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Flying Leap Opposition to HB2876

Mark Beres - Flying Leap President

Dear Honorable Legislators,

My name is Mark Beres, and I am the President & CEO of Flying Leap Vineyards, Inc., a licensed Arizona farm winery and distillery. I am writing you today to lodge our opposition to HB2876, a bill designed to change the farm winery business model in Arizona. We oppose this bill because it will harm Arizona’s farm wineries by altering the state’s farm winery business model in ways that will invite constitutional challenges from across the country by large out-of-state alcohol producers that neither the farm winery industry nor the state of Arizona can win, and it will make it more difficult for farm wineries to compete. The net result will be reduced incentives for Arizonans to plant grape vineyards while creating tax and distribution windfalls for out-of-state wine producers and distributors. Please allow me to provide some background and lay out our opposition in some detail.

Our farm winery is headquartered in Vail, Arizona with our main production facility and cellars in Elgin, Arizona about 50 miles south of metro Tucson in the heart of Arizona wine country. We are one of Arizona’s largest winegrape farming operations, with matured vineyard acreage in both the Willcox and Elgin growing regions of Cochise & Santa Cruz counties, respectively. We are highly vertically-integrated, with a widespread network of wine tasting venues across the state of Arizona, and we are the only Arizona winery that has developed a large-scale self-distribution capacity (that is we do our own wholesaling, primarily in the Tucson area). In 2019, wholesaling of our wines accounted for approximately 20% of our gross revenues. We started our business from scratch, and today employ 24 people. Because we have such a broad, vertically-organized farm winery business in our state, we can offer a highly-qualified opinion regarding HB2876, which is now being circulated in the legislature. On behalf of our company, we are writing to oppose this bill.

The production, distribution and sale of alcohol in Arizona (and other states) is a complex topic, and it’s complexity makes it difficult to explain quickly, or simply. In short, the system was devised by the legislature following the repeal of prohibition to provide for a “clean system” free of the corruption that characterized the liquor industry in the 19th and early 20th centuries. The legislature created the three-tier system to create distinct “swim lanes” in the alcohol business. The business models of producers, distributors and retailers were statutorily-separated by law, meaning separately-licensed such that, e.g. producers couldn’t distribute or sell their products, wholesalers couldn’t produce alcohol or retail it (e.g., operate bars & taprooms), and retailers couldn’t produce or distribute alcohol. Our statutes still manifest this 3-tier system today.

The 3-tier system was created by our legislature to better-regulate and control Arizona’s alcohol industry (providing a cleaner, more corruption-free marketplace) and to ensure the proper levying and collection of taxes on alcohol producers. The current statutory framework of the  farm winery business model in our state is a fairly recent creation of the legislature, dating substantively back to 2007. Our legislature created the farm winery business model to create a native wine industry in Arizona by crafting a statutory licensing framework to incubate small farm wineries by incentivizing capital investment in Arizona agriculture to plant grape vineyards and develop wine production facilities to vinify these harvests into wine.

At the inception of today’s farm winery business model, Arizona had very little commercially-viable vineyard acreage in production (of note – in 2007, Arizona’s total wine production was just 65,000 gallons (source: US TTB)). The capital investment required to develop a commercially-viable wine grape vineyard is enormous, as is the cost of operating the vineyard. These costs must be recouped by selling the crop. The legislature recognized that small wineries bearing high costs of start-up would not be able to compete in the market against well-funded, well-established & highly-capitalized out-of-state wine producers, because the latter could produce wine at a much lower cost basis, and they could produce a lot more of it. These producers also had well-established distribution relationships in Arizona. Accordingly, the small farm wineries needed some form of substantive market advantage in order to be competitive and get a foothold in the Arizona wine market. The legislature established three (3) specific market advantages that characterize today’s small farm winery business model:

[Simplified, but essentially –>] … provided a small farm winery either had a federal winery permit or owned/operated/controlled at least 5 acres of planted vineyard acreage, the small winery could enjoy and/or be permitted to:

