Last week, the Department of Justice filed its lawsuit against Apple and several large publishing companies alleging a complex conspiracy to fix e-book prices and to limit competition among e-book retailers. It didn’t take long for Apple to fire back in a public statement, claiming that the allegations set forth in the DOJ’s complaint “were simply not true” and that Apple’s actions actually served to break “Amazon’s monopolistic grip on the publishing industry” and to encourage — not hamper — competition. Who’s telling the real story?
The tale the DOJ’s complaint tells is a story of how several of the world’s most powerful publishers (as named in the complaint: Hachette Book Group, Inc., HarperCollins Publishers L.L.C., Verlagsgruppe Georg von Holtzbrinck GmbH, Holtzbrinck Publishers, LLC d/b/a Macmillan, The Penguin Group, A Division of Pearson PLC, Penguin Group (USA), Inc., and Simon & Schuster, Inc.) banded together in hopes of tackling what they called, unambiguously, the “Amazon problem.”
These publishers allegedly joined up with Apple to devise and execute a plan that would fundamentally change the e-book industry in a three-step process. First, the publishers would create a new pricing model, which gave them the power to set e-book prices. Second, the publishers would enter into agreements with Apple that relied on this new pricing model and set prices favorable to them. Finally, they would export the new model to the rest of the industry through a combination of self-imposed contractual obligations and heavy-handed negotiation.
E-Books in 2008
For over 100 years, the publishing industry has priced and sold their books under what is known as the wholesale model, meaning, a publisher establishes a “list price” and “recommended retail price” for each of their books. The list price is basically the cost of production for the publisher, and the recommended retail price is, as its name implies, a recommended price for the retailer, although the retailer is free to sell the book at any price – even a loss. Selling at a loss encourages competition among retailers on the final price the consumer pays. This competition benefits the consumer and it is types of healthy competition like this that anti-trust laws are designed to protect.
By 2008, the book-selling landscape had changed dramatically. In 2007, Amazon launched the Kindle and turned the book retail industry on its head by allowing readers to purchase a new type of book: the e-book. Not only was this more convenient for the consumer, but it also benefitted the publishers as e-books represented a new frontier. The immense potential of the Kindle, and e-books in general, was immediately apparent to the publishing industry and they were happy to jump into the digital age. At this point in time, the e-book retail industry continued to follow the traditional wholesale model.
Amazon’s Meteoric Rise
Amazon’s entry into the e-book industry ushered in a change in the traditional book sale model. Amazon started to price its e-books at extremely competitive prices – frequently selling books at a loss (below the list price). The impact of this strategy is obvious – buyers flocked to Amazon and competing book retailers needed to follow suit to remain competitive. Amazon hoped that their e-book pricing would entice new customers to utilize the many other services and products it offers.
It didn’t take long before the publishing industry took notice of this and concluded that Amazon’s prominence, with 90% of the e-book market share, constituted a significant threat to their long-term interests for at least two reasons. First, the lower priced books competed directly with traditional hardcover and paperback books. Second, the publishers viewed Amazon as a hazard to their long-standing role as intermediaries between authors and their audience. What use does an author have for a publisher’s access to, and experience with, book printing if Amazon can offer a more profitable arrangement through e-books? By 2008 Amazon had already begun to contract directly with authors to publish their books in e-book formats and was offering higher royalty rates than publishers normally did.
In light of this threat, the publishers knew they needed to level the playing field. The publishers hated Amazon’s law $9.99 pricing for new e-books. According to the complaint the publishers viewed Amazon’s pricing with disdain. One publisher CEO “bemoaned the ‘wretched $9.99 price point.’” They had to get Amazon (and other digitally-oriented companies) to agree to higher e-book prices. Doing so would ensure that traditional forms of books would remain competitive and, therefore, so would they. The way to accomplish this involved replacing the wholesale model.
The Publishers Seek A Solution to the Amazon Problem
In 2008, the publishers began discussing possible solutions to the Amazon problem. According to the DOJ’s complaint, the discussions between the publishers’ top executives began no later than September 2008. They met in-person, behind closed doors oftentimes at lavish restaurants and lounges.
