<PAGE>   1

===============================================================================



                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                             ----------------------

                                   FORM 10-Q

                             ----------------------

          JOINT QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934
                  FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1998

                             ----------------------

                                BROOKE GROUP LTD.
             (Exact name of registrant as specified in its charter)
<TABLE>
<CAPTION>

               DELAWARE                                1-5759                               51-0255124
<S>                                            <C>                             <C>
   (State or other jurisdiction of             Commission File Number          (I.R.S. Employer Identification No.)
   incorporation or organization)
</TABLE>

                                    BGLS INC.

             (Exact name of registrant as specified in its charter)

<TABLE>
<CAPTION>
               DELAWARE                               33-93576                              13-3593483
<S>                                            <C>                             <C>        
   (State or other jurisdiction of             Commission File Number          (I.R.S. Employer Identification No.)
    incorporation or organization)
</TABLE>

                             100 S.E. SECOND STREET

                              MIAMI, FLORIDA 33131

                                  305/579-8000

     (Address, including zip code and telephone number, including area code,
                       of the principal executive offices)

         Indicate by check mark whether the Registrants (1) have filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934, as amended (the "Exchange Act"), during the preceding 12 months (or
for such shorter period that the Registrants were required to file such
reports), and (2) have been subject to such filing requirements for the past 90
days. [ X ] Yes [ ] No

         At May 15, 1998 Brooke Group Ltd. had 20,454,230 shares of common stock
outstanding, and BGLS Inc. had 100 shares of common stock outstanding, all of
which are held by Brooke Group Ltd.

===============================================================================









<PAGE>   2

                                BROOKE GROUP LTD.
                                    BGLS INC.

                                    FORM 10-Q

                                TABLE OF CONTENTS
<TABLE>
<CAPTION>

                                                                                                             PAGE
                                                                                                             ---- 
<S>                                                                                                          <C>
PART I. FINANCIAL INFORMATION

Item 1. BROOKE GROUP LTD./BGLS INC. CONSOLIDATED FINANCIAL STATEMENTS:

   Brooke Group Ltd. Consolidated Balance Sheets as of March 31, 1998 and
         December 31, 1997.............................................................................       2

   BGLS Inc. Consolidated Balance Sheets as of March 31, 1998 and December 31, 1997....................       3

   Brooke Group Ltd. Consolidated Statements of Operations for the three months ended
         March 31, 1998 and March 31, 1997.............................................................       4

   BGLS Inc. Consolidated Statements of Operations for the three months ended
         March 31, 1998 and March 31, 1997.............................................................       5

   Brooke Group Ltd. Consolidated Statement of Stockholders' Equity (Deficit) for the three
         months ended March 31, 1998...................................................................       6

   BGLS Inc. Consolidated Statement of Stockholder's Equity (Deficit) for the three months
         ended March 31, 1998..........................................................................       7

   Brooke Group Ltd. Consolidated Statements of Cash Flows for the three months ended
         March 31, 1998 and March 31, 1997.............................................................       8

   BGLS Inc. Consolidated Statements of Cash Flows for the three months ended
         March 31, 1998 and March 31, 1997.............................................................       9

   Notes to Consolidated Financial Statements..........................................................      10

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.........      35

PART II.     OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS..............................................................................      47

Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS......................................................      47

Item 3. DEFAULTS UPON SENIOR SECURITIES................................................................      47

Item 6. EXHIBITS AND REPORTS ON FORM 8-K...............................................................      48

SIGNATURES                                                                                                   49

</TABLE>

                                      -1-
<PAGE>   3

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS

                       BROOKE GROUP LTD. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                               March 31,       December 31,
                                                                                 1998              1997
                                                                            ----------------   ------------
<S>                                                                           <C>              <C>      
ASSETS:

Current assets:
  Cash and cash equivalents.............................................      $   4,577        $   4,754
  Accounts receivable - trade...........................................          8,994           10,462
  Other receivables.....................................................          1,589            1,239
  Receivables from affiliates...........................................          3,253            1,978
  Inventories...........................................................         47,697           39,312
  Other current assets..................................................          6,297           10,240
                                                                              ---------         ---------
    Total current assets................................................         72,407           67,985

Property, plant and equipment, at cost, less accumulated
  depreciation of $31,635 and $33,187...................................         47,583           45,943
Intangible assets, at cost, less accumulated amortization
  of $19,639 and $19,302................................................          2,203            2,610
Other assets............................................................         12,240            9,922
                                                                              ---------        ----------
    Total assets........................................................      $ 134,433        $ 126,460
                                                                              =========        =========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt...................      $ 178,661        $   6,429
  Accounts payable......................................................         15,925           10,461
  Due to affiliates.....................................................          4,965            1,226
  Cash overdraft........................................................            937              945
  Accrued promotional expenses..........................................         24,815           26,993
  Accrued taxes payable.................................................         18,222           19,998
  Accrued interest......................................................          9,782           39,782
  Other accrued liabilities.............................................         32,258           34,670
                                                                              ---------        ----------
    Total current liabilities...........................................        285,565          140,504

Notes payable, long-term debt and other obligations, less current
  portion...............................................................        226,724          399,835
Noncurrent employee benefits............................................         29,364           29,366
Other liabilities.......................................................         56,532           45,152

Commitments and contingencies...........................................

Stockholders' equity (deficit):
  Preferred Stock, par value $1.00 per share, authorized
    10,000,000 shares...................................................
  Series G Preferred Stock, 2,184,834 shares, convertible, participating,
    cumulative, each share convertible to 1,000 shares of common stock
    and cash or stock distribution, liquidation preference of $1.00 per
    share...............................................................
  Common stock, par value $0.10 per share, authorized 40,000,000 shares,
    issued 26,498,043 and 24,998,043 shares, outstanding
    20,348,498 and 18,097,096 shares....................................          2,035            1,850
  Additional paid-in capital............................................        122,694           88,290
  Deficit...............................................................       (556,313)        (538,791)
  Accumulated other comprehensive income................................         (1,022)          (5,607)
  Less: 6,149,545 and 6,900,947 shares of common stock in treasury, at        
    cost................................................................        (31,146)         (34,139)
                                                                              ---------        ----------
      Total stockholders' equity (deficit)..............................       (463,752)        (488,397)
                                                                              ---------        ----------
      Total liabilities and stockholders' equity (deficit)..............      $ 134,433        $ 126,460
                                                                              =========        =========
</TABLE>

                  The accompanying notes are an integral part
                   of the consolidated financial statements.


                                      -2-
<PAGE>   4


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

                           BGLS INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                   March 31,        December 31,
                                                                                      1998              1997

                                                                                ----------------- ------------------
<S>                                                                               <C>               <C> 
ASSETS:

Current assets:
  Cash and cash equivalents.................................................       $   4,539         $   4,754
  Accounts receivable - trade...............................................           8,994            10,462
  Other receivables.........................................................           1,548             1,191
  Receivables from affiliates...............................................                             1,603
  Inventories...............................................................          47,697            39,312
  Other current assets......................................................           6,220            10,044
                                                                                   ---------         ---------
      Total current assets..................................................          68,998            67,366

Property, plant and equipment, at cost, less accumulated depreciation of
  $31,172 and $32,760.......................................................          47,451            45,775
Intangible assets, at cost, less accumulated amortization of $19,639 and        
  $19,302...................................................................           2,203

Investment in affiliate.....................................................                             2,610
Other assets................................................................          13,832            13,165
                                                                                   ---------         ---------
      Total assets..........................................................       $ 132,484         $ 128,916
                                                                                   =========         =========

LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt.......................        $178,622        $    6,212
  Accounts payable..........................................................          15,178            10,336
  Cash overdraft............................................................             937               891
  Due to parent.............................................................          34,017            22,951
  Accrued promotional expenses..............................................          24,815            26,993
  Accrued taxes payable.....................................................          18,222            19,998
  Accrued interest..........................................................           9,782            39,782
  Other accrued liabilities.................................................          31,806            34,312
                                                                                   ---------         ---------
      Total current liabilities.............................................         313,379           161,475

Notes payable, long-term debt and other obligations, less current portion...         226,724           399,835
Noncurrent employee benefits................................................          29,364            29,366
Other liabilities...........................................................          62,733            51,355

Commitments and contingencies...............................................

Stockholder's equity (deficit):
  Common stock, par value $0.01 per share; authorized 100 shares,
    issued 100 shares, outstanding 100 shares...............................
  Additional paid-in capital................................................          66,475            39,081
  Deficit...................................................................        (568,521)         (550,339)
  Accumulated other comprehensive income....................................           2,330            (1,857)
                                                                                   ---------         ---------
      Total stockholder's deficit...........................................        (499,716)         (513,115)
                                                                                   ---------         ---------

      Total liabilities and stockholder's equity (deficit)..................       $ 132,484         $ 128,916
                                                                                   =========         =========
</TABLE>


                  The accompanying notes are an integral part
                   of the consolidated financial statements.



                                      -3-
<PAGE>   5


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

                       BROOKE GROUP LTD. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                       Three Months Ended
                                                                                ----------------------------------
                                                                                   March 31,         March 31,
                                                                                      1998             1997
                                                                                ----------------- ----------------

<S>                                                                                  <C>               <C>    
Revenues*..................................................................          $ 84,803          $ 80,005
Cost of goods sold*........................................................            41,656            41,845
                                                                                     --------          --------

Gross profit...............................................................            43,147            38,160
Operating, selling, administrative and general expenses....................            35,604            37,322
                                                                                     --------          --------

Operating income...........................................................             7,543               838

Other income (expenses):

    Interest income........................................................                65               559
    Interest expense.......................................................           (20,786)          (15,467)
    Equity in loss of affiliate............................................            (4,187)           (8,194)
    Sale of assets.........................................................               850            22,021
    Retirement of debt.....................................................                               2,963
    Proceeds from legal settlement.........................................                               4,125
    Other, net.............................................................                81               119
                                                                                     --------          --------

(Loss) income before income taxes..........................................           (16,434)            6,964
Provision for income taxes.................................................               931               744
                                                                                     --------          --------

Net (loss) income..........................................................          $(17,365)         $  6,220
                                                                                     ========          ========


Basic and diluted common share data:

    Net (loss) income applicable to common shares..........................            $(0.89)            $0.34
                                                                                       ======             =====

Weighted average common shares outstanding.................................        19,465,056        18,385,985
                                                                                   ==========        ==========
</TABLE>

---------------------


* Revenues and Cost of goods sold include federal excise taxes of $17,918
  and $19,135 for the periods ended March 31, 1998 and 1997, respectively.





                  The accompanying notes are an integral part
                   of the consolidated financial statements.



                                      -4-
<PAGE>   6


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

                           BGLS INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                       Three Months Ended
                                                                                ----------------------------------
                                                                                   March 31,         March 31,
                                                                                      1998             1997
                                                                                ----------------- ----------------

<S>                                                                                  <C>                <C>    
Revenues*...................................................................         $ 84,803           $80,005
Cost of goods sold*.........................................................           41,656            41,845
                                                                                     --------           -------

Gross profit................................................................           43,147            38,160
Operating, selling, administrative and general expenses.....................           35,371            37,076
                                                                                     --------           -------
Operating income............................................................            7,776             1,084

Other income (expenses):

   Interest income..........................................................               56               559
   Interest expense.........................................................          (21,824)          (16,381)
   Equity in loss of affiliate..............................................           (4,187)           (8,194)
   Sale of assets...........................................................              850            26,384
   Retirement of debt.......................................................                              2,963
   Other, net...............................................................               78               112
                                                                                     --------           -------

(Loss) income before income taxes...........................................          (17,251)            6,527
Provision for income taxes..................................................              931               742
                                                                                     --------           -------
Net (loss) income...........................................................         $(18,182)          $ 5,785
                                                                                     ========           =======

</TABLE>

---------------------

* Revenues and Cost of goods sold include federal excise taxes of $17,918
  and $19,135 for the periods ended March 31, 1998 and 1997, respectively.




                  The accompanying notes are an integral part
                   of the consolidated financial statements.




                                      -5-
<PAGE>   7

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

                       BROOKE GROUP LTD. AND SUBSIDIARIES
            CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                                                                        
                                                                                                             Accumulated 
                                                           Common Stock                                        Other          
                                                       -------------------   Paid-in               Treasury Comprehensive    
                                                         Shares     Amount   Capital    Deficit      Stock     Income     Total
                                                       ----------   ------   -------   ---------   ---------  ---------  --------

<S>                                                    <C>          <C>      <C>       <C>         <C>        <C>        <C>       
Balance, December 31, 1997..........................   18,097,096   $1,850   $ 88,290  $(538,791)  $(34,139)  $ (5,607)  $(488,397)

Net income..........................................                                     (17,365)                          (17,365)

Issuance of warrants................................                           22,421                                       22,421

Issuance of common stock............................    1,500,000      150     11,342                                       11,492

Effectiveness fee on debt...........................                            2,442                 1,663                  4,105

Issuance of treasury stock..........................      751,402       35       (341)      (157)     1,330                    867

Distributions on common stock ($0.075 per share)....                           (1,460)                                      (1,460)

Amortization of deferred compensation...............                                                               399         399

Unrealized holding gain on investment in New Valley.                                                             3,110       3,110

Effect of New Valley capital transactions...........                                                             1,076       1,076
                                                       ----------   ------   --------  ----------  --------    -------   ----------

Balance, March 31, 1998.............................   20,348,498   $2,035   $122,694  $(556,313)  $(31,146)   $(1,022)  $(463,752)
                                                       ==========   ======   ========  =========   ========    =======   =========
</TABLE>



                  The accompanying notes are an integral part
                   of the consolidated financial statements.




                                      -6-
<PAGE>   8

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

                           BGLS INC. AND SUBSIDIARIES
            CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY (DEFICIT)
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                                                            Accumulated  
                                                                    Common Stock     Additional                Other    
                                                                  -----------------    Paid-In             Comprehensive
                                                                  Shares     Amount    Capital    Deficit     Income       Total
                                                                  ------     ------    -------    -------     ------    ----------

<S>                                                                <C>                 <C>       <C>          <C>       <C>       
Balance, December 31, 1997.................................        100                 $39,081   $(550,339)   $(1,856)  $(513,114)

Net income.................................................                                        (18,182)               (18,182)

Effectiveness fee on debt..................................                              2,442                              2,442

Issuance of warrants.......................................                             22,421                             22,421

Amortization of deferred compensation......................

Payment of interest by parent..............................                              2,531                              2,531

Unrealized holding gain on investment in New Valley........                                                     3,110       3,110

Effect of New Valley capital transactions..................                                                     1,076       1,076
                                                                   ---        -----    -------   ---------    -------   ---------
Balance, March 31, 1998....................................        100                 $66,475   $(568,521)   $ 2,330   $(499,716)
                                                                   ---        -----    -------   ---------    -------   ---------
</TABLE>


                  The accompanying notes are an integral part
                   of the consolidated financial statements.




                                      -7-
<PAGE>   9


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

                       BROOKE GROUP LTD. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                       Three Months Ended
                                                                                ----------------------------------
                                                                                   March 31,         March 31,
                                                                                      1998             1997
                                                                                ----------------- ----------------

<S>                                                                                <C>               <C>      
Net cash used in operating activities.......................................       $(25,984)         $(26,619)
                                                                                   --------          --------

Cash flows from investing activities:

  Proceeds from sale of businesses and assets, net..........................          1,217            21,906
  Capital expenditures......................................................           (395)           (1,307)
                                                                                   --------          --------
Net cash provided by investing activities...................................            822            20,599
                                                                                   --------          --------

Cash flows from financing activities:
  Proceeds from debt........................................................                            3,000
  Repayments of debt........................................................           (102)           (6,050)
  Borrowings under revolver.................................................         63,961            81,291
  Repayments on revolver....................................................        (58,799)          (69,224)
  Decrease in cash overdraft................................................            (45)               (6)
  Distributions on common stock.............................................           (900)           (2,745)
  Proceeds from participating loan..........................................         11,000
  Issuance of common stock..................................................          9,796
                                                                                   --------          --------

Net cash provided by financing activities...................................         24,911             6,266
                                                                                   --------          --------

Effect of exchange rate changes on cash and cash equivalents................             79
Net increase in cash and cash equivalents...................................           (172)              246
Cash and cash equivalents, beginning of period..............................          4,749             1,941
                                                                                   --------          --------

Cash and cash equivalents, end of period....................................       $  4,577          $  2,187
                                                                                   ========          ========


Supplemental non-cash financing activities:

  Issuance of stock to Liggett bondholders..................................       $  4,105
  Issuance of warrants......................................................         22,422

</TABLE>



                  The accompanying notes are an integral part
                   of the consolidated financial statements.



                                      -8-

<PAGE>   10


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

                           BGLS INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                       Three Months Ended
                                                                                ----------------- ----------------
                                                                                   March 31,         March 31,
                                                                                      1998             1997
                                                                                ----------------- ----------------

<S>                                                                                 <C>               <C>      
Net cash used in operating activities.......................................        $(17,218)         $(30,609)
                                                                                    --------            ------
Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net..........................           1,217            21,906
  Capital expenditures......................................................            (395)           (1,307)
                                                                                    --------            ------
Net cash provided by investing activities...................................             822            20,599
                                                                                    --------            ------
Cash flows from financing activities:
  Proceeds from debt........................................................                             3,000
  Repayments of debt........................................................            (102)           (4,873)
  Borrowings under revolver.................................................          63,961            81,291
  Repayments on revolver....................................................         (58,799)          (69,224)
  Increase (decrease) in cash overdraft.....................................              47                (6)
  Proceeds from participating loan..........................................          11,000
                                                                                    --------            ------

Net cash provided by financing activities...................................          16,107            10,188
                                                                                    --------            ------

Effect of exchange rate changes on cash and cash equivalents................              79
Net (decrease) increase in cash and cash equivalents........................            (210)              178
Cash and cash equivalents, beginning of period..............................           4,749             1,940
                                                                                    --------            ------

Cash and cash equivalents, end of period....................................        $  4,539          $  2,118
                                                                                     =======           =======



Supplemental non-cash financing activities:

  Issuance of stock to Liggett bondholders..................................        $  4,105
  Issuance of warrants......................................................          22,422

</TABLE>



                  The accompanying notes are an integral part
                   of the consolidated financial statements.