  1. Relief from the statutory limitations of the 3-tier system, thus allowing small farm wineries to do what larger wineries, distributors and on & off-premise wine retailers could not do: simultaneously produce wine, sell the wine directly to consumers by way of tasting rooms, wine clubs and direct shipment, and self-distribute their wines directly to on & off-premise wholesale accounts;

Arizona small farm wineries are allowed by statute to distribute their products directly to licensed on & off-premise wholesale accounts, such as restaurants, bars, package stores and specialty wine shops;

  1. Small farm wineries were allowed to purchase and sell wine to/from other licensed small farm wineries;
  2. Small farm wineries were allowed to have multiple tasting rooms, thus increasing the small farm winery’s outreach and opportunities to retail their products;

These advantages were established to help nurture and develop an Arizona winery industry by incubating small farm wineries; these farm winery advantages were (and still are) considered a sort of economic “training wheels” business model by which wineries of statutorily-defined small volume production were afforded a market advantage not afforded to larger producers. These laws were conceived and established to provide a way for small wineries to establish a market foothold in Arizona, thus creating a financial incentive to plant wine grape vineyards, develop wine production and cellaring capacities/facilities, and grow in-state retail of these products.

The farm winery statutes were never established to provide lucrative market advantages to successful, well-established, large-producing small farm wineries so that they could continue their growth trajectories as functioning, large-scale production operations while simultaneously masquerading in the market as small farm winery operations;

NOTE: as a matter of constitutional law, the Commerce Clause prohibits Arizona’s legislature from creating any statutory scheme that discriminates against wineries outside of Arizona by giving economic protection to Arizona wineries. It is absolutely critical that all Arizona legislators understand this point, because it is fundamental to understanding how production caps work and work to create an constitutionally-acceptable environment to incubate Arizona’s small farm wineries while not discriminating against out-of-state farm wineries.

Because these advantages were (and very much still are) so lucrative, access to them was limited by way of a production cap. The cap was a statutory maximum production level defined as total production gallonage above which the lucrative benefits detailed above would cease. The cap was put in place to draw a bright line between a small farm winery (the business model the legislature was seeking to incubate) and a traditional major producing winery. As I will show you, the production cap establishing the distinction between these two business models was established quite high.

Our legislature created a business model in which the small farm winery’s lucrative relief from 3-tier regulation would end when the small farm winery was no longer “small”, as defined by its annual production level. According to data from the Wine Institute, 81% of America’s wineries produce less than 5,000 cases (12,000 gallons) annually. And, nearly half (45%) produce less than 1,000 cases (2,400 gallons). At the present time, the annual production cap is set at 20,000 gallons. Factually, any farm winery producing this much wine in a given year is a larger producer than more than 81% of all the wineries in the United States. Moreover and at the present time, no Arizona licensed farm winery’s annual production exceeds this amount.

Production caps help incubate a small farm winery industry by “notching” out a region in the wine marketspace that focuses the incentives only on small operators to the express exclusion of major wine producers. This alone has given rise to compelling discussions of such a scheme’s constitutionality. These arguments notwithstanding, today’s Arizona farm winery industry enjoys operations in this notched region of competitive advantage. HB2876 seeks to eliminate the caps, which necessarily eliminates the notched region of competitive advantage small farm wineries currently enjoy, thus destroying the very advantages that create the incentives for small wineries to enter the marketplace in the first place. Because HB2876 eliminates these advantages, it is contrary to the legislative purpose of our state’s farm winery statutes, and it will therefore harm Arizona’s small farm wineries, which is why we are speaking out against this bill.

