Tied House Laws Explained
Framed within a system of alcohol regulations defined by many different types of laws, tied house laws generally limit a manufacturer from controlling and owning both the production and sales sides of a beverage operation. In their seminal work, Alcohol Beverage: Law and Regulation. 5th Edition, the authors define tied house laws as "laws prohibiting manufacturers of alcoholic beverages from being involved in the sale of the alcoholic beverages produced or distributed by other manufacturers." Such laws both limit promotional activities and restrict the relationship between regulators and alcohol industry participants. Promoting the consumer interests of an open market, tied house laws ultimately discourage monopolistic control of the alcohol market.
Tied house laws emerged in the early 1900s in an attempt to regulate alcohol sales. As a battle between manufacturers, distributors, and larger retailers in the alcohol space continued through American history, a United States Supreme Court opinion in 1932 placed an emphasis on the states’ interest in regulating the alcohol market: "The States, as they each may determine, may reestablish themselves in the liquor traffic which they lawfully suppressed [by prohibition], and they may regulate that traffic as they choose." In fact, the Supreme Court further held that a state’s authority to regulate the alcohol market is greater than a state’s ability to regulate other industries .
Addressing a significant concern of promoting health and damaging social effects caused by the inebriation of consumers, states began to put restrictions on the ability of alcohol manufacturers to exert control over the alcohol market. Largely in response to this public health concern, some states (such as California) adopted unwieldy administrative laws to regulate specific aspects of the industry. However, most states modeled their tied house laws largely after California’s Alcoholic Beverage Control Act, the subject of subsequent guidance from the California Supreme Court. California’s own guidance from the California Department of Alcoholic Beverage Control advises: The purpose in imposing tied house restrictions upon manufacturers has been to prevent any manufacturer from gaining market dominance and thus indirectly controlling prices to retailers, consumers and the public; to close the back door to bribery by manufacturers to eliminate selection abuse; and to lessen temptation to excessive consumption by limiting those who exercise a degree of control over sales at retail to those who do not directly benefit economically from the retail sale of alcoholic beverages. As a result, tied house laws emerged as a tool to promote open competition in the alcohol market.
Origins of Tied House Laws
As with so many laws regulating commerce, tied house regulations find their origins in a time when the free market had displeasing or dangerous side effects. After the repeal of Prohibition in 1933, the alcohol industry was free to operate as a for-profit business with little regulation. This meant that companies were free to make business arrangements with retailers that may not have been in the public interest.
The result was competition and conquest, as producers sought to place their products in as many bricks-and-mortar locations as possible. That meant that the more money and the more resources you had, the more powerful you were. Producers with sufficient resources began to "buy up" retailers, ensuring that the retail side of the industry would be "tied" to one producer by way of a particular or exclusive relationship. The resulting "tied houses" had little incentive to sell the products of other producers. It was a pathway to monopolization across the nation.
Meanwhile, the state control system in other parts of the country sought to reverse this trend. It did so by removing the commercial aspects of the industry. By this, we mean that the control states owned or regulated the production and sale of alcohol, removing the financial incentives that drove the proliferation of tied houses.
Today, the alcohol industry is vastly different, and the tightly controlled markets have withered away. Most states are now in a free-market system where wine producers sell to retailers who, in turn, sell to consumers. There are only two control states remaining. Still, the vestiges of tied house laws remain.
The idea is simple: producers must be kept separate from the retailers. This is the goal and remit of tied house laws, at the federal and state level. Just as states found it necessary to break up the relationships between producers and retailers in the early 1900s, modern-day law assumes that these relationships are inherently dangerous. When you have such a sophisticated industry, the widespread limits on alcohol companies incarnate the ideals of those who passed the laws.
Provisions of Tied House Laws
The provisions and requirements of tied house laws vary from state to state. Generally, though, these laws prohibit certain types of business relationships between alcohol manufacturers, wholesalers and retailers. A manufacturer cannot "tide" a house to itself by engaging these prohibited transactions or relationships. States regulate at least 15 basic types of products and services that cannot be used to "tide" a house. While the degree of regulation varies from state to state, the basic types are:
— Bank financing, loans, interest
— Discounts, early payment of deliveries
— Free goods
— Price and purchasing cooperation
— Sponsored samples; industry advertising & promotions
— Furnishing equipment, fixtures, improvements
— Loans of money, other things of value
— Loans, guarantee of credit
— Licensed premises
— Government
— Trade practices, trade discount
— Tied house credit
— Special allowances
— Advertising assistance
— Social level allowance
Of those types, the two most common forms of illegal tied house transactions involve the sale of equipment or the offering of promotional allowances to local retail businesses in exchange for a guarantee that those businesses will "tide" the house (buy more of those manufacturer’s products). These arrangements are almost universally prohibited, as they constitute the manufacturer’s attempt to create a monopoly in the local market by preventing potential competitors from obtaining space in that area.
