Katie Porterfield [1]

It's likely that even the most uninformed Tennesseans heard about it. Throughout March and into April, two pieces of wine-related legislation captured newspaper and television headlines across the state. One would have allowed direct-to-consumer wine shipping to wet counties—an act that currently draws a felony charge for both the seller (out of state or in) who ships the alcohol and the consumer who receives it. The other, which garnered the most media attention, would have allowed the sale of wine in retail food stores that do business in wet counties.

In the end, neither bill could withstand the politics of it all. In an election year filled with promises of campaign contributions and constituent votes, they were relegated to the land of the summer study committee, (which, in a logic peculiar to politics, will likely convene this winter).

Though the reporters have moved on, and the editorials have subsided, both bills—and more importantly, the larger issue they represent—remain. Are Tennessee's alcohol distribution laws, born of Prohibition, still relevant in today's marketplace? Can those laws—and the three-tier system they sustain—withstand a prolonged, if somewhat disjointed, assault from wineries and consumers? And is the Volunteer version of the producer-wholesaler-retailer system a flaunting of Free Market principles, or a necessary exception to them?

The Ties That Bind
The "now" of the alcohol industry's three-tier system is inextricably tied with its "then." Before Prohibition (instituted in 1919 with the ratification of the 18th Amendment), alcohol suppliers typically controlled, or were "tied to," saloons through ownership or contractual obligations. This "tied-house" relationship resulted in marketing practices that promoted consumption and increased sales, but which were also thought to lead to alcohol abuse and other behaviors deemed detrimental to society.

"Local saloons would offer free, heavily salted sandwiches so you would buy more beer and spirits," explains Robert Lipman, third-generation president of Tennessee wholesaler Lipman Brothers. In addition to providing the origin of the expression, "there's no such thing as a free lunch," Lipman says the "over-consumption and promotion eventually stimulated temperance unions."

In 1933, the 21st Amendment repealed Prohibition and granted the states the right to regulate the sale, distribution and consumption of alcohol within their borders—the idea being that they could adopt regulations according to regional attitudes for temperance. The Federal Alcohol Administration Act, passed in 1935, regulates unfair competition and unlawful practices between producers and retailers to prevent the return of tied-house saloons.

Both before and after Prohibition, Tennessee officials did things in their own time. Tennessee instituted its own prohibition 10 years before the 18th Amendment, and the state didn't officially end it until 1937, when counties and cities were granted local option to permit package sales of wine and liquor by referendum. To further prevent tied houses, Tennessee, like most states in the Union, adopted regulations and policies to institute a three-tier system intended to create a physical and economic barrier between the supplier and retailer. The system mandated that producers of alcoholic beverages (the first tier) sell only to wholesalers (the second tier), who, in turn, sell only to retailers (the third tier), who then sell to consumers. The wholesaler's role as a middleman was written into law to prevent over-consumption, minimize opportunities for illegal sales and provide an efficient mechanism for collecting taxes.

Tennessee joined 31 other states in becoming a "license" jurisdiction in which the state issues licenses to private businesses that serve as retailers and wholesalers. (Eighteen other states became control states, meaning the state assumes the role of retailer and/or wholesaler.) In addition, the state determined that a person in one tier cannot have a direct or indirect interest in another tier. Tennessee also emphasized local ownership, meaning the state requires wholesalers and retailers to be Tennessee residents (with a few exceptions).

"[The Legislature] wanted local people who are licensed and under the enforcement of local law enforcement," Lipman says. "If you were someone from England, France or California, law enforcement would have a much more difficult time trying to investigate you and your trade practices."

In addition, in an effort to prevent multi-store entities that could skew the balance of power between the three tiers right off the bat, the state forbade retailers from owning more than one store. Over time, the law has effectively hobbled the retail tier's ability to challenge wholesalers.

And it's not the only law that Tennessee, like other states, has passed that helped secure the wholesaler's role in the three-tier system. For example, only one wholesaler can sell a brand of wine or liquor in each of Tennessee's four territories: The Nashville area, the Knoxville area, the Chattanooga area and the Memphis area. Lipman Brothers, for example, has the exclusive right to sell Jack Daniel's in Middle Tennessee, while D&V Distributing Co. holds the right to sell it in the Knoxville area. (Fifteen states have such territorial provisions.)

