B2B Exchanges

By Alan Gahtan and Jennifer Gray - November 2001

                        As the dust begins to settle on the swift decline of the dot.coms, at least one type of Internet company continues to inspire dreams of a wired business world:  B2B exchanges.  The market’s fascination with B2B exchanges is not difficult to comprehend.  After all, hundreds of exchanges have been unveiled during the past 18 months and their deployment has involved many leading bricks and mortar companies across a wide array of industry sectors spending hundreds of millions of dollars.

                        However, due to the complexities of developing and operating B2B exchanges, it will likely be some time before it becomes clear whether they can firmly establish themselves and flourish in the industries they seek to transform.  In particular, developing and operating an industry exchange of any size presents a web of interrelated, potentially complex legal issues that must be initially resolved and continually revisited as the exchange casts and recasts its business model.  The global nature of such operations and their often international focus can greatly magnify the complexity of legal issues they face.

                        This article focuses on ten significant legal issues with which attorneys must contend to when representing B2B exchanges. Some of the issues and possible resolutions discussed in this article may vary depending on how an exchange decides to organize itself.  However, regardless of organizational structure or industry focus, a B2B exchange will certainly contend with the following issues at some point in its development.

1.                  Navigating Through The Pre-Launch Minefield

                        Suppose your law firm has represented ACME Corp., a large brick and mortar manufacturing company, for a number of years.  ACME has decided to join a number of its key competitors to form a joint venture-based B2B exchange.  While the exchange will be open to any company in the industry, a small number of large competitors will own and operate it.  The consortium has publicly announced the exchange and is ready to begin building necessary exchange infrastructure.  As the founding joint venture partners negotiate capital contributions, equity splits, corporate organization, management issues and the like, they each dedicate a number of employees to the joint venture effort to commence the development process.  ACME has recommended that your law firm handle the legal work associated with getting the exchange off the ground. 

Your firm begins negotiating and drafting agreements with technology providers and service providers, drafting a membership agreement to govern the relationship between the exchange and its member trading partners, and formulating exchange policies and procedures.  Early on, it becomes clear that there may be a conflict in certain positions that would benefit ACME as a trading partner member of the exchange versus positions most favorable to the exchange itself.  For example, in drafting the membership agreement that will govern the rights and liabilities of the exchange as to its trading partner members, should you advocate positions that would favor your client in its role as a member of the exchange or should you be an advocate for the exchange itself?  Part of the answer undoubtedly lies in being clear about whether your client is ACME or the exchange.

Except in the case of a truly private exchange, the marketplace, as well as antitrust enforcement agencies, prefer that exchanges operate as neutral and independent bodies, even if their founding membership is comprised of a handful of competitors.  While striving to be viewed as independent and neutral during the formation stages and possibly longer, the exchange remains largely an amalgam of its founding joint venture partners.  This state of affairs can pose conflicts which counsel must try to resolve.  In the example above, ACME may have retained your law firm for the purpose of handling the legal work necessary to get the exchange up and running, but nevertheless expects you to represent its interests when it comes to membership agreements with the exchange and exchange policies and procedures. 

Another complicating factor is that each of the exchange’s founding partners, ACME included, may also have to negotiate their own agreements to become members of the exchange.  Thus, ACME itself could be simultaneously wearing two hats, one that favors ACME, and one that favors the exchange.  In such situations, any significant delays in forming the legal entity to house the exchange can further complicate the answer to the question, “Who is my client?"

The "fuzzy" pre-launch stage of a B2B exchange may also present a variety of other conflict issues of which counsel should be aware.  For example, if exchange personnel consist largely of employees seconded from the founding member' companies, these individuals may themselves be unclear about where their loyalties lie and the responsibilities they owe the exchange versus their former employers.

2.         Protecting Intellectual Property Rights

The protection of intellectual property rights is a common theme that runs throughout the lifespan of any technology-oriented company.  Even so, certain characteristics of many newly formed B2B exchanges make the task of policing and protecting intellectual property even more daunting than usual.

