<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 SEPTEMBER 30, 1998


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

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

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

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

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






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

         At November 13, 1998 Brooke Group Ltd. had 20,943,730 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 September 30, 1998 and
         December 31, 1997.............................................................................        2

   BGLS Inc. Consolidated Balance Sheets as of September 30, 1998 and December 31, 1997................        3

   Brooke Group Ltd. Consolidated Statements of Operations for the three and nine months
         ended September 30, 1998 and September 30, 1997...............................................        4

   BGLS Inc. Consolidated Statements of Operations for the three and nine months ended
         September, 1998 and September 30, 1997........................................................        5

   Brooke Group Ltd. Consolidated Statement of Stockholders' Equity (Deficit) for the nine
         months ended September 30, 1998...............................................................        6

   BGLS Inc. Consolidated Statement of Stockholder's Equity (Deficit) for the nine months
         ended September 30, 1998......................................................................        7

   Brooke Group Ltd. Consolidated Statements of Cash Flows for the nine months ended
         September 30, 1998 and September 30, 1997.....................................................        8

   BGLS Inc. Consolidated Statements of Cash Flows for the nine months ended
         September 30, 1998 and September 30, 1997.....................................................        9

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

Item 2.  Management's Discussion and Analysis
         of Financial Condition and Results of Operations..............................................       34

PART II.     OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS..............................................................................       48

Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS......................................................       48

Item 3. DEFAULTS UPON SENIOR SECURITIES................................................................       48

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

SIGNATURES ............................................................................................       50

</TABLE>

                                      -1-
<PAGE>   3

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS

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

<TABLE>
<CAPTION>
                                                                              September 30,     December 31,
                                                                                   1998             1997
                                                                             ----------------- ----------------
<S>                                                                           <C>               <C>       
ASSETS:
Current assets:
    Cash and cash equivalents...........................................       $   6,390         $   4,754
    Accounts receivable - trade.........................................          10,858            10,462
    Other receivables...................................................           1,277             1,239
    Inventories.........................................................          47,560            39,312
    Other current assets................................................           6,522            12,218
                                                                               ---------         ---------
        Total current assets............................................          72,607            67,985

Property, plant and equipment, at cost, less accumulated
    depreciation of $32,938 and $33,187.................................          57,761            45,943
Intangible assets, at cost, less accumulated amortization
    of $20,401 and $19,302..............................................             319             2,610
Other assets............................................................          10,643             9,922
                                                                               ---------         ---------
        Total assets....................................................       $ 141,330         $ 126,460
                                                                               =========         =========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt...................        $177,461        $    6,429
  Accounts payable......................................................          19,618            10,461
  Dividends payable.....................................................           1,578
  Cash overdraft........................................................           1,405               945
  Accrued promotional expenses..........................................          27,534            26,993
  Accrued taxes payable.................................................          11,059            19,998
  Accrued interest......................................................          10,006            39,782
  Other accrued liabilities.............................................          22,401            35,896
                                                                               ---------         ---------
    Total current liabilities...........................................         271,062           140,504

Notes payable, long-term debt and other obligations, less current portion        238,591           399,835
Noncurrent employee benefits............................................          25,207            29,366
Other liabilities.......................................................          76,441            45,152

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

Stockholders' equity (deficit):
  Preferred Stock, par value $1.00 per share, authorized
    10,000,000 shares...................................................
  Series G Preferred Stock, 2,184,834 shares, convertible, 
     participating, cumulative, each share convertible to 1,000 
     shares of common stock and cash or stock distribution, 
     liquidation preference of $1.00 per share..........................
  Common stock, par value $0.10 per share, authorized 40,000,000 
    shares, issued 26,498,043 and 24,998,043 shares, outstanding
    20,943,730 and 18,097,096 shares....................................           2,094             1,850
  Additional paid-in capital............................................         122,010            88,290
  Deficit...............................................................        (580,999)         (538,791)
  Other.................................................................          14,397            (5,607)
  Less:  5,554,313 and 6,900,947 shares of common stock in treasury,
          at cost.......................................................         (27,473)          (34,139)
                                                                               ---------         ---------
      Total stockholders' equity (deficit)..............................        (469,971)         (488,397)
                                                                               ---------         ---------

      Total liabilities and stockholders' equity (deficit)..............       $ 141,330         $ 126,460
                                                                               =========         =========
</TABLE>



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



                                      -2-
<PAGE>   4


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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


<TABLE>
<CAPTION>
                                                                                   September 30,     December 31,
                                                                                       1998              1997
                                                                                  ---------------- ------------------
<S>                                                                                 <C>              <C>       
ASSETS:

Current assets:
  Cash and cash equivalents.................................................         $   6,324        $   4,754
  Accounts receivable - trade...............................................            10,858           10,462
  Other receivables.........................................................             1,220            1,191
  Inventories...............................................................            47,560           39,312
  Other current assets......................................................             6,172           11,647
                                                                                     ---------         --------
      Total current assets..................................................            72,134           67,366

Property, plant and equipment, at cost, less accumulated depreciation of
  $32,938 and $32,760.......................................................            57,735           45,775
Intangible assets, at cost, less accumulated amortization of 
  $20,401 and $19,302 ......................................................               319            2,610
Other assets................................................................             9,537           13,165
                                                                                     ---------         --------
      Total assets..........................................................         $ 139,725        $ 128,916
                                                                                     =========        =========

LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt.......................         $ 177,127        $   6,212
  Accounts payable..........................................................            19,486           10,336
  Cash overdraft............................................................             1,405              891
  Due to parent.............................................................            34,981           22,951
  Accrued promotional expenses..............................................            27,534           26,993
  Accrued taxes payable.....................................................            11,059           19,998
  Accrued interest..........................................................            10,006           39,782
  Other accrued liabilities.................................................            21,776           34,312
                                                                                     ---------        ---------
      Total current liabilities.............................................           303,374          161,475

Notes payable, long-term debt and other obligations, less current portion...           238,591          399,835
Noncurrent employee benefits................................................            25,207           29,366
Other liabilities...........................................................            79,877           51,355

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

Stockholder's equity (deficit):
  Common stock, par value $0.01 per share; 100 shares authorized,
    issued and outstanding..................................................
  Additional paid-in capital................................................            68,775           39,081
  Deficit...................................................................          (593,429)        (550,339)
  Other.....................................................................            17,330           (1,857)
                                                                                     ---------        ---------
      Total stockholder's deficit...........................................          (507,324)        (513,115)
                                                                                     ---------        ---------

      Total liabilities and stockholder's equity (deficit)..................         $ 139,725        $ 128,916
                                                                                     =========        =========
</TABLE>


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



                                      -3-
<PAGE>   5


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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


<TABLE>
<CAPTION>

                                                                    Three Months Ended          Nine Months Ended
                                                                --------------------------- ---------------------------
                                                                 Sept. 30,     Sept. 30,     Sept. 30,     Sept. 30,
                                                                    1998          1997          1998          1997
                                                                ------------- ------------- ------------- -------------
<S>                                                              <C>           <C>           <C>           <C>     
Revenues*.................................................       $108,202      $100,308      $304,267      $276,906
Cost of goods sold*.......................................         47,086        53,045       140,422       145,841
                                                                 --------      --------      --------      --------

Gross profit..............................................         61,116        47,263       163,845       131,065
Operating, selling and general expenses...................         48,115        40,498       130,241       117,535
                                                                 --------      --------      --------      --------

Operating income..........................................         13,001         6,765        33,604        13,530

Other income (expenses):
    Interest income.......................................             75           431           325         1,682
    Interest expense......................................        (20,138)      (15,791)      (60,561)      (46,757)
    Equity in loss of affiliate...........................         (8,935)       (6,984)      (20,383)      (21,335)
    Sale of assets........................................            707                       2,025        23,086
    Retirement of debt....................................                                                    2,963
    Proceeds from legal settlement........................                                                    4,125
    Other, net............................................            233          (257)         (765)          (77)
                                                                 --------      --------      --------      --------

Loss from continuing operations before income taxes.......        (15,057)      (15,836)      (45,755)      (22,783)
(Benefit) provision for income taxes......................         (2,447)         (248)       (1,135)           541
                                                                 --------      --------      --------      --------

Loss from continuing operations...........................        (12,610)      (15,588)      (44,620)      (23,324)
                                                                 --------      --------      --------      --------

Discontinued operations:
Gain on disposal of discontinued operations...............          3,208                       3,208     
                                                                 --------      --------     ---------      --------

Net loss..................................................       $ (9,402)     $(15,588)    $ (41,412)    $ (23,324)
                                                                 ========      ========     =========      ========

Basic and diluted common share data:

    Loss from continuing operations.......................         $(0.61)       $(0.86)       $(2.20)       $(1.28)
                                                                   ======        ======        ======        ======
    Income from discontinued operations...................         $ 0.15        $             $ 0.16        $ 
                                                                   ======        ======        ======        ======
    Net loss applicable to common shares..................         $(0.46)       $(0.86)       $(2.04)       $(1.28)
                                                                   ======        ======        ======        ======

Weighted average common shares outstanding................     20,826,231    18,097,096    20,250,199    18,192,233
                                                               ==========    ==========    ==========    ==========

</TABLE>


---------------
*   Revenues and Cost of goods sold include federal excise taxes of $20,244 and
    $19,250 for the three months ended September 30, 1998 and 1997,
    respectively, and $60,589 and $55,263 for the nine months ended September
    30, 1998 and 1997, respectively.



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



                                      -4-
<PAGE>   6


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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

<TABLE>
<CAPTION>

                                                                    Three Months Ended          Nine Months Ended
                                                                --------------------------- ---------------------------
                                                                 Sept. 30,     Sept. 30,     Sept. 30,     Sept. 30,
                                                                    1998          1997          1998          1997
                                                                ------------- ------------- ------------- -------------
<S>                                                              <C>           <C>           <C>           <C>     
Revenues*.................................................       $108,202      $100,308      $304,267      $276,906
Cost of goods sold*.......................................         47,086        53,045       140,422       145,841
                                                                 --------      --------      --------      --------

Gross profit..............................................         61,116        47,263       163,845       131,065

Operating, selling and general expenses...................         46,838        40,502       127,635       117,159
                                                                 --------      --------      --------      --------

Operating income .........................................         14,278         6,761        36,210        13,906

Other income (expenses):
   Interest income........................................             65           431           184         1,670
   Interest expense.......................................        (21,270)      (16,750)      (63,832)      (49,542)
   Equity in loss of affiliate............................         (8,935)       (6,984)      (20,383)      (21,335)
   Sale of assets.........................................                                      1,318        27,663
   Retirement of debt.....................................                                                    2,963
   Other, net.............................................             71          (257)         (930)          (84)
                                                                 --------      --------      --------      --------

Loss from continuing operations before income taxes.......        (15,791)      (16,799)      (47,433)      (24,759)
(Benefit) provision for income taxes......................         (2,447)         (248)       (1,135)          539
                                                                 --------      --------      --------      --------

Loss from continuing operations...........................        (13,344)      (16,551)      (46,298)      (25,298)
                                                                 --------      --------      --------      --------

Discontinued operations:
Gain on disposal of discontinued operations...............          3,208                       3,208     
                                                                 --------      --------      --------      --------

Net loss..................................................       $(10,136)     $(16,551)     $(43,090)     $(25,298)
                                                                 ========      ========      ========      ========
</TABLE>

-----------------------
* Revenues and Cost of goods sold include federal excise taxes of $20,244 and
  $19,250 for the three months ended September 30, 1998 and 1997, respectively,
  and $60,589 and $55,263 for the nine months ended September 30, 1998 and 1997,
  respectively.


