THE APPLE E-BOOKS CASE: WHEN IS A VERTICAL CONTRACT A HUB IN A HUB-AND-

SPOKE CONSPIRACY?

Benjamin Klein

The Apple e-books case highlights the intersection between long-established per se precedents with
regard to hub-and-spoke conspiracies and the now firmly recognized rule of reason analysis of
vertical contractual relationships.

As succinctly summarized by the district court, per se antitrust law with regard to hub-and-spoke
conspiracies requires plaintiffs to “1) demonstrate both that a horizontal conspiracy existed, and 2)
that the vertical player was a knowing participant in that agreement and facilitated the scheme.”

The first requirement, commonly stated in terms of the presence of a horizontal agreement or “rim”
that connects the spokes, is the primary basis by which hub-and-spoke claims are now most
commonly adjudicated. If evidence of a horizontal agreement does not exist or cannot be inferred,
the per se rule does not apply.

This article assumes that a horizontal agreement exists among the spokes in all of the particular hub-
and-spoke cases discussed and focuses solely on the second legal requirement for per se analysis of
whether the hub should be considered a participant in the horizontal conspiracy.

The anticompetitive innovation of a hub-and-spoke conspiracy is in facilitating solutions to these

cartel creation problems of reaching a collusive agreement, detecting cheating, and, most
importantly, providing a more efficient cartel enforcement mechanism.

The Economic Framework of a Hub-and-Spoke Conspiracy  the hub buyer only sets the collusive
terms by which the spoke suppliers are required to deal with rival buyers. This results in an increase
in supplier profits, but it also creates a market advantage for the hub buyer that implies receipt of a
share of the increased profits which substitutes wholly or partially for side payments.

Hub-and-Spoke Cases

Interstate Circuit: Interstate Circuit created a horizontal conspiracy among the major film supplier
distributors, the spokes of the conspiracy, with regard to later-run theaters, the rivals of Interstate
Circuit. Interstate Circuit then enforced this film distributor conspiracy with the threat that any film
distributor that did not comply with these terms would not obtain first-run exhibition in Interstate
Circuit cities. Interstate Circuit purchases accounted for 100 percent of the film distributors’ first-run
film rentals in the relevant geographical market in which Interstate Circuit operated.
Toys “R” Us: Rather than Toys “R” Us requiring toy manufacturers to increase the price its rivals had
to charge, as in Interstate Circuit, the Toys “R” Us agreements involved a modified form of exclusive
dealing that required toy manufacturers not to supply the same products to warehouse club stores
that they supplied to Toys “R” Us. In particular, the Toys “R” Us contracts specified that if similar
products were sold to warehouse club stores, the products had to be provided in different packaged
combinations. Toys “R” Us did not have the ability to unilaterally enforce its warehouse club contract
restrictions. Toys “R” Us accounted for only about 30 percent of the sales of the major toy
manufacturers involved in the conspiracy.

The Apple E-Books Case

The claim  hub-and-spoke conspiracy broadly analogous to the framework described in Interstate
Circuit and Toys “R” Us.

The issue  whether Apple, through its vertical contracts and conduct acted as an intermediary hub
buyer that facilitated this Publisher conspiracy.

“The Publishers”  The five defendant Publishers, who settled before trial, included HarperCollins,
Macmillan, Hachette, Simon & Schuster, and Penguin. The sixth and largest major publisher, Random
House, did not enter a contract with Apple until 2011 and was not charged.

Given Amazon’s 90-percent share of e-book sales the publishers “did not believe… that any one of
them acting alone could convince Amazon to change its pricing policy. They also feared that if they
did not act as a group, Amazon would use its ever-growing power in the book distribution business
to retaliate against them.” The publishers therefore decided they would have to take joint actions to
stop Amazon’s below cost pricing of e-books and began to discuss ways to get Amazon to increase
its e-book prices.

Initially three Publishers (Simon & Schuster, HarperCollins and Hachette) adopted an experimental
windowing program where each Publisher delayed the e-book release of one of their highly
anticipated titles. However, all “of the Big Six both kept one another abreast of their plans to
window, and actively pushed others toward the strategy.”

The Publishers’ windowing announcements, however, initially had no effect on Amazon’s willingness
to bargain with the Publishers over increasing its $9.99 price. It was not until Amazon later learned
that Apple had reached agreement with the Publishers to enter e-book retailing on terms that did
not include windowing that the Publishers’ collusive windowing programs became a significant
credible threat Amazon was forced to respond to.
Apple attempted to avoid this publisher free-riding problem by informing the six major publishers
that it would not enter unless a “critical mass” accepted its contract terms.

During the negotiations with the publishers over iBookstore contract terms Apple actively promoted
its contract proposal as the “best chance for publishers to challenge the $9.99 price point.”

