Can Alcoa fight off the Feds?

July 31, 2012, 9:00 AM UTC

FORTUNE — It isn’t every day that a foreign company volunteers, to the U.S. Department of Justice, a tale of rampant illegality allegedly perpetrated by a Fortune 500 corporation. So imagine prosecutors’ surprise when Aluminium Bahrain, a company controlled by that country’s government, implicated Alcoa — and its own former officials — in massive corruption.

Its claim: Alcoa’s agent had systematically bribed top Bahraini officials, who in exchange paid inflated prices for Alcoa alumina, a key material in aluminum production. Over two decades, the Bahrainis charged, the fraud cost their company more than $420 million.

It seemed like a highly promising case under the Foreign Corrupt Practices Act, which makes it a crime for companies doing business in the U.S. to bribe foreign officials. But more than four years later, after expending huge efforts in the investigation, U.S. prosecutors have yet to secure an indictment, reach a settlement — or drop the case entirely. Nothing, it turns out, is simple when it comes to foreign corruption probes — even when one of the companies involved in the alleged crime says its former officials accepted payoffs. Cases get stalled by murky facts, witnesses located thousands of miles away, jurisdictional conflicts — and myriad other factors. “I was told it would take a long time,” says Mahmood Al Kooheji, the chairman of Aluminium Bahrain (known as Alba). “I respect due process. But I didn’t think it would take this much time.”

The story begins some 40 years ago, when Alba started buying alumina from Alcoa (No. 115 on the Fortune 500). By the late 1980s relations had deteriorated, and someone — Alcoa claims it was a person at Alba; Alba denies it — suggested hiring an emissary to smooth things over. The agent: Victor Dahdaleh.

Dahdaleh, now 68, was more than a mere envoy. A round man of immense charm, with Jordanian blood and a Canadian passport, Dahdaleh was a familiar figure in the region. His family’s nearly 100-year-old investment, trading, and manufacturing firm, Dadco, has operations in the area. And he had previously worked for one of Alcoa’s competitors. Over the years Dahdaleh would develop his own extensive holdings, including an aluminum refinery in Germany that he bought from Alcoa (AA). Today he’s a billionaire who has dined with the Queen of England and socialized with a Prime Minister (Tony Blair) and a President (Bill Clinton).

Alba’s facility in Bahrain produces 2% of the world’s aluminum.

There’s nothing untoward, of course, about hiring an intermediary to bridge cultural and political barriers that can complicate business — in this instance, in the Persian Gulf. Indeed, for a time the U.S. embassy in Bahrain advised American companies to hire agents.

But the line between Dahdaleh and Alcoa was hard to discern, Alba claims. Alcoa allowed Dahdaleh to use its logo on his letterhead. Alba officials were told by an Alcoa official in Pittsburgh that one of Dahdaleh’s entities was “our associated company,” but according to Alba, they didn’t know it was actually owned by Dahdaleh.

The case came to light because of a reform effort inside Bahrain’s royal family. Some years back, a younger generation of Western-educated Bahrainis, led by the Crown Prince, began gaining clout. They started raising questions about procurement practices at state-owned companies. In 2007, Bahrain hired the corporate investigations firm Kroll, which uncovered the payments.

That led to a moment of surreal drama. In early February 2008 representatives of Alba met with Alcoa. “We believe you’ve been bribing us and that it has been going on for a long time,” a lawyer for Alba told Alcoa’s general counsel, Lawrence Purtell, in a conversation confirmed by both sides. Alcoa convened a special board committee to investigate the allegations. Its lawyers’ initial response to Alba: Take a hike; you have no case against us.

Alba then sued Alcoa, Dahdaleh, and an Alcoa vice president in federal court for racketeering and fraud. The suit was delayed until last fall at the request of the Justice Department to avoid complicating the criminal probe. (The SEC is also investigating.) In June a judge rejected Alcoa and Dahdaleh’s motions to dismiss the case. By then Alba had gathered substantial proof that payments were made, including bank documents showing Dahdaleh directed millions of dollars to Alba employees.

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But for U.S. prosecutors — faced with the higher criminal burden of proving accusations beyond a reasonable doubt — preparing a bribery case has been more daunting. The feds may be a bit gun-shy, having lost several high-profile corruption trials in recent years. In corporate cases, typically the government prefers low-friction resolutions: An accused company conducts an investigation, admits culpability, and agrees to penalties. In the Alcoa probe, only one company, Alba, alleges anything improper happened. Alcoa hasn’t denied payments were made; it has gone only so far as to say it doesn’t believe the evidence supports Alba’s charges. (Alcoa could argue, as its internal investigation concluded, that it didn’t know what its agent was doing. But such an argument would fly only if there were no red flags indicating misbehavior might be occurring, says white-collar criminal lawyer Brady Toensing of diGenova & Toensing.)

Meanwhile, a parallel, occasionally competing investigation by the U.K.’s Serious Fraud Office has been gaining momentum. Last year British prosecutors filed criminal charges against Dahdaleh and Alba’s ex-CEO, Bruce Hall.

Hall’s English legal entanglements complicated U.S. efforts to enlist him as a witness. Now Fortune has learned that he has been granted immunity from U.S. prosecution in exchange for his cooperation. Hall is prepared to testify that he received some $5 million from Dahdaleh and that Dahdaleh described one such payment as a “thank-you for a job well done.” (A statement on Dahdaleh’s website asserts, “Dahdaleh has not violated the laws of this country or any other country where he does business, including Bahrain.” Like Alcoa, Dahdaleh has not disputed that payments were made. His defense will be that the Bahraini government knew everything that was happening.)

Alcoa, meanwhile, is stuck between a rock and a hard place. If it fails to reach an agreement with the U.S. government, it faces the possibility of a criminal indictment, a potential catastrophe for a public company. If Alcoa settles with the U.S. and admits wrongdoing in order to avoid indictment, the company could expose itself to the risk of huge damages in the civil case filed by the Bahrainis. That’s why Alcoa hopes to reach simultaneous settlements with both the Justice Department and Alba. That could wipe out as much as a year’s earnings for Alcoa at a time when aluminum prices are depressed and cash is tightening at the company. In its last earnings call, Alcoa estimated that a settlement with Alba alone could cost as much as $120 million. That doesn’t include potential additional concessions on alumina pricing, which could be substantial.

Alcoa’s CEO, Klaus Kleinfeld, inherited the Bahrain mess, but he doesn’t need a reminder of the seriousness of corruption investigations. Kleinfeld resigned as CEO of Siemens (SI) in 2007 amid a huge bribery scandal. He maintained his innocence and was never charged with wrongdoing, but he agreed to pay the company €2 million to put it behind him. As Alcoa’s CEO, Kleinfeld has pushed hard for a settlement. “He’s extremely frustrated that this is dragging on,” says a person close to the company.

For his part, Alba’s Al Kooheji says he looks forward to the day Alcoa and Alba can resume their relationship — this time, presumably, without a middleman.

This story is from the August 13, 2012 issue of Fortune.