Is Wholesale Change in Alcohol Pricing on Tap?

Call it 3.4-Buck Chuck.

Thanks to a convoluted patchwork of state alcohol laws, the Charles Shaw wine that sells for $1.99 at Trader Joe’s in California -- hence its nickname, “Two-Buck Chuck” -- goes for $3.39 in Columbus, Ohio.

Most of the additional $1.40 winds up in the pocket of a wholesaler in Ohio, where state law requires that an intermediary get a slice of any wine, beer or spirits sale.

Empowered by Byzantine regulations that grew out of the repeal of Prohibition in 1933, wholesalers hold a tight grip on the alcoholic beverage industry, maintaining legal monopolies in Ohio and many other states. But now these distributors, who have protected their power for decades, are facing a seismic shift in the liquor business.

Some of the country’s largest retailers and beverage companies are challenging the wholesalers’ power in courts and state capitols. Some want to deal directly with each other, cutting out the middleman, which they say will lead to lower prices for consumers.

For their part, wholesalers say the existing distribution system helps control a potentially dangerous product, and they warn that giving big retailers too much market power would not necessarily be a good thing for liquor producers.

No one is expecting 70 years of alcohol regulation to topple overnight. Yet experts anticipate a gradual loosening of the rules -- especially for wine and beer. The effect on consumers would be felt in many states, although not much in California, which already has more liberal distribution regulations. But the state’s $15-billion wine industry has a large stake in the outcome.

As early as this month, the U.S. Supreme Court is expected to issue a ruling on whether to strike down state laws prohibiting people from buying wines directly from out-of-state vineyards. A decision favoring wineries could allow them to bypass wholesalers by shipping their vintages directly to consumers in lucrative markets such as New York, Miami and Boston.

That would be a major blow to wholesalers.

What’s more, Costco Wholesale Corp., the nation’s largest wine retailer, has challenged liquor distribution rules in its home state of Washington, filing a federal lawsuit alleging that the regulations violate the Sherman Antitrust Act by illegally restraining competition.

The retailer essentially wants to overturn what has become known as the “three-tier system” of alcohol distribution, which dictates that wholesalers provide a legal separation between producers and retailers.

Costco would like to purchase beer and wine directly from manufacturers, lowering its cost and what it charges consumers, said David Burman, the attorney representing the retailer in the case, which is expected to go to trial early next year.

Because Washington adheres to the three-tier system, it prohibits direct purchases from breweries and wineries outside the state. Moreover, it requires wholesalers to charge all retailers the same price, whether they are buying the products a case at a time or by the pallet load. And it doesn’t allow Costco to purchase on credit, despite the chain’s healthy credit rating from Standard & Poor’s.

As a result, Costco said it charged more for alcoholic beverages in Washington than in California, where, with only minor licensing requirements, wineries and brewers can sell to wholesalers or directly to retailers, restaurants and consumers.

“We would hope that other states would take notice of a win here,” said Burman. “If a couple of these obstacles fall, you will see the [alcoholic beverage] industry turned upside down,” said Bob Paulinski, chief wine and spirits merchant for Sam’s Club, a unit of Wal-Mart Stores Inc

Paulinski said Wal-Mart was working behind the scenes to change the system rather than going to court. He wouldn’t elaborate, but the company reportedly has hired lobbyists to push for new laws in states such as Texas.

Costco’s attack on the system, as well as the pending Supreme Court ruling, are sure to be the hot topics when the Wine and Spirits Wholesalers of America annual convention opens today in Orlando, Fla., said Juanita Duggan, the trade association’s president.

Duggan said there were good reasons for keeping the current rules in place.

“Alcohol has to be treated as a special product because when it is misused it causes devastating social consequences,” she said.

Mark Anderson, executive director of the Ohio Liquor Control Commission, said “preventing excessive consumption of alcohol” was one of the considerations behind his state’s regulations.

Distributors also contend that they provide an important function for the industry, linking the thousands of producers of wine, beer and spirits to an even greater number of retailers, restaurants and bars.

“It is expensive to ship wine,” said Wayne Chaplin, president of Southern Wine & Spirits, which operates in 12 states and is the nation’s largest wine and spirits distributor. “It has to be stored properly, and there is a lot of cost savings by consolidating shipments and sending them in bulk.”

