The U.S. Court of Appeals for the District of Columbia Circuit handed down a complex and mixed verdict in the Microsoft antitrust case, leaving plenty of room for interpretation and spin. Microsoft is claiming victory, noting that the threat of breakup has been lifted (for now), and stating, in the words of chief counsel Bill Neukom, that the company "prevailed on virtually all of the issues regarding product design." At the same time, Microsoft opponents have applauded the court's findings that Microsoft has violated federal antitrust laws in order to maintain its Windows monopoly.

The decision will affect Microsoft's future behavior and the eventual outcome of the case, including a possible settlement, and has implications for other technology companies that dominate their respective markets. Therefore, it is important to understand what the court actually said (and did not say) in its 125-page verdict.

Overview of the Verdict

In a unanimous (7-0) verdict, the appeals court made the following determinations:

• Microsoft enjoys monopoly power in the market for operating systems (OSs) on Intel-compatible PCs, as the district court found.
• Microsoft employed anticompetitive means to maintain its OS monopoly, although some of the actions the district court found illegal were, in fact, legal.
• The plaintiffs did not prove that Microsoft attempted to monopolize the Web browser market.
• Microsoft may or may not have broken the law by tying its Web browser to its OS, but the lower court needs to reconsider the evidence and either come up with a new judgment or justify its current judgment.
• The district court needs to decide on a new penalty based on complete consideration of the evidence. The original penalty—breaking Microsoft into two companies—is lifted for the time being.

In addition, the appeals court condemned Judge Thomas Penfield Jackson, the district court judge who heard the case, saying that he showed the appearance of bias by talking to reporters in secret during the case, and was guilty of judicial misconduct. This section of the decision will have little bearing on Microsoft or the technology industry, and therefore does not warrant further coverage here.

Microsoft Has Monopoly Power

In the first section of the decision, the appeals court judges affirmed the district court’s finding that Microsoft has monopoly power in the OS market for Intel-based PCs. Monopoly power is not illegal in and of itself, but a finding of monopoly power is a necessary first step in antitrust litigation.

Relevant market is OSs for Intel-based PCs. The district court defined the relevant market as operating systems for Intel-based PCs. Microsoft argued that Windows also competes against the Macintosh OS, OSs for non-PC devices (such as handheld computers and information appliances), Web portals (which can offer applications), and middleware (such as Java) that exposes its own APIs.

The appeals court disagreed with Microsoft on all of these counts, saying that the Macintosh was not readily interchangeable with Intel-based PCs and that handheld devices, information appliances, and Web site portals do not currently offer enough functions to compete realistically against a Windows-based PC. Most notably, the court said middleware did not provide a threat because it does not expose enough APIs to "serve as a platform for popular applications, much less take over all OS functions."

There is a significant barrier to entry. Although Microsoft has majority market share (which even the company acknowledged), this does not necessarily mean it has monopoly power. But the district court decided that a competing OS would have a hard time gaining market share because of a lack of applications; at the same time, developers would not want to waste time and money creating applications for an OS with very few users. The appeals court agreed that this "application barrier" gives Microsoft monopoly power in the OS market.

Direct proof of monopoly power is not required. Microsoft argued that, in order to be considered a monopolist, the court had to prove that its behavior is consistent with that of a monopolist. Microsoft pointed out that it spends large amounts on research and development, and keeps prices low—two things that a monopolist would not do.

The appeals court disagreed strongly, saying "Microsoft cites no case, nor are we aware of one, requiring direct evidence to show monopoly power in any market." Moreover, the court dismissed Microsoft's examples of its good behavior, saying that research and development and low pricing were not necessarily inconsistent with the behavior of a monopolist and could be used to delay the emergence of competition.

Microsoft Illegally Maintained Its Monopoly

Having established that Microsoft enjoyed monopoly power, the appeals court investigated whether Microsoft violated Section 2 of the Sherman Act by using anticompetitive means to maintain its OS monopoly. The appeals court did not consider any new evidence; rather it investigated the district court's judgments of law one by one, and upheld the majority of them.

