U.S. v Apple: A puzzle with a big piece missing

June 25, 2013: 2:51 PM ET

The government's e-book antitrust case against Apple makes perfect sense -- so long as you don't ask why Amazon was pricing below cost.

By Roger Parloff, senior editor

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FORTUNE -- By the time summations concluded last week in the government's e-book antitrust suit against Apple, Apple had amply vindicated CEO Tim Cook's out-of-court characterization of the case as "bizarre."

Yet it still might not win. On the contrary, if federal judges read the antitrust laws mechanically and read certain emails and testimony uncharitably, it's easy to see how they might conclude that Apple (AAPL) in December 2009 and January 2010 did, indeed, facilitate a price-fixing conspiracy among five of the six major publishing houses when it was arranging the launches of its iPad and iBook store. There can be little question that Apple understood that its entry into the e-book market under the terms of the "agency model" contracts it had negotiated with the publishers would push prevailing prices on most new releases from $9.99 to either $12.99 or $14.99, which is just what it did.

At the same time, all the evidence presented seemed consistent with Apple's contention that it simply sized up the unusual market conditions prevailing when it arrived on the scene in late 2009 and then acted to further its own independent, paradigmatically legitimate business goals: opening a store and trying to make a profit. As a by-product, if not a goal, Apple unquestionably enhanced competition and innovation in a sorely over-concentrated market. (I consequently adhere to my earlier view, expressed here, that if the case reaches the U.S. Supreme Court, Apple will win.)

Yet the crux of what makes the case so peculiar is something we learned surprisingly little about during the three-week trial before U.S. District Judge Denise Cote in Manhattan. When Apple decided to get into the e-book business in November 2009, it confronted a singularly unusual market: one in which an 80% dominant player, Amazon.com (AMZN), was selling nearly every one of the publishers' most desirable titles at $2 to $5 below cost.

The situation had already caused the publishers to rise up in open and highly publicized rebellion. The publishers -- and retailer Barnes & Noble (BKS), too -- complained that Amazon's prices were predatory, i.e., designed to exclude new entrants, drive out competitors, and consolidate monopoly power. The publishers feared that Amazon's pricing would, among other things, diminish the value of all books in the eyes of consumers and cripple publishers' ability to extend advances to unestablished authors and to promote their works.

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Precisely what Amazon was up to, in pricing in this fashion, remained throughout the trial a largely unremarked elephant in the room. Months before trial, during the discovery phase, U.S. District Judge Denise Cote denied Apple the right to inquire into Amazon's business strategy, finding it irrelevant to the issues before her. Accordingly, Amazon's conduct was the missing piece right smack in the middle of the jigsaw puzzle. As observers we must approach this case the way we would a criminal prosecution in which the defendant never takes the stand, and we've been instructed not to hold that against him.

For their part, the lead Department of Justice lawyers, Mark Ryan and Lawrence Buterman, glossed over Amazon's unusual pricing as a routine "loss-leader" strategy, presumably designed to lure more visitors to the Amazon site where they could buy other items at a profit. Garden rakes, maybe.

In its complaint, the government alleged that Amazon wasn't losing money from its pricing strategy, but it presented no evidence on that question during the trial itself. It elicited from Amazon's top Kindle executive, Russ Grandinetti, the puzzling twin statements that Amazon "never used sales of e-books directly to subsidize Kindle sales," though it did sometimes "look at the business holistically as the sum of what the device business and the content business provide together."

However Amazon was doing it, the government accepted Amazon's below-cost pricing as a given, and therefore took Amazon's $9.99 price point to be a natural, "competitive" price for the e-book market. Yet a market dominated by a single 80%-share behemoth is hardly "competitive."

The government then reasoned that any potential new e-book entrant, like Apple, if it wasn't also willing to sell all its best inventory at a $2 to $5 loss , must, by definition, be "inefficient." Under standard economic theory, inefficient competitors are best advised to stay out of a market (even if, as in this case, that means leaving the near-monopolist to thrive unchallenged).

And that's exactly what the government argued in a memorable passage of its pretrial brief, and one that Apple's lead lawyer Orin Snyder highlighted in his summation on June 20.

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Apple's Eddy Cue.

Apple's Eddie Cue.

