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Law and Order on the 'Net Order: Legal Aspects of Internet Use by Associations
01-Mar-2001
Association Management
by Jerald A. Jacobs
Legal issues arising from association's next-generation Internet programs.
SINCE ASSOCIATIONS BEGAN PROLIFERATING in colonial America--born of the singular barn-raising mentality of this country's heritage--nothing has promised greater change in what associations do and how they do it than the technology revolution, particularly the advent of the Internet with its seemingly endless possibilities.
While associations exist for networking, for education, for advocacy, for self regulation, and much more, nearly everyone agrees that the Internet will change how voluntary membership organizations fulfill those functions and will empower them to introduce new, perhaps as-yet-unimagined, functions. This technology-based revolution for membership organizations is universally acknowledged in the field. Most associations are at least carefully studying it; some are comprehensively embracing it; and all are anxious about it--since it threatens to disrupt traditional operations and challenge how associations do what they do.
Preliminary findings of the Association E-Business Questionnaire, a survey of 6,891 ASAE members, of which 790 responded, indicate that 93 percent of the organizations represented have Web sites, and 86 percent see e-business activity in their futures. When asked whether their association's Internet strategy is linked to its business strategy, 58 percent agreed or strongly agreed. Of those associations who were able to estimate, more than half indicated that less than 20 percent of their members were participating in a business-to-business online marketplace. The data suggest that 2 percent of association revenue has been generated from Web site sales during the 12 months prior to the survey (which concluded November 30, 2000). At the same time, 10 percent of associations and 47 percent of their members indicate that "intimidation in the adoption of the Internet" represents a barrier to transition from traditional commerce to e-commerce.
Obviously, many associations are addressing the how and the why, and even the if not, then what of associations' exploitation of the functionality of the Internet. The focus is especially on the elements that distinguish the Internet from every other technological advance that has affected associations: the interactivity and the worldwide accessibility of the Internet. Too little attention, however, has been given to the more mundane nuts-and-bolts aspects of associations' participation in the technology revolution--the legal aspects. Who owns what in the seemingly ephemeral world of bits and bytes? What are the legal risks inherent in situations in which an association considers partners or other sources in order to pay for the stunning--and often stunningly expensive--new technology? What are best practices in technology outsourcing and what sort of due diligence is recommended to avoid liability, loss of intellectual property, and so on? Do technology ventures fit in the traditional structure and governance of nonprofit membership organizations or must associations create other models that do not jeopardize nonprofit status or push traditional boards into unknown territory? What about the implications for the antitrust issues that have loomed over associations for a century? Will the Internal Revenue Service (IRS) consider revenue generated from the new technology to be tax-exempt or taxable?
Limited legal precedence
The answers to many of these questions are simply unknowable because there is too little legal experience in dealing with technology and Internet issues. Ours is a system both of statutory and regulatory mandates passed by legislatures and agencies and of common-law precedents established slowly on a case-by-case basis in the courts. There has been only a smattering of the former--such as the U.S. Congress' moratorium on new taxation of transactions on the Internet. The current moratorium expires next year, but the U.S. House of Representatives has noted a five-year extension. There's no telling what the new Congress will do. And there have been equally few pertinent court decisions. To a significant extent, the association community must rely upon extrapolation and interpretation of old legal precedents in the context of new technology. Despite the difficulty of the effort, however, as associations go beyond the first few iterations of their simple Web sites to next-generation portals, e-commerce ventures, a nd other Web-based functionality, they must pay close attention to legal implications that arise from these new activities.
For starters, it is useful to contrast the application by the Federal Trade Commission (FTC) of antitrust law to Internet issues with the application by the IRS of tax-exemption law to Internet issues. Antitrust law has been built upon broad prohibitions against competitors joining together to make decisions that affect the marketplace or to misuse their market power. Those principles have been relatively easy for federal antitrust authorities to apply-at least hypothetically-to the uses of new technology. The FTC has made clear, for example, that for competitors to agree on price is just as illegal if the agreement occurs via e-mail as if it occurs via notes on cocktail napkins. In contrast, tax-exemption law is far more detailed and condition-specific. The laws are extensive; agency regulations and opinions are seemingly endless; and consequently the law's application can be elusive. Early on, for example, IRS officials informally published such unlikely and awkward conclusions as this: Revenue from static commercial advertising on an exempt organization's Web site may not be taxable but revenue from moving commercial advertising may be taxable. Go figure.