The publishing company’s executives allegedly took measures to keep evidence of the discussions to a minimum. For example, by instructing agents and employees to discuss topics in-person in lieu of email or to “double delete” emails. By the end of 2009, the publishers uniformly acknowledged the threat posed by Amazon and that the best strategy to overcome the Amazon problem would be to fundamentally change the e-book retail industry, departing from the traditional wholesale model and instituting what is known as an “agency” model.
Under an agency model, the publishers would enter into contracts with individual e-book retailers who would act as “agents” for the publishers to sell and deliver e-books to customers in exchange for a flat percentage of each e-book sale. The agency agreements would grant the publisher the power to establish e-book retail prices and the agents were contractually obligated to sell the e-books at the prices set by the publisher.
Unlike the wholesale model, where the retailer was free to set e-book prices, the agency model lets the publishers force retailers to stick to higher e-book prices, removing the perceived threat of below-cost priced e-books. The only problem was how would they ever get Amazon and other retailers to agree to the agency model?
The publishers knew they needed a heavy-hitting e-book retailer on their side if they were going to get Amazon to agree to the agency model. This is where Apple comes in and, as the complaint alleges, “Apple was perfectly willing to help the Publisher Defendants obtain their objective of higher prices…” In 2010 Apple was poised to release what it hoped to be a Kindle-killer, the iPad. Apple obviously saw the immense potential for profit in the e-book market and, with the iPad on the horizon Apple was ready to jump into the fray. According to the complaint Apple CEO Steve Jobs clearly understood the plan’s objectives: “We’ll go to [an] agency model, where you set the price, and we get our 30%, and yes, the customer pays a little more, but that’s what you want anyway.” Apple seems to have played a significant behind-the-scenes role in facilitating the agreement between the various publishers and the execution thereof. Apple quickly became the hub in this hub-and-spoke conspiracy.
In its simplest sense the plan was as follows. The publishers each would enter into a binding agency agreement with Apple where the publishers would let Apple sell their e-books at a fixed price structure (up to $12.99 to $14.99) and Apple would walk away with a 30% of each sale. The final agency agreement, at Apple’s insistence, contained what is known as a “most favored nation” (“MFN”) provision. MFN provisions are common, but this one was a bit unusual because of the way it imposed a duty on the publishers: it required that each signing publisher set their prices to match the lowest price offered by any retailer that sold their e-books – even if that publisher had no control over that particular retailer. The consequence of the MFN was that it guaranteed that no other e-book retailer would ever be able to offer a lower price than Apple. It didn’t just give Apple favorable treatment; it was “designed to protect Apple from having to compete on price at all…”
As negotiations between Apple and the publishers matured Apple allegedly played a significant role in coordinating the timing and reassuring certain publishers that they would not be the only ones to enter into an agency agreement with Apple. The complaint offers a quote from an Apple executive explaining, “All of them were very concerned about being the only ones to sign a deal with us.” The complaint provides details about a number of specific instances where Apple sought to provide the various publishers the assurances they requested. For example,
“On the evening of Saturday, January 23, 2010, Apple’s Cue e-mailed his boss, Steve Jobs, and noted that Penguin USA CEO David Shanks “want[ed] an assurance that he is 1 o f 4 before signing.” The following Monday morning, at 9:46 a.m., Mr. Shanks called another Publisher Defendant’s CEO and the two talked for approximately four minutes. Both Penguin and the other Publisher Defendant signed their Apple Agency Agreements later that day.”
All of the conspiring publishers signed agency agreements with Apple within a three-day period and the agreements simultaneously took effect on the date of the iPad launch.
Publishers Imposed The Agency Model On Others
The agency agreements between Apple and the core group of publishers simultaneously went into effect in April 2010 around the time of the iPad’s release. Once effective, the publishers’ e-book prices applied to all e-book sales sold by Apple and the MFN clause found within the agency agreements further necessitated that the publishers impose the same agency agreements on all other retailers. According to the complaint:
“The purpose of these provisions was to work in concert to enforce the Defendants’ agreement to raise and stabilize retail e-book prices. Apple and the Publisher Defendants recognized that coupling Apple’s right to all of their e-books with its right to demand that those e-books not be priced higher on the iBookstore than on any other website effectively required that each Publisher Defendant take away retail pricing control from all other e-book retailers, including stripping them of any ability to discount or otherwise price promote e-books out of the retailer’s own margins.”
