<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 JUNE 30, 1997


                                BROOKE GROUP LTD.
             (Exact name of registrant as specified in its charter)

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


                                    BGLS INC.
             (Exact name of registrant as specified in its charter)

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

</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

         Explanatory Note: BGLS Inc. is required to file all reports required by
Section 13 or 15(d) of the Exchange Act in connection with its 15.75% Series B
Senior Secured Notes due 2001.

         At August 11, 1997, Brooke Group Ltd. had 18,097,096 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 June 30, 1997 and
         December 31, 1996.............................................................................       2

   BGLS Inc. Consolidated Balance Sheets as of June 30, 1997 and December 31, 1996.....................       3

   Brooke Group Ltd. Consolidated Statements of Operations for the three and six months
         ended June 30, 1997 and June 30, 1996.........................................................       4

   BGLS Inc. Consolidated Statements of Operations for the three and six months ended
         June 30, 1997 and June 30, 1996...............................................................       5

   Brooke Group Ltd. Consolidated Statement of Stockholders' Equity (Deficit) for the six
         months ended June 30, 1997....................................................................       6

   BGLS Inc. Consolidated Statement of Stockholder's Equity (Deficit) for the six months
         ended June 30, 1997...........................................................................       7

   Brooke Group Ltd. Consolidated Statements of Cash Flows for the six months ended
         June 30, 1997 and June 30, 1996...............................................................       8

   BGLS Inc. Consolidated Statements of Cash Flows for the six months ended
         June 30, 1997 and June 30, 1996...............................................................       9

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

Item 2.  Management's Discussion and Analysis
         of Financial Condition and Results of Operations..............................................      28

PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS..............................................................................      38

Item 3. DEFAULTS UPON SENIOR SECURITIES................................................................      38

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS............................................      38

Item 6. EXHIBITS AND REPORTS ON FORM 8-K...............................................................      39

SIGNATURES..............................................................................................     40


</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>
                                                                                           June 30,      December 31,
                                                                                             1997            1996
                                                                                          ---------      ------------
<S>                                                                                       <C>             <C>      
ASSETS:

Current assets:
  Cash and cash equivalents ........................................................      $  19,549       $   1,941
  Accounts receivable - trade ......................................................         12,106          19,475
  Other receivables ................................................................            731           1,217
  Receivables from affiliates ......................................................         11,965              47
  Inventories ......................................................................         47,447          53,691
  Other current assets .............................................................          3,749           4,181
                                                                                          ---------       ---------
    Total current assets ...........................................................         95,547          80,552

Property, plant and equipment, at cost, less accumulated
  depreciation of $32,204 and $31,047 ..............................................         31,605          80,282
Intangible assets, at cost, less accumulated amortization
  of $18,375 and $17,457 ...........................................................          3,524           4,421
Investment in affiliate ............................................................                          3,051
Other assets .......................................................................          4,641           9,371
                                                                                          ---------       ---------
    Total assets ...................................................................      $ 135,317       $ 177,677
                                                                                          =========       =========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt ..............................      $  70,695       $  55,242
  Accounts payable .................................................................         16,224          32,461
  Due to affiliates ................................................................                            990
  Dividends payable ................................................................                          1,387
  Cash overdraft ...................................................................                              6
  Accrued promotional expenses .....................................................         30,390          30,257
  Accrued taxes payable ............................................................         21,350          26,379
  Accrued interest .................................................................         23,383          24,354
  Other accrued liabilities ........................................................         24,350          33,387
                                                                                          ---------       ---------
    Total current liabilities ......................................................        186,392         204,463

Notes payable, long-term debt and other obligations, less current portion ..........        342,253         378,243
Noncurrent employee benefits .......................................................         29,662          31,256
Other liabilities ..................................................................         30,329          18,704

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
    24,998,043 shares, outstanding 18,097,096 and 18,497,096 shares ................          1,850           1,850
  Additional paid-in capital .......................................................         91,454          94,169
  Deficit ..........................................................................       (496,642)       (490,706)
  Other ............................................................................        (15,842)        (27,963)
  Less: 6,900,947 and 6,500,947 shares of common stock in treasury, at cost ........        (34,139)        (32,339)
                                                                                          ---------       ---------
      Total stockholders' equity (deficit) .........................................       (453,319)       (454,989)
                                                                                          ---------       ---------

      Total liabilities and stockholders' equity (deficit) .........................      $ 135,317       $ 177,677
                                                                                          =========       =========
</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>
                                                                                    June 30,      December 31,
                                                                                      1997            1996
                                                                                    ---------     ------------
<S>                                                                                 <C>             <C>      
ASSETS:

Current assets:
  Cash and cash equivalents ..................................................      $  19,273       $   1,940
  Accounts receivable - trade ................................................         12,106          19,475
  Other receivables ..........................................................            700           1,166
  Receivables from affiliates ................................................         11,965              47
  Inventories ................................................................         47,447          53,691
  Other current assets .......................................................          3,293           3,878
                                                                                    ---------       ---------
      Total current assets ...................................................         94,784          80,197

Property, plant and equipment, at cost, less accumulated depreciation of
  $31,848 and $30,762 ........................................................         31,366          79,972
Intangible assets, at cost, less accumulated amortization of $18,375
  and $17,457 ................................................................          3,524           4,421
Investment in affiliate ......................................................                          3,051
Other assets .................................................................          7,884          10,467
                                                                                    ---------       ---------
      Total assets ...........................................................      $ 137,558       $ 178,108
                                                                                    =========       =========

LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt ........................      $  70,220       $  53,945
  Accounts payable ...........................................................         16,099          32,336
  Cash overdraft .............................................................                              6
  Due to parent ..............................................................         22,217          29,598
  Accrued promotional expenses ...............................................         30,390          30,257
  Accrued taxes payable ......................................................         21,350          26,379
  Accrued interest ...........................................................         23,383          24,354
  Other accrued liabilities ..................................................         24,187          32,861
                                                                                    ---------       ---------
      Total current liabilities ..............................................        207,846         229,736

Notes payable, long-term debt and other obligations, less current portion ....        342,253         378,243
Noncurrent employee benefits .................................................         29,662          31,256
Other liabilities ............................................................         36,529          21,958

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

Stockholder's equity (deficit):
  Common stock, par value $0.01 per share; 100 shares authorized,
    issued and outstanding ...................................................
  Additional paid-in capital .................................................         39,081          39,081
  Deficit ....................................................................       (506,211)       (499,264)
  Other ......................................................................        (11,602)        (22,902)
                                                                                    ---------       ---------
      Total stockholder's deficit ............................................       (478,732)       (483,085)
                                                                                    ---------       ---------

      Total liabilities and stockholder's equity (deficit) ...................      $ 137,558       $ 178,108
                                                                                    =========       =========
</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                     Six Months Ended
                                                             -------------------------------       -------------------------------
                                                              June 30,            June 30,           June 30,           June 30,
                                                                1997                1996               1997               1996 
                                                             ------------       ------------       ------------       ------------
<S>                                                          <C>                <C>                <C>                <C>         
Revenues* .............................................      $     96,593       $    125,213       $    176,598       $    215,729
Cost of goods sold* ...................................            50,951             63,522             92,796            110,570
                                                             ------------       ------------       ------------       ------------

Gross profit ..........................................            45,642             61,691             83,802            105,159
Operating, selling, administrative and general expenses            39,715             58,264             77,037            103,156
                                                             ------------       ------------       ------------       ------------

Operating income ......................................             5,927              3,427              6,765              2,003

Other income (expenses):
    Interest income ...................................               692                110              1,251                128
    Interest expense ..................................           (15,499)           (15,457)           (30,966)           (30,234)
    Equity in loss of affiliate .......................            (5,841)            (1,306)           (14,398)            (2,883)
    Sale of assets ....................................             1,065                                23,086
    Retirement of debt ................................                                                   2,963
    Proceeds from legal settlement ....................                                                   4,125
    Other, net ........................................                61              2,219                180              2,334
                                                             ------------       ------------       ------------       ------------

Loss from continuing operations before income taxes ...           (13,595)           (11,007)            (6,994)           (28,652)
Provision (benefit) for income taxes ..................                45               (289)               789                146
                                                             ------------       ------------       ------------       ------------

Loss from continuing operations .......................           (13,640)           (10,718)            (7,783)           (28,798)
                                                             ------------       ------------       ------------       ------------

Discontinued operations:
    (Loss) income from discontinued operations ........              (321)                46                 42                349
    Gain on disposal ..................................                 5                                     5
                                                             ------------       ------------       ------------       ------------
(Loss) income from discontinued operations ............              (316)                46                 47                349
                                                             ------------       ------------       ------------       ------------

Net loss ..............................................           (13,956)           (10,672)            (7,736)           (28,449)
Proportionate share of New Valley capital transaction,
    retirement of Class A Preferred Shares ............                                                                      1,782
                                                             ------------       ------------       ------------       ------------

Net loss applicable to common shares ..................      $    (13,956)      $    (10,672)      $     (7,736)      $    (26,667)
                                                             ============       ============       ============       ============

Per common share:

    Loss from continuing operations ...................      $      (0.75)      $      (0.58)      $      (0.42)      $      (1.46)
                                                             ============       ============       ============       ============
    (Loss) income from discontinued operations ........      $      (0.02)      $                  $                          0.02
                                                             ============       ============       ============       ============
    Net loss applicable to common shares ..............      $      (0.77)      $      (0.58)      $      (0.42)      $      (1.44)
                                                             ============       ============       ============       ============

Weighted average common shares outstanding ............        18,097,096         18,497,096         18,240,743         18,497,096
                                                             ============       ============       ============       ============

