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The Court’s Antitrust Decision Against Apple Is Substantially Flawed.

Last week, United States District Judge Denise Cote of the Southern District of New York issued a 159 page decision in which she found Apple civilly liable for engaging in antitrust violations when it launched the iBookstore with the launch of the iPad. Specifically, the Court found that that Apple engaged in a conspiracy with the large ebook publishers to raise prices. You can find that decision here.

I have read through the Court’s decision and have concluded that the Court’s reasoning and decision is seriously flawed. Others on the web have done a good job of summarizing the Court’s decision. For example, Adam Engst at Tidbits does a nice job summarizing the case and decision. You can also read my lengthy post when the bench trial came to an end where I summed up the positions of the Justice Department and Apple. (see Apple’s Ebook Trial Comes To An End: Will Apple Win?). I suggest you read Adam Engst’s article and mine, and then read my analysis below where I discuss the flaws in the Court’s decision. I hope to supplement this analysis as I reread the decision and address other issues I didn’t cover in this post. But here are my initial thoughts. (I write this not as an expert in antitrust law but as an amateur blogger who has read the Court’s decision and other reports on the case.)

The Court Is Essentially Punishing Apple For Knowing That Publishers Would Use the Agency Model and MFN to Raise Prices, Even Though Such Clauses Of Themselves Are Proper.

The Court concedes that there is nothing wrong with having an agency model, a most-favored-nation (MFN) clause, price tier caps, and negotiating with many suppliers at the same time:

If Apple is suggesting that an adverse ruling necessarily implies that agency agreements, pricing tiers with caps, MFN clauses, or simultaneous negotiations with suppliers are improper, it is wrong. As explained above, the Plaintiffs have not argued and this Court has not found that any of these or other such components of Apple’s entry into the market were wrongful, either alone or in combination. What was wrongful was the use of those components to facilitate a conspiracy with the Publisher Defendants.

The agency clause is where Apple and the publishers agreed that the publishers would set the retail price of the iBooks sold through the iBookstore and Apple would take a 30% cut. Until then, the publishers had been using the wholesale model where they would sell ebooks at a wholesale price to resellers, i.e. Amazon, and the resellers, would then set the retail price.

The MFN clause provided that if an ebook sold for a lower price in another ebookstore, the publisher would lower the price of that ebook in Apple’s iBookstore to match that lower price. That way Apple could insure its ebooks had the lowest price in the ebook market.

Price tier caps were the clause in the agreements where the publishers agreed not to sell certain categories of ebooks above certain tier prices.

The Court held that such clauses themselves were legal.

So what is the Court relying on to show that Apple engaged in price fixing behavior:

  • Apple knew that the publishers hated Amazon’s $9.99 below wholesale pricing.

  • Apple knew that having an agency Model and MFN clauses with the publishers would cause the publishers to go to Amazon and force Amazon to go off the wholesale model and to the agency model.

  • Apple knew that the publishers would then under the agency model raise prices above $9.99.

The Court takes Apple’s knowledge of the publishers desire to raise prices and is essentially arguing that when you couple that knowledge with Apple offering the agency model, the MFN clause, and the price tier caps, then Apple was “conspiring to raise prices.”

Here is where the Court’s logic is strained and incorrect. The Court concedes that there is nothing wrong with using the agency model, the MFN clause or pricing tier caps. So essentially the Court is finding Apple liable for antitrust violations for knowing that the publishers wanted to raise prices. The Court is essentially holding that faced with that knowledge, Apple supplied those terms (agency, MFN, price tiers) to the publishers so they could then go to Amazon and impose the agency model and raise retail prices.

But what should Apple have done when it launched the iPad so that under the Court’s decision it wouldn’t have violated antitrust laws? The Court provides no explanation of how Apple could have complied with the law. Instead, the Court makes this vague suggestion:

It is doubtful that Apple is suggesting that the only way it could have entered the e-book market was to agree with the Publisher Defendants to raise e-book prices. Apple, often through expert negotiations conducted by Cue, has entered many new content markets. It did not attempt to argue or show at trial that the price of admission to new markets must be or is participation in illegal price-fixing schemes.

