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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




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FORM 10-K/A




(Mark
One)

x ANNUAL REPORT PURSUANT
TO SECTION 13 OR 15(d) OF


THE SECURITIES EXCHANGE ACT OF 1934


For the fiscal year ended December 31, 2001

OR

o TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934


Commission file number: 1-6388



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R.J. Reynolds Tobacco Holdings, Inc.

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                     
|------------------------------------------------------------------ |  | ------------------------------------
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|Delaware                                                           |  | 56-0950247                          
|(State or other jurisdiction of incorporation or
    organization) |  | (I.R.S. Employer Identification No.)

401 North Main Street

Winston-Salem, NC 27102-2866


(Address of principal executive offices) (Zip
Code)


(336) 741-5500

(Registrants telephone number, including
area code)




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Securities registered pursuant to Section 12(b) of the
Act:

|                                       |  |                   |          |                     |  |                                       |  |  |          | 
|-------------------------------------- |  | ----------------- | -------- | ------------------- |  | ------------------------------------- |  |  | -------- | 
|                                       |  | Name of each      |          |                     |  | Name of each                         
|                                       |  | exchange on which |          |                     |  | exchange on which                    
|Title of each class                    |  | registered        |          | Title of each class |  | registered                           
|                                       |  |                   |          |                     |  |                                      
|Common Stock, par value $.01 per share |  |                   | New York |                     |  | 8 3/4% Notes due August 15, 2005      |  |  | New York | 
|8 5/8% Notes due December 1, 2002      |  |                   | New York |                     |  | 8 3/4% Notes due July 15, 2007        |  |  | New York | 
|7 5/8% Notes due September 15, 2003    |  |                   | New York |                     |  | 9 1/4% Debentures due August 15, 2013 |  |  | New York | 
|8 3/4% Senior Notes due April 15, 2004 |  |                   | New York |                     |  |                                       |  |  |          | 

Securities registered pursuant to Section 12(g) of the
Act: None

Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
YES x NO
o

Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not contained
herein, and will not be contained, to the best of
registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K.
o

The aggregate market value of common stock held by
non-affiliates of R.J. Reynolds Tobacco Holdings, Inc. on
January 31, 2002 was approximately $5.5 billion, based on
the closing price of $59.75. Certain directors of R.J. Reynolds
Tobacco Holdings, Inc. are considered affiliates for purposes of
this calculation but should not necessarily be deemed affiliates
for any other purpose.

Indicate the number of shares outstanding of each of the
registrants classes of common stock, as of the latest
practicable date: January 31, 2002: 93,242,931 shares of
common stock, par value $.01 per share.



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Documents Incorporated by Reference:

Portions of the Definitive Proxy Statement of R.J. Reynolds
Tobacco Holdings, Inc. to be filed with the Securities and
Exchange Commission pursuant to Regulation 14A of the
Securities Exchange Act of 1934 on or prior to March 15, 2002
are incorporated by reference into Part III of this report.



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INDEX




|           |  |                                                                                           |    |      |    | 
|---------- |  | ----------------------------------------------------------------------------------------- | -- | ---- | -- | 
|           |  |                                                                                           |    | Page
|           |  |                                                                                           |    |     
|Part I     |  |                                                                                           |    |      |    | 
|          
|          
|          
|          
|Item 1.    |  | Business                                                                                  |    |      | 3  | 
|          
|          
|          
|          
|          
|Part II    |  |                                                                                           |    |      |    | 
|          
|          
|          
|          
|Item 6.    |  | Selected Financial Data                                                                   |    |      | 26 | 
|          
|          
|          
|          
|Item 7.    |  | Managements Discussion and Analysis of
    Financial Condition and Results of Operations |    |      | 27 | 
|          
|          
|          
|          
|Item 8.    |  | Financial Statements and Supplementary Data                                               |    |      | 38 | 
|          
|          
|          
|          
|          
|Part IV    |  |                                                                                           |    |      |    | 
|          
|          
|          
|          
|Item 14.   |  | Exhibits, Financial Statement Schedules, and
    Reports on Form 8-K                      |    |      | 85 | 
|          
|          
|          
|          
|Signatures |  |                                                                                           | 86 |     




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EXPLANATORY NOTE







This Form 10-K/A amends the annual report of R. J. Reynolds
Tobacco Holdings, Inc. referred to as RJR, on Form 10-K for the
year ended December 31, 2001, referred to as the 2001 Form 10-K,
filed with the SEC on February 28, 2002. The purpose of this
amendment is to:






| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (1) Include additional disclosure regarding tobacco-related
    litigation in Item 1  Business, Litigation
    Affecting the Cigarette Industry, similar disclosure in
    Item 8  Financial Statements and Supplementary
    Data, Note 14  Commitments and Contingencies, as
    well as additional disclosures in Item 7 
    Managements Discussion and Analysis of Financial Condition
    and Results of Operations. This amendment also includes the
    addition of footnote 2 to the Consolidated Statements of
    Income included in Item 8, to disclose settlement costs
    that were included in cost of products sold.                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
|
|
| | (2) Reclassify an income tax benefit from continuing operations
    to discontinued operations as a result of a misclassification of
    a reduction of tax exposure reserves that occurred in 2000. The
    restatement had no effect on net income, net income per share or
    cash flows for the year ended December 31, 2000, or the
    balance sheet as of December 31, 2000, and no effect on any
    consolidated financial statements for 2001. As a result of the
    restatement, the gain on discontinued operations for 2000 has
    been revised to reflect a $53 million reserve reduction, related
    to the 1999 sale of the international tobacco business to Japan
    Tobacco Inc., and the provision for income taxes on continuing
    operations for 2000 has been revised to reflect the similar
    reserve increase. These changes are reflected in
    Item 6  Selected Financial Data,
    Item 7  Managements Discussion and
    Analysis of Financial Condition and Results of Operations and
    Item 8  Financial Statements and Supplementary
    Data.
|




This amendment is limited in scope to the portions of the 2001
Form 10-K set forth above and does not amend, update or
change any other items or disclosures contained in the original
2001 Form 10-K.




PART I

Item 1. Business

R.J. Reynolds Tobacco Holdings, Inc. was incorporated as a
holding company in 1970, and is listed on the NYSE as RJR.
RJRs wholly owned subsidiaries include its operating
subsidiaries, R. J. Reynolds Tobacco Company, referred to as RJR
Tobacco, and Santa Fe Natural Tobacco Company, Inc. RJR also
wholly owns RJR Acquisition Corp.

RJR has one reportable operating segment, RJR Tobacco, which is
the second largest cigarette manufacturer in the United States.
RJR Tobaccos largest selling cigarette brands, CAMEL,
WINSTON, SALEM and DORAL, were four of the top ten best-selling
brands of cigarettes in the United States in 2001. Those brands,
and its other brands, including VANTAGE, MORE, NOW, MONARCH and
BEST VALUE, are manufactured in a variety of styles and marketed
in the United States to meet a range of adult smoker preferences.

During 1999, RJR and Nabisco Group Holdings Corp., referred to
as NGH, completed a series of transactions to reorganize their
businesses and capital structures. In May 1999, RJR and RJR
Tobacco sold the international tobacco business to Japan Tobacco
Inc. As a result of this sale, RJR Tobaccos business
consists exclusively of the manufacture and sale of cigarettes
in the United States and its territories, commonwealths,
protectorates and possessions. A portion of the proceeds from
the sale of the international tobacco business was used by RJR
to repurchase $4 billion of its debt. Additionally, RJR
transferred $1.6 billion in cash proceeds, together with its
80.5% interest in Nabisco Holdings Corp., referred to as
Nabisco, to NGH through a merger transaction. In June 1999, NGH
distributed all of the outstanding shares of RJR common stock to
NGH common stockholders of record as of May 27, 1999.
Shares of RJR began trading separately on June 15, 1999.

On December 11, 2000, RJR acquired its former parent, NGH,
a non-operating public shell company with no material assets or
liabilities other than $11.8 billion in cash. RJR Acquisition
Corp. paid $30 for each

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On January 16, 2002, RJR acquired 100% of the voting stock
of privately held Santa Fe for $340 million in cash, subject to
post-closing adjustments. Fiesta Acquisition Corp., a wholly
owned subsidiary of RJR, merged with and into Santa Fe, and
Santa Fe, being the surviving corporation, became a wholly owned
operating subsidiary of RJR.

Santa Fe manufactures cigarettes, under the NATURAL AMERICAN
SPIRIT brand, and other tobacco products in the United States
and currently markets its products primarily in the United
States. The financial condition and results of operations of
Santa Fe do not meet the criteria as a reportable operating
segment. As a result, information related to Santa Fe is not
disclosed separately in this document.




RJR believes that the acquisition of NGH and Santa Fe present
meaningful opportunities for RJR to build shareholder value. The
acquisition of NGH provided $1.5 billion of net cash proceeds to
RJR, which has funded RJRs share repurchase programs and
the acquisition of Santa Fe. Santa Fes approach to
building brand equity is consistent with RJR Tobaccos
strategy for its key brands, and the acquisition was originated
in order to enhance RJRs consolidated earnings.




Industry Overview




U.S. cigarette shipments decreased at a compound annual rate of
1.6% from 1987 through 1997. After declining 4.6% in 1998 and 9%
in 1999, shipments remained relatively stable in 2000 and
declined 3.2%, to 406.4 billion units in 2001. From December
1999 to December 2001, wholesale cigarette prices of the major
manufacturers increased $.52 per pack overall. The average
wholesale list price of a pack of RJR Tobaccos full-price
brands was $2.12, $2.45 and $2.64 in 1999, 2000 and 2001,
respectively.




Competition

RJRs operating subsidiaries primarily conduct business in
the highly competitive U.S. market with several large
participants. Based on data collected by Information Resources
Inc./Capstone, during 2001, 2000 and 1999, Philip Morris
Incorporated had an overall retail share of market of 50.45%,
50.37% and 49.58%, respectively. During these same years, RJR
Tobacco had an overall share of 23.42%, 23.58% and 23.92%,
respectively, and the remaining participants held lesser shares.

Competition is primarily based on a brands products,
positioning, consumer loyalty, retail display and promotion and
price. Substantial marketing support, merchandising display and
competitive pricing generally are required to maintain or
improve a brands market position or to introduce a new
brand. Increased selling prices and higher cigarette taxes have
resulted in increased competitive discounting and the
proliferation of deep-discount brands. The cost structures of
manufacturers of these brands are less impacted by the Master
Settlement Agreement and other states settlement agreements than
larger manufacturers.

Anti-smoking groups have attempted to restrict cigarette sales,
cigarette advertising and the testing and introduction of new
cigarette products. The MSA, signed in late 1998, contains
provisions restricting the marketing of cigarettes. See
 Litigation Affecting the Cigarette Industry
for more discussion of the MSA.

Established cigarette brands usually have a competitive
advantage in the United States because of significant cigarette
marketing restrictions. RJR Tobacco has repositioned or
introduced brands designed to appeal to adult smokers of
competing brands in the United States, but there can be no
assurance that such efforts will be successful. See 
Marketing for more discussion of RJR Tobaccos
marketing efforts.

Strategy

RJRs goals are to:



| |   |                                             
| | - | --------------------------------------------
| |  | stabilize, then grow earnings and cash flow;

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| |   |                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------
| |  | deliver an attractive return to stockholders; and                                                           
|
| |  | stabilize, then grow share of market for RJR Tobaccos four
    key brands: CAMEL, WINSTON, SALEM and DORAL.

Marketing

RJRs operating subsidiaries are committed to providing
unique products and increased value to adult smokers. RJR
Tobaccos marketing programs are designed to strengthen
each brands image, build brand awareness and loyalty and
attract adult smokers of competing brands, primarily in an
effort to stabilize, then grow share of market on RJR
Tobaccos four key brands. These brands retail share
of market on a combined basis has been relatively stable since
1999. RJR Tobacco utilizes a two-fold approach to market its key
brands: build strong brand equity while maintaining a
competitive price. In 2001, RJR Tobacco introduced many new
programs and products to build each brands equity and
attract adult smokers of competitive brands.

CAMEL, RJR Tobaccos largest brand, continued to deliver
strong retail share of market growth in 2001. The brands
Pleasure to Burn positioning and new equity programs
like the Seven Pleasures of the Exotic continued to
appeal to competitive adult smokers. New products also enhanced
CAMELs performance in 2001. Following the successful
launch of Turkish Gold in 2000, the brand introduced Turkish
Jade, a menthol line extension, in the third quarter of 2001.

WINSTONs share performance in 2001 benefited from the
launch of new programs and products to modernize the
brands positioning. Contributing to WINSTONs share
increase was the introduction of the No Boundaries, No
Bull promotion offering adult smokers the chance to win a
unique adventure. Beginning in the second quarter, WINSTON
introduced two new styles, S2 and S200s, that feature a
new blend and high impact silver packaging. Silver highlights
were added to the packaging on the brands other styles,
extending the modernization of WINSTONs image.

SALEMs marketing efforts have been concentrated in its
emphasis markets. In these markets, SALEM offers unique programs
and products like the Slide Box styles, which are blended to
offer a richer tobacco taste than other SALEM products. Although
the results in the ten emphasis markets have been better than in
the balance of the country, the brand is evaluating
opportunities to strengthen its performance.

DORALs marketing program continues to focus on exceeding
adult smokers expectations with its Imagine Getting
More positioning. DORAL, the largest savings brand in the
country, offers savings-conscious adult smokers added value at a
competitive price. Due to pricing pressure and the growth of
deep-discount brands, DORALs share started to decline in
the second quarter of 2001 after holding steady for several
quarters. To improve its performance, DORAL has recently
launched a comprehensive upgrade of its products and packaging
with unique advertising to communicate the improvements.

In addition to its marketing programs discussed above, RJR
Tobacco utilizes a defensive retail pricing strategy, including
discounting at retail, to defend its brands share of
market against competitive pricing pressure. RJR Tobacco
continued to enhance its retail strategy during 2001, gaining
increased promotional coverage, broader retail presence and more
competitive pricing.

On a combined basis, RJR Tobaccos four key brands
represent over 80% of its volume and share of market. Additional
RJR Tobacco full-price and savings products are offered to meet
the diverse preferences of adult smokers. Other full-price
brands include VANTAGE, MORE and NOW. In the savings category,
MONARCH, BEST VALUE and various private label brands are
available for cost-conscious adult smokers.

RJR Tobacco also is committed to finding ways to develop and
market consumer-acceptable cigarettes that may present less risk
associated with smoking. In April 2000, RJR Tobacco launched a
new test market of ECLIPSE in the Dallas/Fort Worth area through
direct mail and Internet sales to age-verified, adult smokers.
The Dallas/Fort Worth test market was expanded to include retail
sales in January 2001. ECLIPSE is a cigarette that primarily
heats rather than burns tobacco. Although RJR Tobacco does not
claim that ECLIPSE presents smokers with less risk of
cardiovascular disease or complications with pregnancy,

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RJR Tobacco continues to use advertisements in magazines read
primarily by adults, direct mailings to age-verified adult
smokers and other means to market its brands and enhance their
appeal among adult smokers. RJR Tobacco continues to advertise
and promote at retail cigarette locations and in other adult
venues where permitted. As a result of the MSA and other
federal, state and local legislative and regulatory
restrictions, RJR Tobacco does not utilize television, radio or
billboard advertising or certain other marketing and promotional
tools for cigarettes.

Manufacturing and Distribution




RJR Tobacco owns both of its cigarette manufacturing facilities,
which are located in the Winston-Salem, North Carolina area:
Tobaccoville, a two-million-square-foot facility constructed in
1985; and the Whitaker Park complex, which includes a
one-and-one-half-million-square-foot plant, RJR Tobaccos
Central Distribution Center and a pilot plant for trial
manufacturing of new products. RJR Tobacco has a combined
production capacity of approximately 150 billion cigarettes per
year, and believes its cigarette manufacturing facilities are
technologically advanced.




RJR Tobacco sells its cigarettes primarily to distributors and
wholesalers and to certain large retail stores, which buy on a
spot basis. RJR Tobacco distributes its cigarettes primarily to
public warehouses located throughout the United States that
serve as local distribution centers for its customers. No
significant backlog of orders existed at December 31, 2001
or 2000.




During 2001, 2000 and 1999, sales made by RJR Tobacco to McLane
Company, Inc. and its affiliate, Wal-Mart Stores, Inc.,
comprised 20%, 19% and 17%, respectively, of RJRs
consolidated revenue. No other customer accounted for 10% or
more of RJRs revenue during those years. RJR Tobacco has a
good relationship with McLane Company. RJR Tobaccos sales
to McLane are not governed by any supply contract; however,
McLane and RJR Tobacco are parties to an arrangement, whereby
RJR Tobacco observes McLanes inventory to manage the
supply and level of McLanes inventory. McLane and RJR
Tobacco also are parties to certain contracts in which
consideration is based on McLanes compliance with
specified performance levels and incentive terms.




Raw Materials

In its production of cigarettes, RJR Tobacco uses domestic
burley and flue-cured leaf tobaccos, as well as oriental
tobaccos grown primarily in Turkey and Greece, and certain other
non-domestic tobaccos. RJR Tobacco believes there is a
sufficient supply in the worldwide tobacco market to satisfy its
current and anticipated production requirements.

During 2001, RJR Tobacco primarily contracted directly with U.S.
tobacco growers to purchase flue-cured and burley leaf. The cost
of tobacco purchased by contract from growers has not differed
materially from that purchased through the auction process.

RJR Tobacco has developed a simple, practical way to reduce
tobacco-specific nitrosamines, or TSNAs, by approximately 90% in
flue-cured tobacco, and is converting to the use of low-TSNA
flue-cured tobacco in its cigarette blends.

Tobacco leaf is an agricultural product subject in the United
States to government production controls and price supports that
can affect market prices substantially. The tobacco leaf price
support program is subject to congressional review and may be
changed at any time. In December 1994, Congress enacted the
Uruguay Round Agreements Act to replace a domestic content
requirement with a tariff rate quota system that bases tariffs
on import volumes. The tariff rate quotas have been established
by the United States with overseas tobacco producers and became
effective on September 13, 1995.

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Research and Development

RJR Tobaccos research and development activities are
located in its technologically advanced Bowman Gray Technical
Center in Whitaker Park. Scientists and engineers continue to
create more efficient methods of preparing tobacco blends and
new products, as well as develop product enhancements and
packaging that differentiate CAMEL, WINSTON, SALEM, DORAL and
other RJR Tobacco brands from competitive brands. A major focus
for research and development activity is the development of
products that may present less risk associated with smoking. RJR
Tobaccos research and development expense for the years
ended December 31, 2001, 2000 and 1999 was $64 million, $58
million and $59 million, respectively.

Intellectual Property

RJRs operating subsidiaries own numerous trademarks,
including the brand names of their cigarettes and the
distinctive elements of their packaging and displays. RJRs
operating subsidiaries material trademarks are registered
with the U.S. Patent and Trademark Office. Rights in these
trademarks in the United States will last as long as they
continue to use the trademarks. The operating subsidiaries
consider the blends and recipes used to make each of their
brands distinctive to be trade secrets. These trade secrets are
not patented.

RJR Tobacco sold most of its trademarks and patents outside the
United States in connection with the sale of the international
tobacco business to Japan Tobacco Inc.

Legislation and Other Matters Affecting the Cigarette
Industry

The tobacco industry is subject to a wide range of laws and
regulations regarding the advertising, sale, taxation and use of
tobacco products imposed by local, state, federal and foreign
governments. Various state governments have adopted or are
considering, among other things, legislation and regulations
increasing their excise taxes on cigarettes, restricting
displays and advertising of tobacco products, establishing fire
safety standards for cigarettes, raising the minimum age to
possess or purchase tobacco products, requiring the disclosure
of ingredients used in the manufacture of tobacco products,
imposing restrictions on public smoking and restricting the sale
of tobacco products directly to consumers or other unlicensed
recipients or over the Internet. In addition, in 2002, the U.S.
Congress may consider legislation regarding further increases in
the federal excise tax, regulation of cigarette manufacturing
and sale by the U.S. Food and Drug Administration,
implementation of a national standard for fire-safe
cigarettes and changes to the tobacco price support program.
Together with manufacturers price increases in recent
years and substantial increases in state and federal excise
taxes on cigarettes, these developments have had and will likely
continue to have an adverse effect on cigarette sales. For
further discussion of the regulatory and legislative environment
applicable to the cigarette business, see
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Governmental
Activity in Item 7.

Litigation Affecting the Cigarette Industry




Overview







Introduction.Various tobacco-related legal actions and
proceedings are pending or may be instituted against RJR or its
affiliates, including RJR Tobacco, or indemnitees. These actions
and proceedings raise a variety of claims, including product
liability, health-care cost recovery, consumer protection,
smuggling, RICO, tax, antitrust and trade regulation claims.
During 2001, 129 new tobacco-related actions were served against
RJR Tobacco and/or its affiliates or indemnitees, and 154
actions were dismissed or otherwise resolved in favor of RJR
Tobacco and/or its affiliates or indemnitees without trial. On
December 31, 2001, there were 1,639 active cases pending,
including approximately 1,237 individual smoker cases pending in
West Virginia state court as a consolidated action, as compared
with 1,664 on December 31, 2000, and 541 on
December 31, 1999. As of February 7, 2002, 1,657
active cases were pending against RJR Tobacco and/or its
affiliates or indemnitees: 1,652 in the United States; two in
Puerto Rico and one in each of Canada, Israel and the Marshall
Islands. The U.S. case number does not include the 2,852
Broin II cases pending as of February 7, 2002,
discussed below.




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The U.S. cases, exclusive of the Broin IIcases, are
pending in 35 states and the District of Columbia. The breakdown
is as follows: 1,237 in West Virginia; 77 in New York; 58 in
Florida; 52 in California; 29 in Maryland; 28 in the District of
Columbia; 27 in Louisiana; 23 in Mississippi; 12 in Iowa; 11 in
Massachusetts; 10 in each of Missouri and New Jersey; 9 in
Alabama; 8 in Texas; 7 in Georgia; 6 in each of Illinois and
Tennessee; 4 in each of New Hampshire, Nevada and Pennsylvania;
3 in each of Arizona, Connecticut, Michigan, New Mexico and
Ohio; 2 in each of Kansas, North Carolina, North Dakota and
South Dakota; and 1 in each of Indiana, Maine, Minnesota,
Oklahoma, Utah, Washington and Wisconsin. Of the 1,652 active
U.S. cases, 130 are pending in federal court, 1,518 in state
court and 4 in tribal court. Most of these cases were brought by
individual plaintiffs, but many of these cases seek recovery on
behalf of third parties or large classes of claimants.




Certain Terms and Phrases. Certain terms and phrases that
are used in this disclosure may require some explanation. The
terms judgment or final judgment refer
generally to the final decision of the court resolving the
dispute and determining the rights and obligations of the
parties. At the trial court level, for example, a final judgment
generally is entered by the court after a jury verdict and after
post-verdict motions have been decided. As a general
proposition, the losing party can appeal a verdict only after a
final judgment has been entered by the trial court.







The term damages refers to the amount of money
sought by a plaintiff in a complaint, or awarded to a party by a
jury, or in some cases by a judge. Compensatory
damages are awarded to compensate the prevailing party for
actual losses suffered  if liability is proved. In
cases in which there is a finding that a defendant has acted
willfully, maliciously or fraudulently, generally based on a
higher burden of proof than is required for a finding of
liability for compensatory damages, a plaintiff also may be
awarded punitive damages. Although damages may be awarded at the
trial court stage, a losing party may be protected from paying
any damages until all appellate avenues have been exhausted by
posting a supersedeas bond. The amount of such a bond is
governed by the law of the relevant jurisdiction and generally
is set at the amount of damages plus some measure of statutory
interest, modified at the discretion of the appropriate court or
subject to a cap set by court or statute.







The term settlement refers to certain types of cases
in which cigarette manufacturers, including RJR Tobacco, have
agreed to resolve disputes with certain plaintiffs without
resolving the case through trial. The principal terms of
settlements entered into by RJR Tobacco are explained in the
following disclosure.







Accounting for Tobacco-Related Litigation Contingencies.In accordance with applicable accounting principles, RJR and
RJR Tobacco will record any loss related to tobacco litigation
at such time as an unfavorable outcome becomes probable and the
amount can be reasonably estimated. For the reasons set forth
below, RJRs management continues to conclude that the loss
of any particular smoking and health tobacco litigation claim
against RJR Tobacco or its affiliates, when viewed on an
individual basis, is not probable. RJR Tobacco and its
affiliates, including RJR, believe that they have a number of
valid defenses to the tobacco-related litigation claims against
them, as well as valid bases for appeal of adverse verdicts
against RJR Tobacco. RJR and RJR Tobacco have, through their
counsel, filed pleadings and memoranda in pending
tobacco-related litigation that set forth and discuss a number
of grounds and defenses that RJR, RJR Tobacco and their counsel
believe have a valid basis in law and fact. Based on their
experience in the tobacco-related litigation against them and
the strength of the defenses available to them in such
litigation, RJR Tobacco and its affiliates believe that their
consistently successful defense of tobacco-related litigation in
the past will continue in the future. Therefore, no liability
for pending tobacco-related litigation currently is recorded in
RJRs consolidated financial statements.







Neither RJR Tobacco nor its affiliates, including RJR, have paid
any damages as the result of a final judgment entered after a
fully litigated smoking and health tobacco litigation claim
(i.e., after all appeals have been exhausted), and a very high
percentage of the tobacco-related litigation claims brought
against them continue to be dismissed at or before trial.
Generally, RJR Tobacco and its affiliates, including RJR, have
not settled, and currently do not intend to settle, any smoking
and health tobacco litigation claims. It is the policy of RJR
Tobacco and its affiliates, including RJR, to vigorously defend
all tobacco-related litigation claims.




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The only smoking and health tobacco litigation claims settled by
RJR Tobacco involved (1) the MSA, the related settlements
with the states of Mississippi, Florida, Texas and Minnesota,
and the funding by various tobacco companies of a
$5.2 billion trust fund contemplated by the MSA to benefit
tobacco growers, and (2) the original Broinflight
attendant case discussed below under 
Class Action Suits. Despite having valid legal
defenses, RJR Tobacco settled these matters because of unique
circumstances that do not apply to the other tobacco litigation
cases pending against RJR Tobacco and its affiliates, including
RJR.







The circumstances surrounding the MSA, the state-specific
settlements and the funding of a trust fund to benefit the
tobacco growers are readily distinguishable from the current
categories of cases involving RJR Tobacco. The claims underlying
the MSA and the state-specific settlements were brought by the
states to recover health-care costs paid on behalf of state
citizens suffering from diseases and conditions allegedly
related to tobacco use. The MSA and the state-specific
settlements settled all the health-care cost recovery actions
brought by, or on behalf of, the settling jurisdictions and
contain releases of various additional present and future
claims. In accordance with the MSA, various tobacco companies
agreed to fund a $5.2 billion trust fund to be used to address
the possible adverse economic impact of the MSA on tobacco
growers. A discussion of the MSA and the other state settlement
agreements, and a table depicting the related payment schedule
under these agreements, is set forth below under
 Governmental Health-Care Cost Recovery
Cases  MSA and Other State Settlement
Agreements.







The states were a unique set of plaintiffs and are not
plaintiffs in any of the smoking and health cases remaining
against RJR or RJR Tobacco. Although RJR Tobacco continues to be
a defendant in certain health-care cost recovery cases similar
in theory to the state cases but involving other plaintiffs,
such as unions, hospitals, Native American tribes, and local and
foreign governments, the vast majority of such cases have been
dismissed on legal grounds. Indeed, eight federal courts of
appeals have ruled uniformly that unions cannot successfully
pursue such cases. As a result, no union cases are pending
against RJR or RJR Tobacco. RJR and RJR Tobacco believe that the
same legal principles that have resulted in dismissal of union
and other types of health-care cost recovery cases either at the
trial court level or on appeal should compel the dismissal of
the similar pending cases.







Finally, in the Department of Justice case brought against
various industry members, including RJR Tobacco, the U.S.
District Court for the District of Columbia granted the
non-Liggett defendants motion to dismiss plaintiffs
Medical Care Recovery Act and Medicare Secondary Payer claims.
In these particular claims, the federal government made
arguments similar to the states and sought to recover federal
funds expended in providing health care to smokers who have
developed diseases and injuries alleged to be smoking-related.
The only remaining claims in this case involve alleged
violations of the federal RICO statute.







Similarly, the original Broincase, discussed below under
 Class Action Suits, was settled in
the middle of trial during discussions with the federal
government concerning the possible settlement of the claims
underlying the MSA and the state-specific settlements, among
other things. The Broincase was settled at that time in
an attempt to remove this case as a political distraction during
the industrys settlement discussions with the federal
government and a belief that further Broinlitigation
would be resolved by a settlement at the federal level.







Following is a description of the material pending
tobacco-related litigation to which RJR Tobacco and its
affiliates, including RJR, are subject. Even though RJRs
management continues to conclude that the loss of any particular
smoking and health tobacco litigation claim against RJR Tobacco
or its affiliates, when viewed on an individual basis, is not
probable, the possibility of material losses related to tobacco
litigation is more than remote. However, RJRs management
is unable to predict the outcome of such litigation or to
reasonably estimate the amount or range of any possible loss.
Moreover, notwithstanding the quality of defenses available to
it and its affiliates in tobacco-related litigation matters, it
is possible that RJRs results of operations, cash flows or
financial condition could be materially adversely affected by
the ultimate outcome of certain pending or future litigation
matters.




Theories of Recovery.The plaintiffs seek recovery on a
variety of legal theories, including strict liability in tort,
design defect, negligence, special duty, voluntary undertaking,
breach of warranty, failure to warn, fraud, misrepresentation,
unfair trade practices, conspiracy, aiding and abetting, unjust
enrichment, indemnity,

9



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Broin
II


Defenses.The defenses raised by RJR Tobacco and/or its
affiliates, including RJR, include, where applicable, preemption
by the Federal Cigarette Labeling and Advertising Act of some or
all such claims arising after 1969, the lack of any defect in
the product, assumption of the risk, contributory or comparative
fault, lack of proximate cause and statutes of limitations or
repose. RJR has asserted additional defenses, including
jurisdictional defenses, in many of the cases in which it is
named.

Industry Trial Results in Individual Smoker Cases.The
tobacco industry in general, and RJR Tobacco in particular,
continue to win most individual smoking and health cases. In
Anderson v. Fortune Brands, Inc., a Brooklyn, New York
jury found in favor of the industry, including RJR Tobacco, on
June 27, 2000. The plaintiff failed to perfect his appeal
by submitting his brief and record by June 22, 2001. The
Appellate Division dismissed the appeal on September 18,
2001. In Nunnally v. R. J. Reynolds Tobacco Co., a
Mississippi state court jury found RJR Tobacco not liable on
July 12, 2000. Plaintiffs motion for judgment
notwithstanding the verdict, or in the alternative, for a new
trial, was denied, and plaintiffs appeal to the
Mississippi Supreme Court is pending. On January 16, 2001,
a Brooklyn, New York state court jury returned a verdict in
favor of RJR Tobacco and other cigarette manufacturers in
Apostolou v. American Tobacco Co.On September 7,
2001, the plaintiff appealed the final judgment to the Appellate
Division of the New York Supreme Court. In Little v. Brown
& Williamson Tobacco Corp., a South Carolina federal
district court judge granted a directed verdict in favor of RJR
Tobacco on January 30, 2001. The jury rendered a verdict in
favor of the remaining defendant, Brown & Williamson, on
February 6, 2001. The plaintiff voluntarily dismissed her
appeal to the United States Court of Appeals for the Fourth
Circuit on April 19, 2001. On March 7, 2001, in Grinnell
v. Brown & Williamson Tobacco Corp., a Texas state court
jury returned a verdict in favor of Brown & Williamson. On
May 16, 2001, a state court jury in New Jersey returned a
verdict in favor of RJR Tobacco and Philip Morris in Mehlman
v. Philip Morris, Inc.On October 5, 2001, an Ohio
federal court jury returned a unanimous verdict in favor of
Philip Morris, Brown & Williamson and Lorillard in
Tompkin v. American Tobacco Co.On October 23, 2001,
plaintiff filed a motion for a new trial. The judge in this case
referred the parties to mediation in order to avoid the
transaction costs associated with an appeal. The mediation
failed and the case was returned to the presiding judge who then
denied plaintiffs motion for a new trial. Finally, on
November 13, 2001, a state court judge in Connecticut
granted Brown & Williamsons motion for a directed
verdict in DuJack v. Brown & Williamson Tobacco Co.

