Merrill Lynch has offered to buy back auction-rate debt
New York State's attorney general has threatened to sue Merrill Lynch for misrepresenting certain debt investments as safer than they were.
Andrew Cuomo said that legal action against the US bank was "imminent" after it failed to settle charges of mis-selling with regulators.
Last week, Merrill Lynch offered to buy back $12bn (£6bn) of auction-rate debt. It said it was surprised by the threat.
It comes amid a wide-scale inquiry into misselling of these investments.
Mr Cuomo said that the bank's voluntary buyback was not an adequate amount.
In a statement, Merrill Lynch said: "We have been discussing this issue with New York and other regulators since we announced last week our plan to purchase our retail clients' ARS (auction-rate securities) and we thought we were making progress.
"We anticipated further talks," the firm added.
Within the past eight days, the office of the New York State attorney general has signed agreements to restore billions of dollars to investors around the US.
The country's fourth largest lender, Wachovia, is the latest to settle charges with state regulators, agreeing to buy back $8.5bn worth of auction-rate securities and reimburse customers who had sold these investments at a loss.
North Carolina-based Wachovia will also pay fines of $50m as part of the settlement with New York State and other regulators, including the Securities and Exchange Commission (SEC).
The deal with Wachovia follows similar ones with Citigroup, UBS, JP Morgan and Morgan Stanley.
The crackdown by US regulators comes after the market for auction-rate securities collapsed in February amid the wider credit crisis as investors lost interest in everything but government bonds.
Municipal authorities and state agencies, such as student-loan bodies, have been the worst affected by the problems in this market because they frequently used auction-rate securities to raise funds.
It was a popular choice because investors thought of the debt products as highly liquid investment, almost as safe as cash, but with a higher return.