United States: Court Finds That Apple’s E-Book Market Entry Plan Violates The Sherman Act

Last Updated: August 9 2013
Article by Barbara T. Sicalides

After a three-week bench trial, the court has ruled that Apple violated Section 1 of the Sherman Act. The complaint was filed by the Department of Justice, Antitrust Division (DOJ) against Apple and five book publishers. Before trial began all of the publisher defendants settled, leaving Apple alone to defend against the DOJ's allegations. The court held that Apple "orchestrated" a conspiracy among e-book publishers to eliminate retail price competition in order to raise e-book prices, and that without Apple's participation, the conspiracy would not have succeeded.

The Facts

The evidence of conspiracy among the publishers was strong. The five publishers named as conspirators are among the six largest publishers of general-interest fiction and non-fiction books in the United States. The publishers were concerned that Amazon would start to demand even lower wholesale prices for e-books and might even decide to compete directly with publishers by negotiating directly with authors and literary agents for rights.

The evidence is indisputable that several times each year the CEOs of the publishers attended dinners in private dining rooms of New York restaurants, without counsel. Remarkably, the publishers contended that they were free to discuss pricing because they did not compete on price but instead competed only for authors and agents. The CEOs met for the purpose of discussing the common challenges they faced, including Amazon's pricing policies. E-mails contained striking evidence supporting the publishers' conspiracy – one describing a conversation between competitors: "it would be prudent for you to double delete this from your e-mail files when you return to your office" and one sent from one publisher to a competing publisher: "Well done for the Palin book ... and welcome to the Club!"

When the time came for Apple to launch the iPad and its iBookstore, like most companies launching new products, Apple devised a plan. For the launch, Apple wanted to reach arrangements with a number of the largest publishers and to sell e-books at prices lower than that of hardcopies. In its initial discussions with the publishers, Apple assumed that it would enter the business as an e-book retailer under the wholesale model. Apple, however, was unwilling to sell e-books as a loss leader, like Amazon. At the suggestion of some of the publishers, Apple decided to purchase its e-books under an "agency model," where the publishers would set the prices of e-books sold and Apple would take a 30 percent commission as the selling agent.

The court found that when Apple met with each of the publishers it was well aware that the publishers wanted to raise e-book prices above the $9.99 prevailing price charged by Amazon for many e-book versions of bestselling and new books. Apple also knew that publishers were already acting in concert to place pressure on Amazon to abandon its pricing strategy.

Apple's Agreements with the Publishers

The publishers entered into virtually identical agency agreements with Apple. The Apple agreements contained three key features to assure Apple that it would make desirable margins at prices that would be competitive with other Internet retailers and to assure the publishers that they would be able to take pricing control from Amazon and other retailers and to raise e-book retail prices above $9.99: (1) naming Apple as each publisher's agent rather than selling to Apple on a wholesale basis; (2) a Most Favored Nation clause (MFN) that required each publisher to guarantee that no other retailer could set prices lower than Apple, even if the publishers did not control the other retailer's resale price; and (3) virtually identical pricing tiers (setting maximum prices) for e-books based on the list price of each e-book's hardcopy edition.

The MFN, proposed by Apple, protected Apple by requiring the publishers to designate a new lower retail price to match the lower price at which an Apple competitor is selling a title. According to the court, when Apple decided to demand the MFN, it dropped from its draft the explicit requirement that had appeared in its term sheet that all Internet retailers be switched from wholesale to an agency model. Under the wholesale model the publishers were paid based on a percentage of a physical book's list price, but under the agency model, the publisher was paid a percentage of the actual price at which the e-book is resold. Therefore, unless the publishers converted all of their e-tailers to the agency model and raised e-book prices in all of those e-bookstores, Apple would be selling its e-books at its competitors' lower prices and would, therefore, pay lower prices to the publishers. From the publishers' perspective, HarperCollins acknowledged that "[t]he Apple agency model deal means that we will have to shift to an agency model with Amazon" to "strengthen our control over pricing."

The DOJ alleged that Apple and the publishers knew that their agreements would force other retailers off the wholesale model, eliminate retail price competition for e-books, and allow publishers to raise e-book prices. Apple, however, argued that the price tiers were necessary to prevent the publishers from pricing the e-books too high. Regardless of Apple's intentions, after the agreements went into effect, the publishers almost uniformly set e-book prices at the maximum price levels established in the agreements.

The Court's Opinion

The trial court's interpretation of the publishers' or Apple's documents and testimony reflects its view that neither was credible. Although the evidence of wrongdoing by the publishers seems clear, the evidence against Apple was far less compelling. Indeed, the court was troubled by a number of Apple's activities or writings that could just as easily have reflected perfectly reasonable and lawful business conduct. For example, the court found nefarious the fact that Apple advised the publishers that it would be meeting with other publishers and that it needed a certain critical mass of publishers to make the iBookstore launch successful. But, clearly any publisher considering a new partnership would want and need to understand the scope of the newly proposed product. That was particularly important here where the publishers had no preexisting relationship with Apple, the e-book business was new to Apple, and it was possible that Amazon would be unhappy about the publishers' relationships with Apple regardless of the form of that relationship.

The court concluded that Apple and the publishers shared the same goal – ending price competition at the retail level. The court also found that Apple used one publisher to communicate with and convince other publishers to agree Apple's proposed structure and that Apple kept the publishers informed about the status of its negotiations with other publishers.