Tennessee is also one of 19 states with a statute mandating that once a manufacturer (or importer) such as a winery has a contract with a wholesaler to sell its product, the manufacturer cannot terminate the contract "except for good cause." The Tennessee Department of Revenue, which ultimately determines whether the contract can be terminated, defines good cause as "the failure of the wholesaler or distributor to act in a commercially reasonable manner in carrying out the terms of the contract, or, voluntary abandonment of the contract."

Dan Haskell, an attorney and lobbyist who represents various alcohol-related clients and served as counsel and assistant director of the Tennessee Alcoholic Beverage Commission in the 1980s, says the law has been "messed around with for 30 years to make it harder for a producer to change from wholesaler A to wholesaler B." Haskell says that to get out of a contract, a producer would essentially have to prove that a wholesaler is refusing to sell its product. "That hasn't happened in the last 20 years," he says.

Though taxpayer confidentiality prevents the Tennessee Department of Revenue from revealing information about specific cases, Sophie Moery, director of communications for the Department, does confirm that, "such cases occur relatively infrequently."

To Lipman and other wholesalers, the "franchise laws," as they're often called, guarantee fairness.

"If I sign a contract with a wine maker, and I'm working really hard, they can't just leave me and go to another wholesaler," says Alexei Khimenko, who opened a wholesale business called Aleksey's Imports about three years ago. "When I sign the contract, I sign a life-long contract."

Lipman says the laws were put in place because in the 1960s, suppliers were making what he terms "capricious and arbitrary moves."

"Over the years, the law was tightened up," he explains, "because you had wholesalers that made an investment and put time, energy and activity into a brand" only to have the supplier decide to sever the relationship. "In many cases, that would injure their business," Lipman says.

The Wine Press
In fact, as Lipman points out, in the 31 or so states where there is not a mandated, death-transcending brand contract, companies have gone out of business as the industry has experienced consolidation. (Some states have as few as two wholesalers compared to Tennessee's 29.) This consolidation is often cited by wineries as an argument for legal direct shipping in all 50 states. In 1963, the United States was home to 10,900 wholesalers, according to an April 2000 Duke Law Journal article by Duncan Baird Douglass. Today, the Wine and Spirits Wholesalers of America trade association reports that there are about 350.

Meanwhile, although the liquor markets have not changed drastically—several nationally advertised brands satisfy most of the demand—the wine market, which was practically non-existent in the 1930s, has exploded. By 1963, Douglass writes, there were about 375 wineries throughout the country. Today, according to data from the Wine Institute, a public policy advocacy group that represents more than 600 California wineries and affiliated businesses, there are almost 6,000.

Due to the vast difference between the number of wholesalers and the number of wineries, as well as to laws in states like Tennessee that necessitate that almost every drop of wine go through a wholesaler, wineries across the nation contend they have difficulty getting their products to state markets. Wine Institute surveys reveal that only 17% of U.S. wineries are represented by distributors in all 50 states.

"The mandatory use of the wholesale tier blocks people from getting into the marketplace," says Steve Gross, director of state relations for the Wine Institute. "There are not enough wholesalers to handle all of the brands. If you don't have viable wholesale representation, there is no way to get to the consumer, and you're excluded from the marketplace in states like Tennessee."

Although it seems most of the discussion surrounding the system's so-called shortcomings began in the 1990s with wine lovers who sought to purchase wine over the Internet, wineries began their push to get states to allow direct shipping to consumers as early as the 1980s. Consumers began visiting wine-growing regions in the name of tourism, and once they tasted a product, producers wanted to be able to ship it to them both right then and after they returned home (if they wanted to purchase more). In 1985, Gross says it was illegal to ship wine to any state in the country. Today, 36 states allow some form of direct-to-consumer wine shipping.

Through the years, many states have allowed direct shipping of wine because it stands to benefit their local wine industries. But so far, though Tennessee is now home to about 30 wineries, that has not been reason enough to make direct shipping a legal reality. Even on-site sales are limited. If at least 50% of the agricultural products used to make their wine is produced in Tennessee, wineries can sell an unlimited amount of their product on site. If they don't use 50% Tennessee agriculture, they are limited to selling 20,000 gallons on site each year, unless they can prove an effort has been made to be distributed in the four regions. (In which case, they are still limited to 40,000 gallons/year.)

"There are always going to be regulations in any industry," says Kip Summers, co-owner of Arrington Vineyards in Arrington, Tenn., "but to have regulations that actually limit and restrict the growth of an industry—it doesn't make a whole lot of sense to me."

Summers says it's particularly frustrating because the state stands to make money on the industry, both through tourism and every bottle of wine sold.