B2B exchanges often operate on the cutting edge of technology in application areas where very few substantial organizations have operated.  They typically bring together numerous types of technologies and personnel from a variety of sources.  They also generally are under great pressure to build their infrastructure in aggressive timeframes so that they can begin generating revenue.  Often, such pressure has been magnified because in order to build market excitement, the formation of many exchanges has been announced when the press release was the only part of the exchange that had been built.  Such public announcements of intentions to build exchanges has tended to heighten public expectations of exchanges to levels that may not be realistic in all cases.

Given the aforementioned pressures, it is not surprising that most personnel contributed by shareholders of a new B2B exchange may have many concerns other than protecting intellectual property on their minds on the first day of work at the startup exchange.  It is therefore imperative for the exchange’s lawyers to constantly remind exchange personnel of the importance of intellectual property and to proactively take steps to prevent inadvertent waivers of intellectual property rights.

One particularly challenging area is to put in place practices and procedures for handling outside contractors.  Other areas on which it is prudent to focus on day one include the development and distribution of standard non-disclosure agreements to be executed by both organizations and individuals performing professional services on behalf of the exchange.

A related concern is the negotiation of agreements with technology suppliers.  Waiting to negotiate technology agreements until after the technology has been integrated into the architecture of the exchange will place the exchange in a weak bargaining position.  To the extent that the exchange must begin building its infrastructure before deal terms with its core technology providers have been negotiated, it is preferable to document the key terms early on, even if the agreements may be subject to conditions and renegotiation.

3.         Anticipating The Immediate Needs Of Sales Teams

No matter how little development has actually progressed on any given exchange, sales people will be charged with selling memberships and exchange services, even before the exchange officially launches.  It is not at all unusual for such preliminary sales activities to include individuals who may not have an in-depth understanding of the exchange’s actual service offerings.  In addition, at the time sales activities commence, it is entirely possible that the scope of the service offerings of the exchange, including pricing, may not be fully articulated or finalized. 

One major challenge of working with a new exchange that lawyers face is to anticipate the needs of a nascent sales force which does not have the benefit of working for an organization with an established product line and associated market research data.  The services being offered by an exchange may significantly morph in short periods of time as they adjust to perceived market demand.  Even the most seasoned and well trained sales force is hard pressed to stay abreast of rapidly evolving service offerings and pricing structures, a situation that can lead to confusion and inconsistencies in how product offerings are being pitched to prospective clients.

Attorneys who represent exchanges can easily get caught in the cross-fire of rapidly changing product lines because they are often asked to generate the documentation that accurately describes a product offering and which also adequately protects the exchange’s legal interests.  In order to anticipate such needs and generate accurate contractual documentation, it is essential for counsel to stay in close touch with applicable project managers and product heads.  Understanding the nuances of an exchange’s product offerings is key to writing strong exchange contracts.

4.         Establishing A Membership Framework

One of the fundamental issues that all exchanges face when they are first born is how best to establish a subscriber or membership model which makes sense in light of the exchange’s overall business plan.  Should access to the exchange be open or closed or something in between?  Those exchanges announced early on were largely public exchanges created on the theory that market efficiencies could be maximized by connecting many buyers and many sellers.  Open access polices were also the result of guidance from antitrust enforcement authorities which stressed that first-to-market exchanges could generate significant market power and thereby create "essential facilities" within their industries that could run afoul of antitrust laws unless membership was open. 

However, not all companies desire to have access to the universe of potential business partners, but rather may prefer to develop complex electronic connections or networks only with those companies with whom they have long-standing business relationships.  Private exchanges allow companies to create their own exchanges, customized for their unique needs.  They vary from a simple hosted procurement system provided by one company to its suppliers, to private extranets in which one company collaborates with its supplier base for purchasing and collaborative product development.  The structure of the exchange ultimately depends on the goals, preferences, and technology-base of the participants.

Once the public versus private issue has been determined, a secondary issue is how companies actually become members of the exchange.  In open models, the membership process may be as simple as an on-line subscription agreement which a user completes in order to access the facility.  One the other hand, in some marketplace formats, members must be reviewed and specifically approved by the exchange.  Criteria for membership may include: whether the applicant is financially sound, the creditworthiness of the applicant, the existence of appropriate regulatory controls with respect to the applicant, or the level of participation in an industry.