The court would not give Apple the benefit of the doubt. It routinely drew negative inferences from ambiguous evidence, even when the evidence was clearly subject to different interpretations and Apple offered an innocent or even procompetitive explanation for the evidence. For example, the court clearly believed that the price increases following Apple's agreements were evidence of Apple's participation in a conspiracy with the publishers. Also, the court was influenced by the damning evidence of conspiracy among the publishers and determined that because Apple was essential to the publishers' plan, Apple was part of the conspiracy along with the publishers.

Importantly, the court made clear that the agency model and the way in which Apple negotiated the publisher agreements were lawful. Further, the court recognized that MFNs, price tiers, and price caps are not illegal. The court, however, concluded that Apple made a conscious commitment to enter into a price-fixing conspiracy with the publishers.

On August 2, the DOJ and 33 state attorneys general submitted their proposed remedy to the court for consideration. The proposal would require Apple to terminate its existing agreements with the publisher defendants and would bar it from entering new e-book distribution contracts that would restrain Apple from competing on price. Under the DOJ's proposed remedy, Apple would be prohibited from entering into agreements with suppliers of e-books, music, movies, television shows or other content that are likely to increase the prices at which Apple's competitor retailers may sell that content. Most interesting, however, is the DOJ's request that Apple for two years allow other e-book retailers like Amazon and Barnes & Noble to provide links from their e-book apps to their e-bookstores, allowing consumers who purchase and read e-books on their iPads and iPhones easily to compare Apple's prices with those of its competitors.

The Lessons of the Apple E-Book Case

In a genuine agency relationship, the reseller and the supplier are considered the same person. As a single person, they are unable to reach an agreement or to conspire. Accordingly, the supplier is able to set the retail or resale price without triggering price-fixing concerns under federal or state antitrust laws. Genuine agency arrangements therefore can be used by suppliers to control the resale prices of their products without fear of conspiracy claims.1 Thus, where it makes business sense to use agency, it is one method of avoiding the state patchwork of laws determining whether resale price agreements are subject to the rule of reason or per se analysis.

The problem here was not the agency agreements or any of their features (MFN, price tiers), but that the court perceived that the agreements were reached as part of an overall plan, hatched by the publishers and Apple, to raise retail prices.

Why the court reached that conclusion is the real counseling question and how do firms avoid an agency or a court seeing their conduct similarly? One answer to the question is that the evidence of conspiracy among the publishers was irrefutable and tainted the court's view of Apple. It was difficult to avoid the taint because the iBookstore launch was the vehicle for implementing the conspiracy.

When clients want to affect resale prices, whether by unilateral resale price policies, resale price agreements, unilateral minimum advertised pricing policies, minimum advertised price agreements, or agency relationships, it is critical that the clients do all that they can to avoid even the appearance of involvement with any sort of horizontal discussions. For example, if a manufacturer wants to implement a resale price policy after distributors suggest the idea, the manufacturer must make clear, in writing to the distributors, that it will evaluate independently the value and goals of such a policy, independently decide whether to implement such a policy, and, to the extent possible, independently enforce the policy. During the implementation and enforcement of the policy, the manufacturer must also continually reinforce to the distributors that it will not be pressured by them into enforcing the policy against another competing distributor and that its enforcement decisions must be made unilaterally. Any manufacturer employees involved with the policy must be trained about the danger of horizontal and vertical communications and the way they should handle such communications. And, last but not least, counsel must understand the manufacturer's market, the number of competing suppliers, whether any of the competing suppliers have resale price-related restraints, and the validity of the proposed policy's procompetitive business justifications.

Another answer to the question is that the DOJ had not only direct (and circumstantial) evidence of the publishers' conspiracy, but some of that evidence was also inflammatory. Internal documents should neither recommend that the recipient(s) "double delete" them after reading, nor describe a competitor as a member of "the club." Certain employee conduct must be absolutely or nearly absolutely forbidden. For example, regular dinners with competitors raise intolerably high antitrust risks for the individuals attending the meetings as well as for the firms they represent. Similarly, the number of phone calls among the publishers at key points in the Apple agency agreement negotiations was remarkable. Without knowledge of the content of most of those calls, the court found the frequency and pattern of them to be convincing evidence of conspiracy. Regardless of the employees' position, communications with competitors without a witness or attorney present or without contemporaneous notes explaining the lawful purpose of the communication are risky and should be prohibited and/or reported to counsel promptly. Although Apple's communications with the publishers appear to have been far less inflammatory and were reasonably explained because, as the court noted, Apple was aware of the publishers' goal to raise prices and its relationship with the publishers was the vehicle by which the publishers intended to achieve that goal, Apple was in a very difficult defensive posture.

There is no easy solution for this sort of problem, but it is imperative that firms embarking on strategies aimed at affecting resale price, to the extent possible, distance themselves from potential or apparent horizontal activities at any point in the distribution chain.

Footnotes

1 A transaction will more likely be regarded as a sale rather than a consignment/agency relationship if the putative agent: (1) takes title to the goods at the time they are received; (2) is responsible for payment immediately upon delivery to it; (3) has the power to set resale prices; (4) must make substantial changes in the products; (5) must bear the risk of loss; or (6) pays taxes on the goods as part of inventory.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Barbara T. Sicalides
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