Documents Reveal Shifts in Focus of Iraq Loan Probe : Gulf War: Emphasis was diverted from potential scandal involving Italy’s government. At issue is why.

WASHINGTON — In January, 1991, Justice Department officials in Washington ordered the U.S. attorney in Atlanta in no uncertain terms to renew efforts to determine whether Italian officials had been aware that a U.S. branch of an Italian government bank had secretly been involved in financing Saddam Hussein’s arms buildup.

But six weeks later, that order to pursue the Italian connection vigorously was somehow reversed.

What happened?

In recent months, Washington’s turnaround has become a focal point of growing suspicion as new inquiries are mounted into the Bush Administration’s support for Iraq before the August, 1990, invasion of Kuwait, and as new doubts are raised about the idea that the U.S. bank branch--in Atlanta--was acting without knowledge of Italian authorities.

Members of Congress, lawyers involved in Iraq-related cases and others are now openly asking if the decision was just a flawed legal judgment--or an early sign of a developing cover-up.

The doubts were underscored by two events last week.

First, a judge in London threw out charges against three businessmen accused of selling military technology to Iraq after disclosures that they had acted with approval from the British government as part of a secret policy.

Second, and more significantly, the Justice Department moved a step closer to the appointment of an independent counsel to investigate possible criminal wrongdoing by government officials in the handling of the case.

Newly obtained government documents and interviews provide a detailed, behind-the-scenes reconstruction of critical events in an investigation that has moved to center stage in what has become known as Iraqgate.

The story of how FBI agents raided the Atlanta branch of Banco Nazionale del Lavoro in August of 1989 is well-known. Records seized by the FBI implicated the branch bank for its role in making $5 billion in loans to Iraq that were not reported to federal and state banking regulators, a clear violation of U.S. law. It was determined quickly that some of the loans had gone for military technology.

The records did not make clear whether the Atlanta office operated alone. The assistant U.S. attorney leading the probe in Atlanta, Gail McKenzie, decided early on that bank officials outside Atlanta were unaware of the scheme. The documents show that McKenzie feared her case would amount to little more than technical violations unless the parent bank could be characterized as the victim of a conspiracy.

Her theory faced a critical test in early 1990. Prosecutors anticipated that once the case came to trial, attorneys for the Atlanta employees would argue that Rome had approved the transactions. So in January, 1990, they proposed a trip to Rome to interview BNL officials and examine internal records there.

Another crucial avenue of investigation was to be pursued on the same trip. Investigators planned to go on to Istanbul, Turkey, to question executives of a Turkish company who had promised to shed light on the final destination of up to $2 billion in grain and other commodities purchased by Iraq through BNL.

The commodity purchases amounted to $2 billion of the $5 billion in loans that BNL made to Iraq. The loans were guaranteed by the U.S. Department of Agriculture. The investigators were told in the first weeks of the probe that Iraq had swapped some of those commodities for weapons by diverting the shipments through ports in Jordan and Turkey.

Newly obtained Justice Department records show that the federal investigators were promised access to Turkish businessmen who had handled some of the food deals and could provide “most sensitive” information about Iraq’s misuse of the U.S. loan guarantees.

The itinerary was set--a week in Rome, a week in Istanbul. Two days before departure, the trip was mysteriously canceled.

In a report to Congress last summer, Atty. Gen. William P. Barr said the trip was postponed so that Justice Department lawyers could review the case. However, a February, 1990, Federal Reserve memorandum blamed then-Atty. Gen. Dick Thornburgh for blocking the trip.

Thornburgh has said he does not recall the incident. Other records show that he was being lobbied at the time by the Italian ambassador to limit the investigation into BNL. The lobbying was part of a strong push by the Italian government to use political leverage to contain the investigation.

The trip was rescheduled for May, 1990, but was stopped again. Barr told Congress it was halted the second time because the Turkish businessmen had withdrawn the offer to cooperate. The report did not say why the Rome leg of the trip was canceled. The senior federal investigator on the case testified at a court hearing in September that he was never told why the trip was not allowed.

