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Both the Senate and House Judiciary Committees are holding separate hearings today on the antitrust issues raised by the proposed Google-Yahoo search advertising deal. (More details on the deal here). Microsoft’s general counsel Brad Smith, whose fought his own share of antitrust battles on behalf of Bill Gates, will be wagging the antitrust finger at Google. In his prepared testimony, he will claim that the deal potentially gives Google control of 90 percent of search ads, will lead to fewer choices and higher prices for advertisers, and raise serious privacy concerns for consumers. He will say:

If search is the gateway to the Internet, and most believe that it is, this deal will put Google in a position to own that gateway and the information that flows through it. Never before in the history of advertising has one company been in the position to control prices on up to 90 percent of advertising in a single medium. Not in television, not in radio, not in publishing. It should not happen on the Internet.

Google’s chief legal officer David Drummond will respond that the deal is good for consumers because they will see better ads, and good for advertisers and Web publishers because more people will click on those ads. He will maintain that Google will not control all of Yahoo’s search advertising, and will point out that Yahoo will compete in that arena, continuing to sell its own ads. It will also continue to compete in regular search. And as for privacy, Google and Yahoo will not exchange “personally identifiable information” about each user.

Here are Drummond’s talking points, which are summarized on the Google Policy Blog (where you can also find his full testimony):

* This agreement will be good for Internet users (who will see ads that are better targeted to their interests); advertisers (whose ads will be better matched to users’ interests, allowing them to reach potential customers more efficiently), and website publishers (who will see increased revenue from better-matched ads on their websites).

* Google and Yahoo! will remain vigorous competitors, and that competition will help fuel innovation that is good for users and the economy. As we’ve said before, commercial arrangements between competitors are commonplace in many industries. Antitrust regulators in the US have recognized that consumers can benefit form these arrangements, especially when one company has technical expertise that enables another company to improve the quality of its products.

* Our agreement will not increase Google’s share of search traffic, because Yahoo will continue to run its own search engine and compete in online search.

* We’re particularly excited that as part of the agreement, Yahoo! will make its instant messaging network interoperable with Google’s. This will mean easier and broader communication among a growing number of IM users, and enable users to choose among competing IM providers based on the merits and features of the services.

* We have taken a number of steps in the Yahoo! agreement to protect user privacy. As Google supplies ads to Yahoo! and its partners, personally identifiable information of individual Internet users will not be shared between the companies. Yahoo! will anonymize the IP address of a searcher’s computer before passing a search request to Google.

That last point about Yahoo anonymizing user IP addresses could set an interesting precedent. Advertisers would rather see those IP addresses freely shared across ad networks and Websites so that consumers can be targeted no matter where they go on the Web. But Yahoo and Google obviously felt it could have been a big enough issue to squirrel the deal with the government. As Congress looks at behavioral targeting in general further down the road, that could pop its head up again (even n a non-antitrust context).

These particular antitrust hearings have been brewing for a while. Google and Yahoo have tried to protect themselves against Microsoft’s criticisms by structuring the deal as a straightforward arms-length commercial agreement. And the fact that Microsoft has a lot at stake in seeing the deal squashed doesn’t make it the strongest witness at these hearings. It is not exactly a disinterested third party, since it is still trying to wrangle the search business from Yahoo itself.

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Yahoo rejected a new Microsoft offer to acquire Yahoo’s search business earlier this evening. The offer, which apparently was made on Friday in cooperation with Yahoo investor Carl Icahn, was a variation on Microsoft’s previous offer to acquire Yahoo’s search business in exchange for cash, a partial stock buyout and revenue guarantees, required the complete replacement of the Yahoo board and executive management team, had a 24 hour expiration period and stated that there was no room for negotiation.

Yahoo rejected it, saying that the Google search deal they’ve signed is a better deal and adding that the requirement to replace the board and executive team is “absurd and irresponsible given the complexity of the deal.” We, by the way, agree with both points.

Yahoo formally offered to sell itself whole to Microsoft in the release as well, saying “the Board believes a whole company transaction could be negotiated and executed prior to August 1st,” and suggesting Microsoft’s original $33 offer will work just fine for them right now.

