Source: George Dickel.

The escalating whiskey rebellion between global spirits giant Diageo (NYSE:DEO) and its domestic rival Brown-Forman (NYSE:BF-B) just claimed its first victim: the state of Tennessee, which entered the internecine war on the side of Jack Daniel's maker Brown-Forman, and has now waved the white flag, surrendering its troops to Diageo by abruptly dropping its lawsuit against the London-based distiller.

Last year, the Tennessee legislature bowed to the pressure applied by Brown-Forman to require all whiskey labeled as "Tennessee whiskey" be made using the so-called Lincoln County Process, or running it through charcoal before storing in new, charred-oak barrels. Not coincidentally, that's just how the distiller's premier Jack Daniel's whiskey is made.

Diageo, which makes the rival George Dickel brand of whisky (yes, it's spelled differently), follows all those rules -- it has a storied history in the state almost as long as its iconic peer -- but objected to the new law, saying it inhibited innovation and would suppress the nascent craft distiller industry, particularly because there's a shortage of oak barrels, caused in part by the new law. In response the legislature took up the newly passed law again with an eye toward repealing it, or at least rewriting it to make it less restrictive, but ultimately chose to shelve any action until the summer to give the industry time to offer input.

That apparently didn't sit well with the state's alcoholic beverage commission, which rode like the cavalry to aid Brown-Forman, sending Diageo a letter charging it with violating a 1937 law it dusted off that required distillers to store their spirits either in the county where they're manufactured or in an adjacent one. Because Diageo stores its whisky in warehouses in Louisville, Kentucky, rather than at its Coffee County, Tennessee, distillery, the agency said Diageo violated the law.

The distiller sued the state regulators in federal court, charging them with violating its rights under the commerce clause of the U.S. Constitution. Following testimony given by Diageo's master distiller that said about 60,000 barrels of whisky had been stored out of state over the past five years, Tennessee announced it was dropping all charges against the distiller, though it declined to say why. Diageo says it will seek assurances from the commission that it won't take up arms against the distiller again if it stores its whisky out of state in the future.

Source: Jack Daniel's.

The war, though, is likely to go hot once more when the legislature begins reviewing again the law it passed that started the whole brouhaha, particularly since it was completely unnecessary for Brown-Forman to even start fanning those flames. Jack Daniel's already accounts for 90% of all whiskey sold in the state as it is, and saw net underlying sales jump 6% for the year, with sales outside of the U.S. up 9%. It enjoyed a 32% surge in global sales of its Tennessee Honey brand, following the doubling of sales the year before, all of which occurred as the distiller's global competitors saw moderating growth rates.

In short, Brown-Forman needlessly threw a lit match in a tinderbox ,and as the battle progresses and its reinforcements fall by the wayside or surrender just as the state regulators did, the distiller may find it's run out of ammunition just as Diageo brings in its big guns.