Should Internet companies be allowed free reign in the borderless realm of cyberspace?

Or should they be forced to play by the rules of governments and national laws like Old Economy businesses?

Europe seems to be choosing the second alternative.

In November, European Union Justice Ministers approved the Brussels Regulation, a law that subjects anyone selling goods or services on the Internet to the local consumer protection laws of each of the European Union’s member states.

The regulation, slated to take effect in March 2002, enables consumers to bring foreign online retailers to court within their own country if the retailer “directs its activities” toward consumers in that particular country.

The Brussels Regulation is actually an appended version of the 1968 Brussels Convention, which established that in the case of cross-border transactions, dispute resolution is to be conducted under the jurisdiction of the state in which the consumer resides.

This regulation is now being applied to E- commerce.

Michael Mensik, a partner at international law firm Baker & McKenzie, tells CFO.com: “Arguably, all the Internet does is increase the number of situations where such cross-border claims may be raised, by virtue of increasing the number of cross-border transactions.”

Although it can be viewed as a mere extension of pre-existing law, the Brussels Regulation has ignited a good amount of controversy. Opponents warn that it will stifle E-commerce. Instead of attacking the risk by mastering and complying with consumer protection laws in each EU state, the opponents argue, companies may take the easier route of avoiding the legal risks by simply boycotting the most consumer-friendly EU countries altogether. Germany, France, and some Scandinavian countries, for instance, may be particularly affected.

Thomas Smedinghoff, a partner with Baker & McKenzie who specializes in E-commerce issues, claims that Europe may be fostering a stringent environment for global E-commerce regulation in general. The Brussels Regulation, he says “may have the effect of setting a standard that the rest of the world ends up living up to because they want to do business in Europe.”

On the other hand, the European Commission, the policy-making body of the European Community, contends that the regulation is necessary to protect the rights of online consumers in an emerging arena where adequate protections are sorely lacking. The commission has further argued that consumers should not have to bear the burden of legal action outside their national borders.

Other supporters claim consumers are likely to be more confident about shopping online if they have the protection of their own courts.

Indeed, according to a December report by Forrester Research, the Brussels Regulation will send a comforting message to European online shoppers, helping to boost online sales. The Cambridge, Mass.-based research company asserts that the benefits of this regulation far outweigh the costs since the number of cross-border sales that end up in court is negligible compared to the number of online shoppers that need reassurance.

Some analysts predict that stringent regulations that make Internet companies increasingly vulnerable to local laws, such as the Brussels Regulation, could precipitate cross-border legal battles that may prove detrimental to the spread of global E- commerce. A French judge’s recent order that Yahoo block French Internet users from accessing Nazi-related memorabilia on its auction Web site is a prominent example of such disputes.

In November, two French anti-racism advocacy groups sued Yahoo in French court, accusing the U.S. site of violating French law barring the display or sale of racist materials.

Yahoo responded by filing suit in a U.S. federal court to dispute the French court’s jurisdiction over the company’s operations. Yahoo argued that it is technically impossible to filter out sales made to French citizens.

Shortly after filing suit in the U.S., Yahoo changed tack, banning Nazi items and other hate materials from its auction site. Although the ban signaled a hint of victory for the French, it did not apply to the content areas of Yahoo’s site such as chat rooms and message boards. A ruling on the Yahoo case in U.S. federal court is still pending.

“I suspect that we’ll be seeing a lot of these cases going forward,” says Mensik.

The French case, however, is among the first in which a court has claimed jurisdiction over a foreign Web-site operator, and the outcome is likely to have significant ramifications.

Until now U.S. E-businesses have largely ignored legal environments in foreign countries, says Smedinghoff. “Companies have tended to do business as they have done in the past, simply moving it to the Internet, and have not been overly concerned about the various laws in countries where their customers reside,” he explains.

He adds that this will rapidly change as a consequence of emerging laws and legal charges such as the one against Yahoo. “Companies are being forced to pay attention to the laws of the countries where they do business,” he says.

According to Aileen Pisciotta, a partner specializing in E-commerce and international arbitration at Kelley Drye & Warren LLP, U.S. industry is making a mistake by pushing for less regulation. As long as U.S. corporations don’t come up with ways to regulate their own Internet practices or form initiatives along with U.S. regulatory authorities, they “remain vulnerable to having decisions made for us by foreign authorities,” Pisciotta cautions. U.S. companies must protect themselves by issuing disclaimers, pursuing best practices, increasing their self-regulation, and implementing software solutions, says Pisciotta. Trying to analyze and understand international laws is not a viable or sufficient solution, she believes. To protect themselves against extraterritorial liabilities, companies can also begin to target their content offerings for use by people in a particular country, says Pisciotta. “Part of the secret to the solution will be in creating virtual geographic zones.”

One thing is certain. The Yahoo case and the recent approval of the Brussels Regulation serve as cautionary signals to companies doing business abroad, and suggest that despite the seemingly supra-governmental nature of cyberspace, E-businesses will remain at the mercy of local governments and courts for the time being.

Analysts predict that over time, however, countries in the EU and around the world will harmonize diverging regulatory regimes, making the cross-border transactions less risky for all.

“If we are going to have viable global E- commerce, we have to have a relatively uniform set of rules,” Smedinghoff comments.