Effects of Tied House Laws on the Alcohol Industry
Tied house laws create a unique structure within the alcohol industry. On one hand, both alcoholic beverage manufacturers and suppliers are afforded protections that restrict the second tier from unreasonable competition practices. For example, under the presumption that tied house laws reduce concentration at each distribution tier and establish a three-tier system, antitrust restrictions may apply to those business practices that would otherwise impact market power. On the other hand, tied-house laws can have the effect of limiting retailers’ choice to only those manufacturers whose products are available and the price sensitivity of the products to which retailers presently have sales incentives. These laws create an inter-dependency among manufacturers, suppliers, and distributors. The result is a system of relationships that is both cooperative and competitive with the ability to impact vertical integration.
At the manufacturer/supplier level, a tied house law requires that manufacturers of alcoholic beverages sell their products in commercial or wholesale quantities, solely to wholesale distributors that are licensed by the liquor control jurisdiction in which the alcoholic beverages will be distributed. Additionally, the law prohibits the supplier from further distribution of those products. In many jurisdictions, such as Massachusetts, Maine, Minnesota, Alaska, Nebraska, and Virginia, direct factory sales to retailers are also prohibited. As a result, many manufacturers extend their brands to a large network of franchised wholesalers who pay a fee for the right to distribute the manufacturer’s products. The purpose behind these restrictions is to minimize the predatory tactics of suppliers to gain an unfair advantage in the market by placing unfair pressures on retailers.
Some economists suggest that Oligopolies (i.e., using a tied house system to limit suppliers) are inefficient. A market structure with only a few sellers is said to be inefficient because it leads to the same monopolistic tendencies that make single seller markets so inefficient. Therefore, in this view, tied house laws are necessary to minimize anti-competitive behavior.
At the distributor level, tied house laws to varying degrees, restrict wholesaler practices regarding market share incentives to retailers, influence when and how inventory is purchased and presented to the public. For instance, some tied house laws allow wholesalers to encourage retailers to carry only its products, or pay sales incentives to retailers that do so (e.g., promotional prizes), but some do not. Some tied house laws permit a wholesaler to grant geographical protection to a retailer by limiting its own sales to that geographical area, while others do not. In many states, tied house laws has had the unintended result of creating a market where wholesalers are forced to compete over space at retail rather than over the price and quality of the product they carry. In some jurisdictions, when inventories are sold-out, a wholesaler cannot buy competing products even if the retailer demands it because the tied house law requires the wholesaler to distribute a manufacturer’s product. Over the years, state legislatures have continuously re-evaluated these laws to provide for an efficient distribution system. Nevertheless, their real impact remains because barriers to entry at the retail level are a constant concern.
Innovation, service, and investment to promote the sale of its product are driven out of the market. Instead, tied house laws create a complex relationship of monopoly power among manufacturers who are able to influence the relative product quality, price, and availability.
Tied House Laws: The Contrast of State and Federal Legislation
Tied house laws differ on a state-by-state basis. While there has been some movement to standardize regulations, in most cases the separate systems remain intact, leaving individual states to craft their regulations as they see fit. This has resulted in a complex and confusing set of rules, and, in some circumstances, a tug-of-war between federal and state authorities over jurisdiction. For example, California used tied house laws to restrict the activities of manufacturers, importers, and wholesalers well before the Supreme Court discussed the issue in the context of the Commerce Clause. As a result, California’s tied house laws were (and are) much stricter than those imposed under federal law.
