By Roger Parloff, senior editor
FORTUNE -- After Monday's opening statements in the government's federal antitrust case against Apple -- stemming from Apple's game-changing foray into the then nascent ebooks market in 2010 -- it's apparent that the case raises novel legal questions that could well end up commanding the attention of the U.S. Supreme Court.
For casual observers of the case, this had not been so obvious before. That's because the legal questions raised by the conduct of the five publishing companies who were also originally named as Apple's (AAPL) co-conspirators and co-defendants in the case -- Hachette, HarperCollins, MacMillan, Penguin, and Simon & Schuster -- did not pose comparably challenging questions. (Each publisher settled before trial admitting no wrongdoing.)
Unlike Apple, the publisher defendants were charged with engaging in a horizontal price-fixing conspiracy -- a well-recognized, frequently encountered, and widely condemned variety of collusive behavior. While the publishers' motivations may have been unusual -- some would argue laudable -- there is much evidence that they did, in fact, collude to hike up the price of ebooks. Under Section 1 of the Sherman Act, which forbids conspiracies "in restraint of trade," that's hard to justify.
In contrast, though, Apple had a vertical relationship to all the other players in the alleged plot. As a result, its conduct poses far less familiar factual and legal questions. While there have been prior cases in which vertical players have participated in horizontal antitrust conspiracies, these have usually involved situations where a behemoth vertical player was the instigator and chief beneficiary of the whole scheme -- the "ringmaster," as courts have put it.
Apple doesn't fit that template, though. Far from being a dominant player in the book industry, Apple was a new entrant. Far from instigating the scheme, it was -- even on the government's view of the evidence -- an opportunistic late-comer who exploited a preexisting situation. Moreover, it's not at all far-fetched to believe that Apple behaved at all times in a manner that furthered its own independent, seemingly lawful business objectives: opening a digital bookstore. In the process, Apple brought competition to a market that was, prior to its arrival, dominated by an 80% to 90% near-monopolist, Amazon (AMZN).
The Supreme Court has expressed far more reluctance to intervene in alleged vertical price-fixing conspiracies than in horizontal price-fixing conspiracies, due to having much less confidence in the former context about what constitutes reasonable commercial behavior and wherein lies the public interest. (As recently as 2007, for instance, the Court overturned 96 years of precedent to declare that there was nothing illegal "per se" about vertical price restraints.) The unique facts of Apple's case will make it a singularly sympathetic one to today's markedly pro-business Supreme Court if the case eventually reaches them.
The following basic facts appear to be fairly undisputed. In November 2009, just two months before Steve Jobs made his historic unveiling of the first iPad tablet on January 27, 2010, Apple's head of content, Eddy Cue, convinced Jobs to give the iPad e-reader functionality and use the opportunity to launch a digital bookstore, comparable to Apple's already successful iTunes and Apps Store. Jobs greenlighted the project. But while the new iBookstore would launch on April 3, 2010, Jobs wanted the key contracts with publishers signed by the time of his January iPad unveiling, so he could include it in his presentation. (In his opening, Apple lead lawyer Orin Snyder, of Gibson, Dunn & Crutcher, included a video excerpt from Jobs's masterful iPad launch. While it was a moving and bitter-sweet moment for many of the journalists and business people present, U.S. District Judge Denise Cote, who is hearing the case without a jury, seemed ominously cold during the clip.)
Cue began meeting the CEOs of the six major publishers in mid-December 2009, sent out proposed term sheets in early January, and finally reached signed contracts with five of the publishers over the final three days preceding his January 27 presentation.
Cue knew next to nothing about the book industry when he undertook his task in December, according to Snyder, the attorney for Apple. But one thing everyone knew by then -- because it had been the subject of major articles in the Wall Street Journal and New York Times during the summer of 2009 -- was that the publishing companies were, by this time, furious with Amazon about the rock-bottom $9.99 price at which it was selling the ebook versions of most of their new-releases and New York Times bestsellers.
