The Deal of the Century

by Coll, Steve;

  By the time H. I. Romnes, a brilliant engineer but a relatively ineffective chief executive, announced his retirement as AT&T’s chairman at a February 1972 press conference, John deButts was ready—the sprawling operations and the sacred public mission of the Bell System not only had been drilled into his mind, but had seeped into his soul. Like a king ascending to a corrupted throne, deButts intended to reawaken the spirit of AT&T’s declining empire. In his first weeks on the job, he made plans to travel around the country to deliver pep talks to AT&T employees about the history of the Bell System’s public trust. He ordered emergency construction spending to restore quality phone service in major cities. And he made it plain that there would be no compromises on service—“pots” came first, profits would follow, deButts said.

  But there was one other problem facing AT&T as its executives gathered in Florida that May. And John deButts did not appreciate just how large a problem it was about to become.

  On March 30, in preparation for the Key Largo meeting, deButts’ executive assistant in New York had written letters to all the participants asking if there were any special topics they thought should be included on the conference agenda. The response had been overwhelming. Many of the presidents of the basic operating companies, as well as some top officers of Western Electric, Bell Labs, Long Lines, and other divisions that made up the Presidents’ Conference, agreed that there was one problem facing AT&T that demanded immediate and decisive action: competition.

  John deButts understood why the presidents were upset. The competition AT&T was facing in the telecommunications industry made his blood boil. The new chairman, though, hadn’t yet decided what to do about it.

  The competition came in two varieties. In 1968, in a landmark decision known as Carterfone, the Federal Communications Commission (FCC), the federal government agency responsible for regulation of the communications industries, had ruled that the “terminal equipment” market should be opened up for the first time to companies other than AT&T. “Terminal equipment”—or “CPE” (customer premises equipment), as it was known inside AT&T—was really a bureaucratic euphemism for “telephones” or “telephone equipment.” Before Carterfone, AT&T had owned virtually every residential telephone and business switchboard in the country, and it leased the equipment to customers. But the FCC, which was under political pressure to do something about AT&T’s deteriorating phone service and rising profits, and which felt that AT&T was unable to keep up with the explosion in new telecommunications technologies, decided that independent companies making new communications devices like answering machines and mobile radio phones should be allowed to interconnect with AT&T’s switched phone network, a privilege that had been previously denied them. Suddenly, phone users could buy non-AT&T equipment and plug it into the telephone lines at their homes or businesses.

  But another, even more threatening kind of competition had been nibbling away at AT&T prior to the Key Largo meeting. It was referred to in industry jargon as “intercity services.” And on that clear May morning when the presidents of AT&T’s operating companies gathered in the Ocean Reef Club’s Everglades Meeting Complex for their long-awaited free exchange with John deButts, it quickly became obvious that intercity services competition was the root cause of the executives’ simmering discontent.

  Richard Hough, president of the Long Lines department, began the meeting by briefing his colleagues on where the situation stood. In 1969, one year after Carterfone, the FCC had handed down another decision that had stunned AT&T’s executives: The commission had granted the application of an embryonic, underfinanced, and aggressive company called Microwave Communications, Incorporated, to enter the intercity “private line” business between Chicago and St. Louis. MCI, which then had only about two dozen employees, would sell private long-distance lines to companies with offices in both the cities MCI served, but it would not provide long-distance service to residential or business customers. For a flat monthly rate, a company could connect the phones in its St. Louis offices directly to the phones in its Chicago offices, and it could save money by avoiding AT&T’s switched long-distance network. AT&T was also in the private-line business, but MCI promised the FCC that its prices would be lower than Bell’s because it would operate more efficiently. While AT&T had to pay for the nation’s basic local phone network—made up mainly of expensive copper wires—MCI would employ a new and cheaper technology: microwaves. MCI proposed to erect a string of microwave towers between Chicago and St. Louis and to “broadcast” its calls on a microwave beam. The technology had actually been developed by AT&T, and Bell also employed microwaves on many of its long-distance routes. But since MCI’s costs were not inflated by the upkeep of the basic wire-and-cable phone network, it could reap savings by using microwaves exclusively, and thus could charge less for its private-line service than AT&T. At least, that is what MCI claimed.

  Preoccupied with major service crises such as the one in New York, AT&T’s executives had paid little attention to MCI after its application was granted. There was a serious question as to whether MCI could ever raise enough money to get started with its ambitious microwave construction project. And even if it did, there were doubts about whether the company could find enough customers to support its limited network.

  Three years later, as Hough reminded the assembled membership of the Presidents’ Conference, MCI was still around, and it was beginning to steal away a startling number of AT&T’s Chicago and St. Louis customers by pre-selling its service. (MCI had not yet even begun to construct its microwave towers.) Hough told the AT&T presidents why MCI was having such early success: its monthly rates were at least $100 less than AT&T’s. And then he asked the crucial question: “What should our response be?”

