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U.S. Supreme Court Rules on Direct Shipping

On May 16, 2005, the United States Supreme Court struck down direct shipping laws in Michigan and New York holding that the laws in both States discriminate against interstate commerce in violation of the Commerce Clause, and that the discrimination is neither authorized nor permitted by the 21st Amendment.

For wineries and wholesalers, Granholm v. Heald is notable for different reasons. For wineries, the case makes clear that States' powers to regulate alcohol under the 21st Amendment are not absolute, and that States must treat in-state and out-of-state wineries the same when it comes to the direct shipment of wine. For wholesalers, the decision reaffirmed the legitimacy of the three-tier system and did not establish a right to direct ship.

While the decision is a clear victory for those in favor of direct shipping, the real impact will only be known once we see how States choose to rewrite their laws to respond to the decision, and how the lower courts apply the decision to future challenges to the three-tier system.

Background: The Battle for Shelf Space in a Consolidating Industry

In striking down the Michigan and New York laws, the U.S. Supreme Court recognized the significant and ongoing consolidation in the wine industry. Fewer wineries and fewer distributors now control a larger than ever portion of the wine market, making it increasingly difficult for small wineries to distribute their wines.

At the same time that large wineries and distributors are consolidating, the number of small wineries in the United States is proliferating rapidly, making competition for retail shelf space even fiercer. Furthermore, as the Court noted, even if small wineries could find distributors for their wine in States that prohibit direct shipping, the distributor's mark-up would render such sales through the three-tier system economically infeasible.

As a result, more and more small wineries are turning to direct sales – via the tasting room, mailing list and over the Internet -- as the principal means to sell their wine. This is especially true given the recent technological advancements allowing for the sale of wine over the Internet, without the need for any physical contact with the customer at all.

The States' Powers Are Not Absolute

The States put forth three main arguments to justify discriminatory restrictions on out-of-state wineries: preventing the direct sale of alcohol to minors, improving the ability of states to collect sales tax, and that alcohol is simply different than other articles of commerce. None of these arguments persuaded the Court.

With regard to preventing the direct sale of alcohol to minors, the Court found that minors are less likely to consume wine as opposed to other forms of alcohol, and that minors have easier and quicker means to obtain alcohol than direct purchase through the mail. Moreover, less restrictive means are available to prevent the direct sale of alcohol to minors through the mail; such as requiring an adult signature for delivery and a label stating the requirement on the package itself.

With regard to the collection of sales tax, the Court found that if licensing and self-reporting provide adequate tax collection safeguards for wine distributed through the three-tier system, such mechanisms should work for direct shipments as well. States could require a license as a condition of direct shipping, with a requirement for licensees to submit sales reports and pay sales taxes. Notably, this is the approach recommended by the National Conference of Legislatures in their Model Direct Shipping Bill.

The third justification – that States' should be able to discriminate with regard to commerce in alcohol because alcohol is a unique article of commerce—is harder to dismiss. Concerns about the evils of alcohol abuse are so strong in our nation's history that a State's right to regulate the commerce of alcohol is enshrined in the Constitution itself. Despite acknowledging the unique history of alcohol in the United States, and that States have near absolute power to regulate the commerce of alcohol, the Court refused to allow the States to do so in a discriminatory manner. If a State desires to restrict the commerce of alcohol, it must do so in a way that does not differentiate based on whether a business is located in state or not.

The 21st Amendment and its Limitations

As clear as the Court was in holding that States' may not discriminate against out-of-state wineries with regard to the direct shipment of wine, the Court was equally clear in upholding the validity of the three-tier system and the States' rights to regulate or even ban the commerce of alcohol. The Court noted that the three-tier system is “unquestionably legitimate” and that the 21st Amendment grants the States virtually complete control over whether to permit importation or sale of liquor and how to structure the liquor distribution system.

States' powers to regulate commerce in alcohol are limited only by other provisions of the Constitution itself. In this case, the Court held the Commerce Clause—which stands for the proposition that States cannot treat businesses differently based on whether the business is located in or out of state—trumps the 21st Amendment. According to Justice Kennedy, "If a State chooses to allow direct shipments of wine, it must do so on evenhanded terms.”

