A Closer Look at BCG’s Franchise Law Study
The Boston Consulting Group (BCG) recently released a study finding that the U.S. beer market is “open, freely competitive and driven by consumer choice.” BCG concludes its study by imploring lawmakers to be “skeptical of complaints (legal or otherwise) that the marketplace favors only large players.” In other words, BCG appears to argue that regulators should maintain the status quo and uphold state franchise laws.
For the reasons outlined below, regulators should be wary of any overreaching claims of the BCG study and closely examine the anti-competitive effects of franchise laws.
CELEBRATES COMPETITION AT SUPPLIER TIER; IGNORES LACK OF COMPETITON IN WHOLESALE TIER
BCG cites the tremendous growth in the number of craft breweries in the U.S. over the past twenty-odd years as proof that the U.S. beer market is open and competitive. BCG attributes this success to what it touts as the “open U.S. beer-distribution system.”
But the presence of a high-level of competition in the supplier tier does not necessarily mean there is sufficient competition in the distributor tier. By all accounts, the number of wholesalers continues to shrink. Moreover, many states have imposed franchise laws that insulate wholesalers from competition by making it exceedingly difficult for alcohol beverage producers to sever ties with underperforming wholesalers.
Any assessment of competition in the alcohol beverage industry must assess competition at each tier: producers, wholesaler, and retailer. By focusing solely on competition amongst producers and avoiding an assessment of the wholesale tier, BCG’s study falls short.
RELIES ON HYPOTHETICAL “CLOSED” SYSTEM; FAILS TO ANALYZE IMPACT OF DIFFERENT FRANCHISE LAW REGIMES
BCG’s study centers on a comparison of the average delivery and sales costs under two different types of distribution systems that BCG identifies as the “open” and “closed” systems. Under the “open” system, wholesalers are independent from suppliers and are free to carry both large and small producers in their portfolio. In comparison, in a “closed” network, only products produced or sanctioned by a major brewer could be part of a wholesaler’s network.
BCG calculates that the average delivery and sales cost for craft beer distribution to large grocery stores in a closed network is three-times more than in an open network. Accordingly, craft brewers benefit from franchise laws, since such laws maintain wholesaler “independence” and prevent large suppliers from extracting advantages from distributors at the expense of craft brewers.
The problem with the open vs. closed dichotomy is that it gives the impression that there is no other alternative. But not all states impose franchise laws, and some states have much less restrictive forms of franchise laws. Given the great degree of variation among state alcohol beverage regimes, BCG could have conducted a comparison of distribution costs in states that have varying sorts of franchise law regulations. Instead, however, BCG’s study rests on a hypothetical and fictitious “closed” distribution.
ENTIRELY SILENT ON IMPACT OF FRANCHISE LAWS ON CONSUMERS.
BCG’s study also falls short in that it fails to take into consideration the impact of franchise laws on consumer choice and retail prices. Although BCG states that “consumer preferences have been the main engine” driving growth of craft beers, it makes no effort to determine if strict franchise law states offer more choice and cheaper prices for consumers.
The debate over franchise laws in the alcohol beverage industry continues to grab headlines in a number of states. In March, the New York Times published an anti-franchise law op-ed authored by the co-founder and President of Brooklyn Brewery and a member of the board of directors of the Brewers Association. This summer, the South Dakota’s legislature is conducting a review of alcohol distribution systems.
BCG’s study helps highlight some of the arguments wholesalers will rely on in claiming that states should not repeal or alter alcohol beverage franchise laws. But the study has many shortcomings, and regulators should be skeptical of any arguments that suggest that this report conclusively finds that franchise laws benefit small producers.
FTC Criticizes Franchise Laws…in Automobile Industry
“Regulators should differentiate between regulations that truly protect consumers and those that protect the regulated.”
So concluded the Federal Trade Commission in a recent blog post criticizing franchise laws in the automobile industry. Tesla Motors, a leading manufacturer of high-end electric cars, implemented a sales model to allow it to sell cars direct to consumers. This has upset auto dealerships who have complained that Tesla’s efforts violated state franchise laws that require automobile manufacturers to sell their cars through local, independent auto dealerships.
Last week, the FTC weighed in, and criticized such laws as “bad policy” that protects middlemen and harms consumers. “We hope lawmakers will recognize efforts by auto dealers and others to bar new sources of competition for what they are — expressions of a lack of confidence in the competitive process that can only make consumers worse off.”
