Microsoft's Six Fatal Errors

It was a bleak winter day in early 1998, and Microsoft's lawyers had come from Redmond to appear before Judge Thomas Penfield Jackson in the other Washington. In a legal clash predating the landmark antitrust suit, Jackson had asked the company to remove its Web browser from Windows 95 on the grounds that forcing the browser on PC makers violated a prior pact with the Feds. Microsoft said a separation was technically impossible. But to comply with the judge's order, the company produced one browser-free version of Windows 95 so old that its shelf life was even shorter than Bill Gates's temper. Another browserless version was so broken its only feature was an error message. The judge was clearly angry that Microsoft insisted the only way to comply with his order was to ship defective products. It was a hardball maneuver that cost Bill Gates & Co. dearly.

The judge's frustration had been mounting. Already in this early skirmish, Microsoft had submitted a legal brief questioning the technical know-how of Justice Department attorneys--and by extension the judge--who "have no vocation for software design." It also went over his head to the appeals court. Ultimately siding with Microsoft, the appellate judges overruled Jackson and told him the courts shouldn't be software designers. For Gates's empire, it was a short-lived victory. Looking back recently, one Microsoft insider said that first round clearly came at a high price: "We shouldn't have pissed off the judge."

Last week Jackson ordered the biggest software redesign Microsoft has ever known, concluding that splitting the software giant into two independent companies was "imperative." In one of the few court-ordered breakups over the past 100 years, the judge endorsed the government's plan to create one company that would sell Windows and another that would sell everything else. Jackson's strongly worded opinion left little doubt why he went for the ax, as opposed to milder restrictions: Microsoft's bad attitude. First, he said, the company consistently maintained that it has done nothing wrong. Second, Microsoft could continue to flout the law and unfairly bully competitors. Last, referring to that first encounter more than two years ago, he called Microsoft "untrustworthy." Elaborating on the Windows incident, Jackson told NEWSWEEK, "I found their compliance to be less than genuine." Microsoft's attitude calls for the kind of remedy that it can't weasel out of, the judge seemed to say, because it has been a weasel before.

If upheld, Jackson's order, aside from causing the biggest Windows crash in the company's 25-year history, would bring an end to a software empire that became the planet's most valuable company and an engine of the New Economy. Some--Microsofties among them--will blame the judge. Some will blame an overzealous government that has unsuccessfully tried to rein in Microsoft for more than a decade. A NEWSWEEK reconstruction of the key moments on the road to Microsoft's Judgment Day, however, suggests that the most likely culprit is the same defiant corporate culture that made Microsoft so successful in the first place. In the marketplace, rough-and-tumble tactics can be a virtue, but in the legal arena, Microsoft's blood sport backfired--at least with this judge. One critical turning point: Gates's own videotaped deposition in which he ducked questions and denied the obvious. After the tape was played in court, Jackson noted that Gates wasn't "particularly responsive." Watching the video, the judge wagged his head and rolled his eyes. And he practically double-dared the chairman to testify. "Microsoft took a scorched-earth approach," says Howard University law-school professor Andrew Gavil, "and they got scorched."

Just after the judge's decision, Gates blasted the order as "an unwarranted and unjustified intrusion" but also appeared almost relieved to be heading to any courtroom other than Jackson's. "People say a lot of things about us," Microsoft CEO Steve Ballmer told NEWSWEEK. "But never has anyone said we're untrustworthy." The company likes its odds on appeal. Microsoft's lawyers and executives will be upgraded to geniuses if their reading of the law squares as well with higher courts as it has in the past. Jackson has had his fair share of reversals. The company has plenty of supporting law to lean on, as well as public support from two thirds of Americans. And many antitrust experts think the company won't be broken up even if higher courts find some violations. With the exception of last week's disaster, Microsoft has had a string of successes in the courtroom. "The company is fundamentally arrogant when it comes to litigation," says one company insider, "because it has historically won." Along with the early Windows misstep, there are five other moments that led Gates & Co. to its gloomy Judgment Day:

Let's Not Make a Deal In May 1998, in the weeks before the government filed its latest antitrust action against Microsoft, antitrust chief Joel Klein and Gates met at the offices of Microsoft's lawyers in the capital. Their conversations went well enough that "it looked like we were going to have a settlement," recalled David Boies, Klein's chief prosecutor. But when William Neukom, Microsoft's natty general counsel, met with Klein and officials at the Justice Department on May 15 in an eleventh-hour effort to head off litigation, each side quickly felt the other wasn't serious about settling. By their Saturday-morning meeting, Microsoft thought the government wasn't willing to negotiate; the Feds thought Microsoft was backtracking on its concession to give consumers a choice of browsers. Talks collapsed by midday. "For reasons I will never understand," said one official in the negotiations, "Microsoft was not prepared to implement the settlement." The following Monday, May 18, when Microsoft started shipping Windows 98 with its browser built in, Klein filed the lawsuit, accusing the company of trying to extend its Windows monopoly to the Internet. The news shaved $10 billion off the value of Microsoft shares in a single day.

