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


                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                    FORM 10-Q


          JOINT QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934
                  FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998


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

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

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


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


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


                                   ----------



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

         At August 14, 1998 Brooke Group Ltd. had 20,473,730 shares of common
stock outstanding, and BGLS Inc. had 100 shares of common stock outstanding, all
of which are held by Brooke Group Ltd.




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





<PAGE>   2



                               BROOKE GROUP LTD.
                                    BGLS INC.

                                    FORM 10-Q

                                TABLE OF CONTENTS


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

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

   Brooke Group Ltd. Consolidated Balance Sheets as of June 30, 1998 and
         December 31, 1997.............................................................................   2

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

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

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

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

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

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

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

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

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

PART II. OTHER INFORMATION

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

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

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

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

SIGNATURES.............................................................................................  49


</TABLE>



                                      -1-
<PAGE>   3



Item 1.  CONSOLIDATED FINANCIAL STATEMENTS

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

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

Current assets:
  Cash and cash equivalents ........................................................      $  11,376       $   4,754
  Accounts receivable - trade ......................................................         13,485          10,462
  Other receivables ................................................................          1,391           1,239
  Receivables from affiliates ......................................................          2,147           1,978
  Inventories ......................................................................         45,704          39,312
  Other current assets .............................................................          5,467          10,240
                                                                                          ---------       ---------
    Total current assets ...........................................................         79,570          67,985

Property, plant and equipment, at cost, less accumulated
  depreciation of $32,501 and $33,187 ..............................................         53,744          45,943
Intangible assets, at cost, less accumulated amortization
  of $19,845 and $19,302 ...........................................................            750           2,610
Other assets .......................................................................         11,109           9,922
                                                                                          ---------       ---------
    Total assets ...................................................................      $ 145,173       $ 126,460
                                                                                          =========       =========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt ..............................      $ 177,547       $   6,429
  Accounts payable .................................................................         16,239          10,461
  Due to affiliates ................................................................          3,921           1,226
  Cash overdraft ...................................................................                            945
  Accrued promotional expenses .....................................................         22,891          26,993
  Accrued taxes payable ............................................................         19,345          19,998
  Accrued interest .................................................................         24,042          39,782
  Other accrued liabilities ........................................................         27,718          34,670
                                                                                          ---------       ---------
    Total current liabilities ......................................................        291,704         140,504

Notes payable, long-term debt and other obligations, less current portion ..........        228,184         399,835
Noncurrent employee benefits .......................................................         26,363          29,366
Other liabilities ..................................................................         69,874          45,152

Commitments and contingencies

Stockholders' equity (deficit):
  Preferred Stock, par value $1.00 per share, authorized
    10,000,000 shares...............................................................
  Series G Preferred Stock, 2,184,834 shares, convertible, participating,
    cumulative, each share convertible to 1,000 shares of common stock and cash
    or stock distribution, liquidation preference of $1.00 per share................    
  Common stock, par value $0.10 per share, authorized 40,000,000 shares, issued
    26,498,043 shares, outstanding 20,454,230
    and 18,497,096 shares ..........................................................          2,046           1,850
  Additional paid-in capital .......................................................        122,957          88,290
  Deficit ..........................................................................       (570,997)       (538,791)
  Other ............................................................................          6,659          (5,607)
  Less:  6,043,813 and 6,900,947 shares of common
    stock in treasury, at cost .....................................................        (31,146)        (34,139)
                                                                                          ---------       ---------

      Total stockholders' equity (deficit) .........................................       (470,952)       (488,397)
                                                                                          ---------       ---------

      Total liabilities and stockholders' equity (deficit) .........................      $ 145,173       $ 126,460
                                                                                          =========       =========


</TABLE>

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


                                      -2-
<PAGE>   4


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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


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

Current assets:
  Cash and cash equivalents ..................................................      $  11,376       $   4,754
  Accounts receivable - trade ................................................         13,485          10,462
  Other receivables ..........................................................          1,347           1,191
  Receivables from affiliates ................................................                          1,603
  Inventories ................................................................         45,704          39,312
  Other current assets .......................................................          5,491          10,044
                                                                                    ---------       ---------
      Total current assets ...................................................         77,403          67,366

Property, plant and equipment, at cost, less accumulated depreciation of
  $32,002 and $32,760 ........................................................         53,621          45,775

Intangible assets, at cost, less accumulated amortization of $19,845                      
  and $19,302.................................................................            750
Investment in affiliate ......................................................                          2,610
Other assets .................................................................         12,656          13,165
                                                                                    ---------       ---------
      Total assets ...........................................................      $ 144,430       $ 128,916
                                                                                    =========       =========

LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT):

Current liabilities:
  Notes payable and current portion of long-term debt ........................      $ 177,547       $   6,212
  Accounts payable ...........................................................         16,096          10,336
  Cash overdraft .............................................................                            891
  Due to parent ..............................................................         33,250          22,951
  Accrued promotional expenses ...............................................         22,891          26,993
  Accrued taxes payable ......................................................         19,343          19,998
  Accrued interest ...........................................................         24,042          39,782
  Other accrued liabilities ..................................................         27,193          34,312
                                                                                    ---------       ---------
      Total current liabilities ..............................................        320,362         161,475

Notes payable, long-term debt and other obligations, less current portion ....        228,184         399,835
Noncurrent employee benefits .................................................         26,363          29,366
Other liabilities ............................................................         75,625          51,355

Commitments and contingencies

Stockholder's equity (deficit):
  Common stock, par value $0.01 per share; 100 shares authorized,
    issued and outstanding....................................................
  Additional paid-in capital .................................................         67,597          39,081
  Deficit ....................................................................       (583,293)       (550,339)
  Other ......................................................................          9,592          (1,857)
                                                                                    ---------       ---------
      Total stockholder's deficit ............................................       (506,104)       (513,115)
                                                                                    ---------       ---------

      Total liabilities and stockholder's equity (deficit) ...................      $ 144,430       $ 128,916
                                                                                    =========       =========

</TABLE>

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



                                      -3-
<PAGE>   5


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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


<TABLE>
<CAPTION>
                                                             -------------------------------     -------------------------------
                                                                     Three Months Ended                   Six Months Ended  
                                                             -------------------------------     -------------------------------
                                                               June 30,           June 30,         June 30,           June 30,
                                                                 1998               1997             1998               1997
                                                             ------------       ------------     ------------       ------------
<S>                                                          <C>                <C>              <C>                <C>         
Revenues* .................................................. $    111,262       $     96,593     $    196,065       $    176,598
Cost of goods sold* ........................................       51,680             50,951           93,336             92,796
                                                             ------------       ------------     ------------       ------------

Gross profit ...............................................       59,582             45,642          102,729             83,802
Operating, selling, administrative and general expenses ....       46,643             39,715           82,126             77,037
                                                             ------------       ------------     ------------       ------------

Operating income ...........................................       12,939              5,927           20,603              6,765

Other income (expenses):
    Interest income ........................................          185                692              250              1,251
    Interest expense .......................................      (19,637)           (15,499)         (40,423)           (30,966)
    Equity in loss of affiliate ............................       (7,261)            (6,157)         (11,448)           (14,351)
    Sale of assets .........................................          468              1,065            1,318             23,086
    Retirement of debt .....................................                                                               2,963
    Proceeds from legal settlement .........................                                                               4,125
    Other, net .............................................       (1,079)                61             (998)               180
                                                             ------------       ------------     ------------       ------------

Loss before income taxes ...................................      (14,385)           (13,911)         (30,698)            (6,947)
Provision for income taxes .................................          381                 45            1,312                789
                                                             ------------       ------------     ------------       ------------

Net loss ................................................... $    (14,766)      $    (13,956)    $    (32,010)      $     (7,736)
                                                             ============       ============     ============       ============


Basic and diluted common share data:

    Net loss applicable to common shares ................... $      (0.72)      $      (0.77)    $      (1.60)      $      (0.42)
                                                             ============       ============     ============       ============

Weighted average common shares outstanding .................   20,444,353         18,097,096       19,957,412         18,240,743
                                                             ============       ============     ============       ============


</TABLE>

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

* Revenues and Cost of goods sold include excise taxes of $22,427, $22,103,
  $40,345 and $41,237, respectively.


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


                                      -4-

<PAGE>   6


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


<TABLE>
<CAPTION>
                                                                  -------------------------       -------------------------
                                                                      Three Months Ended               Six Months Ended
                                                                  -------------------------       -------------------------
                                                                   June 30,        June 30,        June 30,        June 30,
                                                                     1998            1997            1998            1997
                                                                  ---------       ---------       ---------       ---------
<S>                                                               <C>             <C>             <C>             <C>      
Revenues* ..................................................      $ 111,262       $  96,593       $ 196,065       $ 176,598
Cost of goods sold* ........................................         51,680          50,951          93,336          92,796
                                                                  ---------       ---------       ---------       ---------

Gross profit ...............................................         59,582          45,642         102,729          83,802
Operating, selling, administrative and general expenses ....         45,426          39,581          80,797          76,657
                                                                  ---------       ---------       ---------       ---------

Operating income ...........................................         14,156           6,061          21,932           7,145

Other income (expenses):
   Interest income .........................................             63             680             119           1,239
   Interest expense ........................................        (20,738)        (16,411)        (42,562)        (32,792)
   Equity in loss of affiliate .............................         (7,261)         (6,157)        (11,448)        (14,351)
   Sale of assets ..........................................            468           1,279           1,318          27,663
   Retirement of debt ......................................                                                          2,963
   Other, net ..............................................         (1,079)             61          (1,001)            173
                                                                  ---------       ---------       ---------       ---------

Loss before income taxes ...................................        (14,391)        (14,487)        (31,642)         (7,960)
Provision for income taxes .................................            381              45           1,312             787
                                                                  ---------       ---------       ---------       ---------

Net loss ...................................................      $ (14,772)      $ (14,532)      $ (32,954)      $  (8,747)
                                                                  =========       =========       =========       =========

</TABLE>

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

* Revenues and Cost of goods sold include excise taxes of $22,427, $22,103,
  $40,345 and $41,237, respectively.


