The Deal of the Century: The Breakup of AT&T

by Steve Coll

The cost of providing basic telephone service to the country was enormous. AT&T had to build, install, maintain, and replace hundreds of thousands of miles of cable and wire, millions of residential telephones and business telephone systems, as well as a sophisticated network of switching stations that directed every call to its proper destination. Just to maintain a system of that magnitude and diversity required huge expenditures by AT&T every year—$7.5 billion in 1971, more money than some large companies would spend in a decade on plants and equipment. And when customers demanded more phone service, as they had throughout the 1960s, AT&T’s capital requirements became astronomical. But if AT&T cheated on its investment, if it failed to spend the necessary money to build new phone lines and switching stations to accommodate new customers, the disastrous results would become quickly apparent. That was exactly what had happened by 1970. Inflation during the 1960s had driven up AT&T’s costs and had squeezed the company’s profits. Rather than raising phone rates to cover inflation, the operating company presidents had decided to cut costs and to stop investing so heavily in the upkeep of the phone system. In the short term, the companies’ profits rose, and the presidents were praised for frugality. But in just a few years, the neglected phone system, unable to accommodate the new demand for telephones, had collapsed under pressure.

In essence, AT&T priced some of its intercity services, such as private line, WATS, and regular long distance, relatively high in order to subsidize the enormous costs of building and maintaining the nation’s wire-and-cable telephone infrastructure. If those costs were just passed on to local telephone users in the monthly bill, the price of residential phone service might double or triple. Instead, local service received a subsidy from long-distance revenues. How great that subsidy was, and what shape it actually took, was something regulators often disagreed about. But there was one thing everyone agreed on: AT&T’s system of pricing kept the cost of basic phone service low for the average customer, as well as for the poor and elderly, who needed phones to obtain vital services. By jumping into just one area of the telecommunications market—private line—MCI was just “creamskimming,” as AT&T’s executives put it.

An antitrust lawsuit against AT&T had been much on McGowan’s mind lately. He had consulted with a number of attorneys about the current negotiations with AT&T. McGowan knew a great deal about antitrust law himself. He knew, particularly, about something called the “essential facilities” doctrine in antitrust law. If one company—say, AT&T—owned exclusive facilities that were essential to the business of another company—say, MCI—then the first company was required to give access to the second company.

Hart even quoted Sherman, who had said on the Capitol floor in 1890, “If we will not endure a king as a political power, we should not endure a king over the production, transportation, and sale of any of the necessities of life. If we would not submit to an emperor, we should not submit to an autocrat of trade, with power to prevent competition and to fix the price of any commodity.”

The state regulators cared about two things: keeping the cost of local phone service low and ensuring the Bell operating companies fair profit margins.

The state commissioners knew that revenues from AT&T’s long-distance services, which were used mainly by businesses, subsidized the costs of maintaining the nation’s local telephone networks. So when the FCC had authorized long-distance competition by approving MCI’s microwave application in 1969, the state commissioners had rallied to AT&T’s side, arguing that competition in the phone business was not in the public’s interest. If AT&T’s long-distance revenues were eroded, or if AT&T was forced to drop its long-distance prices to compete with companies like MCI, the cost of local phone service would rise dramatically. The state commissioners would have no alternative but to raise local phone rates too, and they would then find themselves in the midst of serious political controversy.

For reasons far beyond Bernie Strassburg’s control, the Common Carrier Bureau’s quiet methods of regulation, known in the phone industry as “continuing surveillance,” broke down during the 1960s. Rapid technological advances in fields such as satellites and microwaves began to raise questions about how well the Bell System would keep up in an emerging “information age.” More important was the political furor that erupted during the late 1960s, when AT&T’s service crises in New York and elsewhere, together with the popular suspicions of the period about big corporations, led to an outcry in Congress that the FCC was not doing its job, that the commission was merely AT&T’s servant.

The difference between a private line and an FX line, then, was that rather than connecting two private offices in two cities, an FX line connected one office in one city with all of the phones in a second city.

