<PAGE>   1
================================================================================

                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   ----------

                                    FORM 10-Q

                                   ----------

          JOINT QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
                         SECURITIES EXCHANGE ACT OF 1934
                  FOR THE QUARTERLY PERIOD ENDED MARCH 31, 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 Identification No.)
    incorporation or organization)

</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 Identification No.)
    incorporation or organization)
</TABLE>

                             100 S.E. SECOND STREET
                              MIAMI, FLORIDA 33131
                                  305/579-8000
     (Address, including zip code and telephone number, including area code,
                       of the principal executive offices)



                                   ----------


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

         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 May 12, 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 March 31, 1997 and
         December 31, 1996.............................................................................       2

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

   Brooke Group Ltd. Consolidated Statements of Operations for the three months ended
         March 31, 1997 and March 31, 1996.............................................................       4

   BGLS Inc. Consolidated Statements of Operations for the three months ended
         March 31, 1997 and March 31, 1996.............................................................       5

   Brooke Group Ltd. Consolidated Statement of Stockholders' Equity (Deficit) for the three
         months ended March 31, 1997...................................................................       6

   BGLS Inc. Consolidated Statement of Stockholder's Equity (Deficit) for the three months
         ended March 31, 1997..........................................................................       7

   Brooke Group Ltd. Consolidated Statements of Cash Flows for the three months ended
         March 31, 1997 and March 31, 1996.............................................................       8

   BGLS Inc. Consolidated Statements of Cash Flows for the three months ended
         March 31, 1997 and March 31, 1996.............................................................       9

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

Item 2. Management's Discussion and Analysis
         of Financial Condition and Results of Operations..............................................      27

PART II.     OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS..............................................................................      36
                                                                                                               

Item 2. CHANGES IN SECURITIES..........................................................................      36
                                                                                                               

Item 3. DEFAULTS UPON SENIOR SECURITIES................................................................      36
                                                                                                               

Item 6. EXHIBITS AND REPORTS ON FORM 8-K...............................................................      36
                                                                                                               

SIGNATURES.............................................................................................      38

</TABLE>

                                      -1-

<PAGE>   3




Item 1.  CONSOLIDATED FINANCIAL STATEMENTS

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

<TABLE>
<CAPTION>
                                                                                      March 31,     December 31,
                                                                                        1997            1996
                                                                                      ---------     ------------
<S>                                                                                  <C>             <C>      
ASSETS:

Current assets:
  Cash and cash equivalents ...................................................      $   2,187       $   1,941
  Accounts receivable - trade .................................................          9,802          19,475
  Other receivables ...........................................................            737           1,217
  Receivables from affiliates .................................................         33,587              47
  Inventories .................................................................         52,643          53,691
  Other current assets ........................................................          2,751           4,181
                                                                                     ---------       ---------
    Total current assets ......................................................        101,707          80,552

Property, plant and equipment, at cost, less accumulated
  depreciation of $31,377 and $31,047 .........................................         30,216          80,282
Intangible assets, at cost, less accumulated amortization
  of $17,916 and $17,457 ......................................................          3,979           4,421
Investment in affiliate .......................................................                          3,051
Other assets ..................................................................          5,352           9,371
                                                                                     ---------       ---------
    Total assets ..............................................................      $ 141,254       $ 177,677
                                                                                     =========       =========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt .........................      $  77,446       $  55,242
  Accounts payable ............................................................         18,768          32,461
  Due to affiliates ...........................................................                            990
  Dividends payable ...........................................................                          1,387
  Cash overdraft ..............................................................                              6
  Accrued promotional expenses ................................................         31,850          30,257
  Accrued taxes payable .......................................................         19,986          26,379
  Accrued interest ............................................................          9,401          24,354
  Other accrued liabilities ...................................................         25,113          33,387
                                                                                     ---------       ---------
    Total current liabilities .................................................        182,564         204,463

Notes payable, long-term debt and other obligations,
  less current portion ........................................................        341,506         378,243
Noncurrent employee benefits ..................................................         30,355          31,256
Other liabilities .............................................................         31,404          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 shares ...........          1,850           1,850
  Additional paid-in capital ..................................................         92,811          94,169
  Deficit .....................................................................       (482,686)       (490,706)
  Other .......................................................................        (22,411)        (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) ....................................       (444,575)       (454,989)
                                                                                     ---------       ---------

      Total liabilities and stockholders' equity (deficit) ....................      $ 141,254       $ 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>
                                                                                     March 31,      December 31,
                                                                                       1997            1996
                                                                                     ---------      ------------
<S>                                                                                  <C>             <C>      
ASSETS:

Current assets:
  Cash and cash equivalents ...................................................      $   2,118       $   1,940
  Accounts receivable - trade .................................................          9,802          19,475
  Other receivables ...........................................................            699           1,166
  Receivables from affiliates .................................................         33,575              47
  Inventories .................................................................         52,643          53,691
  Other current assets ........................................................          2,632           3,878
                                                                                     ---------       ---------
      Total current assets ....................................................        101,469          80,197

Property, plant and equipment, at cost, less accumulated depreciation of
  $31,056 and $30,762 .........................................................         29,942          79,972
Intangible  assets, at cost, less accumulated amortization of $17,916 
  and $17,457 .................................................................          3,979           4,421
Investment in affiliate .......................................................                          3,051
Other assets ..................................................................          8,319          10,467
                                                                                     ---------       ---------
      Total assets ............................................................      $ 143,709       $ 178,108
                                                                                     =========       =========

LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt .........................      $  77,326       $  53,945
  Accounts payable ............................................................         18,618          32,336
  Cash overdraft ..............................................................                              6
  Due to parent ...............................................................         22,248          29,598
  Accrued promotional expenses ................................................         31,850          30,257
  Accrued taxes payable .......................................................         19,986          26,379
  Accrued interest ............................................................          9,401          24,354
  Other accrued liabilities ...................................................         24,958          32,861
                                                                                     ---------       ---------
      Total current liabilities ...............................................        204,387         229,736

