When Congress tries to fix leaks in executive pay regulation, it may create new leaks, a finance professor warned lawmakers today.

Kevin Murphy, a professor of business, law and economics at the University of Southern California, appeared at a House Financial Services Committee hearing on the relationship between compensation structure and systemic risk.

No witnesses referred directly in their written testimony to life insurance, disability insurance or annuity arrangements, but several referred to supplemental retirement packages.

Murphy noted that Congress created Section 409(A) of the Internal Revenue Code with a provision of the American Jobs Creation Act of 2004, in an effort to address concerns that Enron Corp., Houston, let a small number of employees withdraw millions of dollars from deferred compensation accounts just before the company filed for bankruptcy.

“In essence, the objectives of Section 409(A) were to limit the flexibility in the timing of elections to defer compensation in nonqualified deferred compensation programs, to restrict withdrawals from the deferred accounts to pre-determined dates (and to prohibit the acceleration of withdrawals), and to prevent executives from receiving severance-related deferred compensation until six months after severance,” Murphy testified, according to a written version of his remarks.

Section 409(A) imposes taxes on individuals with deferred compensation as soon as the amounts payable under the plan are no longer subject to a “substantial risk of forfeiture,” and, if individuals fail to pay taxes on those amounts, the amounts are subject to a 20% excise tax and interest penalties, Murphy said.

In the real world, “Section 409(A) restricts compensation committees from offering many incentive arrangements that are in the best interest of shareholders,” Murphy said. “Such options are often in the interest of shareholders, especially when employees ‘purchase’ the discount options through explicit salary reductions or outright cash exchanges.”

In some cases, Murphy said, Section 409(A) were costly for shareholders.

“Part of the problem is that regulation – even when well-intended – inherently focuses on relatively narrow aspects of compensation allowing plenty of scope for costly circumvention,” Murphy said. “The only certainty with pay regulation is that new leaks will emerge in unsuspected places, and that the consequences will be both unintended and costly.”

Rep. Charlie Wilson, D-Ohio, spoke briefly about H.R. 1603, the TARP Wage Accountability Act, a bill that he introduced earlier in the year.

The bill would require employees of companies getting Troubled Asset Relief Program funds to use the same cost-of-living-adjustment structures used by military and government employees.

This year, for example, the bill would cap salary increases for employees of American International Group Inc., New York, by 3.9%, Wilson said.

Links to documents relating to the hearing are available here.