U.S. Supreme Court Breaks Up the American Tobacco Company

Date May 29, 1911

The U.S. Supreme Court’s ruling that the American Tobacco Company engaged in unreasonable anticompetitive business practices led to the company’s dissolution.

Also known asUnited States v. American Tobacco Company

Locale Washington, D.C.

Key Figures

• James Buchanan Duke (1856-1925), founder and president of the American Tobacco Company
• John Sherman (1823-1900), U.S. senator from Ohio, 1885-1897
• Edward D. White (1845-1921), chief justice of the United States, 1910-1921

Summary of Event

Founded in 1890, the American Tobacco Company became one of the largest holding companies in the United States before its forced dissolution in 1911. In United States v. American Tobacco Co., the company was found guilty under the Sherman Antitrust Act of 1890 of monopolizing the cigarette industry through “unreasonable” business practices, including buying out rivals, excluding rivals from access to wholesalers, and predatory pricing.

The market for tobacco products includes smoking tobacco, chewing tobacco, cigars, snuff, and cigarettes. Developments in the cigarette market have had significant effects on other branches of trade. Early in the 1880’s, the cigarette industry experienced increasing competition in prices. Innovations in production technology, including Bonsack cigarette-making machines, which replaced hand labor, caused oversupply in the market. James Buchanan Duke, who first adopted the Bonsack machine for full-scale production, began to revolutionize the tobacco industry.

Duke entered the cigarette business in 1881 with his father, Washington Duke, in W. Duke Sons and Company, a smoking tobacco manufacturer near Durham, North Carolina. When the government reduced the tax on cigarettes by two-thirds, he cut the price of his cigarettes by half. In addition to price cutting, he launched an extensive advertising and promotion campaign for his Duke of Durham and Cameo brands, using huge newspaper ads and billboard displays. By 1889, advertising and promotion outlays amounted to about 20 percent of sales, an unusually high level within the tobacco industry.

In 1884, Duke began to operate a new factory in New York and to control the northern and western parts of the U.S. market. Price cuts and competitive advertising intensified among his and four other major cigarette manufacturers: Allen & Ginter, Kinney Tobacco Company, William S. Kimball & Company, and Goodwin & Company. In 1890, Duke took advantage of the New Jersey incorporation law of 1889 to organize a merger with those other four major cigarette manufacturers to form the American Tobacco Company. With $25 million in capital, the new company immediately became one of the biggest “trusts” or holding companies in the United States. It controlled nearly 90 percent of all domestic cigarette sales.

American Tobacco continued to expand its spending on cigarette advertising, with expenditures exceeding $4 million in 1910. Its competitive prices were the result of Duke’s efficient management, which kept operating costs substantially below those of most competitors. Duke’s cost-cutting practices included hiring nonunion labor at a wage rate lower than its union counterpart; an exclusive contract with the Bonsack Company for its cigarette-making machines, which cut production costs by fifteen to twenty-five cents per thousand cigarettes; vertical integration through forming extensive networks to perform all functions from purchasing leaf tobacco to warehouse storage to marketing cigarettes through its tobacco product retail chain, the United Cigar Store (which replaced the old industry method of using traveling salespersons); and discontinuing less profitable brands and closing less efficient factories.

By 1900, American Tobacco’s profits had risen to be more than half of sales. As public tastes switched to Turkish tobacco, however, American Tobacco’s cigarettes declined in popularity. Duke fought back with his own Turkish brands, regaining a market share of 85 percent of cigarette sales by 1910. Market shares for the company’s smoking and chewing tobacco also increased, to more than 75 percent of the U.S. market.

American Tobacco bought out about 250 of its competitors before its dissolution in 1911. In 1898, Duke had organized a combination of tobacco plug manufacturers, the Continental Tobacco Company. In 1901, the American and Continental companies were consolidated into the Consolidated Tobacco Company, a holding company that was soon dissolved and reorganized under the original name of the American Tobacco Company. In 1901, it stretched its market power overseas to England by buying Ogden’s Limited of Liverpool, a leading British cigarette manufacturer. One year later, Duke negotiated with the Imperial Tobacco Company to form the British-American Tobacco Company to operate in overseas markets.

The success of American Tobacco in the cigarette market did not prevent Duke from diversifying into other tobacco-related products. He waged the so-called Plug Wars by acquiring plug and smoking tobacco manufacturers including Liggett & Myers Tobacco Company and R. J. Reynolds Tobacco Company. In conjunction with its massive advertising campaign, it deliberately sold various “fighting brands” at prices below cost in order to bankrupt competitors. As American Tobacco became the monopoly in the market, advertising intensity subsided to less than 10 percent of sales.

