Finance and Innovation, 1875–1902

During the nineteenth century, the Bell System gradually developed a four-pronged business strategy.Footnote ⁵ First, operating through regional subsidiaries, the firm exploited scale economies by expanding in traffic-dense, fast-growing urban centers. Second, Bell maximized revenue by developing premium long-distance and toll service that, unlike flat-fee local messaging, was based on call duration and distance. The linking by the 1890s of such major cities as New York, Chicago, Boston, and Washington, D.C. facilitated the exploitation of scope economies. Long distance also differentiated Bell service from that of the independent, local companies that emerged after Alexander Graham Bell's patents expired, from 1892 to 1894. Third, Bell's acquisition of Western Electric created a manufacturing profit center. Finally, it consolidated market power by increasing ownership in partially owned subsidiaries and by acquiring competitors.

The Bell System's financial structure integrated the funding activities of the parent, AT&T (a holding company), with Western Electric Manufacturing and the regional operating subsidiaries. AT&T was the center for external financial contracting. It transferred proceeds from bond or stock sales to the regional companies to fund growth. The subsidiaries were obligated to reimburse the parent through short- and medium-term note borrowing at 6 percent interest. In addition, these regionals were required to lease equipment manufactured by Western Electric. Later, in 1902, a license contract fee of 4.5 percent of the subsidiaries' gross income replaced the lease contracts.Footnote ⁶ The subsidiaries also periodically paid dividends to AT&T. The parent used these remittances to build working capital and to pay interest and dividends to investors. Moreover, because AT&T's financial statements were not consolidated, the intracorporate flows detailed in its annual reports were highly transparent.

Much of Bell's new equity was raised through periodic rights offerings. In 1901 and 1902, Bell raised $21 million in this way. Rights offerings were particularly important to major investors in maintaining their proportional interest in the firm's equity and, thus, voting power in selecting the board of directors. The distribution of ownership was also important to senior managers, whose status and tenure was contingent on continued board support. This reliance on rights offerings also affected dividend policies. The firm sought to keep its effective cost of equity capital low by timing the rights issues for periods of operating strength, when share market values were high.

Although profits grew threefold, from $8 million in 1895 to $25.2 million in 1905, pressures to maintain liquidity and solvency increased because of competition and rising capital outlays to support network expansion.Footnote ⁷ Competition from about nine thousand local rivals that had emerged in the decade after 1894 contributed to a fall in the annual average profit of local exchanges, from $30 to $10.Footnote ⁸ Returns on investment fell as new rivals entered the market and expanded telephone service capacity through the construction of new facilities.Footnote ⁹ Competition encouraged the trade-off of service quality for profits through the use of cheap apparatus.Footnote ¹⁰ The realization of economies of scale remained elusive because of high variable labor costs associated with manual switching, equipment installation, and maintenance.Footnote ¹¹ Moreover, the drive to build a continental system drew the firm to traffic-sparse, less-profitable regions of the South and West. Annual capital expenditure grew from $31.6 million in 1900 to $79.4 million in 1907.Footnote ¹²

The fragmented organization of technical resources and conservative financing policies weakened innovation. In 1875, Bell formed a patent group to acquire technology from external sources. In 1881, the firm established an electrical department that inspected equipment, conducted experimentation in telephone science, and monitored external technological developments. In 1884, a fledgling mechanical department began testing materials and supplies and designing apparatus. In 1890, the firm began to provide long-distance technical assistance for the regional subsidiaries; it grew from 60 members in 1894 to 203 by 1902, including 4 who held doctorates.Footnote ¹³ The total expenditure by AT&T (exclusive of Western Electric) for technical activities between 1901 and 1905 amounted to $1.2 million, or roughly one-third of the direct costs incurred for general corporate purposes.Footnote ¹⁴ However, many of the firm's technological improvements were “oriented toward lowering costs so that profits would not suffer as income per telephone decreased.” This, combined with the belief of a parsimonious board of trustees that research was best conducted in university laboratories, induced Chief Engineer Hammond V. Hayes to institute a policy of relying heavily on external sources and Western Electric for innovation.Footnote ¹⁵ But this did not stop the uncoordinated efforts of several hundred scattered employees within the firm to undertake “engineering work.”Footnote ¹⁶