OEM Agreements

Some of Microsoft's OEM agreements prohibited the OEM from altering the appearance of the Windows desktop (for example, by removing the Internet Explorer icon), from having certain screens appear during the Windows start-up process (for example, a sign-in screen for an ISP that allowed users a choice of Web browsers), and from using Windows Active Desktop to promote third-party products.

Microsoft defended these actions as necessary to protect its intellectual property, but the appeals court disagreed in strong terms, saying "Microsoft's primary copyright argument borders upon the frivolous." Instead, the appeals court agreed that these aspects of the OEM agreements made it hard for OEMs to promote Netscape Navigator, which, in turn, reduced the chance that Netscape and its companion technologies (such as Java) would eventually evolve into viable competitors to Windows. This excluded competition from the OS market, and therefore violated Section 2 of the Sherman Act.

However, the appeals court did agree with Microsoft that an OEM replacing Windows with a different shell would be a "drastic alteration of Microsoft's copyrighted work." Therefore, agreements preventing OEMs from using a new shell are legal.

Integration of IE with Windows

In a section that has caused some confusion, the appeals court said that some of the actions Microsoft took in integrating its Internet Explorer (IE) Web browser with Windows 98 were anticompetitive.

Specifically, the appeals court did not see enough conclusive evidence to overturn the district court's decision that Microsoft "commingled" IE code with Windows code in an illegal fashion; therefore, it upheld this decision. Additionally, the appeals court agreed that Microsoft's refusal to include IE in the "Add/Remove Programs" window in Windows 98 was anticompetitive. (The appeals court did say Microsoft was justified in having IE override a user's choice of Netscape for certain functions, such as when accessing the Windows 98 help file, which uses ActiveX controls not supported by Netscape.)

Some observers have wondered how the appeals court could say that commingling IE and Windows was anticompetitive and then in a later section say that the "tying" claim between IE and Windows was unproven. The difference is the affected market: here, the appeals court was addressing exclusionary conduct in the OS market. The appeals court found that Microsoft's commingling of code deterred OEMs from pre-installing rival browsers, thereby reducing these rivals' market shares, which in turn reduced "developers' interest in rivals' APIs as an alternative to the API set exposed by [Windows]." The tying claim investigated whether bundling the two products together constituted anticompetitive behavior in the browser market, as opposed to the OS market.

IAPs, ISVs, and Apple Computer

The appeals court investigated Microsoft's agreements with Internet access providers (IAPs, which include both traditional ISPs and online service providers such as AOL); independent software vendors; and Apple Computer, and found that many aspects of these agreements were illegal.

IAPs. Microsoft gave some IAPs prominent placement on the Windows desktop; in exchange, these IAPs were forbidden from promoting rival browsers. Microsoft was even stricter in some instances. For example, it forbade AOL to provide Netscape browsers to more than 15% of its users, even if more users requested it. Because these agreements closed off one of Netscape's major channels of distribution, they were illegal.

The appeals court did uphold Microsoft's right to give away both IE and the IE Access Kit (a product which allowed IAPs to create private-label versions of IE) for free. It disagreed with the district court's judgment that this constituted predatory pricing, saying, "the antitrust laws do not condemn even a monopolist for offering its product at an attractive price."

ISVs. In 1997 and 1998, Microsoft entered into a series of "First Wave" agreements with ISVs. In these agreements, Microsoft offered early Windows betas, technical information, and the right to use certain "seals of approval." In exchange, ISVs had to make IE the default browser for any application that was developed with a hypertext-based interface. The appeals court agreed that these deals excluded Netscape as a potential Windows competitor, and therefore violated Section 2 of the Sherman Act.

