NOTE 17    CONTINGENCIES

Government antitrust cases.    We are the defendant in U.S. v. Microsoft and New York v. Microsoft, companion lawsuits filed by the Antitrust Division of the U.S. Department of Justice (DOJ) and a group of eighteen state Attorneys General alleging violations of the Sherman Act and various state antitrust laws. After the trial, the District Court entered Findings of Fact and Conclusions of Law stating that we had violated Sections 1 and 2 of the Sherman Act and various state antitrust laws. A Judgment was entered on June 7, 2000 ordering, among other things, our breakup into two companies. On June 28, 2001, the U.S. Court of Appeals for the District of Columbia Circuit affirmed in part, reversed in part, and vacated the Judgment in its entirety and remanded the case to the District Court for a new trial on one Section 1 claim and for entry of a new judgment consistent with its ruling. In its ruling, the Court of Appeals substantially narrowed the bases of liability found by the District Court, but affirmed some of the District Court's conclusions that we had violated Section 2. We entered into a settlement with the United States on November 2, 2001. Nine states (New York, Ohio, Illinois, Kentucky, Louisiana, Maryland, Michigan, North Carolina and Wisconsin) agreed to settle on substantially the same terms on November 6, 2001. On November 1, 2002, the Court approved the settlement as being in the public interest, conditioned upon the parties' agreement to a modification to one provision related to the Court's ongoing jurisdiction. Two trade groups unsuccessfully sought to intervene to challenge the approval of the settlement and have appealed. Nine states and the District of Columbia continued to litigate the remedies phase of New York v. Microsoft. On November 1, 2002, the Court entered a Final Judgment in this part of the litigation that largely mirrored the settlement between us, the DOJ and the settling states, with some modifications and a different regime for enforcing compliance. The Court declined to impose other and broader remedies sought by the non-settling states. Two states, Massachusetts and West Virginia, appealed from this decision. West Virginia dismissed its appeal as part of a settlement with us of several other cases. On June 30, 2004, the U.S. Court of Appeals for the D.C. Circuit unanimously affirmed the settlement and the Final Judgment.

European Commission competition law matter.    On March 25, 2004 the European Commission announced a decision in its competition law investigation of Microsoft. The Commission concluded that we infringed European competition law by refusing to provide our competitors with licenses to certain protocol technology in the Windows server operating systems and by including streaming media playback functionality in Windows desktop operating systems. The Commission ordered us to make the relevant licenses to our technology available to our competitors and to develop and make available a version of the Windows desktop operating system that does not include specified software relating to media playback. The decision also imposed a fine of €497 million, which resulted in a charge of €497 million ($605 million). We filed an appeal of the decision to the Court of First Instance on June 6, 2004 and will seek interim measures suspending the operation of certain provisions of the decision. We contest the conclusion that European competition law was infringed and will defend our position vigorously. A hearing on our petition for interim measures will be held on September 30 - October 1, 2004. In other ongoing investigations, various foreign governments and several state Attorneys General have requested information from us concerning competition, privacy, and security issues.