                                      -9-
<PAGE>   11
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

1.    PRINCIPLES OF REPORTING

      The consolidated financial statements of Brooke Group Ltd. (the "Company")
      include the consolidated statements of its wholly owned subsidiary, BGLS
      Inc. ("BGLS"). The consolidated statements of BGLS include the accounts of
      Liggett Group Inc. ("Liggett"), Brooke (Overseas) Ltd. ("BOL"), New Valley
      Holdings, Inc. ("NV Holdings"), Liggett-Ducat Ltd. ("Liggett-Ducat") and
      other less significant subsidiaries. Liggett is engaged primarily in the
      manufacture and sale of cigarettes, principally in the United States.
      Liggett-Ducat is engaged in the manufacture and sale of cigarettes in
      Russia. All significant intercompany balances and transactions have been
      eliminated.

      The interim consolidated financial statements of the Company and BGLS are
      unaudited and, in the opinion of management, reflect all adjustments
      necessary (which are normal and recurring) to present fairly the Company's
      and BGLS' consolidated financial position, results of operations and cash
      flows. These consolidated financial statements should be read in
      conjunction with the consolidated financial statements and the notes
      thereto included in the Company's and BGLS' Annual Report on Form 10-K, as
      amended, for the year ended December 31, 1997, as filed with the
      Securities and Exchange Commission. The consolidated results of operations
      for interim periods should not be regarded as necessarily indicative of
      the results that may be expected for the entire year.

      The preparation of financial statements in conformity with generally
      accepted accounting principles requires management to make estimates and
      assumptions that affect the reported amounts of assets and liabilities and
      disclosure of contingent assets and liabilities and the reported amounts
      of revenues and expenses. Actual results could differ from those
      estimates.

      Certain amounts in the 1997 consolidated financial statements have been
      reclassified to conform to the 1998 presentation.

      LIQUIDITY:

      During the year ended December 31, 1997, the Company relied primarily on
      proceeds received on the sale of its indirect subsidiary, BrookeMil Ltd.
      ("BML"), to New Valley to meet its liquidity needs.

      The Company's sources of liquidity for 1998 include, among other things,
      additional public and/or private debt and equity financing, management
      fees and certain funds available from New Valley subject to limitations
      imposed by BGLS' indenture agreements. New Valley may acquire or seek to
      acquire additional operating businesses through merger, purchase of
      assets, stock acquisition or other means, or to make other investments,
      which may limit its ability to make such distributions. New Valley's
      ability to make such distributions is subject to risk and uncertainties
      attendant to its business. (Refer to Note 2.)

      On January 30, 1998, Liggett obtained the consents of the required
      majority of the holders of Liggett's 11.50% Series B and 19.75% Series C
      Senior Secured Notes due 1999 (the "Liggett Notes") to various amendments
      to the Indenture governing the Liggett Notes. The amendments provided,
      among other things, for a deferral of the February 1, 1998 mandatory
      redemption of $37,500 principal amount of the Liggett Notes to the date of
      final maturity, February 1, 1999. (Refer to Note 6.) At maturity, the
      Liggett Notes will require a principal payment of $144,892. Liggett does
      not anticipate it 




                                      -10-

<PAGE>   12

                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      will be able to generate sufficient cash from operations to make such
      payments. In addition, Liggett has a $40,000 revolving credit facility
      expiring March 8, 1999 (the "Facility"), under which $28,628 was
      outstanding at March 31, 1998. Accordingly, the Liggett Notes and the
      balance of the Facility have been reclassified to current liabilities as
      of March 31, 1998. As of March 31, 1998, Liggett had net capital and
      working capital deficiencies of $190,383 and $182,312, respectively. The
      current maturities of the Liggett Notes and the Facility of approximately
      $174,000 contribute substantially to the working capital deficiency. If
      Liggett is unable to refinance or restructure the terms of the Liggett
      Notes or otherwise make all payments thereon, substantially all of the
      Liggett Notes and the Facility would be in default and holders of such
      debt could accelerate the maturity of such debt. In such event, Liggett
      may be forced to seek protection from creditors under applicable laws. Due
      to the many risks and uncertainties associated with the cigarette industry
      and the impact of tobacco litigation, there can be no assurance that
      Liggett will be able to meet its future earnings or cash flow goals. These
      matters raise substantial doubt about Liggett meeting its liquidity needs
      and its ability to continue as a going concern and may negatively impact
      the Company's liquidity.

      The Company has also engaged in negotiations with the principal holders of
      the BGLS 15.75% Series B Senior Secured Notes (the "BGLS Notes") with
      respect to certain modifications to the terms of such debt. On March 2,
      1998, BGLS entered into an agreement with AIF II, L.P. and an affiliated
      investment manager on behalf of a managed account (together, "the Apollo
      Holders"), who hold approximately 41.8% of the $232,864 principal amount
      of the BGLS Notes. Pursuant to the terms of the agreement, the Apollo
      Holders have agreed to defer the payment of interest on the BGLS Notes
      held by them, commencing with the interest payment that was due July 31,
      1997, which they had previously agreed to defer, through the interest
      payment due July 31, 2000. The deferred interest payments will be payable
      at final maturity of the BGLS Notes on January 31, 2001 or upon an event
      of default under the Indenture for the BGLS Notes. (Refer to Note 6.)

      BOL is in the process of constructing a new tobacco factory in Moscow,
      Russia currently scheduled to be operational in early 1999. The remaining
      construction costs and equipment required for the new factory will be
      financed primarily by equipment lease financing currently in place and
      bank or other loans. (Refer to Notes 2 and 3.)

      NEW ACCOUNTING PRONOUNCEMENTS

      In June 1997, the Financial Accounting Standards Board (the "FASB") issued
      Statement on Financial Accounting Standards ("SFAS") No. 130, "Reporting
      Comprehensive Income". SFAS No. 130 establishes standards for reporting
      and display of comprehensive income. The purpose of reporting
      comprehensive income is to present a measure of all changes in equity that
      result from recognized transactions and other economic events of the
      period other than transactions with owners in their capacity as owners.
      SFAS No. 130 requires that an enterprise classify items of other
      comprehensive income by their nature in a financial statement and display
      the accumulated balance of other comprehensive income separately from
      retained earnings and additional paid-in capital in the equity section of
      the balance sheet. For the Company, other components of stockholders'
      equity include such items as minimum pension liability adjustments,
      unearned compensation expense related to stock options and the Company's
      proportionate interest in New Valley's capital transactions. SFAS No. 130
      is effective for fiscal years beginning after December 15, 1997. The
      implementation of SFAS No. 130 for the quarter ended March 31, 1998 did
      not have any material effect on the consolidated financial statements.





                                      -11-
<PAGE>   13
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
      an Enterprise and Related Information". SFAS No. 131 specifies revised
      guidelines for determining an entity's operating segments and the type and
      level of financial information to be disclosed. SFAS No. 131 provides for
      a two-tier test for determining those operating segments that would need
      to be disclosed for external reporting purposes. In addition to providing
      the required disclosures for reportable segments, SFAS No. 131 also
      requires disclosure of certain "second level" information by geographic
      area and for products/services. SFAS No. 131 also makes a number of
      changes to existing disclosure requirements. Management believes that the
      adoption of this pronouncement will not have a material effect on the
      Company's financial statement disclosures. SFAS No. 131 initially is
      effective for annual financial statements for fiscal years beginning after
      December 15, 1997.

      In February 1998, SFAS No. 132, "Employers' Disclosures about Pensions and
      Other Postretirement Benefits," was issued which revises required
      disclosures about pensions and postretirement benefit plans in order to
      facilitate financial analysis. Recognition or measurement issues are not
      addressed in the statement. SFAS No. 132 is effective for the Company for
      the year ended 1998. Management believes that the adoption of this
      pronouncement will not have a material effect on the Company's financial
      statement disclosures.

2.    INVESTMENT IN NEW VALLEY CORPORATION

      At March 31, 1998 and December 31, 1997, the Company's investment in New
      Valley consisted of an approximate 42% voting interest. At March 31, 1998
      and December 31, 1997, the Company owned 57.7% of the outstanding $15.00
      Class A Increasing Rate Cumulative Senior Preferred Shares ($100
      Liquidation Value), $.01 par value (the "Class A Preferred Shares"), 9.0%
      of the outstanding $3.00 Class B Cumulative Convertible Preferred Shares
      ($25 Liquidation Value), $.10 par value (the "Class B Preferred Shares")
      and 41.7% of New Valley's common shares, $.01 par value (the "Common
      Shares").

      The Class A Preferred Shares and the Class B Preferred Shares are
      accounted for as debt and equity securities, respectively, pursuant to the
      requirements of SFAS No. 115, "Accounting for Certain Investments in Debt
      and Equity Securities", and are classified as available-for-sale. The
      Common Shares are accounted for pursuant to APB No. 18, "The Equity Method
      of Accounting for Investments in Common Stock".

      The Company determines the fair value of the Class A Preferred Shares and
      Class B Preferred Shares based on the quoted market price. Through
      September 1996, earnings on the Class A Preferred Shares were comprised of
      dividends accrued during the period and the accretion of the difference
      between the Company's basis and their mandatory redemption price. During
      the quarter ended September 30, 1996, the decline in the market value of
      the Class A Preferred Shares, the dividend received on the Class A
      Preferred Shares and the Company's equity in losses incurred by New Valley
      caused the carrying value of the Company's investment in New Valley to be
      reduced to zero. Beginning in the fourth quarter of 1996, the Company
      suspended the recording of its earnings on the dividends accrued and the
      accretion of the difference between the Company's basis in the Class A
      Preferred Shares and their mandatory redemption price.




                                      -12-
<PAGE>   14
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      The Company's and BGLS' investment in New Valley at March 31, 1998 is
summarized below:

<TABLE>
<CAPTION>

                                                                                      UNREALIZED
                                        NUMBER OF          FAIR        CARRYING         HOLDING
                                          SHARES          VALUE         AMOUNT        GAIN (LOSS)
                                        ---------        -------       --------       -----------
<S>                                        <C>           <C>             <C>             <C>     
   Class A Preferred Shares.......         618,326       $58,277        $ 58,277        $(1,082)
   Class B Preferred Shares.......         250,885         1,505           1,505           (349)
   Common Shares..................       3,989,710         3,740         (59,782)
                                                         -------        --------        -------
                                                         $63,522        $               $(1,431)
                                                         =======        ========        =======
</TABLE>


      In November 1994, New Valley's First Amended Joint Chapter 11 Plan of
      Reorganization, as amended ("Joint Plan"), was confirmed by order of the
      United States Bankruptcy Court for the District of New Jersey and on
      January 18, 1995, New Valley emerged from bankruptcy reorganization
      proceedings and completed substantially all distributions to creditors
      under the Joint Plan. Pursuant to the Joint Plan, among other things, the
      Class A Preferred Shares, the Class B Preferred Shares, the Common Shares
      and other equity interests were reinstated and retained all of their
      legal, equitable and contractual rights.

      The Class A Preferred Shares of New Valley are required to be redeemed on
      January 1, 2003 for $100.00 per share plus dividends accrued to the
      redemption date. The shares are redeemable, at any time, at the option of
      New Valley, at $100.00 per share plus accrued dividends. The holders of
      Class A Preferred Shares are entitled to receive a quarterly dividend, as
      declared by the Board of Directors, payable at the rate of $19.00 per
      annum. At March 31, 1998, the accrued and unpaid dividends arrearage was
      $176,161 ($164.41 per share).

      Holders of the Class B Preferred Shares are entitled to receive a
      quarterly dividend, as declared by the Board, at a rate of $3.00 per
      annum. At March 31, 1998, the accrued and unpaid dividends arrearage was
      $145,671 ($52.20 per share). No dividends on the Class B Preferred Shares
      have been declared since the fourth quarter of 1988.

      Summarized financial information for New Valley as of March 31, 1998 and
      December 31, 1997 and for the three months ended March 31, 1998 and 1997
      follows:

<TABLE>
<CAPTION>
                                                         March 31,          December 31,
                                                            1998                1997
                                                     ------------------- --------------------

<S>                                                       <C>                 <C>      
Current assets, primarily cash and marketable
   securities...................................          $114,991            $ 118,642
Non-current assets..............................           288,248              322,749
Current liabilities.............................           113,710              128,128
Non-current liabilities.........................           163,122              185,024
Redeemable preferred stock......................           271,924              258,638
Shareholders' deficit...........................          (145,517)            (130,399)

</TABLE>

                                      -13-
<PAGE>   15

                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)

<TABLE>
<CAPTION>

                                                                    March 31,
                                                     ----------------------------------------
                                                           1998                1997
                                                     ------------------- --------------------

<S>                                                        <C>                 <C>    
Revenues   .....................................           $33,840             $22,853
Costs and expenses..............................            34,260              33,604
Net income (loss)...............................               157             (10,341)
Net loss applicable to common shares(A).........           (18,675)            (26,321)
</TABLE>
-------------------

          (A) Considers all preferred accrued dividends, whether or not
              declared.

      On January 31, 1997, New Valley acquired substantially all the common
      shares of BML from BOL for $55,000. (Refer to Note 3.)

      On February 20, 1998, New Valley and Apollo Real Estate Investment Fund
      III, L.P. ("Apollo") organized Western Realty Development LLC ("Western
      Realty") to make real estate and other investments in Russia. In
      connection with the formation of Western Realty, New Valley agreed, among
      other things, to contribute to Western Realty the real estate assets of
      its subsidiary BML and Apollo agreed to contribute up to $58,000.

      Under the terms of the agreement governing Western Realty (the "LLC
      Agreement"), the ownership and voting interests in Western Realty are held
      equally by Apollo and New Valley. Apollo is entitled to a preference on
      distributions of cash from Western Realty to the extent of its investment,
      together with a 15% annual rate of return, and New Valley is then entitled
      to a return of $10,000 of BML-related expenses incurred by New Valley
      since March 1, 1997, together with a 15% annual rate of return; subsequent
      distributions will be made 70% to New Valley and 30% to Apollo. Western
      Realty is managed by a Board of Managers consisting of an equal number of
      representatives chosen by Apollo and New Valley. All material corporate
      transactions by Western Realty generally require the unanimous consent of
      the Board of Managers. Accordingly, New Valley accounts for its
      non-controlling interests in Western Realty on the equity method.

      The organization of Western Realty was effected pursuant to the LLC
      Agreement. In 1996, New Valley acquired from an affiliate of Apollo eight
      shopping centers for $72,500. New Valley and pension plans sponsored by
      BGLS have invested in investment partnerships managed by an affiliate of
      Apollo. Apollo's affiliate owns a substantial amount of debt securities of
      BGLS and warrants to purchase common stock of the Company.

      On February 27, 1998, at an initial closing under the LLC Agreement,
      Apollo made an $11,000 loan (the "Loan") to Western Realty. The Loan,
      which bore interest at the rate of 15% per annum and was due September 30,
      1998, was collateralized by a pledge of New Valley's shares of BML. On
      April 28, 1998, the Loan and the accrued interest thereon were converted
      into a capital contribution by Apollo to Western Realty and the BML pledge
      released.

      New Valley recorded its basis in the investment in Western Realty in the
      amount of $59,669 based on the carrying value of assets less liabilities
      transferred. There was no difference between the carrying value of the
      investment and New Valley's proportionate interest in the underlying value
      of net assets of Western Realty.

      Western Realty will seek to make additional real estate and other
      investments in Russia. New Valley and Apollo have agreed to invest,
      through Western Realty or another entity, up to $25,000 in the aggregate
      for the potential development of a real estate project in Moscow. In
      addition, Western Realty has made a $20,000 participating loan to, and
      payable out of a 30% profits interest in, a 




                                      -14-
<PAGE>   16
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      company organized by BOL which, among other things, acquired an interest
      in a new factory being constructed on the outskirts of Moscow by a
      subsidiary of BOL. (Refer to Note 3.)

3.    INVESTMENT IN BROOKE (OVERSEAS) LTD.

      At March 31, 1998, BOL owned approximately 96% of the stock of
      Liggett-Ducat including shares of such stock acquired from Liggett in
      connection with Liggett's debt restructuring (refer to Note 6) and
      purchases of stock from other shareholders.

      Liggett-Ducat is in the process of constructing a new cigarette factory on
      the outskirts of Moscow which is currently scheduled to be operational in
      early 1999. Liggett-Ducat has entered into a construction contract for the
      plant. The remaining liability under that contract, as amended, at March
      31, 1998 is approximately $16,000. Equipment purchase agreements in place
      at March 31, 1998 total $34,355, of which $28,791 will be financed by the
      manufacturers.

      In April, 1998, Western Realty completed making a $20,000 participating
      loan to a company (the "Borrower") organized by BOL which holds BOL's
      interests in Liggett-Ducat and the industrial site and manufacturing
      facility being constructed by Liggett-Ducat on the outskirts of Moscow.
      The loan, which bears no fixed interest, is payable only out of 30% of
      distributions, if any, made by the Borrower to BOL. After the prior
      payment of debt service on loans to finance the construction of the new
      facility, 30% of distributions from the Borrower to BOL will be applied
      first to pay the principal of the loan and then as contingent
      participating interest on the loan. Any rights of payment on the loan are
      subordinate to the rights of all other creditors of the Borrower. An
      initial $11,000 was funded in February 1998, and is classified in other
      long-term liabilities on the consolidated balance sheet at March 31, 1998.
      (Refer to Note 2.)

