<PAGE>   1

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

                                  UNITED STATES
                       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, 1997

                                    ---------

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

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

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

<TABLE>
<S>                                            <C>                             <C>       

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

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


                                    ---------


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

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

         At November 10, 1997, Brooke Group Ltd. had 18,097,096 shares of common
stock outstanding, and BGLS Inc. had 100 shares of common stock outstanding, all
of which are held by Brooke Group Ltd.



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

<PAGE>   2


                                BROOKE GROUP LTD.
                                    BGLS INC.

                                    FORM 10-Q

                                TABLE OF CONTENTS



<TABLE>
<CAPTION>
                                                                                                            Page
                                                                                                            ----
<S>                                                                                                         <C>
PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements

   Brooke Group Ltd./BGLS Inc. Consolidated Financial Statements:

   Brooke Group Ltd. Consolidated Balance Sheets as of September 30, 1997 and
         December 31, 1996.............................................................................       2

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

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

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

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

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

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

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

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

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


PART II. OTHER INFORMATION

Item 1. Legal Proceedings..............................................................................      38

Item 3. Defaults Upon Senior Securities................................................................      38

Item 6. Exhibits and Reports on Form 8-K...............................................................      38

SIGNATURE .............................................................................................      40
</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,
                                                                                 1997              1996
                                                                            ---------------- -----------------
<S>                                                                         <C>              <C>     
ASSETS:
Current assets:
    Cash and cash equivalents...........................................       $  2,361         $  1,941
    Accounts receivable - trade.........................................         11,539           19,475
    Other receivables...................................................            734            1,217
    Receivables from affiliates.........................................         12,050               47
    Inventories.........................................................         41,360           53,691
    Other current assets................................................          3,844            4,181
                                                                               --------         ---------
        Total current assets............................................         71,888           80,552

Property, plant and equipment, at cost, less accumulated
    depreciation of $32,237 and $31,047.................................         36,720           80,282
Intangible assets, at cost, less accumulated amortization
    of $18,837 and $17,457..............................................          3,071            4,421
Investment in affiliate.................................................                           3,051
Other assets............................................................         10,209            9,371
                                                                               --------         --------
        Total assets....................................................       $121,888         $177,677
                                                                               ========         ========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt...................      $  38,245         $ 55,242
  Accounts payable......................................................          9,117           32,461
  Due to affiliates.....................................................                             990
  Dividends payable.....................................................                           1,387
  Cash overdraft........................................................          2,395                6
  Accrued promotional expenses..........................................         31,372           30,257
  Accrued taxes payable.................................................         19,518           26,379
  Accrued interest......................................................         25,121           24,354
  Other accrued liabilities.............................................         25,623           33,387
                                                                               --------         --------
    Total current liabilities...........................................        151,391          204,463

Notes payable, long-term debt and other obligations, less current portion       370,973          378,243
Noncurrent employee benefits............................................         34,630           31,256
Other liabilities.......................................................         28,005           18,704

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

Stockholders' equity (deficit):
  Preferred Stock, par value $1.00 per share, authorized
    10,000,000 shares...................................................
  Series G Preferred Stock, 2,184,834 shares, convertible, participating,
    cumulative, each share convertible to 1,000 shares of common stock and cash
    or stock distribution, liquidation preference of $1.00 per
    share...........................
  Common stock, par value $0.10 per share, authorized 40,000,000 shares, issued
    24,998,043 shares, outstanding 18,097,096
    and 18,497,096 shares...............................................          1,850            1,850
  Additional paid-in capital............................................         90,020           94,169
  Deficit...............................................................       (512,229)        (490,706)
  Other.................................................................         (8,613)         (27,963)
  Less:  6,900,947 and 6,500,947 shares of common stock in
          treasury, at cost.............................................        (34,139)         (32,339)
                                                                               --------         -------- 
      Total stockholders' equity (deficit)..............................       (463,111)        (454,989)
                                                                               --------         -------- 

      Total liabilities and stockholders' equity (deficit)..............       $121,888         $177,677
                                                                               ========         ========

</TABLE>

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


                                      -2-
<PAGE>   4


Item 1.  Consolidated Financial Statements - (Continued)

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


<TABLE>
<CAPTION>
                                                                                 September 30,      December 31,
                                                                                      1997              1996
                                                                                --------------------------------
<S>                                                                              <C>                <C>     
ASSETS:

Current assets:
  Cash and cash equivalents.................................................       $   2,323         $   1,940
  Accounts receivable - trade...............................................          11,539            19,475
  Other receivables.........................................................             693             1,166
  Receivables from affiliates...............................................          13,546                47
  Inventories...............................................................          41,360            53,691
  Other current assets......................................................           3,518             3,878
                                                                                   ---------         ---------
      Total current assets..................................................          72,979            80,197

Property, plant and equipment, at cost, 
  less accumulated depreciation of
  $31,845 and $30,762.......................................................          36,517            79,972
Intangible assets, at cost, less accumulated 
  amortization of $18,837 and $17,457.......................................           3,071             4,421
Investment in affiliate.....................................................                             3,051
Other assets................................................................          13,452            10,467
                                                                                   ---------         ---------
      Total assets..........................................................       $ 126,019         $ 178,108
                                                                                   =========         =========

LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt.......................       $  37,896         $  53,945
  Accounts payable..........................................................           8,992            32,336
  Cash overdraft............................................................           2,395                 6
  Due to parent.............................................................          23,636            29,598
  Accrued promotional expenses..............................................          31,372            30,257
  Accrued taxes payable.....................................................          19,518            26,379
  Accrued interest..........................................................          25,121            24,354
  Other accrued liabilities.................................................          25,580            32,861
                                                                                   ---------         ---------
      Total current liabilities.............................................         174,510           229,736

Notes payable, long-term debt and other obligations, less current portion...         370,973           378,243
Noncurrent employee benefits................................................          34,630            31,256
Other liabilities...........................................................          34,205            21,958

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

Stockholder's equity (deficit):
  Common stock, par value $0.01 per share; 100 shares authorized,
    issued and outstanding..................................................
  Additional paid-in capital................................................          39,080            39,081
  Deficit...................................................................        (522,761)         (499,264)
  Other.....................................................................          (4,618)          (22,902)
                                                                                   ---------         --------- 
      Total stockholder's deficit...........................................        (488,299)         (483,085)
                                                                                   ---------         --------- 

      Total liabilities and stockholder's equity (deficit)..................       $ 126,019         $ 178,108
                                                                                   =========         =========
</TABLE>


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


                                      -3-
<PAGE>   5



Item 1.  Consolidated Financial Statements - (Continued)

                        BROOKE GROUP LTD. AND 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,
                                                                  1997           1996           1997           1996
                                                              -----------    -----------    -----------    -----------

<S>                                                           <C>            <C>            <C>            <C>       
Revenues*.................................................    $   100,308    $   114,635    $   276,906    $   330,364
Cost of goods sold*.......................................         53,045         58,361        145,841        168,931
                                                              -----------    -----------    -----------    -----------

Gross profit..............................................         47,263         56,274        131,065        161,433
Operating, selling and general expenses...................         40,498         55,326        117,535        158,482
                                                              -----------    -----------    -----------    -----------

Operating income..........................................          6,765            948         13,530          2,951

Other income (expenses):
    Interest income.......................................            431             75          1,682            203
    Interest expense......................................        (15,791)       (15,254)       (46,757)       (45,488)
    Equity in loss of affiliate...........................         (7,090)        (4,618)       (21,488)        (7,152)
    Sale of assets........................................                         3,047         23,086          6,745
    Retirement of debt....................................                                        2,963
    Proceeds from legal settlement........................                                        4,125
    Other, net............................................           (257)         3,210            (77)         1,846
                                                              -----------    -----------    -----------    -----------

Loss from continuing operations before income taxes.......        (15,942)       (12,592)       (22,936)       (40,895)
(Benefit) provision for income taxes......................           (248)         1,145            541          1,291
                                                              -----------    -----------    -----------    -----------

Loss from continuing operations...........................        (15,694)       (13,737)       (23,477)       (42,186)
                                                              -----------    -----------    -----------    -----------

Discontinued operations:
Income from discontinued operations.......................            106                           153
                                                              -----------    -----------    -----------    -----------

Net loss..................................................        (15,588)       (13,737)       (23,324)       (42,186)
Proportionate share of New Valley capital transactions,
    retirement of Class A Preferred Shares................                                                       1,782
                                                              -----------    -----------    -----------    -----------

Net loss applicable to common shares......................    $   (15,588)   $   (13,737)   $   (23,324)   $   (40,404)
                                                              ===========    ===========    ===========    ===========

Per common share:

    Loss from continuing operations.......................    $     (0.87)   $     (0.74)   $     (1.29)   $     (2.18)
                                                              ===========    ===========    ===========    ===========
    Loss from discontinued operations.....................    $      0.01    $              $      0.01    $ 
                                                              ===========    ===========    ===========    ===========
    Net loss applicable to common shares..................    $     (0.86)   $     (0.74)   $     (1.28)   $     (2.18)
                                                              ===========    ===========    ===========    ===========

Weighted average common shares outstanding................     18,097,096     18,497,096     18,192,233     18,497,096
                                                              ===========    ===========    ===========    ===========
</TABLE>




*   Revenues and Cost of goods sold include federal excise taxes of $19,250 and
    $26,074 for the three months ended September 30, 1997 and 1996,
    respectively, and $55,263 and $76,758 for the nine months ended September
    30, 1997 and 1996, respectively.




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



                                      -4-
<PAGE>   6

Item 1.  Consolidated Financial Statements - (Continued)

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


<TABLE>
<CAPTION>
                                                                 -----------------------------------------------------------
                                                                      Three Months Ended             Nine Months Ended
                                                                 -----------------------------------------------------------
                                                                  Sept. 30,      Sept. 30,       Sept. 30,        Sept. 30,
                                                                     1997          1996             1997             1996
                                                                 -----------------------------------------------------------

<S>                                                               <C>             <C>             <C>             <C>      
Revenues* ..................................................      $ 100,308       $ 114,635       $ 276,906       $ 330,364
Cost of goods sold* ........................................         53,045          58,361         145,841         168,931
                                                                  ---------       ---------       ---------       ---------

Gross profit ...............................................         47,263          56,274         131,065         161,433

Operating, selling and general expenses ....................         40,502          54,627         117,159         157,287
                                                                  ---------       ---------       ---------       ---------

Operating income ...........................................          6,761           1,647          13,906           4,146

Other income (expenses):
   Interest income .........................................            431              62           1,670             140
   Interest expense ........................................        (16,750)        (16,245)        (49,542)        (48,308)
   Equity in loss of affiliate .............................         (7,090)         (4,618)        (21,488)         (7,152)
   Sale of assets ..........................................                          3,047          27,663           6,745
   Retirement of debt ......................................                                          2,963
   Other, net ..............................................           (257)            502             (84)         (1,528)
                                                                  ---------       ---------       ---------       ---------

Loss from continuing operations before income taxes ........        (16,905)        (15,605)        (24,912)        (45,957)
(Benefit) provision for income taxes .......................           (248)          4,945             539           5,143
                                                                  ---------       ---------       ---------       ---------

Loss from continuing operations ............................        (16,657)        (20,550)        (25,451)        (51,100)
                                                                  ---------       ---------       ---------       ---------

Discontinued operations:
Income from discontinued operations ........................            106                             153
                                                                  ---------       ---------       ---------       ---------

Net loss ...................................................      $ (16,551)      $ (20,550)      $ (25,298)      $ (51,100)
                                                                  =========       =========       =========       =========
</TABLE>



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

* Revenues and Cost of goods sold include federal excise taxes of $19,250 and
  $26,074 for the three months ended September 30, 1997 and 1996, respectively,
  and $55,263 and $76,758 for the nine months ended September 30, 1997 and 1996,
  respectively.






