Besieged by lawsuits, the bank agrees to buy back $3.5 billion of client holdings in the troubled ARS market.

Swiss bank UBS AG announced it is buying back as much as $3.5 billion in auction-rate securities from customers, amid numerous lawsuits that claim the firm and other brokers marketed the investments fraudulently.

UBS clients who bought auction-rate preferred shares by tax-exempt closed-end funds will get their money back plus any unpaid dividends, the bank said. The repurchases will be funded by a reissue of the preferred shares by a newly created trust. UBS is still working through regulatory issues regarding the trust’s proposed structure.

To be eligible for the offer, the auction-rate preferred stock must have been held in the client’s UBS account on July 15, 2008, the bank said.

The holdings affected by Tuesday’s announcement represent less than 15% of UBS customers’ $24 billion in auction-rate investments. Municipalities, student-loan trusts, and taxable closed-end funds were also big issuers of auction-rate instruments.

The $330 billion auction-rate securities market has been virtually frozen since late last year, and individual and corporate clients have been clamoring to liquidate holdings. Banks and brokerages have been accused of blocking investors from selling their ARS instruments in the secondary market at a discount, for fear it would open them up to legal liability.

The commonwealth of Massachusetts filed suit against UBS in late June, claiming the firm pushed the securities as cash-like investments to retirees and small business owners. Similarly, on June 26, Phazar Corp., a maker of military wireless networking systems, filed an arbitration claim against UBS with the Financial Industry Regulatory Authority. It also sued UBS in a Texas district court.

The Phazar lawsuit seeks to prohibit UBS from denying the company access to $2.7 million in cash that the company invested in auction-rate securities. The company says it “invested its liquid assets in auction rate securities based on the fact that UBS repeatedly made material false representations to the Company that the auction rate securities it purchased from UBS were safe, liquid investments.”

Phazar claims that on its May brokerage statement from UBS, the bank abruptly changed the classification of the auction-rate securities from “cash alternatives” to “fixed income investments.”

“The Company never intended to invest its cash in long term fixed income investments and, based on UBS’ express representations, always considered the auction rate securities to be current assets,” the lawsuit says.

As of May 31, about 185 companies had written down an aggregate of $1.85 billion on auction-rate investments, according to Pluris Valuation Advisors LLC. This week Continental Airlines announced it is writing down $29 million in the value of student-loan related auction-rate investments it holds, and chipmaker Advanced Micro Devices announced it expects to record a $12 million charge pertaining to similar investments. According to Pluris, about 200 companies are still accounting for auction-rate holdings at the full par value.