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


                                      -5-
<PAGE>   7

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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



                                                                                                          Accumulated
                                       Common Stock     Additional                                           Other    
                                   --------------------  Paid-In                   Treasury               Comprehensive
                                     Shares     Amount   Capital      Deficit        Stock       Other        Income        Total
                                   ----------   ------  ----------   --------      --------     --------  --------------  ---------
<S>                                <C>          <C>       <C>        <C>           <C>          <C>           <C>         <C>       
Balance, December 31, 1997........ 18,097,096   $1,850    $ 88,290   $(538,791)    $(34,139)    $(8,337)      $ 2,730     $(488,397)

Net loss..........................                                     (41,412)                                             (41,412)

Issuance of options and warrants..                          24,442                                                           24,442

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

Effectiveness fee on debt.........    483,002       48       1,666                    2,391                                   4,105
 
Issuance of treasury stock........    863,632       46         319        (796)       4,275                                   3,844

Distributions on common stock 
 ($0.15 per share)................                          (4,589)                                                          (4,589)

Amortization of deferred 
 compensation.....................                             540                                  817                       1,357

Unrealized holding gain on 
 investment in New Valley.........                                                                             25,340        25,340

Effect of New Valley capital 
 transactions.....................                                                                             (6,153)       (6,153)
                                   ----------   ------    --------    ---------    --------     -------       -------     ---------
Balance, September 30, 1998....... 20,943,730   $2,094    $122,010    $(580,999)   $(27,473)    $(7,520)      $21,917     $(469,971)
                                   ==========   =====     ========    =========    ========     =======       =======     =========

</TABLE>




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



                                      -6-
<PAGE>   8

Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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

<TABLE>
<CAPTION>


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

<S>                                     <C>    <C>                  <C>           <C>        <C>           <C>       
Balance, December 31, 1997............. 100    $         $39,081    $(550,339)    $1,013     $(2,870)      $(513,115)

Net loss...............................                               (43,090)                               (43,090)

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

Capital contribution of options 
  and warrants.........................                   24,442                                              24,442

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

Amortization of deferred compensation..                      279                                                 279

Unrealized holding gain on investment
    In New Valley......................                                                       25,340          25,340

Effect of New Valley capital 
    transactions.......................                                                       (6,153)         (6,153)
                                        ---    -----     -------    ---------     ------     -------       ---------
Balance, September 30, 1998............ 100    $         $68,775    $(593,429)    $1,013     $16,317       $(507,324)
                                        ===    =====     =======    =========     ======     =======       =========

</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 SUBSIDIARY
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>

                                                                                          Nine Months Ended
                                                                                  ----------------------------------
                                                                                   September 30,    September 30,
                                                                                       1998              1997
                                                                                  ---------------- -----------------

<S>                                                                                 <C>              <C>       
  Net cash used in operating activities.....................................        $ (17,847)       $ (30,511)
                                                                                     --------         --------

  Cash flows from investing activities:
    Proceeds from sale of businesses and assets, net........................            2,377           43,091
    Capital expenditures....................................................          (17,289)          (9,857)
                                                                                     --------        ---------

  Net cash (used in) provided by investing activities.......................          (14,912)          33,234
                                                                                     --------         --------

  Cash flows from financing activities:
    Proceeds from debt......................................................            4,425            5,198
    Repayments of debt......................................................           (1,520)         (10,323)
    Borrowings under revolver...............................................          208,434          209,822
    Repayments on revolver..................................................         (210,050)        (202,881)
    Increase in cash overdraft..............................................              460            1,416
    Distributions on common stock...........................................           (3,055)          (5,535)
    Proceeds from participating loan........................................           25,000
    Issuance of common stock................................................           10,144      
                                                                                     --------

  Net cash provided by (used in) financing activities.......................           33,838           (2,303)
                                                                                     --------        ---------

  Effect of exchange rate changes on cash and cash equivalents..............              557
  Net increase in cash and cash equivalents.................................            1,636              420
  Cash and cash equivalents, beginning of period............................            4,754            1,941
                                                                                    ---------        ---------

  Cash and cash equivalents, end of period..................................       $    6,390       $    2,361
                                                                                    =========        =========


Supplemental non-cash investing and financing activities:

  Promissory note from New Valley...........................................                            33,500
  Issuance of stock to Liggett bondholders..................................            4,105
  Issuance of stock to consultants..........................................            3,705
  Issuance of warrants......................................................           22,421

</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>


                                                                                           Nine Months Ended
                                                                                  ------------------ ------------------
                                                                                    September 30,      September 30,
                                                                                        1998               1997
                                                                                  ------------------ ------------------
<S>                                                                                  <C>                <C>       
Net cash used in operating activities.......................................         $    (9,783)       $ (36,989)
                                                                                     -----------        ---------

Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net..........................               1,670           43,091
  Capital expenditures......................................................             (17,289)          (9,857)
                                                                                     -----------        ---------

Net cash (used in) provided by investing activities.........................             (15,619)          33,234
                                                                                     -----------        ---------

Cash flows from financing activities:
  Proceeds from debt........................................................               3,950            4,723
  Repayments of debt........................................................              (1,433)          (8,942)
  Borrowings under revolver.................................................             208,434          209,822
  Repayments on revolver....................................................            (210,050)        (202,881)
  Increase in cash overdraft................................................                 514            1,416
  Proceeds from participating loan..........................................              25,000         
                                                                                     -----------        ---------

Net cash provided by (used in) financing activities.........................              26,415            4,138 
                                                                                     -----------        ---------

Effect of exchange rate changes on cash and cash equivalents................                 557
Net increase in cash and cash equivalents...................................               1,570              383
Cash and cash equivalents, beginning of period..............................               4,754            1,940
                                                                                     -----------        ----------

Cash and cash equivalents, end of period....................................         $     6,324        $    2,323
                                                                                     ===========        ==========



Supplemental non-cash investing and financing activities:

  Promissory note from New Valley...........................................                               33,500
  Issuance of stock to Liggett bondholders..................................               4,105
  Issuance of stock to consultants..........................................               3,705
  Issuance of warrants......................................................              22,421

</TABLE>

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



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



1.    PRINCIPLES OF REPORTING 

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

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

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

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

      LIQUIDITY:

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

      On January 30, 1998, Liggett obtained the consents of the required
      majority of the holders of Liggett's 11.50% Series B and 19.75% Series C
      Senior Secured Notes due 1999 (the "Liggett Notes") to various amendments
      to the Indenture governing the Liggett Notes. The amendments provided,
      among other things, for a deferral of the February 1, 1998 mandatory
      redemption of $37,500 principal amount of the Liggett Notes to the date of
      final maturity, February 1, 1999. (Refer to Note 6.) At maturity, the
      Liggett Notes will require a principal payment of $144,891. Liggett does
      not anticipate it will be able to generate sufficient cash from operations
      to make such payments. In addition, Liggett has a $40,000 revolving credit
      facility expiring March 8, 1999 (the "Facility"), under which $17,674 was
      outstanding at September 30, 1998. Accordingly, the Liggett Notes and the
      balance of the Facility have been reclassified to current liabilities. As
      of September 30, 1998, Liggett had net 



                                      -10-
<PAGE>   12
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (Continued)


      capital and working capital deficiencies of $183,268 and $169,071,
      respectively. The current maturities of the Liggett Notes and the Facility
      of approximately $162,500 contribute substantially to the working capital
      deficiency. If Liggett is unable to refinance or restructure the terms of
      the Liggett Notes or otherwise make all payments thereon, substantially
      all of the Liggett Notes and the Facility would be in default. In such
      event, Liggett may be forced to seek protection from creditors under
      applicable laws. Due to the many risks and uncertainties associated with
      the cigarette industry and the impact of tobacco litigation, there can be
      no assurance that Liggett will be able to meet its future earnings or cash
      flow goals. These matters raise substantial doubt about Liggett meeting
      its liquidity needs and its ability to continue as a going concern and may
      negatively impact the Company's liquidity.

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

      In March 1998, the Company entered into an agreement with significant
      holders of the BGLS 15.75% Series B Senior Secured Notes (the "BGLS
      Notes") with respect to certain modifications to the terms of such debt.
      (Refer to Note 6.)

      NET LOSS PER SHARE

      Stock options, warrants and contingent shares (both vested and non-vested)
      at September 30, 1998 and 1997, respectively (see Note 7), were excluded
      from the calculation of diluted per share results presented because their
      effect was accretive. Accordingly, diluted net loss per common share is
      the same as basic net loss per common share.

      NEW ACCOUNTING PRONOUNCEMENTS

      In June 1997, the Financial Accounting Standards Board issued Statement of
      Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
      Income". SFAS No. 130, which the Company adopted in the first quarter of
      1998, establishes standards for reporting and displaying comprehensive
      income and its components in a full set of general-purpose statements. For
      the Company, other components of stockholders' equity include such items
      as the Company's proportionate interest in New Valley's capital
      transactions and unrealized gains and losses on investment securities. The
      implementation of SFAS No. 130 in the first quarter 1998 did not have any
      material effect on the consolidated financial statements.

      In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
      an Enterprise and Related Information". SFAS No. 131 specifies revised
      guidelines for determining an entity's operating segments and the type and
      level of financial information to be disclosed. Management believes that
      the adoption of this pronouncement will not have a material effect on the
      Company's financial statement disclosures. SFAS No. 131 is initially
      effective for annual financial statements for fiscal years beginning after
      December 15, 1997.

      In February 1998, SFAS No. 132, "Employers' Disclosures about Pensions and
      Other Postretirement Benefits," was issued which revises required
      disclosures about pensions and postretirement benefit plans in order to
      facilitate financial analysis. Recognition or measurement issues are not
      addressed in the statement. SFAS No. 132 is effective for the Company for
      the year ended 1998. Management 




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


      believes that the adoption of this pronouncement will not have a material
      effect on the Company's financial statement disclosures.


2.    INVESTMENT IN NEW VALLEY CORPORATION

      At September 30, 1998 and December 31, 1997, the Company's investment in
      New Valley consisted of an approximate 42% voting interest. At September
      30, 1998 and December 31, 1997, the Company owned 57.7% of the outstanding
      $15.00 Class A Increasing Rate Cumulative Senior Preferred Shares ($100
      Liquidation Value), $.01 par value (the "Class A Preferred Shares"), 9.0%
      of the outstanding $3.00 Class B Cumulative Convertible Preferred Shares
      ($25 Liquidation Value), $.10 par value (the "Class B Preferred Shares"),
      and 41.7% of New Valley's common shares, $.01 par value (the "Common
      Shares").

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

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

      The Company's and BGLS' investment in New Valley at September 30, 1998 is
summarized below:

                                         Number of        Fair        Carrying
                                           Shares         Value        Amount
                                         ---------       -------      --------
   Class A Preferred Shares.......         618,326       $33,390      $ 33,390
   Class B Preferred Shares.......         250,885           502           502
   Common Shares..................       3,989,710         1,496       (33,892)
                                                         -------      -------- 
                                                         $35,388      $      0
                                                         =======      ========

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





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


      The Class A Preferred Shares of New Valley are required to be redeemed on
      January 1, 2003 for $100.00 per share plus dividends accrued to the
      redemption date. The shares are redeemable, at any time, at the option of
      New Valley, at $100.00 per share plus accrued dividends. The holders of
      Class A Preferred Shares are entitled to receive a quarterly dividend, as
      declared by the Board of Directors, payable at the rate of $19.00 per
      annum. At September 30, 1998, the accrued and unpaid dividends arrearage
      was $204,050 ($190.44 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 September 30, 1998, the accrued and unpaid dividends arrearage
      was $158,907 ($56.94 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 September 30, 1998
      and December 31, 1997 and for the three and nine months ended September
      30, 1998 and 1997 follows:

<TABLE>
<CAPTION>

                                                      September 30,        December 31,
                                                          1998                1997
                                                      -------------        ------------
<S>                                                   <C>                  <C>      
Current assets, primarily cash and marketable
   securities...................................      $  73,864            $ 118,642
Non-current assets..............................        177,017              322,749
Current liabilities.............................         67,238              128,128
Non-current liabilities.........................         75,654              185,024
Redeemable preferred stock......................        300,711              258,638
Shareholders' deficit...........................       (192,722)            (130,399)

</TABLE>


<TABLE>
<CAPTION>
                                                          Three Months Ended          Nine Months Ended
                                                      --------------------------- ---------------------------
                                                       Sept. 30,     Sept. 30,     Sept. 30,     Sept. 30,
                                                          1998          1997          1998          1997
                                                      ------------- ------------- ------------- -------------
<S>                                                    <C>           <C>           <C>           <C>      
Revenues   ....................................        $ 19,440      $ 26,704      $ 78,552      $  76,652
Costs and expenses..............................         28,664        33,782        95,633        100,020
Loss from continuing operations.................         (8,739)       (6,574)      (15,458)       (21,944)
Income from discontinued operations.............          6,860                       7,740
Net loss applicable to common shares(A).........        (22,622)      (24,141)      (67,051)       (72,241)
</TABLE>

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

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

      In February 1998, New Valley and Apollo Real Estate Investment Fund III,
      L.P. ("Apollo") organized Western Realty Development LLC ("Western Realty
      Ducat") to make real estate and other investments in Russia. In connection
      with the formation of Western Realty Ducat, New Valley agreed, among other
      things, to contribute the real estate assets of BML, including Ducat Place
      II and the site for Ducat Place III, to Western Realty Ducat and Apollo
      agreed to contribute up to $58,750, including the investment in Western
      Realty Repin discussed below. Through September 30, 1998, Apollo had
      funded $30,550 of its investment in Western Realty Ducat.





                                      -13-
<PAGE>   15
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (Continued)


      The ownership and voting interests in Western Realty Ducat will be held
      equally by Apollo and New Valley. Apollo will be entitled to a preference
      on distributions of cash from Western Realty Ducat to the extent of its
      investment ($40,000), together with a 15% annual rate of return, and New
      Valley will then be entitled to a return of $16,300 of BML-related
      expenses incurred and cash invested by New Valley since March 1, 1997,
      together with a 15% annual rate of return; subsequent distributions will
      be made 70% to New Valley and 30% to Apollo. Western Realty Ducat will be
      managed by a Board of Managers consisting of an equal number of
      representatives chosen by Apollo and New Valley. All material corporate
      transactions by Western Realty Ducat generally require the unanimous
      consent of the Board of Managers. Accordingly, New Valley has accounted
      for its non-controlling interest in Western Realty Ducat using the equity
      method of accounting.