Apple Computer. In one of the most scathing indictments of the original trial, the district court cited e-mail from Bill Gates in which he discussed threatening to cancel Office for the Mac unless Apple agreed to use IE as the default Mac browser and stop promoting Netscape. Shortly after this, the financially strapped Apple— whose very existence would have been threatened by the cancellation of Office— capitulated. The appeals court agreed that Microsoft's dealings with Apple on this point violated the Sherman Act.

JVM Was OK; JVM Promotion Wasn't

Microsoft created and promoted a Java virtual machine (JVM) that allowed Java applications to run faster on Windows (a Java virtual machine translates Java code into instructions for each specific OS). However, Microsoft's JVM was not compatible with the JVM created by Java inventor Sun Microsystems, and Java applications created with Microsoft's Java development tools, although perfectly tailored to Microsoft's JVM, would not always run on other platforms. This effectively undermined the "write once, run anywhere" capability that made Java appealing to developers in the first place. (Sun and Microsoft recently settled a long-standing suit over the JVM and Java; see "Java Suit Settled" on page 31 of the Mar. 2001 Update.)

The appeals court, reversing the district court, said that the JVM itself was legal. First, "a monopolist does not violate the antitrust laws simply by developing a product that is incompatible with those of its rivals." Second, there was a legitimate competitive reason for the JVM: it allowed developers to create Java applications that ran faster on Windows, thereby making Windows a more appealing OS.

However, many of the things Microsoft did to promote its JVM were designed to prevent Java from emerging as a viable Windows competitor, and were therefore illegal:

• Microsoft signed First Wave agreements with ISVs that required them to use the Microsoft JVM.
• Microsoft threatened Intel, which was working on a JVM for Intel-based PCs that would have been truly cross-platform compatible, by promising support to Intel competitor AMD; Intel later capitulated to Microsoft's demand and dropped its JVM project.
• Microsoft "intended to deceive Java developers" into thinking that applications created with its Java development tools would be cross-platform compatible. According to internal e-mails presented as evidence, Microsoft hoped to create a large market for "polluted" Java, and destroy the market for cross-platform Java in the process.

Other Monopoly Maintenance Points

The appeals court addressed two other issues related to the monopoly maintenance claim. First, the district court had decided that Microsoft was not only liable for each of its individual anticompetitive acts but was also liable separately for the total effect of these acts in conjunction with some otherwise-legal actions it took. The appeals court disagreed, and threw out this "general course of conduct" claim.

Second, the appeals court disagreed with an argument Microsoft made on appeal. Microsoft said plaintiffs should have to prove that its anticompetitive actions were directly responsible for its continuing monopoly in the OS market. The appeals court disagreed. In other words, Microsoft can be held liable for monopoly maintenance even if it was only trying to squash potential, as opposed to immediate, threats.

Attempted Monopolization Claim Reversed

The district court ruled that Microsoft used its power in the OS market to try to monopolize the browser market. The appeals court disagreed and reversed this decision. However, this reversal was based on inadequate arguments by the plaintiffs and cannot be construed as vindication of Microsoft's behavior.

The appeals court said the plaintiffs made no effort to define the relevant market for Web browsers, a necessary precursor to proving attempted monopolization in that market. In addition, the appeals court said the plaintiffs failed to show that there were significant barriers to entry in that market and offered "little more than conclusory statements." In concluding this brief section, the appeals court harshly noted that "there is no reason to give [the plaintiffs] a second chance to flesh out a claim that should have been fleshed out the first time around."

Tying Claim Must Be Reconsidered

In antitrust cases, "tying" is defined broadly as forcing users to buy two products together instead of offering them separately—for example, forcing a consumer to pay for 40 rolls of film at the same time she purchases a camera. Tying may be illegal when a monopolist does it, because it makes it difficult for other companies to compete in the market for the tied product (i.e., it would be hard to sell film when every new camera already comes with 40 rolls). In turn, this could lead to reduced customer choice and higher prices.

