The Granholm and Costco cases ushered in a new era for wineries. Vintners nationwide rejoiced when these rulings apparently breached the walls of the three-tier fortress and signaled the advent of free trade in wine. But when the dust settled, the results were just the opposite in many states.
These two court decisions required states to reconsider any discriminatory aspects of their wine distribution scheme, in order to level the playing field between in-state and out-of-state suppliers. The wineries in California and Washington were strong enough to cash in on the promise of free trade, by getting their legislatures to pass laws that granted the privileges enjoyed by domestic wineries to out-of-state suppliers as well. However, vintners in Virginia, Indiana, Illinois, Pennsylvania, Oklahoma, Delaware, Kentucky, and Louisiana were not so fortunate. In those states, the precious privileges of self-distribution and direct-to-consumer sales were attacked by the strong wholesale lobby, and in some cases, wineries actually lost their existing privileges.
In the various political battles occurring across the nation, the sanctity of the three-tier system stands out as one of the primary arguments for curtailing the marketing options of small wineries. But behind the scenes, the controversy is actually being driven by the interplay of several factors that are rarely openly acknowledged in the halls of legislature:
the entrenched economic interests of the wholesale tier,
an antiquated regulatory system designed to solve problems long gone, and
shrinking access to the marketplace for small producers due to consolidation.
It’s time to pull back the curtain and separate the myth from the reality. There is no doubt that the three-tier system is a practical and economic reality, but it is disingenuous of the wholesalers to act as if the three-tier system were enshrined on stone tablets handed down from heaven. While naive wine industry members watch, wholesalers make sure regulators keep chanting their favorite mantra, “we are a three-tier state,” without any of them ever examining whether the law of their state supports that position.
The aim of this article is to help vintners on the frontlines defend their precious marketing privileges by exposing some of the myths surrounding the three-tier system. The wholesale tier is getting away with highway robbery when they portray the three-tier system as an inviolate principle for which your winery’s sales must be sacrificed.
Indeed, there is a surprising abundance of evidence against this largely unquestioned contention. Not only do state laws fail to support the wholesalers’ propaganda, but a close look at the industry reveals that wholesalers themselves are blurring the lines between the tiers. While a single article may not be able to change the balance of power, the insights in this article will help you see through the smoke and mirrors.
What is the three-tier system anyway?
At the end of Prohibition, reformers across the country uniformly decided that the best way to prevent producers from controlling retailers was to establish a legally mandated separation between those two levels of the industry. Part of the motivation for this extreme measure was the desire to shield retailers from the criminal element that had taken over the alcoholic beverage supply chain during Prohibition. It was also believed that the economic power producers had wielded over retailers, evidenced by the abuses of the pre-Prohibition “tied house saloons,” had led to intemperance. Thus, the three-tier system was devised.
The three-tier system prohibits producers from having any financial interest in a retailer, and created a middle tier of independent distributors. So the first tier is the suppliers: wineries, breweries, distillers, and importers. The second tier is wholesalers; the third tier is retailers. The first and second tiers (suppliers and wholesalers) are often referred to collectively as the “upper tiers.”
Under this system, producers sell only to distributors, and distributors sell only to retailers, who then sell to consumers. Upon Repeal most of the states adopted some parts of this system, and both the reality and myth of the three-tier system were born.
The economic and practical reality
The three-tier system is an economic fact in the distribution of alcoholic beverages-virtually every drop of beer, wine and spirits sold in the United States passes through all three tiers. While wineries have the most options for making sales outside of the three-tier system, over 90% of the wine sold in the United States still passes through all three tiers.
Even Costco, having won the right to buy direct from out-of-state wineries and breweries, is finding that most producers still want to use their distributors. Distributors can and do provide valuable services and they will continue to handle the vast majority of wine distribution in the future.
The existing distribution channels for wine are similar to distribution channels for other goods such as soft drinks and other beverages. But what is different in the beverage alcohol supply chain is that the distributors’ role is not dependent on its utilitarian value, but rather on set of legal mandates that have become enshrined in the simple phrase “the three-tier system.” The phrase is often used in lieu of logic and legal research as a stand alone magical incantation to address all issues or objections. Regulators routinely preface their statements with, “You know, we are a three-tier state,” as if that justifies or explains everything. But the truth is, the only way to be sure how strictly separated the tiers are in any state is to investigate what its laws actually say.
What are the legal mandates for a three-tier system?
The wholesalers don’t admit it, but even they can’t deny that there is no nationwide mandate for three separate tiers. The 21st Amendment of the Constitution says nothing about a three-tier system. It left it up to the states to structure some type of non-discriminatory distribution system. Likewise, the Federal Alcohol Administration Act (FAA Act) does not mandate three independent and separate tiers. In fact, it only prohibits partial interests in retailers by upper tier members, but allows suppliers and wholesaler to own retail outlets outright. Further, the FAA Act has no restrictions on cross-ownership between suppliers and wholesalers. While the FAA Act does impose substantial trade practice restrictions on the business practices between members of different tiers in the industry, it does not prohibit a winery from becoming a retailer or a wholesaler, nor a wholesaler from becoming a winery or a retailer.