      New Valley recorded its basis in the investment in Western Realty Ducat in
      the amount of $60,169 based on the carrying value of assets less
      liabilities transferred. There was no difference between the carrying
      value of the investment and New Valley's proportionate interest in the
      underlying value of net assets of Western Realty Ducat.

      Western Realty Ducat will seek to make additional real estate and other
      investments in Russia. Western Realty Ducat has made a $26,300
      participating loan to, and payable out of a 30% profits interest in, a
      company organized by BOL which, among other things, acquired an interest
      in a new factory being constructed on the outskirts of Moscow by a
      subsidiary of BOL. (Refer to Note 3.)

      In June 1998, New Valley and Apollo organized Western Realty Repin LLC
      ("Western Realty Repin") to make a $25,000 participating loan (the "Repin
      Loan") to BML. The proceeds of the loan will be used by BML for the
      acquisition and preliminary development of two adjoining sites totaling
      10.25 acres (the "Kremlin Sites") located in Moscow across the Moscow
      River from the Kremlin. BML, which is planning the development of a 1.1
      million sq. ft. hotel, office, retail and residential complex on the
      Kremlin Sites, owned 94.6% of one site and 52% of the other site at
      September 30, 1998. Apollo will be entitled to a preference on
      distributions of cash from Western Realty Repin to the extent of its
      investment ($18,750) together with a 20% annual rate of return, and New
      Valley will then be entitled to a return of its investment ($6,250),
      together with a 20% annual rate of return; subsequent distributions will
      be made 50% to New Valley and 50% to Apollo. Western Realty Repin will be
      managed by a Board of Managers consisting of an equal number of
      representatives chosen by Apollo and New Valley. All material corporate
      transactions by Western Realty Repin will generally require the unanimous
      consent of the Board of Managers.

      Through September 30, 1998, Western Realty Repin has advanced $19,067 (of
      which $14,300 was funded by Apollo) under the Repin Loan to BML. The Repin
      Loan, which bears no fixed interest, is payable only out of 100% of the
      distributions, if made, by the entities owning the Kremlin Sites to BML.
      Such distributions shall be applied first to pay the principal of the
      Repin Loan and then as contingent participating interest on the Repin
      Loan. Any rights of payment on the Repin Loan are subordinate to the
      rights of all other creditors of BML. BML used a portion of the proceeds
      to repay New Valley for certain expenditures on the Kremlin Sites
      previously incurred. The Repin Loan is due and payable upon the
      dissolution of BML and is collateralized by a pledge of New Valley's
      shares of BML.

      As of September 30, 1998, BML had invested $15,171 in the Kremlin sites
      and held $809, in cash, which was restricted for future investment. In
      connection with the acquisition of its interest in one of the Kremlin
      Sites, BML has agreed with the City of Moscow to invest an additional
      $6,000 in 1998 and $22,000 in 1999 in the development of the property.




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


      The development of Ducat Place III and the Kremlin Sites will require
      significant amounts of debt and other financing. New Valley is actively
      pursuing various financing alternatives on behalf of Western Realty Ducat
      and BML. However, in light of the recent economic turmoil in Russia, no
      assurance can be given that such financing will be available on acceptable
      terms. Failure to obtain sufficient capital for the projects would force
      Western Realty Ducat and BML to curtail or delay the planned development
      of Ducat Place III and the Kremlin Sites.


3.    INVESTMENT IN BROOKE (OVERSEAS) LTD.

      At September 30, 1998, BOL owned approximately 96% of the stock of
      Liggett-Ducat through its subsidiary, Western Tobacco Investments LLC
      ("Western Tobacco"), including shares of such stock acquired from Liggett
      in connection with Liggett's debt restructuring (refer to Note 6) and
      purchases of stock from other shareholders. (Refer to Note 6 for
      information concerning pledges of interests in Western Tobacco.)

      Liggett-Ducat is in the process of constructing a new cigarette factory on
      the outskirts of Moscow which is currently scheduled to be operational in
      the second quarter 1999. Liggett-Ducat has entered into a construction
      contract for the plant. The remaining liability under that contract, as
      amended, at September 30, 1998 is approximately $10,300. Equipment
      purchase agreements in place at September 30, 1998 total $34,355, of which
      $28,791 is being financed by the manufacturers.

      Western Realty has made a $26,300 participating loan to Western Tobacco
      which holds BOL's interests in Liggett-Ducat, as discussed above, and the
      industrial site and manufacturing facility being constructed by
      Liggett-Ducat on the outskirts of Moscow. The loan, which bears no fixed
      interest, is payable only out of 30% of distributions, if any, made by
      Western Tobacco to BOL. After the prior payment of debt service on loans
      to finance the construction of the new facility, 30% of distributions from
      Western Tobacco to BOL will be applied first to pay the principal of the
      loan and then as contingent participating interest on the loan. Any rights
      of payment on the loan are subordinate to the rights of all other
      creditors of Western Tobacco. The loan is classified in other long-term
      liabilities on the consolidated balance sheet at September 30, 1998.
      (Refer to Note 2.)

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

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




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


4.    INVENTORIES

      Inventories consist of:

<TABLE>
<CAPTION>
                                                         September 30,       December 31,
                                                             1998                1997
                                                       ------------------ -------------------
<S>                                                           <C>              <C>    
Finished goods...................................             $17,008          $13,273
Work-in-process..................................               2,886            1,976
Raw materials....................................              22,662           24,495
Replacement parts and supplies...................               9,123            4,466
                                                              -------          -------
Inventories at current cost......................              51,679           44,210
LIFO adjustments.................................              (4,119)          (4,898)
                                                              -------          ------- 
                                                              $47,560          $39,312
                                                               ======           ======
</TABLE>

           At September 30, 1998, Liggett and Liggett-Ducat had leaf tobacco
      purchase commitments of approximately $6,134 and $8,599, respectively.


5.    PROPERTY, PLANT AND EQUIPMENT

      Property, plant and equipment consist of:

<TABLE>
<CAPTION>

                                                  September 30,       December 31,
                                                      1998                1997
                                                  -------------       ------------

<S>                                                    <C>             <C>       
Land and improvements............................   $    411           $    411
Buildings........................................      6,042              6,521
Machinery and equipment..........................     53,063             53,717
Leasehold improvements...........................                           302
Construction-in-progress.........................     31,183             18,179
                                                    --------           --------
                                                      90,699             79,130
Less accumulated depreciation....................    (32,938)           (33,187)
                                                    --------           -------- 
                                                    $ 57,761           $ 45,943
                                                    ========           ========
</TABLE>




                                      -16-
<PAGE>   18
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (Continued)


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

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

<TABLE>
<CAPTION>

                                                                        September 30,     December 31,
                                                                           1998              1997
                                                                        -------------     ------------

         <S>                                                             <C>              <C>  
         15.75% Series B Senior Secured Notes due 2001,
             net of unamortized discount of $19,259 and $1,511.....      $213,606         $231,723
         Deferred interest on 15.75% Series B Senior Secured
             Notes due 2001........................................        24,985
         14.500% Subordinated Debentures due 1998..................                            800
         Notes payable - Foreign...................................        10,000            5,000
         Other.....................................................         4,959              629

         Liggett:
         11.500% Senior Secured Series B Notes due 1999, net of
             unamortized discount of $63 and $206..................       112,549          112,406
         Variable Rate Series C Senior Secured Notes due 1999......        32,279           32,279
         Revolving credit facility.................................        17,674           23,427
                                                                         --------         --------

         Total notes payable, long-term debt and other obligations.       416,052          406,264

         Less:
             Current maturities....................................       177,461            6,429
                                                                         --------         --------

         Amount due after one year.................................      $238,591         $399,835
                                                                         ========         ========
</TABLE>


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

      STANDSTILL AGREEMENT - BGLS:

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

      On February 6, 1998, BGLS entered into a further amendment to the
      standstill agreement with AIF II, LP and an affiliated investment manager
      on behalf of a managed account (together, the "Apollo Holders"), who held
      approximately 41.8% of the $232,864 principal amount of the BGLS Notes
      then outstanding, which extended the termination date of such agreement
      with respect to the Apollo Holders to March 2, 1998. Also on February 6,
      1998, the holder of 41.9% of the BGLS Notes, who had previously been a
      party to the standstill agreement, was paid its pro rata share of the July
      31, 1997 interest payment on the BGLS Notes. The Company also sold stock
      on January 16, 1998 to an affiliate of this holder in which it recorded an
      expense of $2,531 for the first quarter 1998, representing the difference
      between the cost and fair market value of the shares sold. (Refer to Note
      7.)

      On March 2, 1998, the Company entered into an agreement with the Apollo
      Holders in which the Apollo Holders agreed to defer the payment of
      interest on the BGLS Notes held by them, 



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


      commencing with the interest payment that was due July 31, 1997, which
      they had previously agreed to defer, through the interest payment due July
      31, 2000. The deferred interest payments together with interest compounded
      semi-annually thereon will be payable at final maturity of the BGLS Notes
      on January 31, 2001 or upon an event of default under the Indenture for
      the BGLS Notes. Accordingly, accrued interest as of March 2, 1998 was
      reclassified and included in long-term debt. In connection with the
      agreement, the Company pledged 50.1% of Western Tobacco to collateralize
      the BGLS Notes held by the Apollo Holders.

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

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

      15.75% SERIES B SENIOR SECURED NOTES DUE 2001

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

      LIGGETT 11.50% SENIOR SECURED SERIES B NOTES DUE 1999:

      On February 14, 1992, Liggett issued $150,000 in Senior Secured Notes (the
      "Liggett Series B Notes"). Interest on the Liggett Series B Notes is
      payable semiannually on February 1 and August 1 at an annual rate of
      11.50%. The Liggett Series B Notes and Series C Notes referred to below
      (collectively, the "Liggett Notes") required mandatory principal
      redemptions of $7,500 on February 1 in each of the years 1993 through 1997
      and $37,500 on February 1, 1998 with the balance of the Liggett Notes due
      on February 1, 1999. In February 1997, $7,500 of Liggett Series B Notes
      were purchased using the Facility and credited against the mandatory
      redemption requirements. The 




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


      transaction resulted in a net gain of $2,963. The Liggett Notes are
      collateralized by substantially all of the assets of Liggett, excluding
      inventories and receivables. Eve Holdings Inc. is a guarantor for the
      Liggett Notes. The Liggett Notes may be redeemed, in whole or in part, at
      a price equal to 100% of the principal amount at the option of Liggett.
      The Liggett Notes contain restrictions on Liggett's ability to declare or
      pay cash dividends, incur additional debt, grant liens and enter into any
      new agreements with affiliates, among others.

      On January 30, 1998, with the consent of the required majority of the
      holders of the Liggett Notes, Liggett entered into various amendments to
      the Indenture governing the Liggett Notes, which provided, among other
      things, for a deferral of the February 1, 1998 mandatory redemption
      payment of $37,500 to the date of final maturity of the Liggett Notes on
      February 1, 1999. In connection with the consent to the deferral, the
      Company agreed to issue 483,002 shares of the Company's common stock to
      the holders of record on January 15, 1998 of the Liggett Notes. As a
      result of this transaction, Liggett recorded a deferred charge of $4,105
      during the first quarter of 1998 reflecting the fair value of the
      instruments issued. This deferred charge is being amortized over a period
      of one year. The Indenture under which the Liggett Notes are outstanding
      was also amended to prohibit, with limited exceptions, payments of
      dividends and incurrence of new debt by Liggett and to tighten
      restrictions on the disposition of proceeds of asset sales. The Company
      and BGLS also agreed to guarantee the payment, which was made by Liggett,
      of the August 1, 1998 interest payment on the Liggett Notes. In addition,
      Liggett noteholders were granted additional collateral in the form of a
      security interest in 16% of Western Tobacco.

      On February 1, 1999, all of the Liggett Notes, in principal amount of
      $144,891, will reach maturity. There are no refinancing or restructuring
      arrangements in place at this time for the notes and no assurances can be
      given in this regard. (Refer to Note 1.)

