U.S. Supreme Court Establishes the “Rule of Reason” Summary

  • Last updated on November 10, 2022

In its decision to break up the Standard Oil Company, the U.S. Supreme Court established the principle of the “rule of reason” in relation to the violation of antitrust laws.

Summary of Event

Founded in 1870, Standard Oil Company became one of the largest companies in the United States by the end of the nineteenth century. In Standard Oil v. United States, decided on May 15, 1911, the U.S. Supreme Court found the company guilty of violating the Sherman Antitrust Act of 1890 based on alleged “unreasonable” restraints of trade, including buying out small independent oil companies and cutting prices in selected areas to force out rivals. The Court’s decision resulted in the separation of the parent Standard Oil from its thirty-three affiliates. Oil industry;Standard Oil Standard Oil Supreme Court, U.S.;antitrust and corporate regulation Antitrust legislation Standard Oil v. United States (1911) Rule of reason principle [kw]U.S. Supreme Court Establishes the “Rule of Reason” (May 15, 1911) [kw]Supreme Court Establishes the “Rule of Reason,” U.S. (May 15, 1911) [kw]Court Establishes the “Rule of Reason,” U.S. Supreme (May 15, 1911) [kw]"Rule of Reason," U.S. Supreme Court Establishes the (May 15, 1911)[Rule of Reason, U.S. Supreme Court Establishes the (May 15, 1911)] [kw]Reason," U.S. Supreme Court Establishes the “Rule of (May 15, 1911)[Reason, U.S. Supreme Court Establishes the Rule of (May 15, 1911)] Oil industry;Standard Oil Standard Oil Supreme Court, U.S.;antitrust and corporate regulation Antitrust legislation Standard Oil v. United States (1911) Rule of reason principle [g]United States;May 15, 1911: U.S. Supreme Court Establishes the “Rule of Reason”[02800] [c]Trade and commerce;May 15, 1911: U.S. Supreme Court Establishes the “Rule of Reason”[02800] [c]Laws, acts, and legal history;May 15, 1911: U.S. Supreme Court Establishes the “Rule of Reason”[02800] Rockefeller, John D. (1839-1937) White, Edward D.

Eleven years after the historic oil discovery in Titusville, Pennsylvania, that marked the beginning of the modern oil refining industry, the Standard Oil Company was incorporated by John D. Rockefeller in Cleveland, Ohio, on January 10, 1870. At the time of the company’s formation, the oil refining industry was decentralized. Standard Oil’s share of refined oil production in the United States was less than 4 percent, and Rockefeller had to compete with more than 250 other independent refineries.

During the last quarter of the nineteenth century, deflation and oversupply of oil brought down oil prices, causing fierce competition among oil refineries. The price for refined oil fell from more than thirty cents a gallon in 1870 to ten cents a gallon in 1874 and to eight cents in 1885. Compared with other oil refineries, Standard Oil was managed efficiently under Rockefeller and his associates; this enabled it to survive while many competitors failed.

During the post-Civil War deflationary period, the railroad industry became very competitive. Rockefeller took advantage of Standard Oil’s increasing size to secure secret rebates from shipping companies, thus reducing transportation costs and overall operating costs. Rockefeller further reduced Standard Oil’s operating costs by vertically integrating the company, acquiring oil wells, railroads, pipelines, tank cars, and retail outlets. Vertical integration gave the company more control at all stages of production.

Meanwhile, because of declining market conditions, many small and nonintegrated oil companies that were unable to reduce their operating costs became unprofitable to operate. In addition, the method of destructive distillation introduced in 1875 increased the minimum efficient size of a refinery to more than one thousand barrels per day, making smaller companies even less competitive. Rockefeller began to take advantage of the situation, buying out many of the independent refineries in Pittsburgh, Philadelphia, New York, and New Jersey at low prices, often below their original cost. Standard Oil soon refined about 25 percent of the U.S. industry output. In 1882, Rockefeller and his associates formed the Standard Oil Trust in New York, the first major “trust” form of business combination in U.S. history. The company held “in trust” all assets of the many regional Standard Oil subsidiary companies, one of which was Standard Oil of New Jersey, the third-largest U.S. refinery in the 1880’s. Despite the substantial drop in oil prices, Standard Oil was able to increase its profits by reducing costs from about three cents per gallon in 1870 to less than one-half cent per gallon in 1885. By 1900, the oil trust controlled more than 90 percent of the petroleum refining capacity in the United States.

