CHICAGO, July 31 (Reuters) - Massachusetts sued Merrill Lynch & Co MER.N on Thursday, charging the Wall Street firm with fraud over its dealings in the troubled auction-rate securities market.

The case, brought by the Massachusetts secretary of state, charges Merrill with fraud and "dishonest and unethical" conduct for creating and implementing a sales and marketing scheme, which significantly misstated the nature and stability of the auction-rate market. As a result, thousands of investors were abandoned with illiquid investments, the complaint said. (Reporting by Karen Pierog; Editing by James Dalgleish)