The Deal of the Century

by Coll, Steve;

  Except for the inter-intra split. That was the best solution, Hugel thought, the only way to cut the phone company’s Gordian knot.

  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.

  And from that narrow yet essential perspective, the numbers on Charles Hugel’s blackboard were again compelling.

  The essence of John deButts’ “public interest” arguments to Congress and the FCC during the early 1970s was that competition in the telephone industry would destroy AT&T’s system of pricing subsidies. If competition flourished, deButts said, the price of phone equipment and service would no longer be determined by regulation, which was really a form of systematic political compromise between AT&T, the government, and the public. Over the years, those three parties had agreed, for purely political reasons, to keep the price of basic local phone service artificially low—at or below its cost. What outraged deButts and his red team generation of AT&T executives was that the FCC had decided in a piecemeal fashion to disrupt this political accommodation without ever considering, or taking responsibility for, the consequences. Charlie Brown and his generation of Bell executives agreed entirely with de Butts’ assessment, and they shared his outrage. But by the fall of 1981 they had accepted, as deButts never could, that a fundamental shift from regulated pricing to cost-based, free-market pricing was inevitable. The reasons why this radical and fundamental shift had occurred—again, purely political—did not alter the fact. And the fact, once accepted, demanded an equally radical rethinking of AT&T’s structure and business strategy.

  Charlie Brown’s question in August 1980, “Why are we fighting to keep our local monopoly?” preceded an obvious conclusion. If profit and loss in the phone industry now depended on costs, not regulatory accommodation, then the smart thing to do would be to jettison AT&T’s most costly, least profitable subsidiaries, the local operating companies, and retain its high technology profit centers, Western Electric, Long Lines, and Bell Labs. The inter-intra split. It was true that this restructuring was a major goal of the Justice case, but it was not that lawsuit’s only goal. The government was also trying to break off Western and Bell Labs. Losing both the operating companies and AT&T’s manufacturing arm would be an intolerable blow, Brown thought, because in a deregulated, cost-based phone industry, Western would become a major player in the phone equipment and computer markets. Or so it had to be, if AT&T was going to realize Brown’s vision of an emerging information age.

  There was something else. The clarity of the inter-intra split strategy, its appositeness in a fundamentally changing industry, was complemented by the sweet revenge it would wreak on Bill McGowan, the man so singularly responsible for the excruciating dilemma faced by Charlie Brown in the fall of 1981.

  The billion-dollar success of MCI and the vast personal fortune McGowan had made at Bell’s expense sometimes drove even AT&T’s most staid executives into a nearly apoplectic rage. Not only had McGowan built his company through legal skulduggery and deceitful lobbying, Bell’s leaders felt, he was now reaping the immense profits of his malfeasance without anyone calling him to account. Though it was in some aspects self-destructive, a pure inter-intra split was a way to hurry MCI toward its day of reckoning. Simply put, the divestiture of all the local operating companies would give McGowan everything he had ever asked for, and by doing so, it might well destroy him.

  Neither Charlie Brown, Howard Trienens, nor any of the other cautious and solemn top executives at 195 Broadway ever thought of this happy, coincidental consequence of the inter-intra split in such vengeful terms. But they understood it well enough.

  In 1978, in the aftermath of the U.S. Appeals Court decision that sanctified full long-distance competition by approving MCI’s Execunet service, MCI and AT&T had negotiated something called the ENFIA agreement. The agreement, in effect, specified the amount of rent MCI would have to pay the Bell operating companies for access to their local exchanges. The rent was $235 per line, per month. The “line” actually rented was a connection between a local MCI office and an operating company central switching station. An MCI customer’s long-distance call from, say, Washington, would travel by microwave to the MCI office in, say, Chicago. Then it would be routed over the line rented from the operating company to Bell’s central switching station for the Chicago area. From there it would travel through the local exchange to the telephone designated by the MCI customer when he dialed the call. The line between the MCI office and the central switching station could only carry one call at a time. If, at the peak of a business day, for example, MCI had 100 customers calling long distance from Washington to Chicago at the same time, it would need 100 rented access lines in order to route all the calls through the Chicago exchange. If it had not rented 100 lines, some of the callers in Washington would get a busy signal, and, presumably, they would then consider using AT&T’s long-distance service. So it was important for MCI to rent the correct number of lines in each market it served, and those at a low price. If it rented too few, MCI customers would get a lot of busy signals. If it rented too many or paid too much for access, the company would not make a profit.

