The news comes just a couple of weeks before Apple is set to face the DOJ in court. In the trial, beginning June 3, the DOJ will argue that Apple conspired with book publishers to fix ebook prices. Apple counters that the system of  agency pricing it arranged with the publishers is the same as what it uses with all other retailers in iTunes, and that the launch of iBookstore created competition in the marketplace.

Under the proposed settlement, announced Wednesday morning, Penguin would pay $75 million to consumers represented by 33 states’ attorneys general and by Hagens Berman, the Seattle-based law firm that filed the class action suit against Apple and publishers in 2011. The settlement still has to be approved by the courts, in a hearing set to take place later this summer.

Penguin’s settlement with the consumers and states is the largest that any publisher has agreed to. HarperCollins, Hachette and Simon & Schuster settled together for a combined $69 million, while Macmillan agreed to a $20 million payout. The settlements, in most cases, result in customers receiving a credit for online book retailers — meaning the publishers will recoup at least some of what they pay out.

The settlement also clears the way for the Penguin-Random House merger to move forward in the second half of this year. Penguin’s parent company Pearson said in a statement, “In anticipation of reaching this agreement, Pearson had made a $40m provision for settlement in its 2012 accounts. An incremental charge will be expensed in Pearson’s 2013 statutory accounts as part of the accounting for the Penguin Random House joint-venture.

But, as David Streitfeld notes in the New York Times , that hasn’t happened so far. “Prices have selectively fallen but not as broadly or drastically as anticipated,” Streitfeld writes. “The $10 floor that publishers fought so hard to maintain for popular new novels is largely intact.” Streitfeld attributes this to two factors: The growth rate of ebooks isn’t as rapid as it once was, and e-readers are getting so cheap that Amazon can’t afford to lose money on content as well as devices.

I’d offer some totally different explanations.

Ebook prices aren’t dropping faster because they weren’t too high before

A fact that often gets lost in the ebook pricing debate is that most ebooks never cost $9.99 in the first place. Between 2007 and January 2010, when Amazon charged that price for New York Times bestsellers, very few people owned e-readers and Amazon had no competition from other ebook retailers. I’ve written about this more here, but the point is that publishers’ adoption of agency pricing happened as the ebook market was taking off, and was in response to those market changes.

Under agency pricing, publishers sold most frontlist ebooks at $12.99 to $14.99, but priced plenty of older ebooks a lot lower. The pricing strategy developed as the ebook market itself changed. And those prices are still working for the market as it is now. We’ve seen that readers are happy — or at least willing — to pay for hot new ebooks.

Publishers still have power over ebook prices

The settling publishers have not switched back to a wholesale model for ebooks, in which they set a suggested price and the retailer buys the ebooks at a discount (usually 50 percent) and then sells them for whatever price it wants. Rather, publishers are using a modified form of agency: They set an ebook’s list price and pay the retailer a commission (Before the settlement went through, that commission was 30 percent; we don’t know what the new retailer contracts dictate, but the commission is likely still around 30 percent.) In addition, publishers are now free from Apple’s price bands, which tied ebook price directly to print book list price, so if a publisher wants to raise an ebook’s list price — from, say, $12.99 to $16.99 —  it can. A retailer who wants to discount that book to $9.99 will then lose even more money.

This dynamic may keep both ebook prices stable. Publishers can increase their ebook prices, but if they raise them beyond a certain point, they risk losing sales if the retailer doesn’t discount. At the same time, retailers who discount ebooks too heavily may see the publisher respond by raising the ebooks’ list price, causing the retailer to lose even more money by continuing the discount.

Kindle has a lot more competition now

Back when Amazon priced all New York Times bestsellers at $9.99, it was the only player in the game. Streitfeld writes as if Amazon is the only retailer out there, but it now has competition from Barnes & Noble’s Nook, Apple’s iBookstore, Kobo and Google. These retailers have all shown themselves willing to match Amazon’s price drops on ebooks. The prices aren’t always exactly the same across stores, but they are at least close enough that there is little incentive to switch retailers if you’re already using a platform you like.

