The Ebooks Saga: Kobo’s challenge explained

“Book Review”

Ebook retailer Kobo is challenging a settlement entered into by the Competition Bureau with ebook publishers. The settlement has been stayed pending this challenge. Kobo’s challenge may have major implications for competition law enforcement in Canada. Kobo’s case also highlights a little-known area of risk that Canadian businesses face.

Canadians have taken to ebooks and ebook readers. They have many advantages, such as portability and the ability to buy and immediately download new books from nearly anywhere, at any time. But ebook customers cannot have failed to notice that ebooks are not much cheaper paperback books or sometimes even harcover books, even though the ebooks cost less to produce and distribute than physical books.

Competition authorities in Canada, the United States, and Europe noticed this as well and investigated. They found that the replacement of a traditional wholesale price model with an “agency” model, where the publisher sets the retail price and charges a percentage of that price as the wholesale price, led to higher prices for ebooks.

Settlements were eventually reached with ebook publishers in all three jurisdictions, but not with Apple in the US. As a result, the US Department of Justice’s case against Apple went to trial. The court found that Apple conspired with ebook publishers to raise prices by moving the industry from the wholesale model to the agency model.

In Canada, ebook retailer Kobo is challenging the settlement. Kobo claims that the settlement changes the contracts that underpin its business and profitability. The Competition Tribunal has stayed the Canadian ebooks settlement pending Kobo’s challenge.

Kobo’s challenge has the potential to cause major changes in competition law enforcement. It could force Canada’s Competition Bureau to consider the impact of proposed settlements on third parties, and perhaps even to involve those third parties in the negotiations. The Bureau may also find that it can be forced to justify the settlements it enters into by showing at least the outlines of a substantive case.

The dénouement of this saga is yet months away. Yet an important lesson can already be drawn from this case. It has long been established that competition law enforcement can causes changes to contracts that affect third parties. Kobo represents an extreme case: its revenue model was fundamentally changed as a result of competition law enforcement that was not targeted at Kobo. Businesses need to assess and mitigate risks to their business arising from competition law enforcement – and other regulatory enforcement activities – directed not just at themselves, but at key business partners.

Apple orchestrates the e-book conspiracy

Under the wholesale model, the publisher sells the book to the retailer, who then sells it for whatever price it wants. When ebooks were first introduced, publishers typically set wholesale prices about 20% lower than for physical books. Amazon then started selling ebooks for $9.99. Publishers saw this as too low, and they said so. Some of them began to act in concert to protect the higher prices they charged for hardcover books, notably by releasing books in hardcover before releasing the ebook version, a tactic called “windowing”.

In 2009, Apple was about to introduce the iPad. It wanted to offer an “iBookstore”. Apple told publishers that it wanted retail pricing between $11.99 and $14.99 for ebooks, and that it opposed windowing. Apple and the publishers agreed to move to an agency model, which was the model Apple used in its App Store. Under the agency model, the retailer sells the ebook as an agent for the publisher. The publisher sets the retail price; the retailer pays the publisher a wholesale price based on a discount from the retail price. Apple and the publishers agreed on a 30% discount.

Apple realized that its iBookstore could not succeed if Amazon continued to price ebooks at $9.99. Apple therefore proposed that the entire industry move to the agency model. To make this happen, Apple included an MFN (“most favoured nation”) clause in its agreements with publishers. The MFN clause forced publishers to lower Apple’s retail price – and thus also their corresponding wholesale price – if another retailer’s prices were lower.

Apple also insisted on price caps for particular categories of books. For example, New York Times bestsellers would be capped at $12.99, while other caps depended on the hardcover price. Interestingly, these price caps, coupled with the 30% discount, actually lowered wholesale ebook prices, while raising retail prices.

After a rapid series of negotiations, Apple entered into agency agreements with five of the six major book publishers (Hachette, HarperCollins, Macmillan, Simon & Shuster, and Penguin). Random House was the only publisher that refused to sign.

