http://www.fortune.com/fortune/print/0,15935,400412,00.html

INTERTRUST
Can Victor Shear Bring Down Microsoft?
Maybe not. But his company's patent suit is the biggest legal threat to
Microsoft since the antitrust case.
FORTUNE
Tuesday, December 17, 2002
By Roger Parloff


Imagine you had a nickel for every compact disc that's ever been made. The
patent holders of the CD technology do have nearly all those nickels. Sony
Corp. of America and Royal Philips Electronics get 3 cents for every CD
manufactured, plus 3% of the price of every CD player sold.

That's a pretty good revenue stream--several hundred million dollars
annually--as is the one that flows to the ten companies that hold the key
patents on the DVD. Even the subversive, intangible MP3--that symbol of piracy
triumphant--generates money for its patent holders; Thomson Multimedia and the
Fraunhofer Institute of Erlangen, Germany, split 75 cents per MP3 player and
$3.50 to $5.00 per ripping device.

Now there's a new set of technologies whose royalty stream may eventually swamp
those of all its forebears: the so-called trusted systems and digital rights
management (DRM) technologies that enable secure transmission of valuable
files--audio, video, or text--across digital networks. Thanks to Napster and
its ilk, the recording industry and Hollywood have endured a crash course in
the importance of DRM. But DRM's potential applications extend far beyond
consumer media. Such technologies may eventually be crucial, for instance, to
the financial services industry, the health-care sector, law firms, and come to
think of it, any company that wants to be able to send proprietary or
confidential information over digital networks without worrying that it will
wind up posted on YourCompanySucks.com.

Now imagine that one company holds the key patents to the whole shebang--not
just methods to secure music and movies, but the entire spectrum of digital
commerce. Imagine that revenue stream.

A small Santa Clara, Calif., company called InterTrust Technologies maintains
that it is, in fact, that company. Though there are those who dispute this
claim, InterTrust has some awfully big players convinced, including consumer
electronics giants Sony and Philips. Indeed, in November, the two companies
offered to buy InterTrust for $453 million in cash; as FORTUNE goes to press,
they are in the process of trying to close the acquisition.

In its current incarnation, InterTrust consists of 39 employees and a patent
portfolio: 26 issued patents and about 85 more pending, all in the fields of
DRM and trusted systems. InterTrust also has one other asset of note: a suit
against Microsoft that appears to be the highest-stakes patent litigation in
history. The suit's charges give a good feel for the scope and breadth of
InterTrust's patents, at least as InterTrust sees it. The company says its
patents are being infringed every time Microsoft ships its Windows XP operating
system; Office XP suite; Word 2002 word processor; Excel 2002 spreadsheet;
Outlook 2002 e-mail client; PowerPoint 2002 slide presentation software;
Windows Media Player; Xbox videogame console; Microsoft software for servers,
mobile phones, pocket computers, and consumer electronics devices; and many of
the components and tool kits that Microsoft now markets in connection with its
most cutting-edge "bet the company" initiative: the networked computing and
web-services platform known as .NET. Understand what that means: InterTrust is
seeking an injunction barring distribution of about 85% of Microsoft's product
line. (Though the DRM and trusted systems technologies form only a piece of
each product, they have been, in Microsoft's trademark fashion, tightly
integrated into these larger programs.) InterTrust seeks damages too--which
could be trebled if Microsoft were shown to have acted willfully. Polaroid's
spectacular 1976 patent suit against Kodak--which eventually forced Kodak to
scrap its $2 billion foray into instant photography and pay $900 million in
damages--is dwarfed by the scope of the InterTrust-Microsoft litigation.

Since the acquisition is pending, neither Sony nor Philips will comment on the
suit. Their only officially disclosed plan, expressed in a Nov. 13 press
release, is to make "InterTrust's important DRM patents ... more widely
available on a fair and reasonable basis."

