Apple Slicing Up the E-Book Market

In 2009, Apple, Inc., had plans to release a new tablet computer, the iPad. Executives at the company saw an opportunity to sell e-books on the iPad by creating a virtual marketplace, the "iBookstore." Apple went directly into negotiations with six of the major publishing companies in the United States. In two months, it announced that five of those companiesHachette, HarperCollins, Macmillan, Penguin, and Simon & Schuster (Publisher Defendants)had agreed to sell e-books on the iPad under arrangements whereby the publishers had the authority to set prices and could set the prices of new releases and New York Times best sellers as high as $19.99 and $14.99, respectively. Each of these agreements resulted in each Publisher Defendant receiving less per e-book sold via Apple as opposed to Amazon, even given the higher consumer prices. Just a few months after the iBookstore opened, however, every one of the Publisher Defendants had taken control over pricing from Amazon and had raised the prices on many of their e-books, most notably new releases and best sellers.

The Department of Justice and 33 states and territories (plaintiffs) filed suit alleging that Apple, in launching the iBookstore, had conspired with the Publisher Defendants to raise prices across the nascent e-book market and that their agreement violated 1 of the Sherman Antitrust Act. All five Publisher Defendants settled and signed consent decrees, which prohibited them from restricting e-book retailers' ability to set prices. Apple went to trial, and after a three-week bench trial, the district court concluded that, in order to induce the Publisher Defendants to participate in the iBookstore and to avoid the necessity of itself competing with Amazon over the retail price of e-books, Apple orchestrated a conspiracy among the Publisher Defendants to raise the price of e-booksparticularly new releases and New York Times best sellers. [United States v Apple Inc., 952 F. Supp. 2d 638, 647 (S.D.N.Y.2013)] The district court found that the agreement constituted a per se violation of the Sherman Act and, in the alternative, unreasonably restrained trade under the rule of reason. The court issued an injunction that prevents Apple from entering into agreements with the Publisher Defendants that restrict its ability to set, alter, or reduce the price of e-books. Apple appealed.

Judicial Opinion

LIVINGSTON, Circuit Judge

Where Amazon departed from the publishers' traditional business model was in the sale of new releases and New York Times bestsellers. Rather than selling more expensive versions of these books upon initial release (as publishers encouraged by producing hardcover books before paperback copies), Amazon set the Kindle price at one, stable figure$9.99. At this price, Amazon was selling "certain" new releases and bestsellers at a price that "roughly matched," or was slightly lower than, the wholesale price it paid to the publishers.

The most significant attack that the publishers considered and then undertook, however, was to withhold new and bestselling books from Amazon until the hardcover version had spent several months in stores, a practice known as "windowing."

[Apple] devised an alternative to explicitly requiring publishers to switch other retailers to agency [pricing]. This alternative involved the use of a "most-favored nation" clause ("MFN Clause" or "MFN"). In general, an MFN Clause is a contractual provision that requires one party to give the other the best terms that it makes available to any competitor. Put differently, the MFN would require the publisher to offer any ebook in Apple's iBookstore for no more than what the same ebook was offered elsewhere, such as from Amazon.

The Big Six understood the economic incentives that the MFN Clause created. Suppose a new hardcover release sells at a list price of $25, and a wholesale price of $12.50. With Amazon, the publishers had been receiving the wholesale price (or a slightly lower digital wholesale price) for every ebook copy of the volume sold on Kindle, even if Amazon ultimately sold the ebook for less than that wholesale price. Under Apple's initial agency modelwith price caps but no MFN Clausethe publishers already stood to make less money per ebook with Apple. Because Apple capped the ebook price of a $25 hardcover at $12.99 and took 30% of that price, publishers could only expect to make $8.75 per sale. But what the publishers sacrificed in short-term revenue, they hoped to gain in long-term stability by acquiring more control over pricing and, accordingly, the ability to protect their hardcover sales.

This appeal requires us to address the important distinction between "horizontal" agreements to set prices, which involve coordination "between competitors at the same level of [a] market structure," and "vertical" agreements on pricing, which are created between parties "at different levels of [a] market structure." Under 1 of the Sherman Act, the former are, with limited exceptions, per se unlawful, while the latter are unlawful only if an assessment of market effects, known as a rule-of-reason analysis, reveals that they unreasonably restrain trade.

Although this distinction is sharp in theory, determining the orientation of an agreement can be difficult as a matter of fact and turns on more than simply identifying whether the participants are at the same level of the market structure. For instance, courts have long recognized the existence of "hub-and-spoke" conspiracies in which an entity at one level of the market structure, the "hub," coordinates an agreement among competitors at a different level, the "spokes."

Apple argues that the district court impermissibly inferred its involvement in a horizontal price-fixing conspiracy from the Contracts themselves. Because (in Apple's view) the Contracts were vertical, lawful, and in Apple's independent economic interest, the mere fact that Apple agreed to the same terms with multiple publishers cannot establish that Apple consciously organized a conspiracy among the Publisher Defendants to raise consumer-facing ebook priceseven if the effect of its Contracts was to raise those prices. Second, Apple argues that, even if it did orchestrate a horizontal price-fixing conspiracy, its conduct should not be subject to per se condemnation. According to Apple, proper application of the rule of reason reveals that its conduct was not unlawful.

