Bell System Breakup Part 2

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Part 1

Colin here.  The Department of Justice (DOJ) anti-trust lawsuit had been running for a number of years, and by the early 1980s it was finally going to trial. Bell recognized two things:

  1. They could not win this lawsuit
  2. The federal government under president Reagan was not going to intervene. Trial was all but inevitable.

What most people don’t understand was that the DOJ lawsuit was not to break up the Bell System. It was not to sever the Bell operating companies. It didn’t seek to declare the long distance network a monopoly. None of the things that most people think the DOJ lawsuit was about were actually what it was. It is the most mis-understood event in American business history.

The DOJ lawsuit had one single goal: to break Western Electric off from the Bell System. Only. That was its sole objective.

The DOJ had correctly surmised that the problem to consumers wasn’t the monopoly Bell Operating Companies. They were heavily regulated with rates that provided only a modest return on investment. The FCC regulated long distance rates, which had steadily declined in price for more than thirty years.  The DOJ did understand that Western Electric had a stranglehold on the Bell operating companies. It was essentially the exclusive supplier of everything to the Bell Operating Companies, and it could charge whatever it felt like. There was zero regulatory oversight over Western Electric.

Indeed, Western Electric took every advantage of this monopoly to charge staggering prices. A model 500 telephone would cost $8 to manufacture but would be sold for $120. Nobody could manufacture a high quality phone for less, and nobody could sell it for more. Western Electric would always justify its high prices by pointing out the truth that their equipment was the best in the world. Indeed, it was.

But Western Electric made staggering amounts of money. And, no regulator could peer into the operation of this sole source supplier.

This sort of arrangement was not unusual for the time. Even the Red Cross had its sole-source supplier of most of its consumables and this supplier made staggering profits which tidily made it into the pockets of the proper executives. The quite innocent Red Cross was also being bled through a very parallel arrangement. (But that is another story…one that continues in part to this day.)

Much of the money that Western Electric generated was spent as the lead contractor for military projects like SAGE and NORAD where Western Electric was the prime contractor. Every nuclear missile ever designed and built in America was done under the management of the Bell System, who provided this service as a “national service” on a “no fee” contract to the federal government. From missile systems to nuclear warheads, Western Electric was vital to the United States’ military. This arrangement was essential during the Vietnam War era as it allowed these controversial programs to move forward without authorization or funding from Congress.

The DOJ was either oblivious to the military importance of Western Electric or else they were indifferent to it. I don’t think anybody in the Bell System ever knew which it was. But the case was headed to trial.

The end goal, again was that Western Electric would be broken off from the Bell System. This would mean the Bell operating companies would have to purchase on competitive bid and that would mean Western Electric would be left holding the bag with all of these unfunded defense programs.

During this time, senior AT&T management was acutely aware of the problem they had gotten into with Western Electric and its military projects. Throughout the 1970s since the onset of competition senior AT&T management provided increased resistance to undertaking new projects suggested by the military. But the existing extent was immense.

Now nobody had better lawyers than Bell. Truly, they had brilliant lawyers. But they knew that they had a losing case. All you can do with a losing case is damage control.

A key aspect of the trial was expert witnesses. These experts would pass judgment on the accounting and financing within the Bell System, and they would heavily scrutinize the Western Electric operation. They were key to the trial, and they would be the most damming. The facts could be buried in a mountain of paper documents, but expert witnesses cut through all of that with a rendered opinion.

Once again the department I was working in was tasked with an interesting project. I think we always got the interesting projects. Officially, our organization didn’t even exist. We weren’t on any organization chart, and we operated without a budget. Most of the managers and staff in our department were themselves lawyers. We were charged with solving the problem with expert witnesses.

The solution to the expert witness problem was so clever it should go down in the history books!

You see, there is a quirk in US law that an expert witness cannot be an expert for both sides of a court trial. If somebody works for the plaintiff they cannot work for the defense. This is to prevent conflicts of interest. Duh.

So we set out to hire every single economics professor and analyst in the entire United States. We figured that if every single economics professor was under our employ, then the DOJ would not have anybody to give testimony. Of course, this had to be done in such a way that it would neither be discovered nor be apparent while we were doing it.

