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In what became known as the Iran-Contra Affair, US President Ronald Reagan's administration secretly sold arms to Iran, which was engaged in a bloody war with its neighbor Iraq from 1980 to 1988 (see Iran-Iraq War), and diverted the proceeds to the Contra rebels fighting to overthrow the leftist Sandinista government of Nicaragua.
The Israeli government approached the United States in August 1985 with a proposal to act as an intermediary by shipping 508 American-made TOW anti-tank missiles to Iran in exchange for the release of the Reverend Benjamin Weir, an American hostage being held by Iranian sympathizers in Lebanon, with the understanding that the United States would then ship replacement missiles to Israel. Robert McFarlane[?], the Assistant to the President for National Security Affairs, approached United States Secretary of Defense Caspar Weinberger and arranged the details. The transfer took place over the next two months.
In November, there was another round of negotiations, where the Israelis proposed to ship Iran 500 HAWK anti-aircraft missiles in exchange for the release of all remaining American hostages. General Colin Powell attempted to procure the missiles, but realized that the deal would require Congressional notification as its overall value exceeded $14 million. McFarlane responded that the President had decided to conduct the sale anyway. Israel sent an initial shipment of 18 missiles to Iran in late November, but the Iranians didn't approve of the missiles, and further shipments were halted. Negotiations continued with the Israelis and Iranians over the next few months.
In January of 1986, Reagan allegedly approved a plan whereby an American intermediary, rather than Israel, would sell arms to Iran in exchange for the release of the hostages, with profits funnelled to the Contras. In February, 1,000 TOW missiles were shipped to Iran. From May to November, there were additional shipments of miscellaneous weapons and parts.
The proceeds from the arms sales were diverted, via Colonel Oliver North, aide to the U.S. National Security Advisor John Poindexter, to provide arms for the Contras (from Spanish contrarevolucionario, "counter-revolutionary"). The Sandinistas' eventual loss of power in national elections was seen by some as stemming from U.S. support for the contras as well as the effects of a U.S. trade embargo initiated in May 1985.
The U.S. accused the Sandinistas of being backed by the Soviet Union and Cuba, and of supporting in turn left-wing rebels against the U.S.-backed government in El Salvador, scene of a destructive civil war throughout the 1980s. In 1985, the Sandinista movement claimed a majority in elections validated by other independent observers from Western democracies as having been fair and free, but the Reagan administration rejected the election as fraudulent.
Many conservatives agreed with Reagan and ignored the findings of these international observers, comparing the election to one-candidate "elections" in communist countries, although opposition parties ran against the Sandinistas: six parties ran against the Sandinistas in that election, winning 35 of 96 seats in the national legislature.
The Reagan administration, contrary to acts of Congress (specifically the 1982-1983 Boland Amendment), ferried funds and weaponry to the Contras gained by the sale of arms to Iran. The Contras, led by former members of the National Guard of the overthrown Somoza regime (1936-1979) received weapons and training from the U.S. Central Intelligence Agency, especially in guerrilla tactics such as destroying infrastructural elements and assassination.
In November of 1986, the first public allegations of the weapons-for-hostages deal surfaced. The clandestine operation was discovered only after an airlift of guns was downed over Nicaragua. Reagan claimed he had not been informed of the operation and a Presidential Commission, which implicated North, Poindexter, and Weinberger, amongst others, could not conclusively determine the degree of Reagan's involvement as many documents had been destroyed. Nevertheless on February 26, 1986 the Tower Commission rebuked President Reagan for not controlling his national security staff.
Oliver North and John Poindexter were indicted on charges of conspiracy to defraud the United States on March 16, 1988. Poindexter was convicted on several felony counts of lying to Congress, obstruction of justice, conspiracy, and altering and destroying documents pertinent to the investigation. He avoided jail time due to a legal technicality.
There is also evidence that the CIA may have been involved with drug trafficking to raise money for the contra campaign. The Sandinistas lost power in fresh elections in February 1990, following a decade of U.S. economic and military pressure.
The Iran-Contra Affair is significant because it brought many questions into public view:
Most, if not all, of the constitutional and ethical questions are still unresolved. On one view, it appears that if the legislative and executive branches do not wish to work together, there are no legal remedies. These are transient issues in that each of the executive and legislative branches change every few years.
There's more to add here, particularly on the political impact of the scandal on Reagan's presidency. It won't do simply to say "it was damaging"; it's obviously more complicated than that.