Innovative slippage was also evident at Western Electric. Although the manufacturing subsidiary benefited from the inventive genius of such contributors as Elisha Gray in telecommunication studies and Charles Scribner in switchboard design, the level of commitment for such endeavors remained modest. During the 1890s, Western Electric began experiencing competition from three new apparatus manufacturers: Automatic Electric (automatic switches), Stromberg-Carlson (receivers and transmitters), and Kellogg Switchboard (switchboards). In 1901, Bell lost in patent litigation with Professor Michael I. Pupin of Columbia University over loading coils that extended telephone signal range.Footnote ¹⁷ It was not until 1911 that Western Electric organized a research branch in its engineering department.Footnote ¹⁸ Yet in spite of this latter initiative, the perfection of the vacuum tube by Harold D. Arnold in 1913—a major breakthrough in enhancing signal transmission range—depended heavily on the acquisition of independent inventor Lee de Forest's Audion patent.Footnote ¹⁹

Morganization and Enterprise Sustainability, 1902–1907

In 1901, patent attorney Frederick P. Fish assumed the Bell presidency and was soon confronted by the problem of acquiring long-term financial resources to sustain rapid growth. Believing the region could not provide sufficient capital to fund national expansion, Fish sought to diversify the firm's investor base beyond New England, which had accounted for about 75 percent of the firm's stock ownership. Moreover, fast growth compelled Bell to place more reliance on debt finance. Long-term indebtedness grew by 87 percent to $28 million in 1902. Most of the borrowing was secured by hypothecating the parent's investments in its subsidiaries.

Starting in 1902 the evolution of finance was strongly influenced by the House of Morgan. Although Boston-based firms Lee, Higginson & Co. and Kidder, Peabody & Co. had long served as Bell's principal bankers, their primacy was challenged in 1902 when a consortium led by the New York bank, J.P. Morgan & Co., purchased fifty thousand shares of AT&T stock and placed two representatives on its board: George Baker, president of the First National Bank of New York, and John I. Waterbury, president of the Manhattan Trust. They joined another incumbent Morgan ally, T. Jefferson Coolidge, president of the Old Colony Bank and Trust of Boston. J. P. Morgan's protégés represented national banks and trust companies that were significant purchasers of new securities issuances.Footnote ²⁰ The Morgan nexus opened new markets for the sale of AT&T securities because of its strong connections to New York and European finance. Morgan's reputation was stellar following its success in reorganizing bankrupt railroads during the 1890s and, more recently, in consolidating great industrial enterprises such as U.S. Steel and General Electric (GE). Theodore N. Vail, a former senior Bell manager, was tapped for membership to the telephone company's board to represent the interests of John W. McKay, who controlled the Postal Telegraph Company, which J. P. Morgan wanted to merge with AT&T. After McKay's death, and the refusal of the AT&T board to admit his son, Vail continued as a director, drawing closer to the Morgan faction.Footnote ²¹

The New York banking house helped clients achieve financial stability through a process popularly termed “Morganization.”Footnote ²² Morgan did not become actively involved in the operational management but instead monitored client performance to protect the financial interests of customers. The bank sought to reduce client risk and create underwriting opportunities by proposing more sustainable capital structures. In the railroad reorganizations of the 1890s, this often involved the substitution of preferred stock for debt. Risk was reduced because, unlike debt contracts where interest defaults triggered bankruptcy, the failure to pay a dividend could not force receivership. By the early twentieth century, Morgan also began to promote debentures—long-term obligations not secured by corporate assets and whose servicing was contingent on the adequacy of future earnings. The firm advocated the use of convertible debentures that could be exchanged for common stock at a preset strike price. For companies with rising stock prices, there was a possibility of reducing risk by converting debt into equity.Footnote ²³ Stability was also sought through consolidations that reduced industrial competition. Client monitoring was enhanced through interlocking corporate directorates known as “communities of interest.”