As a result, no investigators questioned BNL officials in Rome. Instead, they relied on information provided primarily by the bank’s lawyers, who had an obvious stake in seeing that their client was cast as a victim.

As part of its legal team, BNL hired William P. Rogers, who had served as secretary of state under former President Richard M. Nixon and is considered one of Washington’s most influential lawyers.

Internal bank documents reveal the key elements of the legal and political strategies crafted by Rogers and others. The top priority was convincing the Justice Department that BNL, not U.S. businesses, had lost money because Iraq defaulted on hundreds of millions of dollars in loans. Indicting the bank would make it a victim twice over, they argued.

On the political side, the documents show that Rogers wanted to link the bank as closely as possible to its owner, the Italian government. Soon after he was hired in April, 1990, records show that Rogers suggested the Italian government also hire his firm to “emphasize the importance” the government placed on the case.

Despite such efforts, Laurence A. Urgenson, chief of the Justice Department fraud division, remained unconvinced that the parent bank had been defrauded. He also was concerned that the prosecution team in Atlanta had been swayed by the bank’s strategy.

“In brief, our review continues to raise significant questions concerning the scope and objectivity of the U.S. attorney’s investigation on the central issue of whether Banco Nazionale del Lavoro was an unwitting victim of a scheme to defraud,” Urgenson wrote in a memo to his superiors on Nov. 29, 1990.

Amplifying his suspicion about the involvement of BNL management outside Atlanta, Urgenson wrote: “Part of the difficulty we are experiencing in this regard is the virtual absence of any hard probing of BNL New York or Rome personnel--and a concomitant of relying so heavily upon BNL for assistance.”

So, on Jan. 11, 1991, Urgenson and two other senior lawyers summoned McKenzie, two senior attorneys from Atlanta and the lead investigator to Washington. He ordered them to conduct a thorough inquiry into what BNL officials outside Atlanta knew about the loans, including taking grand jury testimony from bank officials and going to Rome.

For the first time, instead of interviewing bank officials in friendly settings, the prosecutors brought them before the grand jury for sworn testimony, according to defense lawyers and other sources. In the last week of January, more than a dozen bank employees from outside Atlanta were rushed before the grand jury to testify.

Still, there was no trip to Rome, no further attempt to examine records there. The prosecution relied on witnesses and records provided by the bank.

On Feb. 28, 1991--the day after the end of the Persian Gulf War--an indictment was issued blaming the whole $5-billion scandal on the branch bank’s manager and five Atlanta colleagues. The Italian owners were portrayed as unwitting victims of a masterful scheme.

Nonetheless, Urgenson was apparently satisfied.

“The February, 1991, indictment was based upon a comprehensive analysis of all available evidence and was backed by detailed sworn testimony of numerous witnesses before the grand jury,” he told Congress last June. “The possible role of BNL officers and entities above the Atlanta level had been amply investigated.”

Department officials said last week the Rome trip was unnecessary because the bank provided the witnesses in Atlanta.

“They were able to get the job done faster,” said Paul McNulty, the department’s chief spokesman.

McNulty and other officials maintain BNL employees outside Atlanta could still be indicted if new evidence surfaces, although the Atlanta prosecutors have said repeatedly that no one outside Atlanta knew about the loans, which could make future prosecution difficult.

In recent weeks, CIA documents have cast BNL managers in Rome in a sharply different light--and cast doubt on the government’s assertion that the Rome office was in the dark.

Four classified cables from the CIA’s Rome station chief in the weeks after the 1989 FBI raid suggested bank officials there knew of the Iraqi loans while they were being made. The cables were not disclosed to the Justice Department until last September.

Then, earlier this month, The Times obtained a CIA letter written on Jan. 31, 1990, to the Agriculture Department that was even stronger. It concluded that Rome managers were involved in the scandal. That letter did not get to the Justice Department until last month.

The CIA maintains that it could not find the material earlier, but Justice Department officials are privately furious that the material was not turned over sooner.

Under pressure from Congress, the attorney general appointed a retired judge as a special investigator to sort out the dispute between the CIA and Justice Department.

Times staff writer Ronald J. Ostrow contributed to this story.