</TABLE>
----------


* Revenues and Cost of goods sold include federal excise taxes of $19,153,
  $29,487, $36,013 and $50,684, 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               Six Months Ended
                                                             -------------------------       -------------------------
                                                              June 30,        June 30,        June 30,        June 30,
                                                                1997            1996            1997            1996
                                                             ---------       ---------       ---------       ---------
<S>                                                          <C>             <C>             <C>             <C>      
Revenues* .............................................      $  96,593       $ 125,213       $ 176,598       $ 215,729
Cost of goods sold* ...................................         50,951          63,522          92,796         110,570
                                                             ---------       ---------       ---------       ---------

Gross profit ..........................................         45,642          61,691          83,802         105,159
Operating, selling, administrative 
  and general expenses.................................         39,581          58,073          76,657         102,660
                                                             ---------       ---------       ---------       ---------

Operating income ......................................          6,061           3,618           7,145           2,499

Other income (expenses):
   Interest income ....................................            680              60           1,239              78
   Interest expense ...................................        (16,411)        (16,395)        (32,792)        (32,063)
   Equity in loss of affiliate ........................         (5,841)         (1,306)        (14,398)         (2,883)
   Sale of assets .....................................          1,279                          27,663
   Retirement of debt .................................                                          2,963
   Other, net .........................................             61           1,703             173           1,668
                                                             ---------       ---------       ---------       ---------

Loss from continuing operations before income taxes ...        (14,171)        (12,320)         (8,007)        (30,701)
Provision (benefit) for income taxes ..................             45            (253)            787             198
                                                             ---------       ---------       ---------       ---------

Loss from continuing operations .......................        (14,216)        (12,067)         (8,794)        (30,899)

Discontinued operations:
   (Loss) income from discontinued operations .........           (321)             46              42             349
   Gain on disposal ...................................              5                               5               
                                                             ---------       ---------       ---------       ---------
(Loss) income from discontinued operations ............           (316)             46              47             349
                                                             ---------       ---------       ---------       ---------

Net loss ..............................................      $ (14,532)      $ (12,021)      $  (8,747)      $ (30,550)
                                                             =========       =========       =========       =========


</TABLE>



* Revenues and Cost of goods sold include federal excise taxes of $19,153,
  $29,487, $36,013 and $50,684, 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>
                                               Common Stock         Additional
                                          ----------------------      Paid-In                               Treasury
                                            Shares       Amount       Capital      Deficit       Other        Stock        Total
                                          ----------    --------    ----------   ---------     --------     ---------    --------- 
<S>                                       <C>           <C>          <C>         <C>           <C>          <C>          <C>       
Balance, December 31, 1996 ..........     18,497,096    $  1,850     $ 94,169    $(490,706)    $(27,963)    $(32,339)    $(454,989)

Net loss ............................                                               (7,736)                                 (7,736)

Distributions on common stock
  ($0.15 per share) .................                                  (2,715)                                              (2,715)

Amortization of deferred
  compensation ......................                                                               821                        821

Unrealized holding gain on investment
  in New Valley .....................                                                            11,965                     11,965

Effect of New Valley
  capital transactions ..............                                                              (665)                      (665)

Settlement of loan ..................       (400,000)                                1,800                    (1,800)
                                          ----------    --------     --------    ---------     --------     --------     --------- 


Balance, June 30, 1997 ..............     18,097,096    $  1,850     $ 91,454    $(496,642)    $(15,842)    $(34,139)    $(453,319)
                                         ===========    ========     ========    =========     ========     ========     =========

</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>
                                                                     
                                              Common Stock          Additional 
                                         ----------------------      Paid-In
                                          Shares        Amount       Capital         Deficit         Other           Total
                                         -------        ------      ----------      ---------       --------       ---------
<S>                                      <C>           <C>          <C>           <C>             <C>            <C>       
Balance, December 31, 1996 ........          100          $          $39,081      $(499,264)      $(22,902)      $(483,085)

Net loss ..........................                                                  (8,747)                        (8,747)

Unrealized holding gain on
  investment in New Valley ........                                                                 11,965          11,965

Effect of New Valley capital
  transactions ....................                                                                   (665)           (665)

Settlement of loan ................                                                   1,800                          1,800
                                         -------         -----       -------      ---------       --------       ---------

Balance, June 30, 1997 ............          100         $           $39,081      $(506,211)      $(11,602)      $(478,732)
                                         =======         =====       =======      =========       ========       =========

</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>
                                                                               Six Months Ended
                                                                          -------------------------
                                                                           June 30,        June 30,
                                                                             1997            1996
                                                                          ---------       ---------
<S>                                                                       <C>             <C>       
Net cash used in operating activities ..............................      $ (20,003)      $    (735)
                                                                          ---------       ---------

Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net .................         43,245           4,415
  Capital expenditures .............................................         (3,653)        (14,680)
  Dividends from New Valley ........................................                          6,183
  Other, net .......................................................                           (491)
                                                                          ---------       ---------

Net cash provided by (used in) investing activities ................         39,592          (4,573)
                                                                          ---------       ---------

Cash flows from financing activities:
  Proceeds from debt ...............................................          4,225          15,161
  Repayments of debt ...............................................         (6,852)         (7,769)
  Borrowings under revolver ........................................        137,062         172,043
  Repayments on revolver ...........................................       (132,308)       (166,050)
  Decrease in cash overdraft .......................................             (6)         (4,266)
  Distributions on common stock ....................................         (4,102)         (2,775)
                                                                          ---------       ---------

Net cash (used in) provided by financing activities ................         (1,981)          6,344
                                                                          ---------       ---------

Net increase in cash and cash equivalents ..........................         17,608           1,036
Cash and cash equivalents, beginning of period .....................          1,941           3,370
                                                                          ---------       ---------

Cash and cash equivalents, end of period ...........................      $  19,549       $   4,406
                                                                          =========       =========



Supplemental non-cash financing activities:

  Exchange of Series 2 Senior Secured Notes for Series A Notes .....                      $  99,154
  Exchange of 14.50% Subordinated Debentures for Series B Notes ....                        125,495
  Issuance of Series A Notes for options ...........................                            822
  Exchange of Series A Notes for Series B Notes ....................                         99,976
  Issuance of promissory notes for shares of Liggett-Ducat .........                          1,643
  Promissory note from New Valley ..................................      $  33,500




</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>
                                                                               Six Months Ended
                                                                          -------------------------
                                                                           June 30,       June 30,
                                                                             1997            1996
                                                                          ---------       ---------
<S>                                                                       <C>             <C>       
Net cash used in operating activities ..............................      $ (25,202)      $     (73)
                                                                          ---------       ---------

Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net .................         43,245           4,415
  Capital expenditures .............................................         (3,653)        (14,680)
  Dividends from New Valley ........................................                          6,183
  Other, net .......................................................                           (491)
                                                                          ---------       ---------
Net cash provided by (used in) investing activities ................         39,592          (4,573)
                                                                          ---------       ---------

Cash flows from financing activities:
  Proceeds from debt ...............................................          3,750          14,519
  Repayments of debt ...............................................         (5,555)         (7,514)
  Borrowings under revolver ........................................        137,062         172,043
  Repayments on revolver ...........................................       (132,308)       (166,050)
  Decrease in cash overdraft .......................................             (6)         (3,761)
  Distributions paid to parent .....................................                         (3,621)
                                                                          ---------       ---------
Net cash provided by financing activities ..........................          2,943           5,616
                                                                          ---------       ---------

Net increase in cash and cash equivalents ..........................         17,333             970
Cash and cash equivalents, beginning of period .....................          1,940           3,370
                                                                          ---------       ---------

Cash and cash equivalents, end of period ...........................      $  19,273       $   4,340
                                                                          =========       =========

Supplemental non-cash financing activities:

  Exchange of Series 2 Senior Secured Notes for Series A Notes .....                      $  99,154
  Exchange of 14.50% Subordinated Debentures for Series B Notes ....                        125,495
  Issuance of Series A Notes for options ...........................                            822
  Exchange of Series A Notes for Series B Notes ....................                         99,976
  Forgiveness of debt by parent ....................................                         13,705
  Issuance of promissory notes for shares of Liggett-Ducat .........                          1,643
  Promissory note from New Valley ..................................      $  33,500

</TABLE>


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


                                       -9-




<PAGE>   11

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)



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


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, 1996, 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 1996 consolidated financial statements have been
      reclassified to conform to the 1997 presentation.

      LIQUIDITY:

      The Company's principal sources of liquidity for 1997 include, among other
      things, proceeds from the sale of BrookeMil Ltd. ("BML"), a subsidiary of
      BOL, to an affiliate, New Valley Corporation ("New Valley"), on January
      31, 1997, 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.

      Liggett had net capital and working capital deficiencies of $178,660 and
      $78,481, respectively, at June 30, 1997, is highly leveraged and has
      substantial near-term debt service requirements. Further, Liggett's Senior
      Secured Notes (the "Liggett Notes") require a mandatory principal
      redemption of $37,500 on February 1, 1998 and a payment at maturity on
      February 1, 1999 of $107,400, and Liggett's revolving credit facility (the
      "Facility") expires on March 8, 1998 unless extended by its lenders. Based
      on Liggett's net loss for 1996 and anticipated 1997 operating results,
      Liggett does not anticipate it will be able to generate sufficient cash
      from operations to make such payments. While Liggett is currently in
      negotiations with its note holders to restructure the terms of the Liggett
      Notes and, with its lenders, to extend the Facility, there are no
      commitments to restructure the Liggett Notes or to extend the Facility at
      this time, and no assurances can be given in this regard. In conjunction
      with these discussions, the Company is 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 related modifications to the
      terms of such debt.


