(FORTUNE Magazine) – Nothing has stirred up Hollywood lately like Ted Waitt's talented Holstein. Waitt is CEO of Gateway, the nation's fourth-largest PC manufacturer, and the cow is his company mascot. It's the Holstein's spots you see on Gateway packaging. Lately, though, Waitt has been using his sidekick to attack the entertainment industry. In a TV commercial, Waitt is driving down the highway in an 18-wheeler at dusk, with the cow riding shotgun. Waitt shoves a homemade CD into the truck's sound system. Out comes a hip-hop version of Gordon Lightfoot's 1974 classic "Sundown." Waitt raps along as he steers the big rig, bobbing his head to the beat.

"Hey, B, what's the deal?" Waitt asks the cow.

On cue, the Holstein starts rhyming like a bovine Jay-Z: "Sometimes I rap slow, sometimes I rap quick..."

Sounds innocent enough. But as Waitt and cow head off into the sunset, viewers are directed to Gateway's Website, where they can download the song free. There, they are urged to oppose a Hollywood-backed bill in the U.S. Senate intended to end the unlawful distribution of copyrighted music and movies. "Have you seen this??" asks an e-mail circulating among movie-studio and record-company executives. "This is WAR!"

It certainly is. Hollywood has gone to Washington to stop the trading of pirated movies online. It has thrown its lobbying muscle behind a bill, introduced by South Carolina Senator Ernest Hollings, that would order the Federal Communications Commission to find a way to halt this thievery if the entertainment and technology sectors can't come up with their own solution. Disney CEO Michael Eisner, testifying in favor of the bill, took the opportunity to bash Silicon Valley on the Senate floor: "We're dealing with an industry where an unspoken strategy is that the killer app is piracy."

Hollywood has reason to be alarmed. Global music sales declined last year by 5%, largely because you can get any song you want on the Internet these days free. In a recent survey, 23% of music fans told the Recording Industry Association of America that they were buying less music because they were downloading it free from the Web or burning copies of other people's CDs. "We've seen a fundamental collapse of the music business," says Peter Chernin, president of News Corp., owner of 20th Century Fox studios.

Now Hollywood is watching fearfully as free copies of hit movies are beginning to appear in cyberspace. Viant, a Boston consulting firm, has estimated that feature films already are being swapped on the Internet at a rate of 300,000 to 500,000 times a day. Considering that the average cost of making and marketing a movie has reached $78 million, it's easy to see why studio executives have rallied around Eisner in support of the Hollings bill.

The bill, however, is anathema to technology leaders like Intel Chairman Andy Grove and Apple Computer CEO Steve Jobs. They fear the government could muck up the computer industry royally. Moreover, they question whether it's their responsibility to rescue an industry that has historically been more concerned with cranking out Frankenstein sequels than embracing change. "Were the manufacturers of printing presses forced to protect the monks?" Grove asked in a recent op-ed piece. "Was the PC industry forced to protect the mainframe computer industry? Why is this case any different?" In an interview, Grove says, "We spent a decade talking convergence, and now that convergence is about to happen the content industry says, 'Oh, not so soon' and 'Not this way and not that way.' I think they are deadly afraid of [convergence], deadly afraid of what it is going to do to their business." The message is clear: The studio owners are dinosaurs. If they can't adapt to the brave new world that companies like Intel and Apple have ushered in, extinction is what they deserve.

Grove has a point. But so do Hollywood executives who accuse their Silicon Valley counterparts of ignoring Internet piracy because it helps them sell gadgets. Annual sales of CD burners rose 14% last year, to $684 million. Over the past two years the number of portable MP3 players, like Apple's iPod, has more than doubled. It's pretty clear that many of these devices are being used to copy and play stolen tunes.

The irony is, these two industries could really use each other's help. PC sales declined last year for the first time since 1991. Hollywood had a record year at the box office in 2001, but that obscured the fact that average revenue per movie actually declined by 40%, to $22.4 million, as the number of releases grew. Think of the money Hollywood could rake in if it could come up with a way to safely distribute movies over the Internet. Think of all the people who would sign up for broadband and buy swifter computers if everything from Easy Rider to Dude, Where's My Car? were lawfully available online.