"The state sees sales, franchise and excise taxes on every gallon of wine we sell," he says. "They should be saying, 'You guys produce as much as you can; we need the revenue,' but they're not. Meanwhile, they're saying, 'If you're a California winery and you have a Tennessee distributor, bring in as much as you can."

And though, in this instance, Tennessee wineries are exempt from the three-tier system (with, of course, caveats), they are required to abide by it otherwise. Don Collier, president of Tennessee's Viticulture Advisory Board and owner of Mountain Valley Vineyards in Pigeon Forge, says the system serves as the biggest detriment to small farm wineries.

"If a wholesaler is not interested in carrying your brand, then you are not distributed," he says. "Even if a restaurant is 20 miles away and they want to carry your wine, you can't sell it to them without a wholesaler."

Collier estimates that about six of the 31 Tennessee wineries employ distributors to sell their products. But he and Summers say that for most of them, it's not advantageous. If, for example, a winery makes a bottle for about $7 and sells it on site for $20, they make $13 gross profit. If, however, they distribute the product through a wholesaler, they sell it to the wholesaler for about $10 (leaving room for the wholesale and retail markups to reach the $20 price point). For a small operation, that $10 difference can be huge.

"Small wineries can't have razor-thin margins because they're not producing that much," Summers says. "Even if they're grossing $13 a bottle and only have 10,000 bottles to sell, that's $130,000. They can barely turn the lights on and pay someone for that."

It's different than a large California winery that can sell 20 million bottles of wine to a distributor, make $3 a bottle and gross about $60 million.

"The economies of scale get flipped on their head when you're talking about a boutique winery that makes everything by hand, usually employs one person and uses tons of volunteer help," Summers says.

Thus, smaller wineries benefit from being able to ship their products to consumers at retail prices. While Tennessee wineries can ship to residents in 32 states, they can't ship to four states that require reciprocity agreements (a two-way shipping privilege). More importantly, they cannot ship within Tennessee, which would probably be the most beneficial to these wineries.

"A dairy would have no problem shipping cheese or selling milk out its front door," Summers says. "But [wineries] can't ship a bottle of wine to someone's aunt in the Tri-Cities for a birthday present."

Arrington is one of the six Tennessee wineries that uses a distributor, and although Summers says that today, direct shipping is a small part of his business, he estimates that his gross revenues would increase about 15% to 20% if he could ship without restriction.

"After people visit and go home and run out of wine, they don't want to go out and pick up a cheap wine from Australia," Summers says. "They want another bottle of Arrington Vineyards."

Even if a Tennessee winery can afford to go through the wholesaler, some say it can be difficult to get one to carry a smaller brand because it's more beneficial for the wholesalers to focus on brands in greater demand.

"A distributor doesn't want to handle one case of wine," Summers says. "They want to handle 100 cases of wine a week or a month, at least. If they're going to commit to a product line, with the economies of scale, they can't screw around with 12 bottles of this and 24 bottles of that."

Lipman, however, rejects the idea that small wineries can't flourish within the system, saying small and new brands are the lifeblood of his business.

"I would love to represent some of these smaller wineries, but they won't sell to me," he says. "They don't view what I do as a legitimate part of the system, so they don't want me to take a margin, a mark up on their product."

Still, Tennessee's "franchise laws" also come into play here because once a Tennessee winery commits to a wholesaler, breaking ties down the line can be difficult. Although Summers is satisfied with his relationship with his distributor, Lipman Brothers, he can't help but shake his head at the franchise laws.

"It's not a free market economy," Summers says. "The way most middle men or distributors work in America is they have to bust their butts to take care of the product. A manufacturer may say, 'Sell 100 units by next year,' and if you don't, the manufacturer may say, 'We don't want to work with you anymore.' But in Tennessee, in the liquor industry, the producer, no matter where he's located on the planet, has to come down to Nashville and prove economic hardship."

Even death does not the wholesaler/supplier part. If a wholesaler dies and his business is passed to a family member, the brand remains with the wholesaler.

"You may work well with the guy with whom you chose to do business," Collier says, "but when his grandson takes over, he may do a bad job, and you're stuck with him."

The Forgotten Tier
Wineries aren't the only ones pushing for friendlier laws. Just as it has done in other industries, the Internet has reintroduced a player too often bypassed in the negotiations of wholesaler, distributor and retailer—the consumer. With the Internet as an easy medium for both finding and purchasing wine brands not available through local retailers, consumer interest in wine has soared. (Studies regarding health benefits associated with wine consumption haven't hurt demand, either.) As a result, the Wine Institute reports that from 1993 to 2007, the volume of wine sold has increased 66%.

