BusinessTN

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In 1933, the 21st Amendment repealed Prohibition and granted the states the right to regulate the sale, distribution and consumption of alcohol within their borders—the idea being that they could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.