So why can't Hollywood and Silicon Valley find a way to make this happen? The problem is, Hollywood studio owners think they are the lords of the entertainment world. Their Silicon Valley peers see themselves as masters of...well, the universe. Is it any wonder these two industries can't get along?

Michael Eisner loves his iPod. "It's one of the most fabulous things I've seen in the past couple of years," he says. Eisner has no problem with the technology itself, but he deplores the fact that people are using it to avoid paying for Disney products, in effect stealing from the company. "Nothing about technology is threatening or upsetting or negative," he insists. "This is simply about conscious behavior, about right and wrong, and I just don't understand the enormous tidal wave of rhetoric that this issue has created from the so-called technology side. Shakespeare would find it interesting."

Eisner is the most outspoken member of a Who's Who of media moguls--Viacom CEO Sumner Redstone, Vivendi CEO Jean-Marie Messier, and News Corp.'s Chernin--whose movie studios have endorsed the Hollings bill. They are being supported somewhat less enthusiastically by AOL Time Warner CEO Richard Parsons and Sony Corp. of America CEO Sir Howard Stringer, whose companies have one foot in the entertainment business and the other in the technology sector. "Unless you make piracy a very serious issue," Stringer says, "the technology industry won't try, not because they are bloody-minded, but because it complicates their lives." While AOL doesn't endorse the bill, Parsons says, "There is a role for government to play here, but we think it's a narrow one of enforcing agreements hammered out in the marketplace."

The way these CEOs see it, Silicon Valley has put some very powerful tools in the hands of consumers--tools that are now being used to rip off their products. So it's up to these same technology companies to come up with a way to stop this. Eisner and his fellow studio owners would like to see a system designed so that music and movies could be stamped with a "digital watermark." PCs and other digital media players could scan for the watermarks and tell whether content had been acquired legitimately or stolen. "All we have to do is get together and figure out some system," Eisner says. "If we can get to the moon or get to Mars and get those unmanned drone ships to fly to the Middle East, why can't we put a little watermark on our content?"

To Andy Grove, this is typical Hollywood nonsense. These are the same people, he says, who fought tooth and nail to kill the VCR and today get more than 50% of their revenues from video rentals. Now they are running away from the greatest distribution channel ever imagined: the Internet. By failing to offer movies online, Grove continues, they have allowed piracy to flourish and instilled the belief in Web surfers that it's okay to grab whatever's available for nothing on the Internet. "It is going to happen sooner or later," the Intel chairman warns his adversaries. "If it happens later, you will have corrupted your consumers and you are going to antagonize your consumers. So do you want to do it when your customers are still with you, or when they have abandoned you?"

Grove is basically speaking for an A-list of technology industry executives, including Microsoft's Steve Ballmer, Cisco's John Chambers, Dell's Michael Dell, and IBM's Lou Gerstner, all of whom share his concern about what would happen if the government stepped in to set digital-content security standards. Most of them have been quietly working behind the scenes to stop the bill. But because their companies do business with the studios, they are reluctant to speak as bluntly as Grove.

Yet they aren't all holding their tongues. Jobs was mortified in February when Eisner singled out Apple's "Rip, mix, burn" marketing slogan in a Senate hearing as evidence that the technology community is promoting thievery to sell computers. It was particularly galling to Jobs because he is also CEO of Pixar, the digital animation studio that has co-produced hits like Toy Story 2 and Monsters Inc. with Disney. "On a personal basis, I was just floored," Jobs says. "He used 'Rip, mix, burn.' He doesn't understand what it means. He thinks it means download, mix, burn, but ripping of course means you have a physical CD, which is what [the music industry] would like."

Eisner is unapologetic. "I didn't mention his company by name," he says innocently. However, he clearly resents the suggestion that he doesn't "get" technology. Eisner is tired of being told he should just overcome his fears, put his movies online, and trust market forces to work things out. "The only thing I can say is it's very hard to create a business model against something that is a perfect copy for free," he says. "It would even challenge the greatest business man who ever was."

