What’s the Deal with Heald?

OVERVIEW

The 2005 United States Supreme Court case, Granholm v. Heald, reshaped how wine was sold throughout the United States and affirmed a principle of federalism fundamental to the efficiency of the domestic economy. 

The case involved an impressive roster of legal figures: Kathleen M. Sullivan, the former Dean of Stanford Law School, and Kenneth W. Starr, former D.C. Circuit judge, independent counsel on the Monica Lewinsky investigation and recently-disgraced head of Baylor University, appeared on the brief for Respondents.  Eliot Spitzer even made an appearance in his capacity as the New York State Attorney General.

At issue in the case was the practice in Michigan and New York of favoring their home wineries to the detriment of out-of-staters.  Both states used the three-tiered system for wine distribution, where producers, wholesalers, and retailers were separately licensed. 

Michigan gave its approximately 40 in-state wineries the home-court advantage through a special license.  This license allowed Michigan wineries to sell directly to Michigan consumers.  Out-of-state wineries could only sell to wholesalers who would then sell to retailers who, only then would reach the consumer.  Each link in the chain increased the cost, and the price, of getting a bottle of wine into the hands of a Michiganian. 

New York had a similarly skewed system: most wine distribution in the state happened through the three-tiered system, but a winery using only New York grapes could get a license allowing direct-to-consumer shipping.

The Plaintiffs in the case included California wineries and their owners who wished to sell to consumers in New York and Michigan directly.  They did not appreciate the states’ practice of creating structural barriers against healthy competition with in-state wineries.  They decided to take this perceived injustice to the courts, relying on one of the most robust principles of constitutional law to make their case.  However, they would have to overcome one of the most popular constitutional amendments in United State’s history.

LEGAL BACKGROUND

The case pits two clauses of the Constitution against each other.  Favoring the wineries was the Commerce Clause, and favoring the states was the Twenty-First Amendment.

The Commerce Clause, (U.S. Constitution Article 1, Section 8, Clause 3), simply states, “[The Congress shall have Power] To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.”  This means that Congress (not the states) has the power to regulate interstate commerce.  As a corollary, the Supreme Court has read in a prohibition against states discriminating against or unduly burdening interstate commerce. Reading Railroad v. Pennsylvania, 82 U.S. 232 (1873).  This prohibition is captured in a concept known as the “Dormant Commerce Clause.”  Its purpose is “to prohibit state or municipal laws whose object is local economic protectionism,” and ensure efficient trade between states.  C & A Carbone, Inc. v. Town of Clarkstown, N.Y., 511 U.S. 383, 390 (1994).

The Twenty-First Amendment of the Constitution repealed the Eighteenth Amendment and ended Prohibition in the United States.  It reads in relevant part:

Section 2. The transportation or importation into any State, Territory, or possession of the United States for delivery or use therein of intoxicating liquors, in violation of the laws thereof, is hereby prohibited.

Section 2 of the Amendment is generally understood to have delegated the power to regulate the alcoholic beverage industry to the states. 

ARGUMENT AND DECISION

The out-of-state wineries in this case argued that the Dormant Commerce Clause’s prohibition against economic protectionism should trump the Twenty-First Amendment’s delegation of authority to the states.  The states conceded that in any other industry, this regulatory framework wouldn’t fly.  But they said the Twenty-First Amendment made the protectionist statutes a valid exercise of the states’ authority. 

The states also argued in the alternative, that if the dormant commerce clause did apply, their statutory frameworks fell into an exception to the rule that allowed a discriminatory statute to stand if it “advanced a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives.”  The states argued that the framework was necessary to prevent minors from purchasing wine over the internet, and that it prevented tax evasion.

The Supreme Court sided with the wineries on all claims.  It found that the Twenty-First Amendment did not confer on states the authority to defy the principles of the Dormant Commerce Clause.  States, even when it came to regulating wine, could not discriminate against out-of-state providers.  The Court found that

the current patchwork of laws—with some States banning direct shipments altogether, others doing so only for out-of-state wines, and still others requiring reciprocity—is essentially the product of an ongoing, low-level trade war. Allowing States to discriminate against out-of-state wine “invite [s] a multiplication of preferential trade areas destructive of the very purpose of the Commerce Clause.

Heald, 544 U.S. 460 at 473. 

The Court further examined whether the states’ “patchwork of laws” fell into the exception to the Dormant Commerce Clause.  They found the states failed to meet the heavy burden of so proving.

CONCLUSION

After Heald, therefore, if a state wanted to allow its own wineries to ship its wares directly to in-state consumers, it had to do the same for out-of-state wineries.  As we see in the cases, this detangled somewhat the Gordian regulation of the alcoholic beverage industry, and made competition a little a little more fair among producers.

Somm: Into the Bottle

A few days ago I watched Netflix's sequel to the popular Somm movie. The follow-up, called Somm: Into the Bottle, focuses a little bit more on winemaking and other aspects of the wine business besides tasting and the Master Sommelier credential. A few of my favorite parts involved food pairing, value wines, and high-end wines.