The size and power of Standard Oil led to public hostility against the company and against monopolies in general, prompting the U.S. Congress to pass the Sherman Antitrust Act in 1890. Sherman Antitrust Act (1890) During the same year, immediately after New York State’s action against the “sugar trust,” the state of Ohio brought a lawsuit against Standard Oil for illegal monopolization of the oil industry. On March 2, 1892, the Ohio Supreme Court found that Standard Oil had violated the Sherman Act by forming a holding company and forbade the company to operate Standard Oil of Ohio in that state.

The Ohio court decision led to dissolution of the Standard Oil Trust back into its independent parts. The New Jersey unit took advantage of favorable state laws to become the Standard Oil Company of New Jersey, later known as Jersey Standard, as the trust’s parent holding company. Rockefeller remained president, and management of the trust was consolidated through interlocking directorates of the more than thirty subsidiary companies. The supposedly separate companies thus were able to act as a single entity.

In 1901, the discovery of the Spindletop oil field created a boom in oil production on the Gulf coast of Texas. The formation of new oil companies, such as Texaco and Gulf, increased the competition faced by Standard Oil. Standard Oil responded by continuing to buy out independent oil refineries. The Standard Oil Trust’s market share in the oil industry continued to expand.

Meanwhile, the commissioner of the U.S. Bureau of Corporations, James Rudolph Garfield, Garfield, James Rudolph investigated Standard Oil for violations of antitrust law. As a result of his studies, the federal government, led by Attorney General George Woodward Wickersham, Wickersham, George Woodward brought charges in November, 1906, in the Federal Circuit Court of the Eastern District of Missouri against Standard Oil for monopoly and restraint of trade in violation of the Sherman Antitrust Act.

In 1909, the Missouri court found Jersey Standard guilty of violating section 1 of the Sherman Act by forming a holding company and of violating section 2 by restraining competition among merged firms by fixing transportation rates, supply costs, and output prices. Standard Oil appealed the decision to the U.S. Supreme Court, and on May 15, 1911, the Court upheld the Missouri decision. The Court later entered a dissolution decree to dismember the Standard Oil trust and divest the parent holding company, Jersey Standard, of its thirty-three major subsidiaries. Many of its offspring still bore the name Standard Oil. These new companies included the Standard Oil Company of Indiana (later American), the Standard Oil Company (Ohio), Standard Oil Company of California (later Chevron), Standard Oil of New Jersey (later Exxon), and Standard Oil of New York (later Mobil).

Significance

The Standard Oil case marked the beginning of a new direction in U.S. antitrust legislation and prosecution. Along with the Supreme Court’s decision in the American Tobacco case in 1911, the Court’s ruling, led by Chief Justice Edward D. White, departed from rulings in earlier cases. The new interpretation of section 2 of the Sherman Act was that only “unreasonable,” instead of all, restraints of trade were illegal. The Standard Oil decision, followed closely by the American Tobacco case, gave birth to a new doctrine in U.S. antitrust policy known as the rule of reason.

The allegedly “unreasonable” practices by Standard Oil that were ruled illegal under sections 1 and 2 of the Sherman Act included forcing smaller independent companies to be bought on unfavorable terms and selectively cutting prices in market areas where rivals operated, with the intent of bankrupting those rivals, while maintaining higher prices in other markets. Chief Justice White maintained that it was mainly Standard Oil’s merger practices in an attempt to monopolize the oil refining industry that constituted illegal restraint of trade.