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


                                      -5-
<PAGE>   7



Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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




<TABLE>
<CAPTION>
                                                                                                          Accumulated   
                           Common Stock           Additional                                                 Other
                     -------------------------     Paid-In                     Treasury                  Comprehensive
                       Shares        Amount        Capital       Deficit        Stock          Other         Income        Total
                     ----------    -----------   -----------   -----------   ------------  ------------- -------------- -----------
<S>                  <C>          <C>           <C>           <C>            <C>            <C>           <C>           <C>
Balance, December    
 31, 1997 ........   18,097,096   $     1,850   $    88,290   $  (538,791)   $   (34,139)   $    (8,337)  $    (2,730)  $  (488,397)
Net loss..........                                                (32,010)                                                  (32,010)

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

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

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

Issuance of
 treasury stock ..      857,134            46          (449)         (196)         1,330                                        731

Distributions on
 common stock
 ($0.15 per
 share) ..........                                   (3,055)                                                                 (3,055)

Amortization of
 deferred
 compensation ....                                    1,495                                         817                       2,312

Unrealized holding
 gain on
 investment in
 New Valley ......                                                                                             12,432        12,432

Effect of New 
 Valley capital 
 transactions .....                                                                                              (983)         (983)
                     ----------   -----------   -----------   -----------    -----------    -----------   -----------   -----------
Balance, June 30,
 1998 .............  20,454,230   $     2,046   $   122,957   $  (570,997)   $   (31,146)   $    (7,520)  $    14,179   $  (470,952)
                     ==========   ===========   ===========   ============   ===========    ===========   ===========   ===========

</TABLE>


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



                                      -6-
<PAGE>   8



Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


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


<TABLE>
<CAPTION>
                                                                                                    Accumulated          
                                         Common Stock       Additional                                 Other
                                    ----------------------    Paid-In                              Comprehensive
                                      Shares      Amount      Capital       Deficit       Other        Income        Total
                                    ---------    ---------   ----------    ---------    --------    -------------   ---------
<S>                                    <C>          <C>       <C>          <C>           <C>         <C>           <C>       
Balance, December 31, 1997 ........    100       $      --    $  39,081    $(550,339)    $   1,013   $  (2,870)    $(513,115)

Net loss ..........................                                          (32,954)                                (32,954)

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

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

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

Amortization of deferred
 compensation .....................                               1,122                                                1,122

Unrealized holding gain on 
 investment In New Valley .........                                                                     12,432        12,432

Effect of New Valley capital
 transactions .....................                                                                       (983)         (983)
                                       ---       ---------    ---------    ---------     ---------   ---------     ---------

Balance, June 30, 1998 ............    100       $      --    $  67,597    $(583,293)    $   1,013   $   8,579     $(506,104)
                                       ===       =========    =========    =========     =========   =========     =========


</TABLE>





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



                                      -7-



<PAGE>   9


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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


<TABLE>
<CAPTION>
                                                                            Six Months Ended
                                                                       -------------------------
                                                                        June 30,        June 30,
                                                                          1998            1997
                                                                       ---------       ---------
<S>                                                                    <C>             <C>       
Net cash used in operating activities ...........................      $ (17,409)      $ (20,003)
                                                                       ---------       ---------

Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net ..............          1,686          43,245
  Capital expenditures ..........................................         (7,138)         (3,653)
                                                                       ---------       ---------

Net cash (used in) provided by investing activities .............         (5,452)         39,592
                                                                       ---------       ---------

Cash flows from financing activities:
  Proceeds from debt ............................................                            475
  Repayments of debt ............................................         (1,068)         (6,197)
  Borrowings under revolver .....................................        133,671         140,812
  Repayments on revolver ........................................       (129,464)       (132,963)
  Decrease in cash overdraft ....................................           (824)             (6)
  Distributions on common stock .................................         (3,055)         (4,102)
  Proceeds from participating loan ..............................         20,000
  Issuance of common stock ......................................         10,144
                                                                       ---------       ---------

Net cash provided by (used in) financing activities .............         29,404          (1,981)
                                                                       ---------       ---------

Effect of exchange rate changes on cash and cash equivalents ....             84
Net increase in cash and cash equivalents .......................          6,627          17,608
Cash and cash equivalents, beginning of period ..................          4,749           1,941
                                                                       ---------       ---------

Cash and cash equivalents, end of period ........................      $  11,376       $  19,549
                                                                       =========       =========



Supplemental non-cash financing activities:

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


</TABLE>


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



                                      -8-




<PAGE>   10


Item 1.  CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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



<TABLE>
<CAPTION>
                                                                            Six Months Ended
                                                                       -------------------------
                                                                        June 30,        June 30,
                                                                          1998            1997
                                                                       ---------       ---------
<S>                                                                    <C>             <C>       
Net cash used in operating activities ...........................      $ (10,298)      $ (25,202)
                                                                       ---------       ---------

Cash flows from investing activities:
  Proceeds from sale of businesses and assets, net ..............          1,686          43,245
  Capital expenditures ..........................................         (7,138)         (3,653)
                                                                       ---------       ---------

Net cash (used in) provided by investing activities .............         (5,452)         39,592
                                                                       ---------       ---------

Cash flows from financing activities:
  Proceeds from debt ............................................                          3,750
  Repayments of debt ............................................         (1,023)         (4,900)
  Borrowings under revolver .....................................        133,671         140,812
  Repayments on revolver ........................................       (129,464)       (132,963)
  Decrease in cash overdraft ....................................           (891)             (6)
  Proceeds from participating loan ..............................         20,000
                                                                       ---------       ---------

Net cash provided by financing activities .......................         22,293           2,943
                                                                       ---------       ---------

Effect of exchange rate changes on cash and cash equivalents ....             84
Net increase in cash and cash equivalents .......................          6,627          17,333
Cash and cash equivalents, beginning of period ..................          4,749           1,940
                                                                       ---------       ---------

Cash and cash equivalents, end of period ........................      $  11,376       $  19,273
                                                                       =========       =========

Supplemental non-cash financing activities:

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



</TABLE>



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



                                      -9-



<PAGE>   11



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


1.    PRINCIPLES OF REPORTING

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

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

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

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

      LIQUIDITY:

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

      On January 30, 1998, Liggett obtained the consents of the required
      majority of the holders of Liggett's 11.50% Series B and 19.75% Series C
      Senior Secured Notes due 1999 (the "Liggett Notes") to various amendments
      to the Indenture governing the Liggett Notes. The amendments provided,
      among other things, for a deferral of the February 1, 1998 mandatory
      redemption of $37,500 principal amount of the Liggett Notes to the date of
      final maturity, February 1, 1999. (Refer to Note 6.) At maturity, the
      Liggett Notes will require a principal payment of $144,891. Liggett does
      not anticipate it will be able to generate sufficient cash from operations
      to make such payments. In addition, Liggett has a $40,000 revolving credit
      facility expiring March 8, 1999 (the "Facility"), under which $22,678 was
      outstanding at June 30, 1998. Accordingly, the Liggett Notes and the
      balance of the Facility have been reclassified to current liabilities. As
      of June 30, 1998, Liggett had net capital and working 


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




      capital deficiencies of $188,372 and $176,784, respectively. The current
      maturities of the Liggett Notes and the Facility of approximately $167,500
      contribute substantially to the working capital deficiency. If Liggett is
      unable to refinance or restructure the terms of the Liggett Notes or
      otherwise make all payments thereon, substantially all of the Liggett
      Notes and the Facility would be in default. In such event, Liggett may be
      forced to seek protection from creditors under applicable laws. Due to the
      many risks and uncertainties associated with the cigarette industry and
      the impact of tobacco litigation, there can be no assurance that Liggett
      will be able to meet its future earnings or cash flow goals. These matters
      raise substantial doubt about Liggett meeting its liquidity needs and its
      ability to continue as a going concern and may negatively impact the
      Company's liquidity.

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

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

      NET LOSS PER SHARE

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

      NEW ACCOUNTING PRONOUNCEMENTS

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

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

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



                                      -11-
<PAGE>   13

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



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


2.    INVESTMENT IN NEW VALLEY CORPORATION

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

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

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

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

<TABLE>
<CAPTION>
                                                                                       
                                           NUMBER OF         FAIR          CARRYING    
                                             SHARES          VALUE           AMOUNT    
                                           ----------      ---------       --------    
<S>                                           <C>          <C>             <C>         
         Class A Preferred Shares ....        618,326      $  39,035       $  39,035   
         Class B Preferred Shares ....        250,885            597             597   
         Common Shares ...............      3,989,710          1,995         (39,632)
                                                           ---------       ---------    
                                                           $  41,627       $           
                                                           =========       =========   

</TABLE>



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


                                      -12-

<PAGE>   14

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



      the Common Shares and other equity interests were reinstated and retained
      all of their legal, equitable and contractual rights.

