04/20/19 SCENARIO 3: THE FEDS SPLIT MICROSOFT IN TWO

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SCENARIO 3: THE FEDS SPLIT MICROSOFT IN TWO

The most extreme option open to the Justice Dept. is an outright breakup of Microsoft Corp. The government has rarely tried to split up monopolies, preferring less dramatic approaches. Yet from Standard Oil in 1911 through IBM and AT&T in recent decades, the willingness to use the ultimate remedy against excessively powerful companies has been a hallmark of U.S. antitrust policy. That's a key difference between the U.S. and countries such as Japan, which has built its economy around mammoth keiretsu--and appears to be suffering because of it.
While he's not ruling out a breakup, antitrust chief Klein has consistently said it's not a focus right now. But he faces a big problem: Piecemeal remedies may not get at the core issue--Microsoft's control of the operating system and its ability to leverage it in new markets. ''If you think the evil is the structure, then the only fix is by changing these structures,'' says Herbert Hovemkamp, a law professor at the University of Iowa. ''Conduct fixes will always look anemic.''
The most outspoken proponents of a breakup, not surprisingly, are Oracle's Lawrence J. Ellison and Gary L. Reback, an attorney with the Palo Alto (Calif.) law firm of Wilson, Sonsini, Goodrich & Rosati, which represents a number of Microsoft competitors.
CORE PROBLEM. But aside from well-known Microsoft foes, the breakup option is getting serious consideration from a growing number of antitrust experts. ''There is an underlying chronic problem, which is that Microsoft has been endowed by history with control over the operating system,'' says F.M. Scherer, a professor of corporate policy at John F. Kennedy School of Government in Boston. ''That is essentially a structural characteristic, and it isn't going to go away. You solve structural problems structurally, rather than by detailed regulation.''
In the long run, the most straightforward solution to the Microsoft dilemma may be to break it into two entities: an operating-systems company and an applications company. Paradoxically, breakup, the strongest government action, may come closest to being the free-market answer. The two new Microsofts would be allowed to compete in the market as aggressively as they wished, without bureaucrats hovering over their every move.
The idea has its merits. It would once and for all address critics' charges that Microsoft uses its Windows monopoly --and the hefty profits it generates--to gain an unfair advantage in other markets, such as office applications or Internet content. And severing the operating-systems business from the applications business would eliminate the potential for Microsoft to favor its own applications developers with early information about Windows.
Moreover, a breakup would alleviate the worry that a Goliath Microsoft will inevitably stifle innovation. Big companies do innovate, but incrementally. What they aren't so good at is more radical ''disruptive'' innovation.
''FAST FOLLOWER.'' Indeed, for all of Microsoft's success, most of the big new ideas in computing--whether graphical user interfaces or Web browsers--have come from others. The software maker has deftly learned to incorporate those ideas into its products. But many of its efforts to provide more value to customers, such as its current focus on simplifying Windows PCs, have come only after rivals have proposed alternatives--such as Sun Microsystems Inc. and Oracle Corp. did with network computers.
In the absence of a healthy competitive environment, the fear is that Microsoft would not be forced to improve its products rapidly. Nor would it have the necessary vision. Microsoft ''has been a tremendously successful fast follower, but almost to the point where there's no one to borrow ideas from anymore,'' says Paul Saffo, a director at the Institute for the Future.
Slowing innovation may not look like a problem now, given the high-tech sector's dynamism. But some wonder how long that will last if Microsoft is allowed to expand its hegemony in PC software to new areas such as the Internet. And though record numbers of software companies are being created each year, few of them ever reach a critical size. Most fizzle out or are swallowed up by bigger players--including Microsoft. If small, creative companies aren't allowed to grow and remain independent, innovation will be suppressed. Says Christensen of Harvard: ''The economy would be better off if disruptive innovators can play in this game.''
There are already signs of this ''innovation ceiling.'' Venture funding is up, but the number of software companies going public fell to 22 last year, nearly half 1995's number--though that was at least partly because 1996's software IPOs fared poorly. Venture capitalists steer a wide berth around startups that hope to build a business in any area Microsoft competes in. And promising startups such as Netscape, PointCast Inc., and Diba Inc. have seen their potential dimmed by Microsoft's long shadow.
If Microsoft is left alone, ''over the next 5 to 10 years, they will stifle innovation,'' says Stewart A. Schuster, a partner at Brentwood Venture Capital in Menlo Park, Calif. ''That's not good for the industry, consumers, or the U.S.'s lead in competitiveness.''
