Crowd Funding for Alcohol Producers and Retailers – Down the Rabbit Hole with the Tied House laws

Crowdfunding is the most intriguing recent method of raising capital for the development of small new business ventures; typically in small amounts of money from a large number of people.  Couple crowdfunding with the phenomenal increase in small craft producer start-ups in the wine, beer and distilled spirits industries over the course of the last five years and the result is a looming regulatory qualification and tied house nightmare for alcohol agencies operating under decades old rules designed for a past age. 

Because cross-tier relationships are generally prohibited by federal and state laws going back to the repeal of Prohibition, persons investing equity funds through crowd funding sites such as Kickstarter are not permitted to have conflicting inter-tier interests.  The simplest example of a conflicting equity interest would be a person with an ownership interest in a wine, liquor or beer producer investing in a restaurant crowdfund or a person with an ownership interest in a restaurant investing in a small craft producer crowdfund. 

This is not an academic issue. In Texas right now there are several currently pending law suits (Cadena, McLane’s – see below) challenging what has been called the Texas “one-share” rule where investors in industry members on one tier (such as retailers) have investors (often public investment funds) with interests in other tiers (such as international producers).  While the Texas lawsuits (involving very large entities with complex ownership structures) hold the potential of changing the rules dramatically in states like Texas, the small investor Kickstarter type space is where cross-tier tied house challenge across the country is going to face its most serious test.

This conundrum was explored at the recent (end of June) National Conference of State Liquor Law Administrators conference in Chicago. The result was more questions than answers.

What is Crowdfunding?

There are two types of crowdfunding.  One type seeks to raise equity funds in small amounts from a large number of investors.  This is called “equity crowdfunding.” The second type is where items, experiences, products and services are offered in return for funds processed through the crowdfunding website.  This is called “Reward” crowdfunding. The two are different in many ways but also similar with respect to the tied house laws.  Equity funding implicates the basic tied house laws.  Reward funding (especially when products are included) is a form of selling transaction that implicates normal regulatory issues related to product sales, invoices, event restrictions at production and other locations as well as middle tier fulfillment requirements.  Depending on the form of the reward transaction, and the value involved, the “thing of value” (anti-corruption) portion of the tied house laws may also be implicated.

The New Federal Crowdfunding Regulations

Congress enacted “The Jumpstart Our Business Startups Act” (the “JOBS Act”) in April 2012. It included the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” (the “CROWDFUND Act”) as Title III. This set forth a basic structure for legal equity crowdfunding under the Securities laws.

On May 16, 2016, the SEC implemented regulations setting forth the basic investment rules.

The new regulations limit investment amounts and restrict transfers, while allowing crowdfunding for only certain types of companies; and require that investment be conducted through a crowdfunding portal (like Kickstarter, although there are many others) or a licensed broker.

The restrictions are that a company cannot raise more than one million dollars in a twelve-month period and annual financial disclosures are tiered based on the amount raised.

For example: if $100,000 or less is raised, financials are certified by the principal executive officer of the company. If $100,000 to $500,000 is raised, or up to $1,000,000 if it’s the first time crowdfunding, financials are reviewed by an independent public accountant. For repeat funding in the $500,000 to $1,000,000 range the financials must be audited by an independent public accountant.

The purpose of these regulations is to prevent an investment bubble and to protect individual investors.

There are also limits on the amount an individual can invest:

For example: If either annual income or net worth of the investor is less than $100,000, then during any 12-month period, an individual can invest the greater of $2,000 or 5% of the lesser of annual income or net worth. However, if the income and net worth of the investor are over $100,000, then during the 12-month period, the person can invest up to 10% of annual income or net worth, whichever is lesser, but not more than $100,000 total.

The protections include a provision that the investor can change their mind and undo funding up to 48 hours before offer closes and cannot sell the equity investment for at least a year (this is to avoid speculation).

The Tied House Law Requirements

While the JOBS Act does an admirable job of creating a new form of investment market it has nothing to say about investment in regulated industries (such as alcohol, and soon Cannabis). Rather those requirements are left to the state, and they are different in every state.

Equity Issues

The consequence of any equity purchase, however structured or consummated, is to implicate the tied house laws and basic ABC and federal qualification protocols.

First, because equity buyers into licensees are required to undergo state required qualification (and federal qualification if a producer or wholesaler level entity is involved), that fact should be disclosed in the offering documentation and considered by the equity buyer before the investment is made. This is a major trap unless the offeror carefully vets the investors and fully discloses the regulatory qualification requirements.  This is because a failure to vet (and to qualify where qualification is necessary) could not only mean a loss of the investment but could also lead to an enforcement action by the relevant regulatory authorities. In almost every state there is an affidavit submitted as part of the licensing process (and attested to as true and accurate under penalty of perjury as part of the annual license renewal process). The affidavit represents that no owner of the company has an interest in another license on another tier except as disclosed, and failure to disclose is a crime.

