For Iowa Attorney General Tom Miller, the real issue in the long-running Microsoft antitrust case is “getting it right.”

“Ultimately,” says Miller, one of nine state attorneys general who did not sign on to the November 2 settlement between Microsoft and the U.S. Justice Department, “the issue is whether there will be fair competition in a crucial technology sector for years to come. The courts have determined that Microsoft broke the law, and now the issue is whether we will get a remedy that restores and insures lawful competition. We need to get it right.”

That, of course, is easier said than done. Under the controversial November 2 settlement, Microsoft has agreed to give computer makers more freedom to run software on their machines that is made by Microsoft rivals; in addition, Microsoft will share the inner workings of its Windows operating system with other software makers. The agreement was the latest round in the federal government’s 11-year investigation into Microsoft’s business practices and effectively ends the Justice Department’s three-year-old antitrust case against the company.

The early consensus on the November 2 settlement is that Microsoft came out on top. That also seemed to be the verdict on Wall Street: Immediately after the proposed deal was announced Microsoft stock jumped $3.69, or 6.3% and lifted share prices in general. The feeling seemed to be that Microsoft’s $350 billion business would continue undivided – and relatively unfettered – well into the future.

“Who’s the winner?” asks
Eric Clemons, professor of operations and information management (OPIM). “Well, it’s Bill Gates, as always.” “Will this settlement make a big difference?” asks Ravi Aron, also an OPIM professor. “I doubt it. Does this settlement in any way prevent Microsoft from bundling? It’s not clear.”

Scott McNealy, archrival of Bill Gates and chairman of Sun Microsystems, Inc., says the agreement “signals a retreat by the federal government and a defeat for consumers.” Massachusetts Attorney General Tom Reilly, echoing other state attorneys general, calls the settlement “fundamentally flawed,” pointing to “enormous loopholes” that “may prove to be more harmful than helpful to competition and to consumers.”

Microsoft did not respond to an interview request, but co-founder and chairman Bill Gates issued a statement after the settlement saying, “While the settlement goes further than we might have wanted, we believe that settling this case now is the right thing to do to help the industry, and the economy, to move forward.”

The Long and Tangled Legal Trail

Since 1990, when the Federal Trade Commission first started investigating Microsoft’s business practices, the company has continued to fight – and win – a series of high-stakes legal battles with trustbusters. Even a consent decree signed in 1993 by Bill Gates that was meant to reign back Microsoft’s business tactics failed to achieve that goal.

Then in April 2000, the Justice Department won a strong antitrust court decision against Microsoft that, in essence, found the company guilty of anticompetitive practices. U.S. District Judge Thomas Penfield Jackson specifically cited Microsoft’s illegal monopoly in operating systems. Two months later, Jackson ordered the breakup of Microsoft.

In June 2001, the U.S. Court of Appeals in Washington D.C. – in a ruling that has largely been ignored by the Justice Department in its Nov. 2 settlement – found that Microsoft violated antitrust laws by using its monopoly power to bully computer makers, drive rivals out of business and quash competition. Specifically, the Court of Appeals found that Microsoft engaged in unlawful exclusionary conduct by prohibiting computer manufacturers from supporting competing “middleware” products on Microsoft’s operating system. (“Middleware” refers to browsers and other software that runs such things as movies and music recordings.) The court also found that Microsoft prohibited consumers and computer manufacturers from removing Microsoft’s middleware products from the operating system, and that it reached agreements with software developers and third parties to exclude or disadvantage competing middleware products.

But the court also threw out the order to break up the Redmond, Wash., software giant. It sent the case back to a lower court to determine the appropriate punishment.

Instead, to the dismay of critics who had thought that Microsoft’s heavy-handed tactics had finally been dealt a death blow, Microsoft and the Justice Department made a deal. The proposed five-year settlement focuses primarily on giving computer makers more power to offer consumers non-Microsoft products such as rival Internet browsers, Internet service providers and media players.

The settlement also gives software developers increased ability to create rival products by requiring Microsoft to reveal technological secrets about the inner workings of Windows so competitors can ensure that their products will work as well as Microsoft’s own.

Experts and critics say, however, that the new restrictions are much weaker than those that were included in a settlement offer proposed last year before Microsoft had been found liable for breaking antitrust laws. In addition, the settlement does not expressly require Microsoft to acknowledge that it committed any antitrust violations.

To complicate the issue and ensure continued legal wrangling for months to come, nine of the 18 states that had joined the government’s case have refused to accept the settlement and will file their own proposals this week.

No agreement can take effect without the approval of a federal judge, and it is unknown how U.S. District Court Judge Colleen Kollar-Kotelly might react to the concerns of the nine opposing states. It is also uncertain whether her approval of a settlement would prevent the states, which may seek reimbursement from Microsoft for more than $15 million in legal fees, from proceeding with their own antitrust lawsuit against Microsoft. To approve the proposed November 2 settlement, Judge Kollar-Kotelly would have to find that it was in the public interest. The case is in the middle of a 90-day comment period, at the end of which Kollar-Kotelly will issue her ruling.