 5.         Dealing Effectively With Multiple Technology Providers

One of the most pressing tasks an attorney faces when representing a new exchange is the formation of relationships by the exchange with technology providers that will enable the exchange to provide its service offerings to subscribing members.  In many cases, the relationships that exchanges form with their key technology providers will have a significant impact in determining whether or not the venture is ultimately successful.  Of course, an exchange's central concern is to acquire or build the technology infrastructure that is necessary to provide subscribing members with leading edge applications at prices that will allow the exchange to generate profits. 

Ensuring the financial viability of simultaneous technology acquisition transactions is especially important in the event that each proposed agreement contains terms such as ongoing royalty provisions.  While it may be tempting for a new exchange to agree to what appear to be reasonable revenue sharing provisions early on, the exchange and its counsel must be cognizant of potentially overlapping revenue obligations that could significantly eat into operating margins over time if not adequately controlled. 

Another area of concern when dealing with multiple technology providers are service levels.  Service levels are contractual provisions with technology providers that establish  benchmark levels of service and specify remedies for service failures.  Service levels are critical for any party involved in electronic commerce.  However, these may vary depending on the product offering.  Most exchanges, like application service providers ("ASPs"), will typically avoid contractual service level commitments.  Those that do provide such commitments will want to ensure that their pricing covers the additional financial exposure.  Also, the exchange will need to negotiate with its technology providers for commitments equal to or greater than the commitments it provides to its members.  An entity's ability to negotiate and obtain meaningful service levels will be affected by many factors, including how much they are paying for a service, how costly or risky it is for the exchange to make service commitments, and the relative bargaining power of the parties, which can be strongly influenced by the timing of the negotiations and the experience of the lawyers involved. 

An additional area of concern with respect to technology agreements is exclusivity.  Exchanges may seek exclusive arrangements with their technology providers in order to prevent "free- riding" on their domain expertise or in order to gain a competitive advantage and should consult with antitrust counsel as to such provisions.  But because arrangements may foreclose competitors of the vendor or vendee, respectively, from dealing in that technology during the period of exclusivity, they may raise antitrust concerns.  Exclusive technology arrangements should be reviewed by antitrust counsel early on the process of negotiating the agreement.

6.         Addressing International Concerns

Most exchanges either currently provide their services to an international audience or have plans to do so in the future.  The international presence of exchanges present special challenges to attorneys representing them.  One issue is the extent to which the exchange will need to comply with the laws of each jurisdiction in which it plans to do business.  While the Internet presents complex and evolving issues of defining where a company does business, at a minimum, counsel for an exchange needs to be vigilant of the laws in those countries where it will have offices, sales personnel, servers, or other indicia of a business presence.  It is prudent to retain local counsel in those areas.

The difference in Canadian versus foreign laws and regulations may be significant.  For example, the EU Data Protection Directive creates slightly different obligations with respect to privacy and data than do Canadian laws.  In addition, the competition laws of foreign countries are very different, in some cases requiring the filing of “exemptions” for many types of conduct that are normally not problematic under Canadian antitrust laws.  Another area to watch for is differences in business definitions between the Canada and foreign countries.  For example, the term "auction" may have a very specific definition under certain foreign laws and inappropriate use of the term in such jurisdictions (and without appropriate disclosures) could give rise to liability.  Depending on how it is established, the exchange may need to deal with foreign export and trade laws.  In short, it is critical for any exchange with any prospect of operating globally to engage appropriate foreign counsel.

7.         Developing and Implementing a Viable Data Policy

As the implementation of exchanges and other electronic business communications continues apace, the centralization of many industries' operations will lead to the generation of vast quantities of historical transaction-related data.  Such data is potentially valuable because it may reveal important industry trends and insights.  Exchange data can be used to make markets more transparent and efficient and to develop "best practices" and industry standards.  Given its value, transaction data may be sold to a wide variety of industry participants and consultants, generating significant revenue for an exchange.

Ownership, protection, and use of such data is a central issue in negotiations between exchange operators, exchange participants and even technology partners, and may give rise to disputes unless expressly addressed in governing agreements.  Exchange operators are likely to view data concerning transactions that occur on the exchange as the exchange’s property.  However, exchange participants may wish to safeguard data concerning their purchases and sales and may not wish to share such information in a form that identifies them or their transactions.

