Notorious Business Trusts

BY HARRY L. MUNSINGER, J.D., Ph.D.

The idea of using a trust to own related businesses was developed by Samuel C.T. Dodd, Standard Oil’s General Counsel, during the American Civil War. Business trusts allowed companies to cooperate and keep the price of manufactured goods such as kerosene, finished steel, and cigarettes stable, ostensibly benefiting American consumers. Economists of the time believed business trusts would reduce ruinous competition and bring order, stability, and reasonable prices to American consumers.

The Standard Oil Trust was among the first of these arrangements, and its success in stabilizing supply and consumer prices inspired others to adopt the model. However, when the United States government investigated these business trusts, it discovered that the trusts were using unfair business tactics to reduce competition and earn huge profits at the expense of consumers. The operations of business trusts violated a basic tenant of capitalism—that competition lowers prices and spurs development of new products. Eventually, this led to the passage of the Sherman Antitrust Act and the famous “trust busting” efforts by the federal government in the early twentieth century. Existing business trusts were investigated, charged, tried, convicted of restraints of trade, and forced to break up their monopolies by the United States Department of Justice and the United States Supreme Court. Business trusts were gradually phased out in favor of holding companies, which are limited in their power to restrain trade and exercise monopoly pricing power.

The Standard Oil Trust

The Standard Oil Trust was established in 1863 by John D. Rockefeller. By 1868, the Standard Oil Trust was the largest oil refiner in the world, producing primarily kerosene for home lighting. Rockefeller consolidated his oil businesses and invited other business owners to transfer their shares to the Standard Oil Trust, in return for a beneficial interest in profits from the trust. Standard Oil Trust ultimately owned fourteen corporations and exercised control over twenty-six others, creating a monopoly in the production, refining, transportation, and marketing of kerosene in America. Rockefeller claimed he established the Standard Oil Trust to improve the organization and efficiency of his many business interests, but he was accused by journalists and Congressmen of abusing his market power by gaining monopoly control of the oil industry, artificially holding prices at a steady high level, and limiting competition in the sale of kerosene to the public.

The Standard Oil Trust organized committees to control crude oil production, refining, transportation, and marketing—stabilizing the price Americans paid for kerosene to light their homes. However, the stable price of kerosene was deceptive, because the cost of drilling and pumping crude oil, transporting it to market, refining the oil, and distributing kerosene to consumers decreased substantially under the control of Standard Oil Trust. Rather than pass these savings on to their customers, Rockefeller and his trust partners pocketed the profits. Customers did not complain because they were able to buy ample supplies of kerosene at a stable price.

Until the invention of the internal combustion engine for motor vehicles, gasoline was a worthless by-product of refining kerosene. Soon after the invention of the automobile, however, gasoline became Standard Oil’s most important product and earned the trust millions of dollars annually. The Standard Oil Trust was eventually forced to split into several independent oil companies through enforcement of the Sherman Antitrust Act.

The U.S. Steel Trust

J.P. Morgan founded U.S. Steel in 1901, and at its height, the U.S. Steel Trust controlled approximately 60% of the steel industry. Andrew Carnegie, owner of the largest steel manufacturing company in American, was not impressed with Morgan’s idea, predicting that Morgan—a New York banker who knew nothing about running a giant steel company—would fail. Carnegie liked competition and initially declined to join Morgan’s U.S. Steel Trust. Ironically, Morgan had developed the idea of forming U.S. Steel while listening to a December 1900 speech by Charles Schwab, Carnegie’s chief assistant, who was describing the possibility of a vertically integrated super-trust that would own companies making everything from raw steel to finished steel tubes. Morgan was so impressed with the idea that he asked Schwab to meet at Morgan’s home on Madison Avenue, where he offered to buy Carnegie’s steel enterprise. Carnegie thought about the proposal overnight and gave Schwab a slip of paper with the price of his company written on it—$480 million. When Morgan saw the number, he immediately said, “I accept.”

Morgan’s next step was to buy iron ore holdings owned by Rockefeller. Morgan hated Rockefeller, but he needed the iron ore badly, so he agreed to meet Rockefeller at the latter’s home on West 54th Street in New York. Rockefeller told Morgan that he was retired and would not discuss a business proposition at his home. Instead, Rockefeller told Morgan that he needed to discuss buying the iron ore with Rockefeller’s son, John D. Rockefeller, Jr. The two men met and finally agreed on a price of $88.5 million for the iron ore and the ships used to transport ore to the mills. After acquiring the iron ore and ships from Rockefeller, Morgan went on to consolidate large parts of the American steel industry into U.S. Steel and monopolize the business for a generation before the United States Department of Justice sued U.S. Steel Trust for monopolistic practices and unlawful restraint of trade and forced the trust to split into several independent companies.