                                      -10-

<PAGE>   12
Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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



      Pending completion of the negotiations, BGLS and Liggett have postponed
      making the interest payments of approximately $18,338 for the BGLS Notes
      due on July 31, 1997 and approximately $9,700 for the Liggett Notes due on
      August 1, 1997. The indentures governing the BGLS Notes and the Liggett
      Notes provide for a 30-day grace period before the failure to pay interest
      will be an event of default.

      The failure to pay interest on the Liggett Notes would permit Liggett's
      lenders under the Facility to cease making further advances. While the
      lenders have continued to make such advances, and Liggett's management
      currently anticipates that they will continue to do so, no assurances can
      be given in this regard. If Liggett is unable to restructure the terms of
      the Liggett Notes, extend the Facility, or otherwise make all payments
      thereon within the applicable grace periods, substantially all of
      Liggett's long-term debt 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. These matters raise substantial doubt about Liggett meeting its
      liquidity needs and its ability to continue as a going concern.

      BOL is in the process of constructing a new tobacco factory and is
      actively pursuing various potential financial alternatives related 
      thereto. (Refer to Note 5.)

      NEW ACCOUNTING PRONOUNCEMENTS

      In June 1997, the Financial Accounting Standards Board ("FASB") issued
      Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
      Comprehensive Income". SFAS 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 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.
      SFAS 130 is effective for fiscal years beginning after December 15, 1997,
      with earlier application permitted. The Company has not yet determined the
      impact of the implementation of SFAS 130.

      In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
      an Enterprise and Related Information". SFAS 131 specifies revised
      guidelines for determining an entity's operating segments and the type and
      level of financial information to be disclosed. Once operating segments
      have been determined, SFAS 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 131 also requires disclosure of
      certain "second level" information by geographic area and for
      products/services. SFAS 131 also makes a number of changes to existing
      disclosure requirements. SFAS 131 is effective for fiscal years beginning
      after December 15, 1997, with earlier application encouraged. The Company
      has not yet determined the impact of the implementation of SFAS 131.





                                      -11-
<PAGE>   13
Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


2.    INVESTMENT IN NEW VALLEY CORPORATION

      The Company's and BGLS' investment in New Valley at June 30, 1997 is
summarized below:

<TABLE>
<CAPTION>
                                                                                        UNREALIZED
                                        NUMBER OF         FAIR         CARRYING          HOLDING
                                          SHARES         VALUE          AMOUNT             LOSS
                                       ----------        --------       --------       --------
<S>                                      <C>             <C>            <C>            <C>      
   Class A Preferred Shares .....        618,326         $ 57,504       $ 57,504       $(12,412)
   Class B Preferred Shares .....        250,885            1,254          1,254           (600)
   Common Shares ................      3,989,710(A)         3,990        (58,758)
                                                         --------       --------       --------
                                                         $ 62,748       $              $(13,012)
                                                         ========       ========       ========

</TABLE>


   (A) Gives effect to July 1996 one-for-twenty stock split.

   The $15.00 Class A Increasing Rate Cumulative Senior Preferred Shares ($100
   Liquidation Value), $.01 par value (the "Class A Preferred Shares"), and the
   $3.00 Class B Cumulative Convertible Preferred Shares ($25 Liquidation
   Value), $.10 par value (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. 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. New Valley's Common
   Shares, $.01 par value (the "Common Shares"), were accounted for pursuant to
   APB No. 18, "The Equity Method of Accounting for Investments in Common
   Stock".

   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.

   At June 30, 1997, the Company's investment in New Valley consisted of an
   approximate 42% voting interest. The Company's investment is represented by
   618,326 Class A Preferred Shares (57.7%), 3,989,710 Common Shares (41.7%)
   (giving effect to a one-for-twenty reverse stock split by New Valley in July
   1996) and 250,885 Class B Preferred Shares (9.0%).

   During the first quarter of 1996, New Valley repurchased 72,104 Class A
   Preferred Shares for a total amount of $10,530. The Company has recorded its
   proportionate interest in the excess of the carrying value of the shares over
   the cost of the shares repurchased as a credit to additional paid-in capital
   in the amount of $1,782, along with other New Valley capital transactions of
   $1,563, for the six months ended June 30, 1996. No such repurchases have been
   made during the six months ended June 30, 1997. Other New Valley capital
   transactions charged to equity were $665 for the six months ended June 30,
   1997.

   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




                                      -12-
<PAGE>   14
Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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

   any time prior to that date, 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. On March 13, 1996, New
   Valley declared a cash dividend of $10.00 per share on its Class A Preferred
   Shares payable on March 27, 1996. NV Holdings received $6,183 in the
   distribution. At June 30, 1997, the accrued and unpaid dividends arrearage on
   the Class A Preferred Shares was $139,017 or $129.75 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 June 30,
   1997, the accrued and unpaid dividends arrearage on Class B Preferred Shares
   was $127,266 or $45.60 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 June 30, 1997 and
   December 31, 1996 and for the three and six months ended June 30, 1997 and
   1996 follows:

<TABLE>
<CAPTION>
                                                               June 30,      December 31,
                                                                1997             1996
                                                              ---------     ------------
<S>                                                           <C>             <C>      
      Current assets, primarily cash and marketable
         securities ....................................      $ 114,175       $ 183,720
      Non-current assets ...............................        311,005         222,820
      Current liabilities ..............................        127,130          98,110
      Non-current liabilities ..........................        175,258         170,223
      Redeemable preferred stock .......................        233,531         210,571
      Shareholders' equity (deficit) ...................       (110,739)        (72,364)

</TABLE>


<TABLE>
<CAPTION>
                                                                     Three Months Ended              Six Months Ended
                                                                   -----------------------       ----------------------
                                                                   June 30,        June 30,      June 30,      June 30,
                                                                     1997            1996          1997          1996
                                                                   --------       --------       --------      -------- 
<S>                                                                <C>            <C>            <C>           <C>     
      Revenues ..............................................      $ 24,404       $ 30,449       $ 44,157      $ 62,434
      Costs and expenses ....................................        29,594         35,138         61,519        73,316
      Loss from continuing operations .......................        (4,270)        (4,872)       (15,483)      (10,484)
      (Loss) income from discontinued operations ............          (759)           110            113           838
      Net loss applicable to common shares(A) ...............       (21,779)       (20,408)       (48,100)      (36,475)

</TABLE>



   (A) Considers all preferred accrued dividends, whether or not declared, and
       the excess of carrying value of redeemable preferred shares over cost of
       shares purchased.

   ACQUISITION OF COMMON SHARES OF BML:

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

   RJR NABISCO HOLDINGS CORP.:

   At June 30, 1997, New Valley held 1,062,650 shares of RJR Nabisco Holdings
   Corp. ("RJR Nabisco") common stock with a market value of $34,270 (cost of
   $32,574). The unrealized gain on New Valley's investment in RJR Nabisco
   common stock was $1,696 at June 30, 1997. Based on the 





                                      -13-
<PAGE>   15


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


      market price of RJR Nabisco common stock at August 8, 1997 ($30.625 per
      share), no amounts are payable by the Company or New Valley under any of
      its net profit-sharing arrangements with respect to the RJR Nabisco common
      stock.

3.    INVESTMENT IN BROOKE (OVERSEAS) LTD.

      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
      consideration received exceeded the carrying value of the Company's
      investment in BML by $43,700. The Company recognized a gain on the sale 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 is
      subject to a put option held by New Valley. The option allows New Valley,
      under certain circumstances, to put a portion of the property sold back to
      the Company at the greater of the appraised fair value of the property at
      the date of exercise or $13,600. On April 18, 1997, BML sold one of its
      office buildings, Ducat Place I, to a third party. Accordingly, the
      Company recognized approximately $1,240 of its deferred gain on the BML
      sale in the second quarter, 1997.

      On April 28, 1997 and June 30, 1997, New Valley paid BOL $3,500 and
      $18,000, respectively, representing a portion of the promissory note
      together with accrued interest thereon. As of June 30, 1997, the balance
      remaining on the note was $12,000 and is due on December 31, 1997.

      In connection with the sale of its BML shares to New Valley, certain
      specified liabilities aggregating $40,800, including the Vneshtorgbank
      loan with a balance of $13,927 at June 30, 1997, remained with BML, and
      New Valley indemnified the Company and its subsidiaries with respect to
      any obligation arising from such liabilities.

4.    INVENTORIES

      Inventories consist of:
                                                     June 30,      December 31,
                                                       1997           1996
                                                     --------      ------------
            Finished goods ....................      $ 13,874       $ 15,304
            Work-in-process ...................         4,445          4,435
            Raw materials .....................        30,377         34,002
            Replacement parts and supplies ....         5,208          4,406
                                                     --------       --------
            Inventories at current cost .......        53,904         58,147
            LIFO adjustments ..................        (6,457)        (4,456)
                                                     --------       --------
                                                     $ 47,447       $ 53,691
                                                     ========       ========

      At June 30, 1997, Liggett and Liggett-Ducat had leaf tobacco purchase
      commitments of approximately $13,828 and $3,935, respectively.



                                      -14-
<PAGE>   16
Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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




5.    PROPERTY, PLANT AND EQUIPMENT

      Property, plant and equipment consist of:

                                                     June 30,     December 31,
                                                       1997           1996
                                                     --------     ------------
            Land and improvements .............      $    455      $    455
            Buildings .........................         6,443        14,205
            Machinery and equipment ...........        50,663        49,401
            Leasehold improvements ............           302           302
            Construction-in-progress ..........         5,946        46,966
                                                     --------      --------
                                                       63,809       111,329
            Less accumulated depreciation .....        32,204        31,047
                                                     --------      --------
                                                     $ 31,605      $ 80,282
                                                     ========      ========

      On May 6, 1997, Liggett-Ducat Tobacco Ltd., a subsidiary of Liggett-Ducat,
      entered into two contracts for construction of a new tobacco factory on
      the outskirts of Moscow which provide for payments of $1,700 over a
      three-month period ending July 1997 and of $18,760 payable over a
      twelve-month period ending July 1998. In addition, a pre-construction
      payment of $520 was paid in April 1997.