The final Apple contract terms accepted by the five Defendant Publishers for e-book sales at the
iBookstore included four main elements:

1) Agency: Apple proposed a 30-percent share of the revenue, which was similar to the agency
contracts it commonly used in their agency contracts with suppliers of apps sold through the
iPhone App Store. This provided Apple with a guaranteed significant positive margin on
iBookstore sales even if Amazon continued to price below cost at $9.99. In both cases the 30-
percent revenue share may be considered a payment for access to consumers that are using the
Apple platform.

2) MFN: Apple required contractual assurance from the Publishers that their pricing of e-books
under the agency relationship would be competitive with other e-book retailers. Apple
proposed instead a most favored nation (MFN) term that required the Publishers not to set
prices at the iBookstore higher than the retail prices currently set for the same title at other e-
book retailers.

3) Maximum Price Schedule: The maximum price of each e-book title was contractually set based
upon the retail list price of the title in physical book format. This was a reasonable contract
formulation because there was no indication or claim of Publisher collusion with regard to the
setting of physical book list retail prices, and e-book prices would generally be expected to vary
systematically across titles with the physical book list price.

4) Day-and-Date Release: Apple contractually required the Publishers to release e-book titles to the
iBookstore at the same time the Publisher released the physical book title.

Amazon Accepts Agency

What got Amazon’s attention and precluded adoption of a strategy to attempt to break the
Publisher conspiracy was the fact that Amazon knew, as a result of the announcement at the iPad
Launch Event, that the Publishers had reached retailing agreements with Apple. Amazon therefore
knew that in two months when iPad sales would begin, Apple would be retailing all e-book titles at
the iBookstore at the same time as the title’s physical book release.

Amazon therefore recognized that, unless it accepted the Publisher demands and signed agency
agreements, its wait of up to seven months before receipt of new release e-book titles under
windowing created a substantial threat to its e-book business.
ANTITRUST ANALYSIS OF APPLE’S CONDUCT

Leegin

The context in which the Leegin statement is made, that vertical contracts which facilitate a
horizontal conspiracy should be evaluated under a rule of reason, involves a description of two
specific cases where a manufacturer adopts a vertical resale price agreement with its retailers that
may serve to facilitate either a retailer or manufacturer conspiracy.

Leegin therefore does not discard all previous hub-and-spoke conspiracy precedents that find per se
liability for all participants in a horizontal conspiracy.

The Court’s statement in Leegin refers to required rule of reason analysis only in purely intra-brand
resale price maintenance cases where the contract does not refer to a rival of the hub. This
interpretation of Leegin is consistent with one of the two Supreme Court precedents cited by the
court in Apple for continued per se analysis of hub behavior, General Motors

Per Se Analysis

1) Apple’s Contracts Did Not Contractually Specify How the Publishers Were Required to Deal with
Amazon

2) The Apple MFN Was Not a De Facto Contractual Requirement that the Publishers Move Amazon
to Agency

3) Apple Did Not Coordinate the Publisher Windowing Conspiracy

it is important to emphasize that the limited Apple-Publisher communications after the negotiation
of iBookstore contracts are quite distinct from hub coordination of joint spoke acceptance of
collusive contract terms that occurs in a hub-and-spoke conspiracy, as occurred, for example, in Toys
“R” Us. Apple did not play any role in coordinating the Publisher conspiracy to jointly threaten
Amazon with windowing if it did not accept the agency relationship. Such a windowing conspiracy
existed among the Publishers before Apple entered

Rule of Reason

The Apple dissent states that based on Leegin, the appropriate standard of evaluation of Apple’s
contracts should be a rule of reason. However, the Apple vertical contracts are not the purely intra-
brand vertical contracts described in Leegin as requiring rule of reason analysis.

This does not mean that Apple’s contracts are necessarily the type of vertical contracts the Apple
court describes as subject to per se analysis because they “orchestrate” a hub-and-spoke
conspiracy.149 Once the claimed role of the MFN in connecting the Apple iBookstore contracts to
the Publishers’ collusive windowing demands is rejected, Apple’s contracts do not fit the standard
per se role of hub contracts in a hub-and-spoke conspiracy.
Given the extremely low marginal costs of e-books, there was a substantial risk that Amazon would
be able to use its dominant position to negotiate substantially lower wholesale prices for e-books.

Conclusion

The MFN term in the Apple iBookstore contracts forced the Publishers to jointly demand that
Amazon accept agency. This is how the court contractually tied Apple’s contracts to the horizontal
Publisher conspiracy to move Amazon to agency. Instead, it was Apple’s prospective entry in the
face of the Publishers’ windowing programs, collusively introduced before Apple had even begun its
Publisher negotiations, that created the economic motivation for Amazon to rapidly accept agency
and hence the success of the Publisher conspiracy.

It may seem appropriate to attribute part of this apparent anticompetitive effect to Apple because
Apple was aware of the Publisher conspiracy and took advantage of it to negotiate favorable
contract terms and long-run competitive prices in return for its entry. But, once again, what should
Apple have done differently? As we have seen, without the favorable contract terms, Apple was able
to negotiate in return for its entry; e-book prices would have been substantially higher.