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In review: Apple turns tables on DOJ over course of e-book trial

updated 06:00 am EDT, Sun June 23, 2013

Amazon becomes as much a focus as tactics used by Apple

While nobody knows how Judge Denice Cote will rule in the two-week e-book price-fixing trial brought against Apple by the US Department of Justice, everyone who has been keeping tabs on the trial as it unfolded knows one thing: Judge Cote has been given more to consider after hearing Apple's vigorous defense of its actions and the performance of witnesses in the trial -- from both sides of the case. The same judge who had offered a pre-trial opinion that the DOJ would likely prove conspiracies said it all at the close: "things change."

The remark, which was part of a longer speech thanking the two sides for presenting their cases, does not assure that Apple will escape from charges that it conspired (and indeed, according to the DOJ, led a conspiracy) to break Amazon's monopoly on the e-book market in order to enrich itself and its partners, the original big six (now five) publishers who have since settled with the government -- even as they got almost exactly what they wanted in an industry-wide move to "agency" pricing that has irrefutably benefitted the nascent e-book industry in nearly every way, apart from higher prices for consumers on the latest and best-selling book titles.

In the summaries of the case given by both sides on Thursday (slideshows for each side shown below), each made a bold statement: the prosecution contends that Apple, through the use of its "most favored nation" clause in its contracts with publishers, essentially forced them and all other e-book resellers to move to an "agency" model of pricing, which broke the "wholesale" model that allowed loss-leader pricing on e-books and gave consumers below-cost prices on new releases. Apple says it has proven that changes in the e-book business were happening before its entry, that agency pricing was the only sustainable model that would allow competition, and that a guilty verdict would irreparably harm both the publishing industry and any other where content providers and resellers negotiate -- which by necessity requires exchanging information about market conditions, competitors and pricing.

Apple applied the exact same model in going after publishers for its iBookstore as it did with record companies and movie and TV studios in creating those stores: the content creator sets the price, and Apple simply get a cut of whatever that price is. Indeed, Apple and the other digital resellers are in fact more generous in this model than brick-and-mortar stores, in that they also support and takes no percentage from free offerings -- even though those cost the companies money to support in infrastructure. Apple has never been charged with any malfeasance over its music and video deals.

The iPhone maker showed in court -- and in testimony that apparently didn't appear in early pre-trial materials -- that publishers were preparing to adopt the agency model, or to force Amazon to stop undercutting the publishers' pricing on e-books through either withholding books entirely or by a process called "windowing." Windowing, which went so far as to take effect on a few dozen bestselling titles before Amazon capitulated, lets publishers withheld new titles for a period of time (during the case the time period was said to be around seven months) so as to bolster the sales of the print versions of the books, which were at least double the pricing of the e-book "wholesale" price and the main source of revenue for publishers and authors.

Both Apple and, as it turns out, Barnes & Noble had tried to persuade publishers to avoid "windowing," which would hurt the nascent e-book market and turn off consumers, and instead opt for the "agency" model along with "most favored nation" clauses. The MNF clauses essentially said that publishers couldn't sell an e-book to one reseller for less than it offered them to another, but beyond that the clause Apple and B&N used said that if a reseller discounts an e-book below that price, the other resellers could price-match that if they chose to -- and only pay 70 percent of the discounted price to publishers.

It was this portion of the agreements that the DOJ focused on, saying that removed any incentive Amazon had to sell e-books at a loss -- in fact the company had been selling at increasing losses as publishers raised wholesale prices, both to help grow its Kindle e-reader business and to grow the entire e-book industry -- and destroyed the notion of competition on price. Apple -- and all of the publisher representatives called to testify -- have argued that this was cannibalizing the print business, hurting bookstores, making it impossible for new e-book resellers to enter the market and hurting the existing competitors in what amounted to "predatory pricing" and e-book "dumping" (illegal practices often used by large corporations to drive out competitors, whereupon they can either raise prices or demand drops in wholesale prices without fear of competition).

When the publishers agreed to the agency model with Apple, Amazon was forced to do the same, the DOJ argues -- resulting in a price spike on best-sellers and new releases, which rose between 30 and 50 percent (from $10 to between $13 and $15), harming consumers. A raft of experts alongside Apple, however, pointed out that the change to the agency model has been in a broader sense much more beneficial: the industry has grown, there is more competition, e-readers are more sophisticated and flexible, there are more e-bookstores to choose from and all of them offer the full range of publishers' books, and there are more e-books available than ever, and the overall average price of e-books has gone down rather than up.