With $5.5 billion in annual sales, Southern has the reach to get a single bottle onto the store shelf or wine list of well over 100,000 accounts, he said. The company provides its clients with merchandising help and product expertise. Suppliers get important market data such as turnover rates and demographics of consumers, Chaplin added.

Even if the rules change, there’s little chance that wholesalers would be cut out of the business entirely, he said. Chaplin noted that in California, where easy license rules allow all but distilled spirits companies to sell directly to retailers, Southern has a 30% market share.

“Obviously we add value, or else people would use alternatives,” he said.

Sam’s Club executive Paulinski agrees that distributors fulfill an important function when they add value such as “getting tough-to-find wines for us.

“But when they are middlemen, just padding their pockets, I don’t see what the point is.”

In Ohio, beer distributors are guaranteed by state law a markup of not less than 25%, and wine distributors collect a minimum of 33%.

The rationale for the rule, said Anderson, the regulator, is to keep “big chains like Costco” from setting “their prices so low that they get a stranglehold on the market.”

The practical effect of such rules, however, is to guarantee profits for wholesalers, said Douglas Whitman, an economics professor and regulatory expert at Cal State Northridge.

It is a system that is unique to the alcoholic beverage industry, Whitman said. With virtually every other consumer product, there is no legal mandate to use a wholesaler, he said. Distributors come into play only when they bring some special value or expertise to the equation.

But changing the rules has proved difficult, he said.

“The distributors are a very strong and entrenched interest group that is not afraid to use its political clout to maintain the current system,” Whitman said.

Alcoholic beverage wholesale interests donated $404,000 to state campaigns in Ohio last year, according to the Institute on Money in State Politics in Helena, Mont. The distributors and their trade organizations made even larger contributions in nine other states, including Georgia, New York, Texas and Virginia, all known for tight regulations favoring wholesalers.

The recent entrance of retailing giants such as Costco and Wal-Mart into the fray, however, could change the balance of political power by pitting “special interest against special interest,” Whitman said.

Experts say that if there is a regulatory thaw, it will be most evident in beer and wine. Distilled spirits typically have a layer of even stricter regulations that, because of public policy considerations, are thought to be more durable.

The current system goes back to 1933, when the 21st Amendment repealing Prohibition granted states broad jurisdiction over the alcoholic beverage supply chain.

The amendment allowed states to decide how to develop reliable distribution and taxation systems for what had been for 14 years an underground industry controlled by organized crime. Today, 18 states directly control the sales channels by operating state liquor stores or otherwise inserting the government into the distribution system. The remainder have let private industry back into alcohol sales, but typically with rigid controls.

“These types of laws are only in the United States,” said Jess Jackson, chairman of Kendall-Jackson Wine Estates, one of California’s largest wine producers, “and they are descendants of a Prohibition mentality.”

Before Prohibition, beverage makers would sometimes own retail establishments or use inducements such as free equipment or loans to tie the stores into exclusive relationships. Temperance proponents contended that such “tied house” arrangements encouraged the promotion of alcohol consumption and social ills that result from it.

Burman, the Costco attorney, questions how relevant such laws are today.

“The idea that some winery is going to control Costco and force it to sell at a deep discount to encourage consumption is ridiculous,” he said.

And in fact, at the same time the wholesalers association’s Duggan says it is important to maintain laws that prohibit direct dealing and vertical regulations, she also warns that big-box retailers could wield undue influence in the marketplace. Chains such as Costco and Wal-Mart, Duggan said, tend to limit selections in their efforts to increase efficiency and lower expenses.

“I don’t think anybody wants to see a situation in the alcoholic beverage industry where there are 15 brands on the floor and no one else,” she said.

Moreover, those in California’s wine industry pushing for direct sales to consumers and retailers should be careful what they wish for, Duggan added. “People who sell to Wal-Mart don’t make any money,” she said.

Winemaker Jackson doesn’t buy such arguments. He believes fewer restrictions would actually open up the industry, especially for smaller wineries that now struggle to get the attention of distributors.

“It is the little guys who are at the cutting edge of this industry,” Jackson said. “And they need to be able to distribute their wine and build their brands.”