      LIGGETT SERIES C VARIABLE RATE NOTES:

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

      REVOLVING CREDIT FACILITY - LIGGETT:

      On March 8, 1994, Liggett entered into the Facility for $40,000 with a
      syndicate of commercial lenders. The Facility is collateralized by all
      inventories and receivables of Liggett. At September 30, 1998, $8,091 was
      available under the Facility based on eligible collateral. Borrowings
      under the Facility, whose interest is calculated at a rate equal to 1.5%
      above the Philadelphia National Bank's prime rate, bear a rate of 10.0% at
      September 30, 1998, reduced to 9.75% and 9.50% in October and November
      1998, respectively. The Facility requires Liggett's compliance with
      certain financial and other covenants, including restrictions on the
      payment of cash dividends and distributions by Liggett. In addition, the
      Facility, as amended April 8, 1998, imposes requirements with respect to
      Liggett's permitted maximum adjusted net worth (not to fall below a
      deficit of $195,000 as computed in accordance with the agreement, this
      computation was $179,149 at September 30, 1998) and net working capital
      deficiencies (not to fall below a deficit of $17,000 as computed in
      accordance with the agreement, this computation was $2,450 at September
      30, 1998). The Facility, as amended, also provides that a default by
      Liggett or its subsidiaries under the March 1996 Settlements, March 1997
      Settlements and March 1998 Settlements (all as defined below in Note 8)
      shall constitute an event of default under the Facility. In November 1997,
      the Facility was extended for an additional year until March 8, 1999.





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


      On August 29, 1997, the Facility was amended to permit Liggett to borrow
      an additional $6,000 which was used on that date in making the interest
      payment of $9,700 due on August 1, 1997 to the holders of the Liggett
      Notes. BGLS guaranteed the additional $6,000 advance under the Facility
      and collateralized the guarantee with $6,000 in cash, deposited with
      Liggett's lender, $3,000 of which was released in November, 1998. At
      September 30, 1998, this amount is classified in other assets on the
      consolidated balance sheet.

      FOREIGN LOANS:

      At September 30, 1998, Liggett-Ducat had one credit facility outstanding
      for $10,000 with an interest rate of 21% which expires in May of 1999. On
      August 26, 1998, the interest rate over the remaining term of the facility
      increased to 25%.


7.    EQUITY

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

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

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

      On March 12, 1998, the Company granted an option for 1,250,000 shares of
      the Company's common stock to a law firm that represents the Company and
      Liggett. On May 1, 1998 and April 1, 1999, options for 250,000 and
      1,000,000 shares, respectively, of common stock were exercisable at $17.50
      per share. The option expired on March 31, 2003. The fair value of the
      equity instruments was estimated based on the Black-Scholes option pricing
      model and the following assumptions: volatility 77.6%, risk-free interest
      rate of 5.47%, expected life of two years and dividend rate of 0%. The
      Company recognized expense of $1,495 in the second quarter of 1998. On
      October 12, 1998, the Company amended the option to reduce the exercise
      price from $17.50 per share to $6.00 per share and extended the initial
      exercise date on all 1,250,000 shares to April 1, 2000, subject to earlier
      exercise under certain circumstances. The expense at the initial grant
      date was $3,063. Incremental expense incurred due to the modifications of
      the grant was $2,050. At September 30, 1998, $2,019 had been expensed and 
      the remaining amount of $3,095 will be recognized over the period of
      vesting.

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





                                      -20-
<PAGE>   22
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (Continued)


      On October 15, 1998, shareholders of the Company approved the adoption of
      the 1998 Long-Term Incentive Plan (the "Plan"). The Plan, adopted on May
      8, 1998, authorizes the granting of up to 5,000,000 shares of the
      Company's common stock through awards of stock options (which may include
      incentive stock options and/or nonqualified stock options), stock
      appreciation rights and shares of restricted Company common stock. All
      officers, employees and consultants of the Company and its subsidiaries
      are eligible to receive awards under the Plan.

      On July 20, 1998, the Company granted a non-qualified stock option to each
      of Bennett S. LeBow, the Chairman and Chief Executive Officer of the
      Company, and Howard M. Lorber, a consultant to the Company (the "Option
      Holders"), pursuant to the Plan, which grants had been conditioned upon
      the approval of the Plan by the Company's stockholders. Under the options,
      Messrs. LeBow and Lorber have the right to purchase 2,500,000 shares and
      500,000 shares, respectively, of the Company's common stock at an exercise
      price of $9.75 per share (the fair market value of a share of common stock
      on the date of grant). The options have a ten-year term and become
      exercisable as to one-fourth of the aggregate shares covered thereby on
      each of the first four anniversaries of the date of grant. However, any
      then unexercisable portion of the option will immediately vest and become
      exercisable upon (i) the occurrence of a "Change in Control," or (ii) the
      termination of the Option Holder's employment or consulting arrangement
      with the Company due to death or disability.

      The fair value of the equity instruments issued to the consultant was
      estimated based on the Black-Scholes option pricing model and the
      following assumptions: volatility of 82.18%, risk-free interest rate of
      5.47%, expected option life of 10 years and dividend rate of 0%. The
      Company will recognize expense of $3,260 over the vesting period.

      On August 28, 1998, the Company granted 470,000 shares of its common stock
      as part of a performance fee to members of a law firm which represents the
      Company and Liggett. The shares generally are not transferable prior to
      September 1, 1999. The Company recognized an expense of $1,686 in the
      third quarter 1998.

      On October 15, 1998, the Company obtained shareholder approval to increase
      the number of authorized shares of the Company's common stock from
      40,000,000 to 100,000,000 shares.


8.    CONTINGENCIES

      TOBACCO-RELATED LITIGATION:

      OVERVIEW. Since 1954, Liggett and other United States cigarette
      manufacturers have been named as defendants in numerous direct and
      third-party actions predicated on the theory that cigarette manufacturers
      should be liable for damages from cancer and other adverse health effects
      alleged to have been caused by cigarette smoking or by exposure to
      secondary smoke (environmental tobacco smoke, "ETS") from cigarettes.
      These cases are reported hereinafter as though having been commenced
      against Liggett (without regard to whether such cases were actually
      commenced against the Company or Liggett). There has been a noteworthy
      increase in the number of cases commenced against Liggett and the other
      cigarette manufacturers. The cases generally fall into four categories:
      (i) smoking and health cases alleging personal injury brought on behalf of
      individual smokers ("Individual Actions"); (ii) smoking and health cases
      alleging personal injury and purporting to be brought on behalf of a class
      of plaintiffs ("Class Actions"); (iii) health care cost recovery actions





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


      brought by state and local governments ("Attorney General Actions"); and
      (iv) health care cost recovery actions brought by third-party payors
      including asbestos manufacturers, unions and taxpayers ("Third-Party Payor
      Actions"). As new cases are commenced, defense costs and the risks
      attendant to the inherent unpredictability of litigation continue to
      increase. Liggett had been receiving assistance from others in the
      industry in defraying the costs and other burdens incurred in the defense
      of smoking and health litigation and related proceedings, which, for the
      most part, consisted of the payment of counsel fees and costs, but this
      assistance terminated in 1997. 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.
      For the nine months ended September 30, 1998, Liggett incurred counsel
      fees and costs totaling approximately $3,713, compared to $3,287 for the
      comparable prior year period.

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

      INDIVIDUAL ACTIONS. As of September 30, 1998, there were approximately 275
      cases pending against Liggett, and in most cases the other tobacco
      companies, where individual plaintiffs allege injury resulting from
      cigarette smoking, addiction to cigarette smoking or exposure to ETS and
      seek compensatory and, in some cases, punitive damages. Of these, 90 were
      pending in the State of Florida, 88 in the State of New York, 23 in the
      Commonwealth of Massachusetts and 19 in the State of Texas. The balance of
      individual cases was pending in 18 states. There are three individual
      cases pending where Liggett is the only named defendant.

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

      CLASS ACTIONS. As of September 30, 1998, there were approximately 45
      actions pending, for which either a class has been certified or plaintiffs
      are seeking class certification, where Liggett, among others, was a named
      defendant. Two of these cases, FLETCHER, ET AL. V. BROOKE GROUP LTD., ET
      AL. and WALKER, ET AL. V. LIGGETT GROUP INC., ET AL., have been settled by
      the Company, subject to court approval. These two settlements are more
      fully discussed below under the "Settlements" section.





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


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

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

      In May 1996, the Court of Appeals for the Fifth Circuit reversed the Class
      Certification Order and instructed the District Court to dismiss the class
      complaint. The Fifth Circuit ruled that the District Court erred in its
      analysis of the class certification issues by failing to consider how
      variations in state law affect predominance of common questions and the
      superiority of the class action mechanism. The appeals panel also held
      that the District Court's predominance inquiry did not include
      consideration of how a trial on the merits in CASTANO would be conducted.
      The Fifth Circuit further ruled that the "addiction-as-injury" tort is
      immature and, accordingly, the District Court could not know whether
      common issues would be a "significant" portion of the individual trials.
      According to the Fifth Circuit's decision, any savings in judicial
      resources that class certification may bring about is speculative and
      would likely be overwhelmed by the procedural problems certification
      brings. Finally, the Fifth Circuit held that in order to make the class
      action manageable, the District Court would be forced to bifurcate issues
      in violation of the Seventh Amendment.

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

      ATTORNEY GENERAL ACTIONS. As of September 30, 1998, 40 Attorney General
      Actions were filed against Liggett and the Company. As more fully
      discussed below, Liggett and the Company have settled 36 of these actions.
      In addition, the Company and Liggett have reached settlements with nine
      Attorneys General representing states, commonwealths or territories that
      have not commenced litigation against the Company or Liggett. In these
      proceedings, state and local government entities seek reimbursement for
      Medicaid and other health care expenditures allegedly caused by use of
      tobacco products. The claims asserted in these health care cost recovery
      actions vary. In most of these 




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


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

      THIRD-PARTY PAYOR ACTIONS. As of September 30, 1998, there were
      approximately 70 Third-Party Payor Actions pending. The claims in these
      cases are similar to those in the Attorney General Actions. In April 1998,
      a group known as the "Coalition for Tobacco Responsibility", which
      represents Blue Cross and Blue Shield Plans in more than 35 states, filed
      federal lawsuits against the industry seeking payment of health-care costs
      allegedly incurred as a result of cigarette smoking and ETS. The lawsuits
      were filed in Federal District Courts in New York, Chicago, and Seattle
      and seek billions of dollars in damages. The lawsuits allege conspiracy,
      fraud, misrepresentation, and violation of federal racketeering and
      anti-trust laws as well as other claims.

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

      In March 1996, the Company and Liggett entered into a settlement of
      tobacco-related litigation with the Attorneys General of Florida,
      Louisiana, Massachusetts, Mississippi and West Virginia (the "March 1996
      Settlements"). The March 1996 Settlements release the Company and Liggett
      from all 




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


      tobacco-related claims including claims for health care cost reimbursement
      and claims concerning sales of cigarettes to minors. Certain of the terms
      of the March 1996 Settlements are summarized below.

      Under the March 1996 Settlements, the five settling states would share an
      initial payment by Liggett of $5,000, payable over nine years and indexed
      and adjusted for inflation, provided that any unpaid amount will be due 60
      days after either a default by Liggett in its payment obligations under
      the settlement or a merger or other similar transaction by the Company or
      Liggett with another defendant in the lawsuits. In addition, Liggett will
      be required to pay the settling states a percentage of Liggett's pretax
      income (income before income taxes) each year from the second through the
      twenty-fifth year. This annual percentage is 2.5% of Liggett's pretax
      income, subject to increase to 7.5% depending on the number of additional
      states joining the settlement. No additional states have joined this
      settlement to date. All of Liggett's payments are subject to certain
      reductions provided for in the agreement. Liggett has also agreed to pay
      to the settling states $5,000 if the Company or Liggett fails to
      consummate a merger or other similar transaction with another defendant in
      the lawsuits within three years from the date of the March 1996
      Settlement.

      Settlement funds received by the Attorneys General will be used to
      reimburse the states for smoking-related health care costs. The Company
      and Liggett also have agreed to phase in compliance with certain of the
      proposed interim FDA regulations on the same basis as provided in the
      CASTANO settlement. The Company and Liggett have the right to terminate
      the March 1996 Settlements with respect to any settling state if any of
      the remaining defendants in the litigation succeed on the merits in that
      state's respective Attorney General action. The Company and Liggett may
      also terminate the March 1996 Settlements if they conclude that too many
      states have filed Attorney General actions and have not settled such cases
      with the Company and Liggett.

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

      During 1997, Liggett and the Company entered into a comprehensive
      settlement of tobacco litigation through parallel agreements with the
      Attorneys General of 21 states and with a nationwide class of individuals
      and entities that allege smoking-related claims (settlements with these 21
      Attorneys General and with the nationwide class are hereinafter referred
      to as the "March 1997 Settlements"). In March 1998, Liggett and the
      Company announced settlements with the Attorneys General of 15 states, the
      District of Columbia, Guam, Northern Mariana Islands and the U.S. Virgin
      Islands (the "March 1998 Settlements"). The foregoing settlements cover
      all smoking-related claims, including both addiction-based and tobacco
      injury claims against the Company and Liggett, brought by the Attorneys
      General and, upon court approval, the nationwide class.

