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Costablie v. Natus Medical Inc.

United States District Court, N.D. California

February 26, 2018




         Now before the Court for consideration is the motion filed by Natus Medical Incorporated (“Natus Medical”), James B. Hawkins, and Jonathan A. Kennedy (collectively, “Defendants”) seeking to dismiss this securities class action. The Court has considered the parties' papers, relevant legal authority, and the record in this case, and the Court finds the motion suitable for disposition without oral argument. See N.D. Civ. L.R. 7-1(b). For the reasons set forth below, the Court HEREBY GRANTS Defendants' motion to dismiss, but will afford Plaintiff leave to amend.


         Plaintiff John Costabile alleges that he purchased Natus Medical common stock at “artificially inflated” prices due to alleged misrepresentations and omissions made by Defendants regarding a supply contract between a Natus Medical subsidiary and the Venezuelan Ministry of Health.[1] Plaintiff seeks to represent a class of all individuals who purchased or acquired Natus Medical stock during the Class Period (defined as October 16, 2015 and April 3, 2016). (Dkt. No. 25, First Amended Complaint (“FAC”) ¶¶ 1, 122.)

         A. Natus Medical and the Supply Contract with the Venezuelan Ministry of Health.

         Natus Medical is a company which designs, manufactures, and markets newborn care and neurology healthcare products and services worldwide. (Id.¶ 2.) On October 16, 2015, Defendant James Hawkins, Natus Medical's CEO, and Defendant Jonathan Kennedy, the CFO, announced that Natus Medical, through its wholly-owned Argentinian subsidiary Medix I.C.S.A. (“Medix”), had entered into a three-year, $232.5 million supply contract to provide medical equipment, supplies, and services to the Ministry of Health of Venezuela (“Supply Contract”). (Id. ¶ 3.) In the announcement, Defendants represented that $69 million in prepayments under the Supply Contract were expected by the first quarter of 2016. (Id. ¶¶ 3, 50).

         The announcement of the Supply Contract was received as a significant development by analysts. (See, e.g., id. ¶¶ 4-5.) On October 21, 2015, Defendants issued a press release which, quoting Hawkins, provided details regarding the impact of the Supply Contract on Natus Medical's revenue forecasts. Specifically, after citing the Supply Contract, Defendant Hawkins noted how Natus Medical had increased its revenue guidance for the fourth quarter of 2015 by $3 million and its non-GAAP earnings per share from $ 0.47 to $0.49. (Id.¶ 53.) Hawkins also indicated that Defendants were “increasingly confident that we can achieve and potentially exceed our long term operating margin goal of 20% in 2016.” (Id.)

         That same day, Defendants held a conference call with analysts to discuss Natus Medical's earnings. A number of representations were made during this call. For example as with the prior press releases, Defendants represented that the Supply Contract would have a positive impact on Natus Medical's revenue, with payments from the agreement being anticipated by the first quarter of 2016. (Id. ¶ 55.) For instance, Hawkins told analysts:

Last Friday we announced that Medix . . . signed a three-year agreement with the Ministry of Health of Venezuela for $232.5 million to supply Venezuela with neonatal and obstetric equipment supplies and services. As stated in our filing, we are to receive three payments totaling $69 million by the end of the first quarter of 2016. Prepayments are to continue throughout the contract period as we fulfill our requirements. We expect to commence on this contract in our fourth quarter, but revenue is expected to be minimal in the fourth quarter.

(Id.) Later in the call, an analyst asked Hawins to provide additional information on how the Supply Contract would contribute to Natus Medical's revenue and earnings in 2016. Hawkins answered by again referring to anticipated payments being received in the fourth quarter of 2015 and first quarter of 2016:

We expect to receive some payments here by the end of the year, to start those three payments totaling the $69 million. And then to- most likely those would extend into the first quarter of next year . . . As we-way this contract is, we're going to be prepaid throughout the entire contract.

(Id. ¶ 57.) Hawkins further indicated that Natus Medical had, conservatively, included a “couple of million dollars” in its fourth quarter 2015 guidance attributable to the Supply Contract. (Id.¶ 59.)

         In addition, during the conference call Kennedy made the point of highlighting that the Supply Contract was not the first contractual arrangement between the Ministry of Health and Medix. Kennedy instead referenced how the Supply Contract represented a “continuation of an ongoing relationship.” (Id.¶ 61.) Specifically, Kennedy addressed how, around 2010, Medix had completed an almost $100 million deal with Venezuela, thus demonstrating the “ongoing relationship between Medix and other South American countries.” (Id.)

         Finally, analysts during the call asked about the currency exchange risk inherent in the Supply Contract. (Id. ¶ 63.) Kennedy asserted that the risk was “minimal” because Natus Medical was protected by the fact that the Supply Contract was “denominated in dollars, and our payment is a dollar-denominated payment.” (Id.)