The lawyers at Antitrust came in all shapes and sizes, but they were roughly divided along generational lines. On one side were the older, “career” lawyers who had worked in the division for decades, rising slowly through its bureaucracy to supervisory positions. Over the years, these attorneys had tried hundreds of government antitrust cases, large and small. They had won many of them, lost a few, and settled the rest. They had seen political administrations and political movements come and go, and they had survived the tenures of politically appointed Antitrust chiefs of every ideological stripe. And through it all, they had acquired that salty, slightly world-weary, eminently pragmatic outlook peculiar to men of integrity who have spent their lives working in a bureaucracy. On the other side were the young, passionate lawyers like Verveer, most of them politically liberal and graduates of the turbulent 1960s campuses, who had come to Antitrust to combine a respectable profession with furtherance of the movement that had swept them up in school. As lawyers, Verveer and his contemporaries had been trained in caution and diligence, but they were also activists, and there was very little that was cynical about their approach to the legal profession. Inevitably, these two generations within the Antitrust division met, clashed, compromised, and learned from each other. The younger lawyers acquired skills and patience from their supervisors; the older lawyers were reinvigorate...

In sorting through the abuses of power uncovered during his renowned Watergate investigation, Senator Sam Ervin of North Carolina had suggested that perhaps the Justice department should be separated from White House control. It was an idea Saxbe opposed, but more important, it was a signal to him of the deep suspicion in Congress and among the public about Justice’s integrity. Saxbe knew there was only one way he could reverse public opinion about the Justice department—through bold, decisive, and independent action.

Free-market competition was not the sport of gentlemen.

The telephone business offered a classic example of “economies of scale,” AT&T argued. That is, the enormous cost of constructing a national telecommunications network made sense only if the builder could reap revenues from every telephone installed—return on investment rose as volume of traffic increased.

Deregulation was a Capitol Hill buzzword, and the idea was fast gathering force among both Democrats and Republicans. Liberals wanted to deregulate because competition would lead to decentralized ownership and a more diverse economy; conservatives just wanted the government off business’s back. Together, they were an unstoppable coalition: airline, trucking, natural gas, oil, banking, and other industries were all deregulated by Congress during the late 1970s and early 1980s.

The congressmen had good reason to be frightened. With a million employees spread around the country and a sizable political war chest at its disposal, the phone company was able to raise a terrible sound and fury about the Bell Bill. Its attack on Congress resembled a charge by Ayatollah Khomeini’s Iranian army, for what it lacked in strategic planning, it made up for with waves of human flesh. Bell lobbyists, who became known on Capitol Hill as “shepherds” for the hovering attention they paid to their congressional flock, were flown into Washington by the planeload. They were unusual lobbyists. They shunned Italian pinstripes and fancy Washington bistros, and few of them were lawyers. The vast majority were employed not at AT&T’s headquarters at 195 Broadway but by the local operating companies around the country. Unlike any other corporation, the phone company had employees in every congressional district, and this omnipresence became the key to the Bell Bill lobbying strategy.

DeButts’ lobbying blitzkrieg was ill-chosen for reasons beyond its high visibility and its undertone of political blackmail. Most importantly, the campaign inevitably persuaded only those congressmen who could do deButts the least good. Committed chairmanships were awarded on the basis of seniority, so the most powerful members were those with decades of service and electorally safe seats. Such congressmen were unlikely to be intimidated by AT&T’s implied threat of reprisals at the ballot box; they could win reelection with or without the phone company. A weak congressman, with one or two terms of service and a tenuous grip on his district, might well agree to help the phone company in exchange for the votes of its employees, but he was unlikely to wield any real influence in committee or with his party leaders.

“I agree with you,” Wirth said sardonically. “A lot of things are done that the American public doesn’t know about. Frankly, can you tell me how many people AT&T has working full time on this legislation?” “I have no idea, sir, but it is very few—very few. Full time? I doubt if there is a single person in the Bell System that is working full time on this legislation.” With those words, John deButts’ credibility in Congress reached its nadir. No one in the room believed that he was telling the truth—about his lobbyists, about his tactics, about anything. The hearing room erupted in laughter.

And the courts, unlike Congress, were generally interested more in the rule of law than in the “public interest.”

If phones were soon going to be sold like televisions, bicycles, or soap, AT&T had to make rapid and wholesale changes in its structure and corporate culture. Until deButts arrived, the company didn’t even have a marketing department. Its salesmen didn’t work on commission. More fundamentally, the heart and soul of the phone company—its emphasis on service, its conservatism, its impenetrable bureaucracy—was anathema to the culture of a lean and mean competitive corporation.

