The Three-Tier System

What is Wholesaling
The History of the Three-Tier System
Consumer Benefits of the Three-Tier System
The Regulatory and Economic Basis for Wine and Spirits Wholesaling
in the U.S.

What is Wholesaling?
Today's wine and spirits wholesalers are family-owned businesses with deep roots in the communities they serve. The most commonly known function of a wine and spirits wholesalers is to purchase products from a supplier company to sell and deliver to retail establishments, including package stores, restaurants, bars, hotels, grocery stores and liquor stores. However, this is only one of several functions a wholesaler performs.

As proponents of responsible hospitality and as community leaders, they support regulations and community standards that discourage overindulgence, drunk driving and sales to underage persons.

Wholesalers are in most instances the primary collectors of state excise taxes levied on wine and spirits. They provide the data to state governments that enable officials to effectively collect and double-check that taxes are paid on every bottle of alcohol beverage sold within the state.

As a key link in the hospitality industry, wine and spirits distributors perform many behind-the-scenes functions that enable restaurants, bars, retail outlets and other businesses to thrive. For retailers and restauranteurs they extend credit, provide rapid and frequent deliveries, and willingly split cases to accommodate small orders. Their ability to fill small orders for low-demand wine and spirits brands have allowed consumers to choose among hundreds of brands that might otherwise have been pushed from the marketplace.

They are an integral part of the marketing and merchandising process. For restaurants, wholesalers often conduct tasting seminars for wait staff, develop and print wine lists, suggest food/wine pairings and train bartenders in the newest cocktail recipes. They also help organize special events at bars and restaurants, develop special advertising and promotional programs to complement local events and act as the local representative for vintners, distillers, and beverage importers.
For retailers, wholesalers use sophisticated computer programs to develop optimum shelf placements for brands and types of alcohol, and help store operators conduct product tastings and other educational services. Top

The History of the Three-Tier System
Before Prohibition
From the colonial times until 1919, when the 18th Amendment ushered in Prohibition, alcohol beverages were sold in a freewheeling, free-market system. Producers of spirits and beer served small geographic areas and frequently owned their retail outlets. Supplier-owner outlets usually served only their brands. When the outlets were owned by third parties, competition often turned into a free-for-all.
The system had only two tiers-- suppliers and retailers. Although small, the producers were, usually were larger than their retailers and had more capital. Suppliers stimulated sales by furnishing retailers with equipment and supplies, giving rebates to retailers who handled only their brands, extending interest-free loans, etc. In fact, a few suppliers sought to control retailers through intimidation and corruption.
Besides pressuring retailers to handle only their own brands, suppliers pushed retailers to increase sales whatever the social costs. Although per capita consumption levels (slightly below today's levels) were moderate, public drunkenness was still extensive because most consumption was on-premise, and concentrated heavily toward payday binges.

Led by the American Temperance Union and the Anti-Saloon League, social acceptance of the temperance movement gradually shifted alcohol consumption from moderate drinking to complete abstinence.
The economic issues of retailers joined the social issues of abstinence to encourage prohibition. The 18th Amendment, ushering in Prohibition, was passed in 1919. The Volstead Act, passed a year later, was designed to enforce Prohibition.

During Prohibition
To the dismay of Prohibition advocates, the 18th Amendment didn't end commercial alcohol beverage consumption. Like any unpopular law, it was unenforceable. Consumption moved away from the highly visible taverns into speakeasies. Production went underground or offshore and bootlegging became big business. The quality and safety of alcohol fell, prices skyrocketed and, organized crime expanded. Alcohol beverages took over 5% of consumers' spending, compared to about 3% today. At the same time, excise tax revenues from alcohol fell to a trickle.

During the Depression, discussion in Congress about alcohol beverages changed. The focus moved from moral and religious issues to considerations of the potential revenue were these beverages to be legalized again. Legislators also recognized that hundreds of thousands of jobs would be created by a revitalized alcohol beverage industry. Ending Prohibition could make a substantial dent in the unemployment rate, plus help earn federal revenue.

Employment and revenue potential associated with ending Prohibition eventually overrode the moral and religious objections to alcohol consumption, but legislators understood that there was substantial disagreement among and within states regarding the legalization of consumption. A return to pre-Prohibition distribution and consumption practices would be politically unacceptable.

