Jan. 7--Community Trust Bank, the largest state-chartered bank, has sued Merrill Lynch for nearly $40 million related to doomed auction-rate securities the bank bought through the investment firm. The fallout from the meltdown of that market caused a $577,000 loss for the Pikeville-based bank in its third quarter last year.

Community Trust filed the suit in federal court on New Year's Eve, saying it holds $9.9 million of the now essentially worthless securities. The bank bought them beginning in January 2006 because Merrill Lynch had said they were "safe investments for short-term investing," the suit says.

The securities are called auction rate because their interest rates are set at periodic auctions.

But the securities were linked to Fannie Mae, the quasi-governmental mortgage giant, that has since been taken over by the federal government, which stopped paying dividends on the securities.

"When you have a long-standing relationship with somebody like this bank did with Merrill Lynch, you learn to trust them and rely on their skill and judgment, which they did..." said Richard A. Getty, who is representing Community Trust. "It turned out that many things they should have known about these securities were not really fully disclosed."

Among Community Trust's complaints are that Merrill Lynch and other firms allegedly manipulated the auctions to ensure there was demand by making their own bids, unknown to the other buyers.

Federal regulators and state attorneys general including New York's Andrew Cuomo have reached agreements with many investment banks to buy back these securities. And Merrill Lynch agreed to voluntarily buy back securities, but only for retail customers, not institutional investors such as banks, Getty said.

"If Merrill Lynch is going to step up to the plate for retail customers, they should do likewise for the institutional investors," he said.

A Merrill Lynch spokesperson could not be reached for comment.

Community Trust has sued for $9.9 million in compensatory damages and at least $29.7 million in punitive damages.

"There are lots of ways to interpret this," Don Mullineaux, a banking and financial services professor at the University of Kentucky, said of the suit. "Community Trust may have a strong sense they can win the case. Or alternatively you could view it as them putting pressure on Merrill Lynch to settle."

While the write-offs in the third quarter of the Fannie Mae, and some Freddie Mac securities, caused a quarterly loss, it was small compared to its $2.4 billion in deposits.

Without the one-time loss, it would have earned $8.8 million.

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