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




                                      -5-
<PAGE>   7

Item 1.  Consolidated Financial Statements - (Continued)

                        BROOKE GROUP LTD. AND SUBSIDIARY
            CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)


<TABLE>
<CAPTION>
                                       ---------------------------------------------------------------------------------------------
                                              Common Stock          Additional                    
                                       ---------------------------   Paid-In                                  Treasury
                                          Shares        Amount       Capital       Deficit       Other         Stock         Total
                                       ---------------------------------------------------------------------------------------------


<S>                                    <C>              <C>          <C>          <C>          <C>           <C>          <C>       
Balance, December 31, 1996.........    18,497,096       $1,850       $94,169      $(490,706)   $(27,963)     $(32,339)    $(454,989)

Net loss...........................                                                 (23,324)                                (23,324)

Distributions on common 
 stock ($0.225 per share)..........                                   (4,148)                                                (4,148)

Amortization of deferred 
 compensation......................                                                               1,066                       1,066

Unrealized holding gain on 
 investment in New Valley..........                                                               8,801                       8,801

Effect of New Valley 
 capital transactions..............                                                               9,483                       9,483

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

Balance, September 30, 1997........    18,097,096       $1,850       $90,021      $(512,230)   $ (8,613)     $(34,139)    $(463,111)
                                      ===========       ======       =======      =========    ========      ========     ========= 
</TABLE>



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




                                      -6-
<PAGE>   8


Item 1.  Consolidated Financial Statements - (Continued)


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




<TABLE>
<CAPTION>
                                             -------------------------------------------------------------------------------    
                                                 Common Stock        Additional
                                             ----------------------    Paid-In
                                              Shares      Amount       Capital        Deficit        Other         Total
                                             -------------------------------------------------------------------------------  

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

Net loss.................................                                              (25,298)                     (25,298)

Unrealized holding gain on
  investment in New Valley...............                                                              8,801          8,801

Effect of New Valley capital
    transactions.........................                                                              9,483          9,483

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

Balance, September 30, 1997..............       100      $              $39,081      $(522,762)     $ (4,618)     $(488,299)
                                               ====      ========       =======      =========      ========      ========= 
</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,
                                                                                      1997             1996
                                                                                ----------------- ----------------

<S>                                                                             <C>               <C>       
  Net cash used in operating activities.....................................      $ (30,511)        $ (22,000)
                                                                                  ---------         --------- 

  Cash flows from investing activities:
    Proceeds from sale of businesses and assets, net........................         43,091             8,031
    Investments.............................................................                             (482)
    Capital expenditures....................................................         (9,857)          (24,047)
    Dividends from New Valley...............................................                           24,733
                                                                                  ---------         ---------

  Net cash provided by investing activities.................................         33,234             8,235
                                                                                  ---------         ---------

  Cash flows from financing activities:
    Proceeds from debt......................................................          5,198            19,837
    Repayments of debt......................................................        (10,323)           (8,559)
    Borrowings under revolver...............................................        209,822           265,117
    Repayments on revolver..................................................       (202,881)          255,763
    Increase (decrease) in cash overdraft...................................          1,416            (4,266)
    Distributions on common stock...........................................         (5,535)           (4,162)
    Other, net..............................................................                              (18)
                                                                                  ---------         --------- 

  Net cash (used in) provided by financing activities.......................         (2,303)           12,498
                                                                                  ---------         ---------

  Net increase (decrease) in cash and cash equivalents......................            420            (1,267)
  Cash and cash equivalents, beginning of period............................          1,941             3,370
                                                                                  ---------         ---------

  Cash and cash equivalents, end of period..................................      $   2,361         $   2,103
                                                                                  =========         =========



Supplemental non-cash investing and financing activities:

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


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




                                      -8-
<PAGE>   10


Item 1.  Consolidated Financial Statements - (Continued)

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


<TABLE>
<CAPTION>

                                                                                          Nine Months Ended
                                                                                ------------------------------------
                                                                                  September 30,       September 30,
                                                                                       1997               1996
                                                                                ------------------------------------
<S>                                                                             <C>                    <C>
Net cash used in operating activities.......................................       $ (36,989)          $ (21,924)
                                                                                   ---------           --------- 

Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net..........................          43,091               8,031
  Investments...............................................................                                (482)
  Capital expenditures......................................................          (9,857)            (24,047)
  Dividends from New Valley.................................................                              24,733
                                                                                   ---------           --------- 
Net cash provided by investing activities...................................          33,234               8,235
                                                                                   ---------           ---------

Cash flows from financing activities:
  Proceeds from debt........................................................           4,723              18,351
  Repayments of debt........................................................          (8,942)             (8,134)
  Borrowings under revolver.................................................         209,822             264,473
  Repayments on revolver....................................................        (202,881)           (254,963)
  Increase (decrease) in cash overdraft.....................................           1,416              (3,761)
  Distributions paid to parent..............................................                              (3,621)
  Other, net................................................................                                 (18)
                                                                                   ---------           --------- 

Net cash (used in) provided by financing activities.........................          (4,138)             12,327
                                                                                   ---------           ---------

Net increase (decrease) in cash and cash equivalents........................             383              (1,362)
Cash and cash equivalents, beginning of period..............................           1,940               3,370
                                                                                   ---------           ---------

Cash and cash equivalents, end of period....................................       $   2,323           $   2,008
                                                                                   =========           =========



Supplemental non-cash investing and financing activities:

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



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



                                      -9-
<PAGE>   11

Item 1.  Consolidated Financial Statements - (Continued)

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


1.       PRINCIPLES OF REPORTING

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

         The interim consolidated financial statements of the Company and BGLS
         are unaudited and, in the opinion of management, reflect all
         adjustments necessary (which are normal and recurring) to present
         fairly the Company's and BGLS' consolidated financial position, results
         of operations and cash flows. These consolidated financial statements
         should be read in conjunction with the consolidated financial
         statements and the notes thereto included in the Company's and BGLS'
         Annual Report on Form 10-K, as amended, for the year ended December 31,
         1996, as filed with the Securities and Exchange Commission. The
         consolidated results of operations for interim periods should not be
         regarded as necessarily indicative of the results that may be expected
         for the entire year.

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

         Certain amounts in the 1996 consolidated financial statements have been
         reclassified to conform to the 1997 presentation.

         LIQUIDITY:

         The Company's principal sources of liquidity for 1997 include, among
         other things, proceeds from the sale of BrookeMil Ltd. ("BML"), a
         subsidiary of BOL, to an affiliate, New Valley Corporation ("New
         Valley"), on January 31, 1997, and certain funds available from New
         Valley subject to limitations imposed by BGLS' indenture agreements.
         New Valley may acquire or seek to acquire additional operating
         businesses through merger, purchase of assets, stock acquisition or
         other means, or to make other investments, which may limit its ability
         to make such distributions.

         Liggett had net capital and working capital deficiencies of $180,011
         and $47,292, respectively, at September 30, 1997, is highly leveraged
         and has substantial near-term debt service requirements. Further,
         Liggett's Senior Secured Notes (the "Liggett Notes") require a
         mandatory principal redemption of $37,500 on February 1, 1998 and a
         payment at maturity on February 1, 1999 of $107,400. Based on Liggett's
         net loss for 1996 and anticipated 1997 operating results, Liggett does
         not anticipate it will be able to generate sufficient cash from
         operations to make such payments. While Liggett has engaged in
         negotiations with its note holders to restructure the terms of the
         Liggett Notes, there are no commitments to restructure the Liggett
         Notes at this time, and no assurances can be given in this regard. In
         conjunction with these discussions, the Company has also engaged in
         negotiations with the principal holders of the BGLS 15.75% Series B
         Senior Secured Notes (the "BGLS Notes") with respect to certain related
         modifications to the terms of such debt.




                                      -10-
<PAGE>   12
Item 1.  Consolidated Financial Statements - (Continued)

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


      During such negotiations, BGLS and Liggett postponed making the interest
      payments of approximately $18,338 for the BGLS Notes due on July 31, 1997
      and approximately $9,700 for the Liggett Notes due on August 1, 1997. A
      Standstill Agreement and Consent (the "Standstill Agreement") was reached
      on August 28, 1997, as amended, among the holders of more than 83% of the
      BGLS Notes and BGLS whereby each of such principal holders of the BGLS
      Notes waived the right to receive on August 29, 1997 its pro rata share of
      the July 31, 1997 interest payment (in total, $15,340). On August 29,
      1997, BGLS made the interest payment on the BGLS Notes to all holders
      other than the principal holders. Pending completion of the negotiations
      with the principal holders, such holders have agreed with BGLS that they
      will be entitled to receive their portion of the July 31, 1997 interest
      payment only after giving BGLS 20 days' notice but, in any event, by
      December 10, 1997. On August 29, 1997, Liggett's revolving credit facility
      (the "Facility") was amended to permit Liggett to borrow an additional
      $6,000 which was used 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. In
      November 1997, Liggett's Facility was extended for an additional year
      until March 8, 1999.

      If Liggett is unable to restructure the terms of the Liggett Notes or
      otherwise make such payments, substantially all of Liggett's long-term
      debt and the Facility would be in default and holders of such debt could
      accelerate the maturity of such debt. In such event, Liggett may be forced
      to seek protection from creditors under applicable laws. These matters
      raise substantial doubt about Liggett meeting its liquidity needs and its
      ability to continue as a going concern.

