When Galleon Group co-founder Raj Rajaratnam was sentenced to 11 years in prison last October, it appeared the government's high-profile crackdown on insider trading by hedge funds was winding down.

Turns out, it may just have been getting started.

The conviction of Rajaratnam on 14 counts of conspiracy and securities fraud in May 2011 was the signature accomplishment of “Operation Perfect Hedge,” the FBI and the U.S. Attorney for the Southern District of New York's joint effort to target illegal trading that began more than four years ago and has since produced dozens of arrests. Now it is clear that we've only closed one chapter in a much longer saga.

On Jan. 18, Preet Bharara, the U.S. Attorney for the Southern District of New York, announced a new round of charges against seven investment professionals who worked at three different hedge funds and two other investment firms. Bharara charged that the defendants were a “corrupt circle of friends who formed a criminal club” in which they provided each other with material, non-public information about public companies. Bharara described how the group used inside information about Dell and Nvidia to net the three hedge funds more than $61.8 million in illegal profits, and announced that three of the seven professionals charged had already pleaded guilty and were cooperating with prosecutors.

Bharara has emphasized that the fight is far from over. “We have demonstrated through our prosecutions that insider trading is rampant and has its  own social network, a network we intend to dismantle. We will be unrelenting in our pursuit of those who think they are above the law,” he said. The new wave of cases against hedge fund and investment firm professionals even landed Bharara on the February cover of Time Magazine.

Janice Fedarcyk, the FBI's assistant director-in-charge for Operation Perfect Hedge, added ominously that “the FBI has arrested more than 60 people in ‘Operation Perfect Hedge' to date, and this initiative is far from over. If you are engaged in insider trading, what distinguishes you from the dozens who have been charged is not that you haven't been caught; it's that you haven't been caught yet.”

Not only is the federal government pursuing more potential perpetrators, it's also planning stiffer penalties for those who break the rules. On Jan. 19, just one day after Bharara announced this latest wave of hedge fund cases, the U.S. Sentencing Commission proposed amendments to the U. S. Sentencing Guidelines that will further raise the stakes for professionals at hedge funds and other investment firms.

Under the Dodd-Frank Act, the Sentencing Commission is required to ensure that the guidelines provide appropriate penalties for cases involving securities fraud, taking into consideration the potential and actual harm to the public and the financial markets from those offenses. In response to this requirement, the Sentencing Commission has now proposed to amend the guideline dealing with insider trading by two levels if the offense involved “sophisticated insider trading.” An additional four more levels are added if the defendant is an officer or a director of a publicly traded company; a registered broker or dealer, or a person associated with a broker or dealer; or an investment adviser, or a person associated with an investment adviser.

Although hedge funds are not mentioned by name in the proposal, Dodd-Frank requires most hedge funds to register as investment advisers with the SEC, therefore exposing hedge funds to the stricter sentencing guidelines. Moreover, the definition of the phrase “sophisticated insider trading” leaves little doubt that it is aimed directly at hedge funds. The proposal defines “sophisticated insider trading” as “especially complex or intricate offense conduct pertaining to the execution or concealment of the offense.” It instructs courts to evaluate “sophisticated” trading by considering factors such as (a) the number of transactions; (b) the dollar value of the transactions; (c) the number of securities involved; (d) the duration of the offense; (e) whether fictitious entities, corporate shells, or offshore financial accounts were used to hide transactions; and (f) whether internal monitoring or auditing systems or compliance and ethics program standards or procedures were subverted in an effort to prevent the detection of the offense.

Overall, the heightened scrutiny of hedge funds by the government, which appeared to have peaked with the Rajaratnam case, continues unabated.

To see how the proposed stiffer penalties would work, consider the potential sentence of someone like Anthony Chiasson. Chiasson, the co-founder of hedge fund Level Global, was among the seven individuals charged on Jan. 18 in the trading scheme that allegedly allowed three hedge funds to use inside information about Dell to make more than $61 million in illegal profits.

As discussed in a recent article by Wayne State University law professor Peter Henning, if Chiasson is convicted of the insider trading charges against him, the current sentencing guidelines would recommend a sentence of 121 to 135 months in prison. The proposed amendments would not apply retroactively to Chiasson's trading (which allegedly occurred in 2008), but using the alleged conduct in his case as an example, the size of his alleged profits as well as the duration and number of his trades would likely satisfy the proposed “sophisticated insider trading” test, adding two levels to his sentencing calculation.

Moreover, as a hedge fund employee, Chiasson would be further subject to the proposed four-level increase. Thus, Henning concludes, the Proposed Amendments could increase the recommended sentence for a conviction on charges similar to those in Chiasson's case to 235-293 months—that is, 9 to 13 years longer!

Finally, on a different front, a questionable source of inside information that has proven quite profitable for some hedge funds is now under scrutiny by Congress. As part of the debate in late January concerning a “Stop Trading on Congressional Knowledge Act” (STOCK Act) that would ban insider trading by members of Congress, a House version of the bill also takes aim at the “political intelligence industry.” Lobbyists and others in the political intelligence business (now estimated to be a $100 million industry) wrangle information from members of Congress and their staff about legislation that may affect public companies, and then sell that information to hedge funds. Hedge funds then trade and profit on this unusual form of inside information.

Under the House version of the STOCK Act, people operating in the political intelligence industry would no longer be able to work in the shadows, as they would be required to register with the government and disclose information about their clients. The current Senate bill, which was passed in early February, however, does not include this provision, and instead simply calls for a government study of the growing political intelligence businesses. Sen. Joe Lieberman (I-Conn.), one of the bill's sponsors in the Senate, said a study will help clarify who is part of the political intelligence industry and what restrictions or disclosures are appropriate.

Overall, the heightened scrutiny of hedge funds by the government, which appeared to have peaked with the Rajaratnam case, continues unabated. The recent developments discussed above indicate that securities regulators, prosecutors, the FBI, and Congress have all kept hedge funds squarely in their sites. Although 63 people have now been arrested in connection with Operation Perfect Hedge in the past two years, with 56 convictions, these numbers seem certain to rise significantly in 2012. As the FBI's Fedarcyk observed, “each wave of charges and arrests seems to produce leads to lead us to the next phase.”