Apple: Changing More Than Technology

Thursday, August 15, 2013 - 14:29

The recent decision in U.S. v. Apple Inc. (“Apple”), which held that Apple’s agency agreement with publishers was a per se violation of the antitrust laws, may alter the antitrust analysis vertical distribution agreements. Companies with distribution agreements take note.

Adjudication Of Vertical Agreements Pre-Apple

Section 1 of the Sherman Act (15 U.S.C. §1) prohibits agreements that unreasonably restrain trade. Courts scrutinize challenged agreements generally either under a per se illegal standard or under the rule of reason (although there exist nuanced variations of these standards, such as the quick look standard). A plaintiff’s case under the per se standard is rather straightforward. Under the per se standard, courts do not delve into the factual underpinnings of or rationale for the agreement, or the competitive dynamics of the marketplace. A rule of reason analysis weighs the anticompetitive harms posed by the agreement against the pro-competitive benefits, examining market structures and the parties’ rationales for entering the agreement. The rule of reason analysis is a much deeper analysis of the effects of the agreement on the marketplace and offers the companies involved greater opportunity to justify their agreement, and perhaps escape antitrust liability.

Per se illegality is reserved for those agreements that by their very nature are inherently anticompetitive. An agreement between two horizontal competitors (competitors at the same level of distribution to the marketplace) to fix the price of the goods they sell, without any further provisions, is a simple but obvious example of an agreement that would be characterized as per se illegal. By contrast, a distribution agreement between one of many equally sized suppliers of a product and a distributor of those products that limits the scope of the distributor’s distribution might have pro-competitive and redeeming justifications, and would thus be adjudged under the rule of reason.

For years, companies have taken some comfort that, for the most part, vertical agreements (agreements between an upstream supplier and a downstream seller) are adjudged under the rule of reason. Prior to Apple, the trend line evidenced a move by courts away from per se illegality for vertical agreements in most circumstances. The not-so-distant Supreme Court decision in Leegin Creative Leather Products, Inc. v. PSKS, Inc., 551 U.S. 877 (2007), which addressed resale price maintenance – provisions once adjudged under the per se standard, but under Leegin now adjudged under the rule of reason – is illustrative. And under the rule of reason standard, vertical agreements have infrequently been found to violate the antitrust laws. The Apple decision may chip away at that comfort.

The Apple Decision

Prior to the entry of Apple into the electronic books marketplace, publishers and distributors had existed under a wholesale model – a model whereby the publisher established a list price for its content and then sold to the wholesaler distributor at a discount to that list price. The distributor in turn sold to the customer at the price of its choosing. At the time, Amazon was a dominant distributor of electronic books to the consuming public and was often providing such content at $9.99, much to the ire of publishers who sought higher retail pricing for electronic books.

Apple, with advent of the iPad, sought to enter the electronic books marketplace and needed to ensure content for its product. According to the Apple decision, Apple also understood that the publishers were unhappy with Amazon’s pricing. Apple approached each of the publishers with a new business model for electronic book distribution – the agency model. Under the agency model the distributor acted as an agent of the publisher, accepting a commission for the sale of the publisher’s content and selling that content at a price determined by the publisher. Apple brought its agency model to each of the major publishers and promised the agreement of each of the other publishers to the agency model. Each of the publishers understood that its competitors would adopt the agency model.

Apple’s agency distribution agreement with publishers contained a most-favored nation clause (“MFN”) that permitted Apple to match the lowest retail price offered by its competitors and that imposed a penalty upon any publisher that was unable to force Apple’s competitors (and in particular Amazon) to adopt the agency model. The combination essentially forced the marketplace to shift from a wholesale model to an agency model and permitted publishers to set the price of electronic books without fear that Amazon would undercut that price. In addition to forcing the marketplace to adopt the agency model, the MFN clause also limited price competition between other distributors and Apple. As described by the Court, Apple “provided the Publisher Defendants with the vision, the format, the timetable, and the coordination they needed to raise e-book prices.”