As early as February 1904, bankers Waterbury and Coolidge militated unsuccessfully for the convertible bond financing that the House of Morgan had successfully introduced at U.S. Steel, GE, and the Erie Railroad. The majority of AT&T's board, still reflecting predominantly New England interests, rejected the proposal, believing that the convertible feature threatened to disrupt the firm's ownership structure.Footnote ²⁴ Share conversion might conceivably shift voting control and the member composition of the board; such a change might also threaten the tenure and status of corporate managers. By November 1905, however, the pressures of financing growth compelled the board to abandon its opposition to convertible debenture finance. The financial demands of rapid expansion had already contributed to the rise of long-term debt, to $73 million (27 percent of total assets) in 1904. In November 1905, Fish received shareholder approval for the issuance of $100 million (subsequently raised to $150 million) in debentures convertible into shares at $140. The issue would be taken down in tranches to coincide with the funding needs for expansion until 1908. Worries about ownership dilution were also partially assuaged by setting the stock conversion period from 1909 to 1918, thus giving shareholders three years to accumulate the resources needed to maintain their equity positions. The first tranche of $30 million, taken down in 1906, was roughly equivalent to Bell's average annual capital expenditures from 1900 to 1905.Footnote ²⁵ By 1906, long-term borrowing increased to $128 million, or 36.2 percent of total assets.

Yet in spite of these infusions Bell experienced a liquidity stringency because of difficulties in controlling capital spending and a lengthening payback period for subsidiary receivables. Profits leveled off at $13 million in both 1905 and 1906, reflecting the downward effects of the San Francisco earthquake and Western states' expansion.Footnote ²⁶ The firm had also overbuilt in anticipation of strong growth. In 1906, it set a spending record: $79 million on new plants, $33 million on maintenance, and an excess inventory of copper cable worth $25 million.Footnote ²⁷ The parent's bills and accounts receivable, which were due primarily from its subsidiaries, rose by 87.5 percent to $67.5 million in 1906. The consequent slowdown in repayment duration was reflected in the increase in the average days necessary to liquidate the firm's outstanding notes, bills, and accounts receivable, which grew from 698 days in 1905 to 845 days in 1906 (up by 21 percent).Footnote ²⁸ To partially counter this deteriorating trend, Bell issued $21 million in notes, which raised total short-term liabilities to $31.0 million, a 320 percent increase over the 1905 level.

Although Bell's board remained committed to a strong dividend policy, to signal financial sustainability, the decision to increase the rate from 7.5 to 8 percent in July 1906 adversely affected subsidiary finances. The increase raised AT&T's cash outflow by $1.9 million, to $10.3 million, roughly equivalent to the dividend income the parent received from the subsidiaries. Affected most negatively was 60-percent-owned Western Electric, which paid a dividend of $1.2 million in spite of registering losses for 1906 and 1907.Footnote ²⁹ Moreover, the upstreaming of dividends and heavy capital outlays forced eleven of the firm's subsidiaries to increase their collective short-term debt by $19.6 million.Footnote ³⁰ This threatened to erode the market value of the partially owned subsidiary stocks and bonds, which the parent used to collateralize some of its long-term borrowing.Footnote ³¹ These pressures induced Bell to further pyramid its finances by issuing $52.7 million par value stock for twenty-one of its thirty operating subsidiaries and Western Electric. Ironically, this decision led to a reduction in the parent's cash by an estimated $30.9 million, in order to satisfy its long-term policy of maintaining its pro rata ownership interest in any offering of subsidiary equity.Footnote ³²

Seasoned financiers did not miss the significance of these changes nor their implications for business sustainability. Banker Henry L. Higginson, for example, advised clients—such as the Reverend Chandler Robbins, early in 1906—to reassess their commitment to Bell stock. Robbins responded by noting, “The Telephone has been a good friend to me and I hate to part with old friends: but I agree with you about the present situation and shall materially reduce my holdings.”Footnote ³³ In a similar vein, Frank Knight Sturgis, a partner in Strong, Sturgis Company of New York and a future president of the New York Stock Exchange, reported to Higginson in March 1906: “We have had no interest in telephone stock, but we took an interest in the new issue of bonds, which I think will in the long run pay well, but I am inclined to fear that all issues at this time of new securities will be slow to succeed.”Footnote ³⁴