      The Class A Preferred Shares of New Valley are required to be redeemed on
      January 1, 2003 for $100.00 per share plus dividends accrued to the
      redemption date. The shares are redeemable, at any time, at the option of
      New Valley, at $100.00 per share plus accrued dividends. The holders of
      Class A Preferred Shares are entitled to receive a quarterly dividend, as
      declared by the Board of Directors, payable at the rate of $19.00 per
      annum. At June 30, 1998, the accrued and unpaid dividends arrearage was
      $189,729 ($177.07 per share).

      Holders of the Class B Preferred Shares are entitled to receive a
      quarterly dividend, as declared by the Board, at a rate of $3.00 per
      annum. At June 30, 1998, the accrued and unpaid dividends arrearage was
      $152,166 ($54.52 per share). No dividends on the Class B Preferred Shares
      have been declared since the fourth quarter of 1988.

      Summarized financial information for New Valley as of June 30, 1998 and
      December 31, 1997 and for the three and six months ended June 30, 1998 and
      1997 follows:


<TABLE>
<CAPTION>
                                                                 June 30,       December 31,
                                                                   1998             1997
                                                                 ---------      ------------
<S>                                                              <C>             <C>      
         Current assets, primarily cash and marketable
            securities ....................................      $  90,522       $ 118,642
         Non-current assets ...............................        296,950         322,749
         Current liabilities ..............................        101,935         128,128
         Non-current liabilities ..........................        169,409         185,024
         Redeemable preferred stock .......................        285,932         258,638
         Shareholders' deficit ............................       (169,804)       (130,399)

</TABLE>


<TABLE>
<CAPTION>
                                                 ----------------------------  ----------------------------
                                                      Three Months Ended              Six Months Ended
                                                 ----------------------------  ----------------------------
                                                 June 30, 1998  June 30, 1997  June 30, 1998  June 30, 1997
                                                 -------------  -------------  -------------  -------------
<S>                                                <C>            <C>            <C>            <C>     
Revenues ....................................      $ 25,272       $ 27,095       $ 59,112       $ 49,948
Costs and expenses ..........................        32,709         32,634         66,969         66,238
Loss from continuing operations .............        (6,876)        (5,029)        (6,719)       (15,370)
Income from discontinued operations .........           880                           880
Net loss applicable to common shares(A) .....       (25,754)       (21,779)       (44,429)       (48,100)

</TABLE>


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

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

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


                                      -13-

<PAGE>   15

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



      investment in Western Realty Repin discussed below. Through June 30, 1998,
      Apollo had funded $27,900 of its investment in Western Realty Ducat.

      The ownership and voting interests in Western Realty Ducat will be held
      equally by Apollo and New Valley. Apollo will be entitled to a preference
      on distributions of cash from Western Realty Ducat to the extent of its
      investment ($40,000), together with a 15% annual rate of return, and New
      Valley will then be entitled to a return of $10,000 of BML-related
      expenses incurred by New Valley since March 1, 1997, together with a 15%
      annual rate of return; subsequent distributions will be made 70% to New
      Valley and 30% to Apollo. Western Realty Ducat will be managed by a Board
      of Managers consisting of an equal number of representatives chosen by
      Apollo and New Valley. All material corporate transactions by Western
      Realty Ducat will generally require the unanimous consent of the Board of
      Managers. Accordingly, New Valley has accounted for its non-controlling
      interest in Western Realty Ducat using the equity method of accounting.

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

      Western Realty Ducat will seek to make additional real estate and other
      investments in Russia. Western Realty Ducat has made a $20,000
      participating loan to, and payable out of a 30% profits interest in, a
      company organized by BOL which, among other things, acquired an interest
      in a new factory being constructed on the outskirts of Moscow by a
      subsidiary of BOL. (Refer to Note 3.)

      In June 1998, New Valley and Apollo organized Western Realty Repin LLC
      ("Western Realty Repin") to make a $25,000 participating loan (the "Repin
      Loan") to BML. The proceeds of the loan will be used by BML for the
      acquisition and preliminary development of two adjoining sites totaling
      10.25 acres (the "Kremlin Sites") located in Moscow across the Moscow
      River from the Kremlin. BML, which is planning the development of a 1.1
      million sq. ft. hotel, office, retail and residential complex on the
      Kremlin Sites, owned 92.8% of one site and 52% of the other site at June
      30, 1998. Apollo will be entitled to a preference on distributions of cash
      from Western Realty Repin to the extent of its investment ($18,750)
      together with a 20% annual rate of return, and New Valley will then be
      entitled to a return of its investment ($6,250), together with a 20%
      annual rate of return; subsequent distributions will be made 50% to New
      Valley and 50% to Apollo. Western Realty Repin will be managed by a Board
      of Managers consisting of an equal number of representatives chosen by
      Apollo and New Valley. All material corporate transactions by Western
      Realty Repin will generally require the unanimous consent of the Board of
      Managers.

      On June 18, 1998, Western Realty Repin made a $9,000 first advance (funded
      by Apollo) under the Repin Loan to BML. The Repin Loan, which bears no
      fixed interest, is payable only out of 100% of the distributions, if made,
      by the entities owning the Kremlin Sites to BML. Such distributions shall
      be applied first to pay the principal of the Repin Loan and then as
      contingent participating interest on the Repin Loan. Any rights of payment
      on the Repin Loan are subordinate to the rights of all other creditors of
      BML. Apollo funded an additional advance of $5,300 under the Repin Loan on
      July 2, 1998. BML used the proceeds to repay New Valley for certain
      expenditures on the Kremlin Sites previously incurred. The Repin Loan is
      due and payable upon the dissolution of BML and is collateralized by a
      pledge of New Valley's shares of BML.



                                      -14-

<PAGE>   16

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


      As of June 30, 1998, BML had invested $14,423 in the Kremlin sites and
      held $4,165, in cash, which was restricted for future investment. In
      connection with the acquisition of its interest in one of the Kremlin
      Sites, BML has agreed with the City of Moscow to invest an additional
      $6,000 in 1998 and $22,000 in 1999 in the development of the property.


3.    INVESTMENT IN BROOKE (OVERSEAS) LTD.

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

      Liggett-Ducat is in the process of constructing a new cigarette factory on
      the outskirts of Moscow which is currently scheduled to be operational in
      early 1999. Liggett-Ducat has entered into a construction contract for the
      plant. The remaining liability under that contract, as amended, at June
      30, 1998 is approximately $16,000. Equipment purchase agreements in place
      at June 30, 1998 total $34,355, of which $28,791 is being financed by the
      manufacturers.

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

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

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


                                      -15-

<PAGE>   17


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


4.    INVENTORIES

      Inventories consist of:

                                                  June 30,     December 31,
                                                    1998           1997
                                                  --------     ------------

         Finished goods ....................      $ 13,080       $ 13,273
         Work-in-process ...................         2,617          1,976
         Raw materials .....................        28,356         24,495
         Replacement parts and supplies ....         4,972          4,466
                                                  --------       --------
         Inventories at current cost .......        49,025         44,210
         LIFO adjustments ..................        (3,321)        (4,898)
                                                  --------       --------
                                                  $ 45,704       $ 39,312
                                                  ========       ========

           At June 30, 1998, Liggett and Liggett-Ducat had leaf tobacco purchase
      commitments of approximately $7,311 and $11,835, respectively.


5.    PROPERTY, PLANT AND EQUIPMENT

      Property, plant and equipment consist of:

                                                  June 30,     December 31,
                                                    1998           1997
                                                  --------     ------------

         Land and improvements .............      $    411       $    411
         Buildings .........................         6,308          6,521
         Machinery and equipment ...........        55,582         53,717
         Leasehold improvements ............           302            302
         Construction-in-progress ..........        23,642         18,179
                                                  --------       --------
                                                    86,245         79,130
         Less accumulated depreciation .....       (32,501)       (33,187)
                                                  --------       --------
                                                  $ 53,744       $ 45,943
                                                  ========       ========



                                      -16-

<PAGE>   18

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



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

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

<TABLE>
<CAPTION>
                                                                              June 30,    December 31,
                                                                                1998          1997
                                                                              --------    ------------
<S>                                                                            <C>             <C>  
         15.75% Series B Senior Secured Notes due 2001,
             net of unamortized discount of $21,102 and $1,511 .........      $211,762      $231,723
         Deferred interest on 15.75% Series B Senior Secured
             Notes due 2001 ............................................        16,422
         14.500% Subordinated Debentures due 1998 ......................                         800
         Notes payable - Foreign .......................................         9,995         5,000
         Other .........................................................            94           629

         Liggett:
         11.500% Senior Secured Series B Notes due 1999, net of
             unamortized discount of $111 and $206 .....................       112,501       112,406
         Variable Rate Series C Senior Secured Notes due 1999 ..........        32,279        32,279
         Revolving credit facility .....................................        22,678        23,427
                                                                              --------      --------

         Total notes payable, long-term debt and other obligations .....       405,731       406,264

         Less:
             Current maturities ........................................       177,547         6,429
                                                                              --------      --------

         Amount due after one year .....................................      $228,184      $399,835
                                                                              ========      ========

</TABLE>

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

      STANDSTILL AGREEMENT - BGLS:

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

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

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


                                      -17-
<PAGE>   19

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



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

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

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

      In connection with the consents of the Liggett bondholders to the
      restructuring of the Liggett Notes, on February 2, 1998, the Company
      issued 483,002 shares of treasury stock to the Liggett bondholders of
      record as of January 15, 1998. (Refer to Note 7.) The Company recorded a
      deferred charge of $4,105 during the first quarter of 1998 reflecting the 
      fair value of the instruments issued.

