How Apple shook up the electronic book market

A Manhattan court is due to decide whether Apple helped fix the prices of electronic books

Apple didn't try to fix or raise the prices of electronic books when it entered into the market in 2010, according to Apple Senior Vice President Eddy Cue. Rather, he says, the company was only working to ensure a profit for itself.

"We're not willing to lose money in any business," Cue told the court, referring to Amazon's practice of 2009 to sell electronic books for less than what it paid for them.

But in doing so, the U.S. Justice Department contends, Apple violated antitrust laws by colluding with the five largest book publishers -- HarperCollins, the Penguin Group, the Hatchett Group, MacMillan, and Simon & Schuster -- to fix the prices of electronic books. As a result of their actions, the prices of electronic books rose in 2010, the DOJ contended.

While the five publishers have since settled with the DOJ out of court, Apple is defending its practices in a DOJ antitrust trial now under way at the U.S. District Court for the Southern District Court of New York, with District Judge Denise Cote presiding.

In its arguments, the DOJ portrayed Cue as the mastermind of the operation, the one who coordinated the actions of the publisher CEOs while keeping Apple's then-CEO, Steve Jobs, informed of the progress he was making. Last week, Cue took the stand to explain the reasoning that led Apple and the publishers to set up an entirely new pricing model for electronic books, called the agency model.

The agency model works differently from the wholesale model that publishers have been using for centuries. In the wholesale model, the book publisher sells the books to the retailer, and then the retailer can resell the book at whatever price it sees fit, usually at a profit. In the agency model, such as the one Apple uses for its App Store, the manufacturer sets the retail price and the retailer gets a certain percentage of the sale. In Apple's case, it would take 30 percent of whatever publishers intended to charge.

Does the DOJ have a case against Apple? While a move to the agency model may be legal, the work of coordinating competitors in a single market to agree on prices is not, said Keith Hylton, a professor at the Boston University School of Law. The complexity in this case is that the two issues are confounded, he said.

Agency pricing is similar to another mechanism, "resale price maintenance," in which the manufacturer sets the prices of its goods, Hylton said. The U.S. Supreme Court ruled in 2007, in a case concerning the pricing of leather apparel, that resale price maintenance was legal unless the practice was shown to be harmful to consumers.

The agency model, on its own, "doesn't even raise an antitrust issue, because the seller never owns the book," Hylton said.

But while a manufacturer and reseller can work together to determine a price, multiple manufacturers cannot collude together to set prices. The plaintiff, in this case the DOJ, has to make a compelling case that this conspiracy actually took place, Hylton said.

When questioned by DOJ attorney Lawrence Buterman, Cue said he was unaware that publishers were discussing the proposed Apple deals among themselves. He had been unaware, he said, that the CEOs of the largest book publishers had been holding talks among themselves for at least a year prior to meeting with Cue.

What the publishing CEOs were discussing was the issue of how Amazon was selling electronic books for its Kindle book reader, which they called the "$9.99 problem." According to the DOJ, the publishers were frustrated that Amazon was selling their best-selling titles at US$9.99 each, which was, in many cases, less than what Amazon was paying for those electronic books.

The publishing companies feared that if Amazon continued to offer bestsellers at such a reduced rate, the public would come to assume that would be the natural price for a book. They also worried that Amazon was moving to disintermediate publishers, or to cut them out of the publishing cycle and deal directly with authors.

Enter Apple. In December 2009, Apple was preparing to launch its iPad, which Cue thought would make for a terrific electronic book reader. It was Cue's idea for Apple to enter the market for electronic books. Apple CEO Steve Jobs thought the format wouldn't work for either the iPhone or Mac laptops or desktop computers. But the iPad would make a fine reader for electronic books, offering features such as enhanced color and video, Cue thought. Cue felt personally close to Jobs; he had worked closely with him for about 16 years and was aware Jobs was dying. (Jobs died in 2011.) The project to set up the iBookstore "had extra meaning to me," he told the court. 

Cue had to work fast, though. Jobs was planning to introduce the iPad to the world in little more than a month, on Jan. 27, 2010. Cue would need to have preliminary agreements from all the major publishers in place by then for Jobs to include iBookstore in his presentation. 

According to Cue's testimony, he initially approached publishers individually in December 2009 about reselling their books in a typical wholesale model. In Cue's first meeting with a publisher, with HarperCollins, an executive floated the idea of working with Apple under an agency model. Cue took the idea back to Jobs, who approved the basic concept. The company was already using that model for both its App Store and its iTunes music and video service. So over the next few weeks, Cue and his team worked up an agency plan, one that guaranteed Apple a 30 percent cut of each sale. 