RJR Tobacco has prevailed in virtually all individual smoker
cases that have gone to trial. However, in Whiteley v.
Raybestos-Manhattan, Inc., a tobacco-asbestos synergy case
brought in San Francisco Superior Court, the jury found against
RJR Tobacco and Philip Morris on March 20, 2000, and
awarded $1.7 million in compensatory damages. On March 27,
2000, the same jury awarded $20 million in punitive damages, $10
million against RJR Tobacco and $10 million against Philip
Morris. RJR Tobacco and Philip Morris have appealed. In Jones
v. R. J. Reynolds Tobacco Co., a wrongful death case, a
Tampa state court jury found against RJR Tobacco on
October 12, 2000. Although the jury found that RJR Tobacco
was negligent and liable, it refused to find that RJR Tobacco
was part of a conspiracy to defraud. The jury awarded

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Kenyon v. R. J. Reynolds Tobacco Co.


Juries have found for plaintiffs in six smoking and health cases
in which RJR Tobacco was not a defendant. Two of the verdicts
were overturned on appeal and have been dismissed; three others
are on appeal; and damages have been paid in one case. In
February 1999, in Henley v. Philip Morris, Inc., a San
Francisco state court jury awarded an individual smoker $1.5
million in compensatory damages and $50 million in punitive
damages. In April 1999, the trial judge reduced the punitive
damages award to $25 million, but otherwise denied Philip
Morris post-trial motions challenging the verdict. On
November 7, 2001, a California appellate court upheld the
jurys 1999 verdict against Philip Morris.Philip
Morris has appealed that decision to the California Supreme
Court, which accepted the appeal on a grant and hold
basis (another appeal has to be decided prior to ruling on the
Henleypetition). In Williams v. Philip Morris,
Inc., an Oregon state court jury awarded the plaintiff
$800,000 in actual damages, $21,500 in medical expenses and $79
million in punitive damages. The judge reduced the punitive
damages to $32 million. Philip Morris appeal is pending.
On June 6, 2001, in Boeken v. Philip Morris, Inc., a
California state court jury found in favor of the plaintiff and
awarded approximately $5.5 million in compensatory damages and
$3 billion in punitive damages. Philip Morris filed motions to
reduce the damages, for judgment notwithstanding the verdict or
for a new trial. On August 9, 2001, plaintiff agreed to the
courts recommendation that the $3 billion punitive damages
award be reduced to $100 million. On September 7, 2001,
Philip Morris filed its notice of appeal to the California Court
of Appeals. In Carter v. American Tobacco Co., the
Florida Supreme Court, on November 22, 2000, reinstated the
jury verdict against Brown & Williamson. According to press
reports, Brown & Williamson paid approximately $1.09 million
to the plaintiff on February 8, 2001. On June 29,
2001, the U.S. Supreme Court declined to review the case, thus
leaving the jury verdict intact.

Broin II Cases.As of February 7, 2002,
approximately 2,852 lawsuits brought by individual flight
attendants for personal injury as a result of illness allegedly
caused by exposure to secondhand tobacco smoke in airplane
cabins, referred to as the Broin IIcases, are pending in
Florida. In these lawsuits, filed pursuant to the terms of the
settlement of the Broin v. Philip Morris, Inc.class
action, discussed below, each individual flight attendant will
be required to prove that he or she has a disease caused by
exposure to secondhand smoke in airplane cabins.

On October 5, 2000, Judge Robert Kaye entered an order
applicable to all Broin IIcases that the terms of the
Broinsettlement agreement do not require the individual
Broin IIplaintiffs to prove the elements of strict
liability, breach of warranty or negligence. Under this order,
there is a rebuttable presumption in plaintiffs favor on
those elements, and plaintiffs bear the burden of proving that
their alleged adverse health effects actually were caused by
exposure to environmental tobacco smoke. Although defendants
still may prevail on causation and other theories, RJR Tobacco
does not believe that the order is correct under Florida law or
that it accurately reflects the intent of the Broinsettlement agreement. Accordingly, defendants appealed Judge
Kayes ruling to the Third District Court of Appeal on
November 3, 2000. Plaintiffs moved to dismiss the appeal on
November 28, 2000. On January 12, 2001, the Third
District Court of Appeal denied plaintiffs motion and
ordered oral argument. On October 10, 2001, a different
panel of the Third District Court of Appeal dismissed the
appeal, finding that Judge Kayes order is not an
appealable order at this time, but noted that the ruling is
without prejudice to the defendants ability to appeal the
issue at the appropriate time. On January 16, 2002,
defendants filed a writ to invoke the discretionary jurisdiction
of the Florida Supreme Court.

On April 5, 2001, in the first Broin IIflight
attendant case to go to trial, Fontana v. Philip Morris,
Inc., a Florida state court jury returned a verdict in favor
of the defendants, including RJR Tobacco. On April 16,
2001, plaintiff filed motions for a mistrial, judgment
notwithstanding the verdict, or for a new trial. On

11



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Class Action Suits.In May 1996, in Castano v.
American Tobacco Co., the Fifth Circuit Court of Appeals
overturned the certification of a nationwide class of persons
whose claims related to alleged addiction to tobacco. Since this
ruling by the Fifth Circuit, most class-action suits have sought
certification of statewide, rather than nationwide, classes.

Class action suits based on claims similar to those asserted in
Castano have been brought against RJR Tobacco, and in
some cases RJR, in state or federal courts in Alabama, Arkansas,
California, the District of Columbia, Florida, Georgia, Hawaii,
Illinois, Indiana, Iowa, Kansas, Louisiana, Maryland,
Massachusetts, Michigan, Minnesota, Missouri, Nevada, New
Jersey, New Mexico, New York, North Carolina, Ohio, Oklahoma,
Pennsylvania, South Carolina, Tennessee, Texas, Utah, Virginia,
West Virginia and Wisconsin. In addition, a class action filed
in Tennessee seeks reimbursement of Blue Cross and Blue Shield
premiums paid by subscribers throughout the United States and
class-action suits in Illinois, Missouri and New Jersey claim
that the marketing of light and
ultralight cigarettes is deceptive. Plaintiffs have
made similar claims in other lawsuits elsewhere. Other types of
class-action suits also have been filed in additional
jurisdictions. Most of these suits assert claims on behalf of
classes of individuals who claim to be addicted, injured or at
greater risk of injury by the use of tobacco or exposure to
environmental tobacco smoke, or the legal survivors of such
persons. A number of unions and other third-party payors have
filed health-care cost recovery actions in the form of class
actions. These cases are discussed separately below. Class
certification motions are pending in several state and federal
courts.

Few smoker class-action complaints have been certified or, if
certified, have survived on appeal. All 16 federal courts that
have considered the issue, including two courts of appeals, have
rejected class certification in smoker cases. On March 19,
2001, in Guillory v. American Tobacco Co., Inc., the
United States District Court for the Northern District of
Illinois refused to certify a class defined as all
Illinois residents who smoke or smoked cigarettes manufactured
by defendants, who started smoking while a minor, who purchase
or purchased cigarettes in Illinois and who desire to
participate in a program designed to assist them in the
cessation of smoking and/or monitor their medical condition to
promote early detection of disease caused by, contributed, or
exacerbated by cigarette smoking. On May 17, 2001, in
Brown v. Philip Morris, Inc., the United States Court of
Appeals for the Third Circuit affirmed the trial courts
dismissal of a proposed class action alleging the violation of
civil rights by the targeting of African-American
smokers. On June 29, 2001, the United States District
Court for the District of Nevada denied plaintiffs motions
for class certification in three cases involving casino workers
exposed to environmental tobacco smoke and one case involving
smokers with injuries allegedly caused by smoking. These four
cases, which were consolidated for class certification purposes,
are: (1) Badillo v. American Tobacco Co., Inc.; (2)
Christensen v. Philip Morris Cos., Inc.; (3) Dienno v.
Liggett Group, Inc.; and (4) Selcer v. R. J. Reynolds
Tobacco Co. Most recently, two cases, Mahoney v. R. J.
Reynolds Tobacco Co.and Davis v. R. J. Reynolds Tobacco
Co.,were denied class certification by the United States
District Court for the Southern District of Iowa.

Similarly, most state courts have refused to certify smoker
class actions. On December 8, 2000, in Geiger v.
American Tobacco Co., the Appellate Division of the Supreme
Court of New York, Second Judicial Department, affirmed the
trial courts denial of class action status to a purported
class defined as all New York residents, including their heirs,
representatives and estates, who contracted lung and/or throat
cancer as a result of smoking cigarettes. Plaintiffs filed a
motion for leave to appeal the order denying certification to
the New York Court of Appeals, the highest court in the state.
The New York Court of Appeals dismissed plaintiffs appeal
on February 13, 2001.

Classes have been certified thus far in several state court
class-action cases in which RJR Tobacco is a defendant. On
November 5, 1998, in Scott v. American Tobacco Co.,
a Louisiana state appeals court affirmed the certification of a
medical monitoring and/or smoking cessation class of Louisiana
residents who were smokers on or before May 24, 1996. On
February 26, 1999, the Louisiana Supreme Court denied the
defendants petition for writ of certiorari and/or review.
Jury selection began on June 18, 2001. Defendants appealed
the jury selection process to the Louisiana Fourth Circuit Court
of Appeal on July 18, 2001. On

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Trial began on January 4, 2001, in Blankenship v. Philip
Morris, Inc., a West Virginia state court medical monitoring
class action. The trial of this case ended on January 25,
2001, when the judge declared a mistrial. Argument on
decertification of the class, among other things, was held on
February 19, 2001. On March 23, 2001, the judge denied
the defendants motion to decertify the class. The retrial
of this case began on September 5, 2001, and ended on
November 14, 2001, when the jury returned a verdict in
favor of RJR Tobacco and other cigarette manufacturers.

On November 30, 2000, in Daniels v. Philip Morris Cos.,
Inc., a San Diego Superior Court judge reversed a prior
ruling and, based on a California unfair business practices
statute, certified a class consisting of all persons who, as
California resident minors, smoked one or more cigarettes in
California between April 2, 1994 and December 1, 1999.
Trial has been scheduled for July 1, 2002.

On April 11, 2001, in Brown v. American Tobacco Co.,
Inc., the same judge granted in part plaintiffs motion
for class certification. The class is composed of adult
residents of California who smoked at least one of
defendants cigarettes during the applicable time
period, and who were exposed to defendants marketing
and advertising activities in California. Certification was
granted as to plaintiffs claims that defendants violated
§17200 of the California Business and Professions Code. The
court, however, refused to certify the class under the
California Legal Remedies Act. Class certification on
plaintiffs common law claims was denied on April 10,
2000. Defendants petitioned the California Supreme Court to
review the trial courts class certification ruling, but
the Supreme Court denied the petition on January 16, 2002.
The trial has been scheduled for October 11, 2002.

Most recently, on November 14, 2001, in Turner v. R. J.
Reynolds Tobacco Co., an Illinois state court judge
certified a class defined as [a]ll persons who purchased
defendants Doral Lights, Winston Lights, Salem Lights and
Camel Lights, in Illinois, for personal consumption, between the
first date that defendants sold Doral Lights, Winston Lights,
Salem Lights and Camel Lights through the date the court
certifies this suit as a class action . . . . Trial is
scheduled for March 17, 2003. This case currently includes
both RJR and RJR Tobacco as defendants.

Defendants, including RJR Tobacco, settled one class-action
suit, Broin v. Philip Morris, Inc., in October 1997. The
Florida Court of Appeal denied challenges to this settlement on
March 24, 1999, and subsequently denied motions to
reconsider. On September 7, 1999, the Florida Supreme Court
dismissed all proceedings, and the settlement and judgment
became final. The Broin IIcases, discussed above, arose
out of the settlement of this case.

Trial began in July 1998 in Florida state court in Engle v.
R. J. Reynolds Tobacco Co., in which a class consisting of
Florida residents, or their survivors on their behalf, claim to
have diseases or medical conditions caused by their alleged
addiction to cigarettes. On July 7, 1999, the
jury found against RJR Tobacco and the other cigarette
manufacturer defendants in the initial phase, which included
common issues related to certain elements of liability, general
causation and a potential award of or entitlement to punitive
damages.

The second phase of the trial, which consisted of the claims of
three of the named class representatives, began on
November 1, 1999. On April 7, 2000, the jury returned
a verdict against all defendants. They awarded plaintiff Mary
Farnan $2.85 million, the estate of plaintiff Angie Della
Vecchia $4.023 million and

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The trial court also ordered the jury in the second phase of the
trial to determine punitive damages, if any, on a class-wide
basis. On July 14, 2000, the jury returned a punitive
damages verdict in favor of the Florida class of
approximately $145 billion against all the defendants, with
approximately $36.3 billion being assigned to RJR Tobacco.

On July 24, 2000, the defendants, including RJR Tobacco,
filed numerous post-verdict motions, including motions for a new
trial and to reduce the amount of the punitive damages verdict.
On November 6, 2000, the trial judge denied the post-trial
motions and entered judgment. On November 7, 2000, RJR
Tobacco posted an appeal bond in the amount of $100 million,
pursuant to a Florida statute enacted on May 9, 2000, and
intended to apply to the Engle case, and initiated the
appeals process. The opening appellate brief of certain
defendants, including RJR Tobacco, was filed on
November 26, 2001. RJR Tobacco believes it has numerous
bases for a successful appeal, although it cannot predict the
outcome of the appellate process.

On May 7, 2001, three of the defendants entered into
agreements with the Engleclass to deposit an additional
$1.86 billion into separate escrow accounts to ensure that the
stay of execution that is in effect pursuant to the Florida bond
statute will remain in effect as to these three defendants
throughout the appellate process, regardless of the results of a
challenge, if any, to the Florida bond statute. Approximately
$700 million of the total amount deposited by these three
defendants is non-refundable and will go to the trial court to
be distributed, regardless of the result of the appeal. RJR
Tobacco has not entered into a similar agreement with the
Engleclass. Although RJR Tobacco cannot predict the
outcome of any possible challenges to the Florida bond statute,
RJR Tobacco remains confident of the applicability and validity
of the statute in the Englecase. In addition, nine other
states, Georgia, Kentucky, Louisiana, Nevada, North Carolina,
Oklahoma, South Carolina, Virginia and West Virginia, have
enacted legislation similar to the Florida bond statute. The
Mississippi Supreme Court also has placed limits on appeal bonds
by court rule.




RJR Tobacco and other cigarette manufacturer defendants settled
one class-action suit, Broin v. Phillip Morris, Inc., in
October 1997. This case had been brought in Florida state court
on behalf of all flight attendants of U.S. airlines alleged to
be suffering from diseases or ailments caused by exposure to
second hand smoke in airplane cabins. The settlement agreement
required the participating tobacco companies to pay a total of
$300 million in three annual $100 million
installments, allocated among the companies by market share, to
fund research on the early detection and cure of diseases
associated with tobacco smoke. It also required those companies
to pay a total of $49 million for plaintiffs
counsels fees and expenses. RJR Tobaccos portion of
these payments was approximately $86 million. The
settlement agreement bars class members from bringing aggregate
claims or obtaining punitive or exemplary damages and also bars
individual claims to the extent that they are based on fraud,
misrepresentation, conspiracy to commit fraud or
misrepresentation, RICO, suppression, concealment or any other
alleged intentional or willful conduct. The defendants agreed
that, in any individual case brought by a class member, the
defendant will bear the burden of proof with respect to whether
ETS can cause certain specifically enumerated diseases
(general causation). With respect to all other
issues relating to liability, including whether an individual
plaintiffs disease was caused by his or her exposure to
ETS in aircraft cabins (specific causation), the
individual plaintiff will have the burden of proof.
Floridas Third District Court of Appeal denied various
challenges to this settlement on March 24, 1999, and
subsequently denied motions to reconsider. On September 7,
1999, the Florida Supreme Court dismissed all proceedings, and
the settlement and judgment became final. The Broin IIcases, discussed above, arose out of the settlement of this
case.




Governmental Health-Care Cost Recovery Cases.In June
1994, the Mississippi attorney general brought an action,
Moore v. American Tobacco Co., against various industry
members, including RJR Tobacco. This case was brought on behalf
of the state to recover state funds paid for health care and
medical and other assistance to state citizens suffering from
diseases and conditions allegedly related to tobacco use. By
making the state the plaintiff in the case and basing its claims
on economic loss rather than personal injury, the state sought
to avoid the defenses otherwise available against an individual
plaintiff. Most other states,

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On November 23, 1998, the major U.S. cigarette
manufacturers, including RJR Tobacco, entered into the Master
Settlement Agreement with attorneys general representing the
remaining 46 states, the District of Columbia, Puerto Rico,
Guam, the Virgin Islands, American Samoa and the Northern
Marianas. The MSA became effective on November 12, 1999,
when final approval of the settlement was achieved in 80% of the
settling jurisdictions. As of October 17, 2000, final
approval had been achieved in all settling jurisdictions. The
MSA settled all the health-care cost recovery actions brought
by, or on behalf of, the settling jurisdictions and contains
releases of various additional present and future claims.

In the settling jurisdictions, the MSA released RJR Tobacco,
indemnitees and RJR from: (1) all claims of the settling
states and their respective political subdivisions and other
recipients of state health-care funds, relating to past conduct
arising out of the use, sale, distribution, manufacture,
development, advertising, marketing or health effects of, the
exposure to, or research, statements or warnings about, tobacco
products and (2) all monetary claims relating to future
conduct arising out of the use of, or exposure to, tobacco
products that have been manufactured in the ordinary course of
business.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  Monetary Liabilities.In addition to payments
    already made, the MSA calls for additional initial industry
    payments of approximately $2.6 billion and $2.7 billion in 2002
    and 2003, respectively. A substantial portion of the payment due
    in 2002 was prepaid in 2001 to obtain the tax benefit of the
    early payment. The MSA also requires perpetual annual industry
    payments, which started in 2000. The unadjusted annual payment
    currently is $6.5 billion and increases to $8 billion in 2004,
    to $8.14 billion in 2008 and finally to $9 billion in 2018 and
    thereafter. Ten additional payments of $861 million are due
    annually beginning in April 2008. All payments are to be
    allocated among the companies on the basis of relative market
    share and most are subject to adjustments for changes in sales
    volume, inflation and other factors. RJR Tobacco records its
    allocation of charges in cost of goods sold as products are
    shipped.                                                                                                                                                
|
| | The tobacco companies also agreed to (1) make a one-time
    payment of $50 million on March 31, 1999, to establish a
    fund for enforcement of the MSA and laws relating to tobacco
    products and (2) fund activities of the National
    Association of Attorneys General relating to the MSA at the cost
    of $150,000 per year for ten years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| | In addition, the MSA calls for the creation of a national
    foundation to support the study of, and programs to reduce,
    youth tobacco product usage and youth substance abuse, and the
    study of educational programs to prevent diseases associated
    with tobacco product use. The tobacco companies agreed to fund
    the foundation with (1) ten annual payments of $25 million,
    which began on March 31, 1999, (2) further payments of
    $250 million, which began on March 31, 1999, and $300
    million annually thereafter for four years, and
    (3) additional annual payments of $300 million beginning in
    2004 if, during the year preceding the year when payment is due,
    participating manufacturers collectively accounted for at least
    99.05% of the cigarette market. Each of these payments is to be
    allocated among the companies on the basis of relative market
    share. Other than the $25 million annual payments and the $250
    million payment made on March 31, 1999, the payments for
    the foundation are subject to adjustments for changes in sales
    volume, inflation and other factors.
|
| | The manufacturers also agreed to pay the litigation costs,
    including government attorneys fees, of the offices of the
    attorneys general relating to the settled cases and, subject to
    certain quarterly and annual payment caps, the costs and fees of
    outside counsel to the jurisdictions. Outside counsel fees have
    been determined either by arbitration or in accordance with a
    negotiated fee procedure. Awards determined by arbitration will
    be paid subject to an aggregate annual cap on arbitrated
    attorneys fees for all these and certain other settled
    cases of $500 million. Fees set by the negotiated fee procedure
    are subject to an annual cap of $250 million, and will not
    exceed a total of $1.25 billion. As of February 7, 2002,
    publicly announced awards determined by arbitration totaled
    approximately $11.7 billion, and awards determined in accordance
    with a negotiated fee procedure totaled approximately $626
    million.                                                                                                                                             

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Reimbursement of costs is capped at $150 million for litigation
    costs, including government attorneys fees, of the
    attorneys general offices and at $75 million annually for
    outside counsels costs. Payments for attorneys fees
    and costs are to be allocated on a relative market share basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  Growers Trust.As part of the MSA, the
    tobacco companies agreed to work with U.S. tobacco growers to
    address the possible adverse economic impact of the MSA on
    growers. As a result, RJR Tobacco and the three other major
    manufacturers agreed to participate in funding a $5.2 billion
    trust fund to be administered by a trustee, in conjunction with
    a certification entity from each of the tobacco growing states.
    The trust agreement provides for a schedule of aggregate annual
    payments, subject to various adjustments, that are payable in
    quarterly installments each year from 1999 through 2010. The
    aggregate annual payment by all participating manufacturers is
    adjusted each year for inflation and any change in the total
    domestic cigarette volume of all participating manufacturers. In
    general, the annual payment by each participating manufacturer,
    including RJR Tobacco, is based on each manufacturers
    relative market share of total domestic cigarette shipments
    during the preceding calendar year. Each manufacturers
    annual payment is also subject to a tax offset adjustment.
|
| |  Other MSA Obligations.The MSA also contains
    provisions restricting the marketing of cigarettes. Among these
    are restrictions or prohibitions on the use of cartoon
    characters, brand name sponsorships, brand name non-tobacco
    products, outdoor and transit brand advertising, payments for
    product placement, free sampling and lobbying. The MSA also
    required the dissolution of three industry-sponsored research
    and advocacy organizations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

RJR Tobaccos settlement expenses under these agreements
were $2.6 billion, $2.3 billion and $2.2 billion in 2001, 2000
and 1999, respectively. The cash payments made by RJR Tobacco
under the MSA and other existing settlement agreements were $2.4
billion, $2.2 billion and $1.6 billion in 2001, 2000 and 1999,
respectively. RJR Tobacco estimates these payments to be $2.4
billion in 2002 and to exceed $2 billion per year thereafter.
However, these payments will be subject to adjustments based
upon, among other things, the volume of cigarettes sold by RJR
Tobacco, RJR Tobaccos market share and inflation.

Certain litigation has arisen challenging the validity of the
MSA, including cases with claims that the MSA violates antitrust
laws. On January 5, 2001, the United States District Court for
the Northern District of California dismissed one of those
cases, Forces Action Project v. California. On
August 15, 2001, the United States Court of Appeals for the
Ninth Circuit remanded the antitrust claim, but affirmed the
district courts dismissal of the remaining claims. On
January 15, 2002, the United States District Court judge
denied plaintiffs motion to amend the complaint which
effectively dismissed the case.

Six actions are pending against RJR Tobacco alleging various
violations of the MSA. RJR Tobacco believes it has meritorious
defenses to each of these actions.

Arizona, California, New York and Washington have alleged that
the posting of signage advertising RJR Tobaccos brand name
sponsorships violates a provision of the MSA governing the times
during which such signs may be posted. On November 16,
2001, in the Arizona signage action, the trial court granted
summary judgment in favor of the state. On November 27,
2001, the trial court ruled similarly in the California signage
matter. However, on February 1, 2002, a New York trial
court upheld RJR Tobaccos position. Appeals of all of
these decisions are pending or anticipated. Trial in the
Washington matter is scheduled for August 5, 2002.

The State of Ohio has alleged that RJR Tobaccos purchase
of advertising space on matchbooks distributed by an independent
third party violates a provision of the MSA governing brand name
merchandise. In November 2001, the trial court heard arguments
on the parties cross-motions for summary judgment and took
the motions under advisement.

Finally, the State of California has alleged that the
publications in which RJR Tobacco places advertising evidences
direct or indirect targeting of youth which is prohibited by the
MSA. Pretrial discovery is proceeding, and the trial is
scheduled for April 19, 2002.

On June 8, 2001, the Attorney General of the State of
California filed a lawsuit against RJR Tobacco in California
state court alleging that RJR Tobacco violated California state
law by distributing free cigarettes

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On April 20, 1999, the Canadian Province of British
Columbia brought a case in British Columbia Provincial Court,
similar to the U.S. attorneys general cases discussed
above, against RJR Tobacco and certain other Canadian and U.S.
tobacco companies and their parent companies, including RJR.
This lawsuit relied heavily upon special legislation enacted in
British Columbia that was separately challenged by various
Canadian tobacco companies. An agreement was reached with the
government in British Columbia to litigate the separate
constitutional challenges prior to the health-care cost recovery
action. On February 21, 2000, the British Columbia Supreme
Court declared the Cost Recovery Act unconstitutional and
dismissed the action. This decision was not appealed by the
government. On January 24, 2001, the Canadian Province of
British Columbia brought a second action in British Columbia
Provincial Court. A trial is likely to occur in October 2002.

On September 22, 1999, the U.S. Department of Justice
brought an action in the United States District Court for the
District of Columbia against various industry members, including
RJR Tobacco. The government sought to recover federal funds
expended in providing health care to smokers who have developed
diseases and injuries alleged to be smoking-related, and, in
addition, seeks, pursuant to the federal RICO statute,
disgorgement of profits the government contends were earned as a
consequence of a RICO racketeering enterprise. On
December 27, 1999, defendants filed a motion to dismiss
challenging all counts included in the action brought by the
DOJ. On June 6, 2000, the trial court heard oral argument
on the motion. On September 28, 2000, federal court Judge
Gladys Kessler of the United States District Court for the
District of Columbia granted the non-Liggett defendants
motion to dismiss the following counts of plaintiffs
complaint: (1) Medical Care Recovery Act claim, and
(2) Medicare Secondary Payer claim. The court, however,
denied the motion with respect to the RICO claims. On
October 13, 2000, the United States filed a motion to limit
Judge Kesslers September 28, 2000 order to claims for
payments under Medicare and the Federal Employee Health Benefits
Act.

Discovery in the DOJ lawsuit is ongoing, and trial has been
scheduled for July 15, 2003. RJR Tobacco believes it has
meritorious factual and legal defenses to that lawsuit. In June
2001, the United States Attorney General assembled a team of
three DOJ lawyers to work on a possible settlement of the
federal lawsuit. The DOJ lawyers met with representatives of the
tobacco industry, including RJR Tobacco, on July 18, 2001.
No settlement was reached and no further meetings are planned.

Union Cases.Although the MSA settled some of the most
potentially burdensome health-care cost recovery actions, many
other such cases have been brought by other types of plaintiffs.
As of February 7, 2002, approximately 14 lawsuits by union
trust funds against cigarette manufacturers and others are
pending. The funds seek recovery of payments made by them for
medical expenses of their participant union members and their
dependents allegedly injured by cigarettes. The claims in these
cases are almost identical, and several of these cases purport
to be class actions on behalf of all union trust funds in a
particular state.

The defendants in these actions argue, among other things, that
one who pays an injured persons medical expenses is
legally too remote to maintain an action against the person
allegedly responsible for the injury. In addition, they argue
that the traditional subrogation remedy cannot be supplanted by
a direct right of action for the trust fund that strips
defendants of the defenses they would ordinarily have against
the allegedly injured individual.

On March 29, 1999, in the first of these cases to be
considered by a federal court of appeals, Steamfitters Local
Union 420 v. Philip Morris, Inc., the United States Court of
Appeals for the Third Circuit affirmed a district court ruling
dismissing the case on remoteness grounds. Since then, the U.S.
Courts of Appeals for the Second, Third, Fifth, Seventh, Eighth,
Ninth and Eleventh Circuits have all ruled in favor of the
industry in similar union cases. On January 10, 2000, the
United States Supreme Court denied petitions for certiorari
filed in cases from the Second, Third and Ninth Circuits.

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Numerous trial court judges also have dismissed union trust fund
cases on remoteness grounds. Nonetheless, some union, or other
third-party payor, cases have survived motions to dismiss and
have proceeded or may proceed to trial. On August 2, 1999,
a federal district court in New York denied defendants
motions to dismiss in two separate cases heard together,
National Asbestos Workers Medical Fund v. Philip Morris, Inc.and Blue Cross and Blue Shield of New Jersey, Inc. v.
Philip Morris, Inc., discussed below. On December 21,
1999, the federal district court in the District of Columbia
denied defendants motions to dismiss in three cases
consolidated for pretrial purposes: Service Employees
International Union Health and Welfare Fund v. Philip Morris,
Inc., S.E.I.U. Local 74 Welfare Fund v. Philip Morris,
Inc.and Holland v. Philip Morris, Inc.On
May 22, 2001, the United States Court of Appeals for the
District of Columbia reversed the federal district courts
ruling that denied in part defendants motion to dismiss,
and affirmed the portion of the ruling that dismissed the bulk
of plaintiffs claims in these cases. In the same opinion,
the court reversed the district courts ruling that denied
defendants motion to dismiss the RICO and fraud claims in
Sheet Metal Workers Trust Fund v. Philip Morris, Inc.,
which had been consolidated with the first three cases for
purposes of pretrial discovery. The result of the D.C.
Circuits ruling is that all claims in these four cases, as
well as several additional union trust fund cases that had also
been consolidated for purposes of the appeal, were dismissed. On
June 21, 2001, plaintiffs filed a petition for rehearing
before the entire D.C. circuit with respect to these cases,
which was denied on July 13, 2001. On August 20, 2001,
plaintiffs filed a petition for writ of certiorari with the U.S.
Supreme Court, which was denied on October 29, 2001.

On March 3, 2000, a New York state court granted motions to
dismiss ten union cases, Eastern States Health & Welfare
Fund v. Philip Morris, Inc., brought by 14 union trust funds
seeking to recover money paid for medical bills incurred by
their participants and beneficiaries who suffer from alleged
tobacco-caused diseases. This group of cases is on appeal to the
Appellate Division of the Supreme Court of New York. On
September 26, 2000, in Steamfitters Local Union
No. 614 Health and Welfare Fund v. Philip Morris, Inc.,
the Tennessee Court of Appeals affirmed a trial courts
dismissal of an antitrust claim and found that the remaining
claims in the plaintiffs complaint were too remote to
permit recovery. On March 21, 2001, a federal district
court in Connecticut granted defendants motion to dismiss
in Connecticut Pipe Trades Health Fund v. Philip Morris, Inc.Most recently, on January 25, 2002, in Motion
Picture Industry Health Plan v. Philip Morris, Inc., the
California Supreme Court granted plaintiffs petition for
review and deferred further action pending consideration and
disposition of a related issue in Naegele v.
Raybestos-Manhattan, Inc.(pending in San Francisco County
Superior Court), or pending further order of the court. On
October 25, 2001, the California Court of Appeals affirmed
the April 10, 2000, order granting voluntary dismissal of
the case with prejudice as to all defendants.

