July 24, 2013
The Apple Decision: Lessons Taken
Practice Group(s):
By Brian K. McCalmon
Antitrust,
Competition & Trade
Regulation
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 ebooks, which they viewed as a necessary outlet but priced so low by Amazon that traditional brickand-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
The Apple Decision: Lessons Taken
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
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The Apple Decision: Lessons Taken
substantial sales (such that the economics of the agreement with Apple were “terrible,” in the
words of the judge) under an agency model 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.
Author:
Brian K. McCalmon
brian.mccalmon@klgates.com
+1.202.661.6230
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