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The Second Circuit’s Affirmance. The Second Circuit recently rendered its decision in the Apple e-book case, affirming the judgment against Apple after a bench trial in the Southern District of New York. By this judgment, Apple was held liable under Section 1 of the Sherman Act for conspiring with five of the six major book publishers to manipulate and raise the prices of e-books. This decision has been affirmed, but in a manner that I find to be disconcerting.

The E-Book Case: How It Began. Boiled down to its essentials, the case against Apple was as follows. Apple planned to introduce its i-Pad and wanted to offer e-books on this device, selling them to i-Pad users the same way it has sold music to users of i-Pods: If someone were to purchase an i-Pad, she could easily run a software application on it that would allow her to purchase and download e-books for her immediate perusal.

In this manner, Apple contemplated becoming a direct competitor of Amazon, which at the time dominated sales of e-books, selling at least 90% of all e-books sold in the United States. Amazon sold its e-books to customers by selling them its Kindle readers, which they could use to purchase and download e-books sold to them by Amazon. Amazon charged low prices for its e-books, setting prices for most of them at $9.99 – a price that was sometimes lower than what it cost Amazon to purchase the e-books in question. Amazon regarded this price point – an e-book for less than $10 – as a loss leader that would allow it to establish its brand as the brand of reference for e-books. Amazon seems to have used similar pricing strategies for many other products, establishing itself as a major or primary seller of a broad range of products by offering them at cost and by making the entire shopping experience effortless for its customers. By all accounts the strategy has allowed Amazon to evolve into an extraordinary retailing behemoth, but it is not so clear whether it has been profitable to Amazon, which bestrides many product markets, but seems to learn little profit in any of them, at least so far.

In these various markets, inefficient suppliers and rival retailers have gone the way of dinosaurs, undone by a changing environment in which they can no longer survive.

The book publishers, who long dominated the sale of hardcover and paperback books, feared that Amazon’s business model would eventually ruin their own. If customers became accustomed to downloading an e-book onto an Amazon Kindle reader for less than $10, they would soon learn not to pay $25 to a brick-and-mortar seller to purchase the same book in hardcover version, or even pay $15 one year after the book had been released in order to purchase the paperback version of it. Rather, they would learn to remain in the comfort of their home and download the Amazon version for less than $10, perhaps the very day on which the book was released.

Apple wanted to compete against Amazon, and establish its own i-Pad as a rival purveyor of e-books, but feared that it could not earn profits if it must match Amazon’s prices. The book publishers resented and feared Amazon and wanted to end its famous price-point of $9.99. In other words, Apple and the publishers wanted protection from the superior competition offered by Amazon, which they decried as predatory and monopolistic.

The Weak Defense. When later asked about the matter, Apple and the publishers described Amazon as a predatory monopolist that had obtained a monopoly over the “market for e-books” and was charging unreasonably low, or predatory prices in this market, making life impossible for the publishers or any would-be entrant, such as Apple. So did they contact the United States Department of Justice to complain that Amazon was engaged in predatory pricing, and had used it in order to obtain a monopoly of the so-called market for e-books? No. Did they attempt to bring suit against Amazon under federal law for unlawful monopolization on the ground that Amazon was charging predatory low prices in order to establish a monopoly in the market for e-books? Again the answer is no.

Of course, such a suit almost certainly could not have succeeded under modern antitrust jurisprudence: Apple and the publishers would have been obliged to prove that there existed a relevant market for the sale of e-books in the United States; that Amazon held a monopoly position in this market; that Amazon had obtained and perpetuated its monopoly position by charging prices for its e-books that were lower than its costs for them; and that Amazon had or forthwith would raise its prices for e-books to “supra-competitive levels,” but in response no other seller of e-books would be able to re-enter the market and undersell it, so that it could reap monopoly rents with impunity for a sustained period. Of course, nothing could have been further from the truth. Amazon showed no indication that it planned to increase its prices for e-books. If it had done so, Apple and others, including Noble & Barnes and Google, would quickly have stepped in to capture sales at lower prices.

Moreover, there was never any evidence that Apple and the publishers so much as chatted about seeking antitrust relief against Amazon. They apparently did not even discuss bringing a case under the laws of California, where Apple is located. Under California’s Unfair Practices Act, a firm can be held liable for predatory pricing upon a mere showing that it has undermined competitive conditions in its markets by charging prices that are lower than its costs. It is not necessary to prove “recoupment” – i.e., the predatory firm’s specific plan to charge supra-competitive prices with impunity after excluding its rivals by the predatory low prices.

The Hub-and-Spoke Conspiracy. Apple and the book-publishers never discussed any of this, not a word. They simply formed a blatant conspiracy to manipulate and raise the prices of e-books, by which all of them could charge higher prices, bust up Amazon’s position, and further their own long-term strategies. The price-fixing scheme was simple enough: Apple prevailed on five of the six publishers to announce, simultaneously, that they were departing from their historic practice of selling books at wholesale prices to retailers, who were then free to resell them at whatever price they wanted. Rather, with Apple’s advance knowledge these book publishers suddenly announced that for e-books they would set the price of e-books; the retailers would sell the e-books at these prices; the retailers could keep for themselves 30% of the sales receipts and must remit the remainder to the publishers; and, effective immediately, the retail price of e-books would be set at $12.99 or $14.99 in accordance with a specified pricing formula. Apple and the publishers called this new pricing arrangement an “agency” model, since under it the retailers would act as selling agents for the publishers rather than as independent retailers. At the very time when these five major publishers established the agency model, they informed Amazon that it if did not agree to it, they would withhold their e-books from it for six months – which they reckoned was too long for Amazon to wait, since customers would not wait six months to buy an e-book from Amazon that they could purchase six months earlier, upon release, from Apple or another retailer for $12.99 or $14.99. They were right. Amazon folded. It agreed to purchase the publishers’ e-books under the agency model, under which it was required overnight to charge $12.99 or $14.99 for e-books that it otherwise would have continued to sell at $9.99.