The first and only union case to go to trial to date was Iron
Workers Local No. 17 v. Philip Morris, Inc., which was
tried in federal court in Ohio. On March 18, 1999, the jury
returned a unanimous verdict for the defendants, including RJR
Tobacco. The plaintiffs dismissed their appeal of the verdict.

Other Health-Care Cost Recovery and Aggregated Claims
Plaintiffs.Groups of health-care insurers, as well as a
private entity that purported to self-insure its employee
health-care programs, have also advanced claims similar to those
found in the union health-care cost recovery actions.

Two insurer cases, Williams & Drake v.
American Tobacco Co.and Regence Blueshield v. Philip
Morris, Inc., were dismissed in their entirety on remoteness
grounds by federal district courts in Pennsylvania and
Washington. These rulings were then upheld on appeal to the
Third and Ninth Circuits, respectively.

In Group Health Plan, Inc. v. Philip Morris, Inc.and
Medica v. Philip Morris, Inc.,two cases consolidated for
opinion, a federal district judge in Minnesota dismissed all
claims, except a state antitrust claim and a state conspiracy
claim. The federal court certified to the Minnesota Supreme
Court the question of whether these two claims could be pursued
under Minnesota law by Group Health Plan. On January 11,
2001, the Minnesota Supreme Court ruled that the plaintiff could
pursue these claims. Certain defendants, including RJR Tobacco,
filed motions for summary judgment based on (1) the
statutes of limitation on June 15, 2001; and
(2) causation, injury and damages on June 20, 2001. On
January 31, 2002, summary judgment was granted in favor of
certain defendants, including RJR Tobacco, on all causes of
action. Plaintiffs have not yet filed an appeal.

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On June 6, 2001, in Blue Cross and Blue Shield of New
Jersey, Inc. v. Philip Morris, Inc., a federal court jury in
Brooklyn returned a verdict in favor of RJR Tobacco and other
tobacco defendants on common law fraud and civil RICO claims,
but found for the plaintiff, Empire Blue Cross and Blue Shield,
on a claim under a New York state deceptive business practices
statute. Empire pursued its claims against the defendants on
behalf of itself directly, as well as on the behalf of its
insureds, under a theory of subrogation. The jury verdict on the
direct claim was approximately $17.8 million, and the verdict on
the subrogated claim was approximately $11.8 million. RJR
Tobaccos portion of these amounts is $6.6 million and $4.4
million, respectively. Empire is not entitled to recover under
both direct and subrogated claims; thus, Empire must elect one
claim, and thus one jury verdict. The New York statute under
which Empire recovered does not provide for punitive damages,
but does allow for recovery of reasonable attorneys fees.
Plaintiff filed a motion for attorneys fees. On
October 4, 2001, the court denied defendants
post-trial motions, entered final judgment in favor of Empire,
yet retained jurisdiction to decide the attorneys fees
issue. RJR Tobacco and the other tobacco defendants appealed the
final judgment to the United States Court of Appeals for the
Second Circuit. All remaining claims of Blue Cross Blue Shield
plans pending before the court are stayed pending the appeal.

On August 8, 2001, in County of Cook v. Philip Morris,
Inc., the Circuit Court of Cook County granted
defendants motion for judgment on the pleadings based on
remoteness grounds and dismissed plaintiffs complaint in
its entirety. Plaintiffs appealed the dismissal to the Illinois
Appellate Court, First District, on September 5, 2001.
Defendants noticed a cross-appeal to the appellate court on
September 17, 2001, from the trial courts prior
adverse rulings on defendants motions to dismiss on the
grounds of MSA release and lack of standing. The appellate court
has not yet ruled.

Native American tribes have filed similar health-care cost
recovery cases. On December 8, 2000, in Utu Utu Gwaitu
Paiute Tribe v. Philip Morris, Inc., the San Diego Superior
Court denied plaintiffs motion for class certification. On
January 10, 2001, the plaintiffs voluntarily dismissed the
action. On November 12, 1999, in Table Bluff Reservation v.
Philip Morris, Inc., a California federal district court
dismissed plaintiffs lawsuit. On July 16, 2001, the
United States Court of Appeals for the Ninth Circuit affirmed
the federal district courts dismissal. On July 30,
2001, in Acoma Pueblo v. American Tobacco Co., a federal
district court in New Mexico granted defendants motion to
dismiss plaintiffs complaint for failure to state a claim.
The ruling was based on a number of grounds, including
remoteness. On September 17, 2001, plaintiff filed a motion
for reconsideration which was denied on November 1, 2001.
The dismissal was modified to a dismissal with prejudice in
order to facilitate plaintiffs appeal. On August 31,
2001, in Alabama Coushatta Tribe of Texas v. American Tobacco
Co., the United States District Court for the Eastern
District of Texas (Beaumont Division) dismissed plaintiffs
complaint. Plaintiffs appealed to the United States Court of
Appeals for the Fifth Circuit on October 1, 2001. Most
recently, on January 25, 2002, in the Navajo Nation v.
Philip Morris, Inc., the District Court of Navajo Nation
granted in part defendants motion to dismiss the complaint
with respect to the conspiracy, deceptive acts and restraints of
trade claims. The court refused to dismiss plaintiffs
product liability claim. Four such cases remain pending, all
before tribal courts.

Other cost recovery suits have been brought by local
governmental jurisdictions, taxpayers on behalf of a government
jurisdiction, a university and hospitals. On December 14,
1999, a federal district court in Washington dismissed one such
case, Association of Washington Public Hospital Districts v.
Philip Morris, Inc.Plaintiffs appealed this ruling to the
United States Court of Appeals for the Ninth Circuit, which
affirmed the dismissal by the trial court on February 22,
2001. Plaintiffs filed a petition to the U.S. Supreme Court
asking it to review the case on July 16, 2001, but the
court declined plaintiffs petition October 1, 2001.
On May 30, 2000, in A.O. Fox Memorial Hospital v.
American Tobacco Co., Inc., pending in state court in Nassau
County, New York, a group of approximately 175 hospitals filed
suit against the tobacco industry seeking repayment from
cigarette companies for costs expended to treat smoking-related
illnesses. Plaintiffs seek at least $3.6 billion in damages.
Defendants filed a motion to dismiss which was granted on
December 14, 2001. On January 17, 2002, plaintiffs appealed
the dismissal to the Appellate Division of the Supreme Court,
Second Judicial Department.

A number of foreign countries have filed suit in state and
federal courts in the United States against RJR Tobacco and
other tobacco industry defendants to recover funds for health
care, medical and other assistance paid by those foreign
governments to their citizens. Of the 33 cases currently
pending, 6 are pending in state

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Marshall Islands v. American Tobacco Co.


On August 7, 2000, a federal district court in Washington,
D.C. dismissed an international health-care cost recovery action
entitled Ontario v. Imperial Tobacco, Ltd.Plaintiffs
appealed to the United States Court of Appeals for the District
of Columbia. However, on November 29, 2001, the D.C. Court
of Appeals granted plaintiffs motion for a voluntary
dismissal of the appeal, thereby dismissing the case. In Obra
Social de Empleados de la Marina Mercante v. American Tobacco
Co., Inc., the Superior Court in Washington, D.C. granted
defendants motion to dismiss on January 13, 2001.
Plaintiffs appealed the dismissal to the D.C. Court of Appeals;
however, the parties agreed to dismiss the appeal on
October 22, 2001. Additionally, plaintiffs filed a separate
action in the same court on March 23, 2001; that case was
voluntarily dismissed on August 30, 2001. On May 22,
2001, the United States Court of Appeals for the District of
Columbia affirmed the federal district courts dismissal in
the following three matters: (1) Guatemala v. Tobacco
Institute, Inc.(a non-RJR Tobacco action); (2) Nicaragua
v. Liggett Group, Inc.(another non-RJR Tobacco case); and
(3) Ukraine v. American Brands, Inc.(a case involving
RJR Tobacco). Plaintiffs in each of these cases filed a petition
for writ of certiorari to the U.S. Supreme Court on
August 20, 2001. The Supreme Court, on October 29,
2001, denied the petitions. Most recently, on November 20,
2001, in Venezuela v. Philip Morris Cos., Inc.and
Espirito Santo, Brazil v. Brooke Group Ltd., a Florida
state court judge granted defendants motions to dismiss
these matters because the claims were too remote, indirect and
derivative to survive. Plaintiff appealed each case to the Third
District Court of Appeal of Florida on December 19, 2001.

Pursuant to the terms of the 1999 sale of RJRs
international tobacco business, Japan Tobacco Inc. assumed RJR
Tobaccos liability, if any, in the health-care cost
recovery cases brought by foreign countries.

Finally, 11 lawsuits are pending against RJR Tobacco in which
asbestos companies and/or asbestos-related trust funds allege
that they overpaid claims brought against them to
the extent that tobacco use, not asbestos exposure, was the
cause of the alleged personal injuries for which they paid
compensation. One of these lawsuits, Falise v. American
Tobacco Co., was dismissed by the United States District
Court for the Eastern District of New York (Weinstein, J.) on
November 2, 1999, due to a lack of subject matter
jurisdiction. This case was refiled on November 11, 1999.
Trial began on November 27, 2000. On January 22, 2001,
the judge declared a mistrial. The case was dismissed with
prejudice on June 29, 2001 after the plaintiff announced
that it would not retry the case. On May 24, 2001, a
Mississippi state court judge dismissed all claims by
Owens-Corning in a lawsuit similar to Falise.Owens-Corning appealed the dismissal to the Mississippi
Supreme Court on August 15, 2001. A similar case, H. K.
Porter Co., Inc. v. American Tobacco Co., is pending in the
United States District Court for the Eastern District of New
York (Weinstein, J.). In Fibreboard Corp. v. R. J. Reynolds
Tobacco Co., a case pending in state court in California,
Owens-Corning and Fibreboard asserted the same claims as those
asserted in the Mississippi case. Motions to dismiss those
claims have been held in abeyance pending the final
determination of the Mississippi case.

Antitrust Cases. A number of tobacco wholesalers, or
indirect purchasers, have sued United States cigarette
manufacturers, including RJR Tobacco, and its parent company,
RJR, alleging that cigarette manufacturers combined and
conspired to set the price of cigarettes, in violation of
antitrust statutes and various state unfair business practices
statutes, as a result of which plaintiffs suffered economic
injury. Of the 39 cases currently pending, 30 are pending in
state court and 9 are pending in federal court. Plaintiffs are
asking the court to certify the lawsuits as class actions and to
allow the respective plaintiffs to pursue the lawsuits as
representatives of other persons in individual states or
throughout the United States that purchased

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On March 2, 2000, Liggett Group Inc. filed an antitrust
action against RJR Tobacco in the U.S. District Court for the
District of New Jersey. Subsequently, the court granted RJR
Tobaccos motion to transfer this action to the United
States District Court for the Middle District of North Carolina.
On May 3, 2001, the case, which alleged that RJR
Tobaccos Every-Day-Low-Price merchandising program is a
violation of the Sherman Antitrust Act and New Jersey antitrust
laws, was voluntarily dismissed.

In A.D. Bedell Wholesale Co. v. Philip Morris, Inc.,
filed on April 13, 1999, in the United States District
Court for the Western District of Pennsylvania, a cigarette
wholesaler alleged that the MSA restricts cigarette output and
otherwise restrains trade in violation of the Sherman Act. On
March 22, 2000, the district court entered an order granting
defendants motion to dismiss counts I and II of the
complaint, denying defendants motion to dismiss count III,
and denying as moot plaintiffs motion for partial summary
judgment. On April 11, 2000, the plaintiffs and defendant
Philip Morris, the only defendant to which count III applied,
filed a consent order dismissing count III of the amended
complaint. On April 18, 2000, plaintiffs appealed the
dismissal of counts I and II to the United States Court of
Appeals for the Third Circuit. On June 19, 2001, the Third
Circuit affirmed the district courts dismissal of counts I
and II, ruling that tobacco companies that entered into the MSA,
including RJR Tobacco, were immune from potential antitrust
liability that was alleged to arise out of the MSA. The finding
of antitrust immunity is consistent with that of all other
federal courts that have considered antitrust challenges to the
MSA. The plaintiffs filed a petition for rehearing and
suggestion for rehearing before the entire Third Circuit on
July 2, 2001. This petition was denied on July 24,
2001. On October 19, 2001, the plaintiffs filed a petition
for a writ of certiorari with the U.S. Supreme Court, which
denied the petition on January 7, 2002.

On July 30, 1999, Cigarettes Cheaper!, a retailer, filed an
antitrust counterclaim against RJR Tobacco in a gray market
trademark suit originally brought by RJR Tobacco in the United
States District Court for the Northern District of Illinois.
Cigarettes Cheaper! alleges that it was denied promotional
resources in violation of the Robinson-Patman Act. The district
court declined to dismiss the counterclaim. On January 23,
2001, the court granted Cigarettes Cheaper!s motion to
amend its counterclaim to include a violation of the Sherman Act
§1, claiming that RJR Tobacco conspired with other
retailers to deny promotions to Cigarettes Cheaper!, an
allegation that RJR Tobacco denies. On March 21, 2001, RJR
Tobaccos motion to add a trademark dilution claim against
Cigarettes Cheaper! was granted. On June 28, 2001, the
court granted RJR Tobaccos motion to strike with prejudice
several of Cigarettes Cheaper!s affirmative defenses.
These defenses related to: (1) alleged misrepresentations caused
by the packaging of cigarettes manufactured by RJR Tobacco for
export; (2) RJR Tobaccos No Bull
advertising campaign for its WINSTON cigarettes;
(3) antitrust trademark misuse; (4) nominative fair
use; and (5) the first sale doctrine. Fact discovery closed
on October 18, 2001. Expert discovery is presently underway
and dispositive motions likely will be filed this spring or
summer. No trial date is yet set.

On May 10, 2000, the Customer Company, a retailer
affiliated with Cigarettes Cheaper!, filed a similar antitrust
claim against RJR Tobacco in the United States District Court
for the Northern District of California. This case has now been
settled. The settlement terms are confidential; however, the
settlement is not material to RJR Tobacco.

Tobacco Growers Case. On February 16, 2000, a
class action complaint, Deloach v. Philip Morris Cos.,
Inc., was brought against RJR Tobacco, other cigarette
manufacturers and others, in the United States District Court
for the District of Columbia on behalf of a putative class of
all tobacco growers and tobacco

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Scheduled Trials. As of February 7, 2002, RJR
Tobacco is a defendant in two cases currently being tried:
Burton v. R. J. Reynolds Tobacco Co., an
individual case being tried in federal court in Kansas, and
Scott v. American Tobacco Co., a medical monitoring class
action. Jury selection began in the Scott case on
June 18, 2001. After the jury was impaneled, various
rulings required the dismissal of several members of the
original jury (nine jurors and/or alternates). Jury selection
began again on October 22, 2001. On December 26, 2001,
defendants filed an application for supervisory writ to
the Fourth District of the Louisiana Court of Appeals
challenging certain aspects of the second round of jury
selection. Opening statements will not occur until that
application is decided.

Although trial schedules are subject to change and many cases
are dismissed before trial, it is likely that there will be an
increased number of tobacco cases, some involving claims for
possibly billions of dollars, against RJR and RJR Tobacco,
coming to trial during 2002. As of February 7, 2002, there
are 18 cases scheduled for trial. Fourteen Broin IIcases
also are scheduled to be tried in 2002.

Other Developments.RJR Tobacco is aware of a grand jury
investigation being conducted in North Carolina that relates to
the cigarette business of certain of its former affiliates. In
connection with this investigation, RJR Tobacco responded to
document subpoenas dated July 7, 1999 and June 1,
2000, respectively.

On December 22, 1998, Northern Brands International, Inc.
entered into a plea agreement with the United States Attorney
for the Northern District of New York. Northern Brands is a
now-inactive tobacco subsidiary that was part of the business of
R. J. Reynolds International B.V., a former Netherlands
subsidiary of RJR Tobacco which was managed by a former
affiliate, RJR-MacDonald, Inc. On May 12, 1999,
RJR-MacDonald, Inc. was sold to Japan Tobacco Inc. and
subsequently changed its name to JT-MacDonald, Inc. Northern
Brands was charged with aiding and abetting certain customers
who brought merchandise into the United States by means of
false and fraudulent practices . . . . It is understood
that JT-MacDonald, Inc., Japan Tobaccos international
operating company in Canada, is cooperating with an
investigation now being conducted by the Royal Canadian Mounted
Police relating to the same events that gave rise to the
Northern Brands investigation.

On December 21, 1999, the government of Canada filed a
lawsuit in the United States District Court for the Northern
District of New York against RJR Tobacco, RJR, several currently
and formerly related companies, including Northern Brands, and
the Canadian Tobacco Manufacturers Council. The lawsuit alleges
that, beginning in 1991, the defendants conspired with known
distributors and smugglers to illegally import into Canada
tobacco products originally earmarked for export from Canada, in
a fashion that avoided the imposition of certain excise and
retail taxes and duty payments. On June 30, 2000, this case
was dismissed by the United States District Court for the
Northern District of New York. Plaintiff appealed the dismissal
to the United States Court of Appeals for the Second Circuit,
which, on October 12, 2001, affirmed the district
courts dismissal. On December 12, 2001, the Court of
Appeals denied Canadas petition for rehearing. Although
the international tobacco business was sold, RJR Tobacco
retained certain liabilities relating to the events disclosed
above.

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Similar lawsuits have been filed against RJR Tobacco and its
affiliates, along with other cigarette manufacturers, by the
European Community and ten of its member states (Belgium,
Finland, France, Greece, Germany, Italy, Luxembourg, the
Netherlands, Portugal and Spain), Ecuador, Belize and Honduras.
These suits contend that RJR Tobacco and other tobacco companies
in the United States may be held responsible for damages caused
by cigarette smugglers under common law and under the federal
RICO statute. Each of these actions seeks compensatory, punitive
and treble damages. On July 17, 2001, the action brought by
the European Community was dismissed by the United States
District Court for the Eastern District of New York. However,
the European Community and its member states filed a similar
complaint in the same jurisdiction on August 6, 2001. On
October 25, 2001, the court denied the European
Communitys request of August 10, 2001, to reinstate
its original complaint. On November 9, 2001, the European
Community and the ten member states amended their complaint
filed on August 6, 2001, to change the name of defendant
Nabisco Group Holdings Corp. to RJR Acquisition, Inc. RJR
Tobacco and the other defendants filed motions to dismiss that
complaint on November 14, 2001, and the court heard oral
argument on those motions on January 11, 2002. As of
February 7, 2002, a decision is still pending. RJR Tobacco
and other defendants filed in the United States District Court
for the Southern District of Florida motions to dismiss the
actions brought by Ecuador, Belize and Honduras. These motions
have been briefed and argued, and have been taken under
advisement.

On May 23, 2001, Star Scientific, Inc. filed a patent
infringement action against RJR Tobacco in the United States
District Court for the District of Maryland. The suit alleges
infringement of U.S. Patent No. 6,202,649 entitled
Method of Treating Tobacco to Reduce Nitrosamine Content,
and Products Produced Thereby. RJR Tobacco denies that it
has infringed any valid claim of the Star patent. On
June 13, 2001, RJR Tobacco filed a declaratory judgment
action against Star Scientific in the United States District
Court for the Middle District of North Carolina, seeking a
declaration that the patent is invalid and not infringed by RJR
Tobacco. On October 3, 2001, the North Carolina federal
court granted Star Scientifics motion to stay, but denied
its motions to dismiss or transfer the case.

On or about October 30, 1998, a boat manufacturer, American
Marine Holdings, Inc., filed suit against RJR Tobacco claiming
that one of its boats was not properly identified in RJR Tobacco
cigarette advertising. The plaintiff claimed, among other
things, violations of the Lanham Act and breach of an alleged
oral contract. On April 12, 2001, the parties reached an
agreement to settle the matter. The related provision for
settlement is included in the accompanying consolidated
financial statements.

For further discussion of litigation and legal proceedings
pending against RJR, its affiliates, including RJR Tobacco, or
indemnitees, see  Environmental Matters
and Managements Discussion and Analysis of Financial
Condition and Results of Operations  Governmental
Activity in Item 7. For more detailed information
about the class action and other aggregated claims suits pending
against RJR, its affiliates, including RJR Tobacco, or
indemnitees, see Exhibit 99.1 to this report.



---

Litigation is subject to many uncertainties, and it is possible
that some of the tobacco-related legal actions, proceedings or
claims could be decided against RJR Tobacco or its affiliates,
including RJR, or indemnitees. Determinations of liability or
adverse rulings against other cigarette manufacturers that are
defendants in similar actions, even if such rulings are not
final, could adversely affect the litigation against RJR Tobacco
or its affiliates or indemnitees and could encourage an increase
in the number of such claims. A number of political,
legislative, regulatory and other developments relating to the
tobacco industry and cigarette smoking have received wide media
attention. These developments may negatively affect the outcomes
of tobacco-related legal actions and encourage the commencement
of additional similar litigation.

Although it is impossible to predict the outcome of such events
on pending litigation and the rate at which new lawsuits are
filed against RJR Tobacco and RJR, a significant increase in
litigation and/or in adverse outcomes for tobacco defendants
could have an adverse effect on either or both of these
entities. RJR Tobacco and RJR each believe that they have a
number of valid defenses to any of those actions and intend to
defend those actions vigorously.

23



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##### 



RJR believes that, notwithstanding the quality of defenses
available to it and RJR Tobacco in litigation matters, it is
possible that the results of operations or cash flows of RJR in
particular quarterly or annual periods or RJRs financial
condition could be materially affected by the ultimate outcome
of certain pending litigation matters, including bonding and
litigation costs. RJRs management is unable to predict the
outcome of the litigation or to derive a meaningful estimate of
the amount or range of any possible loss in any particular
quarterly or annual period or in the aggregate. Accordingly, no
liability for tobacco-related litigation is currently recorded
in the consolidated financial statements.

Environmental Matters

RJR and its subsidiaries are subject to federal, state and local
environmental laws and regulations concerning the discharge,
storage, handling and disposal of hazardous or toxic substances.
Such laws and regulations provide for significant fines,
penalties and liabilities, sometimes without regard to whether
the owner or operator of the property knew of, or was
responsible for, the release or presence of hazardous or toxic
substances. In addition, third parties may make claims against
owners or operators of properties for personal injuries and
property damage associated with releases of hazardous or toxic
substances. In the past, RJR Tobacco has been named a
potentially responsible party with third parties under the
Comprehensive Environmental Response, Compensation and Liability
Act with respect to several superfund sites. Regulations
promulgated by the U.S. Environmental Protection Agency and
other governmental agencies under various statutes have resulted
in, and likely will continue to result in, substantial
expenditures for pollution control, waste treatment, plant
modification and similar activities. RJR and its subsidiaries
monitor their environmental matters and, dependent upon the
probability of occurrence and reasonable estimation of cost,
accrue or disclose any material liability.

RJR was named in an insurance coverage suit filed
August 13, 1997, by another company named as a potentially
responsible party under CERCLA with respect to a superfund site
in Hawaii at which a former subsidiary of RJR had operations. In
this lawsuit, Del Monte Fresh Produce v. Firemans Fund
Insurance, filed in the First Circuit Court of the State of
Hawaii, the plaintiff sought a declaratory judgment that it is
entitled to insurance coverage for the site or, in the
alternative, that RJR is obligated to indemnify the plaintiff
under the terms of the agreement by which RJR sold that company
in 1989. On June 26, 2001, the plaintiff filed for
dismissal without prejudice as to all claims against RJR. A
motion for summary judgment filed by Firemans Fund
Insurance Company was denied by the court on August 6, 2001.

Del Monte Corporation has been named a defendant in two lawsuits
related to the same Hawaii superfund site, Board of Water
Supply of the City and County of Honolulu v. Shell Oil Companyand Akee v. The Dow Chemical Co., filed in the First
Circuit Court of the State of Hawaii on September 27, 1999,
and October 7, 1999, respectively. Also, Del Monte Corporation
has received a demand for indemnity from an entity that was a
chemical supplier to Del Monte Corporation and is named a
defendant in one of these lawsuits. Del Monte Corporation has
sought indemnity from RJR under the terms of the agreement by
which RJR sold Del Monte Corporation in 1989. RJR, in turn, has
provided notice of these claims to the buyers of the Del Monte
fresh fruit business, asserting the right to be indemnified by
the buyers for any liability arising out of such claims under
the terms of the agreement by which RJR sold the Del Monte fresh
fruit business in 1989.

Pursuant to an agreement dated June 12, 2001, among RJR,
the buyers of the Del Monte fresh fruit business, Del Monte
Corporation and others, the buyers of the Del Monte fresh fruit
business agreed, from the date of the agreement forward, to
indemnify RJR for any liabilities imposed in either Board of
Water Supplyor Akeeand with respect to the
environmental investigation and remediation of the superfund
site in Hawaii currently being required by the EPA. RJR and the
buyers of the Del Monte fresh fruit business also agreed to
engage in good faith negotiations regarding RJRs asserted
right to be indemnified with respect to any liability, cost or
expense related to such matters that was incurred prior to the
date of the agreement. Based on an agreement reached between RJR
and the buyers of the Del Monte fresh fruit business on
December 3, 2001, the buyers have reimbursed RJR for the
amount of legal expenses claimed by RJR in defending the
Board of Water Supplyand Akee cases prior to the
parties agreement of June 12, 2001. Additionally,
pursuant to a settlement agreement executed in December 2001,
among the plaintiff and certain defendants, including the

24



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##### 



Board of
Water Supply Board of Water Supply.


On June 1, 2001, RJR received notice from Del Monte
Corporation of a claim made against it by a Hawaii landowner who
has been sued by a lessee of its land, claiming injuries due to
pesticide contamination of the soil, allegedly caused by Del
Monte Corporation as a prior lessee of the land. The
landowner-defendant has tendered the claim to Del Monte
Corporation for defense and indemnity. Del Monte Corporation has
in turn tendered the claim to RJR for defense and indemnity,
claiming it is entitled to be indemnified under the terms of the
agreement by which RJR sold Del Monte Corporation. Based on the
plaintiffs failure to provide any factual information in
support of its claim that Del Monte Corporation was a prior
lessee of the subject land, Del Monte Corporation has agreed to
extend indefinitely the period during which RJR must respond to
the Del Monte Corporations tender of the claim to RJR for
defense and indemnity, subject to the right to terminate the
indefinite extension on fifteen days notice to RJR.

RJR Tobacco was notified by the EPA on June 11, 2000 of its
potential liability under CERCLA for a superfund site in Greer,
South Carolina. The notice and demand for reimbursement of costs
incurred by the EPA were sent to a group of companies previously
involved as potentially responsible parties in another superfund
site, which includes RJR Tobacco. The EPA alleges that some
waste from the cleanup of the other site was transported to the
site in question. RJR Tobacco has executed a tolling agreement
with the EPA. This tolling agreement provides for entry into
good faith negotiations with the EPA, and is not an admission of
fact or liability. The tolling agreement also should have no
impact on any defense RJR Tobacco may assert, other than a
defense based on the running of the statute of limitations.
Information is still being gathered from other potentially
responsible parties recently notified by the EPA.

RJR and its subsidiaries have been engaged in a continuing
program to assure compliance with federal, state and local
environmental laws and regulations. Although it is difficult to
identify precisely the portion of capital expenditures or other
costs attributable to compliance with environmental laws and
regulations and to estimate the cost of resolving these CERCLA
matters, RJR does not expect such expenditures or other costs to
have a material adverse effect on the business, results of
operations or financial condition of RJR or its subsidiaries.

Employees

At December 31, 2001, RJR and its subsidiaries had
approximately 8,200 employees and 1,100 part-time employees.
None of these employees is unionized. Employee relations are
believed to be good. In January 2001 and 2002, RJR Tobacco was
included in FORTUNE Magazines annual list of the 100
Best Companies to Work For.

