Carving Up Gates

By JOSHUA QUITTNER

All things considered, it must have been a crummy week to be the king of the software world. If you are Bill Gates (and come on, wouldn't you like to be?), you're used to being cussed by competitors, hounded by regulators and lampooned by late-night comics as the perfect--albeit perfectly rich--geek. But no one, not even Gates, could be comfortable with the idea that one's masterpiece--which happens to be the biggest and most powerful software company on earth--could be taken and sliced in two.

But that's precisely what state and federal trustbusters demanded last week. In a filing submitted to federal Judge Thomas Penfield Jackson, the Justice Department and 17 of the 19 states that have brought suits against Microsoft finally agreed: Microsoft should be chopped into two companies. One would develop and sell the Windows operating system that runs 85% of the world's desktop computers. The other business would handle everything else--most notably, the universally used "applications" software, such as Microsoft Office, which includes its dominant word processing and spreadsheet programs, and its Web-browsing Internet Explorer.

The two companies could not collude or cooperate in any way for 10 years. During that time, they would be required to strive ceaselessly against each other. Gates would have to choose which company to run and hold stock in--while competing with the other.

To antitrust chief Joel Klein, the plan strikes a perfect balance: "Neither the heavy hand of ongoing government regulation nor the self-interest of an entrenched monopolist will decide what is in the best interest of consumers," he says. "Rather, consumers will be able to choose for themselves the products they want in a free and competitive marketplace." Counters Gates: "We don't believe the courts are going to uphold this kind of unprecedented and radical regulation of our activities."

But beyond the angry words and legal documents, the proposed remedy marked the culmination of 23 months of state and federal pursuit of Microsoft and represents a clear watershed for the computer and software industries. The ruling that emerges from Judge Jackson's court, and from an appeals process that could last two more years, will do much to determine the course of software development for decades to come--and with it the programs that countless companies and consumers use.

For now, Microsoft attorney William Neukom plans to push for an extension of the company's May 10 deadline for responding to last Friday's Justice Department proposal. Microsoft will want "months and months" of additional hearings in front of Jackson, who ruled on April 3 that the company had illegally and repeatedly used its monopoly power to stifle innovation. A final decision by Jackson might not come until the end of summer. Even then, any breakup that the judge might call for would be on hold until the appeals process is done. That's why Klein and the states want Jackson's ruling to include immediate restrictions on Microsoft's conduct, including a measure that would bar it from retaliating against computer makers that load rivals' software on their machines. In addition, prosecutors want Microsoft to publish a price list that would apply to all its largest customers.

To some experts, the saga of Microsoft is little different from the tale of any other monumentally successful American business, such as Standard Oil and AT&T--both of which were broken up by court order. Like those behemoths, Microsoft saw which way the world was headed and got there first, seizing control of the software market in the process.

But modern capitalism has zealous watchdogs. In such cases, the government may rush in, point out that the game appears to be over, and bust up the winner for abusing its power. "I'm struck by how in past major divestitures like Standard Oil and AT&T, the defendants predicted calamity," says William Kovacic, a George Washington University law professor. "Both said that a restructuring would be destructive in the extreme, and both were wrong. The lesson that teaches me is that this is a highly resilient economy, that business people are highly adaptable, and a breakup might not hurt--and it might even help."

Tell that to Wall Street. Since Judge Jackson found on April 3 that Microsoft broke the law, the company's stock has plunged 34.4%, from $106.25 to $69.75 at the close of business Friday. Indeed, Jackson's ruling triggered weeks of gut-wrenching roller-coaster stock rides, particularly for technology shares, of which Microsoft has long been the leader. (Wait a second: Isn't this case supposed to help Microsoft's competitors? Many investors, however, just didn't see it that way.) To keep its employees from thinking of bolting, Microsoft last week doled out millions of dollars' worth of new options, exercisable at $66.62 a share.

That hardly soothed analysts, who continued to growl that the threat of a breakup clouds Microsoft's future. "We always had the view that a breakup of Microsoft is a negative, not a positive," says Paul Dravis, managing director of Banc of America Securities. The difference between the breakup of Standard Oil or AT&T and Microsoft, he says, is that the first two had physical assets--pipelines or phone lines. In the software giant's case, the assets are intangibles, such as intellectual capital, brand name and management, which could shrivel after a breakup. "At least with Standard Oil," says Dravis, "you still had the oil."

The harsh irony--one that Gates and other Microsoft officials are at pains to point out--is that this effort to defenestrate the company comes at a time when the world is moving away from personal computers to large-scale computer networks. And the very thing that Microsoft has a monopoly on, Windows, is hardly in demand in the emerging post-PC world. Its related operating system, Windows CE, is struggling for a foothold against the venerable Palm, which controls a Redmond-like 79% of the market for personal digital assistants. And Microsoft's online service, MSN, has fewer than 3 million subscribers--vs. 22 million for America Online--despite Microsoft's aggressive bundling of it with Windows.

But such marketplace realities have meant little to Klein and the state attorneys general, whose relations with one another have been contentious from the get-go. Some states first sought to charge that Microsoft's Office suite of programs--which include such software mainstays as Word, Excel and PowerPoint--has a monopoly of its own. But by April 1, a Saturday, all the trustbusters' positions were beginning to converge. That's when mediation talks between Microsoft and the prosecutors broke down, a development Klein learned about while working on the weekend in his third-floor office at Justice. That day, Klein polled five members of his core team and learned that none of them had been happy with the mediation talks anyway. Each and every one said, "Split the company in two," and then they all began to work on finalizing the details. "People have been in here night in and night out for the past several weeks," Klein says. "There are still pizza boxes in the hallways." The result was a breakup proposal that Justice then shopped to the mostly receptive states.

So would a breakup prevent future Netscapes--whose browser Microsoft ran over--from being illegally squashed? "It's a gamble," says lawyer and economist Robert Litan, of the Brookings Institution, who once worked for the Justice Department's antitrust division. Litan, who believes the Feds should go even further, joined three fellow economists in a separate brief that called for Microsoft to be split into three competing pieces. The trouble with Klein's remedy, Litan argues, is that where once there was one monopoly there now could be two--the applications and Windows sides--with the possibility that they will find a way to collude.

From Microsoft's perspective, no breakup is even remotely thinkable. Gates says it's functionally impossible to split the operating system from the applications side. Why? They're interdependent, he insists, and enhance each other. Microsofties point out that consumers, understandably, love that. Moreover, says Gates, "Microsoft could never have developed Windows under these rules." Indeed, by any measure, breaking up is hard to do.

--Reported by David S. Jackson/Los Angeles, Daniel S. Levy/New York and Viveca Novak/Washington

With reporting by David S. Jackson/Los Angeles, Daniel S. Levy/New York and Viveca Novak/Washington