      The performance of Liggett-Ducat's cigarette operations in Russia is
      affected by uncertainties in Russia which may include, among others,
      political or diplomatic developments, regional tensions, currency
      repatriation restrictions, foreign exchange fluctuations, inflation, and
      an undeveloped system of commercial laws and legislative reform relating
      to foreign ownership in Russia.

      On January 31, 1997, BOL sold all its shares of BML to New Valley for
      $21,500 in cash and a promissory note of $33,500 payable $21,500 on June
      30, 1997 and $12,000 on December 31, 1997 with interest at 9%. The note
      was paid in full as of December 31, 1997. The consideration received
      exceeded the carrying value of its investment in BML by $43,700. The
      Company recognized a gain on the sale in 1997 in the amount of $21,300.
      The remaining $22,400 was deferred in recognition of the fact that the
      Company retains an interest in BML through its 42% equity ownership in New
      Valley and that a portion of the property sold (the site of the third
      phase of the Ducat Place real estate project being developed by BML, which
      is currently used by Liggett-Ducat for its existing cigarette factory), is
      subject to a put option held by New Valley. The option allows New Valley
      to put this site back to the Company at the greater of the appraised fair
      market value of the property at the date of exercise or $13,600, during 
      the period Liggett-Ducat operates the factory on such site.




                                      -15-
<PAGE>   17
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


4.    INVENTORIES

      Inventories consist of:
<TABLE>
<CAPTION>

                                                          March 31,        December 31,
                                                            1998               1997
                                                      ------------------ ------------------

<S>                                                          <C>              <C>    
Finished goods...................................            $17,400          $13,273
Work-in-process..................................              2,456            1,976
Raw materials....................................             27,383           24,495
Replacement parts and supplies...................              4,425            4,466
                                                             -------          -------
Inventories at current cost......................             51,664           44,210
LIFO adjustments.................................             (3,967)          (4,898)
                                                             -------          -------
                                                             $47,697          $39,312
                                                             =======          =======
</TABLE>

      At March 31, 1998, Liggett and Liggett-Ducat had leaf tobacco purchase
commitments of approximately $8,714 and $14,200, respectively.

5.    PROPERTY, PLANT AND EQUIPMENT

      Property, plant and equipment consist of:
<TABLE>
<CAPTION>

                                                          March 31,        December 31,
                                                            1998               1997
                                                      ------------------ ------------------

<S>                                                      <C>                <C>       
Land and improvements............................          $    411            $   411
Buildings........................................             6,521              6,521
Machinery and equipment..........................            53,783             53,717
Leasehold improvements...........................               302                302
Construction-in-progress.........................            18,201             18,179
                                                           --------           --------
                                                             79,218             79,130
Less accumulated depreciation....................           (31,635)           (33,187)
                                                           --------           --------
                                                           $ 47,583           $ 45,943
                                                           ========           ========
</TABLE>




                                      -16-

<PAGE>   18
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


6.    NOTES PAYABLE, LONG-TERM DEBT AND OTHER OBLIGATIONS

      Notes payable, long-term debt and other obligations consist of:

<TABLE>
<CAPTION>
                                                                           March 31,        December 31,
                                                                             1998              1997
                                                                       ----------------- -----------------

<S>                                                                         <C>               <C>  
         15.75% Series B Senior Secured Notes due 2001,
             net of unamortized discount of $22,940 and $1,511.....         $209,924          $231,723
         Deferred interest on 15.75% Series B Senior Secured
             Notes due 2001........................................           16,000
         14.500% Subordinated Debentures due 1998..................              800               800
         Notes payable - Foreign...................................            5,000             5,000
         Other.....................................................              300               629

         Liggett:
         11.500% Senior Secured Series B Notes due 1999, net of
             unamortized discount of $159 and $206.................          112,454           112,406
         Variable Rate Series C Senior Secured Notes due 1999......           32,279            32,279
         Revolving credit facility.................................           28,628            23,427
                                                                            --------          --------
         Total notes payable, long-term debt and 
             other obligations.....................................          405,385           406,264

         Less:
             Current maturities....................................          178,661             6,429
                                                                            --------          --------
         Amount due after one year.................................         $226,724          $399,835
                                                                            ========          ========

</TABLE>

      The 14.500% Subordinated Debentures due 1998 in principal amount of $800
      were paid at maturity on April 1, 1998.

      STANDSTILL AGREEMENT - BGLS:

      During negotiations with the holders of more than 83% of the BGLS Notes
      concerning certain modifications to the terms of such debt, BGLS entered
      into a standstill agreement with such holders on August 28, 1997. Pursuant
      to the standstill agreement, as amended, such holders agreed that they
      would be entitled to receive their portion of the July 31, 1997 interest
      payment on the BGLS Notes (in total, $15,340) only after giving BGLS 20
      days' notice but in any event by February 6, 1998.

      On February 6, 1998, BGLS entered into a further amendment to the
      standstill agreement with the Apollo Holders who hold approximately 41.8%
      of the BGLS Notes which extended the termination date of such agreement
      with respect to the Apollo Holders to March 2, 1998. Also on February 6,
      1998, the holder of 41.9% of the BGLS Notes, who had previously been a
      party to the standstill agreement, was paid its pro rata share of the July
      31, 1997 interest payment on the BGLS Notes. The Company also sold stock
      on January 16, 1998 to an affiliate of this holder in which it recorded an
      expense of $2,531 for the first quarter 1998, representing the difference
      between the cost and fair market value of the shares sold. (Refer to Note
      7.)

      On March 2, 1998, the Company entered into an agreement with the Apollo
      Holders in which the Apollo Holders agreed to defer the payment of
      interest on the BGLS Notes held by them, commencing with the interest
      payment that was due July 31, 1997, which they had previously agreed to
      defer, through the interest payment due July 31, 2000. The deferred
      interest payments together with interest compounded semi-annually
      thereon, will be 




                                      -17-
<PAGE>   19
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      payable at final maturity of the BGLS Notes on January 31, 2001 or upon an
      event of default under the Indenture for the BGLS Notes. Accordingly,
      accrued interest as of March 2, 1998 was reclassified and included in
      other long-term obligations.

      In connection with the March 2, 1998 agreement with the Apollo Holders,
      the Company issued to the Apollo Holders a five-year warrant to purchase
      2,000,000 shares of the Company's common stock at a price of $5.00 per
      share. The Apollo Holders were also issued a second warrant expiring
      October 31, 2004 to purchase an additional 2,150,000 shares of the
      Company's common stock at a price of $0.10 per share. The second warrant
      will become exercisable on October 31, 1999, and the Company will have the
      right under certain conditions prior to that date to substitute for that
      warrant a new warrant for 9.9% of the common stock of Liggett.

      Based on the fair value of the equity instruments given to the holders of
      the debt, and the difference between the fair value of the modified debt
      and the carrying value of the debt held by the Apollo Holders prior to the
      transaction, no gain or loss was recorded on the transaction. The fair
      value of the equity instruments was estimated based on the Black-Scholes
      option pricing model and the following assumptions; volatility of 77%,
      risk-free interest rate of 6%, expected life of five to seven years and a
      dividend rate of 0%. Imputed interest of approximately $23,000 will be
      accreted over the term of the modified debt based on its recorded fair
      value.

      In connection with the consents of the Liggett bondholders to the
      restructuring of the Liggett Notes, on February 2, 1998, the Company
      issued 483,002 shares of treasury stock to the Liggett bondholders of
      record as of January 15, 1998. (Refer to Note 7.) The Company recorded a
      deferred charge of $4,105 at January 31, 1998 reflecting the fair value of
      the instruments issued. The Company has agreed to use its best efforts to
      file with the Securities and Exchange Commission ("SEC") a shelf
      registration statement on Form S-3 to be declared effective by May 31,
      1998. If the registration statement has not been declared effective by
      such date, liquidated damages on the shares of common stock will accrue at
      the daily rate of $25, provided that the number of days on which damages
      shall accrue shall not exceed 300 days. Liquidated damages would be
      payable, at the option of the Company, in cash or in shares of common
      stock of the Company.

      15.75% SERIES B SENIOR SECURED NOTES DUE 2001

      The Series B Notes are collateralized by substantially all of BGLS'
      assets, including a pledge of BGLS' equity interests in Liggett, BOL and
      NV Holdings as well as a pledge of all of the New Valley securities held
      by BGLS and NV Holdings. The BGLS Series B Notes Indenture contains
      certain covenants, which among other things, limit the ability of BGLS to
      make distributions to the Company to $6,000 per year ($12,000 if less than
      50% of the Series B Notes remain outstanding), limit additional
      indebtedness of BGLS to $10,000, limit guaranties of subsidiary
      indebtedness by BGLS to $50,000, and restrict certain transactions with
      affiliates that exceed $2,000 in any year subject to certain exceptions
      which include payments to the Company not to exceed $6,500 per year for
      permitted operating expenses, payment of the Chairman's salary and bonus
      and certain other expenses, fees and payments. In addition, the Indenture
      contains certain restrictions on the ability of the Chairman and certain
      of his affiliates to enter into certain transactions with, and receive
      payments above specified levels from, New Valley. The Series B Notes may
      be redeemed, in whole or in part, through December 31, 1999, at a price of
      101% of the principal amount and thereafter at 100%. Interest is payable
      at the rate of 15.75% per annum on January 31 and July 31 of each year.




                                      -18-
<PAGE>   20
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      LIGGETT 11.50% SENIOR SECURED SERIES B NOTES DUE 1999:

      On February 14, 1992, Liggett issued $150,000 in Senior Secured Notes (the
      "Liggett Series B Notes"). Interest on the Liggett Series B Notes is
      payable semiannually on February 1 and August 1 at an annual rate of
      11.50%. The Liggett Series B Notes and Series C Notes referred to below
      (collectively, the "Liggett Notes") required mandatory principal
      redemptions of $7,500 on February 1 in each of the years 1993 through 1997
      and $37,500 on February 1, 1998 with the balance of the Liggett Notes due
      on February 1, 1999. In February 1997, $7,500 of Liggett Series B Notes
      were purchased using the Facility and credited against the mandatory
      redemption requirements. The transaction resulted in a net gain of $2,963.
      The Liggett Notes are collateralized by substantially all of the assets of
      Liggett, excluding inventories and receivables. Eve Holdings Inc. is a
      guarantor for the Liggett Notes. The Liggett Notes may be redeemed, in
      whole or in part, at a price equal to 100% of the principal amount at the
      option of Liggett. The Liggett Notes contain restrictions on Liggett's
      ability to declare or pay cash dividends, incur additional debt, grant
      liens and enter into any new agreements with affiliates, among others.

      On January 30, 1998, with the consent of the required majority of the
      holders of the Liggett Notes, Liggett entered into various amendments to
      the Indenture governing the Liggett Notes, which provided, among other
      things, for a deferral of the February 1, 1998 mandatory redemption
      payment of $37,500 to the date of final maturity of the Liggett Notes on
      February 1, 1999. In connection with the deferral, the Company agreed to
      issue 483,002 shares of the Company's common stock to the holders of
      record on January 15, 1998 of the Liggett Notes. As a result of this
      transaction, Liggett recorded a deferred charge of approximately $4,100
      during the first quarter of 1998 reflecting the fair value of the
      instruments issued. This deferred charge is being amortized over a period
      of one year. The Indenture under which the Liggett Notes are outstanding
      was also amended to prohibit, with limited exceptions, payments of
      dividends and incurrence of new debt by Liggett and to tighten
      restrictions on the disposition of proceeds of asset sales. The Company
      and BGLS also agreed to guarantee the payment by Liggett of the August 1,
      1998 interest payment on the Liggett Notes. In addition, Liggett
      Noteholders were granted additional collateral in the form of a security
      interest in 16% of the stock of Liggett-Ducat or a successor entity held
      by BOL.

      On February 1, 1999, all of the Liggett Notes, approximately $144,900,
      will reach maturity. There are no refinancing or restructuring
      arrangements in place at this time for the notes and no assurances can be
      given in this regard. (Refer to Note 1.)

      LIGGETT SERIES C VARIABLE RATE NOTES:

      The Series C Notes have the same terms (other than interest rate, which is
      19.75%) and stated maturity as the Liggett Series B Notes.

      REVOLVING CREDIT FACILITY - LIGGETT:

      On March 8, 1994, Liggett entered into the Facility for $40,000 with a
      syndicate of commercial lenders. The Facility is collateralized by all
      inventories and receivables of Liggett. At March 31, 1998, $1,483 was
      available under the Facility based on eligible collateral. Borrowings
      under the Facility, whose interest is calculated at a rate equal to 1.5%
      above the Philadelphia National Bank's prime rate, bear a rate of 10.0% at
      March 31, 1998. The Facility requires Liggett's compliance with certain
      financial and other covenants, including restrictions on the payment of
      cash dividends and 





                                      -19-
<PAGE>   21
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      distributions by Liggett. In addition, the Facility, as amended April 8,
      1998, imposes requirements with respect to Liggett's permitted maximum
      adjusted net worth (not to fall below $195,000 as computed in accordance
      with the agreement, this computation was $186,416 at March 31, 1998) and
      net working capital deficiencies (not to fall below a default of $17,000
      as computed in accordance with the agreement, this computation was $4,984
      at March 31, 1998). The Facility, as amended, also provides that a default
      by Liggett or its subsidiaries under the March 1996 Settlements, March
      1997 Settlements and March 1998 Settlements (all as defined below in Note
      8) shall constitute an event of default under the Facility. In January
      1997, the Facility was extended for one year and, in November 1997, was
      extended for an additional year until March 8, 1999.

      On August 29, 1997, the Facility was amended to permit Liggett to borrow
      an additional $6,000 which was used on that date in making the interest
      payment of $9,700 due on August 1, 1997 to the holders of the Liggett
      Notes. BGLS guaranteed the additional $6,000 advance under the Facility
      and collateralized the guarantee with $6,000 in cash, deposited with
      Liggett's lender. At March 31, 1998, this amount is classified in other
      assets on the consolidated balance sheet.

      FOREIGN LOANS:

      At March 31, 1998, Liggett-Ducat had two 6-month credit facilities open
      with a Russian bank. The first, for $2,000, which expired and was paid on
      April 30, 1998, initially bore an interest rate of 21%, subsequently
      raised to 28% on December 2, 1997. The second, for $3,000, which expired
      and was paid on May 16, 1998, initially bore an interest rate of 25%,
      subsequently raised to 28% on December 2, 1997. On April 24, 1998,
      Liggett-Ducat opened a credit facility for $2,000 with a Russian bank. The
      facility, with a variable interest rate (currently 27%), expires October
      25, 1998.

7.    EQUITY

      As of January 1, 1998, the Company granted to employees of the Company
      non-qualified stock options to purchase 42,500 shares of the Company's
      common stock at an exercise price of $5.00 per share. The options have a
      ten-year term and vest in six equal annual installments. The Company will
      recognize compensation expense of $154 over the vesting period.

      On January 16, 1998, the Company entered into a Stock Purchase Agreement
      in which High River Limited Partnership purchased 1,500,000 shares of the
      Company's common stock for $9,000.

      In connection with the March 2, 1998 agreement with the Apollo Holders,
      the Company issued warrants to purchase the Company's common stock. (Refer
      to Note 6.)

      On March 12, 1998, the Company granted an option for 1,250,000 shares of
      the Company's common stock to a law firm that represents the Company and
      Liggett. On May 1, 1998 and April 1, 1999, options for 250,000 and
      1,000,000 shares, respectively, of common stock are exercisable at $17.50
      per share. The option expires on March 31, 2003.

      During April and May 1998, the Company granted 10,000 shares of the
      Company's common stock to each of its three outside directors. Of these
      shares, 7,500 vested immediately and the remaining 22,500 shares will vest
      in three equal annual installments. The Company will recognize
      compensation expense of $404 over the vesting period.




                                      -20-
<PAGE>   22

      On May 8, 1998, the Company adopted its 1998 Long-Term Incentive Plan (the
      "Incentive Plan") subject to approval by the shareholders of the Company
      at the next annual meeting. The Incentive Plan authorizes the granting of
      up to five million shares of the Company's common stock through awards of
      stock options (which may include incentive stock options and/or
      nonqualified stock options), stock appreciation rights and shares of
      restricted Company common stock. All officers, employees and consultants
      of the Company and its subsidiaries are eligible to receive awards under
      the Incentive Plan.

8.    CONTINGENCIES

      TOBACCO-RELATED LITIGATION:

      OVERVIEW. Since 1954, Liggett and other United States cigarette
      manufacturers have been named as defendants in a number of direct and
      third-party actions predicated on the theory that they should be liable
      for damages from cancer and other adverse health effects alleged to have
      been caused by cigarette smoking or by exposure to secondary smoke
      (environmental tobacco smoke, "ETS") from cigarettes. These cases are
      reported hereinafter as though having been commenced against Liggett
      (without regard to whether such cases were actually commenced against the
      Company or Liggett). There has been a noteworthy increase in the number of
      cases pending against both Liggett and the other tobacco companies. The
      cases generally fall into three categories: (i) smoking and health cases
      alleging personal injury brought on behalf of individual smokers
      ("Individual Actions"), (ii) smoking and health cases alleging personal
      injury and purporting to be brought on behalf of a class of plaintiffs
      ("Class Actions") and (iii) health care cost recovery actions brought by
      state and local governments, although recently numerous health care cost
      recovery actions have been commenced on behalf of other third-party payors
      including asbestos manufacturers, unions and taxpayers ("Attorneys General
      Actions"). As new cases are commenced, the costs associated with defending
      such cases and the risks attendant to the inherent unpredictability of
      litigation continue to increase. Liggett had been receiving assistance
      from others in the industry in defraying the costs and other burdens
      incurred in the defense of smoking and health litigation and related
      proceedings, which, for the most part, consisted of the payment of counsel
      fees and costs, but this assistance terminated in 1997. For the three
      months ended March 31, 1998, Liggett incurred counsel fees and costs
      totaling approximately $1,342, compared to $1,037 for the comparable prior
      year period.. The future financial impact on the Company of the
      termination of this assistance and the effects of the tobacco litigation
      settlements discussed below is not quantifiable at this time.