See Decision at 157-158

Should Apple have made no statements to the publishers addressing their unhappiness with Amazon’s $9.99 pricing? I suppose that Eddie Cue could have just called up the publishers and said “we are launching the iPad, we will have an iBookstore, we will offer the agency model, we will have an MFN clause, and you can’t sell books over a certain price. Come ye all.” But the Court still would have found Apple liable under its analysis because as the Court pointed out the publishers were very public about their unhappiness with Amazon’s $9.99 price and wholesale mode. Thus, even if Apple said nothing to the publishers about Amazon’s $9.99 price and offered them the agency model, MFN and price caps, the Court would have still found Apple liable under the reasoning of its decision.

This makes no sense. The Court is saying that these terms — agency, MFN, price ceilings — are perfectly legal, but if you have knowledge that your suppliers want those terms so that they can grab back control of the retail price from another distributor, than those terms are illegal.

Under the Court’s reasoning, the only way Apple could have legally negotiated these terms — agency, MFN, and price ceilings — was it if the publishers had never gone public with their dislike of Amazon’s $9.99 pricing and if neither the publishers nor Apple mentioned that desire during negotiations. But if that had occurred, the exact same economic outcome would have occurred: the publishers would have forced Amazon to go to the agency model and the publishers would have raised prices on certain ebook.

It is Improper For The Court To Hold That Apple Should Have Gone the Route of Below Cost Pricing Under the Wholesale Model.

The Court’s decision suggests that the other lawful route that Apple could have undertaken is to embrace the wholesale model and compete with Amazon. The Court’s decision repeatedly says that Apple refused to compete on price with Amazon, suggesting that Apple somehow had a bad motive because it didn’t want to compete with Amazon on the wholesale model. But the record is clear that one of the reasons that Apple didn’t want to enter the ebook market using the wholesale model because the biggest player in the ebook market, Amazon with 90% market share, was pricing books at a loss or break even. The Court refused to consider how ridiculous and anticompetitive it would have been for Apple to engage Amazon in the competition of “who can price ebooks further below the wholesale price”.

The Court is perverting antitrust laws by arguing that Apple should have entered the ebook market by agreeing to lose money on ebooks. Now in hindsight it is clear that Apple could have engaged in below cost pricing in battling Amazon and Apple has more resources than Amazon to sustain such a battle. Apple has tremendous cash reserves, now over $100 billion, and Apple makes a large profit every quarter. Amazon by contrast, has growing revenue as it captures new markets, but Amazon barely makes any profit and it some quarters loses money.

If Apple engaged Amazon in an ebook price war, Apple could have violated the antitrust laws by engaging in predatory pricing as its prices would have been below wholesale prices. Moreover, Apple could have been accused of using its dominant market share in the smartphone market and the new tablet market, to drive ebook competition out of the market. Could you imaging the internal dilemma Apple’s executives would have faced if they considered selling ebooks at a loss through their iOS ecosystem? What if they had destroyed Amazon’s ebook market share by selling ebooks at a bigger loss than Amazon could have afforded? Wouldn’t Amazon have complained to the Department of Justice that Apple was engaging in predatory pricing?

The Court’s Decision Ignores that the Agency Model Furthers Competition.

The Court’s decision is flawed as it holds that by forcing the publishers to go to the agency model, Apple destroyed competition for retail pricing of books. But that makes no sense. Prior to entering the ebook market, Amazon controlled the market, but as the agency model puts retail pricing in the hands of the defendant publishers, five of the six largest publishers and countless other publishers set the retail prices of books. The Court’s decision ignores that there is no competition in retail pricing under the wholesale model that existed in early 2010 when Amazon controlled the market. The prices of ebooks were low because one dominant reseller, Amazon, was setting the low retail prices of pretty much all ebooks. To give you a sense of how powerful Amazon was in early 2010 when the iPad launched, the five defendant publishers collectively only provided 48% of all ebooks in the United States. See Decision at 13. In contrast, at the same time, Amazon accounted for 90% of all ebook sales. See Decision at 14.