      15.75% SERIES B SENIOR SECURED NOTES DUE 2001

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

      LIGGETT 11.50% SENIOR SECURED SERIES B NOTES DUE 1999:

      On February 14, 1992, Liggett issued $150,000 in Senior Secured Notes (the
      "Liggett Series B Notes"). Interest on the Liggett Series B Notes is
      payable semiannually on February 1 and August 1 at an annual rate of
      11.50%. The Liggett Series B Notes and Series C Notes referred to below



                                      -18-
<PAGE>   20

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


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

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

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

      LIGGETT SERIES C VARIABLE RATE NOTES:

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

      REVOLVING CREDIT FACILITY - LIGGETT:

      On March 8, 1994, Liggett entered into the Facility for $40,000 with a
      syndicate of commercial lenders. The Facility is collateralized by all
      inventories and receivables of Liggett. At June 30, 1998, $5,946 was
      available under the Facility based on eligible collateral. Borrowings
      under the Facility, whose interest is calculated at a rate equal to 1.5%
      above the Philadelphia National Bank's prime rate, bear a rate of 10.0% at
      June 30, 1998. The Facility requires Liggett's compliance with certain
      financial and other covenants, including restrictions on the payment of
      cash dividends and distributions by Liggett. In addition, the Facility, as
      amended April 8, 1998, imposes requirements with respect to Liggett's
      permitted maximum adjusted net worth (not to fall below a deficit of
      $195,000 as computed in accordance with the agreement, this computation
      was $185,051 at June 30, 1998) and net working capital deficiencies (not
      to fall below a deficit of $17,000 as computed in accordance with the
      agreement, this computation was $6,005 at June 30, 1998). The Facility, as
      amended, also 


                                      -19-

<PAGE>   21

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


      provides that a default by Liggett or its subsidiaries under the March
      1996 Settlements, March 1997 Settlements and March 1998 Settlements (all
      as defined below in Note 8) shall constitute an event of default under the
      Facility. In November 1997, the Facility was extended for an additional
      year until March 8, 1999.

      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 June 30, 1998, this amount is classified in other
      assets on the consolidated balance sheet.

      FOREIGN LOANS:

      At June 30, 1998, Liggett-Ducat had two credit facilities outstanding, one
      for $2,000 with an interest rate of 27% which expires August 20, 1998 and
      another for $10,000 with an interest rate of 21% which expires in May of
      1999.

7.    EQUITY

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

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

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

      On March 12, 1998, the Company granted an option for 1,250,000 shares of
      the Company's common stock to a law firm that represents the Company and
      Liggett. On May 1, 1998 and April 1, 1999, options for 250,000 and
      1,000,000 shares, respectively, of common stock are exercisable at $17.50
      per share. The option expires on March 31, 2003. The fair value of the
      equity instruments was estimated based on the Black-Sholes option pricing
      model and the following assumptions: volatility 77.6%, risk-free interest
      rate of 5.47%, expected life of two years and dividend rate of 0%. The
      Company will recognize expense of $3,063 over the vesting period including
      $1,495 in the second quarter of 1998.

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

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


                                      -20-

<PAGE>   22

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



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


8.    CONTINGENCIES

      TOBACCO-RELATED LITIGATION:

      OVERVIEW. Since 1954, Liggett and other United States cigarette
      manufacturers have been named as defendants in numerous direct and
      third-party actions predicated on the theory that cigarette manufacturers
      should be liable for damages from cancer and other adverse health effects
      alleged to have been caused by cigarette smoking or by exposure to
      secondary smoke (environmental tobacco smoke, "ETS") from cigarettes.
      These cases are reported hereinafter as though having been commenced
      against Liggett (without regard to whether such cases were actually
      commenced against the Company or Liggett). There has been a noteworthy
      increase in the number of cases commenced against Liggett and the other
      cigarette manufacturers. The cases generally fall into four categories:
      (i) smoking and health cases alleging personal injury brought on behalf of
      individual smokers ("Individual Actions"); (ii) smoking and health cases
      alleging personal injury and purporting to be brought on behalf of a class
      of plaintiffs ("Class Actions"); (iii) health care cost recovery actions
      brought by state and local governments ("Attorney General Actions"); and
      (iv) health care cost recovery actions brought by third-party payors
      including asbestos manufacturers, unions and taxpayers ("Third-Party Payor
      Actions"). As new cases are commenced, defense costs and the risks
      attendant to the inherent unpredictability of litigation continue to
      increase. Liggett had been receiving assistance from others in the
      industry in defraying the costs and other burdens incurred in the defense
      of smoking and health litigation and related proceedings, which, for the
      most part, consisted of the payment of counsel fees and costs, but this
      assistance terminated in 1997. The future financial impact on the Company
      of the termination of this assistance and the effects of the tobacco
      litigation settlements discussed below is not quantifiable at this time.
      For the six months ended June 30, 1998, Liggett incurred counsel fees and
      costs totaling approximately $2,562, compared to $2,152 for the comparable
      prior year period.

      In June 1992, in an action entitled CIPOLLONE V. LIGGETT GROUP INC., ET
      AL., the United States Supreme Court issued an opinion concluding that The
      Federal Cigarette Labeling and Advertising Act did not preempt state
      common law damage claims but that The Public Health Cigarette Smoking Act
      of 1969 (the "1969 Act") did preempt certain, but not all, state common
      law damage claims. The decision bars plaintiffs from asserting claims
      that, after the effective date of the 1969 Act, the tobacco companies
      either failed to warn adequately of the claimed health risks of cigarette
      smoking or sought to neutralize those claimed risks in their advertising
      or promotion of cigarettes. Bills have been 


                                      -21-
<PAGE>   23


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


      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 June 30, 1998, there were approximately 245
      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, 95 were
      pending in the State of Florida, 84 in the State of New York and 20 in the
      State of Texas. The balance of individual cases was pending in 16 states.
      There are three individual cases pending where Liggett is the only named
      defendant.

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

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

      CLASS ACTIONS. As of June 30, 1998, there were approximately 40 actions
      pending, for which either a class has been certified or plaintiffs are
      seeking class certification, where Liggett, among others, was a named
      defendant. Two of these cases, FLETCHER, ET AL. V. BROOKE GROUP LTD., ET
      AL. and WALKER, ET AL. V. LIGGETT GROUP INC., ET AL., have been settled by
      the Company, subject to court approval. These two settlements are more
      fully discussed below under the "Settlements" section.

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

      In March 1994, an action entitled CASTANO, ET AL. V. THE AMERICAN TOBACCO
      COMPANY INC., ET AL., United States District Court, Eastern District of
      Louisiana, was filed against Liggett and others. The class action
      complaint sought relief for a nationwide class of smokers based on their
      alleged



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


      addiction to nicotine. In February 1995, the District Court granted
      plaintiffs' motion for class certification (the "Class Certification
      Order").

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

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

      ATTORNEY GENERAL ACTIONS. As of June 30, 1998, 40 Attorney General Actions
      were filed against Liggett and the Company. As more fully discussed below,
      Liggett and the Company have settled 36 of these actions. In addition, the
      Company and Liggett have reached settlements with nine Attorneys General
      representing states, commonwealths or territories that have not commenced
      litigation against the Company or Liggett. In these proceedings, state and
      local government entities seek reimbursement for Medicaid and other health
      care expenditures allegedly caused by use of tobacco products. The claims
      asserted in these health care cost recovery actions vary. In most of these
      cases, plaintiffs assert the equitable claim that the tobacco industry was
      "unjustly enriched" by plaintiffs' payment of health care costs allegedly
      attributable to smoking and seek reimbursement of those costs. Other
      claims made by some but not all plaintiffs include the equitable claim of
      indemnity, common law claims of negligence, strict liability, breach of
      express and implied warranty, violation of a voluntary undertaking or
      special duty, fraud, negligent misrepresentation, conspiracy, public
      nuisance, claims under state and federal statutes governing consumer
      fraud, antitrust, deceptive trade practices and false advertising, and
      claims under RICO.

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


                                      -23-

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


      dollars in damages. The lawsuits allege conspiracy, fraud,
      misrepresentation, and violation of federal racketeering and anti-trust
      laws as well as other claims.

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

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

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


                                      -24-
<PAGE>   26

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


      fails to consummate a merger or other similar transaction with another
      defendant in the lawsuits within three years from the date of the March
      1996 Settlement.