Says News Corp.'s Chernin: "All we're asking is for [Andy Grove] not to build a business while stepping on our necks. When technology arises to help solve this problem, trust me, he'll figure out a way to make money on it."

Hollywood and Silicon Valley have always had an uneasy relationship. Eight years ago Grove was invited to investment banker Herb Allen's annual gathering of entertainment-industry moguls in Sun Valley, Idaho, to explain this new thing called the Internet. "They were all fascinated by it," he recalls.

The feeling was mutual in Silicon Valley. Intel, Microsoft, and Sun Microsystems opened Hollywood offices hoping to profit from the marriage of content and the Web. There were lots of discussions but few meaningful deals. Engineers from the Valley found it difficult to communicate with studio executives, some of whom didn't even use e-mail. Hollywood was uncomfortable with Silicon Valley's penchant for coming up with products like TiVo, the commercial-jumping digital video recorder that threatened their television production businesses. "That was a very nice presentation," a studio chief reportedly told a contingent from TiVo after sitting through a demo. "Now go set yourselves on fire."

Hollywood's fears weren't misplaced. Fueled by billions of dollars of venture capital, technology advanced more rapidly in the late '90s than anybody in the media business could have imagined. Instead of becoming a vehicle for legitimate distribution, the Internet became a channel for piracy. Napster, a Web startup led by a 19-year-old college student named Shawn Fanning, linked PC hard drives around the world and created a network where you could make a free copy of any song you desired from a fellow participant's digital collection. Before Napster was shut down by a court order, the tech industry persuaded a generation of music fans to see executives at Sony, Universal, and Warner Music as greedy corporate suits bent on depriving them of their beloved Web "community." By contrast, Fanning became a Time (and Fortune) cover boy.

It was pretty clear to studio executives that bootlegged movies were next on the file-sharing crowd's menu. But when studio executives asked technology CEOs for help, they got nowhere. Eisner personally appealed to IBM's Gerstner, Microsoft's Ballmer, and Compaq's Michael Capellas, but nothing came of it. Other studio owners had similarly frustrating conversations. "You don't know how many times I was told, 'Hey, the express train is running down the tracks, get out of our way,' " Sony's Stringer sighs.

It was too much for Hollywood to swallow. Two years ago at the Sun Valley conference, Viacom Entertainment Group Chairman Jonathan Dolgen dressed down Andy Grove after he had lectured a roomful of media-company CEOs about how they needed to get together among themselves and figure out what to do about piracy so they didn't miss opportunities on the Internet. "You're being disingenuous," Dolgen responded. "You got us into this mess. Now you help us get out of it." The room exploded with applause.

The studios had more leverage than the music business. Napster went mainstream because music is so easy to download. But you need a broadband connection to get Hollywood's products online. Even then it takes two hours to download a movie from a file-sharing service like Morpheus using a cable modem. (It takes two days using a 28.8 modem). So bootlegged-movie viewing is still largely restricted to college campuses, where students have the bandwidth and the time for such frivolity.

Companies like Intel and Microsoft are eager to get a wide variety of movies online because they believe films will drive the large-scale adoption of broadband and help the PC become the center of the home entertainment network. For several years Intel and a consortium of consumer-electronics companies have been trying to persuade Hollywood to endorse a technology that promised to protect movies coming into home networks through a set-top box.

However, in late 2000, Disney decided it was tired of having endless conversations with Silicon Valley and not getting its worries addressed. When the engineers at the meetings said they couldn't do anything to protect Disney's digital "over the air" broadcasts on ABC, Disney refused to endorse the technology. Paramount, Universal, and News Corp.'s 20th Century Fox followed suit, and the negotiations effectively came to a halt. Instead, Eisner set out to reframe the file-sharing debate from a discussion about technology into one about stealing. "Our route is very simple," the Disney CEO says. "Our route is to make this into an issue that somebody will solve."

