The FBI called it "the M8 squad." The agents assigned to it set up an observation post behind the peepholes of a cigarette sign in south Bronx.

The 1979 surveillance was directed at the headquarters of "Pellegrino Masselli Meats -- Wholesale Dealers," a forbidding concrete-block structure by the Harlem River. The bureau had been assured that a well-placed eavesdropping device would give them "the key to organized crime in the city."

The million-dollar investigation, code-named Operation Tumcon, began as a search for a fugitive kingpin from the French Connection. It ended, years later, with a minority-business fraud case in which 10 men, including Secretary of Labor Raymond J. Donovan, were indicted. The case was brought under New York state law, not federal statutes.

The FBI closed down its inquiry in late 1981 under circumstances still unexplained. According to informed sources, approximately 30 "prosecutive summaries" compiled by the M8 squad, each outlining a potential case, were destroyed.

A bizarre chain of events revived the minority business case that led to the indictment of Donovan last September on state charges of defrauding the New York City Transit Authority of $7.4 million.

No trial date has been set for Donovan and his codefendants, but the FBI faces an extraordinary set of hearings, starting Monday in Bronx Supreme Court, over its handling of Operation Tumcon.

The inquiry, which is expected to last several weeks, was ordered by Judge John P. Collins to help him determine a series of defense motions to suppress the FBI's "Tumcon tapes," now the central evidence in the Donovan case. Donovan's lawyers also challenged the tapes, but Donovan does not have standing in the upcoming hearings.

Defense lawyers contend the FBI hoodwinked the Justice Department and a federal judge into authorizing the surveillance and that the tapes were obtained illegally. They maintain that two FBI agents assigned to the case kept the criminal activities of their key informer, ex-convict Michael Orlando, from those in charge of the investigation. They say the Tumcon evidence is, as a consequence, irrevocably tainted.

Bronx prosecutors contend that the two agents, Robert Levinson and Lawrence Sweeney, went by the book and informed their superiors in the New York FBI hierarchy as well as the U.S. attorney's office in Manhattan soon after learning of Orlando's involvement in some of the criminal activities under investigation.

The prosecution argues that the electronic surveillance had started months earlier and had produced more than enough evidence, in addition to crimes by Orlando, to justify continuation.

In any case, the federal judge who authorized the eavesdropping and the wiretapping, the late Henry Werker, was never told of the informer's misdeeds. Orlando, "a top echelon" source in FBI parlance, remained on the bureau's payroll, at $500 a week, for more than a year after the surveillance stopped.

In September 1980, the government "discontinued" him as an informer and decided to charge him, along with William P. Masselli and other confederates, in the only two federal indictments returned as a result of Operation Tumcon.

The dispute, as Judge Collins has suggested, is not tidy. "It has pitted FBI agents against each other and against assistant U.S. attorneys as well as the Department of Justice," Collins said in ordering the inquiry.

The catalyst for all this was Orlando, 44, a one-time schoolteacher who turned to a life of crime that included arson, armed robbery and, by his admission, at least one gangland murder. According to court records and other sources, he was finishing a term for parole violation in December 1976 when FBI agent Sweeney heard he could be helpful on some bank robberies and other cases on Long Island where Sweeney was stationed. Bluffed into thinking that Sweeney could send him back to prison, Orlando served up a few tidbits, got paid for them and, as one source put it, "The information began rolling in," including information about Angelo Tuminaro, the so-called "godfather of drugs."

Levinson, sources say, heard about it as case agent for the Tuminaro fugitive case and coordinator of information for all five Mafia families in the New York area. He was impressed with how much Orlando knew about "all the families and where they hung out," even to the extent of naming Masselli as the "representative" of imprisoned drug trafficker Louis Cirillo, a Tuminaro associate.

Told to stay close to Masselli, Orlando got a job as a "salesman" at Masselli's meat plant and, before long, became his righthand man for a salary of $25,000-plus a year. Orlando was assured he would never have to testify as a government witness and his identity would be protected unless he did "something stupid," sources said.

The Tuminaro connection reportedly faltered when he and Masselli had a dispute. But by the fall of 1978, Masselli had branched out, establishing himself as a trucking subcontractor on a number of New York City subway projects for Donovan's company, Schiavone Construction of Secaucus, N.J.