The End of Prohibition
Congress passed the Cullen-Harrison Act on April 1, 1933 which re-defined "intoxicating liquors" to exclude beer with less the 3.2% alcohol. This action effectively removed low-alcohol beer from coverage by the 18th Amendment unless states specifically prohibited its sale. Twenty states plus the District of Columbia thus permitted the sale of beer on that date.

States' Rights to Regulate Alcohol Beverages
Ratification of the 21st Amendment followed later that year. Section 2 of the Amendment gave states authority to regulate the production, importation, distribution, retail sale and consumption of alcohol beverages inside their borders. This authority was extremely broad and for five decades was held to be nearly absolute.

The FAA Act
Administered by the Bureau of Alcohol, Tobacco, and Firearms (BATF), the Federal Alcohol Administration (FAA) Act set broad limits on the rules states might establish.
First and foremost, the FAA Act was designed to insulate retailers from commercial practices that were deemed especially undesirable before Prohibition. At the top of the list were "tied house" practices that often were associated with partial supplier ownership of a retailer. These practices limit brand selections by retailers and, directly or indirectly, coerced them to favor brands from a particular supplier. The insulator of choice was the wholesaler; the three-tier system was born.

The FAA Act tied-house provisions prohibited many commercial practices that were (and are) not only widely accepted but also taken for granted with other consumer products. They proscribed all practice that would give the appearance of inducing retailers to carry one supplier's brands in lieu of those of other suppliers. Expressly prohibited were gifts to retailers having meaningful value and the providing of bar equipment to bars and taverns. The FAA Act also prohibits suppliers from having ownership interest in retailers, although it does permit them to own retailers outright.

Implementation by the States
As mentioned earlier, 21 states (including Washington, D.C.) permitted the sale of beer with less than 3.2 % alcohol in April 1933, eight months before the 21st Amendment became effective. All states further had to decide whether, and on what basis, they would permit the sale of stronger beer, wine, and distilled spirits when the 21st Amendment did become effective on December 5, 1933. States took two paths. The larger group (now referred to as "license" or "open" states) opted to let beer, wine and spirits be distributed and retailed entirely in the private sector consistent with their own laws and the FAA Act. The smaller group (now referred to as "control" or "monopoly" states) opted to become wholesalers and retailers themselves for wine and spirits (some left table wine in the private sector, and two acted only as wholesalers, selling to private retailers). Beer is sold in the private sector in all states. Top

Consumer Benefits of a Three-Tier System
Statement of
Douglas W. Metz
Managing Director
Wine and Spirits Wholesalers of America
before the Special Joint Hearing of the
California Senate and Assembly Governmental organization committees
Sacramento, California
January 23, 1996

My name is Douglas W. Metz. I am Managing Director of the Wine and Spirits Wholesalers of America (WSWA). WSWA is the national trade association whose members are responsible for more than 90% of the wines and spirits distributed in the license states and more than 75% of wines wholesaled under license in control states.
My purpose is to describe the historical reasons for the creation of the three-tier system, its proven benefits to state governments and the public interest, and why it is needed now more than ever to protect these vital interests.
I. Why the three-tier system was established and the role of tied house laws in Liquor Distribution.

According to historians, prohibition was triggered by social evils occasioned by tied houses, namely, control by large distillers and brewers of most retail outlets in the United States. Control took the form of leases, chattel mortgages, credit and other financial interests.

This control by the supplier level forced retailers to adopt programs to promote consumption and increased sales. Commonly called saloons, these tied houses sponsored activities and fostered levels of beverage alcohol consumption that flagrantly offended the moral and social values of many of the communities in which they were located. The Anti-Saloon League, for example, was organized to fight against the consequences of over-promotion of alcohol beverages, i.e. the tied-house evil.
When prohibition was repealed, the people and the legislatures of the various states were imbued with the same determination as the Federal authorities: to prevent, by all means, the evils and abuses that were recognized as having been associated with the distribution and sale of alcoholic beverages in pre-Prohibition days. Congress found that:

"The foregoing practices (the tied house evils) have in this industry constituted the principal abuses whereby interstate and foreign commerce have been restrained and monopolistic control has been accomplished or attempted. The most effective means of preventing monopolies and restraints of trade in this industry is by prohibiting such practices, thereby striking at the causes for restraints of trade and monopolistic conditions and dealing with such conditions in their incipiency. Furthermore, such abuses were so prevalent before prohibition that they were regarded in large measure as responsible for the evils which led to prohibition." (H. Rept. No. 1542, Federal Alcohol Control Bill, pp. 11 and 12)