25



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##### 






PART II




Item 6. Selected Financial Data




The selected historical consolidated financial data as of
December 31, 2001 and 2000 and for each of the years in the
three-year period ended December 31, 2001 are derived from the
consolidated financial statements and accompanying notes, which
have been audited by RJRs independent auditors. The
historical financial statements for the year ended
December 31, 2000 have been restated. See note 23 to
consolidated financial statements. The selected historical
consolidated financial data as of December 31, 1999, 1998
and 1997 and for the years ended December 31, 1998 and 1997
are derived from audited consolidated financial statements not
presented or incorporated by reference. The financial statements
prior to 2000 segregate the account balances and activities of
the international tobacco business and Nabisco and report those
account balances and activities as discontinued operations. You
should read this table in conjunction with
Managements Discussion and Analysis of Financial
Condition and Results of Operations in Item 7 and the
consolidated financial statements.







|                                                                                     |  |                                                 |        |            |  |      |         |      |  |      |         |   |  |   |         |   |  |   |         | 
|------------------------------------------------------------------------------------ |  | ----------------------------------------------- | ------ | ---------- |  | ---- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | - |  | - | ------- | 
|                                                                                     |  |                                                
|                                                                                     |  | For the Years Ended December 31,               
|                                                                                     |  |                                                
|                                                                                     |  | 2001                                            |        | 2000       |  | 1999 |         | 1998 |  | 1997
|                                                                                     |  |                                                 |        |            |  |      |         |      |  |     
|                                                                                     |  |                                                 |        | (Restated) |  |      |         |      |  |     
|                                                                                     |  |                                                
|                                                                                     |  | (Dollars in Millions, Except Per Share Amounts)
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Results of Operations:                                                               |  |                                                 |        |            |  |      |         |      |  |      |         |   |  |   |         |   |  |   |         | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Net sales (1)                                                                        |  | $                                               | 8,585  |            |  | $    | 8,058   |      |  | $    | 7,468   |   |  | $ | 5,685   |   |  | $ | 4,975   | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Income (loss) from continuing operations                                             |  |                                                 | 444    |            |  |      | 299     |      |  |      | 195     |   |  |   | (519    | ) |  |   | 19      | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Income (loss) from discontinued operations                                           |  |                                                 | (9     | )          |  |      | 53      |      |  |      | 2,398   |   |  |   | 3       |   |  |   | 414     | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Extraordinary items  gain (loss)                                                    |  |                                                 |       |            |  |      | 1,475   |      |  |      | (250    | ) |  |   |        |   |  |   |        | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Net income (loss)                                                                    |  |                                                 | 435    |            |  |      | 1,827   |      |  |      | 2,343   |   |  |   | (516    | ) |  |   | 433     | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Per Share Data:                                                                      |  |                                                 |        |            |  |      |         |      |  |      |         |   |  |   |         |   |  |   |         | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Basic income (loss) from continuing
    operations                                   |  |                                                 | 4.57   |            |  |      | 2.96    |      |  |      | 1.80    |   |  |   | (4.77   | ) |  |   | .17     | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Diluted income (loss) from continuing
    operations                                 |  |                                                 | 4.48   |            |  |      | 2.94    |      |  |      | 1.80    |   |  |   | (4.77   | ) |  |   | .17     | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Basic income (loss) from discontinued
    operations                                 |  |                                                 | (.09   | )          |  |      | 0.52    |      |  |      | 22.10   |   |  |   | .03     |   |  |   | 3.81    | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Diluted income (loss) from discontinued
    operations                               |  |                                                 | (.09   | )          |  |      | 0.52    |      |  |      | 22.08   |   |  |   | .03     |   |  |   | 3.81    | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Basic income (loss) from extraordinary items                                         |  |                                                 |       |            |  |      | 14.56   |      |  |      | (2.30   | ) |  |   |        |   |  |   |        | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Diluted income (loss) from extraordinary
    items                                   |  |                                                 |       |            |  |      | 14.48   |      |  |      | (2.30   | ) |  |   |        |   |  |   |        | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Basic net income (loss)                                                              |  |                                                 | 4.48   |            |  |      | 18.04   |      |  |      | 21.60   |   |  |   | (4.74   | ) |  |   | 3.98    | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Diluted net income (loss)                                                            |  |                                                 | 4.39   |            |  |      | 17.94   |      |  |      | 21.58   |   |  |   | (4.74   | ) |  |   | 3.98    | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Basic weighted average shares, in thousands                                          |  |                                                 | 97,043 |            |  |      | 101,264 |      |  |      | 108,495 |   |  |   | 108,691 |   |  |   | 108,691 | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Diluted weighted average shares, in thousands                                        |  |                                                 | 98,986 |            |  |      | 101,857 |      |  |      | 108,570 |   |  |   | 108,691 |   |  |   | 108,691 | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Cash dividends declared per share of common stock
    (2)                            |  | $                                               | 3.30   |            |  | $    | 3.10    |      |  | $    | 1.55    |   |  | $ |        |   |  | $ |        | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Balance Sheet Data (at end of
    periods):                                          |  |                                                 |        |            |  |      |         |      |  |      |         |   |  |   |         |   |  |   |         | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Total assets                                                                         |  |                                                 | 15,122 |            |  |      | 15,554  |      |  |      | 14,377  |   |  |   | 19,310  |   |  |   | 20,251  | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Long-term debt                                                                       |  |                                                 | 1,631  |            |  |      | 1,674   |      |  |      | 1,653   |   |  |   | 4,861   |   |  |   | 4,944   | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Stockholders equity                                                                 |  |                                                 | 8,026  |            |  |      | 8,436   |      |  |      | 7,064   |   |  |   | 9,886   |   |  |   | 11,079  | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Other Data:                                                                          |  |                                                 |        |            |  |      |         |      |  |      |         |   |  |   |         |   |  |   |         | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Ratio of earnings to fixed charges (3)                                               |  |                                                 | 6.4    |            |  |      | 5.1     |      |  |      | 2.8     |   |  |   |        |   |  |   | 1.5     | 
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Deficiency in the coverage of fixed charges by
    earnings before fixed charges (3) |  | $                                               |       |            |  | $    |        |      |  | $    |        |   |  | $ | (679    | ) |  | $ |        | 









|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Net sales and costs of products sold exclude excise taxes of
    $1.529 billion, $1.631 billion, $1.173 billion, $1.292 billion
    and $1.369 billion for the years ended December 31, 2001,
    2000, 1999, 1998 and 1997, respectively.                                                                                                                                                                                                                                           
|(2) | RJR began trading as a separate company on June 15, 1999.
    From the third quarter of 1999 through the second quarter of
    2001, RJRs board of directors declared a quarterly cash
    dividend of $.775 per common share, or $3.10 on an annualized
    basis. Beginning with the third quarter of 2001, the board of
    directors has declared a quarterly cash dividend of $.875 per
    common share, or $3.50 on an annualized basis, an increase of
    12.9% from $.775.
|(3) | Earnings consist of income before income taxes and fixed
    charges. Fixed charges consist of interest on indebtedness,
    amortization of debt issuance costs and one-third of operating
    rental expense, representative of the interest factor.                                                                                                                                                                                                                               

26



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|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis of Financial
    Condition and Results of Operations




The following is a discussion and analysis of RJRs
business, initiatives, critical accounting policies and its
consolidated results of operations and financial condition.
Following the overview and discussion of business initiatives,
the critical accounting policies disclose certain accounting
policies that are material to RJRs results of operations
and financial condition for the periods presented in this
report. The discussion and analysis of RJRs results of
operations is presented in two comparative sections, 2001
compared with 2000 and 2000 compared with 1999. Disclosures
related to liquidity and financial condition completes
managements discussion and analysis. You should read this
discussion and analysis of RJRs consolidated financial
condition and results of operations in conjunction with the
consolidated financial statements and the related notes as of
December 31, 2001 and 2000 and for each of the years in the
three-year period ended December 31, 2001.







Overview and Business Initiatives







RJRs operating subsidiaries include RJR Tobacco and Santa
Fe. RJRs single reportable operating segment, RJR Tobacco,
is the second largest cigarette manufacturer in the United
States. Santa Fe, acquired by RJR in 2002, manufactures and
markets cigarettes and other tobacco products primarily in the
United States.







RJRs operating subsidiaries primarily conduct business in
the highly competitive U.S. cigarette market with a few large
manufacturers and many smaller participants. The U.S. cigarette
market is believed to be a mature market, and overall consumer
demand is expected to decline over time. Trade inventory
adjustments may result in short-term changes in demand for RJR
Tobaccos products if, and when, wholesale and retail
tobacco distributors adjust the timing of their purchases of
product to manage their inventory level. However, RJR Tobacco
believes it is not appropriate for it to speculate on external
factors that may impact the purchasing decisions of the
wholesale and retail tobacco distributors.







Competition is primarily based on brand positioning and price,
as well as product attributes and packaging, consumer loyalty,
promotions, advertising and retail presence. Cigarette brands
produced by the major manufacturers generally require
competitive pricing, substantial marketing support, retail
programs and other financial incentives to maintain or improve a
brands market position or to introduce a new brand.







RJRs operating subsidiaries are committed to building and
maintaining a portfolio of strong brands. RJR Tobaccos
marketing programs are designed to strengthen each brands
image, build brand awareness and loyalty, and attract adult
smokers of competing brands. RJR Tobacco has repositioned or
introduced brand styles and line extensions designed to build
each brands equity and attract adult smokers of
competitive brands, but there can be no assurance that such
efforts will be successful.







In addition to building strong brand equity, RJR Tobaccos
marketing approach utilizes a retail pricing strategy, including
discounting at retail, to defend its brands shares of
market against competitive pricing pressure. Competitive
discounting has increased significantly as a result of higher
state excise taxes and the growth of deep-discount brands.
Deep-discount brands are brands manufactured by manufacturers
that are not original participants in the MSA, and accordingly,
do not have cost structures burdened with MSA payments to the
same extent as the original participating manufacturers.




Critical Accounting Policies and Recent Accounting
Developments

Accounting principles generally accepted in the United States of
America require estimates and assumptions to be made that affect
the reported amounts in RJRs consolidated financial
statements and accompanying notes. Some of these estimates
require difficult, subjective and/or complex judgments about
matters that are inherently uncertain, and as a result, actual
results could differ from those estimates. Due to the estimation
processes involved, the following summarized accounting policies
and their application are considered to be critical to
understanding the business operations, financial condition and
results of operations of RJR and its subsidiaries.

27



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Tobacco  Related Litigation







RJR and RJR Tobacco disclose information concerning
tobacco-related litigation for which an unfavorable outcome is
other than remote. RJR Tobacco and its affiliates record their
legal expenses and other litigation costs and related
administrative costs as selling, general and administrative
expenses as those costs are incurred.







As discussed in Business  Litigation Affecting
the Cigarette Industry in Item 1 and note 14 to
consolidated financial statements, RJR Tobacco and its
affiliates have been named in a number of tobacco-related legal
actions, proceedings or claims seeking damages in amounts
ranging into the hundreds of millions or even billions of
dollars. Unfavorable judgments awarding compensatory damages,
punitive damages and/or fines have been returned against RJR
Tobacco in the Engle class-action case, a small number of
individual smoking and health cases and a health-care cost
recovery case. However, RJR Tobacco believes that it has
numerous bases for successful appeals in these cases, and both
RJR Tobacco and RJR believe they have a number of valid defenses
to all actions and intend to defend all actions vigorously.
RJRs management continues to conclude that the loss of any
particular smoking and health tobacco litigation claim against
RJR Tobacco or its affiliates, when viewed on an individual
basis, is not probable. Accordingly, no liability for
tobacco-related litigation currently is recorded in RJRs
consolidated financial statements. RJR and RJR Tobacco will
record any loss related to tobacco litigation at such time as an
unfavorable outcome becomes probable and the amount can be
reasonably estimated. When the reasonable estimate is a range,
the recorded loss will be the best estimate within the range. If
no amount in the range is a better estimate than any other
amount, the minimum amount of the range will be recorded.







Litigation is subject to many uncertainties, and it is possible
that some of the tobacco-related legal actions, proceedings or
claims could ultimately be decided against RJR Tobacco or its
affiliates, including RJR. Any unfavorable outcome of such
actions could have a material adverse effect on the financial
condition, results of operations or cash flows of RJR or its
subsidiaries.







Settlement Agreements







As discussed in Business  Litigation Affecting
the Cigarette Industry in Item 1 and note 14 to
consolidated financial statements, RJRs operating
subsidiaries are participants in the MSA and other state
settlement agreements related to governmental health-care cost
recovery actions. Their obligations and the related expense
charges under the MSA and other settlement agreements are
subject to adjustments based upon, among other things, the
volume of cigarettes sold by the operating subsidiaries, their
relative market share and inflation. Since relative market share
is based on cigarette shipments, the best estimate of the
allocation of charges under these agreements is recorded in
costs of products sold as the products are shipped. Settlement
expenses under these MSA and other settlement agreements
recorded in the accompanying consolidated statements of income
were $2.6 billion in 2001, $2.3 billion in 2000 and $2.2 billion
in 1999. RJR Tobacco estimates that its settlement charges will
approximate $2.4 billion in 2002 and $2.1 billion in each of
2003, 2004 and 2005, subject to adjustments, including those
discussed above. Adjustments to these estimates, which
historically have not been significant, are recorded in the
period that the change becomes probable and the amount can be
reasonably estimated.




Goodwill and Trademarks

Goodwill is continually reviewed for impairment. Trademarks are
reviewed for impairment whenever events or changes in
circumstances indicate that the book value of the asset may not
be recoverable. The carrying value of goodwill and trademarks
would be impaired if the best estimate of future undiscounted
cash flows over their remaining amortization period is less than
their carrying value. If an asset is impaired, the loss is
measured using estimated fair value.

In the fourth quarter of 2000, impairment occurred on two of RJR
Tobaccos non-key brands, MAGNA and CENTURY, based on their
estimated undiscounted net future cash flows. Accordingly, RJR
Tobacco recorded an impairment charge of $89 million, based on
the excess of the brands carrying value over fair value.

28



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##### 



Factors that may impact the valuation of goodwill and trademarks
include, among other things, the level of brand support,
consumer demand, governmental regulation and the ability to
raise prices. At December 31, 2001, there were no factors
that indicated that the book value of goodwill and trademarks
might not be recoverable.

In June 2001, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets, which is
effective as of January 1, 2002. SFAS No. 142
substantially changes the accounting for goodwill and
trademarks. SFAS No. 142 requires that goodwill and other
intangible assets with indefinite useful lives no longer be
amortized. This statement also requires that within the first
interim period of adoption, the intangible assets with
indefinite lives should be tested for impairment as of the date
of adoption, and that if any impairment results, it should be
recognized as a change in accounting principle. Additionally,
SFAS No. 142 requires that within six months of adoption,
goodwill be tested for impairment at the reporting unit level as
of the date of adoption. If any impairment is indicated to have
existed upon adoption, it should be measured and recorded before
the end of the year of adoption. SFAS No. 142 requires that
any goodwill impairment loss recognized as a result of initial
application be reported in the first interim period of adoption
as a change in accounting principle, and that the income per
share effects of the accounting change be separately disclosed.

Other intangible assets consist of RJR Tobaccos trademarks
acquired through business combinations, which have indefinite
useful lives. A national appraisal firm has been engaged to
assist in the valuation of the trademarks as of January 1,
2002. No later than March 31, 2002, the existence and
amount, if any, of trademark impairment will be determined by
comparing the fair values of those assets with their carrying
values.

RJRs goodwill as of January 1, 2002 is attributable
to one reporting unit, RJR Tobacco, which comprises
substantially all of RJRs consolidated results of
operations and financial condition. A national appraisal firm
has been engaged to assist in the determination of the fair
value of RJR. Before June 30, 2002, any indication of
goodwill will be determined by comparing RJRs fair value
with its carrying value as of January 1, 2002.

As of December 31, 2001, the carrying values of RJR
Tobaccos goodwill and trademarks were $6.9 billion and
$2.8 billion, respectively. RJR Tobacco recorded goodwill and
trademark amortization expense of $362 million and $366 million
during 2001 and 2000, respectively. As of January 1, 2002,
RJR Tobaccos goodwill and trademarks will no longer be
amortized. Because of the extensive effort needed to comply with
the application of SFAS No. 142, the impairment loss, if
any, related to RJR Tobaccos trademarks or goodwill upon
adoption of this statement cannot be estimated.

Recent Accounting Developments

Effective January 1, 2001, RJRs operating
subsidiaries adopted the Emerging Issues Task Forces Issue
No. 00-14, Accounting for Certain Sales
Incentives, which addresses the recognition, measurement
and income statement classification for certain sales
incentives, including rebates, coupons and free products or
services. EITF No. 00-14 requires that in the accompanying
consolidated income statements, certain costs that historically
were included in selling, general and administrative expenses
now be classified in cost of products sold or as reductions of
net sales. Those costs have been reclassified in prior periods
for comparative purposes. The adoption of EITF No. 00-14
did not impact consolidated annual net income or cumulative
earnings.

As of January 1, 2001, RJR and its subsidiaries adopted
SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities, as amended by SFAS No. 137
and SFAS No. 138. SFAS No. 133 requires that all
derivative instruments be recorded on the consolidated balance
sheet at their fair value. Changes in the fair value of
derivatives are recorded each period in earnings or other
comprehensive income, depending on whether a derivative is
designated and effective as part of a hedge transaction. If it
is, the type of hedge transaction must be disclosed. The
adoption of SFAS No. 133, as amended, did not impact
RJRs consolidated financial position or results of
operations.

29



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##### 



As of December 31, 2001, RJR Tobacco held a forward
currency exchange contract to purchase seven million Euros with
a term of less than 12 months as a hedge of an unrecognized
firm commitment for the purchase of equipment. As of
December 31, 2001, the foreign currency cash flow hedge was
effective and, accordingly, no gain or loss was realized. The
unrealized gain resulting from the increase in the hedges
fair value was insignificant.

Effective January 1, 2002, EITF No. 00-25,
Vendor Income Statement Characterization of Consideration
Paid to a Reseller of the Vendors Products, requires
that consideration paid to a distributor or retailer to promote
the vendors products, such as slotting fees or buydowns,
generally be characterized as a reduction of revenue when
recognized in the vendors income statement. Upon adoption,
RJRs operating subsidiaries will characterize the
applicable costs as a reduction of net sales rather than as
selling, general and administrative expense. Had EITF
No. 00-25 been adopted for 2001 and 2000, selling, general
and administrative expense would have been reduced by $2.3
billion and $2 billion, respectively. The respective amounts
would have been classified as reductions to net sales. The
adoption of EITF No. 00-25 will not impact RJRs
consolidated financial position, operating income or net income.

Results of Operations

|                                             |  |      |       |      |  |      |       |  |  |   |       | 
|-------------------------------------------- |  | ---- | ----- | ---- |  | ---- | ----- |  |  | - | ----- | 
|                                             |  | 2001 |       | 2000 |  | 1999
|                                             |  |      |       |      |  |     
|Net sales                                    |  | $    | 8,585 |      |  | $    | 8,058 |  |  | $ | 7,468 | 
|                                            
|                                            
|                                            
|                                            
|Cost of products sold (*)                    |  |      | 3,560 |      |  |      | 3,436 |  |  |   | 3,292 | 
|                                            
|                                            
|                                            
|                                            
|Selling, general and administrative expenses |  |      | 3,745 |      |  |      | 3,342 |  |  |   | 2,924 | 
|                                             |  |      |       |      |  |      |       |  |  |   |       | 
|Ongoing operating company contribution       |  | $    | 1,280 |      |  | $    | 1,280 |  |  | $ | 1,252 | 
|                                             |  |      |       |      |  |      |       |  |  |   |       | 






|    |                                                                                                                                                                                     
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(*) | $2,584 million, $2,329 million and $2,178 million of ongoing
    settlement expense was recorded in cost of products sold for the
    years ended 2001, 2000 and 1999, respectively.

2001 Compared with 2000

Net salesof $8.6 billion for the year ended
December 31, 2001 increased 6.5% over 2000. This increase
was primarily driven by favorable pricing of $1 billion, as a
result of price increases in 2001 and the last half of 2000,
partially offset by volume declines of $0.5 billion.

RJR Tobaccos total shipment volume for the year ended
December 31, 2001 of 90.7 billion units, excluding Puerto
Rico and certain other U.S. territories volume of 1.3
billion units, decreased 5.9% from the year ended
December 31, 2000. RJR Tobaccos shipment volume
during the year ended December 31, 2001 was adversely impacted
by estimated declines in trade inventory levels and decreased
consumption. Consumption of RJR Tobaccos products,
representing retail sales to consumers, declined approximately
2.8% during 2001 when compared with 2000. Consumption is
expected to continue to decline. For the year ended
December 31, 2001, RJR Tobaccos full-price and
savings shipments decreased 5.7% and 6.2%, respectively, when
compared with the prior year. RJR Tobaccos full-price
shipments represented 63.3% and 63.2% of total shipments for the
years ended December 31, 2001 and 2000, respectively.

CAMEL shipment volume, excluding the non-filter style, for 2001
was up 1.6% versus 2000. WINSTONs base styles decreased
3.7% during 2001 from 2000, and SALEM shipments decreased 13.7%.
DORAL shipments decreased 10.1% when compared with the prior
year.

Industry volume decreased 3.2% for the year ended
December 31, 2001 when compared with 2000. Full-price and
savings shipments for the industry for the year ended
December 31, 2001 decreased 2.7% and 4.4%, respectively,
when compared with the prior year. Industry full-price shipments
represented 73.8% and 73.5% of total shipments for the years
ended December 31, 2001 and 2000, respectively.

RJR Tobaccos retail share of market, according to data
from Information Resources Inc./Capstone, averaged 23.42% for
the year ended December 31, 2001, a decrease of .16 share
points when compared with the prior year.

30



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##### 



CAMEL, RJR Tobaccos largest brand, continued its growth
trend. CAMELs share of market, excluding the non-filtered
style, was 5.52% in 2001, compared with 5.14% in 2000.
CAMELs growth can be attributed to its strong
Pleasure to Burn positioning, which was enhanced by
unique programs such as the Seven Pleasures of the
Exotic consumer events, and the strength of its Turkish
line extensions. Following the successful launch of CAMEL
Turkish Gold in 2000, the brand launched CAMEL Turkish Jade, a
menthol line extension, during the third quarter of 2001.

Base WINSTONs retail share averaged 4.84% in 2001, up from
4.76% in 2000. During 2001, WINSTON modernized its No
Boundaries, No Bull positioning by launching WINSTON S2, a
line extension that features a new blend and high-impact silver
embossed packaging. Additionally, the base WINSTON family was
enhanced to incorporate the same silver highlights.

SALEMs share averaged 2.73% in 2001 compared with 3.01% in
2000. SALEMs decline was due to increased competitive
activity in the menthol category coupled with reduced marketing
support in SALEMs ten emphasis markets in the latter
portion of 2001. While the trend in the ten emphasis markets has
been better than in the balance of the country, the brand is
currently evaluating opportunities to strengthen its performance.

Since the second quarter of 2001, DORALs share of market
has declined after holding relatively steady at 6.1 to 6.2 share
points for several quarters. The retail share of market of
DORAL, the nations best-selling savings brand, was 5.92%
for 2001, down from 6.16% in 2000. To strengthen DORALs
performance, the brand recently launched a comprehensive upgrade
across all categories of DORALs Imagine Getting
More positioning. This upgrade includes a new blend with
higher-quality tobaccos, new bold packaging, new advertising to
support the changes and a new website to enhance DORALs
existing relationship marketing program.

RJR Tobacco also is committed to finding ways to develop and
market consumer-acceptable cigarettes that may present less risk
associated with smoking. In April 2000, RJR Tobacco launched a
new test market of ECLIPSE in the Dallas/Fort Worth area through
direct mail and Internet sales to age-verified, adult smokers.
The Dallas/Fort Worth test market was expanded to include retail
sales in January 2001. ECLIPSE is a cigarette that primarily
heats rather than burns tobacco. Although RJR Tobacco does not
claim that ECLIPSE presents smokers with less risk of
cardiovascular disease or complications with pregnancy, ECLIPSE
may present less risk of cancer, chronic bronchitis and possibly
emphysema when compared with tobacco-burning cigarettes.




Cost of products soldof $3.6 billion increased $124
million from 2000, primarily due to an increase of
$255 million in ongoing settlement costs partially offset
by decreased volume-related expenses and lower raw material
costs.




Selling, general and administrative expensesof $3.7
billion in 2001 increased $403 million from the prior year. This
change over the prior year was primarily due to increased retail
discounting.




Selling, general and administrative expenses include the costs
of litigating and administering product liability claims, as
well as other legal expenses. For the years ended December 31,
2001 and 2000, RJR Tobaccos product liability defense
costs were $165 million and $179 million, respectively.







Product liability cases generally include smoking
and health related cases. In particular, these cases include the
following categories of cases discussed in
Business  Litigation Affecting the Cigarette
Industry in Item 1 and note 14 to consolidated
financial statements:






| |   |                                                           
| | - | ----------------------------------------------------------
|
| |  | individual smoking and health;                            
|
|
|
| |  | flight attendant  ETS (Broin II);                        
|
|
|
| |  | class actions;                                            
|
|
|
| |  | governmental health-care cost recovery;                   
|
|
|
| |  | other health-care cost recovery and aggregated claims; and
|

31



---



##### 








| |   |                       
| | - | ----------------------
| |  | asbestos contribution.







Product liability defense costs include the
following items:






| |   |                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  | direct and indirect compensation, fees and related costs and
    expenses for internal legal and related administrative staff
    administering product liability claims;
|
|
|
| |  | fees and cost reimbursements paid to outside attorneys;                                                                                                                  
|
|
|
| |  | direct and indirect payments to third party vendors for
    litigation support activities;                                                                               
|
|
|
| |  | expert witness costs and fees; and                                                                                                                                       
|
|
|
| |  | payments to the Council for Tobacco Research  U.S.A.,
    which funds are used primarily by the CTR to fund its legal
    defense costs.                                
|




Numerous factors affect the amount of product liability defense
costs. The most important factors are the number of cases
pending and the number of cases in trial or in preparation for
trial (i.e., with active discovery and motions practice). See
Business  Litigation Affecting the Cigarette
Industry in Item 1 and note 14 to consolidated
financial statements for detailed information regarding the
number and type of cases pending, and Business 
Litigation Affecting the Cigarette Industry 
Scheduled Trials in Item 1 and note 14 to
consolidated financial statements for detailed information
regarding the number and nature of cases in trial and scheduled
for trial through the end of 2002. The decrease in product
liability defense costs in 2001 compared with 2000 was primarily
due to a decrease in the level of activity in cases in
preparation for trial, in trial and on appeal in 2001 compared
with 2000.







RJR Tobacco expects that the factors described above will
continue to have the primary impact on its product liability
defense costs in the future. Given the level of activity in
cases in preparation for trial, in trial and on appeal and the
amount of product liability defense costs incurred by RJR
Tobacco over the past three years, RJR Tobaccos recent
experiences in defending its product liability cases and the
reasonably anticipated level of activity in RJR Tobaccos
pending cases and possible new cases, RJR Tobacco does not
expect that the variances in its product liability defense costs
will be significantly different than they have been
historically. However, it is possible that adverse developments
in the factors discussed above, as well as other circumstances
beyond the control of RJR Tobacco, could have a material adverse
effect on the financial condition, results of operation or cash
flows of RJR or its subsidiaries. Those other circumstances
beyond the control of RJR Tobacco include the results of present
and future trials and appeals, and the development of possible
new theories of liability by plaintiffs and their counsel.




Ongoing operating company contribution was unchanged at $1.28
billion for 2001 when compared with the prior year, primarily
due to the factors discussed above. This performance measure
omits up-front, initial tobacco charges, goodwill and trademark
amortization expense and certain other adjustments from
operating income.

Amortization expenseof $362 million during 2001
decreased $4 million, reflecting the impact of trademark
impairment during 2000. Beginning with the adoption of SFAS
No. 142 on January 1, 2002, no amortization expense
will be recorded related to goodwill or trademarks.

An impairment chargeof $89 million, or $54 million after
tax, was incurred during the fourth quarter of 2000 on two of
RJR Tobaccos non-key brands, MAGNA and CENTURY, measured
as the excess of carrying value over fair value.

Other operating expenseincludes activity related to a
$1.4 billion pre-tax tobacco settlement and related charge
recorded in 1998 by RJR Tobacco. At December 31, 1998, $1.3
billion had been utilized. Since December 31, 1998, the
remaining liability for employee severance and related benefits
for workforce reductions totaling approximately 1,300 employees
was utilized through cash expenditures of $76 million and the
reversal of $21 million, due to a less-than-expected workforce
reduction.

Interest and debt expensewas $150 million and $168
million in 2001 and 2000, respectively. This decrease primarily
resulted from lower debt balances.

32



---



##### 



Interest incomeduring 2001 increased $18 million when
compared with the prior year, primarily reflecting a higher
average cash balance during 2001 when compared with 2000,
partially offset by declining interest rates. Lower interest
rates and lower cash balances are expected to cause
significantly lower interest income during 2002, when compared
with 2001.

Other expense, netdecreased $18 million for the year
ended December 31, 2001 from the prior year. This decrease
was primarily due to foreign exchange losses realized during
2000 on debt denominated in foreign currencies. All debt
denominated in foreign currencies was retired in 2000.




Provision for income taxeswas $448 million, or an
effective rate of 50.2%, in 2001 compared with $449 million, or
an effective rate of 60.0%, in 2000. The effective tax rates
exceed the federal statutory rate of 35% primarily due to the
impact of certain nondeductible items, including goodwill
amortization, and to a lesser extent, state taxes. The effective
tax rate during 2002 is expected to be approximately 39% after
the elimination of goodwill amortization expense.







Discontinued operationsin 2001 included a $14 million,
$9 million after tax, purchase price adjustment of the 1999 gain
on the sale of the international tobacco business to Japan
Tobacco Inc. Discontinued operations in 2000 included a
$53 million after-tax gain resulting from re-evaluation of
tax reserves related to the sale of the international tobacco
business. Including this adjustment, the net after-tax gain on
the sale of the international tobacco business was $2.4 billion.




Extraordinary itemincluded a gain of $1.5 billion
realized during the fourth quarter of 2000 in connection with
RJRs acquisition of NGH. See note 3 to the consolidated
financial statements.

2000 Compared with 1999

Net salesof $8.1 billion for the year ended
December 31, 2000 increased 7.9% over 1999. This increase
was driven by favorable pricing of $626 million, as a result of
price increases in 2000 and the last half of 1999, partially
offset by a $38 million unfavorable volume shift in the branded
savings price tier to private label. RJR Tobaccos shipment
volume for the year of 96.4 billion units, excluding Puerto Rico
and certain other U.S. territories volume of 1.4 billion
units, was level with the prior year, while industry volume
increased 0.1% to 419.8 billion units. RJR Tobacco believes that
its shipment volume benefited from an increase in trade
inventory levels. RJR Tobaccos consumption volume declined
3.5%, and the industry consumption volume declined 2.5% during
2000 compared with 1999.

RJR Tobaccos full-price shipments represented 63.2% and
62.6% of its total shipments for the years ended
December 31, 2000 and 1999, respectively. Industry-wide,
full-price shipments represented 73.5% and 73.4% of total
shipments for the years ended December 31, 2000 and 1999,
respectively. RJR Tobaccos full-price shipments increased
0.9%, while the industry full-price increase was 0.2%. CAMEL
shipments, excluding the non-filter style, for 2000 were up
10.2% versus 1999, and WINSTONs base styles increased 0.6%
during 2000 from 1999. SALEM shipments were down 3.9% compared
with the prior year. Shipments for DORAL decreased 1.6% compared
with the prior year, while the industry savings decline was 0.2%.

RJR Tobaccos retail share of market averaged 23.58% for
the year ended December 31, 2000, a decrease of .34 share
points compared with the prior year.

CAMEL, RJR Tobaccos largest full-price brand, continued to
show strong growth. Its share of market, excluding the
non-filtered style, grew .42 share points to 5.14% in 2000.
CAMELs growth was supported by its Pleasure to
Burn positioning, its successful launch of Turkish Gold
and its creative and integrated marketing programs.

Base WINSTONs retail share of 4.76% for the year ended
December 31, 2000 was down slightly from its 1999 share of
4.83%; however, its share increased .16 share points in the
second half compared with the first half of 2000. WINSTONs
No Bull positioning and a more competitive retail
plan contributed to the brands performance.

SALEMs share averaged 3.01% in 2000 compared with 3.17% in
1999, reflecting increased competitive activity in the menthol
category. However, SALEMs share grew in latter 2000 in its
emphasis markets where

33



---



##### 





DORALs retail share of market was 6.16% in 2000, down .14
share points compared with the prior year. Competitive pricing
pressure from deep-discount brands impacted DORALs
performance, particularly in the second quarter of 2000. To more
effectively compete against these brands, refined retail pricing
promotions were begun in mid-2000. These promotions, along with
its Imagine Getting More positioning, contributed to
consecutive share gains in the third and fourth quarters of 2000.

Cost of products soldof $3.4 billion increased $144
million from 1999, primarily due to an increase in ongoing
settlement costs of $151 million and higher promotional costs,
partially offset by lower raw material cost.

Selling, general and administrative expensesof $3.3
billion in 2000 increased $418 million from the prior year. This
change over the prior-year period was primarily due to increased
retail discounting.




Selling, general and administrative expenses include the costs
of litigating and administering product liability claims, as
well as other legal expenses. For the years ended December 31,
2000 and 1999, RJR Tobaccos product liability defense
costs were $179 million and $141 million, respectively. The
increase in product liability defense costs was primarily due to
an increase in the level of activity in cases in preparation for
trial, in trial and on appeal in 2000 compared with 1999.




Ongoing operating company contribution increased 2.2% to $1.28
billion for 2000 when compared with the prior year. This
increase is primarily due to the factors discussed above.

An impairment chargeof $89 million, $54 million after
tax, was incurred during the fourth quarter of 2000 on two of
RJR Tobaccos non-key brands, MAGNA and CENTURY.

Headquarters close-down and related chargesrecorded by
RJR in the second quarter of 1999 of $143 million, $93 million
after tax, reflected the elimination of its New York corporate
headquarters. Total cash expenditures related to this charge
were $122 million. The elimination of the headquarters resulted
from reorganization transactions described in note 2 to the
consolidated financial statements. Approximately $127 million of
the charge was for severance and related benefits for
approximately 100 employees whose employment was terminated. The
remainder of the charge was primarily related to contractual
lease termination payments and the write-off of leasehold
improvements and abandoned equipment.

Other operating expenseduring 2000 and 1999 includes a
reversal of $3 million and $17 million, respectively, from the
liability for employee severance and related benefits to the
$1.4 billion tobacco settlement and related charge recorded in
1998 by RJR Tobacco. The reversal reflected a less-than-expected
workforce reduction. During 1999, RJR Tobacco recorded a charge
of $40 million for initial, up-front costs related to the
tobacco growers settlement.

Interest and debt expensewas $168 million and $268
million in 2000 and 1999, respectively. This decrease resulted
from the repurchase of approximately $4 billion of debt,
partially offset by the issuance of $1.25 billion of debt,
during the second quarter of 1999.