"[Apple] could instead," the government wrote, "have remained out of the market and focused on developing other aspects of its business -- leaving it to Amazon and other retailers to innovate and improve the e-reading experience on Apple's devices -- as they had been doing for years. Given Apple's clear knowledge that it was assisting publisher defendants in their shared quest to raise consumer prices," the government continues, "this would have been the wiser choice from a legal, as well as a business, perspective."

In the government's view, it seemed, Apple had a duty to stay on the sidelines if its entry would disrupt the weird, below-cost-pricing status quo from which consumers were then, for some unexplained reason, benefiting. Entry on any other terms -- even relatively standard, benign-on-their-face, contractual terms -- would be illegal in this context if Apple knew it would be changing industry practices in a way that caused prices to rise, harming consumers.

Strange case, right?

I tried to lay out the basic law and facts of the case in my previous article. To recap what is essential here, Amazon turbocharged the previously feeble e-books market when it launched its popular first Kindle device in November 2007. It soon captured about a 90% share of the e-book market. (Macmillan publisher John Sargent testified that, at its peak, Amazon was selling 95 % of that company's e-books.)

Publishers sold Amazon the digital versions of their books using the same "wholesale model" that they used for selling hardcover and paperback books to brick-and-mortar bookstores. Under that model, they'd sell the book to a retailer at about half the contemplated list price -- say $12.50 for a hardback with a $25 price printed on the jacket -- affording the retailer the discretion to determine how much of a discount it would offer off the list price, if any.

Contemplating a retail price of about $20 for a digital book -- about 20% off the standard $25 price for a new-release hardback, reflecting the lower distribution costs -- publishers sold e-books to Amazon under this wholesale model for about $10. To their horror, however, when Amazon launched its Kindle bookstore it resold these e-books to the public for $9.99 -- a slight actual loss or, as U.S. Department of Justice lawyer Buterman put it in his opening, a "break-even" price.

In late 2008 and early 2009, at least five major publishers responded by raising their wholesale prices to levels to $12, $15, or even more. Amazon stood its ground, selling even those e-books for $9.99 -- now absorbing a $2 to $5 loss on every book sold.

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Whatever Amazon's intent, its below-cost pricing structure appears to have discouraged potential competitors from entering the market. Costco (COST), for instance, wanted to get in the game, according to the testimony of Macmillan CEO Sargent, but "could not figure out a way to [do so] without losing money."

In July 2009 Barnes & Noble entered the e-book market, using the wholesale model. But in matching Amazon's below-cost prices, as consumers demanded, it "immediately began to suffer severe losses," according to B&N's Theresa Horner, its vice president of digital content. Judging the situation "unsustainable," she testified, B&N "contacted several major publishers to again try to persuade them to consider an alternative distribution model." By early December 2009 -- shortly before Apple began approaching publishers about launching its iBook store -- B&N president William Lynch began urging publishers to consider an "agency model" with it, whereby the publisher would set its own retail price for e-books, and B&N would earn a 30% commission on each sale.

Beginning in late 2008 and continuing through at least the summer of 2009, CEOs from all six major publishers began meeting privately, confidentially, and collectively to discuss their "Amazon problem" and how they might "solve" or "fix" it. One way to do so would be to move Amazon off the wholesale model and onto some alternative model, like agency, where the distributors retained pricing control. In the antitrust context, horizontal competitors getting together to discuss how to raise prices across their industry looks very bad, as it at least superficially resembles a horizontal price-fixing conspiracy. (Hachette, HarperCollins, Macmillan, Penguin, and Simon & Schuster were all originally codefendants in the government's antitrust case against Apple. All settled before trial without admitting wrongdoing.)

But no evidence was ever presented suggesting that Apple, which did not begin contemplating entry into the e-book market until November 2009, was aware of, let alone a participant in, any of these allegedly collusive meetings. (Apple officials testified at trial that they knew nothing of them.)

In late 2009, as another way of pushing back against Amazon's below-cost pricing, at least four major publishers began experimenting with "windowing" the e-book versions of their blockbuster new releases, including titles by Stephen King, Sarah Palin, and Ted Kennedy. A common practice with respect to paperback releases, windowing meant refusing to release them until a set number of months after the hardback launch. It was a way to avoid cannabilization of hardback sales.

As Macmillan's Sargent testified at trial, "Traditionally in our relationships with retailers, one party [i.e., the publisher] controls availability, the other party [i.e., the retailer] controls price. [Amazon] wanted to control both. And we were to force their hand to have one or the other."

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Judge Cote.

