Transcript of Remarks and News Teleconference: Brad Smith, Senior Vice President, General Counsel and Corporate Secretary, Microsoft Corporation
European Commission Action on Protocol Pricing
March 1, 2007
BRAD SMITH: Thank you for joining this call today. I thought I would first give you our perspective on three pieces of today’s press announcement from the EC, before answering any questions. I will talk a little about our compliance overall, about the issue of pricing that the Commission has raised today, and about the issue of innovation, which is an important part of today’s announcement.
Implementing and Complying with the Commission’s Decision.
In terms of compliance, Microsoft has spent three years implementing and complying with the Commission’s decision, which was issued in March 2004. We have devoted hundreds of employees and many millions of dollars to this work, and it has not always been a simple process. I think that today’s announcement is, perhaps, a demonstration of that. Although the 2004 decision is literally 300 pages long, it contains only a single sentence that defines what prices for these communications protocols are supposed to be. That single sentence says that the prices are supposed to be reasonable and non-discriminatory, and that they should not reflect the strategic values stemming from Microsoft’s market power in the client PC operating system market or in the work group server operating system market.
Constructing a Pricing Schedule and Rates
We have worked very hard and at great length to construct the type of pricing schedule and rates that we hoped would satisfy the EC. We submitted our most recent pricing proposal last August and have been asking for feedback on that proposal ever since. We are disappointed that it has taken six months to get this feedback and that it is being given in its present form, but if there is a silver lining, perhaps it is that we may now finally have some meetings and discussions to try to resolve this. We have not yet received the Statement of Objections – we have just received the press release – so all that I can speak to is what the press release tells us. We will, however, study the Statement of Objections as soon as we receive it.
Working on Technical Documentation
We also worked at great length on technical documentation. As you know, we submitted revised technical documents to the Commission last July and, as the Commission indicated today, it is still studying it. The technical documentation runs to about 8,000 pages; the documentation supporting the pricing calculations runs to about 1,500 pages. We are hopeful that, at some point in the near future, we will get further feedback on the technical documentation and that it will take a constructive form that facilitates some real dialogue, if there are continuing issues to be discussed. We have spent a great deal of time and money on compliance and we will continue to do so.
Fair and Reasonable Proposed Protocol Prices
Analysis by PricewaterhouseCoopers
With regard to pricing, I would like to interject two thoughts today. First, we believe that we have been fair and reasonable in setting the proposed protocol prices. We based our prices, in part, on an analysis by PricewaterhouseCoopers, which has a number of acknowledged experts in the field of technology pricing, and we wanted to ensure that our prices would be not only as cheap as, but even cheaper than, the prices of comparable technology on the market. In fact, PricewaterhouseCoopers advised us last summer that the prices we were submitting were 30 percent below the market rate for comparable technology.
Context around size of potential fines
I should also give you some context, especially when people think about the size of potential fines. This is not expensive technology, given the very low prices that we have set. If every single company in our industry implemented every single protocol in every single server that they sell, the total cost for the entire industry would be about [US]$30 million, in what is acknowledged to be a multibillion-dollar product market. This is not expensive technology, and you could even compare the total cost to the industry on an annual basis with the prospect of fines that might be levied on a weekly, monthly or yearly basis, and one clearly sees the strong differential.
Second, I should underscore that even the pricing that we have proposed is quite flexible. While we have a price list, we have also done two other things:
First, we have created an alternative price calculation that people could use, based on their own anticipated increase in profitability, so that, if it were cheaper for them to use this alternative method, they could use that instead.
Second, we have always said that we are prepared to entertain any reasonable price offer from any potential licensee. We appreciate that some licensees may have very unique business needs, so we are happy to sit down and talk with them. Indeed, we are currently in negotiation with a number of potential licensees and are on the verge of reaching an agreement with one.
It is helpful, I think, to put the pricing in that kind of context.
Numerous Patents Worldwide
Third and finally, I would mention the issue of innovation. While we have not yet seen the Statement of Objections, the press releases includes the Commission’s conclusion that they do not see this technology as being very innovative; however, as we have pointed out, other government agencies in Europe and the U.S. have found considerable innovation in this technology. U.S. and European patent offices have awarded Microsoft more than 36 patents for the technology in these protocols. In addition, we have another 37 pending patent applications that are currently being reviewed by patent offices around the world. Other government agencies have already looked at this technology and have concluded that, in fact, there is substantial innovation.