Interest incomeincreased $5 million during 2000 when
compared with the prior year, primarily reflecting higher cash
balances and higher interest rates.

Other expense, netdecreased $27 million for the year
ended December 31, 2000 from the prior year. This decrease
was primarily the result of higher 1999 charges related to the
spin-off. See note 2 to the consolidated financial statements.

Provision for income taxeswas $396 million, or an
effective rate of 52.9%, in 2000 compared with $315 million, or
an effective rate of 61.8%, in 1999. The effective tax rates
exceed the federal statutory rate of 35% primarily due to the
impact of certain nondeductible items, including goodwill
amortization, and to a lesser extent, state taxes.

34



---



##### 






Discontinued operationsin 2000 included a $53 million
after-tax gain resulting from re-evaluation of tax reserves
related to the sale of the international tobacco business.
Discontinued operations for the year ended December 31,
1999 included after-tax income of $76 million related to the
operations of the international tobacco business and Nabisco.
Additionally, discontinued operations included a $2.3 billion
gain on the sale of the international tobacco business, net of a
$322 million loss on the recognition of Nabiscos
cumulative translation adjustment account. See note 2 to the
consolidated financial statements.




Extraordinary itemincluded a gain of $1.5 billion
realized during the fourth quarter of 2000 in connection with
RJRs acquisition of NGH. See note 3 to the consolidated
financial statements. An extraordinary loss of $384 million,
$250 million after tax, was incurred during 1999 in connection
with the repurchase of approximately $4 billion of debt
securities. See note 2 to the consolidated financial statements.

Liquidity and Financial Condition

Liquidity

At present, the principal sources of liquidity for RJRs
operating subsidiaries businesses and operating needs are
internally generated funds from their operations and borrowings
through RJR. Cash flows from operating activities are believed
to be sufficient for the foreseeable future to enable the
operating subsidiaries to meet their obligations under the MSA,
to fund their capital expenditures and to make payments to RJR
that will enable RJR to make its required debt-service payments
and to pay dividends to its stockholders. Additionally, the
acquisition of NGH in December 2000 provided $1.5 billion cash
proceeds to RJR Acquisition Corp., a portion of which is funding
RJRs share repurchase programs. While demand for tobacco
products is not materially impacted in the short term by
consumers, the negative impact, if any, on the sources of
liquidity that could result from a decrease in demand for
products due to short-term trade inventory adjustments cannot be
predicted. Additionally, RJR cannot predict its cash
requirements or those of its subsidiaries related to any future
settlements or judgments, including cash required to bond any
appeals, if necessary, and make no assurance that RJR or its
subsidiaries will be able to meet all of those requirements.

Contractual obligations as of December 31, 2001 were:

Payments Due by Period

|                 |                        |       |       |           |  |       |    |       |  |            |     |     |  |   |     |     |  |   |     |     | 
|---------------- | ---------------------- | ----- | ----- | --------- |  | ----- | -- | ----- |  | ---------- | --- | --- |  | - | --- | --- |  | - | --- | --- | 
|                 |                        |       |       | Less than |  | 1-3   |    | 4-5   |  |           
|                 |                        | Total |       | 1 Year    |  | Years |    | Years |  | Thereafter
|                 |                        |       |       |           |  |       |    |       |  |           
|Long-term debt   |                        | $     | 1,674 |           |  | $     | 43 |       |  | $          | 846 |     |  | $ | 527 |     |  | $ | 258 |    
|                
|                
|                
|                
|Operating leases |                        |       | 35    |           |  |       | 19 |       |  |            | 14  |     |  |   | 2   |     |  |   |    |    
|                 |                        |       |       |           |  |       |    |       |  |            |     |     |  |   |     |     |  |   |     |    
|                 | Total cash obligations |       | $     | 1,709     |  |       | $  | 62    |  |            | $   | 860 |  |   | $   | 529 |  |   | $   | 258 | 
|                 |                        |       |       |           |  |       |    |       |  |            |     |     |  |   |     |     |  |   |     |    

For more information about RJRs long-term debt, see
 Debt below. RJR Tobacco estimates that its
settlement charges will approximate $2.4 billion in 2002 and
will exceed $2 billion each year thereafter. For more
information about RJR Tobaccos settlement payments, see
Business  Litigation Affecting the Cigarette
Industry in Item 1 and note 14 to the consolidated
financial statements.

Commitments as of December 31, 2001 were:

Commitment Expiration Per Period

|                                                                  |                   |       |     |           |  |   |     |     | 
|----------------------------------------------------------------- | ----------------- | ----- | --- | --------- |  | - | --- | --- | 
|                                                                  |                   |       |     | Less than
|                                                                  |                   | Total |     | 1 Year   
|                                                                  |                   |       |     |          
|Standby letters of credit backed by revolving
    credit facility |                   | $     | 132 |           |  | $ | 132 |    
|                                                                 
|                                                                 
|                                                                 
|                                                                 
|Trade letter of credit                                            |                   |       | 1   |           |  |   | 1   |    
|                                                                  |                   |       |     |           |  |   |     |    
|                                                                  | Total commitments |       | $   | 133       |  |   | $   | 133 | 
|                                                                  |                   |       |     |           |  |   |     |    

35



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##### 



Debt

On May 18, 1999, RJR completed tender offers to purchase
substantially all of its outstanding debt securities, which
resulted in RJR repurchasing $4 billion of its debt with a
portion of the proceeds from the sale of the international
tobacco business. As a result, RJR recognized an extraordinary
loss from the early extinguishment of debt of $384 million, $250
million after tax.

RJRs revolving credit facility with a syndicate of banks
was amended and restated on November 17, 2000. Under the
amendment and restatement, the committed amount of $1.235
billion was reduced to $622 million as of November 2001 and will
remain at this amount through May 2003. RJR can use the full
facility to obtain loans or letters of credit, at its option.
RJR Tobacco and RJR Acquisition Corp. have guaranteed RJRs
obligations under this revolving credit facility. If RJRs
guaranteed unsecured notes are rated below BBB- by S&P or
Baa3 by Moodys, RJRs other material subsidiaries
will be required to guarantee the facility. If RJR falls below
these thresholds for both of these rating agencies, or two
levels below these thresholds for either of these rating
agencies, RJR and the guarantors will be required to pledge
their assets to secure their obligations.




RJR is not required to maintain compensating balances; however,
commitment fees of 1% of the committed amount are payable
quarterly. The credit facility also limits RJRs ability to
pay dividends, repurchase stock, incur indebtedness, engage in
transactions with affiliates, create liens, acquire, sell or
dispose of specific assets and engage in specified mergers or
consolidations. Under the credit facility, cumulative dividends
and share repurchases generally may not exceed the sum of $500
million plus 50% of cumulative adjusted cash net income. Despite
this general restriction, however, the credit facility further
provides that (1) the remaining amount from the $1.5
billion proceeds from the NGH acquisition, and any further
proceeds thereon, may be used to pay dividends and repurchase
shares, and (2) up to an additional $500 million in dividends
and share repurchases may be made. Stock repurchases also are
limited to the extent that a stated minimum level of net worth
must be maintained. Borrowings under the revolving credit
facility bear interest at rates that vary with the prime rate or
LIBOR. At December 31, 2001, RJR had $132 million in
letters of credit and no borrowings outstanding under the
facility, with the remaining $490 million of the facility
available for borrowing. In January 2002, a $116 million letter
of credit was cancelled resulting in $606 million of the
facility available for borrowing.




Additionally, as of December 31, 2001, RJR had a trade
letter of credit outstanding of $1 million. RJR also has a $30
million uncommitted, unsecured line of credit with one bank. No
borrowings were outstanding on this line of credit at
December 31, 2001.

RJR filed a registration statement, effective October 8,
1999, in order to issue publicly registered notes of $550
million in principal amount at 7.375% due 2003, $500 million in
principal amount at 7.75% due 2006 and $200 million in principal
amount at 7.875% due 2009 in exchange for an aggregate $1.25
billion of private placement debt securities. The net proceeds
received from the private placement were used for general
corporate purposes. These notes are unsecured obligations and,
unlike RJRs other non-bank debt, are guaranteed by RJR
Tobacco and RJR Acquisition Corp. In addition, any other
subsidiaries of RJR that in the future guarantee the $622
million revolving credit facility, as amended and restated, will
also be required to guarantee these notes. In addition, if RJR
and the guarantors are required to pledge their assets to secure
their obligations under the revolving credit facility, as
amended and restated, they will also be required to pledge their
assets to secure these notes. Generally, the terms of the notes
restrict the issuance of guarantees by subsidiaries, the pledge
of collateral, sale/leaseback transactions and the transfer of
all or substantially all of the assets of RJR and its
subsidiaries.

RJR was in compliance with all covenants and restrictions
imposed by its indebtedness at December 31, 2001.

RJR filed a shelf registration statement, effective
December 22, 1999, for $1.876 billion of debt securities,
guaranteed by RJR Tobacco. On April 19, 2001, a
registration statement became effective to add RJR Acquisition
Corp. as a guarantor of these debt securities. As of the date of
this filing, no debt securities have been issued from this
registration.

36



---



##### 



On December 11, 2000, related to the acquisition of NGH,
RJR acquired $98 million of 9.5% junior subordinated debentures,
due in 2047, redeemable on September 30, 2003. Interest on
these debentures is paid quarterly in arrears. These debentures
are effectively defeased by an irrevocable trust, which is
included in other assets and deferred charges in the
accompanying consolidated balance sheets as of December 31,
2001 and 2000. The trust holds certain U.S. government
obligations maturing at such times and in such amounts
sufficient to pay interest and principal.

Statements included in Managements Discussion and
Analysis of Financial Condition and Results of Operations
which are not historical in nature are forward-looking
statements made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995.
Forward-looking statements regarding our future performance and
financial results include certain risks and uncertainties that
could cause actual results to differ materially from those
described in the forward-looking statements. These risks include
the substantial and increasing regulation and taxation of the
cigarette industry; various legal actions, proceedings and
claims arising out of the tobacco business and claimed health
effects of cigarettes that are pending or may be instituted
against RJR or its subsidiaries; the substantial payment
obligations and limitations on the advertising and marketing of
cigarettes, under various litigation settlement agreements; the
continuing decline in volume in the domestic cigarette industry;
competition from other cigarette manufacturers; the success of
new product innovations and acquisitions; the effect of market
conditions on the performance of pension assets and the return
on corporate cash; and the ratings of RJRs securities. Due
to these uncertainties and risks, you are cautioned not to place
undue reliance on these forward-looking statements, which speak
only as of the date of this report.

37



---



##### 



Item 8. Financial Statements and Supplementary Data

Independent Auditors Report

The Board of Directors



We have audited the accompanying consolidated balance sheets of
R.J. Reynolds Tobacco Holdings, Inc. and subsidiaries as of
December 31, 2001 and 2000, and the related consolidated
statements of income, stockholders equity and
comprehensive income, and cash flows for the years then ended.
These consolidated financial statements are the responsibility
of the Companys management. Our responsibility is to
express an opinion on these consolidated financial statements
based on our audits.

We conducted our audits in accordance with auditing standards
generally accepted in the United States of America. Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred
to above present fairly, in all material respects, the financial
position of R.J. Reynolds Tobacco Holdings, Inc. and
subsidiaries as of December 31, 2001 and 2000, and the
results of their operations and their cash flows for the years
then ended in conformity with accounting principles generally
accepted in the United States of America.




As discussed in Note 23 to the consolidated financial
statements, the Company has restated its previously issued 2000
consolidated statement of income for the reclassification of an
income tax benefit from continuing operations to discontinued
operations.




/s/ KPMG LLP

Greensboro, North Carolina









38



---



##### 



Independent Auditors Report

R.J. Reynolds Tobacco Holdings, Inc.:

We have audited the accompanying consolidated statements of
income, cash flows and stockholders equity and
comprehensive income of R.J. Reynolds Tobacco Holdings, Inc. and
subsidiaries (RJR) for the year ended
December 31, 1999. These financial statements are the
responsibility of RJRs management. Our responsibility is
to express an opinion on these financial statements based on our
audit.

We conducted our audit in accordance with auditing standards
generally accepted in the United States of America. Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements present
fairly, in all material respects, the results of operations and
cash flows of RJR for the year ended December 31, 1999, in
conformity with accounting principles generally accepted in the
United States of America.

/s/ Deloitte & Touche LLP

Charlotte, North Carolina





39



---



##### 



Report of Managements Responsibility for Financial
Statements

The financial statements presented in this report are the
responsibility of management, and have been prepared in
accordance with generally accepted accounting principles using,
where appropriate, managements best estimates and
judgment. Management maintains a system of internal controls to
provide reasonable assurance that RJRs assets are
safeguarded and transactions are executed as authorized and
properly recorded. The system includes established policies and
procedures, a program of internal audits, management reviews and
careful selection and training of qualified personnel.

The audit committee of RJRs board of directors is composed
solely of outside directors. It meets periodically with
management, the internal auditors and the independent auditors,
to discuss and address internal accounting control, auditing and
financial reporting matters. Both independent and internal
auditors have unrestricted access to the audit committee.

/s/ Andrew J. Schindler




Chairman of the Board, President and


Chief Executive Officer





/s/ Dianne M. Neal







Executive Vice President and


Chief Financial Officer


40



---



##### 



CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Millions, Except Per Share Amounts)





|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |       |       | 
|---------------------------------------------------------------------------------- | -------------------------------------------------------------------------- | --------------------------------------------------------- | ----- | ---------- | ---- | ---- | ----- | ----- | ----- | - | ----- | ----- | ----- | 
|                                                                                   |                                                                            |                                                          
|                                                                                   |                                                                            | For the Years Ended December 31,                         
|                                                                                   |                                                                            |                                                          
|                                                                                   |                                                                            | 2001                                                      |       | 2000       |      | 1999
|                                                                                   |                                                                            |                                                           |       |            |      |     
|                                                                                   |                                                                            |                                                           |       | (Restated) |      |     
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Net sales (1)                                                                      |                                                                            | $                                                         | 8,585 |            |      | $    | 8,058 |       |       | $ | 7,468 |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Costs and expenses:                                                                |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Cost of products sold (1)(2)                                               |                                                           |       | 3,560      |      |      |       | 3,436 |       |   |       | 3,292 |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Selling, general and administrative expenses                               |                                                           |       | 3,745      |      |      |       | 3,342 |       |   |       | 2,924 |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Amortization of trademarks and goodwill                                    |                                                           |       | 362        |      |      |       | 366   |       |   |       | 366   |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Impairment charge                                                          |                                                           |       |           |      |      |       | 89    |       |   |       |      |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Headquarters close-down and related charges                                |                                                           |       |           |      |      |       |      |       |   |       | 143   |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Other operating expense                                                    |                                                           |       |           |      |      |       | (3    | )     |   |       | 21    |      
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                   |                                                                            | Operating income                                          |       |            | 918  |      |       |       | 828   |   |       |       | 722   | 
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Interest and debt expense                                                          |                                                                            |                                                           | 150   |            |      |      | 168   |       |       |   | 268   |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Interest income                                                                    |                                                                            |                                                           | (137  | )          |      |      | (119  | )     |       |   | (114  | )    
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Other expense, net                                                                 |                                                                            |                                                           | 13    |            |      |      | 31    |       |       |   | 58    |      
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                   |                                                                            | Income from continuing operations before
    income taxes |       |            | 892  |      |       |       | 748   |   |       |       | 510   | 
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Provision for income taxes                                                         |                                                                            |                                                           | 448   |            |      |      | 449   |       |       |   | 315   |      
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                   |                                                                            | Income from continuing operations                         |       |            | 444  |      |       |       | 299   |   |       |       | 195   | 
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Discontinued operations:                                                           |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Income from operations of discontinued
    businesses, net of income taxes |                                                           |       |           |      |      |       |      |       |   |       | 76    |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Gain (loss) on discontinued businesses, net
    of income taxes            |                                                           |       | (9         | )    |      |       | 53    |       |   |       | 2,322 |      
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                   |                                                                            | Income before extraordinary items                         |       |            | 435  |      |       |       | 352   |   |       |       | 2,593 | 
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Extraordinary item  gain on
    acquisition, net of income taxes                  |                                                                            |                                                           |      |            |      |      | 1,475 |       |       |   |      |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|Extraordinary item  loss on early
    extinguishment of debt, net of income taxes |                                                                            |                                                           |      |            |      |      |      |       |       |   | (250  | )    
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                   |                                                                            | Net income                                                |       | $          | 435  |      |       | $     | 1,827 |   |       | $     | 2,343 | 
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|Basic income (loss) per share:                                                     |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Income from continuing operations                                          |                                                           | $     | 4.57       |      |      | $     | 2.96  |       |   | $     | 1.80  |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Income (loss) from discontinued operations                                 |                                                           |       | (.09       | )    |      |       | 0.52  |       |   |       | 22.10 |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Extraordinary items  gain (loss)                                          |                                                           |       |           |      |      |       | 14.56 |       |   |       | (2.30 | )    
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                   |                                                                            | Net income                                                |       | $          | 4.48 |      |       | $     | 18.04 |   |       | $     | 21.60 | 
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|Diluted income (loss) per
    share:                                               |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Income from continuing operations                                          |                                                           | $     | 4.48       |      |      | $     | 2.94  |       |   | $     | 1.80  |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Income (loss) from discontinued operations                                 |                                                           |       | (.09       | )    |      |       | 0.52  |       |   |       | 22.08 |      
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                  
|                                                                                   | Extraordinary items  gain (loss)                                          |                                                           |       |           |      |      |       | 14.48 |       |   |       | (2.30 | )    
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|                                                                                   |                                                                            | Net income                                                |       | $          | 4.39 |      |       | $     | 17.94 |   |       | $     | 21.58 | 
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      
|Dividends declared per share                                                       |                                                                            | $                                                         | 3.30  |            |      | $    | 3.10  |       |       | $ | 1.55  |      
|                                                                                   |                                                                            |                                                           |       |            |      |      |       |       |       |   |       |      









|    |                                                                                                                                                             
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(1) | Excludes excise taxes of $1,529 million, $1,631 million and
    $1,173 million for the years ended December 31, 2001, 2000
    and 1999, respectively.      
|   
|   
|   
|(2) | Includes settlement expense of $2,584 million, $2,329 million
    and $2,178 million for the years ended December 31, 2001,
    2000 and 1999, respectively.
|   

See Notes to Consolidated Financial Statements

41



---



##### 



CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Millions)


|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |        |        |     |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------- | ------------------------------------------------------------------- | ---- | ---- | ---- | ----- | ----- | ------ | ---- | ------ | ------ | ------ | --- | -
|                                                                                                                                                                |                                                                                                |                                                                          
|                                                                                                                                                                |                                                                                                | For the Years Ended December 31,                                         
|                                                                                                                                                                |                                                                                                |                                                                          
|                                                                                                                                                                |                                                                                                | 2001                                                                      |                                                                     | 2000 |      | 1999
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |     
|Cash flows from (used in) operating
    activities:                                                                                                             |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Net income                                                                                     |                                                                           | $                                                                   | 435  |      |      | $     | 1,827 |        |      | $      | 2,343  |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Less income (loss) from discontinued
    operations                                            |                                                                           |                                                                     | (9   | )    |      |       |      |        |      |        | 2,398  |       
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|                                                                                                                                                                | Subtotal                                                                                       |                                                                           |                                                                     | 444  |      |      |       | 1,827 |        |      |        | (55    | )     
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Adjustments to reconcile to net cash flows from
    (used in) continuing operating activities: |                                                                           |                                                                     |      |      |      |       |       |        |      |        |        |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Depreciation and amortization                                             |                                                                     |      | 491  |      |       |       | 485    |      |        |        | 482    |    
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Impairment charge                                                         |                                                                     |      |     |      |       |       | 89     |      |        |        |       |    
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Deferred income tax benefit                                               |                                                                     |      | (43  | )    |       |       | (31    | )    |        |        | (307   | )  
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Extraordinary gain on acquisition                                         |                                                                     |      |     |      |       |       | (1,475 | )    |        |        |       |    
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Extraordinary loss on early extinguishment of debt                        |                                                                     |      |     |      |       |       |       |      |        |        | 384    |    
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Other changes, net of acquisition effects, that
    provided (used) cash: |                                                                     |      |      |      |       |       |        |      |        |        |        |    
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                |                                                                           | Accounts and notes receivable                                       |      |      | (6   | )     |       |        | (12  | )      |        |        | (32 | )
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                |                                                                           | Inventories                                                         |      |      | (141 | )     |       |        | (23  | )      |        |        | (41 | )
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                |                                                                           | Accounts payable and accrued liabilities
    including income taxes |      |      | (211 | )     |       |        | (194 | )      |        |        | (50 | )
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Litigation bonds                                                          |                                                                     |      |     |      |       |       | (118   | )    |        |        |       |    
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Tobacco settlement and related expenses                                   |                                                                     |      | 123  |      |       |       | 82     |      |        |        | 564    |    
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Restructuring and related expenses, net of cash                           |                                                                     |      |     |      |       |       |       |      |        |        | (8     | )  
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Headquarters close-down and related charges, net
    of cash              |                                                                     |      |     |      |       |       |       |      |        |        | 21     |    
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                |                                                                                                | Other, net                                                                |                                                                     |      | (31  | )    |       |       | (40    | )    |        |        | (29    | )  
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|                                                                                                                                                                |                                                                                                | Net cash flows from operating activities                                  |                                                                     |      | 626  |      |       |       | 590    |      |        |        | 929    |    
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|Cash flows from (used in) investing
    activities:                                                                                                             |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Short-term investments                                                                         |                                                                           |                                                                     | (207 | )    |      |       | 110   |        |      |        | (110   | )     
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Capital expenditures                                                                           |                                                                           |                                                                     | (74  | )    |      |       | (60   | )      |      |        | (55    | )     
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Net proceeds from acquisition                                                                  |                                                                           |                                                                     |     |      |      |       | 1,519 |        |      |        |       |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Net proceeds from the sale of the international
    tobacco business                           |                                                                           |                                                                     | (14  | )    |      |       |      |        |      |        | 7,760  |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Other, net                                                                                     |                                                                           |                                                                     | (12  | )    |      |       | 4     |        |      |        | (19    | )     
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|                                                                                                                                                                |                                                                                                | Net cash flows from (used in) investing activities                        |                                                                     |      | (307 | )    |       |       | 1,573  |      |        |        | 7,576  |    
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|Cash flows from (used in) financing
    activities:                                                                                                             |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Repurchase of common stock                                                                     |                                                                           |                                                                     | (494 | )    |      |       | (231  | )      |      |        | (55    | )     
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Dividends paid on common stock                                                                 |                                                                           |                                                                     | (320 | )    |      |       | (322  | )      |      |        | (85    | )     
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Repayments of long-term debt                                                                   |                                                                           |                                                                     | (73  | )    |      |       | (387  | )      |      |        | (4,450 | )     
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Proceeds from exercise of stock options                                                        |                                                                           |                                                                     | 45   |      |      |       | 59    |        |      |        |       |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Proceeds from issuance of long-term debt                                                       |                                                                           |                                                                     |     |      |      |       |      |        |      |        | 1,244  |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Transfers and payments to former parent                                                        |                                                                           |                                                                     |     |      |      |       |      |        |      |        | (1,968 | )     
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Decrease in short-term borrowing                                                               |                                                                           |                                                                     |     |      |      |       |      |        |      |        | (62    | )     
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                                | Other, net                                                                                     |                                                                           |                                                                     |     |      |      |       |      |        |      |        | 17     |       
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|                                                                                                                                                                |                                                                                                | Net cash flows used in financing activities                               |                                                                     |      | (842 | )    |       |       | (881   | )    |        |        | (5,359 | )  
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|Net cash flows related to discontinued operations
    (including income taxes paid on gain on sale of the
    international tobacco business of $2,085 in 1999) |                                                                                                |                                                                           |                                                                    |      |      |      | 84    |       |        |      | (1,969 | )     
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|Net change in cash and cash equivalents                                                                                                                         |                                                                                                |                                                                           | (523                                                                | )    |      |      | 1,366 |       |        |      | 1,177  |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|Cash and cash equivalents at beginning of year                                                                                                                  |                                                                                                |                                                                           | 2,543                                                               |      |      |      | 1,177 |       |        |      |       |       
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|Cash and cash equivalents at end of year                                                                                                                        |                                                                                                | $                                                                         | 2,020                                                               |      |      | $    | 2,543 |       |        | $    | 1,177  |       
|                                                                                                                                                                |                                                                                                |                                                                           |                                                                     |      |      |      |       |       |        |      |        |       
|Income taxes paid, net of refunds                                                                                                                               |                                                                                                | $                                                                         | 457                                                                 |      |      | $    | 309   |       |        | $    | 2,605  |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|Interest paid                                                                                                                                                   |                                                                                                | $                                                                         | 141                                                                 |      |      | $    | 153   |       |        | $    | 341    |       
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|                                                                                                                                                               
|Tobacco settlement and related expense payments                                                                                                                 |                                                                                                | $                                                                         | 2,393                                                               |      |      | $    | 2,247 |       |        | $    | 1,636  |       

See Notes to Consolidated Financial Statements

42



---



##### 



CONSOLIDATED BALANCE SHEETS

(Dollars in Millions)





|                                                                               |                                                                                            |                               |                                    |       |       |       |        |       |       |       | 
|------------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------ | ----------------------------- | ---------------------------------- | ----- | ----- | ----- | ------ | ----- | ----- | ----- | 
|                                                                               |                                                                                            |                              
|                                                                               |                                                                                            | December 31,                 
|                                                                               |                                                                                            |                              
|                                                                               |                                                                                            | 2001                          |                                    | 2000 
|                                                                               |                                                                                            |                               |                                    |      
|Assets                                                                         |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Current assets:                                                                |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Cash and cash equivalents                                                                  |                               | $                                  | 2,020 |       |       | $      | 2,543 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Short-term investments                                                                     |                               |                                    | 207   |       |       |        |      |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Accounts and notes receivable, net of allowance
    (2001  $13; 2000  $11)               |                               |                                    | 106   |       |       |        | 100   |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Inventories                                                                                |                               |                                    | 730   |       |       |        | 588   |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Deferred income taxes                                                                      |                               |                                    | 610   |       |       |        | 459   |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Prepaid excise taxes and other                                                             |                               |                                    | 255   |       |       |        | 181   |      
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                               |                                                                                            | Total current assets          |                                    |       | 3,928 |       |        |       | 3,871 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Property, plant and equipment, at cost:                                        |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Land and land improvements                                                                 |                               |                                    | 94    |       |       |        | 94    |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Buildings and leasehold improvements                                                       |                               |                                    | 668   |       |       |        | 666   |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Machinery and equipment                                                                    |                               |                                    | 1,557 |       |       |        | 1,531 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Construction-in-process                                                                    |                               |                                    | 61    |       |       |        | 34    |      
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                               | Total property, plant and equipment                                                        |                               |                                    | 2,380 |       |       |        | 2,325 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               |                                                                                            | Less accumulated depreciation |                                    |       | 1,330 |       |        |       | 1,277 |      
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                               |                                                                                            |                               | Property, plant and equipment, net |       |       | 1,050 |        |       |       | 1,048 | 
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Trademarks, net of accumulated amortization
    (2001  $1,450; 2000  $1,348) |                                                                                            |                               | 2,773                              |       |       |       | 2,875  |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Goodwill, net of accumulated amortization
    (2001  $3,359; 2000  $3,099)   |                                                                                            |                               | 6,875                              |       |       |       | 7,303  |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Other assets and deferred charges                                              |                                                                                            |                               | 496                                |       |       |       | 457    |      
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                               |                                                                                            | $                             | 15,122                             |       |       | $     | 15,554 |      
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|Liabilities and stockholders
    equity                                       |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Current liabilities:                                                           |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Accounts payable                                                                           |                               | $                                  | 74    |       |       | $      | 80    |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Tobacco settlement and related accruals                                                    |                               |                                    | 1,520 |       |       |        | 1,394 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Accrued liabilities                                                                        |                               |                                    | 1,155 |       |       |        | 1,229 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Current maturities of long-term debt                                                       |                               |                                    | 43    |       |       |        | 73    |      
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                               |                                                                                            | Total current liabilities     |                                    |       | 2,792 |       |        |       | 2,776 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Long-term debt (less current maturities)                                       |                                                                                            |                               | 1,631                              |       |       |       | 1,674  |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Deferred income taxes                                                          |                                                                                            |                               | 1,798                              |       |       |       | 1,856  |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Long-term retirement benefits                                                  |                                                                                            |                               | 514                                |       |       |       | 543    |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Other noncurrent liabilities                                                   |                                                                                            |                               | 361                                |       |       |       | 269    |      
|Commitments and contingencies                                                  |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Stockholders equity:                                                          |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Common stock (shares issued: 2001 
    114,046,712; 2000  112,563,918)                   |                               |                                    | 1     |       |       |        | 1     |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Paid-in capital                                                                            |                               |                                    | 7,371 |       |       |        | 7,291 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Retained earnings                                                                          |                               |                                    | 1,593 |       |       |        | 1,481 |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Accumulated other comprehensive loss 
    cumulative minimum pension liability adjustment |                               |                                    | (121  | )     |       |        | (8    | )    
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Unamortized restricted stock                                                               |                               |                                    | (42   | )     |       |        | (41   | )    
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                               |                                                                                            |                               | 8,802                              |       |       |       | 8,724  |      
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Less treasury stock (shares: 2001 
    19,810,832; 2000  11,299,092), at cost            |                               |                                    | (776  | )     |       |        | (288  | )    
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                               |                                                                                            |                               | Total stockholders equity         |       |       | 8,026 |        |       |       | 8,436 | 
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      
|                                                                               |                                                                                            | $                             | 15,122                             |       |       | $     | 15,554 |      
|                                                                               |                                                                                            |                               |                                    |       |       |       |        |      




