Brian Mawhinney, the party chairman, ordered an immediate investigation into allegations that Serbian businessmen linked to the Bosnian Serb leader, Radovan Karadzic, gave the Tories more than pounds 100,000.
Dr Mawhinney announced he would be speaking "personally" to John Kennedy, a prospective Tory parliamentary candidate, who had links to the Bosnian Serb leadership and is reported to have introduced a prominent Serb businessman to Jeremy Hanley, the then party chairman, in December 1994.
The move came as senior Tories also sought to defend the party from charges that it had refused to pay back pounds 365,000 of stolen money paid to it by the fugitive businessman Asil Nadir. A report by the accountants Touche Ross, leaked to the Independent on Sunday, saying that most of the pounds 400,000 donation by Mr Nadir had been fraudulently acquired, was said to have been given to Conservative Central Office three years ago.
Pressure for full-scale reform of party funding was increased when the CBI President-designate and chairman of British Airways, Sir Colin Marshall, declared it was not "appropriate" for companies to make donations to party funds, adding: "I think that if one wants to make a contribution, one should make it on a personal basis."
The Central Office investigation is into a report in yesterday's Sunday Times about two donations, one in 1992 by a British based "Yugoslav" entrepreneur, and one two years later by the businessman who reportedly met Mr Hanley in a London restaurant.
Lawyers acting for the unnamed businessman of "Yugoslav birth" last night did not deny a donation to Tory funds by their client but adamantly denied he had any links with Mr Karadzic, who is wanted on war crimes charges, or anyone in the Bosnian Serb leadership.
Prominent libel lawyers, Peter Carter Ruck, said in a statement: "Our client is a British citizen of Yugoslav birth and has been resident in the UK for over a decade. Our client has been a director of a number of British limited companies in London who have substantial assets in this country. Our client is outraged by any suggestion that he is linked in any way to Radovan Karadzic or the Bosnian Serbs."
Robin Cook, Labour's the shadow Foreign Secretary, said that, if true, the allegations amounted to "the worst scandal we have seen in this Parliament".
Meanwhile, senior Tory sources insisted that it still had not been proved that the donation made by Mr Nadir had been of stolen funds.
The report drawn up by Christopher Morris, senior partner at Touche Ross, administrators of Mr Nadir's failed company, Polly Peck, gave evidence apparently establishing that the pounds 365,000 came from fraud by the company. It added: "The evidence we have obtained to date shows that a large proportion of the pounds 400,000 donations made to the Conservative Party formed part of Mr Nadir's fraud and/or breach of fiduciary duty and/or breach of trust and/or misfeasance as a director."
The Independent on Sunday said that the report accompanied a request for the return of the money, which was refused - even though a month earlier, Sir Norman Fowler, then the party chairman, had told the Commons that if Touche Ross provided proof that the money was stolen it would be returned.
A senior party source pointed out last night that the Conservatives were not alone as recipients of Mr Nadir's largesse and that a number of charities had received donations. The source said the accountants' report fell far short of proving that the donations were made with stolen money.
It has become clear that some Tory donors in the UK are hiding their support for the party by making non-returnable interest free "loans" instead of giving straight cash payments. Central Office sources have confirmed that corporate donors are now being canvassed to make loans if they feel worried about being publicly revealed as Tory backers.
While a cash payment should be declared as a political donation in company accounts, a loan can be kept secret. A City accountant said it was easy for a company to hide a loan in the "creditors" section of its accounts. When it was not repaid, it would be written off.
The party has received at least pounds 10m in donations over the past 12 months, party insiders confirmed last night. That has enabled Dr Mawhinney to wipe out the overdraft which he announced in March stood at pounds 2.5m. The party is believed to have about a pounds 1m surplus.
Dr Mawhinney said there was no evidence of impropriety over the alleged Serb connection but the claims would be investigated thoroughly. Mr Kennedy was unavailable for comment after issuing a statement denying he had arranged "any donation from any foreign company or individual".
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