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Federal Judge's Rulings Signal Future Changes in Wine Distribution

Costco's lawsuit against Washington state could be the first step toward changes in prices and selection for consumers

Eric Arnold
Posted: December 23, 2005

There's been plenty of action from the federal courts this year, as judges have been forcing states to allow consumers to order directly from wineries and have the bottles shipped to their homes. Even so, people in the wine industry have been keeping a close eye on another legal front. A lawsuit in Washington could eventually have an even bigger impact on which wines are available—and at what prices—to consumers across the country.

Costco Wholesale Corp., the national chain of discount warehouse clubs that has become the largest wine retailer in the United States through its vast purchasing power and low prices, has been waging a controversial battle with the Washington Liquor Control Board since early 2004. Costco argues that its home state's system for alcohol distribution violates federal antitrust law and the U.S. Constitution. On Dec. 21, a federal judge agreed, in part.

Although the case won't go to a full trial until March 2006, U.S. District Judge Marsha Pechman ruled on two pretrial motions this week. Her decisions could lower wine prices for Washington consumers and change how wineries handle sales to the state's retailers and restaurants. Exactly how is not yet certain.

On an issue that could have broad implications for other states as well, Pechman ruled that it was unconstitutional for Washington to allow in-state wineries to sell their wines directly to Washington retailers and restaurants, while out-of-state wineries can not. Such discrimination is a violation of the Commerce Clause, which is also the basis for overturning states' bans on out-of-state wine shipments to consumers. If Costco were able to negotiate deals directly with suppliers, it could eliminate some of the costs inherent in the three-tier distribution system. Some of its savings could be passed on to consumers.

Pechman set a deadline of April 14 for the Washington legislature to change the laws, either by extending self-distribution rights to wineries in other states or by eliminating the practice altogether.

If the deadline passes without legislation, she ruled, Washington wineries will lose the right to self-distribute in the state. That has many producers worried.

For small, startup wineries making 500 to 1,000 cases of wine per year, "there's no way for them to survive without the ability to direct wholesale to retail and restaurant accounts," said Marty Clubb, winemaker and owner of Walla Walla-based winery L'Ecole No. 41. "If you're making a $20 bottle of wine, you wholesale it for $14. If you're forced to go through a distributor network, you're down to $9 a bottle. That just takes all the economics out of being able to compete on a small scale."

Even larger wineries that use a distributor, such as Woodward Canyon, sometimes rely on direct sales, said winemaker Rick Small. Woodward Canyon deals directly with retailers and restaurants in areas that its distributor network doesn't reach, or when the winery has a small-production bottling that the wholesalers won't carry. He has no objection to extending self-distribution rights to out-of-state wineries. "I think everything has to be fair," Small said. "I feel that my wines can stand up against any other wines, so if wineries from California want to deal direct with Costco, I don't have a problem with that."

Neither do some small retailers. Dan McCarthy, owner of Seattle wine shop McCarthy & Schiering, wasn't overly concerned about big-box retailers getting a competitive advantage. He pointed out that retailers have limited floor space. "There's not going to be 6,000 wineries all trying to sell directly to me, and I don't think it's even true of Costco and their size. The number of deals that would be made on a direct basis would be limited to the actual floor space you're willing to devote to it."

The producers are optimistic about getting legislation passed that meets their needs, as the state government has a history of supporting the local wine industry. However it could be a tough fight, as Washington's powerful wholesaler lobby is against changing the laws, though would prefer that any new legislation ban all direct sales, forcing all wineries to use a distributor. The wholesalers have reason to be concerned that a change in Washington could set precedent for other states to allow wineries to bypass the three-tier system.

"The system we have, allowing Washington breweries and wineries to ship direct to retailers, we feel that's lawful, and we wanted to go to trial to defend the system," said Phillip Wayt, executive director of the Washington Beer & Wine Wholesalers Association. "There doesn't seem to be any public cry for change. That tells me that the system works pretty well, and it doesn't happen to fit Costco's business model, so they want to change it." Not fitting a company's business plan is not the same as a violation of federal law, he contends.

"Getting remedial legislation by [the deadline] is a tall order," warned Corbin Houchins, a Seattle attorney, with the law firm Graham & Dunn, who specializes in alcohol-beverage law. "The wholesalers are capable of delaying a bill at least that long. The wholesalers have an easier task than the wineries in many ways, because all they have to do is prolong the negotiations on the wording in committee. It's always easier to stop a bill than to get it passed."

On the other key issue in the case—antitrust matters—Costco has argued against the Washington laws requiring producers and wholesalers to mark up liquor prices a minimum of 10 percent and to post their prices in advance. The company is challenging a set of nine restrictions that, among other things, prevent distributors from offering volume discounts to retailers, claiming they amount to a federal antitrust violation. (Some other states, such as Ohio, have similar laws, which date back to Prohibition.) Costco, which is known for low markups on all the products it sells, claims that these restrictions raise prices unfairly for consumers and limit choice.

The judge denied the motion for summary judgement, saying that the issue was too complex and must go to trial, according to Houchins. Her analysis did state that the minimum markup and other restrictions were anticompetitive and in clear violation of the antitrust Sherman Act. However, she acknowledged that the state might have a defense in the U.S. Constitution's 21st Amendment, which gives states the right to control alcohol sales within their borders. The liquor board is arguing that its restrictions are valid because they are related to the core concerns of the 21st Amendment: encouraging temperance, enforcing an orderly market and collection of taxes.

"The big question for the Costco court at trial is: To what extent are all these restraints bound up in a single system that stands or falls on a 21st Amendment defense?" asked Houchins, who expects the case to take years to work its way through the courts. Some of Washington's restrictions are more or less standard practice for the three-tier distribution system throughout the country. "If the court bundles all these restrictions together and decides the 21st Amendment does not support them, it will have profound effects nationally on the way wine is distributed. It would go a long way toward creating a national, competitive wholesale market in wine."

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