See Notes to Consolidated Financial Statements

43



---



##### 



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

AND COMPREHENSIVE INCOME


(Dollars in Millions)


|                                                                    |  |        |   |         |  |              |        |               |  |             |        |          |  |               |      |   |  |   |     |   |  |   |      |   |  |   |        |  
|------------------------------------------------------------------- |  | ------ | - | ------- |  | ------------ | ------ | ------------- |  | ----------- | ------ | -------- |  | ------------- | ---- | - |  | - | --- | - |  | - | ---- | - |  | - | ------ | -
|                                                                    |  |        |   |         |  | Retained     |        | Accumulated   |  |             |        |          |  |              
|                                                                    |  |        |   |         |  | Earnings     |        | Other         |  | Unamortized |        |          |  | Total        
|                                                                    |  | Common |   | Paid-in |  | (Accumulated |        | Comprehensive |  | Restricted  |        | Treasury |  | Stockholders
|                                                                    |  | Stock  |   | Capital |  | Deficit)     |        | Income (Loss) |  | Stock       |        | Stock    |  | Equity       
|                                                                    |  |        |   |         |  |              |        |               |  |             |        |          |  |              
|Balance at December 31, 1998                                        |  | $      | 1 |         |  | $            | 10,861 |               |  | $           | (516   | )        |  | $             | (460 | ) |  | $ |    |   |  | $ |     |   |  | $ | 9,886  |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Net income                                                          |  |        |  |         |  |              |       |               |  |             | 2,343  |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 2,343  |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Foreign currency translation, net of tax benefit
    of $11 million |  |        |  |         |  |              |       |               |  |             |       |          |  |               | (86  | ) |  |   |    |   |  |   |     |   |  |   | (86    | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Minimum pension liability, net of tax benefit of
    $4 million     |  |        |  |         |  |              |       |               |  |             |       |          |  |               | (7   | ) |  |   |    |   |  |   |     |   |  |   | (7     | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Total comprehensive income                                          |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Dividends                                                           |  |        |  |         |  |              | (169   | )             |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | (169   | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Items related to international tobacco business
    (see note 2)    |  |        |  |         |  |              |       |               |  |             |       |          |  |               | 218  |   |  |   |    |   |  |   |     |   |  |   | 218    |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Merger transaction*                                                 |  |        |  |         |  |              | (3,435 | )             |  |             | (1,958 | )        |  |               | 322  |   |  |   |    |   |  |   |     |   |  |   | (5,071 | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Stock options exercised                                             |  |        |  |         |  |              | 4      |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 4      |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock awarded                                            |  |        |  |         |  |              | 23     |               |  |             |       |          |  |               |     |   |  |   | (32 | ) |  |   |     |   |  |   | (9     | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock amortization                                       |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   | 7   |   |  |   |     |   |  |   | 7      |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Common stock repurchased                                            |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   | (55  | ) |  |   | (55    | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Other                                                               |  |        |  |         |  |              | 3      |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 3      |  
|                                                                    |  |        |   |         |  |              |        |               |  |             |        |          |  |               |      |   |  |   |     |   |  |   |      |   |  |   |        |  
|Balance at December 31, 1999                                        |  |        | 1 |         |  |              | 7,287  |               |  |             | (131   | )        |  |               | (13  | ) |  |   | (25 | ) |  |   | (55  | ) |  |   | 7,064  |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Net income                                                          |  |        |  |         |  |              |       |               |  |             | 1,827  |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 1,827  |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Minimum pension liability, net of tax expense of
    $3 million     |  |        |  |         |  |              |       |               |  |             |       |          |  |               | 5    |   |  |   |    |   |  |   |     |   |  |   | 5      |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Total comprehensive income                                          |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Dividends                                                           |  |        |  |         |  |              | (102   | )             |  |             | (215   | )        |  |               |     |   |  |   |    |   |  |   |     |   |  |   | (317   | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Stock options exercised                                             |  |        |  |         |  |              | 62     |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 62     |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Tax benefit on stock options exercised                              |  |        |  |         |  |              | 7      |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 7      |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock awarded                                            |  |        |  |         |  |              | 37     |               |  |             |       |          |  |               |     |   |  |   | (37 | ) |  |   |     |   |  |   |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock amortization                                       |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   | 19  |   |  |   |     |   |  |   | 19     |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock forfeited                                          |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   | 2   |   |  |   | (2   | ) |  |   |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Common stock repurchased                                            |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   | (231 | ) |  |   | (231   | )
|                                                                    |  |        |   |         |  |              |        |               |  |             |        |          |  |               |      |   |  |   |     |   |  |   |      |   |  |   |        |  
|Balance at December 31, 2000                                        |  |        | 1 |         |  |              | 7,291  |               |  |             | 1,481  |          |  |               | (8   | ) |  |   | (41 | ) |  |   | (288 | ) |  |   | 8,436  |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Net income                                                          |  |        |  |         |  |              |       |               |  |             | 435    |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 435    |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Minimum pension liability, net of tax benefit of
    $61 million    |  |        |  |         |  |              |       |               |  |             |       |          |  |               | (113 | ) |  |   |    |   |  |   |     |   |  |   | (113   | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Total comprehensive income                                          |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Dividends                                                           |  |        |  |         |  |              |       |               |  |             | (324   | )        |  |               |     |   |  |   |    |   |  |   |     |   |  |   | (324   | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Stock options exercised                                             |  |        |  |         |  |              | 42     |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 42     |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Tax benefit on stock options exercised                              |  |        |  |         |  |              | 20     |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   |     |   |  |   | 20     |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock awarded                                            |  |        |  |         |  |              | 18     |               |  |             |       |          |  |               |     |   |  |   | (26 | ) |  |   | 8    |   |  |   |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock amortization                                       |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   | 23  |   |  |   |     |   |  |   | 23     |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock forfeited                                          |  |        |  |         |  |              |       |               |  |             | 1      |          |  |               |     |   |  |   | 2   |   |  |   | (2   | ) |  |   | 1      |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Common stock repurchased                                            |  |        |  |         |  |              |       |               |  |             |       |          |  |               |     |   |  |   |    |   |  |   | (494 | ) |  |   | (494   | )
|                                                                    |  |        |   |         |  |              |        |               |  |             |        |          |  |               |      |   |  |   |     |   |  |   |      |   |  |   |        |  
|Balance at December 31, 2001                                        |  | $      | 1 |         |  | $            | 7,371  |               |  | $           | 1,593  |          |  | $             | (121 | ) |  | $ | (42 | ) |  | $ | (776 | ) |  | $ | 8,026  |  
|                                                                    |  |        |   |         |  |              |        |               |  |             |        |          |  |               |      |   |  |   |     |   |  |   |      |   |  |   |        |  

[Additional columns below]

[Continued from above table, first column(s) repeated]

|                                                                    |  |               |       |  
|------------------------------------------------------------------- |  | ------------- | ----- | -
|                                                                    |  | Comprehensive
|                                                                    |  | Income       
|                                                                    |  |              
|Balance at December 31, 1998                                        |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Net income                                                          |  | $             | 2,343 |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Foreign currency translation, net of tax benefit
    of $11 million |  |               | (86   | )
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Minimum pension liability, net of tax benefit of
    $4 million     |  |               | (7    | )
|                                                                    |  |               |       |  
|Total comprehensive income                                          |  | $             | 2,250 |  
|                                                                    |  |               |       |  
|Dividends                                                           |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Items related to international tobacco business
    (see note 2)    |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Merger transaction*                                                 |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Stock options exercised                                             |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock awarded                                            |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock amortization                                       |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Common stock repurchased                                            |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Other                                                               |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Balance at December 31, 1999                                        |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Net income                                                          |  | $             | 1,827 |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Minimum pension liability, net of tax expense of
    $3 million     |  |               | 5     |  
|                                                                    |  |               |       |  
|Total comprehensive income                                          |  | $             | 1,832 |  
|                                                                    |  |               |       |  
|Dividends                                                           |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Stock options exercised                                             |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Tax benefit on stock options exercised                              |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock awarded                                            |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock amortization                                       |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock forfeited                                          |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Common stock repurchased                                            |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Balance at December 31, 2000                                        |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Net income                                                          |  | $             | 435   |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Minimum pension liability, net of tax benefit of
    $61 million    |  |               | (113  | )
|                                                                    |  |               |       |  
|Total comprehensive income                                          |  | $             | 322   |  
|                                                                    |  |               |       |  
|Dividends                                                           |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Stock options exercised                                             |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Tax benefit on stock options exercised                              |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock awarded                                            |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock amortization                                       |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Restricted stock forfeited                                          |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Common stock repurchased                                            |  |               |       |  
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|Balance at December 31, 2001                                        |  |               |       |  






|  |                                                                                                                                                                      
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | Transfer of RJRs 80.5% interest in Nabisco, together with
    a portion of the proceeds from the sale of the international
    tobacco business, to NGH. See note 2.

See Notes to Consolidated Financial Statements

44



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting
Policies

Basis of Presentation

The consolidated financial statements include the accounts of
R.J. Reynolds Tobacco Holdings, Inc., referred to as RJR, and
its wholly owned subsidiaries, including R. J. Reynolds Tobacco
Company, referred to as RJR Tobacco, and RJR Acquisition Corp.




The equity method is used to account for investments in
businesses that RJR does not control, but have the ability to
significantly influence operating and financial policies. The
cost method is used to account for investments in which RJR does
not have the ability to significantly influence operating and
financial policies. All material intercompany balances have been
eliminated. RJR has no investment greater than 20% in entities
for which it accounts by the cost method, and has no investment
greater than 50% in entities for which it accounts by the equity
method.




The preparation of the consolidated financial statements in
conformity with accounting principles generally accepted in the
United States of America requires estimates and assumptions to
be made that affect the reported amounts in the consolidated
financial statements and accompanying notes. Actual results
could differ from those estimates. Certain reclassifications
were made to conform prior years financial statements to
the current presentation.

Discontinued operations for the year ended December 31,
2001 included a $14 million, $9 million after tax, purchase
price adjustment of the 1999 gain on the sale of the
international tobacco business to Japan Tobacco Inc. Including
this adjustment, the net after-tax gain on the sale of the
international tobacco business was $2.3 billion.

For 1999, the account balances and activities of the
international tobacco business and Nabisco Holdings Corp.,
referred to as Nabisco, are segregated and reported as
discontinued operations in RJRs consolidated financial
statements. See note 2 for more discussion.

All dollar amounts are presented in millions, unless noted
otherwise.

Cash Equivalents and Short-Term Investments

Cash equivalents include money market funds, commercial paper
and time deposits in major institutions with high credit ratings
to minimize investment risk. As short-term, highly liquid
investments readily convertible to known amounts of cash, with
remaining maturities of three months or less at the time of
purchase, cash equivalents have carrying values that approximate
fair values. Debt securities included in cash equivalents are
classified and accounted for as held-to-maturity or, in certain
instances, available-for-sale securities. The appropriate
classification of cash equivalents and short-term investments
are determined at the time of purchase and the classification is
reassessed at each reporting date. Short-term investments
include investment pools that are classified and accounted for
as available-for-sale securities.

Investment securities classified as available-for-sale are
reported at fair value based on current market quotes with
unrealized gains and losses, net of any tax effect, recorded as
a separate component of comprehensive income in
stockholders equity until realized. Interest income and
amortization of premiums and discounts are included in interest
income. Gains and losses on investment securities sold are
determined based on the specific identification method and are
included in other expense, net. Unrealized losses that are other
than temporary are recognized in net income. No securities are
held for speculative or trading purposes.

Inventories

Inventories are stated at the lower of cost or market. The cost
of tobacco inventories is determined principally under the
last-in, first-out, or LIFO, method. The cost of work in process
and finished goods includes materials, direct labor, and
variable and full absorption of fixed manufacturing overhead.
Stocks of

45



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


tobacco, which must be cured for more than one year, are
classified as current assets in accordance with recognized
industry practice.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost and
depreciated using the straight-line method of depreciation over
the estimated useful lives of the assets. Useful lives range
from 20 to 50 years for buildings and improvements and from
3 to 30 years for machinery and equipment. The cost and
related accumulated depreciation of assets sold or retired are
removed from the accounts and the gain or loss on disposition is
recognized in income.

Intangibles

Intangibles include primarily goodwill and trademarks and, for
the periods presented through December 31, 2001, have been
amortized using the straight-line method, principally over
40 years.

Software Costs

Certain computer software and software development costs
incurred in connection with developing or obtaining computer
software for internal use that has a useful life of greater than
one year are capitalized. These costs are amortized over five
years or less. During 2001 and 2000, costs of $12 million and
$19 million, respectively, were capitalized and at
December 31, 2001, the unamortized balance was $28 million.
Related amortization expense was $8 million, $4 million and $1
million for the years ended December 31, 2001, 2000 and
1999, respectively.

Long-Lived Assets

Goodwill is continually reviewed for impairment, and for other
long-lived assets held for use, including trademarks and
property, plant and equipment, whenever events or changes in
circumstances indicate that the book value of the asset may not
be recoverable. The carrying value of long-lived assets would be
impaired if the best estimate of future undiscounted cash flows
over the remaining amortization period is less than the carrying
value. If an asset is impaired, the loss is measured using
estimated fair value. Assets to be disposed of are reported at
the lower of their carrying value or estimated net realizable
value.

Revenue Recognition

Revenue from product sales is recognized upon shipment, when
title and risk of loss passes to the customer. Shipping and
handling costs are classified as cost of products sold.

Advertising and Research and Development

Advertising costs, which are expensed as incurred, were $73
million, $137 million and $168 million in the years ended
December 31, 2001, 2000 and 1999, respectively. Research
and development costs, which are expensed as incurred, were $64
million, $58 million and $59 million in the years ended
December 31, 2001, 2000 and 1999, respectively.

Income Taxes

Income taxes are accounted for under the asset and liability
method. Deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases and operating loss
and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates
is recognized in income in the period

46



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


that includes the enactment date. Income taxes for RJR, RJR
Tobacco and RJR Acquisition Corp. are calculated on a separate
return basis.

Pension and Postretirement

Unrecognized prior service costs are amortized over the
estimated remaining service lives of employees. If the changes
experienced in the projected benefit obligation or plan assets
differ from those assumed, the unrecognized net gain or loss is
amortized over five years.

Recently Adopted Accounting Pronouncements

Effective January 1, 2001, RJRs operating
subsidiaries adopted the Emerging Issues Task Forces Issue
No. 00-14, Accounting for Certain Sales
Incentives, which addresses the recognition, measurement
and income statement classification for certain sales
incentives, including rebates, coupons and free products or
services. EITF No. 00-14 requires that in the accompanying
consolidated income statements, certain costs that historically
were included in selling, general and administrative expenses
now be classified in cost of products sold or as reductions of
net sales. Those costs have been reclassified in prior periods
for comparative purposes. The adoption of EITF No. 00-14
did not impact consolidated annual net income or cumulative
earnings.

As of January 1, 2001, RJR and its subsidiaries adopted the
Financial Accounting Standards Boards Statement of
Financial Accounting Standards No. 133, Accounting
for Derivative Instruments and Hedging Activities, as
amended by SFAS No. 137 and SFAS No. 138. SFAS
No. 133 requires that all derivative instruments be
recorded on the consolidated balance sheet at their fair value.
Changes in the fair value of derivatives are recorded each
period in earnings or other comprehensive income, depending on
whether a derivative is designated and effective as part of a
hedge transaction. If it is, the type of hedge transaction must
be disclosed. The adoption of SFAS No. 133, as amended, did
not impact RJRs consolidated financial position or results
of operations.

As of December 31, 2001, RJR Tobacco held a forward
currency exchange contract to purchase seven million Euros with
a term of less than 12 months as a hedge of an unrecognized
firm commitment for the purchase of equipment. As of
December 31, 2001, the foreign currency cash flow hedge was
effective and, accordingly, no gain or loss was realized. The
unrealized gain resulting from the increase in the hedges
fair value was insignificant.

Recently Issued Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 141, Business
Combinations, which prohibits the pooling-of-interests
method accounting for business combinations initiated after
June 30, 2001 and addresses the accounting for purchase
method business combinations completed after June 30, 2001.
Also in June 2001, the FASB issued SFAS No. 142,
Goodwill and Other Intangible Assets, which is
effective as of January 1, 2002. SFAS No. 142 requires
that goodwill and other intangible assets with indefinite useful
lives no longer be amortized. This statement also requires that
within the first interim period of adoption, the intangible
assets with indefinite lives should be tested for impairment as
of the date of adoption, and that if any impairment results, it
should be recognized as a change in accounting principle.
Additionally, SFAS No. 142 requires that within six months
of adoption, goodwill be tested for impairment at the reporting
unit level as of the date of adoption. If any impairment is
indicated to have existed upon adoption, it should be measured
and recorded before the end of the year of adoption. SFAS
No. 142 requires that any goodwill impairment loss
recognized as a result of initial application be reported in the
first interim period of adoption as a change in accounting
principle, and that the income per share effects of the
accounting change be separately disclosed.

Other intangible assets consist of RJR Tobaccos trademarks
acquired through business combinations, which have indefinite
useful lives. A national appraisal firm has been engaged to
assist in the valuation of the trademarks as of January 1,
2002. No later than March 31, 2002, the existence and
amount, if any, of

47



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


trademark impairment will be determined by comparing the fair
value of those assets with their carrying values.

RJRs goodwill as of January 1, 2002 is attributable
to one reporting unit, RJR Tobacco, which comprises
substantially all of RJRs consolidated results of
operations and financial condition. A national appraisal firm
has been engaged to assist in the determination of the fair
value of RJR. Before June 30, 2002, any indication of
goodwill impairment will be determined by comparing RJRs
fair value with its carrying value as of January 1, 2002.

As of December 31, 2001, the carrying values of RJR
Tobaccos goodwill and trademarks were $6.9 billion and
$2.8 billion, respectively. RJR Tobacco recorded goodwill and
trademark amortization expense of $362 million and $366 million
during 2001 and 2000, respectively. As of January 1, 2002,
RJR Tobaccos goodwill and trademarks will no longer be
amortized. Because of the extensive effort needed to comply with
the application of SFAS No. 142, the impairment loss, if
any, related to RJR Tobaccos trademarks or goodwill upon
adoption of this statement cannot be estimated.

Effective January 1, 2002, EITF Issue No. 00-25,
Vendor Income Statement Characterization of Consideration
Paid to a Reseller of the Vendors Products, requires
that consideration paid to a distributor or retailer to promote
the vendors products, such as slotting fees or buydowns,
generally be characterized as a reduction of revenue when
recognized in the vendors income statement. Upon adoption,
the operating subsidiaries will characterize the applicable
costs as a reduction of net sales rather than as selling,
general and administrative expenses. Had EITF No. 00-25
been adopted for 2001 and 2000, selling, general and
administrative expenses would have been reduced by $2.3 billion
and $2 billion, respectively. The respective amounts would have
been classified as reductions to net sales. The adoption of EITF
No. 00-25 will not impact RJRs consolidated financial
position, operating income or net income.

Note 2  Reorganization

During 1999, RJR and Nabisco Group Holdings Corp., referred to
as NGH, completed a series of transactions to reorganize their
businesses and capital structures. In May 1999, RJR and RJR
Tobacco sold the international tobacco business to Japan Tobacco
Inc. As a result of this sale, RJR Tobaccos business
consists exclusively of the manufacture and sale of cigarettes
in the United States and its territories, commonwealths,
protectorates and possessions. A portion of the proceeds from
the sale of the international tobacco business was used by RJR
to repurchase $4 billion of its debt, which resulted in a $384
million, $250 million after-tax, extraordinary loss from the
early extinguishment of debt. Additionally, RJR transferred $1.6
billion in cash proceeds, together with its 80.5% interest in
Nabisco to NGH through a merger transaction. In June 1999, NGH
distributed all of the outstanding shares of RJR common stock to
NGH common stockholders of record as of May 27, 1999.
Shares of RJR began trading separately on June 15, 1999.




The operating results of the international tobacco business
until May 12, 1999, the date of sale, are segregated and
reported as discontinued operations in the 1999 consolidated
statement of income. Nabiscos operating results through
May 18, 1999, the date of the merger transaction, are
segregated and reported as discontinued operations in the 1999
consolidated statement of income. Summarized operating results
of the discontinued operations include net sales and a provision
for income taxes of $3,827 million and $34 million,
respectively, for the year ended December 31, 1999.
Discontinued operations in 2000 (restated) included a $53
million gain resulting from a re-evaluation of tax reserves.




Note 3  Acquisition

On December 11, 2000, RJR acquired its former parent, NGH.
Pursuant to an agreement and plan of merger dated June 25,
2000, as amended, RJR Acquisition Corp. was merged into NGH,
with NGH being the surviving corporation. After the merger, NGH
changed its name to RJR Acquisition Corp. At the time of the
acquisition, NGH was a non-operating public shell company with
no material assets or liabilities other than $11.8 billion in
cash. RJR accounted for the acquisition as a purchase, and
accordingly, the cost of the

48



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


acquisition was allocated on the basis of the estimated fair
market value of the assets acquired and liabilities assumed. As
consideration, RJR Acquisition Corp. paid $30 for each
outstanding share of NGH, or $9.8 billion in the aggregate. The
$1.5 billion net cash proceeds, after costs related to the
transaction, were recognized as an extraordinary gain on
acquisition in the fourth quarter of 2000. Presentation of pro
forma results of operations would not be meaningful as NGH was a
non-operating public shell company.

Note 4  Impairment Charge

In the fourth quarter of 2000, impairment occurred on two of RJR
Tobaccos non-key brands, MAGNA and CENTURY, based on their
estimated undiscounted net future cash flows. Accordingly, RJR
Tobacco recorded an impairment charge of $89 million, $54
million after tax, or $0.53 per diluted share, based on the
excess of the brands carrying value over fair value,
determined using the present value of estimated future cash
flows assuming a discount rate of 12.0%. This impairment charge
is reflected as an increase in accumulated amortization in the
consolidated balance sheets, as an impairment charge in the 2000
consolidated income statement and had no impact on cash flows.
As a result of this charge, amortization expense related to
trademarks was $4 million lower in 2001 than in 2000.

Note 5  Headquarters Close-Down and Related
Charges

During 1999, RJR recorded a charge of $143 million, $93 million
after tax, to reflect the elimination of its New York corporate
headquarters. Total cash expenditures related to this charge
were $122 million. The elimination of the headquarters resulted
from reorganization transactions, described in note 2, that
fundamentally changed RJRs business and capital structure.
Approximately $127 million of the charge was for severance and
related benefits for approximately 100 employees whose
employment was terminated. The remainder of the charge was
primarily related to contractual lease termination payments and
the write-off of leasehold improvements and abandoned equipment.

Note 6  Other Operating Expense

During 1998, RJR Tobacco recorded pre-tax charges totaling $1.4
billion for the following tobacco settlement and related
expenses: MSA, $620 million; Minnesota Settlement Agreement,
$312 million; Most Favored Nation adjustment of
previously settled states, $145 million; rationalization of
manufacturing operations, $214 million; and employee severance
and related benefits, $151 million. The employee severance and
related benefits portion of this charge was for workforce
reductions totaling approximately 1,300 employees in response to
the changing business conditions expected to result from the MSA
signed in November 1998. At December 31, 1998, $1.3 billion
had been utilized. Since December 31, 1998, the remaining
liability for employee severance and related benefits was
utilized through cash expenditures of $76 million and the
reversal of $21 million, due to a less-than-expected workforce
reduction.

During 1999, RJR Tobacco recorded a charge of $40 million for
initial, up-front costs related to the tobacco growers
settlement.

For more information about the MSA and other state settlement
agreements, see note 14.

In 1997, RJR Tobacco recorded a restructuring expense of $80
million related to a restructuring program that was implemented
to enhance its competitive position and improve its long-term
earnings growth prospects. The $80 million charge included $30
million for the rationalization of manufacturing operations, $20
million for contract termination and other costs and $30 million
for employee severance and related benefits associated with the
closure of a facility resulting in the reduction of 192
full-time positions and 217 seasonal positions. As of
December 31, 1999, the charge was substantially utilized
after a reduction of $2 million reflecting lower-than-expected
expenses. Total cash expenditures were $43 million.

49



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Note 7  Income Per Share

The components of the calculation of income per share were:




|                                              |                                      |                                  |        |      |       |      |         |  |     |   |         |   |    | 
|--------------------------------------------- | ------------------------------------ | -------------------------------- | ------ | ---- | ----- | ---- | ------- |  | --- | - | ------- | - | -- | 
|                                              |                                      |                                 
|                                              |                                      | For the Years Ended December 31,
|                                              |                                      |                                 
|                                              |                                      | 2001                             |        | 2000 |       | 1999
|                                              |                                      |                                  |        |      |       |     
|Income from continuing operations             |                                      | $                                | 444    |      |       | $    | 299     |  |     | $ | 195     |  
|                                             
|                                             
|                                             
|                                             
|Income (loss) from discontinued operations    |                                      |                                  | (9     | )    |       |      | 53      |  |     |   | 2,398   |  
|                                             
|                                             
|                                             
|                                             
|Extraordinary itemsgain (loss)               |                                      |                                  |       |      |       |      | 1,475   |  |     |   | (250    | )
|                                              |                                      |                                  |        |      |       |      |         |  |     |   |         |  
|Net income                                    |                                      | $                                | 435    |      |       | $    | 1,827   |  |     | $ | 2,343   |  
|                                              |                                      |                                  |        |      |       |      |         |  |     |   |         |  
|Basic weighted average shares, in thousands   |                                      |                                  | 97,043 |      |       |      | 101,264 |  |     |   | 108,495 |  
|                                             
|                                             
|                                             
|                                             
|                                              | Effect of dilutive potential shares: |                                  |        |      |       |      |         |  |     |   |         |   |   
|                                             
|                                             
|                                             
|                                             
|                                              |                                      | Options                          |        |      | 1,472 |      |         |  | 371 |   |         |   | 66 | 
|                                             
|                                             
|                                             
|                                             
|                                              |                                      | Restricted stock                 |        |      | 471   |      |         |  | 222 |   |         |   | 9  | 
|                                              |                                      |                                  |        |      |       |      |         |  |     |   |         |  
|Diluted weighted average shares, in thousands |                                      |                                  | 98,986 |      |       |      | 101,857 |  |     |   | 108,570 |  
|                                              |                                      |                                  |        |      |       |      |         |  |     |   |         |  




Outstanding shares of restricted stock of 1.7 million, 1.6
million and .8 million were excluded from the share calculation
for the years ended December 31, 2001, 2000 and 1999,
respectively, as the related vesting provisions had not been met.

Note 8  Short-Term Investments

At December 31, 2001, short-term investments classified as
available-for-sale included $146 million of U.S. government
treasury bills and $61 million of federal agency securities.
Contractual maturities of these securities averaged less than
one year. Realized and unrealized holding gains and losses of
available-for-sale securities for the year ended
December 31, 2001 were not significant and, accordingly,
the amortized cost of these securities approximated fair value.
There were no available-for-sale securities for the years ended
December 31, 2000 and 1999.

Note 9  Inventories

The major components of inventories at December 31 were:

|                    |  |      |     |      |  |   |     | 
|------------------- |  | ---- | --- | ---- |  | - | --- | 
|                    |  | 2001 |     | 2000
|                    |  |      |     |     
|Leaf tobacco        |  | $    | 550 |      |  | $ | 509 | 
|                   
|                   
|                   
|                   
|Raw materials       |  |      | 25  |      |  |   | 26  | 
|                   
|                   
|                   
|                   
|Work in process     |  |      | 49  |      |  |   | 49  | 
|                   
|                   
|                   
|                   
|Finished products   |  |      | 118 |      |  |   | 103 | 
|                   
|                   
|                   
|                   
|Other               |  |      | 26  |      |  |   | 26  | 
|                    |  |      |     |      |  |   |     | 
|Total               |  |      | 768 |      |  |   | 713 | 
|                   
|                   
|                   
|                   
|Less LIFO allowance |  |      | 38  |      |  |   | 125 | 
|                    |  |      |     |      |  |   |     | 
|                    |  | $    | 730 |      |  | $ | 588 | 
|                    |  |      |     |      |  |   |     | 

Inventories valued under the LIFO method were approximately $682
million and $543 million at December 31, 2001 and 2000,
respectively. The LIFO allowance reflects the excess of the
current cost of LIFO inventories at December 31, 2001 and
2000 over the amount at which these inventories were carried on
the consolidated balance sheets. During 2001, 2000 and 1999,
there was no impact on net income from LIFO inventory
liquidations.

50



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Note 10  Short-Term Borrowings and Borrowing
Arrangements




RJRs revolving credit facility with a syndicate of banks
was amended and restated on November 17, 2000. Under the
amendment and restatement, the committed amount of $1.235
billion was reduced to $622 million as of November 2001 and will
remain at this amount through May 2003. RJR can use the full
facility to obtain loans or letters of credit, at its option.
RJR Tobacco and RJR Acquisition Corp. have guaranteed RJRs
obligations under this revolving credit facility. If RJRs
guaranteed unsecured notes are rated below BBB- by S&P or
Baa3 by Moodys, RJRs other material subsidiaries
will be required to guarantee the facility. If RJR falls below
these thresholds for both of these rating agencies, or two
levels below these thresholds for either of these rating
agencies, RJR and the guarantors will be required to pledge
their assets to secure their obligations. RJR is not required to
maintain compensating balances; however, commitment fees of 1%
of the committed amount are payable quarterly. The credit
facility also limits RJRs ability to pay dividends,
repurchase stock, incur indebtedness, engage in transactions
with affiliates, create liens, acquire, sell or dispose of
specific assets and engage in specified mergers or
consolidations. Under the credit facility, cumulative dividends
and share repurchases generally may not exceed the sum of $500
million plus 50% of cumulative adjusted cash net income. Despite
this general restriction, however, the credit facility further
provides that (1) the remaining amount from the $1.5 billion
proceeds from the NGH acquisition, and any further proceeds
thereon, may be used to pay dividends and repurchase shares, and
(2) up to an additional $500 million in dividends and share
repurchases may be made. Stock repurchases also are limited to
the extent that a stated minimum level of net worth must be
maintained. Borrowings under the revolving credit facility bear
interest at rates that vary with the prime rate or LIBOR. At
December 31, 2001, RJR had $132 million in letters of
credit and no borrowings outstanding under the facility, with
the remaining $490 million of the facility available for
borrowing. RJR was in compliance with all covenants and
restrictions imposed by this facility at December 31, 2001.




Additionally, as of December 31, 2001, RJR had a trade
letter of credit outstanding of $1 million. RJR also has a $30
million uncommitted, unsecured line of credit with one bank. No
borrowings were outstanding on this line of credit at
December 31, 2001.