Food Pairing

• The master sommeliers report that "what grows together, goes together." A few of their pairings:
• Muscadet & oysters
• Chianti & lamb
• Gewurtztraminer & sausage
• Sauternes & foie gras
• Syrah & Indian
• Chardonnay & popcorn
• Champagne is generally food friendly

Value Wines

• Sommeliers generally seem to like riesling
• Beaujolais wines are considered high value right now. This wine region, just south of Burgundy in France, makes wines largely from the Gamay grape which has a thin skin and is low in tannins.
• One suggested food pairing for Beaujolais was a hot dog (interesting)

High-End Wines

• Lafite-Rothschild, from last week's case, was mentioned
• It seems that DRC wine is considered even more "exclusive" than Rothschild -- they produce primarily in Burgundy (vs. Bordeaux) and in much smaller quantities than Rothschild. Their bottles can sell for several thousand dollars
• It's interesting to consider DRC as a different strategic play than Rothschild. Rather than branch out geographically or expand production, they've elected to remain small -- and command an even larger price premium than Rothschild as a result.
• This article suggests that Lafite Rothschild produces 20,000 cases of wine annually, compared to 450 cases for DRC.

Taking Flight – Drone Agriculture and the Wine Industry

In my Creating New Ventures in Developing Economies course, we discussed how Aerobotics is using drone and satellite technology to help farmers in South Africa improve their crop yields. Aerobotics is an aerial mapping analytics company specializing in gathering aerial imagery data for use in the agricultural value chain. Our discussion with Christine Wente about the technological advancements in the wine industry, specifically how her family is thinking about these innovations, made me think about my Ventures class and how drones may or may not be taking flight in the wine industry.

So, I did my Googles and came across a few interesting things. The use of drones is rising as the wine industry embraces precision viticulture and data-based decision making.

Colorized images taken by drones alert viticulturists to various levels of health or low health in their vineyard. Data analytics companies VineView and SkySquirrel, for instance, have collaborated on drone-based systems that measure water content in leaves and detect stubborn vine diseases which can be stopped by identifying and removing infected vines. Drones can also spray vineyards with fungicide to prevent fungal diseases that affect grapes, which some would argue is more efficient than hand spraying¹.

But can drones can help wine producers produce better quality wine? Vintner Ryan Kunde, who is the winemaker and co-founder of DRNK Wines, uses drones to exploit variability. He blends grapes from multiple blocks to achieve his desired flavor profile, a complex mix of vigor and maturity.

I’m interested to hear about the new, innovative, and exciting technologies our other speakers are seeing in the industry and to see how those innovations may be applicable in a development context.

¹ Are Flying Vineyard Drones Creating Better Wine?

In Defense of The Three Tiered Model...

I don't think it's a stretch to say that a consistent topic of conversation in the wine industry (as well as in the beer and spirits industry) centers on the three-tiered distribution model where producers sell to distributors and distributors sell to retailer; retailers then selling to consumer. It doesn't take long for the critics of the three-tiered distribution model to denigrate its existence. From far and wide, complaints of the three-tiered system roll in: 

• What started as a means of enforcing competition has become anti-competitive; distributors with regional monopolies may not be incentivized to help newer or niche wineries 
• Distributors are simply another mouth to feed, increasing prices to consumers
• Newer wineries may have a difficult time landing a distribution contract without first establishing their place in the market, this leads to a chicken and egg problem
• Politics with retails may lead to distributor acting in manners that compromise the producers

The list goes on and on. I actually happen to agree with or at least find the validity in many of these points as raised by critics of the system. However, many arguments in opposition of the system fail to adequately think about one key constituent: big box retailers. I'd like to make three points regarding this large but influential set of folks that I think aren't often taking into consideration.

First, and I'm being lazy here and deciding not to find the data so feel free to stop reading, I'd bet that the majority of wine sales in the US go through big box retailers like Safeway or Costco. At this point it makes sense to think about the business model of these companies. Margins are razor thin; both Safeway and Costco have operating margins below 5%. In a business model with margins that thin, inventory turns become paramount, i.e. they need to move good as fast as possible. What that means in practice is that retailers don't want to carry the 1984 vintage red from Burgundy. The want the two-buck chuck that moves quickly. Many point to the distributors as stifling competition by promoting certain wines but the reality is, they respond to retailers. Without, distributors bundling wines together, I'd bet it's likely that consumer choice would be even more limited than it already is.

Second, I'd like to introduce retail slotting fees. What most people don't know is that when you walk into a Safeway or Whole Foods and see an item on a shelf, the producer or manufacturer of that item has in may cases payed for that item to be put there. Think of it like rent or legal bribery. These slotting fees are often pretty hefty with big box retailers collection hundreds of millions of dollars in slotting fees annually. Fortunately for wineries, they have been shielded from this because of the three-tier protections. Thus, the three-tier system restrains the ability of large retailers to exercise their massive purchasing power and unfairly stifle competition. Were wineries not under this protection, they would be subject to massive slotting fees that would pit them in a competition with large grocery producers with sizable assets (Proctor and Gamble, Campbell's, etc.) who could simply afford to pay higher prices than most wineries for slotting fees. Needless to say, the largest wineries would get shelf allocation, and the rest would not.