Liquidity slippage and tight money motivated the House of Morgan to renegotiate the terms of the future convertible bond flotation. In January 1907, AT&T agreed to cut by 3.5 points, to 94 percent of par, the selling price of its convertible bonds to the underwriters because of rising yields in the money market. In addition, the bankers' syndicate provided Bell with intermediate-term financing through the placement of an unsecured three-year, 5 percent note for $25 million to retire a $20-million-dollar note maturing in April 1907.Footnote ³⁵ The loan also reduced floating debt, whose increase to $21 million was euphemistically described as “somewhat abnormal.”Footnote ³⁶ In return, the bankers received an option on an additional $50 million of convertible bonds at 90 (as a percentage of par value of 100), and a 2.5 percent sales commission. In spite of these concessions, the convertibles proved difficult to sell and the syndicate had to be extended another year to place the entire issue.Footnote ³⁷ The new financing arrangements engendered criticism. At the annual meeting on March 27, 1907, AT&T's fifth-largest shareholder, Richard S. Fay Jr. (whose father had served on the board in the 1880s), filed an unsuccessful resolution protesting the underwriters' new terms. President Fish explained that the changes had resulted because “work had proceeded faster than had been expected, and . . . the investment required would have to be larger than anticipated.”Footnote ³⁸

Vail succeeded Fish as president on May 1, 1907, supported by “New York bankers” who had successfully militated for the relocation to New York of the corporation's headquarters. Vail was well known to major investors and management because of his earlier executive service at Bell.Footnote ³⁹ The board was further strengthened with the admission of Sylvanus L. Schoonmaker, a protégé of Andrew Carnegie and Henry Clay Frick and Morgan's Murray Hill neighbor.Footnote ⁴⁰ Pressure to better control spending in order to preserve the firm's credit was applied immediately, however, as reflected in a note from the bankers to Vail:

Vail recruited Charles G. DuBois, the controller of Western Electric, to take steps to ration capital and to eliminate the informational asymmetry that undermined the effectiveness of financial control.Footnote ⁴² The center had been poorly informed about activities at the periphery because of “incomplete and misleading” accounting information submitted by many subsidiaries. In May 1907, Vail set a $42 million capital spending limit for the remainder of the year.Footnote ⁴³ The subsidiaries were also required to submit spending plans identifying projects that were either “imperative,” “necessary,” or “advisable” for possible executive committee approval.Footnote ⁴⁴

Vail pursued sustainability through short-term financial expedients. To conserve cash, the dividend rate was cut from 8 to 6 percent.Footnote ⁴⁵ Treasury stock valued at $21 million was sold through a shareholder rights offering in June 1907.Footnote ⁴⁶ This surprised many in the investment community who had been led to believe that major financing for 1907 had already been completed and thus “brought the stock down 6 points in one day to 100½, the lowest point reached since 1900.”Footnote ⁴⁷ Bell partially replenished the finances of Western Electric by purchasing an additional 30,000 of its shares, thus increasing its holding to 120,000 shares and leaving 30,000 in the hands of minority investors.Footnote ⁴⁸ Prohibitions were placed on the indiscriminant production of new lines of equipment and 12,000 employees were laid off.Footnote ⁴⁹ The stock market reaction to these and other changes became dire at the height of the Panic of 1907, when Bell stock hit a low of $88 on October 30; compare its high, in 1906, of $144⅝.

From the October low point, conditions began to improve steadily. The net cash position of the operating companies had increased by $22.5 million by the end of 1907.Footnote ⁵⁰ Western Electric experienced a net cash improvement of $9.4 million.Footnote ⁵¹ In 1908 and 1909 Vail kept a tight leash on capital spending, at $30 million annually. By 1909, because of expanded business and improved budgetary management, Bell had recovered its ability to fund about one-third of its plant additions from retained earnings.Footnote ⁵² In addition, risk perceptions were reduced by 1911, when $129 million of the $150 million convertible bonds had been exchanged for common stock.Footnote ⁵³

To further assure enterprise sustainability, Vail soon committed the firm to a long-term program of organizational learning that he termed the “universal service” plan.Footnote ⁵⁴ This plan promoted more effective management by creating new organizational structure and clearer lines of reporting. It promoted more effective resource allocation by expanding operating and capital budgeting capabilities. Further, the program reduced costs and assured better service by standardizing technology and management practices.Footnote ⁵⁵

Another dimension of the Morganization drive involved the combination of national telephone and telegraph capacities through Bell's acquisition of control over Western Union Telegraph in 1911. Bell executives anticipated savings from joint maintenance and facilities construction. Telegraph messages could also be transmitted over telephone wires. Western Electric was developing multiplex printing telegraph systems, eliminating the need for telegraphers trained in Morse code.Footnote ⁵⁶ The introduction of telegraph “night letters” also helped to spread the daily network utilization more evenly.Footnote ⁵⁷

