Meet the man who created the ‘linchpin’ of Apple’s e-book strategy

The 48-word paragraph ended up, more or less as Saul drafted it, as Section 5B of the e-book contracts Apple signed with five of the six biggest publishers later that month.

On Tuesday, Saul took the stand in U.S.A. v. Apple as a witness for both plaintiff and defense to answer questions about what came be known as Apple’s price-matching or most-favored nation clause — or simply the MFN.

According Saul, the MFN — which gave Apple the right to match its competitors’ lowest e-book prices — was an “elegant solution” to a knotty business problem Apple faced in the last weeks before the Jan. 27 launch of the iPad.

In late December 2009, Eddy Cue — Apple’s VP of Internet Services — began meeting with book publishers in New York to talk about getting into the e-book business. Cue told them Apple had no interest in doing what Amazon (AMZN) was doing — selling e-book best-sellers as loss leaders for $9.99 apiece. Apple, he said, didn’t do things to lose money. The publishers, for their part, made no secret of the fact that they hated Amazon’s $9.99 price.

David Shanks, CEO of Penguin U.S.A., testified Tuesday that $9.99 was cannibalizing his hardback and trade paperback books, and that he saw Apple’s entry into the market as an opportunity to get rid of it once and for all.

During the 2009-2010 holiday break, Steve Jobs authorized Cue to explore a novel approach — at least in the book business. Apple would suggest to the publishers that they replace their traditional “wholesale” model, where prices were set by the distributor, with an “agency” model, where the publisher set the prices — say, $12.99 or $14.99 — and Apple took a 30% cut.

The problem Saul faced was that the agency model wouldn’t work if Amazon continued to sell e-books for $9.99. Who would buy an e-book from Apple if Amazon was selling the same title for less?

That’s when Saul came up with his price-matching language — a contractual guarantee that Apple’s e-book prices would always be competitive.

In the government’s theory of the case, MFN was the centerpiece of a conscious, deliberate stratagem on Apple’s part to restructure the entire e-book industry.

The idea was to use MFN as a wedge to force all e-book resellers — Amazon and Barnes & Noble (BKS) chief among them — to adopt the agency model. The math was simple. If a publisher was selling e-book rights for a $26 hardback to Amazon for $10, it still got its $10 even if Amazon sold the e-book for $9.99 or less. But if the publisher kept doing business with Amazon after it had thrown in with Apple, the MFN’s price-matching provision would bring the iBookstore price down to $9.99, and publisher’s cut down to $7.

In Apple’s version of events, the company didn’t care what deal the publishers had or didn’t have with Amazon. The only purpose of the MFN was to guarantee that Apple’s iBookstore was competitive. It was not part of an illegal conspiracy with the publishers to violate the antitrust laws.

To support that line of reasoning, Saul testified that far from embracing his MFN, each of the publishers fought tooth and nail against, insisting on revisions or crossing it out altogether.

But for Apple, the MFN was a deal breaker, and according to Saul he spent 12 hours a day for two solid weeks in hard negotiations trying to get at least five of the six major publishers lined up before an Apple employee’s scariest kind of deadline: Steve Jobs was rehearsing for his Jan. 27 iPad introduction and he wanted finished slides — with all the publishers names on it — a week in advance.

As it was, Saul missed his deadline. The fifth and final contract — with Penguin — wasn’t signed until Jan. 25, two days before Jobs took the stage.

In the courtroom, Mark Ryan, the DOJ’s lead attorney, tried every way he could to get Saul to admit that he was well aware of the effect his Section 5B would have on the publishing industry. He knew, didn’t he, that once a publisher agreed to an agency model with the MFN clause it would have only two choices: Either withdraw its books from Amazon or force Amazon to switch to an agency model?

Saul would have none of it. He testified that he was “indifferent” to what arrangement the publishers had with Amazon or any other reseller. It never occurred to him, he said, that his MFN might force Amazon to go to the agency model. He didn’t care what Amazon did, didn’t pay attention to what they did, didn’t talk to his colleagues about what they did, and — to the best of his memory — never heard his colleagues discuss it either.

He stuck to his story even after Ryan showed him an e-mail that Saul sent in March 2010 to a resistant attorney at Wiley, a major educational publisher, in which Saul suggested two ways Wiley’s lawyer might get around her problem with the MFN: Put Wiley’s other resellers on the agency model or withhold Wiley’s books from them until they capitulated.

Since there’s no jury hearing the case, it’s up to U.S. District Judge Denise Cote to decide whether the MFN was merely a fiendishly clever clause designed to further Apple’s legitimate business interests or the linchpin of fiendish — and illegal — conspiracy. It may be telling that she questioned Saul closely about that letter to Wiley before letting him off the stand.

According to Orin Snyder, Apple’s lead attorney, no court has ever found an MFN to be illegal. “The government is trying run away from the MFN,” he said in his opening remarks. “Because if they’re wrong about the MFN, they lose the case.”

As it happens, both Amazon and Barnes & Noble switched to the agency model for e-books within a few months of the iPad’s introduction. And each of their contracts contained some version of Saul’s most-favored nation clause.