The MFN provision gave the agency agreements between Apple and the publishers real teeth because, practically speaking, it required the publishers to take whatever measures necessary in order to guarantee that nobody in the market sold their e-books at rates lower than Apple. If any retailer sold a publisher’s e-books for less than what Apple was selling them for, the publisher was obligated to reduce their prices so Apple could sell the e-book for the lowest price. Obviously, this would destroy the entire point of the agency model (letting the publishers fix advantageous prices) and, therefore, the MFN ensured the publishers would do what was needed to ensure other retailers didn’t lower their prices.
Apple likely understood this provision would encourage the publishers to gang up on uncooperative retailers (even publishers) in order guarantee that everyone played by the new pricing rules. Given the historical context, there seems no other logical reason why Apple would have cooked up and insisted upon such a provision. This suggests that Apple had a sophisticated understanding about the publishers’ strategy, which might prove to be a significant factor in the DOJ’s case against Apple.
The reality of the MFN provision is elucidated within the complaint, which recounts the events that transpired after Apple and the publishers entered into the agency agreements. The publishers knew that they needed to ensure that all retailers who sold their books got onboard with the agency model and that any holdouts were expeditiously dealt with. If they couldn’t accomplish this then their plan simply would not work. For example, when one of the publishers, Macmillan, informed Amazon of the new agency agreement it gave Amazon an ultimatum: agree to the new agency model or we’ll pull our books from your storefront.
Amazon really didn’t like Macmillan’s ultimatum and responded by effectively halting the sale of Macmillan’s books in protest. If Macmillan was alone in imposing this new agency model then Macmillan, a smaller publisher, likely would have had to back down, but that wasn’t the case here. Macmillan wasn’t alone and the publishers banded together. According to the complaint “the CEO of one Publisher Defendant’s parent company instructed the Publisher Defendant’s CEO that ‘[Macmillan CEO] John Sargent needs our help!’ … ‘We need to move the lines. And I am thrilled to know how A[mazon] will react against 3 or 4 of the big guys.’” In two days Amazon got the message and agreed to the agency model.
The story of Macmillan and Amazon was allegedly repeated on a number of occasions between the colluding parties and other organizations – both publishers and book retailers – with similar results. According to the complaint:
“Mr. Shanks also encouraged a large print book and e-book retailer to punish the other publisher for not joining Defendants’ conspiracy. In March 2010, Mr. Shanks sent an e- mail message to an executive of the retailer complaining that the publisher ‘has chosen to stay on their current model and will allow retailers to sell at whatever price they wish.’ Mr. Shanks argued that ‘[s]ince Penguin is looking out for [your] welfare at what appears to be great costs to us, I would hope that [you] would be equally brutal to Publishers who have thrown in with your competition with obvious disdain for your welfare…. I hope you make [the publisher] hurt like Amazon is doing to [the Publisher Defendants].’”
In the end the publishers and Apple got what they wanted: the e-book industry adopted the agency model and bestselling and new release e-books rose to the fixed $12.99 and $14.99 pricing models set by the publishing companies.
Will Apple Settle?
The result of all of this is that Apple and the publishers might have conspired to fix e-book prices and to reduce the effect retail price competition has on the e-book market. That’s what the DOJ thinks and if they’re right then they’re saying this violates anti-trust laws.
As someone who has an appreciation for the depth and reach of modern investigative and discovery processes I hope this case drags on for at least a little while longer – the public stands to benefit from what they might have uncovered. Given the particularity in which the complaint describes Apple’s own conduct it sounds as if there is going to be a mountain of evidence to support the DOJ’s claim that Apple played a substantial role in the conspiracy. I would not be surprised to see Apple (and the remaining publishers) quietly settle this case after the media loses interest. Whether Apple or the publishers in question really did anything wrong… well, that’s another story..