The Court makes much of the fact that after the agency model was implemented, the cost of ebooks was raised a bit. See Decision at 95. But the Court ignores that instead of having one company, Amazon, setting the retail price of ebooks, the agency model provided the six largest publishers and countless other publishers to set the the price of their own ebooks. That creates massive retail price competition. One publisher can’t greatly raise the price of a notable book because another publisher (or author) with a book of the same quality and in the same topic can undercut that price and sell more books. When Amazon sets the price of 90% of the ebooks the consumer is set with no recourse but to rely on Amazon’s goodwill on the retail price. The agency model allows many players to set the retail price. Thus in the long run, such competition is likely to result in the lowering of price.

Apple’s iOS App store is the best evidence of the power of the agency model to cause retail prices to go lower over the long run. Apple’s iOS App store has since its birth in 2008 been based on the agency model. The app developers set the price and Apple takes 30%. There are countless articles about how competition in the App Store has led to the price of apps to plummet. It is well known that the iOS app store is dog-eat-dog in competition. In fact, one projection says that the average price of apps will fall to 8 cents by 2017 because of competition in the iOS App store.

The Court Incorrectly Separates the Innovation of the iPad from the iBookstore.

During the trial, Apple put on substantial evidence that the iBookstore launch was integrated into the launch of the iPad and that together that brought great innovation to the ebook market. Apple put forth this evidence to show that its efforts in early 2010 furthered innovation and competition in the ebook market. The Court gave short shrift to that argument, and seemed to dismiss any connection between the iBookstore and iPad:

It is not entirely clear to what Apple is alluding, however, when it describes its pro-competitive behavior and creation of healthy competition. If it is alluding to the Launch of the iPad, a revolutionary device that has encouraged innovation and competition, then its conduct can fairly be described as pro-competitive. But, this case has been only incidentally about the iPad. The iBookstore was not an essential feature of the iPad, and the iPad Launch would have occurred without any iBookstore. It was the pre-existing, remarkable features of the iPad that made the iBookstore an obvious addition to the device.

Decision at 156.

I found the Court’s reasoning and observations in this regard to be divorced from reality. The suggestion that the iPad wasn’t a major innovation to ebook reading is crazy. Prior to the iPad, ebooks were mainly read on the small screen of the iPhone or the black and white and non-backlit screen of a kindle. The iPad allowed your ebook to exist on a nice backlit screen, with color in the ebook, and with all the multimedia and cool effects that came with the power of a real compute in the iPad. Plus, you had the ebook on the same device that you carried around to do your email, create music, edit movies, write documents, etc. The Kindle was, and still is, a highly limited device.

The Court’s suggestion that the iBookstore was not an essential feature of the iPad is wrong. (I was surprised the Court stated this as during the trial the Judge admitted she uses an iPad.) If Apple launched the iPad without an iBookstore it would have either been at the mercy of Amazon (which had 90% of ebook market) or, if Amazon didn’t launch a Kindle, app, Apple could have sold a lot less iPads. Apple had to have an iBookstore as the iPad by design was a great device for reading ebooks. If Apple did not ensure that ebooks were available on the iPad by creating the iBookstore, then Apple would have had to rely on Amazon to supply the Kindle app to the iPad. Amazon was competing with Apple in selling songs and movies. It made no sense for Apple to launch the iPad and have to rely on Amazon for ebooks on the device.

The Court’s Refusal to Take Into Account Amazon’s Predatory Pricing Could Be Grounds for An Appeal.

Throughout the trial, Apple submitted compelling evidence that Amazon, which controlled 90% of the ebook market, engaged in predatory pricing, i.e., pricing ebooks below the wholesale price that Amazon paid for the ebooks. Apple showed that allot of the publishers actions and Apple’s actions were ultimately pro-competitive as they were addressing a monopolist, Amazon, that was engaging in predatory pricing. Predatory pricing has long been considered an antitrust violations. The Court refused to consider that defense, holding:

If Apple is suggesting that Amazon was engaging in illegal, monopolistic practices, and that Apple’s combination with the Publisher Defendants to deprive a monopolist of some of its market power is pro-competitive and healthy for our economy, it is wrong. This trial has not been the occasion to decide whether Amazon’s choice to sell NYT Bestsellers or other New Releases as loss leaders was an unfair trade practice or in any other way a violation of law. If it was, however, the remedy for illegal conduct is a complaint lodged with the proper law enforcement offices or a civil suit or both. Another company’s alleged violation of antitrust laws is not an excuse for engaging in your own violations of law. Nor is suspicion that that may be occurring a defense to the claims litigated at this trial.