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

      NEW ACCOUNTING PRONOUNCEMENTS

      In June 1997, the Financial Accounting Standards Board ("FASB") issued
      Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
      Comprehensive Income". SFAS 130 establishes standards for reporting and
      display of comprehensive income. The purpose of reporting comprehensive
      income is to present a measure of all changes in equity that result from
      recognized transactions and other economic events of the period other than
      transactions with owners in their capacity as owners. SFAS 130 requires
      that an enterprise classify items of other comprehensive income by their
      nature in a financial statement and display the accumulated balance of
      other comprehensive income separately from retained earnings and
      additional paid-in capital in the equity section of the balance sheet.
      SFAS 130 is effective for fiscal years beginning after December 15, 1997,
      with earlier application permitted. The Company has not yet determined the
      impact of the implementation of SFAS 130.

      In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
      an Enterprise and Related Information". SFAS 131 specifies revised
      guidelines for determining an entity's operating segments and the type and
      level of financial information to be disclosed. Once operating segments
      have been determined, SFAS 131 provides for a two-tier test for
      determining those operating segments that would need to be disclosed for
      external reporting purposes. In addition to providing the required
      disclosures for reportable segments, SFAS 131 also requires disclosure of
      certain "second level" information by geographic area and for
      products/services. SFAS 131 also makes a number of changes to existing
      disclosure requirements. SFAS 131 is effective for fiscal years



                                      -11-
<PAGE>   13
Item 1.  Consolidated Financial Statements - (Continued)

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


         beginning after December 15, 1997, with earlier application encouraged.
         The Company has not yet determined the impact of the implementation of
         SFAS 131.


2.       INVESTMENT IN NEW VALLEY CORPORATION

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

<TABLE>
<CAPTION>
                                                                      Unrealized
                                 Number of         Fair   Carrying     Holding
                                   Shares         Value    Amount        Loss
                                   ------         -----    ------        ----

   <S>                          <C>             <C>       <C>        <C>
   Class A Preferred Shares...    618,326       $56,886   $56,886    $(15,325)
   Class B Preferred Shares...    250,885         1,004     1,004        (251)
   Common Shares..............  3,989,710(A)      3,491   (57,890)
                                                -------   -------    --------
                                                $61,381   $          $(15,576)
                                                =======   =======    ======== 
</TABLE>

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

      The $15.00 Class A Increasing Rate Cumulative Senior Preferred Shares
      ($100 Liquidation Value), $.01 par value (the "Class A Preferred Shares"),
      and the $3.00 Class B Cumulative Convertible Preferred Shares ($25
      Liquidation Value), $.10 par value (the "Class B Preferred Shares"), are
      accounted for as debt and equity securities, respectively, pursuant to the
      requirements of SFAS No. 115, "Accounting for Certain Investments in Debt
      and Equity Securities", and are classified as available-for-sale. Through
      September 1996, earnings on the Class A Preferred Shares were comprised of
      dividends accrued during the period and the accretion of the difference
      between the Company's basis and their mandatory redemption price. New
      Valley's Common Shares, $.01 par value (the "Common Shares"), were
      accounted for pursuant to APB No. 18, "The Equity Method of Accounting for
      Investments in Common Stock".

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

      At September 30, 1997, the Company's investment in New Valley consisted of
      an approximate 42% voting interest. The Company's investment is
      represented by 57.7% of the Class A Preferred Shares, 41.7% of the Common
      Shares and 9.0% of the Class B Preferred Shares.

      During the first quarter of 1996, New Valley repurchased 72,104 Class A
      Preferred Shares for a total amount of $10,530. The Company has recorded
      its proportionate interest in the excess of the carrying value of the
      shares over the cost of the shares repurchased as a credit to additional
      paid-in capital in the amount of $1,782, along with other New Valley
      capital transactions of $1,563, for the nine months ended September 30,
      1996. No such repurchases have been made during the nine months ended
      September 30, 1997. Other New Valley capital transactions charged to
      equity were $9,483 for the nine months ended September 30, 1997, which
      represents the Company's portion of the unrealized gain on investment
      securities at New Valley.



                                      -12-
<PAGE>   14
Item 1.  Consolidated Financial Statements - (Continued)

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


      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 prior to that
      date, at the option of New Valley, at $100.00 per share plus accrued
      dividends. The holders of Class A Preferred Shares are entitled to receive
      a quarterly dividend, as declared by the Board of Directors (the "Board"),
      payable at the rate of $19.00 per annum. At September 30, 1997, the
      accrued and unpaid dividends arrearage on the Class A Preferred Shares was
      $150,871 or $140.81 per share. During the nine months ended September 30,
      1996, NV Holdings received $24,733 ($40.00 per share) on the Class A
      Preferred Shares in dividend distributions. No such dividend distributions
      have been made in 1997.

      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, 1997, the accrued and unpaid dividends arrearage
      on Class B Preferred Shares was $133,248 or $47.75 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, 1997
      and December 31, 1996 and for the three and nine months ended September
      30, 1997 and 1996 follows:


<TABLE>
<CAPTION>
                                                       September 30,        December 31,
                                                            1997                1996
                                                     ------------------- --------------------

<S>                                                  <C>                  <C>     
Current assets, primarily cash and marketable
   securities...................................          $140,465             $183,720
Non-current assets..............................           326,368              222,820
Current liabilities.............................           131,593               98,110
Non-current liabilities.........................           194,040              170,223
Redeemable preferred stock......................           245,740              210,571
Shareholders' equity (deficit)..................          (104,540)             (72,364)
</TABLE>

<TABLE>
<CAPTION>
                                                    --------------------------- ---------------------------
                                                        Three Months Ended          Nine Months Ended
                                                    --------------------------- ---------------------------
                                                     Sept. 30,     Sept. 30,     Sept. 30,     Sept. 30,
                                                        1997          1996          1997          1996
                                                    ------------- ------------- ------------- -------------
<S>                                                 <C>           <C>           <C>           <C>      
Revenues   ....................................      $ 26,448       $ 21,276      $ 70,605     $  83,710
Costs and expenses..............................       34,378         28,998        95,897       102,314
Loss from continuing operations.................       (6,830)        (7,105)      (22,313)      (17,589)
Income (loss) from discontinued operations......          256         (5,339)          369        (4,501)
Net loss applicable to common shares(A).........      (24,141)       (27,844)      (72,241)      (64,319)
</TABLE>

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

ACQUISITION OF COMMON SHARES OF BML:

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



                                      -13-
<PAGE>   15
Item 1.  Consolidated Financial Statements - (Continued)

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


      RJR NABISCO HOLDINGS CORP.:

      At September 30, 1997, New Valley held 762,650 shares of RJR Nabisco
      Holdings Corp. ("RJR Nabisco") common stock with a market value of $26,216
      (cost of $23,378). The unrealized gain on New Valley's investment in RJR
      Nabisco common stock was $2,838 at September 30, 1997.


3.    INVESTMENT IN BROOKE (OVERSEAS) LTD.

      On January 31, 1997, BOL sold all its shares of BML to New Valley for
      $21,500 in cash and a promissory note of $33,500 payable $21,500 on June
      30, 1997 and $12,000 on December 31, 1997 with interest at 9%. The
      consideration received exceeded the carrying value of the Company's
      investment in BML by $43,700. The Company recognized a gain on the sale in
      the amount of $21,300. The remaining $22,400 was deferred in recognition
      of the fact that the Company retains an interest in BML through its 42%
      equity ownership in New Valley and that a portion of the property sold is
      subject to a put option held by New Valley. The option allows New Valley,
      under certain circumstances, to put a portion of the property sold back to
      the Company at the greater of the appraised fair value of the property at
      the date of exercise or $13,600. On April 18, 1997, BML sold one of its
      office buildings, Ducat Place I, to a third party. Accordingly, the
      Company recognized approximately $1,240 of its deferred gain on the BML
      sale in the second quarter, 1997.

      During the second quarter 1997, New Valley paid $21,500 to BOL,
      representing a portion of the promissory note together with accrued
      interest thereon. As of September 30, 1997, the balance remaining on the
      note was $12,000, subsequently reduced to $8,500, which is due on or
      before December 31, 1997.

      In connection with the sale of its BML shares to New Valley, certain
      specified liabilities aggregating $40,800, including the Vneshtorgbank
      loan, which was repaid in full during the third quarter, remained with
      BML, and New Valley indemnified the Company and its subsidiaries with
      respect to any obligation arising from such liabilities.


4.    INVENTORIES

      Inventories consist of:

<TABLE>
<CAPTION>
                                                                     September 30,       December 31,
                                                                         1997                1996
                                                                   ------------------ -------------------

         <S>                                                       <C>                <C>    
         Finished goods........................................           $13,108         $15,304
         Work-in-process.......................................             4,178           4,435
         Raw materials.........................................            25,937          34,002
         Replacement parts and supplies........................             4,546           4,406
                                                                          -------         -------
         Inventories at current cost...........................            47,769          58,147
         LIFO adjustments......................................            (6,409)         (4,456)
                                                                          -------         ------- 
                                                                          $41,360         $53,691
                                                                          =======         =======
</TABLE>

         At September 30, 1997, Liggett and Liggett-Ducat had leaf tobacco
         purchase commitments of approximately $12,207 and approximately
         $23,900, respectively.



                                      -14-
<PAGE>   16
Item 1.  Consolidated Financial Statements - (Continued)

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


5.    PROPERTY, PLANT AND EQUIPMENT

      Property, plant and equipment consist of:

<TABLE>
<CAPTION>
                                                 September 30,     December 31,
                                                     1997              1996
                                                 ------------------------------
         <S>                                     <C>              <C>      
         Land and improvements..............       $   455         $    455
         Buildings..........................         6,443           14,205
         Machinery and equipment............        52,294           49,401
         Leasehold improvements.............           302              302
         Construction-in-progress...........         9,463           46,966
                                                   -------         --------
                                                    68,957          111,329
         Less accumulated depreciation......        32,237           31,047
                                                    ------         --------
                                                   $36,720         $ 80,282
                                                   =======         ========
</TABLE>

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

      On September 9, 1997, BOL entered into a contract to purchase cigarette
      manufacturing and processing equipment to be used in the new factory for
      $15,000. $12,750 will be financed by a series of ten promissory notes
      payable every six months at 6.71% per annum interest with the first note
      due in 1999. The Company is a guarantor of the notes.

      On September 24, 1997, BOL entered into an additional contract to purchase
      cigarette manufacturing and processing equipment to be used in the new
      factory for $12,400, of which $10,500 will be financed by a series of
      sixty promissory notes payable monthly at 7.5% per annum interest. The
      first note will be due six months after delivery of the equipment.
      Delivery is estimated to be completed by September 1998.


