It’s About Time! DoJ Sues Over E-book Price Fixing

On Wednesday the U.S. Department of Justice filed an anti-trust lawsuit against Apple, Hachette Book Group, HarperCollins, Macmillan, Penguin Group USA and Simon & Schuster.  (Note: Hachette, HarperCollins and Simon & Schuster have tentatively agreed to a settlement and, if approved, should be removed from the list of defendants.)

In the past couple years our favorite gadget news sites have sometimes resembled legal reporter sites because of all the inter-company lawsuits, but this lawsuit is significantly different than those lawsuits. It also gives us a view of the effects of digital technology in the book industry, while shedding some light on Apple’s mindset when it comes to competition.

So, what makes this lawsuit different than the slew of patent cases we’ve been bombarded with over the past couple of years? Well, a couple of things. First, it was brought by the U.S. Government and not another company.  The government is going to try to show that the publishers conspired to and did violate the Sherman Antitrust Act (or what we lawyer types refer to as 15 U.S.C. §1). The Sherman Act was passed back in 1890 and was named after its principal author Senator John Sherman (Republican from Ohio). The act allows the U.S. Government to prevent private businesses from engaging in anti-competitive activities. Most notably, it is the law that prohibits monopolies and cartels (multiple companies acting as one).

By the way, when a case brought by the U.S. Government is announced in the courtroom, it is often done by the statement, “The People of the United States vs. ”. It takes a pretty hardened defendant or attorney not to understand the weight of a matter so entitled.

When companies are allowed to become monopolies or when a group of companies conspires to work together, the price of their products tends to rise. That’s when the U.S. Department of Justice is supposed to step in. There have been a number of famous antitrust cases bought by the U.S. against companies such as US Steel, Standard Oil, IBM, AT&T, and Microsoft.

Okay…for the three of you still awake, let’s move on to what happened in the e-book industry that led up to this.

When Amazon released the first Kindle reader, e-books started to become popular. One of the key reasons was that their prices were lower than their paperbound equivalents. That made sense to most people. The publisher no longer had to print books, buy paper stock, or ship and take returns on their books. Amazon also no longer had to purchase and hold them in inventory or put them in a box to ship to their customers. So, by removing these costs, publishers and eBook sellers could retain their profits simply by deducting their cost savings from the price of the book.

Prior to 2010, e-books and paperbound books were sold to resellers at a 30% – 65% discount off the cover (retail) price and the resellers were then free to set their own selling price. So, if a book had a list price of $20 and the reseller paid $8 for it, the store could sell the book at any price it wished with the difference between the selling price and the cost being the gross profit on the item. Consumers could then shop around for the best price on that book.

Amazon began pricing e-books aggressively ($9.99 or lower) in order to increase sales volume and make the Kindle more attractive to purchasers. Not surprisingly, people began to buy e-books rather than their paper-based equivalents—and publishers panicked. You see, they had a problem. While the money made on e-books was roughly equivalent to the sale of a paperback edition, it wasn’t nearly as much as the profits garnered from much higher-priced hardcover editions.

Popular books are generally released in hardcover first, at cover prices ranging from $20 – $50; then six to nine months later the paperback version would retail at $5 – $15. The publishers, who appear to have had a little more foresight than their cousins in music and video, understood that the majority of their customers preferred reading on e-readers and that e-books were soon going to dominate their overall sales. This meant that delaying e-books releases wasn’t going to push people to buy the more expensive hardcover version earlier.

The publishers also considered a sliding scale, with pricing of e-books depending on when they were purchased. So that on the first day of availability, the publisher would list an e-book at $25, and then drop the price as time went on. Once again, this idea was discarded as causing customer confusion and discontent.

The publishers were fearful that Amazon was going to become so dominant in this new marketplace that it would have too much power in their ongoing dealings. Publishers prefer to have at least several resellers sell their products so that no single entity can dictate the terms of their business relationship.

Book sales were already under increasing pressure from other forms of media, and then along came Steve Jobs. He had an idea that would help the publishing industry increase their selling prices, reduce Amazon’s dominance in book (especially e-book) sales, and secure Apple’s own black bottom line. Oh, and if it flew in the face of antitrust laws and competition, so be it.

Apple was about to release the iPad, and while we all recognize it as a hit product now, no one was quite so sure back then. Steve Jobs knew he needed to include books along with music and video in the iTunes market place, but didn’t want to get into a pricing war with Amazon. So he convinced (I have a feeling it wasn’t all that hard to sell) the major book publishers to change from selling their products at a discount off a variable list price to selling them at a fixed price and then giving the reseller a 30% rebate or commission. This is usually called an “agency model”.

All e-books resellers are contractually obligated to sell books at the price stated by the publisher.  If resellers discount the price, not only will they will not receive a commission, but they could lose the rights to sell a publisher’s entire library.

Within a month of the iPad’s release and the adoption of the new agency model, consumers were now paying 33% – 50% more for e-books and there was no pricing competition. All resellers charged the same price. Amazon now puts a note by the price of all affected e-books that the price was set by the publisher.

As a result of this industry-wide agreement, some e-books now cost more than they do bound and printed on paper. For instance, you can purchase George R. R. Martin’s A Game of Thrones four-book set as paperbacks for $21.00 from Amazon, but the e-book version sells at a publisher-fixed price of $29.99, the same price it sells for on iTunes, B&N and others.

I believe that Apple and several of the publishers chose not to settle because they know cases like this can go on for years. Eventually they may settle, but they may be able to wait out the current administration in the Department of Justice and get a more favorable settlement, or the case may be dropped entirely.

Anti-trust cases tend to be very complex, with the government bearing the burden of proof.  In order to pursue a violation of this sort, they must allege and ultimately prove that the defendant entered into a contract, combination, or conspiracy, and that it resulted in an unreasonable restraint of trade. While the actual measure is not the “beyond a reasonable doubt” that we’re all familiar with from the criminal trials that often make headlines, it still won’t be an easy case to prove.

Although, it will be some time before a decision of any sort is rendered in this case, it is undisputed that all of the major publishers shifted to a different pricing model around the same time and that it caused the price of e-books to increase substantially.

As for Apple, while it may have been the instigator of this action and certainly has benefited, it still took the publishing companies’ agreement for this to happen. I believe the only real harm Apple will suffer is a diminishment of their reputation among some consumers.

In a public release after the lawsuit was filed, Apple claimed that it did not collude with the publishers and that by opening the iBook store, they have broken Amazon’s monopolistic hold on the e-book industry. They compare their approach to book selling to the way they allow publishers to set prices on apps in the app store.  In my mind, if Apple had opened their iBook store under a standard pricing model, they still would have done well. But the thought of having to compete on price with other e-book resellers wasn’t to their liking. Apple also failed to mention that the sale of music, which is truly analogous to books, through their iTunes store is not under an agency model, but instead follows the more traditional resale model.

As I wrote earlier, anti-trust actions can be very complex, and Apple and the publishers will present a number of defenses and cite cases where minimum pricing has been allowed. I believe those cases to be significantly different than this current action. Perhaps as this case and story unfolds, we’ll keep a running dialog going in the comments section.

If the vast majority of an industry is allowed to work in lockstep on pricing and business terms, it could set a very bad precedent.