How The Agency Model Led To An Antitrust Suit

As reported yesterday, the Department of Justice has filed its antitrust lawsuit against Apple and five of the largest publishers (Macmillan, Penguin, HarperCollins, Hachette, and Simon & Schuster).

A settlement has been agreed with HarperCollins, Hachette, and Simon & Schuster; Macmillan claimed the terms were too onerous, and Penguin appears to have refused to contemplate settling.

The agreed settlement must still be approved by the court, but among the conditions are the end of Agency (despite the attempted spin by PW in the above-linked article) and the return of pricing control to the retailers (such as Amazon). In addition, the settling parties will be monitored by the DoJ, who must be copied on any communications surrounding this or any related matters.

While the DoJ’s case is getting all the attention, it should not be forgotten that all the above parties are also being sued by sixteen State Attorneys-General who are seeking both injunctive relief, and compensation for “e-book customers paying $100 million in overcharges.” HarperCollins and Hachette have also settled that case; as it stands, the remaining parties will go to court.

Finally, the European Commission has its own continuing investigation. Reuters report that Apple and four of the above publishers have sent a proposal to settle the case (Penguin being the hold-out). It’s far from certain that the Commission will accept this proposal, and they are said to be watching the outcome of the DoJ’s suit with great interest.

Penguin’s strategy of refusing to engage in any settlement negotiations is curious as they appear to have the most to lose if this matter goes to court. As the Bookseller notes from the DoJ suit:

[Penguin] is referenced 41 times, more than Macmillan, and double the number of times any of the settling publishers–HarperCollins, Hachette Book Group, and Simon & Schuster–are referred to. [Penguin CEO John] Makinson is also directly named, as is David Shanks, CEO of Penguin USA, a number of times: again more than any other CEO.

The suit contains a number of juicy allegations, all of it quite damning for Apple and the respective publishers. Despite the robust statements from Macmillan and Penguin – and their cheering-on from certain quarters of the publishing industry – to this layman’s eye the case appears to be clear and substantial, backed up with hard evidence including: phone records of conversations between publishing executives at the various companies and Apple; internal and external email transcripts from the defendants; and, sensationally, an alleged attempt to delete emails “to avoid leaving a paper trail.”

The full 48-page complaint is here, but The Verge do an excellent job of parsing the key points, and The Business Insider have a great blow-by-blow account, highlighting the most important section of the actual suit.

Before the Agency model was brought in at the start of 2010, e-books were sold (like print books) under the wholesale model. What this meant was that publishers would decide the list price of an e-book, and the retailer could set the retail price of their choice.

For example, if a publisher decided that Stephen King’s latest was to be priced at $14.99, Amazon were free to discount the e-book as much as they liked to their customers, but had to pay the publisher as if the e-book had sold for $14.99. Contrary to some widespread misunderstandings, Amazon had no control of the list price publishers would set – which was the price which decided what payment publishers (and authors) would receive from Amazon.

In practice, this meant Amazon discounted a large number of books from publishers, in an attempt to bring the retail price to $9.99 or below. Again, to be clear, this did not affect the payments publishers received, only the price customers paid, with Amazon swallowing the difference.

Publishers were said to be unhappy with Amazon’s discounting policy for two reasons. First, they feared this pricing approach would allow Amazon to grab an increasingly dominant share of a fast-growing market. Second, they worried that aggressive pricing of e-books would hasten the adoption of e-reading, threatening their business model (they largely controlled print distribution, but digital was wide open). The problem, in legal terms, is what happened next.

The DoJ allege that as early as September 2008:

[The publishers’] senior executives engaged in a series of meetings, telephone conversations and other communications in which they jointly acknowledge to each other the threat posed by Amazon’s pricing strategy and the need to work collectively to end that strategy.

The respective CEOs were alleged to have met in secret in the private dining rooms of upscale Manhattan restaurants, talking about how to deal with Amazon.

The DoJ allege that by 2009, the result of these meetings was an agreement “to act collectively to force up Amazon’s retail prices.”

However, in the meantime, while Apple weighed their entry into the e-book market, the DoJ also allege that Apple “contemplated illegally dividing the digital content world with Amazon, allowing each to own the category of its choice – audio/video to Apple and e-books to Amazon.”

By late 2009, “Apple and the [publishers] settled on the strategy that worked,” which was, of course, the Agency model. This model had two key points. First, publishers would control retail pricing. Second, the contracts would contain a most favored nation (MFN) clause, essentially meaning that publishers would not be able to have lower prices on Apple’s competitors.