Notes payable, long-term debt and other obligations, less current portion .....        341,506         378,243
Noncurrent employee benefits ..................................................         30,355          31,256
Other liabilities .............................................................         37,818          21,958

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

Stockholder's equity (deficit):
  Common stock, par value $0.01 per share; authorized 100 shares,
    issued 100 shares, outstanding 100 shares .................................
  Additional paid-in capital ..................................................         39,081          39,081
  Deficit .....................................................................       (491,679)       (499,264)
  Other .......................................................................        (17,759)        (22,902)
                                                                                     ---------       ---------
      Total stockholder's deficit .............................................       (470,357)       (483,085)
                                                                                     ---------       ---------

      Total liabilities and stockholder's equity (deficit) ....................      $ 143,709       $ 179,108
                                                                                     =========       =========

</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
                                                                                    ---------------------------
                                                                                    March 31,         March 31,
                                                                                      1997              1996
                                                                                    ---------         ---------
<S>                                                                              <C>                <C>         
Revenues* .................................................................      $     80,005       $     90,516
Cost of goods sold* .......................................................            41,845             47,048
                                                                                 ------------       ------------

Gross profit ..............................................................            38,160             43,468
Operating, selling, administrative and general expenses ...................            37,322             44,892
                                                                                 ------------       ------------

Operating income (loss) ...................................................               838             (1,424)

Other income (expenses):
    Interest income .......................................................               559                 18
    Interest expense ......................................................           (15,467)           (14,777)
    Equity in loss of affiliate ...........................................            (8,557)            (1,577)
    Sale of assets ........................................................            22,021
    Retirement of debt ....................................................             2,963
    Proceeds from legal settlement ........................................             4,125
    Other, net ............................................................               119                115
                                                                                 ------------       ------------

Income (loss) from continuing operations before income taxes ..............             6,601            (17,645)
Provision for income taxes ................................................               744                435
                                                                                 ------------       ------------

Income (loss) from continuing operations ..................................             5,857            (18,080)
Income from discontinued operations .......................................               363                303
                                                                                 ------------       ------------

Net income (loss) .........................................................             6,220            (17,777)
Proportionate share of New Valley capital transaction, retirement of
    Class A Preferred Shares ..............................................                                1,782
                                                                                 ------------       ------------

Net income (loss) applicable to common shares .............................      $      6,220       $    (15,995)
                                                                                 ============       ============


Per common share:

    Income (loss) from continuing operations ..............................      $       0.32       $      (0.88)
                                                                                 ============       ============
    Income from discontinued operations ...................................      $       0.02       $       0.02
                                                                                 ============       ============
    Net income (loss) applicable to common shares .........................      $       0.34       $      (0.86)
                                                                                 ============       ============

Weighted average common shares outstanding ................................        18,385,985         18,497,096
                                                                                 ============       ============

</TABLE>


----------

* Revenues and Cost of goods sold include federal excise taxes of $16,860
  and $21,197 for the periods ended March 31, 1997 and 1996,
  respectively.


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


                                      -4-


<PAGE>   6


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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





<TABLE>
<CAPTION>
                                                                          Three Months Ended
                                                                       ------------------------
                                                                       March 31,      March 31,
                                                                         1997           1996
                                                                       ---------      ---------
<S>                                                                    <C>            <C>     
Revenues* .......................................................      $ 80,005       $ 90,516
Cost of goods sold* .............................................        41,845         47,048
                                                                       --------       --------

Gross profit ....................................................        38,160         43,468
Operating, selling, administrative and general expenses .........        37,076         44,587
                                                                       --------       --------

Operating income (loss) .........................................         1,084         (1,119)

Other income (expenses):
   Interest income ..............................................           559             18
   Interest expense .............................................       (16,381)       (15,668)
   Equity in loss of affiliate ..................................        (8,557)        (1,577)
   Sale of assets ...............................................        26,384
   Retirement of debt ...........................................         2,963
   Other, net ...................................................           112            (35)
                                                                       --------       --------

Income (loss) from continuing operations before income taxes ....         6,164        (18,381)
Provision for income taxes ......................................           742            451
                                                                       --------       --------

Net income (loss) from continuing operations ....................         5,422        (18,832)
Income from discontinued operations .............................           363            303
                                                                       --------       --------

Net income (loss) ...............................................      $  5,785       $(18,529)
                                                                       ========       ========
</TABLE>

----------

* Revenues and Cost of goods sold include federal excise taxes of $16,860 and
  $21,197 for the periods ended March 31, 1997 and 1996, 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      Stock        Other        Total
                                                ------       ------   ----------   -------    ---------      -----        -----
<S>                                           <C>           <C>        <C>         <C>          <C>         <C>         <C>       
Balance, December 31, 1996 ..............    18,497,096    $ 1,850    $ 94,169    $(490,706)   $(32,339)   $(27,963)   $(454,989)

Net income ..............................                                             6,220                                6,220

Distributions on common stock
  ($0.075 per share) ....................                               (1,358)                                           (1,358)

Amortization of deferred compensation ...                                                                       409          409

Unrealized holding gain on investment
  in New Valley .........................                                                                     5,804        5,804

Effect of New Valley capital transactions                                                                      (661)        (661)

Settlement of loan ......................      (400,000)                              1,800      (1,800)
                                             ----------    -------    --------    ---------    --------    --------    --------- 
Balance, March 31, 1997 .................    18,097,096    $ 1,850    $ 92,811    $(482,686)   $(34,139)   $(22,411)   $(444,575)
                                             ==========    =======    ========    =========    ========    ========    ========= 

</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>       
Balance, December 31, 1996 .............      100                $ 39,081     $(499,264)   $ (22,902)   $(483,085)

Net income .............................                                          5,785                     5,785

Unrealized holding gain on
  investment in New Valley .............                                                       5,804        5,804

Effect of New Valley capital
  transactions .........................                                                        (661)        (661)

Settlement of loan......................                                          1,800                     1,800
                                           ------    --------    ---------    ---------    ---------    ---------
Balance, March 31, 1997 ................      100    $           $  39,081    $(491,679)   $ (17,759)   $(470,357)
                                           ======    ========    =========    =========    =========    =========