"Protection of the consumer and the elimination of improper practices in this industry are imperative and additional legislation to bring back these purposes is necessary." (S. Rept. No. 1215, Federal Alcohol Control Bill, p. 1)

The 21st Amendment to the United States Constitution, enacted December 5, 1933, repealed the national prohibition of alcohol beverages. This Amendment, moreover, provided that "The transportation or importation into any State, Territory, or Possession of the United States for delivery or use therein of any intoxicating liquors, in violation of the laws, thereof, is hereby prohibited."

Under this Amendment, the several states were given virtual plenary powers to regulate alcohol beverages. The Federal government, acting through the Treasury Department, was given specific powers by the Congress to regulate industry activities related to standards of identity and fill, labeling, advertising, and trade practices, plus the collection of federal excise taxes on alcohol beverages.

The basic approach of all the states was to establish control and regulate the channels of distribution from the time that the product reached their borders until it reached the hands of the consumer. Two groups of states accomplished this control in fundamentally different ways - - one by way of state monopoly, the other by the regulation of licensed suppliers, distributors and retailers.

Those states that chose not to go into the liquor business on a monopoly basis had, of course, a different problem. To meet this problem, all of them provided for a system of distribution from supplier to wholesaler and to retailer. All of them prohibited both suppliers and wholesalers from having any interest in retail establishments and, in general, enacted provisions similar to those of the Federal Alcohol Administration (FAA) Act prohibiting free goods, gifts, unfair trade practices, commercial bribery, excessive credit, consignment sales and other practices that tend to result in tied houses or exclusive outlets.

Most of the states (twenty-three) went further and, either initially or later, required suppliers to sell only to locally licensed wholesalers and prohibited them from having any interest in a wholesale establishment as well as prohibiting them from having any interest in a retail establishment. By way of analogy to the monopoly system, this three-tier system, with its independent, licensed wholesaler separating the supplier from the retailer, could be considered effectively to isolate the supplier from the retail outlets and thereby buttress the prohibition against tied-house, exclusive outlets and other undesirable practices.

The establishment by the states of a three-tier system, by providing for an independent wholesaler level to remove the supplier one more step from the retailer, strengthened and supported the purpose of the FAA Act. By prohibiting a vertically integrated system at the supplier and wholesaler levels, the states added additional insurance against anti-competitive practices by large, dominant suppliers, against monopolistic control of the market and against the development of the tied house.

The system also required an independent, locally licensed wholesaler to be the first buyer within the state and established a clear-cut channel of distribution. The wholesaler, being within the jurisdiction of the state, would obviously be more amenable to state control and more sensitive and responsive to local social influences than would be a non-resident supplier operating at a national level. This system strengthened the hand of the state in enforcing its regulatory provisions, protecting its excise tax revenues and achieving the social ends of liquor control. It more fully utilized the full legal power of the state over the channels of distribution to meet the requirements of sound liquor control.

It is obviously simpler for a state to enforce the laws against local, licensed wholesalers than against suppliers - - be they distillers, wineries, brewers or importers - - located outside the state. The state can walk into the wholesale house, inspect its books, examine its inventory and question its officers and employees. It has immediate jurisdiction over all the operations and personnel of the wholesaler. It may suspend or terminate all its operations. Of necessity the local wholesaler is much more sensitive to the need to observe all state laws and regulations and to respect local social attitudes than is a supplier located outside the state, doing business in some fifty states and usually represented in an individual state by a sales representative who, himself, may not be a resident of that state.

In summary, to prevent the social and economic evils of the tied house, the three-tier system removes the supplier one level from the retailer to insulate the latter from the former and to protect him against control by a large dominant supplier. The system was designed to make it more difficult for the supplier to engage in anti-competitive practices leading to the tied house and makes is easier for the state to enforce its statutory and regulatory provisions against such practices.

II. How well has the system worked? Proven benefits since repeal:
By almost any measure chosen, the three-tier system has fulfilled its intended purposes and has surpassed any expectations of its architects. The three-tier system of distribution since repeal has:

Given birth to one of the largest most dynamic and competitive industries in the United States.