The forum he chose was Washington. It wasn't long before Disney and its allies found a champion in Hollings, the powerful Senate Commerce Committee chairman. In March the Senator introduced a bill that would give Hollywood and Silicon Valley a year to address the movie industry's worries before the FCC steps in. The bill mandates that they find a way to encode a "broadcast flag" in free digital television programs so that they can't be uploaded onto the Internet. It gives the same deadline to find a way to keep digital content from being stolen after it is converted into the wave form used for analog television sets in 95% of American homes. The bill also gives the two industries a one-year window to come up with a way to keep copyrighted content from being shared free through services like Morpheus and KaZaA.

Hollywood's pressure tactics had their intended effect. On the eve of the Commerce Committee's hearing on the bill, the heads of the seven largest movie studios received a letter from technology CEOs, including Intel's Craig Barrett, Microsoft's Ballmer, and IBM's Gerstner, asking for "inter-industry cooperation."

Since then, negotiations have moved quickly. Hollywood and Silicon Valley are close to announcing a plan for a broadcast flag. There is also a consensus on using watermarking to protect digital movies when they are converted to analog. Hollywood executives say none of this would have happened without the Hollings bill. "I try not to be cynical," says News Corp.'s Chernin, "but it's hard not to be skeptical when we were nowhere on the broadcast flag until those hearings, and now the broadcast flag is solved." Technology executives say they are able to address Hollywood's concerns more speedily now because the studios are finally back at the negotiating table.

Does all this mean the fight is over? Hardly. Emboldened by its success in Washington, Disney is asking Silicon Valley to design PCs that can sniff every piece of incoming content--including e-mails--for watermarks. "There is a thing in the computer called the CPU, the central processing unit, right?" says Preston Padden, Disney's chief Washington lobbyist. "All the bytes go through there, and we're looking to come up with reasonably standardized watermark detection [that] can effectively read for watermarks on all the content coming through."

Naturally, Silicon Valley is horrified. "Think of all the billions of e-mails that you would have to check," fumes Grove. "Not only are you going to slow down everybody's transmission, but you're going to be guilty of an incredible privacy violation which is more or less equivalent to requiring the U.S. post office to steam open every piece of mail."

"This isn't 1984," Padden says. "We don't want to violate anybody's privacy."

The technology community is using Hollywood's hard line to stir up consumers. That's the thrust of the Gateway anti-Hollings bill advertisement. "Some content distributors want the government to regulate your ability to [use digital media]," the company says on its Website. "There's even a bill before the U.S. Senate that would force the technology industry to implement anti-piracy technology that could prevent all digital copying--even copying that's legal today under U.S. copyright laws." Never mind that the Hollings bill wouldn't do that. Gateway wants to unsettle all those consumers who've invested in CD burners and MP3 players in the past year.

So what we have here is a game of chicken. Unless somebody flinches, both sides stand to lose. And there remains plenty to fight about. The steps the two sides have agreed to will block some sharing of files, but not all. Digital movies broadcast over the air will be given a "flag," a kind of digital stamp that PCs will recognize as a prohibition against uploading to the Internet. But movies that leak out to the Web will still be susceptible to file sharing. Silicon Valley leaders say there's no way to get the genie back in the bottle. There are too many songs on Morpheus that have been ripped from CDs, too many movies that have shown up on the Internet before appearing in theaters because they were stolen directly from studio vaults. Unless content is protected when it is created, they say, there's no way for a PC to tell if it's legitimate or bootlegged.

Hollywood executives think they are getting the typical technology runaround. "We all know GM has a motor in its files that would get 60 miles a gallon," scoffs one of them. "I'm pretty sure Intel has something in its files that will solve our problems." This talk infuriates Apple's Jobs, who says his industry would also love to get this problem behind it: "To say this intractable technology problem is going to be solved by something in the back pockets of technology companies, and they are not sharing it, is unbelievable. This is an important issue, and it's not going to be solved by threatening rhetoric. It's going to be solved by a computer scientist who has an incredibly original idea. We just don't know who or when."

Jobs is right. Name-calling isn't helping matters. However, there's so much bad blood between the movie and technology industries that they don't trust each other anymore. The piracy dilemma won't be solved until that changes. Judging from the things Hollywood and Silicon Valley are saying about each other, it will be a long wait.

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