[1993/oagheade.htm]

OAG 93-74

October 28, 1993

Kim Burse

Secretary of Revenue

Fourth Floor Capitol Annex

Frankfort, Kentucky 40601

Re: Unfair Cigarette Sales Law

Dear Mrs. Burse:

You have asked if the Unfair Cigarette Sales Law is constitutional. It is not.

This law, KRS 365.265 to 365.370, was declared unconstitutional by the Franklin Circuit Court on October 24, 1989. The basis of the court's decision was a finding that the Unfair Cigarette Sales Law is a minimum markup law that “is almost identical in effect to the law declared unconstitutional in Remote Services, Inc., v. FDR Corporation, Ky., 764 S.W.2d 80 (1989).” Revenue Cabinet v. A. Topicz & Sons, Franklin Circuit Court No. 89-CI-0509. In a subsequent legislative session, the law was amended slightly in an apparent attempt to remove the constitutional infirmity. Your question to the attorney general is whether the legislature succeeded in repairing the law.

Minimum Markup Laws In General

The unconstitutionality of minimum markup laws was established in Kentucky Milk Marketing And Antimonopoly Commission v. Kroger Company, Ky., 691 S.W.2d 893 (1985). In that case the court struck down a minimum markup law that forbade retailers to sell milk below cost. “Cost” was defined in the statute to include the invoice price plus the retailer's cost of doing business, including such items as salaries, rent, taxes, and advertising. The court found that “cost” was an arbitrary figure because it required the inclusion of expenses unrelated to the sale of milk. “The evidence is incontrovertible,” the court said, “that many, if not all, of the costs incurred by grocery retailers have nothing do with the actual cost of selling milk.” Id. at 897. By way of example the court noted that the retailer's actual cost in operating a produce section was about 15%, while the actual cost of operating the grocery section (where milk and other items were sold) was 4%. Because the statutorily-derived cost of selling milk was higher than the actual cost, the statute established an arbitrary minimum markup in violation of section two of the Constitution of Kentucky.

In 1989, the court struck down a similar law in Remote Services, Inc., v. FDR Corporation, Ky., 764 S.W.2d 80 (1989). The law involved was the Unfair Trade Practices Act, which the court found “strikingly similar to that in the Milk Marketing case.” Id. at 82. The only essential difference was that the Unfair Trade Practices Act is not limited to a single commodity such as milk, but rather applies to “any article or product, or service or output of a service trade.” KRS 365.030. The definition of cost in the two statutes is essentially the same. The court described its holding in Kentucky Milk Marketing by saying, “It was the definition of 'cost,' which was not confined to cost of the product, but included other legitimate competitive advantage, that abrogated the constitutionality of the statute.” Id. at 82.

How To Calculate Minimum Markup

The milk marketing law, the Unfair Trade Practices Act, and the Unfair Cigarette Sales Law all provide the same sort of general statement about minimum selling price: it cannot be lower than invoice price plus cost of doing business. But the statutes neglect to describe how to perform the computations necessary to make that determination. Two of the variables — invoice cost and selling price — relate to the unit price of the item sold. That is to say, milk costs the retailer $1.50 per gallon and he sells it for $2.00 a gallon, or cigarettes cost the retailer $.90 a pack and she sells them for $1.00 a pack. The third variable — cost of doing business — is generally expressed as a sum of costs incurred over a period of time. For example, the milk retailer's cost of doing business might have been $1,000,000 in 1992. Obviously, the statutes cannot be taken literally; the minimum price of invoice cost plus cost of doing business cannot be deemed to be $2.00 plus $1,000,000. Some manipulation is required in order to express the cost figure in terms of the unit cost or unit price.

In Kentucky Milk Marketing, the court described the computation used by the Milk Marketing Commission in applying cost of doing business. The total cost figure (presumably established over a fixed period such as a year) is divided by the gross sales for the same period. The resulting fraction yields a percentage that is then multiplied by the unit price of the item involved. (There was some uncertainty in the case about whether the multiplicand should be the invoice cost or the proposed selling price.) A computation might look like this:

Cost of doing business: $1,000,000
Divided by gross sales: $1,800,000
Equals: 56%
Invoice cost per unit: $2.00
Plus cost for that item: $1.11 (56% times $2.00)
Equals minimum price: $3.11

One reason the court declared that calculation unconstitutional was that if the invoice cost increased, the minimum selling price necessarily increased by a greater amount, even if the cost of doing business remained the same. In the example just given, if the invoice cost per unit increased to $2.10, the calculation would look like this:

Invoice cost per unit: $2.10
Plus cost for that item: $1.18 (56% times $2.10)
Equals minimum price: $3.28

The minimum selling price thus increased by seventeen cents, even though the invoice cost increased only ten cents and the cost of doing business remained the same. The seven cent differential provides a statutorily-required profit to the seller.

It is apparent that under minimum markup statutes of the sort described in Kentucky Milk Marketing and Remote Services, Inc., a retailer's minimum price for selling an item increases as his cost of doing business increases, even if the cost is unrelated to the sale of the item; and his minimum price for selling the item increases by an amount greater than the amount of any increase in invoice cost, even if the cost of doing business remains the same. These are the two characteristics of minimum markup statutes that place them in violation of section two of the state constitution.

The 1990 Amendments To The Unfair Cigarette Sales Law

Before 1990, the Unfair Cigarette Sales Law was as a practical matter indistinguishable from the two minimum markup laws that were struck down in Kentucky Milk Marketing and Remote Services, Inc. Like the other laws, it forbade the sale of a product below cost, with cost being defined as the seller's total cost of doing business.

The 1990 amendment provides a slightly different approach to the calculation of cost. The current version of the law reads:

“Cost to the retailer” means the basic cost of cigarettes involved to the retailer plus the cost of doing cigarette business by the retailer. In determining the cost of doing cigarette business by the retailer, the cost of doing business by the retailer shall first be determined [in the same manner set out in the previous version; that is, by including all overhead costs to the seller]. The cost of doing business by the retailer shall then be multiplied by the fraction obtained through dividing the retailer's cigarette sales for the preceding six (6) months by the retailer's total sales for the same period and the product thereof shall be the cost of doing cigarette business.

KRS 365.280(12)(a) (emphasis added). Obviously, the statute attempts to restrict the required minimum markup to a cost figure associated exclusively with cigarette sales. The figure thus obtained, if valid, would presumably remedy the problem described in Remote Services, Inc.: a figure “not confined to the cost of the product.”

Our analysis of the 1990 amendment indicates that it changes nothing: “cost of doing cigarette business” is still determined with reference to the seller's total operational expense. Although the current statute utilizes only part of the seller's overall cost of doing business, the overall cost nevertheless is an integral component of the markup calculation. The law therefore contains the same defect that led the Franklin Circuit Court to declare it unconstitutional. A calculation of cost under the amended act is “not confined to cost of the product, but include[s] other legitimate competitive advantage” and thus contains the same fatal infirmity as the milk marketing law and the Unfair Trade Practices Act.

Conclusion

It is our opinion that the Unfair Cigarette Sales Act is a minimum markup law and is unconstitutional under section 2 of the state constitution.

Sincerely,

Chris Gorman

Attorney General

Ross T. Carter

Assistant Attorney General