Legal counsel for an exchange may consider including certain limitations on the exchange's use of data in order to preempt opposition from, or disputes with, potential members.  For example, the exchange may assert ownership over data concerning all transactions but agree to limit its use of data to aggregated forms in order to allay its members' concerns that their competitors will have undue access.  Conversely, legal counsel for exchange participants should carefully consider the impact that disclosure of transactional data could have and whether the safeguards and security protections that the exchange has implemented are sufficient to protect the company's competitiveness.

8.         Identifying And Minimizing Antitrust Risks

Most B2B ventures must grapple with the possibility that they could be used as a vehicle for the transfer or sharing of competitively sensitive information.  The electronic communication of prices and transaction data via an exchange can be a boon to industry participants in many settings because it forces firms to bid more aggressively with one another.  However, it can also facilitate collusion among rival buyers or rival sellers.

Consider the following example.  In 1994, the Department of Justice issued a consent decree concerning the major airlines' use of their joint electronic fare system, Airline Tariff Publishing, Co. (“ATPCo”), to increase fares and discourage discounting, in violation of Section 1 of the Sherman Act.[1]  According to the government's complaint, an airline would use the electronic facility to signal its intention to reduce a fare on a route that was lucrative for its competitor.  The competitor would then respond in kind by signaling its intention to reduce a fare on a route profitable for the first airline.  In some cases, reductions were abandoned or accommodations were reached between the airlines as a result of their advance communications.  The DOJ alleged that the electronic collusion between the airlines amounted to per se price fixing, that had the result of increasing ticket prices to consumers by more than a billion dollars between 1988 and 1992.  The ATPCo case illustrates how real-time electronic price communications may enhance coordinated interaction among either rival buyers or rival sellers, particularly in industries that are highly concentrated. 

A concern with B2B exchanges has been that, like the airlines in the ATPCo case, buyers or sellers can more easily engage in collusion when their prices and price movements are easily observable by their competitors.  In reality, however, most pricing information can easily be restricted to viewing by a small number of participants through the use of technological firewalls.  For example, catalog pricing data may only be made available to specific buyers and not generally observable be participants of the exchange. 

9.         Managing Staffing and Personnel Issues

Newly formed exchanges may find themselves in the disconcerting position of simultaneously building infrastructure, engaging in business and technology development, conducting exchange operations, marketing and responding to customer calls and processing transactions, all within days or weeks of launching.  The staffing demands on a nascent or newly formed B2B exchange are enormous.  The exchange will require management, software engineers, sales and administrative personnel, business development and a host of other staff who have expertise in the industry or in B2B e-commerce.  In order to fill these needs, exchanges may recruit staff from various industry members, consulting companies, third party and other sources.  This rapid fire approach to staffing can create significant business and legal issues.

Security, for example, presents a formidable challenge, particularly during the pre-launch period, when consultants and third party vendors require easy access to the exchange facilities.  It is critical that every employee, consultant or vendor with access to the premises execute a non-disclosure agreement restricting the disclosure of confidential information.  While NDAs are rarely litigated, they have an important deterrent effect in protecting against the disclosure of confidential information.  Additionally, the exchange should develop other securities measures to monitor the entry and exit of people, documents and information from the exchange's facilities.  Seconded employees may come into contact with significant amounts of data and information that could be used to benefit their former employer.  Even inadvertent conversations with former co-workers or seconded employees from competitive companies can lead to significant, albeit inadvertent, security breaches.

10.       Establishing a Contracts Administration Function

Consortia-based exchanges may have sufficient funding to become large scale operations from the outset.  From an administrative point of view, this state of affairs can wreak havoc.  With sale, administrative, business development, and technology personnel moving full force ahead on all fronts, contracts and documentation may be poorly maintained or worse yet, forever lost in he flurry of activity.

Focusing the exchange’s personnel on mundane administrative tasks such as contract administration may be difficult, but it is critical to do so.  Not only is it important to make sure that important contracts are not lost, but in the early days of the exchange, it may be very easy for personnel operating on different fronts to negotiate agreements with conflicting provisions.  A process should be in place for counsel to review contracts under negotiation to ensure that agreements are not conflicting and to records and follow up on contractual obligations.

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