The Tory allegation is that Lord Simon, the former chairman of BP who has become an unpaid minister, has a conflict of interest because he holds pounds 2m worth of BP shares while dealing with matters of interest to BP, like gas liberalisation, in government.
In savage Commons exchanges over Lord Simon on Wednesday, Tony Blair told Mr Hague that if he believed his Minister for Trade and Competitiveness in Europe had broken any rules, "perhaps he should go outside the House and repeat that allegation where it can be properly tested."
The hint that Lord Simon might bring a private action for libel was escalated into an unprecedented threat against the Tory leader last night, after the Cabinet Office published a new code of conduct for ministers.
The code, revised by Mr Blair's new administration, raises the possibility of ministers taking action for defamation, and a spokesman for the Prime Minister said last night that the threat could be applied to the Tory attacks on Lord Simon.
In a letter to Mr Hague on Wednesday, passed to The Independent last night, Mr Blair says: "Instead of hiding behind parliamentary privilege, you should be prepared to state your claims openly and face the full consequences of doing so.
"I therefore invite you to repeat the allegation you made inside the House and set out any evidence you have to support them."
The new code of conduct repeats that ministers occasionally become engaged in legal proceedings, "primarily in their personal capacities but in circumstances which may have implications for them in their official positions. "Defamation is an example of an area where proceedings will invariably raise issues for the Minister's official as well as private position."
In all such cases, the code says, ministers should consult the Government's Law Officers before consulting their own solicitors - and the Law Officers could take charge of proceedings from the outset. Under those circumstances, the taxpayer could be expected to underwrite the minister's costs.
That threat was greeted with some caution last night by John Redwood, shadow President of Trade and the man leading the campaign against Lord Simon's position. He told the Independent: "As neither the Leader of the Opposition nor I have smeared Lord Simon, all we've done is to ask a series of questions about how the Government has arranged its affairs in these important matters, I do not really see the point of the question." He said he did not wish to make any comment on any threat being made by the Government.
Earlier in the Commons, however, Mr Redwood had pressed Margaret Beckett, President of the Board of Trade, over Lord Simon's alleged conflict of interest, questioning why the BP shares had not been sold.
Mrs Beckett said she and her ministers had answered 58 "nit- picking questions" from Opposition MPs about the issue.
"It was plain from the day of Lord Simon's appointment," she said, "that he would not be able to deal and would not deal with matters which related directly to BP, or indeed matters in which BP has a competitive advantage. That is quite clear."
She said Lord Simon could not have sold his shares because such an action would have amounted to illegal insider trading, and Whitehall sources said last night that Lord Simon had been given that advice when he took office in May.
Mr Redwood said it was curious that the government line about insider trading should have emerged for the first time this week - it had not been mentioned in any of Mrs Beckett's many replies before yesterday.
He also attacked the publication of the ministerial code of conduct as a smokescreen; an attempt to divert attention from the Government's problem.Reuse content