Penguin Slayer Tiny SCO Group thinks it can do what Gates can't: Hurt IBM by fighting Linux.
By Adam Lashinsky

(FORTUNE Magazine) – In mid-may, CEOs at every company on the FORTUNE 1,000 and FORTUNE Global 500 opened a letter to discover that despite their various industries, languages, and far-flung locations, they all had something in common: They were about to be sued. It wasn't definite, but if anywhere in their organization some CIO or IT worker had joined the Linux revolution by, say, replacing a Windows-fueled server with a box running Linux--the free, open-source operating system sweeping corporate IT departments--then they were in danger. Some little-known company called SCO Group out of Lindon, Utah, was putting the giants on notice: Linux might be open, and it might be popular, but it definitely wasn't free.

Most of the execs would have routed the letter to their legal department and gone on their way. Not IBM. As the biggest proselytizer for Linux--and the firm most likely to have steered those companies toward the software--Big Blue was taking this very, very seriously. Two months before, SCO had filed a $1 billion lawsuit against IBM, claiming the company had taken chunks of SCO-owned Unix code--software that in the 1980s and 1990s powered most corporate IT shops--and sprinkled it into Linux. Because of the quirky way the open-source software is distributed, SCO's claim meant that IBM's additions are now part of almost all versions of Linux. If SCO is right, everyone will pay for IBM's mistake--but IBM will pay the most.

With 340 employees and revenues last year of $64 million, SCO (typically pronounced "skoh," rhyming with "slow") is the proverbial pimple on IBM's rear end. Yet it has already demonstrated an ability to be more than a little bit of a pain in the you know what. In 2000, SCO's owners won what is one of the largest legal settlements ever against Microsoft. In its current spat with IBM, it has attracted significant backers, sharp-elbowed fighters known far better for battling each other than for fighting on the same side: Microsoft and--as FORTUNE has learned--Sun Microsystems (we'll get to that later).

There's even more: SCO may have stumbled onto the magic bullet Linux-hater Microsoft has been searching for. Linux has been one of the few growth stories in tech over the past few years, mostly at Microsoft's expense. Its penguin mascot and simple selling points of being good and costing only for service and maintenance have captured the minds and wallets of CIOs. In 1998, 60,000 servers shipped loaded with Linux; by last year that number had grown to 600,000. The chilling effect of the SCO letter was quickly evident. Within days, tech research firm Gartner warned clients to consider halting all Linux implementations until the situation cleared up. SCO's effort to collect from IBM promises to be the first major test of just how free Linux really is.

"If something is too good to be true, maybe it is," notes longtime software-industry analyst Nina Lytton, of Open Systems Advisors in Boston. "That has to be running through people's minds right now. Will IT managers approach the procurement of thousands more Linux servers with more caution? I think they will."

As far as penguin hunters go, SCO looks like an improbable candidate. Before its recent actions, SCO, located in a tiny town about 40 minutes from Salt Lake City, had a $10 million market cap and a product line devoted to yesterday's operating system, Unix. It hardly seems a business that would threaten IBM. The log book at SCO's front desk on a sunny day in June shows that, for one thing, nobody seems to take security seriously. One of the few visitors is "Bob Dole," here to see SCO exec "Bob Marley." Meanwhile an office clerk sits on the floor nearby, fastening papers into piles of blue folders.

It's the folders, not the lack of procedures or furniture, that Big Blue needs to worry about. Each folder contains a contract for one of SCO's 6,000 Unix licensees. Darl McBride, the 43-year-old CEO who joined the firm last summer, says it's possible that some of these companies are misusing Unix code by inserting it into other programs they're using, a privilege for which they need to pay SCO in the form of an additional license. He randomly grabs a handful of folders and reads the names: BMC, BMW, Ball State University. "To us this is a treasure trove, a gold mine," says McBride.

The blue folders--kept in a public viewing room--are something of a publicity stunt, but they make for a menacing visual prop. Even if the licensees are using Unix properly, they're not necessarily safe. SCO says it's even more likely that they and thousands of other companies are using Linux code that someone--think IBM--provided them with portions of SCO's Unix code. That could make those companies liable to legal claims--and gives SCO leverage against Big Blue. "As long as this is seen just as a scuffle between SCO and IBM, that plays to IBM's advantage," says McBride, because IBM can use its size and staying power to wait out SCO in court. The more he can scare IBM's customers, he says, the better for SCO.