  The $235 figure, then, was a key to MCI’s profitability in 1981. It represented a substantial percentage—more than one-fourth, and perhaps as much as one-half—of the actual cost of an MCI customer’s call. If the rent went too much higher, MCI’s cost advantage over AT&T—and its profits—would disappear.

  And the inter-intra split offered a way to raise MCI’s rent dramatically.

  In two ways, the monthly ENFIA (Exchange Network Facilities for Interstate Access) rent of $235 was a tremendous bargain for MCI. First of all, when the amount had been negotiated in 1979, it had been based on a hypothetical number of minutes that MCI was expected to use the line—approximately 4,500 minutes per month. Soon after the deal was made, MCI introduced some new, more sophisticated switching equipment that allowed it to use its rented lines about 7,500 minutes a month, over 50 percent more than had been anticipated. Already, then, MCI had achieved more than a 50 percent saving on its rent, a discount that would evaporate when the deal was renegotiated to reflect MCI’s actual usage. Secondly, the $235 price, even without figuring for the extra minutes, was about half what MCI could expect to pay eventually if the operating companies were divested in an inter-intra split. Because MCI’s Execunet long-distance service had been put together under such strange circumstances back in the mid-1970s, it was not really comparable in quality to AT&T’s. The system consisted of inverted FX lines combined in such a way that MCI customers could call freely from all the phones in one city to all the phones in another. But among other differences, MCI customers had to dial more numbers to make a call than did AT&T customers. So the $235 figure, it was agreed by both sides, represented a substantial discount from what MCI would pay if it ever had “equal access” with AT&T to the local exchanges. Such equal access would only be possible, as McGowan had said all along, if the operating companies were separated from his competitor, Long Lines
. Once independent, the operating companies could extract the same rent from MCI as they did from AT&T.

  And there was nothing Charlie Brown would have liked more than to compete with MCI on level ground, with each company paying the same rent for access to the local exchanges. Brown’s main complaint about the S.898 bill and the Quagmire II deal being negotiated with Justice that fall was that neither provided for competition on equal terms. 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.

  The question was, at what price for AT&T?

  In the fall of 1981, key headquarters executives such as Charles Hugel looked to Howard Trienens for leadership in the increasingly intense debate over the phone company’s future. There was no doubt that Charlie Brown was in charge, that he would take final responsibility for any decision about the inter-intra split. But the Bell chairman was a solitary figure on the twenty-sixth floor, a loner, genial but distant. He was not a man with whom one might share a cab uptown to the East 60s and then shoot the breeze over drinks in a hotel bar. In the evenings, he returned to his home in Princeton, New Jersey. In the mornings, he exercised, often alone. Trienens, on the other hand, was more accessible. Though he was a faithful ally of Brown’s, he bridged the generation gap in the company’s senior management. He was able both to synthesize and to separate the legal and business aspects of AT&T’s sundry problems in Washington, and he sponsored an atmosphere of frank but noncombative debate on the executive floors. And it was clear that he had the trust of both Brown and the board of directors.

  Trienens himself saw his job as a matter of analysis, not leadership. In the aftermath of Judge Greene’s September 11 opinion, as the Quagmire II negotiations and the now heavily amended S.898 bill slogged onward, Trienens began to develop for Brown a series of scenarios about AT&T’s legal entanglements. In October, George Saunders told him that he now believed Greene would decide against AT&T on liability and would order the divestiture of some or all of Western Electric, but probably not the operating companies. At the same time, Trienens quietly hired an independent law firm in Washington to conduct a “peer review” of the trial and to analyze its likely outcome. The idea was to bring a fresh set of eyes to a case about which neither Trienens, Saunders, nor any other AT&T lawyer could honestly claim to be objective anymore. The review tended to confirm what Saunders and Trienens had already concluded. Greene would find against the phone company on liability, and there was a serious danger that he would try to break off Western.