They were the kind of lawyers who might enjoy trying a case against each other. And that was a good thing, because by the summer of 1978, one year after Phil Verveer’s resignation, it appeared that U.S. v. AT&T might move to trial faster than any antitrust case of its size in many decades. In part, that was because of Ken Anderson’s expedient methods. In part, too, it was because Charlie Brown’s team of executives, who would soon have full control over AT&T’s policies and strategies, wanted to resolve Bell’s antitrust problems as quickly as possible. They could see that deButts’ stand against competition had failed: MCI was a billion-dollar company now, and Japanese and other equipment makers were rapidly gaining market share at Western Electric’s expense. The challenge now was to free the phone company from its Washington quagmire and prepare for a competitive future, a future that Charlie Brown frequently referred to as the “information age.”

When a man or woman’s talents, convictions, and ambitions coincide with the egress of an entire generation, there is the opportunity to make history, and such a blessing fell upon Harold Greene at the Justice department during the early 1960s.

One measure of whether a judge was more “active” than “judicial” was how often the judge’s decisions were reversed on appeal, and some of the “liberal activist judges” were reversed quite frequently.

For AT&T, though, there was a chilling aspect of Greene’s brand of judicial activism. It came in the form of a question that lingered on the lips of the company’s attorneys in 1979, as Greene pushed relentlessly to bring U.S. v. AT&T to trial. To make his point, to prove that the federal courts could effectively manage a major antitrust case, wouldn’t Greene be more inclined to rule in the government’s favor and break up AT&T? If he pushed the case to trial, and then agreed with the phone company that Justice’s allegations were baseless, wouldn’t his “example” be undermined?

Howard Trienens and Charlie Brown, from their vantage at AT&T’s corporate headquarters in Manhattan, never understood the internal turf wars, personality conflicts, and individual ambitions that caused the Justice lawyers in Washington to appear as uncompromising prosecutors one day and flexible negotiators the next. Even if they had understood, it is doubtful the knowledge would have done anything more than contribute to the mounting frustration and depression they felt about the phone company’s ever-deepening entanglement with the U.S. government.

For his part, Saunders was feverishly anxious to bring the case to court, and to vindicate himself with a victory. “Another billion-eight and they may throw me out on the street,” he joked to the AT&T trial team. So Trienens did not tell Saunders about the phone call from Litvack. It was better that the trial team continue to prepare as if there was no chance of settlement.

The trial was scheduled to begin on January 15, less than four weeks away from Litvack and Trienens’ Friday meeting. Once the trial began, the value to AT&T of any settlement might be severely diminished. There was a section of the antitrust Clayton Act which held that once evidence was entered in a case like U.S. v. AT&T, it could be used on a prima facie basis by other companies suing AT&T for antitrust violations if the United States won its case or if the case was settled by consent decree. That meant that dozens of companies could piggyback on the government case without having to enter and prove their own evidence. The price to AT&T of such piggybacking, in the form of antitrust damage awards, would likely run to billions of dollars.

“Let me clarify one thing,” Trienens added moments later. “I want to say that the ‘ground up’ features of this agreement are unique. I was told by some very learned hands around this town a year ago that the way to get a case settled is you go and sweet-talk the top people who don’t know much about it, and then the people at the bottom who do not want to settle, they have it imposed on them. This is exactly the opposite of the traditional learning, if that is what it is. This does come from the trial staff and it is relevant because these are the institutional people, not the people at the political level.”

He was a sleepy, even-tempered man, the sort of fellow you might say hello to on the elevator for twenty years without even knowing his name.

The reason Baxter liked the case had nothing to do with its factual merits, or with the history of John deButts, MCI, and telephone industry competition. Rather, Baxter was enamored of the government’s relief theory in the case—which sought complete separation of the regulated local operating companies from relatively unregulated Western, Bell Labs, the Long Lines—because it was a flawless example of the free-market economic model Baxter believed in. Baxter argued that no one company should be able to integrate regulated and unregulated divisions of its business, because then it could use the “safe” profits from its regulated side to subsidize the prices of its unregulated products. Such “cross subsidies,” Baxter wrote, skewed the otherwise pristine mechanisms of a free-market economy. Of course, the role of subsidies in the telephone industry was so complex as to be inscrutable, and in some cases the subsidies were designed to achieve social goals such as low-cost local phone service. But Baxter believed that unfettered competition was the only efficient way to achieve such social ends.

