The Class Action Against Netflix: Challenging the Practice of "Throttling," Under Which Not All Customers Are Equal

In late 2003, a Netflix customer named Manuel Villanueva started a website where he documented problems he had experienced with Netflix, a company that provides DVD rentals by mail. He noted that Netflix had violated its agreement to provide him with "unlimited rentals," by engaging in a practice known as "throttling."

As a result of this practice, Villanueva says, he was treated worse than other renters who paid the very same price he did -- $17.99 - for what was supposed to be, in theory, the same service. In addition, he says, Netflix's advertising was misleading: Rentals weren't really unlimited given that Netflix selectively doled out its DVDs.

Villanueva still maintains his Netflix website today, where he sets forth his travails. Other consumers, however, chose to sue Netflix rather than complain.

In September 2004, plaintiff Frank Chavez sued Netflix. He framed his suit as a class action on behalf of all those who had subscribed to Netflix before January 15, 2005. And just this month, a court approved a settlement in the class action. (Mr. Villanueva is not a party to the class action lawsuit).

Throttling is not inherently illegal, nor is it as pernicious as it may sound. As I'll explain below, while Villanueva and Chavez paid the same as the other customers, the different treatment they received wasn't arbitrary or invidious: It was based on the fact that they (and the others in the class) rented many DVDs, while others rented few, or were new to the service.

The problem, though, was that Netflix did not disclose the throttling to consumers up front - and thus arguably misled them as to the service they were purchasing, breaching its agreement with them, as stated in its Terms and Conditions. For this reason, the plaintiff class had a valid claim.

Nevertheless, I will argue that this suit -- which led to a whopping payment to attorneys and limited benefits to DVD renters -- may not have been the best way to protect consumer interests. The lawyers may get as much as $2.5 million in fees. And Netflix subscribers will get an upgrade on their current subscriptions for one month.

How Netflix Worked In Theory

At Netflix, you pay a single fixed, monthly price; for Villanueva, it was $17.99. In exchange, you may rent up to three DVDs at a time.

Every time you return a DVD in the mail (postage is prepaid by the site), and the site receives it, another one is sent to you in the mail. (You can also return the DVD any time you like: There are no late fees.)

In theory, the only limit on the total number of DVDs you could rent per month, would be the speed of the mail. Accordingly, Netflix advertised "unlimited" rentals.

For example, in theory, with Villanueva's plan - assuming he staggered his rentals and saw a DVD every day, and assuming that the mail was quick -- he might have managed to see several dozen DVDs per month. That would have been a great deal for only $17.99.

How Netflix Worked In Practice: The Use of "Throttling"

But that wasn't how Netflix worked in practice, for Villanueva and users liked him.

According to news reports, at first Netflix typically sent 18 to 22 about 13 movies per month to Villanueva's home in Warren, Michigan. So far, so good: That's about what you would expect, as noted above, and it's a terrific deal.

But then the company's automated system identified Villanueva as a heavy renter, and applied what it deems its "fairness" algorithm in a way that meant he was only getting 13 movies per month. That's still a good deal - but not as good a deal as Villanueva initially had gotten.

To understand the "fairness" algorithms, it's necessary to understand a little more about how Netflix works. Users must put their desired movies into a numbered queue, in order of preference. They are then automatically sent the movie at the top of the queue - if it is available.

But what happened if Netflix simply did not have enough DVDs to satisfy demand for a given movie?

Netflix apparently gave high priority to new users and infrequent users, and low priority to frequent users. So the new users and infrequent renters got the popular DVDs, and the frequent renters had to wait.

Allegations suggested that Netflix also waited an extra to ship DVDs to frequent users - lessening the total number of DVDs they could rent in a given month. Allegedly, the delay was up to 6 days for some frequent users.

How did frequent users figure out what was happening? Simple: They spoke to each other at Internet complaint sites, comparing delivery times and, in particular, the times it took for different subscribers to receive the same movie.

It didn't take a rocket scientist: As one site showed, the service even listed different wait times when subscribers living in the same household requested the same DVDs!

In January 2005 -- four months after Mr. Chavez filed his class action - Netflix conceded, in effect, that they were right. It revised its Terms of Use to state clearly: "In determining priority for shipping and inventory allocation, we give priority to those members who receive the fewest DVDs through our service." And it specifically warned that heavy renters are more likely to encounter shipping delays and less likely to immediately be sent their top choices.

Was the Algorithm Truly Unfair? Or Was It a Perk Given For Good Reason?

As noted above, throttling is only a problem, from a legal perspective, if it remains undisclosed - as was the case with Netflix. Indeed, there's a good argument to be made that, if disclosed, "throttling" is only smart business, from the company's standpoint.

For one thing, Netflix's most frequent renters are a loss-making proposition for the company. Each DVD sent out and returned costs 78 cents in postage alone. So if a frequent user paid $17.99 and manages to rent 22 DVDs a month, as Mr. Villanueva did, only 83 cents would be left over after the cost of postage!

In contrast, if an infrequent user with the same package only rented 3 DVDs a month, about $15.65 would be left over after the cost of postage. No wonder Netflix favored infrequent users!

We like to feel that we all get the same service if we pay the same price. But at the same time, we are used to companies offering valuable customers - or new customers they want to court -- special perks.

So whether you view the throttling as fair or unfair, depends on whether you view equal priority in receiving rentals as a contractual right, or an extra perk. And that, in turn, depends on what the company has led you to believe.

The plaintiffs in the lawsuit saw equal treatment as a right, implicit in the company's promise of "unlimited rentals." And they are correct about this - if a company does not disclose that there are certain limits to the "unlimited" feature, this seems clearly misleading.

Once a company has disclosed its business practices, customers can choose to say or to shop elsewhere. Many Netflix customers retain their accounts - even after throttling has been publicized. Why? They think the service is still a good deal.

The Lawsuit Wasn't the Best Alternative to Address Throttling

Now that the Netflix suit is over, attorneys are $2.5 million richer, and affected Netflix subscribers will enjoy a one-month upgrade. In addition, it seems subscribers may get a bit more: After the settlement sparked protests, a hearing on a revised settlement took place this week, and on Wednesday, Netflix told the judge it will ensure that, in addition, 6 million consumers eligible for free DVDs won't be charged automatically after the one-month offer expires.

Since the cost of the suit, and the settlement, may only lead to higher prices for subscribers, one is forced to ask if the game was worth the candle. Perhaps a complaint to a state Attorney General or the Federal Trade Commission would have been preferable. Such a complaint might have resulted in a quick court injunction forcing Netflix to disclose its true practices in its Terms and Conditions - thus avoiding a huge expenditure in attorneys' fees.

One thing is for sure: The suit didn't put a stop to throttling. Netflix is still doing it - and so is Blockbuster, which now also offers a rent by mail service for DVDs. The difference is that now, both are doing it openly.