Indeed, the change has even benefitted Amazon itself: while the company does not hold quite as high a share of the market as it did in 2010, it remains the top seller of e-books with about a 60 percent share, and went from losing at least $3 per e-book it sold to making $3 or more per unit. While the DOJ may yet be able to convince Judge Cote that Apple could have overstepped some boundaries in its negotiations (though most observers agree that any collusion that occurred appears to have been between the publishers before Apple entered the scene), it cannot argue that the industry has been harmed by those actions in any meaningful way, or that consumers pay more overall.

Lawyers for the DOJ argued that the MFN clause made it impossible for publishers to make money, since their revenue from Apple would have been $10 minus Apple's $3 cut. Thus, the government said, publishers were forced to force Amazon to move to the agency model. Judge Cote questioned this assertion of the DOJ's several times, openly expressing doubt that Apple was deliberately conspiring to help publishers raise prices and was instead acting in its own self-interest to level the playing field -- which is not illegal.

Apple's attorneys, who went into the trial hearing the judge express confidence that the government could prove Apple illegally conspired with publishers to raise prices, fought back the charge by showing evidence that publishers were initially very resistant to the "agency" model since they did not believe Amazon would change, and that would put them in a money-losing position. Orin Snyder, Apple's lead counsel on the case, maintained that the publishers were not conspiring by simply noticing what their competitors were doing -- and that if any illegal collusion did occur, it was already going on before Apple entered the fray.

Through testimony, it became clear that in fact long before the iPad debuted, there was talk among the publishers about how unhappy they were with Amazon's undercutting prices and bullying behavior when publishers resisted. Representatives from Amazon all but admitted -- with great reluctance -- that they used the threat of withdrawal of a publishers' e-book to keep them in line.

The DOJ said in court that MFN clauses in this case benefitted publishers by forcing a rise in price on new releases, and that such clauses discourage discounting. Apple and the publishers told the judge that the model Amazon was using was "unsustainable," since inevitably the company would have had to raise prices or bully publishers into accepting lower wholesale rates -- even Amazon can't continue losing money indefinitely. While the DOJ tried to give the appearance that its foremost concern was consumers, the case rapidly became a trial in absentia on Amazon's business practices as much as any possible bad Apple behavior. Do consumers really benefit when a reseller drives out competition and ruins smaller publishers by using its monopoly to force unsustainably low prices?

Legal scholars have argued that even if the publishers are guilty of a conspiracy to try to raise prices -- and the publishers all settled with the Department of Justice before the trial began, and thus can't be prosecuted for that -- it would exclude Apple anyway, since collusion among publishers is a "horizontal" conspiracy (among peers) whereas Apple's role was "vertical" (a reseller with no stake in the health of the publishing industry), and under the law there can't be illegal collusion between a "horizontal" group and a "vertical" player.

Judge Cote also appeared to become more sympathetic to Apple's arguments following the explanations of both Apple's and Jobs' position on various matters by Senior Vice President Eddy Cue, who was the lead negotiator for the iPhone maker when they were setting up Apple's entry into both the tablet and e-book business. Crucially, Cue demonstrated that had Apple not been able to get the deals it wanted from publishers, it could have easily walked away: Amazon would have inevitably put the Kindle app on the tablet if it were a success, as would any other e-bookstores, thus the iPad didn't depend on the iBookstore to sell units.

He also scuttled the government's reliance on Jobs' emails and remarks about the publishing industry, including deconstructing a key draft email (never sent) where Jobs appears to want to force Amazon to move to the agency model. Earlier in the trial, the judge discovered that some of the comments taken from Jobs' correspondence were from drafts and unsent emails (again, not revealed in the pre-trial hearings) and often taken completely out of context, once Apple's attorneys produced the full email drafts. But on the so-called "smoking gun" draft, Cue and the judge agreed that Jobs began the email using terms that Jobs didn't fully understand, which is why he changed them in later drafts -- and that ultimately neither Jobs nor Apple ever put any pressure on publishers to force Amazon to do anything.

Following that, an admission from Amazon that it was already in the process of preparing to change to agency pricing in order to fight the threat of "windowing," and testimony from a Barnes & Noble executive that B&N was proposing an agency model and its own version of a MFN clause -- completely separate of and ahead of Apple's offer -- appeared to effectively shut down a huge portion of the government's case. That Apple was forced to spend weeks negotiating and crafting similar but separate agreements that had differing exceptions for each publisher added strength to Apple's argument that it didn't conspire with publishers to "break" Amazon.

Snyder, in his summation for Apple, told the judge that the DOJ's case amounted to "where there's smoke there's fire" and that it had not met its burden of proof with regards to any conspiracy. Ryan countered by saying that his case was an example of "an old-fashioned, straightforward price-fixing agreement." A ruling against Apple would open the door for a suite of lawsuits by the attorneys general of as many as 33 states and a host of consumer groups to advance.