The five publishers then forced Amazon onto the agency model as well. The effect was to eliminate all retail price competition for ebooks. Price increases followed. At Amazon they averaged 18.6% for all ebooks, and a whopping 42.7% for NYT Bestsellers.

The US court held that Apple committed a per se violation of US antitrust laws by conspiring with the publisher defendants.

The publishers settle competition investigations

Even before the case against Apple went to trial in the US, the publishers reached settlements with US and EU competition authorities. Apple settled in the EU but not in the US.

The settlements, broadly speaking, were substantially the same on both sides of the Atlantic: the publishers agreed to end retail price restrictions and MFN clauses.

The Canadian settlement is also similar. The consent agreement prohibits the publishers from imposing retail prices on retailers. Publishers can still set suggested retail prices, but, with one narrow exception, cannot prevent retailers from selling below the suggested retail prices.

A key feature of the ebooks case is that it involves both horizontal and vertical restraints. The horizontal restraint is the agreement between ebook publishers to impose vertical restraints on retailers. The vertical restraints prevent price competition by retailers, a practice known as price maintenance. The ebooks settlements attack the vertical restraints that flow from the horizontal agreement. The anti-competitive conduct that provides the basis for the enforcement action appears to be the horizontal agreement, however.

The Canadian ebooks settlement is based on an anti-competitive horizontal agreement. The settlement recites an allegation by the Competition Bureau that ebook publishers entered into an agreement that lessened or prevented competition substantially in the market for ebooks. The settlement cites a provision in the Competition Act that allows the Bureau to challenge agreements between competitors that have anti-competitive effects.

It may have been open to the Bureau to challenge the agency agreements under the Competition Act’s price maintenance provisions, by alleging that the price maintenance inherent in the agency model had an adverse effect on competition.

Kobo’s challenges the Canadian settlement

Kobo, a Canadian ebook retailer, is challenging the Canadian settlement under a provision of the Competition Act that allows a person who is directly affected by a consent order to apply to a special court, the Competition Tribunal, for rescission or variation of the order.

Kobo argues that its contracts with the four publishers, Hachette Book Group, HarperCollins, Macmillan, and Simon & Schuster, will be fundamentally altered or terminated because of the settlement, and that it will lose money. Kobo claims that a similar settlement in the US led it to close a US office and refocus on other markets. Kobo claims that it also led another ebook company, Sony, to exit the market, and caused Barnes & Nobles’ “NOOK” ebook division to become unprofitable.

The settlements led publishers to replace the agency model with the so-called “agency lite” model. The agency lite model is essentially the same as the agency model with most of the restrictions on retail price reductions removed. Thus publishers continue to establish a retail price, and are paid a wholesale price based on a discount from the retail price. The key difference is that retailers are free to price below the suggested retail price. The wholesale price does not change, however, even if retailers decrease retail prices. This, Kobo complains, means that retailers bear the losses associated with competition in the marketplace, while publishers’ margins remain protected.

Kobo says that unlike in the US, the shift to agency in Canada was not driven by a conspiracy among publishers, but rather, by Kobo itself in its negotiations with publishers. Kobo’s Chief Content Officer, Michael Tamblin, says that the shift to agency in Canada did not happen simultaneously with Apple’s entry, but afterwards. He says that Kobo had to press the publishers to move to agency.

Indigo Books & Music Inc. has applied for leave to intervene in support of Kobo. Indigo’s CEO Heather Reisman says, in an affidavit, that the settlement threatens to give Amazon a monopoly or near monopoly over the sale of ebooks in Canada.

The Competition Bureau, in its response, contends that Kobo is simply trying to protect the guaranteed 30% margin it has under its existing contracts, and keep prices from falling.

The Tribunal has stayed the registration of the ebooks consent agreement pending the determination of Kobo’s challenge.

Consent agreements

The Competition Act contains provisions allowing the Competition Bureau and companies it is investigating to sign a “consent agreement”. The consent agreement is then registered with a special court, the Competition Tribunal. As soon as it is registered, the consent agreement has the same force as an order of the Tribunal. Importantly, the terms contained in consent agreements must be terms that could be imposed by the Tribunal in an order.