  There were two choices. The company could leave its prices alone and just absorb the loss of private-line revenues as AT&T’s previous chairman, H. I. Romnes, had done. Or, the company could lower its private-line prices and go head-to-head with MCI. This was the strategy the operating company presidents intended to urge on deButts.

  “There’s been a change in MCI’s position,” one of the presidents pointed out as the discussion got under way. “Now they say that the viability of Chicago-St. Louis depends on interconnections with other MCI routes.”

  The implication was clear: there might be no end to MCI’s ambitions. The fledgling company might build on its Chicago–St. Louis route and create a national microwave network. That possibility outraged the AT&T presidents. AT&T’s private-line and other long-distance prices, which were continually disputed and scrutinized by state and federal regulators, were set under a complex system referred to by AT&T as “nationwide average pricing” and “separations.” 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. True, AT&T’s private-line sales represented just a tiny fraction of the company’s enormous revenues, and the FCC had said clearly that MCI would never be permitted to provide regular long-distance service. Still, any form of long-distance competition would inevitably drive AT&T’s prices toward the company’s costs: The price of local service, where costs were high, would rise dramatically, while the price of long-distance, where costs were lower, would decline. This possibility troubled AT&T�
�s executives. What would happen to the Bell’s delicate system of “public service” subsidies if MCI continued to grow? What would happen to AT&T’s profits if it began to lose revenues in areas where AT&T’s profit margins were high?

  Or, as one of the presidents now put it, “How badly would we be hurt if we wait until we see the whites of their eyes?”

  The anger of the local operating company presidents began to pour out. For months now, they had been forced to sit idly by while MCI went after some of their largest business customers. AT&T’s New York management had done nothing to prevent it. “I would meet ’em or beat ’em,” exclaimed T. S. Nurnberger, president of Northwestern Bell. “You bastards are not going to take away my business!”

  “Shouldn’t we act now, rather than wait until they have going businesses which regulators might not permit us to dislodge?” added A. W. Van Sinderen, president of Southern New England Telephone.

  “If we’re going to do this, we have to do it now,” another president chimed in.

  Nurnberger seemed ready to explode. “How many MCIs will proceed with construction plans if we file matching rates now? A big fat zero!”

  “We must take account of the prospect of intrastate competition,” said Charles L. Brown, who was at least as frustrated as Nurnberger—as president of Illinois Bell, Brown’s territory was under direct attack from MCI. “There are large amounts of revenues that are vulnerable, which we can preserve if we choke off now. I think you have to hit the nails on the head.”

  It was a metaphor that Brown, already being groomed as a possible successor to deButts as AT&T’s chairman, would later regret.

  The meeting broke up around noon, and the executives wandered out of the conference room and onto the sunlit grounds of the Ocean Reef Club. DeButts had gotten the free exchange he had asked for—and then some. But what would the new chairman do? The presidents knew that deButts was as distressed by the FCC’s piecemeal, procompetition decisions as they were. But deButts also appeared to believe deeply in the service traditions of the Bell System, including nationwide average pricing, from which he might be unwilling to deviate.

  No direct answers from deButts were forthcoming. But in his closing remarks on Friday, AT&T’s new chairman gave the presidents a glimpse of the strategy he was forming. Addressing the topic of terminal equipment competition, deButts told his lieutenants, “Why, then, is it not an altogether rational position to state that it will take time to resolve an issue of such far-reaching implications as this one? And why shouldn’t we use that time in two ways: one, conveying our concerns in realistic terms to regulators and the public so that the long-term public interest implications are clear, and two, putting our own house in order?”

  There would be no immediate changes. DeButts intended to wait.

  On June 22, 1972, six weeks after the AT&T executives departed Key Largo, MCI issued a public offering of stock and raised more than $100 million for the company. In the prospectus that accompanied the offering, MCI announced plans to expand its Chicago-St. Louis route by constructing a network of microwave communications towers encompassing 165 American cities from coast to coast. When they learned of MCI’s ambitious plans, it seemed to John deButts and his angry presidents that a gauntlet had been laid down.

  Chapter 2

  The First Shot

  William McGowan, the chairman of MCI, had for years been rich in potential but short on cash. So when his fledgling company became suddenly flush in the summer of 1972, one of the first things McGowan did was move its corporate headquarters some three blocks away, into a brand new, twelve-story building at the corner of 17th and M Streets in northwest Washington, D.C. He abandoned the rented office furniture that had cluttered his old headquarters and acquired for himself a large, oval desk with a center standard. The desk lent an air of authority and constancy to McGowan’s new and spacious corner office on the ninth floor—and the impression of permanence was exactly what McGowan intended to cultivate in the months ahead. Though his company had leased only two floors, McGowan persuaded his landlord to affix three large, black letters to the building’s exterior façade so that passing motorists and pedestrians on busy 17th Street would be reminded daily that MCI had arrived.