      In June 1992, in an action entitled CIPOLLONE V. LIGGETT GROUP INC., ET
      AL., the United States Supreme Court issued an opinion concluding that The
      Federal Cigarette Labeling and Advertising Act did not preempt state
      common law damage claims but that The Public Health Cigarette Smoking Act
      of 1969 (the "1969 Act") did preempt certain, but not all, state common
      law damage claims. The decision bars plaintiffs from asserting claims
      that, after the effective date of the 1969 Act, the tobacco companies
      either failed to warn adequately of the claimed health risks of cigarette
      smoking or sought to neutralize those claimed risks in their advertising
      or promotion of cigarettes. Bills have been introduced in Congress on
      occasion to eliminate the federal preemption defense. Enactment of any
      federal legislation with such an effect could result in a significant
      increase in claims, liabilities and litigation costs.






                                      -21-
<PAGE>   23
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      INDIVIDUAL ACTIONS. As of March 31, 1998, there were approximately 250
      cases pending against Liggett, and in most cases the other tobacco
      companies, where individual plaintiffs allege injury resulting from
      cigarette smoking, addiction to cigarette smoking or exposure to ETS and
      seek compensatory and, in some cases, punitive damages. Of these, 108 were
      pending in the State of Florida, 82 in the State of New York and 19 in the
      State of Texas. The balance of individual cases were pending in 16 states.
      There are four individual cases pending where Liggett is the only named
      defendant.

      The plaintiffs' allegations of liability in those cases in which
      individuals seek recovery for personal injuries allegedly caused by
      cigarette smoking are based on various theories of recovery, including
      negligence, gross negligence, special duty, voluntary undertaking, strict
      liability, fraud, misrepresentation, design defect, failure to warn,
      breach of express and implied warranties, conspiracy, aiding and abetting,
      concert of action, unjust enrichment, common law public nuisance,
      indemnity, market share liability and violations of deceptive trade
      practices laws, the Federal Racketeer Influenced and Corrupt Organization
      Act ("RICO") and antitrust statutes. In many of these cases, in addition
      to compensatory damages, plaintiffs also seek other forms of relief
      including disgorgement of profits and punitive damages. Defenses raised by
      defendants in these cases include lack of proximate cause, assumption of
      the risk, comparative fault and/or contributory negligence, lack of design
      defect, statute of limitations, equitable defenses such as "unclean hands"
      and lack of benefit, failure to state a claim and federal preemption.

      On May 12, 1998, Liggett settled an individual tobacco-related action
      entitled WIDDICK V. BROWN & WILLIAMSON, Duval County Circuit Court,
      Florida. The settlement will not have a material affect on the Company's
      or Liggett's financial condition, results of operations or cash flows.

      CLASS ACTIONS. As of March 31, 1998, there were approximately 30 actions
      pending, for which either a class has been certified or plaintiffs are
      seeking class certification, where Liggett, among others, was a named
      defendant. Two of these cases, FLETCHER, ET AL. V. BROOKE GROUP LTD., ET
      AL. and WALKER, ET AL. V. LIGGETT GROUP INC., ET AL., have been settled,
      subject to court approval. These two settlements are more fully discussed
      below under the "Settlements" section.

      In October 1991, an action entitled BROIN, ET AL. V. PHILIP MORRIS
      INCORPORATED, ET AL., Circuit Court of the Eleventh Judicial District in
      and for Dade County, Florida, was filed against Liggett and others. This
      case has been brought by plaintiffs on behalf of all flight attendants
      that have worked or are presently working for airlines based in the United
      States and who have never regularly smoked cigarettes but allege that they
      have been damaged by involuntary exposure to ETS. In October 1997, the
      other major tobacco companies settled this matter which settlement
      provides for a release of the Company and Liggett. In February 1998, the
      Circuit Court approved the settlement, however, a Notice of Appeal was
      filed in the Third District Court of Appeal by an objector to the
      settlement.

      In March 1994, an action entitled CASTANO, ET AL. V. THE AMERICAN TOBACCO
      COMPANY INC., ET AL., United States District Court, Eastern District of
      Louisiana, was filed against Liggett and others. The class action
      complaint sought relief for a nationwide class of smokers based on their
      alleged addiction to nicotine. In February 1995, the District Court
      granted plaintiffs' motion for class certification (the "Class
      Certification Order").

      In May 1996, the Court of Appeals for the Fifth Circuit reversed the Class
      Certification Order and instructed the District Court to dismiss the class
      complaint. The Fifth Circuit ruled that the District 




                                      -22-
<PAGE>   24
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      Court erred in its analysis of the class certification issues by failing
      to consider how variations in state law affect predominance of common
      questions and the superiority of the class action mechanism. The appeals
      panel also held that the District Court's predominance inquiry did not
      include consideration of how a trial on the merits in CASTANO would be
      conducted. The Fifth Circuit further ruled that the "addiction-as-injury"
      tort is immature and, accordingly, the District Court could not know
      whether common issues would be a "significant" portion of the individual
      trials. According to the Fifth Circuit's decision, any savings in judicial
      resources that class certification may bring about is speculative and
      would likely be overwhelmed by the procedural problems certification
      brings. Finally, the Fifth Circuit held that in order to make the class
      action manageable, the District Court would be forced to bifurcate issues
      in violation of the Seventh Amendment.

      The extent of the impact of the CASTANO decision on tobacco-related class
      action litigation is still uncertain, although the decertification of the
      CASTANO class by the Fifth Circuit may preclude other federal courts from
      certifying a nationwide class action for trial purposes with respect to
      tobacco-related claims. The CASTANO decision has had to date, however,
      only limited effect with respect to courts' decisions regarding narrower
      tobacco-related classes or class actions brought in state rather than
      federal court. For example, since the Fifth Circuit's ruling, courts in
      New York, Louisiana and Maryland have certified "addiction-as-injury"
      class actions that covered only citizens in those states. Two class
      actions pending in state court in Florida have also been certified and one
      of the actions, the BROIN case, had begun trial before settling in 1997.
      The CASTANO decision has had no measurable impact on litigation brought by
      or on behalf of single individual claimants.

      ATTORNEYS GENERAL ACTIONS. As of March 31, 1998, 41 Attorneys General
      actions were filed against Liggett and the Company. As more fully
      discussed below, Liggett and the Company have settled 37 of these actions.
      In addition, the Company and Liggett have reached settlements with six
      Attorneys General representing states or territories which have not yet
      commenced litigation. As of March 31, 1998, there were approximately 55
      additional third-party payor actions pending. In certain of the pending
      proceedings, state and local government entities and others seek
      reimbursement for Medicaid and other health care expenditures allegedly
      caused by use of tobacco products. The claims asserted in these health
      care cost recovery actions vary. In most of these cases, plaintiffs assert
      the equitable claim that the tobacco industry was "unjustly enriched" by
      plaintiffs' payment of health care costs allegedly attributable to smoking
      and seek reimbursement of those costs. Other claims made by some but not
      all plaintiffs include the equitable claim of indemnity, common law claims
      of negligence, strict liability, breach of express and implied warranty,
      violation of a voluntary undertaking or special duty, fraud, negligent
      misrepresentation, conspiracy, public nuisance, claims under state and
      federal statutes governing consumer fraud, antitrust, deceptive trade
      practices and false advertising, and claims under RICO.

      On April 29, 1998, a group known as the "Coalition for Tobacco
      Responsibility", which represents Blue Cross and Blue Shield Plans in more
      than 35 states, filed federal lawsuits against the industry seeking
      payment of health-care costs allegedly incurred as a result of cigarette
      smoking and ETS. The lawsuits were filed in Federal District Courts in New
      York, Chicago and Seattle and seek billions of dollars in damages. The
      lawsuits allege conspiracy, fraud, misrepresentation, violation of federal
      racketeering and anti-trust laws as well as other claims.

      SETTLEMENTS. In March 1996, the Company and Liggett entered into an
      agreement, subject to court approval, to settle the CASTANO class action
      tobacco litigation. Under the CASTANO settlement agreement, upon final
      court approval of the settlement, the CASTANO class would be entitled to
      receive 




                                      -23-
<PAGE>   25
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      up to five percent of Liggett's pretax income (income before income taxes)
      each year (up to a maximum of $50,000 per year) for the next 25 years,
      subject to certain reductions provided for in the agreement and a $5,000
      payment from Liggett if the Company or Liggett fail to consummate a merger
      or similar transaction with another non-settling tobacco company defendant
      within three years of the date of settlement. The Company and Liggett have
      the right to terminate the CASTANO settlement under certain circumstances.
      On March 14, 1996, the Company, the CASTANO Plaintiffs Legal Committee and
      the CASTANO plaintiffs entered into a letter agreement. According to the
      terms of the letter agreement, for the period ending nine months from the
      date of Final Approval (as defined in the letter), if granted, of the
      CASTANO settlement or, if earlier, the completion by the Company or
      Liggett of a combination with any defendant in CASTANO, except Philip
      Morris, the CASTANO plaintiffs and their counsel agree not to enter into
      any more favorable settlement agreement with any CASTANO defendant which
      would reduce the terms of the CASTANO settlement agreement. If the Castano
      plaintiffs or their counsel enter into any such settlement during this
      period, they shall pay the Company $250,000 within 30 days of the more
      favorable agreement and offer the Company and Liggett the option to enter
      into a settlement on terms at least as favorable as those included in such
      other settlement. The letter agreement further provides that during the
      same time period, and if the CASTANO settlement agreement has not been
      earlier terminated by the Company in accordance with its terms, the
      Company and its affiliates will not enter into any business transaction
      with any third party which would cause the termination of the CASTANO
      settlement agreement. If the Company or its affiliates enter into any such
      transaction, then the CASTANO plaintiffs will be entitled to receive
      $250,000 within 30 days from the transacting party. In May 1996, the
      CASTANO Plaintiffs Legal Committee filed a motion with the United States
      District Court for the Eastern District of Louisiana seeking preliminary
      approval of the CASTANO settlement. In September 1996, shortly after the
      class was decertified, the CASTANO plaintiffs withdrew the motion for
      approval of the CASTANO settlement.

      In March 1996, the Company and Liggett entered into a settlement of
      tobacco-related litigation with the Attorneys General of Florida,
      Louisiana, Massachusetts, Mississippi and West Virginia (the "March 1996
      Settlements"). The March 1996 Settlements release the Company and Liggett
      from all tobacco-related claims including claims for health care cost
      reimbursement and claims concerning sales of cigarettes to minors. Certain
      of the terms of the March 1996 Settlements are summarized below.

      Under the March 1996 Settlements, the five settling states would share an
      initial payment by Liggett of $5,000 ($1,000 of which was paid on March
      22, 1996, with the balance payable over nine years and indexed and
      adjusted for inflation), provided that any unpaid amount will be due 60
      days after either a default by Liggett in its payment obligations under
      the settlement or a merger or other similar transaction by the Company or
      Liggett with another defendant in the lawsuits. In addition, Liggett will
      be required to pay the settling states a percentage of Liggett's pretax
      income (income before income taxes) each year from the second through the
      twenty-fifth year. This annual percentage is 2-1/2% of Liggett's pretax
      income, subject to increase to 7-1/2% depending on the number of
      additional states joining the settlement. No additional states have joined
      this settlement to date. All of Liggett's payments are subject to certain
      reductions provided for in the agreement. Liggett has also agreed to pay
      to the settling states $5,000 if the Company or Liggett fails to
      consummate a merger or other similar transaction with another defendant in
      the lawsuits within three years of the date of the March 1996 Settlement.

      Settlement funds received by the Attorneys General will be used to
      reimburse the states for smoking-related health care costs. The Company
      and Liggett also have agreed to phase in compliance with 




                                      -24-
<PAGE>   26
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      certain of the proposed interim FDA regulations on the same basis as
      provided in the CASTANO settlement. The Company and Liggett have the right
      to terminate the March 1996 Settlements with respect to any settling state
      if any of the remaining defendants in the litigation succeed on the merits
      in that state's respective Attorney General action. The Company and
      Liggett may also terminate the March 1996 Settlements if they conclude
      that too many states have filed Attorney General actions and have not
      settled such cases with the Company and Liggett.

      In March 1997, Liggett, the Company and the five settling states executed
      an addendum pursuant to which Liggett and the Company agreed to provide to
      the five settling states, among other things, the additional cooperation
      and compliance with advertising restrictions that is provided for in the
      March 1997 Settlements (discussed below). Also, pursuant to the addendum,
      the initial settling states agreed to use best efforts to ensure that in
      the event of a global tobacco settlement enacted through federal
      legislation or otherwise, Liggett's and the Company's financial
      obligations under such a global settlement would be no more onerous than
      under this settlement.

      At December 31, 1995, the Company had accrued approximately $4,000 for the
      present value of the fixed payments under the March 1996 Settlements. At
      December 31, 1997, in connection with the March 1998 Settlements, the
      Company accrued $16,421 for the present value of the fixed payments under
      the March 1998 Settlements. At March 31, 1998, in connection with the
      settlement with the Attorney General of Georgia (discussed below), the
      Company accrued $481 for the present value of the fixed payments under the
      Georgia settlement. No additional amounts have been accrued with respect
      to the recent settlements discussed below. The Company cannot quantify the
      future costs of the settlements at this time as the amount Liggett must
      pay is based, in part, on future operating results. Possible future
      payments based on a percentage of pretax income, and other contingent
      payments based on the occurrence of a business combination, will be
      expensed when considered probable.

      In March 1997, Liggett and the Company entered into a comprehensive
      settlement of tobacco litigation through parallel agreements with the
      Attorneys General of 17 states and with a nationwide class of individuals
      and entities that allege smoking-related claims. Thereafter, during 1997,
      settlements were reached with four more states through their respective
      Attorneys General (settlements with these 21 Attorneys General and with
      the nationwide class are hereinafter referred to as the "March 1997
      Settlements"). On March 12, 1998, Liggett and the Company announced
      settlements with the Attorneys General of 14 states, the District of
      Columbia and the U.S. Virgin Islands (the "March 1998 Settlements"). On
      March 26, 1998, the Company and Liggett settled with the Attorney General
      of Georgia, which joined the March 1998 Settlements. The foregoing
      settlements cover all smoking-related claims, including both
      addiction-based and tobacco injury claims against the Company and Liggett,
      brought by the Attorneys General and, upon court approval, the nationwide
      class.

      The states and territories where settlements have been reached with
      Attorneys General are: Alaska, Arizona, Arkansas, California, Colorado,
      Connecticut, District of Columbia, Florida, Georgia, Hawaii, Idaho,
      Illinois, Indiana, Iowa, Kansas, Louisiana, Maine, Maryland,
      Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana,
      Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, New York, North
      Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Texas, Utah,
      U.S. Virgin Islands, Washington, West Virginia, Wisconsin and Wyoming.
      Other states have either recently filed health care cost recovery actions
      or indicated intentions to do so. Both Liggett and the Company will
      endeavor to resolve those actions on substantially the same terms and




                                      -25-
<PAGE>   27
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      conditions as the March 1998 Settlements, however, there can be no
      assurance that any such settlements will be completed.

      As mentioned above, in March 1997, Liggett, the Company and plaintiffs
      filed a mandatory class settlement agreement in an action entitled
      FLETCHER, ET AL. V. BROOKE GROUP LTD., ET AL., Circuit Court of Mobile
      County, Alabama, where the court granted preliminary approval and
      preliminary certification of the class, and in May 1997, a similar
      mandatory class settlement agreement was filed in an action entitled
      WALKER, ET AL. V. LIGGETT GROUP INC., ET AL., United States District
      Court, Southern District of West Virginia. The Company anticipates that
      should the court in FLETCHER, after dissemination of notice to the class
      of the pending limited fund class action settlement and a full fairness
      hearing with respect thereto, issue a final order and judgment approving
      the settlement, such an order would preclude further prosecution by class
      members of tobacco-related claims against both Liggett and the Company.
      Under the Full Faith and Credit Act, a final judgment entered in a
      nationwide class action pending in a state court has a preclusive effect
      against any class member with respect to the claims settled and released.
      As the class definition in FLETCHER encompasses all persons in the United
      States who could claim injury as a result of cigarette smoking or ETS and
      any third-party payor claimants, it is anticipated that, upon final order
      and judgment, all such persons and third-party payor claimants would be
      barred from further prosecution of tobacco-related claims against Liggett
      and the Company.

      In the FLETCHER action, it is anticipated that class members will be
      notified of the settlement and will have an opportunity to appear at a
      later court hearing. Effectiveness of the mandatory settlement is
      conditioned on final court approval of the settlement after a fairness
      hearing. There can be no assurance as to whether, or when, such court
      approval will be obtained.