The current consent agreement provisions replaced consent order provisions in 2002. The old consent order provisions required the Tribunal’s approval of settlements. The Tribunal made it clear that it would not rubber stamp consent orders. In a number of cases, lengthy hearings with multiple intervenors were held. The Tribunal also rejected proposed consent orders (or parts of consent orders) in the Imperial Oil and Palm Dairies cases. This led to criticism that the consent order process was “uncertain in its operation, time-consuming and costly”.

Under the new consent agreement provisions, a person, in this case Kobo, that is directly affected by a consent agreement, can apply to the Tribunal for rescission or variation of the consent agreement. This is what Kobo has done.

An issue of statutory interpretation

In order to succeed, Kobo will need to satisfy the Tribunal that the terms of the consent agreement could not be the subject of an order of the Tribunal.

The Bureau’s inquiry was under the Competition Act’s anti-competitive agreements provision, section 90.1. Under section 90.1, if the Tribunal finds that an agreement between competitors prevents or lessens competition substantially, it can order anyone (whether or not they are a party to the agreement), from doing anything under the agreement.

Crucially, if the person against whom the order is made consents, the Tribunal can also order that person “to take any other action”. The Tribunal’s powers are therefore extremely broad where there is consent.

It has long been recognized that orders of the Tribunal can affect contracts that parties before the Tribunal have entered into with third parties that are not before the Tribunal.

Consequently, Kobo is unlikely to succeed in showing that the terms in the ebooks consent order are terms that the Tribunal could not impose if it made the requisite finding under section 90.1.

For this reason, Kobo is attacking the foundation underlying the consent agreement. It argues that the ebooks consent agreement’s terms could not be the subject of an order of the Tribunal because the basis does not exist under section 90.1 to make any order at all. Kobo says that because the Commissioner did not allege or identify the existence of an agreement between competitors, there is no basis to make an order under section 90.1. Indeed, Kobo says that in Canada, there was no such agreement.

Underlying this is an interesting issue of statutory interpretation: does the phrase “the terms could not be the subject of an order of the Tribunal” include situations where the merits of the underlying case would not justify the making of an order, or is it limited to inquiring whether the terms in the order are terms that the Tribunal is allowed to order?

The Commissioner says that the validity of consent orders should not be tied to the merits (or lack of merits) of the underlying case. The Commissioner maintains that the Competition Act sets out minimal formal statutory requirements for a valid consent agreement, and that consent agreements do not need to provide any particulars beyond the sections of the Act under which they are made, the names and addresses of the parties, and the terms of the agreement.

Chapter one: the injunction decision

In granting the injunction sought by Kobo, the Tribunal followed the traditional three-part test:

• Serious issue to be tried
• Irreparable harm
• Balance of convenience

The Tribunal held that Kobo’s argument that consent agreements are not valid if the underlying case is not meritorious raised a serious issue. Kobo would suffer irreparable harm is the consent agreement were not stayed pending Kobo’s challenge, because it would suffer financial losses that it could not recover. Finally, the balance of convenience favoured granting a stay, the Tribunal held. The implementation of the ebooks settlement was not so urgent that it could not await the outcome of Kobo’s application.

Kobo’s victory on the injunction is but the first chapter in a long saga, however. The Tribunal’s determination that Kobo has raised a serious issue does not provide any clue as to the likely ultimate answer to the question of statutory interpretation Kobo has raised.

The end of the affair

We cannot know how this affair will end, as the rest of this saga has yet to be written.

What can be said is that, from a policy perspective, both positions have merit.