The pinnacle of Morganization was seen in the composition of Bell's board of directors. Besides Baker, Coolidge, Schoonmaker, and Waterbury, the board in 1910 admitted members who could facilitate the distribution of corporate securities in major business centers. These included J. P. Morgan partner Henry P. Davison and Morgan's personal attorney and trustee of New York's U.S. Trust Company, Lewis Cass Ledyard. There were three representatives of Boston's leading underwriting houses: Robert Winsor and Eugene V. R. Thayer of Kidder, Peabody and Henry L. Higginson of Lee, Higginson & Co. Three additional recruits represented cities important to the telephone company's expansion: Philadelphia-based Rudulf Ellis, president of the Fidelity Trust Company; Chicago-based Norman W. Harris, founder of the Harris Bank and Trust Company; and John J. Mitchell, president of Illinois Bank and Trust Company. The coalescence of a community of interest was further evinced by Vail's recruitment to the boards of Morgan clients GE, U.S. Steel, and the New York, New Haven, and Hartford and the Boston and Maine railroads. Vail became active in developing a comprehensive plan for New England rail consolidation involving the merger of the two railroads.Footnote ⁵⁸ This structure, however, would soon be eclipsed by the new requirements of government at the state and federal levels.

Regulation and Innovation, 1907–1915

Although Progressive regulation helped to reconcile Bell's strategies with the new imperatives of social reform, it also strengthened finances and created an environment more conducive to research. State and municipal commission rate-base cost recovery became a steady source of cash to finance research and development (R&D) expansion. Federal intervention helped to resolve problems of antitrust, national oversight, network access, horizontal growth, and telegraph control. This enabled the firm to concentrate its energies on pursuing growth by exploiting technological opportunities. The prohibition of underwriter-dominated interlocking directorate and communities of interest assured the eventual triumph of managerial over finance capitalism at Bell.

State regulation of the telephone industry first emerged in New York in 1908 and had spread to thirty-nine other states by 1913.Footnote ⁵⁹ This appealed to many Progressives because, among its other goals, it provided a means for reconciling private economic interests that were the source of substantial material uplift with the preservation of traditional republican values that had shaped American culture since the Revolutionary Era. Regulation sought to protect the public against unrestrained monopoly power while mandating the provision of economical and efficient telephone service.

Vail, who early in his career had been in the federal service, did not oppose regulation but shrewdly worked instead to adapt to its requirements in ways that assured corporate sustainability.Footnote ⁶⁰ Commissions could penalize marginal operators who neglected maintenance and capital outlays necessary for inexpensive and efficient service. Commission power over corporate financing plans and territorial franchises could curtail the threat of overexpansion. Most importantly, rate-base cost recovery stabilized the flow of innovation funding. The regional subsidiaries could include in their rate bases Western Electric's license contract fee for equipment leasing and management services, including research. Direct research costs billed to regional units for particular assignments were also includable in the rate base. Later, when Western Electric abandoned licensing in favor of direct sales, research overheads were allocated to equipment and recovered through depreciation charges passed through subsidiary rate bases.

The ability of rate-base finance to invigorate scientific inquiry was reflected in technical employment statistics. The take-off started in 1910 after a two-year hiatus in hiring as Vail closed engineering branches in Chicago and Boston and relocated activities to New York. The focal points for innovation were centered in Western Electric's engineering department and AT&T's department of research and development. In 1909, their combined number of technical personnel amounted to 128 (79 at AT&T; 49 at Western). A year later, this figure had increased nearly four-fold, to 472 (114 at AT&T; 358 at Western); by 1917, the census reached 2,420 (422 at AT&T; 1,998 at Western).Footnote ⁶¹

Federal intervention into interstate telephone regulation did not disturb the subsidization of innovation. Instead, federal reforms created a new environment that encouraged research by reducing opportunities for growth through other strategic initiatives. Placed under federal supervision by the Interstate Commerce Commission (ICC), under the Mann-Elkins Act of 1910, Bell became the subject of an antitrust investigation during the presidency of William H. Taft. Independent telephone companies complained about denial of access to Bell's national grid, its acquisition programs that intensified local competition, its high rates for service in noncompetitive markets, and its discrimination against the Postal Telegraph Company in favor of Western Union.Footnote ⁶² Although initiated in January 1913, the case was not adjudicated, because Congress abolished the Commerce Court that the Mann-Elkins Act had authorized to settle disputes over ICC orders.