      The WALKER court also granted preliminary approval and preliminary
      certification of the nationwide class, however, in August 1997, the court
      vacated its preliminary certification of the settlement class, which
      decision is currently on appeal. The WALKER court relied on the Supreme
      Court's decision in AMCHEM PRODUCTS INC. V. WINDSOR in reaching its
      decision to vacate preliminary certification of the class. In AMCHEM, the
      Supreme Court affirmed a decision of the Third Circuit vacating the
      certification of a settlement class that involved asbestos-exposure
      claims. The Supreme Court held that the proposed settlement class did not
      meet the requirements of Rule 23 of the Federal Rules of Civil Procedure
      for predominance of common issues and adequacy of representation. The
      Third Circuit had held that, although classes could be certified for
      settlement purposes, Rule 23's requirements had to be satisfied as if the
      case were going to be litigated. The Supreme Court agreed that the
      fairness and adequacy of the settlement are not pertinent to the
      predominance inquiry under Rule 23(b)(3), and thus, the proposed class
      must have sufficient unity so that absent class members can fairly be
      bound by decisions of class representatives.

      After the AMCHEM opinion was issued by the Supreme Court in June 1997,
      objectors to Liggett's settlement in WALKER moved for decertification.
      Although Liggett's settlement in the WALKER action is a "limited fund"
      class action settlement proceeding under Rule 23(b)(1) and AMCHEM was a
      Rule 23 (b)(3) case, the court in the WALKER action, nonetheless,
      decertified the WALKER class. Applying AMCHEM to the WALKER case, the
      District Court, in a decision issued in August 1997, determined that while
      plaintiffs in WALKER have a common interest in "maximizing the limited
      fund available from the defendants," there remained "substantial conflicts
      among class members relating to distribution of the fund and other key
      concerns" that made class certification inappropriate.





                                      -26-
<PAGE>   28
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      The AMCHEM decision's ultimate affect on the viability of both the WALKER
      and FLETCHER settlements remains uncertain given the Fifth Circuit's
      recent ruling reaffirming a limited fund class action settlement in IN RE
      ASBESTOS LITIGATION ("AHEARN"). In June 1997, the Supreme Court remanded
      AHEARN to the Fifth Circuit for consideration in light of AMCHEM. On
      remand, the Fifth Circuit made two decisive distinctions between AMCHEM
      and AHEARN. First, the AHEARN class action proceeded under Rule 23(b)(1)
      while AMCHEM was a Rule 23(b)(3) case, and second, in AHEARN, there was no
      allocation or difference in award, according to nature or severity of
      injury, as there was in AMCHEM. The Fifth Circuit concluded that all
      members of the class and all class representatives share common interests
      and none of the uncommon questions, abounding in Amchem, exist.

      The remaining material terms of the March 1996 Settlements, the March 1997
      Settlements and the March 1998 Settlements are described below.

      Pursuant to each of the settlements, both the Company and Liggett agreed
      to cooperate fully with the Attorneys General and the nationwide class in
      their respective lawsuits against the tobacco industry. The Company and
      Liggett agreed to provide to these parties all relevant tobacco documents
      in their possession, other than those subject to claims of joint defense
      privilege, and to waive, subject to court order, certain attorney-client
      privileges and work product protections regarding Liggett's
      smoking-related documents to the extent Liggett and the Company can so
      waive these privileges and protections. The Attorneys General and the
      nationwide class agreed to keep Liggett's documents under protective order
      and, subject to final court approval, to limit their use to those actions
      brought by parties to the settlement agreements. Those documents that may
      be subject to a joint defense privilege with other tobacco companies will
      not be produced to the Attorneys General or the nationwide class, but will
      be, pursuant to court order, submitted to the appropriate court and placed
      under seal for possible IN CAMERA review. Additionally, under similar
      protective conditions, the Company and Liggett agreed to offer their
      employees for witness interviews and testimony at deposition and trial.
      Pursuant to the settlement agreements, Liggett also agreed to place an
      additional warning on its cigarette packaging stating that "Smoking is
      Addictive" and to issue a public statement, as requested by the Attorneys
      General. Liggett has commenced distribution of cigarette packaging which
      displays the new warning label.

      Pursuant to the March 1996 Settlements, any other tobacco company
      defendant, except Philip Morris, merging or combining with Liggett or the
      Company, prior to the third anniversary of the settlement, would receive
      certain settlement benefits, including limitations on potential liability.
      Pursuant to the agreement, any such combining tobacco company would be
      released from the lawsuits brought by the five initial settling states.
      Such combining tobacco company would be obligated to pay into the
      settlement fund within sixty days of becoming bound to the agreement
      $135,000, and make annual payments of 2.5% of the combining company's
      pre-tax income (but not less than $30,000 per year). Such combining
      tobacco company would also have to comply with the advertising and access
      restrictions provided for in the agreement, and would have to withdraw
      their objections to the FDA rule.

      Pursuant to the March 1997 Settlements, any other tobacco company
      defendant, except Philip Morris, merging or combining with Liggett or the
      Company, prior to the fourth anniversary of the settlements, would receive
      certain settlement benefits, including limitations on potential liability
      for affiliates not engaged in domestic tobacco operations and a waiver of
      any obligation to post a bond to appeal any future adverse judgment. In
      addition, within 120 days following any such combination, Liggett would be
      required to pay the settlement fund $25,000. Under all settlements, the
      plaintiffs 




                                      -27-
<PAGE>   29
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      have agreed not to seek an injunction preventing a defendant tobacco
      company combining with Liggett or the Company from spinning off any
      affiliate which is not engaged in the domestic tobacco business.

      Pursuant to the March 1998 Settlements, Liggett is required to pay each of
      the settling states and territories their relative share (based on the
      Medicaid population of each state over the total Medicaid population of
      the United States) of between 27.5% and 30% of Liggett's pre-tax income
      each year for 25 years, with a minimum payment guarantee of $1,000 per
      state over the first nine years of the agreement. The aggregate liability
      under the March 1996 Settlements, the March 1997 Settlements and the March
      1998 Settlements (including the Georgia settlement) is $39,556, the
      present value of which, when discounted at the rate of 18% per annum, is
      $19,365 at December 31, 1997. Minimum payments to be made for these
      settlements over the next five years and thereafter are: 1998: $4,144;
      1999: $4,518; 2000: $4,518; 2001: $4,577; 2002: $4,630; thereafter:
      $18,169. The annual percentage is subject to increase, pro rata from 27.5%
      up to 30%, depending on the number of additional states joining the
      settlement. Pursuant to the "most favored nation" provisions under the
      March 1996 Settlement and the March 1997 Settlements, each of the states
      settling under those settlements could benefit from the economic terms of
      the March 1998 Settlements. In the case of the March 1997 Settlements, in
      the event that the Fletcher class is approved, monies collected in the
      settlement fund will be overseen by a court-appointed committee and
      utilized to compensate state health care programs and settlement class
      members and to provide counter-market advertising. In all settlements,
      Liggett agreed to phase-in compliance with certain proposed FDA
      regulations regarding smoking by children and adolescents, including a
      prohibition on the use of cartoon characters in tobacco advertising and
      limitations on the use of promotional materials and distribution of sample
      packages where minors are present. The March 1998 Settlements provide for
      additional restrictions and regulations on Liggett's advertising,
      including a prohibition on outdoor advertising and product advertising on
      the Internet and on payments for product placement in movies and
      television.

      Under all settlements, the Company and Liggett are also entitled to most
      favored nation treatment in the event any settling Attorney General
      reaches a settlement with any other defendant tobacco company. Under the
      March 1996 Settlement and March 1997 Settlements, in the event of a global
      settlement involving federal legislation with any other defendant tobacco
      company, the settling Attorneys General agreed to use their "best efforts"
      to ensure that the Company and Liggett's liability under such legislation
      should be no more onerous than under these settlements. Under the March
      1998 Settlements, the settling Attorneys General agreed to write letters
      to Congress and the President of the United States to ensure that the
      Company and Liggett's liability under any such legislation should be no
      more onerous than under these settlements.

      Copies of the various settlement agreements are filed as exhibits to the
      Company's Form 10-K and the discussion herein is qualified in its entirety
      by reference thereto.

      TRIALS. On May 8, 1998, the other tobacco companies settled the litigation
      in Minnesota known as the STATE OF MINNESOTA BY HUBERT H. HUMPHREY, III,
      ITS ATTORNEY GENERAL AND BLUE CROSS AND BLUE SHIELD OF MINNESOTA V. PHILIP
      MORRIS INCORPORATED, ET AL. Liggett settled the claims of the State of
      Minnesota on March 20, 1997, but still remains a defendant in the case
      with respect to Blue Cross and Blue Shield of Minnesota as to one claim
      seeking equitable relief. There are several other trial dates scheduled
      during 1998 for individual cases; however, trial dates are subject to
      change.




                                      -28-
<PAGE>   30
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      PROPOSED RESOLUTION. In June 1997, Philip Morris Incorporated ("Philip
      Morris"), R. J. Reynolds Tobacco Company ("RJR"), B&W, Lorillard Tobacco
      Company ("Lorillard") and the United States Tobacco Company, along with
      the Attorneys General for the States of Arizona, Connecticut, Florida,
      Mississippi, New York and Washington and the CASTANO Plaintiffs'
      Litigation Committee executed a Memorandum of Understanding to support the
      adoption of federal legislation and necessary ancillary undertakings,
      incorporating the features described in a proposed resolution (the
      "Resolution"). The proposed Resolution mandates a total reformation and
      restructuring of how tobacco products are manufactured, marketed and
      distributed in the United States.

      The proposed Resolution includes provisions relating to advertising and
      marketing restrictions, product warnings and labeling, access
      restrictions, licensing of tobacco retailers, the adoption and enforcement
      of "no sales to minors" laws by states, surcharges against the industry
      for failure to achieve underage smoking reduction goals, regulation of
      tobacco products by the FDA, public disclosure of industry documents and
      research, smoking cessation programs, compliance programs by the industry,
      public smoking and smoking in the workplace, enforcement of the proposed
      Resolution, industry payments and litigation.

      The proposed Resolution would require the FDA to impose annual surcharges
      on the industry if targeted reductions in underage smoking incidence are
      not achieved in accordance with a legislative timetable. The surcharge
      would be based upon an approximation of the present value of the profit
      the companies would earn over the lives of all underage consumers in
      excess of the target, and would be allocated among participating
      manufacturers based on their market share of the United States cigarette
      industry.

      The proposed Resolution would require participating manufacturers to make
      substantial payments in the year of implementation and thereafter
      ("Industry Payments"). Participating manufacturers would be required to
      make an aggregate $10 billion initial Industry Payment on the date that
      federal legislation implementing the terms of the proposed Resolution is
      signed. This Industry Payment would be based on relative market
      capitalization. Thereafter, the participating companies would be required
      to make specified annual Industry Payments determined and allocated among
      the companies based on volume of domestic sales as long as the companies
      continue to sell tobacco products in the United States. These Industry
      Payments, which would begin on December 31 of the first full year after
      implementing federal legislation is signed, would be in the following
      amounts (at 1996 volume levels) -- year 1: $8.5 billion; year 2: $9.5
      billion; year 3: $11.5 billion; year 4: $14 billion; and each year
      thereafter: $15 billion. These Industry Payments would be increased by the
      greater of 3% or the previous year's inflation rate, and would be adjusted
      to reflect changes from 1996 domestic sales volume levels.

      The Industry Payments would be separate from any surcharges. The Industry
      Payments would receive priority and would not be dischargeable in any
      bankruptcy or reorganization proceeding and would be the obligation only
      of entities selling tobacco products in the United States (and not their
      affiliated companies). The proposed Resolution provides that all payments
      by the industry would be ordinary and necessary business expenses in the
      year of payment, and no part thereof would be either in settlement of an
      actual or potential liability for a fine or penalty (civil or criminal) or
      the cost of a tangible or intangible asset. The proposed Resolution would
      provide for the pass-through to consumers of the annual Industry Payments
      in order to promote the maximum reduction in underage use.




                                      -29-
<PAGE>   31

                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)

      If enacted, the federal legislation provided for in the proposed
      Resolution would settle present attorney general health care cost recovery
      actions (or similar actions brought by or on behalf of any governmental
      entity other than the federal government), PARENS PATRIAE and smoking and
      health class actions and all "addiction"/dependence claims, and would bar
      similar actions from being maintained in the future. However, the proposed
      Resolution provides that no stay applications will be made in pending
      governmental actions without the mutual consent of the parties. The
      proposed Resolution would not affect any smoking and health class action
      or any health care cost recovery action that is reduced to final judgment
      before implementing federal legislation is effective.

      Under the proposed Resolution, the rights of individuals to sue the
      tobacco industry would be preserved, except as expressly changed by
      implementing federal legislation. Claims, however, could not be maintained
      on a class or other aggregated basis, and could be maintained only against
      tobacco manufacturing companies (and not their retailers, distributors or
      affiliated companies). In addition, all punitive damage claims based on
      past conduct would be resolved as part of the proposed Resolution, and
      future claimants could seek punitive damages only with respect to claims
      predicated upon conduct taking place after the effective date of
      implementing federal legislation. Finally, except with respect to actions
      pending as of June 9, 1997, third-party payor (and similar) claims could
      be maintained only if based on subrogation of individual claims. Under
      subrogation principles, a payor of medical costs can seek recovery from a
      third party only by "standing in the shoes" of the injured party and being
      subject to all defenses available against the injured party.

      The proposed Resolution contemplates that participating tobacco
      manufacturers would enter into a joint sharing agreement for civil
      liabilities relating to past conduct. Judgments and settlements arising
      from tort actions would be paid as follows: The proposed Resolution would
      set an annual aggregate cap of up to 33% of the annual base Industry
      Payment (including any reductions for volume declines). Any judgments or
      settlements exceeding the cap in a particular year would roll over into
      the next year. While judgments and settlements would run against the
      defendant, they would give rise to an 80-cents-on-the-dollar credit
      against the annual Industry Payment. Finally, any individual judgments in
      excess of $1 million would be paid at the rate of $1 million per year
      unless every other judgment and settlement could first be satisfied within
      the annual aggregate cap. In all circumstances, however, the companies
      would remain fully responsible for costs of defense and certain costs
      associated with the fees of attorneys representing certain plaintiffs in
      the litigation settled by the proposed Resolution.

      Under the proposed Resolution, the Company and Liggett would be deemed to
      be a "non-participating manufacturer". The proposed Resolution provides,
      among other things, that a non-participating manufacturer would be
      required to place into escrow, each year, an amount equal to 150% of its
      share of the payment required of participating manufacturers (other than
      the portion allocated to public health programs and federal and state
      enforcement). These funds would be earmarked for potential liability
      payments and could be reclaimed, with interest, after 35 years, to the
      extent they had not been paid out in liability.

      The proposals are currently being reviewed by the White House, Congress
      and various public interest groups. Separately, the other tobacco
      companies negotiated settlements of the Attorneys General health care cost
      recovery actions in Mississippi, Florida, Texas and Minnesota. Management
      is unable to predict the ultimate effect, if any, of the enactment of
      legislation adopting the proposed resolution. Management is also unable to
      predict the ultimate content of any such




                                      -30-
<PAGE>   32
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      legislation; however, adoption of any such legislation could have a
      material adverse effect on the business of the Company and Liggett.

      OTHER RELATED MATTERS. In March 1997, RJR, Philip Morris, B&W and
      Lorillard obtained a temporary restraining order from a North Carolina
      state court preventing the Company and Liggett and their agents,
      employees, directors, officers and lawyers from turning over documents
      allegedly subject to the joint defense privilege in connection with the
      settlements, which restraining order was converted to a preliminary
      injunction by the court in April 1997. In March 1997, the United States
      District Court for the Eastern District of Texas and state courts in
      Mississippi and Illinois each issued orders enjoining the other tobacco
      companies from interfering with Liggett's filing with the courts, under
      seal, those documents.

      The Company understands that a grand jury investigation is being conducted
      by the office of the United States Attorney for the Eastern District of
      New York (the "Eastern District Investigation") regarding possible
      violations of criminal law relating to the activities of The Council for
      Tobacco Research - USA, Inc. (the "CTR"). Liggett was a sponsor of the CTR
      at one time. In May 1996, Liggett received a subpoena from a Federal grand
      jury sitting in the Eastern District of New York, to which Liggett has
      responded.

      In March 1996, and in each of March, July, October and December 1997, the
      Company and/or Liggett received subpoenas from a Federal grand jury in
      connection with an investigation by the United States Department of
      Justice (the "DOJ Investigation") involving the industry's knowledge of:
      the health consequences of smoking cigarettes; the targeting of children
      by the industry; and the addictive nature of nicotine and the manipulation
      of nicotine by the industry. Liggett has responded to the March 1996,
      March 1997 and July 1997 subpoenas and is in the process of responding to
      the October and December 1997 subpoenas. The Company understands that the
      Eastern District Investigation and the DOJ Investigation have, for all
      intents and purposes, been consolidated into one investigation being
      conducted by the Department of Justice (the "DOJ"). The Company and
      Liggett are unable, at this time, to predict the outcome of this
      investigation.

      On April 28, 1998, the Company announced that Liggett had reached an
      agreement with the DOJ to cooperate in both the Eastern District
      Investigation and the DOJ Investigation. The agreement does not constitute
      an admission of any wrongful behavior by Liggett. The DOJ has not provided
      immunity to Liggett and has full discretion to act or refrain from acting
      with respect to Liggett in the investigation.

      Litigation is subject to many uncertainties, and it is possible that some
      of the aforementioned actions could be decided unfavorably against the
      Company or Liggett. An unfavorable outcome of a pending smoking and health
      case could encourage the commencement of additional similar litigation.
      The Company is unable to evaluate the effect of these developing matters
      on pending litigation or the possible commencement of additional
      litigation.

