Bell System History

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Bell System History

    The Bell System

    From "Encyclopedia of Telecommunications" - Charles L. Brown

    Copyright ? 1991 by Marcel Dekker, Inc.

    On March 10, 1876, when Alexander Graham Bell spoke into the transmitting instrument, "Mr. Watson, come here, I want to see you," he could envision already a great

    national telephone system. As he wrote to his father that same evening, "I feel that I have at

    last found the solution of a great problem, and the day is coming when telegraph wires will be

    laid on to houses just like water or gas is, and friends will converse with each other without

    leaving homes." Bell later expanded upon his expectations:

    It is conceivable that cables of telephone wires could be laid underground, or

    suspended overhead, communicating by branch wires with private dwellings, country

    houses, shops, manufacturers, etc., etc., uniting them through the main cable with a

    central office where the wire could be connected as desired, establishing direct

    communication between any two places in the city. Such a plan as this will, I firmly

    believe, be the outcome of the introduction of the telephone to the public. Not only so,

    but I believe in the future wires will unite the head offices of the Telephone Company

    in different cities, and a man in one part of the country may communicate with another

    in a different place. (1)

    All of this and more would come true, of course, but even the optimistic inventor could not have predicted what would grow to be an association of companies that bore his name,

    the Bell System. By the time of its breakup nearly 108 years later, the Bell System would

    have assets of $150 billion and over one million employees. It would be the largest private

    business enterprise in the world.

    Ever the inventor, Alexander Graham Bell was not interested in the business of converting an invention into a successful enterprise. Apart from public talks to publicize his

    invention, and later appearances as a witness in the extensive litigation over his patents,

    Alexander Graham Bell became simply a Stockholder whose primary interests were in other

    scientific and humanitarian endeavors.

Origins and Early Corporate Development (Table 1)

    Actually, the first business venture had begun before the invention with an agreement between Thomas Sanders, Gardiner G. Hubbard, and Bell dated February 27, 1875. Formed

    as a basis for financing Bell's experiments, the agreement came to be called the Bell Patent

    Association. The only tangible assets of this association were an early Bell patent,

    "Improvements in Transmitters and Receivers for Electric Telegraph," his basic telephone

    patent, No. 174,465, an "Improvement in Telegraphy" (March 7, 1876), and two additional

    patents that followed. With his efforts successful, Bell married Mabel Hubbard, his partner's

    daughter, in July of 1877, and as they prepared to leave for Europe, the three members of

    the patent agreement formed the Bell Telephone Company, a Massachusetts association. At

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    first, the company had only one full-time employee, Thomas Watson, but a few days later, R. W. Devonshire was hired - to keep the books. The company's 5,000 shares of stock were

    distributed as follows:

    Alexander Graham Bell - 10 shares

    Mabel Bell - 1497 shares

    Gardiner Hubbard - 1387 shares

    Gertrude Hubbard (née Mercer) - 100 shares

    Thomas Sanders - 1497 shares

    Thomas Watson - 499 shares

    C. E. Hubbard (Gardiner's brother) - 10 shares

    The enterprise's prospects were poor. Shortly after the Bells left for Europe, Gardiner

    Hubbard offered to sell all the Bell patents to William Orton, president of the giant Western

    Union Company, for $100,000. Seeing no way that the “electrical toy" could benefit his

    business, Orton refused the offer. Rejected, Hubbard set out again to turn Bell's invention into a successful business. His first and most important decision was to lease the telephone instruments instead of selling them. A similar strategy had been adopted by the Gordon-McKay Shoe Machinery Company, for which Hubbard had been an attorney. Although

    leasing would enable the Bell interests to protect their patent rights, it actually increased the enterprise's needs for funds to move the business forward.