Note 11  Accrued Liabilities

Accrued liabilities at December 31 included:

|                              |  |      |       |      |  |   |       | 
|----------------------------- |  | ---- | ----- | ---- |  | - | ----- | 
|                              |  | 2001 |       | 2000
|                              |  |      |       |     
|Payroll and employee benefits |  | $    | 398   |      |  | $ | 293   | 
|                             
|                             
|                             
|                             
|Marketing and advertising     |  |      | 378   |      |  |   | 406   | 
|                             
|                             
|                             
|                             
|Accrued interest              |  |      | 20    |      |  |   | 24    | 
|                             
|                             
|                             
|                             
|Other                         |  |      | 359   |      |  |   | 506   | 
|                              |  |      |       |      |  |   |       | 
|                              |  | $    | 1,155 |      |  | $ | 1,229 | 
|                              |  |      |       |      |  |   |       | 

51



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Note 12  Income Taxes

The components of the provision for income taxes from continuing
operations were:




|                           |                 |                     |     |      |   |      |     |     |   |   |      |      |  
|-------------------------- | --------------- | ------------------- | --- | ---- | - | ---- | --- | --- | - | - | ---- | ---- | -
|                           |                 |                    
|                           |                 | For the Years Ended
|                           |                 | December 31,       
|                           |                 |                    
|                           |                 | 2001                |     | 2000 |   | 1999
|                           |                 |                     |     |      |   |     
|                           |                 |                    
|                           |                 | (Restated)         
|                          
|                          
|                          
|                          
|Current:                   |                 |                     |     |      |   |      |     |     |   |   |      |     
|                          
|                          
|                          
|                          
|                           | Federal         |                     | $   | 426  |   |      | $   | 368 |   |   | $    | 530  |  
|                          
|                          
|                          
|                          
|                           | State and other |                     |     | 65   |   |      |     | 59  |   |   |      | 92   |  
|                           |                 |                     |     |      |   |      |     |     |   |   |      |     
|                           |                 |                     | 491 |      |   |      | 427 |     |   |   | 622  |     
|                           |                 |                     |     |      |   |      |     |     |   |   |      |     
|Deferred:                  |                 |                     |     |      |   |      |     |     |   |   |      |     
|                          
|                          
|                          
|                          
|                           | Federal         |                     |     | (36  | ) |      |     | 23  |   |   |      | (265 | )
|                          
|                          
|                          
|                          
|                           | State and other |                     |     | (7   | ) |      |     | (1  | ) |   |      | (42  | )
|                           |                 |                     |     |      |   |      |     |     |   |   |      |     
|                           |                 |                     | (43 | )    |   |      | 22  |     |   |   | (307 | )   
|                           |                 |                     |     |      |   |      |     |     |   |   |      |     
|Provision for income taxes |                 | $                   | 448 |      |   | $    | 449 |     |   | $ | 315  |     
|                           |                 |                     |     |      |   |      |     |     |   |   |      |     




The current deferred income tax asset shown on the consolidated
balance sheets at December 31 included:

|                     |                                                                       |      |     |      |   |   |     |      |  
|-------------------- | --------------------------------------------------------------------- | ---- | --- | ---- | - | - | --- | ---- | -
|                     |                                                                       | 2001 |     | 2000
|                     |                                                                       |      |     |     
|Deferred tax assets: |                                                                       |      |     |      |   |   |     |     
|                    
|                    
|                    
|                    
|                     | LIFO inventories                                                      |      | $   | (131 | ) |   | $   | (136 | )
|                    
|                    
|                    
|                    
|                     | Pension and other postretirement liabilities                          |      |     | 62   |   |   |     | 31   |  
|                    
|                    
|                    
|                    
|                     | Tobacco settlement related accruals and other
    accrued liabilities |      |     | 607  |   |   |     | 564  |  
|                     |                                                                       |      |     |      |   |   |     |     
|                     |                                                                       | $    | 538 |      |   | $ | 459 |     
|                     |                                                                       |      |     |      |   |   |     |     

The non-current deferred income tax liability shown on the
consolidated balance sheets at December 31 included:

|                          |                                                                       |      |       |       |   |   |       |       |  
|------------------------- | --------------------------------------------------------------------- | ---- | ----- | ----- | - | - | ----- | ----- | -
|                          |                                                                       | 2001 |       | 2000 
|                          |                                                                       |      |       |      
|Deferred tax assets:      |                                                                       |      |       |       |   |   |       |      
|                         
|                         
|                         
|                         
|                          | Pension and other postretirement liabilities                          |      | $     | (191  | ) |   | $     | (208  | )
|                         
|                         
|                         
|                         
|                          | Tobacco settlement related accruals and other
    accrued liabilities |      |       | (119  | ) |   |       | (109  | )
|                          |                                                                       |      |       |       |   |   |       |      
|                          |                                                                       |      | (310  | )     |   |   | (317  | )    
|                          |                                                                       |      |       |       |   |   |       |      
|Deferred tax liabilities: |                                                                       |      |       |       |   |   |       |      
|                         
|                         
|                         
|                         
|                          | Property and equipment                                                |      |       | 300   |   |   |       | 310   |  
|                         
|                         
|                         
|                         
|                          | Trademarks                                                            |      |       | 1,080 |   |   |       | 1,121 |  
|                         
|                         
|                         
|                         
|                          | Other                                                                 |      |       | 656   |   |   |       | 742   |  
|                          |                                                                       |      |       |       |   |   |       |      
|                          |                                                                       |      | 2,036 |       |   |   | 2,173 |      
|                          |                                                                       |      |       |       |   |   |       |      
|                          |                                                                       | $    | 1,726 |       |   | $ | 1,856 |      
|                          |                                                                       |      |       |       |   |   |       |      

52



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


The differences between the provision for income taxes and
income taxes computed at statutory U.S. federal income tax rates
were:




|                                                                     |  |                     |       |      |  |      |       |  |  |   |       | 
|-------------------------------------------------------------------- |  | ------------------- | ----- | ---- |  | ---- | ----- |  |  | - | ----- | 
|                                                                     |  |                    
|                                                                     |  | For the Years Ended
|                                                                     |  | December 31,       
|                                                                     |  |                    
|                                                                     |  | 2001                |       | 2000 |  | 1999
|                                                                     |  |                     |       |      |  |     
|                                                                     |  |                    
|                                                                     |  | (Restated)         
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Income taxes computed at statutory U.S. federal
    income tax rates |  | $                   | 312   |      |  | $    | 262   |  |  | $ | 178   | 
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|State and local income taxes, net of federal tax
    benefits        |  |                     | 37    |      |  |      | 33    |  |  |   | 30    | 
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Goodwill amortization                                                |  |                     | 91    |      |  |      | 91    |  |  |   | 91    | 
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Adjustment of tax reserve (See Note 23)                              |  |                     |      |      |  |      | 53    |  |  |   |      | 
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Other items, net                                                     |  |                     | 8     |      |  |      | 10    |  |  |   | 16    | 
|                                                                     |  |                     |       |      |  |      |       |  |  |   |       | 
|Provision for income taxes                                           |  | $                   | 448   |      |  | $    | 449   |  |  | $ | 315   | 
|                                                                     |  |                     |       |      |  |      |       |  |  |   |       | 
|Effective tax rate                                                   |  |                     | 50.2% |      |  |      | 60.0% |  |  |   | 61.8% | 
|                                                                     |  |                     |       |      |  |      |       |  |  |   |       | 




Note 13  Long-Term Debt

Long-term debt at December 31 included:

|                                                               |  |      |       |      |  |   |       |  
|-------------------------------------------------------------- |  | ---- | ----- | ---- |  | - | ----- | -
|                                                               |  | 2001 |       | 2000
|                                                               |  |      |       |     
|7.625%-9.25% unsecured notes, due 2002 to 2013                 |  | $    | 330   |      |  | $ | 404   |  
|                                                              
|                                                              
|                                                              
|                                                              
|7.375%-7.875% guaranteed unsecured notes, due
    2003 to 2009 |  |      | 1,246 |      |  |   | 1,245 |  
|                                                              
|                                                              
|                                                              
|                                                              
|9.5% junior subordinated debentures, due 2047                  |  |      | 98    |      |  |   | 98    |  
|                                                              
|                                                              
|                                                              
|                                                              
|Current maturities of long-term debt                           |  |      | (43   | )    |  |   | (73   | )
|                                                               |  |      |       |      |  |   |       |  
|                                                               |  | $    | 1,631 |      |  | $ | 1,674 |  
|                                                               |  |      |       |      |  |   |       |  

The payment of long-term debt is due as follows:

|           |  |        |       | 
|---------- |  | ------ | ----- | 
|Year       |  | Amount
|           |  |       
|2003       |  | $      | 740   | 
|          
|          
|          
|          
|2004       |  |        | 56    | 
|          
|          
|          
|          
|2005       |  |        | 50    | 
|          
|          
|          
|          
|2006       |  |        | 498   | 
|          
|          
|          
|          
|Thereafter |  |        | 287   | 
|           |  |        |       | 
|           |  | $      | 1,631 | 
|           |  |        |       | 

On May 18, 1999, RJR completed tender offers to purchase
substantially all of its outstanding debt securities, which
resulted in RJR repurchasing $4 billion of its debt with a
portion of the proceeds from the sale of the international
tobacco business. As a result, RJR recognized an extraordinary
loss from the early extinguishment of debt of $384 million, $250
million after tax.

RJR filed a registration statement, effective October 8,
1999, in order to issue publicly registered notes of $550
million in principal amount at 7.375% due 2003, $500 million in
principal amount at 7.75% due 2006 and $200 million in principal
amount at 7.875% due 2009 in exchange for an aggregate $1.25
billion of private placement debt securities. The net proceeds
received from the private placement were used for general
corporate purposes. These notes are unsecured obligations and,
unlike RJRs other non-bank debt, are guaranteed by RJR
Tobacco and RJR Acquisition Corp. In addition, any other
subsidiaries of RJR that in the future guarantee the $622
million revolving credit facility, as amended and restated, will
also be required to guarantee these notes. In addition, if RJR
and the guarantors are required to pledge their assets to secure
their obligations under the revolving credit facility, as
amended and restated, they will also be required to pledge their
assets to secure these notes. Generally, the terms of the notes
restrict the issuance of guarantees by subsidiaries, the pledge
of collateral, sale/leaseback transactions and the transfer of
all or substantially all of

53



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


the assets of RJR and its subsidiaries. RJR was in compliance
with all covenants and restrictions imposed by its indebtedness
at December 31, 2001. See note 21 for condensed
consolidating financial information, which separates the account
balances and activities of the issuer, the guarantors and the
subsidiaries of RJR and RJR Tobacco that are not guarantors of
the notes.

RJR filed a shelf registration statement, effective
December 22, 1999, for $1.876 billion of debt securities,
guaranteed by RJR Tobacco. On April 19, 2001, a
registration statement became effective to add RJR Acquisition
Corp. as a guarantor of these debt securities. As of
December 31, 2001, no debt securities had been issued from
this registration.

On December 11, 2000, related to the acquisition of NGH,
RJR acquired $98 million of 9.5% junior subordinated debentures,
due in 2047, redeemable on September 30, 2003. Interest on
these debentures is paid quarterly in arrears. These debentures
are effectively defeased by an irrevocable trust, which is
included in other assets and deferred charges in the
accompanying consolidated balance sheets as of December 31,
2001 and 2000. The trust holds certain U.S. government
obligations maturing at such times and in such amounts
sufficient to pay interest and principal.

The estimated fair value of RJRs long-term debt was $1.8
billion as of December 31, 2001 and $1.7 billion as of
December 31, 2000. The fair values are based on available
market quotes, discounted cash flows and book values, as
appropriate.

Note 14  Commitments and Contingencies

Tobacco Litigation




Overview







Introduction.Various tobacco-related legal actions and
proceedings are pending or may be instituted against RJR or its
affiliates, including RJR Tobacco, or indemnitees. These actions
and proceedings raise a variety of claims, including product
liability, health-care cost recovery, consumer protection,
smuggling, RICO, tax, antitrust and trade regulation claims.
During 2001, 129 new tobacco-related actions were served against
RJR Tobacco and/or its affiliates or indemnitees, and 154
actions were dismissed or otherwise resolved in favor of RJR
Tobacco and/or its affiliates or indemnitees without trial. On
December 31, 2001, there were 1,639 active cases pending,
including approximately 1,237 individual smoker cases pending in
West Virginia state court as a consolidated action, as compared
with 1,664 on December 31, 2000, and 541 on
December 31, 1999. As of February 7, 2002, 1,657
active cases were pending against RJR Tobacco and/or its
affiliates or indemnitees: 1,652 in the United States; two in
Puerto Rico and one in each of Canada, Israel and the Marshall
Islands. The U.S. case number does not include the 2,852
Broin II cases pending as of February 7, 2002,
discussed below.




The U.S. cases, exclusive of the Broin IIcases, are
pending in 35 states and the District of Columbia. The breakdown
is as follows: 1,237 in West Virginia; 77 in New York; 58 in
Florida; 52 in California; 29 in Maryland; 28 in the District of
Columbia; 27 in Louisiana; 23 in Mississippi; 12 in Iowa; 11 in
Massachusetts; 10 in each of Missouri and New Jersey; 9 in
Alabama; 8 in Texas; 7 in Georgia; 6 in each of Illinois and
Tennessee; 4 in each of New Hampshire, Nevada and Pennsylvania;
3 in each of Arizona, Connecticut, Michigan, New Mexico and
Ohio; 2 in each of Kansas, North Carolina, North Dakota and
South Dakota; and 1 in each of Indiana, Maine, Minnesota,
Oklahoma, Utah, Washington and Wisconsin. Of the 1,652 active
U.S. cases, 130 are pending in federal court, 1,518 in state
court and 4 in tribal court. Most of these cases were brought by
individual plaintiffs, but many of these cases seek recovery on
behalf of third parties or large classes of claimants.




Certain Terms and Phrases. Certain terms and phrases that
are used in this disclosure may require some explanation. The
terms judgment or final judgment refer
generally to the final decision of the court resolving the
dispute and determining the rights and obligations of the
parties. At the trial court level, for example, a final judgment
generally is entered by the court after a jury verdict and after
post-verdict motions




54



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)





have been decided. As a general proposition, the losing party
can appeal a verdict only after a final judgment has been
entered by the trial court.







The term damages refers to the amount of money
sought by a plaintiff in a complaint, or awarded to a party by a
jury, or in some cases by a judge. Compensatory
damages are awarded to compensate the prevailing party for
actual losses suffered  if liability is proved. In
cases in which there is a finding that a defendant has acted
willfully, maliciously or fraudulently generally, based on a
higher burden of proof than is required for a finding of
liability for compensatory damages, a plaintiff also may be
awarded punitive damages. Although damages may be awarded at the
trial court stage, a losing party may be protected from paying
any damages until all appellate avenues have been exhausted by
posting a supersedeas bond. The amount of such a bond is
governed by the law of the relevant jurisdiction and generally
is set at the amount of damages plus some measure of statutory
interest, modified at the discretion of the appropriate court or
subject to a cap set by court or statute.







The term settlement refers to certain types of cases
in which cigarette manufacturers, including RJR Tobacco, have
agreed to resolve disputes with certain plaintiffs without
resolving the case through trial. The principal terms of
settlements entered into by RJR Tobacco are explained in the
following disclosure.







Accounting for Tobacco-Related Litigation Contingencies.In accordance with applicable accounting principles, RJR and
RJR Tobacco will record any loss related to tobacco litigation
at such time as an unfavorable outcome becomes probable and the
amount can be reasonably estimated. For the reasons set forth
below, RJRs management continues to conclude that the loss
of any particular smoking and health tobacco litigation claim
against RJR Tobacco or its affiliates, when viewed on an
individual basis, is not probable. RJR Tobacco and its
affiliates, including RJR, believe that they have a number of
valid defenses to the tobacco-related litigation claims against
them, as well as valid bases for appeal of adverse verdicts
against RJR Tobacco. RJR and RJR Tobacco have, through their
counsel, filed pleadings and memoranda in pending
tobacco-related litigation that set forth and discuss a number
of grounds and defenses that RJR, RJR Tobacco and their counsel
believe have a valid basis in law and fact. Based on their
experience in the tobacco-related litigation against them and
the strength of the defenses available to them in such
litigation, RJR Tobacco and its affiliates believe that their
consistently successful defense of tobacco-related litigation in
the past will continue in the future. Therefore, no liability
for pending tobacco-related litigation currently is recorded in
RJRs consolidated financial statements.







Neither RJR Tobacco nor its affiliates, including RJR, have paid
any damages as the result of a final judgment entered after a
fully litigated smoking and health tobacco litigation claim
(i.e., after all appeals have been exhausted), and a very high
percentage of the tobacco-related litigation claims brought
against them continue to be dismissed at or before trial.
Generally, RJR Tobacco and its affiliates, including RJR, have
not settled, and currently do not intend to settle, any smoking
and health tobacco litigation claims. It is the policy of RJR
Tobacco and its affiliates, including RJR, to vigorously defend
all tobacco-related litigation claims.







The only smoking and health tobacco litigation claims settled by
RJR Tobacco involved (1) the MSA, the related settlements
with the states of Mississippi, Florida, Texas and Minnesota,
and the funding by various tobacco companies of a
$5.2 billion trust fund contemplated by the MSA to benefit
tobacco growers, and (2) the original Broinflight
attendant case discussed below under 
Class Action Suits. Despite having valid legal
defenses, RJR Tobacco settled these matters because of unique
circumstances that do not apply to the other tobacco litigation
cases pending against RJR Tobacco and its affiliates, including
RJR.







The circumstances surrounding the MSA, the state-specific
settlements and the funding of a trust fund to benefit the
tobacco growers are readily distinguishable from the current
categories of cases involving RJR Tobacco. The claims underlying
the MSA and the state-specific settlements were brought by the
states to recover health-care costs paid on behalf of state
citizens suffering from diseases and conditions allegedly
related to tobacco use. The MSA and the state-specific
settlements settled all the health-care cost recovery actions
brought by, or on behalf of, the settling jurisdictions and
contain releases of various additional present and future
claims. In accordance with the MSA, various tobacco companies
agreed to fund a $5.2 billion trust




55



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)





fund to be used to address the possible adverse economic impact
of the MSA on tobacco growers. A discussion of the MSA and the
other state settlement agreements, and a table depicting the
related payment schedule under these agreements, is set forth
below under  Governmental Health-Care Cost
Recovery Cases  MSA and Other State Settlement
Agreements.







The states were a unique set of plaintiffs and are not
plaintiffs in any of the smoking and health cases remaining
against RJR or RJR Tobacco. Although RJR Tobacco continues to be
a defendant in certain health-care cost recovery cases similar
in theory to the state cases but involving other plaintiffs,
such as unions, hospitals, Native American tribes, and local and
foreign governments, the vast majority of such cases have been
dismissed on legal grounds. Indeed, eight federal courts of
appeals have ruled uniformly that unions cannot successfully
pursue such cases. As a result, no union cases are pending
against RJR or RJR Tobacco. RJR and RJR Tobacco believe that the
same legal principles that have resulted in dismissal of union
and other types of health-care cost recovery cases either at the
trial court level or on appeal should compel the dismissal of
the similar pending cases.







Finally, in the Department of Justice case brought against
various industry members, including RJR Tobacco, the U.S.
District Court for the District of Columbia granted the
non-Liggett defendants motion to dismiss plaintiffs
Medical Care Recovery Act and Medicare Secondary Payer claims.
In these particular claims, the federal government made
arguments similar to the states and sought to recover federal
funds expended in providing health care to smokers who have
developed diseases and injuries alleged to be smoking-related.
The only remaining claims in this case involve alleged
violations of the federal RICO statute.







Similarly, the original Broincase, discussed below under
 Class Action Suits, was settled in
the middle of trial during discussions with the federal
government concerning the possible settlement of the claims
underlying the MSA and the state-specific settlements, among
other things. The Broincase was settled at that time in
an attempt to remove this case as a political distraction during
the industrys settlement discussions with the federal
government and a belief that further Broinlitigation
would be resolved by a settlement at the federal level.







Following is a description of the material pending
tobacco-related litigation to which RJR Tobacco and its
affiliates, including RJR, are subject. Even though RJRs
management continues to conclude that the loss of any particular
smoking and health tobacco litigation claim against RJR Tobacco
or its affiliates, when viewed on an individual basis, is not
probable, the possibility of material losses related to tobacco
litigation is more than remote. However, RJRs management
is unable to predict the outcome of such litigation or to
reasonably estimate the amount or range of any possible loss.
Moreover, notwithstanding the quality of defenses available to
it and its affiliates in tobacco-related litigation matters, it
is possible that RJRs results of operations, cash flows or
financial condition could be materially adversely affected by
the ultimate outcome of certain pending or future litigation
matters.




Theories of Recovery.The plaintiffs seek recovery on a
variety of legal theories, including strict liability in tort,
design defect, negligence, special duty, voluntary undertaking,
breach of warranty, failure to warn, fraud, misrepresentation,
unfair trade practices, conspiracy, aiding and abetting, unjust
enrichment, indemnity, medical monitoring, public nuisance and
violations of state and federal antitrust and RICO laws.
Punitive damages, often in amounts ranging into the hundreds of
millions or even billions of dollars, are specifically pleaded
in a number of cases, in addition to compensatory and other
damages. Of the 1,652 active cases in the United States, eight
cases, plus the 2,852 Broin IIcases, involve alleged
nonsmokers claiming injuries resulting from exposure to
environmental tobacco smoke. Twenty-nine cases purport to be
class actions on behalf of thousands of individuals. Purported
classes include individuals claiming to be addicted to
cigarettes, individuals and their estates claiming illness and
death from cigarette smoking, persons making claims based on
alleged exposure to environmental tobacco smoke,
African-American smokers claiming their civil rights have been
violated by the sale of menthol cigarettes, current smokers who
have no tobacco-related disease but are seeking to recover the
costs of medical monitoring, purchasers of light and
ultra light cigarettes claiming to have been
defrauded and seeking to recover the costs of their cigarette
purchases, and Blue Cross

56



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


and Blue Shield subscribers seeking reimbursement for premiums
paid. Approximately 59 cases seek recovery of the cost of
Medicaid/Medicare payments or other health-related costs paid
for treatment of individuals suffering from diseases or
conditions allegedly related to tobacco use. Eleven cases,
brought by entities administering asbestos liability, seek
contribution for the costs of settlements and judgments.

Defenses.The defenses raised by RJR Tobacco and/or its
affiliates, including RJR, include, where applicable, preemption
by the Federal Cigarette Labeling and Advertising Act of some or
all such claims arising after 1969, the lack of any defect in
the product, assumption of the risk, contributory or comparative
fault, lack of proximate cause and statutes of limitations or
repose. RJR has asserted additional defenses, including
jurisdictional defenses, in many of the cases in which it is
named.

Industry Trial Results in Individual Smoker Cases.The
tobacco industry in general, and RJR Tobacco in particular,
continue to win most individual smoking and health cases. In
Anderson v. Fortune Brands, Inc., a Brooklyn, New York
jury found in favor of the industry, including RJR Tobacco, on
June 27, 2000. The plaintiff failed to perfect his appeal
by submitting his brief and record by June 22, 2001. The
Appellate Division dismissed the appeal on September 18,
2001. In Nunnally v. R. J. Reynolds Tobacco Co., a
Mississippi state court jury found RJR Tobacco not liable on
July 12, 2000. Plaintiffs motion for judgment
notwithstanding the verdict, or in the alternative, for a new
trial, was denied, and plaintiffs appeal to the
Mississippi Supreme Court is pending. On January 16, 2001,
a Brooklyn, New York state court jury returned a verdict in
favor of RJR Tobacco and other cigarette manufacturers in
Apostolou v. American Tobacco Co.On September 7,
2001, the plaintiff appealed the final judgment to the Appellate
Division of the New York Supreme Court. In Little v. Brown
& Williamson Tobacco Corp., a South Carolina federal
district court judge granted a directed verdict in favor of RJR
Tobacco on January 30, 2001. The jury rendered a verdict in
favor of the remaining defendant, Brown & Williamson, on
February 6, 2001. The plaintiff voluntarily dismissed her
appeal to the United States Court of Appeals for the Fourth
Circuit on April 19, 2001. On March 7, 2001, in Grinnell
v. Brown & Williamson Tobacco Corp., a Texas state court
jury returned a verdict in favor of Brown & Williamson. On
May 16, 2001, a state court jury in New Jersey returned a
verdict in favor of RJR Tobacco and Philip Morris in Mehlman
v. Philip Morris, Inc.On October 5, 2001, an Ohio
federal court jury returned a unanimous verdict in favor of
Philip Morris, Brown & Williamson and Lorillard in
Tompkin v. American Tobacco Co.On October 23, 2001,
plaintiff filed a motion for a new trial. The judge in this case
referred the parties to mediation in order to avoid the
transaction costs associated with an appeal. The mediation
failed and the case was returned to the presiding judge who then
denied plaintiffs motion for a new trial. Finally, on
November 13, 2001, a state court judge in Connecticut
granted Brown & Williamsons motion for a directed
verdict in DuJack v. Brown & Williamson Tobacco Co.

RJR Tobacco has prevailed in virtually all individual smoker
cases that have gone to trial. However, in Whiteley v.
Raybestos-Manhattan, Inc., a tobacco-asbestos synergy case
brought in San Francisco Superior Court, the jury found against
RJR Tobacco and Philip Morris on March 20, 2000, and
awarded $1.7 million in compensatory damages. On March 27,
2000, the same jury awarded $20 million in punitive damages, $10
million against RJR Tobacco and $10 million against Philip
Morris. RJR Tobacco and Philip Morris have appealed. In Jones
v. R. J. Reynolds Tobacco Co., a wrongful death case, a
Tampa state court jury found against RJR Tobacco on
October 12, 2000. Although the jury found that RJR Tobacco
was negligent and liable, it refused to find that RJR Tobacco
was part of a conspiracy to defraud. The jury awarded
approximately $200,000 in compensatory damages; however, the
jury refused to award punitive damages. On December 28,
2000, the trial judge granted RJR Tobaccos motion for a
new trial. The plaintiff has appealed the new trial ruling to
the Florida Second District Court of Appeal. Most recently, in
Kenyon v. R. J. Reynolds Tobacco Co., on
December 12, 2001, a Tampa jury determined that Floyd
Kenyon had been adequately warned about the risks of smoking and
that RJR Tobacco was not negligent in designing its products.
The jury did find that some of RJR Tobaccos products were
defective and awarded the plaintiff $165,000 in compensatory
damages. RJR Tobacco believes that the jurys findings were
not supported by the evidence in the case. Accordingly, on
December 26, 2001, RJR Tobacco asked the court to set aside
the verdict or to grant a new trial. A hearing on RJR
Tobaccos motion has been scheduled for February 27,
2002.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Juries have found for plaintiffs in six smoking and health cases
in which RJR Tobacco was not a defendant. Two of the verdicts
were overturned on appeal and have been dismissed; three others
are on appeal; and damages have been paid in one case. In
February 1999, in Henley v. Philip Morris, Inc., a San
Francisco state court jury awarded an individual smoker $1.5
million in compensatory damages and $50 million in punitive
damages. In April 1999, the trial judge reduced the punitive
damages award to $25 million, but otherwise denied Philip
Morris post-trial motions challenging the verdict. On
November 7, 2001, a California appellate court upheld the
jurys 1999 verdict against Philip Morris.Philip
Morris has appealed that decision to the California Supreme
Court, which accepted the appeal on a grant and hold
basis (another appeal has to be decided prior to ruling on the
Henleypetition). In Williams v. Philip Morris,
Inc., an Oregon state court jury awarded the plaintiff
$800,000 in actual damages, $21,500 in medical expenses and $79
million in punitive damages. The judge reduced the punitive
damages to $32 million. Philip Morris appeal is pending.
On June 6, 2001, in Boeken v. Philip Morris, Inc., a
California state court jury found in favor of the plaintiff and
awarded approximately $5.5 million in compensatory damages and
$3 billion in punitive damages. Philip Morris filed motions to
reduce the damages, for judgment notwithstanding the verdict or
for a new trial. On August 9, 2001, plaintiff agreed to the
courts recommendation that the $3 billion punitive damages
award be reduced to $100 million. On September 7, 2001,
Philip Morris filed its notice of appeal to the California Court
of Appeals. In Carter v. American Tobacco Co., the
Florida Supreme Court, on November 22, 2000, reinstated the
jury verdict against Brown & Williamson. According to press
reports, Brown & Williamson paid approximately $1.09 million
to the plaintiff on February 8, 2001. On June 29,
2001, the U.S. Supreme Court declined to review the case, thus
leaving the jury verdict intact.

Broin II Cases.As of February 7, 2002,
approximately 2,852 lawsuits brought by individual flight
attendants for personal injury as a result of illness allegedly
caused by exposure to secondhand tobacco smoke in airplane
cabins, referred to as the Broin IIcases, are pending in
Florida. In these lawsuits, filed pursuant to the terms of the
settlement of the Broin v. Philip Morris, Inc.class
action, discussed below, each individual flight attendant will
be required to prove that he or she has a disease caused by
exposure to secondhand smoke in airplane cabins.

On October 5, 2000, Judge Robert Kaye entered an order
applicable to all Broin IIcases that the terms of the
Broinsettlement agreement do not require the individual
Broin IIplaintiffs to prove the elements of strict
liability, breach of warranty or negligence. Under this order,
there is a rebuttable presumption in plaintiffs favor on
those elements, and plaintiffs bear the burden of proving that
their alleged adverse health effects actually were caused by
exposure to environmental tobacco smoke. Although defendants
still may prevail on causation and other theories, RJR Tobacco
does not believe that the order is correct under Florida law or
that it accurately reflects the intent of the Broinsettlement agreement. Accordingly, defendants appealed Judge
Kayes ruling to the Third District Court of Appeal on
November 3, 2000. Plaintiffs moved to dismiss the appeal on
November 28, 2000. On January 12, 2001, the Third
District Court of Appeal denied plaintiffs motion and
ordered oral argument. On October 10, 2001, a different
panel of the Third District Court of Appeal dismissed the
appeal, finding that Judge Kayes order is not an
appealable order at this time, but noted that the ruling is
without prejudice to the defendants ability to appeal the
issue at the appropriate time. On January 16, 2002,
defendants filed a writ to invoke the discretionary jurisdiction
of the Florida Supreme Court.

On April 5, 2001, in the first Broin IIflight
attendant case to go to trial, Fontana v. Philip Morris,
Inc., a Florida state court jury returned a verdict in favor
of the defendants, including RJR Tobacco. On April 16,
2001, plaintiff filed motions for a mistrial, judgment
notwithstanding the verdict, or for a new trial. On
October 1, 2001, the trial judge denied plaintiffs
post-trial motions. Plaintiff appealed to the Florida Third
District Court of Appeal. Defendants cross-appealed on
November 8, 2001.

Class Action Suits.In May 1996, in Castano v.
American Tobacco Co., the Fifth Circuit Court of Appeals
overturned the certification of a nationwide class of persons
whose claims related to alleged addiction to tobacco. Since this
ruling by the Fifth Circuit, most class-action suits have sought
certification of statewide, rather than nationwide, classes.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Class action suits based on claims similar to those asserted in
Castano have been brought against RJR Tobacco, and in
some cases RJR, in state or federal courts in Alabama, Arkansas,
California, the District of Columbia, Florida, Georgia, Hawaii,
Illinois, Indiana, Iowa, Kansas, Louisiana, Maryland,
Massachusetts, Michigan, Minnesota, Missouri, Nevada, New
Jersey, New Mexico, New York, North Carolina, Ohio, Oklahoma,
Pennsylvania, South Carolina, Tennessee, Texas, Utah, Virginia,
West Virginia and Wisconsin. In addition, a class action filed
in Tennessee seeks reimbursement of Blue Cross and Blue Shield
premiums paid by subscribers throughout the United States and
class-action suits in Illinois, Missouri and New Jersey claim
that the marketing of light and
ultralight cigarettes is deceptive. Plaintiffs have
made similar claims in other lawsuits elsewhere. Other types of
class-action suits also have been filed in additional
jurisdictions. Most of these suits assert claims on behalf of
classes of individuals who claim to be addicted, injured or at
greater risk of injury by the use of tobacco or exposure to
environmental tobacco smoke, or the legal survivors of such
persons. A number of unions and other third-party payors have
filed health-care cost recovery actions in the form of class
actions. These cases are discussed separately below. Class
certification motions are pending in several state and federal
courts.

Few smoker class-action complaints have been certified or, if
certified, have survived on appeal. All 16 federal courts that
have considered the issue, including two courts of appeals, have
rejected class certification in smoker cases. On March 19,
2001, in Guillory v. American Tobacco Co., Inc., the
United States District Court for the Northern District of
Illinois refused to certify a class defined as all
Illinois residents who smoke or smoked cigarettes manufactured
by defendants, who started smoking while a minor, who purchase
or purchased cigarettes in Illinois and who desire to
participate in a program designed to assist them in the
cessation of smoking and/or monitor their medical condition to
promote early detection of disease caused by, contributed, or
exacerbated by cigarette smoking. On May 17, 2001, in
Brown v. Philip Morris, Inc., the United States Court of
Appeals for the Third Circuit affirmed the trial courts
dismissal of a proposed class action alleging the violation of
civil rights by the targeting of African-American
smokers. On June 29, 2001, the United States District
Court for the District of Nevada denied plaintiffs motions
for class certification in three cases involving casino workers
exposed to environmental tobacco smoke and one case involving
smokers with injuries allegedly caused by smoking. These four
cases, which were consolidated for class certification purposes,
are: (1) Badillo v. American Tobacco Co., Inc.; (2)
Christensen v. Philip Morris Cos., Inc.; (3) Dienno v.
Liggett Group, Inc.; and (4) Selcer v. R. J. Reynolds
Tobacco Co. Most recently, two cases, Mahoney v. R. J.
Reynolds Tobacco Co.and Davis v. R. J. Reynolds Tobacco
Co.,were denied class certification by the United States
District Court for the Southern District of Iowa.