Full text of release:

Yahoo! Rejects Microsoft/Icahn Search and Restructuring Proposal
Yahoo! Suggests Microsoft Make A Proposal To Acquire Whole Company

SUNNYVALE, Calif., Jul 12, 2008 (BUSINESS WIRE) — Yahoo! Inc. (Nasdaq:YHOO), a leading global Internet company, confirmed today that it has rejected a joint proposal from Microsoft Corporation and Carl Icahn for a complex restructuring of Yahoo! that would include the acquisition of Yahoo!’s search business by Microsoft.

The proposal was made on Friday evening and Yahoo! was given less than 24 hours to accept the proposal, the fundamental terms of which Microsoft and Mr. Icahn made clear they were unwilling to negotiate. After reviewing the proposal with its legal and financial advisers, Yahoo!’s Board of Directors determined that accepting the proposal is not in the best interests of its stockholders.

The Board’s rejection of the proposal was based on a number of factors, including the following:

1. Yahoo!’s existing business plus its recently signed commercial agreement with Google has superior financial value and less complexity and risk than the Microsoft/Icahn proposal.

2. The Microsoft/Icahn proposal would preclude a potential sale of all of Yahoo! for a full and fair price, including a control premium.

3. The major component of the overall value per share asserted by Microsoft/Icahn would be in Yahoo!’s remaining non-search businesses which would be overseen by Mr. Icahn’s slate of directors, which has virtually no working knowledge of Yahoo!’s businesses.

4. The Microsoft/Icahn proposal would require the immediate replacement of the current Board and removal of the top management team at Yahoo!. The Yahoo! Board believes these moves would destabilize Yahoo! for the up to the one year it would take to gain regulatory approval for this deal.

Roy Bostock, Chairman of Yahoo! said, “This odd and opportunistic alliance of Microsoft and Carl Icahn has anything but the interests of Yahoo!’s stockholders in mind. Clearly, Microsoft, having failed to advance in search, is aligning with the short-term objectives of Mr. Icahn to coerce Yahoo! into selling its core strategic search assets on terms that are highly advantageous to Microsoft, but disadvantageous to Yahoo! stockholders. Yahoo’s Board of Directors will not allow that to happen. Yahoo!’s Board remains open to any transaction that delivers full value to our stockholders - we just do not believe such a transaction should be dictated by Microsoft and a single short-term investor.”

Mr. Bostock continued, “After negotiating among themselves without the involvement of Yahoo!, Carl Icahn and Microsoft presented us with a ‘take it or leave it’ proposal under which we would be required to restructure the Company, hand over to Microsoft Yahoo!’s valuable search business and to Carl Icahn the rest of the Company, giving us less than 24 hours to respond. It is ludicrous to think that our Board could accept such a proposal. While this type of erratic and unpredictable behavior is consistent with what we have come to expect from Microsoft, we will not be bludgeoned into a transaction that is not in the best interests of our stockholders.”

Mr. Bostock also noted that Microsoft’s position that it would not deal with, or otherwise engage with, Yahoo!’s management to reach agreement on this proposal or to implement it, is completely absurd and irresponsible given the complexity of the deal - one that requires the removal of half of Yahoo!’s business from Yahoo! and then the integration of it into Microsoft.

Yahoo!’s Board points out that a transaction to acquire the whole company would be much more straightforward and involve far less risk than the new proposal or any similar alternative. The Board believes a whole company transaction could be negotiated and executed prior to August 1st. In rejecting the Microsoft/Icahn proposal, Yahoo! not only repeated its offer to sell the entire Company to Microsoft for at least $33 per share, but also offered to negotiate an improved search only transaction. Microsoft rejected both offers.

Ironically, Carl Icahn, who jointly with Microsoft developed and presented this proposal, had previously urged Yahoo! not to sell its search business to Microsoft. Specifically, in an interview on CNBC’s Fast Money program, on June 4, 2008, Mr. Icahn said, “… it’s crazy for this company now to do this alternative deal and give the store away, because obviously, an alternative deal is a poison pill because once you’ve done an alternative deal and given the search to Microsoft, you don’t need Microsoft to buy you anymore. So, that would be a poison pill….”