Here are the realities of the current status-quo with respect to how Arizona’s farm wineries utilize the privileges of the Arizona farm winery business model:

  • The only Arizona licensed farm winery that has substantively-exercised the statutory allowance to self-distribute their products is our company, Flying Leap Vineyards. Several Arizona farm wineries use some degree of self-distribution, but to our knowledge only Flying Leap has essentially created its own in-house distribution company to market and distribute its wines to licensed on & off-premise wholesale accounts. Most Arizona wineries who distribute a substantive volume of wine do so by way of portfolio-placement with an Arizona distributor;
  • No Arizona farm winery at this time is altering their production behavior because of the production caps;
  • Many Arizona wineries do not own vineyards;
  • Many Arizona wineries don’t make wine;

HB2876 is bad for Arizona’s farm wineries because it changes the state’s farm winery business model in a way that will invite legal challenges from across the country by large out-of-state alcohol producers that the farm winery industry cannot sustain. Arizona’s farm winery business model is simple and as a matter of public policy has a very specific legislative purpose: as codified in ARS Title 4, statutorily-granted privileges to farm wineries exist to provide small-scale wine producers relief from the 3-tier system (the three-tier system of alcohol distribution is the system for distributing alcoholic beverages set up in the United States after the repeal of Prohibition. The three tiers are producers (e.g., wineries); distributors; and retailers. The basic structure of the system is that producers can sell their products only to wholesale distributors who then sell to retailers, and only retailers may sell to consumers). Collectively, these measures provide an incentive for people to deploy their savings in planting grape vineyards in Arizona, vinifying their annual crops and generating revenues by which to sustain & grow their operations by way of direct-to-consumer retailing (e.g., tastings room sales, online sales and wine clubs) and self-distribution of their wines to licensed wholesale accounts. Arizona’s small farm winery business model also has a statutory provision allowing so-licensed businesses to purchase and sell bulk wine to other farm wineries, either in or out-of-state. As a matter of public policy, these privileges are designed to incubate, nurture and build a commercially-viable Arizona farm wine industry. Any changes to the Arizona farm winery business model must be done so as to be consistent with its legislative purpose.

The Arizona farm winery business model does not exist to carve out lucrative statutory gems to allow successful, well-established Arizona small farm wineries to grow into larger-scale commercial wine producers who, unshackled by the restraints that govern the rest of the American wine industry can then shield themselves from the burdens of the 3-tier system to in-effect “masquerade” in the market as small farm wineries while functionally and in-scale being nothing of the sort. Thus, at its core, HB2876 now in circulation at the legislature is literally an attack on the small farm winery business model. The Arizona farm winery business model only exists to incubate small wineries by incentivizing investment in Arizona agriculture and wine production from these harvests. All changes to the farm winery business model must be evaluated against the legislative purpose of the business model in statute. That is, when changing the farm winery business model one must ask themselves, “does this change better-incubate small wineries? and, does it incentivize investment in Arizona agriculture and wine production from the fruits of these investments?” And, ultimately one must ask if the changes being presented make for good public policy.

The very premise of HB2876 – that Arizona’s farm wineries are disadvantaged by the current statutory system regulating them, is as preposterous as it is factually false. There already exists in Arizona a clear, unambiguous statutory path to growing out of the small farm winery business model. The system is designed to allow for this – the small farm winery’s lucrative relief from 3-tier regulation ends when the small farm winery is not longer “small”, as defined by its production. According to data from the Wine Institute, 81% of America’s wineries produce less than 5,000 cases (12,000 gallons) annually. And, nearly half (45%) produce less than 1,000 cases (2,400 gallons). It is impossible to argue that a winery producing more wine than 81% of the wineries in the United States is a “small farm winery”. And yet, that is precisely what this poorly conceived bill does. Arizona’s current statutes allow for a winery in Arizona (or out-of-state by way of the Series 2W license) to enjoy the lucrative benefits of the Series 13 Farm Winery license so long as their annual production doesn’t exceed 20,000 gallons (8,400 cases). Any winery producing this volume is a larger producer than most of the wineries in the United States.

Successful small farm wineries who reach the production cap are statutorily-required to surrender their farm winery license and secure a producer’s license. As a producer, the winery can still have a tasting room at their production facility, and they can still sell their wines direct by way of a wine club and online, just as they could with the farm winery license. The only substantive differences are that the producer cannot have remote tasting rooms, neither can they self-distribute. However, keep in mind that the only substantive self-distribution in Arizona currently is by our company. The argument that being required to move to a producer license structure harms Arizona’s farm wineries is bad because of the loss of self-distribution privileges is weak, because so few Arizona farm wineries self-distribute their products.