  The touch was typical of McGowan, a man who believed in playing every angle, especially when there was money at stake. Once, vacationing on a Caribbean island and finding himself stranded by a local airline strike, McGowan had chartered a jet to the States and paid for it by selling tickets to frustrated tourists at the airport, rescuing his fellow travelers and clearing a handsome profit at the same time.

  He had grown up in Wilkes-Barre, Pennsylvania, a bleak Appalachian coal town colored gray by smoke and soot from dozens of nearby anthracite coal plants. His father was a union organizer who worked with the men at Wilkes-Barre’s bustling railyards, where tons of coal moved in and out of the city on five different railroad lines. McGowan knew early and profoundly the ethic of relentless hard work that drove Wilkes-Barre’s smokestack industries, and if he was ever inclined to forget that ethic in adolescence, the corporal discipline meted out by the nuns in the Catholic schools he attended provided a painful reminder of his obligations.

  McGowan seldom needed to be pushed, however. By the time he graduated from a local college, the coal fields were nearly depleted and Wilkes-Barre was in decline; and McGowan was determined to leave the city’s encroaching despair behind him. After brief military service, he worked his way through Harvard Business School on the G.I. bill, graduating in 1954 in the top five percent of his class. His classmates went on to entry-level management jobs in America’s largest corporations, including AT&T, but McGowan shunned such opportunities. He began to hustle, working for a multitude of small, entrepreneurial, start-up companies that were dabbling in new technologies. Five years out of school, McGowan launched the Powertron Corporation, a modestly successful company that made ultrasonic devices. He sold the company quickly and invested his cash in new ventures.

  In 1968, a lawyer in Chicago told McGowan about a company called Microwave Communications, Incorporated, which was in desperate need of both management and financial assistance. MCI was a skeleton then—it had no full-time employees, and its principal asset was a five-year-old application that had been filed with the FCC to provide point-to-point private-line service over microwaves between St. Louis and Chicago. McGowan investigated the idea and decided to put his money behind it. Immediately, he was appointed the company’s chairman and chief executive officer. One year later, McGowan’s gamble paid off—the FCC approved MCI’s application.

  By early 1973, aided by a $72 million line of bank credit, McGowan had taken MCI public, begun construction of the Chicago-St. Louis line, moved into his new Washington offices at 17th and M Streets, and laid plans for a national network of microwave towers. If all went well, Bill McGowan would soon be a very rich man, proprietor of the first independent, alternative long-distance telephone network in America.

  But all was not going well, and that was why, on an unseasonably warm Tuesday in early January 1973, McGowan summoned six of MCI’s key executives to the company’s ninth-floor conference room.

  The problem was AT&T. In order for MCI to pre-sell its new service to customers and to map out a business plan for its ambitious construction projects, the company had to make a deal with AT&T. MCI did not own any telephones, or local telephone lines, or any switching stations to connect them all together—nor did it ever intend to own such things. AT&T owned, maintained, and controlled the nation’s basic phone network. What MCI wanted was to interconnect with that network in the major cities where it planned to sell its private line services. An MCI customer in St. Louis, for example, would still use his Western Electric-made AT&T-owned telephone to call Chicago on an MCI private line. When he dialed, his call would travel out of his office over AT&T-owned lines, through a few local AT&T switching stations, and finally to a larger AT&T switching station that served the St. Louis area. Without MCI, the
call would then have been routed onto one of AT&T’s Long Lines to Chicago, where once again it would be switched through the local exchanges and into the customer’s branch office. What MCI proposed to do was to substitute its microwave system for the Long Lines part of AT&T’s network. When its St. Louis customer’s call reached the AT&T regional switching station, instead of traveling on an AT&T Long Line, the signal would be switched over to MCI’s microwave towers and would be beamed all the way to Chicago. At the Chicago end, the call would again be switched over to AT&T’s local lines, wending its way over the regular network into the branch office. This was the only feasible way for MCI to provide its service. It would be financially impossible for MCI to build its own labyrinthine local phone networks in St. Louis and Chicago simply to handle the long-distance calls of MCI’s customers.

  That meant that MCI had to negotiate to use AT&T’s local phone networks in every city where there were MCI customers—and there was the rub. AT&T was not going to let MCI use its local networks for free. When the FCC authorized MCI to go into business, over the strenuous objections of AT&T’s Washington lobbyists, the commission told AT&T that it had to allow MCI to interconnect with the basic phone network. But the commission didn’t tell AT&T how much it should charge MCI for connections, or how fast AT&T should install MCI’s lines, or how AT&T should calculate its own costs when determining an interconnection price for MCI. All of that was to be worked out in negotiations between AT&T and MCI.