      The Company is unable to make a meaningful estimate with respect to the
      amount of loss that could result from an unfavorable outcome of the cases
      pending against the Company, because the complaints filed in these cases
      rarely detail alleged damages. Typically, the claims set forth in an
      individual's complaint against the tobacco industry pray for money damages
      in an amount to be determined by a jury, plus punitive damages and costs.
      These damage claims are usually stated as being for at least the minimum
      necessary to invoke the jurisdiction of the court.





                                      -31-
<PAGE>   33
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      Third-party payor claimants and others have set forth several additional
      variations on relief sought: funding of corrective public education
      campaigns relating to issues of smoking and health; funding for clinical
      smoking cessation programs; disgorgement of profits from sales of
      cigarettes; restitution; treble damages; and attorneys' fees.
      Nevertheless, no specific amounts are provided. It is, however, understood
      that requested damages against the tobacco company defendants in these
      cases may be in the billions of dollars.

      It is possible that the Company's consolidated financial position, results
      of operation and cash flow could be materially adversely affected by an
      unfavorable outcome in any of such pending tobacco-related litigation.

      Liggett has been involved in certain environmental proceedings, none of
      which, either individually or in the aggregate, rise to the level of
      materiality. Liggett's management believes that current operations are
      conducted in material compliance with all environmental laws and
      regulations. Management is unaware of any material environmental
      conditions affecting its existing facilities. Compliance with federal,
      state and local provisions regulating the discharge of materials into the
      environment, or otherwise relating to the protection of the environment,
      has not had a material effect on the capital expenditures, earnings or
      competitive position of Liggett.

      There are several other proceedings, lawsuits and claims pending against
      the Company unrelated to smoking or tobacco product liability. Management
      is of the opinion that the liabilities, if any, ultimately resulting from
      such other proceedings, lawsuits and claims should not materially affect
      the Company's financial position, results of operations or cash flows.

      LEGISLATION AND REGULATION:

      In August 1996, the FDA filed in the Federal Register a Final Rule (the
      "FDA Rule") classifying tobacco as a drug, asserting jurisdiction by the
      FDA over the manufacture and marketing of tobacco products and imposing
      restrictions on the sale, advertising and promotion of tobacco products.
      Litigation was commenced in the United States District Court for the
      Middle District of North Carolina challenging the legal authority of the
      FDA to assert such jurisdiction, as well as challenging the
      constitutionality of the rules. The court, after argument, granted
      plaintiffs' motion for summary judgment prohibiting the FDA from
      regulating or restricting the promotion and advertising of tobacco
      products and denied plaintiffs' motion for summary judgment on the issue
      of whether the FDA has the authority to regulate access to, and labeling
      of, tobacco products. The four major cigarette manufacturers and the FDA
      have filed notices of appeal. The Company and Liggett support the FDA Rule
      and have begun to phase in compliance with certain of the proposed interim
      FDA regulations. See discussions of the CASTANO and Attorneys General
      settlements above.

      In August 1996, the Commonwealth of Massachusetts enacted legislation
      requiring tobacco companies to publish information regarding the
      ingredients in cigarettes and other tobacco products sold in that state.
      In December 1997, the United States District Court for the District of
      Massachusetts enjoined this legislation from going into effect, however,
      in December 1997, Liggett began complying with this legislation by
      providing ingredient information to the Massachusetts Department of Public
      Health.




                                      -32-
<PAGE>   34
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      In February 1996, the United States Trade representative issued an
      "advance notice of rule making" concerning how tobaccos imported under a
      previously established tobacco rate quota ("TRQ") should be allocated.
      Currently, tobacco imported under the TRQ is allocated on a "first-come,
      first-served" basis, meaning that entry is allowed on an open basis to
      those first requesting entry in the quota year. Others in the cigarette
      industry have suggested an "end-user licensing" system under which the
      right to import tobacco under the quota would be initially assigned on the
      basis of domestic market share. Such an approach, if adopted, could have a
      material adverse effect on the Company and Liggett.

      In April 1994, the United States Occupational Safety and Health
      Administration ("OSHA") issued a proposed rule that could ultimately ban
      smoking in the workplace. Hearings were completed during 1995. OSHA has
      not yet issued a final rule or a proposed revised rule. While the Company
      cannot predict the outcome, some form of federal regulation of smoking in
      workplaces may result.

      In January 1993, the United States Environmental Protection Agency ("EPA")
      released a report on the respiratory effect of ETS which concludes that
      ETS is a known human lung carcinogen in adults and in children, causes
      increased respiratory tract disease and middle ear disorders and increases
      the severity and frequency of asthma. In June 1993, the two largest of the
      major domestic cigarette manufacturers, together with other segments of
      the tobacco and distribution industries, commenced a lawsuit against the
      EPA seeking a determination that the EPA did not have the statutory
      authority to regulate ETS, and that given the current body of scientific
      evidence and the EPA's failure to follow its own guidelines in making the
      determination, the EPA's classification of ETS was arbitrary and
      capricious. Whatever the outcome of this litigation, issuance of the
      report may encourage efforts to limit smoking in public areas.

      As part of the budget agreement recently approved by Congress, federal
      excise taxes on a pack of cigarettes, which are currently 24 cents, would
      rise 10 cents in the year 2000 and 5 cents more in the year 2002. In a
      speech in September 1997, President Clinton called for federal legislation
      that, among other things, would raise cigarette prices by up to $1.50 per
      pack. Since then, several bills have been introduced in the Senate that
      purport to propose legislation along these lines. Management is unable to
      predict the ultimate content of any such legislation; however, adoption of
      any such legislation could have a material adverse effect on the business
      of the Company and Liggett.

      In addition to the foregoing, there have been a number of other
      restrictive regulatory actions, adverse political decisions and other
      unfavorable developments concerning cigarette smoking and the tobacco
      industry, the effects of which, at this time, the Company is not able to
      evaluate.

      OTHER MATTERS:

      In June 1993, the Company obtained expropriation and forced abandonment
      insurance coverage for its investment in its Ducat Place I real estate
      project in Moscow, Russia. Shortly thereafter, the Company submitted a
      Notice of Loss to the insurer, under and pursuant to the policy. The
      insurer denied the claim and, in July 1994, arbitration proceedings were
      commenced in the United Kingdom. In January 1997, the Company recognized a
      gain of $4,125 in settlement of the dispute.




                                      -33-
<PAGE>   35
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (CONTINUED)


      On or about March 13, 1997, a shareholder derivative suit was filed
      against New Valley, as a nominal defendant, its directors and the Company
      in the Delaware Chancery Court, by a shareholder of New Valley. The suit
      alleges that New Valley's purchase of the BML Shares constituted a
      self-dealing transaction which involved the payment of excessive
      consideration by New Valley. The plaintiff seeks (i) a declaration that
      New Valley's directors breached their fiduciary duties, the Company aided
      and abetted such breaches and such parties are therefore liable to New
      Valley, and (ii) unspecified damages to be awarded to New Valley. The
      Company's time to respond to the complaint has not yet expired. The
      Company believes that the allegations are without merit. Although there
      can be no assurances, management is of the opinion, after consultation
      with counsel, that the ultimate resolution of this matter will not have a
      material adverse effect on the Company's consolidated financial position,
      results of operations or cash flows.

9.    RELATED PARTY TRANSACTIONS

      On January 31, 1997, New Valley entered into a stock purchase agreement
      with BOL pursuant to which New Valley acquired 10,483 shares of BML common
      stock (99.1%) for a purchase price of $55,000, consisting of $21,500 in
      cash and a $33,500 promissory note with an interest rate of 9%. The note
      was paid in full in 1997. (Refer to Notes 3 and 8.)

      In January 1998, the Company entered into an amendment to the Amended and
      Restated Consulting Agreement dated as of January 1, 1996 with a
      consultant who also serves as a director and President of New Valley. The
      amendment provides that the consultant is entitled on an annual basis to
      receive additional payments in an amount necessary to reimburse him, on an
      after-tax basis, for all applicable taxes incurred by him during the prior
      calendar year as a result of the grant to him, or vesting, of a 1994 award
      of 500,000 restricted shares of the Company's Common Stock and 1995 and
      1996 awards of 500,000 and 1,000,000, respectively, options to acquire
      shares of the Company's Common Stock. The consultant received an
      additional consulting payment of $425,000 in January 1998, which the
      consultant and the Company have agreed will constitute full satisfaction
      of the Company's obligations under the amendment with respect to 1997.

      Effective May 1, 1998, a former officer of the Company entered into a
      severance agreement in which the Company will pay him a total of $2,208 in
      stock or cash in quarterly installments over a period of 6 years. The
      Company will recognize the expense during the second quarter 1998.





                                      -34-
<PAGE>   36

ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
           RESULTS OF OPERATIONS

                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

INTRODUCTION

         The following discussion provides an assessment of the consolidated
results of operations, capital resources and liquidity of Brooke Group Ltd. (the
"Company") and its subsidiaries and should be read in conjunction with the
Consolidated Financial Statements and notes thereto of the Company and BGLS Inc.
("BGLS") included elsewhere in this document. BGLS is a wholly owned subsidiary
of the Company. The consolidated financial statements include the accounts of
BGLS, Liggett Group Inc. ("Liggett"), Brooke (Overseas) Ltd. ("BOL"), New Valley
Holdings, Inc. ("NV Holdings"), Liggett-Ducat Ltd. ("Liggett-Ducat") and other
less significant subsidiaries. The Company holds an equity interest in New
Valley Corporation ("New Valley") through NV Holdings.

         On January 31, 1997, BOL sold its interest in BrookeMil Ltd. ("BML"), a
real estate investment company doing business in Russia, to New Valley. See Note
3 to the Company's Consolidated Financial Statements.

         The Company is a holding company for a number of businesses which it
holds through its wholly-owned subsidiary BGLS. Accordingly, a separate
Management's Discussion and Analysis of Financial Condition and Results of
Operations for BGLS is not presented herein as it would not differ materially
from the discussion of the Company's consolidated results of operations, capital
resources and liquidity.

         For purposes of this discussion and other consolidated financial
reporting, the Company's significant business segment is tobacco for the three
months ended March 31, 1998 and March 31, 1997.

RECENT DEVELOPMENTS

         THE COMPANY

         STANDSTILL AGREEMENT. On March 5, 1998, BGLS entered into an agreement
(the "Standstill Agreement") with AIF II, L.P. and an affiliated investment
manager on behalf of a managed account (the "Apollo Holders"), who together hold
approximately 41.8% of the $232,864 principal amount of BGLS' 15.75% Senior
Secured Notes due 2001 (the "BGLS Notes").

         Pursuant to the terms of the Standstill Agreement, the Apollo Holders
agreed to defer the payment of interest on the BGLS Notes held by them,
commencing with the interest payment that was due July 31, 1997, which they had
previously agreed to defer, through the interest payment due on July 31, 2000.
The deferred interest payments will be payable at final maturity of the BGLS
Notes on January 31, 2001 or upon an Event of Default under the Indenture for
the BGLS Notes. In connection with the Standstill Agreement, the Company issued
to the Apollo Holders a five-year warrant to purchase 2,000,000 shares of the
Company's common stock at a price of $5.00 per share. The Apollo Holders were
also issued a second warrant expiring October 31, 2004 to purchase an additional
2,150,000 shares of the Company's common stock at a price of $0.10 per share.
The second warrant will become exercisable on October 31, 1999 and the Company
will 




                                      -35-
<PAGE>   37

have the right under certain conditions prior to that date to substitute for
that warrant a new warrant for 9.9% of the common stock of Liggett.

         On February 6, 1998, the holder of 41.9% of the BGLS Notes, who had
previously been a party to the Standstill Agreement, was paid its pro-rata share
of the July 31, 1997 interest payment on the BGLS Notes. On March 2, 1998, BGLS
made the interest payment due on January 31, 1998 to all holders of the BGLS
Notes other than the Apollo Holders.

         SALE OF STOCK. On January 16, 1998, the Company entered into a Stock
Purchase Agreement with High River Limited Partnership ("High River") in which
High River purchased 1,500,000 shares of the Company's common stock for $9,000.

         LIGGETT

         NOTES RESTRUCTURING. On January 30, 1998, with the consent of the
required majority of the holders of the Liggett 11.50% Series B and 19.75%
Series C Senior Secured Notes due 1999 (the "Liggett Notes"), Liggett entered
into various amendments to the Indenture governing the Liggett Notes which
provided, among other things, for a deferral of the February 1, 1998 mandatory
redemption payment of $37,500 to the date of final maturity of the Liggett Notes
on February 1, 1999. In connection with the deferral, the Company agreed to
issue 483,002 shares of the Company's common stock to the holders of record on
January 15, 1998 of the Liggett Notes. The Indenture under which the Liggett
Notes are outstanding was also amended to prohibit, with limited exceptions,
payments of dividends and incurrence of new debt by Liggett and to tighten
restrictions on the disposition of proceeds of asset sales. The Company and BGLS
also agreed to guarantee the payment by Liggett of the August 1, 1998 interest
payment on the Liggett Notes.

         NEW VALLEY

         WESTERN REALTY. In February 1998, New Valley and Apollo Real Estate
Investment Fund III, L.P. ("Apollo") organized Western Realty to make real
estate and other investments in Russia. In connection with the formation of
Western Realty, New Valley agreed, among other things, to contribute the real
estate assets of BrookeMil Ltd. ("BML") to Western Realty and Apollo agreed to
contribute up to $58,000. Western Realty will seek to make additional real
estate and other investments in Russia. New Valley and Apollo have agreed to
invest, through Western Realty or another entity, up to $25,000 in the aggregate
for the potential development of a real estate project in Moscow. In addition,
Western Realty made a $20,000 participating loan to, and payable out of a 30%
profits interest in, a company organized by BOL which will, among other things,
acquire an interest in an industrial site and manufacturing facility being
constructed on the outskirts of Moscow by a subsidiary of BOL.

         NEW ACCOUNTING PRONOUNCEMENTS

         In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement on Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income". SFAS No. 130 establishes standards for reporting and
display of comprehensive income. The purpose of reporting comprehensive income
is to present a measure of all changes in equity that result from recognized
transactions and other economic events of the period other than transactions
with owners in their capacity as owners. SFAS No. 130 requires that an
enterprise classify items of other comprehensive income by their nature in a
financial statement and display the accumulated balance of other comprehensive
income separately from retained earnings and additional paid-in capital in the
equity section of the balance sheet. For the Company, other components of
stockholders' equity include such items as minimum pension liability
adjustments, unearned compensation expense related to stock options and the
Company's proportionate interest in New Valley's capital transactions. SFAS No.
130 is effective for fiscal years beginning after December 15, 1997, with
earlier application 




                                      -36-
<PAGE>   38

permitted. The implementation of SFAS No. 130 for the quarter ended March 31,
1998 did not have a material impact on the consolidated financial statements.

         In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments
of an Enterprise and Related Information". SFAS No. 131 specifies revised
guidelines for determining an entity's operating segments and the type and level
of financial information to be disclosed. SFAS No. 131 provides for a two-tier
test for determining those operating segments that would need to be disclosed
for external reporting purposes. In addition to providing the required
disclosures for reportable segments, SFAS No. 131 also requires disclosure of
certain "second level" information by geographic area and for products/services.
SFAS No. 131 also makes a number of changes to existing disclosure requirements.
Management believes that the adoption of this pronouncement will not have a
material effect on the Company's financial statement disclosures. SFAS No. 131
is initially effective for fiscal years beginning after December 15, 1997, with
earlier application encouraged.

         In February 1998, SFAS No. 132, "Employers' Disclosures about Pensions
and Other Postretirement Benefits," was issued which revises required
disclosures about pensions and postretirement benefit plans in order to
facilitate financial analysis. Recognition or measurement issues are not
addressed in the statement. SFAS No. 132 is effective for the Company for the
year ended 1998. Management believes that the implementation of this
pronouncement will not have a material effect on the Company's financial
statement disclosures.

RECENT DEVELOPMENTS IN THE CIGARETTE INDUSTRY

         PRICING ACTIVITY. On March 7, 1997, R. J. Reynolds Tobacco Company
("RJR") initiated a list price increase on all brands of $.40 per carton
(approximately 4%). Brown & Williamson Tobacco Corporation ("B&W"), Lorillard
Tobacco Company ("Lorillard") and Liggett matched this increase, and, on March
21, 1997, Philip Morris Incorporated ("Philip Morris") announced a price
increase of $.50 per carton. Subsequently, Liggett and the other manufacturers
matched Philip Morris' price increase. On August 29, 1997, Philip Morris
announced a second price increase of $.70 per carton. During the first week of
September, all other major United States cigarette makers, including Liggett,
matched this increase.

         On January 23, 1998, Philip Morris and RJR announced a list price
increase of $.25 per carton (approximately 2 1/2%). This action was matched by
Liggett and the other manufacturers during the following week. On April 3, 1998,
Philip Morris announced a second list price increase of $.50 per carton
(approximately 4.5%). This action was matched by Liggett and the other
manufacturers. Again, on May 11, 1998, Philip Morris and RJR announced another
list price increase of $.50 per carton on all brands. This action was matched by
Liggett and the other manufacturers during the following week.