</TABLE>

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


                                      -7-

<PAGE>   9


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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


<TABLE>
<CAPTION>
                                                                            Three Months Ended
                                                                            ------------------
                                                                           March 31,   March 31,
                                                                            1997         1996
                                                                           ---------   ---------
<S>                                                                      <C>          <C>      
Net cash used in operating activities ................................   $ (26,619)   $(11,568)
                                                                         ---------    --------
Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net ...................      21,906
  Capital expenditures ...............................................      (1,307)     (6,939)
  Dividends from New Valley ..........................................                   6,183
  Other, net .........................................................                     174
                                                                         ---------    --------

Net cash provided by (used in) investing activities ..................      20,599        (582)
                                                                         ---------    --------

Cash flows from financing activities:
  Proceeds from debt .................................................       3,000      11,347
  Repayments of debt .................................................      (6,050)     (6,537)
  Borrowings under revolver ..........................................      81,291      87,794
  Repayments on revolver .............................................     (69,224)    (76,629)
  Decrease in cash overdraft .........................................          (6)       (449)
  Distributions on common stock ......................................      (2,745)     (1,369)
                                                                         ---------    --------

Net cash provided by financing activities ............................       6,266      14,157
                                                                         ---------    --------

Net increase in cash and cash equivalents ............................         246       2,007
Cash and cash equivalents, beginning of period .......................       1,941       3,370
                                                                         ---------    --------

Cash and cash equivalents, end of period .............................   $   2,187    $  5,377
                                                                         =========    ========



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


</TABLE>


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


                                      -8-


<PAGE>   10


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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



<TABLE>
<CAPTION>
                                                                         Three Months Ended
                                                                     -------------------------
                                                                     March 31,       March 31,
                                                                       1997            1996
                                                                     ---------       ---------
<S>                                                                  <C>             <C>      
Net cash used in operating activities .........................      $ (30,609)      $(11,685)
                                                                     ---------       --------
Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net ............         21,906
  Capital expenditures ........................................         (1,307)        (6,939)
  Dividends from New Valley ...................................                         6,183
  Other, net ..................................................                           174
                                                                     ---------       --------

Net cash provided by (used in) investing activities ...........         20,599           (582)
                                                                     ---------       --------

Cash flows from financing activities:
  Proceeds from debt ..........................................          3,000         11,347
  Repayments of debt ..........................................         (4,873)        (6,410)
  Borrowings under revolver ...................................         81,291         87,794
  Repayments on revolver ......................................        (69,224)       (76,629)
  (Decrease) increase in cash overdraft .......................             (6)            56
  Distributions paid to parent ................................                        (1,922)
                                                                     ---------       --------

Net cash provided by financing activities .....................         10,188         14,236
                                                                     ---------       --------

Net increase in cash and cash equivalents .....................            178          1,969
Cash and cash equivalents, beginning of period ................          1,940          3,370
                                                                     ---------       --------

Cash and cash equivalents, end of period ......................      $   2,118       $  5,339
                                                                     =========       ========



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



</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 believes it will have sufficient liquidity for 1997. This is
      based on, among other things, 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.

      Liggett had net capital and working capital deficiencies of $179,782 and
      $81,170, respectively, at March 31, 1997, is highly leveraged and has
      substantial near-term debt service requirements. Further, Liggett's Senior
      Secured 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 expires on March 8, 1998
      unless extended by its lenders. While Liggett's management currently
      intends to seek to refinance and/or restructure the redemption and
      maturity requirements on the Senior Secured Notes with Liggett's note
      holders and to extend the revolving credit facility, there are no
      refinancing or restructuring arrangements for the notes or commitments to
      extend the facility at this time, and no assurances can be given in this
      regard. 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. If Liggett is
      unable to refinance or restructure such obligations, renegotiate the
      payment terms of the Senior Secured Notes, extend the revolving credit
      facility, or otherwise make such payments,



                                      -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) - (CONTINUED)
                                   (UNAUDITED)




      substantially all of its long-term debt and revolving credit 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.


2.    INVESTMENT IN NEW VALLEY CORPORATION

      The Company's and BGLS' investment in New Valley at March 31, 1997 is
      summarized below:

<TABLE>
<CAPTION>
                                                                                           Unrealized
                                             Number of          Fair          Carrying       Holding
                                               Shares           Value          Amount      Gain (Loss)
                                             ---------          -----         --------     -----------
<S>                                           <C>             <C>            <C>            <C>      
        Class A Preferred Shares .....        618,326         $ 70,489       $ 70,489       $(19,924)
        Class B Preferred Shares .....        250,885            2,573          2,572            718
        Common Shares ................      3,989,710(A)         5,985        (73,061)
                                                              --------       --------       -------- 
                                                              $ 79,047       $              $(19,206)
                                                              ========       ========       ======== 
</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 Statement of Financial Accounting Standards ("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 March 31, 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 


                                      -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) - (CONTINUED)
                                   (UNAUDITED)



      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 $1,852, for the three months
      ended March 31, 1996. No such repurchases have been made during the
      quarter ended March 31, 1997. Other New Valley capital transactions
      charged to equity were $661 for the three months ended March 31, 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 any time, at the option of
      New Valley, at $100.00 per share plus accrued dividends. The holders of
      Class A Preferred Shares are entitled to receive a quarterly dividend, as
      declared by the Board of Directors, payable at the rate of $19.00 per
      annum. 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 March 31, 1997, the
      accrued and unpaid dividends arrearage on the Class A Preferred Shares was
      $127,779 or $119.26 per share.

      Holders of the Class B Preferred Shares are entitled to receive a
      quarterly dividend, as declared by the Board, at a rate of $3.00 per
      annum. At March 31, 1997, the accrued and unpaid dividends arrearage on
      Class B Preferred Shares was $121,502 or $43.54 per share. No dividends on
      the Class B Preferred Shares have been declared since the fourth quarter
      of 1988.