But many observers think the consumer electronics giants are purchasing more
than just a potential revenue stream. Rather, the companies may be acquiring
what the feds failed to get via their sputtering antitrust suit: a Microsoft
containment strategy. Microsoft's critics complain that the company is now
leveraging its monopoly PC operating system to gain an advantage in the
software markets for servers, set-top boxes, mobile phones, handheld devices,
and consumer electronics devices--all of which are becoming more "intelligent,"
linked, and convergent with computers. InterTrust's patent portfolio may give
Sony and Philips the hammer they need to beat back Microsoft. "I'd look to see
a trade," says one security solutions vendor. "It could be as simple as
'Microsoft, you stay out of consumer electronics. You can have the PC.' That
scale of trade."

InterTrust is the brainchild of a mad-scientist type named Victor Shear, who
founded the company and is still its chairman. The son of a renowned cancer
researcher, Shear, 55, aspired to achievements that not only would be
personally remunerative but would also advance civilization. "Victor grew up in
an environment," says one InterTrust executive, "where you don't come home
unless you've put a satellite in orbit or something." (Citing legal advice
prompted by the pending acquisition, Shear declined to be interviewed.)

"Victor Shear is without question the most fascinating man I've ever met in my
life," says one dissatisfied yet mesmerized customer of a software product
InterTrust marketed in the mid-1990s. "He's passionate, knowledgeable, and
incredibly determined," the customer continues. "Those were his best and worst
qualities."

Equipped with only a BA in sociology, Shear is almost entirely self-taught in
the realm of technology. In 1990, when commerce over the Internet was still
illegal--the National Science Foundation lifted the ban the following
year--Shear founded InterTrust with the extravagant aim of inventing core
technologies that would enable "technology-mediated commerce," as he put it. He
envisioned a world in which most commercial transactions would be conducted
electronically between a wide variety of hardware and software devices that
would interact, for instance, via telephone modem connections to proprietary
servers (which were already common) and perhaps eventually the Internet. These
hardware devices and the software within them would all require ways of
assuring themselves that they could "trust" one another to handle valuable
digital property in accordance with predictable rules.

The key problem was how to provide persistent protection to digital files. If
Jack wanted to send Jill a privileged legal document or a copyrighted movie,
encryption would protect the file from being intercepted and read en route. But
it did nothing to stop Jill, once she had the file, from making a million
perfect digital copies of it and distributing them all over the globe. To
prevent that one had to wrap the file in a secure digital container and tag it
with rules describing how it could be used, such as: You may open this file
only if you show proper authorization, or pay $1.99 to a clearinghouse; You may
open this file X number of times or for Y number of days; and so on. To play or
read the encrypted file, recipients would need special software or hardware
that could be trusted by the content originator to enforce the rules. (Xerox's
Palo Alto Research Center and IBM were developing similar schemes at the same
time.)

Shear believed DRM would empower both producers and consumers by unleashing an
array of new commercial relationships that had hitherto been impossible. "He
never let us forget," recalls one former employee, "that we were not
'protecting music,' but 'developing the basis for a civil society in
cyberspace.' "

David Van Wie, who became Shear's collaborator in the InterTrust venture in
early 1991, says that while Shear and he wanted to market a software product
eventually, they understood that they first needed to develop a bulletproof
patent portfolio. "It would be a backstop if we weren't successful with
technology development," he explains. The patents--which would encompass both
software and hardware solutions to the problems--would give the young company a
potential source of revenue via licensing.

On Feb. 13, 1995, Shear filed a behemoth, 1,000-page patent application,
referred to in-house as the "Big Book." It incorporated InterTrust's sprawling
vision of a method for conducting electronic commerce securely. Even that was
really just the first installment of Shear's vision; for years afterward,
InterTrust filed periodic supplements to the Big Book as well as entirely new
patent applications.

With the patent application in place, Shear then turned to the business of
producing an actual product: a software tool kit to be known as the Commerce
Architecture. The tools would include software to package valuable digital
content; server software to keep track of validations and authorizations;
clearinghouse software to accept customer payments, track usage, and pay rights
holders; and software to sit on end users' PC desktops and let them open secure
files.