Because associations' adoption of new technology remains relatively recent, most associations are struggling more today with the transaction aspects than with the policy or regulatory aspects of implementing advance-function Internet programs or other such technologies. Associations are looking for technology deals whereby they can quickly upgrade the functionality of their Web sites for such purposes as enhanced member service or development of an online revenue stream, usually with outside partners or vendors. And they are wondering how to best ensure that the deals succeed as intended.
Wary partners
Association ventures with outside commercial firms, of course, have always involved some culture-clash issues. Traditional association business partners, such as insurance providers, credit card companies, and other partners in association affinity programs, have become accustomed to some of these cultural characteristics. But the newer dot-com business models and those of other firms that are just now tapping the association market seldom understand that associations are structured, governed, and managed differently than for-profit businesses. Here are some characteristics that must be factored into potential partnerships.
1. Associations typically have a slow decision process. While there is growing evidence that associations are working on ways to speed up their decision-making processes, boards and memberships meet only occasionally, and smaller governing groups such as task forces need authority and ratification from larger ones.
2. Associations are comparatively risk-averse. Volunteers serve limited terms in governance positions, often positions of prestige and honor. They want to leave legacies of progress and achievement; they do not want to be accused of rash or overly speculative judgments.
3. Associations have limited access to capital resources. As nonprofit corporations and tax-exempt organizations, associations often have only modest liquid surplus assets and little in the way of collateral to support commercial loans. It's not that they are poor risks; they simply have not had much experience in capital markets.
4. Associations' volunteer and staff leadership tend toward a lack of sophistication in technology matters, particularly in smaller-staff associations. They often find themselves having to rely upon consultants--sometimes very young ones who may be competent but with whom the leadership may not feel comfortable--for major decisions that the leadership cannot expect to completely understand or control.
5. Like many organizations, associations prefer to deal with safe and known vendors. Relatively few blue-chip names in the technology world have openly and aggressively embraced nonprofit membership organizations as major market opportunities. Hence, for associations, acquiring the right technology partner can be more difficult than acquiring other types of products or services.
In short, both associations and commercial firms have to adjust, sometimes dramatically, to the realities of doing business in the new economy. Commercial firms that want to do business with associations must adjust to some of the singular attributes, environments, and processes of volunteer membership groups. At the same time, associations must consider modifying some of their traditional ways of working in order to take advantage of Internet opportunities.
Complex considerations
A mountain of legal issues must be tackled when associations launch major new technology programs; the areas are familiar to associations but tend to arise in new ways. Here are some of them, with examples of how associations are coping.
Organizational form. Many associations have by now had their Web sites up and running for four to six years. Typically, the early sites were characterized by their emphasis on information and communication functions, often with only limited interactivity and worldwide purview, the two characteristics that make the Internet different from anything that preceded it. These first-generation association Web sites were likely to include functions such as constituency information; announcements; online newsletters; convention, seminar, and meeting promotion; dues information and collection; membership lists; convention registration; membership recruitment; chat rooms and e-lists; publication sales; grassroots advocacy; and hyperlinks to members, government agencies, and other associations or vendors.
Increasingly, associations are attempting to add to their sites functionality that emphasizes interactivity and worldwide purview, sometimes to the extent that they become industry or professional portals. These next-generation Web sites are likely to include Web-based functions such as distance education, virtual trade shows, virtual meetings, interactive scientific journals, online credentialing, charitable solicitation, members-only stores, member subsites, virtual chapters, online insurance and travel agencies, link to legislators, and data mining.
The question quickly arises as to where to put these next-generation association technology programs. In many cases, there are tax considerations based on nondues revenue derived from the online products and services. Some endeavors may be expected to generate sufficient revenue subject to unrelated business income tax (UBIT) that it may be prudent to organize them in separate taxable corporations to protect the association's federal tax-exempt status. Like all exempt organizations, an association is permitted to realize only limited amounts of UBIT itself. If UBIT-eligible revenue is substantial, it threatens the association's exempt status.