According to the DoJ’s suit, “instead of an MFN designed to protect Apple’s ability to compete, the MFN was designed to protect Apple from having to compete on price at all.”

I just want to pause here for a moment, because I believe this is a crucial point. Defenders of Agency have argued that the model gave Apple (and other retailers) an opportunity to compete. The DoJ’s suit quite clearly alleges that the model prevented competition.

The result, of course, was increased e-book prices. This was predicted by Steve Jobs, who famously said in his authorized biography (and these words are repeated in the suit), “We’ll go to [an] agency model, where [publishers] set the price, and we get our 30%, and yes, the customer pays a little more, but that’s what [publishers] want anyway.”

As the suit alleges in quite bald terms:

Apple was perfectly willing to help [publishers] obtain their objective of higher prices for consumers by ending Amazon’s “$9.99” price program as long as Apple was guaranteed its 30 percent margin and could avoid retail price competition from Amazon.

Of course, the Agency model would only do its job if all the other retailers signed on. To that end, the DoJ’s suit alleges that Apple and the publishers “set in motion a plan that would compel all non-Apple e-book retailers also to sign to agency or else as [Steve Jobs] put it, the [publishers] all would say, ‘we’re not going to  give you the books.’”

The suit goes on to give further details about pricing based on internal Apple emails which are alleged to show that the publishers were dead-set against Amazon’s $9.99 pricing for new releases and bestsellers, weren’t crazy about Apple’s proposed $12.99 price point, and successfully negotiated a tiered pricing structure to include some bestsellers and new releases at $14.99.

As to whether the publishers colluded, or acted in concert with each other, the allegations in the DoJ’s suit are clear. They quote internal Apple emails from an executive called Eddy Cue (Apple’s Vice President of Internet Services) who claimed that “all of [the publishers] were very concerned about being the only ones to sign a deal with us.” And the suit further states:

Penguin explicitly communicated to Apple that it would sign an e-book distribution agreement with Apple only if at least three of the other [publishers] did as well. Apple supplied the needed assurances.

The suit goes on to state that a further publisher (presumably Random House) who hadn’t signed up to Agency saw its market share grow. As a result, the DoJ allege, they came under increasing pressure to toe the line.

Penguin – and its US CEO David Shanks – are alleged to have taken the lead in convincing Random House to switch to Agency, actions which included encouraging “a large print book and e-book retailer to punish the other publisher for not joining the defendants’ conspiracy.”

The DoJ is quite clear about Apple’s role, alleging that they “knowingly served as a critical conspiracy participant” by promising the same deal to all the publishers and keeping each player in the loop as to the status of negotiations.

The suit goes into forensic detail about all the meetings that took place between the various parties, and clearly synchronizes email communications and phone calls between Apple and the publishers, as well as between the publishers themselves.

So that’s the DoJ’s case. As for the settlement, Wired do an excellent job of summarizing the key points from the agreement reached between the DoJ and Hachette, HarperCollins, and Simon & Schuster.

In short, Agency is toast. Presuming the settlement is approved, the publishers will be forced to terminate their agency contracts with Apple within seven days. A lot of speculation will surround what will replace those contracts, but the DoJ have set out clear guidelines.

For a (minimum) two-year period, any new contracts will not be allowed to prevent any retailers from discounting. For a (minimum) five-year period, those contracts will not be permitted to contain the “most favored nation” clause that caused such problems for the DoJ (and which was the backbone of the alleged price-fixing effects of Agency).

Finally, there are a series of onerous compliance conditions for the settling parties including designating an antitrust compliance officer, providing copies of any agreements with e-book retailers for a five-year period, notifying the DoJ of any joint venture with other publishers regarding e-books, and copies of any (non-privileged) communications regarding plans or strategies related to e-books. The DoJ also warned against the publisher retaliating against any retailers (presumably Amazon). It looks like the DoJ will be keeping a very close eye on the settling parties.

As for the parties which didn’t settle – Penguin, Macmillan, and Apple – they face a range of possible outcomes. Some anti-trust experts believe the DoJ has a much stronger case against the publishers than it does against Apple, and the details of the suit do seem to focus much more on the respective publishers’ actions. That may not matter, however. With three of the publishers agreeing a settlement to end Agency, it’s hard to see how it continues in any form.

What takes its place is less obvious. Will the wholesale model return? Or will the publishers come up with an alternative system? If it’s the latter, the DoJ will be watching closely to make sure that doesn’t result in higher prices for consumers – which was the one of the key aims of Agency in the first place.

Whatever happens, one thing seems clear: e-books are about to get cheaper.