Dodgy MS data undermines Schmalensee

For the first time in the case, Judge Jackson used a different form of words at the beginning of the day when he addressed the witness: "I remind you, as I am obliged to do every morning, that you're still under oath." Previously he had not mentioned that he was obliged to do this, but it may give some indication that the judge is finding Richard Schmalensee's evidence hard to swallow. Schmalensee was more cautious when David Boies, the DoJ's special trial counsel, invited him to lecture about the kernel of operating systems. The ready-to-eat breakfast cereal industry expert (on his own admission) suddenly capitulated: "I'm not a computer scientist." He continued to offer replies that drew attention to the slightness of his knowledge about the case, saying for example that he understood the DoJ's case to be that "distribution of Internet Explorer has eliminated consumer choice." He could not remember the broad outline of the Complaint, it appeared. Like any good mercenary, Schmalensee had a curious facility only for seeing his client's best intentions, so when Boies asked him about a document in which Microsoft said it was going to bind IE to the shell "so much that using any other browser would be a jolting experience", Schmalensee interpreted it as Microsoft intending to make IE such an excellent browser (he must have intended to say browsing technology) that "using any other browser would be unpleasant". It just didn't occur to him to see this as a threat to Netscape, except that he added that "the issue here is what they did, not what they said" which seemed to leave the door open. He had "seen no evidence or, indeed, allegation that Microsoft had somehow sabotaged the operation of Netscape on Windows 98" but Boies had not asked him whether he had. This was curious. So far as attempts by Microsoft to sabotage competing products such as QuickTime was concerned, Schmalensee said he did not attach much weight to the claims, which seemed like a judgment that would be better made by a computer scientist. Boies asked how much incremental disk space IE took, and was not happy with the response, so he asked again: "Do you think it is all misleading to reference the one-tenth of one percent that was, in your testimony, removed by Mr Felten when you know that there is much more code in there that could be removed if Microsoft chose to?" Ever-mobile Microsoft attorney Richard Urowsky bounced up to object, saying that Felten had said he was not a computer science expert. Judge Jackson overruled him. IE for Windows 3.x was an application and not part of the operating system, the witness agreed, adding gratuitously that it had "a [sic] different code, it's a different product" which was a bold statement for a non-computer scientist. Moving to the issue of Microsoft's screen restrictions, Schmalensee relied in his testimony on what he had been told by Microsoft. Boies asked if the restrictions were imposed to prevent Netscape's icon being displayed more prominently, and the details were reluctantly dragged from him: Schmalensee: "Well, I did see an email in which one of the Microsoft people reported that they had gone out and bought computers at retail with Windows 95 and found that, on several of them, the Internet Explorer icon was not visible." Boies: When you say one of the Microsoft people - Schmalensee: It was a fairly senior person writing the email. I don't remember who it was. Boies: Maybe somebody as senior as the chief executive officer of the company, sir? Boies then produced an email from Gates, dated 5 January 1996 (not to Gates as Schmalensee said). Gates: "Winning Internet browser share is a very, very important goal for us... apparently a lot of OEMs are bundling non-Microsoft browsers and coming up with offerings with Internet service providers that get displayed on their machines in a far more prominent way than MSN or our Internet browser." Schmalensee maintained that Gates had not mentioned a link between IE icon prominence and screen restrictions. so Boies produced a Microsoft OEM sales mid-year review dated 22 January 1996, a couple of weeks after Gates' complaint, that noted "what we missed in the first half of FY '96" included "control over start-up screens, MSN and IE placement" which proved the link. The unhappiness of OEMs about Microsoft's different policies to favoured OEMs concerning start-up screens was also aired. A 1996 document from HP to Microsoft said: "As was clearly stated on many occasions to you and other members of the OEM team, Microsoft's mandated removal of all OEM boot-sequence and auto-start programs for OEM licensed systems has resulted in significant and costly problems for HP-Pavillion line of retail PCs. . . "If we had a choice of another supplier, based on your actions in this area, I assure you, you would not be our supplier of choice." (HP exec to MS: we'd dump Windows if