Costco Challenges Washington State Liquor Laws Costco's attorneys wrote to the Washington Attorney General's office on August 29, 2003 laying out a number of challenges to the existing Washington laws on alcohol sales and distribution, including challenges of the state's rules prohibiting quantity discounts to retailers, requiring advance price posting (which requires distributors to post prices and maintain them for all retailers for a month), prohibiting credit sales or provision of extra services to retailers, establishing minimum price markup requirements for distributors. The letter also challenged the fact that the State sells wine through state liquor stores in competition with Costco and other retailers, but does not itself follow the restrictive rules that apply to other distributors and retailers. (Many smaller Washington wine producers rely heavily on sales through the Washington State liquor stores, and so very much favor what the Washington State Liquor Control Board (WSLCB) is currently doing--it is not clear they would be as widely distributed if the State stopped selling wine at retail.) In many cases, it appears that Costco would like to order products directly from suppliers in and outside Washington, have them delivered to stores or a central Costco staging point, and then distribute the product direct to its customers. (Costco presents itself as a wholesaler, but if Costco is successful here, there is no reason why large retailers would not follow suit.) It is widely believed in the industry that if Costco is successful in Washington, it or other large sellers would go on to challenge the alcohol regulatory structure in other states to avoid the three-tier system and other restrictions on alcohol sales, so this challenge is generating national interest. Costco's challenge is based largely on the Sherman Act (which is the basis for most antitrust cases) and the Commerce Clause of the US Constitution (which prohibits laws that discriminate against interstate commerce). While states have broad powers to regulate alcohol sales and distribution under the 21st Amendment to the US Constitution which ended Prohibition, there are limits under the Sherman Act to what a state can do to limit or regulate competition, and some state actions can violate the antitrust laws. The exact boundaries between a state's regulatory power under the 21st amendment and the limitations of the antitrust laws is not clear, but federal courts generally will strike down state statutes that improperly favor in-state producers or businesses over out of state businesses. Costco more or less stated that all the statutes and regulations that underlie the Washington regulatory system for sale and distribution of alcohol could not be enforced, and asked for a response within 30 days to avoid litigation. The Attorney General's office asked for and received more time to analyze the issues. During November of 2003, the Attorney General's office responded by stating, in essence, that it was obliged to uphold and defend state statutes against challenges such as Costco's, but it also offered to sit down with Costco if Costco wanted to discuss specific problems and potential solutions. Costco agreed, and a private meeting was scheduled to occur in December. The Washington Beer and Wine Wholesalers Association (WBWWA) is closely following the matter, and believes the current laws should be defended. It will likely seek to intervene as a party in the event of litigation in support of the position of the Washington State Liquor Control. wbm

We live in interesting times. Not since Repeal have so many fundamental changes been afoot in the distribution of licensed beverages, all aimed at permitting products to flow in commerce like other packaged goods, with only those restrictions that realistically impede intemperance and access by minors. We have only begun to understand the implications of direct shipment from winery to consumer. Now the next stage is at hand.

Waiting in the wings is competition in price, distribution efficiency, and service at all levels. For the rest of the US economy, that is merely the post-1898 legal environment, in which restraints of trade are highly disfavored and ultimate purchasers receive the benefits of only lightly regulated market forces. For some players in the wine industry, it will be cataclysmic.

Constitutional Contradictions

To understand what is going on, we have to look at three aspects of the US constitution that can be difficult to reconcile with one another.

One is the Commerce Clause, which in a sense is the raison d'etre of the constitution itself as successor to the Articles of Confederation. Its broad policy is a national market, playing under uniform rules with only a narrow exception for the rare local health and safety rules that cannot be national. At the core of the Commerce Clause is the prevention of discrimination by states in favor of local commerce at the expense of interstate commerce.

Another is the Supremacy Clause, also a source of uniformity in market regulation, which causes federal laws related to national welfare and interstate commerce to invalidate inconsistent state laws, and in some circumstances causes Congress to refrain from federal regulation in a subject area to preclude state regulation of the same subject. Notable among federal laws that are superior to conflictingstate laws when interstate commerce is affected is the Sherman Act, an 1898 antitrust statute that outlaws unreasonable restraints of trade.

