AT&T Is Ordered to Reduce Charges

Date July 5, 1967

Suspicious accounting practices triggered an investigation of AT&T’s activities that resulted in a $120 million reduction in charges for long-distance services.

Also known as American Telephone and Telegraph Company

Locale Washington, D.C.

Key Figures

• Rosel H. Hyde (1900-1992), chairman of the Federal Communications Commission, 1966-1969
• Frederick R. Kappel (1902-1994), chairman and chief executive officer of AT&T in 1967
• Edward B. Crosland (b. 1912), American lobbyist for AT&T
• Benjamin Javits (1894-1973), American shareholder in AT&T
• Frank Morissey (fl. mid-twentieth century), California public utility commissioner

Summary of Event

After the Communications Act of 1934, the telephone communications market slowly evolved from a pure monopoly to a competitive oligopoly, in which a few carriers compete to provide long-distance and international telephone services. Under the Communications Act, a common (or main) carrier such as the American Telephone and Telegraph Company (AT&T) and its affiliated companies is compelled to make telephone services available to all customers at the same fees. A cornerstone for allowing AT&T to operate without competitive forces was that the government regarded the telecommunications industry as a natural monopoly. In a natural monopoly, a single firm can produce at a lower cost than can two or more firms in competition. Government regulation may then be appropriate to correct any problems caused by the lack of outside competition, such as high prices.

The Federal Communications Commission (FCC) has repeatedly stated that competition provides the best means for furthering the goals of the Communications Act, namely, providing the public with efficient telecommunication services through adequate facilities at reasonable prices. The underlying rationale for the FCC’s reasoning is that competition brings prices down to the level of costs, thereby eliminating all profits above a normal rate of return while promoting innovation and improved quality of products and services.

AT&T’s confrontation with the government dates to 1949, when a report on Bell system practices found them in violation of the Sherman Antitrust Act , the main antitrust legislation of the United States. This report prompted the Justice Department to launch its first antitrust suit against the carrier. The Justice Department cited AT&T for maintaining a monopoly on the manufacture, distribution, and installation of telephones and related equipment. It forced AT&T to cut links with Western Electric, which manufactured telephone equipment. Under the court settlement, AT&T would not engage in any business other than common-carrier communications and therefore would be prevented from later entering areas such as computer software, hardware, office automation equipment, cable television, data processing, and electronic information publishing. Some of these areas did not yet exist, but the general restrictions covered them. At the same time, Western Electric was restricted to the manufacture of equipment used by the Bell system.

By the 1950’s, the Bell system was under close watch for keeping telephone rates far above costs. The resulting profits caused other companies to raise the issue of antitrust violation. In 1956, the U.S. court of appeals reversed an FCC decision and ruled that Bell customers had the right to choose telephone equipment manufactured by companies other than Western Electric. The FCC had sided with AT&T, which had long contended that it could not provide telephone service except to customers with Western Electric equipment because it could not otherwise ensure safety or quality.

The origins of the FCC’s first confrontation with AT&T can be traced to the CaliforniaPublic Utility Commission (CPUC), which launched an official probe of Pacific Telephone and Telegraph (PT&T), a Bell subsidiary. Throughout the 1940’s and 1950’s, PT&T had managed to receive authorizations for many of the rate increases it sought from the utility commission. These increases ensured a comfortable rate of return for PT&T that climbed gradually from 5.5 percent to 6.75 percent per year. The 1960’s marked a new direction for the utility commission. Its economists found that the PT&T rate increases over the preceding years had been excessive. The CPUC internal study coincided with preparations by PT&T for a request for one of the largest rate increases ever.

The commission held public hearings on the issue for forty-nine days. It questioned PT&T’s accounting practices, which inflated operating expenses and therefore understated the company’s rate of return. The CPUC found that had PT&T adopted sound bookkeeping techniques, California telephone users would have saved more than $40 million per year. The findings led the commission on June 11, 1964, to order PT&T to cut its charges by approximately half and to refund all excessive charges retroactively. PT&T immediately appealed the decision to the California Supreme Court, which upheld the CPUC’s findings on April 28, 1965, but overturned the refund.

Prior to the turmoil, PT&T had maintained good relations with the CPUC. One of the reasons for this was that the CPUC had followed the FCC’s approach for negotiation, which allowed the phone company to present its case in private and then receive a rate increase. Strenuous relations between the CPUC and PT&T led the FCC to suspect that the impropriety surrounding the accounting techniques might not be an isolated incident, since the Bell subsidiaries used bookkeeping practices similar to those of AT&T. If PT&T had overcharged Californians, AT&T might be doing the same nationwide. Pressure on the FCC to investigate was exacerbated by the fact that it had never conducted an investigation of AT&T’s accounting practices. FCC Chairman Rosel H. Hyde, a longtime ally of AT&T, resisted the investigation as being unnecessary. Faced with opposition from within the commission, he finally yielded on October 28, 1965, and ordered AT&T to disclose “wide variations in earnings,” a precursor to a formal inquiry into its accounting practices.

AT&T’s chairman and chief executive officer, Frederick R. Kappel, announced that the investigation was “unwarranted and unnecessary” and tried to push for a return to the old tacit agreement with the FCC of surveillance and negotiation. He predicted that the public would be the ultimate loser. Kappel summoned AT&T’s chief Washington lobbyist, Edward B. Crosland, to raise opposition to the FCC decision. An AT&T shareowners committee was formed to lobby for that effort and prevent AT&T stock from falling in price. The committee included several influential figures such as Benjamin Javits, a New York attorney and brother of Senator Jacob K. Javits.