If Microsoft had offered to give consumers a choice of browsers and give PC makers more control of software they wished to promote, the government's case might never have been filed. "It would have blunted the case," conceded one government official. Such a settlement would have spared Microsoft the subpoena wars that allowed the government to rifle through more than 3 million company documents and produce one damning e-mail after another. ("This antitrust thing will blow over," Gates purportedly said, according to one of the government's favorite documents.) The hunt only served to broaden the charges against the software giant. "At that point, we were not aware of all the powerful evidence that later would be disclosed," said Connecticut Attorney General Richard Blumenthal, "and that led to heightened demands for stronger remedies."

Candid Camera It was August 1998, and Bill Gates was under oath. In a Redmond conference room filled with leather chairs and a government video camera, Gates sat next to three Microsoft lawyers he apparently didn't think he needed. He refused to answer questions on his own during the 30-hour deposition. Shifting and rocking in his chair, he appeared either petulant, contemptuous or bored. Whether Gates received good coaching from his lawyers or ignored it may never be known. He quibbled over the meaning of the simplest words ("compete" and "ask" were real stumpers). And on the occasions that he remembered e-mails he authored, he denied knowing what he meant by them. The same detail-oriented, driven genius who created the world's most valuable company--and a GDP-size fortune of his own--was seemingly out to lunch.

The video was a turning point for three reasons. First, it indicated that Gates & Co. were more confident than careful. "Nobody realized," admitted one Microsoft insider, "they were going to be able to play the Gates video in trial"--which they did, starting just after the gavel fell on day one. (Microsoft says the judge admitted the video into court after he originally said he wouldn't.) The video also set the stage for a massive credibility attack on the company, casting doubt on the dozen Microsoft witnesses who followed. Any judge weighing conflicting testimony is inclined to accept the more believable witness. And from his first ruling it was clear that none of Microsoft's witnesses convinced the judge of anything. "Credibility, in general and in the abstract," Jackson said last week, "is very important." The video seemed to head off any argument from Microsoft's lawyers that the company's aggressive tactics were the work of rogue employees. Finally, antitrust experts think the video was a blown opportunity to introduce themes for the defense that could be reinforced throughout the trial. The company failed "to use the deposition as a chance to create a commercial," says George Washington University law-school professor William Kovacic. Instead, the government put it on heavy rotation.

The E-Mail Trail By January 1999, as Microsoft began its defense, the credibility attack seemed to be working. Typically, each of the company's witnesses would give no ground in testimony, only to be embarrassed when Boies produced an e-mail that directly refuted his or her version of events. The darkest day of testimony was when Microsoft's lord of Windows, Jim Allchin, took the stand. Far from the stereotype of the rabid Microsoft executive, Allchin is a soft-spoken man whose silver hair and pale complexion suggest he's been weathered by years of hard work. Antitrust experts say Allchin was a perfect example of a missed opportunity to explain the wonders of Windows and how trifling with it would be dangerous. Instead, a videotape intended to demonstrate that Microsoft couldn't separate the browser from the operating system without damaging Windows looked doctored. Icons on the computer screen in the tape mysteriously appeared from one moment to the next. As Boies pointed out inconsistencies, the judge watched, head in hand. "It simply casts doubt on the reliability--the entire reliability--of the video demonstration," Jackson finally intoned. It was as if Microsoft hadn't taken the case seriously enough to make sure everything was Boies-proof.

None of these courtroom gaffes might have mattered; they could have been dismissed as theatrics with no bearing on the law--a point Microsoft made almost every day on the courthouse steps. But in his findings of fact issued last November, the judge's first ruling, Jackson quoted Allchin's e-mail at length and identified him as the mastermind behind the strategy to crush rival Netscape by bolting Internet Explorer to the operating system. It was just the kind of monopoly leveraging--using one monopoly product to enter into a new market--that sets off antitrust alarms. And there it was in Allchin's e-mail: "We must leverage Windows more." To the judge, no courtroom testimony could explain that e-mail away.

By the time Microsoft's final witness took the stand in February 1999, the judge seemed to have had enough of Microsoft's denials. Microsoft's last witness, group vice president Robert Muglia, was trying to explain a piece of Gates's e-mail in which the chairman appeared to be trying to hobble a competitor. After the judge expressed doubt about Muglia's gentler spin, Muglia persisted. Jackson erupted in one of his angriest outbursts. Pointing at Muglia he yelled, "No! Stop!" and then called a recess.

