It was front-page news: A giant defense contractor and the NASA administrator, a former company executive, accused of conspiring to bilk the government out of millions of dollars.

Once again, said Robert C. Bonner, the U.S. attorney in Los Angeles, where the case was filed in December 1985, a defense contractor had been caught "pillaging the U.S. Treasury."

More than 18 months later, it was front-page news of a different sort: the government forced to confess error and drop its case against General Dynamics, against James M. Beggs, who had been forced to resign from the National Aeronautics and Space Administration after the indictment, and against three other corporate officials accused of conspiring to overcharge the Defense Department by more than $3 million in a contract to produce prototypes for the Divad antiaircraft gun.

"The government is standing up and saying, 'We were wrong,' " said Assistant Attorney General William F. Weld, chief of the Justice Department's Criminal Division.

The disintegration of the General Dynamics case occurred at a time when the Justice Department was already under fire for dropping other high-profile military fraud cases, including closing its three-year investigation of fraud in General Dynamics submarine contracts, and declining to prosecute Pratt & Whitney Aircraft Group for $22 million in improper charges. All three cases are to be the subject of a hearing today by a House Energy and Commerce subcommittee headed by Rep. John D. Dingell (D-Mich.).

The story of how the General Dynamics Divad case fizzled reflects the difficulty of tackling the byzantine bureaucracy and arcane, nebulous rules of military procurement. It also illustrates the strange, almost incestuous relationship between military contractors and the Pentagon, a relationship that many observers said results in programs being knowingly underfunded in order to win congressional approval and the Pentagon acquiescing in other billings to compensate contractors for expected overruns.

In the Divad project, for example, the Defense Department privately estimated that the cost of building the prototypes would be $60 million, not the $39 million eventually awarded, according to Edward Miller, a former assistant secretary of the Army. Army officials and General Dynamics never discussed how the difference would be made up, he said.

To lawyers for the company and the officials accused of criminal misconduct, the General Dynamics case shows what happens when prosecutors fail to interview key witnesses before bringing an indictment and then refuse to back down. The Justice Department "ran amok" in the case, said Beggs' lawyer, Vincent J. Fuller of Williams & Connolly. "I don't see how they did any homework."

To Justice Department officials confronted with one of the most embarrassing federal foul-ups in recent memory, the lesson is that prosecutors can be tripped up by people who are supposedly on their side: Defense Department auditors and Army officials who insisted General Dynamics was cheating the government.

"The defense procurement system is one of the most complicated processes with which we've ever been confronted," said Associate Attorney General Stephen S. Trott. "We received information from people who should have known what they were looking at, credible sources, not one, not two, but sufficient numbers to convince prosecutors acting in good faith that the claims were true. The government believed in good faith that General Dynamics had done what the Department of Defense said they did."

It was only after the indictment that prosecutors were to learn that other Army officials believed the overhead charges were proper and to discover boxes of documents -- which the Army had failed to turn over earlier -- that supported General Dynamics' position.

And to yet other prosecutors involved in the case, it was a prosecution that perhaps should not have been abandoned.

"If the decision was truly based on the reasons I read that the department felt were the basis for the dismissal, I had systematically disagreed with that position and would disagree with it today," said Robert Ogren, former chief of the Justice Department's fraud section, which brought the case.

Ultimately, the demise of the General Dynamics case can be traced to two words buried in a two-inch thick contract to build a prototype for the Divad (Division Air Defense) gun: "best efforts."

In 1977, General Dynamics won a $39 million contract to build two protoypes of what became known as the Sgt. York. General Dynamics and Ford were to compete in a "shoot-off" for the ultimate prize, a $5 billion contract to produce the radar-guided weapons system.

In the language of military procurement, there are two main types of contracts: "cost-plus" in which defense contractors may charge the government as much as it takes to build the weapon, and "firm fixed-price" in which manufacturers are generally held to the agreed-upon ceiling on costs.

General Dynamics' agreement with the Army on the Divad prototype was a highly unusual hybrid: a "firm fixed-price (best efforts)" deal.

Confronted with this strange animal, inspectors from the Defense Contract Audit Agency (DCAA), in a 1984 review, ignored the "best efforts" language and treated the agreement as a firm fixed-price contract. So when they discovered instance after instance in which General Dynamics billed costs related to the Divad contract to overhead expenses -- either for research and development or for preparing future bids -- Pentagon auditors, and later, Justice Department lawyers, believed they had uncovered a smoking arsenal of blatant mischarging.