         The representations by Hawkins and Kennedy continued into November and December 2015 at various healthcare conferences. On November 19, 2015, during his opening remarks to a conference, Hawkins expressed “pride” at Natus Medical's financials and lauded the “major” $232 million Supply Contract. (Id. ¶ 65.) Hawkins not only touted the ultimate value of the Supply Contract, but emphasized that Natus Medical was to “be paid up front as we go on this business” with the first payment expected “by the end of the year, and .. . . continu[ing] throughout the life of the contract.” (Id.)

         At least one analyst at the conference asked how confident Hawkins was regarding Venezuela's ability to perform on the Supply Contract over the entire three-year term. (Id. ¶ 67.) Hawkins responded to this question by acknowledging that there is “always a potential risk with any contract.” (Id.) He then sought to downplay this risk by pointing to Medix's prior contractual relationship with Venezuela:

Yes, so, always a potential risk with any contract. The one thing I would say with this one, before we bought our subsidiary, which is located in Buenos Aires, which is who received this order, a company called Medix, they had received an $82 million order maybe seven years ago and it came through just fine. The money showed up as expected, and it did happen.
So we have pretty good confidence that it should happen. We have been told the money is set aside, and we are looking to get our first payment here by the end of December.


         At a similar December 1, 2015 healthcare conference, Hawkins again lauded the “very large order that [Natus Medical] received from Venezuela totaling $ 232.5 million.” (Id. ¶ 71.) As he had in October and November, he again asserted that Natus Medical was anticipating receiving revenue under the Supply Contract before the end of 2015:

We look to some of these revenues to start in December. We expect to get our first $23 million payment in the weeks ahead and then we'll be prepaid on all of this as we go forward on a rolling basis. It's quite a big order for us and we are very excited to not only have it ourselves, but also for the babies and mothers in Venezuela.

(Id.) Later, in response to a request from an analyst for additional details, Hawkins again pointed to the imminent commencement of payments and its impact on Natus Medical's financials:

The money . . . that we are receiving for this purchase is all in U.S. dollars. And there always is some potential currency risk as we transfer those dollars into Argentine pesos to do the purchasing and delivering of product. But overall, over this three-year period, we are convinced it's going to be a good piece of business for us.
It will have average corporate margins of 18% to 20%. And although the gross profits won't be near that, but the bottom line operating margin should be the same. So we are quite encouraged. We're expecting to get payment here in the next few weeks and looking for this to kick off . . . .

(Id. ¶ 73.)

         In summary, throughout the fourth quarter of 2016, Defendants represented that the Supply Contract was a done deal that would have a significant positive impact on Natus Medical's revenue, starting in the fourth quarter of 2015. As alleged in the FAC, the market responded favorably to this news, and on December 17, 2015, Natus Medical shares reached an all-time high closing price of $50.48 per share. (Id. ¶ 12.)

         B. The Alleged Undisclosed Truth.

         Plaintiff, however, alleges that the above representations regarding the existence of the Supply Contract and its potential impact on Natus Medical's revenue were false and misleading for a number of reasons.

         First, and most fundamentally, Plaintiff contends that that there was no enforceable contract at all. Plaintiff relies on a confidential witness (“CW1”) who served as the Venezuelan Ministry of Health's Purchasing Coordinator between February 2016 and July 2016. (Id. ¶ 40.) In this role, CW1 was responsible for “preparing price quotes, handling and maintaining information regarding payments due under contracts for purchases and services, and tracking receipt of goods and services.” (Id. ¶¶ 40.) Plaintiff alleges that CW1 has represented that the Supply Contract was “substantially negotiated” leading up to the fourth quarter of 2015, but not actually executed. (Id. ¶ 43.) As a result, Plaintiff asserts there was, in fact, no Supply Contract in the fourth quarter of 2015 or first quarter of 2016, thus rendering all of Defendant's statements about that contract (and its potential impact on revenue) misleading. Specifically, he asserts that because the Supply Contract was not executed, no prepayments were scheduled or owed in the fourth quarter of 2015 or first quarter of 2016, contrary to Defendants representations. (Id. ¶ 42.)

         Second, even if the Supply Contract had been executed, Plaintiff contends that Defendants did not disclose to investors that the Ministry of Health failed to make required payments. As detailed above, Defendants repeatedly asserted that they expected the Ministry of Health to begin making prepayments by the first quarter of 2016. Plaintiff contends that these representations were misleading, however, because the terms of the Supply Contract required the Ministry of Health to make prepayments in October, November, and December 2015. (Id. ¶ 13.) None of these prepayments were timely made. In fact, Plaintiff alleges that by December 1, 2015-when Defendants were still touting the imminent receipt of the pre-payments-the Ministry of Health was $47 million in default under the terms of the Supply Contract as the October and November payments had not been made. (Id. ¶ 72.)