Trienens and Brown had both cautiously assumed that President Reagan would appoint an Antitrust chief who shared Regan’s apparent view that U.S. v. AT&T was a mistake. When questions about the case occasionally arose during the 1980 presidential campaign, Reagan had responded by telling a story about his days in Hollywood. He recalled that the price of a first-class stamp in the 1940s was just a few cents, while a long-distance phone call was fairly expensive. Since that time, Reagan said, the price of postage had risen almost tenfold, while the cost of long-distance calls had dropped dramatically. “And, of course,” the candidate said, emphasizing his theme that big government was the root of America’s problems, “the government is suing the phone company.”

In an early review of which specific programs, weapons systems, and policies were needed to bolster the nation’s defenses, Weinberger heard from the Defense Communications Agency (DCA) that, in its opinion, dismissal of U.S. v. AT&T should be one of the secretary’s highest priorities. The DCA worked closely with AT&T to design, maintain, and operate the strategic communications network that served military, intelligence, and other national security services. Among other things, this “defense net,” as the system was sometimes called, provided for sophisticated communications between political and military officials in the event of a nuclear crisis. It was the opinion of the DCA staff, as well as of its leader, General Hillsman, that if the Justice department succeeded in breaking up AT&T, the nation’s defense communications system would be severely impaired and its national security threatened. Of course, the communications experts DCA relied on in formulating this view were AT&T employees, who were not likely to offer objective analysis of U.S. v. AT&T. And it was also true that by relying on a centralized, large “sole supplier” such as AT&T for communications, Pentagon bureaucrats enjoyed both convenience and protection from mistakes by smaller, potentially unreliable contractors. The cozy relationship between DCA and AT&T no doubt predisposed the defense department to defend the phone company against the Justice lawsuit. Nonetheless, it was an unavoidable fact that Penta...

Connell noticed early on, for example, that when Greene was becoming impatient with a witness, the judge began to tap his pencil nervously and unconsciously, like a drummer. Whenever Connell saw that pencil tapping, he immediately ended his examination of the witness on the stand, or else quickly moved on to the next point.

Connell boosted morale among the nearly four dozen young lawyers in his charge during the trial by promising that every attorney on the team would be allowed to examine at least one witness in court. It was a safe idea. All the direct examinations, even those presented by Connell or his senior lieutenants, were rehearsed, question by question, the night before. Connell intended to stick to an old rule of cautious trial lawyering: Never ask a question to which you don’t already know the answer.

Whereas Gerry Connell cut and pasted his argument together, creating a vast collage of disparate evidence, Saunders’ purpose was to transform this collection of unrelated bits and parts into a mosaic, a sweeping and well-defined picture of misguided government regulation and greedy, creamskimming opportunists such as McGowan. If Saunders tried to attack the government’s case on its own terms, if he responded to each of Connell’s anecdotes in isolation, his cause would fail. Besides, that wasn’t how Saunders saw the case. To him, U.S. v. AT&T was not confusing, or unwieldy, or even very complicated. It was a “rip-off” and an “outrage” that AT&T’s competitors, and the government, had twisted the facts around to make AT&T appear the villain, when all the company was trying to do was adapt to change while continuing to serve the public and its shareholders well.

But with dozens of well-groomed executives and a stable of high-priced lawyers surrounding him, McGowan was no longer “a little guy,” an iconoclastic cowboy capitalist. He was the fabulously rich chief executive of a sprawling, publicly-held corporation. Finally, he had become a fat cat. And that April, he was also the chairman of a company that had recently been awarded $1.8 billion in antitrust damages by a federal jury in Chicago, an award that was like an insurance policy guaranteeing MCI’s future growth and profitability. But the award was on appeal and would not be final for months, probably years. If, while testifying for Justice in the government case, McGowan contradicted any of the Chicago testimony that had led to the jury’s award, he could jeopardize the outcome of his $1.8 billion appeal, and indirectly, the future of his company and his personal fortune. In conversations and meetings with the government trial teams, McGowan and his attorneys were unyielding on this issue; they protected their $1.8 billion like it was a newborn infant.

