U.S. hotel expansion in Cuba recently grabbed a series of headlines and the attention and imagination of those U.S. franchisors eager to access the Cuban market. However, the details of this expansion reveal a number of inherent risks and uncertainties that are common for the expansion of a U.S. franchise system into any developing market.
On March 19, 2016, after receiving special approvals from the Office of Foreign Assets Control (OFAC) of the U.S. Department of the Treasury, Starwood Hotels and Resorts signed historic agreements in Cuba, announcing a multi-million dollar investment to operate certain Havana hotels.
Starwood entered into separate management agreements with two Cuban state enterprises to rebrand local hotels. Starwood entered into an agreement with Gran Caribe to rebrand Hotel Inglaterra as a member of The Luxury Collection. It also entered into a management agreement with Grupo de Turismo Gaviota S.A. to rebrand Hotel Quinta Avenida as a Four Points by Sheraton. Additionally, Starwood entered into a letter of intent with Habaguanex, a Cuban state-run company that owns many properties in Old Havana, to rebrand Hotel Santa Isabel, pending OFAC approval. Under these management agreements, the hotels will be run by management staff from Starwood but will be primarily staffed by Cuban nationals. Starwood would be paid a management fee to run the hotels, but the hotel will remain owned by the Cuban state enterprises.
Recently, Marriott International also received approval from OFAC to pursue business transactions in the country and is in discussions with Cuban officials to operate or develop hotels there. Marriott CEO, Arne Sorenson, alluded that although franchising may eventually be an option, Cuba is currently interested in Marriott as a manager of local hotels.
Any such management agreement (or franchise agreement) must be structured in a manner that is compliant with existing legislation. Cuba has enacted foreign investment laws that limit the ownership stake that foreign companies can have and requires such companies to only hire workers approved by the government. Under these laws, the Cuban government negotiates with the foreign company and designates the people that are allowed to be hired. The foreign company is required to pay the Cuban government directly, and the designated workers are paid the typical Cuban salary of about $25 a month, while the government keeps the remaining amount.
In addition to the arcane Cuban foreign investment and other applicable laws, the U.S. prohibits all persons and entities subject to its jurisdiction from conducting business or investing in Cuba, unless authorized and specifically granted a license by OFAC. This prohibition would, of course, include U.S. franchisors.
Generally, a U.S. franchisor entering into a franchise agreement with a Cuban entity would be barred by U.S. law. Since OFAC would likely view the franchise agreement (and typical training and other ongoing support within such arrangements) as the export of services to Cuba, the licensing of franchisor’s intellectual property to a Cuban entity would likely violate the prohibition on dealing in property subject to the jurisdiction of the U.S. and a franchisor’s receipt of ongoing royalty payments could be seen as a prohibited payment from an investment in Cuba. In short, all of these activities would need to fall under a general or specific license issued by OFAC.
Specifically, OFAC only permits and provides licenses for the establishment of a business presence and/or physical presence in Cuba for certain types of persons or entities. Effective as of March 16, 2016, certain amendments to sections 515.575, 515.574, and 515.576 of the Cuban Assets Control Regulations (CACR) expanded the existing authorization for “physical presence” (such as an office, retail outlet or warehouse) to include entities that engage in authorized humanitarian projects, entities that engage in authorized commercial activities intended to provide support for the Cuban people and private foundations or research or educational institutes engaging in certain authorized activities.
The amendments also expanded the existing authorization for “business presence” (such as a joint venture) to include exporters of goods that are authorized for export or re-export to Cuba or that are exempt, entities providing mail or parcel transmission services or cargo transportation services and providers of carrier and travel services to facilitate authorized transactions.
For those franchise systems that require franchisees to purchase proprietary products or other tangible goods from the U.S. franchisor, such exports by a U.S. franchisor will be subject to export and re-export restrictions administered by the U.S. Department of Commerce Bureau of Industry and Security (BIS). This would require the U.S. franchisor to obtain authorizations from both OFAC and BIS.
The recent amended regulations clarified that physical and business presence authorizations allow exporters and re-exporters of authorized or exempt goods to assemble such goods in Cuba. The BIS has made conforming changes to the Export Administration Regulations (EAR) to authorize exports and re-exports of eligible items to establish and maintain OFAC authorized physical or business presences in Cuba. Please see our recent alert detailing OFAC’s significant amendments to the Cuban Assets Control Regulations (CACR) here.
Although these amendments are a step in the right direction, it will likely take at least several years before Cuba is completely open to U.S. franchisors. For the near future, OFAC and its license application remains a major roadblock to any business expansion into Cuba. In fact, it remains unclear what criteria and under what circumstances OFAC provided for the necessary approvals for Starwood and Marriott to operate in Cuba. This lack of clarity regarding U.S. regulations, coupled with the Cuban laws preventing foreign companies from outright ownership of properties and hiring restrictions, will likely limit the willingness and interest of U.S. companies trying to expand into Cuba.
Even with the required approvals from the U.S., franchisors will face many other hurdles. Similar to China when it first opened to U.S. companies in the 1980s, it took over a decade before regulations stabilized and made investment in the country less risky. Most companies looked toward the potential of tapping into China’s population of approximately 1.3 billion and its exploding middle class. In contrast, however, Cuba is a small island country with a population of approximately 11 million and a relatively small middle class. Most of the Cuban economy is run by and through the government, with very little contribution from the private sector. The Cuban government will have to figure out how to issue operating permits, business licenses and other import/export regulations, if any. Although expansion into Cuba may seem like a great opportunity, franchisors must weigh the inherent risks and uncertainties that will likely last for years. It is imperative to practice thorough due diligence of the legal and business environment before investing heavily in Cuba.
Parts of this alert were based on excerpts from Franchising in the Americas 2016: Legal and Business Considerations, a book edited by Kendal H. Tyre, Diana V. Vilmenay-Hammond and Keri McWilliams to be published in late 2016. It will be the third book in the “Franchising In” international book series published by LexNoir Foundation. Other titles included Franchising in Africa 2014: Legal and Business Considerations and Franchising in Asia 2015: Legal and Business Considerations.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.