Protecting the Outside Director: The "Red Flag Review"

The civil liability of outside directors under the securities laws has coalesced around the concept of "red flags". What is a red flag? In law, as in everyday life, it is simply a "danger sign". Chest pain that worsens on exertion is a red flag to a cardiologist; if the patient experiencing the pain previously has had a coronary, the red flag is flagrant. The furtive exchange of a small package for cash is a red flag to a narcotics cop. A series of such exchanges, in the doorway of a known crack house, may establish probable cause for an arrest.

What is a red flag in a securities case against an outside director? It is something the director encounters that is inconsistent with an important representation by management about the company’s condition. In principle, there is no reason the inconsistency should imply management fraud: a red flag could be a warning sign that management has made an innocent mistake, albeit a mistake with material consequences. Nevertheless, the term is most commonly used to mean notice of malfeasance, that is, "notice that the audited company was engaged in wrongdoing to the detriment of its investors."

by David S. Hammer

Full Story: http://vcexperts.com/vce/news/buzz/archive_view.asp?id=354