During a decade of nonstop legal wrangling with AT&T, McGowan had become a sophisticated witness. He challenged the premise of every question, argued vigorously with his examiner, and conceded only the narrowest points.

Reagan frequently said in public that he instructed his cabinet officers only to discuss the merits of an issue while in his presence, never its political consequences. In 1981, virtually all of the President’s cabinet secretaries believed Reagan meant what he said.

As Rose told Baxter, “If you’re a White House staffer, you want to deliver to the President the best result, the least damage, and the best policy—sometimes in that order.”

The general rule at Jim Baker’s White House, Rose said, was that if something was going to hurt the President, “they want to get it out of there and take it on over to Defense or Justice or OMB or wherever—just get it away from the President.”

Rarely did the President get involved in the details or even the debate about a decision such as dropping the AT&T case. His easygoing personality was better suited to detachment: he let his top aides do battle with each other over an issue until they presented him with a firm consensus. The advantage of Reagan’s style was that on many issues, that consensus led to unity and strong, positive leadership within the administration. The disadvantage was that the President had a slim grasp of the questions being deliberated by his counselors and was thus unable to intervene when, as was the case early that summer, debate on a particular issue became skewed by personality clashes, turf wars, and internal White House politics.

Perhaps, they told themselves at their nightly caucuses in George Saunders’ Madison Hotel suite, the basic problem was that Greene could never be comfortable with the phone company’s gargantuan size. Perhaps the judge’s jokes about “the well-oiled machine” genially masked a deeply held suspicion about huge, centrally managed organizations. Although he never dwelled on it, Greene had seen during his childhood in Nazi Germany the extreme consequences of manipulated, concentrated power, and perhaps the experience, understandably, had left an indelible impression.

Ian Ross, the Bell Labs president, agreed with Tanenbaum’s assessment, and he argued loud and long against the interintra split that Hugel had devised. There had long been a tension in Bell System management between executives like Tanenbaum and Ross on the one hand, who were scientists committed to the purity and independence of Bell Labs’ research, and executives like Hugel on the other, who felt that the Labs ought to be more closely integrated with Western Electric in a traditional “product development” relationship. Hugel felt that in the precompetitive era, it had been fine for the Labs to be unusually independent, almost like a university science center. The country as a whole derived obvious benefits from that structure, since Bell Labs was required by law to license to competitors the many patents it developed. But now that the competitive era had arrived, this “ivory tower” system would cripple Western’s attempt to compete against the likes of IBM, Xerox, Wang, and other large, sophisticated computer and communications equipment companies. It was Hugel’s view that divestiture of the operating companies was an acceptable trade-off for the opportunity to transform Western and the Labs into a “lean and mean” product-oriented, competitive organization. Such a transformation was precisely what Ross, particularly, dreaded; he was determined to argue at every opportunity against divestiture. But the long-standing antagonism between Western and Bell Labs colored his oppo...

During the 1970s, as he had risen through AT&T’s management ranks to the elite corps around Charlie Brown, Hugel had been frustrated by his company’s seeming inability to shake off its past. For example, Hugel believed that Bell had wasted an opportunity in the late 1960s and early 1970s to “trade off” politically the possibility of unlimited phone equipment competition for the right to preserve its national network. But instead of accepting equipment competition, deButts had pursued his PCA strategy. “The old telephone people didn’t recognize terminal equipment for what it was—not an integral part of the network,” Hugel said later. “There was the PCA argument, and the studies about harm to the network were legitimate, but that really wasn’t seeing the forest for the trees.”

When contemplating such a radical strategy, which by its nature contravened the precepts of Bell System culture, it was helpful for executives like Hugel to address the bottom line: the interests of AT&T’s three million shareholders. This was not simply an obligation of corporate officers, who serve at the pleasure of a company’s shareholders. It was a matter of self-interest and even survival. No matter what course they chose in October 1981 or later, Charlie Brown and his senior managers had to be certain they protected themselves and their board of directors from shareholder lawsuits, which at the least would be embarrassing and distracting, and at the worst could cost them millions of dollars and their jobs and reputations. The only way to prevent litigation that challenged their management decisions was to pursue a strategy that could be justified purely as a matter of profit and loss. To each of the alternatives facing AT&T’s senior executives that fall—the Quagmire II deal with Justice, congressional legislation along the lines of S.898, continued litigation against the Justice department, the interintra split—a price tag had to be attached.