To those out of the tech industry, this all looks like a David and Goliath tale with tort law substituting for slingshots. But the story of how SCO ended up as the enemy of free Linux defies easy categorization. The company traces its roots to a string of firms started in 1996 by Ray Noorda, the retired CEO of networking-software pioneer Novell. During Noorda's tenure, Novell purchased the rights to Unix, invented at AT&T in the 1970s. After he stepped down, Noorda opened a private investment vehicle called Canopy Group and convinced Novell to sell him the rights to Unix. He then transferred those rights to a company he formed called Caldera, whose managers promptly stuck them in the vault--they had their own plans. In April 2000, Caldera's IPO opened above a reverse-split-adjusted $100 a share by touting applications that ran on--of all things--Linux. The products, though, never took hold, and the stock tanked. It wasn't until 2002 that Caldera's owners remembered the Unix rights given them by Noorda, now retired. This March the company renamed itself SCO--a name short for Santa Cruz Operation, a software company whose assets Caldera had purchased in 2001--and turned from coding to lawyering.

The mastermind behind SCO's fight with IBM is Ralph Yarro, a 38-year-old ex--software developer whom Noorda picked in 1996 to oversee Canopy. That firm, owned by Noorda, his family, and Yarro, is made up of 35 startup companies, including the publicly traded software-maker Altiris and a 43% stake in SCO. Yarro's most visible talent has been his willingness to go to court. In the suit against Microsoft he won $250 million, asserting that the giant had blocked Noorda from making money on rights he held to an early version of DOS, a predecessor operating system to Windows. Another Canopy company, software vendor Center 7, is suing Computer Associates, also in a breach-of-contract dispute. The suit is set to go to trial Aug. 11 in federal court in Salt Lake City. "Intellectual property is everything," says Yarro. "It's like location in real estate."

Tech companies long have fiercely guarded their intellectual property. Microsoft, for example, scours the ranks of small companies and foreign countries that might be using pirated copies of its software. IBM famously deploys teams of patent lawyers to ferret out un-authorized users of its technology. Intellectual property is guarded everywhere, that is, but in the world of Linux, whose guiding light, Finnish technologist Linus Torvalds, believes that users should share software freely. While companies like Microsoft and Sun have jealously protected the basic source code of their software--allowing developers to write applications that work with the code, but not allowing them to replicate or even see the code itself--Linux is different. It's a derivative of Unix and has always been free. Under the terms of various open-source agreements, notably the General Public License, Linux's core, or kernel, is posted for anyone to see, modify, or redistribute. The only catch is that anyone else must be able to do the same to the modifications. That openness makes it awfully tough to make money by selling operating systems.

IBM saw the problem firsthand. In the late 1990s the company watched Linux eat into sales of its version of Unix, called AIX, and decided that instead of fighting the penguin lovers, it would co-opt them. In 2001, IBM pledged to invest $1 billion in Linux--making money by selling the boxes that run the operating system and supplying the support necessary to keep them going. One added benefit: Microsoft, enemy No. 1, was terrified of open-source. Soon IBM was Linux's biggest champion.

Yarro had followed IBM's Linux conversion closely--and not just because Caldera too was trying to sell Linux systems. With its Linux products going nowhere and its stock price below $1, Yarro in June 2002 hired ex-Novell executive McBride and turned to Plan B: using SCO's rediscovered Unix licenses to chase IBM.

SCO's contention is this: IBM has added some of its Unix code--code IBM licenses from SCO--to the Linux kernel. To back up its claim, SCO has presented (under nondisclosure agreements) portions of its code that it says are identical to portions of Linux. It insists that major parts of the contaminated code were introduced by IBM. Under what SCO's McBride calls the "hot potato" theory, any company ultimately using this code--at least a version not blessed by SCO--could be in violation of SCO's licenses. With an estimated 2.4 million Linux servers shipped since 2001, SCO says the missed licensing opportunities could run into the billions of dollars.

So SCO went calling on IBM last fall for back payment. When Big Blue balked at buying a license for each of its Linux server shipments, McBride flew to the Florida offices of Boies Schiller & Flexner for a meeting with famed anti-Microsoft battler David Boies. He agreed to take up the case on a combination contingency and hourly-fee basis. "A third-grader could understand their IP violations," McBride says. "So it turns out what we really needed was a litigator."