Google and Amazon have petitioned the court to require Apple to redact sales figures of e-books and the growth of free e-books between 2009 and 2011, saying making such information public will have "serious competitive harm" to the two companies. Amazon has traditionally refused to ever give specific sales information on its products, even to its own shareholders -- only describing them in general terms or mentioning when a milestone is achieved. Google called itself a "very small rival" in e-book sales and said it would be hurt by the publication of specific e-book sales information.

Judge Cote's admission during the summations that she had thought that she was "well-prepared" by reading the pre-trial evidence but had "learned a lot" from the presentations on both sides and added that "it seems to me that the issues have somewhat shifted during the course of the trial" appeared to indicate that she had re-thought her existing positions on Apple's role in the case. She also used much of the second half of the trial to ask questions that generally challenged the government's contentions, though she also asked Apple lawyers for clarifications or further details on matters they raised as well.

Independent legal observers seem to be in agreement that it would be unusual for the judge to rule completely against Apple based on the evidence presented in court. Given that the publishers were excluded from prosecution by way of short-term settlements, that Amazon's tactics are not (as of yet) the subject of government scrutiny and that most of the evidence against Apple is drawn from inference and unsent draft emails rather than evidence of actual actions involving collusion, the consensus outside the courtroom is that the DOJ brought a fairly weak case with them, and that Apple offered a reasonable defense.

Judge Cote's remarks may be indicative of a shift towards Apple's view of the situation, or they could be a jurist making a best effort to see both sides having previously announced a position before the trial even began. As the matter is a bench trial, it is entirely up to Judge Cote to set a ruling, which may come at any time (though on average such decisions generally take a couple of months or more). One thing is certain: Apple changed the e-book market when it entered it -- nearly as dramatically as it changed the tablet market -- and the decision from the judge, particularly if it goes against Apple, will change the industry again.


DOJ Summation




Apple Summation




Google Petition to Redact



By Electronista Staff
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Comments

  1. vinnieA2

    Fresh-Faced Recruit

    Joined: 03-28-05

    Subhead is wrong: "because" instead of "becomes"

  1. Inkling

    Mac Enthusiast

    Joined: 07-25-06

    To understand this dispute, it helps to understand what the differences are between print publishing and digital publishing. I do both on a small and easily manageable scale, so I'll offer a few numbers. Keep in mind that matters are much more complicated for major publishers--returns, warehousing etc.--but the basic pattern is the same.

    In the dark ages about four years ago, pricing print books was simple. I generally took the cost to print (via print on demand), multiplied it by four and then rounded up or down, whichever was closest to a $X.99 price. That meant that the printing cost was a little under 25% of the cost, wholesale distribution took 10%, and the retailers had a 45% markup from which they could discount the price. That left a little over 20% of retail for me as the writer, editor and publisher, and from that I had to pay all my expenses. Believe me, unless you hit a bestseller, it's not the path to riches.

    Digital changes everything about pricing. Except for Amazon's long-outdated download fees, there are no production or distribution costs because there's nothing physical. With the exception of Smashwords, which takes a small cut for distributing my ebooks to every retail outlet but Amazon and Apple, there's no wholesaler cut either. Instead, under the agency model, I set the retail price and take a 70/30% split with the retailer.

    Do the numbers, and you'll see what difference that makes. At best, a $14.99 book will earn me about $3.74. With that 70/30 split, I can earn the same by pricing the ebook version at $5.34, so I'd probably price it at $4.95, at least to start.

    As the one doing the publishing, the real difference lies in the distinction between my print profit (more typically 20%) and my digital profit (70%), over three times as much. Pricing print books was frustrating. Raising or lowering the price by $1.00 meant I only got 20 cents more or less. Also, given the large, built-in costs, that only meant my possible price extended over a small range, say $13.95 to $15.95. That was unlikely to have a dramatic impact on sales. In practice, my price was driven mostly by the price of books I saw as competitors.

    Digital flips that upside down. Now, if I raise the price by $1, I get 70 cents more. If I cut it by a $1, I get 70 cents less. That would seem to encourage price gouging but for another factor. Because retail prices are much lower, that $1 up or down makes a huge difference in the buyer's willingness to buy, particularly in competition with other ebooks. Pricing that ranges from $3.99 to $5.99 will have a major impact on sales and that's even more true if the price range runs a more typical five-fold range from $0.99 to $4.99. If dropping the price by a $1 will double sales, it makes a lot of sense. That creates an incentive to move the price down.

    From my perspective, agency pricing makes a lot of sense because it lets me set a price that my customers seem to like: not so high that they don't buy, not so low that I lose any incentive to write similar books.

    Setting a wholesale price doesn't do that. It merely creates a suggested retail price that a retailer can ignore. And one retailer, meaning Amazon, selling below cost to destroy competitors, means a mess for me. Other retailers will demand that I cut their wholesale price so they can match Amazon's money-losing prices--precisely what Apple was doing with the Big Six in 2010.