Second, unless the state has a relevant minority shareholder or public company ownership exception (i.e., that share ownership is under some small number, like 5%, or the shares are publicly traded - most states do NOT have these exceptions), the licensee should be counselled to submit requalification documentation at the completion of the offering program with appropriate certifications of compliance with the tied house laws or other laws or regulations.

Third, other laws in many states may also limit or prohibit ownership interest in a particular license type or licensed business; such as the prohibitions on the number of premise licenses in which any one person may hold an interest. Each state has its own regulations and limitations.  In California, for example, a winegrower may have an interest in no more than two on-premises licenses (subject to conditions) and in many other states there is a limitation on how many off-premises licenses may be held (such as NY, where the limit is one, NJ two, etc.).  This is why all investment offerings should be cleared with legal advisors before being finalized.

Reward issues

Reward crowdfunding, not involving equity, refers to transactions where consideration is exchanged for things and experiences (such as holding events at the producer location, the right to post or be featured on artwork, the right to receive special products in the future, the right to assist in production – the imagination knows no bounds for the marketer).

Rewards should always be treated as a sale of merchandise, goods or services (including tax, invoicing and accounting consequences). There are many other potential issues with crowd-sourced rewards. For example, rewards offered by suppliers (small craft producers) and purchased by retailers (or vice versa) implicate the tied house law “thing of value” regulations as well (if product is involved) as the basic three-tier system requirements (including brand registration, invoicing, non-discrimination rules and price posting) in the state at issue for the flow of product into the marketplace.  

Every Reward should be analyzed in the context of existing regulations in the state. The best way to start the analysis is to ask if you can sell the goods or services for the price expected in the normal course of business; if you can, then it is likely that you can also crowd fund the reward.

Texas – A Laboratory for Inter-tier ownership Issues

There are two pending Texas cases involving inter-tier licensing issues now in the courts, one involving a retailer and one involving a wholesaler, and both raising the thorny issue of how much (if any) remote inter-tier cross ownership is permitted. 

In Cadena, an application for licensure of a convenience store chain (OXXO) was denied because the Mexican owner of the chain (FEMSA) has a 20% interest in Heineken in Europe.  Cadena lost its fight to be licensed at the lower court level and is now appealing to the Texas Supreme Court. The claim there is that the Texas one-share rule (which the TABC, by the way, denies is a rule) is unconstitutional, arbitrary, vague and, generally speaking, absurd.  Here is a link to the lower court decision

In McLane’s, a national food distributor (McLane’s is a major public company substantially owned by Berkshire Hathaway with somewhere around $48 billion in annual sales from 39 distribution centers covering all 50 states) is seeking a wholesale distributor license in Texas following its licensure as a distributor in several other states (including Tennessee). The TABC denied licensure on the grounds that Berkshire Hathaway (a public company) also has ownership interests in public investment funds that own shares in major retailers. McLane’s is now suing the TABC on various constitutional grounds that run the gamut of claims (equal protection, arbitrary and capricious, due process, Commerce Clause, etc.) but boil down to the observation that if McLane’s is in violation of the law so is every major pension fund in the US, including the one for the TABC employees. The "absurd" argument is also made in this case. Here is a link to the lawsuit filing announcement

While these cases are Texas specific the results could very well frame the next generation of tied house analysis in all the rest of the states with respect to inter-tier equity analysis.

Conclusion

Crowdfunding under the new SEC rules is an exciting development in the on-going effort to capitalize small businesses, such as restaurants and craft producers. With proper attention to basic detail (qualification and vetting of proposed participants and through explanation of the limitations in the offering material) this can be the answer to the capital dreams of many entrepreneurs.  However, given the danger posed by the country’s antiquated tied house laws, any budding businessperson looking to the crowdfunding capital markets for a growth solution is strongly encouraged to carefully clear their material through their accountant and their attorney.  Nothing is worse than raising money and then having to give it back because due diligence was not done. Maybe one thing is worse: committing a crime (violating the tied house laws is a statutory misdemeanor in most states) without knowing about it, exposing your investing friends in the process and then having to give the money back.

Remember, as the old Sargent on Hill Street Blues said over 35 years ago: “Be careful, it’s dangerous out there.”  We would add to that admonition: Do your due diligence when you raise money.

