Business Law Today: American Bar Association

Volume 14, Number 6 July/August 2005

More Wine, Less Whining
Commerce Clause trumps state statutes
By John McGee

Several industries, including sellers of products as diverse as alcoholic beverages, cigarettes, automobiles and caskets, have for years used the legal system to create for themselves what they would call a protected niche but what others would call an oligopoly. The legal arguments used to sustain these oligopolies have become as aged as the wine they attempt to protect, but one by one the walls are tumbling down.

In a continuing series of cases begun in February of 2000, wine consumers and out-of-state wine sellers challenged several state laws restricting the sale of alcoholic beverages. Despite a spirited defense of these laws by state attorneys general protecting their statutes and alcohol wholesalers protecting themselves, as well as decades of precedents favoring the industry, defense motions to dismiss the cases were denied and consumers prevailed, often by summary judgment. The demand created by e-commerce, with its promise of lower prices, made direct shipping rules an issue of national importance.

The Supreme Court struck down these rules (5-4) in mid- May in the consolidated cases of Granholm v. Heald, Michigan Beer & Wine Wholesalers Association v. Heald, and Swedenburg v. Kelly. Granting that the states have broad power to regulate liquor under the 21st Amendment, the court refused to allow states to ban, or severely limit, the direct shipment of out-of- state wine while simultaneously authorizing direct shipment by in-state producers. New York and Michigan regulations that discriminated against out-of-state wine producers were voided under the Commerce Clause.

When the 21st Amendment repealed Prohibition in 1933, most states adopted a three-tier system of manufacturers, wholesalers and retailers and prohibited any one owner from investing in more than one tier. This prohibition keeps manufacturers from owning a retail license, thus preventing them from selling directly to consumers and allegedly keeping mobsters out of the liquor business.

It also keeps small wineries from selling directly to consumers. There are 2,000 wineries with 7,000 different wines in the United States; most are too small to produce enough wine to attract wholesalers, so they rely heavily on direct sales to consumers. There have been stories in the media of wine being shipped in unmarked boxes, customers giving fake addresses, and shipments of "Olive Oil" in plain brown wrappers being mailed all over the country.

Making direct purchase by consumers from out-of-state illegal may or may not deter mobsters, but it clearly serves to limit consumer choice and protect wine wholesalers. By voiding the New York and Michigan regulations, the court has told the states that they may no longer force out-of-state wineries to participate in their three-tier system — that economic protectionism is not a valid reason to discriminate. Wholesalers and their allies in various state governments may keep their strict system of licensing so long as the restrictions do not discriminate against out- of-state purchasers. States do not, in other words, have sovereign regulatory power under the 21st Amendment.

One of the first legal challenges, Dickerson v. Bailey, was brought by wine drinkers in Houston against the administrator of the Texas Alcoholic Beverage Commission (TABC), alleging that restrictions in the Texas alcoholic beverage code that kept them from purchasing wines directly from out-of-state suppliers limited their participation in interstate commerce and thus violated the Commerce Clause of the U.S. Constitution. Texas, of course, requires consumers to purchase only from licensed retailers, who may purchase only from licensed wholesalers, who must purchase only from licensed producers.

The threshold question was the same as in any Commerce Clause challenge: Does the challenged statute discriminate on its face against interstate commerce and in favor of local businesses, thereby rendering it per se invalid, or does it regulate commerce evenhandedly with only incidental effects on interstate commerce? If the statute does not discriminate on its face, then a balancing test is applied to determine its constitutionality, and the court should uphold the statute unless the burden it places on interstate commerce is clearly excessive in relation to its benefits. The plaintiffs in Dickerson claimed the three-tier system of liquor licenses in Texas impeded the free flow of goods from one state to another and was therefore per se illegal under the "dormant" Commerce Clause of the Constitution.

The wholesalers and the state argued that the three-tier system regulates commerce evenhandedly, with only incidental effects on interstate commerce, and therefore any discrimination was demonstrably justified by a valid factor unrelated to economic protectionism. The regulation was defensible, they argued, because of the 21st Amendment's grant to states of broad powers to regulate the transportation and importation of alcohol for delivery and use within their borders.

Fears about large companies with monopolistic tendencies dominating all levels of the alcoholic beverage industry were trotted out. If wineries used catalogs or the Internet to sell their products, they argued, Texas might lose total control over the import and distribution of alcoholic beverages within its borders. The proper taxes might not be collected; shippers might ship to dry areas of the state; sales of alcoholic beverages to minors might increase. They cited language from the 1936 Supreme Court Young's Market case indicating that the 21st Amendment essentially repealed the Commerce Clause where liquor regulation was concerned.

The plaintiffs, however, had done their homework. An FTC report concluded that states that allow direct shipping have procedural safeguards against shipments to minors and report "few or no problems" with these shipments.