Finally, I want to address this notion that retailers are in the business of promoting choice to consumers. Specialty retailers (a term that derived from selling niche products) are in that business but big-box retailers are not. They want to sell what moves quickly (inventory turns) at the highest margins possibly (lowering their costs) and will bully their way to do so. Recently in Indiana, the state briefly allowed beer distributors to sell anywhere in the state. In response, the major big box retailers went from distributor to distributor, negotiating the best price possible on large orders. In the end, the retailers were able to force prices so low that a number of the distributors wound up out of business. As a result, craft brewers who had relied on some of those distributors lost their access to the retail market. To prevent further damage, Indiana re-instituted a territory system, so that retailers could no longer play the distributors against each other, to the death. While this has to do with distributors, the reality is that retailers would do this to anyone if allowed (distributors, producers, importers, etc.). The three-tiered system at least prevents some of this egregious behavior.

For the record - I'm not sitting here waving the flag for the three-tiered system. I see the good and bad of it and I think I can be objective about its pros and where it falls flat. I'm also not suggesting there is not a better system; their must be. All I'm trying to point out is that wholesale repeal of the system needs to be more well-thought out, accounting for the incentives of each participant in the supply chain. 

Who wants a replica...

Our discussion in class last week as to whether the Rothschild organisation should expand their presence in Bordeaux and, in so doing, become even more inextricably linked with this celebrated region, put me in mind of the time I myself in that beautiful part of the world last summer. While I did not, unfortunately, spend my three days in Bordeaux drinking solely Chateau Lafite (#studenteconomies), my experience there was a stark reminder of just how much this region has to offer and precisely why the Bordeaux “brand” commands such gravitas globally. In Bordeaux you have a unique combination of history, culture, gastronomic traditions as well as wine. So, while other wine regions throughout the world can try as hard as they like to emulate the “wine piece” of that equation by boasting of sympathetic terrains and climates or superior methodologies that culminate in their own “Bordeaux blends”, they are still slightly off the mark. Bordeaux has a history which cannot be recreated, emulated or aped. This is a place where you can go on wine biking tours around a city named by former French kings the “the Pearl of Aquitaine” and pass by Gallo-Roman ampitheatres, thirteenth century clock-tours, proud imperial palaces while stopping off at countless wine shops and bistros for tastings along the way. This is a region where tour group “day trips to wine country” involve exploring turret-laded wine-making chateaux, all of which have their own 300 years of history as well as the vineyard out back. A place where you taste wines in majestic 17^th century dining rooms, or anterooms, or reception rooms, surrounded by ancient heirlooms while talking about terroir (/pretending you can denote hints of cherry/strawberry/pepper/tar --- delete as appropriate). Wine is a vehicle to all of this and tastes all the better for not being drunk in purpose-built tasting rooms, which feel at best commercial and at worst clinical because, by very nature, there is nothing else to experience or imbibe in them other than, well, wine.

That for me the magic of wine-drinking goes hand in hand with the opportunity it affords to drink in the history, culture and environment that surrounds it particularly struck me on a recent trip to Sonoma where I visited a couple of wineries, one of which was Rhine varietal in its specialty and another of which was of an Italian tilt. As I perused the store of the latter haunt, scanning the overpriced Italian olive oil range that had somehow found itself in the middle of Californian wine country, I just couldn’t be enchanted by a vineyard that was defining itself as, essentially, a would-be replica of the original model found elsewhere. By extension, why as a seemingly-coveted-by-every-wine-region Chinese consumer I would buy a Californian-produced Bordeaux blend as opposed to the real deal, isn’t necessarily clear to me. Why I would cross the world to visit Rothschild’s Opus One, and find myself in a region where any restaurant that serves food with actual taste requires you to book a year in advance (unless you’re Alyssa and have the French Laundry tricks of the trade up your sleeve J ) – as opposed to sipping my way around the turreted chateaux of the Left and Right Bank and witnessing 6^th century monasteries in St Emilion before returning to a regal city burgeoning with delicacies in every street side “cave” from foie gras to cannelle – again, isn’t that intuitive. Without, therefore, any more profound an insight than the innate belief that when you are drinking a glass of Bordeaux you are also drinking in an irreplicable history and rich culture, my own one-quarter-into-an-MBA-with-no-prior-experience-in-any-industry-of-use strategic analysis leads me to conclude that “doubling-down” in Bordeaux is, indeed, the way to play for la famille Rothschild (no doubt they’ll be just thrilled to have my stamp of approval...).

PS – should anyone want to read even more of my profound insights a propos Bordeaux, feel free to peruse my purpose-void blog (#cross-selling).