Dodgy donations: How Labour's cash crisis led to the biggest sleaze scandal in the party's history

By Marie Woolf

When Labour Party officials headed to the costume outfitters Mad World during the general election campaign to hire six Star Trek outfits, including Vulcan ears, they probably thought nothing about paying the £300 bill. The cost of their stunt highlighting the Vulcan traits of Conservative MP John Redwood was, after all, nothing compared to the £7,700 charged to Labour for Cherie Blair's personal hair stylist.

But the party was living on credit - and the money used to hire Redwood's ears came from an £18m fighting fund that would, within months, become the subject of a high-level police investigation and plunge the party into the worst sleaze scandal in its history.

This weekend, as we reveal on page one, Tony Blair is facing a fresh crisis. A senior Labour official has told the police that the party had made a "deliberate attempt" to get round the law in raising the fund through loans from controversial millionaires who were later proposed by Mr Blair for peerages, in what some have alleged is a "cash-for-honours" deal.

The empty state of the party coffers had become apparent in the months leading up to the 2005 election when Labour officials consulted their balance sheets. What was worse, the Tories' coffers were swelling from the generosity of millionaire supporters, among them Lord Ashcroft who was bankrolling the campaigns of Conservative candidates in a number of target seats.

In Labour's cramped Old Queen Street headquarters, a brisk 10-minute walk from the House of Commons, Matt Carter, Labour's youthful General Secretary, pored over the figures. Labour could not possibly afford the billboards, television ads and battle buses that election chiefs were planning. Mr Blair and Lord Levy, the Prime Minister's fundraiser, were told the party needed cash fast - the question was how to raise it.

Labour knew that the Tories had for some time been raising millions through soft loans from supporters - some of which would subsequently be rolled over into donations and never paid back. In highly confidential meetings between a close coterie of senior figures, the question was raised: should Labour go down the same route?

All eyes turned to Lord Levy, a charismatic former pop impresario who was behind the careers of Alvin Stardust and Chris Rea. He was Labour's link man with millionaire businessmen. Would they be willing to bankroll the party with loans? Lord Levy hesitated. Even if they would, he had severe doubts whether raising loans instead of donations was advisable.

Not only were donations transparent (unlike commercial loans, they would have to be publicly declared), unlike loans they would not have to be repaid. Friends of Lord Levy say he made a strong case against accepting loans - not least because the party would have to find millions of pounds later to pay them back, with interest.

But with Mr Blair determined not to be trumped by the Tories, Lord Levy lost the argument. A determining factor was that loans had the potential for raising more cash than donations. What was more, several figures who had been approached about making donations were nervous about being publicly identified as Labour supporters. Under rules brought in by Mr Blair, anyone donating £5,000 or more would have to be disclosed, whereas the identity of people making loans at commercial rates could remain secret.

Once Mr Blair, Matt Carter, Lord Levy and a handful of Labour officials were agreed, Ian McCartney, then Labour chairman, was informed of the strategy to raise money in loans from businessmen - although he was never told their identity. But others high up in the Labour Party were kept in the dark. Those not informed included Gordon Brown, the Chancellor of the Exchequer, Jack Dromey, party treasurer, John Prescott, the Deputy Prime Minister, and the members of Labour's governing body, the National Executive Committee.

A major charm offensive was ordered, and Lord Levy, or Lord Cashpoint, as he is nicknamed, was instructed to go and seek out loans. At his north London mansion, wealthy businessmen, many of whom had donated in the past, found themselves invited to dinner or afternoon drinks. It was not unusual for Mr Blair - who happened to be Lord Levy's tennis partner - to drop in, as if by chance, to say "Hi".

Within months the energetic peer had filled Labour's election coffers with almost £14m in loans. The lenders included some of Britain's most successful and flamboyant businessmen, including Sir Gulam Noon, a curry millionaire, Dr Chai Patel, founder of the Priory group of clinics which have treated a string of celebrities, and the biotechnology entrepreneur Sir Christopher Evans, who loaned £1m. Later the name of Richard Caring, a tennis partner of Lord Levy and owner of the Ivy restaurant, who lent £2m, would be added to the list.

The loans were charged at 2 per cent above the bank base rate which, according to City figures, is a generous rate of interest for unsecured loans to a body mired in debt. The businessmen could not have anticipated they would find themselves themselves at the centre of a police inquiry into allegations that Mr Blair had awarded honours in return for cash.