  1. CBD: An Exciting New Fall Schedule… or Not?
  2. MISSISSIPPI RISING - A VICTORY FOR LEGAL RETAILER TO CONSUMER SALES, AND PASSAGE OF TITLE UNDER THE UNIFORM COMMERCIAL CODE
  3. California ABC's Cannabis Advisory - Not Just for Stoners
  4. NEW CALIFORNIA WARNINGS FOR ALCOHOLIC BEVERAGES AND CANNABIS PRODUCTS TAKE EFFECT AUGUST 30, 2018, NOW INCLUDING ADDENDUM REGARDING 2014 CONSENT AGREEMENT PARTIES AND PARTICIPANTS
  5. National Conference of State Liquor Administrators – The Alcohol Industry gathers in Hawaii to figure out how to enforce the US “Highly Archaic Regulatory Scheme.”
  6. Founder John Hinman Honored with the Raphael House Community Impact Award
  7. ROUTE TO MARKET AND MARKETING RESTRICTIONS - NAVIGATING REGULATORY SYSTEM CONSTRAINTS
  8. Alcohol and Cannabis Ventures: Top 5 Legal Considerations
  9. ATF and TTB: Is Another Divorce on the Horizon? What’s Going on with the Agency?
  10. STRIKE 3 - YOU REALLY ARE OUT! THE ABC'S STRICT APPLICATION OF PENALTIES FOR SALES TO MINORS
  11. TTB Temporarily Fixes Problem with Fulfillment Warehouse Tax Credits - an “Alternate Procedure” for Paying Taxes & Reporting
  12. CUSTOMERS WHO HAVE HAD ONE TOO MANY - THE FREE TRANSPORTATION DILEMMA
  13. The Renaissance of Federal Unfair Trade Practices - Current Issues and Strategies
  14. ‘Twas the week before New Year’s and the ABC is out in Force – Alerts for the Last Week of 2017, including the Limits on Free Rides
  15. Big Bottles, Caviar and a CA Wine Strong Silent Auction for the Holidays!
  16. The FDA and the Wine and Spirits Industry – Surprise inspections anyone?
  17. NORTHERN CALIFORNIA WILDFIRES: UPDATED REGULATORY AGENCY DISASTER RELIEF RESOURCES AT A GLANCE
  18. NORTHERN CALIFORNIA WILDFIRES: REGULATORY AGENCY DISASTER RELIEF RESOURCES AT A GLANCE
  19. Soon to come to your Local Supermarket– Instant Redeemable Coupons of the digital age!
  20. The License Piggyback Dilemma – If it Sounds Too Good to be True, it Probably is
  21. A timely message from our Florida colleagues on the tied house laws, the three-tier system and the need for reform
  22. ABC Declaratory Rulings – A Modest Proposal Whose Time has Come
  23. More on FDA Inspections - Breweries, Distilleries and Questions
  24. WHY THE FDA IS INSPECTING WINERIES
  25. Senate Bill 378—The Proposed Demise of Due Process for Alcohol Licensees
  26. ABC Enforcement - Trends and Predictions
  27. The Corruption Chronicles – Volume One: A New Hope
  28. New Alcohol Delivery Oversight on the Horizon
  29. Michigan: Canary in the DtC Coal Mine?
  30. California ABC and Federal Credit Laws – Active Enforcement and Lots of Questions!
  31. Big Bottles For The Holidays - The Highest Calling Of The Winemaker's Art
  32. FINAL COMMENTS TO TTB NOTICE 160 DUE ON WEDNESDAY DECEMBER 7TH – WE ARE ASKING THE TTB TO EXTEND THE COMMENT PERIOD AGAIN TO ALLOW FOR INDUSTRY NEGOTIATION AND ALIGNMENT OF INTERESTS
  33. SONOMA COUNTY WINERY USE PERMITS, EVENT RESTICTIONS AND DTC
  34. New TTB Labeling Requirement Regulations: Out-of-State Bottling Is Not Created Equal and Consumers Right to Know Where the Grapes in their Wine Come from is Compromised
  35. Isn't A Written Agreement With A Distributor Worthless In A Franchise State?
  36. Crowd Funding for Alcohol Producers and Retailers – Down the Rabbit Hole with the Tied House laws
  37. Everything you ever wanted to know about the BPA Warning Statement but were afraid to ask
  38. AB 2082 - A Hunting License for Police and a Lethal Weapon for Politicians that Deprives Licensees of Currently Available Due Process Rights
  39. “Better Late Than Never”-- Judge in Illinois Dismisses 201 Sales Tax Cases against Retailers
  40. The Day the Music Almost Died: The Story of the BottleRock ABC Accusations, the ABC Appeals Board and a Victory for a Common Sense Interpretation of the Tied House Laws
  41. The Arsenic in Wine Class Action Dismissal – what it means
  42. Counterfeit or Artisanal Mexican Spirits? Pick your Poison, or your lime wedge
  43. Warning - CA ABC enforcement teams are on the prowl this weekend!