Through the complex system of local service subsidies, called “separations payments,” AT&T’s Long Lines was already paying a higher “rent” to the operating companies than MCI’s $235 fee, although Bell’s payment system was put together much differently than MCI’s. Because of its market share and the size of its system, AT&T could afford to pay $500, even $600 in rent if the operating companies were divested in an inter-intra split. And because the whole idea of such divestiture, at least as McGowan and the Justice department had always stated it, was unmitigated equal access, MCI and the other competitors would eventually have to pay the same amount. When that happened, the competitors’ cost and pricing advantage would disappear, their profits would come under tremendous pressure, and they would probably all be facing insolvency within a decade, if not sooner. If the cost of doing business was the same for everyone, there simply wasn’t much room in the long-distance market. It was, as George Saunders was so desperately trying to convince Judge Greene, a natural monopoly. Or so believed the executives of AT&T. Certainly, none of them was reluctant to test their belief against the likes of Bill McGowan. Long Lines was never going to go out of business. MCI very well might.

A decision by the judge to split off the equipment side of AT&T’s business might be very difficult to reverse on appeal. Such a decision would be easier for appeals judges to understand than if Greene ordered the breakup of the operating companies. There was more precedent for divesting the manufacturing arm of a monopoly whose primary business was not manufacturing.

Bitten, the AT&T trial team retreated to its caucus suite at the Madison Hotel. “What can we do to convince this guy?” Saunders asked, referring to Greene. “What haven’t we tried?” It was then that Saunders seized on the “parade of stars” idea. The plan was, as one of the AT&T lawyers put it later, to tell Judge Greene, in effect, “Look, you dumb son of a bitch, this is not a liberal-conservative thing. Good, honest people who you respect share our opinion on this thing.” One Sunday morning, the senior trial team convened in Saunders’ suite to discuss what kinds of witnesses might be able to soften Greene’s harsh attitude toward the phone company. “If you could have anybody in the world come in and talk to Greene—anybody in the whole world—who would it be?” Saunders asked his partners. They made a list on a blackboard and tried, once again, to work up the judge’s psychological profile. George McGovern was an obvious candidate. Maybe a Kennedy. Benjamin Hooks, NAACP president and a former FCC commissioner, seemed a good choice. They tried to narrow the profile even further. What about someone who shared Greene’s most fundamental life experience, his escape from Nazi Germany?

One firm tenet of Baxter’s theoretical views about antitrust law was that neither huge size nor large market share was by itself a violation of the antitrust laws. The only thing that really mattered to Baxter was economic efficiency. If IBM had become a huge corporation because it was more efficient than its competitors, then it deserved its riches.

“Now, when you see them, you should be gracious to the AT&T lawyers. Your exuberance will be matched by their lack of it. Do justice to yourselves, and don’t rub it in.”

There was good reason for congressmen and consumer activists to be concerned about the viability of the operating companies and the future of cheap, high-quality, local phone service after divestiture. If it was true, as AT&T had been saying for more than a decade, that revenues from profitable long-distance service subsidized the high cost of the local telephone infrastructure, then wouldn’t divestiture of the operating companies inevitably result in higher local rates to make up for the local subsidies? And wouldn’t the quality of local service suffer because the now cash-poor operating companies would be unable to invest sufficiently in their local plant? Obviously, these were not new issues. For one thing, they had been the foundations of George Saunders’ relief defense in the trial before Judge Greene. At the Friday press conference, Brown and Baxter had both answered questions about higher local rates with the same answer: It was competition in the phone industry generally, not the breakup of the Bell System, that was the culprit.

In a 1985 interview, Greene insisted that he had not decided during the trial how he would finally rule on U.S. v. AT&T, but he also observed, “I have no doubt about the correctness of deregulation. The basic fact of the phone industry is it grew up when it was a natural monopoly: wooden poles and copper wires. Once it became possible to bypass this network through microwaves, AT&T’s monopoly could not survive. What the Bell System did was illegal. It abused its monopoly in local service to keep out competitors in other areas. Competition will give this country the most advanced, best, cheapest telephone network.”