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A Tenacious Microsoft Emerges From Suit
With Its Software Monopoly Largely Intact
By JOHN WILKE
Staff Reporter of THE WALL STREET JOURNAL

WASHINGTON -- The breakthrough in settlement talks in the Microsoft Corp. antitrust case came at about 1 p.m. on Oct. 31.

On that day, Charles James, the Justice Department antitrust chief, pressed Microsoft for an important concession. He wanted to limit the software titan's ability to extend its Windows operating-system monopoly from the desktop-computer market to the market for large corporate "server" computers, where it still faces competition. Without such a provision, Mr. James told Microsoft, the 18 states that had sued alongside the Justice Department would walk.

Microsoft had resisted the demand, but a court-imposed deadline loomed. So, with a go-ahead from Chairman Bill Gates, Microsoft's lawyers drafted a paragraph agreeing to disclose additional information about how its desktop software works with its server software. The disclosure was supposed to improve rivals' chances of designing programs that could operate well with the ubiquitous Windows desktop software.

Mr. James was satisfied. But as Microsoft wrote it, the concession was so narrowly drawn that it would disclose little of use to the company's competitors, according to those rivals. And it didn't go far enough for nine of the co-plaintiff states, which ended up refusing to join the settlement.

The pattern repeated itself often in the negotiations that concluded last Friday with Microsoft and the federal government announcing that the historic three-year-old case had been resolved. After an epic battle in one of the biggest antitrust cases ever, the settlement leaves Microsoft's personal-computer software monopoly largely intact and is unlikely to hinder its march into such new markets as online services, music distribution and telecommunications.

Classic Display

In a classic display of Microsoft pugnacity, the company hammered opposing government lawyers on nearly every conceivable point, no matter how small. Eventually exhaustion became a factor, lawyers on the government side acknowledge. "It was a marathon session, and new [settlement] language that had not been there before and that had not been vetted by the staff showed up in new drafts," one government attorney says. "The provisions were weakened at every turn by qualifying exceptions."

The entire legal and political context had shifted since last year, when a federal trial judge here found Microsoft had repeatedly violated antitrust law and, in an extraordinary step, ordered it broken into two companies. The Clinton administration officials who sought that drastic remedy had been replaced by Bush appointees less inclined to use antitrust law aggressively.

And while a federal appeals court in June had affirmed the core of the government's case -- that Microsoft had unlawfully shielded its Windows monopoly from competition -- the court rejected the breakup order. No longer at risk of dismemberment, the company could focus on haggling over the details of licensing agreements and the like.

Herding Antagonists

Adding pressure for some sort of swift truce, a new trial judge invoked the national economic downturn that was exacerbated by the Sept. 11 terror attacks. The judge brought in a professional mediator famous for herding antagonists to common ground.

Now, the terms that Microsoft obtained could shape the future of competition in the computer industry -- to Microsoft's clear advantage. The dissenting nine states, led by California, Connecticut and Iowa, are waging a last-ditch effort to toughen the deal, but they face long odds.

The Justice Department's Mr. James says the settlement addresses Microsoft's antitrust violations within the limits of the appeals-court ruling. "We wanted to stop the violations now, not after years of further proceedings and appeals," Mr. James says.

The settlement gives personal-computer makers greater freedom to install non-Microsoft software on new machines and to remove access to competing Microsoft features, such as Internet browsers. It also bans retaliation against companies that take advantage of these freedoms, prohibits exclusive contracts and requires Microsoft to disclose design information to hardware and software makers so they can build competing products that run smoothly with Windows.

Mr. James says these terms are sufficient. He criticizes Microsoft's competitors for urging the government to impose provisions that would hobble the company and go beyond the violations affirmed by the appeals court.

The deal came together after three settlement attempts over the past two years had failed. U.S. District Judge Colleen Kollar-Kotelly, a Clinton appointee, took over the case in late summer, with responsibility for crafting a less-stringent remedy. She is known as a jurist who in ordinary times pushes litigants to settle. On Sept. 28, she told the parties in the Microsoft case that "the recent tragic events affecting our nation" demanded a prompt end to litigation that had already roiled the stock market and generated economic uncertainty.