Around this time, the 10-agent M8 squad was formed, primarily to pursue the trails Orlando had outlined. One was Masselli's relationship with a black state senator, Joseph Galiber, Masselli's partner in the Jopel Construction & Trucking Co., whose authenticity as a "minority business enterprise" is at issue in the criminal case involving Donovan.

Orlando and another informer, court records show, also told the FBI that Masselli was receiving loads of hijacked meat and an FBI surveillance team said it spotted a stolen shipment pulling into the plant's truck bay shortly after noon on Nov. 30, 1978. Government prosecutors prepared the papers for a court-ordered surveillance, including an affidavit that Sweeney censored to protect Orlando's identity. Judge Werker signed the order on Jan. 4, 1979, and a special FBI team stole into the warehouse that night to plant a bug in Masselli's office.

"They made it look like a burglary," Masselli's lawyer, John Nicholas Iannuzzi, told a reporter. "We thought it was just some kids. They broke in the door and took some things, little stuff."

Now defense lawyers are claiming that Orlando masterminded the Nov. 30 hijacking to provide an excuse for the surveillance. They also charge that the FBI, particularly Levinson and Sweeney, knew about it, but withheld that information from their superiors and Judge Werker.

Now serving a seven-year prison term for hijacking, Masselli contends that he was persuaded by Orlando to take the hot shipment in return for about $1,500 Orlando owed him.

"He Orlando comes along one day, he brought me some stolen goods," Masselli asserted in a recent interview at the Bronx House of Detention where he is awaiting trial as one of Donovan's co-defendants. "He Orlando says, 'If you don't take it, I won't be able to pay you.' And I fell for the okey-doke and I took the stuff. And that was the downfall of my whole thing."

Bronx prosecutors dispute the allegation. They say they know of no evidence that Orlando took part in any hijackings until nearly three months after the surveillance started and they point out that he was later prosecuted for those offenses along with Masselli. FBI agents Levinson and Sweeney say they reported Orlando's involvement to FBI Assistant Director Neil Welch on April 9, 1979, and then to U.S. Attorney Robert Fiske at an April 20, 1979, conference arranged by Welch.

The decision the next year to prosecute Orlando at the risk of exposing his status as an informer led, however, to bitter feelings among members of the M8 squad. The recriminations led to an internal inquiry by a high-ranking New York FBI official, Donald T. McGorty.

The findings of the McGorty inquiry have never been made public. And the existence of the Tumcon tapes, which included several mentions of "Ray" Donovan as well as conversations with five other executives of Schiavone Construction, was never mentioned to the Senate Labor and Human Resources Committee before it voted on Donovan's nomination.

Instead then-FBI Assistant Director Francis M. (Bud) Mullen Jr. told the committee that "no information of pertinence that is not in our report concerning Donovan was developed concerning Donovan or the Schiavone Construction Co." He told the committee the FBI had an investigation under way on "the fradulent establishment of a minority-business enterprise" and that the records of Schiavone had been subpoenaed by a federal grand jury in New York.

Mullen further told the committee, "Neither Mr. Donovan nor Schiavone Construction Co. is the target of this investigation."

Asked about Masselli, whom the report described as "a self-admitted 'soldier' " in the Genovese crime family, Mullen stated, "I do not have any background whatsoever on him."

Indicted on hijacking and narcotics-trafficking charges four months later, Masselli, Orlando and a number of gangland confederates pleaded guilty to reduced charges that fall. The Tumcon tapes were put back under seal.

According to informed sources, the nearly 30 "prosecutive summaries" of other potential cases -- three-ring binders including conversations, witness interviews and other relevant evidence distilled from the mountainous main Tumcon file -- were destroyed in a clean-up of the "Tumcon backroom" between November 1981 and June 1982.

The supervisor of the M8 squad, FBI agent James E. Moody, told FBI internal investigators in January that his successors "apparently cleaned out the room completely" to make room for another squad. He estimated perhaps 10 of the packages could be reconstructed from files of federal prosecutors in New York and portions of another eight to 10 might be found in organized crime "tickler files" at FBI headquarters.

According to FBI Assistant Director William Baker, Moody also located a copy of one, dealing with a potential prosecution for minority business fraud. Bronx prosecutors have asked the FBI for a copy of that summary but have yet to receive it.