      The states, commonwealths and territories where settlements have been
      reached with Attorneys General are: Alaska, Arizona, Arkansas, California,
      Colorado, Connecticut, District of Columbia, Florida, Georgia, Guam,
      Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Louisiana, Maine,
      Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri,
      Montana, Nebraska, Nevada, New 




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


      Hampshire, New Jersey, New Mexico, New York, North Dakota, Northern
      Mariana Islands, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island,
      Texas, Utah, U.S. Virgin Islands, Washington, West Virginia, Wisconsin and
      Wyoming. Other states have either recently filed health care cost recovery
      actions or indicated intentions to do so. Both Liggett and the Company
      will endeavor to resolve those actions on substantially the same terms and
      conditions as the March 1998 Settlements, however, there can be no
      assurance that any such settlements will be completed.

      As mentioned above, in March 1997, Liggett, the Company and plaintiffs
      filed a mandatory class settlement agreement in an action entitled
      FLETCHER, ET AL. V. BROOKE GROUP LTD., ET AL., Circuit Court of Mobile
      County, Alabama, where the court granted preliminary approval and
      preliminary certification of the class, and in May 1997, a similar
      mandatory class settlement agreement was filed in an action entitled
      WALKER, ET AL. V. LIGGETT GROUP INC., ET AL., United States District
      Court, Southern District of West Virginia. On July 2, 1998, Liggett, the
      Company and plaintiffs filed an amended class action settlement agreement
      in FLETCHER. Pursuant to the amended agreement, Liggett is required to pay
      to the class 7.5% of Liggett's pre-tax income each year for 25 years, with
      a minimum annual payment guarantee of $1,000 over the term of the
      agreement. The amended agreement does not set forth a formula with respect
      to the distribution of settlement proceeds to the class. On September 10,
      1998, the Circuit Court held a hearing with respect to the parties' motion
      for reaffirmance of preliminary approval of the amended agreement. The
      court has not yet ruled on this motion. The Company anticipates that
      should the court in FLETCHER, after dissemination of notice to the class
      of the pending limited fund class action settlement and a full fairness
      hearing with respect thereto, issue a final order and judgment approving
      the settlement, such an order would preclude further prosecution by class
      members of tobacco-related claims against both Liggett and the Company.
      Under the Full Faith and Credit Act, a final judgment entered in a
      nationwide class action pending in a state court has a preclusive effect
      against any class member with respect to the claims settled and released.
      As the class definition in FLETCHER encompasses all persons in the United
      States who could claim injury as a result of cigarette smoking or ETS and
      any third-party payor claimants, it is anticipated that, upon final order
      and judgment, all such persons and third-party payor claimants would be
      barred from further prosecution of tobacco-related claims against Liggett
      and the Company.

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

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





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


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

      The AMCHEM decision's ultimate affect on the viability of both the WALKER
      and FLETCHER settlements remains uncertain given the Fifth Circuit's
      recent ruling reaffirming a limited fund class action settlement in IN RE
      ASBESTOS LITIGATION ("AHEARN"). In June 1997, the Supreme Court remanded
      AHEARN to the Fifth Circuit for consideration in light of AMCHEM. On
      remand, the Fifth Circuit made two decisive distinctions between AMCHEM
      and AHEARN. First, the AHEARN class action proceeded under Rule 23(b)(1)
      while AMCHEM was a Rule 23(b)(3) case, and second, in AHEARN, there was no
      allocation or difference in award, according to nature or severity of
      injury, as there was in AMCHEM. The Fifth Circuit concluded that all
      members of the class and all class representatives share common interests
      and none of the uncommon questions abounding in AMCHEM exist. On June 22,
      1998, the Supreme Court granted certiorari to review the Fifth Circuit
      decision.

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

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

      Pursuant to the March 1996 Settlements, any other tobacco company
      defendant, except Philip Morris, merging or combining with Liggett or the
      Company, prior to the third anniversary of the settlement, would receive
      certain settlement benefits, including limitations on potential liability.
      Pursuant to the agreement, any such combining tobacco company would be
      released from the lawsuits brought by the five initial settling states.
      Such combining tobacco company would be obligated to pay into the
      settlement fund within sixty days of becoming bound to the agreement





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


      $135,000, and make annual payments of 2.5% of the combining company's
      pre-tax income (but not less than $30,000 per year). Such combining
      tobacco company would also have to comply with the advertising and access
      restrictions provided for in the agreement, and would have to withdraw
      their objections to the FDA rule.

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

      Pursuant to the March 1998 Settlements, Liggett is required to pay each of
      the settling states and territories their relative share (based on the
      Medicaid population of each state over the total Medicaid population of
      the United States) of between 27.5% and 30% of Liggett's pre-tax income
      each year for 25 years, with a minimum payment guarantee of $1,000 per
      state over the first nine years of the agreement. The aggregate payments
      required under the March 1996, March 1997 and March 1998 Settlements are
      $45,000, of which $3,639 has been paid as of September 30, 1998. The
      annual percentage is subject to increase, pro rata from 27.5% up to 30%,
      depending on the number of additional states joining the settlement.
      Pursuant to the "most favored nation" provisions under the March 1996
      Settlement and the March 1997 Settlements, each of the states settling
      under those settlements could benefit from the economic terms of the March
      1998 Settlements. In all settlements, Liggett agreed to phase-in
      compliance with certain proposed FDA regulations regarding smoking by
      children and adolescents, including a prohibition on the use of cartoon
      characters in tobacco advertising and limitations on the use of
      promotional materials and distribution of sample packages where minors are
      present. The March 1998 Settlements provide for additional restrictions
      and regulations on Liggett's advertising, including a prohibition on
      outdoor advertising and product advertising on the Internet and on
      payments for product placement in movies and television.

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

      The Company accrued approximately $4,000 for the present value of the
      fixed payments under the March 1996 Settlements and $16,902 for the
      present value of the fixed payments under the March 1998 Settlements. No
      additional amounts have been accrued because the Company cannot quantify
      the future costs of the settlements as the amounts Liggett must pay are
      based, in part, on



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


      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.

      Separately, the other tobacco companies negotiated settlements of the
      Attorney General Actions in Mississippi, Florida, Texas, and Minnesota and
      it has been widely publicized that the other companies have engaged in
      negotiations to settle with the Attorneys General of the remaining states.

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

      TRIALS. On July 6, 1998, trial commenced in the ENGLE, ET AL. V. PHILIP
      MORRIS INCORPORATED, ET AL., case, a class action pending in Miami Dade
      County, Florida, brought on behalf of all Florida residents allegedly
      injured by smoking. There are several trial dates scheduled during 1999
      for Third-Party Payor and Individual Actions; however, trial dates are
      subject to change.

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

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

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

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




                                      -29-
<PAGE>   31
                                BROOKE GROUP LTD.
                                    BGLS INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
         (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - (Continued)


      In September 1998, Liggett received a subpoena from a federal grand jury
      in the Eastern District of Philadelphia investigating possible antitrust
      violations in connection with the purchase of tobacco by and for tobacco
      companies. Liggett is in the process of responding to this subpoena.
      Liggett and the Company are unable, at this time, to predict the outcome
      of this investigation.

      Litigation is subject to many uncertainties, and it is possible that some
      of the aforementioned actions could be decided unfavorably against the
      Company or Liggett. An unfavorable outcome of a pending smoking and health
      case could encourage the commencement of additional similar litigation.
      The Company is unable to evaluate the effect of these developing matters
      on pending litigation or the possible commencement of additional
      litigation. The Company is also unable to make a meaningful estimate with
      respect to the amount of loss that could result from an unfavorable
      outcome of many of the cases pending against the Company, because the
      complaints filed in these cases rarely detail alleged damages. Typically,
      the claims set forth in an individual's complaint against the tobacco
      industry pray for money damages in an amount to be determined by a jury,
      plus punitive damages and costs. These damage claims are typically stated
      as being for the minimum necessary to invoke the jurisdiction of the
      court.

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

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

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

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


      LEGISLATION AND REGULATION:

      In January 1993, the United States Environmental Protection Agency ("EPA")
      released a report on the respiratory effect of ETS which concludes that
      ETS is a known human lung carcinogen in adults and in children, causes
      increased respiratory tract disease and middle ear disorders and increases
      the severity and frequency of asthma. In June 1993, the two largest of the
      major domestic cigarette 



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


      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. In July
      1998, the court ruled that the EPA made procedural and scientific mistakes
      when it declared in its 1993 report that secondhand smoke caused as many
      as 3,000 cancer deaths a year among nonsmokers.

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

      In August 1996, the FDA filed in the Federal Register a Final Rule (the
      "FDA Rule") classifying tobacco as a drug, asserting jurisdiction by the
      FDA over the manufacture and marketing of tobacco products and imposing
      restrictions on the sale, advertising and promotion of tobacco products.
      Litigation was commenced in the United States District Court for the
      Middle District of North Carolina challenging the legal authority of the
      FDA to assert such jurisdiction, as well as challenging the
      constitutionality of the rules. The court, after argument, granted
      plaintiffs' motion for summary judgment prohibiting the FDA from
      regulating or restricting the promotion and advertising of tobacco
      products and denied plaintiffs' motion for summary judgment on the issue
      of whether the FDA has the authority to regulate access to, and labeling
      of, tobacco products. The Fourth Circuit Court reversed the district court
      on appeal and on August 14, 1998 held that the FDA cannot regulate tobacco
      products because Congress had not given them the authority to do so. The
      Company and Liggett support the FDA Rule and have begun to phase in
      compliance with certain of the proposed interim FDA regulations. See
      discussions of the CASTANO and Attorney General Actions settlements above.

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

      As part of the budget agreement recently approved by Congress, federal
      excise taxes on a pack of cigarettes, which are currently 24 cents, would
      rise 10 cents in the year 2000 and 5 cents more in the year 2002.
      Additionally, the citizens of California recently voted in favor of a 50
      cents per pack tax on cigarettes sold in that state.




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


      PROPOSED RESOLUTION. In June 1997, Philip Morris Incorporated ("Philip
      Morris"), R. J. Reynolds Tobacco Company ("RJR"), B&W, Lorillard Tobacco
      Company ("Lorillard") and the United States Tobacco Company, along with
      the Attorneys General for the States of Arizona, Connecticut, Florida,
      Mississippi, New York and Washington and the CASTANO Plaintiffs'
      Litigation Committee executed a Memorandum of Understanding to support the
      adoption of federal legislation and necessary ancillary undertakings,
      incorporating the features described in a proposed resolution (the
      "Resolution"). The proposed Resolution mandates a total reformation and
      restructuring of how tobacco products are manufactured, marketed and
      distributed in the United States. (The proposed Resolution is discussed in
      the Company's 1997 Form 10-K/A No. 1.)

      In a speech in September 1997, President Clinton called for federal
      legislation that, among other things, would raise cigarette prices by up
      to $1.50 per pack. Since then, several bills have been introduced in
      Congress, including bills modeled after the proposed Resolution, that
      purport to propose legislation along these lines. The White House,
      Congress, and various public interest groups are currently reviewing the
      proposed Resolution along with other proposed federal tobacco legislation.
      Management is unable to predict whether the proposed Resolution or other
      federal legislation will be enacted or the form any such enactment might
      take. The present legislative and litigation environment is substantially
      uncertain and could have a material adverse effect on the business of the
      Company and Liggett.

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


      OTHER MATTERS:

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

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

      On or about September 18, 1998, a lawsuit was commenced against the
      Company, New Valley, certain officers, directors and shareholders and
      others in the United States District Court, Southern District of Texas,
      Houston Division. The defendants have moved for a more definite statement
      and for an extension of time to answer the complaint.





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


9.    RELATED PARTY TRANSACTIONS

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

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

      Effective May 1, 1998, a former officer of the Company entered into a
      consulting agreement in which the Company will pay him a total of $2,254
      in stock or cash in quarterly installments over a period of 6 years. The
      Company recognized the expense during the second quarter 1998.

      In September 1998, New Valley made a one-year $950 loan to BGLS which
      bears interest at 14% per annum.




                                      -33-
<PAGE>   35

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

                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


INTRODUCTION


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

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

         For purposes of this discussion and other consolidated financial
reporting, the Company's significant business segment is tobacco in the United
States and Russia for the nine months ended September 30, 1998 and September 30,
1997.


RECENT DEVELOPMENTS

         THE COMPANY

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

         Pursuant to the terms of the Standstill Agreement, the Apollo Holders
agreed to defer the payment of interest on the BGLS Notes held by them,
commencing with the interest payment that was due July 31, 1997, which they had
previously agreed to defer, through the interest payment due on July 31, 2000.
The deferred interest payments will be payable at final maturity of the BGLS
Notes on January 31, 2001 or upon an Event of Default under the Indenture for
the BGLS Notes. In connection with the Standstill Agreement, the Company issued
to the Apollo Holders a five-year warrant to purchase 2,000,000 shares of the
Company's common stock at a price of $5.00 per share. The Apollo Holders were
also issued a second warrant expiring October 31, 2004 to purchase an additional
2,150,000 shares of the Company's common stock at a price of $0.10 per share.
The second warrant will become exercisable on October 31, 1999 and the Company
will have the right under certain conditions prior to that date to substitute
for that warrant a new warrant for 9.9% of the common stock of Liggett.