6.    INCOME TAXES

      The provision for taxes for the six months ended June 30, 1997 and 1996
      does not bear the customary relationship to the pretax loss/income for the
      Company and BGLS due principally to the effects of taxes provided for
      foreign operations and an increase in the valuation allowance related to
      deferred tax assets.


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

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

<TABLE>
<CAPTION>
                                                                              June 30,    December 31,
                                                                                1997         1996
                                                                             --------     -----------
<S>                                                                             <C>        <C>  
            15.75% Series B Senior Secured Notes due 2001,
                net of unamortized discount of $1,326 and $1,511 ......      $231,538      $231,353
            14.500% Subordinated Debentures due 1998 ..................           800           800
            Notes payable - Foreign ...................................         5,755        22,668
            Other .....................................................         1,240         2,425

            Liggett:
            11.500% Senior Secured Series B Notes due 1999, net of
                unamortized discount of $302 and $424 .................       112,310       119,688
            Variable Rate Series C Senior Secured Notes due 1999 ......        32,279        32,279
            Revolving credit facility .................................        29,026        24,272
                                                                             --------      --------

            Total notes payable and long-term debt ....................       412,948       433,485

            Less current maturities ...................................        70,695        55,242
                                                                             --------      --------

            Amount due after one year .................................      $342,253      $378,243
                                                                             ========      ========

</TABLE>

      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 June 30, 1997, 



                                      -15-
<PAGE>   17

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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



      $209 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 (8.25%),
      bore a rate of 9.75% at March 31, 1997. On April 1, 1997, Philadelphia
      National Bank raised its prime rate to 8.5%, thereby increasing Liggett's
      interest rate to 10.0%. The Facility requires Liggett's compliance with
      certain financial and other covenants. The Facility also limits the amount
      of cash dividends and distributions by Liggett and imposes requirements
      with respect to Liggett's adjusted net and working capital. In January
      1997, the Facility was extended for one year. The Facility is classified
      as short-term at June 30, 1997, since it is due on March 8, 1998, unless
      extended by the lender. No assurances can be given that the Facility will
      be further extended.

      During the first quarter of 1997, Liggett violated the working capital
      covenant contained in the Facility. This violation occurred during
      February 1997 when $37,500 of the Liggett Notes were reclassified from
      long-term to current as a result of the February 1, 1998 mandatory
      redemption requirement of such Notes. On March 19, 1997, the lead lender
      agreed to waive this covenant default, and the Facility was amended as
      follows: (i) the working capital definition was changed to exclude the
      current portion of the Liggett Notes; (ii) the maximum permitted working
      capital deficit was reduced to $12,000 (as computed in accordance with the
      agreement); (iii) the maximum permitted adjusted net worth deficit was
      increased to $180,000 (as computed in accordance with the agreement); and
      (iv) the permitted advance rates under the Facility for eligible inventory
      were reduced by five percent.

      LIGGETT 11.500% 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
      11.5%. The Liggett Notes referred to below require 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 102% and 100% of the principal
      amount in the years 1997 and 1998, respectively, 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.

      ISSUANCE OF LIGGETT SERIES C VARIABLE RATE NOTES:

      On January 31, 1994, Liggett issued $22,500 of Variable Rate Series C
      Senior Secured Notes Due 1999 (the "Liggett Series C Notes"). The Liggett
      Series C Notes bore a 16.5% interest rate, which was reset on February 1,
      1995 to 19.75%, the maximum reset rate. The Series C Notes have the same
      terms (other than interest rate) and stated maturity as the Liggett Series
      B Notes.

      FOREIGN LOANS:

      On January 31, 1997, in connection with the sale of BML shares to New
      Valley, the Russian bank loan in the amount of $20,419 remained with BML
      (refer to Note 3). The Company is a guarantor on lines of credit opened by
      BOL during the first quarter 1997 with two Russian banks in total amount
      of $4,000. These lines of credit are collateralized by accounts
      receivable, inventory and equipment.



                                      -16-
<PAGE>   18

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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




      At June 30, 1997, the balance outstanding was $3,250. Interest on such
      lines of credit is currently 23%. The lines of credit expire in August
      and September 1997.

      SUBSEQUENT EVENT:

      As discussed above, the Liggett Notes require a mandatory principal
      redemption of $37,500 on February 1, 1998 and a payment at maturity on
      February 1, 1999 of $107,400, and the Facility expires on March 8, 1998
      unless extended by Liggett's lenders. Liggett is currently in negotiations
      with its note holders to restructure the Liggett Notes and, with its
      lenders, to extend the Facility. In conjunction with these discussions,
      the Company is also engaged in negotiations with the principal holders of
      the BGLS Notes with respect to certain related modifications to the terms
      of such debt.

      Pending completion of the negotiations, BGLS and Liggett have postponed
      making the interest payments due on July 31, 1997 on the BGLS Notes and on
      August 1, 1997 on the Liggett Notes, respectively. The indentures
      governing the BGLS Notes and the Liggett Notes provide for a 30-day grace
      period before the failure to pay interest will be an event of default. The
      failure to pay interest on the Liggett Notes would permit the lenders
      under the Facility to cease making further advances. While the lenders
      have continued to make such advances, and Liggett's management currently
      anticipates that they will continue to do so, no assurances can be given
      in this regard. For information concerning Liggett's substantial near-term
      debt service requirements and other related matters, refer to Note 1.

8.    STOCK COMPENSATION

      As of January 1, 1997, the Company granted to employees of the Company
      non-qualified stock options to purchase 422,000 shares of the Company's
      common stock at an exercise price of $5.00 per share. The options, which
      will become exercisable over the ten-year term, vest in six equal annual
      installments. No compensation expense was recorded in this transaction,
      since the options had no intrinsic value.

9.    RELATED PARTY TRANSACTIONS

      Effective July 1, 1990, a former executive transferred all of his equity
      in the Company to the Chairman and resigned from substantially all of his
      positions with the Company and its affiliates. In consideration for this
      transfer, a partnership (the "Partnership") controlled by the Chairman
      agreed, among other things, to make certain payments to the Company on
      account of the former executive's outstanding indebtedness of $8,677
      (deducted from equity). In connection with this transaction, the
      Partnership pledged 1,681,715 of the shares it held of the Company's
      common stock to secure this non-recourse obligation, except as to the
      pledged shares. In May 1994, the Partnership paid $3,200 in partial
      satisfaction of the obligation. In consideration thereof, the Company
      released 1,281,715 of the pledged shares. On March 7, 1997, the
      Partnership transferred to the Company the remaining 400,000 pledged
      shares in final satisfaction of the obligation. As a result, the Company
      credited retained earnings $1,800, the fair market value of the pledged
      shares which were returned to treasury.


                                      -17-
<PAGE>   19



Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


10.   RESTRUCTURING CHARGES

      During the first six months of 1997, Liggett reduced its headcount by 114
      full-time positions and recorded a $1,831 restructuring charge to
      operations for severance programs, primarily salary continuation and
      related benefits for terminated employees. Approximately $285 in
      restructuring charges will be funded in subsequent years. Liggett expects
      to continue its cost reduction programs.

11.   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: Individual Actions, Class
      Actions and Attorneys General Actions, although recently several actions
      have been commenced on behalf of other interest groups. 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 certain financial and other
      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, but these benefits have ended. Certain joint defense
      arrangements, and the financial benefits incident thereto, have also
      ended. 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.

      INDIVIDUAL ACTIONS. As of June 30, 1997, there were 145 cases pending
      against Liggett 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, 57 are
      pending in the State of Florida, 43 are pending in the State of New York
      and 17 are pending in the State of Texas. The balance of individual cases
      are pending in 14 states.

      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. Plaintiffs also seek punitive damages
      in many of these cases. 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. Several
      representative cases are described below.



                                      -18-
<PAGE>   20

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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



      On June 24, 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.

      On March 27, 1987, an action entitled ROGERS V. LIGGETT GROUP INC. ET AL.,
      Superior Court, Marion County, Indiana, was filed against Liggett and
      others. The plaintiff sought compensatory and punitive damages for cancer
      alleged to have been caused by cigarette smoking. Trial commenced on
      January 31, 1995. The trial ended on February 22, 1995 when the trial
      court declared a mistrial due to the jury's inability to reach a verdict.
      The court directed a verdict in favor of the defendants as to the issue of
      punitive damages during the trial of this action. A second trial commenced
      on August 5, 1996 and, on August 23, 1996, the jury returned a verdict in
      favor of the defendants. This verdict is currently on appeal.

      On May 12, 1992, an action entitled CORDOVA V. LIGGETT GROUP INC., ET AL.,
      Superior Court of the State of California, City of San Diego, was filed
      against Liggett and others. In her complaint, plaintiff, purportedly on
      behalf of the general public, alleges that defendants have been engaged in
      unlawful, unfair and fraudulent business practices by allegedly
      misrepresenting and concealing from the public scientific studies
      pertaining to smoking and health funded by, and misrepresenting the
      independence of, the Council on Tobacco Research ("CTR") and its
      predecessor. The complaint seeks equitable relief against the defendants,
      including the imposition of a corrective advertising campaign, restitution
      of funds, disgorgement of revenues and profits and the imposition of a
      constructive trust. On June 5, 1997, Liggett settled this matter.

