Apple Computer Inc. (“Apple”)’s use of technology that makes the company’s popular iPod and iTunes music store incompatible with other digital music players and online music stores might constitute illegal tying, a U.S. District Court judge has ruled in denying Apple’s motion to dismiss a host of antitrust claims against it.

Apple, like most legitimate online music merchants, formats music files sold via its iTunes online music store so that consumers cannot make unauthorized copies. The formatting technology is generally called Digital Rights Management (or "DRM") technology, and Apple calls its format “FairPlay.” Apple's FairPlay format also prevents purchasers from playing the songs on digital music players other than the iPod. Apple also rigs its iPods so that they cannot play music files using formats other than FairPlay, effectively making it impossible to play on an iPod music (and video) purchased from other online stores, according a complaint filed in U.S. District Court in San Jose last year. Tucker v. Apple Computer Inc., No. C-06-04457-JW (N.D. Cal. Filed July 21, 2006).

Plaintiff Melanie Tucker seeks to represent classes of iPod and iTunes purchasers. She claims that the restrictions Apple imposes on its customers allow the company to charge supracompetitive prices and make it virtually impossible for iPod or iTunes users to switch to a different technology. The complaint alleges that the arrangements constitute illegal tying (she alleges that iTunes music is tied to the iPod, and vice-versa), unlawful maintenance or acquisition of monopoly power in the digital music player market, attempted monopolization of online music and video markets, and related state law claims.

Apple moved to dismiss, making two basic arguments. First, Apple points out that nowhere in Tucker’s complaint does she allege that Apple forced her to buy an iPod or music from the iTunes store. Thus, Apple argues, Tucker’s tying claim fails because Apple did not condition the sale of one product on the other. Since Tucker bought both the iPod and the iTunes songs voluntarily, Apple argues, her tying claim is missing the essential element of coercion. Indeed, Apple argues, many people buy iPods without buying iTunes music, and vice-versa. 

Second, Apple argues that the only real alternative to developing its FairPlay DRM was to license Microsoft’s format. Nothing in the antitrust laws requires Apple to use another company’s technology rather than develop its own, Apple argues. "Apple has no antitrust duty to do business with Microsoft," Apple asserts in its moving papers. Apple cites the U.S. Supreme Court’s decision in Verizon Communications, Inc. v. Law Offices of Curtis V. Trinko, LLP, 540 U.S. 398 (2004) as authority that a competitor’s refusal to do business with a rival, when there has been no history of cooperation between the two, does not violate Sherman Act Section 2.

In a ruling issued Dec. 20, 2006, U.S. District Judge James Ware rejected both arguments. First, Ware recognized that a plaintiff alleging a per-se illegal tying arrangement must show “some modicum of involuntariness or coercion” forcing the buyer to purchase a tied product that the buyer didn’t want or might have preferred to purchase elsewhere. Order Denying Defendant’s Motion to Dismiss, p. 7. However, Ware found that “there is no requirement that individual purchaser plaintiffs must allege coercion at the individual level, rather than at the market level” to state a tying claim. Thus, Tucker alleged a satisfactory tying claim by asserting merely that Apple used its leverage to force her to buy something she would not in a competitive market. Id.

The tying claim is not defeated simply because some purchasers bought an iPod without buying iTunes music, or vice-versa, Ware found. The judge cited Eastman Kodak Co. v. Image Tech. Servs., 504 U.S. 451 (1992) as an example of a case in which the high court found a viable tying claim despite facts showing that some consumers purchased the tying and tied products separately.

The Court also rejected Apple’s argument that the complaint essentially seeks to force it to license Microsoft’s technology. There are many other ways in which Apple could make the iPod and iTunes content compatible with other competing products, Ware said: Apple could modify its software to make iTunes music and video compatible with other portable music players; it could allow other companies to sell music and videos on the iTunes platform; it could license the FairPlay technology; or it could use a different technology altogether to ensure that iTunes files are not illegally copied. “The Court finds that Plaintiff’s allegations are not reducible to the single contention that Apple should license Microsoft’s [formatting technology]”. Id. at 11.