Before American Tobacco was dissolved by order of the Supreme Court, the company had acquired approximately 95 percent of sales of snuff, 85 percent of chewing tobacco and cigarettes, and 75 percent of smoking tobacco. By the end of the nineteenth century, the growth and practices of large trusts, especially those in the oil, sugar, and tobacco industries, had brought the attention of the U.S. Department of Justice, which sought to restore competition in the marketplace.

In 1890, the first major U.S. antitrust legislation, the Sherman Antitrust Act, written by Senator John Sherman, was passed. It outlawed any restraints of trade (section 1) and attempts or conspiracy among competitors to monopolize a market (section 2). The antitrust campaign was intensified by President Theodore Roosevelt. On July 19, 1907, after one of American Tobacco’s subsidiaries was indicted for price fixing in the District Court for the Southern District of New York, the Justice Department filed a petition against the entire tobacco trust for violating sections 1 and 2 of the Sherman Act.

In November, 1908, American Tobacco was ruled guilty in a three-to-one vote. That decision was not finalized until May 29, 1911, when the Supreme Court sustained the lower court’s verdict. In the Court’s opinion, Chief Justice Edward D. White, following logic developed in the Court’s ruling against Standard Oil two weeks earlier, used the “rule of reason” principle in regard to American Tobacco’s monopolization of the cigarette industry. The rule of reason stated that monopolies were not necessarily unlawful; they violated the law only by acting “unreasonably.” White noted that the “undisputed” evidence of “unreasonable” business practices was overwhelming. This evidence included the original formation of the tobacco trust through the buying out of competitors, the use of the trust’s power to monopolize the trade in tobacco and the plug and snuff business further by using below-cost pricing, attempts to conceal the trust’s practices through secret agreements and creation of brands falsely promoted as independent, the practice of vertical integration with wholesalers and leaf tobacco suppliers to blockade the entry of others into the tobacco trade, and price fixing with some formerly independent tobacco companies.

The case resulted in a dissolution decree, which was issued in November, 1911. The circuit court was directed to form a plan to dissolve the trust and form a new decentralized market structure. As a result, American Tobacco was split into sixteen successor companies, including a new American Tobacco Company, Liggett & Myers Tobacco Company, P. Lorillard Company, R. J. Reynolds Company, and the American Snuff Company. It was dissolved from its purchasing subsidiaries and separated from Imperial Tobacco, its overseas subsidiary.

Significance

Along with the Standard Oil case in the same year, the American Tobacco case significantly altered the course of both the U.S. history of big business and the development of antitrust law. The victory of the U.S. government in these two cases highlighted federal efforts to promote competition in U.S. markets.

As for the tobacco industry, however, American Tobacco’s successor companies continued to have considerable market power. The dissolution decree gave the new American Tobacco, Liggett & Myers, Lorillard, and Reynolds a combined 80 percent of the smoking and chewing tobacco facilities of that time. Despite declining profits, the successor companies continued to increase advertising spending, which exceeded $10 million in 1912. Their total sales increased from the old American Tobacco’s $6.9 billion in 1910 to $11.8 billion in 1912.

In October, 1912, in response to declining market shares, four of the independent companies formed Tobacco Products Corporation. The new trust soon was joined by six more independents. Because the government concentrated its attention on American Tobacco’s successor companies after the dissolution decree, the case actually gave birth to other industrial combinations. The next few decades witnessed the rise of Brown & Williamson Tobacco Company and Philip Morris Company, the latter of which grew to become the biggest U.S. tobacco manufacturer by 1990.

In the 1911 Supreme Court decision against American Tobacco, Chief Justice White explained the Court’s interpretation and application of the Sherman Act, arguing that not all restraints of trade were violations of the antitrust law, only the “unreasonable” ones. White emphasized that it was not the mere size of American Tobacco in relation to its market that the Court condemned but the evidence of its “unreasonable” restraints of trade. The new doctrine, known as the rule of reason, set a precedent for a new era of Supreme Court antitrust decisions. The rule of reason stayed in force until the Alcoa case in 1945.

