Isn't A Written Agreement With A Distributor Worthless In A Franchise State?

We get this question all the time from clients, and we understand the pessimism. Why bother to draft an agreement when state law would trump any contract that conflicted with franchise laws designed to protect distributors?

If you’re a producer who sells your products in multiple states, you are probably already acquainted with alcohol franchise laws –legislation protective of distributors that seems more appropriate for, say, a McDonald’s franchisee whose entire livelihood rests on its right to use the McDonald’s name than for an alcoholic beverage distributor that sells dozens or even hundreds of brands.

Lawmakers might once have been able to make the dubious claim that alcoholic beverage franchise laws were needed to counter the “intimidation, bullying and abuse” (as one franchise state’s law puts it) of the small and powerless distributor at the hands of the big bad supplier.

Of course that notion is laughable now, when distributor consolidation and the proliferation of small craft producers have flipped that power dynamic on its head. Now it’s the giant distribution companies that wield the power, and suppliers find themselves without leverage or even a route to market in many states. Yet these outdated protectionist laws remain on the books in many states – in fact they have been recently added to the books in certain jurisdictions -- in part due to robust lobbying by the distributor tier. It’s no wonder our clients have resigned themselves to thinking the only way out in these states is through protracted litigation or expensive buyouts.

But that’s not the whole story. In the August issue of Practical Winery & Vineyard, we lay out in detail some of the reasons why a written distribution agreement can provide important protections even in franchise states, and we provide real-life tips for tracking distributor performance and managing your brand in franchise states.  Read more here.

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.

Everything you ever wanted to know about the BPA Warning Statement but were afraid to ask

By John Edwards and John Hinman

This is about BPA and the emergency regulation that was adopted in May by the California Office of Environmental Health Hazard Assessment (“OEHHA”). Many trade associations, Family Winemakers and the Wine Institute most prominently, have sent bulletins to their members advising them of the new regulation.

Our goal is to pass on the best recommendations for protecting your license against public and potential private enforcement. The penalties if the signage is required and is not up could be as much as $2,500 per day, and in the background loom the plaintiff’s lawyers looking for an easy payday (as happened in the arsenic cases that are now on appeal after being dismissed - see blog).

Who is required to post a sign and where does it have to be posted? Every manufacturer, importer or retailer that sells canned and bottled foods and beverages, including alcoholic beverages, that MAY contain BPA must post the warning at the point of sale. This includes out of state wineries and retailers with customers in California. The point of sale definition includes the check-out page of the seller’s website, as well as winery tasting rooms, bars, restaurants, supermarkets and wine and spirits merchants.

Who does NOT have to post the sign? If the products that you sell do NOT contain BPA, no sign is needed.  However to be protected by this exception you must know for certain that no product you sell (or material included in the products you sell) contains BPA. This is difficult to determine because BPA is found in so many different products.

How do you know if the product contains BPA?  You ask your vendors or have the products tested. The Wine Institute recommendation is that sellers and manufacturers ask their vendors for affirmative certification that there is NO BPA in their products (“We hereby certify that there is no Bisphenol A (BPA) in [name of] product”).  That is prudent advice. If you are a manufacturer you would be asking your product vendors (bottles, capsules, etc.).  If you are reseller (such as a retailer) the certification would be asked for from the manufacturer (winery, brewery or distillery) directly or through the wholesaler. Licensees should both require the certification and post the warning statement. The downside of the vendor certification is that if it turns out to be not true the licensee relying on the certification might have a lawsuit against the vendor but is not relieved from liability from the warning statement requirement.

The “Emergency Regulation” and the Warning Statement

On May 16th OEHHA adopted emergency regulations that require manufacturers and retailers of food and beverage containers containing a compound known as Bisphenol A or “BPA” to provide a specific warning about that compound. The Emergency regulation will be in place for an 18-month period while final regulations (probably the same as the emergency regulations) are being drafted and adopted.

OEHHA is the agency responsible for enforcing “Proposition 65,” the California law that requires warnings to the public about compounds that OEHHA determines may cause cancer (carcinogens) or reproductive harm (teratogens). 