Streitfeld does note that “it is possible that Amazon, which controls about 60 percent of the e-book market, is merely holding back with price cuts for the right moment.” The same is for any of the other retailers selling ebooks. A retailer simply may not see much incentive to drop ebook prices by a dollar or two if a) people are already buying those ebooks through them at the higher price; b) other retailers are likely to match the discount and c) the slightly lower price won’t convert many new buyers.

Macmillan is the smallest of the big-six publishers, and the only one that is wholly privately owned. Sargent says there are two reasons Macmillan is not settling: “First, it is hard to settle when you have done nothing wrong. Much as the lawyers explain to me that settling is completely standard business procedure, it still seems fundamentally flawed to me somehow.” More importantly, he writes:

Since the very beginning, the government’s demands have never wavered in all our discussions. They still insist on the two year discounting regime that forms the heart of the agreement signed by the three settling publishers. It was our belief that Amazon would use that entire discount for the two years. That would mean that retailers who felt they needed to match prices with Amazon would have no revenue from ebooks from five of the big publishers (and possibly the sixth) for two years. Not no profit, no revenue. For two years. We felt that few retailers could survive this or would choose to survive this.

Nevertheless, Macmillan has entered new contracts with most ebook retailers “except one whose term was not up yet” (he does not specify which one). Sargent explains the new terms: “All the new contracts are compliant with the government’s requests in their complaint. They contain no most-favored nations clauses and no price limits. They also allow 10 percent discounting on individual books priced at $13.99 and above.” (This was partially reported by Publishers Weekly on Monday.) (Macmillan settled in the European Union “because of many differences in their system and because the discounting change will not materially affect the market there for us.”)

Despite these measures, the lawsuit continues. “The legal bills look like the unit sales numbers for 50 Shades of Grey,” Sargent writes. But though Macmillan is the smallest of the big-six publishers it has no plans to merge with another as Random House and Penguin are doing. Being small “has never hurt us in the past, and I expect it will not hurt us in the future,” Sargent writes. “Publishing trade books is, in the end, a human endeavor…You need a certain level of capital and infrastructure, but that does not require being a behemoth. We will be more than fine in the land of the giants. I expect we will continue to grow and prosper.”

Sargent also comments on Macmillan’s business overall. Twenty-six percent of the publisher’s sales were digital in 2012, and “our e-book business has been softer of late, particularly for the last few weeks, even as the number of reading devices continues to grow.”

The DOJ alleges that publishers, fearing Amazon’s practice of selling ebooks at $9.99, conspired with Apple at the launch of the iPad and iBookstore to adopt agency pricing, in which the publisher sets an ebook’s price and pays the retailer a commission. Previously, publishers had used wholesale pricing for ebooks, where the publisher sets a suggested list price and the retailer buys the ebook at a discount (usually 50 percent) and can then sell it at whatever price it wants. The DOJ says that that the alleged collusion led to higher ebook prices for consumers and harmed competition in the ebook marketplace. Publishers maintain that agency pricing created a more diverse marketplace by leveling the playing field and reducing Amazon’s power. (Here’s some background on the case.)

Penguin said in a statement:

Penguin has always maintained, and continues to maintain, that it has done nothing wrong and has no case to answer. Penguin continues to believe that the agency pricing model has encouraged competition among distributors of both ebooks and ebook readers and, in the company’s view, continues to operate in the interest of consumers and authors. But it is also in everyone’s interests that the proposed Penguin Random House company should begin life with a clean sheet of paper.

The DOJ said it is “currently reviewing the proposed joint venture announced by Penguin and Random House Inc., the largest U.S. book publisher. Should the proposed joint venture proceed to consummation, the terms of Penguin’s settlement will apply to it.” Random House was not included in the DOJ’s original lawsuit, because it adopted agency pricing over a year after after the other big-six publishers did.