'Still in Denial' Just days earlier Microsoft had taken its second stab at a settlement. In three meetings at the Justice Department beginning on Feb. 24, the two sides sat down to talk. Microsoft submitted several drafts to Klein. "We put three proposals on the table," said one Microsoft insider. "We felt like we were offering more." But more wasn't enough. The government, which was considering a breakup even then, wanted Microsoft to submit to curbs on its behavior. Microsoft refused many of them, such as putting government-appointed people on the board. To Microsoft, the government was simply taking control of the company and nationalizing it. To the government, "they were still in denial that they would lose," said Boies. The government believed Microsoft was submitting the same settlement proposal it had offered before the trial began. By the last meeting on June 2, the talks had stalled.

A month earlier Jackson set up a procedural framework that would give Microsoft another opportunity to settle. In an unusual move, he decided not to release his findings of fact (his decisive version of the facts) and his conclusions of law (how those facts overstepped antitrust law) simultaneously. Instead, he staggered their release. That way, he could focus both sides on arguing the same set of facts--his own. And by releasing his facts first, he would tip his hand and give the losing side incentive to wrap up the case.

That incentive arrived in Redmond on Nov. 5 last year. If Microsoft had missed any prior signals that things were going badly, only a megaphone might have been clearer than Jackson's findings of fact. Of the document's 412 paragraphs, no more than four looked favorably on Microsoft.

The Last Dance Weeks later Jackson appointed Judge Richard Posner, one of the most respected jurists in the country, to try to make a deal. A prolific author and revered professor, Posner is most importantly a member of the Seventh Circuit Court of Appeals and is well schooled in the economic and legal gymnastics of antitrust law. In a case certain to be appealed by either side, there was perhaps no one better to peer over the legal horizon and give both sides enough to worry about to make a settlement look irresistible. Posner met with both sides separately, probing the facts and the elasticity of each side's stance. He met privately in Chicago with Gates, who convinced the judge, himself a conservative wary of government intervention, that a breakup was out of the question.

There was a moment of hope in February. Posner asked the government if it was willing to set aside breakup proposals and base a settlement on rules that Microsoft must live by. Though some of the 19 states that were also parties to the suit opposed the idea, the Feds decided that they could live with "conduct remedies" if it meant they'd be implemented quickly, rather than at the end of protracted litigation. It was a major concession, one that could have given Microsoft one last opportunity to dodge the breakup bullet. But to Microsoft, the conduct remedies were "effective breakups anyway," said one Microsoftie. And the company didn't want to strike a deal with the Feds if the 19 states wouldn't also agree to it.

The government, for its part, believed Gates & Co. weren't going far enough and hadn't faced the fact they were about to lose in court yet again when the judge issued his conclusions of law. "Microsoft's argument kept coming down to: we're not really a monopoly, so we should be able to do what we want," Boies explained last week. "They were not willing to constrain their conduct in any way." By Saturday morning, April Fools' Day, Posner, sensing that the gap between the two sides couldn't be bridged, called off the talks. They headed back to the courtroom, and last week the judge issued his devastating ruling.

Now Microsoft faces an uphill battle to reverse the judge's decision. It has delayed the breakup pending an appeal and is trying to hold off the conduct restrictions that Jackson imposed. It may be even harder to reverse the collateral damage from the rulings. Goldman Sachs analyst Rick Sherlund estimates that the lawsuit has lopped off as much as $175 billion from Microsoft's market capitalization. The expense of the suit, the distraction and the demoralization of the past two years have taken an emotional toll. Some employees, once true believers, are now skittish, wondering for the first time whether they should head for the exits. And what about the confidence of customers and software partners? "It's not something you put in a spreadsheet," says Sherlund. "But it is something that concerns us."

Private antitrust suits are also threatening the company. Had Microsoft settled, it could have prevented last week's ruling. Instead, for the roughly 170 law firms pressing 137 lawsuits against the company, the document is Exhibit No. 1 in their effort to prove that Microsoft harmed consumers. Though many of the cases won't prevail, any that do will win treble damages. That dollar figure, says high-octane class-action lawyer Stanley Chesley, "could be in the billions." That may not dent the company's $21 billion war chest. But Chesley vows to exercise the right "to take the deposition of every major officer of Microsoft."

Now Microsoft's fate rests in the hands of higher courts. If the company wins, the victory would be more stunning than the government's. But it's a win so costly that it could still seem like a loss.