Engines That Move Markets (2nd Ed) Page 13

  Since two similar applications had appeared on the same day, the examiner for the US Patent Office, Zenas F. Wilber, followed procedure and suspended both for investigation. Hubbard’s lawyers appealed successfully, ensuring that Bell’s patent application was recognised as taking precedence, on the basis that it was filed first and was a full patent application while Gray’s was only a caveat. When Bell arrived in Washington in late February, he visited the Patent Office and spoke to the patent examiner. Bell was able to point out that he had submitted other applications 12 months before, for work which was similar to that in Gray’s later patent application. The examiner allowed Bell to amend his specification to refer to the prior application, and his 12 February 1876 patent application was accepted. On 7 March 1876 the US Patent Office issued a patent named ‘Improvement in Telegraphy’ to Alexander Graham Bell.

  The saga of the patent application could have caused real problems, but the courts repeatedly dismissed claims against Bell’s patent and upheld his rights as the original inventor. Although Western Union was the most powerful company of the day, it was forced to capitulate in the face of the evidence supporting Bell. This was due in part to Bell’s habit of keeping extensive notes, and also to the presence in the partnership of Gardiner Hubbard, a man whose background as a patent attorney made him highly sensitive to the need to document research work to protect future rights. Any invention that turns out to be a success inevitably acts as a magnet to those intent on sharing in the wealth it creates. Bell eventually had to fight more than 500 cases against Western Union and others to protect his rights.

  The landmark case was the one involving Western Union. The case demonstrated the importance of the telephone for all to see, and in effect was the foundation on which the future telephone industry and its domination by Bell’s company was built. That said, it took some time for the importance of the crude first telephone to be recognised, and for Bell to establish a commercial venture. Bell’s first step was to strengthen his management by recruiting Theodore Vail, former chief of the United States Railway Mail Service. Vail had managed a group of over 3,500 employees and developed a nationwide mail system. Bell’s second step was to commence a lawsuit citing a Western Union agent for patent infringement.

  The capital position of the Bell company, still effectively funded by Sanders, remained weak. It was insufficient to sustain the growth of the business or the attacks from Western Union. As a consequence, a new company was formed to bring in further investors, and the presidency of the company passed to Colonel William Forbes. Within two months of Vail’s appointment, sufficient capital had been raised to launch the Bell Telephone Company with a capitalisation of $450,000 ($37m).

  The importance of patents

  There followed a sustained fight by the new company to hold its ground against the massive Western Union. Agents were reminded of Bell’s patent, contracts were restricted to five years and agents were granted franchises for intra-city rights only, Bell retaining the inter-city traffic rights. This was the embryonic design for a federal telephone system. Some may have seen this as a futile challenge to the hegemony of Western Union. For a while, the Bell Telephone Company certainly slipped behind in both market penetration and equipment manufacturing. These low expectations were reflected in the performance of the share price, which by late 1879 stood at $50, little higher than the price at which the shares had been initially offered.

  The pretrial depositions for the patent infringement lawsuit took place in April 1879. The case continued until November of that year. Testimony was taken from Bell, who proved to be a first-class witness, and Gray, whose evidence was undermined by his letter of acknowledgement to Bell. Western Union had hoped that its strength as a company would see it to victory, but even its own chief electrical expert concluded after exhaustive study that any working telephone would have to incorporate the principles embodied in Bell’s patent. Western Union was meanwhile coming under concerted attack once more from Jay Gould, this time through American Union. The twin distractions of combatting Gould and the gloomy prognosis for the legal case influenced Western Union to negotiate a settlement with Bell. The head lawyer of Western Union recognised that Bell would undoubtedly win. The agreement Western Union negotiated with the Bell Telephone Company reaffirmed Bell’s patent and introduced a non-compete clause, excluding Bell from the telegraph business and Western Union from telephones. The parties also agreed that Bell would purchase the Western Union telephone system and pay them a royalty of 20 cents on all telephone rentals. At a stroke, the deal transformed Bell from a fledgling operator to a major company with more than 50,000 subscribers in more than 50 cities. The stock market understood this quickly and the company’s share price reacted accordingly, soaring from $50 to $300 in a matter of weeks, and to $500 by the end of 1879.

  The effect of the Western Union agreement was to propel the telephone to a different level of development and give the Bell Telephone Company access to America’s most comprehensive wire network. However, this was only the first stage in its commercial deployment. Shortly after the agreement with Western Union was reached, the Bell Telephone Company was recapitalised at $6m ($0.5bn) and renamed the American Bell Telephone Company. This enabled the Bell company to buy Western Electric and merge it with its own equipment-producing subsidiary. Given that Western Electric was to end up as AT&T’s manufacturing arm, it is ironic that the company was founded by Bell’s rival Elisha Gray and E. M. Barton to produce telephone equipment for Western Union. After the court settlement, this equipment was deemed an infringement of the patent and the way was thus paved for American Bell to acquire control in late 1881. As a footnote, Gray’s own partner Barton commented: “Of all the men who didn’t invent the telephone, Gray was the nearest.”