      On September 10, 1993, an action entitled SACKMAN V. LIGGETT GROUP INC.,
      United States District Court, Eastern District of New York, was filed
      against Liggett alleging as injury lung cancer. On May 25, 1996, the
      District Court granted Liggett summary judgment on plaintiff's fraud and
      breach of warranty claims, but, on June 9, 1997 denied Liggett's Motion
      for Summary Judgment on plaintiffs' conspiracy claim. On June 27, 1997,
      the magistrate issued an order compelling Liggett to produce certain CTR
      documents with respect to which Liggett had asserted various privilege
      claims. The other cigarette manufacturers and the CTR are appealing the
      order.

      In February 1995, an action entitled CARTER, ET AL. V. THE AMERICAN
      TOBACCO COMPANY, ET AL., Superior Court for the State of Florida, Duval
      County, was filed against Liggett and others. Plaintiff sought
      compensatory damages, including, but not limited to, reimbursement for
      medical costs. Both American Tobacco and Liggett were subsequently
      dismissed from this action. On August 9, 1996, a jury returned a verdict
      against the remaining defendant, Brown & Williamson Tobacco Corporation
      ("B&W"), in the amount of $750. The court also awarded plaintiff's
      attorney's fees in the amount of $1,785. B&W has appealed this verdict.




                                      -19-
<PAGE>   21


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


      CLASS ACTIONS. As of June 30, 1997, there were 29 actions pending, which
      have either been certified as a class or 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 "Attorneys
      General Actions" section.

      On October 31, 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 was the first class action commenced against the industry and 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. The trial in this action
      commenced on June 2, 1997 and is currently in progress.

      On March 25, 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. The District Court granted
      plaintiffs' motion for class certification.

      On March 12, 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
      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 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. On September 6, 1996, the CASTANO
      plaintiffs withdrew the motion for approval of the CASTANO settlement.

      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 


                                      -20-
<PAGE>   22

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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



      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.

      ATTORNEYS GENERAL ACTIONS. As of June 30, 1997, 32 Attorneys General
      actions were filed and served on Liggett and the Company. As more fully
      discussed below, Liggett has reached settlements in 25 of these actions.
      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 tobacco products. The claims asserted in
      these Medicaid recovery actions vary. All 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 May 23, 1994, an action entitled MOORE, ATTORNEY GENERAL, EX REL STATE
      OF MISSISSIPPI V. THE AMERICAN TOBACCO COMPANY, ET AL., Chancery Court of
      Jackson County, Mississippi, was commenced against Liggett and others
      seeking restitution and indemnity for medical payments and expenses
      allegedly made or incurred for tobacco related illnesses. In May 1994, the
      State of Florida enacted legislation, effective July 1, 1994, allowing
      certain state authorities or entities to commence litigation seeking
      recovery of certain Medicaid payments made on behalf of Medicaid
      recipients as a result of diseases (including, but not limited to,
      diseases allegedly caused by cigarette smoking) allegedly caused by liable
      third parties (including, but not limited to, the tobacco industry). On
      February 21, 1995, the State of Florida commenced an action pursuant to
      this statutory scheme. The Florida Medicaid trial has recently commenced.
      See "Settlements", below. Legislation similar to that enacted in Florida
      has been introduced in the Massachusetts and New Jersey legislatures.

      SETTLEMENTS. On March 15, 1996, in addition to the CASTANO settlement
      discussed above, the Company and Liggett entered into a settlement of
      tobacco-related litigation with the Attorneys General of Florida,
      Louisiana, Mississippi, West Virginia and Massachusetts. The settlement
      with the Attorneys General releases the Company and Liggett from all
      tobacco-related claims by these states including claims for Medicaid
      reimbursement and concerning sales of cigarettes to minors. The settlement
      provides that additional states which commence similar Attorney General
      actions may agree to be bound by the settlement prior to six months from 
      the date thereof (subject to extension of such period by the settling
      defendants). Certain of the terms of the settlement are summarized below.

      Under the Attorneys General settlement, the five 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 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 



                                      -21-

<PAGE>   23


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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



      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.

      Settlement funds received by the Attorneys General will be used to
      reimburse the states' smoking-related healthcare costs. The Company and
      Liggett also have agreed to phase in compliance with 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 settlement with
      respect to any state participating in the settlement if any of the
      remaining defendants in the litigation succeed on the merits in that
      state's Attorney General action. The Company and Liggett may also
      terminate the settlement if they conclude that too many states have filed
      Attorney General actions and have not resolved such cases as to the
      settling defendants by joining in the settlement.

      At December 31, 1995, the Company had accrued approximately $4,000 for the
      present value of the fixed payments under the March 1996 Attorneys General
      settlement, and 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.

      On March 20, 1997, Liggett, together with the Company, entered into a
      comprehensive settlement of tobacco litigation through parallel agreements
      with the Attorneys General of 17 additional states and with a nationwide
      class of individuals and entities that allege smoking-related claims.
      Thereafter, settlements were entered into with several other Attorneys
      General. The 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.

      As of June 30, 1997, settlements with 25 Attorneys General were reached,
      including the Attorneys General of Alaska, Arizona, California,
      Connecticut, Hawaii, Illinois, Indiana, Iowa, Kansas, Maryland, Michigan,
      Minnesota, New Jersey, New York, Oklahoma, Oregon, Texas, Utah, Washington
      and Wisconsin. The Company's and Liggett's previous settlements on March
      15, 1996 with the Attorneys General of Florida, Louisiana, Massachusetts,
      Mississippi and West Virginia remain in full force and effect. Other
      states have either recently filed Medicaid recovery actions or indicated
      intentions to do so. Both Liggett and the Company will endeavor to resolve
      those matters on substantially the same terms and conditions as the prior
      settlements; however, there can be no assurance that any such settlements
      will be completed.

      The settlement with the nationwide class covers all smoking-related
      claims. On March 20, 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 


                                      -22-
<PAGE>   24

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


      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.

      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. There are no opt out provisions in this
      settlement, except for Medicaid claims by states that are not party to the
      Attorneys General settlements.

      Pursuant to the settlements, 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 both
      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.

      Under the terms of the new settlement agreements, Liggett will pay, on an
      annual basis, 25% of its pretax income for the next 25 years into a
      settlement fund, commencing with the first full fiscal year starting after
      the date of the agreements. 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. 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.

      Under both settlement agreements, any other tobacco company defendant,
      except Philip Morris, merging or combining with Liggett or the Company,
      prior to the fourth anniversary of the settlement agreements, would
      receive certain settlement benefits, including limitations on potential
      liability and not having to post a bond to appeal any future adverse
      judgment. In addition, within 120 days following such a combination,
      Liggett would be required to pay the settlement fund $25,000. Both the
      Attorneys General and the nationwide class have agreed not to seek an
      injunction preventing a defendant tobacco company combining with Liggett
      or the Company from spinning off any of its affiliates which are not
      engaged in the domestic tobacco business.

      The Company and Liggett are also entitled to certain "most favored nation"
      benefits not available to the other defendant tobacco companies. In
      addition, in the event of a "global" tobacco settlement 




                                      -23-
<PAGE>   25

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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



      enacted through Federal legislation or otherwise, the Attorneys General
      and tobacco plaintiffs agreed to use their "best efforts" to ensure that
      the Company and Liggett's liability under such a plan should be no more
      onerous than under these new settlements. See "Other Matters", below.

      IMMINENT TRIALS. Although trial schedules are subject to change, the next
      individual cases scheduled for trial, where Liggett is a defendant, are
      WESTMORELAND V. LIGGETT GROUP INC., ET AL., United States District Court,
      Middle District of Florida, Tampa Division, and SACKMAN, both of which are
      scheduled for trial in October, 1997. There are two other individual cases
      scheduled for trial in 1997. In addition to the BROIN trial currently in
      progress, there is one other class action scheduled for trial in 1997,
      ENGLE, ET AL. V. R. J. REYNOLDS TOBACCO COMPANY, ET AL.

      OTHER MATTERS. On June 20, 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
      proposed resolution mandates a total reformation and restructuring of how
      tobacco products are manufactured, marketed and distributed in the United
      States. The proposals are currently being reviewed by the White House,
      Congress and various public interest groups. 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.

      On March 20, 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 on April 9,
      1997. This ruling is currently on appeal by the Company and Liggett. On
      June 5, 1997, the North Carolina Supreme Court denied Liggett's Motion to
      Stay the case pending appeal. On March 24, 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 regarding possible violations of criminal law relating to the
      activities of The Council for Tobacco Research - USA, Inc. Liggett was a
      sponsor of The Council for Tobacco Research - USA, Inc. at one time. The
      Company is unable, at this time, to predict the outcome of this
      investigation.

      In March 1996, Liggett received a subpoena from a Federal grand jury
      sitting in the Southern District of New York. Documents have been produced
      in response to the subpoena. The Company understands that this
      investigation has been transferred to the main office of the United States
      Department of Justice. In addition, in May 1996, Liggett was served with a
      subpoena by a grand jury sitting in the District of Columbia, to which
      Liggett has responded by producing documents. Liggett was also served with
      a subpoena from the District of Columbia grand jury in July, 1997. Liggett
      is in the process of responding to that subpoena. The Company and Liggett
      are unable, at this time, to predict the outcome of these investigations.



                                      -24-
<PAGE>   26
Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


      The Antitrust Division of the United States Department of Justice
      investigation into the United States tobacco industry activities in
      connection with product development efforts regarding "fire-safe" or
      self-extinguishing cigarettes has been concluded. No action by the
      Department of Justice was taken.

      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.

      There are several other proceedings, lawsuits and claims pending against
      the Company unrelated to 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.

      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 and cash flows
      could be materially adversely affected by an ultimate unfavorable outcome
      in any of such pending litigation.