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

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

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

      The states, commonwealths and territories where settlements have been
      reached with Attorneys General are: Alaska, Arizona, Arkansas, California,
      Colorado, Connecticut, District of Columbia, Florida, Georgia, Guam,
      Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Louisiana, Maine,
      Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri,
      Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, New
      York, North Dakota, Northern Mariana Islands, Ohio, Oklahoma, Oregon,
      Pennsylvania, Rhode Island, Texas, Utah, U.S. Virgin Islands, Washington,
      West Virginia, Wisconsin and Wyoming. Other states have either recently
      filed health care cost recovery actions or indicated intentions to do so.
      Both Liggett and the Company will endeavor to resolve those actions on
      substantially the same terms and conditions as the March 1998 Settlements,
      however, there can be no assurance that any such settlements will be
      completed.

      As mentioned above, in March 1997, Liggett, the Company and plaintiffs
      filed a mandatory class settlement agreement in an action entitled
      FLETCHER, ET AL. V. BROOKE GROUP LTD., ET AL., Circuit Court of Mobile
      County, Alabama, where the court granted preliminary approval and
      preliminary certification of the class, and in May 1997, a similar
      mandatory class settlement agreement was filed in an action entitled
      WALKER, ET AL. V. LIGGETT GROUP INC., ET AL., United States District
      Court, Southern District of West Virginia. On July 2, 1998, Liggett, the
      Company and plaintiffs filed an amended class action settlement agreement
      in FLETCHER. Pursuant to the amended agreement, Liggett is required to pay
      to


                                      -25-

<PAGE>   27

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


      the class 7.5% of Liggett's pre-tax income each year for 25 years, with a
      minimum annual payment guarantee of $1,000 over the term of the agreement.
      The amended agreement does not set forth a formula with respect to the
      distribution of settlement proceeds to the class. The Company anticipates
      that should the court in FLETCHER, after dissemination of notice to the
      class of the pending limited fund class action settlement and a full
      fairness hearing with respect thereto, issue a final order and judgment
      approving the settlement, such an order would preclude further prosecution
      by class members of tobacco-related claims against both Liggett and the
      Company. Under the Full Faith and Credit Act, a final judgment entered in
      a nationwide class action pending in a state court has a preclusive effect
      against any class member with respect to the claims settled and released.
      As the class definition in FLETCHER encompasses all persons in the United
      States who could claim injury as a result of cigarette smoking or ETS and
      any third-party payor claimants, it is anticipated that, upon final order
      and judgment, all such persons and third-party payor claimants would be
      barred from further prosecution of tobacco-related claims against Liggett
      and the Company.

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

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

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

      The AMCHEM decision's ultimate affect on the viability of both the WALKER
      and FLETCHER settlements remains uncertain given the Fifth Circuit's
      recent ruling reaffirming a limited fund class action settlement in IN RE
      ASBESTOS LITIGATION ("AHEARN"). In June 1997, the Supreme Court remanded
      AHEARN to the Fifth Circuit for consideration in light of AMCHEM. On
      remand, the Fifth Circuit made two decisive distinctions between AMCHEM
      and AHEARN. First, the AHEARN class action proceeded under Rule 23(b)(1)
      while AMCHEM was a Rule 23(b)(3) case, and second, in AHEARN, there was no


                                      -26-

<PAGE>   28

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


      allocation or difference in award, according to nature or severity of
      injury, as there was in AMCHEM. The Fifth Circuit concluded that all
      members of the class and all class representatives share common interests
      and none of the uncommon questions abounding in AMCHEM exist. On June 22,
      1998, the Supreme Court granted certiorari to review the Fifth Circuit
      decision.

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

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

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

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



                                      -27-
<PAGE>   29

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



      Pursuant to the March 1998 Settlements, Liggett is required to pay each of
      the settling states and territories their relative share (based on the
      Medicaid population of each state over the total Medicaid population of
      the United States) of between 27.5% and 30% of Liggett's pre-tax income
      each year for 25 years, with a minimum payment guarantee of $1,000 per
      state over the first nine years of the agreement. The aggregate payments
      required under the March 1996, March 1997 and March 1998 Settlements are
      $45,000. Of this amount, $3,389 has been paid as of June 30, 1998. The
      annual percentage is subject to increase, pro rata from 27.5% up to 30%,
      depending on the number of additional states joining the settlement.
      Pursuant to the "most favored nation" provisions under the March 1996
      Settlement and the March 1997 Settlements, each of the states settling
      under those settlements could benefit from the economic terms of the March
      1998 Settlements. In all settlements, Liggett agreed to phase-in
      compliance with certain proposed FDA regulations regarding smoking by
      children and adolescents, including a prohibition on the use of cartoon
      characters in tobacco advertising and limitations on the use of
      promotional materials and distribution of sample packages where minors are
      present. The March 1998 Settlements provide for additional restrictions
      and regulations on Liggett's advertising, including a prohibition on
      outdoor advertising and product advertising on the Internet and on
      payments for product placement in movies and television.

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

      The Company accrued approximately $4,000 for the present value of the
      fixed payments under the March 1996 Settlements and $18,301 for the
      present value of the fixed payments under the March 1998 Settlements. No
      additional amounts have been accrued because the Company cannot quantify
      the future costs of the settlements as the amounts Liggett must pay are
      based, in part, on future operating results. Possible future payments
      based on a percentage of pretax income, and other contingent payments
      based on the occurrence of a business combination, will be expensed when
      considered probable.

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

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

      TRIALS. On May 8, 1998, the other tobacco companies settled the litigation
      in Minnesota known as the STATE OF MINNESOTA BY HUBERT H. HUMPHREY, III,
      ITS ATTORNEY GENERAL AND BLUE CROSS AND BLUE SHIELD OF MINNESOTA V. PHILIP
      MORRIS INCORPORATED, ET AL. Liggett settled the claims of the State of
      Minnesota 


                                      -28-
<PAGE>   30

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


      on March 20, 1997 and on June 2, 1998 settled the claims of Blue Cross and
      Blue Shield of Minnesota. There are several other trial dates scheduled
      during 1998 for individual cases; however, trial dates are subject to
      change.

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

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

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

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

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

                                      -29

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



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

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

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

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


      LEGISLATION AND REGULATION:

      In January 1993, the United States Environmental Protection Agency ("EPA")
      released a report on the respiratory effect of ETS which concludes that
      ETS is a known human lung carcinogen in adults and in children, causes
      increased respiratory tract disease and middle ear disorders and increases
      the severity and frequency of asthma. In June 1993, the two largest of the
      major domestic cigarette 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. On July 17,
      1998, the court ruled that the EPA made procedural and scientific mistakes
      when it declared in its 1993 report that secondhand smoke caused as many
      as 3,000 cancer deaths a year among nonsmokers.

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

      In February 1996, the United States Trade representative issued an
      "advance notice of rule making" concerning how tobaccos imported under a
      previously established tobacco rate quota ("TRQ") should be allocated.
      Currently, tobacco imported under the TRQ is allocated on a "first-come,
      first-served" 


                                      -30-
<PAGE>   32

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


      basis, meaning that entry is allowed on an open basis to those first
      requesting entry in the quota year. Others in the cigarette industry have
      suggested an "end-user licensing" system under which the right to import
      tobacco under the quota would be initially assigned based on domestic
      market share. Such an approach, if adopted, could have a material adverse
      effect on the Company and Liggett.

      In August 1996, the FDA filed in the Federal Register a Final Rule (the
      "FDA Rule") classifying tobacco as a drug, asserting jurisdiction by the
      FDA over the manufacture and marketing of tobacco products and imposing
      restrictions on the sale, advertising and promotion of tobacco products.
      Litigation was commenced in the United States District Court for the
      Middle District of North Carolina challenging the legal authority of the
      FDA to assert such jurisdiction, as well as challenging the
      constitutionality of the rules. The court, after argument, granted
      plaintiffs' motion for summary judgment prohibiting the FDA from
      regulating or restricting the promotion and advertising of tobacco
      products and denied plaintiffs' motion for summary judgment on the issue
      of whether the FDA has the authority to regulate access to, and labeling
      of, tobacco products. The 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 Attorney General
      Actions settlements above.

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

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

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

      In a speech in September 1997, President Clinton called for federal
      legislation that, among other things, would raise cigarette prices by up
      to $1.50 per pack. Since then, several bills have been introduced in
      Congress, including bills modeled after the proposed resolution that
      purport to propose legislation along these lines. The White House,
      Congress, and various public interest groups are currently reviewing the
      proposed Resolution along with other proposed federal tobacco legislation.
      Management is unable to predict whether the proposed Resolution or other
      federal legislation will be enacted or the form any such 


                                      -31-
<PAGE>   33

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


      enactment might take. The present legislative and litigation environment
      is substantially uncertain and could have a material adverse effect on the
      business of the Company and Liggett.

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

      OTHER MATTERS:

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

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


9.    RELATED PARTY TRANSACTIONS

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

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


                                      -32-
<PAGE>   34

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




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
















                                      -33-
<PAGE>   35




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

                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


INTRODUCTION


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

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

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


RECENT DEVELOPMENTS

         THE COMPANY

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

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

         On February 6, 1998, the holder of 41.9% of the BGLS Notes, who had
previously been a party to the Standstill Agreement, was paid its pro-rata share
of the July 31, 1997 interest payment


                                      -34-
<PAGE>   36

on the BGLS Notes. On March 2, 1998, BGLS made the interest payment due on
January 31, 1998 to all holders of the BGLS Notes other than the Apollo Holders.