The Court also found no significance in the lack of cooperative history between Apple and other online sellers of digital content or makers of portable digital devices. Cases like Trinko and Aspen Skiing Co. v. Aspen Highlands Skiing Corp., 472 U.S. 585 (1985), only highlight the prior history between rivals to shed light on one party’s later refusal to deal – that is, a prior profitable relationship may help show that a company’s later refusal to deal is motivated by “anticompetitive malice.” Id. at 13. In the Apple case, the court found that Tucker had sufficiently alleged that Apple had an anticompetitive motive when it designed its products to be incompatible with competing products: Apple wanted to charge supracompetitive prices. “The inference is that Apple deliberately foregoes iPod sales to prospective customers who have purchased digital media files from other vendors and want a digital media player on which they can place these files. By so doing, Plaintiff alleges that Apple has been able to charge iPod purchasers a supracompetitive price and has deterred iPod purchasers from even considering doing business with its music and video competitors.” Id. at 14. Apple’s proposed business rationales for these decisions are questions of fact and not appropriate for resolution at the motion-to-dismiss stage, the court found. Id.

Authored by:

Tyler Cunningham

(415) 774-3208

tcunningham@sheppardmullin.com

FTC Releases Report on Horizontal Merger Investigations

• The Federal Trade Commission released a report on January 25 which detailed the characteristics of the horizontal mergers it has challenged from 1996 to 2005. Although the 6 page written portion of the report only described which variables the FTC had examined, the tables included with the report allow the reader to compare how those variables affect the odds of the FTC challenging a merger for which the it has issued a second request.

Looking at the 188 second requests issued between 1996 and 2005 in which the FTC had pursued a horizontal theory, the FTC noted that it had examined 976 different relevant markets in those 188 investigations, although it acknowledged that 45% of the markets had involved either the oil industry or the grocery industry, which tend to have numerous local geographic markets. Looking at all markets, the FTC had blocked acquisitions 97.5% of the time when the merger would decrease the number of competitors from 2 to 1, 85.8% of the time when the merger would decrease the number of competitors from 3 to 2, 72.7% of the time when the merger would decrease the number of competitors from 4 to 3, and 60.6% of the time when the merger would decrease the number of competitors from 5 to 4. Overall, when looking at all markets, the FTC had blocked horizontal mergers in 77.4% of the markets which the second request had targeted.

However, if oil, grocery, chemicals, and pharmaceuticals are excluded, the results indicate that mergers in 5 to 4 or 4 to 3 markets have a significantly better of chance of being approved, as the statistics indicated that the FTC only blocked those mergers 44.4% and 52.2% of the time versus 60.6% and 72.7% of the time for all horizontal mergers, respectively. In addition, if the merger involves an oil relevant market, the FTC is more likely to try to block the merger or force divestitures, as mergers in 4 to 3 oil markets were blocked 100% of the time versus 52.2% for other types of mergers; 5 to 4 oil markets were blocked 83.3% of the time versus 44.4% of the time for other mergers, and 6 to 5 oil mergers were blocked 54.5% of the time versus 20% for other types of mergers. Although the sample size may not be large enough to draw any statistically significant conclusions from the figures, as the FTC only had data on 41 of the oil markets at which it had looked, the large differences do indicate that the FTC looks very closely at mergers and acquisitions involving the oil industry.

In addition to the industry, the FTC also provided statistics on the effect of other features of challenged mergers, focusing on the presence of "hot" documents, ease of entry, and the presence of strong customer complaints. The FTC defined "hot" documents as documents that indicated that the combined company would be able to raise price post merger or that the company had been planning on raising price, but the entry of the target had prevented them from doing so. Although not having a "hot document" did not appear to make a difference in 2 to 1 or 3 to 2 mergers, the absence of a "hot document" in mergers involving markets where the number of competitors would decrease from 4-3, 5-4, and 6-5 did decrease the chances of the FTC blocking a merger. The FTC had sought to block 64.2% of all mergers with any of those number of competitors, while it had sought to block only 36.2% for mergers with any of those numbers of competitors without a hot document. 