Antitrust, unfair competition and overcharge class actions.    A large number of antitrust and unfair competition class action lawsuits have been filed against us in various state and federal courts. The federal cases have been consolidated in the U.S. District Court for Maryland. These cases allege that we have competed unfairly and unlawfully monopolized alleged markets for operating systems and certain software applications, and they seek to recover on behalf of variously defined classes of direct and indirect purchasers' alleged overcharges for these products. To date, courts have dismissed all claims for damages brought against us by indirect purchasers under federal law and in 14 states. Nine of those state court decisions have been affirmed on appeal. Claims on behalf of foreign purchasers have also been dismissed by the federal court in Maryland. Appeals of these state rulings are pending in two states. Courts in eleven states have ruled that these cases may proceed as class actions, while courts in two states have denied class certification. The Maryland federal District Court has certified a class of direct purchasers of certain of our operating system software that acquired the software from the shop.Microsoft.com web site or pursuant to a direct marketing campaign and otherwise denied certification of the proposed classes. The denial of certification of the proposed classes has been appealed and that appeal is still pending. Members of the certified class licensed fewer than 550,000 copies of at-issue operating system software from us. In September 2003, we reached an agreement with plaintiffs' counsel to settle that action, which received final approval in April 2004. In 2003, we reached an agreement with counsel for the California plaintiffs to settle all claims in 27 consolidated cases in that state. Under the proposed settlement, class members will be able to obtain vouchers on a claims made basis that entitle the class members to be reimbursed up to the face value of their vouchers for purchases of a wide variety of platform-neutral computer hardware and software. The total amount of vouchers issued will depend on the number of class members who claim and are issued vouchers. Two-thirds of the amount of vouchers unissued or unredeemed by class members will be made available to certain schools in California in the form of vouchers that also may be redeemed for cash against purchases of a wide variety of platform-neutral computer hardware, software and related services. Since the beginning of 2003, we also reached similar agreements to settle all claims in a number of other states. The proposed settlements in these states are structured similarly to the California settlement, except that, among other differences, one-half of the amounts of vouchers unissued to class members will be made available to certain schools in the relevant states. The maximum amount of vouchers to be issued in these settlements, including the California settlement, is $1.55 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools who are issued and redeem vouchers. The settlements in California, Florida, Kansas, Montana, North Carolina, North Dakota, South Dakota, Tennessee and West Virginia have received final approval by the relevant court. The proposed settlements in Arizona, the District of Columbia, Massachusetts, Minnesota, New Mexico and Vermont have received preliminary approval by the courts in those states, but still require final approval. We estimate the total cost to resolve all of these cases will range between $1.1 billion and $1.2 billion with the actual cost dependent upon many unknown factors such as the quantity and mix of products for which claims will be made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims process. In accordance with SFAS 5, Accounting for Contingencies, and FIN 14, Reasonable Estimation of the Amount of a Loss, we have recorded a contingent liability of $1.04 billion, net of administrative expenses and legal fees paid.

RealNetworks litigation.    On December 18, 2003, RealNetworks, Inc. filed suit against us alleging violations of federal and state antitrust and unfair competition laws, related to streaming media features of Windows and related technologies. RealNetworks seeks damages and injunctive relief, including a permanent injunction requiring us to offer a version of Windows products with no streaming media features. We deny the allegations and will vigorously defend the action. RealNetworks filed the case in federal court in San Jose, California. It has been consolidated for pretrial purposes with other cases pending in the U.S. District Court in Baltimore.

Patent cases.    We are the defendant in more than 30 patent infringement cases that we are defending vigorously. In the case of Eolas Technologies, Inc. and University of California v. Microsoft, filed in the U.S. District Court for the Northern District of Illinois on February 2, 1999, the plaintiffs accused the browser functionality of Windows of infringement. On August 11, 2003, the jury awarded the plaintiffs approximately $520 million in damages for infringement from the date the plaintiffs' patent issued through September 2001. The plaintiffs are seeking an equitable accounting for damages from September 2001 to the present. On January 14, 2004, the trial court entered final judgment of $565 million, including post-trial interest of $45 million, and entered an injunction against distribution of any new products, but stayed execution of the judgment and the injunction pending our appeal. We filed our notice of appeal on February 12, 2004. On October 30, 2003, the U.S. Patent Office issued a letter stating that it has initiated a Director-ordered re-examination of the Eolas patent. On February 26, 2004, pursuant to this re-examination proceeding, the Patent Office issued an Office Action rejecting the claims of the Eolas patent. We believe the total cost to resolve this case will not be material to our financial position or results of operations. The actual costs are dependent upon many unknown factors such as success on appeal and the events of a retrial of the case should the case be remanded to trial following appeal. In Research Corporation Technologies, Inc. v. Microsoft, filed in U.S. District Court for the District of Arizona, plaintiff has asserted a family of six patents relating to halftoning which it believes are infringed by certain printing and display functionality allegedly present in different versions of Windows and Office. Plaintiff seeks an as yet unspecified amount of damages in the form of "reasonable royalties" on various Microsoft products dating as far back as Windows and Office 2000. The case is scheduled for trial in April of 2005. In TVI v. Microsoft, filed in U.S. District Court for the Northern District of California, plaintiff accuses the Autoplay feature of Windows of infringement. This case is scheduled for trial in September 2004. In Arendi USA, Inc. and Arendi Holding Limited v. Microsoft, filed in U.S. District Court for the District of Rhode Island, plaintiff has accused certain Smart Tags features in Microsoft Office XP and Office 2003 of infringing one patent. Trial is scheduled for September, 2004. Adverse outcomes in some or all of the pending cases may result in significant monetary damages or injunctive relief against us adversely affecting distribution of our operating system or application products. The risks associated with an adverse decision may result in material settlements.