The current status-quo provides many lucrative benefits to small farm wineries, and most-importantly provides an incentive for Arizonans to invest their capital in planting grape vineyards and developing wine production and retail operations. Farms pay large taxes, hire lots of people and put investment capital in Arizona’s poorest counties. The problem is that the wine industry at-large is extraordinarily litigious, and the 2005 US Supreme Court decision in RE: Granholm and numerous subsequent challenges to in-state winery protectionist measures in the federal circuit courts of appeal have had a major impact to the farm winery business model, as these protectionist measures enacted by state legislatures have been challenged and beaten. In short, states cannot protect their native wine industries from out-of-state competition. Any lucrative benefits afforded by way of statute to a state’s native wineries must be identically-afforded to out-of-state wineries. Currently, Arizona complies with this by way of the Series 2W Out-of-State Farm Winery license, which affords out-of-state wineries the same statutory privileges as the Series 13 Farm Winery license provides to in-state wineries.

If production caps are eliminated – as is being requested by some of the state’s farm winery owners, then the Constitution’s commerce clause and a bulwark of courts decisions require that they be eliminated for out-of-state wineries too. Elimination of the production cap itself would harm Arizona farm wineries because it would allow any out-of-state winery (regardless of size) with nothing more than a federal winery permit to obtain an Arizona Series 2W Out-of-State Farm Winery license and masquerade as a small farm winery in our market (the Dormant Commerce Clause would prohibit the state of Arizona from carving out any special exemptions for its own farm winery industry). Quite literally, Fortune 500 beer, wine and spirits mega-brands with annual revenues in the billions, thousands of employees and ownership of numerous wine brands could obtain an Arizona Series 2W license and set up shop in Arizona as a small farm winery without regard to production, enabling them to self-distribute a limitless supply of wines without any constraints. Any sort of exclusionary measures put into the law to prevent this are unconstitutional. Accordingly, HB2876 as written today would not help small farm wineries, neither would it nurture or incubate new operations, and it wouldn’t do anything to encourage deploying capital to plant grape vineyards in our state. What it would do instead is provide a powerful incentive for large, well-capitalized producers from out-of-state to secure farm winery privileges in Arizona to allow them to masquerade in Arizona as small farm wineries un-burdened by restraints the 3-tier system. The lawsuits that would ensure would be dizzying.

We are an integral part to and believe in and support the Arizona farm winery industry. We want to see Arizonans deploy their capital in Arizona agriculture, small farms and new wineries. To sustain these small businesses, productions caps do far more good than bad. Eliminating them as is proposed here will cripple and harm the delicate market structure and balance that currently exist to incubate such businesses. Because these proposed changes will harm Arizona’s farm wineries, we are steadfastly against this bill and urge a do-not-pass recommendation.

If the legislature is looking for possible ways to compromise and save this bill in some form by retaining some of its elements, we do support a slight increase in the production cap from 20,000 gallons to no more than 40,000 gallons. Our reasoning is as follows: A well-run, efficiently farmed 40-acre vineyard in Arizona can produce a wine grape crop of about 150-180 tons. Such an operation could produce about 24,000 gallons of wine. Conceivably, these stocks could be increased by way of wholesale program growth to the 36,000-44,000-gallon range. Thus, a 40,000-gallon production operation could be characterized as a 40-acre, efficiently run vineyard operation with some augmentation from bulk wine purchases from other farm wineries, and which has substantial retail, wine club and wholesale market breadth. Accordingly, such a wine operation could be defined as the maximum upper limit of what constitutes a “small farm winery”. Additionally, a 40,000-gallon production cap is consistent with other states (Texas, for example places its farm winery cap at 35,000-gallons of annual production).

V/r,
mark

Mark W. Beres

President & CEO, Flying Leap Vineyards, Inc.