Qualcomm vs. Apple and Lessons in Contracting

I’ve been spending the last several days reviewing testimony and precedents in the FTC case against Qualcomm that appears to have been caused by an Apple complaint. These kinds of actions are very dangerous because the FTC, like any government agency, doesn’t work for the complainant (Apple) and—given Apple itself could be considered a situational monopoly—they could easily spin against Apple much like the European Commission spun against Google after Google drove actions against Microsoft. Currently, Apple is operating under a lock-in strategy, showcasing excessive margins for their industry, and has unilaterally decided to not pay Qualcomm what they owe—demonstrating what is clearly a power imbalance in favor of Apple.

But I also concluded that Apple is a very dangerous company to contract with and understanding this could prevent a serious—if not existential—threat to anyone contracting with them.

Abuse of Power

It is not uncommon for someone who is rich to feel that whatever they make is proper and whatever someone else makes is excessive—even if it is a small amount—or to feel they can dictate terms unilaterally. Every time I think of this, I think of the fictional John Wick movie where John, in the beginning, loses his wife who then leaves him a puppy to keep him company. He goes for a drive in his Restomod Mustang, which a rich kid wants to buy but he won’t sell. So, the kid breaks into his house, kills his dog, and beats him up because the kid feels he is entitled to the car and Wick is nobody. It is hard to get the image of the dying puppy crawling to the unconscious Wick out of your mind or that his attacker is remorseless—feeling entitled to both the car and whatever he did to get it. Spoiler alert, it doesn’t end well for the kid.

When I was young, I was abused like this by my uncle and it kind of sticks with you. People in power often feel entitled to behave badly and this case, in my mind, is largely about Apple having excessive power they are clearly abusing. What adds insult to injury for Qualcomm is that they are trying to get the FTC to see far smaller and weaker Qualcomm as the abuser even though it seems incredibly obvious that this isn’t the case.

Forgotten Contracting Best Practice

I did several jobs for IBM when I worked there and two of them are to this point. One was as a contract administrator and the other was as an internal auditor trained in contract reviews. One of the best practices for those experienced in contracting is to assure both parties intend to live under the contract and that the contract reflects the agreement between the parties.

Prior to the Qualcomm-Apple dustup, the first time I saw this demonstrated was when HP contracted—at Steve Jobs’ insistence—to resell the Apple iPod. The verbal agreement was that Apple would exit retail, HP would buy at wholesale prices, and that HP would be free to build the product in any color and connect it to Microsoft’s PlaysForSure back end. But no one assured the contract specifically spelled this out. Apple never intended to live under this agreement, and HP eventually had to walk away from the deal because Apple reneged on all these promises which partially resulted in the termination of HP’s then-CEO, Carly Fiorina. Steve’s alleged secret goal was to knock HP out of the MP3 player business and he executed that strategy perfectly—screwing overly trusting HP.

This makes it incredibly important that both parties have a history of living under the contracts they agree to and that the interests of both parties are aligned.

Apple’s Testimony

In reading Apple’s testimony in the current FTC case, it became clear that Apple never really agreed to the price Qualcomm was charging for their patents even though it appeared that they got a steeper discount than either most anyone else or everyone else. Apple argued that it was Qualcomm’s monopoly power that forced them to sign, but I found the arguments uncompelling—largely because Apple is far larger and stronger than Qualcomm. It seems highly unlikely that little Qualcomm, with a valuation around a tenth of Apple’s, could bully vastly larger and more powerful Apple to assure a favorable outcome for Qualcomm. Far more likely is that Apple bullied Qualcomm to get a discount below everyone else’s, which—to me—seemed far clearer from the testimony.

It is brilliant misdirection to have the FTC focused on what Apple has represented as excessive cost, but once the amount—$7.50 for each phone—was known (Apple sells phones costing in excess of $1,200) and their excessive margins are also known (the general margin for firms in this segment is around 17 percent, Apple’s margins approach 45 percent and excessive profits are a clear sign of monopoly pricing and cost abuse). In a competitive market, margins tend to be tight—protecting the interests of consumers—but Apple’s excessive margins suggest their market isn’t competitive and that they, at least, have monopoly power, and at most, are abusing it against Qualcomm (and likely others). The fact that Apple can successfully not pay over $5B in owed and contracted for royalties is also a sign of both excessive power and potential abuse. It also appears Apple stole trade secrets from Qualcomm and supplied them to Intel to avoid paying.

In addition, it seemed clear that Apple had no intention of living under the Qualcomm contract any more than they intended to live under the HP contract years ago. This isn’t a unique situation. Companies, particularly large ones, often will sign contracts they have no intention of complying with relying on their size and litigation budgets to keep the firm they’ve contracted with at bay. President Trump is famous for not paying his obligations and with both entities this likely not only improves their profitability at the expense of subcontractors—it makes them incredibly risky to contract with.

In fact, in this situation it is generally advised to either avoid contracting with the firm or to factor in the cost of their likely not paying the agreed-on costs into the pricing. I’ve often advised doing backgrounds on firms signing large contracts, particularly with seeming favorable terms to make sure they’ll live under them. In this instance rather than giving Apple an extreme discount, Qualcomm should have charged them more as insurance against the likely, and now certain, outcome of Apple’s breaching the contract.

I remain convinced that it is very foolish to contract with a company that has a history of breaching contracts. Once a firm gets the mindset that they are above the law, they represent an excessive and avoidable risk. And my standing advice, which originally came from Intel’s Andy Grove, is to not contract with Apple. (Apple apparently burned him badly).

Wrapping Up

It is frustrating to watch an organization like the FTC be misled, but it also isn’t unusual. But that organization isn’t staffed by idiots and eventually they’ll likely step back and realize the economic disparities between Qualcomm’s size and profitability and Apple’s suggests they are focused on the wrong monopoly. When that happens the fallout for Apple will likely be extreme, largely because regulatory bodies don’t like being played for fools and they really don’t like abusive monopolies. (And given the current government shutdown, they are likely not particularly pleased with any company using a Trump strategy against its subcontractors or employees).

But the real lesson here is that there are some companies, and individuals, that have a history of breaching contracts. Those breaches should be factored into the negotiations and Apple is an example of a firm that is incredibly attractive to contract with, but who represents far too much risk for any but the largest of firms. A firm far smaller than Qualcomm would have likely been forced out of business by now and that does appear to be one of Apple’s primary goals.

Learn from Qualcomm’s pain and recognize there are some deals where the best move is to walk away.

One final thought. To make their case, Apple must consistently argue that they can’t do business without Qualcomm’s technology. Investors don’t really care if a firm is being abused, but they do care if a firm can’t compete, and this testimony (which investors don’t know is false) is likely having a massive adverse impact on Apple’s valuation. In my opinion, Apple’s actions aren’t just dishonest they are incredibly shortsighted and stupid.