The Apple Decision: Lessons Taken

by K&L Gates LLP
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On July 10, 2013, Judge Denise Cote of the United States District Court for the Southern District of New York ruled that Apple Inc. committed a per se illegal violation of Section 1 of the Sherman Act when it instigated and facilitated a horizontal conspiracy between several leading book publishers to raise retail prices to consumers for electronic versions of books (“e-books”). Because the publishers had all settled the allegations against them prior to trial, trial testimony and the opinion focused most heavily on Apple’s actions and liability for encouraging and enabling the conspiracy. The opinion offers useful lessons for counsel and companies in complex distribution relationships.

According to Judge Cote, with the release of the iPad quickly approaching, Apple wanted badly to launch its own e-bookstore that would compete directly with Amazon and leverage the comparative advantage iPad would have over Amazon’s Kindle as an e-reader. It needed books to offer to iBookstore users and that meant that it needed to ink deals with publishing houses, and quickly. Amazon, however, bought titles from publishers under a traditional wholesale distribution model and had demonstrated a willingness to set retail prices at $9.99, which roughly matched its wholesale cost. Apple feared that its entry under a similar model and at similar prices would prevent Apple from achieving a profit, a strategy it was unwilling to take. 

Judge Cote found that, for their part, the publishing houses had long wished to raise retail prices for e-books, which they viewed as a necessary outlet but priced so low by Amazon that traditional brick-and-mortar book outlets and the integrity of the pricing structure for hardcover copies were threatened. The traditional wholesale distribution model, however, left pricing mostly in the discretion of the retailer, and Amazon had priced most of its books at $9.99, a price the publishers feared would become the e-book standard. So when Apple approached the publishers separately to discuss its plans for the iPad and the iBookstore, each of them engaged Apple eagerly. Within a few months, after multiple discussions between the publishers themselves and multiple negotiation sessions between Apple and each publisher separately, Apple and the publishers agreed to scrap the traditional wholesale distribution model and move to an agency model. The publishers would set the retail price for titles and be able to set higher prices for e-books according to a tiered system (but still not as high as some of them would have liked). Apple would receive a 30 percent commission.  Although the publishers would actually lose e-book sales in the near term under the agency arrangement than they were making in wholesale distribution to Amazon, they were willing to sacrifice short-term profits to protect the pricing of their hardcover and new release titles and to secure the right to direct the pricing decisions of the emerging e-book industry.

Now in the e-book game, Apple shared the publishers’ desire to avoid a price war with Amazon, but for a different reason. Apple wanted to ensure that it would make money with the iBookstore and gain critical mass among customers at launch. Realizing that relinquishing pricing authority to the publishers would leave Apple vulnerable to price competition from Amazon (which remained on the wholesale model), Apple convinced the publishers that the industry as a whole must move to an agency model, and the agreements eventually contained a “Most Favored Nations” (“MFN”) clause to ensure it. The MFN gave Apple the right to match the lowest prices of any other e-retailer, so leaving Amazon in control of retail prices would eventually destroy the publishers’ profits for sales by Apple because commissions made them variable. One by one, after contentious negotiations the publishers extracted agreements from Amazon to move to the agency model advocated by Apple and adopted by the publishers. Not surprisingly, the simultaneous nature of the publishers’ demands (along with evidence that they were communicating with each other about their individual negotiations with Amazon) led Amazon to file a complaint with the Federal Trade Commission, and eventually the Department of Justice brought its case.

Apple’s chief legal argument was that none of the vertical negotiation tactics or agreement terms employed by Apple was inherently illegal or even unreasonable. Judge Cote agreed as a general principle, but found this irrelevant in light of the ample direct and circumstantial evidence that Apple both knew about the horizontal price-fixing conspiracy between the publishers, and actively planned and assisted in its implementation by orchestrating negotiations and driving the industry’s move to an agency model of distribution. In Judge Cote’s view, Apple used its status as a powerful new entrant and the tools of agency distribution and MFN to motivate and empower the publishing industry collectively to blunt Amazon’s ability to discount retail e-book prices. Without Apple’s participation, the publishers would not have begun the effort, and could not have succeeded even had they attempted it. In her view, this case was not about vertical negotiations between supplier and distributor, but about Apple’s success in enabling a horizontal conspiracy to succeed at the publishing level.

Apple has announced it will appeal. Regardless of the outcome, companies engaged in distribution relationships, particularly those in the middle of the supply chain, can draw from the ruling a number of useful lessons about antitrust risk:

1. Distributors and others in the midst of a supply chain should pay close attention to the motivations of customers and suppliers, particularly if asked for information or asked to take action. The court’s decision follows a line of cases establishing antitrust liability for knowingly facilitating a horizontal conspiracy at another level in the supply chain. Often, a company upstream or downstream in the supply chain is in a unique position to effect such a conspiracy, as it may have competitively sensitive pricing or other data of customers or suppliers and their competitors, or they may have a commercial relationship with a company the conspirators wish to target in some manner. As suppliers to Amazon, the publishers had the latter. Apple had neither. But it had exactly what the publishers needed to move them to joint action, what no other company had – another outlet for the publishers to reach the e-books market.  Companies should be wary when customers or suppliers ask them to take action, particularly if the action may harm a competitor.

2. Vertical arrangements are not free of risk simply because they are vertical. One of Apple’s key arguments underscored that as a purchaser, not a competitor, of the publishers, its negotiated agreement terms like the agency model, the MFN, and price tiers were all vertical agreements intended to secure Apple’s own economic interests and ensure the success of its iBookstore, and thus were not illegal. But as the trial court ruled, a company can act in its own economic interest and still be held per se liable for knowingly facilitating the separate anticompetitive purposes and acts of a group of conspiring competitors at another level in the supply chain if direct evidence supports the charge. If the ruling is upheld by the appellate court, the often-prevalent assumption that vertical arrangements are nearly always evaluated under a reasonableness standard has been given a sharp reality check, particularly if there is direct evidence of an intent to facilitate a horizontal conspiracy.

Even where such direct evidence is lacking, parties should examine whether an agreement makes economic sense for the parties when evaluated on its own merits. Apple would only accomplish its goal to eliminate the possibility of a price war with Amazon if all of the publishers struck the same agreement. The court cited evidence showing that the publishers would (and did) lose substantial sales (such that the economics of the agreement with Apple were “terrible,” in the words of the judge) under an agency with Apple, if any of them continued to sell to Amazon under a wholesale model. Only by moving the entire industry to an agency model in concert and securing pricing authority with publishers, could the publishing industry force the model on Amazon and ensure that Apple would be safe from price competition with Amazon after the iBookstore launched. Based on this and other factors, the court ruled that Apple’s conduct was unreasonable as well as per se illegal. Arrangements that make economic sense only if others follow suit should raise a red flag and companies should scrutinize them carefully.

3. Documents really matter. Perhaps no surprise, but underscored in stark relief in this case. Judge Cote found the testimony of Apple’s key witnesses to be largely incredible and cited a contrary documentary record extensively. Emails, memos, even handwritten notes—all found their way into the opinion as evidence against Apple. And several of the documents contained very troubling statements—one advised the recipient to destroy it after reading. The influence these types of statements have in setting the tone of the trial and impressions of the judge would be difficult to overstate. The judge ultimately based her opinion not on economic theory but on her strong conviction of Apple's intent to conspire with the publishers and its knowledge of what its negotiating tactics would do—conclusions supported mostly by documents. For companies and counsel, the lesson continues to be that vigorous antitrust training, with a strong component regarding document creation, is always a sound investment of resources.

 

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