    And since I am not a Big Six publisher, that doesn't mean negotiations at Manhattan restaurants. I means that all the other retailers, soon followed by Amazon, will simply dictate that I cut my wholesale price to less than what they want my retail price to be. That's what the MFN clause standing alone was about. It's why publishers, from large to small, don't want an MFN without agency pricing. Without agency, their prices could be caught in a death spiral, since any retailer could force the retail price down below costs and thus wholesale prices for the entire market down.

    And having been pushed into agency pricing to avoid the horrors of MFN without agency, publishers have come to like it. I've not been able to quite discover what it is, but there's something about digital products that mean two pricing models make the most sense: agency pricing for the average consumer and subscriptions for heavy users. That's proved true with music and movies. It's proving to be true with digital books. In opposing agency for books, the DOJ is simply out of touch with reality.

    I'll add one other remark about this lawsuit. Read through the DOJ's arguments, and you'll soon realize that their lawyers aren't really thinking about the public interest. The public has clearly benefited from changes in the market since 2010, when the DOJ alleges, Apple and the Big Six wreaked so much harm on ebook sales. Prices have come down. Reader devices are far more common. (A market dominated by Amazon would mean an ereader market dominated by Kindles.) There's little or no delay between the release of print books and ebooks. Rhe market is no longer heavily dominated by one retailer. All those are good for the public. There's been only one loser in all this and that's Amazon, who now has to deal with genuine competition.

    It's the trouble these changes, particularly MFN plus agency, has meant for Amazon's urge to dominate, that has the DOJ all hot and bothered. They're using our tax money to serve Amazon's interests not ours. That's Chicago Machine politics, but it is depressing to see it taken to a national level.

    I'll add one additional comment as a publisher who does his own book layout. The ebook market isn't just competing over price. It's also competing over just how versatile and complex a book's layout can be, as well as whether there will be a single ebook standard used by all retailers. Those matter too, particularly if we want to have high school and college textbooks move to much cheaper digital formats.

    Because most books, novels and biographies, don't have complex layouts, Amazon has been lagging badly in that area. Even though it was created by Amazon's own Kindle plug-in for InDesign, my latest book, Hospital Gowns and Other Embarrassments, looks dreadful on iPad's Kindle reader. The pictures, which look marvelous in iBooks, are only a little larger than thumbnails. In that area, it's Apple who is dragging Amazon, kicking and screaming, into improving the way their books look.

    And while Amazon, unlike Apple, is also resisting the move to the ePub standard for ebooks, sticking with its proprietary formats, it does seem aware that some day it will have to conform, Their new KF8 format is close enough, experts tell me, that changing it to ePub wouldn't be that hard.

    All that suggests that, contrary to these DOJ lawyers, the competition that Apple is offering Amazon is good for the public. Let's hope that judge really has changed her mind and Apple wins this one.

  1. aardman

    Fresh-Faced Recruit

    Joined: 11-18-09

    Thanks Inkling, for a most enlightening exposition. I too am truly appalled that the DoJ, out of sheer incompetence and ignorance, rather than corruption and malevolence, has taken on the task of defender of one of the two most predatory enterprises in existence today. Amazon is out to sew up all of retailing and they are doing so using their own smarts, which is okay, but in combination with government largesse (sales tax exemption) and parasitic opportunism (free showrooms courtesy of brick and mortar stores), both of which are not okay. For the DoJ to not notice this at all and come riding to the rescue as if Amazon was this helpless mom and pop store that was being devoured by Apple and the publishers is a display of willful stupidity that is truly breathtaking.

    The ideal verdict is for Judge Cote to say that the eBook market has never been a competitive market; restraint of trade in the eBook market was already occurring well before Apple entered the fray. What we are seeing are elephants fighting it out and the best remedy is no remedy, let the elephants sort things out on their own.

  1. Charles Martin

    MacNN Editor

    Joined: 08-04-01

    Vinnie: thanks for noticing that, I will have it fixed. Cheers.

    Inkling: thanks for taking the time and effort to lay that all out for us, very enlightening.

  1. TheGreatButcher

    Mac Enthusiast

    Joined: 06-11-00

    Sorry if this sounds ignorant, but isn't Amazon selling these eBooks at a loss sort of illegal like the idea of a gas station selling gas at a loss to drive their competitors out of business?

  1. Charles Martin

    MacNN Editor

    Joined: 08-04-01

    GreatButcher: they're not doing that anymore, but yes "predatory pricing" is illegal *if* you are doing it to drive out competitors. Amazon would argue they were doing it to grow the e-book industry and promote their Kindle hardware, not sure if a non-biased DOJ would have bought that argument ...

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