The DOJ’s last best chance in the Apple e-book case has passed

June 14, 2013, 11:30 AM UTC

Cue leaving the courthouse. Photo: Victor J. Blue, Bloomberg

FORTUNE — The Department of Justice spent a little over three hours Thursday cross-examining Apple senior vice president Eddy Cue — the alleged “ringmaster” of an illegal conspiracy to raise the price of e-books — and when it was over it wasn’t clear whether the government had let its last best chance slip through its fingers or whether it never had a chance at all.

Part of the problem was that Cue established himself early on as an unusually credible witness. He was calm and unhesitant when he disagreed with the government’s assumptions. He must have answered “No, that is not correct” several dozen times.

But he also cheerfully granted points government lawyers had been laboring to make with a parade of resistant witnesses for nearly two weeks.

  • Of course the prices of some e-books went up after five of the six biggest book publishers put their titles on the iBookstore, he told Larry Buterman, one of the DOJ’s co-counsels. “I gave them the opportunity to raise their prices.”
  • Yes he met with all the publishers, offered them essentially the same terms and kept them apprised of how many of their competitors had thrown in with Apple. In the tens of thousands of media contracts he’s negotiated over the years — including the iTunes Radio deals he announced Monday at Apple’s developers conference — that’s how he’d always operated.
  • And he made no apology for telling the publishers in late December 2009 that for Apple to enter the e-book market all retailers — including Amazon — would have to switch from the “wholesale” model (where Amazon set the prices), to the so-called “agency” model (where the publishers set them). That was his plan for about two weeks until he realized in early January that it wouldn’t work.

That last point may be critical. Central to the government’s case is the theory that Apple (AAPL), hearing the publishers’ complaint that Amazon’s $9.99 e-book pricing was hurting their hardcover book business, deliberately set out to upend the retailing giant — a major competitor —  by giving the publishers the means and the mechanism to “gang up” (to use Amazon’s phrase) on the company that controlled 90% of the e-book market.

Apple’s first plan was to ask publishers to sign a contract that required them to change their deal with Amazon. The government claims that Apple soon realized that would be illegal, and that Apple’s second plan — to replace that requirement with a price-matching provision — was just another way to achieve the same result.

The best defense against that charge — given the Supreme Court’s recent antitrust rulings — would be to show that Apple had good business reasons to structure its e-book deal the way it did, independent of whatever collusion the publishers might have engaged in. And when Orin Snyder, Apple’s chief counsel, began his cross examination, he had Cue walk through in more detail than we’ve heard before the reasons Apple switched in early January 2010 from Plan A to Plan B.

Plaintiff’s Exhibit 867. Collusion or negotiation?

Cue had assumed when he began talking to the publishers in mid December that he would be offering them some kind of wholesale deal — like Amazon’s — where Apple would buy e-books at a discount and sell them for a small profit. But when he learned that Amazon was paying $12.50 to $15 for e-books and selling them for $9.99, he realized that wouldn’t work. Apple, he said, doesn’t go into new businesses to lose money.

When two of the publishers suggested the agency model, something clicked. That’s how Cue had structured his App Store contracts: Developers set the prices for their iPhone apps, and Apple took 30% off the top.

By Dec. 18, he and Steve Jobs had talked it through and settled on the agency model as the path they were going to take.

“My first thought was if the publishers are really interested in agency,” Cue testified, “let’s have them all move to agency with all retailers.” And his first e-mails to the publishers reflected that approach.

But in early January, he began to have second thoughts. He saw three problems with Plan A:

1. How could he be sure that the terms of the agency deals the publishers made with him would be the same as the terms in his competitors’ contracts?

2. Even if Apple got the same terms for e-books, Amazon (AMZN) and Barnes & Noble (BKS) had enormous leverage with the publishers because of their physical book businesses. They could offer deals that Apple — which didn’t sell physical books — couldn’t match.

3. Even if he put the all-retailers-to-agency requirement in the contract, how could he enforce it? What if Amazon and Barnes & Noble simply refused to go along? “I can sue them?” Cue said on the stand, throwing his arms in the air. “I can do what?”

“I realized I’d made a mistake,” Cue testified. “I had to come up with another idea.”

That other idea was the so-called most-favored nation clause — or MFN — which included a price-matching provision that said that if any retailer sold an e-book for less than the price on Apple’s iBookstore, Apple could match it.

“I felt great about that,” Cue testified. “I thought it was a really smart idea on our part.”

What made it smart was that it not only guaranteed that the iBookstore’s prices would be competitive with Amazon’s, but once it was in place, it didn’t matter to Cue what business model Amazon used. If it mattered to the publishers, well, that was their problem, not Apple’s.

Cue introducing iTunes Radio.

Cue returns to the court Monday to complete his testimony. Apple has a few witnesses it wants to call, and then summations are scheduled for Thursday.

What U.S. District Judge Denise Cote must decide, having heard from the alleged “ringmaster,” is whether what Cue did constitutes a violation of the Sherman antitrust act.

Before the trial started, Judge Cote said she believed the government would be able to show that Apple “knowingly participated in and facilitated a conspiracy to raise prices of e-books.” She did not say whether she believed that was illegal.

The law is very clear that competitors — like the publishers who settled with the government before the trial started — are not permitted to form “horizontal agreements” to set or raise prices.

What’s not so clear, as my colleague Roger Parloff points out, is what rules govern the behavior of retailers like Apple that have a “vertical” relationship with the market. To find against Apple at this point would be a stretch. But if Judge Cote does it, Parloff believes that the case could be headed to the Supreme Court, where a business-friendly majority is more likely to see things Apple’s way.

The case is U.S.A. v. Apple.