A government witness from IBM Corp. today detailed the extraordinary troubles the world's second largest PC manufacturer had negotiating to license Microsoft Corp.'s Windows 95 operating system after refusing to abandon IBM's own PC operating system and other rival software products.
At one point, witness Garry Norris, program director of IBM's Network and Hardware Division, said a top Microsoft Corp. vice president, Joachim Kempin, proposed to IBM officials that they agree not to ship a competing office suite of software programs "for six months to a year" to settle the negotiations.
IBM refused to delay plans to ship that program, Smart Suite, which it acquired when it bought Lotus Development Corp. The company also reiterated its intentions to continue support of IBM's own competing PC operating system, OS/2. But IBM offered to pay Microsoft a lump-sum payment of US$10 million [M], commit in writing to paying interest and penalties if royalties weren't properly accounted for, and officials wrote personally to Bill Gates seeking ways to resolve a stalemate in negotiations.
Norris, who was testifying during his first day on the witness stand at Microsoft's antitrust trial, was the IBM official leading negotiations with Microsoft from 1995 to 1997. Despite IBM's efforts, the company did not sign a licensing agreement until 15 minutes before Microsoft's Aug. 24 Windows 95 launch event. At that point, IBM was the only PC manufacturer that hadn't reached a licensing agreement with Microsoft for the new operating system. That delay caused IBM to miss out on the spike in sales after the launch, the fall back-to-school season and to even be late on shipments for the Christmas season.
"There was a lot of pent-up demand for Windows 95," Norris testified. "As a result, we would miss that initial spurt in sales -- we missed that ... We were impacted measurably on our business."
Phil Malone, attorney for the U.S. Justice Department, asked Norris whether IBM considered shipping its computers with an alternative operating system. "We did our own studies," Norris replied. "We would lose 70 to 90 percent of PC volume sales."
Malone then asked whether there was "a commercially viable alternative."
"There was no place to go -- without Windows 95 you couldn't be in the PC business," Norris said.
The testimony from IBM, which had provided the government with another witness earlier in the trial to testify about Microsoft's actions to thwart OS/2, provided the government with a missing component that is key to its case. While other PC manufacturers had disputes with Microsoft over restrictions imposed in the Windows 95 licensing agreements, as documents entered into evidence have shown, none have provided witnesses to detail Microsoft's tactics in those negotiations. In fact, to date, the only other executive to testify from a computer manufacturer, John Rose of Compaq Computer Corp., was called by Microsoft.
The negotiations with IBM were a bit different than they were with other computer manufacturers. IBM produces both software and hardware and acts as both a Microsoft customer and competitor. Microsoft was upset at IBM's failure to satisfy an audit of royalties it owed Microsoft for past operating system licenses. In mid-July 1995, during the course of IBM's negotiations over a Windows 95 license, Microsoft tied the settlement of that audit to IBM's ability to license the software.
Norris said IBM paid Microsoft $40 million [M] for Windows royalties in 1995, $220 million [M] in 1996, $330 million [M] in 1997, and $448 million [M] in 1998.
The testimony today provided a glimpse into the way Microsoft prices its operating system software. According to a Market Development Agreement Microsoft proposed to IBM before negotiations for a licensing agreement could get underway, Microsoft would charge IBM $75 per machine for Windows 95. (Norris said that was a sharp increase from the Window 3.11 licensing fee of $9 per machine, which he agreed was a "favorable" price.) The fee for Windows 95 could be lowered if IBM agreed to meet certain conditions. One of those proposed conditions was "adopt Win95 as the standard operating system for IBM" which would result in a $3 per machine discount. Norris said that IBM wasn't able to qualify for all the reductions but suggested alternatives of its own and eventually discounted the $75 per machine rate by $15.
After the pricing structure was agreed upon, both sides entered into licensing negotiations. Norris said when he took over the lead in negotiations in March 1995, the two sides were able to make a lot of progress, reducing from 38 to 10 the points of disagreement. But starting in mid-June, Microsoft executives stopped returning phone calls, faxes were slow to be returned and the negotiations hit a wall.
Norris suggested that the negotiations with Microsoft hit a stalemate because IBM announced a hostile bid for Lotus in June and closed on its acquisition in early July. According to internal IBM e-mails, Kempin, who headed Microsoft's sales to computer manufacturers, heard a rumor that IBM was planning to pre-load the Lotus Smart Suite office software on all IBM PCs and offer to sell it to other PC makers for $5 per unit. Microsoft feared that such a move would cut into its profits on its Office line of software.
"LVG should have called Gates to explain," IBM's Tony Santelli, who managed one of IBM's computing divisions, recounted Kempin saying, in an e-mail to one of his superiors in June 1995. LVG refers to IBM chief executive Louis V. Gerstner.
By mid-July, Norris turned to his superiors for help. On July 20, 1995, IBM's senior vice president G. Richard Thoman wrote to Microsoft Chairman Bill Gates speculating that the relationship between the two companies "may be in even worse shape than I thought." "IBM's team has been very frustrated with the pace of these discussions as well as Microsoft's reluctance to accept proposals which appear to be in our mutual best interests," he wrote. "In spite of that, the IBM team believed that we would close an agreement, albeit in an excessive matter of time. Today, Microsoft introduced a new issue, the pace of an existing contract audit, the settlement of which your team wants as a condition of finishing the contract and shipping product. This is a complete reversal of Microsoft's prior position."
(Wasserman is Washington bureau chief for The Industry Standard.)