A few years ago one our winery clients in an Eastern state wanted to become an importer and wholesaler of French wines. When we discussed his plan with the state regulators, we were told he wasn’t eligible for the additional licenses he’d need, since it was a “three-tier state.” It was true that the state regulations precluded him having an interest in both the supplier and wholesale tier. However, the state’s regulations stated they were based on “federal law.” (Can you see what’s wrong with that position? If not, go back and read the preceding paragraph!) When we pointed out that federal law does not prohibit our client from operating in both upper tiers, the state readily capitulated, and granted him a wholesaler license. Reality prevailed over the myth.
While a few states adopted laws that explicitly require a strict division between tiers, many did not. Almost all the states do have laws requiring the separation between the retailers and the upper tiers; virtually all the states prohibit a supplier or wholesaler from having an interest in a retail license. Winery tasting rooms and restaurants owned by wineries are common exceptions, as are brewpubs. But in many states there is no prohibition barring upper tier integration. Several states allow in-state manufacturers to sell directly to retailers or allow the manufacturer to hold wholesale licenses for the same purpose. The truth is, these states only have a two-tier system for in-state producers, since no law mandates the separation of upper tier interests.
In the past, states often allowed in-state licensees to bridge the two upper tiers, but did not give out-of-state producers the same privilege. Today, under the Granholm decision, such discriminatory treatment of out-of-state suppliers could be challenged. Fear of that possibility galvanized the wholesalers in Virginia and Louisiana to successfully lobby for legislation depriving their in-state wineries of the privilege of self-distribution.
But surprisingly, a few states have traditionally allowed out-of-state wineries and brewers to hold a wholesale licenses and self-distribute their own product in that state. Other laws requiring wholesalers to have a minimum amount of warehouse space, investment and inventory may make the exercise of that privilege impractical in specific cases, but the fact remains that the three-tier system is not legally mandated in those states.
So, we have seen that the three-tier system is not mandated by the Constitution or by Federal law, but only by state laws in some states. Regardless of the aura surrounding the three-tier system, it may not be essential to the maintenance of temperance, orderly market conditions, or collection of taxes. Do California and Washington have any less orderly markets since they’ve allowed both in and out of state wineries to become wholesalers or sell direct to retailers? Do they have problems with intemperance or collection of taxes? Most would agree that the answer is “no” on both accounts.
Not surprisingly, the California Beer and Beverage Distributors Association claimed that California has a problem and proposed legislation to add new “intent language” to California’s ABC code. Even though California law recognizes all three tiers of distribution, it is not labeled a “three-tier system.” In a bold move to protect their shrinking turf, the Distributors Association wanted to add language to the law that stated it was “three-tier system,” and that such a system was “essential for temperance, orderly markets, and tax collection.” Officially, the Association claimed the rationale for the addition was to avoid linking higher excise taxes to temperance and to update the law for technological changes. The bill never advanced from committee and left most wondering what the distributors had been smoking. In their zeal to get the “myth of the three-tier system” enshrined into law, the distributors completely ignored reality: California law freely allows upper tier integration.
The unholy double standard
Undoubtedly the distributor lobby in Virginia and Louisiana wielded the holy grail of preserving the three-tier system when they succeeded in removing the rights of in-state wineries to self-distribute. But, ironically, an importer-wholesaler from one of those states wanted to buy a winery in another state. After being initially told that its plan would violate its home state’s three-tier system, its legal counsel proved that the statute did not make it illegal for the importer-wholesaler to own a supplier in another state. So while the wineries have been made to suffer in order to preserve the myth that the three-tier system must be maintained at all costs, this middle tier member had no compunction about transcending the system to become a supplier.
Ironically, although wholesalers passionately crusade for three separate tiers, there are relatively few barriers preventing wholesalers from being or acting like suppliers. For foreign products, wholesalers routinely act as importer-of-record-a blending of the first and second tier. Since most states license importers as wholesalers, we have an integrated upper tier for virtually all imported brands. Wholesalers also act like suppliers by becoming brand owners. While the actual production is contracted out, the wholesaler-brand owner makes all of the major decisions for the brand. Many major wholesalers already have interests in brands, such as Young’s Market’s ownership of the Seagram’s Vodka brand, or Southern Wine & Spirits’ ownership of Shaw Ross and its many imported brands.
Clearly, if wholesalers are acting like suppliers, they are demonstrating there is no tied house evil in upper tier integration. If wholesalers can be suppliers, why can’t wineries be wholesalers or sell direct to retailers? To end this illogical double standard, should wholesalers be prohibited from having any interest in a supplier, including being an importer or owning brands? Such a suggestion would be strongly opposed by them, we’re sure. Actually abiding by a strict three-tier system would cramp their style!
Let’s get real
They’ll never admit it, but wholesalers’ own behavior makes it obvious that the myth of the three-tier system has become a specious, hypocritical argument by which the second tier protects its economic interests at the expense of wineries. If wineries hope to defeat this large, well-organized opponent, we’d better start educating ourselves and our regulators in the difference between myth and reality.
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