall Street brokers abandoned their routine role as buyers of last resort for auction-rate securities in mid-February, allowing the $330 billion market to collapse. Massachusetts last month filed a complaint against UBS AG, Switzerland's biggest bank. A related investigation of Bank of America Corp. is ``still going on,'' said Brian McNiff, Galvin's spokesman.

Auction-rate securities are long-term bonds or perpetual shares with interest rates adjusted typically every seven, 28 or 35 days through a dealer-run bidding process, providing them with the characteristics of money-market instruments. Firms historically supported the markets, without contractual obligation, when demand dried up.

Market Size

Municipal auction-rate bonds totaled about $166 billion at the time of the market's collapse in February; student-loan- backed debt and closed-end mutual funds' preferred shares comprised most of the rest.

Officials in at least 12 U.S. states are investigating auction-rate sales practices after receiving complaints from investors unable to access their cash. New York Attorney General Andrew Cuomo last week sued UBS, alleging the bank's promotion of auction-rate securities as safe investments was fraudulent.

One of two former Credit Suisse Group AG brokers suspected in a federal probe related to auction-rate securities may have fled to his native Bulgaria, the Wall Street Journal reported.

``In September 2007, two former employees resigned after we detected their prohibited activity and promptly suspended them,'' said Regula Arrigoni, a Credit Suisse spokeswoman. ``Credit Suisse immediately informed our regulators and we continue to assist the authorities.''

Congressional Hearing

U.S. House Financial Services Committee Chairman Barney Frank said today his congressional panel will hold a hearing in September to find out what went wrong in the collapse of the auction-rate securities market.

Merrill decided to stop supporting bids on auction-rate bonds with its own money five days after one of its analysts told financial advisers the bonds represented ``a good, conservative, reasonable investment,'' according to Galvin's release.

``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,'' said Mark Herr, a spokesman for Merrill. ``We are disappointed that Massachusetts filed this action.''

The amount of auctions that failed to draw enough bidders during two decades of the auction-rate market was ``small,'' Herr said. ``In 2007, there were no failed auctions of securities sold to retail clients and, in fact, none to these clients until late January 2008.''

Failed auctions, where issuers' interest costs reset to a penalty rate as high as 20 percent or pegged to a money-market formula, have since become more common than successful ones.

Profitable Segment

Merrill, which trails Goldman Sachs Group Inc. and Morgan Stanley in market value, made about $90 million in profit during 2006 and 2007 from its auction-rate program, Galvin said.

One executive cited in Galvin's complaint said in a November 2007 personal e-mail: ``Market is collapsing. No more $2K dinners at CRU,'' a Manhattan restaurant where the wine list includes dozens of bottles for more than $1,000.

``Time after time, when confronted with conflicts of interest, Merrill Lynch was consistent in that it placed its own interests ahead of its investor clients,'' according to the secretary of state's complaint.

Biased Research

During the dot-com boom that peaked in 2000, Merrill was among firms accused of publishing tainted research to promote Internet companies. Through Henry Blodget and other technology analysts, Merrill issued reports urging investors to buy shares of companies such as 24/7 Real Media Inc. and Interliant Inc. The value of 24/7 shares fell from a peak of $323.13 in January 2000 to 45 cents by September 2001; Interliant peaked at $54.44 per share in February 2000 and reached 13 cents by May 2002.

Regulators, including the U.S. Securities and Exchange Commission and then-New York Attorney General Eliot Spitzer, accused the investment banks of using the biased research to lure investment-banking clients. Merrill, Citigroup Inc. and eight other securities firms agreed to pay $1.4 billion to settle the matter in 2002.

According to the complaint Galvin released today, Merrill's sales and trading department pressed the firm's analysts to endorse auction-rate securities and took them to task over their reports and conference calls. Year-end employment reviews for some analysts evaluated how much support they gave to ``business partners'' on the firm's auction-rate desk, he said.

Research Report

In one incident, Frances Constable, the desk's managing director, objected to an analyst's report in August 2007 that noted auction-rate bonds don't have a so-called ``hard put,'' like variable-rate demand notes, which obligate the issuer to arrange for buying any unwanted securities when rates reset.

The reference was misleading, she argued, because the report focused on municipal bonds and auctions for those instruments weren't yet failing. Researchers rewrote the piece, Galvin argued.

``In fact, there were no material changes in the reports, and the same facts contained in the first report were all retained in a longer, fuller and clearer version,'' Herr said. ``These two analysts are men of integrity and intellectual honesty. They called the ARS market as they saw it, not the way anyone else did.''

That same month, Constable sent messages to an analyst during a conference call with financial advisers. After a participant asked a question, she urged the analyst to ``shut this guy down,'' adding: ``He is focusing attention away from your positive message.''

The objections had an effect, Galvin said. In January, one researcher asked if someone could review his work before publication to ensure it wouldn't upset the auction desk.

Constable wasn't named as a defendant in the complaint. A call to her office was referred to Merrill's spokesman, Herr, who said Constable had no comment.

To contact the reporters on this story: David Scheer in New York at dscheer@bloomberg.net, or Jeremy R. Cooke in New York at jcooke8@bloomberg.net.

Last Updated: July 31, 2008 17:36 EDT