April 2016 Issue of Wines & Vines

Why Wine Producers Hate Franchise Laws

A system designed for selling cars still applies to wine sales in many states

by John Trinidad
Southern Wine & Spirits warehouse” welcome=
Wine is meted out for distribution at a warehouse belonging to Southern Wine & Spirits. Nearly half of states have franchise laws that dictate how difficult it is for wineries to change their distribution agreements. Credit: Unex
Editor’s Note: This is the first installment in a two-part series about franchise laws by attorneys John Trinidad of Dickenson, Peatman & Fogarty and Suzanne DeGalan of Hinman & Carmichael. DeGalan’s article about how wineries can protect themselves while engaging wholesalers in franchise states will appear in the August issue of Wines & Vines.

Media attention descended on Missouri as Diageo geared up to do battle with one of the state’s largest wholesalers, Major Brands, in 2014. The central topic: state franchise laws that make it difficult for a producer to terminate a wholesaler relationship. The Wall Street Journal deemed this the “Missouri liquor wars,” but much of the fanfare went away once the parties settled their dispute in September.

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What are franchise laws?
Franchise laws come in many shapes and sizes, but all share one primary characteristic: They make it exceedingly difficult and costly for a producer to terminate a state wholesaler. States with some form of franchise law for wine include Alabama, Arkansas, Connecticut, Delaware, Georgia, Idaho, Kansas, Maine, Massachusetts, Michigan, Missouri, Montana, Nevada, New Jersey, New Mexico, North Carolina, Ohio, Tennessee, Vermont, Virginia, Washington and Wisconsin (according to the Wine Institute).

Wine Institute reports there are 21 states that have “monopoly protection laws” that include some sort of termination or good-cause provision. Such provisions are implied in any alcoholic beverage supplier-distributor agreement, including verbal and “implied in fact” agreements. Suppliers, therefore, need to be careful when they consider entering into a franchise law state that their words or actions will not lock them into a franchise agreement with distributors they are considering.

Typically, states require that a producer have “good cause” to get out of a distribution relationship, but in practice, “good cause” has been narrowly defined by state regulatory agencies and courts, making it difficult for producers to terminate even for well-founded business reasons.

For example, Virginia’s franchise law states: “Notwithstanding the terms, provisions or conditions of any agreement, no winery shall unilaterally amend, cancel, terminate or refuse to continue to renew any agreement, or unilaterally cause a wholesaler to resign from an agreement, unless…good cause exists.”

In 1989, a winery with multiple distributors throughout Virginia decided to consolidate the total number of distributors for efficiency purposes and issued a termination letter to a select number of its distributors.

Some of the terminated Virginia distributors filed a complaint with the state Alcoholic Beverage Control Board, claiming that the termination violated the state’s Wine Franchise Act.

The parties asked the board to answer a simple question: Does the good faith exercise of business judgment by the winery, absent any evidence of deficiencies in the distributor’s performance, constitute good cause for purposes of the franchise law act?

The board found that it does not, that the winery had violated the state franchise law, and the Virginia Supreme Court affirmed this decision in 1996. This case demonstrates the excessively narrow reading of the “good cause” termination provision in franchise law states.

Although some states offer exemptions to the application of franchise laws, those exemptions are also narrowly construed. Ohio, for example, allows for termination of a wholesaler agreement absent good cause when there is a transfer of ownership of a particular beverage alcohol brand so long as the distributor is compensated and given notice of the termination within 90 days of the transaction (often referred to as the “successor manufacturer” exception).

But courts have consistently denied attempts by large beer companies, including Miller Brewing and Heineken USA Inc., from taking advantage of these exemptions to terminate Ohio distribution agreements.

Terminating an agreement in a franchise law state can carry a heavy price tag. In North Carolina, a winery wishing to terminate a distributor in violation of state law may face suspension or revocation of its permit, an order suspending shipment of that winery’s product into the state and a financial penalty ranging from $15,000 to $35,000.

Other states including Delaware require that suppliers terminating a distributor relationship provide the distributor with “reasonable compensation” for the value of the wholesaler’s business related to the terminated brands. This is generally based on the average annual gross profits of those terminated brands.

The excessively broad scope of franchise laws in certain states have forced producers to choose between continuing a distribution relationship that they wish to terminate or leaving the state altogether.

Georgia, for example, requires producers to register each brand they sell in the state with the Department of Revenue’s Alcohol & Tobacco Division and designate a state wholesaler with that brand. If the producer wishes to change distributors for that brand, it must file a “notice of intention” with the commissioner and serve a copy to the current wholesaler. The wholesaler can object to the notice and trigger an administrative hearing. Absent the voluntary release of the brand by the wholesaler or a positive outcome at the hearing, the producer may be forced to withdraw the brand from the state for a period of four years before it can be distributed by a different wholesaler.

What this basically boils down to is the state intervening in the private contractual relationship between wineries and distributors, and tilting the balance in favor of the distributor. State law, in essence, inserts the termination provisions for any wine wholesale agreement for distribution within that state.

Why did states adopt franchise laws?
The rise of franchise laws in the United States traces its roots back to the early years of the Ford Motor Co. Ford had to determine how to get their cars out to consumers from its plant in Michigan and adopted a “franchise model,” whereby Ford could control how the cars were sold by third-party distributors.

Ford, the supplier, dictated the terms of the franchise relationship. “Ford-authorized dealers” sprang up across the United States. Ford would often require the dealers to exclusively carry its cars, required them to meet certain sales goals and adhere to certain company standards, in essence allowing Ford to control the consumer experience from beginning to end.