6.    INCOME TAXES

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



                                      -15-
<PAGE>   17

Item 1.  Consolidated Financial Statements - (Continued)

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


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

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

<TABLE>
<CAPTION>
                                                                          Sept. 30,        December 31,
                                                                             1997              1996
                                                                       ----------------- -----------------

         <S>                                                           <C>               <C>     
         15.75% Series B Senior Secured Notes due 2001,
             net of unamortized discount of $1,233 and $1,511......         $231,631          $231,353
         14.500% Subordinated Debentures due 1998..................              800               800
         Notes payable - Foreign...................................                             22,668
         Other.....................................................              936             2,425

         Liggett:
         11.500% Senior Secured Series B Notes due 1999, net of
             unamortized discount of $254 and $424.................          112,358           119,688
         Variable Rate Series C Senior Secured Notes due 1999......           32,279            32,279
         Revolving credit facility.................................           31,214            24,272
                                                                            --------          --------

         Total notes payable and long-term debt....................          409,218           433,485
         Less current maturities...................................           38,245            55,242
                                                                            --------          --------

         Amount due after one year.................................         $370,973          $378,243
                                                                            ========          ========
</TABLE>

      STANDSTILL AGREEMENT-BGLS:

      During negotiations with the BGLS and Liggett note holders, BGLS postponed
      making the interest payments of approximately $18,338 for the BGLS Notes
      due on July 31, 1997. (Refer to Note 1.) A Standstill Agreement and
      Consent (the "Standstill Agreement") was reached on August 28, 1997, as
      amended, among the holders of more than 83% of the BGLS Notes and BGLS
      whereby each of such principal holders of the BGLS Notes waived the right
      to receive on August 29, 1997 its pro rata share of the July 31, 1997
      interest payment (in total, $15,340).

      On August 29, 1997, BGLS made the interest payment on the BGLS Notes to
      all holders other than the principal holders. Pending completion of the
      negotiations with the principal holders, such holders have agreed with
      BGLS that they will be entitled to receive their portion of the July 31,
      1997 interest payment only after giving BGLS 20 days notice but in any
      event by December 10, 1997.

      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, 1997, $2,809 was
      available under the Facility based on eligible collateral. Borrowings
      under the Facility, whose interest is calculated at a rate equal to 1.5%
      above the Philadelphia National Bank's prime rate (8.25%), bore a rate of
      9.75% at March 31, 1997. On April 1, 1997, Philadelphia National Bank
      raised its prime rate to 8.5%, thereby increasing Liggett's interest rate
      to 10.0%. The Facility requires Liggett's compliance with certain
      financial and other covenants. The Facility also limits the amount of cash
      dividends and distributions by Liggett and imposes requirements with
      respect to Liggett's adjusted net and working capital. In January 1997,
      the Facility was extended for one year and in November 1997 was extended
      for an additional year until March 8, 1999.

      During the first quarter of 1997, Liggett violated the working capital
      covenant contained in the Facility. This violation occurred during
      February 1997 when $37,500 of the Liggett Notes were reclassified 



                                      -16-
<PAGE>   18
Item 1.  Consolidated Financial Statements - (Continued)

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


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

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

      LIGGETT 11.500% SENIOR SECURED SERIES B NOTES DUE 1999:

      On February 14, 1992, Liggett issued $150,000 in Senior Secured Notes (the
      "Liggett Series B Notes"). Interest on the Liggett Series B Notes is
      payable semiannually on February 1 and August 1 at an annual rate of
      11.5%. The Liggett Notes referred to below required mandatory principal
      redemptions of $7,500 on February 1 in each of the years 1993 through 1997
      and $37,500 on February 1, 1998 with the balance of the Liggett Notes due
      on February 1, 1999. In February 1997, $7,500 of Liggett Series B Notes
      were purchased using the Facility and credited against the mandatory
      redemption requirements. The transaction resulted in a net gain of $2,963.
      The Liggett Notes are collateralized by substantially all of the assets of
      Liggett, excluding inventories and receivables. Eve Holdings Inc. is a
      guarantor for the Liggett Notes. The Liggett Notes may be redeemed, in
      whole or in part, at a price equal to 102% and 100% of the principal
      amount in the years 1997 and 1998, respectively, at the option of Liggett.
      The Liggett Notes contain restrictions on Liggett's ability to declare or
      pay cash dividends, incur additional debt, grant liens and enter into any
      new agreements with affiliates, among others.

      ISSUANCE OF LIGGETT SERIES C VARIABLE RATE NOTES:

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

      As discussed above, the Liggett Notes require a mandatory principal
      redemption of $37,500 on February 1, 1998 and a payment at maturity on
      February 1, 1999 of $107,400. Liggett has engaged in negotiations with its
      note holders to restructure the Liggett Notes. In conjunction with these
      discussions, the Company is also engaged in negotiations with the
      principal holders of the BGLS Notes with respect to certain related
      modifications to the terms of such debt. (Refer to Note 1.)

      FOREIGN LOANS:

      The Company was a guarantor on lines of credit opened by BOL during the
      first quarter 1997 with two Russian banks in total amount of $4,000
      with interest at 23%. These lines of credit were





                                      -17-
<PAGE>   19
Item 1.  Consolidated Financial Statements - (Continued)

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


      collateralized by accounts receivable, inventory and equipment. The lines
      of credit expired in August and September 1997 with balances paid in full.


8.    STOCK COMPENSATION

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


9.    RELATED PARTY TRANSACTIONS

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


10.   RESTRUCTURING CHARGES

      During the first nine months of 1997, Liggett reduced its headcount by 123
      full-time positions and recorded a $1,926 restructuring charge to
      operations for severance programs, primarily salary continuation and
      related benefits for terminated employees. Approximately $285 in
      restructuring charges will be funded in subsequent years. Liggett expects
      to continue its cost reduction programs.


11.   CONTINGENCIES

      TOBACCO-RELATED LITIGATION:

      Overview. Since 1954, Liggett and other United States cigarette
      manufacturers have been named as defendants in a number of direct and
      third-party actions predicated on the theory that they should be liable
      for damages from cancer and other adverse health effects alleged to have
      been caused by



                                      -18-
<PAGE>   20
Item 1.  Consolidated Financial Statements - (Continued)

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


      cigarette smoking or by exposure to secondary smoke (environmental tobacco
      smoke, "ETS") from cigarettes. These cases are reported hereinafter as
      though having been commenced against Liggett (without regard to whether
      such cases were actually commenced against the Company or Liggett). There
      has been a noteworthy increase in the number of cases pending against both
      Liggett and the other tobacco companies. The cases generally fall into
      three categories: (i) smoking and health cases alleging personal injury
      brought on behalf of individual smokers ("Individual Actions"), (ii)
      smoking and health cases alleging personal injury and purporting to be
      brought on behalf of a class of plaintiffs ("Class Actions") and (iii)
      health care cost recovery actions brought by state and local governments,
      although recently several health care cost recovery actions have been
      commenced on behalf of other third-party payors including asbestos
      manufacturers, unions and taxpayers ("Attorneys General Actions"). As new
      cases are commenced, the costs associated with defending such cases and
      the risks attendant to the inherent unpredictability of litigation
      continue to increase. Liggett had been receiving assistance from others in
      the industry in defraying the costs and other burdens incurred in the
      defense of smoking and health litigation and related proceedings, but
      these benefits have ended. The future financial impact on the Company of
      the termination of this assistance and the effects of the tobacco
      litigation settlements discussed below is not quantifiable at this time.

      On June 24, 1992, in an action entitled Cipollone v. Liggett Group Inc.,
      et al., the United States Supreme Court issued an opinion concluding that
      The Federal Cigarette Labeling and Advertising Act did not preempt state
      common law damage claims but that The Public Health Cigarette Smoking Act
      of 1969 (the "1969 Act") did preempt certain, but not all, state common
      law damage claims. The decision bars plaintiffs from asserting claims
      that, after the effective date of the 1969 Act, the tobacco companies
      either failed to warn adequately of the claimed health risks of cigarette
      smoking or sought to neutralize those claimed risks in their advertising
      or promotion of cigarettes. Bills have been introduced in Congress on
      occasion to eliminate the federal preemption defense. Enactment of any
      federal legislation with such an effect could result in a significant
      increase in claims, liabilities and litigation costs.

      Individual Actions. As of September 30, 1997, there were 218 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, 103 are pending in the
      State of Florida, 62 are pending in the State of New York and 19 are
      pending in the State of Texas. The balance of individual cases are pending
      in 15 states. Of the 218 individual cases, there are five 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



                                      -19-
<PAGE>   21
Item 1.  Consolidated Financial Statements - (Continued)

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


      negligence, lack of design defect, statute of limitations, equitable
      defenses such as "unclean hands" and lack of benefit, failure to state a
      claim and federal preemption.

      On September 10, 1993, an action entitled Sackman v. Liggett Group Inc.,
      United States District Court, Eastern District of New York, was filed
      against Liggett alleging as injury lung cancer. On October 6, 1997, the
      parties settled this matter.

      Class Actions. As of September 30, 1997, there were 39 actions pending,
      for which either a class has been certified or plaintiffs are seeking
      class certification, where Liggett, among others, was a named defendant.
      Two of these cases, Fletcher, et al. v. Brooke Group Ltd., et al. and
      Walker, et al. v. Liggett Group Inc., et al. have been settled, subject to
      court approval. These two settlements are more fully discussed below under
      the "Settlements" section.

      On October 31, 1991, an action entitled Broin, et al. v. Philip Morris
      Incorporated, et al., Circuit Court of the Eleventh Judicial District in
      and for Dade County, Florida, was filed against Liggett and others. This
      case has been brought by plaintiffs on behalf of all flight attendants
      that have worked or are presently working for airlines based in the United
      States and who have never regularly smoked cigarettes but allege that they
      have been damaged by involuntary exposure to ETS. On October 10, 1997, the
      other major tobacco companies settled this matter, subject to a fairness
      hearing, which settlement would provide for a full release on behalf of
      the Company and Liggett.

      On March 25, 1994, an action entitled Castano, et al. v. The American
      Tobacco Company Inc., et al., United States District Court, Eastern
      District of Louisiana, was filed against Liggett and others. The class
      action complaint sought relief for a nationwide class of smokers based on
      their alleged addiction to nicotine. On February 17, 1995, the District
      Court granted plaintiffs' motion for class certification. 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.

      Attorneys General Actions. As of September 30, 1997, 38 state Attorneys
      General actions were filed and served on Liggett and the Company. As more
      fully discussed below, Liggett has reached settlements in 26 of these
      actions. As of September 30, 1997, there were 18 additional third-party
      payor actions pending. In certain of the pending proceedings, state and
      local government entities and others seek reimbursement for Medicaid and
      other health care expenditures allegedly caused by use of tobacco
      products. The claims asserted in these health care cost recovery actions
      vary. In most of these cases, plaintiffs assert the equitable claim that
      the tobacco industry was "unjustly enriched" by plaintiffs' payment of
      health care costs allegedly attributable to smoking and seek reimbursement
      of those costs. Other claims made by some but not all plaintiffs include
      the equitable claim of indemnity, common law claims of negligence, strict
      liability, breach of express and implied warranty, violation of a
      voluntary undertaking or special duty, fraud, negligent misrepresentation,
      conspiracy, public nuisance, claims under state and federal statutes
      governing consumer fraud, antitrust, deceptive trade practices and false
      advertising, and claims under RICO.