Made alcohol beverages consistently the best bargain of any commodity or service in the consumer price index for the last two decades - - despite being the most highly taxed and regulated of any consumer item.

Provided consumers with ready access to a selection of brands which in number and variety is unparalleled by any other consumer goods industry.
Assured consumers of product purity and integrity through primary source and brand registration laws.

Ensured collection of billions of tax dollars to federal, state and local governments; thereby creating the world's most cost effective system of revenue collection and alcohol beverage control. In California, combined state and local taxes, including sales taxes on alcoholic beverages, approximates three-quarters of a billion dollars per year.
Established a regulatory system that has encouraged unprecedented levels of compliance and prevented vertical monopolies and tied houses.
Fixed accountability at the local level for the enforcement of underage drinking and drunk driving laws.

Since repeal of prohibition, breaches of the three-tier system of distributing alcohol beverages have rarely occurred. These have been either rationalized or repaired. Various aspects of the system have been, and will continue to be, challenged -- in the various state legislatures and in the courts.

It is quite clear that the three-tier system has weathered the test of time. It has been progressively established by law in twenty-three of the thirty-two license states for wines and spirits -- and, for wine wholesalers, in most of the control states. In fact, with a few exceptions, the three-tier system is in effect, de facto, even in the nine license states that have not required it by law. It has proved to be a practical and effective method of distribution of a product that is subject to abuse, is highly regulated and is highly taxed.

As noted above, this system of three independent distribution levels also serves another important objective of the state with reference to alcoholic beverages -- the collection of taxes. The wholesaler pays the state excise taxes. It facilitates the collection of these taxes to have the flow of merchandise channeled through the hands of a relatively few locally licensed wholesalers, rather than shipped from hundreds of suppliers directly to thousands of retailers. This system has worked so well that many states have eliminated tax stamps and rely simply upon an accounting (or reporting) method of collection from wholesalers.

In summary, the three-tier system of distribution of alcoholic beverages has made possible efficient and effective liquor control; protected the public against tied houses and exclusive outlets and anti-competitive and monopolistic practices; fostered a stable industry; and has provided an orderly and safe method for the collection of billions of dollars of state excise taxes.

III. Why the three-tier system is needed now more than ever.
Modern advances on communications technology have increased temptations to bypass the three-tier system, thereby evading payment of state excise and sales taxes, trade practice regulations and laws against sales to underage youth. Today hundreds of brands of wine, spirits and malt beverages can be ordered from websites in cyberspace. The estimated volume of direct sales of alcohol beverages currently exceeds $1 billion according to informed estimates. I am not referring to legitimate direct sales of small quantities of wine pursuant to reciprocal state statutes. I am concerned with the growing volume of direct sales that evade and undermine state laws designed for revenue protection, product integrity and consumer protection, and prevention of sales to children.

In Kentucky, for example, a 14 year-old son of a licensed retailer ordered and received large quantities of tax-free distilled spirits and malt beverages as well as wine. The resulting concern prompted legislative proposals to strengthen the three-tier system by extending primary source requirements to all alcoholic beverages and strengthening laws that require such products to come to rest in a wholesaler's warehouse before shipment to a retailer.

In summary, in alcoholic beverage control, the current and foreseeable need is to strengthen not weaken three-tier laws including:

Tied house laws that prevent vertical monopoly and control of retailers and prohibit promotional practices that result in immoderate consumption and anti-social behavior.
Primary source and brand regulation laws that assure product integrity and accountability in the chain of distribution.

Revenue protection laws that rely on wholesalers as the point of payment of state excise taxes.

At rest laws that protect state tax revenues by preventing direct shipment of alcohol beverages.

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The Regulatory and Economic Basis for Wine and Spirits Wholesaling
in the U.S.
The following is an excerpt from a study prepared for WSWA by Steve L. Barsby & Associates. To order copies of this study see the publications section of this website.

Wine and spirits are distributed through what is called the "three-tier system" in the United States. State laws formed the three-tier system following the repeal of Prohibition in December 1933 to prevent the recurrence of marketing abuses that characterized supplier-retailer relationships before Prohibition. States established wine and spirits wholesalers as the middle tier separating producers from retailers.
Except for general guidelines in the Federal Alcohol Administration Act, the control of alcohol beverages is a state matter. Regulations and laws vary by state. In some states, called "control states," the state government serves as wholesaler (and often as retailer as well) for wine and spirits. Beer is distributed and sold through the private sector in all states. Although a menagerie of state laws and regulations controlling the alcohol beverage industry exists, all states have mandated the separation of the production tier from retailing.