Typically, the warning requirements are satisfied by posting the signs we see everywhere in California (even in hospitals) warning that a facility or a consumer product contains compounds “known to the State of California” to cause cancer or reproductive harm.  Naming all of the listed compounds in the facility is not generally required, which is fortunate, because the list of “known” carcinogens and teratogens contains hundreds of compounds.

The purpose of the emergency regulations is to provide warnings to consumers about BPA either on product labels or at the Point of Sale during the anticipated 18-month interim period.  The Regulations require a manufacturer of any canned or bottled beverages that contain BPA either to:

• Place a warning label on the product itself stating: “WARNING: This product contains a chemical known to the State of California to cause birth defects or other reproductive harm;” or
   
• Notify all California retailers of any of its products that may result in an exposure to BPA and provide a sufficient number of compliant Point of Sale warning signs.

The Regulations require retailers to display compliant warnings at each Point of Sale, which includes not only cash registers and checkout lines, but “electronic checkout functions on internet websites.”  The warning signs must be at least 5” X 5” and contain the following

WARNING

Many food and beverage cans have linings containing bisphenol A (BPA), a chemical known to the State of California to cause harm to the female reproductive system. Jar lids and bottle caps may also contain BPA.

You can be exposed to BPA when you consume foods or beverages packaged in these containers.

For more information, go to: www.P65Warnings.ca.gov/BPA.

The BPA warning is, of course, in addition to the warning signs that retailers of alcoholic beverages are already required to display, which state:

WARNING: Drinking Distilled Spirits, Beer, Coolers, Wine and Other Alcoholic Beverages May Increase Cancer Risk, and, During Pregnancy, Can Cause Birth Defects.”

These warning signs should soon be going up in tasting rooms, restaurants and retail stores throughout the state.  But if the product at issue is shipped to the consumer the “Point of Sale” is considered to be the check-out page of the internet website of the seller.       

What is BPA?

BPA is a compound that is used in the manufacture of polycarbonate plastics and epoxy resins.  Polycarbonate plastics are used to make bottles, bottle caps, and flasks.  Epoxy resins are used to coat metal cans containing food and beverages, and they may also be used to coat metal caps used on glass bottles.  Given the widespread use of plastics and epoxy resins in packaging for alcoholic beverages, the new OEHHA regulation affects both manufacturers and retailers of those beverages.

BPA is also used in the manufacture of carbonless copy paper—including the paper used in printed sales receipts.  For this reason the BPA warning requirement is particularly relevant to retailers and in tasting rooms.

Why do the agencies think that BPA is bad?

BPA has been accused of causing fetal and developmental abnormalities, endocrine systems abnormalities, and cancer.  The compound has been studied extensively, with inconclusive results.  The FDA has concluded that the use of BPA at current levels in the nation’s food supply is safe and has approved the use of BPA in food and beverage containers (except for baby formula), notwithstanding that minute amounts of BPA may leach from the container into the contents.  The EU has reached the same conclusion.  On the federal level, the only substantive action has been a ban on the use of BPA in baby formula cans, baby bottles and toddler cups.

In 2009, the California OEHHA unanimously decided that BPA would not be listed as a “known” teratogen.  In 2015, however, the OEHHA reversed that decision and decided that the State now “knows” that BPA causes reproductive harm. 

Prop 65 provides a year for compliance after a compound is listed, because listing imposes an arduous process on affected businesses.  Each business must determine whether any of its products expose individuals to the compound above a regulatory safe harbor, if any has been set.  If so, the business must then provide the generic warning conspicuously on the label, shelf tags, menus or any combination of those.  Identification of the specific compound in the product is not generally required.

OEHHA decided that emergency action was needed in the “unique” situation of BPA because:

• BPA was widely used in food and beverage containers prior to the 2015 listing.  Many of those containers are still in the stream of commerce and have no warnings at all.  Removal of these items from commerce because of enforcement concerns could jeopardize the food supply.
   
• OEHHA has not set a safe harbor for oral exposure to BPA, because there is no consensus on the Maximum Allowable Dose Level for that exposure.  OEHHA expects to have the results of federally-sponsored research on that issue by late 2017 or 2018.
   
• The listing of BPA could cause a plethora of warnings on products and shelves that might alarm or confuse consumers.
   