      Settlements. On March 12, 1996, the Company and Liggett entered into an
      agreement, subject to court approval, to settle the Castano class action
      tobacco litigation. Under the Castano settlement agreement, upon final
      court approval of the settlement, the Castano class would be entitled to
      receive up to five percent of Liggett's pretax income (income before
      income taxes) each year (up to a maximum of $50,000 per year) for the next
      25 years, subject to certain reductions provided for in the 



                                      -20-
<PAGE>   22
Item 1.  Consolidated Financial Statements - (Continued)

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


      agreement. 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. 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 September 6, 1996, shortly after
      the class was decertified, the Castano plaintiffs withdrew the motion for
      approval of the Castano settlement.

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

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



                                      -21-
<PAGE>   23
Item 1.  Consolidated Financial Statements - (Continued)

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


      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 Settlement 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 Settlement if they conclude that too many
      states have filed Attorney General actions and have not settled such cases
      with the Company and Liggett.

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

      On March 20, 1997, Liggett, together with the Company, entered into a
      comprehensive settlement of tobacco litigation through parallel agreements
      with the Attorneys General of 17 additional states (the "March 1997
      Settlement") and with a nationwide class of individuals and entities that
      allege smoking-related claims. The settlements cover all smoking-related
      claims, including both addiction-based and tobacco injury claims against
      the Company and Liggett, brought by the Attorneys General and, upon court
      approval, the nationwide class.

      As of September 30, 1997, settlements with a total of 26 Attorneys General
      were reached, including the Attorneys General of Alaska, Arizona,
      California, Connecticut, Hawaii, Illinois, Indiana, Iowa, Kansas,
      Maryland, Michigan, Minnesota, Nevada, New Jersey, New York, Oklahoma,
      Oregon, Texas, Utah, Washington and Wisconsin. The March 1996 Settlement
      remains in full force and effect. 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 1997 Settlement;
      however, there can be no assurance that any such settlements will be
      completed.

      As mentioned above, on March 20, 1997, Liggett, the Company and plaintiffs
      filed the mandatory class settlement agreement in an action entitled
      Fletcher, et al. v. Brooke Group Ltd., et al., Circuit Court of Mobile
      County, Alabama, where the court granted preliminary approval and
      preliminary certification of the class, and on May 15, 1997, a similar
      mandatory class settlement agreement was filed in an action entitled
      Walker, et al. v. Liggett Group Inc., et al., United States District
      Court, Southern District of West Virginia. The Walker court also granted
      preliminary approval and preliminary certification of the nationwide
      class; however, on August 5, 1997, the court vacated its preliminary
      certification of the settlement class, 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, such court
      approval will be obtained.



                                      -22-
<PAGE>   24
Item 1.  Consolidated Financial Statements - (Continued)

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


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

      Under the terms of the new settlement agreements, Liggett will pay, on an
      annual basis, 25% of its pretax income for the next 25 years into a
      settlement fund, commencing with the first full fiscal year starting after
      the date of the agreements. Monies collected in the settlement fund will
      be overseen by a court-appointed committee and utilized to compensate
      state health care programs and settlement class members and to provide
      counter-market advertising. Liggett agreed to phase-in compliance with
      certain proposed FDA regulations regarding smoking by children and
      adolescents, including a prohibition on the use of cartoon characters in
      tobacco advertising and limitations on the use of promotional materials
      and distribution of sample packages where minors are present.

      Under the recent settlement agreements, any other tobacco company
      defendant, except Philip Morris, merging or combining with Liggett or the
      Company, prior to the fourth anniversary of the 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. The settling Attorneys
      General and the nationwide class have agreed not to seek an injunction
      preventing a defendant tobacco company combining with Liggett or the
      Company from spinning off any affiliate which is not engaged in the
      domestic tobacco business.

      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. In addition, in the event of a "global"
      tobacco settlement enacted through Federal legislation or otherwise, the
      settling Attorneys General and tobacco plaintiffs agreed to use their
      "best efforts" to ensure that the Company and Liggett's liability under
      such a plan should be no more onerous than under these new settlements.

      Imminent Trials. Although trial schedules are subject to change, the next
      case scheduled for trial, where Liggett is a defendant, is State of
      Minnesota by Hubert H. Humphrey, III, its Attorney General and Blue
      Cross and Blue shield of Minnesota V. Philip Morris Incorporated, et al.,
      District Court of the Second Judicial District, Ramsey County, Minnesota,
      which is scheduled for trial in January 1998. Liggett settled the claims
      of the State of Minnesota on March 20, 1997, but still remains a
      defendant in the case with respect to the State's co-plaintiff, Blue
      Cross and Blue Shield of Minnesota. In addition, there is one class
      action, Engle, et al. v. R.J. Reynolds Tobacco Company, et al., Circuit
      Court, 11th Judicial Circuit, Dade County, Florida and one individual ETS
      case, Dunn and Wiley v. RJR Nabisco Holdings Corp., et al., Superior
      Court, Delaware County, Indiana, scheduled for trial in February 1998. 

      Other Matters. On June 20, 1997, Philip Morris Incorporated ("Philip
      Morris"), R. J. Reynolds Tobacco Company ("RJR"), B&W, Lorillard Tobacco
      Company ("Lorillard") and the United States Tobacco Company, along with
      the Attorneys General for the States of Arizona, Connecticut, Florida,
      Mississippi, New York and Washington and the Castano Plaintiffs'
      Litigation Committee executed a



                                      -23-
<PAGE>   25
Item 1.  Consolidated Financial Statements - (Continued)

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


      Memorandum of Understanding to support the adoption of federal legislation
      and necessary ancillary undertakings, incorporating the features described
      in a proposed resolution. The proposed resolution mandates a total
      reformation and restructuring of how tobacco products are manufactured,
      marketed and distributed in the United States. The proposals are currently
      being reviewed by the White House, Congress and various public interest
      groups. Separately, the other tobacco companies negotiated settlements of
      the Attorneys General health care cost recovery actions in Mississippi and
      Florida. Management is unable to predict the ultimate effect, if any, of
      the enactment of legislation adopting the proposed resolution. Management
      is also unable to predict the ultimate content of any such legislation;
      however, adoption of any such legislation could have a material adverse
      effect on the business of the Company and Liggett.

      On March 20, 1997, RJR, Philip Morris, B&W and Lorillard obtained a
      temporary restraining order from a North Carolina state court preventing
      the Company and Liggett and their agents, employees, directors, officers
      and lawyers from turning over documents allegedly subject to the joint
      defense privilege in connection with the settlements, which restraining
      order was converted to a preliminary injunction by the court on April 9,
      1997. This ruling is currently on appeal by the Company and Liggett. On
      June 5, 1997, the North Carolina Supreme Court denied Liggett's Motion to
      Stay the case pending appeal. On March 24, 1997, the United States
      District Court for the Eastern District of Texas and state courts in
      Mississippi and Illinois each issued orders enjoining the other tobacco
      companies from interfering with Liggett's filing with the courts, under
      seal, those documents.

      The Company understands that a grand jury investigation is being conducted
      by the office of the United States Attorney for the Eastern District of
      New York regarding possible violations of criminal law relating to the
      activities of The Council for Tobacco Research - USA, Inc. (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. The Company is
      unable, at this time, to predict the outcome of this investigation.

      In March 1996, March 1997, July 1997 and October 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, relating to
      issues raised in testimony provided by tobacco industry executives before
      Congress and other related matters. Liggett has responded to the March
      1996 and March 1997 subpoenas and is in the process of responding to the
      July and October 1997 subpoenas. The Company and Liggett are unable, at
      this time, to predict the outcome of this investigation.

      Liggett has been involved in certain environmental proceedings, none of
      which, either individually or in the aggregate, rise to the level of
      materiality. Liggett's current operations are conducted in 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.

      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.



                                      -24-
<PAGE>   26
Item 1.  Consolidated Financial Statements - (Continued)

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


      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.

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


      LEGISLATION AND REGULATION:

      On August 28, 1996, the FDA filed in the Federal Register a Final Rule
      (the "FDA Rule") classifying tobacco as a drug, asserting jurisdiction by
      the FDA over the manufacture and marketing of tobacco products and
      imposing restrictions on the sale, advertising and promotion of tobacco
      products. Litigation was commenced in the United States District Court for
      the Middle District of North Carolina challenging the legal authority of
      the FDA to assert such jurisdiction, as well as challenging the
      constitutionality of the rules. The court, after argument, granted
      plaintiffs' motion for summary judgment prohibiting the FDA from
      regulating or restricting the promotion and advertising of tobacco
      products and denied plaintiffs' motion for summary judgment on the issue
      of whether the FDA has the authority to regulate access to, and labeling
      of, tobacco products. The four major cigarette manufacturers and the FDA
      have filed notices of appeal. The Company and Liggett support the FDA Rule
      and have begun to phase in compliance with certain of the proposed interim
      FDA regulations. See discussions of the Castano and Attorneys General
      settlements above.

      In August 1996, the Commonwealth of Massachusetts enacted legislation
      requiring tobacco companies to publish information regarding the
      ingredients in cigarettes and other tobacco products sold in that state.
      On February 7, 1997, the United States District Court for the District of
      Massachusetts denied an attempt to block the new legislation on the ground
      that it is preempted by federal law. The Company and Liggett support this
      proposed legislation.

      On September 13, 1995, the President of the United States issued
      Presidential Proclamation 6821, which established a tariff rate quota
      ("TRQ") on certain imported tobacco, imposing extremely high tariffs on
      imports of flue-cured and burley tobacco in excess of certain specified
      levels, which levels vary by country. Management believes that the TRQ
      levels are sufficiently high to allow Liggett to operate without material
      disruption to its business. On February 20, 1996, the United States Trade
      representative issued an "advance notice of rule making" concerning how
      tobaccos imported under the TRQ should be allocated. Currently, tobacco
      imported under the TRQ is allocated on a "first-come, first-served" basis,
      meaning that entry is allowed on an open basis to those first requesting
      entry in the quota year. Others in the cigarette industry have suggested
      an "end-user licensing" system under which the right to import tobacco
      under the quota would be initially assigned on the basis of domestic
      market share. Such an approach, if adopted, could have a material adverse
      effect on the Company and Liggett.



                                      -25-
<PAGE>   27
Item 1.  Consolidated Financial Statements - (Continued)

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


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

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

      As part of the budget agreement recently approved by Congress, federal
      excise taxes on a pack of cigarettes, which are currently 24 cents, would
      rise 10 cents in the year 2000 and 5 cents more in the year 2002.