The American Tobacco Company

James Duke began small-scale production and marketing of cigarettes in Durham, North Carolina. Advances in cigarette manufacturing technology allowed him to expand cigarette production and sales rapidly. Duke took advantage of the efficiency and volume of cigarettes he was able to produce with the new machines to integrate the tobacco industry from top to bottom and to expand his business by lowering prices and spending lavishly on advertising. However, intense competition with other cigarette companies cut into Duke’s profits, so he began searching for a better business model to make more money.

New Jersey passed a statute allowing a holding company to own several related businesses, so Duke convinced his competitors to merge into a single entity called the American Tobacco Company, which ultimately controlled almost 90% of the United States market for cigarettes. Duke also vertically integrated his tobacco business, combining entities that specialized in buying tobacco leaves, manufacturing cigarettes, and selling the finished produce in Duke’s own retail tobacco stores. Duke quickly dropped less profitable cigarette brands and concentrated his advertising on a few popular and profitable ones. The American Tobacco Company dominated the United States tobacco market for years.

American Tobacco became so powerful the United States Justice Department filed suit against it in 1907. By 1911, the Justice Department had won an antitrust judgment under the Sherman Act, convicting the American Tobacco Company of “unreasonable business practices,” including monopoly practices and restraint of trade. Even after being broken up, the American Tobacco Company still controlled a significant portion of the United States tobacco market because it was allowed to control successful brands such as Pall Mall cigarettes, which the company marketed aggressively. Over the next few decades, however, American Tobacco began to lose market share to R.J. Reynolds Tobacco Co., which heavily advertised Camel cigarettes and eventually controlled over a third of the market for cigarettes in the United States.

The Sherman Antitrust Act did not toll the death knell for the cigarette giants, but later federal regulation did. Because of health concerns, the United States government restricted the advertising of cigarettes in America and issued strong health warnings that reduced the number of people smoking cigarettes in the latter part of the twentieth century, with the trend continuing into the twenty-first century.

De Beers Diamond Company

De Beers was named after a huge diamond mine discovered on the De Beers farm in South Africa. Cecil Rhodes began his monopoly diamond trust by buying the diamond mining claim on De Beers’ farm, and his company eventually became De Beers Consolidated Mines, Ltd. By accumulating several mining claims in the area and convincing competing diamond mining companies to join De Beers’ marketing scheme, Rhodes was able to control the supply of diamonds offered for sale and expand the market for diamonds by aggressively focusing on distributing, advertising, and selling diamonds worldwide. Rhodes developed an efficient distribution and marketing system and convinced other diamond mining companies to market their production through his company—promising that De Beers would control the supply and, therefore, the price of diamonds, thereby guaranteeing cooperating companies a handsome profit if they joined his marketing venture.

In 1914, De Beers sent Ernest Oppenheimer to South Africa to survey its mining claims. Oppenheimer reported that the diamonds were laying around on the surface and could be found easily and cheaply without digging deep into the earth. Oppenheimer saw an opportunity for himself and bought the German mining claims in South Africa during the early months of World War I. The Germans were willing to sell because they believed the British would confiscate their holdings in South Africa during the war. Once Oppenheimer controlled a significant share of the existing diamond mining claims in South Africa, he sent an ultimatum to De Beers, stating that if the company did not make him chairman of De Beers Consolidated Mines, Ltd., Oppenheimer would flood the market with diamonds and drive De Beers out of business. The company agreed, and he became chairman in 1929.

To keep diamond prices high during the Great Depression, Oppenheimer limited the supply of diamonds offered to customers. When market demand became strong again after the Second World War, the company released more diamonds to the market. By 1990, the De Beers cartel controlled the marketing of approximately 90% of the world’s diamonds. However, market factors and antitrust litigation caused this well-known monopoly to lose its dominance of the diamond trade late in the twentieth century.

Several different events broke De Beers’ hold on the diamond trade. First, the Soviet Union dissolved, and Russian companies began selling diamonds outside the De Beers marketing and distribution system to make a quick profit. Next, the United States Justice Department filed an antitrust suit against De Beers. Then Rio Tinto, another mining company, broke with De Beers and began selling its diamonds through Argyle Diamonds, instead. Finally, a class action civil suit charging price fixing was filed in federal court against the De Beers corporation.