ENVIABLE POSITIONS. So what would a Microsoft breakup look like? Chairman Bill Gates, who owns 22.3% of Microsoft, would have to pick which side to stay with--the operating-systems company or the applications company--and divest from the other. Gates is so linked with the company he founded 23 years ago that it's hard to imagine any part of it not being run by him. But it seems obvious where Microsoft's soul resides. Jeffrey S. Raikes, a Microsoft group vice-president, sales and marketing, didn't hesitate when asked where he would go in the case of a breakup: ''With Bill.'' And where would Bill go? ''The Windows company.''
No matter which corner office Gates picked, the resulting ''Baby Bills'' would be in enviable positions. Indeed, each one would have its own monopoly: the operating-systems company with Windows and the applications company with Office 97--a suite of desktop applications that claims some 94% of that $5.2 billion market.
Office and Windows are Microsoft's biggest moneymakers, generating almost $5 billion each last year and nearly $2 billion apiece in 1998's first quarter alone. Their operating margins, 95% and 85%, respectively, are among the highest in the software business. Each company would have an army of roughly 5,000 programmers. The operating-systems company could be regulated. But if not, you could bet it would soon be competing with the applications company.
The advantages of such a split: increased competition and unleashed innovation. Consider, for example, the bust-up of AT&T. Under court order, AT&T's government-regulated telephone monopoly was ended, and long-distance service was opened to competition. The old monopoly company was split into the new AT&T, a long-distance carrier, and seven regional Baby Bell operating companies.
The effects were profound. Because of competition, prices plunged, quality improved, and innovation was spurred. Telephones proliferated in every color and shape imaginable. Today, the Baby Bells have a collective market capitalization approaching $300 billion, vs. $100 billion for AT&T. And Lucent Technologies Inc., the former AT&T equipment arm that was spun off in 1996, trails just behind its former parent at a $78 billion valuation. Prior to its 1984 breakup, AT&T's total market cap was about $60 billion.
LONG-TERM GAIN. Gates would ferociously fight any attempt to break up Microsoft. But even an unsuccessful breakup case brought against Microsoft could change the company's behavior and create more room in the market for rivals. Look at IBM. The government's attempt to slice up Big Blue in the 1970s and early 1980s rattled the giant and made it less willing to squeeze out startups such as Digital Equipment Corp.--and Microsoft. While many view this kind of government hounding as undesirable, the result was a thriving minicomputer and PC industry.
A breakup of Microsoft would have mixed results--especially in the short run. It would be unsettling for the rest of the industry because PC makers and applications developers depend on a steady march of Microsoft's operating-system upgrades to add capabilities to their products and drive demand by consumers and corporate customers. Any disruption hurts business. And a Microsoft split-up could cause enough confusion to temporarily stop customers from buying--putting a drag on the entire high-tech sector.
While a Baby Bill scenario would theoretically require less government oversight than middle-path regulations, it would still be messy, requiring heavy government supervision. ''I don't see a way to break up the company without regulatory oversight,'' says William E. Kovacic, an antitrust professor at George Mason University School of Law. ''There is no clean, attractive structural solution.''
In the AT&T case, a federal judge constantly had to monitor the division and resolve intercarrier pricing conflicts. Groups of people who had worked together for decades were split, some going to AT&T and others to the Bells. In some offices and switching centers, lines had to be drawn down the middle of the floor to delineate who owned what.
A Microsoft split would be equally complicated, if not more so. The company's 17,700 U.S. employees are concentrated in two locations in suburban Redmond, Wash.--a main campus with 30 buildings, and another, ''RedWest,'' down the road, with just five. Some 8,000 additional sales, marketing, and development employees are scattered across offices in 60 countries.
It's easy to see how the operating-systems people and the applications people could be divided--they're already organized into two separate divisions. But where would browser technology go--with the operating system or the applications? Like some of the middle-path remedies, this would put the government in the position of defining what makes up an operating system. And there's lots of arcane technology--such as a piece of basic building-block software known as
Active X--that pervades most of the company's products. There's no doubt that a split would mean a ''very messy, inefficient destruction of productive resources,'' says Lloyd Constantine, a New York antitrust attorney. ''They would have to cut some real important hoses and valves and connections.''
Breaking up Microsoft would be a high-risk undertaking. ''Structural remedies are big, they are blunt, they potentially have major consequences for the good and the bad,'' says Larry White, a New York University economist. A breakup would cause damage in the short run. But would it be worthwhile if it results in increased innovation and competition in the long run? That's the question.
By Amy Cortese and Mike France in New York, Susan Garland in Washington, D.C., Steve Hamm in San Mateo, Calif., and Michael J. Mandel in New York

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