Sun Microsystems agreements.    On April 1, 2004, we entered into a series of agreements with Sun Microsystems, Inc. to resolve all pending litigation between the parties, attempt to avoid future disputes, and create an environment conducive to future cooperation. These agreements included a Settlement Agreement, a Patent Covenant and Standstill Agreement, and a Technology Collaboration Agreement. Pursuant to the agreements, we made payments totaling $1.95 billion to Sun.

In the Settlement Agreement, Sun agreed to discontinue its participation in proceedings pending against Microsoft instituted by the Commission of the European Communities and agreed to dismiss with prejudice the action it filed in the Northern District of California, Sun Microsystems, Inc. v. Microsoft Corp., Civil Action No. C-02-01150 RMW (PVT) (N.D. Cal.), and later transferred to the United States District Court for the District of Maryland under MDL Docket No. 1332. Sun released Microsoft from any claims that were or could have been asserted in the proceedings pending before the European Communities, its action pending in the U.S., and any claims based on any actions or events discussed in the Findings of Fact in United States v. Microsoft Corp. and New York, et al. v Microsoft Corp., 84 F. Supp. 2d 9 (D.D.C. 2002). Pursuant to the terms of the Settlement Agreement, Microsoft paid Sun $700 million, which was recorded as litigation related expense.

The Patent Covenant and Standstill Agreement provides that neither Sun nor Microsoft will sue the other, or certain authorized channel and end user licensees, for damages for past patent infringement. Microsoft has the option of extending this covenant not to sue each year until 2014 in exchange for an annual extension payment, so long as certain conditions are met. The agreement provides that on April 1, 2014, provided that certain conditions are met, the companies will grant each other irrevocable, non-exclusive, perpetual patent licenses, with some reciprocal limitations as to scope and use, as well as an additional ten year covenant not to sue for patent infringement with respect to certain products. Pursuant to the terms of this Agreement, Microsoft paid Sun $900 million, which was recorded as litigation related expense.

Sun and Microsoft also entered into a reciprocal Technology Collaboration Agreement. This collaboration agreement provides both companies with access to aspects of each other's server-based technology for use in developing new server software products and/or enhancing existing server software products, in order to improve interoperability. It provides a perpetual license between Microsoft and Sun pursuant to all subject intellectual property rights (including patents and trade secrets) to enable either company to implement in its server operating system products any server-based communications protocols that are implemented over a seven year period by the other company in order to interoperate with their respectively identified server and/or client operating system products. Royalty obligations incurred by Microsoft for use or inclusion of covered Sun technology in Microsoft products will, as incurred, be credited against the $350 million already paid pursuant to the terms of the Technology Collaboration Agreement, based on royalty rates to be determined in the future by Sun. This license removes concerns under traditional patent and trade secret intellectual property frameworks by enabling Microsoft's current and future client and server operating system products to interoperate with the most popular Sun products in a wide range of customer computing environments.

The extent and timing of Microsoft's consumption of this credit is subject to uncertainty. Much of the technology that the companies agreed to license to each other does not exist in a useable form and the agreement does not specify individual royalty payments for implementation of specifications for particular communications protocols. After reaching this agreement with Sun, we valued the intellectual property rights received. In determining the fair value of the intellectual property received, we considered the uncertainty associated with the timing and likely use of Sun's technology, which included estimating the likelihood of adoption of protocols and potential royalties saved. That valuation resulted in a fair value of $29 million for the right to use Sun's licensed protocols in certain products, which we recorded as an intellectual property asset. Reflecting the uncertainty associated with the timing and likely use of Sun's technology, the remaining amount of $321 million was recorded as litigation related expense.

Intertrust settlement.    On April 3, 2004, the previously reported case of InterTrust v. Microsoft was settled by agreement of the parties. Under the terms of this agreement, we have taken a comprehensive license to InterTrust's patent portfolio, including pending patent applications, and agreed to make a one-time payment to InterTrust of $440 million. The agreement involved a combination of a license of intellectual property assets for which we recorded an intangible asset of $266 million and a payment of $174 million for settlement of legal claims. Of the total payment, $174 million was recovered through insurance and had no impact on our results of operations. The agreement resolves all outstanding litigation between the parties.

Other.    We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. While management currently believes that resolving all of these matters, individually or in aggregate, will not have a material adverse impact on our financial position or our results of operations, the litigation and other claims noted above are subject to inherent uncertainties and management's view of these matters may change in the future. Were an unfavorable final outcome to occur, there exists the possibility of a material adverse impact on our financial position and the results of operations for the period in which the effect becomes reasonably estimable.