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DIRECT SHIPPING: IS THE THREE TIER SYSTEM AT RISK?

By Gary Ettelman, Esq. and Keith B. Hochheiser, Esq.

Wholesalers beware! There is a growing trend in the United States, fueled by the rapid development of the internet, for manufacturers to sell their wares directly to consumers. Log on to the internet and you can buy just about anything directly from the manufacturer. Proponents of e-commerce extol the virtues of convenience, greater selection and reduced prices. Distributors are already experiencing reduced sales, and it would be foolish to believe that the trend of direct shipping is anywhere near reaching its potential. Should beer wholesalers be concerned? You bet they should. Fortunately, however, beer wholesalers (and wholesalers of other alcoholic beverages) have a weapon that other wholesalers do not – the 21st Amendment to the Constitution. While the 21st Amendment clearly offers protection to wholesalers of alcoholic beverages, recent cases demonstrate that this protection is far from absolute.

The 21st Amendment, which repealed prohibition, grants to the States the right to regulate the importation, transportation, sale and use of alcoholic beverages within their borders. Historically, distributors of alcohol have been protected in two distinct but similar ways. First, States have enacted legislation establishing a three tier system of alcohol distribution. The first tier (the manufacturer) may only sell to the second tier (the wholesaler) which may only sell to the third tier (the retailer). Under the three tier system, consumers may only purchase from the third tier. Second, many States have enacted legislation which prohibits the direct shipment of alcoholic beverages to consumers.

In this column we will discuss (within the constraints of a two page article!) some recent cases dealing with “direct shipping” statutes, what the potential impact of these cases have on the continued viability of the three tier system and how two separate provisions of the Constitution – the 21st Amendment and the Commerce Clause - affect the issue.

Constitutional Background

Before prohibition, alcohol regulation was solely a State and local issue. Not surprisingly, there were significant differences in the policies of different States, with many States banning the sale of alcohol altogether. Clever suppliers, however, were able to avoid the impact of “dry State” legislation by setting up shop in a non-dry State and shipping their product to the dry State. Because regulation of interstate commerce was solely within the province of Congress, States were powerless to pass legislation restricting the flow of interstate commerce. Accordingly, suppliers were able to avoid such state legislation. In order to thwart the suppliers’ end-run of state legislation, in 1913 the federal government passed the Webb-Kenyon Act which made it illegal for a supplier to sell or transport liquor in violation of State law.

Then, with the ratification of the 18th Amendment to the Constitution in 1919, the federal government imposed a “one-size fits-all” policy on the country. The 18th Amendment prohibited the manufacture, sale, or transportation of alcoholic beverages into, out of, or within any State. Prohibition came to an end in 1933 with the ratification of the 21st Amendment, which in general, scrapped the national policy, and allowed each State to individually regulate alcohol within their respective borders. Similar to the Webb-Kenyon Act, the 21st Amendment provides that the “transportation or importation into any State . . . for delivery or use therein of intoxicating liquors, in violation of the laws thereof, is hereby prohibited.”

It would appear that the 21st Amendment gave to the States unlimited power to regulate the importation, transportation and sale of liquor and the early cases on the subject mirrored that view. However, another provision of the Constitution, known as the Commerce Clause, which gives to Congress the right to regulate commerce between the States, has muddied the waters. Congress’ power under the Commerce Clause has been broadly construed by the courts, to the point that Congress can enact legislation on nearly any matter, as long as a legitimate argument can be made that the matter travels in, or effects interstate commerce. Not surprisingly, the clashing of these diametrically opposed Constitutional provisions has spawned significant litigation.

The Supreme Court Steps In

The tug-of-war between the Commerce Clause and the 21st Amendment provisions can best be demonstrated by a look at the decisions of the United States Supreme Court. In State Board of Equalization of California v. Young’s Market, a 1936 case and one of the first Supreme Court cases construing the 21st Amendment, the Court reviewed a California statute imposing a fee on beer imported from outside California, while exempting beer brewed inside the State from the fee. The Court upheld the statute, on the ground that the 21st Amendment exempted California from other Constitutional requirements, namely the Commerce Clause. More recent Supreme Court cases have, however, taken a different view.

For example, in 1984, the Supreme Court decided Bacchus Imports v. Dias, involving a Hawaiian law exempting in-state liquor manufacturers from a state tax. The Court struck down the law, on the ground that it discriminated against out-of-state manufacturers, in violation of the Commerce Clause. The Court stated that the Hawaiian statute could not be saved by Hawaii’s rights under the 21st Amendment, because the statute constituted mere “economic protectionism,” which was clearly not the intent of the 21st Amendment. In other words, the Court ruled that because the statute’s purpose was solely to protect Hawaiian suppliers at the expense of suppliers outside Hawaii, the statute was not afforded the protections of the 21st Amendment. Similarly, in 1989, in Healy v. The Beer Institute the Court struck down a Connecticut law requiring out-of-state shippers to certify that the prices charged to Connecticut wholesalers were not higher than the prices charged to wholesalers in bordering States. The court struck down the law, on the grounds that it violated the Commerce Clause, because the law constituted “economic protectionism”. However, in 1990 the Court turned around and allowed a State statute to stand. In North Dakota v. United States the Court found that a pair of State statutes concerning labeling and reporting requirements was permissible under the 21st Amendment. The Court’s decision rested on the fact that the statutes fell “within the core of the State's power under the Twenty-first Amendment.” Such “core” power included the State’s interest in “promoting temperance, ensuring orderly market conditions, and raising revenue.”

