InterTrust Says it Owns DRM, is Suing Microsoft

[Seth Johnson <seth.johnson@RealMeasures.dyndns.org>]

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

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.

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?