  44. RELIEF AT LAST! ILLINOIS MOVES TO FIX THE SALES TAX LAWSUITS AGAINST OUT-OF-STATE SELLERS BUT PROPOSES TO PENALIZE WINERIES AND RETAILERS THAT SHIP WITHOUT PERMITS
  45. The TTB Speaks on Category Management or, be Careful What you Ask for Because you might Get it!
  46. Hinman & Carmichael LLP Announces the Addition of Jeremy Siegel to its team of top beverage law lawyers
  47. 2016 LEGISLATIVE UPDATES: Part IV
  48. 2016 LEGISLATIVE UPDATES: Part III
  49. 2016 LEGISLATIVE UPDATES: Part II
  50. 2016 LEGISLATIVE UPDATES: Part I
  51. Hinman & Carmichael LLP is Hiring!
  52. John Hinman Presents NBI Webinar on Basics of Alcohol Beverage Law
  53. ABC DISMISSES SAVE MART GRAPE ESCAPE ACCUSATION BUT REFUSES TO ADOPT JUDGE’S DECISION FINDING NO STRICT LIABILITY FOR ABC VIOLATIONS
  54. Speakeasies are still with us, and proliferating!
  55. The War for the Soul of Sonoma County – the Winery Working Group Battle
  56. Santa Claus isn’t the only one coming to town this Christmas!
  57. Arizona's Direct to Consumer Shipping Rules - An Exercise in Complexity
  58. AB 780 - Social Media and the ABC: The California Legislative “Fix” that Fails
  59. Illinois Finally Offers Certainty and Relief for Victims of Sales Tax Lawsuits, but Prompt Action is Required in Pending Cases
  60. A Modest Proposal – Adopt the federal rule on Tied-House liability in California
  61. The Grapes Escaped - Why the First Amendment Matters
  62. Appellate Court Ruling Strikes Blow Against State’s Arbitrary Beer Label Ban
  63. Illinois Attorney General's Office Announces Intention to Dismiss False Claims Act Against Liquor Retailers
  64. Commercial Speech And Alcoholic Beverages - Part III
  65. Commercial Speech And Alcoholic Beverages - Part II
  66. Craft Beverages: Social Media Marketing the Effective and Compliant Way
  67. Commercial Speech And Alcoholic Beverages - Part I
  68. A LAYPERSON LOOKS AT ARSENIC IN WINE
  69. The Biggest Retailer in the World vs. the TABC
  70. Rebecca Stamey-White presents Emerging Issues in Wine Law
  71. Top Beverage Alcohol Law Firm Adds and Elevates Partners
  72. Illinois Qui Tam Lawsuits—Private Enforcement Of a State Claim: A Bonanza For A Plaintiff’s Lawyer And A Rip-Off Of Retailers
  73. BOOZE RULES OF SOCIAL MEDIA: The Retailer Right to Pay Exception
  74. LIONS AND TIGERS AND TWEETS, OH MY!
  75. AB 2004: Brewer's Incremental Parity with Wine Makers
  76. Expanding, Proud Of It, and Wanting to Tell the World
  77. DC Weighs in Strongly on Third Party Marketer Delivery Services
  78. “Visual Links” between Beer, Wine and Spirits Labels and Retailers Ruled Unlawful in California — the tied house laws run amok
  79. Hard Cider Legislative Update
  80. New Marketing Model for New York – Lot 18 and the NYSLA
  81. Sweeping Changes in Proposed NYSLA Bill Include Expansion for Craft
  82. Minimum Resale Price Policies - How to Control Price-Cutters
  83. AB 2130 – Gloves Off?
  84. “Gluten-Free” Labels for Wine, Beer and Distilled Spirits. We’re Still Waiting.
  85. AB 1252: Sanitation Overkill?
  86. Growlers: Not Just for Beer Anymore
  87. California Legislative Roundup 2014
  88. Build It and They Will Come: Craft Products Get New Privileges in CA and TX
  89. AB 1128: Veto of the “Serve a Minor” Felony Penalty Bill, or How to Lose a Winery in One Sale
  90. California Grocers Association v. ABC, Part 2: California Appeals Court Vacates ABC’s Adoption of a Trade Advisory That Correctly Guided Licensee Conduct
  91. California Grocers Association v. ABC, Part 1: California Appeals Court Prohibits Alcohol Sales at Self-Check Out Stands
  92. AB 1128: The “Serve a Minor” Felony Penalty Bill, or How to Lose a Winery in One Sale
  93. The New York SLA and Online Wine Sales: A Work in Progress
  94. California SB 635: What the 4am Bill Really Means for California Communities
  95. Electronic Invoices in California: Welcome to the 19th Century
  96. The History of Amazon and Wine: What Has Changed?
  97. Third Party Marketing Checklist
  98. BOOZE RULES – PROMOTIONAL APPEARANCES AND AUTOGRAPHS
  99. Washington State: Down the Rabbit Hole of the Tied-House Laws