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




                                      -34-
<PAGE>   36

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

         LIGGETT

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

         NEW VALLEY

         WESTERN REALTY DUCAT. In February 1998, New Valley and Apollo Real
Estate Investment Fund III, L.P. ("Apollo") organized Western Realty Development
LLC ("Western Realty Ducat") to make real estate and other investments in
Russia. In connection with the formation of Western Realty Ducat, New Valley
agreed, among other things, to contribute the real estate assets of BrookeMil
Ltd. ("BML") to Western Realty Ducat and Apollo agreed to contribute up to
$58,750, including the investment in Western Realty Repin discussed below.
Western Realty Ducat will seek to make additional real estate and other
investments in Russia. Western Realty Ducat has made a $26,300 participating
loan to, and payable out of a 30% profits interest in, a company organized by
BOL which, among other things, acquired an interest in an industrial site and
manufacturing facility being constructed on the outskirts of Moscow by a
subsidiary of BOL.

         THE KREMLIN SITES. BML is planning the development of two adjoining
sites totaling 10.25 acres (the "Kremlin Sites") located in Moscow across the
Moscow River from the Kremlin. BML, which is planning to develop a 1.1 million
sq. ft. hotel, office, retail and residential complex on the Kremlin Sites,
owned 94.6% of one site and 52% of the other site at September 30, 1998. In June
1998, New Valley and Apollo organized Western Realty Repin LLC to make a $25,000
participating loan to BML. The proceeds of the loan will be used by BML for the
acquisition and preliminary development of the Kremlin Sites, including the
repayment to New Valley for certain expenditures on the Kremlin Sites previously
incurred (see Note 3 to the Company's Consolidated Financial Statements).

         NEW ACCOUNTING PRONOUNCEMENTS

         In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income". SFAS No. 130, which the Company adopted in the first quarter of 1998,
establishes standards for reporting and displaying comprehensive income and its
components in a full set of general-purpose statements. For the Company, other
components of stockholders' equity include such items as the Company's
proportionate interest in New Valley's capital transactions and unrealized gains
and losses on investment securities. The implementation of SFAS No. 130 in the
first quarter 1998 did not have any material effect on the consolidated
financial statements.




                                      -35-
<PAGE>   37

         In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments
of an Enterprise and Related Information". SFAS No. 131 specifies revised
guidelines for determining an entity's operating segments and the type and level
of financial information to be disclosed. Management believes that the adoption
of this pronouncement will not have a material effect on the Company's financial
statement disclosures. SFAS No. 131 is effective for fiscal years beginning
after December 15, 1997, with earlier application encouraged.

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

         YEAR 2000 COSTS

         The Company utilizes management information systems and software
technology that may be affected by Year 2000 issues throughout its operations.
Liggett has evaluated the costs to implement century date change compliant
systems conversions and is in the process of executing a planned conversion of
its systems prior to the Year 2000. To date, the focus of Year 2000 compliance
and verification efforts has been directed at the implementation of new customer
service, inventory control and financial reporting systems at each of the three
regional Strategic Business Units, part of the Company's reorganization which
began in January 1997. In January of 1998, Liggett initiated a major conversion
of factory accounting and information systems at its Durham production facility,
with the assistance of outside consultants, to upgrades that have been
successfully tested for Year 2000 compliance. This project is expected to be
completed by the end of November.

         All costs incurred to date are considered an integral part of the
normal expenditures required for business systems enhancements and upgrades. It
is anticipated that all factory, corporate, field sales and physical
distribution systems will be completed in sufficient time to support Year 2000
compliance and verification.

         Although such costs may be a factor in describing changes in operating
profit in any given reporting period, the Company currently does not believe
that the anticipated costs of Year 2000 systems conversions will have a material
impact on its future consolidated results of operations. Based on the progress
Liggett has made in addressing Year 2000 issues and its strategy and timetable
to complete its compliance program, the Company does not foresee significant
risks associated with its Year 2000 initiatives at this time. However, if the
Company identifies any significant risks related to its Year 2000 compliance
effort, or if its progress deviates from the projected timetable, Liggett will
develop contingency plans it deems necessary to meet compliance deadlines at
that time. Due to the interdependent nature of computer systems, the Company may
be adversely impacted in the year 2000 depending on whether it or its vendors or
customers have addressed this issue successfully.


RECENT DEVELOPMENTS IN THE CIGARETTE INDUSTRY

         PRICING ACTIVITY. As of November 13, 1998, list price increases during
1998 amount to $1.85 per carton. On January 23, 1998, Philip Morris and RJR
announced a list price increase of $.25 per carton. This action was matched by
Liggett and the other manufacturers during the following week. On April 3, 1998,
Philip Morris announced a second list price increase of $.50 per carton. This
action was matched by Liggett and the other manufacturers. On May 11, 1998,
Philip Morris and RJR announced a third list price increase of $.50 per carton
on all brands. This action 




                                      -36-
<PAGE>   38

was matched by Liggett and the other manufacturers during the following week. On
July 31, 1998, Philip Morris announced a fourth list price increase of $.60 per
carton on all brands. This action was matched by Liggett and the other
manufacturers during the following week.

         LEGISLATION, REGULATION AND LITIGATION. The cigarette industry
continues to be challenged on numerous fronts. New cases continue to be
commenced against Liggett and the Company and other cigarette manufacturers. As
of September 30, 1998, there were approximately 275 individual suits, 45
purported class actions and 110 state, municipality and other third-party payor
health care reimbursement actions pending in the United States in which Liggett
is a named defendant. As new cases are commenced, the costs associated with
defending such cases and the risks attendant to the inherent unpredictability of
litigation continue to increase. Recently, there have been a number of
restrictive regulatory actions from various Federal administrative bodies,
including the United States Environmental Protection Agency ("EPA") and the Food
and Drug Administration ("FDA"), adverse political decisions and other
unfavorable developments concerning cigarette smoking and the tobacco industry,
including the commencement and certification of class actions and the
commencement of Medicaid reimbursement suits by various states' Attorneys
General. These developments generally receive widespread media attention. The
Company is not able to evaluate the effect of these developing matters on
pending litigation or the possible commencement of additional litigation, but it
is possible that Company's financial position, results of operations and cash
flows could be materially adversely affected by an ultimate unfavorable outcome
in any of such pending litigation. (See Note 8 to the Company's Consolidated
Financial Statements for a description of legislation, regulation and
litigation.)

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

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

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




                                      -37-
<PAGE>   39

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

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

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

         In 1997, Liggett and the Company entered into a comprehensive
settlement of tobacco litigation through parallel agreements with the Attorneys
General of 21 states and with a nationwide class of individuals and entities
that allege smoking-related claims (collectively, the "March 1997 Settlements").
In March 1998, the Company and Liggett entered into additional settlements with
the Attorneys General of 15 states, the District of Columbia, Guam, the Northern
Mariana Islands and the U. S. Virgin Islands (the "March 1998 Settlements"). The
foregoing settlements cover all smoking-related claims, including both
addiction-based and tobacco injury claims against the Company and Liggett
brought by the states and, upon court approval, the nationwide class.





                                      -38-
<PAGE>   40

         In March 1997, Liggett, the Company and plaintiffs filed a mandatory
class settlement agreement in an action entitled FLETCHER, ET AL. V. BROOKE
GROUP LTD., ET AL., Circuit Court of Mobile County, Alabama, where the court
granted preliminary approval and preliminary certification of the class, and in
May 1997, a similar mandatory class settlement agreement was filed in an action
entitled WALKER, ET AL. V. LIGGETT GROUP INC., ET al., United States District
Court, Southern District of West Virginia. On July 2, 1998, the Company and
plaintiffs filed an amended class action settlement agreement in FLETCHER.
Pursuant to the amended agreement, Liggett is required to pay to the class 7.5%
of Liggett's pre-tax income each year for 25 years, with a minimum annual
payment guarantee of $1,000 over the term of the agreement. The amended
agreement does not set forth a formula with respect to the distribution of
settlement proceeds to the class. On September 10, 1998, the Circuit Court held
a hearing with respect to the parties' motion for reaffirmance of preliminary
approval of the amended agreement. The court has not yet ruled on this motion.
The WALKER court also granted preliminary approval and preliminary certification
of the nationwide class; however, on August 5, 1997, the court vacated its
preliminary certification of the settlement class, which decision is currently
on appeal.

         In the FLETCHER action, it is anticipated that class members will be
notified of the settlement and will have an opportunity to appear at a later
court hearing. Effectiveness of the mandatory settlement is conditioned on final
court approval of the settlement after a fairness hearing. There can be no
assurance as to whether or when court approval will be obtained. (For additional
information concerning the FLETCHER action, see Note 8 to the Company's
Consolidated Financial Statements.)

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

         The Company accrued approximately $4,000 for the present value of the
fixed payments under the March 1996 Settlements and $16,902 for the present
value of the fixed payments under the March 1998 Settlements. No additional
amounts have been accrued because the Company cannot quantify the future costs
of the settlements as the amounts Liggett must pay are based, in part, on future
operating results. Possible future payments based on a percentage of pretax
income, and other contingent payments based on the occurrence of a business
combination, will be expensed when considered probable. (See the discussions of
the tobacco litigation settlements appearing in Note 8 to the Company's
Consolidated Financial Statements.)

         Separately, the other tobacco companies negotiated settlements of the
Attorney General Actions in Mississippi, Florida, Texas and Minnesota and it has
been widely publicized that the other companies have engaged in negotiations to
settle with the Attorneys General of the remaining states.

         OTHER MATTERS. On June 20, 1997, Philip Morris, RJR, B&W, Lorillard and
the United States Tobacco Company, along with the Attorneys General for the
States of Arizona, Connecticut, Florida Mississippi, New York and Washington and
the CASTANO Plaintiffs' Litigation Committee executed a Memorandum of
Understanding to support the adoption of federal legislation and necessary
ancillary undertakings, incorporating the features described in a proposed
resolution. The proposed 



                                      -39-
<PAGE>   41

resolution mandates a total reformation and restructuring of how tobacco
products are manufactured, marketed and distributed in the United States. (For
additional information concerning the proposed resolution, see Note 8 of the
Company's Consolidated Financial Statements.) The White House, Congress and
various public interest groups are currently reviewing the proposed resolution
along with other proposed federal tobacco legislation. Management is unable to
predict the ultimate effect, if any, of the enactment of legislation adopting
the proposed resolution. Management is also unable to predict the ultimate
content of any such legislation. However, adoption of any such legislation could
have a material adverse effect on the business of the Company and Liggett.


RESULTS OF OPERATIONS

<TABLE>
<CAPTION>
                          REVENUES             OPERATING INCOME              REVENUES              OPERATING INCOME
                     -------------------      -------------------       -------------------       ------------------
                     THREE MONTHS ENDED       THREE MONTHS ENDED        NINE MONTHS ENDED         NINE MONTHS ENDED
                       SEPTEMBER 30,             SEPTEMBER 30,            SEPTEMBER 30,             SEPTEMBER 30,
                     -------------------      -------------------       -------------------       ------------------
                     1998         1997         1998         1997         1998        1997          1998        1997
                  ---------    ---------      -------      ------      --------    --------       -------    -------  
<S>                <C>          <C>           <C>          <C>         <C>         <C>            <C>        <C>    
Liggett            $ 85,630     $ 79,368      $ 8,685      $4,581      $234,654    $223,811       $23,830    $ 9,380

Liggett-Ducat        22,572       20,940        2,200       1,398        69,613      53,095         9,679      3,012

Other                                           2,116         786                                      95      1,138 
                   --------     --------      -------      ------      --------    --------       -------    -------

Total              $108,202     $100,308      $13,001      $6,765      $304,267    $276,906       $33,604    $13,530
                   ========     ========      =======      ======      ========    ========       =======    =======
</TABLE>

THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE MONTHS ENDED 
SEPTEMBER 30, 1997.

         REVENUES. Total revenues were $108,202 for the three months ended
September 30, 1998 compared to $100,308 for the three months ended September 30,
1997. This 7.9% increase in revenues was due to a $6,262 or 7.9% increase in
revenues at Liggett and an increase of $1,632 or 7.8% in revenues at 
Liggett-Ducat. The increases in revenues in both the premium and discount
segments at Liggett were due to price increases of $15,723 (see "Recent
Developments in the Cigarette Industry - Pricing Activity") partially offset by
an 11.7% decrease in Liggett's unit sales volume (188.6 million units)
accounting for $9,264 in volume variance and an unfavorable product mix of $197.
The decline in premium and discount unit sales volume was due to certain
competitors continuing leveraging rebate programs tied to their products and
increased promotional activity by certain other manufacturers.