  Competition arrives

  The growth of the telephone business, and the returns it brought to the Bell company, acted like blood in the water to a school of sharks. Within three years, 125 companies had been launched, and over the 17-year period when Bell’s invention was supposed to be protected by patent, more than 1,700 telephone companies were formed. Some were genuine challengers to Bell, but most simply set out to violate his patents. Many companies tried to take advantage of the euphoria surrounding the telephone and take money from the investing public. Roughly $225m ($18bn) was raised by these companies, although few ever managed to launch a telephone business. Some were straightforward scams. One company raised $15m (over $1bn) without putting together any capital or holding any patents.²⁶ The new companies could be split broadly into two types: those that claimed to have some precedence over the Bell patents, and those that simply ignored them, either in the hope that they would not be pursued for their patent infringement, or that any legal process would be so protracted as to outrun the life of the patent.

  In the former camp, the claimants ranged from the obviously frivolous to the potentially serious. Many candidates presented themselves as the ‘true’ inventor of the telephone. Professor Amos Emerson Dolbear, for example, had a reasonable claim in that he was a serious scientist who had been conducting parallel work to Bell. Dolbear claimed an improvement to a telephone based on the work of the German inventor Philipp Reis. Unfortunately, despite repeated attempts, the apparatus upon which the claim was based refused to work successfully in a courtroom demonstration. As a consequence, in early 1883, the action of the American Bell Telephone Company against the Dolbear Electric Telephone Company was upheld, effectively forcing the latter out of business. If Dolbear had a reasonable claim based on his scientific pedigree and the work he had conducted, there were others with substantially less foundation.

  An amateur inventor called Daniel Drawbaugh claimed to have constructed a working telephone before Bell, despite the fact that in court he could not explain how he had come to make the invention. Even so, anti-monopolist sentiment allowed the case to drag on for some time and it reached the Supreme Court before being settled in Bell’s favour. Drawbaugh’s backing came from
a group of investors who had filed for a patent on his behalf, using this to raise $5m (over $400m) in capital to form the People’s Telephone Company. Drawbaugh may have been a poor backwoodsman, but he was to profit personally, as were his backers, from the long drawn-out case. (Drawbaugh was later to claim to have also invented the radio before Marconi.) In New York, a Staten Island candlemaker named Antonio Meucci also laid claim to precedence over Bell. The court examinations of his claim pointed merely to his success in non-electric instrumentation, involving a taut wire stretched between two tin cans.²⁷ Despite the flimsy nature of the claim, it too had been used to underpin the formation of a company, The Globe Company. The need to resist legal claims, however flimsy, was a financial drain on the Bell companies, and also took up a great deal of management time. Shareholders needed to be reassured. Many cases made it to the US Supreme Court, where the Bell patent was invariably upheld, but this process took five years – sometimes longer – to complete.

  In many more instances, claims were knowingly based on flimsy scientific evidence, to put it kindly. The most notorious claim was from an entity called the Pan-Electric Company, which was launched in the mid-1880s and capitalised at $5m (over $400m). The basis of the company was the claim by a Mr Brown to have invented the telephone, a claim later described as: “about one per cent inspiration, ninety-nine per cent tracing paper”.²⁸ The assets of the company were paper drawings of the telephone, later shown to be tracings of Bell’s patents! The backers distributed shares in the company to prominent politicians. Augustus Garland, who subsequently became attorney general under President Grover Cleveland, received 10% of the outstanding shares. Garland filed for an annulment of Bell’s patents on the basis that they had been obtained by fraud and bribery. Backing up this assertion was an affidavit from the patent office official, Wilber Zenas, who recanted his previous sworn testimony, claiming that he had been afflicted by alcoholism at the time he granted the original patent.

  3.5 (a) and (b) – Monopoly profits draw speculators: Pan-Electric conspiracy

  Source: New York Times, 28 February 1886 and 29 January 1886.

  The real basis of the Pan-Electric Company, though, was not a genuine claim on precedence; rather it rested upon an attempt to use political influence to allow unhindered patent infringement to take place. The scheme involved Garland and a large number of influential southern politicians. Essentially, they attempted to use their influence in the southern states, and later in the federal government, to circumvent the Bell patents. This involved both an attempt to establish precedence and an attempt to have the Bell patents annulled. The manoeuvres were cleverly planned. Their objective was to try and appropriate some of the value vested in the Bell patents for the shares in the Pan-Electric Company. Although this plot eventually failed, it required a concerted effort by the Bell companies to prevent it succeeding, and significant corruption of the United States government. The New York Times later published a damning investigation into the activities of the Pan-Electric conspirators.