According to the DOJ’s competitive impact statement (PDF), Penguin has agreed to “substantially the same terms” that the three other settling publishers — HarperCollins, Simon & Schuster and Hachette — agreed to in April: The publisher will terminate its existing agreements with ebook retailers and enter into new ones that, for two years, allow retailers to freely discount its ebooks (with a few limitations). Most-favored nation clauses (which state that no other retailer can charge a lower price) are prohibited for five years. If and when the settlement is approved by Judge Denise Cote of the New York federal court, Random House will be subject to the same terms and will also have to negotiate new retailer contracts.

Like the original settlement, the DOJ’s proposed settlement with Penguin (PDF) is subject to a 60-day public comment period. The DOJ received over 800 public comments on the original settlement, the vast majority of them opposing it. Judge Cote approved it anyway.

Since the original settlement went through, HarperCollins, Simon & Schuster and Hachette have entered new ebook contracts with Amazon and other ebook retailers. They are still setting the prices for their ebooks and paying retailers a commission, but retailers can discount the books as they wish and can sell them at a loss. The DOJ claims that “[the] settlement likely will lead to lower e-book prices for many Penguin titles; prices for titles offered by HarperCollins, Hachette, and Simon & Schuster fell soon after those publishers entered into new contracts as a result of the Original Judgment.” (Many of the settling publishers’ ebooks have only dropped in price slightly.)

Penguin is discussing a similar settlement with the European Commission.

The DOJ notes that “of course, the case against the remaining Defendants” — Apple and Macmillan’s parent company Holtzbrinck — will continue.

As previously reported, the impending EU settlement includes Apple, Simon & Schuster, HarperCollins, Hachette and Macmillan’s parent company, Holtzbrinck. Apple and Holtzbrinck are settling in Europe, but not in the United States. The U.S. Department of Justice reached a settlement with HarperCollins, Hachette and Simon & Schuster and it was approved in September. Penguin is not settling in Europe or in the U.S.

The European Commission began its formal antitrust investigation last December and, like the U.S. Department of Justice, accused Apple and publishers of colluding to fix ebook prices. Like the U.S. settlement, the proposed EU settlement requires Apple and settling publishers to terminate their agency agreements and, for two years, prevents publishers from “restrict[ing], limit[ing] or imped[ing] ebook retailers’ ability to set, alter or reduce retail prices for ebooks and/or to offer discounts or promotions.”

As Publishers Lunch notes, “any EC settlement would have real impact in just one territory: the UK. The next two largest book markets (and the only two ebook markets of any scale right now) — Germany and France — have strict laws on book pricing that prevent discounting, and the EC has made clear the settlement has no effect on those laws”

In September, the EC gave consumers a month to comment on the proposed settlement. I’m not sure if those comments were made available to the public, but haven’t yet been able to find them online.

In a document filed with the U.S. District Court for the Southern District of New York, the states’ attorneys lay out two modifications to their original settlement:

1. Payouts: The settlement had originally said that consumers who bought agency-priced ebooks between April 1, 2010 and May 21, 2012 would receive $1.32 per book for purchase of New York Times bestsellers, $0.36 per book for frontlist titles [in their first year of publication], and $0.25 for backlist [older] titles.” But retailers have said they “will be unable to provide the degree of precision needed to accurately separate and identify frontlist and backlist purchases,” so instead there will now be just two payout categories: $1.32 for New York Times bestsellers and $0.3o for all other titles.

2. Credits: The way that customers receive credits is also changing. The settlement had originally said that retailers like Amazon and Barnes & Noble

would automatically deposit the calculated credit amount in eligible customers’ accounts and would send a notice to consumers telling them that the credit is available for use. As credits are used, the retailer would bill the settlement escrow account for reimbursement. At the end of one year, unused credits would expire.

Amazon will still use this system, and unused credits will expire after a year for Amaozn customers. But other retailers told the states “they would be unable to track the   amount of the specific settlement credit within a customer’s account if that customer has other sources of credit in the account, such as a refund for a returned book or a gift certificate.” The other retailers said they wouldn’t be able to terminate the credits after a year and wouldn’t know when they were used. “Retailers have also expressed concern that their particular method of crediting accounts might be viewed a gift card and could run afoul of certain state laws that require that gift cards have no expiration date.”