A vast effort was made to contact every economics professor in every university. We would give them a small grant to research something. It didn’t matter how small the grant was, nor what was being researched. So, for smaller university professors we would give them a $250 grant to produce some paper on something like “Forecast of the economy for the next decade” or “Projection of copper prices for the next five years” or perhaps even “Forecasts of marketshare from telecommunications competition.” The 1970s and early 1980s were a period of high inflation and energy uncertainty so those were popular topics. In many cases we would let the professor propose their own topic. The only key was that they needed to do the work such as a paper, and we would pay them.

I think we ended up hiring some 50,000 college professors that year. Most of them got small grants and produced some ditty of a document for us. This may seem grand but the total cost of the program came to something like $10 Million. That amount is so trivial to an operation like the Bell System as to not require altering any department’s budget. For that, we solved the #1 problem with the DOJ case. So the DOJ had an interesting problem: Every time they proposed using some expert witness, we would go into our files and produce this ditty of a report that the professor had done for us. That person would then be disqualified. Over and over, endlessly, the DOJ struggled to find somebody to serve as their experts and that was’t conflicted by the Bell System. Anybody of any prominence was simply not an option.

The case did go to trial, and throughout the trial there were endless references made to how breaking-off of Western Electric would hurt the national defense. Finally, Judge Greene, in a rather exasperated response said that he needed specifics. He needed to understand what this vast threat to the nation was by breaking off Western Electric. Eventually, the reality hit home: Western Electric would in all likelihood need to be divested, almost immediately.

Western Electric wielded tremendous power within the Bell System because of its ability to generate cash and political capital. And, for the first time it faced death. The eleventh hour arrived, and if things went any further it was almost a certainty that Judge Greene would sever Western Electric from the Bell System. And, that could not be allowed to happen. Thus was born what became the divestiture that we all know as history.

Western Electric decided that perhaps it could keep its alliance with AT&T Long Lines and separate itself from the Bell operating companies. For a while, they would continue to have strong preference for Western Electric products because they had always purchased from Western. Further, the Bell operating companies had absolutely no ability to specify, competitively bid, evaluate, or manage non-Western products. Perhaps it would not be so bad.

But Western and AT&T Long Lines (ATTLL) would remain together. Western would continue to reap great profits from selling things to AT&T and perhaps it could scale back some of the military projects and find a happy balance.
Thus, the consent decree was proposed to the DOJ. From the DOJ standpoint it was a compromise. The Western Electric ATTLL alliance was still there, but the fundamental separation between the local Bell companies and Western Electric would happen. The Bell operating companies would not compete against each other as they were territorial.

Initially, the thought was to break each of the independent Bell Operating Companies off as separate entitles. But that created a problem for Western Electric. It would be too many decision makers to manage and keep in line. These companies would gradually form their own identities and needs and some would inevitably defect from Western Electric products. It would be better to have a smaller number of customers who could be kept in line. Eventually, the seven regional Bell companies were proposed, not coincidentally along geographic boundaries not entirely dissimilar to the Western Electric distribution regions.

The public today views the break-up of the Bell System as an effort to instill competition and break the monopoly. But breaking up a national organization does not really foster competition at the local level. Breaking up WallMart into seven regions does nothing in particular. The regions don’t compete and each is large enough to maintain its economies of scale. But the public view is still that this break-up somehow was about competition.

The truth is that the DOJ lawsuit was never about breaking up the Bell System or the problem with the monopolistic Bell operating companies. That wasn’t a goal of the DOJ nor a concern. The issue was Western Electric.

Post divestiture Western Electric generated far less cash than before, because it did have to compete. Northern Telecom grew rapidly post-divestiture. As a result, Western Electric continued the pattern that had been started in the 1970s of scaling back its military projects. Western Electric was not accustomed to selling the federal government military projects, and getting funding for things like nuclear bomb design and manufacture was politically difficult.

Within a year of so, Western Electric gave notice to the Federal Government that it was withdrawing from a number of programs, including the management of Sandia Laboratories. In 1993 it was picked up by the Martin Marietta Corporation which two years later merged and became Lockheed Martin Corporation.

And, you thought that the Bell System was all about touch-tone calling?

Colin Berkshire