      LEGISLATION AND REGULATION:

      On August 28, 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. The FDA's stated objective and focus for its initiative is to
      limit access to cigarettes by minors by measures beyond the restrictions
      either mandated by existing federal, state and local laws or voluntarily
      implemented by major manufacturers in the industry. 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.
      On February 7, 1997, the United States District Court for the District of
      Massachusetts denied an attempt to block the new legislation on the ground
      that it is preempted by federal law. The Company and Liggett support this
      proposed legislation.


                                      -25-

<PAGE>   27
Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


      On September 13, 1995, the President of the United States issued
      Presidential Proclamation 6821, which established a tariff rate quota
      ("TRQ") on certain imported tobacco, imposing extremely high tariffs on
      imports of flue-cured and burley tobacco in excess of certain levels which
      vary from country to country. Oriental tobacco is exempt from the quota as
      well as all tobacco originating from Canada, Mexico or Israel. Management
      believes that the TRQ levels are sufficiently high to allow Liggett to
      operate without material disruption to its business.

      On February 20, 1996, the United States Trade representative issued an
      "advance notice of rule making" concerning how tobaccos imported under the
      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.

      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 current operations are conducted in accordance 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, have not had a material effect on the
      capital expenditures, earnings or competitive position of 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.




                                      -26-
<PAGE>   28

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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



12.   SALES OF ASSETS

      On January 31, 1997, BOL sold 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. (Refer to Note 3.)

      On March 11, 1997, Liggett sold to Blue Devil Ventures, a North Carolina
      limited liability partnership, certain surplus realty for $2,200 and
      recognized a gain of $1,531.





                                      -27-
<PAGE>   29



ITEM  2.  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 report. 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.


         For purposes of this discussion and other consolidated financial
reporting, the Company's significant business segments are tobacco for the six
months ended June 30, 1997 and tobacco and real estate for the six months ended
June 30, 1996.


RECENT DEVELOPMENTS

         NEW VALLEY. As of June 30, 1997, New Valley held 1,062,650 shares of
RJR Nabisco Holdings Corp. ("RJR Nabisco") common stock with a market value of
$34,270 (cost of $32,574). New Valley's unrealized gain on its investment in RJR
Nabisco common stock was $1,696 at June 30, 1997. For information concerning the
acquisition of BML by New Valley, see "BOL" below.

         BOL. On January 31, 1997, New Valley acquired from BOL 10,483 shares
(99.1%) of common stock of BML for a purchase price of $55,000, consisting of
$21,500 in cash and a $33,500 9% promissory note of New Valley (the "Note"). The
Note is collateralized by the BML Shares. During the second quarter 1997, New
Valley paid $21,500 to BOL. The remaining balance on the note is $12,000 and is
due on December 31, 1997. The Company recognized a gain of $21,300 on the sale
in the first quarter, 1997. On April 18, 1997, BML sold one of its office
buildings to a third party. Accordingly, the Company recognized approximately
$1,240 of the deferred gain. See Note 3 to the Company's Consolidated Financial
Statements.

         LIGGETT. In January 1997, Liggett underwent a major restructuring from
a centralized organization to a decentralized enterprise with four Strategic
Business Units, each a profit center, and a corporate headquarters. This
restructuring is intended to more closely align sales and marketing strategies
with the unique requirements of regional markets as well as reduce working
capital by improved production planning and inventory control. As a result of
this reorganization, Liggett is further reducing its salaried, hourly and
part-time headcount by a total of 273 positions (35%) over an eight-month
transition period.

         On March 11, 1997, Liggett sold to Blue Devil Ventures, a North
Carolina limited liability partnership, certain surplus realty for $2,200. The
Company recognized a gain of $1,531.

         NEGOTIATIONS WITH NOTE HOLDERS. Liggett is engaged in negotiations with
a committee composed of a majority of its note holders with respect to a
restructuring of the terms of Liggett's Senior Secured Notes (the "Liggett
Notes") and, with its lenders, to extend its revolving credit facility (the
"Facility"). In conjunction with these discussions, the Company is 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 related modifications
to the terms 



                                      -28-
<PAGE>   30

of such debt. Pending completion of the negotiations, BGLS and Liggett have
postponed making the interest payments due on July 31, 1997 on the BGLS Notes
and on August 1, 1997 on the Liggett Notes.

         With respect to Liggett's near-term debt service requirements and
related matters, refer to "Capital Resources and Liquidity" below.

      NEW ACCOUNTING PRONOUNCEMENTS. In June 1997, the Financial Accounting
Standards Board ("FASB") issued Statement of Financial Accounting Standards
("SFAS") No. 130, "Reporting Comprehensive Income". SFAS 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 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. SFAS 130 is
effective for fiscal years beginning after December 15, 1997, with earlier
application permitted. The Company has not yet determined the impact of the
implementation of SFAS 130.

      In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
an Enterprise and Related Information". SFAS 131 specifies revised guidelines
for determining an entity's operating segments and the type and level of
financial information to be disclosed. Once operating segments have been
determined, SFAS 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 131 also requires disclosure of certain "second level"
information by geographic area and for products/services. SFAS 131 also makes a
number of changes to existing disclosure requirements. SFAS 131 is effective for
fiscal years beginning after December 15, 1997, with earlier application
encouraged. The Company has not yet determined the impact of the implementation
of SFAS 131.


RECENT DEVELOPMENTS IN THE CIGARETTE INDUSTRY

         PRICING ACTIVITY. On March 7, 1997, R. J. Reynolds Tobacco Company
("RJR") initiated another list price increase on all brands of $.40 per carton
(approximately 4%). Brown & Williamson Tobacco Corporation ("B&W"), Lorillard
Tobacco Company ("Lorillard") and Liggett have 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.

         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 June 30, 1997, there were 145 individual suits, 29 class actions or actions
where class certification has been sought and 32 state (and several
municipality) Medicaid reimbursement actions pending in the United States in
which Liggett is a named defendant and has been served. 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 and legal 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 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 the 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 11
to the Company's Consolidated Financial Statements for a description of
legislation, regulation and litigation.

                                      -29-
<PAGE>   31


         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. Plaintiffs also
seek punitive damages in many of these cases. 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, equitable defenses such as "unclean hands" and lack of benefit,
failure to state a claim and federal preemption.

         The claims asserted in the Medicaid recovery actions vary. All
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.

         SETTLEMENTS. On March 12, 1996, Liggett, together with the Company,
entered into an agreement to settle the CASTANO class action tobacco litigation,
and on March 15, 1996, Liggett, together with the Company, entered into 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. 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 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
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. On September 6, 1996, the CASTANO plaintiffs withdrew the motion for
approval of the CASTANO settlement.

         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 (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.



                                      -30-
<PAGE>   32

         Under the Attorneys General settlement, the five 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 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.

         On March 20, 1997, Liggett, together with 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, settlements were
entered into with several other Attorneys General. The settlements cover all
smoking-related claims, including both addiction-based and tobacco injury claims
against Liggett and the Company, and upon court approval, the nationwide class.

         As of June 30, 1997, settlements with 25 Attorneys General were
reached, including the Attorneys General of Alaska, Arizona, California,
Connecticut, Hawaii, Illinois, Indiana, Iowa, Kansas, Maryland, Michigan,
Minnesota, New Jersey, New York, Oklahoma, Oregon, Texas, Utah, Washington and
Wisconsin. The Company's and Liggett's previous settlements on March 15, 1996
with the Attorneys General of Florida, Louisiana, Massachusetts, Mississippi and
West Virginia remain in full force and effect. Other states have either recently
filed Medicaid recovery actions or indicated intentions to do so. Both Liggett
and the Company will endeavor to resolve those matters on substantially the same
terms and conditions as the prior settlements; however, there can be no
assurance that any such settlements will be completed.

         The settlement with the nationwide class covers all smoking-related
claims. On March 20, 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.

         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, court approval will be obtained. There are no
opt out provisions in this settlement, except for Medicaid claims by states that
are not party to the Attorneys General settlements.

         Pursuant to the settlements, 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 


                                      -31-
<PAGE>   33

testimony at deposition and trial. Pursuant to both 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.

         Under the terms of the new settlement agreements, Liggett will pay on
an annual basis 25% of its pretax income for the next 25 years into a settlement
fund, commencing with the first full fiscal year starting after the date of the
agreements. 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. 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.

         Under both settlement agreements, any other tobacco company defendant,
except Philip Morris, merging or combining with Liggett or the Company, prior to
the fourth anniversary of the settlement agreements, would receive certain
settlement benefits, including limitations on potential liability and not having
to post a bond to appeal any future adverse judgment. In addition, within 120
days following such a combination, Liggett would be required to pay the
settlement fund $25,000. Both the Attorneys General and the nationwide class
agreed not to seek an injunction preventing a defendant tobacco company
combining with Liggett or the Company from spinning off any of its affiliates
which are not engaged in the domestic tobacco business.

         The Company and Liggett are also entitled to certain "most favored
nation" benefits not available to the other defendant tobacco companies. In
addition, in the event of a "global" tobacco settlement enacted through Federal
legislation or otherwise, the Attorneys General and tobacco plaintiffs agreed to
use their "best efforts" to ensure that the Company and Liggett's liability
under such a plan should be no more onerous than under these new settlements.
See "Other Matters" below.

         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 and no additional amounts have been accrued with respect to the
recent 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 11
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. The proposals are currently being reviewed by the White
House, congress and various public interest groups. 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.


RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 1997 COMPARED TO THREE MONTHS ENDED JUNE 30, 1996.