The first "crucial question in a Section 1 case is therefore whether the challenged conduct 'stem[s] from independent decision or from an agreement, tacit or express.'" Apple portrays its Contracts with the Publisher Defendants as, at worst, "unwittingly facilitat[ing]" their joint conduct. All Apple did, it claims, was attempt to enter the market on profitable terms by offering contractual provisionsan agency model, the MFN Clause, and tiered price capswhich ensured the company a small profit on each ebook sale and insulated it from retail price competition. This had the effect of raising prices because it created an incentive for the Publisher Defendants to demand that Amazon adopt an agency model and to seize control over consumer-facing ebook prices industry-wide. But although Apple knew that its contractual terms would entice the Publisher Defendants (who wanted to do away with Amazon's $9.99 pricing) to seek control over prices from Amazon and other ebook retailers, Apple's success in capitalizing on the Publisher Defendants' preexisting incentives, it contends, does not suggest that it joined a conspiracy among the Publisher Defendants to raise prices. In sum, Apple's basic argument is that because its Contracts with the Publisher Defendants were fully consistent with its independent business interests, those agreements provide only "ambiguous" evidence of a 1 conspiracy, and the district court therefore erred in inferring such a conspiracy.

We disagree. Apple offered each Big Six publisher a proposed Contract that would be attractive only if the publishers acted collectively. Under Apple's proposed agency model, the publishers stood to make less money per sale than under their wholesale agreements with Amazon, but the Publisher Defendants were willing to stomach this loss because the model allowed them to sell new releases and bestsellers for more than $9.99. Because of the MFN Clause, however, each new release and bestseller sold in the iBookstore would cost only $9.99 as long as Amazon continued to sell ebooks at that price. So in order to receive the perceived benefit of Apple's proposed Contracts, the Publisher Defendants had to switch Amazon to an agency model as wellsomething no individual publisher had sufficient leverage to do on its own. Thus, each Publisher Defendant would be able to accomplish the shift to agencyand therefore have an incentive to sign Apple's proposed Contractsonly if it acted in tandem with its competitors.

As a sophisticated negotiator, Apple was fully aware that its proposed Contracts would entice a critical mass of publishers only if these publishers perceived an opportunity collectively to shift Amazon to agency. In fact, this was the very purpose of the MFN, which Apple devised as an elegant alternative to a provision that would have explicitly required the publishers to adopt an agency model with other retailers. The MFN "force[d] the model" from wholesale to agency. Indeed, the MFN's capacity for forcing collective action by the publishers was precisely what enabled [Steve] Jobs to predict with confidence that "the price will be the same" on the iBookstore and the Kindle when he announced the launch of the iPadthe same, Jobs said, because the publishers would make Amazon "sign ... agency contract[s]" by threatening to withhold their ebooks. Apple was also fully aware that once the Publisher Defendants seized control over consumer-facing ebook prices, those prices would rise. It knew from the outset that the publishers hated Amazon's $9.99 price point, and it put price caps in its agreements because it specifically anticipated that once the publishers gained control over prices, they would push them higher than $9.99, higher than Apple itself deemed "realistic."

On appeal, Apple nonetheless defends the Contracts that it proposed to the publishers as an "aikido move" that shrewdly leveraged market conditions to its own advantage. "[A]ikido move" or not, the attractiveness of Apple's offer to the Publisher Defendants hinged on whether it could successfully help organize them to force Amazon to an agency model and then to use their newfound collective control to raise ebook prices. The Supreme Court has defined an agreement for Sherman Act 1 purposes as "a conscious commitment to a common scheme designed to achieve an unlawful objective."

To begin with, it is well established that vertical agreements, lawful in the abstract, can in context "be useful evidence for a plaintiff attempting to prove the existence of a horizontal cartel," particularly where multiple competitors sign vertical agreements that would be against their own interests were they acting independently.

Horizontal price-fixing conspiracies traditionally have been, and remain, the "archetypal example" of a per se unlawful restraint on trade. By contrast, the Supreme Court in recent years has clarified that vertical restraintsincluding those that restrict pricesshould generally be subject to the rule of reason.

"The true test of legality" under 1 of the Sherman Act "is whether the restraint imposed is such as merely regulates and perhaps thereby promotes competition or whether it is such as may suppress or even destroy competition."

Consistent with this principle, the Supreme Court and our Sister Circuits have held all participants in "hub-and-spoke" conspiracies liable when the objective of the conspiracy was a per se unreasonable restraint of trade.

The rule of reason is unquestionably appropriate to analyze an agreement between a manufacturer and its distributors to, for instance, limit the price at which the distributors sell the manufacturer's goods or the locations at which they sell them. But the relevant "agreement in restraint of trade" in this case is not Apple's vertical Contracts with the Publisher Defendants (which might well, if challenged, have to be evaluated under the rule of reason); it is the horizontal agreement that Apple organized among the Publisher Defendants to raise ebook prices. [H]orizontal agreements with the purpose and effect of raising prices are per se unreasonable because they pose a "threat to the central nervous system of the economy"; that threat is just as significant when a vertical market participant organizes the conspiracy.

