Snopes has a report on this now.
snopes.com: Obama Flag
What I took away or learned..
In fairness to the vets, they asked them to remove the flag - offerred a POW/MIA flag in it's place.
However, they also claimed that the flag violated federal flag code. There sort of is NOT a 'law', as we understand them, covering handling the flag.
As outlined here:
USFlag.org: A website dedicated to the Flag of the United States of America - United States Code
...there IS a 'code' but there are no penalties outlined for violating it. That's left to the states. Now, in Florida, it's covered by Florida Statute 256.05.
Quote:
No person shall, in any manner, for exhibition or display:
(1) Place or cause to be placed any word, figure, mark, picture, design, drawing or advertisement of any nature upon any flag, standard, color, ensign or shield of the United States or of this state, or authorized by any law of the United States or this state; or
(2) Expose to public view any such flag, standard, color, ensign or shield upon which shall have been printed, painted or otherwise produced, or to which shall have been attached, appended, affixed or annexed any such word, figure, mark, picture, design, drawing or advertisement.
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Now, the real question is the flag in question itself. It's clearly INSPIRED by the American flag, but defacing it? I don't think that hold up. First off, it was never an American flag - the stars were never added. But if it's "look and feel" well, then you're outlawing anyone flying the Liberian or Malaysian flags which are clearly inspired by the Stars and Stripes.