         Premium sales at Liggett for the three months ended September 30, 1998
amounted to $26,986 and represented 31.5% of Liggett's total revenues, compared
to $26,867 and 33.9% of total sales for the same period in 1997. In the premium
segment, revenues increased by 0.4% ($119) over the three months ended September
30, 1998, compared to the same period in 1997, due to price increases of $4,010,
partially offset by a 14.5% decline in unit sales volume (64.6 million units)
accounting for $3,891 in volume variance.

         Discount sales at Liggett (comprising the brand categories of branded
discount, private label, control label, generic, international and contract
manufacturing) for the three months ended September 30, 1998 amounted to $58,644
and represented 68.5% of Liggett's total revenues, compared to $52,501 and 66.1%
of total sales for the same period in 1997. In the discount segment, revenues
increased by 11.7% ($6,143) over the three months ended September 30, 1998,
compared to the same period in 1997, due to price increases of $11,713 partially
offset by a 10.6% decline in unit sales volume (approximately 124.0 million
units) accounting for $5,566 in volume variance and an unfavorable product mix
among the discount brand categories of $4. For the three months ended September
30, 1998, fixed manufacturing costs on a basis comparable to the same period in
1997 were $384 higher, with costs per thousand units increasing $0.63 per
thousand.





                                      -40-
<PAGE>   42

         Net sales at Liggett-Ducat for the three months ended September 30,
1998 increased 7.9% ($1,632) over the same period in 1997 due primarily to an
increase of 33.4% ($6,998) in unit sales volume (1,240.6 million units) and
favorable product mix of 1.9% ($400). This increase was partially offset by
price decreases of 27.5% ($5,766) due to devaluation of the Russian currency.

         GROSS PROFIT. Gross profit was $61,116 for the three months ended
September 30, 1998 compared to $47,263 for the three months ended September 30,
1997, an increase of $13,853 when compared to the same period last year,
reflecting an increase in gross profit at Liggett of $10,850 and an increase at
Liggett-Ducat of $3,002 for the three months ended September 30, 1998 compared
to the same period in the prior year.

         In the three months ended September 30, 1998, Liggett's premium and
discount brands contributed 30% and 59%, respectively, to the Company's overall
gross profit. Over the same period in 1997, Liggett's premium and discount
brands contributed 35% and 57%, respectively, to total Company gross profit.
Liggett-Ducat contributed 11% to the Company's overall gross profit for the
three months ended September 30, 1998 compared to 8.0% in the same period in
1997.

         Gross profit at Liggett of $54,247 for the three months ended September
30, 1998 increased due primarily to the price increases discussed above. (See
"Recent Developments in the Cigarette Industry - Pricing Activity".) As a
percent of revenues (excluding federal excise taxes), gross profit at Liggett
increased to 78.9% for the three months ended September 30, 1998 compared to
72.2% for the same period in 1997, with gross profit for the premium segment at
80.8% and 76.5% in the third quarter of 1998 and 1997, respectively, and gross
profit for the discount segment at 78.0% and 69.8% in the third quarter of 1998
and 1997, respectively. This increase is the result of the September 1997,
January 1998, April 1998, May 1998 and August 1998 list price increases and
improved production variances. These increases were partially offset by
increased tobacco costs at Liggett due to a reduction in the average discount
available to the Company from leaf tobacco dealers on tobacco purchased under
prior years' purchase commitments.

         As a percent of revenues (excluding Russian excise taxes), gross profit
at Liggett-Ducat increased to 35.0% for the three months ended September 30,
1998 compared to 21.2% in the same period in 1997.

         EXPENSES. Operating, selling and general expenses were $48,115 for the
three months ended September 30, 1998 compared to $40,498 for the same period
last year due to increases in expenses at Liggett of $6,841 and at Liggett-Ducat
of $1,186 and higher expenses at corporate resulting from non-cash charges for
consulting services. Selling, general and administrative expenses at Liggett
were $45,562 for the three months ended September 30, 1998 compared to $38,721
for the same period for the prior year. This increase in expense was due
primarily to $4,059 in higher promotional and marketing costs as well as higher
legal expenses, including non-cash stock-based expense of $2,019 at Liggett,
partially offset by reductions in systems development costs of $648
and reduced administrative costs.

         OTHER INCOME (EXPENSE). Interest expense was $20,138 for the three
months ended September 30, 1998 compared to $15,791 for the same period last
year, an increase of $4,347 primarily due to the debt restructuring at BGLS and
Liggett. (See Note 6 to the Company's Consolidated Financial Statements.)
Additional interest expense of $821 at Liggett-Ducat and BOL was reported for
the three months ended September 30, 1998, compared with the same period in
1997.

         Equity in earnings of affiliate was a loss of $8,935 for the three
months ended September 30, 1998 compared to a loss of $6,984 for the three
months ended September 30, 1997 and relates in both periods to New Valley's net
loss applicable to common shares of $22,622 and $24,141, respectively.





                                      -41-
<PAGE>   43

         For the three months ended September 30, 1998, the losses from
continuing operations were partially offset by the income from discontinued
operations at New Valley of $3,208.

NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED 
SEPTEMBER 30, 1997.

         REVENUES. Total revenues were $304,267 for the nine months ended
September 30, 1998 compared to $276,906 for the nine months ended September 30,
1997. This 9.9% increase in revenues was due to a $10,843 or 4.8% increase in
revenues at Liggett and an increase of $16,740 or 31.7% at Liggett-Ducat.
Revenues at Liggett increased in both the premium and discount segments due to
price increases of $33,760 (see "Recent Developments in the Cigarette Industry -
Pricing Activity") and improved product mix of $470 offset by a 10.4% decline in
unit sales volume (486.8 million units) accounting for $23,387 in volume
variance. The decline in premium and discount unit sales volume was due to
certain competitors continuing leveraging rebate programs tied to their products
and increased promotional activity by certain other manufacturers.

         Premium sales at Liggett for the nine months ended September 30, 1998
amounted to $76,898 and represented 32.8% of Liggett's total revenues, compared
to $74,780 and 33.4% of total sales for the same period in 1997. In the premium
segment, revenues grew by 2.8% ($2,118) due to price increases of $9,189 offset
by a 9.5% decline in unit sales volume (119.3 million units) accounting for
$7,071 in volume variance over the nine months ended September 30, 1998,
compared to the same period in 1997.

         Liggett's discount sales (comprising the brand categories of branded
discount, private label, control label, generic, international and contract
manufacturing) over this period amounted to $157,756 and represented 67.2% of
Liggett's total revenues, compared to $149,031 and 66.6% of total sales for the
same period in 1997. In the discount segment, revenues grew by 5.9% ($8,725)
over the nine months ended September 30, 1998, compared to the same period in
1997, due to price increases of $24,751 and improved product mix among the
discount brand categories of $277 offset by a 10.8% decline in unit sales volume
(367.5 million units) accounting for $16,123 in volume variance. For the nine
months ended September 30, 1998, fixed manufacturing costs on a basis comparable
to the same period in 1997 were $929 lower, and costs per thousand units
decreased $0.01 per thousand.

         The increase in tobacco revenues at Liggett-Ducat is attributable to
increased unit sales volume of 35.9% ($18,962) and a favorable product mix of
0.5% ($262). This increase was slightly offset by price decreases of 4.7%
($2,485) due to devaluation of the Russian currency.

         GROSS PROFIT. Gross profit was $163,845 for the nine months ended
September 30, 1998 compared to $131,065 for the nine months ended September 30,
1997, an increase of $32,780 or 25.0% when compared to the same period last
year, due to price increases at Liggett and volume and price increases at
Liggett-Ducat discussed above.

         Liggett's premium and discount brands contributed 31% and 57%,
respectively, to the Company's overall gross profit for the nine months ended
September 30, 1998 compared to the same period in 1997 during which Liggett's
premium and discount brands contributed 35% and 58%, respectively. Liggett-Ducat
contributed 12% to total Company gross profit for the nine months ended
September 30, 1998 compared to 7% in the same period in 1997.

         Gross profit at Liggett for the nine months ended September 30, 1998
was $143,968 compared to $121,367 for the same period in the prior year.
Liggett's gross profit as a percentage of its revenues (excluding federal excise
taxes) for the period increased to 77.4% compared to 72.0% in the same period in
the prior year. Gross profit for the premium segment was 79.8% and 




                                      -42-
<PAGE>   44
76.3%, respectively, in the nine months ended September 30 of 1998 and 1997,
respectively, and gross profit for the discount segment was 76.1% and 69.7% in
1998 and 1997, respectively. These increases are the result of the March 1997,
September 1997, January 1998, April 1998, May 1998 and August 1998 list price
increases and improved production variances. See "Recent Developments in the
Cigarette Industry - Pricing Activity". These increases were partially offset by
increased tobacco costs at Liggett due to a reduction in the average discount
available to Liggett from leaf tobacco dealers on tobacco purchased under prior
years' purchase commitments.

         As a percentage of revenues (excluding Russian excise taxes), gross
profit at Liggett-Ducat increased to 33.3% for the nine months ended September
30, 1998 compared to 20.4% in the same period in 1997.

         EXPENSES. Operating, selling, general and administrative expenses were
$130,241 for the nine months ended September 30, 1998 compared to $117,535 for
the same period last year. The increase of $12,706 is due primarily to $8,055 in
higher spending for promotional and marketing programs, higher legal expenses of
$5,042 including non-cash stock-based expense of $2,019 at Liggett. Such
expenses were partially offset by the absence of the 1997 restructuring expenses
which had included systems development costs of $3,541, and the absence of
severance payments made in the comparable prior period.

        OTHER INCOME (EXPENSE). Interest expense was $60,561 for the nine months
ended September 30, 1998 compared to $46,757 for the same period last year. The
increase in interest expense was primarily due to charges for debt restructuring
of approximately $9,000 at corporate and $3,800 at Liggett as well as an
increase of $1,315 at BOL and Liggett-Ducat offset by lower interest expense due
to lower outstanding balances on the revolving credit facility at Liggett.

        Equity in earnings of affiliate was a loss of $20,383 for the nine
months ended September 30, 1998 compared to a loss of $21,335 for the nine
months ended September 30, 1997 and relates to the decline in market value of
the Class A Preferred Shares and to New Valley's net loss applicable to common
shares of $67,051 in 1998 compared to its net loss of $72,241 in 1997. The loss
is offset by income from New Valley's discontinued operations of $3,208 for the
nine months ended September 30, 1998.

        For the nine months ended September 30, 1998, a gain on the sale of
various assets of $2,025 is compared to the gain of $23,086 for the same period
in 1997 which included the sale of the BML shares and surplus realty at Liggett,
and proceeds from a legal settlement. See Notes 3 and 8 to the Company's
Consolidated Financial Statements.


CAPITAL RESOURCES AND LIQUIDITY

         Net cash and cash equivalents increased $1,636 and $420 for the nine
months ended September 30, 1998 and September 30, 1997, respectively. Net cash
used in operating activities was $17,847 and $30,511 for the nine months ended
September 30, 1998 and 1997, respectively. Net cash used in the 1998 period was
$12,664 lower than in the same period in 1997, primarily due to a reduction in
cash interest payments of approximately $7,000 at BGLS and an increase in net
income at Liggett over the prior year of approximately $4,200. For the nine
months ended September 30, 1997, net cash used in operations was due to a
decrease in accounts payable and accrued expenses of approximately $21,600, and
an increase in notes receivable of $32,500 due to the sale of the BML shares
partially offset by a decrease in receivables at Liggett, equity in loss of
affiliate of $14,400 and the impact of the deferred gain on the sale of the BML
shares of approximately $22,000.

         Cash used in investing activities of $14,912 compares to cash provided
of $33,234 for the periods ended September 30, 1998 and 1997, respectively. In
1998, capital expenditures of 




                                      -43-
<PAGE>   45

$17,289, principally at Liggett-Ducat for construction of the new factory in
Russia were partially offset by proceeds from sales of equipment. In 1997,
proceeds included cash of $43,000 received in the sale of the BML shares to New
Valley partially offset by capital expenditures of $9,857 at Liggett-Ducat, BOL
and Liggett.

         Cash provided by financing activities was $33,838 for the nine months
ended September 30, 1998 as compared with cash used in financing activities of
$2,303 for the nine months ended September 30, 1997. Proceeds in the 1998 period
include proceeds from the participating loan made by Western Realty Ducat of
$25,000, cash of $10,144 received from the sale of common stock and exercise of
stock options, proceeds from notes payable at BOL and corporate of $4,425 and an
increase in cash overdraft at Liggett. Such proceeds were offset by net
repayments of $1,616 on credit facilities at Liggett and Liggett-Ducat and
distributions on common stock of $3,055. Distributions of common stock for the
third quarter 1998 were paid on October 2, 1998. Proceeds from financing
activities in 1997 include net borrowings under credit facilities at BOL and
Liggett of $7,849. 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 of
$4,102 in the 1997 period include distributions declared in the fourth quarter
1996 which were paid in January 1997 and distributions declared and paid in the
first two quarters of 1997.