As early as October 1995, the company announced Commerce's imminent release.
Top-tier clients lined up, including Universal Music Group, Bertelsmann,
National Westminster Bank, Mitsubishi, and Reciprocal, a now defunct DRM
clearinghouse that had contracts with clients like Sony Music Entertainment and
McGraw-Hill. But while prototypes and components of the Commerce product
emerged, InterTrust did not provide its customers with a usable, complete
software tool kit for three more years--and even then customers still had to
design their own applications.

Having paid, in some instances, millions of dollars in fees, customers were
understandably peeved. Says one: "Victor's attitude was 'Look, this is going to
be the best technology ever created in the history of man, so be a good boy and
wait.' "

Even without releasing a product, InterTrust awakened the sleeping giant. In
1997 officials from Microsoft's electronic commerce division held their first
tentative meetings with InterTrust officials. By the end of 1998 the companies
were locked in serious negotiations over a variety of possible relationships.
Negotiations continued into 1999, when in April the U.S. Patent and Trademark
Office granted the first in a string of patents based on the Big Book. Intense
talks proceeded through that summer. Evidently anticipating an alliance, chief
Microsoft negotiator Will Poole gushed to the Wall Street Journal: "InterTrust
is solving problems that won't be in the mainstream for quite some time. It's
visionary."

Today Poole is Microsoft's vice president for the Windows new-media platform
division. Looking back on that statement, he says, "I think it's fair to say I
was at times an outspoken advocate of working with them and finding ways to
come up with a win-win deal, even when others, internally, weren't sure it made
sense.

"Their view was that their system would effectively be the backbone fabric of
all e-commerce transactions," he adds. "One could not help but be impressed
with the scope of that vision. But dreams without implementation are fairly
easy to come by, particularly in the software industry."

In the summer of 1999 the parties were discussing the possibility of
Microsoft's paying InterTrust about $140 million for a 20% stake in the
company--plus a commitment to begin shipping the company's software in every
copy of Windows starting in 2002, according to a former InterTrust executive.
But the deal never happened. "InterTrust passed on an opportunity better than
any deal I've seen Microsoft do," says this former official, who believes the
company succumbed to the "hubris" of the times. InterTrust strongly denies
walking away from that deal.

At the time, of course, the tech bubble was still inflating, and InterTrust was
poised to go public. Its October 1999 IPO raised $123.4 million; six months
later it fetched $92.2 million more in a secondary offering. The stock, which
opened at $9 a share, peaked at $97 in February 2000. InterTrust expanded to
376 people.

You can guess what happened next. By August 2001 the stock was under $1. In
early 2000, as InterTrust's market cap began vanishing, Microsoft launched its
.NET initiative, with its focus on networked computing. InterTrust executives
watched in horror as Microsoft began introducing DRM and trust features on
nearly all its products.

Because Microsoft provides software tools to developers, the company
extensively documents the way its products work. "That's a good thing for
Microsoft's customers," explains David Maher, InterTrust's chief technology
officer, "but it has also enabled us, frankly, to pretty clearly see that
they're infringing."

Maher speaks in measured, deliberate sentences. Before coming to InterTrust,
Maher--who has a Ph.D. in mathematics--was a research engineer at Bell Labs,
where he was the principal designer of the secure telephones used by U.S.
military and intelligence and high-level government officials, including the
President.

InterTrust does not believe that all DRM products necessarily infringe its
patents. "There are lots of noninfringing security capabilities out there,"
Maher says--including DRM techniques. "There's a difference between how we do
things and how IBM did, or how Xerox did," he adds. "Microsoft picked the way
we did it. How and why, I'm not going to conjecture." So in April 2001,
InterTrust sued Microsoft.