Although the administration of President Woodrow Wilson renewed litigation in federal district court later in 1913, Attorney General James C. McReynolds persuaded Bell to resolve these conflicts through voluntary mediation, an option also used in cases with U.S. Steel and the New York, New Haven, and Hartford Railroad.Footnote ⁶³ This avoided the high costs of litigation while reducing the risk of internal party polarization over antitrust, which had split the Republicans in 1912. Compromise also helped the Wilson administration conserve the political capital necessary for promoting its ambitious reform agenda. On December 19, 1913, Bell agreed under what has been termed the Kingsbury Agreement—after Bell negotiator and vice president Nathan Kingsbury—to (1) divest its interest in Western Union, (2) allow independent telephone companies to connect to its national network, and (3) restrict future horizontal expansion. Henceforth, the exploitation of science would eclipse the increase in geographic scope as a primary growth driver. These actions also helped to defuse congressional advocacy for cheaper service with nationalization through the Post Office, as was done in Britain in 1912.Footnote ⁶⁴ Although telecommunications were nationalized in World War I, this temporary expedient was abandoned with the return of peace.

Federal activism led to a decline in the direct influence of Morgan allies on Bell's board. The writings of Wilson advisor Louis D. Brandeis, particularly his classic Other Peoples' Money and How the Bankers Use It, and the findings of the Pujo Committee fanned public concerns over interlocking directorates.Footnote ⁶⁵ The Clayton Act, ratified in October 1914, prohibited such boards when they acted to restrain trade. By 1915, six of Morgan's principal allies on the board—Ellis, Davison, Harris, Mitchell, Schoonmaker, and Winsor—had resigned, with control reverting back largely to members of the founding families and management. (This however, did not prevent the House of Morgan from serving as the primary underwriter for Bell debentures for the next twenty years.)

The Legacy

Rate-base research subsidization reduced risk and enhanced corporate sustainability by strengthening Bell's operational capabilities. It enabled the firm to bid for well-trained physicists, mathematicians, and engineers—professionals in short supply early in the twentieth century. It enabled a close integration of research, manufacturing, and networking, which Kenneth Lipartito believes contributed strongly to successful innovation.Footnote ⁶⁶ It facilitated the extension of technical and management knowledge that raised productivity in the Bell-dominated telephone industry. Economist Alexander Field notes that total factor productivity (TFP)—the national income metric that estimates the average annual percent increase in productivity from corporate learning—grew in telecommunications from 1.6 percent in the period from 1919 to 1929 to 2.01 percent in the period from 1929 to 1941.Footnote ⁶⁷ Creative finance made possible the establishment of a world-class telecommunications laboratory. Unlike companies operating in more competitive industries, the rate base provided Bell with a financial buffer against business downturns. Moreover, prohibitions against bonus compensation reduced management's incentive to cut forward-directed spending for activities like research to bolster profits and stock prices. Finally, commission regulation insulated research against political risks from public concerns about the governance of an industrial leviathan.

Although the model was challenged, these attacks had little impact until the 1940s. One concern was the fairness of equipment transfer prices from the unregulated Western Electric to the regulated operating subsidiaries. Although the Supreme Court in 1923, in Southwestern Bell Tel. Co. v. Public Svc. Commission, upheld the right of the operating subsidiaries to include the 4.5 percent license contract charge in their rate bases, Justice Louis Brandeis's dissent on the need for precise costing eventually proved decisive.Footnote ⁶⁸ The problem was the lack of transparency; regulators could not meaningfully deconstruct the service charge, thus making it difficult to judge the fairness of the transfers. Bell responded in 1927 by unbundling equipment costs and reducing the license fee to 1.5 percent, which included a research overhead charge. Eventually, in 1930, the Supreme Court in Smith v. Illinois Bell Telephone mandated the requirement of precise cost information in rate evaluations.Footnote ⁶⁹