De Beers settled the Sherman Antitrust case against it in the United States and a European Union antitrust case against it in Europe. The company also settled all civil class action suits against it for conspiring to fix the price of diamonds, sponsoring false and misleading advertising, and unlawfully monopolizing the diamond supply. De Beers paid approximately $300 million to the class action plaintiffs and their attorneys, and agreed to stop violating federal and state antitrust statutes. Because of these legal and market problems, De Beers’ share of the diamond trade dropped below 35% by 2018. Eventually, the De Beers mines became depleted and the company began manufacturing and selling man-made diamonds under the Lightbox label. The company began a new marketing strategy by focusing on its own brand of diamonds rather than trying to convince others to join the De Beers diamond marketing company. De Beers was no longer able to control the market for diamonds.

International Mercantile Marine Co.

The International Mercantile Marine Co. (“IMM”), a shipping combine, joined several companies into a single entity controlled by J. Pierpont Morgan. Morgan’s goal was to dominate transatlantic shipping, but he failed for two main reasons.

The first cause of IMM’s failure was the serious harm it faced due to competition from the British Cunard Line. In its early years, IMM had prospered by moving immigrants from Europe to the United States. In 1902, the company had carried nearly 65,000 passengers across the Atlantic. Cunard Line, however, was subsidized by the British government and built two giant ocean liners—the Lusitania and the Mauretania, which cut into IMM’s profits. Competition from these two super-liners, which were placed into service in 1907, forced IMM to build three large ocean liners of its own—RMS (Royal Mail Ship) Olympic, RMS (Royal Mail Ship) Titanic, and HMHS (His Majesty’s Hospital Ship) Britannic. The sinking of IMM’s ocean liner Titanic on April 15, 1912, on her first voyage across the North Atlantic, caused major financial losses and serious damage to the company’s reputation. Partly as a result of bad publicity and financial problems associated with thesinking of Titanic, IMM suffered cash flow problems and defaulted on interest payments in 1914.

The loss of Titanic also brought new regulatory scrutiny to IMM. The American commission of inquiry looking into the causes of the shipwreck highlighted IMM’s monopolistic nature, and the company was attacked by members of the United States Senate for its unfair business practices. The second cause of IMM’s failure was not due to antitrust laws, though, but rather was due to the fact that airplanes became the preferred way to travel across the Atlantic because of their greater speed. In 1916, the cartel reorganized its finances and emerged as a stronger business, when the shipping business was revived for a time by demand for moving troops and supplies across the Atlantic Ocean to Europe during World War I.

The Match King

Ivar Kreuger was hailed as the savior of Europe after World War I because his company made loans to bankrupt countries at reasonable interest rates. Kreuger’s company had a better credit rating than many European governments, so he was able to offer bonds to cash-strapped countries at a lower interest rate than the governments of France or Germany, for example, could attract on the open market. Kreuger was able to make a profit by taking out low-interest loans based on his good credit and reselling these bonds to governments at a higher interest rate.

Kreuger was born in 1880 in Sweden and emigrated to the United States when he was twenty years old. For several years he worked on construction projects around the world and learned everything about reinforced concrete construction. He returned to Sweden in 1907, formed a partnership with a young Swedish engineer named Toll, and went into the construction business. By 1923, Kreuger and Toll were successfully making matches and constructing commercial buildings. However, that was not enough for Kreuger—he wanted to dominate the financial world, so he shifted his interests from manufacturing and construction to market manipulation and financial engineering. Kreuger decided to concentrate his business in finance and began to manipulate the price of his stock by paying higher and higher dividends.

Eventually, Kreuger overextended his financial empire and transformed his business into a giant Ponzi scheme that defrauded thousands of investors when it failed after the 1929 stock market crash and Great Depression. Kreuger bought other companies—including a telephone company (Ericsson) that still exists today—by manipulating the price of his company’s stock and by paying high dividends out of capital. Like all Ponzi schemes, this one was doomed to fail sooner or later because the cost of paying high dividends to stockholders out of capital guaranteed that the company would eventually go broke.

