The Bell System divestiture: background, implementation, and outcome. (The Enduring Lessons of the Breakup of AT&T: A Twenty-Fiv

I. INTRODUCTION

The telephone industry in the United States started with the Bell patent in 1878. Telephones were introduced into many communities during the next twenty years. After the Bell patents expired, around the turn of the century, multiple telephone companies began operations in many cities. In many cases, these companies did not even interconnect, so people needed two or three telephone services in order to be in contact with all of their friends and customers. This chaotic situation also caused the carriers great financial difficulty.

In 1907, Theodore Vail, having been installed as president of AT&T after the "Panic of 1907," proposed that telephone service in the United States be provided based on the philosophy of "one system, one policy, universal service." (1) This concept involved monopoly provision of service, coupled with pervasive government oversight and regulation. It was promoted in advertisements from 1908 and formalized in the so-called Kingsbury Commitment of 1913, (2) when AT&T was allowed to operate without governmental interference, but agreed to stop acquiring telephone companies and to interconnect with others.

The Bell System followed that idea for half a century, fully integrating its systems and procedures to provide end-to-end service. In order to ensure a reliable supply of standardized equipment, it also designed and manufactured its own equipment. Bell Laboratories (Bell Labs)--created from a merger of the design department of the manufacturer, Western Electric, and the engineering department of the operator, AT&T--also embarked on an extensive and successful effort to perform the research necessary to promote technological progress in telecommunications.

Using this model, AT&T successfully expanded telephone service in the United States until the 1950s, when universal service was essentially achieved. During this period, the concept of "service" was the predominant value within the organization, becoming almost a religion. "Independent" telephone companies, mostly in rural areas, were made partners in the system, encouraged by generous "settlement" payments from long-distance service.

II. THE RISE OF COMPETITION

Starting in the 1960s, new technologies, many pioneered at Bell Labs, were stimulating competitive activities. There were four principal technologies that led to this: (1) large radio systems for carrying long-distance calls; (2) semiconductor devices built for computers that could be used for switches; (3) miniature connectors for telephones and other terminal equipment; and (4) tone signaling, that allowed signals to be sent over the network after a connection was established.

Regulators, intent on limiting the rate of growth of the Bell System, tended to allow competitive entrance into various portions of the market, albeit slowly and unevenly. Competition began in the following areas:

* Large companies began building their own private microwave systems for internal communications;

* Telecommunications equipment manufacturers began building terminal equipment and customer switches that could be connected to the telephone network;

* Other manufacturers began trying, with some success, to sell equipment to the Bell companies; and

* MCI built a long-distance network using microwave radio systems, allowing people to make local calls to MCI's switches, and complete the calls by using tone signaling to get the necessary information to the MCI network. Others followed.

The last development was not based on new technology so much as on pricing distortions that had grown up over the years. For many years, technological advances had benefited long-distance services more than local services. In order to maintain the stability of local pricing, long-distance prices were allowed to remain well above cost, the difference being used to reduce the cost of local service. MCI's idea exploited this arrangement. It used its own long-distance network and paid Bell only the subsidized price for local access.

Bell objected furiously, guided in part by their sense of "service" and partly by financial considerations, but in a series of FCC and court decisions, Bell was gradually forced to give ground in a number of areas.

Terminal equipment--telephones, customer switches, etc.--was deregulated. Bell had strongly defended its "end-to-end service" mantra, but a series of FCC decisions (Hush-A-Phone (3) and Carterfone (4)) weakened its position. It became apparent that customer-owned terminal equipment could be connected to the network without service degradation. The FCC finally adopted a set of interconnection standards and deregulated the provision of terminal equipment. Competition developed quickly, spurring innovation in that market. As a precursor of things to come, controversies quickly developed as to the location of the "network interface" where equipment was regulated on one side, and deregulated on the other side. This definition became increasingly difficult as more complex services evolved.

AT&T agreed to connect to MCI, and other long-distance carriers (e.g., Sprint). After strenuous complaints by AT&T and several court rulings, the FCC ordered MCI and others to pay the so-called Exchange Network Facilities for Interstate Access (ENFIA) rates for local access. These prices were higher than basic phone rates, but included less than half of the subsidy that AT&T's long-distance services contributed to local service.

Other manufacturers began to sell equipment to the Bell telephone companies. AT&T and Western Electric management attempted to suppress this, but some local Bell managers bought equipment from other manufacturers when they thought it superior to Western's.

In addition, data communications began to increase in importance. The line between computers and communications became increasingly blurred, but AT&T was prohibited from providing computer services by a 1956 consent decree. (5) The FCC kept trying to draw bright lines between computers and communications without much success. In a series of Computer Inquiries, (6) the FCC attempted to distinguish between "basic" and "enhanced" services, regulating the former and deregulating the latter. Despite many years of effort, these definitions were impossible to implement in a workable way. The major result was to prevent Bell from offering services that had "enhanced" components.

III. THE ANTITRUST SUIT

In 1973, the Federal government filed a lawsuit alleging that AT&T had: (1) illegally limited the kinds of connections and services MCI and others could get, and (2) illegally prevented other manufacturers from selling equipment to Bell companies.

The lawsuit wended its way through the legal system while all of the activities mentioned above were taking place, and finally came to trial in 1981. It should be noted that the allegation dealt principally with equipment provision and access for long-distance services, which were deemed competitive. The local exchange monopoly was recognized and accepted. The lawsuit was not intended to change that. In fact, the initial settlement agreement (referred to as a Modification of Final Judgment, or "MFJ" (7), which harkened back to the 1956 consent decree) attempted to draw a bright line between monopoly and competitive services, the former of which were to remain regulated, while the latter would be removed from regulatory oversight.

AT&T followed standard practice in dealing with the lawsuit, dragging it out with endless filings and hearings. (8) When Judge Harold Greene took over the case, he vowed to move it along, and he did.

What were AT&T's alternatives?

1. Fight the case to the end. If AT&T lost any significant part of the suit, it could lead to ruinous private litigation. AT&T initially did fight the case in court, but after comments by Judge Greene in response to a petition for dismissal in the summer of 1981, the company realized it probably could not prevail in court, and began to think about settlement.

2. Agree to some kind of injunctive relief that would have saddled AT&T with significant operational constraints. The injunctive relief scenarios proposed by the Department of Justice were so restrictive that the operations people at AT&T did not think that they could properly operate the business.

3. Give up Western Electric. This involved giving up most of Bell Labs, widely (if incorrectly) viewed as the crown jewel of the empire. Also, this did not solve the problem of MCI and long-distance competition. Finally, this was prominent in the minds of AT&T management, as it did not relieve AT&T of the restrictions from the 1956 consent decree preventing it from entering the computer business. They somehow believed that the computer business was the key to AT&T's future, and that Bell Labs technology would allow them to become a major force in the industry.

4. Split off the monopoly telephone companies from the competitive long-distance and manufacturing businesses (divestiture), with the following implications, some positive and some negative:

* Telephone service might be severely disrupted, which might take years to sort out and resolve. This loomed large in the minds of management and operations people who had spent their entire careers overseeing an integrated entity, and who placed great importance on service quality;

* AT&T would be freed from a restrictive consent decree dating from 1956, and would be allowed to enter the computer business;

* The local telephone companies would be prevented from offering long-distance services, so local and long-distance services could be effectively separated; and

* AT&T's long-distance services would be deregulated.

Obviously, alternative four was chosen. A number of difficult administrative, technical, and operational problems needed to be addressed and resolved.