Costco Wholesale Corp. thinks Washington state is drunk with power. In a case before the 9th Circuit, the retailer claims the state’s alcohol regulations are overly restrictive and anti-competitive.

The feud began in 2003 when John Sullivan, Costco’s deputy general counsel for litigation, started researching why the company was paying significantly more to sell alcohol in Washington than it was in any other state.

What he discovered was a patchwork of legislation that Costco claims discourages competitive pricing among producers and wholesalers and inflates the costs associated with selling alcohol. For example, according to Washington’s laws, producers and wholesalers must set prices about a month in advance and cannot alter these prices for the month they are in use. Costco claims this discourages competitive pricing.

“Washington has more restrictions and limitations concerning the sale of alcohol than a lot of states,” says Michael Newman, partner and team leader at Holland & Knight. “A lot of these restrictions go to pricing.”

Hindered from strategically pricing alcohol to boost sales, Costco took the state’s Liquor Control Board to federal court in February 2004. In early 2006, the U.S. District Court dealt Costco a win, ruling that the state’s regulations were too burdensome on businesses and did not serve to further an important state interest.

In March 2007, the two parties argued before the 9th Circuit. A decision isn’t expected for another six months.

If the 9th Circuit upholds the lower court’s ruling, Costco’s case may convince other states to redraft their regulations. If the court overturns the lower court’s ruling, it will be a win for state’s rights.

“This case addresses the whole structure of the alcohol beverage industry,” Newman says. “From a legal perspective, it’s pretty critical. My guess is it’s going to go to the U.S. Supreme Court.”

Taking Shots

Washington’s alcohol regulations are far reaching. The laws force producers and wholesalers to mark up alcohol products by 10 percent; require immediate payment from retailers upon receipt; and bar retailers from selling to other retailers. In addition, distributors can’t deliver alcohol to a retailer’s central warehouse. Instead, they have to deliver directly to each individual store, a law the state claims helps regulators keep tabs on alcohol distribution. However, this makes it much more costly for a large company such as Costco to sell alcohol.

Costco is relying on the Sherman Act to force Washington to deregulate. Its argument is that although the 21st Amendment gives states the power to regulate the beverage industry, Washington’s laws unjustly restrict companies’ ability to compete with one another.

“The state has the authority to regulate, but it has to show it is advancing certain core interests,” Newman says. “In a sense, it’s a balancing test.”

These core interests include temperance, ensuring an orderly market and raising state revenue.

In its defense, the state is relying on the 21st Amendment and state-action immunity from antitrust laws, a concept the Supreme Court established in 1943 in Parker v. Brown.

“According to Parker, the antitrust laws cannot prevent a state from imposing any regulations it wants on commerce,” says Garret Rasmussen, partner at Orrick, Herrington

& Sutcliffe.

Rasmussen says that state-action immunity should apply to Washington’s Liquor Control Board because the governor appoints its members. The 9th Circuit will have to weigh these two arguments. It’s likely that the state will try once again to argue that these regulations serve the state’s core interests. To win though, it will need concrete evidence to back up its claim.

“The state is going to have to be able to support and document that their laws are addressing the core interests,” Newman says. “It has to be more than just lip service.”

For example, the state could show its system reduces alcohol abuse or that it stops minors from purchasing alcohol.

Spill Over

Legal experts are split on the likelihood of whether such an argument will influence the court. Rasmussen is fairly confident that state-action immunity will win out in the end.

“This is an odd case because the 21st Amendment doesn’t even need to come into play,” he says. “The state can pass any law it wants to just as long as the Constitution doesn’t stop it from passing that law.”

If the state does lose its case, however, it will have to rewrite its alcohol and beverage laws.

“First, Washington will have to come up with new laws,” Newman says. “After that, you may see other states reviewing their laws in anticipation of legal challenges.”

The Costco case also could have repercussions outside the alcohol and beverage industry. A win for Costco could weaken state-action immunity. If this happens, retailers across the country may try to invalidate state laws they view as hindering competition.