So now, Barnes & Noble, Apple and Kobo will use a different credit system. (Google and other ebook retailers are sending out paper checks.) Eligible customers will instead get an email about an account credit and will then have to activate that credit, either by clicking a “click to activate” button or by typing a code into their account. “The customers will have an entire year to activate their credits. However, once activated the credit will be available in the customer’s account for use at any time, and will not expire.”

Here’s the full filing, including a copy of the notice that will be sent to customers.

<em>Photo courtesy of Shutterstock user <a href=”http://www.shutterstock.com/pic.mhtml?id=104965325″>Mohd Hasmi Hamidi</a>.</em>

Like the Department of Justice in the United States, the European Commission, which began its formal antitrust investigation last December, accused Apple and publishers of colluding to fix ebook prices. While ebook sales made up 15 percent of trade book sales in the US in 2011, and — according to this report from yesterday — 12.9 percent of UK book sales for the first six months of 2012, ebooks are still a tiny sliver of total book sales in other European countries.

The EC reports in its Official Journal (PDF) that “by jointly switching the sale of ebooks from a wholesale model to an agency model with the same key terms on a global basis, the Four Publishers and Apple engaged in a concerted practice with the object of raising retail prices of ebooks in the EEA [European Economic Area, which includes the 27 countries in the European Union plus Iceland, Norway and Liechtenstein],” breaching EEA competition rules.

The EC also calls attention to most-favored nation clauses (MFNs) in Apple’s Agency agreements: “to avoid lower revenues and margins for their ebooks on the iBookstore, the publishers had to pressure other major e-book retailers offering ebooks to their consumers in the EEA to adopt the agency model.”

The Commission notes that Apple and the settling publishers don’t agree with its assessment but have agreed to settle anyway. Macmillan’s parent company Holtzbrinck, which is settling in the EU but not in the United States, said in a statement to The Bookseller, “From the outset, the Holtzbrinck group has strongly denied all charges of collusion in relation to its ebook businesses. That said, we believe it is in the best interests of our European business to proceed towards a settlement and have agreed to this set of draft principles, ready for a period of market consultation.”

Here are the terms of the proposed agreement, which largely mirror those in the ebook settlement in the United States:

• Apple, Simon & Schuster, HarperCollins, Hachette and Macmillan will terminate their agency agreements. Penguin, which is not included in the settlement (the EC is “still investigationg [its] conduct”), also has the option to terminate its agency agreement with Apple; if it doesn’t, Apple will “terminate the agreement in line with the conditions laid down therein.”
• Other retailers, like Amazon, will also have the option to end their agency agreements with the four publishers; if they don’t, the publishers will end them according to the contract terms.
• For two years, the publishers “will not restrict, limit or impede ebook retailers’ ability to set, alter or reduce retail prices for ebooks and/or to offer discounts or promotions.”
• There is some protection for ebook prices under agency agreements, however: “The aggregate value of the price discounts or promotions offered by any retailer should not exceed the aggregate amount equal to the total commissions the publisher pays to that retailer over a 12-month period in connection with the sale of its ebooks to consumers.” In the United States, publishers have the right to negotiate such a clause with retailers. In the EU, however, it appears that the clause is a requirement (i.e., a retailer can’t say no).
• Apple and the four publishers can’t enter ebook contracts with MFN clauses for five years, and “Apple will inform any publisher with which it has an ebook agency agreement that it will not enforce a retail price MFN clause in any such agreement for a period of five years.”

Consumers have a month (starting today) to comment on the proposed settlement. They can send comments “under reference number COMP/39.847/E-BOOKS, either by e-mail (COMP-GREFFE-ANTITRUST@ec.europa.eu), by fax (+32 22950128) or by post, to the following address: European Commission Directorate-General for Competition Antitrust Registry, 1049 Bruxelles/Brussel, BELGIQUE/BELGIË.”

The settlement covers all the states except Minnesota, and five territories including Washington, D.C.