Krueger’s empire began to show cracks in October 1929, after the New York Stock Market began to fall. He tried several desperate moves to restore confidence in his business, including a loan of $125 million to the German government that he could not afford and the forging of nearly £29 million in Italian government bonds. He added a large part of these fake Italian bonds to the balance sheet of Kreuger and Toll, in an effort to make his financial empire appear solvent. The ploy worked for a few months until the next set of dividend payments came due. In desperate need of cash, Kreuger had to sell Ericsson to raise money to pay the coming dividend and continue his Ponzi Scheme. International Telegraph & Telephone Company agreed to buy Ericsson, but when its auditors looked at Ericsson’s books in detail, they discovered a twenty-seven-million kroner asset that was nothing more than a claim by Ericsson on Kreuger’s other businesses—in other words, worthless paper with no specific assets as collateral.

With his empire collapsing, Kreuger became more and more anxious, distracted, and despondent. His business empire eventually failed as the United States stock market collapsed, and the world economy fell into depression. Kreuger was tried, convicted of fraud, and sent to prison. No one is certain how much money disappeared in Kreuger’s Ponzi scheme—estimates range from $250 million to over $400 million, and his investors collected only pennies on each dollar they invested in his company.

To avoid a repeat of Kreuger’s Ponzi Scheme, the United States Congress passed The Trust Indenture Act in 1939, to regulate the type and amount of collateral required to make a loan in the United States. In 1934, Congress had established the Securities Exchange Commission (SEC) to regulate stock market activities, prosecute stock market fraud, and monitor insider trading in securities.

The Sherman Antitrust Act

In 1890, Congress passed the Sherman Antitrust Act, to limit anticompetitive agreements and monopoly market activities among American businesses, like those just described. The United States Justice Department was authorized to investigate and sue any entity or group that limited competition. The Act was intended to keep businesses from artificially restricting the supply of goods coming to market so they could control the price they charged consumers. The Act was also intended to prevent agreements among businesses designed to limit competition and manipulate prices. The Act’s purpose was to maintain a competitive marketplace in the United States.

The Act is divided into three parts: (1) section one prohibits specific types of anticompetitive acts; (2) section two deals with results that are anticompetitive; and (3) section three extends jurisdiction to enforce the Act to United States Territories and the District of Columbia. The United States Justice Department began applying the Sherman Antitrust Act to monopolistic business practices immediately after it was enacted. During the twentieth century, over half a dozen monopolies were broken up through Supreme Court decisions or out-of-court settlements. In 1902, the Chesapeake & Ohio Fuel Company trust was dissolved. In 1904, Northern Securities was disbanded. In 1906, the Standard Oil Trust was broken up. In 1911, the American Tobacco Co. was divided into four new tobacco companies. In 1911, General Electric Co., Philips, Sylvania, Tungsol, Consolidated Chicago Miniature, Corning, and Westinghouse were all forced to sign consent decrees that they had violated the Sherman Antitrust Act. By contrast, the Federal Baseball Club was found to have not violated the Sherman Act because the United States Supreme Court determined that baseball organizations did not engage in interstate commerce and, therefore, were not subject to the Sherman Antitrust Act.

The Act continues to be a powerful tool in the federal government’s arsenal. In 1982, AT&T agreed to a breakup of its businesses through negotiations with the United States Justice Department. In 2001, Microsoft Corporation settled with the United States Justice Department without being required to break up, although Microsoft was required to modify its business practices to allow more competition in the computer industry. The Biden Administration’s first proposed budget includes a hefty increase for the Federal Trade Commission and the Department of Justice’s Antitrust Division, presumably to fund the actions recently filed against large technology companies.

The purpose of the Sherman Antitrust Act is to prevent price manipulation by agreements among companies to restrict competition. A monopoly developed solely because a business is better than its competition is not affected by the Sherman Antitrust Act, which does not protect inefficient businesses from effective competition. Instead, the Act is designed to prevent illegal secret agreements among businesses to raise prices by limiting competition and restricting the supply of goods coming to market. In that way, that Act is designed to protect consumers by maintaining a competitive marketplace.

Some economists and judges have criticized the Sherman Antitrust Act on various grounds. For example, Alan Greenspan claimed the Act stifles innovation and harms American consumers by causing capital to be allocated in non-optimal ways. Judges Robert Bork and Richard Posner, moreover, have proposed that, under the Sherman Antitrust Act, alleged monopolies should be evaluated for both economic efficiency and restraint of trade; and that inefficient cartels could be eliminated by market forces alone, thereby eliminating the need for antitrust legislation.

Harry Munsinger recently concluded a long practice that focused on Collaborative Divorces, Estate Planning, and Probate matters. Harry holds a Ph.D. in psychology from the University of Oregon and a J.D. from Duke University School of Law, where he was a member of the Duke Law Journal.