The snag was that they had not grappled with the implications of the "best efforts" language.

"We look at a contract and it's a fixed-price contract," DCAA executive officer Phillip Rogers said. "It may have some words buried in it and it says 'best efforts,' " Rogers said, but "that's a new term . . . . The fact that someone coins a phrase and puts it in there -- it's not as clear as the nose on your face as to what it means at the time."

General Dynamics argued -- and the Justice Department eventually conceded -- that the "best efforts" language meant that the company -- so long as it tried hard to produce a working gun -- could spend the $39 million and turn up with a "bucket of bolts." That "bucket of bolts" argument meant that the bulk -- if not all -- of the overhead charges appeared to be legitimate.

Military contracting rules permit defense contractors to bill the Pentagon for independent research and development (IRAD) or for the costs of preparing to bid on contracts (B&P) -- so long as these expenses are not incurred in satisfaction of direct contract requirements. Contractors are given a pool of such money annually.

If General Dynamics could show up with the proverbial bucket of bolts, so the argument went, the company was free to charge the costs to IRAD or B&P as part of its forward-looking effort to win the shoot-off.

In the months of intensive, almost round-the-clock work leading up to the indictment, Justice Department lawyers paid little attention to the "best efforts" language -- and, consequently, did not interview the Army officials who had been involved in formulating the negotiating strategy for the contract.

"Two program managers said it was theft," Trott said. "I thought that was pretty high up the line."

So when General Dynamics lawyers raised the "best efforts" argument, "it was discounted as an 'after-the-fact' construction of defense counsel," prosecutors wrote in an internal Justice Department memo obtained by The Washington Post. "In fact, the provision was deemed of such little consequence that it was omitted entirely from the description of the contract set forth in the indictment," said the June 15 memo, which recommended that the case be dismissed.

Within months, however, the government's case began to erode.

In mid-1986, in response to a January Freedom of Information Act request by General Dynamics, the Army -- which in August 1985 told Randy Bellows, the principal prosecutor on the case, that it had delivered all relevant documents -- came up with 82 additional boxes of material, including documents discussing the "best efforts" issue.

In addition, prosecutors and defense lawyers found more than 20 Army witnesses who agreed with General Dynamics' interpretation of "best efforts."

"The terms 'fixed price' and 'best efforts' . . . seem almost incompatible. In reality, it will be a cost-type contract," Army deputy general counsel Stanley N. Nissel warned in an April 1977 memo.

However, said Ogren, from the government's perspective, even the "best efforts" language would not permit General Dynamics' charges to IRAD and B&P before it spent the $39 million -- and prosecutors had uncovered hundreds of documents indicating that the company had altered time cards and travel records to bill contract work to overhead, and that the company was trying to hide projected overruns.

"This case is a classic example of a careful, concerted effort to defraud the United States," prosecutors wrote in an April 1986 brief.

"From my perspective 'best efforts' is maybe something we're going to have to cope with but we still have this core of the case that will carry us through," Ogren recalls thinking at the time. "To this day I don't understand why that's not so."

However, prosecutors reviewing the case in the June 15 memo concluded that, at best, they could bring a mischarging case involving less than $200,000 -- a "mere fraction" of the original $3 million alleged in the indictment -- and that, even on this limited amount, there was "substantial doubt" the case could be won.

The case might have been dropped earlier, but it was sidetracked while the government appealed a ruling transferring the case to an administrative board to interpret the contract -- a precedent the Justice Department feared would cripple criminal prosecutions, not only of defense fraud, but also other white-collar cases. In April, the 9th U.S. Circuit Court of Appeals overturned the ruling.

On Friday, June 19 -- with arguments on defense lawyers' motion to dismiss scheduled the following Monday -- the government moved to drop the case.

In the end, General Dynamics said it spent $13 million of its own money on the Divad protoypes but lost the shoot-off. After sinking $1.8 billion into the Divad program, the Defense Department canceled the gun in August 1985. And, congressional sources said, General Dynamics is likely to bill the government for the $21 million it spent to defend itself against the criminal charges. The Justice Department is still weighing whether to press forward with a separate civil case.

"We now know when dealing with government contracting you can't rely on anybody until you have talked to everybody," Trott said. Still, he said, "There's nobody on this planet that can promise anybody there's never going to be another General Dynamics case."