Despite claims that the probe was a conspiracy against telephone users, the FCC was determined to proceed with the investigation. It succeeded in confronting a barrage of telephone calls from angry stockholders, lobbyists, congressmen, and senators. The FCC chairman, now firmly supportive of the commission probe, launched an investigation into all aspects of AT&T’s charges and bookkeeping. The investigation found that AT&T’s records showed several accounting irregularities. AT&T was inflating operating expenses by adding expenses that did not pertain to its operations, such as lobbying and advertising. The result was a reduction in reported profits that made it easier to receive approval for petitions for rate increases. AT&T’s “base rate,” used to petition for rate increases, included among other things approximately $550 million for plants under construction. This was analogous to charging a potential tenant rent on a dwelling under construction.

AT&T billed its customers one month in advance for telephone charges and taxes. Advance billing gave the company interest-free use of money for one month, valued at $200 million a year. The company elected not to take faster depreciation rates for its equipment allowed under a ruling by the Internal Revenue Service. Had the company adopted the alternative depreciation method, it would have passed on these savings to the general public in the form of rate rollbacks, which would have reduced current profits and potentially made it harder to petition for rate increases. The FCC estimated that the difference in the two depreciation methods amounted to $4 billion in excessive billing between 1954 and 1966.

After two and a half months of testimony by more than sixty witnesses, the FCC concluded on July 5, 1967, that AT&T’s rate of return was higher than that of any comparable public utility and should therefore be reduced, from 8.5 percent to 7 or 7.5 percent. In addition, AT&T’s accounting techniques should be amended. The FCC’s verdict amounted to an annual cut of $120 million in AT&T’s revenues.

Significance

The development of microwave technology brought to the market significant transformations, by enabling carriers to connect users without wire facilities. The new technology revolutionized service and allowed expansion into otherwise inaccessible and unprofitable areas. In 1969, the FCC authorized Microwave Communications, Inc. (MCI) to construct and lease microwave facilities under a specialized common-carrier status. Soon thereafter, several other companies applied for the specialized common-carrier status.

Faced with overwhelming competition, AT&T tried to block the entry of new companies on the grounds that they would skim off the most profitable customers, thus taking away profits that AT&T used to subsidize service to unprofitable geographical locations. AT&T was forced to provide services to those locations under the terms of the Communications Act, but the new competitors would not be. In 1971, the FCC reaffirmed its inclination to limit AT&T’s dominance and rejected this “cream-skimming” contention.

One of the difficulties the FCC had to confront in regulating a natural monopoly was how to assess AT&T’s fair rate of return, which ultimately would influence long-distance rates. Although the theory of monopoly regulation is extensive, the telecommunications industry had specific issues that needed to be addressed. These included the lag between the time a rate is filed and when it becomes effective, the administrative costs of monitoring AT&T’s activities, and the inefficiencies resulting from a lack of incentives to compete.

A solution the FCC contemplated was to peg AT&T’s profits as a specified rate of return on investment. This policy’s shortcoming was that it would induce AT&T to increase its investments in an attempt to maximize its profits. The added spending might be beyond that required for efficiency.

An alternative control on profits was the FCC implementation of price caps, which limited rates rather than profits. The underlying belief was that price caps would entice AT&T to reduce its costs through efficiencies and innovation. At the same time, price caps avoided problems of wasteful overinvestment and minimized the administrative costs of regulation.

Bibliography

Averch, Harvey A., and Leland L. Johnson. “Behavior of the Firm Under Regulatory Constraint.” American Economic Review 52 (December, 1962): 1052-1069. A classic article on the economics of monopoly regulation, for the more sophisticated reader. Requires some background in economic and mathematical analysis.

Cauley, Leslie. End of the Line: The Rise and Fall of AT&T. New York: Free Press, 2005. Comprehensive history of the telecommunications giant, from its origins through the early twenty-first century. Bibliographic references and index.

Evans, David S., ed. Breaking Up Bell: Essays on Industrial Organization and Regulation. New York: North-Holland, 1983. A classic textbook on the issues surrounding telephone regulation, price ceilings, and rate control.

Faulhaber, Gerald R. Telecommunications in Turmoil. Cambridge, Mass.: Ballinger, 1987. A textbook on developments and reorganizations in the telecommunications industry following the breakup of AT&T. Ties the changes to public policy issues.

Johnson, Leland L. Competition and Cross-Subsidization in the Telephone Industry. Santa Monica, Calif.: RAND Corporation, 1982. Written for a nontechnical audience. Summarizes the economics of regulation before the breakup of AT&T.

Larson, Alexander C., Calvin S. Monson, and Patricia J. Nobles. “Competitive Necessity and Pricing in Telecommunications Regulation.” Federal Communications Law Journal 42 (December 1, 1989): 1. A detailed article on competition in telecommunications, written from a legal perspective. Easy to read, with many nontechnical references.

Shooshan, Harry M., III, ed. Disconnecting Bell. New York: Pergamon Press, 1984. Discusses the Bell breakup and the impact of the AT&T divestiture.

Stehman, Jonas Warren. The Financial History of the American Telephone and Telegraph Company. 1925. Reprint. New York: A. M. Kelley, 1967. A historical reference that tracks AT&T’s financial activities. Simple and nontechnical.

Stone, K. Aubrey. I’m Sorry, the Monopoly You Have Reached Is Not in Service. New York: Ballantine Books, 1973. Provides excellent detail on the events that culminated in the FCC decision to launch its first investigation of AT&T. A simple, easy-to-read text for someone who hates technical reading.