      Summarized financial information for New Valley as of March 31, 1997 and
      December 31, 1996 and for the three months ended March 31, 1997 and 1996
      follows:

<TABLE>
<CAPTION>
                                                             March 31,      December 31,
                                                               1997            1996
                                                             ---------      ------------
<S>                                                          <C>             <C>      
          Current assets, primarily cash and marketable
             securities .................................... $ 149,244       $ 183,720
          Non-current assets ...............................   309,098         222,820
          Current liabilities ..............................   155,091          98,110
          Non-current liabilities ..........................   176,213         170,223
          Redeemable preferred stock .......................   221,753         210,571
          Shareholders' equity (deficit) ...................   (94,715)        (72,364)
</TABLE>





                                      -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) - (CONTINUED)
                                   (UNAUDITED)



<TABLE>
<CAPTION>
                                                                   March 31,
                                                            -----------------------
                                                               1997         1996
                                                               ----         ----
<S>                                                         <C>            <C>    
          Revenues ....................................     $ 19,753       $ 31,985
          Costs and expenses ..........................       31,925         38,178
          Loss from continuing operations .............      (11,213)        (5,612)
          Income from discontinued operations .........          872            728
          Net loss applicable to common shares(A) .....      (26,321)       (16,067)
</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 March 31, 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 March 31, 1997. Based on the market
      price of RJR Nabisco common stock at March 31, 1997, 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 will be 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.

      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 $20,419, remained with BML, and New Valley
      indemnified the Company and its subsidiaries with respect to any 
      obligation arising from such liabilities.






                                      -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) - (CONTINUED)
                                   (UNAUDITED)


      SUBSEQUENT EVENTS:

      On April 18, 1997, BML sold one of its office buildings, Ducat Place I, to
      a third party. Accordingly, the Company will recognize approximately
      $1,240 of its deferred gain on the BML sale in the second quarter, 1997.

      On April 28, 1997, New Valley paid BOL $3,500, representing a portion of
      the promissory note payment due to BOL on June 30, 1997, together with
      accrued interest thereon.


4.    INVENTORIES

      Inventories consist of:

<TABLE>
<CAPTION>
                                                                                        March 31,     December 31,
                                                                                          1997           1996
                                                                                        ---------     ------------

<S>                                                                                    <C>            <C>     
             Finished goods .....................................................      $ 15,639       $ 15,304
             Work-in-process ....................................................         5,126          4,435
             Raw materials ......................................................        32,274         34,002
             Replacement parts and supplies .....................................         4,465          4,406
                                                                                       --------       --------
             Inventories at current cost ........................................        57,504         58,147
             LIFO adjustments ...................................................        (4,861)        (4,456)
                                                                                       --------       --------
                                                                                       $ 52,643       $ 53,691
                                                                                       ========       ========
</TABLE>

      At March 31, 1997, Liggett and Liggett-Ducat had leaf tobacco purchase 
      commitments of approximately $21,217 and $4,934, respectively.


5.    PROPERTY, PLANT AND EQUIPMENT

      Property, plant and equipment consist of:

<TABLE>
<CAPTION>
                                                    March 31,     December 31,
                                                       1997           1996
                                                    ---------     ------------
<S>                                                <C>             <C>      
          Land and improvements .............      $     455       $     455
          Buildings .........................          6,443          14,205
          Machinery and equipment ...........         49,647          49,401
          Leasehold improvements ............            302             302
          Construction-in-progress ..........          4,746          46,966
                                                   ---------       ---------
                                                      61,593         111,329
          Less accumulated depreciation .....         31,377          31,047 
                                                   ---------       ---------
                                                   $  30,216       $  80,282
                                                   =========       =========
</TABLE>



                                      -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) - (CONTINUED)
                                   (UNAUDITED)



6.    LONG TERM DEBT

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

<TABLE>
<CAPTION>
                                                                            March 31,    December 31,
                                                                              1996          1996
                                                                            ---------    ------------
<S>                                                                         <C>           <C>
          15.75% Series B Senior Secured Notes due 2001,
              net of unamortized discount of $1,418 and $1,511 .......      $231,446      $231,353
          14.500% Subordinated Debentures due 1998 ...................           800           800
          Notes payable - Foreign ....................................         4,758        22,668
          Other ......................................................         1,067         2,425

          Liggett:
          11.500% Senior Secured Series B Notes due 1999, net of
              unamortized discount of $349 and $424 ..................       112,263       119,688
          Variable Rate Series C Senior Secured Notes due 1999 .......        32,279        32,279
          Revolving credit facility ..................................        36,339        24,272
                                                                            --------      --------

          Total notes payable and long-term debt .....................       418,952       433,485

          Less current maturities ....................................        77,446        55,242
                                                                            --------      --------

          Amount due after one year ..................................      $341,506      $378,243
                                                                            ========      ========
</TABLE>

      REVOLVING CREDIT FACILITY - LIGGETT:

      On March 8, 1994, Liggett entered into a revolving credit facility (the
      "Facility") for $40,000 with a syndicate of commercial lenders. The
      Facility is collateralized by all inventories and receivables of Liggett.
      At March 31, 1997, $461 was available under the Facility based on eligible
      collateral. Borrowings under the Facility bore interest at the rate of
      9.75%, a rate which is equal to 1.5% above the Philadelphia National
      Bank's prime rate (8.25%) 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 March 31, 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 Senior Secured 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.



                                      -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) - (CONTINUED)
                                   (UNAUDITED)


      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 Series B Notes and Series C Notes referred to below
      (collectively, the "Liggett Notes") 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. While Liggett management
      currently intends to seek to refinance and/or restructure with Liggett's
      note holders the February 1, 1998 mandatory redemption payment of $37,500
      and the $107,400 payment due on February 1, 1999 on maturity of the
      Liggett Notes and to extend its revolving credit facility, there are no
      refinancing or restructuring arrangements for the notes or commitments to
      extend the facility at this time, and no assurances can be given in this
      regard.

      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.

      For information concerning Liggett's substantial near-term debt service
      requirements and other related matters, refer to Note 1.

