SOON after Lord Goldsmith, then Tony Blair’s attorney-general, announced the government had dropped its corruption inquiry into the defence giant BAE Systems, he decided the fraud agency that had run it needed a thorough makeover.

Goldsmith wanted an objective outsider to run the rule over the Serious Fraud Office (SFO). The agency’s BAE inquiry had examined alleged bribes by the company to senior members of the Saudi royal family. But the case had back-fired, prompting a diplomatic showdown with the Saudis, who threatened to cut off economic and intelligence ties with the UK.

The irony, as Goldsmith later remarked, was that the case had never been strong enough to prosecute in the first place. To his finely tuned legal brain it had been handled appallingly.

In March 2007 he invited Jessica de Grazia, a vivacious brunette and former New York prosecutor, to review the SFO. De Grazia had been an assistant district attorney in Manhattan for 13 years before going on to publish a book about drug smuggling, which had become the subject of a BBC documentary series. She was virtually unknown in London legal circles, and her appointment raised eyebrows in Whitehall. Inside the SFO, her arrival at the agency’s Holborn headquarters sparked panic.

Robert Wardle, the SFO’s director, had been cajoled by Goldsmith to commission the report. An affable Whitehall bureaucrat with a fondness for long liquid lunches and game shooting in the Cambridge fens, Wardle had been anxious that, after the BAE fiasco, his contract might not be extended.

His nervousness turned out to be justified. Goldsmith gave de Grazia an unrestricted remit. She set about interviewing many of the agency’s staff, asking them what they thought of their bosses, their subordinates and the SFO itself. Her results were devastating.

“She caused chaos,” one of her eventual victims recalled last week. “She called meetings of case controllers and asked them to identify the crap assistant directors. Then she went to the investigators and asked them who was a crap case controller.”

In her “private and confidential” 71-page report for Baroness Scotland, Goldsmith’s successor, at the end of 2007, she painted a graphic picture of a law enforcement agency that was manifestly unfit for purpose.

The SFO had been set up in 1988 to lead the fight against fraud and corruption in the City. With an annual budget of £42m last year and a staff of more than 300 lawyers, accountants and investigators, it was designed to spearhead the fight against corporate graft.

Instead, de Grazia saw a failing organisation paralysed by perceived cronyism, paranoia and a lack of firm leadership and direction. She uncovered seething resentment among the staff. “Many of the interviews with SFO staff were emotional events, with employees expressing anger, frustration and despair. On a few occasions individuals broke down in tears,” she wrote in her report to Scotland, who was now in the cabinet and oversaw the SFO.

Her draft report, seen by The Sunday Times, amounts to one of the most damning official indictments of a government agency ever penned.

In a heavily sanitised version published last summer, de Grazia wrote that prosecutions by the SFO were poorly structured and underresourced. They could take up to seven years to get to court, although many failed to get that far.

But in her unpublished private and confidential draft for Scotland, de Grazia focused on what she saw as the root cause of this problem. The SFO was “a demoralised and underperforming agency” where the work of many dedicated and competent employees was “ blocked by inadequate management and leadership”, she said.

She offered a withering critique of the promotion of people into the middle and upper tiers of the SFO’s management. “The inadequacy of the current promotion process has led to the perception that lawyers are promoted because they are friends of the director. Fairly or unfairly, this perception is widespread and has resulted in allegations of cronyism and corruption,” she said.

In a sentence that pointed the finger of blame directly at Wardle she said: “People have been promoted not because of their proven track record - but because they have been perceived to be a nice person [or] made a good impression [or] have potential. This is a primary source of low morale.” “The widespread perception of cronyism” had damaged the SFO, because there had been “inappropriate appointments” to senior positions, she added.

According to her report, one lawyer told her: “The trouble with this place is that it is a bit of an old boys’ club.”

A financial investigator remarked: “The SFO has a system where the mediocre flourish.” A second described how one investigation drifted nowhere: “We were like a rudderless ship,” he said.

When her report was published last June all of these criticisms had been been removed. But so, too, had Wardle, after he was told that his contract was not going to be extended. Several of his top lieutenants have also stepped down, some suffering humiliation and anguish.

Last April Richard Alderman, a teetotal senior lawyer at HM Revenue & Customs, replaced Wardle. He says convictions are now up and more experienced lawyers are being recruited.

As part of a staff “restructuring” Alderman has been allocated Treasury cash to pay off dozens of staff he wants to dispose of. Last Monday, all SFO employees received an e-mail from Linda Thorpe, the agency’s chief people officer, outlining the new redundancy package. The offer, which the SFO said this weekend was not linked to the report’s criticisms, includes an enhanced version of the generous civil service pension along with a tax-free retirement payment worth up to three times the enhanced pension. John Lawson, head Standard Life pensions, said that for someone on a £80,000 salary the offer could be worth up to £240,000 in a lump sum with a £22,000 annual pension.

Contacted at his home this weekend Wardle seemed relaxed about de Grazia’s criticisms. “This was a draft. You’ve seen the final report which was different, so what? There were a number of recommendations. Some were accepted by the attorney-general, some weren’t,” he said.

A close friend said: “You get these sorts of issues in any organisation. But it’s bollocks to say Robert promoted people because they were his friends. He’s promoted people who are complete c***s.”

FAILED CASES

2003 - Andrew Regan acquitted of theft and bribery involving the Coop after six years and three trials. Estimated cost: £6.3m

1996 - The SFO’s pursuit of Kevin and Ian Maxwell on fraud charges ends in failure. Estimated cost: £20m-£30m

1994 - George Walker, the boxer turned businessman, cleared of all charges after 18-week trial. Estimated cost: £40m

1992 - Court of Appeal overturns SFO convictions of four directors of Blue Arrow describing the 12-month trial as a “costly disaster”. Estimated cost: £40m

Explore Economics

• Pre-Budget Report 2009

• Budget 2009

• World Economic Forum

• The Times MPC

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive