(FORTUNE Magazine) – 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?