Rate-base funding supported a high level of innovative activity into the 1930s.Footnote ⁷⁰ It helped to fund in 1925 a new subsidiary, the Bell Telephone Laboratories Inc. led by Dr. Frank B. Jewett, that unified the activities of both the AT&T and Western Electric scientific staffs. The number of technical personnel at the new unit hit a high point of 6,670 in 1930 before falling back to 4,836 in 1934.Footnote ⁷¹ Total engineering and research expense increased from $9.2 million in 1920 to a high of $22.6 million in 1930 before falling back to $16.6 million in 1935. During the period from 1925 to 1935, Bell Laboratories spent $51.3 million on research in fifteen areas of telephone science. The largest outlays were for wire and radio transmission systems and general transmission apparatus, accounting for 46 percent of total spending. Wire transmission research included carrier cables, voice frequency equipment and circuits, telephone, picture transmission, coaxial cable, and submarine cable. Radio transmission research concentrated on shortwave experimentation for marine and air applications. Research for general transmission apparatus dealt principally with vacuum tubes. Moreover, expenditure levels did not always equate directly with impact. Inspection engineering, for example, ranked twelfth in spending but revolutionized production management by developing statistical quality control.Footnote ⁷² Awards and patents affirmed the firm's leadership in science. Clinton J. Davisson of Bell Laboratories, a student of Nobel Prize winner Robert A. Millikan of the University of Chicago, won the company's first Nobel Prize in Physics, in 1937, for experimental work in 1927 that provided evidence of the wave nature of electron particles. By the 1930s, the firm also controlled a significant body of patents: for telephony (2,578 patents, or 46.2 percent of the total registered with the U.S. Patent Office); telegraph, teletype, and television (832, 45.2 percent); radio (875, 15.1 percent); and sound recording (821, 16.1 percent).Footnote ⁷³

While early financial market reform initiatives—such as the securities acts of 1933 and 1934 and the Public Utility Holding Company Act of 1935—of President Franklin D. Roosevelt's New Deal administration had little impact on the cross subsidization of scientific endeavor at Bell, the newly formed Federal Communications Commission (FCC) launched an extensive investigation of the telephone industry. In 1939, the FCC's investigation criticized the pace of innovation and the cost of new equipment. Among its other recommendations, the federal agency wanted to regulate Western Electric and to prescribe uniform production accounting methods. Neither proposal was adopted, probably because of a shift in government focus to political problems in Europe and the Far East.

The federal government provided a second source of funding as defense became a higher national priority. A major achievement was microwave research to develop radar, a project first begun for the U.S. Navy in 1937.Footnote ⁷⁴ Although this project was financed initially through the rate base, federal funding increased rapidly with the beginning of the war. By 1943, about 80 percent of Bell Laboratories' research budget was committed to defense projects. Although this ratio dropped to about 20 percent after V-J Day, it remained much higher than it had been before the war.Footnote ⁷⁵ Bell also continued to strengthen national defense during the Cold War. In 1949, it contracted to operate the Sandia facility in New Mexico for the U.S. Atomic Energy Commission.Footnote ⁷⁶ That year it also became involved in the design and production of the Nike missile system for defending American cities against air attack. Further, Bell also created the Distant Early Warning (DEW) radar system in Canada to protect against air attacks over the North Pole.Footnote ⁷⁷

The rate base again became a major source of funding for four major initiatives during the 1950s. The first was the invention of the transistor, which revolutionized electronics by making possible circuit miniaturization, displacing bulky, less efficient vacuum tubes. This invention led to the award of the Nobel Prize in Physics in 1956 to its developers, John Bardeen, Walter H. Brattain, and William B. Shockley. Bell also enhanced transistor efficiency through the development of high-purity silicon chips.Footnote ⁷⁸ The second major initiative was the launching of information theory, by Claude Shannon, which introduced the notion that communications consisted of bits of information that could be digitized through a binary coding system.Footnote ⁷⁹ This had tremendous implications for the development of electronic computers and digital telephone communication. The third involved the substitution of cheap microwaves for costly copper in long-distance transmissions. In 1951, Bell built a network of 107 towers equipped with innovative horn antennas for relaying microwave signals coast-to-coast.Footnote ⁸⁰ The fourth initiative was the transatlantic cable that connected the United States and Britain in 1956, which utilized 1930s vacuum-tube technology.Footnote ⁸¹

Despite these achievements, legal challenges threatened the economic benefits of Bell's rate-base financing of science. Although the Justice Department in 1956 dropped its antitrust prosecution of Western Electric, it extracted from Bell an agreement to (1) allow free access by any American applicant to its portfolio of over 8,600 patents issued through January 1956 and (2) license any later patents for a nominal fee. The rationale was that since research funding came through the rate base, any consequent patents were to be considered public goods. In addition, the firm agreed not to enter either the consumer electronics or computer industries.Footnote ⁸²