No Easy Remedies

Attorney General Miller is one of many who question whether the settlement hammered out after “days of round-the-clock negotiations really accomplishes what it purports to do … Numerous provisos and exceptions in the settlement may undercut or even swallow up the protections it contains. That’s why we are going forward with the remedy phase.”

Critics of the settlement acknowledge that there are no easy solutions to the Microsoft dilemma. “It’s like they are locking the barn door after all of the horses have gotten out,” says Aron. “Microsoft has more than 90% of the operating systems market and 90% of the office software market. If you stop them now, what are you going to gain? The question then becomes what happens in all of the other [areas] where Microsoft is [doing] very well and where it wants to become the standard, like it has in operating systems. The trick is becoming a monopoly without using anticompetitive practices.”

Adds Clemons: “If you believe there was no damage, then there shouldn’t be a need for a settlement at all. If you agree there was damage, then is the compensation sufficient to make restitution? I happen to be one of those people who believe that there is significant damage. The Department of Justice has established that. I don’t see that the amended decision provides any assurance against future abuse. If there was abuse, and I believe there was, then the settlement is wholly inadequate.”

“The main problem that has always faced the court, Justice Department and Microsoft,” says Dennis Yao, professor of business and public policy and a member of the Federal Trade Commission from 1991-94, “is that there is no suitable remedy that doesn’t do more harm than good. The Justice Department doesn’t like remedies that are regulation-oriented and that require continued oversight. That’s why they were interested so long in a structural remedy and a breakup. But they have given up on that.”

To Gerald Faulhaber, professor of business and public policy, a good remedy just doesn’t exist. “This was a case with no good remedy in any way,” he states. “It might have very well been the case that Microsoft did bad things. I think a good case can be made that they did. The issue, then, is what to do about it. I don’t think there is a good answer.”

As far as similarities between this case and the landmark AT&T breakup, Faulhaber says there aren’t any. “The AT&T case made some sense as a divestiture decision, but it didn’t make sense with Microsoft. This settlement didn’t do what it was supposed to do to separate monopoly versus anticompetitive practices. So what exactly will it do? Where we have gone is to a behavioral, not structural, remedy which says ‘don’t do these bad things’ in an attempt to keep Microsoft from some of its anticompetitive practices. But to be effective with this you almost need a regulator watching it all the time. These conduct and behavioral remedies just aren’t enough because Microsoft’s track record is that it will always find a way to get around them.”

A possible solution – although a drastic one – to the Microsoft monopoly issue was missed years ago, according to Faulhaber. “The only possible thing to have done was to have jumped in early and forced the company to open up its Windows code so everyone could see it. It would have been an aggressive [move]. We didn’t do it.”

Looking at the future, “how do we deal with the new economy firms, like Microsoft, in terms of antitrust?” Faulhaber asks. “Are they home free? How do we deal with the new economy in the long run? There are some very important issues and we don’t know the answers. Working with a standard is important, but if you do then you will have these short-term and long-term monopolies.”

Finding New Markets to Dominate

Another new economy firm involved in this drama is AOL Time Warner, which has been very critical of the November 2 settlement. It “does too little to promote competition and protect consumers, and can too easily be evaded by a determined monopolist like Microsoft,” the media giant says.

“Then what do we do with AOL?” asks Faulhaber, noting that AOL is similar to Microsoft in that they both dominate their markets. “We can’t deal with firms like these the same way we did with the auto and oil companies. In contrast to autos and oil, these new markets are driven by innovation with big network effects. With AT&T we could simply regulate it. We can’t do that here because it hurts innovation.”

Five years from now, adds marketing professor David Reibstein, what the Microsoft case may have accomplished is to “instill within the company a caution they may not have had previously. Unlike IBM, which in the regulatory environment of the 1970s was very conscious of its actions and made sure to manage its market share to keep it below a certain point, Microsoft was born in the 1980s, which was a Republican decade, under different rules. Because of that, Microsoft didn’t develop the kind of consciousness IBM did.”

Whether Microsoft will ever develop that kind of “market consciousness” will be debated for many years. Some experts predict that Microsoft will fall back into old habits and try to dominate other markets and products, but do it using different tactics that won’t raise anticompetitive charges.

Aron says the “action is almost over” in the PC industry and believes Microsoft will remain dominant in a “stagnant market.” But he says for Microsoft to justify its high share price it must become strong in new markets. He points to its .NET strategies as one area where the software giant will try to gain new dominance. “Where is Microsoft going to get its revenue in the future?” he asks. “Obviously, not just selling more copies of Windows XP. Certainly there is some money to be made there, but being a pure Windows play will not get the kind of revenues the company needs to maintain its high stock price. So it will look for new markets.”

Those markets, according to Aron, are in web services – .NET – and in video game consoles, notably the Xbox where Microsoft is launching a two-pronged attack – on the hardware business by manufacturing the console as well as on the software side. Microsoft has committed $500 million to marketing the Xbox worldwide over the next 18 months.

“They are willing to take losses until 2005 on the Xbox before they make a profit,” says Aron. “Should convergence take place with one box serving as your PC and game console, then Microsoft would be ideally positioned with its Xbox play and its operating system.”