Decision at 156-157.

The Court should have considered the defense that Amazon was engaged in predatory pricing. The Court’s decision is predicated on evidence that after Apple and the publishers entered into the agency agreements, price of certain ebooks were raised. But what if as Apple argued those prior ebook prices were improper because Amazon was engaged in predatory pricing? Then the $9.99 price was never legitimate. So how can the Court not consider whether the $9.99 price that Amazon was legitimate when deciding if the defendants improperly engaged in conduct that raised prices? It makes no sense that a book price that was predatory would be then used by the Court as the bench mark as to whether prices were improperly raised.

The Court suggests that Apple and the publishers can raise the predatory pricing argument with the Justice Department or lodge their own civil suit against Amazon. Is that practical? Apple could not launch the iPad and then wait years to prove that Amazon is engaged in predatory pricing?

Significantly, the Court in its decision cites no case law supporting its position that it shouldn’t take into account Amazon’s predatory pricing of ebooks. But the overall mandates from the 2nd Circuit that the Court cites indicates that the Court should have factored in Amazon’s predatory pricing.

It is certainly true that our nation’s antitrust laws should be applied with care. Courts must be sensitive to the unique features of any market and the ambiguities of commercial conduct to avoid chilling lawful competition. Providing new entrants with the ability to access markets has long been a mainstay of our economy and any court should be wary of discouraging such access or interfering with the natural evolution of markets. See, e.g., United States v. Grinnell Corp., 384 U.S. 563, 589 (1966). As the Second Circuit observed in Capital Imaging, 996 F.2d 537, “[a]ntitrust law is not intended to be as available as an over-the-counter cold remedy, because were its heavy power brought into play too readily it would not safeguard competition, but destroy it.” Id. at 539.

Decision at 155.

In the end, it is essential to remember that the antitrust laws were enacted for “the protection of competition, not competitors.” Brown Shoe Co. v. United States, 370 U.S. 294, 320 (1962).

Decision at 158.

The Court had a duty to look at the overall market and not narrowly apply the antitrust laws. As the cases the Court itself cited say “[p]roviding new entrants with the ability to access markets has long been a mainstay of our economy …” In this instance, the Court is refusing to consider the competitive impact that Amazon was a 90% owner of the ebook market and that it was stifling competition in the ebook industry by selling books a break-even or below cost. This failure to consider the overall market appears to be at odds with what the higher courts have instructed. What the Court failed to take into account was that allowing the publishers to go to the agency model, it would facilitate competition in the sale and distribution of ebooks. The agency model, which provides Apple and other resellers with a percentage of the price set by publishers, ensures that the ebook stores and ebook devices will not sell at a loss. The Court failed to evaluate the competitive landscape in 2010 which allowed Amazon to hold 90% of the ebook market. How come Amazon had no competition? Amazon used its size and below-cost pricing to destroy competing ebook sellers. Apple’s implementation of the agency model and entrance into the book market with the iPad and iBookstore breathed life into the ability for ebook stores and ebook devices to compete with Amazon, the ebook goliath.

The Court’s Dismissal of Apple’s Monsanto Defense Is a Tautology Resulting in the Court Wrongly Not Following the Supreme Court.

The Court addressed and dismissed what it characterized as Apple’s “Crown Jewel” of its defense: The Monsanto defense that Apple is entitled to a verdict in its favor since the evidence does not “tend to exclude” the possibility that Apple acted in a manner consistent with its lawful business interests. The Supreme Court, in a long ago decision called Monsanto, held that in a vertical price fixing case there “must be evidence that tends to exclude the possibility that the manufacturer and nonterminated distributors were acting independently.” See Decision at 124 through 128. The Court then cited a Second Circuit case interpreting Monsanto as a basis for narrowing the importance of that test:

According to the Second Circuit, [i]t is important not to be misled by Matsushita’s statement … that the plaintiff’s evidence, if it is to prevail, must “tend … to exclude the possibility that the alleged conspirators acted independently.” The Court surely did not mean that the plaintiff must disprove all nonconspiratorial explanations for the defendants’ conduct. Not only did the court use the word “tend,” but the context made clear that the Court was simply requiring sufficient evidence to allow a reasonable fact-finder to infer that the conspiratorial explanation is more likely than not.