That exhortation hit home. After Sept. 11, "the world had changed, with war abroad, threats at home and a deteriorating economy, creating a powerful dynamic to settle," says Richard Blumenthal, Connecticut's attorney general and one of the more-aggressive state officials involved in the case.

As it happens, the company and the federal government had scheduled a new round of secret settlement talks to begin at 2 p.m. on Sept. 11, at the main Justice Department building in Washington. One Justice official involved in the case says, "The last thing I remember doing after someone came into my office to say, 'We're getting out of here, now,' was to call and tell [the Microsoft team] that the meeting would be canceled."

On the Road

With airlines shut down, a group of Microsoft's lawyers, led by William Neukom, senior vice president, drove a rental car most of the way back to Redmond, Wash. They were finally able to get on a plane in Montana. Iowa's attorney general, Tom Miller, took a train to Des Moines. Nothing much happened in the case for two weeks.


Then, Judge Kollar-Kotelly put the talks back on track, ordering the parties to work "seven days a week, around the clock." She threatened to impose a mediator if quick progress wasn't made. Despite the pressure, there was little progress. On Oct. 15, the judge named a Boston University law professor, Eric Green, to step in as mediator.

Mediation in the Microsoft case had already been tried, without success, by Richard Posner, a nationally known U.S. appeals-court judge in Chicago. Mr. Green, 55 years old, has a reputation as a tireless and skilled mediator. He has settled scores of seemingly intractable cases, from claims over a rash of childhood cancers in a small New Jersey town in the 1990s to an international price-fixing case in the vitamin industry.

Mr. Green concedes that he isn't an expert on antitrust law or computer software. He declines to discuss specifics of the Microsoft mediation. But he says, "It was one of the most challenging mediations I've done, because of the complexity of the case and the technology."

Under his supervision, the parties began spending long hours in tedious debate over each of the conduct restrictions ordered by U.S. District Judge Thomas Penfield Jackson last year and later set aside when the appeals court rejected the breakup in June.

This time around, the government wanted Microsoft to let personal-computer makers choose more easily among competing software that works with Windows, such as media players, instant-messaging programs and Internet software. The appeals court had found in June that Microsoft used its monopoly -- Windows runs more than 90% of PCs -- to coerce PC makers to use Microsoft's own versions of such software for the Internet and other purposes, instead of accommodating programs sold by rivals.

The states and the Justice Department also sought provisions to deter Microsoft from punishing computer makers that don't bow to its demands -- for example, by charging those companies more for Windows if they install non-Microsoft programs in their machines. And the government lawyers wanted clearer disclosure of the inner workings of Windows, so that rival software firms could build products that work well with Windows.

Microsoft wanted any settlement to allow it to pursue its longtime strategy of building new features into Windows -- what the company calls its "freedom to innovate." Microsoft says weaving these features into the Windows system benefits customers. But the Microsoft strategy also has meant that companies selling their own innovations, such as instant-messaging software, were often thwarted. That's because so many PC makers preferred to take the Windows package, as is, and install it on their machines.

The talks came to a head on Halloween. Teams of lawyers representing the Justice Department, the states and Microsoft took over most of the ninth floor of the Washington offices of one of Microsoft's law firms, Fried Frank Harris Shriver & Jacobson.

The Microsoft team included in-house lawyer David Heiner; Charles F. Rule, a Washington lawyer with Fried Frank; and Steven Holley of New York's Sullivan & Cromwell, all veterans of the case. The states, which were represented most of the time by staff lawyers from Ohio and New York, operated cohesively at the outset, although a division would surface later.

The Justice Department team usually included Phil Malone, the San Francisco-based career-government attorney who had helped put the original case together; Mr. Malone's boss, Debbie Majoras, an experienced antitrust lawyer and Bush appointee; and Mr. James, who as the assistant attorney general for antitrust, made most of the critical decisions for the government. Other Justice Department staff members shuttled back and forth from the department's cluttered "war room" a few blocks away.

On the morning of Oct. 31, Mr. James huddled alone with his opponent, Mr. Rule, who in the late 1980s had been antitrust-division chief in the Reagan administration. These occasional private sessions, without Justice Department staff, helped move negotiations along, Mr. James says.

By midafternoon, the two sides had agreed on the provision that supposedly promoted competition in the market for corporate server computers. Microsoft faces competition in that market from International Business Machines Corp. and Sun Microsystems Inc., among others.