      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 presently a guarantor on lines of credit
      opened by BOL in 1997 with two Russian banks. The aggregate amount
      available under these lines of credit is $3,000. Interest on such lines of
      credit is currently 23%.

7.    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.

                                      -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) - (CONTINUED)
                                   (UNAUDITED)


8.    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.


9.    RESTRUCTURING CHARGES

      During the first quarter of 1997, Liggett reduced its headcount by 87
      positions and recorded a $1,761 restructuring charge to operations for
      severance programs, primarily salary continuation and related benefits for
      terminated employees. Approximately $197 in restructuring charges will be
      funded in subsequent years. Liggett expects to continue its cost reduction
      programs.


10.   CONTINGENCIES

      TOBACCO-RELATED LITIGATION:

      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). New
      cases continue to be commenced against Liggett and other cigarette
      manufacturers. 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 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 below is not
      quantifiable at this time.

      As of March 31, 1997, there were 107 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, 53 are pending in the
      State of 



                                      -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) - (CONTINUED)
                                   (UNAUDITED)



      Florida and 20 are pending in the State of New York. The balance of
      individual cases are pending in 14 different states. The next individual
      case scheduled for trial where Liggett is a defendant is CHUTZ-REYMERS ET
      AL. V. LIGGETT GROUP INC., ET AL., United States District Court, Middle
      District of Florida, Tampa Division, which is scheduled for trial in June
      1997. In light of the settlements discussed below, this case will not
      proceed against Liggett on that date. In addition to the foregoing, there
      are four individual cases scheduled for trial in 1997 where Liggett is a
      defendant, although trial dates are subject to change.

      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, strict liability, fraud, misrepresentation,
      design defect, failure to warn, breach of express and implied warranties,
      conspiracy, concert of action, unjust enrichment, common law public
      nuisance, indemnity, market share liability, and violations of deceptive
      trade practices laws 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.

      On June 24, 1992, in the action entitled CIPOLLONE V. LIGGETT GROUP INC.,
      ET AL., the United States Supreme Court issued an opinion concluding that
      the 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 YVONNE 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. A Notice of Appeal has been filed by the
      plaintiff.

      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. Plaintiffs' motion to certify
      the action as a class action was granted. The suit is scheduled to go to
      trial on June 2, 1997. In addition to Broin, as of March 31, 1997 there
      were 16 actions which have either been certified as a class or are seeking
      class certification. One of these actions, ENGLE, ET AL. V. R. J. REYNOLDS
      TOBACCO COMPANY, ET AL., Circuit 



                                      -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) - (CONTINUED)
                                   (UNAUDITED)


      Court of the Eleventh Judicial Circuit in and for Dade County, Florida,
      involving a certified class of smokers in the State of Florida, is
      scheduled to commence trial on September 8, 1997.

      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. The case is presently in the discovery phase. This
      action is scheduled for trial on December 12, 1997. A similar action has
      been filed in the Superior Court for the State of California, City of San
      Francisco.

      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. In addition, the District Court vacated the
      Magistrate's March 19, 1996 order compelling Liggett to produce certain
      CTR documents with respect to which Liggett had asserted various privilege
      claims, and allowed the other cigarette manufacturers and the CTR to
      intervene in order to assert their interests and privileges with respect
      to those same documents. The Magistrate Judge is presently reconsidering
      plaintiffs' motion to compel production of documents. No trial date has
      been set.

      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 May 23, 1996, the Fifth
      Circuit Court of Appeals decertified the class and instructed the District
      Court to dismiss the class complaint. 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 5% of
      Liggett's pretax income (income before income taxes) each year (up to a
      maximum of $50,000 per year) for the next twenty-five years, subject to
      certain reductions provided for in the agreement, and a $5,000 payment
      from Liggett if the Company or Liggett 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 



                                      -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) - (CONTINUED)
                                   (UNAUDITED)

      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 thirty days of the
      more favorable agreement and offer the Company and Liggett the option to
      enter into a settlement on terms at least as favorable as those included
      in such other settlement. The letter agreement further provides that
      during the same time period, and if the CASTANO settlement agreement has
      not been earlier terminated by the Company in accordance with its terms,
      the Company and its affiliates will not enter into any business
      transaction with any third party which would cause the termination of the
      CASTANO settlement agreement. If the Company or its affiliates enter into
      any such transaction, then the CASTANO plaintiffs will be entitled to
      receive $250,000 within thirty days from the transacting party.

      In February 1995, an action entitled GRADY 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 Corp., in the
      amount of $750. Brown & Williamson has filed a Notice of Appeal.

      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. In addition to Florida and Mississippi, similar
      actions have been filed by many other states and municipalities. The
      Mississippi, Florida and Texas Medicaid recovery actions are scheduled for
      trial in 1997 (see settlement discussions below). Legislation similar to
      that enacted in Florida has been introduced in the Massachusetts and New
      Jersey legislatures.

      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 the Federal Racketeer
      Influenced and Corrupt Organization Act.

      On March 15, 1996, 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 



                                      -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) - (CONTINUED)
                                   (UNAUDITED)


      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 settlement, the 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 sixty 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.

      Settlement funds received by the Attorneys General will be used to
      reimburse the states' smoking-related healthcare costs. While neither
      consenting to FDA jurisdiction nor waiving their objections thereto, 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, on April 14, 1997, the State of California entered into a
      settlement agreement with Liggett and BGL of the action which it
      contemplates commencing against the industry and on May 6, 1997 the State
      of Alaska entered into a settlement agreement with Liggett and the Company
      of the action which it recently commenced against the industry. 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.


                                      -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) - (CONTINUED)
                                   (UNAUDITED)


      The recent Attorneys General settlements, which do not require court
      approval, include the states of Alaska, Arizona, California, Connecticut,
      Hawaii, Illinois, Indiana, Iowa, Kansas, Maryland, Michigan, Minnesota,
      New Jersey, New York, Oklahoma, 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. (Several other states have
      either recently filed Medicaid recovery actions or indicated intentions to
      do so. Both Liggett and BGL 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. 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 have agreed to
      cooperate fully with the Attorneys General and the nationwide class in
      their lawsuits against the tobacco industry. The Company and Liggett have
      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 have 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 have agreed to offer their employees
      for witness interviews and testimony at deposition and trial. Pursuant to
      both settlement agreements, Liggett has 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.

