The U.S. Court of Appeals for the Second Circuit affirmed on June 30, 2015 a district court ruling that Apple, Inc. had conspired with publishers to enter the e-book market in 2010. In a 2-1 ruling, the court held that Apple’s conduct was a per se violation of Section 1 of the Sherman Act, prohibiting conspiracies in unreasonable restraint of trade. The dissent rejected application of the per se rule and viewed Apple’s conduct as lawful under the rule of reason. The decision reflects sharp disagreement over whether Apple should be condemned for the way it entered the market or commended for breaking Amazon’s monopoly over e-book retail distribution.

This disagreement highlights a matter of fundamental antitrust importance in an era of rapidly evolving technology: What Section 1 rules should apply to market entry by a firm whose product transforms the market?

Facts & Trial Court Ruling

The U.S. Department of Justice and 33 states sued Apple and major publishers – Macmillan, HarperCollins, Hachette, Penguin and Simon & Schuster – in 2012 in the U.S. District Court for the Southern District of New York, alleging they had conspired in violation of Section 1 to facilitate Apple’s entry into the e-book market and to fix retail prices. All of the publishers settled before trial. Following a bench trial, the district court entered judgment against Apple for violation of Section 1.1 The Court of Appeals accepted the trial court’s findings, which are summarized as follows:

As it prepared to introduce the iPad, Apple sought to reach agreement with major publishers on e-book distribution. Before Apple opened its iBooks Store in 2010, Amazon had 90 percent of the market for retail distribution of e-books in the United States. Its customers could read e-books on Amazon’s Kindle. It charged readers $9.99 for new books and bestsellers under what was known as a “wholesale” pricing model.

In contrast, Apple proposed that publishers should set the retail price for e-books under an “agency” pricing model. Publishers had objected to Amazon’s $9.99 price point because it threatened the profitability of hardcover editions and sales at brick-and-mortar stores.

In negotiations with publishers, Apple insisted on including a most-favored nation (MFN) clause in the distribution agreement, i.e., a promise by the publisher that it would sell a new release to Apple at a price equal to its lowest price to any other retailer. The trial court found that the publishers understood they would have to move Amazon from the wholesale pricing model to the agency model if the arrangement with Apple were to prove profitable. Otherwise Apple would, by operation of the MFN clause, be selling titles at $9.99 alongside Amazon. The trial court rejected Apple’s argument that the MFN clause was needed to protect Apple from price competition, finding instead that it gave publishers an incentive to abandon the wholesale pricing model:

The MFN was sufficient to force the change in model. The economics of the Agreements were, simply put, “terrible” for the Publishers. The Publisher Defendants already expected to lose revenue from their substitution of an agency model for the wholesale model of e-book distribution. Unless a Publisher Defendant followed through and transformed its relationships with Amazon and other resellers into an agency relationship, it would be in significantly worse terms financially as a result of its agency contract with Apple.2

Apple entered into a separate distribution agreement with each publisher, and the publishers then notified Amazon that they would require it to convert to the agency pricing model. Amazon acquiesced. The trial court held that Apple had violated Section 1 of the Sherman Act by facilitating the publishers’ conversion to the agency pricing model:

Apple is liable here for facilitating and encouraging the Publisher Defendants’ collective, illegal restraint of trade. Through their conspiracy they forced Amazon (and other resellers) to relinquish retail pricing authority and then they raised retail e-book prices. Those higher prices were not the result of market forces but of a scheme in which Apple was a full participant.3

Appeals Court Ruling

In an opinion by Judge Livingston, the Court of Appeals held that Apple had participated in a classic “hub-and-spokes” conspiracy. Recognizing the publishers had engaged in a horizontal conspiracy to elevate e-book prices, it affirmed the trial court’s finding that Apple had participated in their conspiracy to force abandonment of the wholesale pricing model. It turned aside Apple’s argument that its agreements with publishers were conventional vertical supply arrangements. Because Apple was a knowing participant in the price-fixing agreement among the publishers, the court affirmed the trial court’s conclusion that its conduct amounted to a per se violation of Section 1. In a concurring opinion, Judge Lohier joined in affirming on the basis of the per se rule.

Judge Jacobs dissented on the ground that Apple’s conduct should be subject to evaluation under the rule of reason, not the per se rule. Applying the rule of reason, he concluded that the conduct did not violate Section 1. Pointing to the U.S. Supreme Court’s continuing circumscription of the per se rule, Judge Jacobs took issue with the majority’s view that a hub-and-spokes conspiracy is to be evaluated under the per se rule. He noted, “Collusion among competitors does not describe Apple’s conduct or account for its motive . . . [and] Apple’s conduct had no element of collusion with a horizontal rival.” Because Apple was downstream from the publishers, rule of reason analysis should have been followed, and Judge Jacobs had no difficulty concluding that Apple’s entry into the e-book retail market was procompetitive: “Apple’s challenged conduct broke Amazon’s monopoly, immediately deconcentrated the e-book retail market, added a platform for reading e-books, and removed barriers to entry by others.”

Next Step

The Second Circuit’s disposition casts in sharp relief the important antitrust issues posed by the case, and Judge Jacobs is clear in his dissent that Supreme Court review is warranted to resolve whether rule of reason treatment is appropriate for a hub-and-spokes conspiracy such as this. In light of the dissent and Apple’s insistence that market entry was procompetitive, it can be expected that the next step in the case, assuming no petition for rehearing, will be a petition for certiorari.