McBride also got busy talking to other potential licensees, including Sun and Microsoft. In a little-noticed transaction a decade ago, Sun paid Novell $82 million for a thorough license to its Unix operating system. "I had a very good working relationship with Ray Noorda," says Scott McNealy, Sun's CEO. "So before he rode off into the sunset, I told him I wanted this. He was agreeable but for a big bag of money." When Sun realized this spring that SCO was going to challenge IBM, it was only too happy to buy an additional "clean-up" license, further bulletproofing its rights to SCO's Unix. Sun got something else in the exchange: warrants to buy 210,000 shares of SCO's stock at $1.83 per share. At SCO's resurgent stock price of around $10, Sun's stake already is worth nearly $2 million.

Around the same time, SCO landed another high-profile licensee, Microsoft, and immediately the software industry began clucking that Microsoft was behind SCO's assault on IBM. McBride simply says that it is "flat-out not true" that the software giant is pulling SCO's strings behind the scenes. Microsoft denies it too; it says it took out the license to provide products to customers who want their Unix applications to communicate with Windows-based programs. (According to SCO's securities filings, Sun and Microsoft together will pay SCO $13 million this year.)

Whatever the case, Microsoft is clearly delighted somebody is fighting IBM --and Linux. The company has been warning for two years that users of supposedly free software could find themselves facing intellectual-property problems. Its obsession with the dangers of Linux is well documented: In his recent annual letter to employees, CEO Steve Ballmer mentions Linux 14 times, never favorably. Microsoft has steadfastly refused to comment on the IBM litigation. But Craig Mundie, Microsoft's chief technical officer and policy maven, dances around it with glee. "There is no free lunch," he says. "People have been chowing down on what they thought was a free lunch. You'll start to see more and more thoughtful analysis on this subject."

The open-source community, meanwhile, has reacted with outrage. SCO-related articles and message boards dominate industry sites like MozillaQuest, Slashdot, and OSNews. And the anger hasn't just been online: One anonymous caller phoned McBride and challenged him to a fistfight. He declined. Linux creater Torvalds himself has come out swinging, telling eWeek Magazine that "SCO is full of it" and angrily dismissing SCO's efforts: "I'm sure that they are confident that they own the collective work of Unix, but that's a separate thing entirely legally from being the actual copyright owner of any specific section of code."

The rest of the industry has been poring over its intellectual-property positions, in some cases huddling with SCO to find out if there's a problem. HP, another big Unix vendor that also sells Linux servers, told FORTUNE it's been approved by SCO: "Our understanding is that after careful review of the Linux source, SCO has not discovered any areas where HP has violated our Unix source license agreement with SCO," the company said in a statement. "We are therefore confident that we don't have the same issues that IBM has." To further protect itself, HP is also scrambling to set up a board that will scour all HP open-source projects to make sure the company doesn't offer up licensed intellectual property by accident.

IBM maintains that it has done nothing wrong--and shrugs off threats by SCO to revoke its Unix rights, which could also send IBM's AIX customers into chaos. IBM insists that its rights under its Unix contract are irrevocable and perpetual. Says a spokeswoman: "IBM will defend this case vigorously in court. It's clear to IBM that on some level this is an attack on the open community, and we plan to stand by the open community."

SCO plans to stand by its intellectual property. It took four years for its owners to win that $250 million from Microsoft. SCO says it's hunkering down for the IBM fight as well. And in the meantime, the company might well be successful in selling additional licenses: insurance policies for Linux users hoping to stay out of court. That prospect has caught the eye of Wall Street. "SCO has effectively become the controlling owner of an enormous repository of intellectual property," says Jonathan Cohen, a former Merrill Lynch Internet analyst who manages an investment fund that's been buying SCO's shares. "And that body of intellectual property runs the world. The question is, Can they monetize it? I think so."

There's one other way SCO might make money out of this: by getting acquired by IBM, or someone who wants to keep potentially valuable Unix licenses out of IBM's hands. According to securities filings, SCO last summer hired Memphis investment bank Morgan Keegan to explore "various financial and strategic alternatives," including selling the company. Neither McBride nor Yarro do anything to dampen such speculation, saying only that SCO's current market value of $120 million wouldn't be an acceptable buyout offer. "Given the rights that [an acquirer would] have, there's no doubt this would make a portfolio of business for somebody," says McBride. Adds Yarro: "There's a time that you fight your competitors, and there's a time you're in bed." Judging from the escalating nature of this spat, it's fair to say it's not time for love just yet.

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