  The market matures

  The large number of telephone companies which sprang up in the ten years after the formation of the Bell companies were prone to disappear. Patent protection proved its worth, although continuous and large-scale litigation was necessary to enforce them. Despite the cost of the legal protection, the companies prospered. As telephone penetration increased, so did the profits of American Bell and its operating subsidiaries. The return on investment from expansion was high, and the barriers to entry allowed market segmentation with different price points for each segment. This situation could not endure indefinitely, and the American Bell Telephone Company was well aware of the potentially transitory nature of its success. Bell knew that the 17 years before the patent expired in 1893–4 had to be utilised to the full, to accumulate profits and build a protected position. American Bell incorporated AT&T in 1885 to raise further capital to fund its continued expansion and protect its market position.

  A number of different tactics were used to protect its market expansion. Firstly, non-Western Electric equipment was banned from Bell lines. Second, Western Electric refused to sell its equipment to competitors of Bell. Third, long-distance interconnection between independent phone companies via Bell lines was prohibited. The response from independent companies salivating at the profits and growth potential of the industry was predictable. Since Western Electric equipment could not be purchased by the independents, new producers of equipment emerged. By the mid-1890s, sentiment had turned against the Bell companies, at a time when the remaining patents – the ‘Berliner’ patents – were nowhere near as robust as the original Bell ones. As a consequence, the patents provided little by way of a barrier to new entrants and were not sustained in the courts. The market for new equipment proved sufficiently large that these new producers could survive quite happily without selling to Bell companies.

  The refusal by the Bell companies to allow connection of non-Bell networks to the Bell local and national systems served a purpose to some extent, in that it effectively isolated all non-Bell subscribers. The result was that two different telephone systems developed in many areas. The decision on which system to subscribe to depended upon which system one’s friends were on. In the urban areas, this led to social stratification, as most early subscribers were typically wealthy citizens already on the Bell system, while new subscribers went to the independents.

  3.6 – The end of the monopoly: growth of the US telephone market and percentage of phones supplied by Bell companies

  Source: US Department of Commerce, Historical Statistics of the United States, Series R-12, Bureau of the Census.

  As competition intensified and the patent expiries loomed, Bell’s tactics shifted to include fresh weapons. The company’s pricing policies had until now allowed a degree of market segmentation. Now it gradually lowered its prices, entering the middle and lower market segments where the independents had largely operated. Bell also accelerated the expansion of the telephone system to give comprehensive market coverage. Throughout the early 1900s, its main competitive response was to offer increasingly competitive pricing in any districts where the independents appeared to be gaining ground. In some areas prices would halve and halve again within a 12-month period. This tactic was soon augmented by a drive to increase the rate of business growth in a bid to reduce the opportunities for new entrants, and by moves to take control of competitors, either publicly or secretly. By the late 1890s American Bell had become AT&T, and moved its incorporation and headquarters to New York, where laws were less restrictive than in Massachusetts. As regards the acquisition of competitors, the company was greatly influenced by J. P. Morgan, the financier. He had increased his holdings in AT&T and repeatedly pushed for the company to develop as much of a stranglehold on the market as possible.

  The competitive threat was sufficiently strong for AT&T and its licencees to be drawn into a number of nefarious schemes to thwart the ambitions of the independents. One such alleged scheme was planned with the rival equipment manufacturer Kellog, by which AT&T would quietly acquire control of Kellog and enter into a patent suit against them. Kellog would deliberately lose, and thus allow AT&T to remove Kellog equipment from the independents. This scheme was thwarted when it came to light in mid-1903 that AT&T had effectively controlled Kellog Switchboard for the preceding 18 months. Other schemes involved setting up supposedly independent competition, while AT&T actually retained control. The period of the early 1900s was therefore one of continued growth, but set against a backdrop of increased competition and decreasing balance sheet strength, as funds were utilised to underpin growth and undermine or acquire competitors.

  Enter Theodore Vail

  The increased demand for outside capital was such that the company was inevitably drawn into the sphere of J. P. Morgan, North America’s principal financier. By 1907, J. P. Morgan’s financial resources had become indispensable to AT&T in its fight against the independents. It was perhaps inevitable tha
t the company would fall into Morgan’s hands. In 1907 Morgan organised additional funding of $130m ($8bn) and attained control of AT&T. Once in control, he appointed Theodore Vail to a new position of authority with the express goal of reducing costs and moving to a position of market dominance, preferably outright monopoly. Vail had resigned from the Bell companies in 1887 after failing to win the presidency of the parent group. Over the ensuing period, AT&T ruthlessly built up its network and removed competition. The axis of Morgan’s control and influence over the availability of funding, access to the long-distance network and AT&T’s competitive pricing was to drive many competitors into the arms of AT&T.

  Under Vail, the strategy at AT&T remained broadly the same but tactics changed substantially. The market strategy was fairly simple: to achieve as close to a monopoly as possible by growth and acquisition, but also to seek to reduce prices in order to stimulate line usage and exclude new competitors. These tactics demanded that AT&T become more efficient and Vail moved to reduce costs by eliminating duplication and increasing efficiency. One by-product of this drive was the consolidation of research activities into what later became the Bell Laboratories. It also involved the abandonment of a number of projects where returns were uncertain.