Not the Sole Litmus Test
Agreed pricing principles set in June 2005 set a two-part test
Even so, we do not think that innovation is or can be the sole litmus test for putting a price tag on technology that is very expensive to develop. That is not the way technology markets work; neither is it the way intellectual property (IP) markets work. Microsoft and the EC agreed to a very explicit set of pricing principles in June 2005, and those pricing principles are on our website today. They establish a two-part test:
That the prices have to enable implementation in a commercially practicable manner.
That the prices have to reflect the value conferred upon a licensee to the exclusion of any strategic value that stems from Microsoft’s market power.
Four factors to be taken into consideration in the case of disagreement
As you can see, if you take a glance at the pricing principles, they say that, in considering the second part of that test, the trustee, if there is a disagreement between Microsoft and a potential licensee about a reasonable price, can consider four factors, and should do:
Whether the protocols represent Microsoft’s own creation
Whether the creations by Microsoft constitute innovation
A market valuation of comparable technologies
Any other factors that the trustee deems appropriate
There are, therefore, four factors, one of which is innovation, that the trustee should consider with respect to one half of the two-part path. I think those pricing principles, while somewhat complicated, are very clear when one takes a look at them.
EC Focusing on Innovation Alone
I do worry that at least the text of today’s press release appears to be articulating a new approach for price regulation for technology, at least by large companies that have a dominant market share. The test focuses on innovation, and innovation alone, to the exclusion of other factors that are important in technology markets. The test has been applied so that something is considered innovative only if, in fact, it is patentable, yet there are valuable IP rights in the world that are not patents and that do not represent technology that is patentable; they may be protected by copyrights, trade secrets or other forms of industrial property rights. It would, therefore, be a significant change in government policy if price regulation for technology is based on this new approach.
Application of Regional Policy on a Worldwide Basis
This is compounded by the fact that this is being applied by the EC on a worldwide basis. It is not confined to technology that is created or licensed within the European Union (EU). It is both somewhat interesting and slightly ironic that we had, in effect, this issue arise on two continents within the course of eight days. Last Wednesday, we were before the U.S. Supreme Court, urging it to ensure that U.S. patent law is not applied to products that are made and sold in Europe or elsewhere outside the U.S. Here we are, this week, advocating that the EC not seek to regulate the pricing of technology that is created or distributed in the U.S. or elsewhere outside the EU. We do worry that, if multiple governments are all trying to apply their laws to new technology on a worldwide basis, we will inevitably see increased confusion and even contradictory rulings. That, in turn, is going to make it harder for technology companies to comply with all of these laws, and that, in turn, can slow the pace of technology innovation.
Looking forward to Dialogue
We do believe that there are some important issues that are worth considering here, and we look forward to having a dialogue and sitting down with the EC to have that kind of conversation. We will be happy to talk about the most detailed aspects of our technology and prices, as well as the most general and far-reaching aspects of the policies that are implicated by this set of decisions.
QUESTIONS AND ANSWERS
QUESTION: Immediately after the July fines, you said that you would appeal. Do you have any idea at this stage whether you will appeal this Statement of Objections? Have you any idea of the grounds that you would apply the July fines on and when you might file an appeal on that?
BRAD SMITH: That really raises the question: what is the process for the next steps? This is a Statement of Objections that, as Jonathan Todd indicated earlier today, expresses the Commission’s preliminary views, so there will be a process in which we will submit a response to the Commission and the Commission will come to its final views. If the Commission comes to a final view that takes the form of what is called an Article 24.2 decision, and if there is the imposition of a fine, then and only then would Microsoft even have a right, under European law, to file an appeal. It is, therefore, too early to know whether there will be an appeal and to know what the Commission’s final views will be. We hope to be able to persuade the Commission and to sit down and have a constructive conversation with them, and we will see where all of that takes us.
QUESTION: What about the July fines?
BRAD SMITH: We did file an appeal on the July fines, and that is one of the cases before the European Court of First Instance in Luxembourg. There are some issues in that case that are similar and some that are different. The degree of similarly or difference, ultimately, will depend on what process and form this particular matter takes.
QUESTION: Could you tell us what is similar?
BRAD SMITH: The similarly perhaps involves most particularly the fact that we have a very complicated set of technical obligations that are spelled out very briefly in a 2004 decision. On the documentation side, there was just a paragraph or two that told us what we were supposed to do. On the pricing side, there is only a sentence that tells us what we are supposed to do. Out of that came 8,000 pages of technical documents and a grid with 19 different rows of prices, supported by 1,500 pages of documents to explain and support the calculations. If there is a common thread that runs through both parts of this, it is our view that it is sometimes very difficult to "read the tealeaves" and know exactly what we are supposed to do, when the decision is both so complicated and the directions are so brief.