we could) A new revelation was that Microsoft had started referring its proposed actions to internal lawyers ("the antitrust team") for opinions about antitrust matters before decisions were taken. Joachim Kempin, in charge of OEM sales for Microsoft, agreed in a 12 May 1998 email (just days before the current DoJ case was launched) that Packard Bell, Gateway and Compaq were being allowed to opt out of the referral server infrastructure in Windows 98. Boies asked Schmalensee about the "concern within Microsoft that doing this would undermine Microsoft's purported defence of the screen restrictions as designed to create a consistent windows experience". Schmalensee replied: "Well, what we have to that effect here is - in the paragraph beginning 'Joachim thinks this cave-in... Carl and Kurt inform me that the reaction from Dave Heiner [a Microsoft lawyer] and the antitrust team was negative. Changes like this undermine our whole case in defence of Windows experience.'" Boies produced a Microsoft browser marketing fiscal year 1999 review dated 8 May 1998 which noted that "IE is fundamentally not compelling, not differentiated from Netscape version 4, seen as a commodity." Furthermore, Brad Chase had told Gates in September 1997 that "consistent with other leading studies, Netscape is still perceived among this audience as having 'the best browser' and 'setting standards on the Internet.'" This detracted from the "evidence" that Schmalensee had in his testimony from the "independent" reviews in the trade press that were claimed by Microsoft to make IE the clear winner. Schmalensee back-tracked a little to say that the reviews did not say that IE was not "significantly better", just "better". Then he put his foot in his client's case: "[Saying] 'Netscape has had a material drop in people's perception of the quality of their products' is kind of an interesting perception that is not consistent, frankly, with my understanding of the quality of Netscape's products." It turned out that Schmalensee used Netscape at MIT because it was the preferred browser. The revelations du jour were however reserved for Schmalensee's observations on Microsoft's bookkeeping practices. Boies teased from the reluctant witness that Microsoft had probably spent $500 million on IE development (he bid him up from a starter of $100 million). Boies went on to enquire about IE marketing and distribution costs. There were no figures, Schmalensee said, and "given the way Microsoft tends to do business... [this] is not surprising." His next response was the revelation: "One of the characteristics of this company on a range of issues, including this, is when you say where is the detailed business plan, the detailed study, and all of the arithmetic worked out that I can see, as I might see for the phone company or some other business, there are these incredulous looks. 'How would we do that? We don't do that.' And if they've got such documents on a range of issues, I've never seen them. I've asked." Apart from the issues this raises, like the doubtful value of business plans to outstanding financial success, it hints at Schmalensee's suspicion that he might not have seen everything. He had been told that Microsoft "hadn't done refined calculations" about costs... "they didn't exist". Boies explored Microsoft's original plan to charge for IE in 1995, as part of the code-worded "frosting" addition to Windows 95. As the questioning continued, the suspicion grew stronger that Microsoft had told Schmalensee very little, and had probably held back a great deal from him. Boies introduced excerpts from a new book by Cusumano and Yoffie, but it appeared to offer little that was new, except perhaps to Schmalensee. The language in the book seemed to have been chosen to be sensational and in rather bad taste, for example when it is mentioned that Gates "was willing to sacrifice one child (MSN) to promote a more important one (Internet Explorer)". Allowing AOL to put its icon "on the Windows 95 desktop, perhaps the most expensive real estate in the world..." is not a correct view, as Schmalensee agreed (they should have said the online services folder). It was later admitted that Russ Siegelman, the first general manager of MSN, resigned because of the decision to disadvantage MSN. A long discussion on the merits of different data sets ensued, but the tables referred to were blanked in Schmalensee's direct testimony. The conclusions that could be drawn were that Microsoft did not show Schmalensee all the market data available, and that he laboured with the one set of data that Microsoft had commissioned that was consistent with the view Microsoft wished to project. The detailed work had been done by Schmalensee's "staff" as he was now calling his colleagues from NERA. A weakness of the MDC data (and Judge Jackson asked if the data were "commissioned from a polling firm by Microsoft") was that the AOL