Finally, the absence of strong customer complaints appeared to significantly decrease the chances that the FTC would try to block the merger. Although 2 to 1 mergers were blocked by the FTC 97.5% of the time overall, 2 to 1 mergers without a strong customer complaint were only blocked 92.1% of the time. In addition, without a strong customer complaint, the FTC only pursued 66.7% of 3 to 2 mergers, while it pursued 85.8% of all 3 to 2 mergers, and the rate of blocking 4 to 3 mergers dropped from 72.2% of all mergers to 41.7% in the absence of a strong customer complaint. Looked at another way, the absence of a complaining customer is roughly the equivalent of adding 2 more competitors into the relevant market.

Although the sample sizes provided by the figures is probably too small to make any statistically significant conclusions, it does reinforce the importance to the FTC's horizontal investigations of customer complaints and "hot documents." In addition, it also supports the impression that the FTC is especially cognizant of horizontal effects in oil mergers. The statistics in the report should provide valuable assistance to lawyers advising their clients on how to navigate negotiations with the FTC both before and after a second request has been issued.

FTC Requires Carlyle and Riverstone to Implement Changes in Representation of Subsidiaries in Energy Acquisition

• On January 25, 2007, the FTC announced that it had reached an agreement with Carlyle, Riverstone, and their associated subsidiaries as a condition of permitting their involvement in the acquisition of Kinder Morgan, Inc.

  Kinder Morgan, Inc. ("KMI") is a large energy transportation, distribution, and storage company. Carlyle and Riverstone are two investment funds who are participating in the purchase of KMI. Riverstone is participating through the involvement of CR-III, a subsidiary it jointly owns with Carlyle, while Carlyle is participating through CR-III and CP-IV, a wholly-owned subsidiary of Carlyle. CR-III and CP-IV are to acquire 11.3% of KMI each, for a combined share of 22.6%. In addition, Carlyle also obtains the right to appoint a board member through CP-IV to KMI's 11 member board, while Riverstone and Carlyle may appoint another board member through CR-III. 

  The antitrust problem arises because Carlyle and Riverstone also jointly own CR-II, which controls 50% of the general partner who controls Magellan, a petroleum transportation, distribution, and storage company that competes with KMI in 11 southeastern markets. The other 50% of the general partner is owned by MDP. Carlyle and Riverstone, through CR-II, have the right to appoint 2 members of the 4 member board that control Magellan, and have veto power over the actions of the board of Magellan. Therefore, the FTC worried that the acquisition "will have the effect of combining two companies through partial ownership", that Carlyle and Riverstone could decrease Magellan's competitiveness through use of its veto power, and that Carlyle and Riverstone could facilitate the exchange of confidential information between KMI and Magellan.

  To remedy the problem, the FTC required that CR-II agree not to exercise its right to appoint directors to the board that manages Magellan, that CR-II not exercise its veto power at Magellan, that Carlyle and Riverstone erect firewalls to prevent the flow of sensitive information between KMI and Magellan, and that Kevin Study, an Associate Director at Navigant Consulting, study the compliance of Carlyle and Riverstone with these provisions. 

  The consent decree shows the FTC's willingness to use remedies outside of divestiture when examining a proposed merger that it feels has issues. In addition, the case also highlights the importance of analyzing the impact of every participant in a transaction, as even though one participant might not be the planned ultimate parent entity of the target nor be the ultimate parent entity of any competitors, its influence through its holdings of other companies could still raise delays in the closing of the transaction.

Authored by:

Chris Bowen

(202) 772-5348

cabowen@sheppardmullin.com