Significantly, the Board believes Microsoft and Mr. Icahn are overstating the value their search and restructuring proposal would deliver to Yahoo! stockholders and are substantially understating the risks. Yahoo! noted that a transaction that would separate the Company’s search and display businesses is an undertaking of great complexity. While the Board acknowledges that the current proposal contains a number of improvements over Microsoft’s earlier proposal, the Yahoo! Board’s conclusion that the current proposal is not in the best interests of stockholders is based on a number of factors, including:

– The revenue guarantees suggested, which are conditional and subject to reduction, are well below the search revenue that the Company is expected to generate on its own and in association with its announced commercial agreement with Google. That agreement alone is estimated to generate $250 to $450 million of incremental cash flow for the first twelve months following implementation, while allowing Yahoo! to remain a principal in paid search;

– The success of the remaining Company is critically dependent on Microsoft’s ability to effectively monetize search;

– Microsoft/Icahn’s proposed Traffic Acquisition Costs rates are below market;

– The proposal calls for Yahoo! to sell its industry-leading algorithmic search business and its related strategic and valuable intellectual property portfolio for no incremental consideration; and

– Many of the components of the headline value that Mr. Icahn and Microsoft put forward, such as the spin-off of the Yahoo!’s Asian assets and the return of cash to stockholders, are steps that could be taken by Yahoo! on its own and the Board continues to evaluate these options.

Mr. Bostock concluded, “Microsoft and Mr. Icahn are trying to dismantle the Company and deliver our search business to Microsoft on terms that would be disadvantageous to Yahoo! stockholders. We are prepared to let our stockholders, not Microsoft and Carl Icahn, decide what is in their best interests and we look forward to the upcoming vote.”

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Until today I’ve largely been a big supporter of Microsoft’s efforts to acquire Yahoo. A couple of days before Microsoft placed its initial $44.6 billion bid for the company, I told Fox Business Channel that a Microsoft merger had to happen to save Yahoo (and I certainly wasn’t the first to say this, I just had magnificent timing).

Throughout the ups and downs and stupendous drama of the negotiations, I held firm that a deal was in the best interests of both companies. Not because I’m a huge Microsoft fan, but because the health of the Internet requires a competitive search market. Google controls too much market share and too much related search revenue. A counterbalancing force is needed to keep the system healthy. And Microsoft or Yahoo standing alone cannot counter Google.

But when Microsoft pulled its bid just as Yahoo was about to accept and replaced it with a search buyout deal that I described as equivalent to them trying to get the milk for free instead of buying the cow, I began to wonder if things were getting out of hand. Since then, Yahoo has quite literally prostrated themselves before Microsoft to get a merger done, even perhaps at a price much lower than Microsoft’s original bid. And Microsoft has largely toyed with them.

Yesterday’s shenanigans, however, clearly crossed a line. Microsoft and activist Yahoo shareholder Carl Icahn jointly announced that they’ve been talking, and that Microsoft may be willing to entertain a full buyout offer once again. But only on the condition that Yahoo’s board of directors is replaced: “We confirm, however, that after the shareholder election Microsoft would be interested in discussing with a new board a major transaction with Yahoo!, such as either a transaction to purchase the “Search” function with large financial guarantees or, in the alternative, purchasing the whole company.”

Icahn explained further, saying that Microsoft can’t be expected to let Yahoo stay in current management’s hands during the months-long closing period after a transaction is consummated. He added: “Jerry Yang and the current board of Yahoo! will not be able to “botch up” a negotiation with Microsoft again, simply because they will not have the opportunity.”

This is largely complete nonsense. During the transition period after a merger agreement Microsoft and Yahoo would be working closely and Yahoo would be unlikely to take any actions that jeopardize the deal. What’s far more likely is that Microsoft, led by CEO Steve Ballmer, have taken Yahoo’s rebuffs entirely too personally. It’s no longer just about business, it’s about destroying and humiliating the people who embarrassed Microsoft. And sadly, that has nothing to do with creating a balance of power in search.

Just as I criticized Yahoo for not quickly accepting Microsoft’s offer in early February before the mass executive exodus and destruction of shareholder value, I now point the finger at Microsoft. Yahoo is standing at the altar waiting for you to say “I do,” Microsoft. Time to put up or shut up.