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

         LIGGETT

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

         NEW VALLEY

         WESTERN REALTY DUCAT. In February 1998, New Valley and Apollo Real
Estate Investment Fund III, L.P. ("Apollo") organized Western Realty Development
LLC ("Western Realty Ducat") to make real estate and other investments in
Russia. In connection with the formation of Western Realty Ducat, New Valley
agreed, among other things, to contribute the real estate assets of BrookeMil
Ltd. ("BML") to Western Realty Ducat and Apollo agreed to contribute up to
$58,750, including the investment in Western Realty Repin discussed below.
Western Realty Ducat will seek to make additional real estate and other
investments in Russia. Western Realty Ducat has made a $20,000 participating
loan to, and payable out of a 30% profits interest in, a company organized by
BOL which, among other things, acquired an interest in an industrial site and
manufacturing facility being constructed on the outskirts of Moscow by a
subsidiary of BOL.

         THE KREMLIN SITES. BML is planning the development of two adjoining
sites totaling 10.25 acres (the "Kremlin Sites") located in Moscow across the
Moscow River from the Kremlin. BML, which is planning to develop a 1.1 million
sq. ft. hotel, office, retail and residential complex on the Kremlin Sites,
owned 92.8% of one site and 52% of the other site at June 30, 1998. In June
1998, New Valley and Apollo organized Western Realty Repin LLC to make a $25,000
participating loan to BML. The proceeds of the loan will be used by BML for the
acquisition and preliminary development of the Kremlin Sites (see Note 3 to the
Company's Consolidated Financial Statements).

         NEW ACCOUNTING PRONOUNCEMENTS

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



                                      -35-
<PAGE>   37

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

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


YEAR 2000 COSTS

         The Company has evaluated the costs to implement century date change
compliant systems conversions and is in the process of executing a planned
conversion of its systems prior to the year 2000. Although such costs may be a
factor in describing changes in operating profit for one or more of the
Company's business segments in any given reporting period, the Company
currently does not believe that the anticipated costs of year 2000 systems
conversions will have a material impact on its future consolidated results of
operations or cash flows. However, due to the interdependent nature of computer
systems, the Company may be adversely impacted in the year 2000 depending on
whether it or entities not affiliated with the Company have addressed this issue
successfully.


RECENT DEVELOPMENTS IN THE CIGARETTE INDUSTRY

         PRICING ACTIVITY. As of August 14, 1998, list price increases during
1998 amount to $1.85 per carton. On January 23, 1998, Philip Morris and RJR
announced a list price increase of $.25 per carton. This action was matched by
Liggett and the other manufacturers during the following week. On April 3, 1998,
Philip Morris announced a second list price increase of $.50 per carton. This
action was matched by Liggett and the other manufacturers. On May 11, 1998,
Philip Morris and RJR announced a third list price increase of $.50 per carton
on all brands. This action was matched by Liggett and the other manufacturers
during the following week. On July 31, 1998, Philip Morris announced a fourth
list price increase of $.60 per carton on all brands. This action was matched by
Liggett and the other manufacturers during the following week.

         LEGISLATION, REGULATION AND LITIGATION. The cigarette industry
continues to be challenged on numerous fronts. New cases continue to be
commenced against Liggett and the Company and other cigarette manufacturers. As
of June 30, 1998, there were approximately 245 individual suits, 40 purported
class actions and 60 state, municipality and other third-party payor health care
reimbursement actions pending in the United States in which Liggett is a named
defendant. As new cases are commenced, the costs associated with defending such
cases and the risks attendant to the inherent unpredictability of litigation
continue to increase. Recently, there have been a number of restrictive
regulatory actions from various Federal administrative bodies, including the
United States Environmental Protection Agency ("EPA") and the Food and Drug
Administration ("FDA"), adverse political decisions and other unfavorable
developments concerning cigarette smoking and the tobacco industry, including
the commencement and certification of class actions and the commencement of
Medicaid reimbursement suits by various states' Attorneys General. These
developments generally receive widespread media attention. The Company is not
able to evaluate the effect of these developing matters on pending litigation or
the possible commencement of additional litigation, but it is possible that
Company's financial position, results of operations and cash flows could be
materially adversely affected by an ultimate unfavorable outcome in any of such
pending litigation. (See Note 8 to the Company's Consolidated Financial
Statements for a description of legislation, regulation and litigation.)

         The plaintiffs' allegations of liability in those cases in which
individuals seek recovery for personal injuries allegedly caused by cigarette
smoking are based on various theories of recovery, including negligence, gross
negligence, special duty, voluntary undertaking, strict liability, fraud,
misrepresentation, design defect, failure to warn, breach of express and implied
warranties, conspiracy, aiding and abetting concert of action, unjust
enrichment, common law public nuisance, indemnity, market share liability, and
violations of deceptive trade practices laws, RICO and antitrust statutes. In
many of these cases, in addition to compensatory damages, plaintiffs also seek
other forms of relief including disgorgement of profits and punitive damages.
Defenses raised



                                      -36-
<PAGE>   38

by defendants in these cases include lack of proximate cause, assumption of the
risk, comparative fault and/or contributory negligence, lack of design defect,
statutes of limitations or repose, equitable defenses such as "unclean hands"
and lack of benefit, failure to state a claim and federal preemption.

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

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

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

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



                                      -37-
<PAGE>   39

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

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

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

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

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



                                      -38-
<PAGE>   40

         The Company accrued approximately $4,000 for the present value of the
fixed payments under the March 1996 Settlements and $18,301 for the present
value of the fixed payments under the March 1998 Settlements. No additional
amounts have been accrued because the Company cannot quantify the future costs
of the settlements as the amounts Liggett must pay are based, in part, on future
operating results. Possible future payments based on a percentage of pretax
income, and other contingent payments based on the occurrence of a business
combination, will be expensed when considered probable. (See the discussions of
the tobacco litigation settlements appearing in Note 8 to the Company's
Consolidated Financial Statements.)

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

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

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





                                      -39-

<PAGE>   41


RESULTS OF OPERATIONS

<TABLE>
<CAPTION>
                             REVENUES                OPERATING INCOME                  REVENUES               OPERATING INCOME
                       ----------------------      ----------------------       ----------------------      ----------------------
                         THREE MONTHS ENDED         THREE MONTHS ENDED             SIX MONTHS ENDED           SIX MONTHS ENDED
                              JUNE 30,                   JUNE 30,                      JUNE 30,                    JUNE 30,
                       ----------------------      ----------------------       ----------------------      ----------------------
                         1998          1997          1998           1997          1998          1997          1998          1997
                       --------      --------      --------      --------       --------      --------      --------      --------
<S>                    <C>           <C>           <C>           <C>            <C>           <C>           <C>           <C>     
Liggett ............   $ 83,398      $ 78,142      $ 10,125      $  4,428       $149,024      $144,443      $ 17,026      $  4,786

Liggett-Ducat ......     27,864        18,451         6,059         1,217         47,042        31,932         7,479         1,614

Other ..............                                     93           282                          223          (564)          365
                       --------      --------      --------      --------       --------      --------      --------      --------

Total ..............   $111,262      $ 96,593      $ 16,277      $  5,927       $196,065      $176,598      $ 23,941      $  6,765
                       ========      ========      ========      ========       ========      ========      ========      ========

</TABLE>


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

         REVENUES. Total revenues were $111,262 for the three months ended June
30, 1998 compared to $96,593 for the three months ended June 30, 1997. This
15.2% increase in revenues was primarily due to a $5,256 or 6.7% increase in
revenues at Liggett and an increase of $9,413 or 51.0% in revenues at BOL. The
increase in revenues in both the premium and discount segments at Liggett was
due to price increases of $10,754 (see "Recent Developments in the Cigarette
Industry - Pricing Activity") and improved product mix of $290 partially offset
by a 7.4% decrease in Liggett's unit sales volume (119.5 million units)
accounting for $5,788 in volume variance. The decline in premium and discount
unit sales volume was due to certain competitors continuing leveraging rebate
programs tied to their products and increased promotional activity by certain
other manufacturers.

         Premium sales at Liggett for the three months ended June 30, 1998
amounted to $26,951 and represented 32.3% of total revenues, compared to $25,309
and 32.4% of total sales for the same period in 1997. In the premium segment,
revenues increased by 6.5% ($1,642) over the three months ended June 30, 1998,
compared to the same period in 1997, due to price increases of $3,015, partially
offset by a 5.4% decline in unit sales volume (23.0 million units) accounting
for $1,373 in volume variance.

         Discount sales (comprising the brand categories of branded discount,
private label, control label, generic, international and contract manufacturing)
for the three months ended June 30, 1998 amounted to $56,447 and represented
67.7% of total revenues, compared to $52,833 and 67.6% of total sales for the
same period in 1997. In the discount segment, revenues increased by 6.8%
($3,614) over the three months ended June 30, 1998, compared to the same period
in 1997, due to price increases of $7,738 and improved product mix among the
brand categories of $162, partially offset by an 8.1% decline in unit sales
volume (96.5 million units) accounting for $4,286 in volume variance. For the
three months ended June 30, 1998, fixed manufacturing costs on a basis
comparable to the same period in 1997 were $1,062 lower, and costs per thousand
units decreased $0.87 per thousand, due to lower severance costs.