"The consumer wants one thing—easy access to a variety of different wine," says Tom Wark, executive director of Specialty Wine Retailers Association, a national group of wine merchants and consumers. "You couldn't say that 20 years ago. People were happy to drink Gallo and other high-end brands. Today, there are thousands of brands being discussed on the Internet."

In Tennessee, that means the collectors have joined in the call for direct shipping. Nashville resident and collector John Brittle says that when the Wine Spectator's top 100 wine list comes out each year, there are typically about 50 wines on the list that he can't buy in Tennessee.

"What bothers me is, being in America and being a consumer, I don't have the rights that other people have in other states to buy the wine that I want to buy," he says. "People say, 'Well, there's plenty of wine already here.' My response to that is, 'Why do you get to pick what I want to drink?'"

But Chip Christianson, president of the Tennessee Wine and Spirits Retailers Association and owner of Nashville's J. Barleycorn's wine and spirits store, says that although there are expensive wines that people would have difficulty getting here, it's a rarity when people can't get what they want in a Tennessee retail store.

"We sell thousands of wines in our retail store," he says. "If something can't be happy with the wine in Tennessee retail stores, it's really kind of silly."

Land of the Free Market
In the complaints of both wineries and consumers, it's impossible not to detect a common theme one would expect to resonate in a pro-business state—let the Free Market reign. Not surprisingly, free marketers take a dim view of the mandated three-tier system, arguing that it stifles free enterprise to the detriment of the consumer and the other tiers.

That does not mean free market proponents consider the three-tier system of no value.

"We would prefer that the middle tier have to compete on an economic basis for its business, rather than a legally mandated basis," says Alex Heckathorn, a Compliance Services of America attorney who advises wineries, brewpubs, importers and wholesalers across the nation on compliance issues.

Wine Institute data reveals that today, more than 95% of wine is delivered through the three-tier system. Heckathorn and others believe that will continue to be the case, even if all 50 states permit direct shipping. That's because wholesalers provide the most efficient means to move large quantities of alcohol—especially for large California wineries that have upwards of 73,000 retail accounts.

"Why do Coke and other beverages and products use distributors?" Heckathorn asks. "Because there is something about the system that is efficient. Look at Sysco. They've made an entire business out of delivering food."

Corbin Hutchins, a Seattle-based lawyer who is a member of Graham & Dunn's Hospitality, Beverage and Franchise Team, says it's unfair to force suppliers to use a wholesaler irrespective of economic decision.

"If it makes economic sense for me to sell to a distributor, then I want to do that," he says. "If not, then I don't want to do that."

By mandating the use of the wholesaler tier and providing protection laws like the "franchise" agreements, he says states subsidize wholesalers.

"[If the laws were altered], the pattern would change to favor the efficient and disfavor the inefficient," he says. "In other industries, if you're not good at a business, you take your capital and talents elsewhere."

In a 2003 report tackling the direct shipping issue, the FTC found that the three-tier mandate not only limited consumer choices, but also increased prices. Citing research from consulting firm Booz Allen Hamilton, the report notes that wine and spirits distributors have profit margins more than twice those in the food business. The report also includes statements from University of California at Berkley economist Daniel L. McFadden, who purports that "consumers benefit from free markets operated with the minimum government regulation required for consumer protection ... The restrictions on direct purchase of premium wines and their interstate shipment that have been adopted by a number of States are, I believe, another example of abuse of the regulatory process to protect concentrated economic interests."

MTSU economics professor and blogger Martin Kennedy agrees.

"You want freer markets and consumers to have access to goods that they want. To the extent that regulations exist, they should make markets more efficient and address public health concerns," he says.

Even for interested parties such as the Wine Institute, it all comes down to the free market-flavored stance—contractual relationships between a supplier and a wholesaler shouldn't be different than that for other general business contracts.

"We think our contracts should be able to be governed by contract law," Gross says. "You can make a contract and agree to any [conditions] you so choose, but to create statutes that require all this stuff is advantageous to the wholesaler and disadvantages the supplier."