[P]rice-fixing cartels are condemned per se because the conduct is tempting to businessmen but very dangerous to society. Apple and its amici argue that the horizontal agreement among the publishers was not actually a "price-fixing" conspiracy that deserves per se treatment in the first place. But it is well established that per se condemnation is not limited to agreements that literally set or restrict prices. The conspiracy among Apple and the Publisher Defendants comfortably qualifies as a horizontal price-fixing conspiracy.

This conspiracy to raise prices also had its intended effect. Immediately after the Publisher Defendants switched Amazon to an agency model, they increased the Kindle prices of 85.7% of their new releases and 96.8% of their New York Timesbestsellers to within 1% of the Apple price caps. They also increased the prices of their other ebook offerings. Within two weeks of the move to agency, the weighted average price of the Publisher Defendants' ebookswhich accounted for just under half of all ebook sales in 2010had increased by 18.6%, while the prices for Random House and other publishers remained relatively stable.

This sudden increase in prices reduced ebook sales by the Publisher Defendants and proved to be durable. One analysis compared two-week periods before and after the Publisher Defendants took control over pricing and found that they sold 12.9% fewer ebooks after the switch. Another expert for Plaintiffs conducted a regression analysis, which showed that, over a six-month period following the switch, the Publisher Defendants sold 14.5% fewer ebooks than they would have had the price increases not occurred. Nonetheless, ebook prices for the Publisher Defendants over those six months, controlling for other factors, remained 16.8% higher than before the switch. And even Apple's expert produced a chart showing that the Publisher Defendants' prices for new releases, bestsellers, and other offerings remained elevated a full two years after they took control over pricing.

[N]either Apple nor the dissent has presented any particularly strong reason to think that the conspiracy we have identified should be spared per se condemnation.

Affirmed

JACOBS, Circuit Judge, dissenting:

I respectfully dissent.

I have no quarrel with the district court's conscientious findings of fact; I affirmatively rely on them, and cite them throughout. The 156 pagess of findings track communications and interactions that happened over the 48-day course of events, detail by detail.

The district court committed three decisive errors:

• The district court ruled (and the majority affirms) that a vertical enabler of a horizontal price-fixing conspiracy is in per seviolation of the antitrust laws. However, the Supreme Court teaches that a vertical agreement designed to facilitate a horizontal cartel "would need to be held unlawful under the rule of reason.
• The district court's alternative ruling under the rule of reason was predetermined by its (erroneous) per se ruling. Thus the district court assessed impacts on competition without recognizing that Apple's role as a vertical player differentiated it from the publishers. The court should instead have considered Apple as a competitor on the distinct horizontal plane of retailers, where Apple competed with Amazon (and smaller players such as Barnes & Noble).
• Apple's conduct, assessed under the rule of reason on the horizontal plane of retail competition, was unambiguously and overwhelmingly pro-competitive. Apple was a major potential competitor in a market dominated by a 90 percent monopoly [Amazon], and was justifiably unwilling to enter a market on terms that would assure a loss on sales or exact a toll on its reputation. In that connection, the district court erroneously deemed the monopolist's $9.99 price as categorically good for competition because it was lower than cost, and because e-book prices rose after the monopoly was broken.

A further and pervasive error (by the district court and by my colleagues on this appeal) is the implicit assumption that competition should be genteel, lawyer-designed, and fair under sporting rules, and that antitrust law is offended by gloves-off competition.

Amazon's 90 percent market share constituted a monopoly under antitrust law. Amazon's below-cost pricing was a barrier to entry by Apple in 2009, when it contemplated entry into the e-book retail market via the iPad.

The district court's principal legal error, from which other errors flow, is its conclusion that Apple violated 1 under the per se rule. Having found that the publishers' coordinated strategy was a horizontal price-fixing conspiracy, and that Apple had facilitated that conspiracy in its vertical relationship with the publishers, the district court drew the legal conclusion that these facts established a per se violation of the Sherman Act by Apple. This appeal turns on whether purely vertical participation in and facilitation of a horizontal price-fixing conspiracy gives rise to per se liability.

Section 1 of the Sherman Act "outlaw[s] only unreasonable restraints"; so a court weighing an alleged violation "presumptively applies rule of reason analysis, under which antitrust plaintiffs must demonstrate that a particular contract or combination is in fact unreasonable and anticompetitive before it will be found unlawful." The exception, liability per se, is reserved for those categories of behavior so definitively and universally anti-competitive that a court's consideration of market forces and reasonableness would be pointless.

Traditionally, restraints that are per se unlawful take the form of horizontal agreements "raising, depressing, fixing, pegging, or stabilizing the price of a commodity." A vertical relationship that facilitates a horizontal price conspiracy does not amount to a per se violation.

Case Questions

1 - Was Apple's conduct a violation of the Antitrust laws? If so, why?;

2 - Explain the scheme Apple set up with the publishers and why;

3 - What is the "hub and spoke" theory of antitrust violations and why is it important in this case?; and

4 - What is the significance of a dissenting opinion and what issue did the dissent raise regarding the case?