The History Between IBM and Microsoft

4. IBM

5. IBM is both a hardware and a software company. On the hardware side, IBM manufactures and licenses, among other things, Intel-compatible PCs. On the software side, IBM develops and sells, among other things, Intel-compatible PC operating systems and office productivity applications.

   
   

   The IBM PC Company relies heavily on Microsoft’s cooperation to make a profit, for few consumers would buy IBM PC systems if those systems did not work well with Windows and, further, if they did not come with Windows included. IBM’s software division, on the other hand, competes directly with Microsoft in other respects.

   
   

   For instance, IBM has in the past marketed OS/2 as an alternative to Windows, and it currently markets the SmartSuite bundle of office productivity applications as an alternative to Microsoft’s Office suite.

   
   

   The fact that IBM’s software division markets products that compete directly with Microsoft’s most profitable products has frustrated the efforts of the IBM PC Company to maintain a cooperative relationship with the firm that controls the product (Windows) without which the PC Company cannot survive.

   
   

6. Whereas Microsoft tried to convince Netscape to move its business in a direction that would not facilitate the emergence of products that would compete with Windows, Microsoft tried to convince IBM to move its business away from products that themselves competed directly with Windows and Office.

   
   

   Microsoft leveraged the fact that the PC Company needed to license Windows at a competitive price and on a timely basis, and the fact that the company needed Microsoft’s support in many more subtle ways.

   
   

   When IBM refused to abate the promotion of those of its own products that competed with Windows and Office, Microsoft punished the IBM PC Company with higher prices, a late license for Windows 95, and the withholding of technical and marketing support.

   
   

7. In the summer of 1994, the IBM PC Company told Microsoft that, with respect to licensing Microsoft’s operating-system products, it wanted to be quoted terms just as favorable as those extended to IBM’s competitor, Compaq. It was IBM’s belief that Compaq paid the lowest rate in the industry for Windows and enjoyed unparalleled marketing and technical support from Microsoft.

   
   

   In response to the IBM PC Company’s request, Microsoft proposed that the companies enter into a “Frontline Partnership” similar to the one that existed between Microsoft and Compaq.

   
   

   Pursuant to that proposal, Microsoft and the IBM PC Company would perform joint sales, marketing, and development work, and the PC Company would receive future Microsoft products at the lowest rates in the industry.

   
   

8. At the same time that it offered the IBM PC Company the rather general terms in the Frontline Partnership Agreement, Microsoft also offered the PC Company specific reductions in the royalty rate for Windows 95 if the company would focus its marketing and distribution efforts on Microsoft’s new operating system.

   
   

   Specifically, the PC Company would receive an $8 reduction in the per-copy royalty for Windows 95 if it mentioned no other operating systems in advertisements for IBM PCs, adopted Windows 95 as the standard operating system for its employees, and ensured that it was shipping Windows 95 pre-installed on at least fifty percent of its PCs two months after the release of Windows 95.

   
   

   Given the volume of IBM’s PC shipments, the discount would have amounted to savings of between $40 million and $48 million in one year. Of course, accepting the terms would have required IBM, as a practical matter, to abandon its own operating system, OS/2.

   
   

   After all, IBM would have had difficulty convincing customers to adopt its own OS/2 if the company itself had used Microsoft’s Windows 95 and had featured that product to the exclusion of OS/2 in IBM PC advertisements.

   
   

9. Representatives from IBM and Microsoft, including Bill Gates, met to discuss the relationship between their companies at an industry conference in November 1994. At that meeting, IBM informed Microsoft that, rather than enter into the Frontline Partnership with Microsoft, IBM was going to pursue an initiative it called “IBM First.”

   
   

   Consistent with the title of the initiative, IBM would aggressively promote IBM’s software products, would not promote any Microsoft products, and would pre-install OS/2 Warp on all of its PCs, including those on which it would also pre-install Windows.

   
   

   IBM thus rejected the terms that would have resulted in an $8 reduction in the per-copy royalty price of Windows 95.