Protectionism Versus Fair Play
The 21st Amendment grants Tennessee the right to regulate alcohol distribution within its borders, which means, to a degree unheard of in most other industries, state lawmakers can shield its alcohol industry from economic pressures. Legislators can maintain and pass laws that subsidize the local wholesaler tier—the 29 family businesses that, in many cases, have been a part of Tennessee communities for 75 years. They can do the same to protect the mom-and-pop retail tier (particularly when it comes to the wine in food store issue). And they can do it all in the name of societal protection, public health and tax collection, if they so choose.

But that begs the question: Should they?

If lawmakers carefully consider whether the alcohol distribution laws truly accomplish goals related to temperance and tax collection, they're likely to find that direct shipping bans, franchise laws and a host of other regulations raise costs, limit consumer choice and restrict competition. That hardly seems like the kind of protection a pro-business state should seek to provide. Why, for example, should wholesalers and/or retailers be insulated when mom-and-pop wineries that stand to bring in tourism revenues are not?

When it comes to direct shipping, much of the defense relied upon by wholesalers (and sometimes retailers)—be it underage drinkers, vanished taxes or even longer view fears of tainted product—is focused on the proverbial camel's nose getting under the tent. But it's hard not to recognize the presence of another camel and another tent. When a group holds the power that wholesalers hold in their particular triumvirate, almost any shift in the balance of power will be one that impacts their bottom line. (Indeed, the Internet introduces options that would circumvent them entirely.) Many of the concerns voiced by wholesalers are familiar refrains heard across industries. "What if a client treats me in a manner that hurts my business?" "What if the marketplace changes in a way that renders me obsolete?" For now, thanks to the carefully constructed and preserved regulatory environment, the middle tier has the luxury of fighting such battles by proxy (i.e. lobbyists) in the political arena. If consumers and producers gain more traction, wholesalers may find themselves in a wilder, and certainly more treacherous, arena—the Free Market.

The North Carolina Grapeheels?

In a report published by MKF Research titled "Economic Impact of Wine and Grapes in Tennessee 2007," the full economic impact of wine, wine grapes, and related industries and services was approximately $139 million, based on 2005 year-end data. And while that may seem like progress to an outsider, talk to anyone in the local winery camp, and chances are you'll hear a different story—one that usually involves one of Tennessee's neighbors, North Carolina.

Fifteen years ago, says Don Collier, president of Tennessee's Viticulture Advisory Board and owner of Mountain Valley Vineyards in Pigeon Forge, North Carolina had about six wineries, compared to Tennessee's 20. Today, with about 74 wineries, North Carolina's industry is more than twice as big as Tennessee's. It ranks 10th in the nation in wine production.

"It's a booming industry [in North Carolina], and the real impact is not the product; it's the fact that it's a tourism destination," Collier says.

In fact, the most impressive stats involve the industry's economic impact. MFK Research, the same group that conducted the economic impact report on Tennessee's wineries, determined that the total economic impact of North Carolina's wine and grape industry was about $813 million, according to 2005 data. So why has North Carolina's wine industry left Tennessee's in the dust?

In 1986, the state established the North Carolina Wine and Grape Council to stimulate the growth of the state's wine and grape industry through research, education and marketing. Funded by a portion of the excise taxes collected on wine bottled in the state, the Council has been instrumental not only in promoting the industry, but also in helping tobacco farmers—forced to diversify due to tobacco buyouts—transition to growing grapes.

In addition to allowing wineries to ship wine within the state, North Carolina doesn't have a cap on how much wine its wineries can sell out their front door, regardless of whether they're using North Carolina agriculture. In most cases, North Carolina wineries are also permitted to sell their products directly to restaurants and retailers without using an independent distributor.

"A winery here is eligible for a wholesaler permit," says Margo Knight Metzger, executive director of North Carolina's Wine and Grape Council. "[A winery can] get an additional permit to be its own distributor, with one exception. If a winery produces more than 100,000 cases a year, they are not allowed to self-distribute, but I can't think of anyone who produces more than a 100,000 cases a year who would want to self-distribute."

Those who own and operate Tennessee wineries are envious of the regulatory climate in North Carolina.

"The attitude in North Carolina is, 'Hey you want to be successful, go for it. We're not going to put a limit on you,'" says Kip Summers, co-owner of Tennessee's Arrington Vineyards.

To Summers and Collier, North Carolina's thriving industry is an example of what could be in Tennessee.

"Tennessee isn't taking advantage of that potential," Collier says. "We deny our farmers a cash crop, and we deny the state millions of dollars in tourism, and the only reason we do it is because of multi-million dollar wholesaler families who have a monopoly and like it that way."