After Labour won the election, the Prime Minister was asked to draw up a list of names to take up Labour seats in the House of Lords. He was presented with a file drawn up by his officials of suitable candidates, with short biographies. From the list of names, Mr Blair chose several of the most generous Labour lenders, including Sir Gulam Noon, Sir David Garrard, Barry Townsley and Dr Chai Patel.

The names were sent for approval to the honours vetting watchdog, the House of Lords Appointments Commission, a little-known body whose last foray into the public eye was their selection of "People's Peers". The vetting body was not told that these men had given loans to the party. They were not the only ones. Ian McCartney, the Labour chairman recovering from an operation in hospital, was asked to sign the nomination certification forms. He too was not told that the nominees had lent substantial sums to Labour.

Even the lenders themselves were advised that it would be best if the loans were kept secret.

Dr Patel was told by Lord Levy, in a discussion about his House of Lords nomination form, that the rules did not require him to mention the loan. And when Sir Gulam Noon, after consulting his accountant, mentioned his £250,000 loan on his nomination form, an extraordinary turn of events took place.

Shortly after submitting the forms to Downing Street, he had a conversation with Lord Levy. The Labour fundraiser advised him to remove the reference to the loan. Sir Gulam duly obliged and filled out a fresh form which omitted the £250,000 figure.

The question now vexing the police is precisely how Lord Levy knew of the reference. Labour sources suggest that Downing Street and the Prime Minister's fundraiser discussed the nomination forms, and although this has not been denied, friends of Lord Levy will say no more than that it is an "allegation".

With no mention of the loans on nomination forms, the body vetting the peerages were unaware of the additional financial connection between Mr Blair and his nominees for peerages. That was until news of the peerages leaked to the press. On 23 October, under the banner headline "Cash for peerages row as Blair honours top donors", this newspaper revealed that Mr Blair was preparing to ennoble a clutch of millionaire Labour Party donors including Dr Patel, Sir Gulam Noon and Sir David Garrard. Months later, The Independent on Sunday disclosed that the men had also given secret loans to Labour in the run-up to the general election.

After months of damaging headlines, Mr Blair was forced to withdraw the names from his honours list. His aides hoped that this would draw a line under the affair. But a little-known Scottish Nationalist MP, Angus MacNeil, complained to the Metropolitan Police that the award of honours to backers may have breached the 1925 Honours (Prevention of Abuses) Act.

When the MP made the complaint, Labour officials privately scoffed that it would go nowhere. They had not reckoned on the assiduousness of the officer put in charge of the inquiry, Deputy Assistant Commissioner John Yates, known as Yates of the Yard, holder of the Queen's Police Medal. He hand-picked a team of detectives who wasted no time in interviewing the key players.

The police were trying to find out whether the loans were on fully commercial terms. If it turned out they were preferential to Labour - or that they were never meant to be paid back - the party may have flouted the law by failing to declare them. According to senior Labour sources, the hope has long been that some of the loans would be converted into donations, but the problem for the police was assembling the proof.

As police officers carried away boxes of paperwork from the Cabinet Office and Labour officials were called to give evidence, the inquiry took a more serious turn. Lord Levy was arrested. According to friends, the arrest came as a shock because Lord Levy had offered fully to co-operate, provide paperwork and speak to the police.

On attending a police station he found himself under arrest. Now the inquiry was getting perilously close to the gates of Downing Street with speculation that the Prime Minister himself would face an interview.

Last week, Lord Levy was questioned again, and rebailed by police. He kept his counsel, but another figure embroiled in the affair was less sanguine. Sir Christopher Evans, a leading figure in the biotechnology industry, complained bitterly after being arrested last Wednesday. He said he was "extremely shocked and dismayed" and would never have loaned the money to Labourif he had anticipated what would happen. He described the arrest as "mindboggling" and denied having done anything wrong.

He is not the only one to feel bruised. Barry Townsley, who lent £1m, and Sir David Garrard, who lent £2.3m, are angry. They have lost the chance of a peerage and have seen their names dragged through the press. "They think it is horrible, smelly, smeary. They don't blame the Labour Party. They blame the media, the system, and they think the police are overstating it," said one friend.

Friends of both men say that they will expect to have their loans repaid, although they have not called them in yet. Unlike Lord Levy they have not been recalled by police for questioning. But their ordeal may not be over. A committee of MPs plans to summon them and other donors to give evidence in their role in the affair.

The Public Administration Committee has put its inquiry on ice while the police inquiry continues. But the MPs are now getting impatient. "We intend to call all the witnesses including the donors and Lord Levy," said one committee member, adding: "In fact, I wouldn't even rule out summoning Tony Blair."