Amazon then controlled about an 80% to 90% share of the ebook market, having helped pioneer that market with its November 2007 launch of the Kindle e-reader. Publishers sold Amazon the digital versions of their books using the same so-called "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 they'd 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 -- publishers sold ebooks to Amazon under this wholesale model for about $10. To their horror, however, Amazon resold the ebooks to the public for $9.99 -- a slight actual loss or, as U.S. Department of Justice lawyer Lawrence E. Buterman put it in his opening, a "break-even" price. Buterman didn't explain why Amazon did this in his opening, but Amazon evidently viewed the low-priced books as a way to kickstart a new market and stimulate sales of its new Kindle devices. Publishers feared, however, that such a low price would pull down the price of hardbacks and paperbacks, diminish authors' royalties, torpedo the viability of brick-and-mortar bookstores, and possibly lead to the elimination of publishers altogether (disintermediation) as ebook distributors like Amazon would begin contracting directly with authors.
In response, some publishers chose to raise their wholesale ebook prices to $12 or even $15, but Amazon continued to sell even those ebooks for $9.99 -- now absorbing a $2 to $5 loss on every single book sold. Government attorney Buterman glossed over Amazon's below-cost pricing without comment, though such pricing in other contexts, at least in the past, has been itself branded an antitrust violation ("predatory pricing").
Some publishers began withholding ebooks from Amazon altogether, or adopting "windowing" policies, where they would delay releasing an ebook until a certain number of months after the hardcover release. Some of Amazon's ebook competitors, like Barnes & Noble (BKS), also complained that Amazon's below-cost pricing was enabling it to monopolize the market and exclude would-be market entrants.
This brouhaha was widely known and reported as it was happening. What was less known at the time was that by the summer of 2009 the CEOs of the six major publishing companies had also begun meeting in private to discuss the future of their "industry" and what could be done about Amazon's $9.99 pricepoint. There is evidence that they tried to keep these meetings secret, presumably out of concern that the discussions might be thought to violate the antitrust laws.
"I think it would be prudent for you to double delete this from your mail files when you return to your office," one high-level Hachette executive told another at the close of an August 2009 email discussing conversations with other publishing houses, for instance.
If the publishers' meetings during the summer of 2009 did, in fact, constitute an antitrust conspiracy, however, there is no question that Apple was not part of it -- at least not yet. Eddy Cue, Apple's head of content, had not even conceived the notion of going into the ebook industry until November 2009, Snyder contends.
Apple also contends that it never knew about the extent of the publishers' horizontal collusion with one another, which seems both plausible to an extent, and implausible to an extent. Part of the problem here is that the concept of "collusion" is a funny one in the antitrust context. Whenever a traveler compares airline fares between two cities at a desired departure time, for example, he usually finds that all the key competitors charge exactly the same price -- down to the penny. That's not illegal price-fixing, so long as one Airline A set its price first, and Airlines B and C simply chose to match that fare later. If, on the other hand, all the competitors agreed beforehand that Airline A would announce its price first and that the others would then purport to "match" it after the fact, that's illegal price-fixing. It's a fine line for pragmatical, aggressive, business people to observe.
The government's theory, in any case, is that once Apple did decide to get into the ebook business, it learned of the conspiracy and then exploited it. Apple gave the publishers a way to force Amazon to abandon the wholesale model, and to impose a new "agency" model on the entire ebook industry. This was "a deliberate scheme orchestrated by Apple to fix prices," Buterman said on Monday.
Under the agency model, book publishers would set the retail price of the book themselves, and Apple would take 30% of the revenue as its commission (as it already was doing with its iTunes and App stores). Thus Apple joined the publishers' scheme, Buterman said, "as a quid pro quo to ensure they'd enter the market with guaranteed 30% margins and without price competition."
The government theorizes that no publisher acting alone had the leverage to force Amazon to abandon the wholesale model, but that five major publishers acting in concert did have that leverage, and that Apple was the crucial "go-between," "facilitator," or "ringmaster" that could orchestrate this united effort. The government will point to some emails between Apple's Cue and individual publisher CEOs in which Cue appears to reveal, when prodded, how many other publishers have committed to sign, or are likely to.
When Cue circulated the original proposed "agency model" term sheets to publishers in early January, each included a bullet-point stating that "all resellers of new titles must be in agency model." Thus, the government argues, Apple was requiring each publisher to insist that it alter its relationship with Amazon -- abandoning the wholesale model.
Negotiations continued, however, and by the time contracts were signed in late January, there was no provision in any of the publisher's contracts with Apple explicitly prohibiting anyone from using the wholesale model with other retailers if they wished. Instead, there was a so-called "most-favored nation" clause (MFN), which is a fairly common feature in distributors' contracts. This clause provided that if some other retailer was selling an ebook for less than a publisher wanted to sell it at Apple's iBookstore, Apple was free to match that lower price.