      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 has also 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.

                                      -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) - (CONTINUED)
                                   (UNAUDITED)


      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 million. Both the
      Attorneys General and the nationwide class have also 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 have 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.

      On March 20, 1997, R.J. Reynolds Tobacco Company, Philip Morris, Inc.,
      Brown & Williamson Tobacco Corporation and Lorillard Tobacco Company, Inc.
      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 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. 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.

      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. An unfavorable outcome of a pending smoking and health case could
      encourage the commencement of additional similar litigation. The Company
      is not able to evaluate the effect of these developing matters on pending
      litigation or the possible commencement of additional litigation.


                                      -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) - (CONTINUED)
                                   (UNAUDITED)


      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
      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. A hearing on the
      tobacco industry's motion for summary judgment in that case was held on
      February 10, 1997 and a decision by the Court was issued on April 25,
      1997. The court granted plaintiffs' motion for summary judgment
      prohibiting the FDA from regulating or restricting the promotion and
      advertising of tobacco products. The court 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, while neither consenting to FDA jurisdiction nor
      waiving their objections thereto, agreed to withdraw their objections and
      opposition to the proposed rule making and 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.
      Regulations adopted pursuant to this legislation are scheduled to become
      effective on July 1, 1997. 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.



                                      -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) - (CONTINUED)
                                   (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.

      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 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.

      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.



                                      -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) - (CONTINUED)
                                  (UNAUDITED)



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

      OTHER MATTERS:

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

      On or about March 13, 1997, a shareholder derivative suit was filed
      against New Valley, as a nominal defendant, its directors and the Company
      in the Delaware Chancery Court, by a shareholder of New Valley. The suit
      alleges that New Valley's purchase of the BML shares constituted a
      self-dealing transaction which involved the payment of excessive
      consideration by New Valley. The plaintiff seeks (i) a declaration that
      New Valley's directors breached their fiduciary duties, the Company aided
      and abetted such breaches and such parties are therefore liable to New
      Valley, and (ii) unspecified damages to be awarded to New Valley. The
      Company's time to respond to the complaint has not yet expired. The
      Company believes that the allegations are without merit, and it intends to
      defend the suit vigorously.

      At March 31, 1997, there were several other proceedings, lawsuits and
      claims pending against the Company and its subsidiaries. The Company is of
      the opinion that the liabilities, if any, ultimately resulting from such
      other proceedings, lawsuits and claims should not materially affect its
      consolidated financial position, results of operations or cash flows.

11.   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.





                                      -26-
<PAGE>   28

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 document. BGLS is a wholly owned subsidiary
of the Company. The consolidated financial statements include the accounts of
BGLS, Liggett Group Inc. ("Liggett"), Brooke (Overseas) Ltd. ("BOL"), New Valley
Holdings, Inc. ("NV Holdings"), Liggett-Ducat Ltd. ("Liggett-Ducat") and other
less significant subsidiaries. The Company holds an equity interest in New
Valley Corporation ("New Valley") through NV Holdings.

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

         For purposes of this discussion and other consolidated financial
reporting, the Company's significant business segments are tobacco for the three
months ended March 31, 1997 and tobacco and real estate for the three months
ended March 31, 1996.


RECENT DEVELOPMENTS

         NEW VALLEY. As of March 31, 1997, New Valley held 1,062,650 shares of
RJR Nabisco Holdings Corp. ("RJR Nabisco") common stock with a market value of
$35,997 (cost of $32,574). New Valley's unrealized gain on its investment in RJR
Nabisco common stock was $1,697 at March 31, 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 and is payable $21,500 on June 30, 1997
and $12,000 on December 31, 1997. The Company recognized a gain of $21,300 on
the sale in the first quarter, 1997. A prepayment of $3,500 on the Note together
with accrued interest was made on April 28, 1997 which reduces the June payment
discussed above to $18,000. 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 will further reduce 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 $1,521.



                                      -27-
<PAGE>   29



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, Inc. ("Lorillard") and Liggett have matched this increase, and,
on March 21, 1997, Philip Morris, Inc. ("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 March 31, 1997, there were 107 individual suits, 14 purported class actions
and 22 state (and several municipality) Medicaid reimbursement actions pending
in the United States in which Liggett is a named defendant. As new cases are
commenced, the costs associated with defending such cases and the risks
attendant to the inherent unpredictability of litigation continue to increase.
Recently, there have been a number of restrictive regulatory actions from
various Federal administrative bodies, including the United States Environmental
protection Agency ("EPA") and the Food and Drug Administration ("FDA"), adverse
political 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 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 10
to the Company's Consolidated Financial Statements for a description of
legislation, regulation and litigation.

         The plaintiffs' allegations of liability in those cases in which
individuals seek recovery for personal injuries allegedly caused by cigarette
smoking are based on various theories of recovery, including negligence, gross
negligence, strict liability, fraud, misrepresentation, design defect, failure
to warn, breach of express and implied warranties, conspiracy, concert of
action, unjust enrichment, common law public nuisance, indemnity, market share
liability, and violations of deceptive trade practices laws and antitrust
statutes. Plaintiffs also seek punitive damages in many of these cases. Defenses
raised by defendants in these cases include lack of design defect, statutes of
limitations or response, equitable defenses such as "unclean hands" and lack of
benefit, failure to state a claim and preemption by the Federal Cigarette
Labeling and Advertising Act, as amended.

         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 the Federal Racketeer Influenced and Corrupt Organization Act.

         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 5% of
Liggett's pretax income (income before income taxes) each year (up to a maximum
of $50,000 per year) for the next twenty-five years, subject to certain
reductions provided for in the agreement, and a $5,000 payment from Liggett if
the Company or Liggett 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 


                                      -28-
<PAGE>   30

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 thirty days of the more
favorable agreement and offer the Company and Liggett the option to enter into a
settlement on terms at least as favorable as those included in such other
settlement. The letter agreement further provides that during the same time
period, and if the CASTANO settlement agreement has not been earlier terminated
by the Company in accordance with its terms, the Company and its affiliates will
not enter into any business transaction with any third party which would cause
the termination of the CASTANO settlement agreement. If the Company or its
affiliates enter into any such transaction, then the CASTANO plaintiffs will be
entitled to receive $250,000 within thirty days from the transacting party.