   
   

10. True to its word, IBM began vigorous promotion of its software products. This effort included an advertising campaign, starting in late 1994, that extolled OS/2 Warp and disparaged Windows. IBM’s drive to best Microsoft in the PC software venue intensified in June 1995, when IBM reached an agreement with the Lotus Development Corporation for the acquisition of that company.

    
    

    As a consequence of the acquisition, IBM took ownership of the Lotus groupware product, Lotus Notes, and the Lotus SmartSuite bundle of office productivity applications. Microsoft had already identified Notes as a middleware threat, because it presented users with a common interface, and ISVs with a common set of APIs, across multiple platforms.

    
    

    For its part, SmartSuite competed directly with Microsoft Office. In mid-July 1995, IBM announced that it was going to make SmartSuite its primary desktop software offering in the United States.

    
    

11. Microsoft did not intend to capitulate. In July, Gates called an executive at the IBM PC Company to berate him about IBM’s public statements denigrating Windows. Just a few days later, Microsoft began to retaliate in earnest against the IBM PC Company.

    
    

12. The IBM PC Company had begun negotiations with Microsoft for a Windows 95 license in late March 1995. For the first two months, the negotiations had progressed smoothly and at an expected pace.

    
    

    After IBM announced its intention to acquire Lotus, though, the Microsoft negotiators began canceling meetings with their IBM counterparts, failing to return telephone calls, and delaying the return of marked-up license drafts that they received from IBM.

    
    

    Then, on July 20, 1995, just three days after IBM announced its intention to pre-install SmartSuite on its PCs, a Microsoft executive informed his counterpart at the IBM PC Company that Microsoft was terminating further negotiations with IBM for a license to Windows 95.

    
    

    Microsoft also refused to release to the PC Company the Windows 95 “golden master” code. The PC Company needed the code for its product planning and development, and IBM executives knew that Microsoft had released it to IBM’s OEM competitors on July 17.

    
    

    Microsoft’s purported reason for halting the negotiations was that it wanted first to resolve an ongoing audit of IBM’s past royalty payments to Microsoft for several different operating systems.

    
    

13. Prior to the call on July 20, neither company’s management had ever linked the ongoing audit to IBM’s negotiations for a license to Windows 95. IBM was dismayed by the abrupt halt in the license negotiations and the prospect that it might not get a license for Windows 95 until the audit process concluded. IBM’s executives executives surmised that all of its major competitors had already signed licenses for Windows 95.

    
    

    The PC Company would lose a great deal of business to those competitors during the crucial back-to-school season if it could not begin pre-installing Windows 95 on its PCs immediately. The conclusion of the audit appeared to be weeks, if not months, away. The PC Company thus faced the prospect of missing the holiday selling season as well.

    
    

    IBM executives pleaded with Microsoft to uncouple the license negotiations from the ongoing audit and offered Microsoft a $10 million bond that Microsoft could use to indemnify itself against any discrepancies that the audit might ultimately reveal.

    
    

    IBM also offered to add a term to any Windows 95 license agreement whereby IBM would pay penalties and interest if any future audit disclosed under-reporting of royalties by IBM.

    
    

14. On August 9, 1995, a senior executive at the IBM PC Company went to Redmond to meet with Joachim Kempin, the Microsoft executive in charge of the firm’s sales to OEMs. At the meeting, Kempin offered to accept a single, lump-sum payment from IBM that would close all outstanding audits.

    
    

    The amount of this payment would be reduced if IBM offered a concession that Kempin could take back to Gates. As one possibility, Kempin suggested that IBM agree to not bundle SmartSuite with its PCs for a period of six months to one year.

    
    

    He explained that the prospect of IBM bundling SmartSuite with its PCs threatened the profit margins that Microsoft derived from Office and constituted a core issue in the relationship between the two companies.

    
    

    The IBM executive rejected Kempin’s suggestion. In a follow-up letter, Kempin stated that Microsoft would require approximately $25 million from IBM in order to settle all outstanding audits. Kempin reiterated that,

    
    

If you believe that the amount I am asking for is too much, I would be willing to trade certain relationship improving measures for the settlement charges and/or convert some of the amounts into marketing funds if IBM too agrees to promote Microsoft’s software products together with their hardware offerings.