Consumers will be notified within 30 days if they are eligible for a small payment, but they won’t receive the actual payments until next year. That’s because Judge Cote also approved a “fairness hearing,” to be held on February 8, 2013 in New York. (I’ll attend this hearing.) The hearing will “consider the fairness, reasonableness and adequacy of the Settlements, the dismissal with prejudice of this action to the Defendants, and the entry of final judgment in this action.”

Consumers who oppose the settlement can speak at the hearing if they file a notice with the court by December 19, 2012.

As we reported earlier, consumers who bought qualifying ebooks from Amazon, Barnes & Noble, Kobo or Apple between April 1, 2010 and May 21, 2012 will receive an automatic account credit if the settlement is approved. Those who bought ebooks fron Sony will receive a check. And those who bought ebooks from any other retailer — like Google — must file a claim form. Payments per book range from $0.25 to $1.32 depending on the book’s date of publication and whether it was a New York Times bestseller.

Consumers could get a top-up if the states reach a similar settlement with Penguin and Macmillan, who are fighting the price-fixing allegations case in court, along with Apple. The trial is set to begin in June 2013.

The filing, which includes a copy of the notice that consumers will receive, is below. More information will be available at http://www.ebooksagsettlements.com, but the site isn’t up and running yet.

State eBook Settlement Approval

Now that the settlement is approved, when will we see changes?

According to the terms of the settlement, the settling publishers — HarperCollins, Hachette and Simon & Schuster — have seven days to terminate their agency contracts with Apple. They also must terminate agreements with other retailers, like Amazon, “as soon as each contract permits,” i.e., when the contract expires, or the retailers can terminate the contracts on 30 days’ notice. Then the settling publishers and retailers can enter into new contracts. If appeals are denied, we could see new agreements with Apple by this Friday, September 14 and new agreements with other retailers in mid-October. Update, 5:30 PM: HarperCollins has already entered into new agreements with ebook retailers and Amazon is already discounting its titles. The approaching holidays provide publishers and retailers with extra impetus to reach new agreements quickly so that they don’t miss out on sales.

Entertainment industry attorney Bob Kohn, who also filed an amicus brief, has asked Judge Cote to suspend the proceedings until an appeals court weighs in. Apple is also likely to appeal. However, Judge Cote is likely to reject the request for stay.

How low will prices go?

Retailers will be free of almost all restrictions on pricing. As I wrote in April, we are likely see deep discounts on bestselling titles from HarperCollins, Hachette and Simon & Schuster — and while those discounts are especially likely at Amazon, retailers like Barnes & Noble and Kobo will want to match at least some of the prices in order to compete.

Apple is a bit of a wildcard: Because of the MFNs in its contracts for all types of content, it hasn’t had to think about matching discounts before. “Without that protection, how will Apple compete? They’ve never had to do competitive pricing of commodity products before,” writes publishing industry consultant Mike Shatzkin on his blog. “I will be very impressed if Apple can get through the price fights about to take place without an obvious black eye. They haven’t been training for this.”

As I noted in April, the settlement also allows for new types of pricing promotions like bundling, buy-one-get-one-free or subscriptions. In her approval of the settlement, Judge Cote agrees with the DOJ that agency agreements “eliminated potential pricing innovations, such as ‘all-you-can-read’ subscription services, book club pricing specials, and rewards programs.” Those are back on the table now.

Amazon could also begin including Hachette, HarperCollins and Simon & Schuster titles in the Kindle Owners’ Lending Library for Amazon Prime members. It doesn’t have to have their permission; as it has already done with some titles from some other publishers, it could just pay the wholesale price each time an ebook is borrowed.

What are the restrictions or exceptions?

Macmillan and Penguin, the two publishers fighting the Department of Justice in court (along with Apple) don’t have to enter into new contracts, nor does the final big-six publisher, Random House, which wasn’t named in the DOJ lawsuit. Those publishers may have to drop their own prices, though, in order to compete.

