According to the Australian, Paul Anastassiou, acting for Merrill's subsidiary Berndale Securities, told the supreme court of Victoria that David Waterhouse's complaint effectively amounts to an allegation that Berndale had a fiduciary duty to break the law.
The accusation of insider trading is part of a A$4 million ($3.25 million) counter-claim launched by Mr Waterhouse in response to a A$9 million lawsuit brought by Berndale over unpaid debts on his account, which operated as How Trading.
In his complaint, Mr Waterhouse alleges that Merrill Lynch executives offered to "short the hell out of stocks" using privileged information about losses from its New York office in order to cover How Trading's options positions.
However, Mr Anastassiou said the investor then claims that Berndale, having shorted the shares, promised to defer buying back the positions until "such a time as to maximize profit".
Judge James Judd said he would not resolve the insider trading allegations because, although serious, they are only relevant as a possible reason for the short selling.
The case continues.