The message was clear: IBM could resolve the impasse ostensibly blocking the issuance of a Windows 95 license — the royalties audit — by de-emphasizing those products of its own that competed with Microsoft and instead promoting Microsoft’s products.

125. IBM never agreed to renounce SmartSuite or to increase its support for Microsoft software, and in the end, Microsoft did not grant IBM a license to pre-install Windows 95 until fifteen minutes before the start of Microsoft’s official launch event on August 24, 1995. That same day, the firms brought the audit issue to a close with a settlement agreement under which IBM ultimately paid Microsoft $31 million.

     
     

     The release of Windows 95 had been postponed more than once, and many consumers apparently had been postponing buying PC systems until the new operating system arrived. The pent-up demand caused an initial surge in the sales of PCs loaded with Windows 95.

     
     

     IBM’s OEM competitors reaped the fruits of this surge, but because of the delay in obtaining a license, the IBM PC Company did not.

     
     

     The PC Company also missed the back-to-school market. These lost opportunities cost IBM substantial revenue.

126. Even once the companies had resolved the audit dispute, Microsoft continued to treat the IBM PC Company less favorably than it did the other major OEMs, and Microsoft executives continued to tell PC Company executives that the treatment would improve only if IBM refrained from competing with Microsoft’s software offerings.

     
     

     On January 5, 1996, Kempin sent a letter to a counterpart at the IBM PC Company. In it, Kempin expressed his belief that the PC Company would enjoy a closer, more cooperative relationship with Microsoft if only IBM’s software arm did not compete as aggressively with the products that comprised the core of Microsoft’s business:

As long as IBM is working first on their competitive offerings and prefers to fiercely compete with us in critical areas, we should just be honest with each other and admit that such priorities will not lead to a most exciting relationship and might not even make IBM feel good when selling solutions based on Microsoft products.

. . .You are a valued OEM customer of Microsoft, with whom we will cooperate as much as your self-imposed restraints allow us to do. Please understand that this is neither my choice or preferred way of doing business with an important company like IBM.

In addition, we would like to see the IBM PC company being more actively involved in assisting Microsoft to bring key products to market . . . . To date the IBM PC company has not always been an active participant in these areas - understandable given your own internal product priorities. I hope you can help me to change this.

In closing, Kempin wrote, “You get measured in selling more hardware and I firmly believe if you had less conflict with IBM’s software directions you actually could sell more of it.”

127. When Kempin spoke to the same executive at the end of the month, he repeated a message he had delivered more than once before: The fact that the IBM PC Company preinstalled SmartSuite on its PC systems made Microsoft reluctant to help IBM sell more PC systems.

     
     

     After all, the more PC systems IBM sold with SmartSuite, the fewer copies of Office Microsoft could sell. For this reason, as Kempin explained to a group of IBM PC Company representatives in August 1996, Microsoft refused to provide IBM press releases with quotes endorsing any PC system that IBM shipped with SmartSuite.

     
     

     Microsoft later expanded that rule to cover any IBM PCs shipped with the World Book electronic encyclopedia instead of Microsoft’s Encarta. IBM might have been less concerned about Microsoft’s refusal to offer endorsements if such quotes did not appear frequently and prominently in press releases announcing new PC systems from other OEMs such as Compaq.

     
     

     Microsoft’s conspicuous silence with respect to IBM PCs sent the message to customers that IBM’s PCs did not support Windows as well as PCs manufactured by other OEMs did.

128. Microsoft also denied the IBM PC Company access to the so-called “enabling programs” that Microsoft ran for the benefit of OEMs such as Compaq, Hewlett-Packard, and DEC, even though IBM met the prescribed objective criteria for admission.

     
     

     Like the absence of public endorsements, IBM’s exclusion from Microsoft’s enabling programs led customers to question whether the Microsoft software they needed would work optimally with IBM’s PCs.

