• Chart: Pending Patent Infringement Suits

With the possibility of a government-mandated breakup safely behind it and other antitrust cases nearing resolution, patent and intellectual property lawsuits are emerging as Microsoft's largest legal battleground. Although these cases will never pose as much of a threat as the government's antitrust lawsuit, they might help major competitors, such as Sony and AOL, block Microsoft from gaining ground in new markets. Delay, which helped Microsoft in its antitrust battle, is less effective in these cases, and Microsoft will look to settle them with patent swaps or one-time payments. But it will remain reluctant to pay ongoing license fees.

Dot-Com Bust Could Spur New Litigation

In a speech to financial analysts in New York on Jan. 22, Microsoft Chief Financial Officer John Connors listed six reasons why the company maintains such a large cash hoard—US$43.4 billion at last count—relative to similar companies. The risk of payouts from ongoing antitrust litigation was not mentioned. Instead, Connors predicted "a big increase" in intellectual property and patent litigation "over the next several years" and suggested that Microsoft wanted to keep some cash on hand to fight these battles.

Patent infringement lawsuits are nothing new for Microsoft—the company has been involved in dozens since its inception, and has settled high-profile cases with companies such as Apple, Borland, and Priceline. But Microsoft is particularly wary of patent-related lawsuits now because of the fallout from the technology bust of the last two years. As Connors said, "a number of companies who did not survive the bubble…are turning to patent issues as a way to increase value or a way to extract cash from other companies." Microsoft's US$43 billion in cash makes it a prime target for these lawsuits. (For a partial list, see the chart "Pending Patent Infringement Suits".)

Most of the current crop of patent infringement lawsuits were filed by small companies that otherwise pose little competitive threat to Microsoft. Although relatively insignificant compared with the harm Microsoft could have suffered at the hands of the U.S. Department of Justice, these lawsuits will still affect the company in the following ways:

Perception. These suits contribute to the impression that Microsoft is not trustworthy in its business practices, making other companies hesitant to partner with it.

Distractions. Development teams could be distracted from creating new products, particularly if the plaintiffs obtain preliminary injunctions against specific products or technologies.

Money. Along with ongoing legal costs, Microsoft might have to pay cash to settle cases in which it's unlikely to prevail.

However, the most significant threat from these lawsuits is that they might attract the attention of a major competitor who could use the patents in question to delay Microsoft's expansion into a new or important market. As Eolas CEO Mike Doyle, who has sued Microsoft for infringing a patent for delivering interactive content in a Web page, suggested, "What if some other big player were to acquire or merge with us?"

Sony, Philips Back Intertrust in DRM Fight

This is precisely what happened to Intertrust, which owns 26 patents related to protecting digital data from unauthorized duplication and use. Since Apr. 2001, Intertrust has filed 144 infringement claims against 33 Microsoft products and technologies, including Windows, Office applications, the .NET Framework, and the Xbox game console. Although the case is still in the discovery stage and no trial date has been set, Sony and Philips, working through a joint venture called Fidelio, acquired Intertrust for approximately US$450 million in Jan. 2003. This is a fat premium for a company that reported profits of only US$5.0 million on US$8.8 million in revenues in its last quarter (ending Sept. 30, 2002) and whose total stockholder equity was just over US$100 million, suggesting that Sony and Philips were not interested in Intertrust solely for its existing business.

Rather, Sony and Philips made the purchase to gain the upper hand in the nascent market for digital rights management (DRM) technology. Broadly defined, DRM technology enables the creator of a digital file to control how others can use that file—for example, how many times they can open or copy it. DRM’s most obvious application is for protecting digital media content, such as music and movies, from unauthorized duplication and subsequent swapping on file-sharing networks.

Microsoft has provided DRM software for Windows Media files since 1999 and recently introduced a toolkit for content owners to protect content on CDs and DVDs. (See "Windows Media DRM Comes to CDs, DVDs".) It is also building a trusted computing platform, formerly code-named Palladium, that could provide the foundation for more secure DRM systems. Sony, which is a major content owner as well as a consumer electronics manufacturer, has supported its own DRM technology, OpenMG, in some of its devices, and is reportedly working on a successor. Philips has conducted its own DRM research, and teamed up with IBM in Sept. 2002 to develop a DRM system based on IBM's Electronic Music Management System (EMMS) technology.

Although technical flaws and consumer resistance have limited the market for DRM so far, all three companies see a huge opportunity: if any DRM solution becomes popular, its creator can extract license fees both from content owners, who will want to protect their material, and from the manufacturers of software and hardware, who will need to license the technology to unlock the content so it can be played. Microsoft, Sony, and Philips would all rather collect than pay these fees.

DRM is not the only area in which Microsoft could face a patent fight from a major competitor. In 2002, AOL received a patent covering many concepts used in instant messaging (IM), including a peer-to-peer communication network of terminals, the ability to detect other users' presence on the network, and the ability to create "buddy lists." (The patent was filed in 1997 by Mirabilis, which developed the first widespread IM system, ICQ; AOL bought Mirabilis in 1998.) Although AOL has indicated no plans to enforce the patent, it could eventually use it as the basis for lawsuits that could stall Microsoft's advances in real-time communications.

Likely Responses: Acquire Patents, Settle

Microsoft's response to patent infringement suits is driven by the imperative to avoid paying per-unit license fees, even if it means making large one-time payments. In general, Microsoft's preferred business model is to sell large volumes of relatively inexpensive software—as CEO Steve Ballmer has said, "When you multiply little numbers by big numbers, you can still get big numbers." Having to pay a per-unit license fee would turn this model on its head—the more units sold, the more Microsoft would have to pay—and would enable other companies to profit from Microsoft's distribution channels.

Microsoft will fight what it views as frivolous or ungrounded patent infringement suits for as long as necessary. However, tying up the issue in court, which has worked for Microsoft in some legal cases (particularly the federal antitrust suit), can backfire in patent infringement suits: the more units Microsoft ships in a certain market, the more it would have to pay if it lost a patent suit related to that market. In addition, delays create customer uncertainty, which hampers Microsoft’s ability to gain ground with emerging technologies such as DRM.

Thus, when facing a potentially difficult patent case in a strategic area, the company will probably pursue the two-pronged strategy it has used in past patent disputes:

Get similar patents. Microsoft will file for its own patents or acquire others' patents in the area in question. For example, after Intertrust filed its patent infringement suits, Microsoft patented its own plans for a trusted operating system in Dec. 2001 and paid struggling digital media company Liquid Audio US$7 million for DRM patents in Oct. 2002.

Settle. Microsoft will try to settle these disputes using a combination of patent swaps, one-time payments, or equity investments. However, it will avoid settlements that involve per-unit or periodic fees.

Resources

For background on the trusted computing platform formerly known as "Palladium," see "'Palladium' Plan for Trustworthy OS Revealed" on page 10 of the Aug. 2002 Update.

To search for a specific patent, see www.uspto.gov/patft/.