In a somewhat tense exchange at a congressional hearing, SEC Corporation Finance Director Keith Higgins and Massachusetts Democrat Stephen Lynch went back and forth over the issue, with Higgins saying the SEC does not use waiver denials to punish wrongdoers.

"The SEC needs to ensure that the American people are protected from egregious conduct ... The SEC should penalize the Royal Bank of Scotland for its conduct instead of granting them a waiver," Lynch told Higgins at a hearing before a U.S. House of Representatives financial services panel.

"I want you to persuade me that I am wrong here."

Lynch's concerns center on a growing controversy surrounding what is known as a "well-known seasoned issuer" or WKSI waiver.

A WKSI tag is generally afforded only to companies that raise large amounts of capital and are widely followed in the market. Companies that have a WKSI status enjoy numerous benefits, including qualifying for automatic shelf registrations, which allow companies to raise money immediately from securities offerings without having to wait for the SEC to review offering documents.

Companies can potentially lose their "WKSI" status if they are convicted of a felony or if they violate the civil anti-fraud laws, but SEC rules give companies a way to avoid losing it through a waiver.

Earlier this year, SEC Democratic Commissioner Kara Stein made scathing public comments and dissented over granting Royal Bank of Scotland a WKSI waiver, after one of its units pleaded guilty and paid a fine for its role manipulating the Libor interest rate benchmark.

Stein said the SEC had gotten into the habit of routinely granting waivers to big banks that break the law, in what may be creating a policy of "too big to bar."

Since then, her comments have sparked a major debate on Capitol Hill and within the SEC.

Higgins' division is the one that is tasked with reviewing applications for WKSI waivers.

It has the authority to grant or deny a request, though in the case of the Royal Bank of Scotland the issue was elevated to the full five-member commission for a vote because of concerns by both Stein and Democrat Luis Aguilar.

Higgins told Lynch Thursday that the U.S. Justice Department had already punished RBS and ordered the bank to pay a fine.

"That's being paid ... by the investors," Lynch responded. "The investors are getting penalized with the fine. And that's it?"

"The WKSI disqualification was never considered by the commission to be a penalty for the underlying conduct," Higgins said.

(Reporting by Sarah N. Lynch; Editing by Bernadette Baum)

By Sarah N. Lynch