    When the Bell Telephone Company was formed on August 1, 1877, only 778

    telephones were in use and the firm desperately needed additional capital. Hubbard's second strategic decision was to solve that problem by using agents to develop the business in other regions and in promising local markets. Thomas Sanders managed to convince a group of

    men from Massachusetts and Rhode Island to invest in a firm to develop the telephone in New England. On February 12, 1878, they formed the New England Telephone Company

    (this firm has no direct relationship with the present-day New England Telephone and

    Telegraph Co.) and set about the task of leasing the telephones to customers in the urban Northeast. Still, the Bell interests were short of funds, and to bring in new investors and the much needed capital, they incorporated a reorganized Bell Telephone Company in

    Massachusetts on June 30, 1878. The next month, Hubbard persuaded Theodore N. Vail,

    then superintendent of the government's Railway Mail Service, to join the new company as general manager. Along with O. E. Madden (who was recruited from the Domestic Sewing

    Machine Company and placed in charge of agency operations), Vail brought professional

    management to the Bell enterprise for the first time.

    One of the other hallmarks of the American telephone system - rapid technological

    progress - also became evident during these early years. At first, each pair of telephones was connected by a single line-an expensive and ineffective arrangement. The solution to this problem was the telephone switch and central office or exchange (and with it, the first operators). At the exchange, all of the local telephones were connected to a switch, very

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    simple at first, but growing increasingly complex as more and more lines were added. The switch became the switchboard, and the first telephone exchange opened on January 28, 1878, in New Haven, Connecticut.

    The Bell Company soon was able to demonstrate that the telephone worked, that it

    was useful, and that large numbers of urban Americans would pay to have this service. Indeed, only a few months after turning down Hubbard's offer, Western Union realized that it had made a mistake: customers for the telegraph company's stock ticker service were busily ordering telephones. In 1878, Western Union bought Elisha Gray's telephone patents, commissioned Thomas Edison to work on improvements, and organized the American

    Speaking Telephone Company. This set the stage for a major corporate battle with the fledgling Bell Company (2).

    Vail, the new Bell general manager, took up the battle. Vail sent a copy of the Bell

    patent to every agent, along with a letter asking each of them to keep fighting. "We have the original telephone patents," he wrote. "We have organized and introduced the business and do not propose to have it taken from us by any corporation." He tried to bolster the agencies so they would have "sufficient vitality to carry on a fight . . . " (2). At this point, however, the situation looked bleak. Edison had developed a much better transmitter. Western Union was using its superior resources to gather in new subscribers in the nation's largest cities and had penetrated even the Bell stronghold in Massachusetts. Hubbard and Vail responded with a patent infringement suit, but that legal skirmish threatened to drag on for many months. It was thought that the Bell firm might well go under before the courts could decide the matter.

    Determined to best the telegraph company, Bell's investors decided to strengthen and

    reorganize their undertaking in late 1878. They brought William Forbes, a Boston financier, onto the board of directors. Forbes had considerable business experience and a keen appreciation of the problems of running a large, complex company. He submitted a reorganization plan that the board accepted early in 1879. Under this plan, authority was centralized in a new executive committee. Hubbard and Sanders were no longer in charge. Forbes became president of the revamped and recapitalized National Bell Telephone Company, an organization that consolidated the New England Company and the old Bell Company. Theodore Vail continued to serve as chief operating officer for the consolidated operations.

    Revitalized, National Bell intensified the competition throughout the country, and

    Western Union, concerned that the courts might uphold the Bell patents, decided to negotiate a peace treaty. Western Union agreed on November 10, 1879, to a settlement of the infringement suit and withdrew from the telephone business for the duration of the Bell patents. It sold its 56,000 telephones to National Bell. In return, Bell agreed to refrain from entering the telegraph business and to pay Western Union 2007o of all royalties paid under its former license contracts. The agreement reflected the fact that, in 1879, telephone and telegraph technologies were essentially complementary: the telephone could not be used over long distances, but it was more practical than the telegraph for local communications.

    Before many years had passed, however, technological progress undercut the

    agreement. The Bell Company could now raise the capital it needed to promote the toll

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business between exchanges, to acquire new patents covering all aspects of telephone

    equipment and operations, and to defend the original patents. (During the 17 years of the

    patent monopoly, the Bell companies filed over 600 infringement suits and won all of them.)