For this and other reasons a number of associations have created-- through a variety of business models--for-profit entities through which to conduct their commercial Internet activities. (See the article "A Dot-Coin of Their Own" beginning on page 40 of this issue for a discussion of associations that have collaborated or partnered with other organizations to create such for-profit opportunities.) If outside investors participate in funding the program, they may demand a share of ownership. This situation, in particular, will dictate creating a separate entity--perhaps an equity corporation, a limited-liability corporation, or a joint venture partnership--based on consideration of all the relevant factors.
Finally, if the program involves activities that could result in legal claims, liability may become an issue. Online testing and certification, online consulting, and electronic commerce are examples of Internet functions that can, in some circumstances, have higher risk factors. In this case, it might be best to try to isolate those activities within an entity separate from the association. Typically, associations that launch or participate in large e-commerce ventures have established them as separate corporations.
Capital and ownership. These issues often go hand-in-hand because outside firms that are willing to supply funding to an association's technology venture will often do so only on condition of sharing in the ownership of the venture. One national professional society that has begun an already-successful e-commerce Web site, specializing in distance education for constituent professionals and others, obtained seven-figure financing from a group of large vendors to the profession. Each of the funding vendors received preferred stock in the new company formed to operate the site, while the association itself maintained majority ownership of the company in the form of common stock.
This kind of transaction is a major one--entailing agreements on stock ownership and rights (such as rights of registration, voting, conversion, liquidation, and so on); agreements on intellectual property licensing; consideration of securities law issues; preparation of corporate governance documents addressing shareholder rights; opinions on tax and antitrust matters; and many other issues that require legal research and documentation. An undertaking requiring this much legal support--at potential five- or six-figure costs--would only make sense in cases where a major association technology initiative stands to gain significant and secure downstream revenue potential.
Technology acquisition. Associations are familiar with technology outsourcing from years of acquiring database programming and other computer systems. Techniques for negotiating outsourcing contracts have become extremely sophisticated. (See sidebar, "Technology Outsourcing: It Hasn't Gotten Any Easier.")
The majority of associations that have developed next-generation interactive Web site functions have relied upon one main developer, or umbrella vendor, to deal with the acquisition of technology from a variety of other firms. An example is a large national charity that has entered into a joint- venture project with a commercial firm to assist with charitable solicitation nationwide. The commercial firm is the umbrella vendor that is pulling together all the pieces for this functionality of the charity's site. The association identified this commercial firm through a conventional request for proposal process. Here the relationship with the charity is much simpler than in a stock transaction involving a forprofit subsidiary. A joint venture is essentially governed by a contract in which each venture partner has obligations and revenue is typically shared. The joint-venture contract must be both detailed and flexible if it is to be enduring.
In contrast with these examples, other organizations prefer to negotiate with multiple vendors, despite the fact that it requires multiple contracts and more research. (See sidebar, "Choose From a Plethora of Partners.")
Tax exemption. The IRS has been slow to opine on how tax-exempt organizations should treat income from Internet activities. The best advice at present is to use common sense and attempt to apply existing precedents. For example, payment from a commercial firm for a link from an association's informational site to the firm's e-commerce site might well be considered advertising revenue subject to UBIT. By comparison, revenue from an association's distance education offerings on the Internet, where the subjects are within the area of the association's mission, would likely be tax-exempt. Some associations, particularly smaller state and local ones, are managing this issue by merely passively sponsoring Web site functions provided by outside vendors in return for royalty income to the associations. If done carefully, this may well achieve exempt income for the associations.
Intellectual property. This may be the most delicate legal issue of all--and one in which associations are particularly vulnerable given their traditional role as repository of industry information, knowledge, and analysis. An association's partnership with one or more outside Internet providers to create Web-based content and related applications usually involves each partner's contribution of something of value. The association may contribute its reputation and prestige (through its community) as well as existing content or new content (developed by the association and its staff, members, or consultants). The outside firms are likely to contribute funding, software, management expertise, and other business resources.