Unintended Consequences: Are Reciprocal Laws Unconstitutional?

Although the ruling focuses on two States' laws that clearly discriminate against out-of-state wineries, the decision likely renders unconstitutional the direct shipping laws of other States whose laws are not commonly viewed as discriminatory. Good examples are those States with so-called reciprocal laws—laws that allow direct shipping only from States who in turn allow direct shipping into their State.

Ironically, California is a prime example of a State whose reciprocal direct shipping laws are now arguably unconstitutional under Granholm v. Heald. In fact, the Supreme Court in its ruling specifically mentioned California's reciprocal laws as illustrating the type of fragmented, alliance-driven patchwork of laws that has led to discrimination against out-of-state wineries. As the Court stated: "The current patchwork of laws—with some States banning direct shipments altogether, other doing so only for out-of-state wines, and still others requiring reciprocity—is essentially the product of an ongoing, low-level trade war."

Anticipating a challenge, the California Family Winemakers and the Wine Institute, among others, are already working on direct shipping amendments to replace the existing reciprocal laws in California with laws allowing for direct shipping from all States, regardless of reciprocity.

More Questions Than Answers: What Now?

It is worth repeating that the Court's decision does not authorize direct shipping. In fact, for those States that prohibit all direct shipping, the ruling has no direct affect because such laws treat in-state and out-of-state wineries the same. For those States whose laws do discriminate in one form or another, as stated by the Wine Institute, these states will have to take some legislative or regulatory action to address the discrimination issue and to build a framework for shipments to be made.

The ruling does suggest that requiring a physical presence in-state as a condition to direct ship is unconstitutional. This calls into question state laws that require in-state retailers, who buy from wholesalers, to buy from wholesalers located in-state. Costco is currently challenging such a law, among others, in the State of Washington. Also called into question are laws that allow in-state wineries, but not out-of-state wineries, to sell directly to restaurants and other retailers located in-state. Such a law currently exists in California, and if repealed, would adversely affect many California wineries that rely heavily on local retail direct sales.

Another broader question is in those States where the legislature requires all alcohol sales to go through a licensed entity, can these States require that the licensee maintain a physical in-state presence? From one perspective, the Court suggests it strongly disfavors state statutes that require in-state business operations. On the other hand, the three-tier system's middle tier is highly dependent on the in-state business requirement, and the Court went out of its way to declare the three-tier system as "unquestionably legitimate."

Although these positions seem at odds with each other, one way to reconcile them might be to reinterpret the Court's holding to be that States may not discriminate against out-of-state wineries unless they have a good reason for doing so. Thus far, the States' arguments have not been persuasive. It remains to be seen whether the lower courts will allow certain types of discrimination to survive if the States are able to provide strong enough justifications for doing so.

For example, what if States focused regulations on production amounts rather than the location of the winery? If States could assure wholesalers that the largest wineries would have to use the three-tier system, the wholesalers' interests might be satisfied. For smaller wineries, their low production could qualify them for an exemption from the three-tier system and allow them to direct ship.

The Opportunity and the Danger: Legislative Free for All

For all the noise this case has generated, the only thing we know for sure is that many States legislatures will be called on to rewrite their direct shipping laws. This presents an opportunity for wineries to push for legislatures to open their laws to direct shipping. However, it also presents a danger that the powerful wholesalers' lobby will convince State legislatures to impose more onerous restrictions on direct shipping than already exist, or to shut direct shipping down completely. Even in states like California where the wineries are at their strength, direct shipping proponents have an uphill battle to push through any legislation without the support of the wholesalers' lobby.

As part of any new legislation, many believe the wholesalers' lobby will push hard to include onerous paperwork, licensing and fee requirements in an attempt to make it as inconvenient and expensive as possible to direct ship. The more onerous the paperwork, the license requirements and the fees, the less wineries stand to gain.

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