Other states have taken a similar approach to California. New York, for example, tends to restrict transactions involving promotional items more so than the three-tier system requires . Over time, some states have opted to take a "wholesale" approach to lawmaking, regulating the tied house through administrative agencies rather than legislation. But even then, there are exceptions to the rule. Michigan state regulations, for example, have been interpreted by the state agency as precluding a brewer from offering discounts to certain customers in violation of the tied house regulations. This interpretation seems to be at odds with the intent of the Michigan law. Several other states have similar provisions. With increasing pressure from some sectors of the industry to reign in if not eliminate the restrictions on tied houses presented in the "mother law" known as the U.S. Constitution, there may be a tipping point when states become more cautious about their tied house relationships.
Challenges Facing Tied House Laws and Cases
Not all tied house laws have survived intact as a result of their legal challenges. As a general matter, the legislative foundation of tied house laws in most states has been tested under both equal protection and due process theories under the 14th Amendment of the United States Constitution. The Due Process Clause is intended to protect the fundamental rights of individuals. It also requires that all similarly situated persons are treated equally under the law. The Equal Protection Clause requires that as between two classes of citizens: (i) different rules cannot be applied to members of the two classes, and (ii) a rationale for treating the classes differently must be articulated by the state.
The rationales given in passing tied house laws include the need to limit the market power of an industry when it is strong, and the need to ensure that that an industry does not use its market power to jeopardize the survival of a weaker local industry. The legislative history of many tied house laws acknowledges these two purposes. While the government may demand justification for regulations affecting fundamental rights, no such justification is required for regulations of economic matters. So long as a law is rationally related to a government objective, the law meets constitutional requirements. Only the most extreme classification may be overturned as a violation of the Equal Protection Clause.
While challenged tied house laws have survived as least scrutiny in the "strong" industry cases, those affecting small brewers that address falling consumption levels usually have attracted more scrutiny than might appear warranted. That is because constitutions are not indifferent to the plight of one class of merchants at the expense of another class.
Tied house restrictions are not immune from antitrust scrutiny, both criminal and civil. Federal enforcement agencies have attacked some tied house laws on the ground that they violate Section 1 of the Sherman Act which prohibits various trade restraints, including tying, or Section 2 which prohibits monopolization. While there are few vertically restrained tied house cases, an option was attached to this type of agreement by the Justice Department giving it the ability to investigate violations of tied house laws. No criminal indictments have been issued under the option, but tied house cases have been settled by consent decrees.
Tied house cases involve facts that the courts tend to decide either in favor of the state’s exercise of its police power or in favor of the defendant industry. The Supreme Court of the United States has never directly ruled on the legality of a state’s tying laws, but it decided several cases where the validity of voluntary tying arrangements were at issue. The United States has been the only litigant in tied houses cases that has not lost. So there is no clear guidance on the constitutionality of the laws in virtually any state.
The Future of Tied House Laws
Like any other legal requirements, tied house restrictions are not cast in stone and can be amended. Positive changes are coming and should continue. Increasing public awareness of the intolerable effects of Prohibition-type restrictions will increasingly force government to reconsider statutory tied house restrictions on the alcohol beverage market. Both the federal and state governments have levers that can be pulled to bring about easing the redistributive restriction effects on small suppliers and distributors. Reform efforts likely will not come from private right of action lawsuits. Any challenge to a tied house restriction’s constitutionality or as an "unfair trade practice" would be too expensive, and unlikely to be successful. A better approach for reform would be through either regulatory or legislative changes. On the regulatory side, the TTB, as it did after its multi-year rulemaking process, could issue regulations providing that common ownership between suppliers and distributors or retailers is not, in itself, a violation of the tied house laws. Another regulatory path could lead Blumberg’s percentages of ownership in a distributorship , if applied to a small business supplier, as being insufficient to establish common control. Legislative changes, particularly in California, are unlikely as state legislators have been slow to respond to changes that would ease tied house restrictions even when, for example, public safety interests are shown to be unaffected as they were with the rise of craft breweries. On the other hand, there are signs that the feds may move forward with increasing preemption of state tied house laws so that manufacturers, including small businesses, can sell to any state-licensed wholesaler anywhere in the United States and without the need for the federal collateral agreements between the supplier and distributor that are required today. Such changes at the federal level will cause state restrictions to fall and likely will result in the merger of distributors into larger companies as consolidation continues with the watering down of the wholesalers tier in the vertical three-tier system. It appears that U.S. Congress may be more likely to meaningfully address the negative impact of tied house restrictions than the California State Legislature.