    Their resources were now up to the task of encouraging technical development and rapid

    growth. When a new Massachusetts corporation, American Bell Telephone Company, was

    organized in April 1880, it was capitalized at $10 million. American Bell could afford to press

    forward with the toll business, gradually extending the distance over which long distance

    transmission was possible. When the local exchanges hesitated to comply, American Bell

    began to consolidate them into larger units. An 1891 annual report commented:

    As methods are devised for making the telephone commercially useful over long lines,

    the advantages of the centralization of management will be more apparent, as well as

    the importance to the public of having the business done in large territories under one

    responsible head, with far-reaching connections throughout the whole country. (3)

    In addition to consolidating the licensees, American Bell acquired a larger, more productive manufacturing installation. Initially, all of its telephone equipment was

    manufactured at Charles Williams's electrical shop in Boston, where Watson and Bell had

    conducted their early experiments. However, the demand for the telephone apparatus soon

    became too large for this shop and manufacturing was contracted out to several

    independently owned and managed electrical manufacturing firms. But the problems of

    enforcing contractual agreements, maintaining quality, and adhering to patent specifications

    ultimately forced Vail and Forbes to decide that American Bell should exercise direct

    managerial control of this function. In February 1882, American Bell acquired the Chicago-

    based electrical manufacturing firm, Western Electric, and gave it exclusive rights to

    manufacture Bell telephone equipment.

    Other changes followed. In December 1883, the company split its small Electrical and Patent Department into two, more specialized units. Originally, it had organized this unit

    primarily to evaluate patents and devices developed by independent inventors. Now it

    organized a Mechanical and Testing Department responsible for "experimental work relating

    to circuit design and equipment inspection" (4). The staff of the two departments grew from 2

    to 20 and the Mechanical and Testing Department became the nascent research arm for the

    Bell Company. Vertical integration along these lines would be another hallmark of the Bell

    System for the next century. By 1884, when the 5-year license contracts had been replaced

    with perpetual contracts allowing American Bell to take equity positions in the licensees, the

    Bell enterprise was a far different entity than the loosely coordinated set of interests

    established in 1880.

    Despite its reorganization and recapitalization, American Bell was having trouble developing long-distance service between the exchanges. By early 1885, the limits of its

    approach to the regional toll business were evident. The Southern New England Telephone

    Company announced it was abandoning its 200-mile segment of the experimental toll line

    between Boston and New York City, even though the line was a technical success. For the

    most part, transmission problems had been solved, but the line turned out to be more costly

    than anticipated and the regional company was not interested in bearing the additional


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    These complications prompted Theodore Vail to devise a new way of organizing the

    long-distance service. With the blessings of his Boston superiors, Vail developed a separate, wholly-owned long-distance subsidiary. He recruited Edward J. Hall from the Buffalo, New York, exchange as general manager and Angus S. Hibbard from the Wisconsin Telephone Company as general superintendent (5). Vail, who became president of the new company, instructed Hall to incorporate the subsidiary, named the American Telephone and Telegraph Company (AT&T), in New York State, which had far less restrictive incorporation laws than Massachusetts. The charter would allow AT&T to increase its financing to "an unlimited amount." "Make the powers of this Company to build, buy, own, operate, lease, etc. . . . lines extending from any city in the state to each and every other city in the United States, Canada, and Mexico and to be connected by cable with the rest of the known world," Vail told Hall (6). The 1885 AT&T charter of incorporation contained these exact words. With the formation of AT&T, all of the basic functions-long-distance service, local operations, manufacturing, and research and development -that would comprise the Bell System were now in place and, with the addition of network manager responsibilities, American Bell's role as parent company became more complex.

    Hall recognized that AT&T's commercial success depended upon its ability to use all of

    the existing exchange and toll facilities belonging to Bell licensees as "feeders" into its inter-city network. But it was no simple matter to persuade the licensees to cooperate. They had their own business to tend to and their own interests to serve. AT&T found itself embroiled in such disputes as the one that arose over the building of a trunk line between New York and Philadelphia; American Bell, the Metropolitan Telephone and Telegraph Company of New York, and the Bell Telephone Company of Philadelphia could not agree on the terms of interconnection. This dispute held up construction of the line until January 1886. Some officials in American Bell thought the answer was to make all the associated companies wholly-owned subsidiaries. But Hall cautioned that a more gradual restructuring was needed. American Bell, he thought, should avoid a conspicuous move toward establishing a national telephone monopoly. His view won out, although American Bell did increase its equity position in the licensees. Ten years later, a complete consolidation of the associated companies was again considered and rejected for the same reasons.