respondents to the poll often did not know what browser they were using, so assumptions were made that must cast considerable doubt on the validity of the data set, and the analysis by Schmalensee's staff. The cross-examination turned to profit-maximising issues. Schmalensee's thesis, in his direct testimony, that Microsoft could charge $2,000 for Windows, at least in the short term, did not stand up well to cross examination. The issue as to whether Microsoft is maximising profits turns on more than one factor, it is clear, and these must include a consideration of the long term as well as short term. Schmalensee, Boies said, just assumed that Microsoft was charging a profit-maximising price because he thought that it was sensible to do that. It was not denied. Boies had been very courteous in his treatment of Schmalensee, but could not suppress his incredulity about the claim that Microsoft was not a monopoly. "Sir, you're not telling this court, are you, that you have not been retained by Microsoft to help them convince other people, the FTC, the Justice Department, the court in the Bristol case, this court and other courts, that Microsoft does not have monopoly power? You understand that that's part of what you're doing, don't you?" Schmalensee: Mr. Boies, I have been retained to do economic analysis. I value my professional reputation very highly. I am not giving this because it is in Microsoft's interests. I'm giving this because I believe it to be correct. Boies: Let's see if we could parse that just a little bit, since you brought it up, sir. First, you knew that Microsoft was trying to convince people that it did not have monopoly power; correct? Schmalensee: Correct. Boies: And you knew that that was one of the purposes that Microsoft had for using your testimony; correct? Schmalensee: Correct. Boies: And you knew that your testimony would not be used if you concluded that Microsoft, in fact, had monopoly power; correct? Schmalensee: That was never said to me. It's a reasonable inference as it is with any expert hired by anybody for any purpose. Boies: And when you came up with and used and refined this pricing analysis, you knew that this pricing analysis was going to be used to convince people, or to try to convince, people that Microsoft did not have monopoly power; correct? Schmalensee: I suppose that's correct. The final issue in Boies cross-examination was Microsoft's profits, which had been announced the previous day to be a profit of £2 billion in the quarter, up 75 percent on the previous year. Schmalensee did grudgingly admit that persistent profits were always suggestive of monopoly power. But the most surprising information was that Microsoft had told him that it was not possible to find out how much of Microsoft's reported profits came from operating systems. He did ask, he said, "and I was told the data that's separated in that fashion simply didn't exist." Register readers will know more than Schmalensee, since we presented a breakdown of revenue taken from Microsoft's latest accounts. To divide common expenses, it is not unreasonable to allocate them pro-rata. It does seem that Schmalensee was fobbed off, however, and this merely adds to the suspicion that has always surrounded Microsoft's accounting practices. Boies asked if Schmalensee accepted the results at face value: Schmalensee: I was surprised, but I will be honest with you, the state of Microsoft's internal accounting systems do not always rise to the level of sophistication one might expect from a firm as successful as it is. That explanation is consistent with other information I had received about the nature of their internal systems and records... I was interested in the question of what's a reasonable assumption for the sort of ancillary revenues, say, from applications programs that Microsoft might expect as a consequence of Windows sales. I said, can you separate the company into the two pieces, so I might be able to address that question? The answer was there were a lot of common costs that aren't allocated between those two businesses, and the records just don't let you do it. That seemed to me consistent with the other things I knew about the company. Boies: And just to be clear, you were told that Microsoft doesn't have any records that show how profitable their operating system is, doesn't have any records that show what ancillary revenues or profits it receives, and you accepted that on face value; correct? Schmalensee: Mr. Boies, they record operating system sales by hand on sheets of paper. Under those circumstances, I accepted the absence of a detailed cost allocation system absolutely. Boies chose this most appropriate point to conclude his cross-examination, leaving in the air questions about the legal adequacy of Microsoft's internal systems, and the integrity of its auditors in not qualifying Microsoft's accounts. ® Complete Register trial coverage