Brad Smith, who became Microsoft's general counsel this past July, groups the
InterTrust case with nearly two dozen other patent cases his deep-pocketed
employer has been hit with in recent years. He attributes them at least in part
to the bursting of the bubble. "There were a number of businesses that had
interesting and at times even valuable ideas," says Smith, "but business models
that were either not likely to succeed or at a minimum were ahead of their
times." Projecting the kinder, gentler face of post-antitrust-suit Microsoft,
Smith continues, "In some cases, there was just an unrealistic expectation
about the return that would come from IP rights. InterTrust might be--might
be--one example of that." Certainly Microsoft's recent patent litigation track
record tends to support Smith's point: Since 1994, when it lost a $120 million
verdict, the company has won nine straight patent cases litigated to
conclusion. And it's won three more judgments now on appeal.

But the InterTrust case differs from those other suits both in scope and, more
important, staying power. Most of those other actions have been brought by
struggling, tiny companies or even by individual inventors. In contrast,
InterTrust today has $125 million in cash--and it's not going to run out
anytime soon. In April 2002, with the market for DRM products still nascent,
InterTrust stopped selling its products and became a pure intellectual-property
company, paring its workforce down to 39 and its quarterly burn rate to just
over $4 million.

A month later Sony licensed InterTrust's patents, agreeing to pay an up-front
fee of $28.5 million, as well as royalties. The patents are pertinent, for
instance, to Sony's branded line of DRM-protected audio and video players, as
well as memory sticks and software for handheld devices, all of which look
forward to a day when the record labels and Hollywood will widely release their
wares in DRM-protected formats. This deal gave InterTrust the first profitable
quarter of its life and represented a major vote of confidence in the
importance and validity of its patent portfolio.

At the nitty-gritty level, Microsoft's defense against the patent suit is
twofold: Its products do not infringe, and even if they did, InterTrust's
patents are invalid. Poole emphasizes that the engineers who developed
Microsoft's DRM products never saw InterTrust's. InterTrust did permit two
Microsoft engineers, under a nondisclosure agreement, to spend a day looking at
InterTrust's technology to try to verify that InterTrust really had what it
claimed, Poole says. But these reviewing engineers were cordoned off from those
who actually design and build Microsoft's products and were provided very
limited information from InterTrust anyway, according to Poole.

In fact, InterTrust's secrecy was at times "surreal," Poole claims. "We were
talking about making investments of millions of dollars in a private company
where I personally, as sponsor of the investment, had never ever seen their
product operating. I imagined myself at the time sitting in a review with Bill
Gates and saying, 'Well, Bill, I haven't seen it but, trust me, Victor says
it's good.' "

Poole's account does not dispel the possibility of patent infringement,
however. One can infringe unintentionally; willfulness only increases the
damages. And of course InterTrust executives insist Microsoft's infringement
was nothing if not willful. "I don't think there's anything inadvertent about
this case whatsoever," says InterTrust executive vice president Patrick Nguyen,
one of the negotiators. "When we first talked to them, they had not done
anything--or even thought about DRM or trust," he contends. "We spent a fair
amount of time with them educating them."

As for Microsoft's challenges to the validity of InterTrust's patents, they are
premised on their alleged indefiniteness, obviousness, and lack of innovation.
Even outside Redmond there is some skepticism about the InterTrust patents
among rival DRM researchers. During the early 1990s, if not earlier,
researchers were grappling with similar problems at IBM and Xerox and at
universities both here and in Japan. If any of them came across the same
solutions that InterTrust later patented, those particular claims would be
invalidated due to "prior art."

But until a judge and jury trudge through the tedious task of comparing
InterTrust's patents, claim by claim, with a slew of "prior art" contestants
and then with the inner workings of dozens of Microsoft products, no one knows
if InterTrust's patents will hold up.

And even if InterTrust's chances of winning were slight, its leverage would
still be enormous. "I just don't see how a company the size of Microsoft can
take the risk of having this go to trial and suffering the potential
consequences," says Nguyen. "We have 144 claims. All it takes is one claim to
prevail."

