Toyota's unknown business partners

NEW YORK (Fortune) -- A lawsuit among Toyota dealers has shed new light on one of the Japanese automaker's less well-known business practices: its use of independent distributors to sell cars in the United States.

The use of distributors is a practice that has been followed by Toyota (TM) for decades but one that provides little apparent benefit -- either for the company or its customers. The distributors act as middlemen -- buying cars from Toyota and reselling them to local dealers at a considerable profit. They control large swaths of territory in the South and Southwest, where Toyota sales are growing briskly.

For a company that prides itself on squeezing its value chain for every last penny of cost, the distribution system seems anachronistic and out-of-character. Using middlemen to distribute highly sought-after products is akin to real estate brokers in New York City who charge 15% of the annual rent to allocate scarce apartment space. The apartments would get rented even if the brokers stayed home. Likewise, Toyota gets along without distributors in most parts of the country and works directly with dealers. Why the reliance on distributors in a few places?

The answer is historic. Back in the late 1960s when Toyota was first getting started in the United States, it turned to local businessmen to help find dealers and to smooth any political bumps they might encounter. Toyota handled distribution for itself on the West Coast and the New York area but used independent operators to organize the rest of the country. According to a history by Automotive News, the distributors were given enormous leeway to do business as they saw fit: setting prices, determining product mix, dictating trim packages and creating marketing plans. The distributors even sold all the spare parts and created their own captive finance companies to make loans to consumers -- two operations that can be even more profitable than selling new cars.

As Toyota became more successful, it bought out some of the distributors. Since the cars practically sold themselves, why did it need to cut a third party in on the action? But two distributors -- who were perhaps too powerful to mess with -- remained and they eventually grew into multi-billion-dollar businesses.

One is Southeast Toyota in Florida, which controls 20% of Toyota sales nationwide through its territory of Florida, Georgia, Alabama, and North and South Carolina. In the 1990s, it was the target of numerous lawsuits by dealers who claimed, among other things, that they were being driven out of business so that the distributor could replace them with new dealers who would pay more. The verdicts in those cases cost Southeast more than $100 million in verdicts, costs and fines, but Toyota never wavered in its support.

The other distributor is Gulf States Toyota of Houston, which runs 150 dealers in Texas, Oklahoma, Louisiana, Arkansas and Mississippi. In 2006, Group 1 (GPI, Fortune 500), a public company that owns 104 dealerships, filed suit against Gulf States, charging it improperly encouraged two Group 1 executives to leave the company and buy a Toyota dealership in Dallas. For the executives, it was like hitting the jackpot. Toyota dealerships are highly profitable, frequently making twice as much as comparable domestic dealers.

The suit places Group 1 in an awkward position because it depends on Gulf States for its supply of new cars and parts. That would make the dealer group a sitting target for retribution, like receiving extra allocations of slow-selling FJ Cruisers.

Although it can't be happy to see its business practices under scrutiny, Toyota is sticking by its distributors. In a statement, it says they "bring a culture of innovation, responsiveness and agility" and prices for consumers that "are the same" or "even more competitive" than prices in regions where there are no distributors.

As the suit progresses, it is likely to expose some of the less-visible practices of the distributors, such as packing high-margin options on hot-selling models to squeeze out a few extra bucks of profit. At a time when Toyota, now the world's largest car company and the second largest in U.S. sales after General Motors (GM, Fortune 500), is extra-conscious about its public image, the revelations could be a big embarrassment.