In spite of these regulatory challenges, rate-base-funded research initiatives continued to revolutionize telecommunications science. What unified much of this inquiry was the desire to achieve the traditional goals of economical and efficient service through the discovery of new materials and equipment that could increase traffic load and improve transmission quality at a lower cost. One such effort was the successful drive to overcome the inherent limitations in undersea cable operations by refocusing global transmission capabilities through outer space in the Echo (1960) and Telstar (1962) satellite programs. Besides horn antennas and transistors, the satellites incorporated Bell-invented solar cells to charge batteries, traveling-wave tubes to amplify signals, and masers for transmitting signals to outer space. The firm's involvement, however, ended with the passage of the Communication Satellite Act of 1962, which vested these activities with the government-owned Comsat Corporation.Footnote ⁸³ Investigations into the potentials of outer space also affected scientific inquiry in other ways. Research on understanding static interference on telephone lines led to the 1964 discovery of cosmic microwave radiation by Arno A. Penzias and Robert W. Wilson; this breakthrough both provided evidence in support of the Big Bang theory and led to the awarding of Nobel Prizes to Penzias and Wilson in 1978.Footnote ⁸⁴ In 1999, Willard Boyle and George E. Smith invented the charge-coupled device, enabling the transfer of electronic charges in semiconductors; the device was initially used in the creation of digital imaging capabilities from outer space and later revolutionized photography by making possible the shift from its traditional base in chemistry to digital technology. Boyle and Smith received Nobel Prizes in 2009 for their work.Footnote ⁸⁵

In 1964 the Bell System began a costly and long-term project to replace electromechanical with electronic switching. This was the largest R&D program Bell had ever undertaken. The integration of transistors and diodes provided greater flexibility and mobility, which made possible call waiting, conference calls, and touch-tone dialing, among other new features. It also facilitated interconnectivity between telephones and computers.Footnote ⁸⁶ These developments—which benefited from the theoretical insights of Phillip Warren Anderson into electronic flows in solid state media—facilitated the design of inexpensive switching and memory devices, an achievement that provided the basis for his Nobel Prize in 1977.Footnote ⁸⁷

During the late 1960s Bell also became interested in exploring the potential communication interfaces between telecommunications and computer technology. The transfer of computer data promised greater economies in system operation, from higher load factors, and the possibility of achieving higher system utilization in low peak time periods, such as in the evening. At the forefront of such innovation was Bell's creation of the Unix operating system and C programming language, beginning in 1969, to support the rapid expansion of electronic data processing.Footnote ⁸⁸ These new technologies continued to evolve in the following decades with the growth of the Internet and information technology.

Although Alexander Graham Bell had transmitted sound through light as early as the 1880s, the substitution of optical glass for copper as a medium of transmission in telecommunication became practical only in the 1970s. Although other firms, such as Corning Glass, were major developers of the new technology, Bell, through its extensive research into lasers and materials, contributed significantly to the new technology. Optical fiber was advantageous because it reduced costs and increased efficiency. Laser-generated light beams carried telephone signals through highly purified glass fibers. The new system was superior to that of copper cables because it was cheaper, accommodated broader bandwidths, experienced lower signal attenuation, and was not subject to electromagnetic interference.Footnote ⁸⁹ Its faster baud rates facilitated connectivity with computers, cable television, and the Internet.Footnote ⁹⁰

Bell's foothold in microwave transmission also received a strong boost with the advent of improved cellular telephones. In 1980, the efficiency of cellular technology was greatly enhanced when the firm patented code division multiple access (CDMA) and time division multiple access (TDMA) technology for use with digital telephones. When introduced for service in 1982, these modalities enhanced operational load capacity by dividing frequency channels so that many customers could transmit simultaneously.Footnote ⁹¹

The Bell Laboratories in the 1980s also continued to make important contributions to basic science, as evinced in part by the success of its scientists in receiving Nobel Prizes. New insights into the potentials of solid state physics derived from a 1982–1983 discovery by Horst L. Störmer, Robert B. Laughlin, and Daniel C. Tsui related to the fractional quantum Hall effect.Footnote ⁹² In 1997, Steven Chu—who would eventually become the secretary of energy, from 2009 to 2013—won a Nobel Prize for discovering how to employ lasers to trap and cool atoms.Footnote ⁹³