The consent order system has much to be said for it. It allows merging parties to resolve the Commissioner’s competition concerns by entering into a binding resolution, and thus close mergers in a timely way. It allows parties under investigation for potential abuse of dominance, anti-competitive agreements with competitors, and other conduct that harms competition, to agree to a binding resolution. The Commissioner and the merging parties, or the parties under investigation, obtain certainty and avoid the costs, delays, and risks associated with Tribunal proceedings. Allowing third parties to challenge consent orders on the basis that the underlying case is not strong enough would undercut these advantages. It would allow a third party for force the Commissioner and the parties to the consent agreement to litigate the merits, which is precisely what the consent agreement is designed to avoid. In other words, Kobo’s position runs counter to the rationale underlying the consent agreement system.

It is well-established that orders of the Tribunal can affect the rights of third parties because they can force the respondents to make major changes to business practices. In contested proceedings, the Tribunal does not make an order unless the requisite harm to competition is shown. As well, the affected third parties are able to apply to intervene and make submissions about the impact they may suffer. In other words, in a contested case, the third party will only be affected if it is demonstrated in the Tribunal that the arrangements to which it is a party harm competition.

Consent orders can have the same impact on third parties, but without the safeguards inherent in Tribunal proceedings. The process does not require the Commissioner to prove that the conduct at issue harms competition, or even, for that matter, to have a case that is ready to take to the Tribunal. Nor are there any procedural safeguards for the interests of third parties before the consent agreement is registered. As a result, through a consent order, the Commissioner and the target of an inquiry can agree to make changes to business practices that will damage a third party, without any prior oversight at all.

Once registered, a consent order attains the status of a Tribunal order; to breach it is a criminal offence. Having agreed with the Commissioner to breach its contracts with third parties, the target is now forced to, under pain of criminal sanction. This may give it a defence when it breaks the contracts. This in turn creates a moral hazard: targets have an incentive to agree to settlements that are the most advantageous to them. In extreme cases, the process may offer a way for targets to get out of contracts they don’t like. There is no one standing up for the third parties in this process. The Commissioner’s interest is to resolve competition concerns, and not to protect the business interests of third parties.

The Kobo case may be an example of this problem. If the facts of the Apple case apply in Canada, the publishers may have had little incentive to fight to retain the agency model; they may have been quite happy to move away from the agency model to the agency lite model, which keeps the wholesale price constant despite movements in the retail price. The agency model actually reduced wholesale prices charged by publishers for ebooks. Under the agency lite model, publishers may be able to keep a larger portion of the actual retail price than under the agency model. Thus it is entirely possible that it was in the ebook publishers’ financial interest to agree to a settlement that ends the agency contracts. That settlement, however, rips up the contracts that underlie Kobo’s business and financial model. It is certainly open to be argued that Kobo should have the right not to have its business fundamentally changed through regulatory action unless competitive harm is proven.

Potential impact on competition law enforcement

A win by Kobo would have a major impact on competition law enforcement. The Competition Bureau would have to consider whether proposed settlements are likely to have an impact on third parties.

This could lead to the Bureau preferring outcomes that have less impact on third parties. Equally, it could lead to the Bureau involving the third parties in the negotiations in order to avoid a challenge. It could also lead to more contested cases in the Competition Tribunal, either because of challenges by third parties, or because the Bureau refuses to settle because it anticipates a challenge. It could potentially even lead to firms under investigation encouraging their business partners to raise objections to potential settlements, and even to their encouraging challenges. Finally, it would force the Bureau to ensure that it has a defensible case on the merits any time it enters into a settlement.

Risk mitigation strategies for businesses

The Kobo case provides a compelling reminder of the regulatory risks to business arrangements. Businesses need to consider what regulatory risks could affect their key contracts, and take steps to mitigate those risks.

Steps that might be taken include:

• Make changes to the underlying business relationship or contract to reduce the likelihood that it could trigger competition or other regulatory enforcement.
• Allocate responsibilities for losses in the event that competition or other regulatory enforcement nullifies or substantially changes the contract.
• Include fight or compensate clauses that require a party either to fight any enforcement action or compensate the other party to the contract.
• Require a party negotiating a settlement with an enforcement agency to advise the other party of the proposed settlement.