The Standard Oil case of 1911 significantly altered the course of American business history as well as the development of U.S. antitrust laws. The victory of the government against a powerful trust provided an important lesson in the early history of antitrust. The dissolution of Standard Oil into many independent companies effectively increased competition in the oil industry. In addition, the case provides a classic study of the development of American big business at the beginning of the twentieth century.

A 1911 editorial cartoon suggests that the tobacco trust might be next after the Supreme Court’s censure of the oil industry.

(Library of Congress)

The first major antitrust law was the Sherman Antitrust Act of 1890, which emerged largely from public dissatisfaction with the monopoly power gained by Standard Oil in the oil refining market. The Sherman Act prohibits conspiracies or combinations in restraint of trade (section 1) and any attempts to create them, known as monopolization (section 2). The limits of the law regarding what constitutes unlawful practices were not precisely defined in the act, leading to different judicial interpretations of the act.

In the first decade following passage of the Sherman Act, only sixteen antitrust cases were brought to court. Even though the courts began to establish that actions such as formal agreements to fix prices or limit output were definitely illegal, judges were equivocal in their treatments of the existing large trusts in industries such as oil (Standard Oil), tobacco (American Tobacco), and steel (United States Steel).

The Supreme Court’s decision against Standard Oil marked the beginning of a new era in antitrust legislation and prosecution. It established the “rule of reason” approach, by which Chief Justice White maintained that it was not the history or the relative size of a monopoly such as Standard Oil in its market that was an offense against the law, but rather its “unreasonable” business practices. This new doctrine set a precedent for cases involving antitrust laws that was not broken until the Alcoa case in 1945.

The Supreme Court decision in the Standard Oil case highlighted the need for additional legislation to define specific business practices that constitute “unreasonable,” and thus illegal, conduct. That need led to passage of the Clayton Antitrust Act Clayton Antitrust Act (1914) and the Federal Trade Commission Act Federal Trade Commission Act (1914) in 1914. The Clayton Act declared illegal specific “unfair” business practices, including price discrimination, exclusive dealing and tying contracts, acquisitions of competing firms, and interlocking directorates. The Federal Trade Commission Act gave birth to a new government authority, the Federal Trade Commission, to enforce compliance of the modified antitrust law.

The government’s victory in its prosecution of Standard Oil, together with passage of the Clayton Act, led to more vigorous enforcement of the antitrust laws. The U.S. Justice Department filed suit in the 1910’s and early 1920’s against many trusts in other industries, including American Can Company (tin cans), United Shoe Machinery Company (shoe machinery), International Harvester Company (farm machinery), and United States Steel Corporation (steel). The Supreme Court decision against Standard Oil also signified the government’s attitude toward mergers. Mergers;U.S. Mergers and acquisitions subsided briefly, until the government’s failure in prosecuting the merger practices of the United States Steel Corporation in 1920.

The dissolution of the oil monopoly, Standard Oil, effectively changed the structure of the oil industry. On one hand, its successor companies, particularly the New Jersey unit, maintained considerable market power in their regional territories. The retail price of gasoline increased sharply in 1915, leading to government investigation of the extent of competition in the oil industry. On the other hand, the government apparently succeeded in enforcing competition among the separated units. As a result of the dissolution, Standard Oil’s successor companies were allowed to operate only in the oil refining business. They began to confront competition from other companies, such as Shell, Gulf, and Sun, which operated with the advantage of vertical integration.

In an attempt to battle the rising competition, two of Standard Oil’s successor companies, Standard Oil of New York and the Vacuum Oil Company, proposed a merger in 1930. The government filed suit in federal district court against the merger, asserting that it would violate the 1911 decree. The court’s decision in favor of the merger began a new era of merger movement in the oil industry. Through mergers, the original thirty-four successor companies combined into nineteen companies during the 1930’s.

