By Nelson D. Schwartz

(FORTUNE Magazine) – SIPPING A COLD BEER IN THE MAIN square of Wolfsburg, the German town that's home to Volkswagen, former auto worker Christian Hälse is sure of who's to blame for the scandal that has rocked VW and filled German papers with stories on der Sexmanager and die Lustreisen, or love trips, on which VW labor leaders supposedly downed Viagra, then partied with prostitutes. "I hope it goes to the top," says Hälse.

Hälse's wish may soon come true. German state prosecutors, internal VW auditors, and accountants from KPMG are all investigating allegations of misconduct at the company, and KPMG is due to present its first findings to members of VW's supervisory board in late July. The scandal has already forced the resignation of VW personnel chief Peter Hartz and the top labor advocate on VW's board, Klaus Volkert. What KPMG uncovers could amplify growing calls in the German press for the ouster of Chairman Ferdinand Piëch, a legendary figure in the auto world and one of Germany's most powerful businessmen.

Piëch has been silent, but CEO Bernd Pischetsrieder wrote in a letter to employees that expense accounts "were probably used for things we cannot tolerate." Piëch, a scion of the Porsche family, is considered more vulnerable than Pischetsrieder, because Piëch served as CEO of VW from 1993 to 2002, when many of the alleged sex romps took place. "He presided over a pretty rotten system," says Garel Rhys, head of the Center for Automotive Research at Cardiff University in Wales. "I think he really should go."

One key allegation: that Volkert used company money to pay for prostitutes and pleasure trips for high-ranking worker representatives, easing labor relations, while VW brass turned a blind eye. Volkswagen itself has also accused two other former managers of channeling VW money into front companies they'd secretly set up.

The affair could even threaten German Chancellor Gerhard Schröder. He faces a tough reelection vote next month, was on VW's supervisory board for much of the 1990s, and the now disgraced Hartz was one of his key advisors. The opposition Christian Democratic Party is likely to paint Schröder as too close to Germany's unions--and the VW scandal.

The turmoil at Europe's biggest automaker comes when VW desperately needs the cooperation of its 336,000 employees worldwide to cut costs and boost profits, which have fallen from $3.5 billion in 2001 to a projected $970 million in 2005. Analysts and investors are betting that, with labor leaders under scrutiny, Pischetsrieder will be able to extract union concessions--the stock is up 12.5% since the end of June. But that optimism could well be misplaced. Standing in the shadow of Volkswagen's sprawling Wolfsburg factory, employees like 28-year-old component maker Michael Banz are in no mood to compromise. Top labor officials and execs "are all in each other's pockets," says Banz. "Workers feel ripped off. We're going to be watching them more closely." -- Nelson D. Schwartz