• The general Prop 65 warning could create “a uniquely high potential for confusion” about BPA.
   
• Interim regulations will inform and protect the public and allow manufacturers to reduce or eliminate BPA exposure.

OEHHA will replace the emergency regulations with likely identical interim regulations, which will are expected to be in effect for about 18 months.

What does OEHHA want to accomplish with these Emergency Regulations?

Keeping in mind that the OEHHA already “knows” that alcohol itself can be a carcinogen (if abused) and a teratogen, you may ask what the OEHHA hopes to accomplish by duplicating the existing warning with one specifically targeting minute amounts of BPA that may have leached from the container.  Frankly, we can only guess at the end-game, and our best guess starts with the phrase “regulatory overkill.”

A Current BPA Issue —Sales Receipts and “Unclean Hands”

As noted above, the OEHHA has not yet been able to set a Maximum Allowable Dose Level for oral consumption of BPA.  It has, however, set a Maximum Allowable Dose Level for dermal exposure to BPA from solid materials at 3 micrograms/day, and that level goes into effect in October of this year (2016).  Once in effect, potential higher exposure will trigger a warning requirement for dermal exposure.

BPA is being used in carbonless copy paper, which is used to make the multiple copies of receipts that emerge from cash registers and charge card readers.  One of the “private enforcers” of Prop 65 has already raised a new issue of concern to on-site sellers of alcohol: dermal exposure to BPA from sales receipts. 

Even before the OEHHA had announced its 3 mg./day Maximum Allowable Dose Level for dermal exposure to BPA, an “environmental advocacy group” had issued a Notice of Violation to a fast food restaurant, alleging that its sales receipts violated Prop 65 because of dermal exposure to BPA. 

No one knows whether that group can prove that a sales receipt results in dermal exposure to more than 3 mg. of BPA per day or whether that Notice portends additional action relating to BPA in copy paper.  If it does, printing the notice, “WARNING: This product contains a chemical known to the State of California to cause birth defects or other reproductive harm” on the receipt will likely be the result.  We can only imagine what the credit card equipment manufacturers will do with such a requirement.

We recommend that:

• Manufacturers selling products in California analyze their packaging or require certifications about BPA content from their suppliers.  Ongoing monitoring is required to protect against suppliers that change their formulas or their own suppliers and thereby introduce BPA where none existed before.  If BPA is being or has been used on products in retailers’ inventories, manufacturers should immediately notify their California retailers and provide the required Point of Sale warning signs.
   
• Retailers should post the required BPA warning, unless they have certifications from every supplier that none of the products in their inventories contain BPA, which is an unlikely occurrence.  Retailers with a large number of items in inventory (including items made before May 2016) and suppliers from outside California are unlikely to have the certainty that their products are free from BPA.  Providing the warning is a prudent protective measure.
   
• Our final recommendation is that all affected sellers spend some quality time with their trade associations to see if some sanity can be brought into the OEHHA system of regulation.  BPA may be a problem, but there should be a better way to address it than to require extensive warning signage that most consumers (if they read it) will ignore.

AB 2082 - A Hunting License for Police and a Lethal Weapon for Politicians that Deprives Licensees of Currently Available Due Process Rights

Every licensee in California will be at risk of closure without an effective right of defense if the legislation proposed in AB 2082 (Campos) takes effect.  AB 2082 authorizes an immediate shutdown of any licensee by the ABC and effectively suspends all current due process protections and rights to a hearing in the interim.  All that it takes to close a business down would be a complaint made by a police department or public official to the ABC that there is “direct evidence” of an “immediate threat” to the public safety. This “threat” could either be the result of the operation of the premises, or a result of potentially dangerous conditions in areas close to the affected business.  Under this bill most licensees in cities like Oakland, San Francisco, LA, Fresno and San Jose could be at immediate risk of being put out of business simply because of the dangerous neighborhoods they are located in.

This bill is a hunting license for the police and a lethal weapon for the politicians. While we believe that most police departments and political officials act in good faith and in accordance with their responsibilities to the public, it is also unfortunately the case that an active minority do not. What this bill does is empower the minority of enforcement officials who do not respect, and are frustrated by, the due process safeguards built into the current system.