      In a speech on September 17, 1997, President Clinton called for federal
      legislation that, among other things, would raise cigarette prices by up
      to $1.50 per pack. In November 1997, several bills were introduced in the
      Senate that purport to propose legislation along these lines. Management
      is unable to predict the ultimate content of any such legislation;
      however, adoption of any such legislation could have a material adverse
      effect on the business of the Company and Liggett.

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


12.   SALES OF ASSETS

      On January 31, 1997, BOL sold BML to New Valley for $21,500 in cash and a
      promissory note of $33,500 payable $21,500 on June 30, 1997 and $12,000 on
      December 31, 1997. (Refer to Note 3.)

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










                                      -26-
<PAGE>   28



ITEM  2.             MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



INTRODUCTION

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

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

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


RECENT DEVELOPMENTS

         BOL. On January 31, 1997, New Valley acquired from BOL 10,483 shares
(99.1%) of common stock of BML (the "BML Shares") for a purchase price of
$55,000, consisting of $21,500 in cash and a $33,500 9% promissory note of New
Valley (the "Note"). The Note is collateralized by the BML Shares. During the
second quarter 1997, New Valley paid $21,500 to BOL. The remaining balance on
the Note at September 30, 1997 was $12,000, subsequently reduced to $8,500 and
is due on or before December 31, 1997. The Company recognized a gain of $21,300
on the sale in the first quarter, 1997. On April 18, 1997, BML sold one of its
office buildings to a third party. Accordingly, the Company recognized
approximately $1,240 of the deferred gain. See Note 3 to the Company's
Consolidated Financial Statements.

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

         Debt Service. Liggett has engaged in negotiations with its note holders
with respect to a restructuring of the terms of Liggett's Senior Secured Notes
(the "Liggett Notes"). In conjunction with these discussions, the Company has
also engaged in negotiations with the principal holders of the BGLS 15.75%
Series B Senior Secured Notes (the "BGLS Notes") with respect to certain related
modifications to the terms of such debt. A Standstill Agreement and Consent (the
"Standstill Agreement") was reached on August 28, 1997, as amended, among the
principal holders of the BGLS Notes and BGLS whereby each of the principal
holders of the BGLS Notes waived the right to receive on August 29, 1997 its pro
rata share of the July interest amount ($15,340). Other BGLS note holders and
the Liggett note holders received the interest payments which had been due on
July 31, 1997 and on August 1, 1997, respectively, on August 29, 1997. Pending
completion of the negotiations with the principal holders, such holders have
agreed with BGLS that they will be entitled 




                                      -27-
<PAGE>   29

to receive their portion of the July 31, 1997 interest payment only after giving
BGLS 20 days notice but in any event by December 10, 1997. On August 29, 1997,
Liggett's revolving credit facility (the "Facility") was amended to permit
Liggett to borrow an additional $6,000 which was used 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. With respect to Liggett's liquidity and near-term debt service
requirements and related matters, refer to "Capital Resources and Liquidity"
below.

      New Accounting Pronouncements. In June 1997, the Financial Accounting
Standards Board ("FASB") issued Statement of Financial Accounting Standards
("SFAS") No. 130, "Reporting Comprehensive Income". SFAS 130 establishes
standards for reporting and display of comprehensive income. The purpose of
reporting comprehensive income is to present a measure of all changes in equity
that result from recognized transactions and other economic events of the period
other than transactions with owners in their capacity as owners. SFAS 130
requires that an enterprise classify items of other comprehensive income by
their nature in a financial statement and display the accumulated balance of
other comprehensive income separately from retained earnings and additional
paid-in capital in the equity section of the balance sheet. SFAS 130 is
effective for fiscal years beginning after December 15, 1997, with earlier
application permitted. The Company has not yet determined the impact of the
implementation of SFAS 130.

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


RECENT DEVELOPMENTS IN THE CIGARETTE INDUSTRY

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

         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, 1997, there were 218 individual suits, 39 class actions or
actions where class certification has been sought and 38 state (and numerous
municipality and other third-party payor) health care cost reimbursement actions
pending in the United States in which Liggett is a named defendant and has been
served. As new cases are commenced, the costs associated with defending such
cases and the risks attendant to the inherent unpredictability of litigation
continue to increase. Recently, there have been a number of restrictive
regulatory actions from various Federal administrative bodies, including the
United States Environmental Protection Agency ("EPA") and the Food and Drug
Administration ("FDA"), adverse political and legal decisions and other
unfavorable developments concerning cigarette smoking and the tobacco industry,
including the commencement and certification of class actions and the
commencement of Medicaid reimbursement suits by various states' Attorneys
General. These developments generally receive widespread media attention. The
Company is not able to evaluate the effect of these developing matters on
pending litigation or the possible commencement of additional litigation, but it
is


                                      -28-
<PAGE>   30

possible that the Company's financial position, results of operations and cash
flows could be materially adversely affected by an ultimate unfavorable outcome
in any of such pending litigation. See Note 11 to the Company's Consolidated
Financial Statements for a description of legislation, regulation and
litigation.

         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,
statutes of limitations, equitable defenses such as "unclean hands" and lack of
benefit, failure to state a claim and federal preemption.

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

         Settlements. On March 12, 1996, Liggett, together with the Company,
entered into an agreement to settle the Castano class action tobacco litigation,
and on March 15, 1996, Liggett, together with the Company, entered into an
agreement with the Attorneys General of West Virginia, Florida, Mississippi,
Massachusetts and Louisiana to settle certain actions brought against Liggett
and the Company by such states. Liggett and the Company, while neither
consenting to FDA jurisdiction nor waiving their objections thereto, agreed to
withdraw their objections and opposition to the proposed FDA regulations and to
phase in compliance with certain of the proposed interim FDA regulations.

         Under the Castano settlement agreement, upon final court approval of
the settlement, the Castano class would be entitled to receive up to five
percent of Liggett's pretax income (income before income taxes) each year (up to
a maximum of $50,000 per year) for the next 25 years, subject to certain
reductions provided for in the agreement. The Company and Liggett have the right
to terminate the Castano settlement under certain circumstances. On May 11,
1996, the Castano Plaintiffs Legal Committee filed a motion with the United
States District Court for the Eastern District of Louisiana seeking preliminary
approval of the Castano settlement. On May 23, 1996, the Court of Appeals for
the Fifth Circuit reversed the February 17, 1995 order of the District Court
certifying the Castano suit as a nationwide class action and instructed the
District Court to dismiss the class complaint. On September 6, 1996, the Castano
plaintiffs withdrew the motion for approval of the Castano settlement.

         On March 14, 1996, the Company, the Castano Plaintiffs Legal Committee
and the Castano plaintiffs entered into a letter agreement. According to the
terms of the letter agreement, for the period ending nine months from the date
of Final Approval (if granted) of the Castano settlement or, if earlier, the
completion by the Company or Liggett of a combination with any defendant in
Castano, except Philip Morris, the Castano plaintiffs and their counsel agree
not to enter into any more favorable settlement agreement with any Castano
defendant which would reduce the terms of the Castano settlement agreement. If
the Castano plaintiffs or their counsel enter into any such settlement during
this period, they shall pay the Company $250,000 within 30 days of the more
favorable agreement and offer the Company and Liggett the option to enter into a
settlement on terms at least as favorable as those included in such other
settlement. The letter agreement further provides that during the same time
period, and if the Castano settlement agreement has not been earlier terminated
by the Company in accordance with its 




                                      -29-
<PAGE>   31

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.

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

         On March 20, 1997, Liggett, together with the Company, entered into a
comprehensive settlement of tobacco litigation through parallel agreements with
the Attorneys General of 17 states and with a nationwide class of individuals
and entities that allege smoking-related claims. The settlements cover all
smoking-related claims, including both addiction-based and tobacco injury claims
against Liggett and the Company, and upon court approval, the nationwide class.

         As of September 30, 1997, settlements with a total of 26 Attorneys
General were reached, including the Attorneys General of Alaska, Arizona,
California, Connecticut, Hawaii, Illinois, Indiana, Iowa, Kansas, Maryland,
Michigan, Minnesota, Nevada, New Jersey, New York, Oklahoma, Oregon, Texas,
Utah, Washington and Wisconsin. The Company's and Liggett's previous settlement
on March 15, 1996 with the Attorneys General of Florida, Louisiana,
Massachusetts, Mississippi and West Virginia remains in full force and effect.
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 matters on substantially the same terms and conditions as the
prior settlements; however, there can be no assurance that any such settlements
will be completed.

         As mentioned above, on March 20, 1997, Liggett, the Company and
plaintiffs filed the mandatory class settlement agreement in an action entitled
Fletcher, et al. v Brooke Group Ltd., et al., Circuit Court of Mobile County,
Alabama, where the court granted preliminary approval and preliminary
certification of the class, and on May 15, 1997, a similar mandatory class
settlement agreement was filed in an action entitled Walker, et al. v. Liggett
Group Inc., et al., United States District Court, Southern District of West
Virginia. The Walker court also granted preliminary approval and preliminary
certification of the nationwide class; however, on August 5, 1997, the court
vacated its preliminary certification of the settlement class, 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.

         Pursuant to the above-mentioned settlements, the Company and Liggett
agreed to cooperate fully with the Attorneys General and the nationwide class in
their respective lawsuits against the tobacco industry. The Company and Liggett
agreed to provide to these parties all relevant tobacco documents in their
possession, other than those subject to claims of joint defense privilege, and
to waive, subject to court order, certain attorney-client privileges and work
product protections regarding Liggett's smoking-related documents to the extent
Liggett and the Company can so waive these privileges and protections. The
Attorneys General and the nationwide class agreed to keep Liggett's documents
under protective order and, subject to final court approval, to limit their use
to those actions brought by parties to the




                                      -30-
<PAGE>   32

settlement agreements. Those documents that may be subject to a joint defense
privilege with other tobacco companies will not be produced to the Attorneys
General or the nationwide class, but will be, pursuant to court order, submitted
to the appropriate court and placed under seal for possible in camera review.
Additionally, under similar protective conditions, the Company and Liggett
agreed to offer their employees for witness interviews and testimony at
deposition and trial. Pursuant to both settlement agreements, Liggett also
agreed to place an additional warning on its cigarette packaging stating that
"smoking is addictive" and to issue a public statement, as requested by the
Attorneys General. Liggett has commenced distribution of cigarette packaging
which displays the new warning label.

         Under the terms of the new settlement agreements, Liggett will pay on
an annual basis 25% of its pretax income for the next 25 years into a settlement
fund, commencing with the first full fiscal year starting after the date of the
agreements. Monies collected in the settlement fund will be overseen by a
court-appointed committee and utilized to compensate state health care programs
and settlement class members and to provide counter-market advertising. Liggett
agreed to phase in compliance with certain proposed FDA regulations regarding
smoking by children and adolescents, including a prohibition on the use of
cartoon characters in tobacco advertising and limitations on the use of
promotional materials and distribution of sample packages where minors are
present.