Numerous states have protectionist franchise laws that govern supplier-distributor relationships in the alcohol beverage industry. Such franchise laws vary in their scope from state to state, but generally restrict producers from terminating distributors absent “good cause.” In practice, “good cause” has been narrowly defined by state regulatory agencies and courts, making it difficult for producers to terminate even for well-founded business reasons. Some states impose severe penalties for terminating or restructuring distribution arrangements absent “good cause,” including significant fines and potential suspension or revocation of the wineries’ state permits.
One has to wonder if the FTC’s recent statement on automobile dealership franchise laws could have any repercussions in the alcohol beverage industry.
Federal Court Dismisses Diageo’s Complaint in Franchise Law Case
Earlier this week, Missouri distributor Major Brands, Inc. won the most recent round in its year-long franchise law litigation with Diageo Americas, Inc. The federal district court in Connecticut has dismissed Diageo’s complaint, and the parties dispute appears to be gearing up for a trial in Missouri state court this summer.
Last March, Diageo brought suit in federal district court in Connecticut seeking declaratory relief to allow Diageo to terminate its relationship with Major Brands. In its complaint, Diageo argued that the parties’ contract included a clause that stated that their agreement would be construed under Connecticut law. Enforcement of such a clause would avoid the application of Missouri franchise law. Even though Connecticut also has a franchise law, Diageo argued that it only applied to franchise agreements that would require the distributor to maintain a place of business in that state. Since Major Brands was not required to establish a business in Connecticut, then the Diageo-Major Brands agreement falls outside the scope of Connecticut’s franchise laws, according to Diageo’s complaint.
Major Brands brought its own suit in Missouri state court against Diageo and its new Missouri distributor, Glazer’s, and filed a motion to dismiss in Diageo’s federal court case. In that motion, Major Brands argued that the forum selection clause did not apply and also argued that the federal court should abstain given the parallel state court litigation and Missouri’s strong interest in regulating and enforcing its own alcohol beverage laws:
“The heart of this suit is the applicability of Missouri’s Franchise Act to the relationship between Plaintiff, a supplier of liquor in Missouri, and Defendant, a licensed liquor distributor and wholesaler doing business in Missouri. The Twenty-first Amendment recognizes each State’s sovereign interest in regulating and enforcing its own liquor distribution laws….”
On March 19, 2014, the federal court granted Major Brands’ motion, finding that the forum selection clause that Diageo relied on did not apply to the products at issue in the immediate case. The court did not address Major Brands’ abstention argument.
But this does not bring an end to the Diageo-Major Brands battle. Major Brands’ state court suit in Missouri continues, and the parties have engaged in extensive discovery in that forum. A trial date is set for July 21, 2014.
Update on The Battle of Missouri and Franchise Distribution Law
In its June 20, 2013 ruling on Major Brands’ request for a preliminary injunction, the Missouri Circuit Court, to the chagrin of the large producers, affirmedMissouri’s franchise law. The Court further held that there was no good cause for Diageo’s termination of its distribution agreement with Major Brands. However, in a partial victory for Diageo, the Court declined to issue a preliminary injunction forcing Diageo to continue working with Major Brands – Major Brands would be entitled to money damages only.
The battle in Missouri is far from over. Bacardi is also seeking to terminate its relationship with Major Brands, and litigation is pending in both Federal and State Courts. And certainly, the lobbying efforts of both distributors and producers will continue in earnest.
For more information or assistance on distribution litigation contact us.
Franchise Laws and Diageo’s Recent Distributor Termination Action in Missouri
We usually see this alleged “breach of franchise agreement” used as the basis for a counter-claim by the purchaser of our client’s wine. Typically, XYZ Winery sells its wine to a retail establishment in a franchise state, which then doesn’t pay for the wine. When our client sues the purchaser in California state court, the purchaser counter sues for breach of the alleged franchise agreement, and will sometimes remove the case to federal court. The purchaser will then use the cost of litigation of its counter-claim to negotiate a discount on the amount owed, or a complete “walk-away” settlement.
In a recent Missouri case, however, Diageo sued its distributor in the state to terminate its distribution agreement. Diageo argues thatMissouri state law should not apply to the two distribution contracts in question. Diageo relies on language in its distribution contract with Major Brands that states that the contract’s terms are to be governed by Connecticut law for certain products, and New York law for certain other products. In the alternative, Diageo argues that it has good cause to terminate the agreement should Missouri law apply, claiming that Major Brands failed to devote sufficient resources to the promotion of Diageo’s products, among other things.
We will be watching this case and will report on its outcome.