Unlike current law, which requires notice of violation and a hearing at which a licensee can defend itself, as well a right to an appeal to the ABC Appeals Board (the governing agency over the ABC, and often the only real source of justice because ABC hearing officers are all retired ABC prosecutors), AB 2082 permits the business to be closed first and defenses raised later. This presupposes (of course) that the licensee can immediately find and engage a lawyer; all the while avoiding going bankrupt from being out of business during what will most certainly be months if not years of litigation. This is regardless of the attempt to build impossible to manage expedited procedures into the legislation. Few licensees can make payroll and rent if they can’t remain open, and getting expedited hearings is next to impossible considering the nature of the current hearing system.

This bill is also an open invitation to public official and law enforcement abuse of licensees whose businesses are not well liked because they attract young people, people of color, or the licensee hosts events that irritate neighbors because they create noise, or have experienced substance abuse problems or cause allegedly hazardous traffic conditions.  This includes nightclubs, restaurants that provide entertainment, dancing and music to the younger crowd as well as supplier licensees (such as wineries, breweries and now distilleries) that host events where traffic, noise and substance abuse are alleged to be a problem for the neighbors.  This can also include grocery and liquor stores in undesirable neighborhoods where the clientele is poor and struggling.

All it takes to close a business under AB 2082 is an alleged “immediate threat to public safety.”  Who interprets what the threat really is and what really caused it are at the heart of the danger that this bill poses. For example, we are involved in a current case where the police allege that public safety was threatened because patrons of a club where a hip-hop entertainer played went to a pizza parlor across the street after the club closed and got into a fight with a police officer. How was that the fault of the club?  Yet that is what the police alleged and attempted to prove. Their theory is that the fight would not have occurred had the Club been closed and no patrons been at the show.

Oher “threats” to public safety that have been alleged in recent cases include fights in a parking lot down the block from a nightclub (but not part of the premises, and that services multiple clubs), assaults causing serious injury by one girl against another at a bachelorette party at a winery, incidents on the sidewalk in front of a grocery store involving teen-agers hanging out and harassing passers-by, being caught with drugs at a rock concert in a licensed venue, and a fatal auto accident in the middle of the night on a road in wine county where the driver had been drinking at the licensed premises earlier in the evening. 

These are all incidents which could, under AB 2082, have resulted in the immediate closure of the subject licensed business. In our experience, some police officers (usually acting as surrogates for public officials) consider any licensed business that offers alcohol, music and/or dancing to be a potential threat to public safety.  The fact that due process currently exists forces law enforcement to adopt measured responses to situations that they believe threaten public safety. AB 2082 strips away measured responses, as well as due process, and leaves in its place the potential for arbitrary and punitive reactions.

Do you trust public officials and police to be free from bias against specific businesses, or specific operators?  While the great majority of police officers and public officials are responsible and act in good faith, our experience is that there are a minority of police and public officials who hold grudges for all kinds of reasons. This legislation gives the minority who are frustrated by the concept of due process and having to prove their case the cover they need to go after those who opposed them in the past with immediate retribution.

This is a bill that must be defeated for the licensed alcohol industry to be able to stand up to overzealous officials, whether law enforcement or politicians.  This bill is not intended to solve a public safety problem but rather to hand law enforcement and politicians a lethal weapon to use against licensees.

“Better Late Than Never”-- Judge in Illinois Dismisses 201 Sales Tax Cases against Retailers

Is This the End of the Road for Steve Diamond's One-Man Crusade to Become Wealthy from Suing the Wine Industry?

By John W. Edwards II and John Hinman 

We have been reviewing the progress of the Illinois “Whistle-Blower” sales tax on shipping fees cases for well over a year while the cases have been pending [Illinois Qui Tam Lawsuits - Private Enforcement of a State Claim: A Bonanza for a Plaintiff's Lawyer & a Rip-Off of Retailers; IL Attorney General’s Office Announces Intention to Dismiss False Claims Act Against Liquor Retailers; IL Finally Offers Certainty & Relief for Victims of Sales Tax Lawsuits, but Prompt Action is Required in Pending Cases; Relief at Last! IL Moves to Fix the Sales Tax Lawsuits Against Out-Of-State Sellers But Proposes to Penalize Wineries & Retailers That Ship Without Permits]. 