I’m all for a merger. But I won’t stand by quietly while Microsoft destroys what’s left of Yahoo just because it can.

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Dissident Yahoo shareholder Carl Icahn and Microsoft have been talking to each other (as has everyone else involved in a possible Yahoo deal, including Yahoo and AOL over the weekend). In a letter to shareholders, reproduced below, Icahn notes that he and Microsoft CEO Steve Ballmer have been discussing possible transactions over the past week, and that Ballmer ” made it clear to me that if a new board were elected, he would be interested in discussing a major transaction with Yahoo! . . . immediately.”

Microsoft is throwing its weight behind Icahn’s proxy battle, going so far as to signal that an Icahn-controlled Yahoo is the only one that it is willing to restart negotiations with. Icahn says Microsoft won’t enter into any deal with the current Yahoo board because of the risk that the company will be “mismanaged” in the nine months or more it could take to finalize a deal of this size. He states:

Steve made it abundantly clear that, due to his experiences with Yahoo! during the past several months, he cannot negotiate any transaction with the current board.

In a coordinated statement it just released, Microsoft confirms that while it has “concluded that we cannot reach an agreement” with the current board and management at Yahoo, and that “after the shareholder election Microsoft would be interested in discussing with a new board a major transaction with Yahoo!”

Microsoft is basically telling the market that the only way a Microsoft deal can be revived is by voting the current board out. Yahoo’s stock is up 10 percent this morning on the news to $23.50, last time I checked.

Icahn makes it sound like he and Ballmer are closer than two teenage Best Friends Forever, talking on the phone for “as long as an hour,” gossiping about what they plan to do to Yahoo. But Microsoft is not guaranteeing anything, just that it would talk to Yahoo again if a new board is elected that is more open to a deal than the current one. It would be Microsoft’s fiduciary duty to do so anyway. Ballmer just likes slapping Yahoo around. He is not really committing to anything.

Yahoo, for its part, plans on arguing at its shareholder meeting that selling its search business to Microsoft makes no sense. But one of its counterpoints to Icahn’s original five-point plan, that Microsoft is no longer interested in a full acquisition of Yahoo, is now officially invalid.

Update: Yahoo responds, saying these announcements are silly because Yahoo’s current board is ready to negotiate a full sale of the company with Microsoft. Here is the full statement (I’ve bolded parts of it for emphasis):

Yahoo!’s Board of Directors continues to stand ready to enter into negotiations with Microsoft Corporation for an acquisition of Yahoo!. Indeed, as recently as June, Yahoo!’s independent directors and management approached Steve Ballmer about just such a transaction, only to be told that Microsoft was no longer interested even in the price range which they had previously proposed. Now Mr. Ballmer and Mr. Icahn have teamed up in an apparent effort to force Yahoo! into selling to Microsoft its Search business at a price to be determined in a future “negotiation” between Mr. Icahn’s directors and Microsoft’s management. We feel very strongly that this would not lead to an outcome that would be in the best interests of Yahoo!’s stockholders. If Microsoft and Mr. Ballmer really want to purchase Yahoo!, we again invite them to make a proposal immediately. And if Mr. Icahn has an actual plan for Yahoo! beyond hoping that Microsoft might actually consummate a deal which they have repeatedly walked away from, we would be very interested in hearing it.

Read both Microsoft’s and Icahn’s coordinated statements after the break:

Here is Microsoft’s statement:

In the past week we have had the opportunity to discuss with Carl Icahn the prospects for a possible agreement between Microsoft and Yahoo!.

Despite working since January 31 of this year, as well as in the early part of last year, we have never been able to reach an agreement in a timely way on acceptable terms with the current management and Board of Directors at Yahoo!. We have concluded that we cannot reach an agreement with them. We confirm, however, that after the shareholder election Microsoft would be interested in discussing with a new board a major transaction with Yahoo!, such as either a transaction to purchase the “Search” function with large financial guarantees or, in the alternative, purchasing the whole company.

As Mr. Icahn notes in his statement today, it would be premature to discuss at this time important details such as the price or other terms of a possible transaction. We respect the right of Yahoo!’s shareholders to determine the destiny of their company, and we do not intend to engage in ongoing commentary on these issues in advance of Yahoo!’s shareholder meeting.

