New York Attorney General Andrew M. Cuomo filed a lawsuit on Thursday charging UBS Securities LLC and UBS Financial Services with using deceptive tactics to market auction-rate-securities.

Cuomo alleged that UBS falsely sold and marketed the controversial commercial paper as safe, highly liquid, and cash-equivalent securities. But when the market for ARS came under tremendous strain, the securities wound up with mounting liquidity risks that eventually blocked thousands of customers across New York and the nation from accessing their holdings, according to the suit.

The attorney general also alleged that as the securities market started to collapse, at least seven top executives at the bank quickly sold off $21 million in personal holdings of auction rate securities but continued to market them to individual consumers and corporations that bought them with plans to use the proceeds for such things as “payroll, operating costs, and capital improvements.”

Cuomo said internal UBS E-mails subpoenaed by his office detail top executives’ efforts to sell off personal holdings of ARS. “Not only is UBS guilty of committing a flagrant breach of trust between the bank and its customers, its top executives jumped ship as soon the securities market started to collapse, leaving thousands of customers holding the bag,” said Cuomo. “Today we bring the first nationwide lawsuit against UBS, seeking to recover billions of dollars for customers and sending a resounding message to the rest of the industry that this type of deceptive behavior will not be tolerated.”

Not unexpectedly, the suit irked the bank. “It is frustrating that the New York Attorney General has filed this complaint while we have been fully engaged in good faith negotiations with his office to bring liquidity to our clients holding auction rate securities,” according to UBS, which said in a statement that it would “vigorously defend ourselves against this complaint.”

The bank reported that it conducted an internal investigation on sales of personal holdings of ARS. “While UBS does not believe that there was illegal conduct by any employee, we have found cases of poor judgment by certain individuals and are evaluating appropriate disciplinary measures for these individuals,” it said.

“UBS categorically rejects any claim that the firm engaged in a widespread campaign to move ARS inventory from the firm’s own books and into private client accounts. Our records demonstrate that UBS built up its own inventory of ARS from $5.9 billion at the end of 2007 to approximately $11 billion at the end of 1Q08, while Wealth Management US clients were reducing their positions,” according to the statement.

UBS also asserted that it’s “well-known” that the bank “continued to support the auctions longer than any other major firm.”

Cuomo said UBS customers currently hold more than $25 billion in illiquid, long-term paper as a result of UBS’s fraudulent misrepresentations and illegal conduct. “UBS’s fraudulent sales practices proved effective ,” the lawsuit states.

The lawsuit calls on UBS to buy back ARS from defrauded customers at par. It also seeks disgorgement of ill-gotten gains, restitution, and other damages, and injunctions from further violations of New York’s securities law. The civil lawsuit was filed in the Supreme Court of New York, New York County.

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