As an offshoot to the separation of production and retailing, government officials created (probably by happenstance) an efficient distribution system. Wholesalers serve as "order consolidators," reducing the number of transactions required for all suppliers to reach all retailers. As a result, even smaller suppliers have potential access to the 300,000 wine and spirits retailers in the U.S. In addition, wholesalers serve as conduits for local market information to suppliers. Wholesalers also reduce the amount of inventory that suppliers and retailers need to carry. Likewise, consumers benefit from wider distribution of products and from lower prices stemming from the distribution efficiency of wine and spirits wholesalers.

Wine and spirits wholesalers have a meaningful impact on states' economies. Directly and indirectly, they help create more than 177,700 jobs paying $4.3 billion in wages and adding more than $15 billion to the national Gross Domestic Product. They directly pay almost $1.6 billion in state and local product specific taxes and, overall, their activity helps create a total of $3.8 billion in state and local revenues.
Sales of wine and spirits wholesalers have been expanding less rapidly than those of the wholesaling industry for two main reasons. First, total consumption volumes of spirits have been declining for about a decade; wine volumes also have peaked. Second, the product mix has been changing away from the more expensive distilled spirits toward the less expensive wine. Consequently, the inflation-adjusted average price of products carried by wine and spirits wholesalers has been declining rapidly. As a result of these trends, wine and spirits wholesalers are under significant wage and operating cost pressures. Sales costs are especially high; as wine and spirits wholesalers devote significant resources toward adding value to the products they sell.
When wine and spirits wholesaling is tested for strength of competition, the industry was found to exhibit many characteristics of competitive industries. Returns on sales and net worth are at or below the average for overall wholesaling. Gross margins are surprising flat over time given the operating cost pressures they have faced. Several wholesalers compete in virtually every market, and entry by new wholesalers is constant. Wholesalers deal with numerous suppliers and each sells to hundreds of retailers. Market shares of leading suppliers and brands shift rapidly, and new brand introductions abound even from smaller suppliers.

The extent of competition in wine and spirits wholesaling is often called into question because of the predominance of exclusive territories (the dominant form of distribution in 24 of the 33 license states) and its near-twin area of primary responsibility (APR). Exclusive territories and APR's are one form of what is called vertical restraints (where one level, or tier, of an industry imposes limits on the business practices of another level). Legal and economic scholars have debated exclusive territories in the context of competition and consumer welfare. Exclusive territories depend on inter-brand competition (individual brands are sold by only one firm in a given territory but the brand competes directly with different brands sold by different firms) to keep competitive pressures strong.

Suppliers use exclusive territories as a means of inducing wholesalers to invest in marketing and merchandising the brands they represent and in developing markets for new brands. Without exclusive territories, some wholesalers "free ride" on the marketing investments of others, and value-added services provided by wholesalers become merely an addition to costs and subject to being eliminated through price competition. Price competition (or intra-brand competition) in the setting of this industry has long-run implications that may increase concentration among suppliers and wholesales, and raise barriers to entry through the loss of broad distribution abilities and the introduction of new brands. The number of selling locations for wine and spirits could fall, as could the number of brands available to consumers.

Empirical data show that eliminating exclusive territories does not improve the competitive performance of wine and spirits wholesaling nor increase efficiency in the economy. After Minnesota made exclusive territories illegal, the number of wholesalers declined and market concentration among suppliers rose. Wholesaler gross margins, already low compared to wholesaling industry standards, remained virtually unchanged. The trend in retail prices appeared to be unaffected.

An econometric study of beer wholesaling concluded that the sales and marketing activities of beer wholesalers under mandated exclusive territories added more value to beer as measured by demand than the price increases occasioned by those activities. Moreover, excluding excise tax increases, the retail price of beer has lagged behind the CPI. Consequently, the researchers concluded that exclusive territories acted to make consumers better off. Economists would say that consumer welfare was increased. Since beer wholesaling closely resembles wine and spirits wholesaling in terms of market structure, this finding may extend to wine and spirits wholesaling as well. The available evidence examined in the entire text of this study overwhelmingly suggests that the pro competitive aspects of exclusive territories far outweigh the effects of any monopoly power that they grant.

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