The competition to run trains on the West Coast Main Line has been cancelled following the discovery of "significant technical flaws" in the way the franchise process was conducted, it has been announced.
The Department for Transport (DfT) will no longer be awarding a franchise contract to run the West Coast service to FirstGroup when the current franchise expires in December.
FirstGroup was due to take over the running of the London to Scotland line after being awarded the contract by the DfT in August, but Virgin Rail, which currently runs the service, launched a High Court challenge against the decision.
Richard Branson offered to run the train line on a not-for-profit basis in August if parliament wanted more time to consider their decision
The DfT will no longer contest the judicial review sought by Sir Richard Branson's company and there will be two independent reviews into the competition process.
The flaws uncovered by the DfT relate to the way the procurement was conducted by department officials, it said.
An announcement is expected to be made later about the suspension of government staff while the investigations are conducted.
The government said it was "resolving urgently" the future arrangements for operation of the West Coast service - which was due to be handed over to FirstGroup on December 9.
Mr McLoughlin said: "I have had to cancel the competition for the running of the West Coast franchise because of deeply regrettable and completely unacceptable mistakes made by my department in the way it managed the process."
He added: "West Coast passengers can rest assured that while we seek urgently to resolve the future arrangements the trains that run now will continue to run, with the same drivers, the same staff and timetables as planned.
"The tickets that people have booked will continue to be valid and passengers will be able to make their journeys as planned."
Officials have now been asked to examine the options for the operation of the service after December 9.
Branson thanked Ross McKillop, who started the petition, writing: "All of us at Virgin Trains are overwhelmed and thank you. Let us hope that sense prevails and your views are acted on quickly."
The government has also paused all the other outstanding franchise competitions (Great Western, Essex Thameside and Thameslink) pending the independent reviews.
DfT permanent secretary Philip Rutnam said: "The errors exposed by our investigation are deeply concerning.
"They show a lack of good process and a lack of proper quality assurance.
"I am determined to identify exactly what went wrong and why, and to put these things right so that we never find ourselves in this position again."
The first "urgent" independent review will be to focus on what lessons are to be learned from the DfT's handling of the flawed competition process.
It will be conducted by independent advisers and overseen by Centrica chief executive Sam Laidlaw and former PricewaterhouseCoopers strategy chairman Ed Smith, both DfT non-executive directors.
An initial report is expected to be delivered by the end of October.
The second review, undertaken by Eurostar chairman Richard Brow, will examine the wider DfT rail franchising programme and look in detail at whether changes are needed to the way risk is assessed.
The bidding and evaluation processes will also be examined, with a report expected by the end of December.
Evidence of significant flaws in the DfT's approach emerged while officials were gathering evidence for the High Court legal proceedings, the department said.
It said the flaws stemmed from the way the level of risk in the bids was evaluated.
Mistakes were made in the way in which inflation and passenger numbers were taken into account and how much money bidders were then asked to guarantee as a result, the DfT added.
The department said it could not be confident that the flaws would not have changed the outcome of the competition or that any of the four bidders would not have chosen to submit different offers.
All the bidders have been contacted by the DfT and will have their bid costs reimbursed, it added.
The government said a fresh competition will be started as soon as "the lessons of this episode are learned".
It had delayed the final signing of the West Coast franchise contract due to the Virgin legal challenge.
Sir Richard said the DfT did not follow its own rules in choosing FirstGroup rather than Virgin to run the new 13-year franchise and described the bidding process as "insane".
FirstGroup said that until it was notified by the DfT last night, it had no indication there were any problems with the franchise process.
The firm said in a statement: "Until this point we had absolutely no indication that there were any issues with the franchise letting process and had received assurances from the DfT that its processes were robust and that it expected to sign the contract with FirstGroup soon.
"We are extremely disappointed to learn this news and await the outcome of the DfT's inquiries.
"The DfT has made it clear to us that we are in no way at fault, having followed the due process correctly
"We submitted a strong bid, in good faith and in strict accordance with the DfT's terms."
Virgin said it would assist the DfT by continuing to run the service while the independent reviews are conducted.
It said in a statement: "We welcome today's frank announcement by the secretary of state, acknowledging the flaws in the way the InterCity West Coast competition was assessed and launching a review into franchising more widely.
"We are ready to play a full part in assisting the review to help deliver a franchising system that better serves passengers, taxpayers and the interests of all bidders.
"In the meantime, we will assist the Department for Transport in ensuring continuity of service for the millions of customers who depend on train services on the West Coast mainline."
Labour MP Louise Ellman, who chairs the Commons Transport Select Committee, said she was "astonished" by the development.
"It puts the whole franchising process in disarray," she said.
Writing on his blog on the Virgin website, Sir Richard welcomed the decision and said he was always convinced the government's competition process was flawed.
He added: "From the moment we found out that FirstGroup had been made the preferred bidder with a completely unrealistic bid, we questioned the way the offers had been assessed, and asked the Government to review and explain how it came to its decision.
"We were convinced the process was flawed but despite our best efforts we were met with silence by the Department for Transport.
"We also asked for the government to appoint an independent advisor to look at the situation, which was turned down.
"Reluctantly we were forced to seek a judicial review."
Sir Richard continued: "At the House of Commons Select Committee we called for all franchise competitions to be paused and a thorough, independent review of the process.
"We are grateful that Patrick McLoughlin is now doing this.
"We also appreciate the DfT publicly acknowledging these errors, and are hopeful they will now accept that Virgin Trains should carry on running the West Coast Main Line and ensure that passengers continue receiving our team's award-winning service."
Liberal Democrat party president Tim Farron, who is MP for Westmorland & Lonsdale in Cumbria, said "people must be held accountable" for the errors.
He said: "The West Coast Main Line franchise is without doubt the biggest issue that local people have raised with me on my recent annual summer advice surgery tour.
"I have taken their concerns to government and done everything I can to fight our communities' corner in Westminster over the last few weeks.
"I have always said that announcing the franchise decision in the recess when MPs are away from Westminster and not able to properly hold the Government to account is unfair and unacceptable.
"Now we know the bid from First Group was unacceptable and it really does show why we needed proper scrutiny of bids like this to begin with.
"Lessons must be learned and people must be held accountable."
The DfT said it was due to submit all its evidence to the High Court in relation to Virgin's legal challenge tomorrow.
A department spokeswoman said it would be handing papers to court officials later today informing them that it is not contesting the judicial review sought by the Sir Richard's company.
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