     
     

     IBM learned through surveys it conducted that the firm had lost between seven and ten large accounts, representing about $180 million in revenue for IBM, because the tension between Microsoft and IBM led customers to doubt that Windows would not work as well with IBM PCs as with PCs produced by firms with which Microsoft was on cordial terms.

     
     

     Microsoft justified its exclusion of the PC Company from the enabling programs with its suspicion that IBM might use the programs to gain entrée with customers and then attempt to sell those customers IBM software instead of Microsoft products.

     
     

     At the same time, a Microsoft executive told a counterpart at IBM that the PC Company would be admitted to the programs when IBM’s CEO repaired his relationship with Bill Gates.

129. Microsoft’s executives were persistent despite IBM’s repeated refusals to sacrifice its own software ambitions to improve its relations with Microsoft. In February 1997, one executive from Microsoft told a group of IBM PC Company executives that Gates might relent in his reluctance to cooperate with their company if IBM moderated its support for Notes and SmartSuite.

     
     

     In a meeting held the next month, Microsoft representatives conditioned fulfillment of two objects of IBM’s desires on the company’s willingness to pre-install Microsoft’s products in the place of competing applications, such as SmartSuite, and objectionable middleware, such as Notes.

     
     

     The first inducement that the Microsoft representatives blandished before the PC Company was early access to Windows source code, which Compaq and a handful of other OEMs enjoyed. IBM wanted this early access in order to ensure its hardware’s contemporaneous compatibility with Microsoft’s operating system products.

     
     

     Next, Microsoft offered IBM permission to certify itself as being compliant with certain hardware requirements that Microsoft imposed (and that customers had come to look for as a sign of an OEM’s ability to support Windows).

     
     

     Self-certification would have decreased the time it took IBM PCs to reach the market, and IBM knew that the privilege was already being extended to some of its main OEM competitors.

     
     

     With respect to both benefits, the representatives from Microsoft explained that Microsoft would extend them to the PC Company on the condition that it stop loading its PC systems with software that threatened Microsoft’s interests.

130. The discriminatory treatment that the IBM PC Company received from Microsoft on account of the “software directions” of its parent company also manifested itself in the royalty price that IBM paid for Windows. In the latter half of the 1990s, IBM (along with Gateway) paid significantly more for Windows than other major OEMs (like Compaq, Dell, and Hewlett- Packard) that were more compliant with Microsoft’s wishes.

     
     

131. Finally, Microsoft made its frustration known to IBM by reducing, from three to one, the number of Microsoft OEM account managers handling Microsoft’s operational relationship with the IBM PC Company. This reduced support impaired still further IBM’s ability to test, manufacture, and ship its PCs on schedule, further delaying IBM’s efforts to bring its PC products to market against the competition in a timely manner.

     
     

132. In sum, from 1994 to 1997 Microsoft consistently pressured IBM to reduce its support for software products that competed with Microsoft’s offerings, and it used its monopoly power in the market for Intel-compatible PC operating systems to punish IBM for its refusal to cooperate.

     
     

     Whereas, in the case of Netscape, Microsoft tried to induce a company to move its business away from offering software that could weaken the applications barrier to entry, Microsoft’s primary concern with IBM was to reduce the firm’s support for software products that competed directly with Microsoft’s most profitable products, namely Windows and Office.

     
     

     That being said, it must be noted that one of the IBM products to which Microsoft objected, Notes, was like Navigator in that it exposed middleware APIs.

     
     

     In any event, Microsoft’s interactions with Netscape, IBM, Intel, Apple, and RealNetworks all reveal Microsoft’s business strategy of directing its monopoly power toward inducing other companies to abandon projects that threaten Microsoft and toward punishing those companies that resist.

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This court case Civil Action No. 98-1232 (TPJ) retrieved on 2-06-2023, from justice.gov is part of the public domain. The court-created documents are works of the federal government, and under copyright law, are automatically placed in the public domain and may be shared without legal restriction.