    During these years, the Bell System experienced only modest growth in the number of

    exchanges, but the pace of technical advancement was very rapid. Circuit capacity was increased; grounded iron wire was replaced by new metallic circuits; and the common battery system was improved. As long-distance operations reached into more and more local areas, American Bell pressed the local companies to standardize their equipment. These efforts often were rebuffed by the local companies. Bell officials found that they had to proceed gradually, developing new specifications by consensus and leaving compliance to be monitored by the local firms in the System. American Bell also recognized that a standardized accounting system was needed to report results throughout the System, but attempts to introduce one ran into many of the same problems of implementation. In fact, it was 1891 before a compromise plan, reflecting an emphasis on operations as the main source of revenue rather than patent-based royalties derived from equipment rentals, could be introduced (5).

    Although American Bell was making progress in spreading the telephone and

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    integrating the System's technology, Vail was not satisfied. He thought the Boston investors were too interested in large dividends and wanted those funds to be pumped back into the long-distance network. Disgruntled over the firm's shortsighted policies, he left the telephone business in 1887. When the Bell patents expired in 1893 and 1894, American Bell would have to face a new era without Vail.

Competition and Consolidation-The National Network Emerges

    On the eve of that new age in 1892, there were nearly 240,000 telephones in use in

    the United States, most of them in urban areas, largely in the eastern part of the country. Within 6 years after the patents expired, over 6000 independent telephone companies had entered the business, quickly extending service into rural areas and small communities. Some cities found themselves with two or even three competing firms offering services, usually at rates lower than the local Bell Company. Competition forced the Bell companies to cut prices and seek new ways to enhance operating and managerial efficiency.

    As the competition intensified, American Bell's need for capital to finance growth

    became enormous. After reaching an accommodation with the state of Massachusetts, the firm issued 5000 new shares in late 1894, followed by another block of 10,000 in 1895, and another of 21,500 a year later. In 1898, American Bell took advantage of a recovering economy to issue $10 million in 10-year bonds, launching a new phase in the company's financing. Even though the Bell System was continuing thus to grow, its managers decided that the corporate climate of Massachusetts was too restrictive, and on December 31, 1899, they made the New York-based American Telephone and Telegraph Company the parent company of the System. At this point the Bell System-the name now appearing on the company's new seal-was organized institutionally much as it would be some 83 years later (Fig. 1).

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    Fierce competition forced the Bell company to develop a variety of new policies: for

    instance, it began sublicensing of some independent exchanges, in effect bringing them into the System; it began to extend greater financial aid to Bell exchanges; it continued to push the expansion of the long-distance lines; it acquired strategically located independent exchanges, and it launched patent infringement suits. Clearly, its long-distance network was the single most significant edge the company had (just as Vail had predicted). The independent companies made several attempts-some individually and others collectively through their association, the Independent Telephone Association-to develop competing networks, but all of these efforts failed. Nevertheless, the competitive battle continued to accelerate telephone development: by 1907, there were about 3,132,000 Bell telephones and 2,987,000 independent telephones in use.

    Other important changes took place in the Bell System during these years, but they

    were obscured by the furor over competition. The company's precarious financial situation allowed the J. P. Morgan banking interests to gain a strong voice in the company's affairs, and in 1901, Morgan tried to entice Vail to return to Bell's management. He refused, but did become a member of AT&T's board of directors. Efforts at administrative centralization and standardization also continued. The AT&T Engineers Department had by this time become the focal point for developing specifications and encouraging technical progress throughout the System. By this time, too, Western Electric had become more than just a manufacturer of equipment; it provided purchasing services, warehousing, and distribution for the various Bell companies. In 1908, these arrangements were institutionalized with the introduction of the "standard supply contract" between Western and each of the licensees (5).

    Under President Frederick Fish (1901-1906) the company made great strides, taking

    on the characteristics of an integrated (albeit somewhat loosely organized) system. But competition became even more fierce. By 1906-1907, AT&T had run out of funds essentially

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and was forced to curtail virtually all licensee capital expenditure programs. The bankers

    were worried understandably, and they finally enticed Vail to return to active management. In

    1907, he became president of AT&T.