Prior to contracts being signed and the site going live, associations need to ask some critical questions. When the site is up and running, which party will own what? Will contributions be returned to their respective entities if the venture fails? The typical solution is for the association to license use of its name, sponsorship, and contributed content to the endeavor on condition that those assets be maintained in such a way that they can be extracted if the partnership should end. This may require that the commercial firm license use of its software source codes in the event of termination for a long enough time to permit the association to transfer its property elsewhere. It should be emphasized that it is insufficient merely to state in a contract with a technology supplier that the association's intellectual property must be returned if the venture fails, the supplier goes out of business, or other eventualities prevail. There should be a step-by-step explanation in the contract as to which party or parties will be responsible for affecting extraction of the association's property. Even during the term of the contract, the outside firm might be required to verify from time to time that the association's intellectual property is indeed extractable.
Management. Some associations have struggled with how to attract and keep professional and entrepreneurial managers and technology experts to staff their Internet ventures. In many areas, technology firms are competing aggressively with other local employers to find candidates; the compensation and benefits packages offered by those firms are sometimes overwhelming. The usual reasons why good employees join the staffs of associations--shared nonprofit mission, team approach to problem solving, and so on--may not always apply in the technology area.
One association established its new Internet project as a separate for-profit corporation, in part to be able to offer stock options to staff. The problem, of course, is that the stock options may not be able to be valued unless there is a public offering, often only a distant hope. There are also methods for nonprofit organizations to create phantom stock option plans to help compete with technology firms in recruiting and keeping good employees. One type of plan might provide shares redeemable for cash upon a vesting schedule with the shares valued on the basis of an index of publicly traded competitor firms. Another type might involve purchase of a fund of publicly traded stock with portions of the fund--or perhaps only of the fund's appreciation--provided to beneficiaries. Obviously, any such plan must be carefully structured and managed in accordance with securities law, tax law, and benefits law.
While such creative approaches may be necessary when competing for employees with technology firms, associations still often find that the best answer to attracting people to run their technology ventures is to do it the old-fashioned way--by demonstrating that the work is useful, satisfying, challenging, and rewarding. (See how some have enhanced those basics with other retention techniques in "Pop the Question," in the August 2000 issue of ASSOCIATION MANAGEMENT.)
Disclaimers. Associations are used to including disclaimers on their Web site pages, often on or near the home page. Disclaimers might warn visitors that interactive functions must not be used for illegal purposes such as intellectual property infringement, invasion of privacy, antitrust conspiracies, communication of pornography, and so on. While one cannot always predict the legal effect of disclaimers when claims arise, they remain well worthwhile in both deterring claims and in successfully defending claims. The kind of disclaimers to make depends on what kinds of activities occur on the association's Web site. One association has taken the novel approach of making its Web site disclaimers extremely short, simple, and in plain language, a practice that is entirely consistent with the purpose of disclaimers in the first place. Privacy issues also pose legal risks. (See this month's "Legal" column beginning on page 19 for a detailed discussion on protecting personal privacy online.)
International issues. The Internet is the first technology that easily permits people to access an association's services from anywhere in the world. That raises myriad legal issues. For example, other countries have laws applicable to taxation, privacy, intellectual property, and other areas that differ from those of the United States. No association can afford to research all laws in all countries. But attention needs to be paid to legal issues if an association's Web site--especially an e-commerce site--develops extensive traffic in other countries. As one example, a large national trade association created partially different Web site features for constituents in a few other countries from which their site received extensive electronic traffic. Each of the specialized sites has a country-specific domain name linked from the association's main site, while the foreign sites are translated into the countries' pri mary languages. Obviously, it is often necessary to take into account currency differences, cultural differences, and other nuances to successfully engage in e-commerce abroad.
Exit strategy. Internet ventures of associations deserve careful attention to the possibility of things not working out. Creating an exit strategy is always well advised when a new activity is attempted. But it is especially pertinent when associations are considering next-generation technology ventures, the results of which may be less predictable than those arising from other activities. Any sponsorship contract, technology outsourcing contract, or other vendor/partner arrangement should forthrightly address the prospect of project failure or contract termination or expiration. This requires particular discipline in circumstances in which all parties are enthusiastic and hopeful about success. But a careful exit strategy can minimize disputes down the road and can even help motivate the parties to be sure to avoid circum stances in which the exit strategy is triggered. Subjects to consider in fashioning an exit strategy include: reversion of ownership of intellectual property and cancellation of intellectual property licenses, responsibility for debts or obligations that remain unpaid, severance or other soft landing provisions for terminated employees, adequate notice to permit all parties to make other arrangements, division of any jointly created assets, joint or separate announcements, and so on.