The only way to reach a result, in my opinion, that is likely to be satisfactory to everyone is have lots of discussion. There is a process that involves the submission of proposals by us, after which we await feedback from the Commission after it has studied our proposals. However, the process is so much more constructive when we get some clear guidance and we can sit down in a room. If there is a path forward that is likely to be beneficial to people in the industry, as well as to customers, on this pricing issue, it is likely to take that form.
QUESTION: The Commission is saying that your charge structure would account for 35% of net profits in the industry, which it says is ridiculous. I do not know if you agree with that number or what your impression is, but how do you see a fair calculation for the sector, and what can you do to find some sort of common ground here?
BRAD SMITH: We should probably start by trying to sit down and agree on what the prices are and how much of the industry’s profits they represent, because I do not think that one can conclude that $30 million of royalties for the entire industry equals 35 percent of the industry’s profits. That is a great example of the kind of thing that one should sit down and have a constructive process around to discuss, rather than waiting for seven months without feedback and then getting something like this today.
It is worth noting that one of the things that we submitted in August, in our new pricing proposal, was this alternative calculation. We were very explicit; we tried to respond to the Commission’s interest in this particular issue, so we proposed what we called a "flexible income" approach, under which a licensee would have to pay Microsoft, as a royalty, only a percentage of its new and incremental profit from the use of our technology.
In other words, you would look at the profit that the company was already making and they would not have to pay anything with respect to that. If the licensee’s own calculations showed that it was likely to generate new profit, in addition to what it was making, the royalty would be based on a part of the new profit. Specifically, the royalty was even designed so that the payments would not have to be made until the implementation work was completed and the licensee began to see that profit materialise.
In some respects, if the "ships are passing in the night" on questions as basic as how these calculations work and how much cost, revenue or profit is at stake, that really underscores the importance of sitting down to talk about something that is quite complicated. Press releases are fine, but they are not the same as sitting down and having that conversation.
QUESTION: I do not think that anyone would dispute that this is quite complicated. I just wanted to follow up on what you said a moment ago, in your introductory remarks, about being on the verge of an agreement with one company. Could you specify which company that is, because the Commission told us today that no companies have signed up, since they claim it is too expensive? Their figure of 35-percent net operating profit is based on a calculation of a maximum 5.95 percent royalty rate, which I found on your Web site.
BRAD SMITH: I am not in a position to give out the name of the company, but after the agreement is signed, I suspect we will make some kind of appropriate public announcement. I should note that we have 25 licensees for our protocol licensing program in the U.S. The pricing is very comparable between Europe and the U.S., and when we finished the documentation last year, we started to make it available and launched a new marketing program.
We have been discussing the agreement with potential licensees and I have to say that, by and large, the feedback that we have been getting from them is that our pricing is reasonable. In part, that is based on the specific needs and technologies in which licensees are interested, but I would say that, in addition, licensees also understand that they have choices. In effect, they have three choices:
First, they can look at the price list – including the one that you are looking at – and say, "I like that price for what I want."
Second, using this alternative calculation under this incremental or "flexible income" approach, they can run that calculation and see if that generates a lower number.
Third, if they do not like either of the first two choices, they can say, "This is what we need and want; this is the price that we think works for us."
The way markets work is that buyers and sellers come together, and we have always tried to be very explicit about this in Europe and have always worked under this principle in the U.S. We are the seller of technology; potential licensees are the buyers. You sit down and sort out what it is that people want and a price that works for both sides. That has to work if this is going to be a functioning market for the future as well.
QUESTION: They are saying that there could be a nominal charge; you are saying free. That might be simply a difference in wording, but could you comment on that? You quoted a study that said that you are 30 percent less; could you tell us who the more expensive company is and who you are measuring against? Lastly, you said that you do not yet have the Statement of Objections. The Commission says that it has a confirmation fax that it was delivered four and a half hours ago to you, at about 11.30 this morning. What might have happened there?
