The U.S. Court of Appeals for the Second Circuit recently reversed a district court decision dismissing a complaint alleging the defendants conspired to fix prices of digital music in violation of the Sherman Act §1. Starr v. Sony BMG Music Entertainment, Case No. 08-5637 (2nd Cir., Jan. 13, 2010) (Katzmann, J.).

The plaintiffs purport to represent a nationwide class of digital music purchasers. They alleged that the defendants, which include four of the nation’s major music labels, conspired to fix the prices and impose digital rights management restrictions on digital music available through the internet to make it “less attractive to consumers, thereby buoying the prices” of compact discs. The defendants created two joint ventures to sell music over the internet. The plaintiffs allege that the defendants used these joint ventures to illegally exchange price information and set a wholesale price floor for digital music. The plaintiffs also allege that the defendants used the joint ventures to enforce “most favored nation” clauses with their licensees, such that all the defendants benefited from receiving the same licensing terms as every other defendant or licensor. The most favored nation clauses also allegedly helped the defendants maintain their agreed upon wholesale price floor.

The District Court for the Southern District of New York dismissed the complaint, holding that the Supreme Court’s decision in Bell Atlantic v. Twombly required the plaintiffs to plead more facts tending to show a conspiracy in order to survive a motion to dismiss. Because joint ventures are generally not prohibited, the district court refused to draw a negative inference of collusion simply because the defendants entered into two of them. The court stated that the defendants’ seemingly collusive actions in setting prices could just as likely have been parallel pricing, which is not illegal. Similarly, the defendants’ enforcement of digital rights management restrictions—for example, preventing one purchaser of a digital song from sharing it with others who have not purchased the song themselves or from transferring the song from the purchaser’s computer to an iPod—could have been legal parallel use restrictions. The district court held that the facts the plaintiffs alleged in their complaint were just as consistent with independent action as with conspiracy and therefore the claim had to be dismissed.

Moreover, the district court stated that the plaintiffs’ conclusion that the price and use restrictions were against the defendants’ self-interest could not support an inference of an agreement. The district court noted that pirating music, that is, acquiring a digital song without purchasing it, is widespread and has been detrimental to music distributors and music artists. Thus, even though digital rights management restrictions are unpopular, it is in the companies’ best interest to enforce them. Starr appealed.

The Second Circuit reversed, holding that the complaint contained enough factual matter, taken as true, to suggest an illegal agreement. The Second Circuit criticized the district court’s reference to Matsushita Elec. v. Zenith Radio as the basis for finding the plaintiffs needed to plead “plus factors” that tended to rule out the possibility that the defendants were acting independently. The Court explained that Matsushita is a summary judgment standard, not a pleading standard. While Twombly requires more than a bare assertion of conspiracy, it does not require the level of factual information that a summary judgment standard requires. Thus, here, the Second Circuit found that the non-conclusory factual allegations of parallel conduct were enough to plausibly state a claim for relief.

The Second Circuit first focused on the joint ventures among the defendants that allegedly charged such unreasonably high prices such that “nobody in their right mind” would purchase music from them. In addition, there was evidence that the defendants formed the joint ventures to “stop the continuing devaluation of music.” The court also took exception to the most favored nation clauses, which guaranteed that the defendant licensors received terms no less favorable than the terms offered to other licensors. These clauses also allegedly facilitated the defendants in setting a wholesale price floor. Even more compelling to the court was the fact that the defendants tried to hide these most favored nation clauses.

The Second Circuit pointed to other factors supporting the claim, including: not reducing prices for internet music despite dramatic cost reductions, the substantial price difference between the defendants’ wholesale price and the second most popular music retailer’s price, all the defendants raising their wholesale prices around the same time and past criminal investigations for price fixing.

Taking all these factual allegations to be true, the Second Circuit held that the plaintiffs had “alleged behavior that would plausibly contravene each defendants’ self-interest in the absence of similar behavior by rivals” under Twombly. The court remanded the case back to the district court for further proceedings.

Practice Note: When structuring joint ventures with competitors, parties need to be careful that they do not violate antitrust laws. Setting minimum prices, exchanging price information or distributing the revenue from the joint venture equally instead of by market share will raise red flags. Using the joint venture to enforce non-price restrictions, such as the most-favored-nation clauses in this case, will also invite antitrust scrutiny.