But it is web services, namely its .NET strategy, which holds the most promise for future Microsoft revenues, according to Aron. Microsoft got to be “the behemoth it is because it took control of standards.” And, although it was late to embrace the Internet, Aron says Microsoft has caught up. “Microsoft wants to get its .NET strategy adopted as a universal standard. It wants to own the market with .NET and become a monopoly without using anticompetitive practices. One way it is doing this is by embracing third-party developers. In the end, Microsoft seeks ownership of the standard, like it has in operating systems, becoming the de facto sole player and generating a huge revenue stream.”

Aron says it’s not clear what will become the standard for web services or which company will be the standard setter. He says that IBM, Hewlett-Packard, Sun, and BEA Systems are serious challengers to Microsoft. “People have learned how Microsoft first embraces, then extends and then extinguishes the competition,” says Aron. “I don’t think the settlement does anything to stop those objectives. It just makes certain tactics no longer available. There is nothing in this settlement that says this practice is likely to stop.”

Aron points to the fact that as a standard like Windows or Microsoft Office grows, it greatly benefits from positive feedback. As more users adopt a platform, the value of the installed base increases almost exponentially. “Basically more begets more. When we have a product, like Windows, characterized by network externalities, you frequently have associated positive economic feedback. There are two sides to this story. First is that consumers are better off because they can share files with more people. If everyone moves onto the Microsoft Windows platform, that makes it easier to share.

“The other side of the story that is frequently being ignored by the news media is the positive economic feedback on the developer side,” continues Aron. “For example, if I’m developing an application and have to decide to write it for a platform, such as Windows, with 95% of the market, or write it for the other 5%, which includes Linux and a splinter group, which do I spend my time doing? The answer is simple: Windows, because it the most cost-effective application. So, more software is developed, and the more useful and robust the platform becomes, the more its market share increases. Microsoft went out of its way to treat independent software developers very well.”

Meanwhile, Microsoft also has to deal with the European Union, which has its own antitrust case against the company based on a complaint filed three years ago by Sun Microsystems. Sun had accused Microsoft of withholding crucial software codes and other information necessary for competitors to create compatible servers.

The European Union: A Check on Microsoft?

The EU already has issued a “statement of objections” against Microsoft claiming it illegally bundled its Windows Media Player software into the Windows operating system. Observers say the EU is concerned that Microsoft will use the media player to obstruct future access to emerging markets by rivals such as AOL Time Warner and RealNetworks. EU regulators also have said they believe that Microsoft’s power must be harnessed before it grabs control of new markets emerging from the wireless Internet. If it presses its case against Microsoft and wins, the EU would have the authority to impose financial penalties up to 10% of the company’s annual global sales.

Reibstein cites the EU case as a sign that Microsoft still faces some major legal battles. “You can imagine the EU wanting to reduce the power of a super non-European company and allow for the inroads of some European companies,” he says, noting that similar issues were raised with the proposed merger of GE and Honeywell. (The deal was squelched when the EU raised antitrust concerns over the aircraft systems divisions.)

And in still another twist on this case, Microsoft has also proposed to settle more than 150 class-action lawsuits – claiming the company overcharged consumers for the operating system and popular software programs, such as Microsoft Office – by agreeing to donate $1 billion worth of refurbished computers and Windows operating software to low-income school districts. The settlement would also apply to any claims pending against Microsoft.

But there is growing opposition to a deal that gives one million computers loaded with Windows to schools in need. On November 27, Federal Judge J. Frederick Motz questioned whether Microsoft’s plan would give it an unfair advantage in one of the few markets where it faces competition from Apple Computer. Currently, Apple has a 47% share of the U.S. school-computer market, while Microsoft’s Windows has 53%.

Providing free copies of Microsoft’s Windows operating system might “have an indirect anticompetitive effect” because schools would choose to receive computers compatible with Microsoft software “as opposed to buying” from Apple, the judge noted.

“The question in this case,” says Clemons, “is whether the remedy is correct. First, the schools were not the harmed parties. So it is restitution that is not going to the right group. The value of the restitution is less than the cost of the damage to the harmed consumers, who might otherwise have bought Windows at a lesser price. If you actually believe damage occurred to consumers, then this solution is wholly inadequate. If you don’t believe it was adequately deserved, then this seems to be a windfall for the schools.”

A Question of Standards

No matter what the final outcome of the Microsoft case – if there ever is one – the issue of how to deal with monopoly and anticompetitive issues in the new information economy will not go away.

“I think the main thing to understand,” says Yao, “is the difficulty of fashioning a remedy that will work now and in some sense work in the future without disrupting a very dynamic and innovative company and industry. Figuring out a way to reign in what people allege to be anticompetitive actions, which I agree with, is a very difficult problem. That is the starting point to begin to understand the Justice Department-Microsoft issues. And Microsoft knows it’s hard to come up with a remedy; that gives it more bargaining leverage as a result.”

Because the information economy depends on standards, it naturally lends itself to situations in which one firm may dominate, Yao says. “So it may be a problem we see in varying forms in the future.”