In the 1920’s, Standard Oil’s successor companies began to expand their oil exploration overseas, particularly in the Middle East and Europe. That exploration continued as American resources were exhausted. Increased imports of oil, notably from the Organization of Petroleum Exporting Countries (OPEC) after its formation in 1960, intensified competition in the U.S. oil market and reduced American companies’ market shares. The oil refining industry developed into one with companies operating worldwide, many of them large relative to the industry as a whole but none with the power formerly held by Standard Oil. Oil industry;Standard Oil Standard Oil Supreme Court, U.S.;antitrust and corporate regulation Antitrust legislation Standard Oil v. United States (1911) Rule of reason principle

Further Reading
  • citation-type="booksimple"

    xlink:type="simple">Adams, Walter, and James Brock, eds. The Structure of American Industry. 10th ed. Upper Saddle River, N.J.: Prentice Hall, 2000. Chapter 2 provides good coverage of the background and historical development of the petroleum industry as well as discussions of the industry’s structure, price behavior, and performance. Valuable for undergraduate and graduate students in industrial organization.
  • citation-type="booksimple"

    xlink:type="simple">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. Chapter 4 covers the Standard Oil case. Includes an appendix of relevant sections of antitrust laws. Written for undergraduate business and economics students.
  • citation-type="booksimple"

    xlink:type="simple">Bradley, Robert L. Oil, Gas, and Government: The U.S. Experience. Washington, D.C.: Cato Institute, 1996. The second section of this book presents a comprehensive account of the U.S. oil industry’s history, including interventions in the industry by state and federal governments and the courts.
  • citation-type="booksimple"

    xlink:type="simple">Destler, Chester McArthur. Roger Sherman and the Independent Oil Men. Ithaca, N.Y.: Cornell University Press, 1967. A biographical study of the author of the Sherman Antitrust Act, who fought for small independent oil refineries against the monopolization of the industry by Standard Oil in the northeastern region.
  • citation-type="booksimple"

    xlink:type="simple">Gibb, George Sweet, and Evelyn H. Knowlton. The Resurgent Years, 1911-1927. Vol. 2 in History of Standard Oil Company (New Jersey), edited by Henrietta M. Larson. New York: Harper & Brothers, 1956. Discusses the evolutionary development of the New Jersey unit following the Standard Oil case in 1911, including operations overseas, increased competition with other Standard Oil successors, and labor relations.
  • citation-type="booksimple"

    xlink:type="simple">Hall, Kermit L., ed. The Oxford Guide to United States Supreme Court Decisions. New York: Oxford University Press, 1999. Multiauthored collection of essays on more than four hundred significant Court decisions, with supporting glossary and other aids.
  • citation-type="booksimple"

    xlink:type="simple">Hidy, Ralph W., and Muriel E. Hidy. Pioneering in Big Business, 1882-1911. Vol. 1 in History of Standard Oil Company (New Jersey), edited by Henrietta M. Larson. New York: Harper & Brothers, 1955. Comprehensive documentation of the company’s early history, particularly its administration and vertically integrated operations in the oil business. Good discussion of the dynamic development of a big corporation from the perspectives of business administration and business history. Valuable for business students.
  • citation-type="booksimple"

    xlink:type="simple">McGee, John. “Predatory Price Cutting: The Standard Oil (N.J.) Case.” Journal of Law and Economics 1 (October, 1958): 137-169. Controversial article provides arguments and evidence against accusations of predatory pricing practices by Standard Oil. This critique led to debates about the profitability of predatory price cutting and its violation of antitrust law.
  • citation-type="booksimple"

    xlink:type="simple">Whitney, Simon N. Antitrust Policies: American Experience in Twenty Industries. 2 vols. New York: Twentieth Century Fund, 1958. Chapter 3 of volume 2 provides a case study of the petroleum industry until 1950. Good economic analysis of the impacts of the antitrust suit on development of the industry. Other chapters are case studies of other major industries. Appendix contains critiques of the studies of economists and government officials.

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