Finally, there is, of course, the Twenty-first Amendment, which prohibits traffic in liquor contrary to the laws of a state. The meaning of that prohibition is much debated and has clearly changed significantly in the years since Repeal. No clear boundaries of state regulatory power emerge from connecting the disparate dots of Supreme Court cases, but it is undeniable that state interference in the marketplace bears increasing scrutiny under the pro-competitive antitrust policy of federal law. Since the US Supreme Court Midcal decision in 1980, invalidating a California price-posting law that set minimum retail prices, it has been clear that invoking the amendment does not exempt anticompetitive regulatory schemes from antitrust challenge.

A Shot Across the Bow

Observers have long questioned the validity of familiar features of liquor regulation, such as price posting, prohibition of quantity, and bans on shipments to chain warehouses.

Currently, the Issaquah, Washington- based chain retailer Costco is challenging state attorneys general to look closely at liquor regulation and come to an agreement on the invalidity of those parts that contravene federal antitrust law (see "Costco Challenges Washington state Liquor Laws," next page). Almost every regulatory restriction on price and distribution benefits someone at the expense of someone else, by shielding a portion of the industry from competition. Benefits now under attack are both huge in dollars and fundamental to a mandated three-tier system.

The outcome is a question of survival for middle-tier industry members that are profitable only because doing business with them is mandatory, and a major economic issue for all wholesalers. The challenge also presents very interesting questions for wineries that have not operated with make-a-deal pricing or full-blown chain buying power.

At present, the Costco negotiations appear to be heading toward a familiar posture, with the complaining innovator contending the state should voluntarily abandon the anticompetitive statutes and regulations, and the state agency asserting that the proposed changes would require new legislation. If matters stall there, we are likely to see resolution by lawsuit. In 1988 Costco achieved a negotiated change in a mandatory margin regulation only after initiating litigation.

Easy Marks

As with direct shipment, existing three-tier distribution laws are most vulnerable when they discriminate against interstate commerce.

Current interpretation of the Commerce Clause points unmistakably toward invalidating almost any scheme that gives in-state sellers a benefit denied out of state sellers in reaching the same market. Thus, if a state allows its own wine industry to sell and deliver directly to consumers, it must allow out of state wineries the same benefit, subject only to light procedural differences in licensing, tax returns, and the like. Note that for Commerce Clause purposes the discrimination can be cured either by allowing everyone to ship directly or by requiring everyone to go through the in-state licensed wholesaler-retailer system.

Some state laws also allow in-state wineries to sell directly to retailers. In most instances, such provisions were expressly adopted to promote the local industry by relieving it of unnecessary distribution costs, an objective directly contrary to the Commerce Clause, but formerly thought shielded from constitutional attack by the Twenty-first Amendment. It now seems unlikely differential treatment would survive in the courts.

Self-distribution to retail accounts is an essential part of the business plan of many small and medium-size wineries. It is unlikely they would be harmed by allowing out of state wineries to do it, but they have a strong interest in averting the solution of shutting it off for everybody.

However, a court deals with the remedy for discrimination, the next round would likely be in the state legislature. There compromise may be possible, as discriminating on the basis of annual production, rather than location, would blunt the Commerce Clause argument. Because wholesaler interests can be adequately served by making only the larger suppliers go through the three-tier system, the potential schism between large wineries and the rest may prove as significant as the supplier-distributor battle line.

The Other Shoe

Current challenges are not limited to Commerce Clause infirmities. It doesn't matter whether a state law discriminates or not if it is incompatible with the Sherman Act and no antitrust immunity applies.

Price posting is a prime example of an activity that can go on only if protected from antitrust scrutiny. Announcing your prices in advance on an understanding that you and your competitors will not change them for a month is enough to land you in Joliet if you are not immune from prosecution. It's classic price-fixing, which robs the public of the benefits free enterprise is supposed to provide and is deemed inherently unreasonable without any inquiry into its benefits.

Sovereign states are immune from antitrust liability when they act as states. In some cases, state action can involve private businesses in a regulatory scheme with a legitimate state purpose. The Midcal case taught us that "it's liquor" is not enough to invoke immunity for state-mandated price-fixing.

Antitrust lawyers differ in their analyses, but it seems clear enough after Midcal that before it can permit businesses to fix prices, the state must both clearly enunciate a public policy of abandoning competition in favor of a market that is regulated for some legitimate end and actively supervise the market it has chosen to regulate, to prevent simple price-fixing with no public policy benefit. Subsequent cases have knocked out unsupervised posting at other levels of distribution in several other states.