         Net sales at Liggett-Ducat for the three months ended June 30, 1998
increased 51.0% ($9,413) over the same period in 1997 due primarily to an
increase of 45.4% ($8,369) in unit sales volume (1,646.3 million units) and
price increases of 5.5% ($1,015).

         GROSS PROFIT. Consolidated gross profit was $59,582 for the three
months ended June 30, 1998 compared to $45,642 for the three months ended June
30, 1997, an increase of $13,940 when compared to the same period last year,
reflecting an increase in gross profit at Liggett of $8,388 and an increase at
Liggett-Ducat of $5,958 for the three months ended June 30, 1998 compared to the
same period in the prior year.


                                      -40-
<PAGE>   42

         Gross profit at Liggett of $50,316 for the three months ended June 30,
1998 increased due primarily to the price increases discussed above. (See
"Recent Developments in the Cigarette Industry - Pricing Activity".) In 1998,
Liggett's premium and discount brands contributed 34.9% and 65.1%, respectively,
to the Company's overall gross profit. Over the same period in 1997, Liggett's
premium and discount brands contributed 36.5% and 63.5%, respectively, to total
gross profit. As a percent of revenues (excluding federal excise taxes), gross
profit at Liggett increased to 76.5% for the three months ended June 30, 1998
compared to 71.1% for the same period in 1997, with gross profit for the premium
segment at 79.4% and 75.7% in the second quarter of 1998 and 1997, respectively,
and gross profit for the discount segment at 75.1% and 68.7% in the second
quarter of 1998 and 1997, respectively. This increase is the result of the
September 1997, January 1998, April 1998 and May 1998 list price increases and
improved production variances. These increases were partially offset by
increased tobacco costs at Liggett due to a reduction in the average discount
available to the Company from leaf tobacco dealers on tobacco purchased under
prior years' purchase commitments.

         As a percent of revenues (excluding Russian excise taxes), gross profit
at Liggett-Ducat increased to 39.46% for the three months ended June 30, 1998
compared to 20.37% in the same period in 1997.

         EXPENSES. Operating, selling, general and administrative expenses were
$46,643 for the three months ended June 30, 1998 compared to $39,715 for the
same period last year due to increases in expenses at Liggett of $3,921 and at
Liggett-Ducat of $1,296 and higher expenses at corporate resulting from a
non-cash charge for an option award. Operating, selling, general and
administrative expenses at Liggett were $41,421 for the three months ended June
30, 1998 compared to $37,500 for the same period for the prior year, an increase
of $3,921. This increase in operating expense was due primarily to $3,549 in
higher promotional and marketing costs as well as higher legal settlement
charges of $1,399 partially offset by reductions in systems development costs of
$868 and reduced administrative costs.

         OTHER INCOME (EXPENSE). Interest expense was $19,637 for the three
months ended June 30, 1998 compared to $15,499 for the same period last year, an
increase of $4,138 primarily due to the debt restructuring at BGLS and Liggett
in which the Company took additional charges of approximately $3,875 for the
three months ended June 30, 1998. (See Note 6 to the Company's Consolidated
Financial Statements.) In addition, Liggett-Ducat and BOL had total interest
expense of $525 for the three months ended June 30, 1998, compared with $304 for
the same period in 1997.

         Equity in earnings of affiliate was a loss of $7,261 for the three
months ended June 30, 1998 compared to a loss of $6,157 for the three months
ended June 30, 1997 and relates in both periods to New Valley's net loss
applicable to common shares of $25,754 and $21,779, respectively.

         For the three months ended June 30, 1997, interest expense and loss in
equity of affiliate were slightly offset by the gain on sale of assets, which
included the sale of the BML shares and surplus realty at Liggett.


SIX MONTHS ENDED JUNE 30, 1998 COMPARED TO SIX MONTHS ENDED JUNE 30, 1997.

         REVENUES. Total revenues were $196,065 for the six months ended June
30, 1998 compared to $176,598 for the six months ended June 30, 1997. This 11.0%
increase in revenues was due to a $4,581 or 3.2% increase in revenues at Liggett
and an increase of $15,110 or 47.3% at Liggett-Ducat. Revenues at Liggett
increased in both the premium and discount segments due to price increases of
$18,064 (see "Recent Developments in the cigarette Industry - Pricing Activity")
and improved product mix of $667 offset by a 9.8% ($14,150) decline in unit
sales volume, a 



                                      -41-
<PAGE>   43

decrease of 298.1 million units. The decline in premium and discount unit sales
volume was due to certain competitors continuing leveraging rebate programs tied
to their products and increased promotional activity by certain other
manufacturers. The increase in tobacco revenues at Liggett-Ducat is attributable
to increased unit sales volume of 37.3% ($11,888) and price increases of $3,307
slightly offset by unfavorable product mix.

         Premium sales for the six months ended June 30, 1998 amounted to
$49,925 and represented 33.5% of total revenues, compared to $47,914 and 33.2%
of total sales for the same period in 1997. In the premium segment, revenues
grew by 4.2% ($2,011) due to price increases of $5,212 offset by a 6.7% decline
in unit sales volume (54.5 million units) accounting for $3,201 in volume
variance over the six months ended June 30, 1998, compared to the same period in
1997.

         Liggett's discount sales (comprising the brand categories of branded
discount, private label, control label, generic, international and contract
manufacturing) over this period amounted to $99,099 and represented 66.5% of
total revenues, compared to $96,529 and 66.8% of total sales for the same period
in 1997. In the discount segment, revenues grew by 2.7% ($2,570) over the six
months ended June 30, 1998, compared to the same period in 1997, due to price
increases of $12,851 and improved product mix among the discount brand
categories of $276 offset by a 10.9% decline in unit sales volume (243.6 million
units) accounting for $10,557 in volume variance. For the six months ended June
30, 1998, fixed manufacturing costs on a basis comparable to the same period in
1997 were $1,314 lower, and costs per thousand units decreased $0.34 per
thousand, due to lower severance costs.

         GROSS PROFIT. Gross profit was $102,729 for the six months ended June
30, 1998 compared to $83,802 for the six months ended June 30, 1997, an increase
of $18,927 or 22.6% when compared to the same period last year, due to price
increases at Liggett and volume and price increases at Liggett-Ducat discussed
above. Liggett's gross profit as a percentage of revenues (excluding federal
excise taxes) for the period increased to 77.0% compared to 71.5% in the same
period in the prior year. For the six months ended June 30, 1998, Liggett's
premium and discount brands contributed 36.1% and 63.9%, respectively, to
Liggett's overall gross profit. Over the same period in 1997, Liggett's premium
and discount brands contributed 37.4% and 62.6%, respectively, to total gross
profit. Gross profit for the premium segment was 79.6% and 76.1%, respectively,
in the six months ended June 30 of 1998 and 1997, respectively, and gross profit
for the discount segment was 75.6% and 69.0% in 1998 and 1997, respectively.
These increases are the result of the March 1997, September 1997, January 1998,
April 1998 and May 1998 list price increases and improved production variances.
See "Recent Developments in the Cigarette Industry - Pricing Activity". These
increases were partially offset by increased tobacco costs at Liggett due to a
reduction in the average discount available to Liggett from leaf tobacco dealers
on tobacco purchased under prior years' purchase commitments. See "Recent
Developments in the Cigarette Industry".

         As a percentage of revenues (excluding Russian excise taxes), gross
profit at Liggett-Ducat increased to 32.44% for the six months ended June 30,
1998 compared to 19.96% in the same period in 1997.

         EXPENSES. Operating, selling, general and administrative expenses were
$80,797 for the six months ended June 30, 1998 compared to $76,657 for the same
period last year. The increase of $4,140 is due primarily to higher promotion
and marketing expenses at Liggett and higher legal settlement charges of $1,881.
Such expenses were partially offset by restructuring including decreases in
systems development costs over the prior year.

        OTHER INCOME (EXPENSE). Interest expense was $40,423 for the six months
ended June 30, 1998 compared to $30,966 for the same period last year. The
increase in interest expense was primarily due to charges for debt restructuring
of approximately $6,300 at corporate and $4,100 at Liggett offset by lower
interest expense due to lower outstanding balances on the revolving credit
facility at Liggett.


                                      -42-
<PAGE>   44

        Equity in earnings of affiliate was a loss of $11,448 for the six months
ended June 30, 1998 compared to a loss of $14,351 for the six months ended June
30, 1997 and relates to the decline in market value of the Class A Preferred
Shares and to New Valley's net loss applicable to common shares of $44,429 in
1998 compared to its net loss of $48,100 in 1997.

        In 1997, interest expense and loss in equity of affiliate were offset by
the gain on sale of assets, which included the sale of the BML shares and
surplus realty at Liggett, and proceeds from a legal settlement.
See Notes 3 and 8 to the Company's Consolidated Financial Statements.


CAPITAL RESOURCES AND LIQUIDITY

         Net cash and cash equivalents increased $6,627 and $17,608 for the six
months ended June 30, 1998 and June 30, 1997, respectively. Net cash used in
operating activities was $17,409 and $20,003 for the six months ended June 30,
1998 and 1997, respectively. In the 1998 six-month period, cash payments
included primarily semi-annual interest payments by Liggett and BGLS of
approximately $9,700 and $10,800, respectively, as well as a deferred July 1997
interest payment to a principal holder of the BGLS Notes of $8,347. In
addition, increases in inventories and receivables were partially offset by
increases in payables and in other long-term liabilities. For the six months
ended June 30, 1997, net cash used in operations was due to a decrease in
accounts payable and accrued expenses of approximately 421,600, and an increase
in notes receivable of $32,500 due to the sale of the BML shares partially
offset by a decrease in receivables at Liggett, equity in loss of affiliate of
$14,400 and the impact of the deferred gain on the sale of the BML shares of
approximately $22,000.