         Under the Attorneys General settlement, the five states would share an
initial payment by Liggett of $5,000 ($1,000 of which was paid on March 22,
1996, with the balance payable over nine years and indexed and adjusted for
inflation). 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.

         RECENT SETTLEMENTS. 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, on April 14, 1997, the State of California settled, on the same
terms, the action which it contemplates commencing against the industry and on
May 6, 1997, the State of Alaska settled, with the Company, the action which it
recently commenced against the industry. The 24 Attorneys General 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.

         The settlements with the Attorneys General, which do not require court
approval, include the states of Alaska, Arizona, California, Connecticut,
Hawaii, Illinois, Indiana, Iowa, Kansas, Maryland, Michigan, Minnesota, New
Jersey, New York, Oklahoma, 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. Both the Company and Liggett 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.
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 


                                      -29-
<PAGE>   31



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 have agreed to
cooperate fully with the Attorneys General and the nationwide class in their
lawsuits against the tobacco industry. The Company and Liggett have 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 have 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 have agreed to offer their employees for
witness interviews and testimony at deposition and trial. Pursuant to both
settlement agreements, Liggett has 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.

         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
has also 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 million. Both the Attorneys General and the nationwide class
have also 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 have
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.

         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. 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 these four companies from interfering with
Liggett's filing with the courts, under seal, those documents.

         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 


                                      -30-

<PAGE>   32



of the tobacco litigation settlements appearing in Note 10 to the Company's
Consolidated Financial Statements.

RESULTS OF OPERATIONS

THREE MONTHS ENDED MARCH 31, 1997 COMPARED TO THREE MONTHS ENDED MARCH 31, 1996.

         REVENUES. Total revenues were $80,005 for the three months ended March
31, 1997 compared to $90,516 for the three months ended March 31, 1996. This
11.6% decrease in revenues was primarily due to a $12,187 or 15.5% decrease in
revenues at Liggett reflecting a 21.6% decrease in Liggett's unit sales volume,
partially offset by an increase of $3,311 over the same period in 1996 in
tobacco revenues at Liggett-Ducat. The decline in overall units sales volume of
21.6% at Liggett was comprised of declines within the premium segment of 13.5%
and discount segment (which includes generic, control label and branded discount
products) of 22.7%. 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
decline in the discount segment is consistent with industry trends.

         GROSS PROFIT. Gross profit was $38,160 for the three months ended March
31, 1997 compared to $43,468 for the three months ended March 31, 1996, a
decrease of $5,308 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 0.3% 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 72.9%
compared to 73.7% in the same period in the prior year. This decrease is the
result of increased tobacco costs due to reduced worldwide supply of tobacco and
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 $37,322 for
the three months ended March 31, 1997 compared to $44,892 for the same period
last year. The decrease of $7,570 is due primarily to lower advertising,
marketing and administrative expenses at Liggett partially offset by
restructuring charges of $1,761 and higher legal expenses at Liggett.

        OTHER INCOME (EXPENSE). Interest expense was $15,467 for the three
months ended March 31, 1997 compared to $14,777 for the same period last year,
an increase of $690 primarily due to the issuance of additional debt of $7,397
at BGLS in March 1996 and higher average outstanding balances on Liggett's
revolving credit facility in 1997.

        Equity in earnings of affiliate was a loss of $8,557 for the three
months ended March 31, 1997 compared to a loss of $1,577 for the three months
ended March 31, 1996 and relates primarily to New Valley's net loss of $10,341
in 1997 compared to its net loss of $4,884 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, 10 and 11 to the
Company's Consolidated Financial Statements.


CAPITAL RESOURCES AND LIQUIDITY

         Net cash and cash equivalents increased $246 and $2,007 for the three
months ended March 31, 1997 and 1996, respectively. Net cash used in operations
for the three months ended March 31, 1997 was $26,619 compared to net cash used
in operations of $11,568 for the comparable period of 1996, due to an increase
in receivables of $33,500 resulting from the sale of the BML shares to New
Valley, a decrease in accounts payable of $8,300 and a decrease in accrued
liabilities of approximately $24,000. These items were offset by a decrease in
trade receivables at Liggett due to declining sales volume, equity in loss of
affiliate of approximately $8,500 and the impact of the deferred gain on the
sale of the BML shares of approximately $23,000.


                                      -31-
<PAGE>   33



         Cash provided by investing activities of $20,599 for the period ended
March 31, 1997 includes principally cash of $21,500 received in the sale of the
BML shares to New Valley and cash of $2,049 received in the sale of certain of
Liggett's surplus realty to Blue Devil Ventures. Cash received was offset by
capital expenditures of $1,307 at Liggett and BOL and the impact of the sale of
BML to New Valley in the consolidated financial statements. Cash used in
investing activities of $582 for the period ended March 31, 1996 includes
capital expenditures of $5,500 and $1,350 for real estate development at BOL and
for equipment modernization at Liggett, respectively. Capital expenditures for
the period ended March 31, 1996 were offset by dividends from New Valley to NV
Holdings of $6,183 ($10.00 per share) on the Class A Preferred Shares.

         Cash provided by financing activities was $6,266 for the three months
ended March 31, 1997 compared to cash provided of $14,157 for the same period in
1996. Proceeds from financing activities include proceeds at BOL from credit
lines and net borrowings under Liggett's revolving credit facility of $12,067.
These proceeds were offset by repayments on debt including principally the
required repurchase of $7,500 face amount of Liggett bonds on February 1, 1997
at a net gain of $2,963. Distributions on common stock include distributions
declared in the fourth quarter 1996 which were paid in January 1997 and
distributions declared and paid in March for the first quarter 1997. Proceeds
from debt in the same period in 1996 includes 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 $5,282 and borrowings
of $11,015 by Liggett under its revolving credit facility. These transactions
were primarily offset by the redemption for approximately $6,300 of BGLS'
16.125% Senior Subordinated Reset Notes (the "Reset Notes"), including premium 
and accrued interest thereon, and distributions to the Company's shareholders 
of $1,369.