New imperatives
Legal issues that arise when nonprofit membership organizations attempt to harness the unique interactivity and accessibility of the Internet are not new issues. They are merely old issues placed in new contexts that require different level of scrutiny. Rarely will they completely prohibit an otherwise viable Internet strategy for an association. But they can pose challenges. The range and intensity of effects of legal issues upon association technology initiatives varies greatly. A small-or medium-size association may merely sponsor and endorse an Internet vendor's offering; if the association has done its due diligence in investigating the viability of the vendor and the quality of its services, the relationship is likely to be a mutually beneficial one. Contracting problems here are little different from those arising when the association sponsors or endorses, for example, a member discount program on rental cars.
As the size and complexity of an association's next-generation Internet programs increase, so of course do the legal issues that must be addressed. A patient and careful sorting out of each specific issue, however, is likely to pay dividends in a smooth and successful venture benefiting members, bringing revenue to the association, and helping to ensure the association's position in the rapidly changing technological world.
Side-bar column:
A Plethora of Potential Partners
Associations are accustomed to starting new programs with only one outside firm as a vendor or partner. Examples of programs that might call for a vendor partner include insurance programs, consulting programs, credit card programs, and a host of others that typify association affinity programs and services.
Major Internet ventures, however, need lots of different kinds of outside services, each often available from only a single kind of firm. Dealing with multiple outside vendors or partners is not unusual. Most associations will find it attractive and convenient to contract with just one umbrella firm as the developer of the project, with that firm enlisting the others essential to the project's success. A few associations, however, have preferred to pick their vendors or partners one-by-one, a decision that then must be followed up with contract negotiations with each.
Here is a representative list of the kinds of firms that might be necessary to assist a large association in initiating a major consumer e-commerce Internet site to provide member retailers, for example, with a means of competing with large commercial e-tailers. (This particular list is based upon the experience of a national association that has its site up and running.)
1. VENTURE CAPITAL FIRM. This company puts up all or most of the funding for the project, in return for a large share of stock ownership in it. The venture capital firm hopes that the project will be sufficiently successful that stock in it can be sold in an initial public offering within a few years.
2. WEB SITE DESIGNER. This firm creates the look and feel of the site--and is responsible for the design and dynamics of the site that the user actually sees and uses. Elements of the site design might include an online logo, navigation menu, special graphics, and so on.
3. WEB SITE HOST. The typical hosting company maintains large computers--sometimes in remote locations--that actually run the Web site software, maintain its Internet connections, and so forth.
4. CONTENT OWNERS. The Web site may need news, articles, lists, catalogs, and all manner of content that must be either created or acquired from others in copyright licensing transactions.
5. SYSTEMS OWNERS. The Web site may incorporate other software programs for ease of use by visitors, such as word processing; rights to this software must likewise be acquired from its owners in copyright licensing transactions.
6. FULFILLMENT HOUSE. If consumer transactions are to occur on the Web site in which products are sold, someone must maintain inventories and have the capability to pack and ship individual orders, just as associations now often use fulfillment houses to distribute books, audiotapes, and other products.
7. PAYMENTS FACILITATOR. A means is necessary to accept payment, particularly credit card payment; some firms specialize in this. function for e-commerce Web sites.
8. SECURITY PROVIDER. Privacy and security are among the most talked-about legal and practical issues in e-commerce. There are vendors who specialize in providing these functions.
9. USER MANAGER. E-commerce companies see great opportunities in data mining to focus marketing on particular classes, areas, or even individual buyers. Specialized vendors provide the customized software and services that are needed here.
10. TRADITIONAL SERVICE PROVIDERS. As with any major new venture, a variety of conventional service providers may have to be enlisted to provide support and guidance in their areas of expertise--insurance agents, public accountants, attorneys, advertising agencies, public relations consultants, and so on.
Jerald A. Jacobs is a partner in the law firm of Shaw Pittman, Washington, D.C., and serves as ASAE's general counsel.
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