    Although 62 years old, Vail dug into the System's problems with unusual vigor. He kept investors and the general public well informed about the problems and the solutions he was

    developing. The AT&T annual reports for the years 1907 through 1915, reportedly written by

    Vail himself, directly addressed the company's difficulties and clearly spelled out Vail's

    policies and strategies. He clearly articulated the company's central mission - universal

    service - in the 1909 Annual Report:

    The value of a telephone system is measured by the possibility of reaching through its

    connection anyone-at any possible place.... It must be a system that will afford

    communication with anyone that may possibly be wanted, at any time. To do this, the

    system must offer a connection of some kind, and at such rates, as will correspond to

    the value of the system to each and every user.

    As Vail explained, the Bell network was "one system telephonically interconnected,

    intercommunicating, and interdependent" (7). Vail made "One System, One Policy, Universal

    Service" the Bell System credo. Government regulation also played a role in Vail's plans. He

    clearly recognized that the System he proposed a universal, integrated monopoly - would not

    meet with public approval without some form of public control. Wanting to avoid municipal

    ownership and the ever-present specter of nationalization, Vail embraced state regulation.

    Although he liberalized AT&T's policy on interconnection with the independent companies, Vail continued an active policy of acquiring other firms. Consistent with his vision

    of a single integrated national system was AT&T's acquisition of a 30% interest in Western

    Union. For a short time, the telegraph company was operated in conjunction with AT&T.

    Meanwhile, Vail moved to strengthen the company internally. He shifted the AT&T Engineering Department from Boston to New York and consolidated it with the Western

    Electric research staff. In 1907, he launched a major reorganization of operations, changing a

    territorial organization into a functional one with three major operating departments-plant,

    commercial, and traffic. First, he reorganized the Long Lines Department. It proved more

    difficult to persuade the associated Bell companies to adopt the new structure, and Vail

    accepted a reasonable amount of latitude where they were concerned. But no longer would

    he allow the operating companies to direct Western Electric to manufacture equipment to

    their own specifications. AT&T now standardized the equipment and began to set standards

    for operating procedures as well throughout the Bell System.

    By 1911, the Bell System was gaining the upper hand in the national marketplace for telephone service. Independent company growth had stopped and the number of

    independent company stations in service declined as Vail's aggressive policies took effect.

    The independents fought back by protesting to the U.S. Department of Justice, which began

    monitoring AT&T for potential antitrust violations. Under this pressure from the independent

    companies, the government filed a suit in July 1913. The complaint focused on AT&T's

    interconnection and acquisition policies in Oregon and sought divestiture of the acquired

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    properties. With antitrust sentiment strong throughout the nation and the Postmaster General advocating nationalization of the telephone system, AT&T decided to settle the case. AT&T vice president Nathan C. Kingsbury sent the government a letter of agreement that became known as the Kingsbury Commitment. In it, AT&T agreed: (1) to dispose of its Western Union holdings; (2) to permit the independent companies limited interconnection with its long-distance network; and (3) to refrain from purchasing additional independent properties without approval from the U.S. Interstate Commerce Commission.

    Although the Kingsbury Commitment settled the antitrust issue for a time, the

    government took over the telephone and telegraph systems for a short period during World War I. After the war, there was some interest again in nationalization, but the government returned the System to private operation as of August 1, 1919. Congress endorsed this arrangement-including the Kingsbury understanding-by the passage of the Willis-Graham Act in 1921.

    One of the strongest arguments for private ownership and operation was the Bell

    System's record of technological progress. Vail clearly had improved the technical performance of the network. Bell engineers had risen to Vail's challenge to complete a transcontinental line in time for the Panama-Pacific Exposition. The line formally opened on January 25, 1915, with a ceremonial call between Alexander Graham Bell in New York, Thomas Watson in San Francisco, and Theodore Vail in Jekyll Island, Georgia. On October 21 of the same year, Bell engineers conquered the Atlantic, when one engineer atop the Eiffel Tower in Paris listened to another in Arlington, Virginia, via radio transmission. Such accomplishments as these highlighted the heavy investment AT&T was now making in research and engineering. The new, more important, position of research and development in the Bell System was institutionalized in 1925 with the founding of Bell Telephone Laboratories.