  Though he spent considerable time psychoanalyzing Judge Greene with Brown and the trial lawyers in Washington, Trienens knew that it would be a monstrous error to rely on his or anyone else’s predictions about Greene while developing a business strategy for AT&T. Confident though he was about where Greene was going to come out, it was impossible to forecast precisely another man’s actions, especially a man as subtle and complex as Harold Greene. Instead, Trienens developed that fall what he called “best case” and “worst case” scenarios about the Justice trial. In the best case, AT&T would win everything and the government would be forced to appeal. In the worst case, AT&T would lose and Greene would order the divestiture of all the operating companies, as the government was seeking. The odd thing about it was, as Trienens and Brown pored over the scenarios, the worst case seemed closer to being “good” than did the scenarios in between. That was because, as Trienens advised Brown, the more radical Greene’s verdict, the more likely it would be that the Supreme Court would hear the case and reject the divestiture. The idea that Greene himself would decide against AT&T was not a major concern for Trienens. Assuming the case was not settled or dropped, U.S. v. AT&T was ultimately going to be decided on appeal, not by Greene. What troubled Trienens was the possibility that Greene might leave the operating companies alone and divest some or all of Western. Trienens felt that Western was especially vulnerable because it had a long history in the litigation, dating even beyond the still-lingering 1956 settlement scandal. 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. And viewed in the context of seven decades of litigation between the U.S. government and the phone company, during which so many ill-fated attempts had been made to break off Western, its divestiture by Greene might seem politically acceptable to an appeals court—even logical.

  But as their hopes for a victory before Judge Greene were deteriorating in October, Trienens and Brown had reason to be optimistic that they might yet extricate themselves from their debilitating morass without having to sacrifice the operating companies in an inter-intra split. After all, though they were heavily capitalized and relatively unprofitable, the local operating companies nonetheless represented more than $80 billion in assets, $50 billion in annual revenues, and $5 billion in profits. No sane man would give them up unnecessarily.

  On October 7, the Senate had finally pushed S.898 to the floor, where it had passed 90–4. Privately, Trienens and Brown thought the bill was a mess—complex, ineffective, and unfair—but they continued to back it publicly in the hope that new compromises could be reached in the House or in conference. There was nothing to be gained by preemptively sabotaging the first telephone competition bill to clear a house of Congress in over a decade. One problem was that Bill Baxter had not been similarly reserved about expressing his opinion on S.898. The day after the bill cleared the Senate, the Antitrust chief had announced that if the House passed the bill in its present form, he would not drop U.S. v. AT&T—as he had promised the previous summer—because the Senate and the administration had tinkered with his amendments, the renowned Baxter I and Baxter II. Until the amendments were fixed, Baxter would withold his support.

  Despite the Antitrust chief’s tirade, Brown and Trienens were confident that once Representative Tim Wirth began to work on S.898 in November, serious bargaining would begin anew. Wirth was awaiting the results of a sweeping study on telephone industry competition that was being prepared by his staff. Once the study was complete, he would draft a companion to the Senate bill. Wirth was no friend of the phone company, but he had now been thrust into a position of leadership on an issue in which he had always taken a deep interest: telecommunications regulation. Brown and Trienens assumed that if nothing else, Wirth would want to take credit for authoring the first major telephone reform act passed by Congress since 1934 and would thus be in a deal-making mood. As the two AT&T executives liked to say when discussing the problems faced by their company that fall, “Congress sets the policy. That’s what they teach you in civics class.”

  And for the time being, Brown and Trienens were content to sit, and wait, and learn. No matter what Wirth did wit
h the reform legislation in the House, they knew that they could always go back to Charles Hugel’s blackboard.

  “Perhaps I was naive,” Charlie Brown said later, “but my basic thought was that policy was being made in the wrong place. I wanted to give every opportunity for the right place to be making the decision, and the Congress seemed the right place. Theoretically, everybody agreed about that; the problem was how to do it.… I was still optimistic about Wirth taking a leadership role.”

  Chapter 27

  Court of Last Resort

  Judge Greene’s face was contorted in agitation. Before him was a list of nearly 100 new witnesses, including several present and former cabinet secretaries, senators, famous business executives, the president of the National Association for the Advancement of Colored People, and assorted other public policy celebrities, all of whom George Saunders intended to call before AT&T rested its defense case. The judge had received the list earlier in the morning, and the rage it had produced in him was only now boiling to the surface.

  “And some of these people,” Greene was exclaiming to Saunders and Connell, who stood before the judge’s wooden bench on a cloudy November morning, “I don’t know what they are going to testify about, but it looks to me, at first glance, that they are more here for—I use my words carefully—for publicity value than for contributions to this case. I have tried very hard to not have this case deteriorate, and I am not going to have it conclude on a circus-like note!”