Court decisions after 1936 suggested that states could avoid problems with direct sales by:

requiring purchases to be made by credit card,
requiring a sizable minimum purchase,
requiring age verification by the seller through faxed identification and delivery only to an adult identified in the identification document,
requiring labeling of products on the outside of shipping wrappers, or requiring age verification of the recipient by the transporter.

Moreover, trade associations representing alcohol manufacturers had already agreed to submit to state licensing and tax collection requirements if direct sales were allowed. Moreover, many states already allowed direct interstate shipment of wine — collecting taxes by requiring a permit in order to ship wine into the state.

The district court easily determined that the Texas Alcohol Beverage Code discriminated against interstate commerce by favoring in-state economic interests at the expense of out-of-state interests. But did the 21st Amendment "repeal" the Commerce Clause in connection with alcohol regulation, saving the statutes from invalidation? Not, said the court, if reasonable, nondiscriminatory alternatives could be found to address the state's interests in taxes and dry areas.

Since there are many alternatives for collecting taxes on out-of-state wine sales and there are criminal laws that prohibit the sale of alcoholic beverages to minors and those in dry areas of the state, the state failed in its attempt to prove that the local benefits justified the Commerce Clause violation and the total ban on direct shipments to consumers was over-inclusive. Texas consumers were allowed to purchase wines directly from out-of-state sellers and ship wines purchased elsewhere to their homes in Texas.

The 21st Amendment, appropriately narrowed and modified by 60 years of opinions, was no longer sufficient to save the regulations from invalidation under the Commerce Clause. Judge Harmon rebuked the defendants for relying on older cases that "fail to reflect the marked evolution of law in this area" and concluded that there was "no temperance goal served by the statute since Texas residents can become as drunk on local wines or wines of large out-of-state suppliers able to pass into the state through its distribution system, and available in unrestricted quantities, as those that, because of their seller's size or (other) constraints, are in practical effect kept out of state by the statute."

Judge Harmon's Dickerson decision partly relied on a broad holding in a contemporaneous Indiana case that the 21st Amendment does not immunize state liquor control laws from invalidation under the Commerce Clause. When the Indiana case was reversed by the Seventh Circuit as a direct challenge to the entire three-tier distribution system, Dickerson was reopened for consideration. Both parties revised their arguments and prepared to return to the courtroom.

Meanwhile, the Texas legislature got involved by passing the Texas Wine Marketing Assistance Program Act, with the expressed purpose to "assist Texas wineries in capturing a greater part of the market for wine, at the expense of out-of-state wineries."

This left no doubt that the intent of the statute was economic protectionism. In-state wineries were exempted from the three-tier system by permitting them to deal directly with Texas consumers in both selling and shipping wines. In contrast, Texans could not personally bring into the state more than three gallons of wine purchased from an out-of-state vintner. Texas wineries were also permitted to ship directly to a Texas consumer any wine sold to him, but out-of-state wineries were prohibited, under the threat of criminal penalties, from shipping any alcoholic beverage directly to any Texas resident.

On reconsideration, the new Texas regulatory scheme fared no better with Judge Harmon. The state was engaging in "economic determination" by applying its regulatory scheme to favor local producers over out-of-state producers. The new statute was discriminatory and violated the dormant Commerce Clause; it was not "saved" by the 21st Amendment. The 21st Amendment does not allow states to control alcohol any way they like — they must treat the importation of liquor similarly to the way they treat in- state sales of liquor. The judge actually challenged Judge Easterbrook's Seventh Circuit opinion for using terms like "orderly market conditions" ("a euphemism for reducing competition and facilitating tax collection") and "express grant of plenary power" ("this reveals his own leaning").

She even asserted that the Seventh Circuit's deference was based on a flawed interpretation of the Constitution because it did "not even mention the burdens on small out-of-state wineries or consumers that might result from the regulatory process, thus ignoring the last 40 years of Supreme Court cases balancing the dormant Commerce Clause and the 21st Amendment."

The Fifth Circuit likewise showed little patience with the state's reformulated argument that the plaintiffs were attempting to overthrow the entire three-tier system and establish an unregulated national market in wine. The court even accused the state of misrepresenting the central legal issue of the case, noting that the TABC's worries about a totally unregulated market arose only after the Seventh Circuit decision.

The Fifth Circuit accepted the wineries' express disavowal of any attempt to overturn the three-tier system and declared itself in conformity with the Seventh Circuit, which had qualified its approval of the Indiana system with the words "unless the state has used its power to impose a discriminatory condition on importation." Since the Texas requirements clearly imposed discriminatory conditions on out-of-state wineries, Judge Harmon's injunction was upheld and when the state decided not to appeal further it had to pay the plaintiff's attorney fees of $160,000.