Both the state and federal government grew concerned about the unequal bargaining relationship between the iconic Ford Motor Co. and in-state mom-and-pop dealers. They adopted laws in the 1950s that governed the contractual relationship between auto manufacturers and in-state dealerships, requiring “good-faith” behavior, limiting the suppliers’ ability to unilaterally terminate an agreement and imposed penalties for violations.

By 1970, distributors in other industries—envious of the franchise law protections granted to auto dealers—sought similar protection for themselves, even though some of the key characteristics of the automobile franchise model (such as exclusivity and supplier control) were not always evident.

States tried to define a “franchise” relationship to include other industries (such as restaurant business format franchises) and generally limited the definition of “franchise” to require a strong link between the supplier’s trademark and the distributor (such as a licensing agreement and a “community of interest”).

Despite the fact that alcoholic beverage distribution agreements do not generally require supplier exclusivity or involve trademark licensing, certain states applied franchise laws to the alcoholic beverage industry. New Mexico, for example, adopted an alcoholic beverage franchise law act in 1978, finding that there was a need to “provide an equal bargaining position between the parties” and ensure an orderly and fair distribution system.

Today, wholesalers continue to defend franchise laws on similar grounds. According to the Virginia Wine Wholesalers Association, state franchise law “protect(s) distributors from intimidation, bullying and abuse by more powerful (producers).”

However, the wine industry has undergone significant changes since these franchise laws were first adopted in the 1970s. The number of wineries has exploded and, at the same time, there has been a massive consolidation of the wholesale tier.

In October 2015, Wirtz Beverage Group and Charmer Sunbelt Group announced their merger to become the nation’s second-largest distributor with an estimated $8 billion in gross annual sales. Later that month, Southern Wine & Spirits and Glazer’s announced plans to merge—a combination of the first- and fourth-largest spirits and wine wholesalers.

This ongoing wholesaler consolidation makes it increasingly difficult for suppliers to find adequate distribution arrangements and has given wholesalers the upper hand in negotiating distribution agreements.

Although certain wineries have been able to bypass this bottleneck in the distribution of alcohol by having strong wine club and direct-to-consumer programs, most wineries continue to rely heavily on the three-tier system to sell their wines.

With this drastic shift in bargaining power between suppliers and wholesalers, one could question whether the franchise law protections for distributors are still warranted, or whether they are simply antiquated laws meant to solve problems past. In short, the reasons for adopting franchise laws may no longer be present in today’s wine industry.

Why should producers and consumers care?
The cost of anti-competitive franchise laws is borne by both producers and consumers.

Producers may be locked into under-performing distributor relationships that are too costly to terminate, damaging their bottom line and brand value. As in the Virginia example, even if a producer has valid economic reasons to terminate a distributor relationship, that may not be enough to meet the “good cause” requirement.

A winery that feels its distributor is not adequately representing its brands not only faces diminished sales but also may see the goodwill associated with its intellectual property—its brands—diminished in that franchise law state.

Consumers feel the impact of franchise laws through higher prices and more limited choices. In a 2013 study, researchers at Sonoma State University’s Wine Business Institute compared wine sales in Florida, a non-franchise law state, and Georgia, which has strict franchise law regulations. The study concluded that Florida consumers enjoyed generally lower prices for wine brands that were sold in both Florida and Georgia, and that Florida offered a wider wine selection.

The study used qualitative interviews with 14 wineries, distributors and retailers, statistical analysis of Nielsen Scantrack data and an online survey of 401 wine consumers in Georgia and Florida. This was the first empirical study in the United States to focus on the impact of wine franchise laws on consumer choice and wine price. (See “The Impact of Wine Franchise Laws on Consumer Choice and Pricing: A Comparison Between Georgia (a Franchise Law State) and Florida (a Non-Franchise Law State)” in the International Journal of Wine Business Research issue 25, No. 2.)

Franchise laws may negatively affect the ability of a wine industry to innovate its distribution and sales models. For example, when Tesla Motors, a leading manufacturer of high-end, cutting-edge electric cars adopted a direct-to-consumer sales model, auto dealers in a number of states complained that such a model circumvented state franchise laws that require automakers to sell through local, independent auto dealerships. In an April 2014 blog post, the Federal Trade Commission (FTC) called these laws “bad policy” and chastised auto dealers for attempting to thwart “new sources of competition.”

Lawmakers and industry members should continue to examine the impact of franchise laws in light of the current state of the wine industry—wherein there are a thriving number of small producers and an increasingly consolidated and powerful wholesale tier—and determine if franchise laws serve any other purpose than to favor in-state wholesaler interests.

As the FTC concluded in its Tesla post, “Regulators should differentiate between regulations that truly protect consumers and those that protect the regulated.” Industry members should consider what potential actions they can take to rescind such nakedly protectionist laws. That may include lobbying for legislative change as well as potentially adopting a litigation strategy to challenge franchise laws.

John Trinidad works with the Wine Law, Alcohol Beverage, Business, Geographical Indications and Intellectual Property groups at Dickenson Peatman & Fogarty in Napa, Calif. He advises wine industry clients on a broad range of issues and also serves as general counsel to the American Wine Consumers Coalition, an advocacy organization seeking to protect consumer rights and lower barriers to wine access. He is a member of the Advisory Board of the Napa Valley Wine Library Association.

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