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Saturday, March 18, 2006 - Page updated at 12:30 AM

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Why Costco's face-off with state Monday may cut wine prices

Seattle Times retail reporter

Days before Christmas, a federal judge delivered this lump of coal to the Washington State Liquor Control Board:

Part of its 73-year-old system to import, distribute and sell wine and beer conflicted with federal antitrust law, while another part violated the U.S. Constitution.

Costco had sued the state two years earlier, charging that its system artificially inflated prices.

But the judge's December decision didn't mark the end.

"They're just one step closer in a board game," David Hankins, a state assistant attorney general, said at the time of the ruling.

Costco will face the state Monday in U.S. District Court in a battle that may fundamentally alter who profits from the sale of wine and beer and how much consumers pay for it.

Al Capone, be gone

The laws that govern how you buy wine and beer in the state were once meant to crush the Al Capones of the world.

The 21st Amendment ended Prohibition in 1933, granting each state broad power to control the sale of alcoholic beverages within its borders.

For Washington, the answer was a three-tier system designed to prevent overconsumption and to keep any one entity from monopolizing the process from beginning to end, as gangsters did during Prohibition. The state sought to accomplish this by injecting a middleman into the process.

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By law, wineries and breweries (the first tier) were required to sell their products to distributors or wholesalers (the second tier). The distributors or wholesalers then sold those products to retailers (the third tier).

Even today, a winery can't operate a bar where it sells its own wine, although it is permitted to have tasting rooms.

Costco's business model rests on its ability to buy products directly from the manufacturer, offer them at a deep discount and sell them in massive quantities.

Mandatory markups

The state created other tight controls. Winemakers and distributors were free to set prices, but both tiers had to mark up the cost of their products by at least 10 percent. Today, each tier marks up its products by roughly 30 percent, industry observers say.

In simple terms, if a consumer pays $20 for a bottle of merlot at the grocery store, it means the winery sold that bottle to a distributor for $9.80 and the distributor sold that bottle to the store for $14.

To further encourage moderation (Prohibition had been enacted to discourage a society of drunken malcontents), state law prohibited distributors from extending credit to retailers or offering volume discounts to superbuyers, among other restrictions.

Because of this, Costco — which sold $330 million in fine wines last fiscal year — paid roughly the same per-bottle price for 1,000 cases of chardonnay as a wine shop that bought three bottles from the same distributor.

Costco Chief Executive Jim Sinegal said those restrictions make wine unnecessarily expensive for the consumer.

"Any time you set into motion some artificial secondary and tertiary steps, the consumer pays a price," Sinegal said. "There should be some efficiencies built into any system."

Advocates say the three-tier system has protected smaller, independent wine shops from folding — in an age when superretailers have forced consolidation in other industries.

"We can order three or four bottles from a distributor, at the same price [for each bottle] as a case," said Emile Ninaud, who owns Champion Wine Cellars in Seattle. "There is no favoritism involved."

Costco challenge

But even proponents say they expected someone to challenge the system in a significant way. It should come as no surprise that Costco, the maverick success story of the retail world, would be the one.

The Issaquah-based company, which charges members an annual fee for access to deeply discounted bulk products, has built a retail empire by defying conventional wisdom.

The company sells a limited stable of items and pays its employees significantly more than its competitors. It has conditioned American consumers to shop like survivalists in exchange for a discount.

Today, members don't wince at buying a 7-carat diamond ring in a place whose trademark and pride are the $1.50 hot dog and drink, with free refill. The average warehouse last fiscal year posted $122 million in sales.

When Costco sued the state in February 2004, the retailer said it didn't seek to dismantle the three-tier system, but rather subject it to the same free-market forces that allow the company to deeply discount everything else from couches to tires.

And in filing the suit, Costco made the first significant challenge to the system. While other retailers have challenged parts of the regulatory systems in other states, Costco is the first to challenge the system as a whole.

If those restraints are gone, "they have effectively eliminated the three tiers," said Hankins, assistant attorney general.

California's system is much like Costco envisions in Washington.

Two decisions

In December, U.S. District Court Judge Marsha Pechman partly agreed with Costco.

In one of two separate rulings, Pechman concluded the state violated the U.S. Constitution's commerce clause by allowing in-state beer and wine producers to sell directly to retailers, while out-of-state producers cannot.

The judge didn't go so far as to dismantle the state's regulatory system, but rather gave the Legislature until April 14 to level the playing field — either by allowing out-of-state producers to bypass the middleman and sell directly to retailers or by stripping that right from in-state producers.

The Legislature acted with speed, passing a bill that allows in-state and out-of-state producers alike to do business without a distributor. No one sees a big change in the way alcohol is bought and sold in the state. Rather, the law was about preserving a right mostly smaller local wineries and breweries use.

Back to court

The judge's second ruling could have a far more sweeping effect.

Pechman concluded the state's system is "irreconcilably in conflict with federal antitrust law." That said, Costco and the state will meet in court to argue whether the state is shielded by the U.S. Constitution, despite those violations.

The state must show the court that its three-tier system meets several core concerns to remain protected by the 21st Amendment — that it promotes moderate consumption, efficient revenue collection and an orderly market.

"We believe we will be able to show the court that Washington's system meets that core-concern test," Hankins said.

It's unclear what will happen if Costco prevails in court. It mostly depends on how many parts of the system, if any, the judge determines aren't shielded by the 21st Amendment.

For instance, if Costco is able to receive volume discounts — a right the state of California already extends to large retailers — some wineries worry that their wines will be sold at too steep a discount. Lower prices may condition shoppers to buy only at that price, and eventually dilute the winery's brand.

More work for state

Meanwhile, the state Liquor Control Board could be forced to revamp its system. Now, distributors take care of monitoring the sale and taxation of products. That job would fall on the state.

"It's going to be a lot more work for us," board spokesman Bob Burdick said.

At the Washington Wine Warehouse in Olympia, co-owner Pam Zyck said she worries less about competition from Costco than she does from the state.

The Liquor Control Board isn't required to buy wine through the three-tier system and can sell wines at lower prices at its 161 state-run stores and at 151 mostly rural retailers that have contracts with the state.

"I've lost sales because the state Liquor Control Board can buy cheaper than I can buy wholesale," Zyck said.

The state conducted a study last year to determine if its wine prices were significantly different. It then raised some prices. Burdick said state stores make 10 percent of the wine sales in Washington state.

"We don't represent enough of the market to move the market in one way or another," he said.

Who wins?

In the end, Costco may not even expand its wine selection by much. Its business model, after all, rests on selling a limited number of products to consumers, in massive quantities.

Sinegal said the challenge was a matter of principle.

"Everybody thinks we're [kidding] them; that's not the case," he said, regarding the motivation behind the lawsuit.

"We feel an obligation. Our customers expect it."

Monica Soto Ouchi: 206-515-5632 or msoto@seattletimes.com

Copyright © 2006 The Seattle Times Company

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