Refocusing in the Interwar Years

    By the time Vail retired as president in 1919, the Bell System had achieved its modern

    structure and mode of operations. The vertically integrated System was centralized technologically and dedicated to ongoing technical innovation. The operating companies still had considerable discretion in financial and political matters so that they could adapt to local conditions. This decentralization became increasingly important as state regulatory commissions strengthened their statutory authority.

    During the 1920s, with Harry Thayer and then Walter Gifford (1925) at the helm, the

    Bell System continued to expand service despite the financial problems of operating a regulated network in an inflationary era. In an effort to strengthen investor confidence, management set the annual dividend at $9 in 1921. But it was not easy to maintain this standard. The Bell System had a 46% debt ratio, and its costs were climbing faster than its revenues. Improved earnings were needed, so the Bell System vigorously and successfully pursued a round of rate cases through the state commissions. These state agencies had considerable latitude in determining the rate base and the rate of return, but their commissioners were often unsure how far their authority extended. There was great variation

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    among the commissions and, therefore, among the Bell companies both in the rates they charged and in the levels of earnings they allowed. Nevertheless, the commissions and Bell management were committed to achieving satisfactory and efficient universal service, and they functioned in relative harmony through the 1920s.

    During this period, Walter S. Gifford provided the Bell System with decisive and

    innovative leadership. For a while, AT&T had followed its research and development successes into new fields. It launched a commercial radio station, WEAF, in August 1922, and in October 1923, it established the Red Network. Adventures in the world of Hollywood with sound motion pictures began with Don Juan in 1926. Management organized a Western Electric subsidiary, Electrical Research Products, Inc. (ERPI) to market its new sound-equipment products. But Gifford decided the Bell System should concentrate on one business, providing communications services in the United States. He began to spin off or license many of these by-products of Bell research to others. He sold radio broadcasting to the National Broadcasting Company in 1926. Western Electric sold its extensive and well-established international equipment business, International Western Electric Co., to International Telephone and Telegraph Company (ITT) in 1925; 3 years later Western sold the Graybar Electric Co., an electrical supply subsidiary, to its employees. ERPI was allowed to continue, but it became a low-key, low-priority part of Western's business. As Gifford explained to the National Association of Railroad and Utility Commissioners in 1927, the Bell System had an unusual obligation "to provide the most telephone service and the best, at least cost consistent with financial safety" (8). Anything that threatened to interfere with the fulfillment of that "obligation" had to be changed or eliminated.

    Although the Depression hit the Bell System hard, AT&T was able to maintain the $9

    dividend and, along with it, investor confidence. The number of telephones in service actually declined and did not regain the 1930 peak until 1937, but Gifford was able to sustain public faith in the Bell System, which was particularly difficult since Congress was considering new legislation to regulate the telephone, telegraph, and broadcasting industries. In 1934, the legislature passed the Communications Act, which created a new independent regulatory agency, the Federal Communications Commission (FCC). The FCC quickly initiated the first comprehensive government investigation of the telephone industry. AT&T cooperated by turning over voluminous company files to the special investigation, but Bell management strongly criticized the fact that the FCC refused to allow the company to bring its own witnesses or cross-examine those called by the Commission. AT&T had cause to be concerned: Commissioner Paul Walker's report (1938) was a full-swinging attack on the Bell System, with particular emphasis on the ties to and the operation of Western Electric. AT&T replied in detail, and in 1939, the FCC approved a substitute for the Walker Report, retaining the data but toning down the criticisms of the Bell System. Still, the investigation and report drew lines of battle between the government and the Bell System, whose structure and monopoly status would be challenged again and again in the following years.

    During the next few years, however, the government was more interested in economic

    performance than in antitrust. World War II tested the Bell System's organizational and technological abilities to the utmost. Almost 70,000 Bell System employees went into the armed services, while on the homefront Bell Labs and Western Electric virtually stopped developing civilian telephone equipment in order to provide telephone facilities for army

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