As we explained on June 12 when Yahoo! announced an agreement with Google, we believe that our proposed search acquisition and partnership would have delivered superior value to Yahoo!’s shareholders and the marketplace as a whole. We have not changed our position, even as we continue to move forward with our own online search and advertising offerings. We therefore welcome interest by Mr. Icahn in pursuing this and other discussions.

While of course there can be no assurance of a future transaction, we will be prepared to enter into discussions immediately after Yahoo!’s shareholder meeting if a new board is elected.

Here is Carl Icahn’s letter to Yahoo shareholders that Microsoft is responding to:

Carl C. Icahn
ICAHN CAPITAL LP
767 Fifth Avenue, 47th Floor
New York, NY 10153

July 7, 2008

Dear Yahoo! Shareholders:

During the past week I have spoken frequently with Steve Ballmer, CEO of
Microsoft. Several of our conversations have lasted as long as an hour. Also,
a few of our discussions have taken place while other top executives, such as
Kevin Johnson, participated. Our talks centered on the industry in general
but, more importantly, on how Yahoo! and Microsoft can do a transaction
together. Steve made it abundantly clear that, due to his experiences with
Yahoo! during the past several months, he cannot negotiate any transaction
with the current board. His logic is simple. If and when a transaction was
consummated, Microsoft would be guaranteeing a great deal of capital at
closing. However, a transaction could take at least nine months and perhaps
longer to obtain regulatory clearance in the U.S., Europe, and elsewhere.
During that period, if the current board and management team of Yahoo!
mismanage the company (and their recent track record is far from reassuring),
Microsoft would be putting its money at risk and a great deal could be lost.

For example, in a transaction to purchase the whole company, a very large
amount of capital would be due at closing. Even in an “alternate” transaction,
where just the “Search” assets were purchased, large guarantees would have to
be made and, again, large sums could be lost if the company was mismanaged.
Microsoft perceives this risk may be quite high with the current board and
management in place. However, Steve made it clear to me that if a new board
were elected, he would be interested in discussing a major transaction with
Yahoo!, such as either a transaction to purchase the “Search” function with
large financial guarantees or, in the alternative, purchasing the whole
company. He stated that Microsoft would be willing to enter into discussion
immediately if the new board that has been nominated were elected. While there
can be no assurance of a future transaction, as many of you know, I have
negotiated successfully a large number of transactions over the past years. If
and when elected, I strongly believe that in very short order the new board
would, subject to its fiduciary duties, be presenting to shareholders either a
purchase offer for the whole company or a very attractive offer to purchase
“Search” with large guarantees. I hope to continue to be speaking to Steve
over the next few weeks; however, since I do not as yet represent the Yahoo!
board, both Steve and I do not wish to get into details over price, or even
which of these transactions makes the most sense.

Much has been said about how badly the Yahoo! board has “botched up”
negotiations with Microsoft over the past months. There is no need to keep
pointing out the mistakes I believe Yahoo! made by not immediately taking a
$33 offer made by Microsoft. But one thing is clear — Jerry Yang and the
current board of Yahoo! will not be able to “botch up” a negotiation with
Microsoft again, simply because they will not have the opportunity.

Our company is now moving toward a precipice. It is currently losing
market share in its “Search” function; our current Board has failed to bring
in a talented and experienced CEO to replace Jerry Yang and return Jerry to
his role as Chief Yahoo!, and currently it is witnessing a meaningful exodus
of talent. It is no secret that Google (which hired a great operator as CEO)
continues to dramatically outperform Yahoo!. According to publicly available
information, Google’s income from operations grew 59% per year over the last
two years while Yahoo!’s shrank 21% per year. However, none of the above has
caused the Yahoo! board to hesitate in paying themselves $10,000 per week. IT
IS TIME FOR A CHANGE.

If elected, I have little doubt that the new board, subject to its
fiduciary duties, will do what the current board will not do, i.e.,

— Immediately start negotiation with Microsoft to sell the whole company
or, in the alternative, sell “Search” with large guarantees.

— Move expeditiously to replace Jerry Yang with a new CEO with operating
experience.

Sincerely yours,

CARL C. ICAHN

(Photo by Sam Lustgarten).

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