Apple, Amazon, the Sherman Act, and freedom

Memo to Tim Cook: we've finally found a good use for a portion of Apple's enormous hoard of cash -- take the recent civil antitrust case against your company all the way to the Supreme Court.*

Yesterday, in a press conference, Attorney General Eric Holder explained the lawsuit that his Department of Justice is bringing against Apple and five large book publishers. Three of these publishers have already settled with the DOJ, while Apple and two others so far have not.

The details of the DOJ lawsuit can be found in this 36-page complaint, and it makes for fascinating reading. We would urge all investors who are interested in understanding more about the tremendous disruption and power shifts that the ongoing digital and mobile revolution is making in many industries (including the book industry) read the entire thing.

In this case, the DOJ asserts that the publishers banded together to resist the pricing pressures unleashed by the 2007 introduction of the first Amazon Kindle device, which propelled the e-book from a novelty to a real source of potential sales.* The publishers were delighted at the increased sales channel, but frustrated with Amazon's policy of dictating a price of $9.99 or lower for e-books sold through Amazon. They were also frightened at the possibility that such a price would create an expectation among consumers that e-books should never be priced higher than $10, and that this new consumer expectation would erode the value that consumers saw in physical books as well (in other words, erode the price that physical books, including new hardbound bestsellers, could command).

According to the DOJ, the five publishers colluded with Apple in 2009, which was at the time preparing for its launch of the first iPad in April 2010 -- a device that the publishers realized could give them a market for e-books other than Amazon and enable them to have some power to bargain against Amazon's stubborn refusal to sell e-books at prices above $9.99. According to the lawsuit, the publishers along with Apple signed an agreement with one another in January 2010, and not long after that they challenged Amazon with the ultimatum: let us price our e-book releases. When the publisher sets the sale price it is know as an agency model rather than a wholesale model wherein the retailer purchases the book or e-book at a wholesale price and then sells it for whatever price they want.

Because the five publishers collectively represented nearly 50% of Amazon's e-book sales, the DOJ complaint reports that Amazon caved within two days and allowed the publishers to have an agency model and to sell the e-book version of bestsellers for prices above $9.99.

The remarks by Attorney General Holder call this an affront to Amazon's "freedom to reduce the prices of their e-book titles" and the DOJ complaint alleges that the actions and agreements of the publishers and Apple violate the Sherman Act, which was passed in 1890 in order "To protect the consumers by preventing arrangements designed, or which tend, to advance the cost of goods to the consumer."

It would certainly seem that the actions of the publishers and Apple made some "arrangements designed, or which tend, to advance the cost of goods to the consumer" -- after all, their arrangements broke the $9.99 price cap and enabled publishers to sell e-books priced at $12.99, $14.99, and even $16.99 or more in some cases.

But let's step back and ask why the United States Department of Justice should be jumping into the fray to force publishers to sell books through Amazon at $9.99. If you were an author of a highly-anticipated book, one that was already on the bestseller lists or was certain to jump onto the bestseller list the moment it was released, and you felt that you would be able to sell just as many e-books at $19.99 as you could sell at $9.99, why should the government tell you that you must give away that additional $10 per book? After all, nobody is holding a gun to anyone's head and forcing them to buy the books -- it's their own money, and presumably if they are willing to pay $19.99 for an e-book of your new bestseller, that means that the new bestseller is worth $19.99 to them.

Of course, defenders of this action might argue that no one is forcing the author (or her publisher) to sell the e-book through Amazon either, but that is not entirely true, is it? In a free environment, the author (or her publisher) could say to Amazon, "OK, if you won't let us sell this e-book for $19.99 (and it's worth at least that much), then we will just take our ball and go home. We will set up our own website and sell the e-book there, or sell it to users of the Apple iPad, and instead of getting a piece of the sales, you will not see any of it." That's what the publisher could say, and that's exactly what the DOJ complaint alleges that the publishers did say, and now the DOJ is filing a lawsuit against them because of it.

Note that in the business world, if you realize that the person you are bargaining with cannot walk away, you have no reason to accede to any of their demands. In this case, the DOJ is saying that the publishers cannot bargain with Amazon, or at least that if they bargain with Amazon, they cannot threaten to take their ball and go home, because if they do that, DOJ will stop them.

While we like inexpensive e-books as much as the next person, we wonder where exactly the DOJ found a Constitutional right for all consumers to buy e-books for $9.99 or less (no matter how new or how popular, and no matter how much the author or her publisher wants to charge for them).

Some might argue that it's OK for one author or one publisher to try to bargain with Amazon, but that the problem arose when the publishers got together to increase their bargaining power over Amazon (the DOJ also seems upset that the CEOs of the publishing companies met in "upscale Manhattan restaurants," as if all CEOs should hold their meetings at fast-food restaurants and that those who do not are insidious). However, we would again ask why trying to increase one's bargaining power should be against the law -- it is actually a very common practice to increase scale and get a better deal. Should farmers' co-operatives be busted up by the DOJ? Should online coupon companies that offer consumers a better price for something as long as a certain number of them all show up to buy the product be illegal?

Also, while it's nice that the DOJ is so concerned for the readers of e-books, it seems quite unfair that they don't seem to be concerned at all for the authors. Eric Holder's statement describes the retailers' "freedom to reduce the prices of their e-book titles," but doesn't seem to care about the authors' "freedom to have any say in the prices of their e-book titles." Isn't it true that if e-book titles are priced too high, that consumers will buy less of them, or stop buying them at all?

We are on record as being huge supporters of innovation, and the value-adding (and price-reducing) power of new technology, including Amazon's Kindle and the e-book. We are, in fact, shareholders of Amazon as well as Apple (as disclosed below). However, we believe that this is a fight that should be allowed to work itself out without the interference of the federal government.

If the DOJ wants to maintain this line, Apple should take it all the way to the Supreme Court. It is an important issue of personal freedom.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple (AAPL) and Amazon (AMZN). They do not own securities issued by any other company mentioned in this post.