Cue proposed different pricing tiers that publishers had to adhere to. Electronic versions of best-selling hardcover books, for example, could be sold at $12.99 or $14.99. At the publishers' insistence, he added $16.99 and $19.99 as well. The contracts also prohibited the publishers from "windowing," or delaying the electronic release of popular books on Apple's store. "If you run a store, you can't have windowing at all," Cue explained before the court. "Even though some prices would go up, in exchange, [there would be] no more windowing."

Cue quickly realized that, in order for the agency model to work, the same deal must be struck with all electronic book vendors, lest Apple's prices be undercut by other retailers. The problem, Cue recalled Apple's legal counsel telling him, was that Apple couldn't force publishers to change their contracts with other retailers.

Instead, Cue introduced what he called a "Most Favored Nation" clause, in which the book publishers would guarantee that they would offer their books to Apple at 30 percent less than any other e-book retailer's price. In this way, Cue explained, publishers would not have to sign over the rest of their clients to the agency selling model. "In a legal agreement, I couldn't force Amazon and Barnes & Noble to move to the agency model," he said. The DOJ has maintained that the MFN clause in effect forced book sellers to move to an agency model.

With the public launch of the iPad coming up on Jan. 27, Cue rushed to get all the publishers to sign contracts by a week before then. Book publisher Hatchett signed an agency-model deal on Jan. 24, and the other four publishers signed similar deals within the following two days. In the following months, the publishers struck agency deals with other electronic book retailers. The Apple contract took effect on April 3, and the prices of the best sellers quickly rose to the top $16.99 tier in the weeks after. (As part of their 2011 settlements with the DOJ, the book publishers ended all their agency-model contracts).

In antitrust cases, "Once there is a proof of conspiracy, it is up to the defendant to prove that the consumer wasn't harmed," Hylton said. In this case, the DOJ focused its questioning on the increase in book prices right after the new agreements were in place.

When Buterman asked if he knew book prices would jump after the agreement, Cue refused to acknowledge that electronic book prices increased overall. He replied that while some book prices increased, the prices for other books would be priced more "flexibly," and still other books were introduced to the market that previously weren't available in electronic form, thanks to Apple's insistence on not windowing or withholding book releases.

"I expected higher prices for some books, but [there would be] flexibility for other books," Cue said. He also noted that not all the prices for electronic books increased. Most of the price increases were for new, best-selling books.

"Do you recall customers calling to thank you for raising [electronic book] prices?" Buterman asked.

"They thanked me for opening an iBookstore," Cue responded.

During questioning by Apple's own attorney, Orin Snyder, Cue maintained that Apple did not have a set expectation for how much electronic books should cost. "$9.99 might be the right price, but we didn't know what the right price was," he said. Rather, Apple left it to the publishers to set the prices, requiring only 30 percent of the final price in order to keep its own business profitable. After expenses of delivering product and maintaining an electronic commerce store, Apple would reap a net profit in the "high single percentages," Cue said.

"Volume, not price, drives Apple's profits," Cue said.

In its case, the DOJ contends that Apple coordinated the activities of the five publishers, informing them that each of their contracts would be similar, and keeping each of the publishers abreast of what the other publishers were thinking. To this end, DOJ says it has plenty of electronic evidence, between emails and phone calls, that publishers were conferring with each other on the issue. For example, Jobs, in one email, stated that Apple could help publishers solve "the Amazon problem."

Another key part of the evidence was a quote from Steve Jobs, made right after the iPad launch. When asked by The Wall Street Journal why someone would pay $14.99 for a book on an iPad when they could get the same book for $9.99 from Amazon or Barnes & Noble, Jobs replied "that won't be the case ... the prices will be the same." For the DOJ, this quote was evidence that Apple knew it was asking all the publishers to raise prices for their books across the board.

The DOJ, however, still has to back its argument by showing very clearly that collusion took place. "If you want to prove conspiracy, you better bring very strong evidence. It can't be stuff that people can confer by just connecting the dots," Hylton said. Apple, meanwhile, is charging that the DOJ is taking these electronic documents out of context.

Cue, when questioned by Buterman, denied that he or Apple spoke with any of the publishers about what the other publishers were doing. He also repeatedly denied that he pitched publishers with the idea that Apple could incite a change in the structure of the entire electronic book market. He said he did not know who came up with the idea of all publishers going to an agency model at the same time. "My concern was to remain competitive," he said.

Concluding arguments from both sides are expected later this week.

Joab Jackson covers enterprise software and general technology breaking news for The IDG News Service. Follow Joab on Twitter at @Joab_Jackson. Joab's e-mail address is Joab_Jackson@idg.com

Tags U.S. Department of JusticeAppleamazon.comlegal

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Joab Jackson

IDG News Service

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