We are now pleased to report that the end of the line for the plaintiff appears to be getting closer.  The plaintiff Chicago law firm headed up by Steve Diamond had most of his cases against retailers dismissed last week. Diamond has been enriching himself for ten years through “settlements” with out-of-state producers and retailers (in recent years involving many producers and retailers of alcoholic beverages) by claiming a failure to pay sales taxes on shipping and handling charges paid by Illinois residents who purchase wine from out of state retailers and wineries for shipment to their homes, and then suing the producers and retailers on behalf of the state.   His scheme, at least as it involves retailers and producers without Illinois permits or licenses, may finally be ending.

Illinois Attorney General Lisa Madigan moved to dismiss 201 cases against out-of-state retailers in the trial court of Cook County.  The cases included many that were still “sealed,” meaning that the State had not decided whether to intervene.  The Attorney General had previously moved to dismiss 350 other cases filed by Diamond.  The Attorney General’s motion to dismiss these 201 cases asserted that that they were “unlikely to be viable…because the relator’s [Diamond’s] complaints contained no allegations that the defendants had any presence in Illinois that could establish tax liability.” What this means is that without a state license or a state direct shipping permit (which establishes an agreement to submit to the jurisdiction of the state), or affirmative acts of marketing to Illinois residents, the seller was not doing business in Illinois and therefore could not be sued in Illinois. The motion was granted by the trial court on May 23, 2016.

Diamond opposed the Attorney General’s motion.  The Court ruled, however, that Illinois law provides discretion to the Attorney General to dismiss qui tam (Latin for “whistle blower”) cases brought on behalf of the State. The court said that the decision to dismiss can be overruled only upon a showing of “glaring bad faith” by the Attorney General.  Left unsaid, of course, was what the result should be when it is shown that Diamond has acted with “glaring bad faith.”

Diamond can appeal the trial court’s decision.  However, given the uniquely high standard of proof that Diamond must meet (“glaring bad faith” by the Attorney General), the prospects for a successful appeal appear bleak.  That is very good news for those that have been brought kicking and screaming into the Illinois courts by Diamond – their ordeal may finally be coming to an end!

Looking inside the decision of this court, however, we see the application of a principle that may protect retailers who are legally prohibited from obtaining direct shipping permits from states such as Illinois, as well as the wineries that ship wine purchased by their winery visitors to the buyers home without direct shipping permits (which is the case with many very small wineries throughout the US).  That is, if the seller doesn’t (or is not permitted to) register with the state, and the seller requires the purchaser to be the party legally sending the wine to the address desired by the purchaser, then the receiving state doesn’t have an adequate “nexus” (connection) with the out of state seller to assert liability for taxes. This also presumptively applies to other forms of liability (such as criminal or civil liability against the seller for assisting the state resident buyer’s violation of the relevant direct shipping protocol).  This would certainly validate the common seller (retailers and wineries alike) practice of paying sales taxes on sales in their home state and putting the onus on the buyer to be responsible for taxes in the state of the buyer. This makes the common invoice admonition “title passes to the buyer at the winery (or the store)” a potentially very powerful legal protection.

However, this compounds the uncertainly that is currently playing out in states such as New York over initiatives to hold retailers (such as Empire wine in Albany) responsible for violating the laws of other states by permitting (or assisting) customers buying in New York to ship to themselves in other states. Did the Illinois court really find that Illinois has no jurisdiction over New York (or California, or other states) retailers or producers with customers from Illinois if the goods are actually imported by the buyer as a technical contractual matter? A strong argument can be made that this is exactly what happened on May 23rd (which, if true, may soon be known as direct shipping freedom day in Illinois).

The stakes continue to rise across the US as retailers, international producers and small wineries without direct shipping permits continue to accommodate consumer demand for their products by allowing consumers to ship wine to themselves regardless of where they live. Stay tuned because this Illinois battle is not yet over.  There is too much money in it for Diamond who, rumor has it, is very well connected politically in the Illinois capital.