ANALYSIS by Susan Garland

MICROSOFT GETS THE FIRST LAUGH

The Justice Dept. always knew it faced an uphill battle in its Windows 98 antitrust case against Microsoft Corp. One insider recently chuckled that it didn't hurt the government's image to appear as the David fighting the well-armed and high-priced legal forces of Bill "Goliath" Gates.

But government lawyers aren't laughing now. The software giant won the first round in its showdown with Justice, and won it big. On June 23, the U.S. Court of Appeals overturned an injunction that banned Microsoft from forcing computer makers to carry its Internet Explorer as a condition for licensing Windows 95. But the panel's 2-1 ruling also could undermine Justice's second, and more important, lawsuit charging Microsoft with illegally integrating the browser into Win 98.

The court, essentially, backed Microsoft's longtime practice of adding new features to its dominant Windows operating system. It noted that a company can integrate features when there is a "plausible claim that it brings some advantage." Says Chicago antitrust attorney Hillard M. Sterling: "The ruling shakes the pillars of the government's larger case." (For more on the possible outcomes for the case, see BW, June 29, 1998, "Microsoft vs. the Feds: Oddsmakers Bet on Bill.")

Microsoft officials were jubilant. General Counsel William H. Neukom says the decision "does have bearing on the Windows 98 litigation. It's fully consistent with Microsoft's position: Integration in a product like ours is fully legitimate if it offers some benefit to consumers."

The Appeals Court ruled on procedural grounds that U.S. District Judge Thomas Penfield Jackson erred when he issued the preliminary injunction against Microsoft in December. The higher court said the judge overstepped his bounds because the government had not even sought an injunction when it filed its suit last October. Justice had asked the court to hold Microsoft in contempt for violating a 1995 consent decree by tying its browser to Win 95. The court agreed with Microsoft's argument that the company never had a chance to argue against the injunction.

But the court used the ruling to go far beyond the procedural issues -- with implications, according to several antitrust experts, for Justice's broader, antitrust case that was filed on May 18. Justice is arguing that Microsoft, by integrating Internet Explorer into Win 98, is using its monopoly power in operating systems to win control of the browser market and Internet commerce. The government is seeking to force Microsoft to either unbundle its browser from the operating system or to carry a browser made by its Netscape, its chief competitor. A trial is set for Sept. 8 before Jackson.

Justice is arguing that such integration is an illegal "tie" under antitrust law. Government lawyers intend to point to precedents that ban monopolists from bundling functions if there is separate consumer demand for each product.

But the opinion, written by Judges Stephen F. Williams and Raymond A. Randolph (with Judge Patricia M. Wald dissenting in part), knocked down a key precedential case that Justice intends to use to buttress its claims. The ruling noted that integration would be acceptable if there is some improvement in performance that consumers couldn't achieve on their own. The court says Microsoft seems to have shown that there are "benefits to its integrated design as compared to an operating system combined with a stand-alone browser such as Netscape's Navigator."

Robert Lande, an antitrust professor at the University of Baltimore School of Law, says this bodes badly for a case on Win 98, which has functions more tightly integrated than Win 95. "The court is saying that Windows 95 is one product," he says. "If that is true for Windows 95, then it is a thousand times more true for Windows 98. The government [case] is dead."

Justice Antitrust Div. chief Joel I. Klein, who has criticized Microsoft in harsh terms in the past, is remaining mum on his next move. Justice issued a terse statement after the Appeals Court decision: "We remain confident that the evidence and our legal arguments in our antitrust case filed on May 18, 1998, will demonstrate that Microsoft's conduct has violated antitrust laws."

Though there's no guarantee that Justice will draw the same appeals panel in its monopolization case, the decision still could be influential with other judges in the circuit. It also sends a strong signal to Jackson to tread carefully. And it virtually guarantees a trip to the Supreme Court.

Antitrust experts note that even if the same panel oversees the broader case, a full antitrust trial with new evidence could change the judges' minds. Justice lawyers are armed with documents that they say prove Microsoft integrated Internet Explorer into Windows with the sole intent of monopolizing the browser market. If that's the case, government attorneys will argue, improved benefits are irrelevant.

Even so, Justice lawyers will be hard-pressed to persuade the court to rule for its controversial remedy of forcing Microsoft to carry Netscape's browser. The judges strongly noted that courts have been averse to making decisions on product design. Says William E. Kovacic, professor of antitrust at George Mason University School of Law: "The prospect of a robust remedy is disappearing in the twilight here."

Garland is covering the battle between Justice and Microsoft from Business Week's Washington bureau

Edited by Richard S. Dunham