         LEGISLATION, REGULATION AND LITIGATION. The cigarette industry
continues to be challenged on numerous fronts. New cases continue to be
commenced against Liggett and the Company and other cigarette manufacturers. As
of March 31, 1998, there were approximately 250 individual suits, 30 purported
class actions and 95 state, municipality and other third-party payor health care
reimbursement actions pending in the United States in which Liggett is a named
defendant. As new cases are commenced, the costs associated with defending such
cases and the risks attendant to the inherent unpredictability of litigation
continue to increase. Recently, there have been a number of restrictive
regulatory actions from various Federal administrative bodies, including the
United States Environmental Protection Agency ("EPA") and the Food and Drug
Administration ("FDA"), adverse political decisions and other unfavorable
developments concerning cigarette smoking and the tobacco industry, including
the commencement and certification of class actions and the commencement of
Medicaid reimbursement suits by various states' Attorneys General. These





                                      -37-
<PAGE>   39

developments generally receive widespread media attention. The Company is not
able to evaluate the effect of these developing matters on pending litigation or
the possible commencement of additional litigation, but it is possible that
Company's financial position, results of operations and cash flows could be
materially adversely affected by an ultimate unfavorable outcome in any of such
pending litigation. (See Note 8 to the Company's Consolidated Financial
Statements for a description of legislation, regulation and litigation.)

         The plaintiffs' allegations of liability in those cases in which
individuals seek recovery for personal injuries allegedly caused by cigarette
smoking are based on various theories of recovery, including negligence, gross
negligence, special duty, voluntary undertaking, strict liability, fraud,
misrepresentation, design defect, failure to warn, breach of express and implied
warranties, conspiracy, aiding and abetting concert of action, unjust
enrichment, common law public nuisance, indemnity, market share liability, and
violations of deceptive trade practices laws, RICO and antitrust statutes. In
many of these cases, in addition to compensatory damages, plaintiffs also seek
other forms of relief including disgorgement of profits and punitive damages.
Defenses raised by defendants in these cases include lack of proximate cause,
assumption of the risk, comparative fault and/or contributory negligence, lack
of design defect, statutes of limitations or repose, equitable defenses such as
"unclean hands" and lack of benefit, failure to state a claim and federal
preemption.

         The claims asserted in the health care cost recovery actions vary. In
most of these cases, plaintiffs assert the equitable claim that the tobacco
industry was "unjustly enriched" by plaintiffs' payment of health care costs
allegedly attributable to smoking and seek reimbursement of those costs. Other
claims made by some but not all plaintiffs include the equitable claim of
indemnity, common law claims of negligence, strict liability, breach of express
and implied warranty, violation of a voluntary undertaking or special duty,
fraud, negligent misrepresentation, conspiracy, public nuisance, claims under
state and federal statutes governing consumer fraud, antitrust, deceptive trade
practices and false advertising, and claims under the RICO.

         SETTLEMENTS. In March 1996, Liggett and the Company entered into an
agreement to settle the CASTANO class action tobacco litigation and an agreement
with the Attorneys General of West Virginia, Florida, Mississippi, Massachusetts
and Louisiana to settle certain actions brought against Liggett and the Company
by such states (the "March 1996 Settlements"). Liggett and the Company, while
neither consenting to FDA jurisdiction nor waiving their objections thereto,
agreed to withdraw their objections and opposition to the proposed FDA
regulations and to phase in compliance with certain of the proposed interim FDA
regulations.

         Under the CASTANO settlement agreement, upon final court approval of
the settlement, the CASTANO class would be entitled to receive up to 5% of
Liggett's pretax income (income before income taxes) each year (up to a maximum
of $50,000 per year) for the next twenty-five years, subject to certain
reductions provided for in the agreement, and a $5,000 payment from Liggett if
the Company or Liggett fails to consummate a merger or similar transaction with
another non-settling tobacco company defendant within three years of the date of
the settlement. The Company and Liggett have the right to terminate the CASTANO
settlement under certain circumstances. On May 11, 1996, the CASTANO Plaintiffs
Legal Committee filed a motion with the United States District Court for the
Eastern District of Louisiana seeking preliminary approval of the CASTANO
settlement. On May 23, 1996, the Court of Appeals for the Fifth Circuit reversed
the February 17, 1995 order of the District Court certifying the CASTANO suit as
a nationwide class action and instructed the District Court to dismiss the class
complaint. (For additional information concerning the Fifth Circuit's decision,
see Note 8 to the Company's Consolidated Financial Statements.) In September
1996, the CASTANO plaintiffs withdrew the motion for approval of the CASTANO
settlement.





                                      -38-
<PAGE>   40

         In March 1996, the Company, the CASTANO Plaintiffs Legal Committee and
the CASTANO plaintiffs entered into a letter agreement. According to the terms
of the letter agreement, for the period ending nine months from the date of
Final Approval (if granted) of the CASTANO settlement or, if earlier, the
completion by the Company or Liggett of a combination with any defendant in
CASTANO, except Philip Morris, the CASTANO plaintiffs and their counsel agree
not to enter into any more favorable settlement agreement with any CASTANO
defendant which would reduce the terms of the CASTANO settlement agreement. If
the CASTANO plaintiffs or their counsel enter into any such settlement during
this period, they shall pay the Company $250,000 within thirty days of the more
favorable agreement and offer the Company and Liggett the option to enter into a
settlement on terms at least as favorable as those included in such other
settlement. The letter agreement further provides that during the same time
period, and if the CASTANO settlement agreement has not been earlier terminated
by the Company in accordance with its terms, the Company and its affiliates will
not enter into any business transaction with any third party which would cause
the termination of the CASTANO settlement agreement. If the Company or its
affiliates enter into any such transaction, then the CASTANO plaintiffs will be
entitled to receive $250,000 within thirty days from the transacting party.

         Under the Attorneys General settlement, the five states would share an
initial payment by Liggett of $5,000 ($1,000 of which was paid in March 1996,
with the balance payable over nine years and indexed and adjusted for
inflation), provided that any unpaid amount will be due 60 days after either a
default by Liggett in its payment obligations under the settlement or a merger
or other similar transaction by the Company or Liggett with another defendant in
the lawsuits. In addition, Liggett will be required to pay the states a
percentage of Liggett's pretax income (income before income taxes) each year
from the second through the twenty-fifth year. This annual percentage is 2-1/2%
of Liggett's pretax income, subject to increase to 7-1/2% depending on the
number of additional states joining the settlement. No additional states have
joined this settlement to date. All of Liggett's payments are subject to certain
reductions provided for in the agreement. Liggett has also agreed to pay to the
states $5,000 if the Company or Liggett fails to consummate a merger or other
similar transaction with another defendant in the lawsuits within three years of
the date of the settlement.

         In March 1997, Liggett and the Company entered into a comprehensive
settlement of tobacco litigation through parallel agreements with the Attorneys
General of 17 states and with a nationwide class of individuals and entities
that allege smoking-related claims. Thereafter, during 1997, settlements were
reached with four more states through their respective Attorneys General
(collectively, the "March 1997 Settlements"). The settlements cover all
smoking-related claims, including both addiction-based and tobacco injury claims
against the Company and Liggett brought by the states and, upon court approval,
the nationwide class. On March 12, 1998, the Company and Liggett entered into
additional settlements with the Attorneys General of 14 states, the District of
Columbia and the U. S. Virgin Islands (the "March 1998 Settlements"). On March
26, 1998, the Company and Liggett settled with the Attorney General of Georgia
which joined the March 1998 Settlements.

         As mentioned above, in March 1997, Liggett, the Company and plaintiffs
filed the mandatory class settlement agreement in an action entitled FLETCHER,
ET AL. V. BROOKE GROUP LTD., ET AL., Circuit Court of Mobile County, Alabama,
where the court granted preliminary approval and preliminary certification of
the class, and on May 15, 1997, a similar mandatory class settlement agreement
was filed in an action entitled WALKER, ET AL. V. LIGGETT GROUP INC., ET AL.,
United States District Court, Southern District of West Virginia. The WALKER
court also granted preliminary approval and preliminary certification of the
nationwide class; however, on August 5, 1997, the court vacated its preliminary
certification of the settlement class, which decision is currently on appeal.

         In the FLETCHER action, it is anticipated that class members will be
notified of the settlement and will have an opportunity to appear at a later
court hearing. Effectiveness of the 




                                      -39-
<PAGE>   41
mandatory settlement is conditioned on final court approval of the settlement
after a fairness hearing. There can be no assurance as to whether or when court
approval will be obtained. (For additional information concerning the FLETCHER
action, see Note 16 to the Company's Consolidated Financial Statements.)

         Under the March 1998 Settlements, Liggett is required to pay each of
the 14 settling states and territories their relative share (based on the
Medicaid population of each state over the total Medicaid population of the
United States) of between 27.5% and 30% of Liggett's pre-tax income each year
for 25 years, with a minimum payment guarantee of $1,000 per state over the
first nine years of the agreement. The annual percentage is subject to increase,
pro rata from 27.5% up to 30%, depending on the number of additional states
joining the settlement. Pursuant to the "most favored nation" provisions under
the March 1996 Settlements and the March 1997 Settlements, each of the states
settling under those settlements could benefit from the economic terms of the
March 1998 Settlements.

         At December 31, 1995, the Company had accrued approximately $4,000 for
the present value of the fixed payments under the initial Attorneys General
settlement. At December 31, 1997, in connection with the March 1998 Settlements,
the Company accrued $16,421 for the present value of the fixed payments under
the March 1998 Settlements. At March 31, 1998, in connection with the settlement
with the Attorney General of Georgia, the Company accrued $481 for the present
value of the fixed payments under the Georgia settlement. No additional amounts
have been accrued with respect to the settlements discussed above. The Company
cannot quantify the future costs of the settlements at this time as the amount
Liggett must pay is based, in part, on future operating results. Possible future
payments based on a percentage of pretax income, and other contingent payments
based on the occurrence of a business combination, will be expensed when
considered probable. (See the discussions of the tobacco litigation settlements
appearing in Note 8 to the Company's Consolidated Financial Statements.)

         OTHER MATTERS. On June 20, 1997, Philip Morris, RJR, B&W, Lorillard and
the United States Tobacco Company, along with the Attorneys General for the
States of Arizona, Connecticut, Florida Mississippi, New York and Washington and
the CASTANO Plaintiffs' Litigation Committee executed a Memorandum of
Understanding to support the adoption of federal legislation and necessary
ancillary undertakings, incorporating the features described in a proposed
resolution. The proposed resolution mandates a total reformation and
restructuring of how tobacco products are manufactured, marketed and distributed
in the United States. (For additional information concerning the proposed
resolution, see Note 8 of the Company's Consolidated Financial Statements.) The
proposals are currently being reviewed by the White House, Congress and various
public interest groups. Separately, the other tobacco companies negotiated
settlements of the Attorneys General health care cost recovery actions in
Mississippi, Florida and Texas. Management is unable to predict the ultimate
effect, if any, of the enactment of legislation adopting the proposed
resolution. Management is also unable to predict the ultimate content of any
such legislation. However, adoption of any such legislation could have a
material adverse effect on the business of the Company and Liggett.

         In a speech in September 1997, President Clinton called for federal
legislation that, among other things, would raise cigarette prices by up to
$1.50 per pack. Since then, several bills have been introduced in the Senate
that purport to propose legislation along these lines. Management is unable to
predict the ultimate content of any such legislation; however, adoption of any
such legislation could have a material adverse effect on the business of the
Company and Liggett.




                                      -40-
<PAGE>   42


RESULTS OF OPERATIONS

                            REVENUES                OPERATING INCOME
                       -------------------         -----------------
                       THREE MONTHS ENDED          THREE MONTHS ENDED
                           MARCH 31,                    MARCH 31,
                       ------------------          ------------------        
                       1998          1997          1998          1997
                       ----          ----          ----          ----

Liggett              $65,626       $66,301        $6,251        $  371

Liggett-Ducat         19,154        13,481         1,710         1,462

Other                     23           223          (418)         (995)
                     -------       -------        ------        ------ 

Total                $84,803       $80,005        $7,543        $  838
                     =======       =======        ======        ======


THREE MONTHS ENDED MARCH 31, 1998 COMPARED TO THREE MONTHS ENDED MARCH 31, 1997.

         REVENUES. Total revenues were $84,803 for the three months ended March
31, 1998 compared to $80,005 for the three months ended March 31, 1997. This
6.0% increase in revenues was primarily due to a $5,695 or 42.2% increase in
revenues at BOL slightly offset by a decrease of $675 or 1.0% in revenues at
Liggett reflecting a 12.5% decrease in Liggett's unit sales volume (178.9
million units) accounting for $8,300 in volume variance partially offset by
price increases of $7,285 (see "Recent Developments in the Cigarette Industry -
Pricing Activity") and improved product mix of $340. The decline in premium and
discount unit sales volume was due to certain competitors continuing leveraging
rebate programs tied to their products and increased promotional activity by
certain other manufacturers.

         Premium sales over this period amounted to $22,483 and represented
34.3% of total revenues, compared to $22,604 and 34.1% of total sales for the
same period in 1997. In the premium segment, revenues declined by 0.5% ($121)
over the three months ended March 31, 1998, compared to the same period in 1997,
as a result of a 8.0% decline in unit sales volume (31.5 million units)
accounting for $1,816 in volume variance, which was partially offset by price
increases of $1,695.

         Discount sales (comprising the brand categories of branded discount,
private label, control label and generic) over this period amounted to $43,143
and represented 65.7% of total revenues, compared to $43,698 and 65.9% of total
sales for the same period in 1997. In the discount segment, revenues declined by
1.3% ($555) over the three months ended March 31, 1998, compared to the same
period in 1997, as a result of a 14.2% decline in unit sales volume (147.4
million units) accounting for $6,211 in volume variance, partially offset by
price increases of $5,590 and improved product mix among the brand categories of
$66. For the three months ended March 31, 1998, fixed manufacturing costs on a
basis comparable to the same period in 1997 were $251 lower, although costs per
thousand units increased $0.13 per thousand due to lower production volumes.

         Net sales at Liggett-Ducat for the three months ended March 31, 1998
increased 42.8% ($5,695) to $19,177 over the same period in 1997 due primarily
to an increase of 27.0% ($3,630) in unit sales volume (292 million units), price
increases ($1,231) and the effect of excise tax increases ($834) included in
revenues and cost of goods sold.

         GROSS PROFIT. Consolidated gross profit was $43,147 for the three
months ended March 31, 1998 compared to $38,160 for the three months ended March
31, 1997, an increase of $4,987 when compared to the same period last year,
reflecting an increase in gross profit at Liggett of $3,363 and an increase at
Liggett-Ducat of $1,418 for the three months ended March 31, 1998 compared to
the same period in the prior year.





                                      -41-
<PAGE>   43

         Gross profit at Liggett of $39,405 for the three months ended March 31,
1998 increased due primarily to the price increases discussed above. (See
"Recent Developments in the Cigarette Industry - Pricing Activity".) In 1998,
Liggett's premium and discount brands contributed 36.1% and 63.9%, respectively,
to the Company's overall gross profit. Over the same period in 1997, Liggett's
premium and discount brands contributed 38.5% and 61.5%, respectively, to total
gross profit. As a percent of revenues (excluding federal excise taxes), gross
profit at Liggett increased to 77.5% for the three months ended March 31, 1998
compared to 72.9% for the same period in 1997, with gross profit for the premium
segment at 79.2% and 76.6%, respectively, in the first quarter of 1998 and 1997,
respectively, and gross profit for the discount segment at 76.6% and 69.5% in
1998 and 1997, respectively. This increase is the result of the March 1997,
September 1997 and January 1998 list price increases and improved production
variances. These increases were partially offset by increased tobacco costs at
Liggett due to a reduction in the average discount available to the Company from
leaf tobacco dealers on tobacco purchased under prior years' purchase
commitments.

         As a percent of revenues (excluding Russian excise taxes), gross profit
at Liggett-Ducat increased to 22.0% for the three months ended March 31, 1998
compared to 19.0% in the same period in 1997.

         EXPENSES. Selling, general and administrative expenses were $35,604 for
the three months ended March 31, 1998 compared to $37,322 for the same period
last year due to a decrease in expenses at Liggett of $2,110, offset by an
increase of $480 at Liggett-Ducat. In the three months ended March 31, 1997,
higher expenses included $1,761 of restructuring charges at Liggett. Operating,
selling, general and administrative expenses at Liggett were $33,154 for the
three months ended March 31, 1998 compared to $33,910 for the same period for
the prior year, a decrease of $756. This reduction in operating expenses was due
primarily to Liggett's decrease in unit sales volume which lowered distribution
expense by $552 and costs incurred in systems development which were $2,025
lower than in the prior period. In addition, no severance costs were incurred
during the quarter ended March 31, 1998 whereas costs in the prior period were
$1,172. Such reductions were partially offset by increases in spending on
promotional and marketing programs of $573 and higher legal expenses of $642.

         OTHER INCOME (EXPENSE). Interest expense was $20,786 for the three
months ended March 31, 1998 compared to $15,467 for the same period last year,
an increase of $5,319 primarily due to the debt restructuring at BGLS and
Liggett in which the Company took additional charges of approximately $4,800 for
the three months ended March 31, 1998. (See Note 6 to the Company's Consolidated
Financial Statements.) In addition, Liggett-Ducat and BOL had total interest
expense of $527 for the three months ended March 31, 1998, compared with $254
for the same period in 1997.

         Equity in earnings of affiliate was a loss of $4,187 for the three
months ended March 31, 1998 compared to a loss of $8,194 for the three months
ended March 31, 1997 and relates in both periods to New Valley's net loss
applicable to common shares of $18,675 and $26,321, respectively.

         For the three months ended March 31, 1997, interest expense and loss in
equity of affiliate were offset by the gain on sale of assets, which includes
the sale of the BML shares and surplus realty at Liggett, and proceeds from a
legal settlement.