         REVENUES. Total revenues were $96,593 for the three months ended June
30, 1997 compared to $125,213 for the three months ended June 30, 1996. This
22.9% decrease in revenues was primarily due to 




                                      -32-
<PAGE>   34

a $35,144 or 31.0% decrease in revenues at Liggett reflecting a 38.3% decrease
in Liggett's overall unit sales volume, partially offset by an increase of
$8,463 or 84.7% over the same period in 1996 in tobacco revenues and an increase
of 39.5% in overall unit sales volume at Liggett-Ducat. (See also "Recent
Developments in the Cigarette Industry-Pricing Activity" for a discussion of the
March 1997 price increase). The decline in overall units sales volume of 38.3%
at Liggett was comprised of declines within the premium segment of 32.9% and
discount segment (which includes generic, control label and branded discount
products) of 36.2%. 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. The
increase in tobacco revenues at Liggett-Ducat is attributable to increased unit
sales volume of 39.5% and significant net price increases. The increase in
tobacco revenues at Liggett-Ducat is offset by a decline in real estate revenues
of $668 due to the sale of the BML Shares.


         GROSS PROFIT. Gross profit was $45,642 for the three months ended June
30, 1997 compared to $61,691 for the three months ended June 30, 1996, a
decrease of $16,049 when compared to the same period last year, due primarily to
the decline in unit sales volume at Liggett discussed above. Overall, the
Company's gross profit as a percentage of revenues decreased 2.0% when compared
to the same period in the prior year. Liggett's gross profit as a percentage of
revenues (excluding federal excise taxes) for the period decreased to 71.1%
compared to 72.5% in the same period in the prior year. This decrease is the
result of increased tobacco costs due to a reduction in the average discount
available to Liggett from leaf tobacco dealers on tobacco purchased under prior
years' purchase commitments, partially offset by the March 1997 list price
increase discussed above. See "Recent Developments in the Cigarette Industry".

         EXPENSES. Selling, general and administrative expenses were $39,715 for
the three months ended June 30, 1997 compared to $58,264 for the same period
last year. The decrease of $18,549 is due primarily to lower promotion,
marketing and administrative expenses at Liggett partially offset by
restructuring charges of $70 and higher legal expenses at Liggett.

         OTHER INCOME (EXPENSE). Interest expense was $15,499 for the three
months ended June 30, 1997 compared to $15,457 for the same period last year.

         Equity in earnings of affiliate was a loss of $5,841 for the three
months ended June 30, 1997 compared to a loss of $1,306 for the three months
ended June 30, 1996 and relates primarily to the decline in market value of the
New Valley Class A Preferred Shares and to New Valley's net loss of $5,029
compared to its net loss of $4,762 in 1996.

         Interest expense and loss in equity of affiliate were partially offset
by the sale of assets of $1,065, primarily recognition of the deferred gain on
Ducat Place I which was sold to a third party by BML on April 18, 1997.


SIX MONTHS ENDED JUNE 30, 1997 COMPARED TO SIX MONTHS ENDED JUNE 30, 1996.

         REVENUES. Total revenues were $176,598 for the six months ended June
30, 1997 compared to $215,729 for the six months ended June 30, 1996. This 18.1%
decrease in revenues was primarily due to a $47,331 or 24.7% decrease in
revenues at Liggett reflecting a 31.5% decrease in Liggett's unit sales volume,
partially offset by an increase of $11,774 or 58.0% over the same period in 1996
in tobacco revenues and an increase of 24.8% in overall unit sales volume at
Liggett-Ducat. The decline in overall units sales volume of 31.5% at Liggett was
comprised of declines within the premium segment of 24.8% and discount segment
(which includes generic, control label and branded discount products) of 30.6%.
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. The increase in
tobacco revenues at Liggett-Ducat is attributable to increased unit sales volume
of 24.8% and significant net price increases. The increase in tobacco revenues
at Liggett-Ducat is offset by a decline in real estate rental revenues of $1,116
due to the sale of the BML Shares.

         GROSS PROFIT. Gross profit was $83,802 for the six months ended June
30, 1997 compared to $105,159 for the six months ended June 30, 1996, a decrease
of $21,357 when compared to the same period last year, due primarily to the
decline in unit sales volume at Liggett discussed above. Overall, the Company's
gross profit as a percentage of revenues decreased 1.3% when compared to the
same period in the prior year. Liggett's gross profit as a percentage of
revenues (excluding federal excise taxes) for the period decreased to 71.9%
compared to 73.0% in the same period in the prior year. This decrease is the


                                      -33-
<PAGE>   35

result of increased tobacco costs due to a reduction in the average discount
available to Liggett from leaf tobacco dealers on tobacco purchased under prior
years' purchase commitments, partially offset by the March 1997 list price
increase. See "Recent Developments in the Cigarette Industry".

         EXPENSES. Selling, general and administrative expenses were $77,037 for
the six months ended June 30, 1997 compared to $103,156 for the same period last
year. The decrease of $26,119 is due primarily to lower promotion, marketing and
administrative expenses at Liggett due primarily to the decline in unit sales
volume discussed above partially offset by restructuring charges of $1,831 and
higher legal expenses at Liggett.

         OTHER INCOME (EXPENSE). Interest expense was $30,966 for the six months
ended June 30, 1997 compared to $30,234 for the same period last year.

        Equity in earnings of affiliate was a loss of $14,398 for the six months
ended June 30, 1997 compared to a loss of $2,883 for the six months ended June
30, 1996 and relates to the decline in market value of the Class A Preferred
Shares and to New Valley's net loss of $15,370 in 1997 compared to its net loss
of $9,646 in 1996.

        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. See Notes 3, 11 and 12 to the
Company's Consolidated Financial Statements.


CAPITAL RESOURCES AND LIQUIDITY

         Net cash and cash equivalents increased $17,608 and $1,036 for the six
months ended June 30, 1997 and 1996, respectively. Net cash used in operations
for the six months ended June 30, 1997 was $20,003 compared to net cash used in
operations of $735 for the comparable period of 1996, due to a net loss of
$7,736, an increase in receivables of $32,498 resulting from the sale of the BML
shares to New Valley, a decrease in accounts payable and accrued expenses of
$21,564. These items were offset by a decrease in trade receivables at Liggett
due to declining sales volume, equity in loss of affiliate of $14,398 and the
impact of the deferred gain on the sale of the BML shares of approximately
$22,000.

         Cash provided by investing activities of $39,592 for the period ended
June 30, 1997 includes principally cash of $43,000 received in the sale of the
BML shares to New Valley and net cash received in the sale of certain of
Liggett's surplus realty to Blue Devil Ventures. Cash received was offset by
capital expenditures of $3,653 at Liggett and BOL. Capital expenditures include
$1,086 and $2,567 for real estate development at BOL and for equipment
modernization at Liggett, respectively. Cash used in investing activities of
$4,573 for the six months ended June 30, 1996 includes capital expenditures of
approximately $12,200 for real estate development at BOL and $2,500 for
equipment modernization at Liggett. Capital expenditures were offset by
dividends received on the New Valley Class A Preferred Shares of $6,183 or
$10.00 per share and proceeds from the sale of certain surplus realty at
Liggett.

         Cash used in financing activities was $1,981 for the six months ended
June 30, 1997 compared to cash provided of $6,344 for the same period in 1996.
Proceeds from financing activities primarily include proceeds at BOL from credit
lines of $3,250 and net borrowings under Liggett's Facility of $4,754. These
proceeds were offset by repayments on debt including principally the required
repurchase of $7,500 face amount of the Liggett Notes on February 1, 1997 at a
net gain of $2,963. Distributions on common stock include distributions declared
in the fourth quarter 1996 which were paid in January 1997 and distributions
declared and paid in March and June 1997. Proceeds from debt in the same period
in 1996 include the private placement of BGLS' Series A Notes (later exchanged
for Series B Notes) for net cash proceeds of $6,065, borrowings by BOL for real
estate development of $8,454 and borrowings of $6,000 by Liggett and BOL under
their revolving credit facilities. These transactions were primarily offset by
the 



                                      -34-
<PAGE>   36

redemption for approximately $6,237 of BGLS' 16.125% Senior Subordinated Reset
Notes including premium and accrued interest thereon, and distributions to the
Company's shareholders of $2,775.

      LIGGETT. Liggett had a net capital deficiency of $178,660 as of June 30,
1997, is highly leveraged and has substantial near-term service requirements.
Due to the many risks and uncertainties associated with the cigarette industry
and the impact of recent tobacco litigation settlements, there can be no
assurance that Liggett will be able to meet its future earnings or cash flow
goals. Consequently, Liggett could be in violation of certain debt covenants,
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.

      Further, the Liggett Notes require a mandatory principal redemption of
$37,500 on February 1, 1998 and a payment at maturity on February 1, 1999 of
$107,400, and the Facility expires on March 8, 1998 unless extended by its
lenders. Based on Liggett's net loss for 1996 and anticipated 1997 operating
results, Liggett does not anticipate it will be able to generate sufficient cash
from operations to make such payments. While Liggett is currently in
negotiations with its note holders to restructure the terms of the Liggett Notes
and, with its lenders, to extend the Facility, there are no commitments to
restructure the Liggett Notes or to extend the Facility at this time, and no
assurances can be given in this regard. In conjunction with these discussions,
the Company is also engaged in negotiations with the principal holders of the
BGLS Notes with respect to certain related modifications to the terms of such
debt. Pending completion of the negotiations, both BGLS and Liggett have
postponed making the interest payments of approximately $18,338 for the BGLS
Notes due on July 31, 1997 and approximately $9,700 for the Liggett Notes due on
August 1, 1997. The indentures governing the BGLS Notes and the Liggett Notes
provide for a 30-day grace period before the failure to pay interest will be an
event of default.