         LIGGETT. Liggett had a net capital deficiency of $183,268 at September
30, 1998 and is highly leveraged. In addition, the Liggett Notes mature on
February 1, 1999 and the revolving credit facility (the "Facility") expires on
March 8, 1999. Due to the many risks and uncertainties associated with the
cigarette industry, the impact of recent tobacco litigation settlements (see
"Recent Developments in the Cigarette Industry - Legislation and Litigation")
and increased tobacco costs, there can be no assurance that Liggett will be able
to meet its future earnings goals. Consequently, Liggett could be in violation
its debt covenants, including covenants limiting the maximum permitted adjusted
net worth and net working capital deficiencies, and if its lenders were to
exercise acceleration rights under the Facility or the Liggett Notes' Indenture
or refuse to lend under the Facility, Liggett would not be able to satisfy such
demands or its working capital requirements. (See below for additional
information concerning these covenants.)

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

         On January 30, 1998, Liggett obtained the consents of the required
majority of the holders of the Liggett Notes to various amendments to the
Indenture governing the Liggett Notes. The amendments provide, among other
things, for a deferral of the February 1, 1998 mandatory redemption of $37,500
principal amount of the Liggett Notes to the date of final maturity, February 1,
1999. In addition, the amendments prohibit, with limited exceptions, payments of
dividends and incurrence of new debt by Liggett and tighten restrictions on the
disposition of proceeds of asset sales. The interest payment on the Liggett
Notes, which was paid on August 1, 1998, was guaranteed by the Company and BGLS.
(Refer to Note 6 to the Company's Consolidated Financial Statements.)





                                      -44-
<PAGE>   46
         At maturity, the Liggett Notes will require a principal payment of
$144,891. Liggett does not anticipate it will be able to generate sufficient
cash from operations to make such payments. In addition, Liggett also has a
$40,000 Facility expiring March 8, 1999, under which $17,674 was outstanding at
September 30, 1998. While Liggett's management currently intends to seek to
refinance and/or restructure with Liggett's note holders the 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. If
Liggett is unable to refinance or restructure the terms of the Liggett Notes or
otherwise make all payments thereon, the Liggett Notes and the Facility would be
in default and holders of such debt could accelerate the maturity of such debt.
In such event, Liggett may be forced to seek protection from creditors under
applicable laws. (Refer to Note 1 to the Company's Consolidated Financial
Statements.)

         On August 29, 1997, the Facility was amended to permit Liggett to
borrow an additional $6,000 which was used on that date in making the interest
payment of $9,700 due on August 1, 1997 to the holders of the Liggett Notes.
BGLS guaranteed the additional $6,000 advance under the Facility and
collateralized the guarantee with $6,000 in cash, deposited with Liggett's
lender, $3,000 of which was released in November 1998. At September 30, 1998,
the amount of $6,000 was classified in other assets on the Company's balance
sheet. Availability under the Facility was approximately $8,091 based on
eligible collateral at September 30, 1998. The Facility is collateralized by all
inventories and receivables of Liggett. Borrowings under the Facility, whose
interest is calculated at a rate equal to 1.5% above Philadelphia National
Bank's (the indirect parent of Congress Financial Corporation, the lead lender)
prime rate, bear a rate of 10.0% at September 30, 1998, which was reduced to
9.75% and 9.50% in October and November 1998, respectively. The Facility
contains certain financial covenants similar to those contained in the Liggett
Notes' Indenture including restrictions on Liggett's ability to declare or pay
cash dividends, incur additional debt, grant liens and enter into any new
agreements with affiliates, among others. In addition, the Facility, as amended
on April 8, 1998, imposes requirements with respect to Liggett's adjusted net
worth (not to fall below a deficit of $195,000 as computed in accordance with
the agreement, this computation was $179,149 at September 30, 1998) and working
capital (not to fall below a deficit of $17,000 as computed in accordance with
the agreement, this computation was $2,450 at September 30, 1998). At September
30, 1998, Liggett was in compliance with all covenants under the Facility. The
Facility, as amended, also provides that a default by Liggett under the March
1996 Settlements, March 1997 Settlements and March 1998 Settlements shall
constitute an event of default under the Facility.

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

         The Company believes, and has been so advised by counsel handling the
respective cases, that the Company and Liggett have a number of valid defenses
to the claim or claims asserted against them. Litigation is subject to many
uncertainties, and it is possible that some of these actions could be decided
unfavorably. An unfavorable outcome of a pending smoking and health case could
encourage the commencement of additional similar litigation. Recently, there
have been a number of adverse regulatory, political and other developments
concerning cigarette smoking and the tobacco industry, including the
commencement of the purported class actions referred to above. These
developments generally receive widespread media attention. Neither the Company
nor Liggett is able to evaluate the effect of these developing matters on
pending litigation or the possible commencement of additional litigation. (See
"Recent Development in the Cigarette Industry - Legislation, Regulation and
Litigation" and "--Settlements" above and Note 8 to the Company's Consolidated
Financial Statements.)





                                      -45-
<PAGE>   47

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

         BGLS. On March 5, 1998, BGLS entered into the Standstill Agreement
whereby the Apollo Holders agreed to the deferral of interest payments,
commencing with the interest payment due July 31, 1997 through the interest
payment due July 31, 2000. (See "Recent Developments - The Company - Standstill
Agreement".) At September 30, 1998, the carrying value of BGLS' long-term debt
(net of unamortized discount of $19,259) was approximately $238,591, based on
modification of the terms of the debt with the Apollo Holders.

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

         Liggett-Ducat is building a new cigarette factory on the outskirts of
Moscow. The new factory, which will utilize Western cigarette making technology
and have a capacity of 30 billion units per year, will produce American and
international blend cigarettes, as well as traditional Russian cigarettes.
Western Realty Ducat has made a $26,300 participating loan to, and payable out
of a 30% profits interest, in a company organized by BOL, Western Tobacco, which
holds BOL's interests in Liggett-Ducat and the new manufacturing facility. (See
"Recent Developments - New Valley" and Note 3 to the Company's Consolidated
Financial Statements.) In addition, BOL has entered into equipment purchases of
approximately $35,400, of which $28,800 will be financed over five years
beginning in 1998. The Company is a guarantor of one of the purchases for which
the remaining obligation is approximately $7,000.

         THE COMPANY. The Company has remaining scheduled debt maturities of
approximately $1,807 due in the year 1998. Liggett has a payment due on the
Liggett Notes at maturity on February 1, 1999 of approximately $145,000 and the
Facility expires on March 8, 1999. The Company believes that it will continue to
meet its liquidity requirements through 1998, although the BGLS Notes Indenture
limits the amount of restricted payments BGLS is permitted to make to the
Company during the calendar year. At September 30, 1998, the remaining amount
available through December 31, 1998 in the Restricted Payment Basket related to
BGLS' payment of dividends to the Company (as defined by the BGLS Notes
Indenture) is $11,086. Company expenditures remaining in 1998 at September 30,
1998 include dividends on the Company's shares (currently at an annual rate of
approximately $6,100) and corporate expense. Third quarter distributions on
common stock were made on October 2, 1998 in the amount of $1,534. The Company
anticipates funding 1998 current operations and long-term growth with the
proceeds from public and/or private debt and equity financing, management fees
and other payments from subsidiaries of approximately $3,600 and distributions
from New Valley. New Valley may acquire or seek to acquire additional operating
businesses through merger, purchase of assets, stock acquisition or other means,
or to make other investments, which may limit its ability to make such
distributions.


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 




                                      -46-
<PAGE>   48
"safe-harbor" provisions of the Reform Act, the Company is hereby identifying
important factors that could cause actual results to differ materially from
those contained in any forward-looking statement made by or on behalf of the
Company. Liggett continues to be subject to risk factors endemic to the domestic
tobacco industry including, without limitation, health concerns relating to the
use of tobacco products and exposure to ETS, legislation, including tax
increases, governmental regulation, privately imposed smoking restrictions,
governmental and grand jury investigations and litigation. Each of the Company's
operating subsidiaries, namely Liggett and Liggett-Ducat, are subject to intense
competition, changes in consumer preferences, the effects of changing prices for
its raw materials and local economic conditions. Furthermore, the performance of
Liggett-Ducat's operations in Russia are affected by uncertainties in Russia
which include, among others, political or diplomatic developments, regional
tensions, currency repatriation restrictions, foreign exchange fluctuations,
inflation, and an undeveloped system of commercial laws and legislative reform
relating to foreign ownership in Russia. Liggett has a high degree of leverage
and substantial near-term debt service requirements, including a payment at
maturity of the Liggett Notes of $144,891 on February 1, 1999, as well as a
significant net worth deficiency and working capital deficiency, and is highly
dependent upon its revolving credit facility which currently expires in March
1999. In addition, the Company has a high degree of leverage and substantial
near-term debt service requirements, as well as a net worth deficiency and
recent losses from continuing operations. The Indenture for the BGLS Notes
provides for, among other things, the restriction of certain affiliated
transactions between the Company and its affiliates, as well as for certain
restrictions on the use of future distributions received from New Valley. Due to
such uncertainties and risks, readers are cautioned not to place undue reliance
on such forward-looking statements, which speak only as of the date on which
such statements are made. The Company does not undertake to update any
forward-looking statement that may be made from time to time by or on behalf of
the Company.





                                      -47-
<PAGE>   49

                                     PART II

                                OTHER INFORMATION




Item 1.       LEGAL PROCEEDINGS

              Reference is made to Note 8, incorporated herein by reference, to
              the Consolidated Financial Statements of Brooke Group Ltd. and
              BGLS Inc. (collectively, the "Companies") included elsewhere in
              this report on Form 10-Q which contains a general description of
              certain legal proceedings to which the Company and/or BGLS or
              their subsidiaries are a party and certain related matters.
              Reference is also made to Exhibit 99.1 for additional information
              regarding the pending material legal proceedings to which the
              Company, BGLS and/or Liggett are party. A copy of Exhibit 99.1
              will be furnished to security holders of the Company and its
              subsidiaries without charge upon written request to the Company at
              its principal executive offices, 100 S.E. Second St., Miami,
              Florida 33131, Attn. Investor Relations.

Item 2.       CHANGES IN SECURITIES AND USE OF PROCEEDS

              No securities of the Company which were not registered under the
              Securities Act of 1933, as amended (the "Securities Act"), have
              been issued or sold by the Company during the three months ended
              September 30, 1998, except as follows: On August 28, 1998, the
              Company awarded to four members of a law firm that represents the
              Company and Liggett 470,000 shares of its common stock.

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

Item 3.       DEFAULTS UPON SENIOR SECURITIES

              As of September 30, 1998, New Valley Corporation, the Companies'
              affiliate, had the following respective accrued and unpaid
              dividend arrearages on its 1,071,462 outstanding shares of $15.00
              Class A Increasing Rate Cumulative Senior Preferred 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) $204.1 million
              or $190.44 per Class A Share; and (2) $158.9 million or $56.94 per
              Class B Share.

Item 6.       EXHIBITS AND REPORTS ON FORM 8-K

              (a)    EXHIBITS

              3.1          Certificate of Amendment of the Restated Certificate 
                           of Incorporation of the Company.

            *10.1          Brooke Group Ltd. 1998 Long-Term Incentive Plan
                           (incorporated by reference to the Appendix to the
                           Company's Proxy Statement dated September 15, 1998,
                           Commission File No. 1-5759).



                                      -48-
<PAGE>   50



             *10.2         Stock Option Agreement, dated July 20, 1998, between
                           the Company and Bennett S. LeBow (incorporated by
                           reference to Exhibit 6 in the amendment no. 5 to the
                           Schedule 13D filed by Bennett S. LeBow on October 16,
                           1998 with respect to the common stock of the
                           Company).

             10.3          Stock Option Agreement, dated July 20, 1998, between
                           the Company and Howard M. Lorber.

             10.4          Amended and Restated Stock Option Agreement, dated as
                           of October 12, 1998, by and between the Company and
                           Kasowitz, Benson, Torres & Friedman LLP, Marc E.
                           Kasowitz and Daniel R. Benson.

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

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

             99.1          Material Legal Proceedings.

             99.2          Liggett Group Inc.'s Interim Consolidated Financial
                           Statements for the quarterly periods ended September
                           30, 1998 and 1997.

             99.3          New Valley Corporation's Interim Consolidated
                           Financial Statements for the quarterly periods ended
                           September 30, 1998 and 1997.

             99.4          Brooke (Overseas) Ltd.'s Interim Consolidated
                           Financial Statements for the quarterly periods ended
                           September 30, 1998 and 1997.

             99.5          New Valley Holdings, Inc.'s Interim Consolidated
                           Financial Statements for the quarterly periods ended
                           September 30, 1998 and 1997.

              (b)          REPORTS ON FORM 8-K

                           None.





                                      -49-

<PAGE>   51


                                   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:  November 13, 1998






                                               BGLS INC.
                                               (REGISTRANT)



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

Date:  November 13, 1998




                                      -50-