A court case in Australia involving Merrill Lynch and the son of a national bookmaking legend could entangle the global bank in a giant insider trading probe.

Regulators are looking closely at the case which will begin in Sydney on Tuesday. At the heart of the story are claims by David Waterhouse, the son of Sydney bookmaker Bill Waterhouse, in relation to a margined multi-million dollar options account Waterhouse held with Merill Lynch.

Waterhouse, like his father a former bookmaker, claims in a witness statement he arrived at the Sydney offices of Merrill Lynch on January 14 last year in company with his accountant. He was ushered through the maximum security entry on the ground floor up to the Mrrill Lynch boardroom. His accountant was not allowed entry. Waterhouse says he met with Dan Ritchie, the bank’s head of equity trading, John Laws, the bank’s global markets financing chief, and Michael Horrax, Merrill’s General Counsel.

What follows has captured the fornt pages of the nation’s financial press, and the attention of the local regulator, the ASIC (Australian Securities Investments Commission).

Waterhouse was facing a margin call, had provided $1 million in cash, and a $4 mortgage second mortgage over Waterhouse’s Sydney Harbour manion as additional security. The bank however wanted $1 million more, according to Waterhouses’s statement. He alleges Laws told him, “Unless you come up with the $1 million this minute we are taking the account back and we are going to close positions in the account in our sole discretion.”

At this point, says Waterhouse, Ritchie took him aside and escorted him to the elevators. The conversation that took place during this short walk is now what is reverberating around the halls of Australian markets and ASIC. According to Waterhouse Ritchie said to him, ”David you are a nice guy and you have done the right thing, but the market has gone against you. The market is expecting Merrill Lynch in New York to come out with a bad result on Thursday night. Its not going to be bad, its going to be awful, and this market is going to plummet on Friday and may fall leading up to the result as it will start to leak out. I know you have other accounts with other brokers. Do yourself a favour, do not write any put options whatsoever this week.”

If that was not explosive enough, Waterhouses alleges Ritchie went on to say, “We will short the hell out of stocks in the market that you have option positions on, maybe up to $100 million, which will more than match your option positions. Its a great opportunity for you that we know what is coming this week. With this huge short sale we will then close the option positions and at the same time buy back the short sale stock, which will support the price on the options. It will be done over the next couple of weeks. Your account will be contained at $5 million, which is covered by the $4 million guarantee, we maybe give you money back, depends on the size of our short sale, if we go as much as a hundred big ones.”

Waterhouse left the building in company with his accountant Anthony Tighe who he told of his encounter. Tighe says he stressed to Waterhouse he should not himself trade in any options or shares based on the information he had received about the Merrill Lynch results as it would be considered insider trading. In a statement to the court Tighe said, “"David returned and told me what had happened at the meeting. At the end of the conversation I made the file note of what David said, then I said: 'David, now that you have told me this, do not trade on the information regarding Merrill Lynch, in any way whatsoever.'" (Tighe’s file note of the conversation has been submitted as evidence).

Later that day Merrill Lynch took control of Waterhouse’s account and bought $51.6 million worth of put options on Australian blue-chip stocks.

Three days later on January 17 2008 Merrill Lynch reported it had lost a record $9.83 billion, or $12.01 a share for the December quarter, which Bloomberg on the day said was “three times higher than analysts forecasts." The Dow dropped 307 points in its worst one-day rout in two months.

The following day, Friday January 18 2008 the Sydney Morning Herald headed its stock market report for the day, “The S&P/ASX 200 (Australia’s benchmark stock index) shed more than 3 per cent in morning trading, to a low of 5,619.3 points, after massive losses announced by US broking house Merrill Lynch overnight.”

Merrill Lynch this week released a statement rejecting the allegations and denying Ritchie had made the comments alleged.

All eyes will be on proceedings on Tuesday when the Victorian Supreme Court trial commences. Merrill Lynch is suing Waterhouse for what it says is a $9.2 million debt, while Waterhouse is counter-suing the bank for $4 million for breach of contract and unjust enrichment.

A spokesman for the Australian Securities Exchange said, "We can't comment on any specific matter, but our practice is that whenever we find evidence of insider trading, we refer the matter to ASIC."