The Direct Shipping Cases

Of recent vintage (pun intended) are several lawsuits championed by a number of vintners attacking the constitutionality of State statutes banning the direct shipment of wine. In Bridenbaugh v. Freeman-Wilson, a federal appellate court upheld an Indiana law prohibiting the shipment of alcohol from out-of-state suppliers directly to Indiana consumers. Indiana consumers challenged the law, arguing that because the statute restricted only sellers in another State or country, it discriminated against out-of-state entities in violation of the Commerce Clause. The Seventh Circuit disagreed, finding that the law did not discriminate in favor of local wineries, since no matter where the alcohol originated – in-state or out-of-state - a permit was required to distribute it to Indiana consumers. The court relied on the 21st Amendment’s broad grant of power to the States to regulate alcohol and limited its analysis to whether the statute was discriminatory.

Two years later, a different federal appellate court rejected the Bridenbaugh court’s approach when it analyzed a Florida law in Bainbridge v. Turner. Florida’s law had an exception for in-state wineries allowing them to hold vendor’s permits as well as manufacturer’s permits. With a vendor’s permit, in-state wineries could ship directly to consumers, bypassing the three-tier system. The Bainbridge court said that Florida’s exception for in-state wineries was discriminatory towards out-of-state wineries and violated the Commerce Clause. Nevertheless, applying a type of balancing test, the court held the statute could be “saved” if it was a valid exercise of State “core” powers under the 21st Amendment. In other words, if Florida could demonstrate to the trial court that its statutory scheme was “closely related to a core concern of the 21st Amendment of raising revenue and not a pretext for mere protectionism,” Florida’s law could be upheld. In reaching its decision, the court found that interests besides temperance, such as ensuring orderly market conditions and raising revenue, were “unquestionably legitimate” under the 21st Amendment.
Another example is a recent case in New York, Swedenburg v. Kelly, in which a federal trial court held that the New York State ban on direct shipments of out-of-state wine directly to consumers is unconstitutional, violating the Commerce Clause. In the Swedenburg case, the State actually acknowledged that the statute was passed to protect in-state suppliers against out-of-state suppliers. Hence, the court had little difficulty finding the statute a classic case of discriminatory economic protectionism, and a per se violation of the Commerce Clause.

Three Cheers for Three Tiers

So, what does it all mean? Some experts have argued that the recent decisions which have struck down direct shipping statutes rejecting the States’ arguments under the 21st Amendment are a death-knell for the 21st Amendment and a pre-cursor to invalidating the three tier system altogether. We respectfully disagree. We believe the 21st Amendment is still alive and kicking. These failed statutes had one thing in common – they discriminated against out-of-state suppliers in favor of in-state suppliers or to put it in the words of the Supreme Court, the statutes constituted “mere economic protectionism.” The 21st Amendment was never intended as a tool to promote in-state suppliers over out-of-state suppliers. Rather, the 21st Amendment was and still is a broad grant of power to the States to regulate the transportation, importation and distribution of alcoholic beverages within their borders. Provided the States exercise this power in an evenhanded non-discriminatory manner, their actions are not likely to be upset.
As far as the effect of these cases on the three tier system is concerned, few people would argue that establishing a three tier distribution system is discriminatory – at least not in the context of the Supreme Court’s concept of discrimination. Accordingly, as long as the Supreme Court maintains its view that absent economic protectionism, the States retain the ability to structure their distribution systems under the 21st Amendment, the continued viability of the three tier system looks good.

Is it time for beer wholesalers to breathe easy? Unfortunately, not yet. It is likely that alcohol suppliers will continue their battle to ship directly, and until the Supreme Court has addressed the precise issue, there can be no guaranty either that the three tier system will prevail or that suppliers will not gain broad direct shipping rights. From a practical standpoint, however, in the beer industry it appears that the only viable direct shipping situations are i) sales by microbrewers without significant distribution channels, which should not be of significant concern to most wholesalers; and ii) sales by major suppliers to chain stores, franchises and club stores, which should be of major concern to wholesalers. As we have preached in previous columns, the pro-active wholesaler can protect themselves, in this instance from competition arising by reason of direct shipping. The trick here is to make sure when you are negotiating your distribution agreements that you obtain exclusive distribution rights in your territory. That way, even if your supplier is not prohibited by statute from direct shipment, it will be prohibited contractually. A final word of caution: scrutinize the language of appointment carefully. For example, while an appointment as “the sole wholesaler in the Territory” may seem to give you exclusive rights, in all likelihood it does not. Rather, such language would enable the supplier to argue that it was only prohibited from appointing other wholesalers in the Territory, but not from selling directly! Be vigilant!

Gary Ettelman and Keith Hochheiser are co-founding partners at Ettelman & Hochheiser, P.C., a national law firm concentrating in corporate and commercial transactions, distribution and licensing agreements, mergers/acquisitions, tax-free reorganizations and related litigation. The firm can be reached at: (516) 227-6300 or www.e-hlaw.com.

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