         Under the recent settlement agreements, any other tobacco company
defendant, except Philip Morris, merging or combining with Liggett or the
Company, prior to the fourth anniversary of the 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. The settling Attorneys General and the nationwide
class agreed not to seek an injunction preventing a defendant tobacco company
combining with Liggett or the Company from spinning-off any of its affiliates
which are not engaged in the domestic tobacco business.

         The Company and Liggett are also entitled to certain most favored
nation treatment in the event any settling Attorney General reaches a settlement
with any other defendant tobacco company. In addition, in the event of a
"global" tobacco settlement enacted through Federal legislation or otherwise,
the settling Attorneys General and tobacco plaintiffs agreed to use their "best
efforts" to ensure that the Company and Liggett's liability under such a plan
should be no more onerous than under these new settlements.

         At December 31, 1995, the Company had accrued approximately $4,000 for
the present value of the fixed payments under the initial Attorneys General
settlement and no additional amounts have been accrued with respect to the
recent settlements discussed above. The Company cannot quantify the future costs
of the settlements at this time as the amount Liggett must pay is based, in
part, on future operating results. Possible future payments based on a
percentage of pretax income, and other contingent payments based on the
occurrence of a business combination, will be expensed when considered probable.
See the discussions of the tobacco litigation settlements appearing in Note 11
to the Company's Consolidated Financial Statements.

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

         In a speech on September 17, 1997, President Clinton called for federal
legislation that, among other things, would raise cigarette prices by up to
$1.50 per pack. In November 1997, several bills were introduced in the Senate
that purport to propose legislation along these lines. Management is unable to
predict the ultimate content of any such legislation; however, adoption of any
such legislation could have a material adverse effect on the business of the
Company and Liggett.




                                      -31-
<PAGE>   33

RESULTS OF OPERATIONS

Three Months Ended September 30, 1997 Compared to Three Months Ended September
30, 1996.

         Revenues. Total revenues were $100,308 for the three months ended
September 30, 1997 compared to $114,635 for the three months ended September 30,
1996. This 12.5% decrease in revenues was primarily due to a $21,757 or 21.5%
decrease in revenues at Liggett reflecting a 29.6% decrease in Liggett's overall
unit sales volume, partially offset by an increase in tobacco revenues at
Liggett-Ducat of $8,100 or 63.1% over the same period in 1996 and an increase of
22.8% in overall unit sales volume. (See also "Recent Developments in the
Cigarette Industry-Pricing Activity" for a discussion of the March and September
1997 domestic price increases). The decline in overall unit sales volume of
29.6% at Liggett was comprised of declines within the premium segment of 18.6%
and discount segment (which includes generic, control label and branded discount
products) of 28.8%. The decline in premium and discount unit sales volume was
due to certain competitors' continuing leveraged rebate programs tied to their
products and increased promotional activity by certain other manufacturers. The
increase in tobacco revenues at Liggett-Ducat is attributable to increased unit
sales volume of 22.8% and price increases. The increase in tobacco revenues at
Liggett-Ducat is offset by a decline in real estate revenues of $668 due to the
sale of the BML Shares.

         Gross Profit. Gross profit was $47,263 for the three months ended
September 30, 1997 compared to $56,274 for the three months ended September 30,
1996, a decrease of $9,011 when compared to the same period last year, due
primarily to the decline in unit sales volume at Liggett discussed above.
Overall, the Company's gross profit as a percentage of revenues decreased 2.0%
when compared to the same period in the prior year. Liggett's gross profit as a
percentage of revenues (excluding federal excise taxes) for the period decreased
to 72.2% compared to 74.0% in the same period in the prior year. This decrease
is the result of increased tobacco costs due to a reduction in the average
discount available to Liggett from leaf tobacco dealers on tobacco purchased
under prior years' purchase commitments, partially offset by the March and
September 1997 list price increases discussed above. See "Recent Developments in
the Cigarette Industry". Gross profit at Liggett-Ducat increased $3,712 over the
prior year due to increased sales volume and cigarette price increases.

         Expenses. Selling, general and administrative expenses were $40,498 for
the three months ended September 30, 1997 compared to $55,326 for the same
period last year. The decrease of $14,828 is due primarily to a decrease in
expenses at Liggett of approximately $13,300 which include lower promotion,
marketing and administrative expenses as well as lower charges for restructuring
partially offset by higher legal expenses at Liggett and a decrease of
approximately $900 in operating expenses at BOL due to the sale of BML Shares in
January 1997.

         Other Income (Expense). Interest expense was $15,791 for the three
months ended September 30, 1997 compared to $15,254 for the same period last
year.

         Equity in earnings of affiliate was a loss of $7,090 for the three
months ended September 30, 1997 compared to a loss of $4,618 for the three
months ended September 30, 1996 and relates primarily to losses at New Valley.


Nine Months Ended September 30, 1997 Compared to Nine Months Ended September 30,
1996.

         Revenues. Total revenues were $276,906 for the nine months ended
September 30, 1997 compared to $330,364 for the nine months ended September 30,
1996. This 16.2% decrease in revenues was primarily due to a $69,008 or 23.6%
decrease in revenues at Liggett reflecting a 30.8% decrease in Liggett's overall
unit sales volume, partially offset by an increase of $19,874 or 60.2% over the
same period in 1996 in tobacco revenues and an increase of 24.1% in overall unit
sales volume at Liggett-Ducat. The decline in overall units sales volume at
Liggett was comprised of declines within the premium segment of 22.7% and
discount segment (which includes generic, control label and branded discount
products) of 30.0%. The decline in premium and discount unit sales volume was
due to certain competitors' continuing



                                      -32-
<PAGE>   34

leveraged rebate programs tied to their products and increased promotional
activity by certain other manufacturers. Liggett has had two price increases
this year as compared with one price increase in 1996 and Liggett-Ducat has also
experienced price increases. The increase in tobacco revenues at Liggett-Ducat
is offset by a decline in real estate rental revenues of $1,783 due to the sale
of the BML Shares.

         Gross Profit. Gross profit was $131,065 for the nine months ended
September 30, 1997 compared to $161,433 for the nine months ended September 30,
1996, a decrease of $30,368 when compared to the same period last year, due
primarily to the decline in unit sales volume at Liggett discussed above.
Overall, the Company's gross profit as a percentage of revenues decreased 1.5%
when compared to the same period in the prior year. Liggett's gross profit as a
percentage of revenues (excluding federal excise taxes) for the period decreased
to 72.0% compared to 73.3% in the same period in the prior year. This decrease
is the result of increased tobacco costs due to a reduction in the average
discount available to Liggett from leaf tobacco dealers on tobacco purchased
under prior years' purchase commitments, partially offset by the March and
September 1997 list price increases. See "Recent Developments in the Cigarette
Industry".

         Expenses. Selling, general and administrative expenses were $117,535
for the nine months ended September 30, 1997 compared to $158,482 for the same
period last year. The decrease of $40,947 is due primarily to lower promotion,
marketing and administrative expenses at Liggett caused by the decline in unit
sales volume discussed above partially offset by restructuring charges of
$1,926, as compared with restructuring charges of $1,180 in the same period in
the prior year, and higher legal expenses at Liggett.

         Other Income (Expense). Interest expense was $46,757 for the nine
months ended September 30, 1997 compared to $45,488 for the same period last
year. The increase is due to additional interest expense at corporate
headquarters and higher outstanding balances under Liggett's Facility partially
offset by the redemption of $7,500 Liggett Series B Notes in February 1997.

        Equity in earnings of affiliate was a loss of $21,488 for the nine
months ended September 30, 1997 compared to a loss of $7,152 for the nine months
ended September 30, 1996 and relates to losses at New Valley and the decline in
market value of the Class A Preferred Shares.

        Interest expense and loss in equity of affiliate were offset by the gain
on sale of assets, which includes the sale of the BML Shares and surplus realty
at Liggett, and proceeds from a legal settlement of $4,125. See Notes 3 and 12
to the Company's Consolidated Financial Statements.


CAPITAL RESOURCES AND LIQUIDITY

         Net cash and cash equivalents increased $420 and decreased $1,267 for
the nine months ended September 30, 1997 and 1996, respectively. Net cash used
in operations for the nine months ended September 30, 1997 was $30,511 compared
to net cash used in operations of $22,000 for the comparable period of 1996,
primarily due to net losses of $23,324 and $40,404, respectively. Such losses
included interest payments of approximately $41,000 in 1997 as compared with
$53,000 in 1996. In addition, there was an increase in receivables from
affiliates of $28,190 resulting from the sale of the BML Shares to New Valley, a
decrease in accounts payable and other accrued liabilities of $26,058. These
items were offset by a decrease in trade receivables and inventories at Liggett
due to declining sales volume, and non-cash items including equity in loss of
affiliate of approximately $22,000 and the impact of the deferred gain on the
sale of the BML Shares of approximately $22,000.

         Cash provided by investing activities of $33,234 for the period ended
September 30, 1997 includes principally cash of $43,000 received in the sale of
the BML Shares to New Valley and net cash received in the sale of certain of
Liggett's surplus realty to Blue Devil Ventures. Cash received was offset by
capital expenditures of $9,857, principally at BOL. Capital expenditures include
costs incurred in the development of the new Russian cigarette factory and
equipment purchases and $1,282 in costs for equipment modernization at Liggett.
Cash used in investing activities of $8,235 for the nine months ended September
30, 1996 includes capital expenditures of approximately $24,047, principally for
real estate development at BOL and for costs of $2,983 for equipment
modernization at Liggett. Capital expenditures in 1996 were



                                      -33-
<PAGE>   35

offset by dividends received on the New Valley Class A Preferred Shares of
$24,733 or $40.00 per share and proceeds from the sale of certain surplus realty
at Liggett and the sale of assets of COM Products Inc.

         Cash used in financing activities was $2,303 for the nine months ended
September 30, 1997 compared to cash provided of $12,498 for the same period in
1996. Proceeds from financing activities of $5,198 primarily include proceeds at
BOL from credit lines and net borrowings under Liggett's Facility of $6,941.
These proceeds were offset by repayments on credit lines and on debt including
principally the required repurchase of $7,500 face amount of the Liggett Notes
on February 1, 1997 at a net gain of $2,963. Distributions on common stock
include distributions declared in the fourth quarter 1996 which were paid in
January 1997 and distributions declared and paid in March, June and September
1997. Proceeds from debt in the same period in 1996 include the private
placement of BGLS' Series A Notes (later exchanged for Series B Notes) for net
cash proceeds of $6,065, borrowings by BOL for real estate development of
$12,400 and borrowings of $9,500 by Liggett and BOL under their revolving credit
facilities. These transactions were primarily offset by the redemption for
approximately $6,237 of BGLS' 16.125% Senior Subordinated Reset Notes including
premium and accrued interest thereon, and distributions to the Company's
shareholders of $4,162.