         Third, Plaintiff alleges that Defendants failed to disclose that the Supply Contract left Natus Medical with no effective means to enforce its rights under the agreement. Plaintiff relies on the fact that the Supply Contract provided that any questions of interpretation, application, and performance of the contract would be governed by the laws of Venezuela with the City of Caracas being the “special domicile” for such enforcement. (Id. ¶ 47.) According to Plaintiff, this left Defendants with “no means of effectively enforcing their rights under the Supply Contract” because they would be forced to litigate in a Venezuelan court against the Venezuelan government. (Id. ¶ 48.) In support of this contention, Plaintiff points to the allegedly “turbulent legal, political, and economic systems in Venezuela” and the Venezuelan government's alleged intrusion into the independence of the judicial system. (Id.)

         Compounding this issue, Plaintiff contends that contracts with the government of Venezuela were often disregarded when ministers were replaced. CW1, for example, asserts that “Here things happen in a different way. The minister leaves and everything that he does that isn't invoiced gets lost - if the money is not committed. One thing is a promise to do a contract and another thing is a contract.” (Id. ¶ 49.) Given this reality, Plaintiff contends that Defendants either were aware, or should have been aware, that imminent elections in Venezuela meant that there was a significant risk that the unsigned Supply Contract would never come to fruition. (Id.)

         Fourth, Plaintiff asserts that it was misleading for Defendants to bolster public perception of the Supply Contract by referencing the prior agreement prior between Venezuela and Medix. While acknowledging that Medix and the Venezuelan Ministry did have a prior agreement in 2011, Plaintiff contends that the prior agreement did not match Defendants' rosy description. Again relying on CW1, Plaintiff alleges that the prior agreement “failed to come to completion and was cancelled or suspended when the final amounts owing under the contract were not paid to Medix by the Ministry of Health.” (Id. ¶ 44.) Another confidential witness (“CW2”), who worked as Natus Medical's Director of Operations in Argentina from 2011 to 2013, supports CW1's description, stating that the prior agreement “was always in the air. Medix was always trying to close it” and that there had been a “history of difficulties with payments with Venezuela.” (Id. ¶ 46.)

         Fifth, Plaintiff alleges that Defendants misrepresented to investors that the Supply Contract called on the Ministry of Health to make payments in dollars. (Id. ¶ 63.) In fact, Plaintiff contends that the Supply Contract calls for payments to be made in “Argentinian Pesos at the current exchange rate for the effective day of payment.” (Id. ¶ 64.)

         C. Problems with the Supply Contract Materialize.

         Plaintiff alleges that the truth about the Supply Contract-withheld from investors during the fourth quarter of 2015-began to come to light in January 2016.

         On January 11, 2016, Natus Medical filed a Form 8-K which announced that the company had failed to meet its revenue guidance for the fourth quarter of 2015. The attached press release, signed by Kennedy, blamed this on the fact that the prior guidance had “included expected revenue of approximately $4 million under the new Venezuelan Ministry of Health contract” but the expected prepayment had been “delayed.” (Id. ¶ 75.) Instead, Kennedy revealed the company “now expects to receive prepayment and begin shipments in the first quarter of 2016.” (Id.) He stated that $5 million of revenue from the Supply Contract was included in the new revenue guidance for the first quarter of 2016 and $60 million for the full year guidance.

         Similarly, on January 27, 2016, another Form 8-K was filed which again blamed the fourth quarter 2015 shortfall on a “delay” in prepayments under the Supply Contract and this time made a general reference to unspecified “risks associated with our Venezuela contract.” (Id. ¶ 80.) Similar representations were made during a conference call that same day. (Id. ¶¶ 82.) During that call, and in response to a question from an analyst, Hawkins expressed “confid[ence] that this business will happen” and stated it was “safe to assume guidance implies about $0.20 in earnings from Venezuela this year.” (Id. ¶ 84.) Kennedy similarly assured analysts regarding economic benefit of the Supply Contract, by stating “[i]f I had a gun to my head and had to predict, it's probably in the mid-40%s for a gross profit margin.” (Id. ¶ 86.)

         Plaintiff contends that these partial disclosures of a “delay” and references to unspecified “risks” were themselves misleading as they failed to disclose known fundamental risks and issues with the Supply Contract. (Id. ¶¶ 77, 87.) For instance, Defendants continued to not disclose the fact that three pre-payments had been missed during the fourth quarter of 2015. (Id.)

         Analysts expressed reservation about the prospects of the Supply Contract and at least some analysts removed the Supply Contract from their guidance. (See Id. ¶ 88.) Consequently, shares of Natus Medical declined. On January 11, 2016, Natus Medical closed at $38.25, down from $43.20, after a day of unusually high trading volume. (Id. ΒΆ 76.) On January 27, 2016, following the second Form 8-K and ...

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