Apple E-Book Trial, Week 2: The Emerging Case for Letting Apple Off the Hook

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Robert Galbraith / REUTERS

As the U.S. government’s closely watched e-book price-fixing trial against Apple enters its second week, the tech giant appears to be on stronger footing than it was at the beginning of the case, thanks in part to a key legal question concerning Apple’s culpability that was raised by the federal judge overseeing the trial. Did Apple “force” the five major publishers to demand that Amazon change its business model — resulting in higher prices for consumers — or did the publishers act out of their own self-interest? If the latter is true, Apple could be off the hook.

Throughout the trial’s first week, Apple’s lawyers chipped away at the government’s basic assertion that the tech giant conspired with five major publishers to raise the price of e-books as Apple prepared to launch the iPad in early 2010. Apple, its lawyers have argued, was merely a new entrant in a market then dominated by Amazon, and simply negotiated in its own best interest with the publishers.

(MORE: Apple Says It’s Not an E-Book Crook as Price-Fixing Trial Begins)

Apple didn’t force the publishers to demand that Amazon move to a new business model with higher prices for consumers, its lawyers have argued. Rather, the publishers did so out of self-interest, because they had a business incentive to pressure Amazon themselves. It’s a nuanced distinction in an already complex legal case, but one that could determine the outcome of the trial. Late last week, U.S. District Judge Denise Cote, who is overseeing the nonjury trial, signaled that she might be sympathetic to that argument, in questions to a key prosecution witness that appeared to visibly embolden Apple’s defense lawyers, according to Fortune’s Philip Elmer-Dewitt.

A little background on the case: by the time Apple launched the iPad in early 2010, Amazon’s Kindle e-reader dominated the e-book space with an estimated 80% market share. This dominance, the publishers believed, was attributable in part to Amazon’s strategy of pricing new e-book best sellers at $9.99. Amazon was able to do this thanks to the industry’s then prevailing business model, the so-called wholesale model. Under this arrangement, the publishers would sell books to retailers at a discount — say, $15, or about half the list price of $25 to $35 — and then the retailers could decide how much to mark up the books to consumers.

In a typical scenario, brick-and-mortar retailers like Barnes and Noble would offer a best seller at somewhere between the $15 wholesale price they paid to publishers and the $25 to $35 list price on the jacket cover. For years, the model worked well for all parties. The publishers would get their $15, and the retailers would sell the books for $20 — the $5 upside was their profit margin — and consumers felt like they were getting a good deal because they were getting the books at a “discount” to the list price.

(MORE: How Apple’s Steve Jobs and Book Publishers Cost Consumers Millions)

Amazon disrupted the wholesale model, because instead of marking e-books up from the wholesale price, which the publishers set at about $10, the company simply turned around and priced popular electronic titles at $9.99. This “break even” price point distressed the publishers, who believed Amazon was taking advantage of the wholesale model by foregoing a profit on the e-books themselves, in order to drive Kindle sales. According to the government, the publishers were concerned that lower e-book prices would eventually lead to a “deflation” of hardcover book prices, as consumers grew accustomed to the $9.99 price point.

Here’s where the alleged conspiracy occurred, according to the government. The publishers were eager to raise e-book prices before $9.99 became an “entrenched consumer expectation.” Apple offered a solution by proposing that the publishers shift from the wholesale model to a so-called agency model, in which the publishers would set the retail price — say from $12.99 and $14.99 — and Apple, as the “agent,” would receive a 30% commission. Crucially, Apple’s arrangement with the publishers included a so-called “most favored nation” clause, which ensured that if a retailer like Amazon undercut the publisher’s price — which it had shown a willingness to do — Apple had the right to do so as well.

Having struck their deal with Apple, the publishers presented Amazon with an ultimatum, according to the government: either adopt the agency model or lose the ability to sell new best sellers for several months after publication, a practice known as windowing. Amazon was furious but quickly gave in and accepted the agency model. In short order, e-book prices increased by as much as $5 per unit, according to the government. (Apple disputes the government’s assertion that e-book prices increased, and says it will show during the trial that the opposite is true, but has yet to introduce evidence to that effect.)

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The government argues that Apple’s most-favored-nation clause gave the publishers the incentive to demand that Amazon move to the agency model, which had the effect of raising prices for consumers. That’s because if Amazon sold e-books at below cost, which it was allowed to do under the wholesale model, Apple had the right to match that lower cost. This presented the publishers with a conundrum, because if Apple matched Amazon’s $10 price point under the agency model, the publishers would only get $7 — after paying Apple a 30% commission — which is even less than the $10 they were getting from Amazon under the wholesale model. This is why the publishers demanded that Amazon move to the agency model, in which the publishers would set the price of $12.99 to $14.99, guaranteeing that they would at least make the $10 they were previously making under the wholesale model.

A central question in the case is whether Apple used the most-favored-nation clause to “force” the publishers to demand that Amazon agree to the agency model, or whether the publishers acted on their own, out of self-interest. This question was at the heart of testimony last week by Laura Porco, an Amazon executive who negotiated book deals with publishers. In written testimony, Porco had said the publishers told Amazon that they were “requiring” the company to switch to the agency model, because that’s what Apple “required” them to do. But she also testified that the publishers said Apple included “restrictions” that made it “technically impossible” for them to continue doing business with Amazon on a wholesale basis.

Before oral arguments began last Monday, Judge Cote indicated that the Justice Department had a strong case against Apple. But on Thursday, Cote seemed to breathe new life into Apple’s position when she suggested a distinction between Apple “requiring” the publishers to “require” Amazon to shift to the agency model, and the publishers acting on their own once they realized that the most-favored-nation clause made it “technically impossible” for them to agree to continue a wholesale relationship with Amazon. How Judge Cote ultimately decides that question could determine the outcome of the case.

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