Agency pricing has been declared legal, and it doesn’t go away now. The settling publishers can still sell their ebooks to retailers under agency contracts, where they set a book’s list price and the pay the retailer a commission. The difference now is that retailers can discount the ebooks however they want.

However, there are limited exceptions: The settlement allows HarperCollins, Hachette and Simon & Schuster to negotiate new contracts that include “a commitment from an e-book retailer that a retailer’s aggregate expenditure on discounts and promotions of the Settling Defendant’s ebooks will not exceed the retailer’s aggregate commission under an agency agreement in which the publisher sets the ebook price and the retailer is compensated through a commission.” The settling publishers can also negotiate one-year contracts that “prevent e-book retailers from cumulatively selling that Settling Defendant’s e-books at a loss over the period of the contract.”

It’s not clear, though, how those “commitments” will be enforced or what kind of reporting the retailers would have to do to show publishers that they’re not selling all of their books at a loss. “If you were a publisher wanting to make sure that a retailer had not exceeded their allowed discounting, you would want to know precise data about how many units were sold at which price points,” Michael Cader writes in a really excellent explainer post at Publishers Lunch (paywall). “But retailers have never provided that kind of the data in the past, and are expected to resist strongly on that point.”

Will ebook prices actually go up?

Publishers Lunch’s Cader raises the seemingly counterintuitive point that settling publishers may actually raise their ebooks’ list prices. Nothing in the settlement prevents them from doing so, and “higher list prices could ‘use up’ a retailer’s annual discount pool more quickly and provide some protection against devaluation in the marketplace of a publisher’s biggest properties.” In other words, HarperCollins, Hachette and Simon & Schuster could raise the list prices on bestselling ebooks from $12.99 to, say, $18.99. A retailer like Amazon would then have to pay those publishers a higher commission and discount their ebooks even more steeply, if the retailer wants to offer the greatest discounts.

Photo courtesy of Shutterstock

The states accuse Apple of colluding with publishers to set ebook prices. Apple and the other two publishers in the case — Macmillan and Penguin — are not settling, but the states’ settlement would provide payouts to consumers who bought ebooks from Macmillan and Penguin as well.

“This action sends a strong message that this sort of anticompetitive behavior will not be accepted,” said Connecticut Attorney General George Jepsen, who led the states’ investigation into ebook pricing along with the state of Texas. “Through our ongoing litigation, we hope to provide additional restitution to consumers. Additionally, I’m especially proud of the exemplary bipartisan cooperation on both the state and federal level on this matter, which involved 54 states and jurisdictions working together on behalf of consumers across the country.”

The states’ proposed settlement with publishers is not yet available online, but reports from various state newspapers are trickling out this evening. If the settlement is approved, eligible Connecticut ebook buyers would receive up to $1.26 million in total compensation, for example, while Washington ebook buyers would receive up to $2 million, Maryland ebook buyers would receive up to $1.64 million and Hawaii ebook buyers would receive up to $300,000. In addition, the settling publishers would pay $7.5 million in court fees.

How will consumers be paid? Baltimore’s ABC News reports that “in most cases, consumers may choose to receive the value of their restitution by check or by crediting the amount to future purchases of e-books. E-book retailers Amazon, Barnes & Noble, Apple and Kobo have agreed to identify and contact each eligible customer by email.  Retailers Google and Sony will also notify affected customers. Sony will inform customers that checks will automatically be issued. Google customers will be directed to submit a claim on a settlement website.”

Payments are set to begin 30 days after the settlement’s approval.

The Department of Justice’s proposed settlement with HarperCollins, Hachette and Simon & Schuster, which is vehemently opposed by many in the book publishing industry and related fields, is still awaiting approval from U.S. District Judge Denise Cote. The DOJ received 868 public comments on the proposed settlement, with the majority of them against it. Cote has granted Barnes & Noble, the American Booksellers Association, the Authors Guild and attorney and music industry executive Bob Kohn, all of whom oppose the settlement, permission to act as “friends of the court” and weigh in on the settlement in amici curiae briefs.

Photo courtesy of Shutterstock user Mohd Hasmi Hamidi.