Leading executives at car maker Volkswagen (VW) are facing dramatic corruption allegations that could shatter the company's unique co-determination system.

Company executives at VW and its Skoda subsidiary are accused of secretly operating front companies that bid for lucrative VW contracts. State prosecutors are studying further allegations that company works council members were bribed with luxury holidays and prostitutes.

Six companies have been uncovered in the Czech Republic, France, Angola and India, all operated by a Swiss holding company with links to company executives including former Skoda boss Helmut Schuster and Klaus Volkert, the VW works council boss who resigned last week.

The Süddeutsche Zeitung alleges that the company flew works council executives on luxury holidays to Brazil and introduced them to "high-class hookers", as one source told the newspaper.

The allegations could be damaging for the man alleged to have signed off the expenses claims, VW personnel boss Peter Hartz, a close friend of chancellor Schröder and the brains behind the government's "Hartz" reform programme.

The scandal investigation is in its early days, but could weaken the so-called "Volkswagen system", a nexus of managers, union leaders and politicians who run the company and which critics call overly opaque.

The state government of Lower Saxony, where the company's Wolfsburg plant is situated, has a 20 per cent shareholding and, along with the union-appointed employee representatives, can vote down anyone else on the supervisory board.

The company has expanded heavily into central Europe, buying up rivals and opening new plants, but still faces increasing competition from Japanese and Korean rivals. The company lost €53 million in the first quarter of 2005 alone.

If the investigation discredits the "Volkswagen system", it may open the door to the drastic reform plans of Wolfgang Bernhard, the 44-year-old VW brand manager hired last autumn from Daimler-Chrysler, where he had made a name for himself as a ruthless cost-cutter.

"We are standing at a crossroads," he told VW employees in a letter. "One thing is clear: we have to negotiate, and quickly."

"The scandal might be a good thing for shareholders, if it leads to change in how the company is run," said Mr Albrecht Denninghoff, auto industry analyst at Hypovereinsbank.

But Mr Bernhard faces a challenge from union-allied Bernd Osterloh, the new head of the VW works council.