See Decision at 128.

Then the Court determined that there is evidence showing that most likely than not that Apple engaged in illegal conspiracy to raise prices. But the Court’s reasoning in its decision is a tautology:

In rhetoric, a tautology (from Greek tauto, “the same” and logos, “word/idea”) is a series of statements that form an argument, whereby the statements are constructed in such a way that the truth of the proposition is guaranteed or that, by defining a dissimilar or synonymous term in terms of another, the truth of the proposition or explanation cannot be disputed.

[Wikipedia](http://en.wikipedia.org/wiki/Tautology_(rhetoric).

I say it is a tautology because the Court holds that the activity Apple engaged in is a conspiracy to fix prices and the Court gives no explanation what facts could ever be lawful. But the Court, as discussed above, did concede that it is lawful to have an agency clause, an MFN clause and price tier caps. The Court in rejecting the Monsanto defense that Apple put forward does not explain where Apple crossed the line. Instead, the Court just says that the totality of the evidence is that Apple crossed the line. But each thing that Apple did or knew of in the negotiation with the publishers was lawful. For example there is nothing wrong with Apple meeting with a publisher and the publisher telling Apple that it didn’t like Amazon’s pricing. There is nothing wrong with Apple offering an Agency selling model in the iBookstore rather than a wholesale model. There is nothing wrong with Apple having a MFN clause. But the Court in conclusory fashion says when you add up all the facts it looks like Apple engaged in illegal conduct. Here is the best example of the Court’s tautological analysis:

The Plaintiffs do not argue, and this Court has not found, that the agency model for distribution of content, or any one of the clauses included in the Agreements, or any of the identified negotiation tactics is inherently illegal. Indeed, entirely lawful contracts may include an MFN, price caps, or pricing tiers. Lawful distribution arrangements between suppliers and distributors certainly include agency arrangements. It is also not illegal for a company to adopt a form “click-through” contract, negotiate with all suppliers at the same time, or share certain information with them. Indeed, as Apple indicates, many common business practices have been found necessary for the efficient distribution of goods and services. See Monsanto, 465 U.S. at 763-64. That does not, however, make it lawful for a company to use those business practices to effect an unreasonable restraint of trade. And here, the evidence taken as a whole paints quite a different picture — a clear portrait of a conscious commitment to cross a line and engage in illegal behavior with the Publisher Defendants to eliminate retail price competition in order to raise retail prices.

See Decision at 132.

I expect that Apple’s appeal will focus on Monsanto and how Apple had every good reason to negotiate an agency clause, an MFN clause and price tier caps with each publishers. I hope also that Apple points out that the trial court’s decision doesn’t really point out what Apple could have done not to violate the law and that as a result, every legal act it took are then magically turned into a violation by the Court.

Conclusion: The Court Ignored The Realty of the Ebook Marketplace.

The irony of the Court’s decision is that it comes at the same time as Barnes & Noble has announced that its Nook ebook business and device is losing money and that company is ditching the Nook altogether. See CNET: Barnes & Noble Bails Out On Nook Tablet Biz. Even more disturbing, the Court’s decision comes as evidence is mounting that Amazon, having driven out competitors, is now raising prices. See New York Times July 4, 2013: As Competition Wanes, Amazon Cuts Back Discounts. The Authors Guild, commenting on the NYT July 4 article, points out how Amazon’s dominance is driving out competitors:

…smaller publishers and their authors are among those most directly affected by Amazon’s market dominance. Larger publishers, of course, have greater negotiating leverage with the retailing giant, but even the largest publishers fear Amazon’s growing ability to dictate sales terms. This is one of the reasons industry observers expect further consolidation in the book industry, such as the merger of Penguin and Random House that was finalized last week.

Let us hope that Apple prevails on its appeal to the higher courts, or, that the Court, in fashioning a remedy, does not hamper Apple’s ability to compete with Amazon.