The district court found that Microsoft violated Section 1 of the Sherman Act by unlawfully tying its browser to its operating system. However, the appeals court vacated and remanded this judgment. This does not mean the tying claim was reversed or thrown out, but that the district court made its judgment based on invalid case law and insufficient evidence. The appeals court sent the tying claim back to the district court for a new judgment and laid down very strict parameters within which the plaintiffs must re-argue the claim.

Case-by-Case Determination of Tying

The appeals court noted that much of the existing case law on tying is inapplicable to the software market generally, and to the IE-Windows tie specifically. It also acknowledged that an outright ban on the ability of companies to take features formerly included in separate software products and combine them in a single product could have a chilling effect on innovation in the software industry.

Among other points, the court said that merging products in the software industry "may produce efficiencies that courts have not previously encountered," thereby rendering past case law irrelevant. For example, bundling browser APIs with the OS allows an ISV to count on the existence of those APIs. Without this benefit, an ISV would have to expend resources determining which browser APIs were necessary for its application to work properly, determining whether they were present, hunting the absent ones down, and then bundling them with its application. All this could lead to higher costs, which would be passed along to consumers.

In addition, the appeals court noted that Microsoft is in a unique position because its browser and OS were more technically integrated than comparable products from any other company. Therefore, comparing Microsoft with other companies that also sold an OS and browser (including companies that, unlike Microsoft, offered an OS and browser as separate products) would be like comparing "apples and oranges."

The end result was that the appeals court felt uncomfortable banning software tying on a "per se" basis, as the district court had done. Instead, it deferred to the "rule of reason," saying that each tying claim must be decided on a case-by-case basis that closely examines the relevant market.

The appeals court also laid down some new rules that will make it substantially more difficult for the plaintiffs to argue the tying claim for a second time. The claim must be limited to harm in the Web browser market that stems directly from Microsoft's action of including a Web browser in Windows, and the plaintiffs must prove that, on balance, everything Microsoft did in integrating the two products was done more to exclude competition (anticompetitive) than to improve its Web browser (procompetitive). Additionally, the lower court must consider Microsoft's pricing of IE and Windows, an area that was ignored last time.

Penalty Must Be Redecided

Finally, the appeals court also vacated and remanded the district court's final judgment, including the order to break Microsoft in two, and said that a different judge on the district court would have to reach a new decision. It provided several reasons for this action:

• The district court held no hearing during the remedy phase to consider the evidence for and against a breakup, even though Microsoft wanted to present evidence about the effect of a breakup order on stockholders and consumers.
• The district court failed to provide adequate reasons for its remedies.
• The appeals court has redefined the scope of Microsoft's liability (including throwing out the "general course of conduct" liability claim), which requires a new penalty decision.

Although it did not preclude a breakup order entirely, the appeals court did suggest, in very strong language, that the district court needed to consider all the effects of a breakup before deciding on such a harsh verdict. In particular, the appeals court noted that breakup orders of unitary companies (companies such as Microsoft that have grown primarily through organic means, rather than through acquisitions) are very rare historically, and enormously difficult to carry out logistically.

Also, the appeals court said the lower court should consider whether Microsoft's illegal conduct (as discussed above in the monopoly maintenance section) actually helped it maintain its OS monopoly. Based on past case law, a structural remedy— such as breakup—that is "designed to eliminate the monopoly together" should be handed down only when there is "significant causal relation" between a company's behavior and its monopoly status. Otherwise, the suggested remedy is merely "an injunction against continuation of [the illegal] conduct."

Resources

The entire text of the appeals court's decision is at http://pacer.cadc.uscourts.gov/common/opinions/200106/00-5212a.txt, or at www.microsoft.com/presspass/trial/appeals/06-28opinion.asp.

A transcript of the Microsoft press conference about the decision, including comments from Bill Gates and Productivity and Business Applications Group Vice President Jeff Raikes, is at www.microsoft.com/presspass/trial/jun01/06-28newsconftrans.asp.