Judge Cote.

In late 2009, four publishers announced publicly that they would greatly expand their windowing practices on e-books beginning in January 2010 -- a development that was widely reported in the press.
Amazon CEO Jeff Bezos saw "windowing" as a "nuclear" threat, according to an email introduced in evidence by Apple. He saw it that way, Apple lawyer Snyder argued, because it threatened to turn the Kindle e-book store into a "second-class," backlist warehouse where consumers could not obtain the latest, buzziest titles.

Apple CEO Steve Jobs saw "windowing" exactly the same way, which is why, when he began considering opening an e-book store in November 2009, he told his head of content, Eddy Cue, that he would do so only if the store sold new releases.

Cue began calling publishers on December 9, 2009. (All of these conversations were bilateral.) Cue had a very tight deadline, because Jobs wanted to include the iBook store in his product launch presentation when he unveiled the first iPad on January 27, 2010. (Cue didn't tell publishers about the iPad, but many speculated that Apple would be launching a tablet soon.)

Though Cue initially assumed Apple would be buying e-books from the publishers under the wholesale model, two publishers urged him early on to adopt an agency model, instead, giving the publishers more pricing control. After initially resisting, Cue and Jobs quickly changed their minds, deciding that a 30% commission agency approach -- which Apple was already using profitably at its App Store -- made sense here, too. (Apple's iTunes store was technically operating on a wholesale model, but Apple made 30% gross margins there, too. With both arrangements, Apple was generating single-digit net margins.)

As negotiations commenced, Apple's Jobs and Cue believed that the publishers wanted to price e-books at levels too high for the digital market to bear. They therefore sought price caps for certain tiers of books, which after negotiations came to rest at $12.99 and $14.99 levels. While it was foreseeable that publishers would in almost all cases set prices at the maximum permissible level, the caps benefitted consumers, Apple contends, in that they kept prices from being even higher. (Apple also denies that its plan truly "raised" prices because, once publishers started windowing on a grand scale, the $9.99 price wasn't going to be available in most cases for the types of books Apple planned to sell for $12.99 and $14.99. Those books weren't going to be available on Amazon at all, due to windowing.)

Still, the agency model obviously wouldn't work if the publishers continued to sell e-books to Amazon under the wholesale model, since Amazon's prices would in many cases undercut Apple's. So in term sheets sent to the six major publishers on January 4 and 5, 2010, Cue included a bullet-point that read: "all resellers of new titles must be in agency model."

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The government regards that bullet-point, contained in identical terms sheets sent to each of the six major publishers, as evidence of collusion, since Apple was telling the publishers, in effect, that the whole industry -- all publishers and all retailers, including Amazon -- had to be moved to agency.

The bullet-point never made it to the formal contract stage, however. When draft contracts were drawn up they included, instead, a so-called most-favored nation clause, or MFN, which gave Apple the right to match the lowest price that any other e-book retailer might be offering for the same title. MFN clauses are common, and the conventional assumption in antitrust law is that they are benign.

(Coincidentally, a few days before Apple's Cue started approaching publishers, Barnes & Noble also started approaching them. B&N also urged them to adopt an agency model. B&N eventually included an MFN clause in its contracts with publishers, all of whom eventually signed. Similarly, when Amazon later capitulated and negotiated agency contracts with all the major publishers, it too insisted on the inclusion of MFN clauses in the contracts.)

The MFN, Apple contends, simply made Apple indifferent as to whether publishers continued to use the wholesale model with Amazon, since all it cared about was price parity. (With a 30% gross margin, it knew it could make a profit at $9.99 or even lower, since it was already doing so at iTunes and the App Store.)

The government protests, however, that in this special context Apple's MFN was a way to ensure that the entire publishing industry, acting collusively, would force Amazon off the wholesale model. (If Amazon stayed on the wholesale model while Apple went to agency, yet Apple could match Amazon's $9.99 prices, the publishers would receive from Apple only $6.99 (70% of $9.99) for a book for which the they were used to receiving $12 to $15 under the wholesale model.) While a publisher acting on its own might have been afraid to insist that Amazon move to agency -- fearing devastating retaliation by Amazon, which could simply stop selling that company's digital and print books altogether -- publishers might be willing do so as part of a united front. Apple's materially uniform contracts gave them that opportunity, the government says.

And Apple's contracts did give the publishers that opportunity, which they did exercise. Is that illegal?

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