The Supreme Court ruling illustrated the need for additional legislation that would define specific business practices that were “unreasonable” and thus illegal. That need led to passage of the Clayton Antitrust Act and the Federal Trade Commission Act in 1914, which respectively declared specific business practices, including attempts to monopolize through mergers and acquisitions, to be “unfair” and gave birth to the Federal Trade Commission as an agency to enforce compliance with the modified antitrust law. In 1938, the Wheeler-Lea Amendment to the Federal Trade Commission Act was passed to give the Federal Trade Commission authority over consumer protection matters.

The dissolution of American Tobacco transformed the structure of the U.S. tobacco industry from a near monopoly to an oligopolistic structure with a few large companies. That character prevailed until the end of the century. The dissolution of American Tobacco immediately resulted in increased competition among its successor companies. Product variety and advertising and promotional efforts increased in attempts to increase brand loyalty. The average advertising expenses in the tobacco industry doubled in the two years following the dissolution. In 1913, R. J. Reynolds Tobacco Company introduced a new brand of cigarettes, Camel. Lorillard responded with its Tiger brand in 1915 and Old Gold in 1926, American Tobacco with Lucky Strike in 1916, and Liggett & Myers with Chesterfield in 1920.

The American Tobacco case, along with the Standard Oil case, signified the government’s negative attitude toward merger and acquisition activities. Mergers appeared to level off until the government’s failure in prosecuting the merger practices of U.S. Steel in 1920. As for the tobacco industry, even though competition increased with the rise of Brown & Williamson Tobacco Company and Philip Morris Tobacco Company, the biggest three successor companies to American Tobacco—the new American Tobacco, Reynolds, and Liggett & Myers—still maintained considerable market power, as a group controlling between 65 percent and 90 percent of the U.S. tobacco product sales during the next two decades. Such a market without major entry became the main evidence used by the Supreme Court to convict the largest three successor companies of conspiracy in monopolization and restraint of trade in 1946.

The practices of the American Tobacco Company contributed important lessons not only in the development of antitrust law but also in the role of marketing and advertising in business practices. Tactics innovated by James Duke and later by American Tobacco’s successor companies, including heavy use of advertising, became common in other markets for nearly identical products, such as the market for gasoline. Consequently, in 1938, the government stepped in with passage of the Wheeler-Lea Act, which gave the Federal Trade Commission jurisdiction to regulate advertising and promotional activities.

Bibliography

Adams, Walter, and James Brock, eds. The Structure of American Industry. 10th ed. Upper Saddle River, N.J.: Prentice Hall, 2000. Provides good coverage of the development of the tobacco industry as well as discussions of the industry’s structure, price behavior, and performance. Valuable for undergraduate and graduate students in industrial organization.

Armentano, Dominick T. Antitrust and Monopoly: Anatomy of a Policy Failure. 2d ed. Oakland, Calif.: Independent Institute, 1990. Covers major antitrust lawsuits since the Sherman Act and the development of antitrust legislation. Includes discussion of the American Tobacco case. Features an appendix of relevant sections of antitrust laws.

Cox, Reavis. Competition in the American Tobacco Industry, 1911-1932. New York: Columbia University Press, 1933. A good study of the performance and competition among the major tobacco companies.

Hovenkamp, Herbert. Federal Antitrust Policy: The Law of Competition and Its Practice. 2d ed. Eagan, Minn.: West, 1999. Covers nearly all aspects of U.S. antitrust policy in a manner understandable to readers with no background in economics. Chapter 2 discusses “history and ideology in antitrust policy.”

Porter, Patrick G. “Origins of the American Tobacco Company.” Business History Review 43 (Spring, 1969): 59-76. Concise historical study of the tobacco company until its dissolution in 1911 draws comparisons between big tobacco and the oil industry.

Tennant, Richard B. The American Cigarette Industry. New Haven, Conn.: Yale University Press, 1950. Detailed history of the cigarette industry through the 1940’s. Includes analysis of market behavior using economic models and statistical regression analysis. Excellent business or economics case study for undergraduate-level readers.

U.S. Bureau of Corporations. Report of the Commissioner of Corporations on the Tobacco Industry. Washington, D.C.: Government Printing Office, 1908-1909. Presents the findings of a government investigation of the tobacco industry, particularly the American Tobacco Company.

Whitney, Simon N. Antitrust Policies: American Experience in Twenty Industries. 2 vols. New York: Twentieth Century Fund, 1958. Chapter 11 of volume 2 provides in-depth discussion of the tobacco industry from different perspectives, including its price and product competition and its performance that resulted in the second antitrust lawsuit. Other chapters offer case studies of other major industries. Appendix contains critiques of the studies by economists and government officials.