So the MFN did not literally require publishers to abandon the wholesale model, though it certainly incentivized them to do so. (Here's why: If a publisher allowed Amazon, under the wholesale model, to continue to sell one of its books at $9.99, Apple could do so, too, under the MFN. But now the publisher would be receiving in return from Apple only $6.99 [70 per cent of $9.99] rather than the $10 wholesale price it was used to getting from Amazon.)
In late January 2010, after signing its agency contract with Apple, Macmillan CEO John Sargent met with Amazon and demanded that it switch to the agency model of pricing (at least once the iBookstore got up and running in April). After a brief tantrum -- Amazon initially deleted the buy buttons from all of Macmillan's books on Amazon.com -- Amazon capitulated.
In April 2010, when the iBookstore opened, most new-release ebook prices for the five major publishers jumped from $9.99 to either $12.99 or $14.99. (Apple's agency contracts had included the $12.99 and $14.99 price caps on different tiers of books because Apple feared the publishers would otherwise charge more than the digital market would bear.)
The final impact of the adoption of the agency model on prices is, nevertheless, sharply disputed. Apple's Snyder claims the evidence will show that the average prices for the categories of ebooks in dispute actually declined over the course of the alleged conspiracy. The government's Buterman said that these declines in average prices over time merely reflected "trends" that were already "under way before Apple entered the market."
In context, then, was Apple's inclusion of an MFN clause into its contracts with publishers illegal? That, after all, is the mechanism that eventually, if indirectly, led to the demise of the wholesale pricing model.
The government claims that it is. In its antitrust complaint it characterized Apple's MFN clause as "the key commitment mechanism to keep the Publisher Defendants advancing their conspiracy in lockstep." And in its pretrial memorandum of law the government argued: "Apple knew that . . . the retail price MFN would sharpen [publishers'] incentives to follow through on raising prices across all retailers."
Apple's Snyder, on the other hand, argued that "no court has ever held an MFN to be illegal." On its face, certainly, an MFN simply gives a retailer the right to offer consumers the lowest available price. How could that be illegal, then, Snyder asked rhetorically. The MFN, indeed, made Apple agnostic to whether the publishers continue to use the wholesale model with Amazon or any other retailer, he said, since Apple (and its consumers) would be guaranteed the lowest available price no matter what.
And while the MFN does, indeed, give each publisher who signs with Apple an incentive to stop using the wholesale model with Amazon or anyone else -- so what? The entry of a new competitor into a market always changes every market participants' incentives.
"I'm aware of no antitrust case that's been based on 'sharpening another company's incentives,' " he said in his opening. "What does it even mean 'to sharpen incentives'? . . . That's no standard at all?"
MORE: Apple's day in court
In apparently having made an MFN clause the lynchpin of its conspiracy theory, the government may face another hurdle as well. At least according to Snyder, the evidence will show that each of the publishers during the negotiation process resisted the inclusion of that clause in their contracts with Apple. Snyder claims, for instance, that Hachette initially deleted it from the contract, calling it a "deal-breaker." HarperCollins CEO Brian Murray refused to sign until Steve Jobs went over his head, to News Corp. executive James Murdoch, and persuaded Murdoch of the wisdom of the deal. Random House, the largest publisher in the world, refused to ever sign Apple's agency contract, at least in part due to the presence of that clause, Snyder claims. (Random House was never named as a defendant in the government's case.)
"Each [publisher] was negotiating against the provision that supposedly held this conspiracy together," Snyder contended in his opening. "The publishers opposed the very contract term that the United States says was the secret sauce, the magic bullet … that enabled the conspirators to kill the $9.99 price point."
Of course, it remains to be seen whether, over the next three weeks of trial, the evidence will in fact come in the way Snyder has promised that it will, or whether it will, in the end, conform more closely to the more damning narrative predicted by Justice Department attorney Buterman.
Yet even though it's still hypothetical, highly contingent, and years down the road at best, it's hard not to already hear Justice Antonin Scalia's taunting voice at an oral argument, caustically demanding: "Mr. Buterman, can you name another case in which we have held that a company violates the antitrust laws by 'sharpening the incentives' of a contractual partner to act in certain ways?"
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