         LIGGETT. Liggett had a net capital deficiency of $179,782 as of March
31, 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
goals. Consequently, Liggett could be in violation of certain debt covenants,
and if its lenders were to exercise acceleration rights under the Revolving
Credit Facility (the "Facility") or the Senior Secured Notes (the "Liggett
Notes") indentures or refuse to lend under the Facility, Liggett would not be
able to satisfy such demands or its working capital requirements.

         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 March 31, 1997, $36,339 was outstanding and $461 was available under
the Facility based on eligible collateral at December 31, 1996. The Facility is
collateralized by all inventories and receivables of Liggett. Borrowings under
the Facility, whose interest is calculated at a rate equal to 1.5% above
Philadelphia National Bank's (the indirect parent of Congress Financial
Corporation, the lead lender) prime rate, bear a rate of 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 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 March 31, 1997,
since it is due on March 8, 1998, unless extended by the lender.

         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 Senior Secured 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 Senior Secured Notes; (ii) the maximum permitted working capital
deficit, as defined, was reduced to $12,000; (iii) the maximum permitted
adjusted net worth deficit, as defined, was increased to $180,000; and (iv) the 
permitted advance rates under the Facility for eligible inventory were reduced 
by five percent.


                                      -32-
<PAGE>   34



         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. The Notes due on February 1998 ($37,500) are classified as a
short-term debt at March 31, 1997. 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 $81,170 at March 31, 1997.

         While Liggett management currently intends to seek to refinance and/or
restructure with Liggett's note holders the redemption and maturity requirements
on the Liggett Notes and to extend the Facility, there are no refinancing or
restructuring arrangements for the notes or commitments to extend the Facility
at this time, and no assurances can be given in this regard. Based on Liggett's
net loss for 1996 and projected 1997 operating results, Liggett does not
anticipate it will be able to generate sufficient cash from operations to make
such payments. If Liggett is unable to refinance or restructure such
obligations, renegotiate the payment terms of the Liggett Notes, extend the
Facility, or otherwise make such payments, substantially all of its long-term
debt and the Facility would be in default and debt holders 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 Liggett's ability to continue as a
going concern.

         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 March 31, 1997, BGLS' long-term debt was approximately
$233,000.

         BOL. 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, payable $21,500 on June 30, 1997 and $12,000 on
December 31, 1997. On April 28, 1997, New Valley paid $3,500 of the promissory
note due to BOL on June 30, 1997.

                                      -33-
<PAGE>   35



          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 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 March 31, 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 Company
believes that it will continue to meet its liquidity requirements through 1997,
although the BGLS Series B Notes Indenture limits the amount of restricted
payments BGLS is permitted to make to the Company during the calendar year. At
March 31, 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 BGLS' Series B 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. The Indenture 


                                      -34-
<PAGE>   36



for BGLS' Series B 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.










                                      -35-
<PAGE>   37


                                     PART II
                                OTHER INFORMATION



Item 1.    LEGAL PROCEEDINGS

           Reference is made to information entitled "Contingencies" in Note 6
           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 2.    CHANGES IN SECURITIES

           During the first quarter of 1997, Brooke Group Ltd. granted stock
           options to purchase 422,000 shares of its common stock at $5.00 per
           share to certain employees. These transactions did not involve public
           offerings of the company's securities and were exempt from the
           registration requirements of the Securities Act of 1933, as amended,
           pursuant to Section 4(2) thereunder. See Note 7 to the Consolidated
           Financial Statements of the Companies included elsewhere in this
           report on Form 10-Q.

Item 3.    DEFAULTS UPON SENIOR SECURITIES

           Reference is made to information entitled "Revolving Credit Facility"
           in Note 7 to the Consolidated Financial Statements of the Companies
           included elsewhere in this report on Form 10-Q.

           As of March 31, 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) $127.8 million or $119.26 per Class A Share; and
           (2) $121.5 million or $43.54 per Class B Share.

Item 6.    EXHIBITS AND REPORTS ON FORM 8-K

           (a)    EXHIBITS

                  10.43    Addendum to Initial States Settlement Agreement.

                  10.44    Settlement Agreement, dated April 14, 1997, by and 
                           among the State of California, Brooke Group Ltd. and
                           Liggett Group Inc.

                  10.45    Settlement Agreement, dated May 6, 1997, by and 
                           among the State of Alaska, 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
                           March 31, 1997.


                                      -36-
<PAGE>   38

                  99.2     New Valley Corporation's Interim Consolidated 
                           Financial Statements for the quarterly period
                           ended March 31, 1997.

           `      99.3     Brooke (Overseas) Ltd.'s Interim Consolidated 
                           Financial Statements for the quarterly period ended 
                           March 31, 1997.

                  99.4     New Valley Holdings, Inc.'s Interim Consolidated 
                           Financial Statements for the quarterly period  
                           ended March 31, 1997.


           (b)    REPORTS ON FORM 8-K

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

<TABLE>
<CAPTION>
      Registrant(s)            Date of Report           Items         Financial Statements
      -------------            --------------           -----         --------------------
<S>                         <C>                         <C>           <C>                 
1.  Brooke Group Ltd.       January 31, 1997             2, 7        Unaudited pro-forma
    BGLS Inc.                                                        financial statements for
                                                                     the nine months ended
                                                                     September 30, 1996

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

3.  Brooke Group Ltd.       February 25, 1997             7                    None



</TABLE>






                                      -37-



<PAGE>   39


                                   SIGNATURES





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





                                            BROOKE GROUP LTD.
                                            (REGISTRANT)

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

Date:  May 15, 1997






                                            BGLS INC.
                                            (REGISTRANT)

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

Date:  May 15, 1997







                                      -38-