The direct and circumstantial evidence was overwhelming. Apple coordinated the entire operation and even devised the clever use of an MFN clause in its contracts with the publishers to give them the necessary incentive to insist that Amazon adopt their agency model. Had they continued to let Amazon sell e-books at $9.99, they would have become obliged under Apple’s MFN clause to instruct Apple to sell their e-books for $9.99 and to accept 70% of $9.99 as their share of this price! Amazon would have continued to undermine their sales model, and in the bargain they would be obliged in effect to sell e-books to Apple for a miserable $6.99, rather than get between $9 and $10.49 per copy and support price-points at $12.99 and $14.99, which they opined would not undermine their preferred prices for hardbacks and paperbacks the same way as did Amazon’s price-point of $9.99. At Apple’s insistence, the publishers even agreed to place a cap on the prices that they would set for e-books, which they would instruct their e-sellers to sell at $12.99 or $14.99 (depending on the book), but no higher.

In other words, Apple successfully rallied the predominant publishers of books to establish a new pricing arrangement under which they acted in concert and on the basis of a common understanding to control, raise, and enforce pre-specified prices for e-books sold in the United States. They did so to upend Amazon, which arguably had established a (lawful) monopoly in an arguable submarket that was limited to the sale of e-books.

Only One Outcome Possible. To state the facts of this case is to condemn the practice. Apple argued unsuccessfully at trial that it had merely introduced innovation in a moribund market that had been suffocated by Amazon’s predatory monopoly, and that its different arrangements with the publishers were mere vertical pricing agreements that must be evaluated under the rule of reason. The trial court had none of this and rightly condemned Apple for its role as the organizer of a blatant conspiracy among a cartel of direct competitors to manipulate, raise and fix their prices. The trial court expressed little patience for Apple’s defense that it was an innovator that was introducing competition in the affected market. It was right to do so.

The antitrust laws do not say, “thou shalt not collude with thine direct competitors in order to manipulate and set prices – except that thou may do so to undermine a monopoly position, even one that thou likely could not prove was unlawful under existing antitrust law.” There is no provision to this effect in any of the doctrines I have ever seen – except now in the dissenting opinion of our troubling Second Circuit decision, the one that affirmed the judgment against Apple.

In this decision, the majority felt obliged to give an extensive, overly elaborate justification of its straightforward assessment that Apple and the book publishers had indeed committed the cardinal sin of antitrust law by conspiring to manipulate and fix the prices charged by direct competitors. The decision would have been better if it had been limited to a statement of the facts and a resounding, short finding that such practices necessarily constitute unlawful price-fixing per se, and that Apple’s defenses could not be considered, since horizontal price-fixing is a per se violation.

Instead, the majority felt obliged to state its case in a majority opinion that is forty-two pages long. It also felt obliged to explain why Apple’s conduct also constituted a violation of Section 1 under the rule of reason. This issue should not have been so difficult. A rule-of-reason discussion should have been rejected on principle as superfluous to the case.

Far more troubling is that one of the three judges on the panel that heard this appeal actually was persuaded by Apple’s arguments. This judge found that the coordination of a horizontal price-fixing conspiracy must be reviewed under the rule of reason when the coordinator has vertical dealings with the horizontal price-fixers. He further found that the particular coordinator in question, Apple, had not committed even a rule-of-reason offense by orchestrating the above conspiracy, by which the price of e-books overnight was successfully increased nationwide by 30% to 50%!

This does not auger well for the antitrust law. It has suddenly become possible not to find per se price-fixing where there is overwhelming, undisputed evidence that it has occurred. In the Libor case, a federal judge concluded that the participating banks had not committed price-fixing because they were engaged in a cooperative arrangement when committing the conduct in question, which had the effect of lowering the prices that they must pay to their customers under derivative instruments that they sold to them, and of raising the prices that their customers must pay to them under such derivative instruments.

This was a lovely invitation to every cartel the world over to establish cooperative forums at which they could fix their prices.

So too did the dissenting opinion in Apple invite would-be cartels to appoint a customer or supplier to coordinate their conspiracy, so that each can say that it merely had vertical dealings with the coordinator, and so that each vertical component of the horizontal conspiracy must be reviewed under the amorphous rule of reason rather than have even a blatant, successful horizontal conspiracy condemned for what it is and on its face as a matter of per se policy.

There is an unsettling tendency afoot. It has become possible for respected, highly capable jurists to opine that direct collusion by direct competitors to set, manipulate and alter their prices is in fact no longer a per se violation of Section 1.

Price-Fixing by Direct Competitors Is Almost Universally Anticompetitive and Should Not Be Tolerated. I think that the earlier courts were right, and that such practices rarely or never serve the greater good, but instead allow cartels to practice price-gouging with impunity and at everyone else’s cost. Horizontal price-fixing should remain the cardinal sin of the antitrust laws. When a customer or supplier acts as the “hub” of the conspiracy, it should be held liable too under the per se rule. There should be no exceptions. I hope that the Libor decision is overturned on appeal, and that the dissent in Apple remains an insignificant footnote in the annals of antitrust jurisprudence.

The majority rightly ruled against Apple, but gave far too much indulgence to its misplaced arguments. The dissenting opinion declined to follow a century of jurisprudence and invited jurists and litigants to trod down a treacherous slippery slope, one that leads only to a poor destination – the realm of cartels that act with impunity and enjoy cozy dealings at our expense.