      Liggett. Liggett had a net capital deficiency of $180,011 as of September
30, 1997, is highly leveraged and has substantial near-term debt service
requirements. Due to the many risks and uncertainties associated with the
cigarette industry and the impact of recent tobacco litigation settlements,
there can be no assurance that Liggett will be able to meet its future earnings
or cash flow goals. Consequently, Liggett could be in violation of certain debt
covenants, and if its lenders were to exercise acceleration rights under the
Facility or the Liggett Notes indenture, or refuse to lend under the Facility,
Liggett would not be able to satisfy such demands or its working capital
requirements.

      Further, the Liggett Notes require a mandatory principal redemption of
$37,500 on February 1, 1998 and a payment at maturity on February 1, 1999 of
$107,400. Based on Liggett's net loss for 1996 and anticipated 1997 operating
results, Liggett does not anticipate it will be able to generate sufficient cash
from operations to make such payments. While Liggett has engaged in negotiations
with its note holders to restructure the terms of the Liggett Notes, there are
no commitments to restructure the Liggett Notes at this time, and no assurances
can be given in this regard. In conjunction with these discussions, the Company
has also engaged in negotiations with the principal holders of the BGLS Notes
with respect to certain related modifications to the terms of such debt. During
such negotiations, both BGLS and Liggett postponed making the interest payments
of approximately $18,338 for the BGLS Notes due on July 31, 1997 and
approximately $9,700 for the Liggett Notes due on August 1, 1997. On August 29,
1997, Liggett's 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 Liggett note holders. BGLS guaranteed the additional
$6,000 advance under the Facility and collateralized the guarantee with $6,000
in cash, deposited with Liggett's lenders.

      If Liggett is unable to restructure the terms of the Liggett Notes, or
otherwise make all payments thereon, substantially all of Liggett's long-term
debt and the Facility would be in default and holders of such debt could
accelerate its maturity. In such event, Liggett may be forced to seek protection
from creditors under applicable laws. These matters raise substantial doubt
about Liggett meeting its liquidity needs and its ability to continue as a going
concern.

         On March 8, 1994, Liggett entered into the Facility under which it can
borrow up to $40,000 (depending on the amount of eligible inventory and
receivables as determined by the lenders) from a syndicate of commercial
lenders. At September 30, 1997, $31,214 was outstanding and $2,809 was available
under the Facility based on eligible collateral. The Facility is collateralized
by all inventories and receivables of Liggett. Borrowings under the Facility are
charged interest at a rate equal to 1.5% above Philadelphia National Bank's (the
indirect parent of Congress Financial Corporation, the lead lender) prime rate.
Liggett's interest rate is currently 10.0%. The Facility contains certain
financial covenants similar to those contained in the Liggett Notes Indenture,
including restrictions on Liggett's ability to declare or pay cash dividends,
incur additional debt, grant liens and enter into any new agreements with
affiliates, among others. In addition, the Facility currently imposes
requirements with respect to Liggett's adjusted net worth



                                      -34-
<PAGE>   36
 (not to fall below a deficit of $180,000 as computed in accordance with the
agreement, this computation is currently $173,602) and working capital (not to
fall below a deficit of $12,000 as computed in accordance with the agreement,
this computation is currently $3,492).

         During the first quarter of 1997, Liggett violated the working capital
covenant contained in the Facility as a result of the 1998 mandatory redemption
payment on the Liggett Notes becoming due within one year. On March 19, 1997,
the lead lender agreed to waive this covenant default, and the Facility was
amended as follows: (i) the working capital definition was changed to exclude
the Liggett Notes; (ii) the maximum permitted working capital deficit, as
defined, was reduced to $12,000 (as computed in accordance with the agreement);
(iii) the maximum permitted adjusted net worth deficit, as defined, was
increased to $180,000 (as computed in accordance with the agreement); and (iv)
the permitted advance rates under the Facility for eligible inventory were
reduced by five percent.

         In November 1997, the Facility was extended until March 8, 1999. The
balance on the Facility, $31,214, was reclassified from current to long-term
debt as of September 30, 1997.

         In February 1997, Liggett purchased $7,500 of Series B Notes using
Facility availability and credited such Notes against the 1997 mandatory
redemption requirement. Liggett recorded a net gain of $2,963 for this
transaction in the first quarter, 1997. BGLS or its affiliates may, from time to
time, based on current market conditions, purchase Liggett Notes in the open
market or in privately negotiated transactions. Current maturities of the
Liggett Notes of $37,500 contribute substantially to Liggett's working capital
deficit of $47,292 at September 30, 1997.

         Liggett (and, in certain cases, the Company) and other United States
cigarette manufacturers have been named as defendants in a number of direct and
third-party actions (and purported class actions) predicated on the theory that
they should be liable for damages from cancer and other adverse health effects
alleged to have been caused by cigarette smoking or by exposure to so-called
secondary smoke (environmental tobacco smoke) from cigarettes. As new cases are
commenced, the costs associated with defending such cases and the risk attendant
to the inherent unpredictability of litigation continue. Liggett had been
receiving certain assistance from others in the industry in defraying the costs
and other burdens incurred in the defense of smoking and health litigation and
related proceedings, but these benefits have ended. The future financial impact
on the Company of the termination of this assistance and the effects of the
tobacco litigation settlements discussed above is not quantifiable at this time.

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

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

         BGLS. At September 30, 1997, BGLS' long-term debt was approximately
$233,000. In connection with the interest payment BGLS made on August 29, 1997,
the Standstill Agreement was reached with the



                                      -35-
<PAGE>   37
principal holders of BGLS debt on August 28, 1997, as amended, and interest was
paid to other BGLS note holders in the amount of $3,039 on August 29, 1997. (See
"Recent Developments" and Liggett discussion above).

         BOL. As discussed in "Recent Developments," on January 31, 1997, BOL
sold its 99.1% interest in BML to New Valley for $55,000. The purchase price
paid was $21,500 in cash and a 9% promissory note of $33,500, of which $21,500
was paid during the second quarter 1997. The remaining balance of $12,000,
subsequently reduced to $8,500, is due on or before December 31, 1997.

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

         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.
Construction has begun, and management is actively pursuing various potential
financing alternatives that would permit the new factory to be operational by
the end of 1998, although no assurance can be given that such financing can be
obtained on satisfactory terms.

         In connection with the new cigarette factory, BOL has entered into
equipment purchases of approximately $28,000, of which $23,000 will be financed
over 5 years beginning in 1998. The Company is a guarantor of one of the
purchases for which the remaining obligation is $12,750.

         The Company. As a result of the 1995 debt exchange offer, the
redemption of the Reset Notes in 1996, the sale of the BML Shares to New Valley
in January 1997, the redemption of $7,500 of the Liggett Notes on February 1,
1997 and the extension of the Liggett Facility through March 8, 1999, the
Company decreased its scheduled near-term debt maturities to $38,245 due in the
year 1998; at September 30, 1997, $37,500 of this debt relates to Liggett. In
addition, Liggett has a payment due at maturity of the Liggett Notes on February
1, 1999 of $107,400. The BGLS Notes Indenture limits the amount of restricted
payments BGLS is permitted to make to the Company during the calendar year. At
September 30, 1997, the remaining amount available through December 31, 1997 in
the Restricted Payment Basket related to BGLS' payment of dividends to the
Company (as defined by the BGLS Notes Indenture) is $6,443. In March and June
1997, the Company provided for its quarterly dividends with proceeds from the
legal settlement received in January 1997. Company expenditures (exclusive of
Liggett and Liggett-Ducat) in 1997 for current operations include debt service
originally estimated at $36,800 on which payments of $21,377 have been made. The
remaining balance of $15,340 is the subject of the Standstill Agreement with the
principal holders of the BGLS Notes discussed above and is due upon 20 days'
notice by such holders but in any event by December 10, 1997. Additional
expenditures include dividends on the Company's shares (currently at an annual
rate of approximately $5,500) and corporate expense. The Company anticipates
funding current operations with the remaining proceeds from the sale of BML,
management fees and other payments from subsidiaries of approximately $5,000.
The Company expects to finance its long-term growth, working capital
requirements, capital expenditures and debt service requirements through a
combination of cash provided from operations, proceeds from the sale of certain
assets, additional public or private debt and/or equity financing and
distributions from New Valley. New Valley may acquire or seek to acquire
additional operating businesses through merger, purchase of assets, stock
acquisition or other means, or to make other investments, which may limit its
ability to make such distributions.


SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

         The Company and its representatives may from time to time make oral or
written "forward-looking statements" within the meaning of the Private
Securities Reform Act of 1995 (the "Reform Act"), including any 




                                      -36-
<PAGE>   38

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











                                      -37-
<PAGE>   39


                                     PART II
                                OTHER INFORMATION


Item 1.     Legal Proceedings

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

Item 3.     Defaults Upon Senior Securities

            As of September 30, 1997, 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"): (i) $150.9 million or $140.81 per Class A
            Share; and (ii) $133.2 million or $47.75 per Class B Share.

Item 6.     Exhibits and Reports on Form 8-K

            (a)   Exhibits

<TABLE>
                  <S>      <C>                                         
                  10.1     Settlement Agreement dated September 15, 1997 by and
                           among the State of Nevada and Brooke Group Ltd. and
                           Liggett Group Inc.

                  10.2     Settlement Agreement dated June 9, 1997 by and among
                           the State of Oregon and Brooke Group Ltd. and
                           Liggett Group Inc.

                  10.3     Standstill Agreement and Consent ("Standstill
                           Agreement"), dated as of August 28, 1997, among BGLS
                           Inc., AIF II, L.P., Artemis America Partnership and
                           Tortoise Corp. (incorporated by reference to exhibit
                           99.2 in the Companies' Form 8-K dated August 29,
                           1997.

                  10.4     Amendment to Standstill Agreement dated November 13,
                           1997.

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

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

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

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

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

                  99.4     New Valley Holdings, Inc.'s Interim Consolidated
                           Financial Statements for the quarterly period ended
                           September 30, 1997.
</TABLE>


                                      -38-
<PAGE>   40

           (b)    Reports on Form 8-K

                  During the third quarter of 1997, the Companies filed current
                  reports on Form 8-K, dated July 31, 1997 and August 29, 1997,
                  concerning Items 5 and 7 (no financial statements were
                  included therewith).



                                       39
<PAGE>   41


                                   SIGNATURES





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





                                              BROOKE GROUP LTD.
                                              (REGISTRANT)

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

Date:  November 17, 1997




                                              BGLS INC.
                                              (REGISTRANT)

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

Date:  November 17, 1997


                                       40