By September of 2000, district courts in seven states had concluded that alcoholic beverage statutes were in violation of the dormant Commerce Clause. Florida and the District of Columbia upheld the statutes anyway, finding them a constitutional exercise of sovereign regulatory power under the 21st Amendment even though they "may have protectionist overtones." Other states found mixed motives, some legitimate and some protectionist, with the legitimate motives outweighing the burden placed on interstate commerce. Still other states declared their otherwise unconstitutional statutes "saved" by the 21st Amendment.

According to the Wall Street Journal, some states made it easy to order wine online, some made it tricky, some remained tough, and there were seven states where bypassing wholesalers was sometimes a felony. After the wineries' legal campaign got under way, Virginia, North Carolina and other states followed Texas' lead and permitted direct shipping, but only by in-state wineries.

Meanwhile, the Institute for Justice filed Swedenburg as a national test case in New York, the second-largest wine market after California, against four large liquor wholesalers on behalf of small wineries and consumers, arguing that the state's direct shipment laws violated the Commerce Clause. The Institute refers to restrictions on direct shipment as "the oldest gambit of American politics: economic protectionism" designed to "preserve the monopoly of liquor wholesalers who control all out-of- state wine..." Restrictions on interstate wine shipping, they allege, make it impossible for out-of- state wineries to ship wine to New York consumers, thereby trammeling their economic liberty. New York claimed that its absolute power under the 21st Amendment to regulate the distribution of alcohol insulates it from any constitutional attack.

In an opinion echoed later by the Supreme Court and with national ramifications for Internet commerce, the court voided New York's ban on direct shipments as violative of the Commerce Clause, agreeing to allow "only those restrictions which directly promote temperance." The wineries' victory celebration, however, was premature.

Granting that the direct shipment ban "would be a problem" if the goods involved were not alcohol, the Second Circuit joined four other circuits in rejecting any analysis that "unnecessarily limit(s) the authority delegated to the states through the clear and unambiguous language of the 21st Amendment." In an opinion that would later be repeated by dissenters on the Supreme Court, the Second Circuit held that the 21st Amendment "repealed" the Commerce Clause wherever regulation of liquor is concerned. The legal history of Prohibition was used to show that the Commerce Clause was not intended to restrict any state regulatory scheme focusing on the importation of liquor and that "changes in marketing techniques or national consumer demand for a product do not alter the meaning of a constitutional amendment."

By ruling that states may not use alcohol distribution laws to bar out-of-state competitors from shipping wine while allowing local wineries to ship directly to consumers, the Supreme Court "has not diminished the 21st Amendment; it has merely reinforced its earlier position." It still recognizes that the 21st Amendment makes liquor special and that the states have valid regulatory concerns. The court has merely rejected the notion that the 21st Amendment somehow "immunizes" states from the Commerce Clause.

In his dissent from what he calls a "confused mismash elite opinion," Justice Thomas argues that concerns about the application of the Commerce Clause to liquor regulation have been displaced not only by the 21st Amendment but by the express language of the Webb- Kenyon Act that prohibits any "shipment or transportation" of alcoholic beverages "into any state" when those beverages are "intended, by any person interested therein, to be received, possessed, sold, or in any manner used . . . in violation of any law of such state." This, he says, authorizes states to discriminate. A separate dissent by Justice Stevens insists that the will of Prohibition-era drafters be honored even though applying the Commerce Clause "may represent sound economic policy and may be consistent with the policy choices of the contemporaries of Adam Smith who drafted our original Constitution."

If consumers are to be allowed access to the wine market at all, then they must be able to access the direct market via the Internet. States will continue to strictly regulate alcohol and most regulations (possibly even a total ban on shipments of wine to consumers) will be upheld, so long as they do not discriminate. The Supreme Court has merely held that states do not have the right to discriminate in order to overcome trade barriers and that it will invoke strict scrutiny of any purportedly legitimate local purpose.

The court's 1984 holding in Baccus that "The central purpose of the 21st Amendment was not to empower states to favor local liquor industries by erecting barriers to competition... State laws that constitute mere economic protectionism are not entitled to the same deference as laws enacted to combat the perceived evils of unrestricted traffic in liquor" has become "If a state chooses to allow direct shipment of wine, it must do so on evenhanded terms" in 2005.

The establishment of a common market for wine sales will increase opportunities for small wineries to tap major markets, increase choices for consumers and lower prices. E-commerce will be furthered by having common rules for what can be sold over the Internet, and regulatory matters such as tax collection and sales to minors can be handled in less intrusive ways than banning all out-of-state sales.

States have always tried to erect statutory barriers to shield their merchants from the rigors of competition and that is exactly what the Commerce Clause was enacted to prevent; indirect trade barriers to preseve an oligopoly will not work in the age of globalization and the Internet. Consumers demand access to products at the lowest cost and this may force certain industries to change their business practices to insure they are pro- consumer, nonprotectionist — and as efficient as possible.

McGee is a professor at Texas State University, in San Marcos, Texas. His e-mail is jm28@txstate.edu.

ABA Section of Business Law