A key point the Midcal case left unexplained is exactly what a state must do to achieve "active supervision." For a decade, the industry tended to assume that some state employees filing copies of price postings, checking the arithmetic to assure some margin between tiers, and granting an occasional exception on grounds involving little or no economic analysis, was enough supervision. Then, in 1992, another price posting case, this time for insurance policies rather than liquor, seemed to raise the bar to a level of supervision that no liquor control board has provided. A recent electric power pricing case points the same way. There is a good chance present price posting laws are as illegal as the no-supervision systems already struck down.

If states have to give public utility-level supervision to wine prices in order to keep price posting in place, we can anticipate intense negotiations in the regulatory and legislative halls before the issue is settled. Wineries that base business plans on economic features of posting, which may extend beyond suspension of front-line price competition to restriction or prohibition of SPAs, quantity discounts, special packaging, etc., will have a significant stake in the outcome.

Significantly, none of the price posting systems knocked out by Midcal and cases that follow it has been repaired by introducing a supervisory element. Nevertheless, amendment rather than abandonment remains an interesting possibility. Although we know that the 21st Amendment does not insulate anticompetitive liquor laws from Sherman Act claims, the Supreme Court has not settled the question whether it permits a state more leeway in balancing competition against regulation in liquor than in other goods.

Getting to Gray

Another thing Midcal didn't tell us is how its principles apply to non-price trade restraints whose unreasonableness may not be a given, such as prohibiting suppliers to ship to retailers at their central warehouses.

It's clear enough that, absent state action immunity, wineries could not get together and agree not to sell to customers that maintain their own distribution systems. The state does require it. Will that requirement fare better than price posting in providing the immunity? We can't know with certainty until the courts have addressed the issue directly.

In the gray zone lie numerous practices that increase the cost of wine to the consumer without improving its profitability to the producer. Some, like mandatory markups, mandatory delivered pricing, and prohibitions on credit to retailers, are analytically close to price-fixing. Others, such as mandatory distribution channels and limitations on supplier services to retailers, that only indirectly effect price, could be condemned as inherently unlawful or deemed defensible if reasonable for legitimate state purposes, depending on how the court assesses antitrust policy and 21st Amendment aims.

It has been obvious for a long time that a if a multi-outlet retailer has the volume and the capital to maintain a distribution warehouse with trucks and personnel where it receives large shipments from the manufacturer, the economic pie is larger if it does so, rather than contract with another company to provide that service. Prices are lower to the consumer, and the manufacturer's selling price is not markedly different from the price to the independent warehouse operator that was also an intermediate purchaser.

Apart from the obvious disadvantage to licensed wholesalers, central warehouse delivery presents a complex picture to wine industry members. In the 1930s, Congress dealt with what it regarded as an inequitable consequence of distribution efficiency based on volume purchases, by enacting an antitrust law prohibiting large chain buyers from getting deep discounts that were not available to their smaller competitors and not justified by actual handling cost savings (which are far smaller than commonly supposed). That protection applies only to sales in interstate commerce or in states that have enacted similar legislation, and prevents only injury to competition, not harm to individual competitors, but it is supplemented by other antitrust laws restricting predatory pricing. The net effect of antitrust protections is to make removal of outright prohibitions of free market pricing and central delivery less dangerous to smaller players than it might appear, but cost-benefit analysis is still difficult.

Blind Siding

In addition to all the constitutional and statutory issues arising under US law, we must take into account the international trade regime administered by the World Trade Organization.

Wine distribution restrictions that work to the disadvantage of international traders are subject to negotiated changes in the give and take ofongoing trade negotiations and also to potential complaints by individual countries based on existing obligations of WTO members. Although the most prominent target in the beverage industry is probably state monopolies, all departures from equal market access for international commerce raise compliance issues (as do tax credits available only to domestic producers). Thus, a parallel challenge could come from unexpected extra-national sources.

Certainly Uncertain

No one can predict with certainty whether regulation of wine distribution will be altered profoundly, modestly, or not at all, though the no-change scenario appears unlikely. The most important point is that pressure for drastic change is present and real, not a possible future development. Distinguishing the blessings of change from the curses and finding a voice in the process are current agenda items for any producer whose business extends past the tasting room door. wbm