      The failure to pay interest on the Liggett Notes would permit Liggett's
lenders under the Facility to cease making further advances. While the lenders
have continued to make such advances, and Liggett's management currently
anticipates that they will continue to do so, no assurances can be given in this
regard. If Liggett is unable to restructure the terms of the Liggett Notes,
extend the Facility, or otherwise make all payments thereon within the
applicable grace periods, substantially all of Liggett's long-term debt 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. These matters raise substantial doubt
about Liggett meeting its liquidity needs and its ability to continue as a going
concern.

         On March 8, 1994, Liggett entered into the Facility under which it can
borrow up to $40,000 (depending on the amount of eligible inventory and
receivables as determined by the lenders) from a syndicate of commercial
lenders. At June 30, 1997, $28,767 was outstanding and $209 was available under
the Facility based on eligible collateral. 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, bore a rate of 9.75% at March 31, 1997. On April 1, 1997,
Philadelphia National Bank raised its prime rate to 8.5%, thereby increasing
Liggett's interest rate to 10.0% for the quarter ended June 30, 1997. 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 currently
imposes requirements with respect to Liggett's adjusted net worth (not to fall
below a deficit of $180,000 as computed in accordance with the agreement) and
working capital (not to fall below a deficit of $12,000 as computed in
accordance with the agreement). The Facility is classified as short-term at June
30, 1997, since it is due on March 8, 1998, unless extended by the lender. As
discussed above, Liggett is currently in negotiations to extend the Facility.

         During the first quarter of 1997, Liggett violated the working capital
covenant contained in the Facility as a result of the 1998 mandatory redemption
payment on the Liggett Notes becoming due within one year. On March 19, 1997,
the lead lender agreed to waive this covenant default, and the Facility was
amended as follows: (i) the working capital definition was changed to exclude
the Liggett Notes; (ii) the maximum permitted working capital deficit, as
defined, was reduced to $12,000 (as computed in 


                                      -35-
<PAGE>   37

accordance with the agreement); (iii) the maximum permitted adjusted net worth
deficit, as defined, was increased to $180,000 (as computed in accordance with
the agreement); and (iv) the permitted advance rates under the Facility for
eligible inventory were reduced by five percent.

         In February 1997, Liggett purchased $7,500 of Series B Notes using
revolver availability and credited such Notes against the 1997 mandatory
redemption requirement. Liggett recorded a net gain of $2,963 for this
transaction in the first quarter, 1997. Current maturities of both the Liggett
Notes and the Facility of approximately $74,000 contribute substantially to the
working capital deficit of $78,481 at June 30, 1997.

         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. As new cases are
commenced, the costs associated with defending such cases and the risk attendant
to the inherent unpredictability of litigation continue. Liggett had been
receiving certain financial and other 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, but these benefits have recently
ended. Certain joint defense arrangements, and the financial benefits incident
thereto, have also ended. The future financial impact on the Company of the
termination of this assistance and the effects of the tobacco litigation
settlements discussed above is not quantifiable at this time.

         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 or the possible commencement of additional litigation.

         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. At June 30, 1997, BGLS' long-term debt was approximately
$233,000. See "Liggett" above for a discussion of certain recent developments
with respect to the BGLS Notes. BGLS or its affiliates may, from time to time,
based on current market conditions, purchase Liggett Notes in the open market
or in privately negotiated transactions.

         BOL. As discussed in "Recent Developments," on January 31, 1997, BOL
sold its 99.1% interest in BML to New Valley for $55,000. The purchase price
paid was $21,500 in cash and a 9% promissory note of $33,500, of which $21,500
was paid during the second quarter 1997. The remaining balance of $12,000 is due
on December 31, 1997.

         In October 1995, Liggett-Ducat entered into a loan agreement with
Vneshtorgbank, Moscow, Russia, to borrow up to $20,400 to fund real estate
development. Interest on the note is based on the London Interbank Offered Rate
plus 10%. The Company has guaranteed the payment of the note. In December 1996,
the loan was assigned by Liggett-Ducat to BML. On January 31, 1997, New Valley
purchased BOL's 99.1% interest in BML and indemnified the Company and its
subsidiaries with respect to the loan. 

         Liggett-Ducat plans to build a new cigarette factory on the outskirts
of Moscow. The new factory, which will utilize Western cigarette making
technology and have a capacity of 24 billion units per year, will produce
American and international blend cigarettes, as well as traditional Russian
cigarettes. Preliminary construction has begun, and management is actively
pursuing various potential financing alternatives that 



                                      -36-
<PAGE>   38



would permit the new factory to be operational by the end of 1998, although no
assurance can be given that such financing can be obtained on satisfactory
terms.

         THE COMPANY. As a result of the 1995 debt exchange offer, the
redemption of the Reset Notes in 1996, the sale of the BML shares to New Valley
in January 1997 and the redemption of $7,500 of the Liggett Notes on February 1,
1997, the Company decreased its scheduled near-term debt maturities to
approximately $74,000 due in the year 1998; at June 30, 1997, substantially all
of this debt relates to Liggett. In addition, Liggett has a payment due at
maturity of the Liggett Notes on February 1, 1999 of $107,400. The BGLS Notes
Indenture limits the amount of restricted payments BGLS is permitted to make to
the Company during the calendar year. At June 30, 1997, the remaining amount
available through December 31, 1997 in the Restricted Payment Basket related to
BGLS' payment of dividends to the Company (as defined by the BGLS Notes
Indenture) is $7,801. In March 1997, the Company provided for its quarterly
dividend of $1,395 with proceeds from the legal settlement received in January
1997. Company expenditures (exclusive of Liggett and Liggett-Ducat) in 1997 for
current operations include debt service estimated at $36,800, dividends on the
Company's shares (currently at an annual rate of approximately $5,500) and
corporate expense. The Company anticipates funding 1997 current operations with
the proceeds from the sale of BML, management fees and other payments from
subsidiaries of approximately $5,000 and the proceeds from the legal settlement
of $4,100. The Company expects to finance its long-term growth, working capital
requirements, capital expenditures and debt service requirements through a
combination of cash provided from operations, proceeds from the sale of certain
assets, additional public or private debt and/or equity financing 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.


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 cigarette 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. See "Capital Resources and Liquidity" for a discussion of
certain matters which raise substantial doubt about Liggett meeting its
liquidity needs and its ability to continue as a going concern. 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.



                                      -37-
<PAGE>   39

                                     PART II
                                OTHER INFORMATION



Item 1.  LEGAL PROCEEDINGS

         Reference is made to information entitled "Contingencies" in Note 11 to
         the Consolidated Financial Statements of Brooke Group Ltd. and BGLS
         Inc. (collectively, the "Companies") included elsewhere in this report
         on Form 10-Q.

Item 3.  DEFAULTS UPON SENIOR SECURITIES

         As of June 30, 1997, New Valley Corporation, the Companies' affiliate,
         had the following respective accrued and unpaid dividend arrearages on
         its 1,072,462 outstanding shares of $15.00 Class A Increasing Rate
         Cumulative Senior Preferred 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) $139.0 million or $129.75 per Class A Share; and (2) $127.3 million
         or $45.60 per Class B Share.

Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS

         During the second quarter of 1997, the Company submitted the following
         matter to a vote of security-holders at its Annual Meeting of
         Stockholders held on June 2, 1997 (the "Annual Meeting"). Proxies for
         the Annual Meeting were solicited pursuant to Regulation 14A under the
         Securities Exchange Act of 1934, as amended.

         The sole matter voted upon at the Annual Meeting was the election of
         three (3) directors and the following is a tabulation of the results:

         Total shares of Common Stock outstanding as of April 28, 1997 (the
         record date) - 18,097,096

         Total shares of Common Stock voted in person or by proxy - 17,415,378

                             Election of Directors:

                                                 FOR              WITHHOLD

               Bennett S. LeBow               17,727,829           86,884
               Robert J. Eide                 17,727,829           88,890
               Jeffrey S. Podell              17,727,829           86,884



                                      -38-

<PAGE>   40


Item 6.    EXHIBITS AND REPORTS ON FORM 8-K

           (a)    EXHIBITS

                  10.1     Class Settlement Agreement, dated May 15, 1997, by
                           and between the named and representative plaintiff in
                           EARL WILLIAM WALKER, ET AL. V. LIGGETT GROUP INC. ET
                           AL., for himself and on behalf of the plaintiff
                           settlement class, and Brooke Group Ltd. and Liggett
                           Group Inc.

                  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     Liggett Group Inc.'s Interim Consolidated Financial
                           Statements for the quarterly period ended June 30,
                           1997.

                  99.2     New Valley Corporation's Interim Consolidated
                           Financial Statements for the quarterly period ended
                           June 30, 1997.

                  99.3     Brooke (Overseas) Ltd.'s Interim Consolidated
                           Financial Statements for the quarterly period ended
                           June 30, 1997.

                  99.4     New Valley Holdings, Inc.'s Interim Consolidated
                           Financial Statements for the quarterly period ended
                           June 30, 1997.


           (b)    REPORTS ON FORM 8-K

                  During the second quarter of 1997, the following current
                  reports on Form 8-K were filed:

<TABLE>
<CAPTION>

      REGISTRANT(S)            DATE OF REPORT          ITEM(S)           FINANCIAL STATEMENTS
      -------------            --------------          -------           --------------------
<S>                           <C>                      <C>                <C>
1.  Brooke Group Ltd.           June 11, 1997            5, 7                    None
    BGLS Inc.

2.  Brooke Group Ltd.          April 14, 1997             7                      None

</TABLE>


                                      -39-
<PAGE>   41


                                   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:  August 19, 1997




                                       BGLS INC.
                                       (REGISTRANT)

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

Date:  August 19, 1997








                                      -40-