News Corp's Australian shares sank to a two-year low on Monday as the UK phone hacking scandal fallout worsened, raising concerns that a $2 billion bid for an Australian pay-tv firm involving News Corp could be derailed by political intervention.

Investors sent News Corp shares down as much as 7 percent in heavy volume after Rebekah Brooks, the former head of the company's UK paper business, was arrested on Sunday and top policeman Paul Stephenson quit over the scandal.

I think people would rather be cautious and mark it down rather than find a reason to defend it, said Invesco senior investment manager Jackson Leung in Melbourne. Invesco is News Corp's second-largest institutional shareholder with a 1.68 percent stake, according to Thomson Reuters data.

News Corp shares ended down 4.1 percent at A$14.16 after touching a low of A$13.65.

Shares in a News Corp takeover target, pay-tv firm Austar , also fell on worries the deal may not proceed after the furor in Britain forced News to drop a $12 billion plan to buy all of highly profitable broadcaster BSkyB .

Austar has agreed to a $2 billion-plus takeover offer from its bigger rival Foxtel, which is owned by News Corp's News Ltd division, billionaire James Packer's Consolidated Media Holdings , and telecoms firm Telstra .

The Australian government last week said it may review media laws and ownership, following pressure from the influential Greens party.

Rupert Murdoch's News Ltd dominates the Australian newspaper industry, commanding nearly three-quarters of daily metropolitan newspaper circulation, and the UK scandal has riveted attention in his homeland.

Murdoch, who now has U.S. citizenship, started his global media empire in Adelaide when he inherited the now defunct Adelaide News from his father, Sir Keith Murdoch.

He owns 150 national, capital city and suburban news brands in Australia, which include mass circulation daily tabloids in Sydney (Daily Telegraph) and Melbourne (Sun Herald) and the national daily The Australian.

Austar closed down 3.8 percent while Consolidated Media fell 2.9 percent, against a flat broader market, reflecting investor concerns on the future of the deal.

Still, the Austar and Foxtel camps and banking sources familiar with the deal said the offer was on track and did not expect it to be derailed because Foxtel is only 25 percent owned by News Corp.

This has long been a transaction with a compelling logic to it and is in the best interests of shareholders. We will continue to keep the market informed as and when appropriate, a spokeswoman for Austar told Reuters in an e-mailed message.

Australia's competition watchdog is due to rule on the bid for Austar on July 21.

Murdoch, through BSkyB, also has an interest in 24-hour news channel Sky News Australia, which is 33 percent-owned by BSkyB. Sky News TV in Australia is in a battle with the government-owned Australian Broadcasting Corp to run the country's overseas TV network -- Australia Network.

On Sunday, detectives arrested Brooks, former head of News Corp's British newspaper arm, on suspicion of intercepting communications and corruption.

Stephenson, London's police commissioner, quit in the face of allegations that police officers had accepted money from the paper and had not done enough to investigate hacking charges that surfaced as far back as 2005.

SHARES OFF 18 PERCENT IN JULY

News Corp's Australian shares have dived 18 percent, or nearly A$3, this month as the News of the World hacking scandal engulfed News Corp executives.

On Monday, the shares fell 7.6 percent to an intraday low of A$13.65, the weakest since July 2009, and also a 7.4 percent discount to News Corp's last U.S. close, implying a $3 billion drop of market capitalization at that level.

Volume was 11.4 million shares, or 4.5 times the average daily volume over the past 90 days, according to Thomson Reuters data.

A News Ltd spokesman in Sydney declined to comment on the share move, saying any comment would have to come out of New York.

There's a lot of sentiment and emotion driving the stock, said Simon Burge, chief investment officer at ATI Asset Management in Sydney, which holds News Corp shares.

From an earnings point of view, News of the World was less than 1 percent of earnings but this has catapulted to something greater and it is hard to quantify.

In a report on its web site, Bloomberg News cited two unnamed sources as saying independent directors of New York-based News Corp have begun questioning the company's response to the crisis and whether a leadership change is needed.

On the board, venture capital executive Tom Perkins and Viet Dinh, a law professor at Georgetown University, were leading the efforts of independent directors, according to one of the people in the Bloomberg report.

However, in an emailed response to Reuters, Perkins denied the report.

The Bloomberg reporter didn't talk to me. There is no substance to her speculations, as far as I know, Perkins said.

The News of the World, which published its final edition a week ago, is alleged to have hacked up to 4,000 phones including that of murdered 13-year-old Milly Dowler.

(Additional reporting by Michael Erman in New York and Sonali Paul in Melbourne; Editing by Balazs Koranyi and Lincoln Feast)

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