"I think you could think of each of these claims as a nuclear warhead," adds
Mark Scadina, InterTrust's vice president and general counsel. "So if ten of
these get through, it would be disastrous from the defendant's perspective."

Which brings us back to Sony and Philips. Assuming their acquisition of
InterTrust is finalized, they will have to decide how to proceed with this
extraordinary suit--which, aside from the patent portfolio, is nearly all that
remains of InterTrust.

The new owners need to decide soon, since the case is headed toward a crucial
hearing in May, where U.S. District Judge Saundra Armstrong will define key
patent terms. Since broad definitions often foreshadow a plaintiff's victory
while narrow ones presage defeat, it is a pivotal event.

Some observers think that Sony and Philips, which have existing business
relationships with Microsoft, will quickly settle, giving each side peace of
mind: assurance for Microsoft that its business won't be shut down, and
assurance for Sony and Philips that the guts of their brand-new patent
portfolio won't be judicially nullified.

But others can't believe these companies would have spent a half-billion
dollars on an unproven patent portfolio if licensing were their only goal. They
see the patents as weapons for defending turf in a convergent universe--one in
which the functions of TVs and audio players and computers will increasingly
overlap.

"Philips and Sony don't want to be disintermediated from their customers the
way PC manufacturers were," asserts one longtime DRM industry participant.
"They may have found a very efficient bargaining leverage with the InterTrust
IP.... This is the core of what all this is about."

It's a remarkably high-stakes battle over a market that doesn't exist yet. No
company, including Microsoft, is yet making money with its DRM products. The
long-anticipated "early adopters"--the recording industry and Hollywood--are
still only testing the waters. There are persistent doubts about whether DRM
products will ever be able to ward off hackers or win consumer acceptance. No
one has yet figured out how secure music or video will compete successfully
against their free counterparts, which abound on peer-to-peer sharing bazaars.

Nevertheless, Microsoft and InterTrust have each put hundreds of millions of
dollars behind their belief that the logjam will be broken, and Sony and
Philips are now adding a half-billion dollars of their own to that pot.

Microsoft general counsel Brad Smith claims that DRM is already beginning to
find its market. "There are seven music and video subscription services today
using Windows DRM," he says. "Our DRM technology has empowered more than 11
million transactions to date in terms of actual acquisition of
content-protected music and the like." In fact, when Smith gets rolling on the
subject of DRM, he sounds like no one as much as InterTrust founder
Shear--albeit a polished, down-to-earth version. Smith stresses that the future
of DRM will extend far beyond the protection of entertainment-based content. It
will be used, for example, "to protect medical records, and financial data, and
corporate information, and legal and business documents, and the like," he
says.

InterTrust and Microsoft clearly agree that DRM will eventually succeed in
enabling businesses to assert ownership over any type of digital property. The
only question then will be, Who will own DRM?



© Copyright 2002 Time Inc.

Microsoft also holds some DRM patents

If intertrust does manage to stop microsofts infringement it is going to do some serious damage, so expect MS to throw everything its got into this case. If just one or two of those patents work its going to really annoy microsoft. But dont expect this to ruin it. MS has money, lots of money. They can always license the patents from intertrust or buy them. I doupt intertrust would turn down a few billion dollars, and Microsoft can afford that seemingly-rediculous price if nessicary.

My Oh My!!! HA HA.
This may actually get MS to behave.

Unlikely. Intertrust is a large fly to microsoft. Its annoying and noisey, but it can be tolerated, and if it gets too annoying they can always get some fly spray.

M$ has THE deepest pockets. With that much money, they are ruling the world.

Them and a few other large corporations.

There is a sociology textbook I have read with a photo of a shanty town in some poor country. In the center of the town is a giant billboard with an advert for coca-cola . Never mind proper houseing or water, get priority right and make sure they join the international community of consumers.

Microsoft is headed by an $80million man. OF course they're not going under.

i like your fly analysis gold its very accurate =P