The market structure in which Apple and the publishers interacted was a vertical arrangement. Apple was the downstream distributor of the publisher’s content. Yet, the Court condemned the agency arrangement as per se illegal. The Court held that per se agreements include those agreements whereby a vertical player “participates in and facilitates a horizontal conspiracy” and “Apple played a central role in facilitating and executing [the] conspiracy.”

In so holding, the Court relied on the holding in Toys “R” Us, Inc. v. FTC, 221 F.3d 928 (7th Circuit 2000), in which Toys “R” Us was found to have violated the Sherman Act by agreeing with toy manufacturers to limit the supply of toys to warehouse clubs. The agreements at issue in Toys “R” Us were also vertical arrangements; however, while the court never declared the standard under which it was adjudging the case, the analysis undertaken conforms more to a rule of reason analysis than to a declaration of per se illegality.

Implications For Companies With Distribution Agreements

Assuming the Apple decision is good law and is not overturned on appeal, is Apple a change in the way vertical arrangements are reviewed? Perhaps. In terms of how vertical agreements are reviewed by the courts, the Apple decision moves the needle, but not to any great degree. On the one hand, the comfort that companies have taken with regard to the review of vertical agreements under the rule of reason may be diminished. On the other hand, prudent companies should not become overly anxious.

Prior precedent indicates that there is a safe harbor from per se illegality for agency or consignment relationships in a vertical setting. That safe harbor derives from the 1926 Supreme Court decision in U.S. v. General Electric Co., 272 US 476, where the Court reasoned: “The owner of an article patented or otherwise is not violating the common law or the Anti-Trust Act by seeking to dispose of his articles directly to the consumer and fixing the price by which his agents transfer the title from him directly to such consumer.” That case involved patented goods, but that does not necessarily change the rationale of the decision – a supplier can set the price that he sells to consumers, whether directly or through an agent. But, it also involved a single upstream entity setting the price to downstream agents – the inverse of what occurred in Apple.

Under Apple, in order for a vertical agreement to fall into per se illegality, a horizontal conspiracy must exist, and the vertical player must knowingly participate in the conspiracy and facilitate its existence. The evidence in Apple demonstrated that Apple both was a knowing and active member of the conspiracy, and “forcefully facilitated it.” Such circumstances can only exist in an industry conducive to coordinated and conspiratorial action with a vertical actor that has significant downstream market power. The alignment of these two factors is likely infrequent.

In both Toys “R” Us and Apple, the subject agreements shifted the marketplace model that had been in place for some time. The shift enhanced (or maintained) the market position of the vertical actor but did not necessarily enhance the position of the horizontal players. In both cases, the horizontal conspirators agreed to terms that were not necessarily in their best interest, at least short term.

In Toys “R” Us, toy manufacturers were best served by a business strategy that included distribution to the largest and most diverse number of outlets. The requirements imposed by Toys “R” Us on toy manufacturers were neither necessary nor wanted. Similarly, in Apple, the agency agreement left less in the hands of publishers than the wholesale agreement that preceded it. The Court emphasized that “there was no financial incentive” for the publishers to sign Apple’s agency agreement.

Most companies will not be in the same position as Apple – able to influence (or exert) downstream power over upstream suppliers. The inverse is more often reality. But distributors with significant downstream market power will want to double check that their distribution agreements do not contribute to an upstream horizontal conspiracy.

The case is docketed as Nos. 12 Civ. 2826(DLC), 12 Civ. 3394(DLC) (S.D.N.Y.) and the opinion was rendered on July 10, 2013.

Timothy Cornell heads Clifford Chance's U.S. Antitrust Practice. Mr. Cornell advises clients on antitrust issues in government civil and criminal investigations, the regulatory review of mergers and acquisitions, intellectual property and technology licensing, supply and distribution agreements, joint venture formation, retail pricing issues, horizontal and vertical restraints, private party civil litigation, and the adoption of antitrust best practices. He obtained his JD from Georgetown University, cum laude, and his bachelor of science in Political Science from the United States Naval Academy. He is an editor of the American Bar Association Section of Antitrust Law's treatise on multijurisdictional investigations and sits on the Board of Directors of City Year DC.   

 

Please email the author at timothy.cornell@cliffordchance.com with questions about this article.