BRAD SMITH: We just received an e-mail from our competition lawyer in Brussels, saying that he just received confirmation from the Commission that we will receive the Statement of Objections in an hour. I can tell you that it has not come to my fax machine, or to our competition lawyer’s fax machine in Brussels. I walked down to Steve Ballmer’s office about 45 minutes ago, just to ask if it happened to have arrived on his fax machine, and it was not there either. Be that as it may, it is going to come. If there is one thing that I will predict with confidence this morning, it is that we will receive the Statement of Objections. We will pick it up, read it and have a conversation.
In terms of pricing, the Commission uses the word "nominal," which typically refers to a small, onetime, fixed fee to handle the administrative expenses for Microsoft of providing the documentation to a licensee. That is typically set at something like $5,000, so you can talk about whether it is free or almost free; it is free, but you pay shipping and handling. It all falls into that kind of category.
In terms of comparative companies, I do not remember which were expensive. In one instance, we showed that there was a set of protocols licensed by IBM. In fact, IBM’s protocols were something of the order of three to four times as expensive as what we were offering.
QUESTION: According to a statement, Neelie Kroes said that Microsoft agreed that the main basis for pricing should be whether its protocols are innovative, which seems to contradict what you have been saying throughout this call, which is that innovation should be just one of the factors. Second, in terms of interoperative systems, the EC also issued a statement today, criticising you for refusing to license open source under any conditions whatsoever, and for not making interoperability information available for "Longhorn" and Vista.
BRAD SMITH: With respect to pricing, the short answer is: no, we do not have the same interpretation, apparently, of what was established. The long version is that each of you can go and read exactly what was established, because it was reduced to writing, and every word was negotiated and has been on our website since June 2005. Tom Brookes or others can provide you with a link to the website –
QUESTION: Are these your words?
BRAD SMITH: No, these words were negotiated between Microsoft and the EC, so when you see this document, which is Appendix 1, it says "Pricing Principles." It is posted as a draft appendix to the agreement, but every word of it was negotiated and, in many instances, I personally negotiated the words with senior people at the EC. The document speaks for itself. You can read it and see how many parts of the test there are and how many factors there are. As recently as last July, when I sent a letter with new information on our documents, I said:
"As discussed in my 4 May 2006 letter, we are submitting these reports" – these are reports about innovation – "with the understanding that 'innovation' is one of three elements for consideration by the trustee under the WFPP (Work Group Server Protocol Programme) pricing principles and is being assessed at the Commission’s request by Professor Barrett under a patent law standard of non-obvious and inventive steps."
People can read that and it is very clear what it says.
With respect to the European Committee for Interoperable Systems (ECIS), which is the group that principally represents IBM at this point – and whenever I see ECIS, I equate it with IBM – what they are saying, in my opinion, is not well-founded. It is certainly ironic that ECIS is making a point about pricing when IBM’s own pricing policies have, at time, put prices considerably above those that we are charging.
We have provided documentation for the new interoperability technologies in Windows Vista and in the data of our Longhorn server. As I recall, that is even referred to explicitly, either in the frequently asked questions published by the Commission or in the press release itself. They acknowledge that we have been doing that and that we have priced it as well, and their statements today address our prices.
However, in my opinion, what this demonstrates, more than anything else, whether in terms of pricing principles or new technology, is that it underscores how very complex this is and why one needs a constructive process, with real dialogue, if one is going to do anything that is going to benefit people in a practical way.
Consider this for a moment: we have been complying with antitrust rulings on five continents for 15 years, yet we are not experiencing these kinds of issues or this type of process anywhere else. We have not experienced this kind of problem in Korea, for example, even though we have been complying with a decision of the Korea Fair Trade Commission since December 2005. We have not seen discussions of these kinds of fines, or any fines, for compliance issues in Korea, or in the U.S., even though we have been complying with a consent decree and a court order in the U.S. since 2002.
We comply with antitrust rulings in several other countries and in a number of continents. At some point, I think one has to step back and ask why. I am always willing to sign up for the proposition that we should work harder and do more and find ways of doing things in a better manner, and I hope that we will always bring that kind of attitude to what we do, but you cannot reach an agreement if you are just talking to yourself: you have to have real dialogue in a room with people on both sides of the table. That is what we have in other countries, and that is what we need in Brussels, if Europe is going to have an economy that genuinely fosters technology innovation.
This is just a preliminary statement that the Commission has put out today, so I am not suggesting for a moment that this will not create the foundation to have that kind of dialogue. If it does, perhaps today is a step in the right direction, but it really does need to lead to that kind of dialogue, particularly at a time when we are all waiting for the Court of First Instance to tell us what the law is going to require of us.