                                      -42-
<PAGE>   44


CAPITAL RESOURCES AND LIQUIDITY

         Net cash and cash equivalents decreased $172 for the three months ended
March 31, 1998 and increased $246 for the three months ended March 31, 1997. Net
cash used in operations for the three months ended March 31, 1998 was $25,984
compared to net cash used in operations of $26,219 for the comparable period of
1997. In the 1998 period, cash was used in operations for a reduction of accrued
interest of $30,000 ($16,000 of which has been reclassified to long-term debt),
reductions in promotional expenses, taxes payable and other accrued liabilities,
in total amount of $6,366, and an increase in inventories of $8,385. These items
were partially offset by an increase in accounts payable of $4,842. In the 1997
period, cash used in operations was primarily due to an increase in receivables
of $33,500 resulting from the sale of the BML shares to New Valley, a decrease
in accounts payable of $8,300 and a decrease in accrued liabilities of
approximately $24,000. In 1997, these items were offset by a decrease in trade
receivables at Liggett due to declining sales volume, equity in loss of
affiliate of approximately $8,500 and the impact of the deferred gain on the
sale of the BML shares of approximately $23,000.

         Cash provided by investing activities of $822 compares to cash provided
of $20,599 for the periods ended March 31, 1998 and 1997, respectively. In 1998,
proceeds from sales of equipment and an investment were partially offset by
capital expenditures of $395 at Liggett and BOL. In 1997, proceeds include cash
of $21,500 received in the sale of the BML shares to New Valley and cash of
$2,049 received in the sale of certain of Liggett's surplus realty offset by
capital expenditures of $1,307 at Liggett and BOL.

         Cash provided by financing activities was $24,911 and $6,266 for the
three months ended March 31, 1998 and 1997, respectively. Proceeds in the 1998
period include cash received from the sale of common stock and exercise of stock
options, in total $9,796, proceeds from the participating loan made by Western
Realty, and net repayments under Liggett's revolving credit facility (the
"Facility") of $5,162 partially offset by distributions on common stock of $900.
Proceeds from financing activities in 1997 include proceeds at BOL from credit
lines and net borrowings under the Facility of $12,067 at March 31, 1997. These
proceeds were offset by repayments on debt including principally the required
repurchase of $7,500 face amount of Liggett bonds on February 1, 1997 at a net
gain of $2,963. Distributions on common stock in the 1997 period include
distributions declared in the fourth quarter 1996 which were paid in January
1997 and distributions declared and paid in March for the first quarter of 1997.

         LIGGETT. Liggett had a net capital deficiency of $190,383 at March 31,
1998, is highly leveraged and has substantial near-term debt service
requirements. In addition, the Liggett Notes mature on February 1, 1999 and the
Facility expires on March 8, 1999. Due to the many risks and uncertainties
associated with the cigarette industry, the impact of recent tobacco litigation
settlements (see "Recent Developments in the Cigarette Industry - Legislation
and Litigation") and increased tobacco costs, there can be no assurance that
Liggett will be able to meet its future earnings goals. Consequently, Liggett
could be in violation its debt covenants, including covenants limiting the
maximum permitted adjusted net worth and net working capital deficiencies, and
if its lenders were to exercise acceleration rights under the Facility or the
Liggett Notes' Indenture or refuse to lend under the Facility, Liggett would not
be able to satisfy such demands or its working capital requirements. (See below
for additional information concerning these covenants.)

         The Liggett Series B Notes ($150,000) and Liggett C Notes ($32,279)
issued in 1992 and in 1994, respectively, pay interest semiannually at an annual
rate of 11.5% and 19.75%, respectively. The Liggett Notes required mandatory
principal redemptions of $7,500 on February 1 in each of the years 1993 through
1997 and $37,500 on February 1, 1998 with the balance of the Liggett Notes due
on February 1, 1999 (see below). The Liggett Notes are collateralized by
substantially all of the assets of Liggett, excluding accounts receivable and
inventory. Eve is guarantor for the Liggett Notes. The Liggett Notes may be
redeemed, in whole or in part, at a price equal to 100% of the principal amount,
at the option of Liggett. The Liggett Notes contain restrictions on Liggett's
ability 




                                      -43-
<PAGE>   45

to declare or pay cash dividends, incur additional debt, grant liens and
enter into any new agreements with affiliates, among others.

         On January 30, 1998, Liggett obtained the consents of the required
majority of the holders of the Liggett Notes to various amendments to the
Indenture governing the Liggett Notes. The amendments provide, among other
things, for a deferral of the February 1, 1998 mandatory redemption of $37,500
principal amount of the Liggett Notes to the date of final maturity, February 1,
1999. In addition, the amendments prohibit, with limited exceptions, payments of
dividends and incurrence of new debt by Liggett and tighten restrictions on the
disposition of proceeds of asset sales. The Company and BGLS also agreed to
guarantee the payment by Liggett of the August 1, 1998 interest payment on the
Liggett Notes. (Refer to Note 6 to the Company's Consolidated Financial
Statements.) At maturity, the Liggett Notes will require a principal payment of
$144,891. Based on Liggett's results of operations for 1997 and the three months
ended March 31, 1998, Liggett does not anticipate it will be able to generate
sufficient cash from operations to make such payments.

         As discussed above, Liggett also has a $40,000 Facility expiring March
8, 1999 under which $28,628 was outstanding at March 31, 1998. On August 29,
1997, the Facility was amended to permit Liggett to borrow an additional $6,000
which was used on that date in making the interest payment of $9,700 due on
August 1, 1997 to the holders of the Liggett Notes. BGLS guaranteed the
additional $6,000 advance under the Facility and collateralized the guarantee
with $6,000 in cash, deposited with Liggett's lender. At March 31, 1998, this
amount is classified in other assets on the balance sheet. Availability under
the Facility was approximately $1,483 based on eligible collateral at March 31,
1998. The Facility is collateralized by all inventories and receivables of
Liggett. Borrowings under the Facility, whose interest is calculated at a rate
equal to 1.5% above Philadelphia National Bank's (the indirect parent of
Congress Financial Corporation, the lead lender) prime rate, bear a rate of
10.0% at March 31, 1998. The Facility contains certain financial covenants
similar to those contained in the Liggett Notes' Indenture including
restrictions on Liggett's ability to declare or pay cash dividends, incur
additional debt, grant liens and enter into any new agreements with affiliates,
among others. In addition, the Facility, as amended on April 8, 1998, imposes
requirements with respect to Liggett's adjusted net worth (not to fall below a
deficit of $195,000 as computed in accordance with the agreement, this
computation was $186,416 at March 31, 1998) and working capital (not to fall
below a deficit of $17,000 as computed in accordance with the agreement, this
computation was $4,984 at March 31, 1998). At March 31, 1998, Liggett was in
compliance with all covenants under the Facility. The Facility, as amended, also
provides that a default by Liggett under the March 1996 Settlements, March 1997
Settlements and March 1998 Settlements shall constitute an event of default
under the Facility.

         Liggett (and, in certain cases, the Company) and other United States
cigarette manufacturers have been named as defendants in a number of direct and
third-party actions (and purported class actions) predicated on the theory that
they should be liable for damages from cancer and other adverse health effects
alleged to have been caused by cigarette smoking or by exposure to so-called
secondary smoke (environmental tobacco smoke) from cigarettes.

         The Company believes, and has been so advised by counsel handling the
respective cases, that the Company and Liggett have a number of valid defenses
to the claim or claims asserted against them. Litigation is subject to many
uncertainties, and it is possible that some of these actions could be decided
unfavorably. An unfavorable outcome of a pending smoking and health case could
encourage the commencement of additional similar litigation. Recently, there
have been a number of adverse regulatory, political and other developments
concerning cigarette smoking and the tobacco industry, including the
commencement of the purported class actions referred to above. These
developments generally receive widespread media attention. Neither the Company
nor Liggett is able to evaluate the effect of these developing matters on
pending litigation 




                                      -44-
<PAGE>   46
or the possible commencement of additional litigation. (See "Recent Development
in the Cigarette Industry - Legislation, Regulation and Litigation" and
"--Settlements" above and Note 8 to the Company's Consolidated Financial
Statements.)

         The Company is unable to make a meaningful estimate of the amount or
range of loss that could result from an unfavorable outcome of the cases pending
against the Company and Liggett. It is possible that the Company's consolidated
financial position, results of operations or cash flows could be materially
affected by an ultimate unfavorable outcome in any such pending litigation.

         BGLS. On March 5, 1998, BGLS entered into the Standstill Agreement
whereby the Apollo Holders agreed to the deferral of interest payments,
commencing with the interest payment due July 31, 1997 through the interest
payment due July 31, 2000. (See "Recent Developments - The Company - Standstill
Agreement".) At March 31, 1998, the carrying value of BGLS' long-term debt (net
of unamortized discount of $22,940) was approximately $226,724, based on
modification of the terms of the debt with the Apollo Holders.

         The 14.500% Subordinated Debentures due 1998 in principal amount of
$800 were paid at maturity on April 1, 1998.

         Liggett-Ducat is building a new cigarette factory on the outskirts of
Moscow. The new factory, which will utilize Western cigarette making technology
and have a capacity of 30 billion units per year, will produce American and
international blend cigarettes, as well as traditional Russian cigarettes.
Western Realty has made a $20,000 participating loan to, and payable out of a
30% profits interest, in a company organized by BOL which holds BOL's interests
in Liggett-Ducat and the new manufacturing facility. (See "Recent Developments -
New Valley" and Note 3 to the Company's Consolidated Financial Statements.) In
addition, BOL has entered into equipment purchases of approximately $35,400, of
which $28,800 will be financed over five years beginning in 1998. The Company is
a guarantor of one of the purchases for which the remaining obligation is
approximately $7,000.

         THE COMPANY. The Company has scheduled debt maturities of $6,427 due in
the year 1998; approximately $5,000 of this debt relates to credit lines
established by Liggett-Ducat which have been paid as of May 16, 1998. Liggett
has a payment due on the Liggett Notes at maturity on February 1, 1999 of
approximately $145,000 and the Facility expires on March 8, 1999. The Company
believes that it will continue to meet its liquidity requirements through 1998,
although the BGLS Notes Indenture limits the amount of restricted payments BGLS
is permitted to make to the Company during the calendar year. At March 31, 1998,
the remaining amount available through December 31, 1998 in the Restricted
Payment Basket related to BGLS' payment of dividends to the Company (as defined
by the BGLS Notes Indenture) is $11,086. Company expenditures in 1998 for
current operations include debt service estimated at $30,715, dividends on the
Company's shares (currently at an annual rate of approximately $6,100) and
corporate expense. The Company anticipates funding 1998 current operations and
long-term growth with the proceeds from public and/or private debt and equity
financing, management fees and other payments from subsidiaries of approximately
$3,600 and distributions from New Valley. New Valley may acquire or seek to
acquire additional operating businesses through merger, purchase of assets,
stock acquisition or other means, or to make other investments, which may limit
its ability to make such distributions.




                                      -45-
<PAGE>   47


SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

         The Company and its representatives may from time to time make oral or
written "forward-looking statements" within the meaning of the Private
Securities Reform Act of 1995 (the "Reform Act"), including any statements that
may be contained in the foregoing discussion in "Management's Discussion and
Analysis of Financial Condition and Results of Operations", in this report and
in other filings with the Securities and Exchange Commission and in its reports
to shareholders, which reflect management's current views with respect to future
events and financial performance. These forward-looking statements are subject
to certain risks and uncertainties and, in connection with the "safe-harbor"
provisions of the Reform Act, the Company is hereby identifying important
factors that could cause actual results to differ materially from those
contained in any forward-looking statement made by or on behalf of the Company.
Liggett continues to be subject to risk factors endemic to the domestic tobacco
industry including, without limitation, health concerns relating to the use of
tobacco products and exposure to ETS, legislation, including tax increases,
governmental regulation, privately imposed smoking restrictions, governmental
and grand jury investigations and litigation. Each of the Company's operating
subsidiaries, namely Liggett and Liggett-Ducat, are subject to intense
competition, changes in consumer preferences, the effects of changing prices for
its raw materials and local economic conditions. Furthermore, the performance of
Liggett-Ducat's operations in Russia are affected by uncertainties in Russia
which include, among others, political or diplomatic developments, regional
tensions, currency repatriation restrictions, foreign exchange fluctuations,
inflation, and an undeveloped system of commercial laws and legislative reform
relating to foreign ownership in Russia. In addition, the Company has a high
degree of leverage and substantial near-term debt service requirements, as well
as a net worth deficiency and recent losses from continuing operations. The
Indenture for the BGLS Notes provides for, among other things, the restriction
of certain affiliated transactions between the Company and its affiliates, as
well as for certain restrictions on the use of future distributions received
from New Valley. Due to such uncertainties and risks, readers are cautioned not
to place undue reliance on such forward-looking statements, which speak only as
of the date on which such statements are made. The Company does not undertake to
update any forward-looking statement that may be made from time to time by or on
behalf of the Company.





                                      -46-
<PAGE>   48


                                     PART II
                                OTHER INFORMATION

Item 1.    LEGAL PROCEEDINGS

           Reference is made to Note 8, incorporated herein by reference, to the
            Consolidated Financial Statements of Brooke Group Ltd. and BGLS Inc.
            (collectively, the "Companies") included elsewhere in this report on
            Form 10-Q which contains a general description of certain legal
            proceedings to which the Company and/or BGLS or their subsidiaries
            are a party and certain related matters. Reference is also made to
            Exhibit 99.1 for additional information regarding the pending
            material legal proceedings to which the Company, BGLS and/or Liggett
            are party.

Item 2.    CHANGES IN SECURITIES AND USE OF PROCEEDS

           No securities of the Company which were not registered under the
            Securities Act of 1933, as amended (the "Securities Act"), have been
            issued or sold by the Company during the three months ended March
            31, 1998, except as follows:

           (i)    As of January 1, 1998, the Company granted to officers of the
                  Company stock options to purchase 42,500 shares of the
                  Company's common stock at a price of $5.00 per share.

           (ii)   On January 16, 1998, High River Limited Partnership purchased
                  1,500,000 shares of the Company's common stock at a price of
                  $6.00 per share (an aggregate of $9,000,000).

           (iii)  On February 2, 1998, the Company issued 483,002 shares of its
                  common stock to the holders of the Liggett Notes in connection
                  with amendments to the Indenture governing the Liggett Notes.

           (iv)   On March 12, 1998, the Company granted a law firm that
                  represents the Company and Liggett an option for 1,250,000
                  shares of the Company's common stock at a purchase price of
                  $17.50 per share.

           (v)    In March 1998, a consultant to the Company purchased 181,800
                  shares of the Company's common stock upon exercise of options
                  at a price of $2.00 per share (an aggregate of $363,600).

           (vi)   In March 1998, employees of the Company purchased 86,632
                  shares of the Company's common stock upon exercise of options
                  at a price of $5.00 per share (an aggregate of $433,160).

           The foregoing transactions were effected in reliance on the exemption
            from registration afforded by Section 4(2) of the Securities Act or
            did not involve a "sale" under the Securities Act.

Item 3.    DEFAULTS UPON SENIOR SECURITIES

           As of March 31, 1998, New Valley Corporation, the Companies'
           affiliate, had the following respective accrued and unpaid dividend
           arrearages on its 1,071,462 outstanding shares of $15.00 Class A
           Increasing Rate Cumulative Senior Preferred 




                                      -47-

<PAGE>   49

           Shares ($100 Liquidation Value), $.01 par value per share (the "Class
           A Shares") and 2,790,776 outstanding shares of $3.00 Class B
           Cumulative Convertible Preferred Shares ($25 Liquidation Value), $.10
           par value per share (the "Class B Shares"): (1) $176.2 million or
           $164.41 per Class A Share; and (2) $145.7 million or $52.20 per Class
           B Share.

Item 6.    EXHIBITS AND REPORTS ON FORM 8-K

          (a)   EXHIBITS

            27.1      Brooke Group Ltd.'s Financial Data Schedule (for SEC use
                      only).

            27.2      BGLS Inc.'s Financial Data Schedule (for SEC use only).

            99.1      Material Legal Proceedings.

            99.2      Liggett Group Inc.'s Interim Consolidated Financial
                      Statements for the quarterly period ended March 31, 1998.

            99.3      New Valley Corporation's Interim Consolidated Financial
                      Statements for the quarterly period ended March 31, 1998.

            99.4      Brooke (Overseas) Ltd.'s Interim Consolidated Financial
                      Statements for the quarterly period ended March 31, 1998.

            99.5      New Valley Holdings, Inc.'s Interim Consolidated Financial
                      Statements for the quarterly period ended March 31, 1998.

           (b)   REPORTS ON FORM 8-K

                 The Company filed the following reports on Form 8-K during the
first quarter of 1998.

                  DATE                ITEMS           FINANCIAL STATEMENTS
                  ----                -----           --------------------
   1.     January 12, 1998            5, 7                    None

   2.     January 14, 1998              5                     None

   3.     January 16, 1998            5, 7                    None

   4.     January 21, 1998              5                     None

   5.     February 2, 1998            5, 7                    None

   6.     February 6, 1998            5, 7                    None

   7.     March 2, 1998               5, 7                    None




                                      -48-
<PAGE>   50


                                   SIGNATURES

    Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned thereunto duly authorized.


                                              BROOKE GROUP LTD.
                                              (REGISTRANT)



                                               By: /s/ Joselynn D. Van Siclen
                                               ------------------------------ 
                                                       Joselynn D. Van Siclen
                                                       Vice President and Chief
                                                       Financial Officer


Date:  May 20, 1998

                                               BGLS INC.
                                               (REGISTRANT)



                                               By: /s/ Joselynn D. Van Siclen
                                               ------------------------------
                                                       Joselynn D. Van Siclen
                                                       Vice President and Chief
                                                       Financial Officer

Date:  May 20, 1998




                                      -49-