         Cash used in investing activities of $5,452 compares to cash provided
of $39,592 for the periods ended June 30, 1998 and 1997, respectively. In 1998,
capital expenditures of $7,138, principally at Liggett-Ducat were partially
offset by proceeds from sales of equipment. In 1997, proceeds included cash of
$43,000 received in the sale of the BML shares to New Valley slightly offset by
capital expenditures of $3,653 at Liggett and BOL.

         Cash provided by financing activities was $29,404 for the six months
ended June 30, 1998 as compared with cash used in financing activities of $1,981
for the six months ended June 30, 1997. Proceeds in the 1998 period include
proceeds from the participating loan made by Western Realty Ducat of $20,000,
cash received from the sale of common stock and exercise of stock options, in
total $10,144, net borrowings under credit facilities at both Liggett and BOL of
$4,245, partially offset by distributions on common stock and a decrease in cash
overdraft. Proceeds from financing activities in 1997 include net borrowings
under credit facilities at BOL and Liggett of $7,849. These proceeds were offset
by repayments on debt including principally the required repurchase of $7,500
face amount of Liggett bonds on February 1, 1997 at a net gain of $2,963.
Distributions on common stock of $4,102 in the 1997 period include distributions
declared in the fourth quarter 1996 which were paid in January 1997 and
distributions declared and paid in the first two quarters of 1997.

         LIGGETT. Liggett had a net capital deficiency of $188,372 at June 30,
1998 and is highly leveraged. In addition, the Liggett Notes mature on February
1, 1999 and the revolving credit facility (the "Facility") expires on March 8,
1999. Due to the many risks and uncertainties associated with the cigarette
industry, the impact of recent tobacco litigation settlements (see "Recent
Developments in the Cigarette Industry - Legislation and Litigation") and
increased tobacco costs, there can be no assurance that Liggett will be able to
meet its future earnings goals. Consequently, Liggett could be in violation its
debt covenants, including covenants limiting the maximum permitted adjusted net
worth and net working capital deficiencies, and if its lenders were to exercise
acceleration rights under the Facility or the Liggett Notes' Indenture or refuse
to lend under the Facility, Liggett would not be able to satisfy such demands or
its working capital requirements. (See below for additional information
concerning these covenants.)

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

                                      -43-

<PAGE>   45

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

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

         As discussed above, Liggett also has a $40,000 Facility expiring March
8, 1999 under which $22,678 was outstanding at June 30, 1998. On August 29,
1997, the Facility was amended to permit Liggett to borrow an additional $6,000
which was used on that date in making the interest payment of $9,700 due on
August 1, 1997 to the holders of the Liggett Notes. BGLS guaranteed the
additional $6,000 advance under the Facility and collateralized the guarantee
with $6,000 in cash, deposited with Liggett's lender. At June 30, 1998, this
amount is classified in other assets on the balance sheet. Availability under
the Facility was approximately $5,946 based on eligible collateral at June 30,
1998. The Facility is collateralized by all inventories and receivables of
Liggett. Borrowings under the Facility, whose interest is calculated at a rate
equal to 1.5% above Philadelphia National Bank's (the indirect parent of
Congress Financial Corporation, the lead lender) prime rate, bear a rate of
10.0% at June 30, 1998. The Facility contains certain financial covenants
similar to those contained in the Liggett Notes' Indenture including
restrictions on Liggett's ability to declare or pay cash dividends, incur
additional debt, grant liens and enter into any new agreements with affiliates,
among others. In addition, the Facility, as amended on April 8, 1998, imposes
requirements with respect to Liggett's adjusted net worth (not to fall below a
deficit of $195,000 as computed in accordance with the agreement, this
computation was $185,051 at June 30, 1998) and working capital (not to fall
below a deficit of $17,000 as computed in accordance with the agreement, this
computation was $6,005 at June 30, 1998). At June 30, 1998, Liggett was in
compliance with all covenants under the Facility. The Facility, as amended, also
provides that a default by Liggett under the March 1996 Settlements, March 1997
Settlements and March 1998 Settlements shall constitute an event of default
under the Facility.

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

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




                                      -44-
<PAGE>   46

Industry - Legislation, Regulation and Litigation" and "--Settlements" above and
Note 8 to the Company's Consolidated Financial Statements.)

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

         BGLS. On March 5, 1998, BGLS entered into the Standstill Agreement
whereby the Apollo Holders agreed to the deferral of interest payments,
commencing with the interest payment due July 31, 1997 through the interest
payment due July 31, 2000. (See "Recent Developments - The Company - Standstill
Agreement".) At June 30, 1998, the carrying value of BGLS' long-term debt (net
of unamortized discount of $21,102) was approximately $211,762, based on
modification of the terms of the debt with the Apollo Holders.

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

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

         THE COMPANY. The Company has remaining scheduled debt maturities of
$2,094 due in the year 1998; approximately $2,000 of this debt relates to credit
lines established by Liggett-Ducat which expires August 18, 1998. Liggett has a
payment due on the Liggett Notes at maturity on February 1, 1999 of
approximately $145,000 and the Facility expires on March 8, 1999. The Company
believes that it will continue to meet its liquidity requirements through 1998,
although the BGLS Notes Indenture limits the amount of restricted payments BGLS
is permitted to make to the Company during the calendar year. At June 30, 1998,
the remaining amount available through December 31, 1998 in the Restricted
Payment Basket related to BGLS' payment of dividends to the Company (as defined
by the BGLS Notes Indenture) is $11,086. Company expenditures remaining in 1998
include dividends on the Company's shares (currently at an annual rate of
approximately $6,100) and corporate expense. The Company anticipates funding
1998 current operations and long-term growth with the proceeds from public
and/or private debt and equity financing, management fees and other payments
from subsidiaries of approximately $3,600 and distributions from New Valley. New
Valley may acquire or seek to acquire additional operating businesses through
merger, purchase of assets, stock acquisition or other means, or to make other
investments, which may limit its ability to make such distributions.


SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

         The Company and its representatives may from time to time make oral or
written "forward-looking statements" within the meaning of the Private
Securities Reform Act of 1995 (the "Reform Act"), including any statements that
may be contained in the foregoing discussion in "Management's Discussion and
Analysis of Financial Condition and Results of Operations", in this report and
in other filings with the Securities and Exchange Commission and in its reports
to shareholders, which 



                                      -45-

<PAGE>   47

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







                                      -46-
<PAGE>   48

                                     PART II
                                OTHER INFORMATION



Item 1.    LEGAL PROCEEDINGS

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

Item 2.    CHANGES IN SECURITIES AND USE OF PROCEEDS

           No securities of the Company which were not registered under the
           Securities Act of 1933, as amended (the "Securities Act"), have been
           issued or sold by the Company during the three months ended June 30,
           1998, except as follows:


           (i)  In April 1998, a consultant to the Company purchased 68,200
                shares of the Company's common stock upon exercise of options at
                a price of $2.00 per share (an aggregate of $136,400).

           (ii) On April 28, 1998 and May 1, 1998, the Company awarded each of
                the three outside directors of the Company 10,000 shares of its
                common stock for services as a director.

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


Item 3.    DEFAULTS UPON SENIOR SECURITIES

           As of June 30, 1998, New Valley Corporation, the Companies'
           affiliate, had the following respective accrued and unpaid dividend
           arrearages on its 1,071,462 outstanding shares of $15.00 Class A
           Increasing Rate Cumulative Senior Preferred Shares ($100 Liquidation
           Value), $.01 par value per share (the "Class A Shares") and 2,790,776
           outstanding shares of $3.00 Class B Cumulative Convertible Preferred
           Shares ($25 Liquidation Value), $.10 par value per share (the "Class
           B Shares"): (1) $189.7 million or $177.07 per Class A Share; and (2)
           $152.2 million or $54.52 per Class B Share.





                                      -47-
<PAGE>   49


Item 6.    EXHIBITS AND REPORTS ON FORM 8-K

           (a)   EXHIBITS


    10.1       Participating Loan Agreement, dated as of April 28, 1998, by and
               among Western Realty Development LLC, Western Tobacco Investments
               LLC and Brooke (Overseas) Ltd. (incorporated by reference to
               exhibit 10.2 in New Valley Corporation's Form 10-Q for the
               quarter ended June 30, 1998, Commission File No. 1-2493).

    10.2       Consulting Agreement, dated as of May 1, 1998, between the
               Company and J. Sauter Enterprises, Inc. (incorporated by
               reference to exhibit 4.1 in the Company's Registration Statement
               on Form S-8, No. 333-59615).

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

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

    99.1       Material Legal Proceedings.

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

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

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

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


           (b)   REPORTS ON FORM 8-K

                 None.





                                      -48-

<PAGE>   50


                                   SIGNATURES



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





                                             BROOKE GROUP LTD.
                                             (REGISTRANT)

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

Date:  August 14, 1998






                                             BGLS INC.
                                             (REGISTRANT)




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

Date:  August 14, 1998






                                      -49-