The states wanted to force Microsoft to show its competitors certain key functions of the Windows system that would allow Windows PCs to work smoothly with servers such as Sun's and IBM's, not just Windows-equipped machines.

Limited Offer

Mr. James approved of the compromise Microsoft offered. But the original Microsoft language limited the provision to a single type of server. Thus, it wasn't broad enough, according to Sun, IBM and other rivals.

Still, the agreement on this provision triggered a negotiating session on other issues that lasted through the night. Groups of lawyers met in as many as four or five conference rooms at one time, hammering out specific language. Mr. Green, the mediator, ordered a dozen large pizzas, then moved among the various groups of attorneys, goading them along.

"More than once, I had to find someone to address a point and would find them stretched on the floor, sound asleep," he says. "I'd wake them and bring them to the table."

Thoughts of war and terrorism were never far away, as has been true in the capital since Sept. 11. "It was on the minds of everyone at the table," says Mr. Green. Only days before the negotiating marathon, men in white moon suits and respirators had swept the Fried Frank offices for anthrax.

Microsoft lawyers invoked a more-threatening world when they proposed inserting a security exemption in a different part of the settlement. The exemption applied to provisions that require the company to disclose the inner workings of Windows to competitors who want to make all sorts of software that works well with Windows. The company said it needed the exemption to guard against cyber-sabotage.

Mr. James thought this was reasonable and agreed to the exemption, according to people close to the deliberations.

The exemption frees the company from having to disclose anything that "would compromise the security of antipiracy, antivirus, software licensing, digital-rights management, encryption or authentication systems." Microsoft's competitors and some of the states claim that these technologies are used so commonly that the provision could shield a number of Microsoft's products from competition.

One example is Passport, a Microsoft service that helps consumers make Internet purchases and is crucial to Microsoft's push into online commerce. The exemption also could be read to shield Media Player, Microsoft's entrant in the market for online music and video distribution.

Mr. James rejects these criticisms and says the decision to protect Microsoft's security provisions was "one of those 'duh' issues." He continues: "Microsoft has security protocols. Are we going to tell everyone how they work? Do you want people to get access to your credit-card information when you shop on line?"

More broadly, "competitors would like it better if they had access to all of Microsoft's proprietary information," he says. "And any company that thinks Microsoft's security protocols are a form of predation, let them sue."

Mr. James and his deputy, Ms. Majoras, say their decisions were constrained by the June appeals-court ruling, which narrowed the remedies they could seek. Mr. James also sketches a more-generous view than his predecessors of Microsoft's legal right to "bundle" the software code for Windows with the code for such features as the company's Internet browser.

While the appeals court found that in the past Microsoft had installed a browser in Windows to protect its monopoly, Mr. James says that today various Internet features are woven more deeply into Windows, offering consumers such benefits as one-click access to the Internet from e-mail.

"How would consumers be served if we forced Microsoft to remove that code?" he asks. "The market has changed."

When Mr. James and Attorney General John Ashcroft unveiled the settlement last Friday, it was met by a storm of criticism from competitors, who said the antiretaliation provisions would stop only some ways that Microsoft can discipline other companies. The rivals also said Microsoft would be able to evade other settlement terms too easily.

In a hearing before Judge Kollar-Kotelly, all 18 states split with the Justice Department and asked for more time to evaluate the deal. Over the weekend, they listened to Microsoft's competitors list criticisms of the settlement in hours of conference calls. Mr. James had declined to meet with the rivals during the mediation.

Although Mr. James insisted that no changes would be made, nine of the states, led by New York, persuaded Microsoft to tighten some provisions, in exchange for their endorsement of the pact. The New York group won a clarification in the provision on server-information disclosure, among other modest changes.

The back-channel negotiations infuriated the other nine states, however. Tuesday morning, the holdout states, led by California, Connecticut and Iowa, told Judge Kollar-Kotelly they couldn't accept the settlement without further changes. She has asked the dissenters for their proposals and scheduled additional hearings for March.

Before then, the deal faces a mandatory public-comment period and a full-scale court hearing on whether it is in the public interest, giving everyone at least one more chance to have a say on U.S. v. Microsoft.

Write to John Wilke at john.wilke@wsj.com