Similarly, most state courts have refused to certify smoker
class actions. On December 8, 2000, in Geiger v.
American Tobacco Co., the Appellate Division of the Supreme
Court of New York, Second Judicial Department, affirmed the
trial courts denial of class action status to a purported
class defined as all New York residents, including their heirs,
representatives and estates, who contracted lung and/or throat
cancer as a result of smoking cigarettes. Plaintiffs filed a
motion for leave to appeal the order denying certification to
the New York Court of Appeals, the highest court in the state.
The New York Court of Appeals dismissed plaintiffs appeal
on February 13, 2001.

Classes have been certified thus far in several state court
class-action cases in which RJR Tobacco is a defendant. On
November 5, 1998, in Scott v. American Tobacco Co.,
a Louisiana state appeals court affirmed the certification of a
medical monitoring and/or smoking cessation class of Louisiana
residents who were smokers on or before May 24, 1996. On
February 26, 1999, the Louisiana Supreme Court denied the
defendants petition for writ of certiorari and/or review.
Jury selection began on June 18, 2001. Defendants appealed
the jury selection process to the Louisiana Fourth Circuit Court
of Appeal on July 18, 2001. On September 4, 2001, the
Court of Appeal dismissed two jurors because of bias, but
declined to dismiss jurors with immediate family members who
were members of the class. On September 5, 2001, defendants
sought review by the Louisiana State Supreme Court. On September
25, 2001, the Louisiana State Supreme Court dismissed seven
additional jurors because they have immediate family members who
are members of the class and the seven jurors expressed a desire
that those family members receive medical monitoring or smoking

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(Continued)


cessation assistance. On October 9, 2001, the defendants
asked the Louisiana Supreme Court to declare a mistrial because
of the irregularities in the jury selection process. This
petition was denied on October 15, 2001. Jury selection
resumed again on October 22, 2001, and a full complement of
12 jurors and 10 alternates was selected. On December 26,
2001, defendants filed an application for supervisory writ
to the Fourth District of the Louisiana Court of Appeals
challenging certain aspects of the second round of jury
selection. Opening statements will not occur until that writ is
decided.

Trial began on January 4, 2001, in Blankenship v. Philip
Morris, Inc., a West Virginia state court medical monitoring
class action. The trial of this case ended on January 25,
2001, when the judge declared a mistrial. Argument on
decertification of the class, among other things, was held on
February 19, 2001. On March 23, 2001, the judge denied
the defendants motion to decertify the class. The retrial
of this case began on September 5, 2001, and ended on
November 14, 2001, when the jury returned a verdict in
favor of RJR Tobacco and other cigarette manufacturers.

On November 30, 2000, in Daniels v. Philip Morris Cos.,
Inc., a San Diego Superior Court judge reversed a prior
ruling and, based on a California unfair business practices
statute, certified a class consisting of all persons who, as
California resident minors, smoked one or more cigarettes in
California between April 2, 1994 and December 1, 1999.
Trial has been scheduled for July 1, 2002.

On April 11, 2001, in Brown v. American Tobacco Co.,
Inc., the same judge granted in part plaintiffs motion
for class certification. The class is composed of adult
residents of California who smoked at least one of
defendants cigarettes during the applicable time
period, and who were exposed to defendants marketing
and advertising activities in California. Certification was
granted as to plaintiffs claims that defendants violated
§17200 of the California Business and Professions Code. The
court, however, refused to certify the class under the
California Legal Remedies Act. Class certification on
plaintiffs common law claims was denied on April 10,
2000. Defendants petitioned the California Supreme Court to
review the trial courts class certification ruling, but
the Supreme Court denied the petition on January 16, 2002.
The trial has been scheduled for October 11, 2002.

Most recently, on November 14, 2001, in Turner v. R. J.
Reynolds Tobacco Co., an Illinois state court judge
certified a class defined as [a]ll persons who purchased
defendants Doral Lights, Winston Lights, Salem Lights and
Camel Lights, in Illinois, for personal consumption, between the
first date that defendants sold Doral Lights, Winston Lights,
Salem Lights and Camel Lights through the date the court
certifies this suit as a class action . . . . Trial is
scheduled for March 17, 2003. This case currently includes
both RJR and RJR Tobacco as defendants.

Defendants, including RJR Tobacco, settled one class-action
suit, Broin v. Philip Morris, Inc., in October 1997. The
Florida Court of Appeal denied challenges to this settlement on
March 24, 1999, and subsequently denied motions to
reconsider. On September 7, 1999, the Florida Supreme Court
dismissed all proceedings, and the settlement and judgment
became final. The Broin IIcases, discussed above, arose
out of the settlement of this case.

Trial began in July 1998 in Florida state court in Engle v.
R. J. Reynolds Tobacco Co., in which a class consisting of
Florida residents, or their survivors on their behalf, claim to
have diseases or medical conditions caused by their alleged
addiction to cigarettes. On July 7, 1999, the
jury found against RJR Tobacco and the other cigarette
manufacturer defendants in the initial phase, which included
common issues related to certain elements of liability, general
causation and a potential award of or entitlement to punitive
damages.

The second phase of the trial, which consisted of the claims of
three of the named class representatives, began on
November 1, 1999. On April 7, 2000, the jury returned
a verdict against all defendants. They awarded plaintiff Mary
Farnan $2.85 million, the estate of plaintiff Angie Della
Vecchia $4.023 million and plaintiff Frank Amodeo $5.831
million. The jury also found, however, that Frank Amodeo knew or
should have known of his claim prior to May 5, 1990. The legal
effect of that finding should be to bar his claim based on the
applicable statute of limitations.

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(Continued)


The trial court also ordered the jury in the second phase of the
trial to determine punitive damages, if any, on a class-wide
basis. On July 14, 2000, the jury returned a punitive
damages verdict in favor of the Florida class of
approximately $145 billion against all the defendants, with
approximately $36.3 billion being assigned to RJR Tobacco.

On July 24, 2000, the defendants, including RJR Tobacco,
filed numerous post-verdict motions, including motions for a new
trial and to reduce the amount of the punitive damages verdict.
On November 6, 2000, the trial judge denied the post-trial
motions and entered judgment. On November 7, 2000, RJR
Tobacco posted an appeal bond in the amount of $100 million,
pursuant to a Florida statute enacted on May 9, 2000, and
intended to apply to the Engle case, and initiated the
appeals process. The opening appellate brief of certain
defendants, including RJR Tobacco, was filed on
November 26, 2001. RJR Tobacco believes it has numerous
bases for a successful appeal, although it cannot predict the
outcome of the appellate process.

On May 7, 2001, three of the defendants entered into
agreements with the Engleclass to deposit an additional
$1.86 billion into separate escrow accounts to ensure that the
stay of execution that is in effect pursuant to the Florida bond
statute will remain in effect as to these three defendants
throughout the appellate process, regardless of the results of a
challenge, if any, to the Florida bond statute. Approximately
$700 million of the total amount deposited by these three
defendants is non-refundable and will go to the trial court to
be distributed, regardless of the result of the appeal. RJR
Tobacco has not entered into a similar agreement with the
Engleclass. Although RJR Tobacco cannot predict the
outcome of any possible challenges to the Florida bond statute,
RJR Tobacco remains confident of the applicability and validity
of the statute in the Englecase. In addition, nine other
states, Georgia, Kentucky, Louisiana, Nevada, North Carolina,
Oklahoma, South Carolina, Virginia and West Virginia, have
enacted legislation similar to the Florida bond statute. The
Mississippi Supreme Court also has placed limits on appeal bonds
by court rule.




RJR Tobacco and other cigarette manufacturer defendants settled
one class-action suit, Broin v. Phillip Morris, Inc., in
October 1997. This case had been brought in Florida state court
on behalf of all flight attendants of U.S. airlines alleged to
be suffering from diseases or ailments caused by exposure to
second hand smoke in airplane cabins. The settlement agreement
required the participating tobacco companies to pay a total of
$300 million in three annual $100 million
installments, allocated among the companies by market share, to
fund research on the early detection and cure of diseases
associated with tobacco smoke. It also required those companies
to pay a total of $49 million for plaintiffs
counsels fees and expenses. RJR Tobaccos portion of
these payments was approximately $86 million. The
settlement agreement bars class members from bringing aggregate
claims or obtaining punitive or exemplary damages and also bars
individual claims to the extent that they are based on fraud,
misrepresentation, conspiracy to commit fraud or
misrepresentation, RICO, suppression, concealment or any other
alleged intentional or willful conduct. The defendants agreed
that, in any individual case brought by a class member, the
defendant will bear the burden of proof with respect to whether
ETS can cause certain specifically enumerated diseases
(general causation). With respect to all other
issues relating to liability, including whether an individual
plaintiffs disease was caused by his or her exposure to
ETS in aircraft cabins (specific causation), the
individual plaintiff will have the burden of proof.
Floridas Third District Court of Appeal denied various
challenges to this settlement on March 24, 1999, and
subsequently denied motions to reconsider. On September 7,
1999, the Florida Supreme Court dismissed all proceedings, and
the settlement and judgment became final. The Broin IIcases, discussed above, arose out of the settlement of this
case.




Governmental Health-Care Cost Recovery Cases.In June
1994, the Mississippi attorney general brought an action,
Moore v. American Tobacco Co., against various industry
members, including RJR Tobacco. This case was brought on behalf
of the state to recover state funds paid for health care and
medical and other assistance to state citizens suffering from
diseases and conditions allegedly related to tobacco use. By
making the state the plaintiff in the case and basing its claims
on economic loss rather than personal injury, the state sought
to avoid the defenses otherwise available against an individual
plaintiff. Most other states, through their attorneys general or
other state agencies, sued RJR Tobacco and other U.S. cigarette
manufacturers based on similar theories. The cigarette
manufacturer defendants, including RJR Tobacco,

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(Continued)


settled the first four of these cases scheduled to come to
trial, those of Mississippi, Florida, Texas and Minnesota, by
separate agreements between each state and those manufacturers
in each case.

On November 23, 1998, the major U.S. cigarette
manufacturers, including RJR Tobacco, entered into the Master
Settlement Agreement with attorneys general representing the
remaining 46 states, the District of Columbia, Puerto Rico,
Guam, the Virgin Islands, American Samoa and the Northern
Marianas. The MSA became effective on November 12, 1999,
when final approval of the settlement was achieved in 80% of the
settling jurisdictions. As of October 17, 2000, final
approval had been achieved in all settling jurisdictions. The
MSA settled all the health-care cost recovery actions brought
by, or on behalf of, the settling jurisdictions and contains
releases of various additional present and future claims.

In the settling jurisdictions, the MSA released RJR Tobacco,
indemnitees and RJR from: (1) all claims of the settling
states and their respective political subdivisions and other
recipients of state health-care funds, relating to past conduct
arising out of the use, sale, distribution, manufacture,
development, advertising, marketing or health effects of, the
exposure to, or research, statements or warnings about, tobacco
products and (2) all monetary claims relating to future
conduct arising out of the use of, or exposure to, tobacco
products that have been manufactured in the ordinary course of
business.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  Monetary Liabilities.In addition to payments
    already made, the MSA calls for additional initial industry
    payments of approximately $2.6 billion and $2.7 billion in 2002
    and 2003, respectively. A substantial portion of the payment due
    in 2002 was prepaid in 2001 to obtain the tax benefit of the
    early payment. The MSA also requires perpetual annual industry
    payments, which started in 2000. The unadjusted annual payment
    currently is $6.5 billion and increases to $8 billion in 2004,
    to $8.14 billion in 2008 and finally to $9 billion in 2018 and
    thereafter. Ten additional payments of $861 million are due
    annually beginning in April 2008. All payments are to be
    allocated among the companies on the basis of relative market
    share and most are subject to adjustments for changes in sales
    volume, inflation and other factors. RJR Tobacco records its
    allocation of charges in cost of goods sold as products are
    shipped.                                                                                                                                                
|
| | The tobacco companies also agreed to (1) make a one-time
    payment of $50 million on March 31, 1999, to establish a
    fund for enforcement of the MSA and laws relating to tobacco
    products and (2) fund activities of the National
    Association of Attorneys General relating to the MSA at the cost
    of $150,000 per year for ten years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| | In addition, the MSA calls for the creation of a national
    foundation to support the study of, and programs to reduce,
    youth tobacco product usage and youth substance abuse, and the
    study of educational programs to prevent diseases associated
    with tobacco product use. The tobacco companies agreed to fund
    the foundation with (1) ten annual payments of $25 million,
    which began on March 31, 1999, (2) further payments of
    $250 million, which began on March 31, 1999, and $300
    million annually thereafter for four years, and
    (3) additional annual payments of $300 million beginning in
    2004 if, during the year preceding the year when payment is due,
    participating manufacturers collectively accounted for at least
    99.05% of the cigarette market. Each of these payments is to be
    allocated among the companies on the basis of relative market
    share. Other than the $25 million annual payments and the $250
    million payment made on March 31, 1999, the payments for
    the foundation are subject to adjustments for changes in sales
    volume, inflation and other factors.
|
| | The manufacturers also agreed to pay the litigation costs,
    including government attorneys fees, of the offices of the
    attorneys general relating to the settled cases and, subject to
    certain quarterly and annual payment caps, the costs and fees of
    outside counsel to the jurisdictions. Outside counsel fees have
    been determined either by arbitration or in accordance with a
    negotiated fee procedure. Awards determined by arbitration will
    be paid subject to an aggregate annual cap on arbitrated
    attorneys fees for all these and certain other settled
    cases of $500 million. Fees set by the negotiated fee procedure
    are subject to an annual cap of $250 million, and will not
    exceed a total of $1.25 billion. As of February 7, 2002,
    publicly announced awards determined by arbitration totaled
    approximately $11.7 billion, and awards determined in accordance
    with a negotiated fee procedure totaled approximately $626
    million.                                                                                                                                             

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)




| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Reimbursement of costs is capped at $150 million for litigation
    costs, including government attorneys fees, of the
    attorneys general offices and at $75 million annually for
    outside counsels costs. Payments for attorneys fees
    and costs are to be allocated on a relative market share basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  Growers Trust.As part of the MSA, the
    tobacco companies agreed to work with U.S. tobacco growers to
    address the possible adverse economic impact of the MSA on
    growers. As a result, RJR Tobacco and the three other major
    manufacturers agreed to participate in funding a $5.2 billion
    trust fund to be administered by a trustee, in conjunction with
    a certification entity from each of the tobacco growing states.
    The trust agreement provides for a schedule of aggregate annual
    payments, subject to various adjustments, that are payable in
    quarterly installments each year from 1999 through 2010. The
    aggregate annual payment by all participating manufacturers is
    adjusted each year for inflation and any change in the total
    domestic cigarette volume of all participating manufacturers. In
    general, the annual payment by each participating manufacturer,
    including RJR Tobacco, is based on each manufacturers
    relative market share of total domestic cigarette shipments
    during the preceding calendar year. Each manufacturers
    annual payment is also subject to a tax offset adjustment.
|
| |  Other MSA Obligations.The MSA also contains
    provisions restricting the marketing of cigarettes. Among these
    are restrictions or prohibitions on the use of cartoon
    characters, brand name sponsorships, brand name non-tobacco
    products, outdoor and transit brand advertising, payments for
    product placement, free sampling and lobbying. The MSA also
    required the dissolution of three industry-sponsored research
    and advocacy organizations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

RJR Tobaccos settlement expenses under these agreements
were $2.6 billion, $2.3 billion and $2.2 billion in 2001, 2000
and 1999, respectively. The cash payments made by RJR Tobacco
under the MSA and other existing settlement agreements were $2.4
billion, $2.2 billion and $1.6 billion in 2001, 2000 and 1999,
respectively. RJR Tobacco estimates these payments to be $2.4
billion in 2002 and to exceed $2 billion per year thereafter.
However, these payments will be subject to adjustments based
upon, among other things, the volume of cigarettes sold by RJR
Tobacco, RJR Tobaccos market share and inflation.

Certain litigation has arisen challenging the validity of the
MSA, including cases with claims that the MSA violates antitrust
laws. On January 5, 2001, the United States District Court for
the Northern District of California dismissed one of those
cases, Forces Action Project v. California. On
August 15, 2001, the United States Court of Appeals for the
Ninth Circuit remanded the antitrust claim, but affirmed the
district courts dismissal of the remaining claims. On
January 15, 2002, the United States District Court judge
denied plaintiffs motion to amend the complaint which
effectively dismissed the case.

Six actions are pending against RJR Tobacco alleging various
violations of the MSA. RJR Tobacco believes it has meritorious
defenses to each of these actions.

Arizona, California, New York and Washington have alleged that
the posting of signage advertising RJR Tobaccos brand name
sponsorships violates a provision of the MSA governing the times
during which such signs may be posted. On November 16,
2001, in the Arizona signage action, the trial court granted
summary judgment in favor of the state. On November 27,
2001, the trial court ruled similarly in the California signage
matter. However, on February 1, 2002, a New York trial
court upheld RJR Tobaccos position. Appeals of all of
these decisions are pending or anticipated. Trial in the
Washington matter is scheduled for August 5, 2002.

The State of Ohio has alleged that RJR Tobaccos purchase
of advertising space on matchbooks distributed by an independent
third party violates a provision of the MSA governing brand name
merchandise. In November 2001, the trial court heard arguments
on the parties cross-motions for summary judgment and took
the motions under advisement.

Finally, the State of California has alleged that the
publications in which RJR Tobacco places advertising evidences
direct or indirect targeting of youth which is prohibited by the
MSA. Pretrial discovery is proceeding, and the trial is
scheduled for April 19, 2002.

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(Continued)


On June 8, 2001, the Attorney General of the State of
California filed a lawsuit against RJR Tobacco in California
state court alleging that RJR Tobacco violated California state
law by distributing free cigarettes and free coupons for
discounts on cigarettes on public grounds, even
though the promotions occurred in an adult-only
facility at a race track. RJR Tobacco answered the
complaint on July 19, 2001, asserting that its promotions
complied with all laws, including California state law. The
trial is scheduled for April 30, 2002.

On April 20, 1999, the Canadian Province of British
Columbia brought a case in British Columbia Provincial Court,
similar to the U.S. attorneys general cases discussed
above, against RJR Tobacco and certain other Canadian and U.S.
tobacco companies and their parent companies, including RJR.
This lawsuit relied heavily upon special legislation enacted in
British Columbia that was separately challenged by various
Canadian tobacco companies. An agreement was reached with the
government in British Columbia to litigate the separate
constitutional challenges prior to the health-care cost recovery
action. On February 21, 2000, the British Columbia Supreme
Court declared the Cost Recovery Act unconstitutional and
dismissed the action. This decision was not appealed by the
government. On January 24, 2001, the Canadian Province of
British Columbia brought a second action in British Columbia
Provincial Court. A trial is likely to occur in October 2002.

On September 22, 1999, the U.S. Department of Justice
brought an action in the United States District Court for the
District of Columbia against various industry members, including
RJR Tobacco. The government sought to recover federal funds
expended in providing health care to smokers who have developed
diseases and injuries alleged to be smoking-related, and, in
addition, seeks, pursuant to the federal RICO statute,
disgorgement of profits the government contends were earned as a
consequence of a RICO racketeering enterprise. On
December 27, 1999, defendants filed a motion to dismiss
challenging all counts included in the action brought by the
DOJ. On June 6, 2000, the trial court heard oral argument
on the motion. On September 28, 2000, federal court Judge
Gladys Kessler of the United States District Court for the
District of Columbia granted the non-Liggett defendants
motion to dismiss the following counts of plaintiffs
complaint: (1) Medical Care Recovery Act claim, and
(2) Medicare Secondary Payer claim. The court, however,
denied the motion with respect to the RICO claims. On
October 13, 2000, the United States filed a motion to limit
Judge Kesslers September 28, 2000 order to claims for
payments under Medicare and the Federal Employee Health Benefits
Act.

Discovery in the DOJ lawsuit is ongoing, and trial has been
scheduled for July 15, 2003. RJR Tobacco believes it has
meritorious factual and legal defenses to that lawsuit. In June
2001, the United States Attorney General assembled a team of
three DOJ lawyers to work on a possible settlement of the
federal lawsuit. The DOJ lawyers met with representatives of the
tobacco industry, including RJR Tobacco, on July 18, 2001.
No settlement was reached and no further meetings are planned.

Union Cases.Although the MSA settled some of the most
potentially burdensome health-care cost recovery actions, many
other such cases have been brought by other types of plaintiffs.
As of February 7, 2002, approximately 14 lawsuits by union
trust funds against cigarette manufacturers and others are
pending. The funds seek recovery of payments made by them for
medical expenses of their participant union members and their
dependents allegedly injured by cigarettes. The claims in these
cases are almost identical, and several of these cases purport
to be class actions on behalf of all union trust funds in a
particular state.

The defendants in these actions argue, among other things, that
one who pays an injured persons medical expenses is
legally too remote to maintain an action against the person
allegedly responsible for the injury. In addition, they argue
that the traditional subrogation remedy cannot be supplanted by
a direct right of action for the trust fund that strips
defendants of the defenses they would ordinarily have against
the allegedly injured individual.

On March 29, 1999, in the first of these cases to be
considered by a federal court of appeals, Steamfitters Local
Union 420 v. Philip Morris, Inc., the United States Court of
Appeals for the Third Circuit affirmed a district court ruling
dismissing the case on remoteness grounds. Since then, the U.S.
Courts of Appeals for the Second, Third, Fifth, Seventh, Eighth,
Ninth and Eleventh Circuits have all ruled in favor of the
industry in

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(Continued)


similar union cases. On January 10, 2000, the United States
Supreme Court denied petitions for certiorari filed in cases
from the Second, Third and Ninth Circuits.

Numerous trial court judges also have dismissed union trust fund
cases on remoteness grounds. Nonetheless, some union, or other
third-party payor, cases have survived motions to dismiss and
have proceeded or may proceed to trial. On August 2, 1999,
a federal district court in New York denied defendants
motions to dismiss in two separate cases heard together,
National Asbestos Workers Medical Fund v. Philip Morris, Inc.and Blue Cross and Blue Shield of New Jersey, Inc. v.
Philip Morris, Inc., discussed below. On December 21,
1999, the federal district court in the District of Columbia
denied defendants motions to dismiss in three cases
consolidated for pretrial purposes: Service Employees
International Union Health and Welfare Fund v. Philip Morris,
Inc., S.E.I.U. Local 74 Welfare Fund v. Philip Morris,
Inc.and Holland v. Philip Morris, Inc.On
May 22, 2001, the United States Court of Appeals for the
District of Columbia reversed the federal district courts
ruling that denied in part defendants motion to dismiss,
and affirmed the portion of the ruling that dismissed the bulk
of plaintiffs claims in these cases. In the same opinion,
the court reversed the district courts ruling that denied
defendants motion to dismiss the RICO and fraud claims in
Sheet Metal Workers Trust Fund v. Philip Morris, Inc.,
which had been consolidated with the first three cases for
purposes of pretrial discovery. The result of the D.C.
Circuits ruling is that all claims in these four cases, as
well as several additional union trust fund cases that had also
been consolidated for purposes of the appeal, were dismissed. On
June 21, 2001, plaintiffs filed a petition for rehearing
before the entire D.C. circuit with respect to these cases,
which was denied on July 13, 2001. On August 20, 2001,
plaintiffs filed a petition for writ of certiorari with the U.S.
Supreme Court, which was denied on October 29, 2001.

On March 3, 2000, a New York state court granted motions to
dismiss ten union cases, Eastern States Health & Welfare
Fund v. Philip Morris, Inc., brought by 14 union trust funds
seeking to recover money paid for medical bills incurred by
their participants and beneficiaries who suffer from alleged
tobacco-caused diseases. This group of cases is on appeal to the
Appellate Division of the Supreme Court of New York. On
September 26, 2000, in Steamfitters Local Union
No. 614 Health and Welfare Fund v. Philip Morris, Inc.,
the Tennessee Court of Appeals affirmed a trial courts
dismissal of an antitrust claim and found that the remaining
claims in the plaintiffs complaint were too remote to
permit recovery. On March 21, 2001, a federal district
court in Connecticut granted defendants motion to dismiss
in Connecticut Pipe Trades Health Fund v. Philip Morris, Inc.Most recently, on January 25, 2002, in Motion
Picture Industry Health Plan v. Philip Morris, Inc., the
California Supreme Court granted plaintiffs petition for
review and deferred further action pending consideration and
disposition of a related issue in Naegele v.
Raybestos-Manhattan, Inc.(pending in San Francisco County
Superior Court), or pending further order of the court. On
October 25, 2001, the California Court of Appeals affirmed
the April 10, 2000, order granting voluntary dismissal of
the case with prejudice as to all defendants.

The first and only union case to go to trial to date was Iron
Workers Local No. 17 v. Philip Morris, Inc., which was
tried in federal court in Ohio. On March 18, 1999, the jury
returned a unanimous verdict for the defendants, including RJR
Tobacco. The plaintiffs dismissed their appeal of the verdict.

Other Health-Care Cost Recovery and Aggregated Claims
Plaintiffs.Groups of health-care insurers, as well as a
private entity that purported to self-insure its employee
health-care programs, have also advanced claims similar to those
found in the union health-care cost recovery actions.

Two insurer cases, Williams & Drake v.
American Tobacco Co.and Regence Blueshield v. Philip
Morris, Inc., were dismissed in their entirety on remoteness
grounds by federal district courts in Pennsylvania and
Washington. These rulings were then upheld on appeal to the
Third and Ninth Circuits, respectively.

In Group Health Plan, Inc. v. Philip Morris, Inc.and
Medica v. Philip Morris, Inc.,two cases consolidated for
opinion, a federal district judge in Minnesota dismissed all
claims, except a state antitrust claim and a state conspiracy
claim. The federal court certified to the Minnesota Supreme
Court the question of whether these two claims could be pursued
under Minnesota law by Group Health Plan. On January 11,
2001, the Minnesota Supreme Court ruled that the plaintiff could
pursue these claims. Certain defendants, including RJR Tobacco,

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


filed motions for summary judgment based on (1) the
statutes of limitation on June 15, 2001; and
(2) causation, injury and damages on June 20, 2001. On
January 31, 2002, summary judgment was granted in favor of
certain defendants, including RJR Tobacco, on all causes of
action. Plaintiffs have not yet filed an appeal.

On June 6, 2001, in Blue Cross and Blue Shield of New
Jersey, Inc. v. Philip Morris, Inc., a federal court jury in
Brooklyn returned a verdict in favor of RJR Tobacco and other
tobacco defendants on common law fraud and civil RICO claims,
but found for the plaintiff, Empire Blue Cross and Blue Shield,
on a claim under a New York state deceptive business practices
statute. Empire pursued its claims against the defendants on
behalf of itself directly, as well as on the behalf of its
insureds, under a theory of subrogation. The jury verdict on the
direct claim was approximately $17.8 million, and the verdict on
the subrogated claim was approximately $11.8 million. RJR
Tobaccos portion of these amounts is $6.6 million and $4.4
million, respectively. Empire is not entitled to recover under
both direct and subrogated claims; thus, Empire must elect one
claim, and thus one jury verdict. The New York statute under
which Empire recovered does not provide for punitive damages,
but does allow for recovery of reasonable attorneys fees.
Plaintiff filed a motion for attorneys fees. On
October 4, 2001, the court denied defendants
post-trial motions, entered final judgment in favor of Empire,
yet retained jurisdiction to decide the attorneys fees
issue. RJR Tobacco and the other tobacco defendants appealed the
final judgment to the United States Court of Appeals for the
Second Circuit. All remaining claims of Blue Cross Blue Shield
plans pending before the court are stayed pending the appeal.

On August 8, 2001, in County of Cook v. Philip Morris,
Inc., the Circuit Court of Cook County granted
defendants motion for judgment on the pleadings based on
remoteness grounds and dismissed plaintiffs complaint in
its entirety. Plaintiffs appealed the dismissal to the Illinois
Appellate Court, First District, on September 5, 2001.
Defendants noticed a cross-appeal to the appellate court on
September 17, 2001, from the trial courts prior
adverse rulings on defendants motions to dismiss on the
grounds of MSA release and lack of standing. The appellate court
has not yet ruled.

Native American tribes have filed similar health-care cost
recovery cases. On December 8, 2000, in Utu Utu Gwaitu
Paiute Tribe v. Philip Morris, Inc., the San Diego Superior
Court denied plaintiffs motion for class certification. On
January 10, 2001, the plaintiffs voluntarily dismissed the
action. On November 12, 1999, in Table Bluff Reservation v.
Philip Morris, Inc., a California federal district court
dismissed plaintiffs lawsuit. On July 16, 2001, the
United States Court of Appeals for the Ninth Circuit affirmed
the federal district courts dismissal. On July 30,
2001, in Acoma Pueblo v. American Tobacco Co., a federal
district court in New Mexico granted defendants motion to
dismiss plaintiffs complaint for failure to state a claim.
The ruling was based on a number of grounds, including
remoteness. On September 17, 2001, plaintiff filed a motion
for reconsideration which was denied on November 1, 2001.
The dismissal was modified to a dismissal with prejudice in
order to facilitate plaintiffs appeal. On August 31,
2001, in Alabama Coushatta Tribe of Texas v. American Tobacco
Co., the United States District Court for the Eastern
District of Texas (Beaumont Division) dismissed plaintiffs
complaint. Plaintiffs appealed to the United States Court of
Appeals for the Fifth Circuit on October 1, 2001. Most
recently, on January 25, 2002, in the Navajo Nation v.
Philip Morris, Inc., the District Court of Navajo Nation
granted in part defendants motion to dismiss the complaint
with respect to the conspiracy, deceptive acts and restraints of
trade claims. The court refused to dismiss plaintiffs
product liability claim. Four such cases remain pending, all
before tribal courts.

Other cost recovery suits have been brought by local
governmental jurisdictions, taxpayers on behalf of a government
jurisdiction, a university and hospitals. On December 14,
1999, a federal district court in Washington dismissed one such
case, Association of Washington Public Hospital Districts v.
Philip Morris, Inc.Plaintiffs appealed this ruling to the
United States Court of Appeals for the Ninth Circuit, which
affirmed the dismissal by the trial court on February 22,
2001. Plaintiffs filed a petition to the U.S. Supreme Court
asking it to review the case on July 16, 2001, but the
court declined plaintiffs petition October 1, 2001.
On May 30, 2000, in A.O. Fox Memorial Hospital v.
American Tobacco Co., Inc., pending in state court in Nassau
County, New York, a group of approximately 175 hospitals filed
suit against the tobacco industry seeking repayment from
cigarette companies for costs expended to treat smoking-related
illnesses. Plaintiffs seek at

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(Continued)


least $3.6 billion in damages. Defendants filed a motion
to dismiss which was granted on December 14, 2001. On
January 17, 2002, plaintiffs appealed the dismissal to the
Appellate Division of the Supreme Court, Second Judicial
Department.

A number of foreign countries have filed suit in state and
federal courts in the United States against RJR Tobacco and
other tobacco industry defendants to recover funds for health
care, medical and other assistance paid by those foreign
governments to their citizens. Of the 33 cases currently
pending, 6 are pending in state court and 27 are pending in
federal court. Eleven of these cases have been transferred to,
and are still pending before, the Judicial Panel on
Multi-District Litigation in the United States District Court
for the District of Columbia. Other foreign governments and
entities have stated that they are considering filing such
actions in the United States. In addition, in the Marshall
Islands v. American Tobacco Co., the Republic of the
Marshall Islands brought a health-care cost recovery lawsuit in
the Marshall Islands against RJR Tobacco and other cigarette
manufacturers. On February 22, 2001, the High Court of the
Marshall Islands granted defendants motions for summary
judgment on all counts except the Consumer Protection Act. The
parties stipulated to a dismissal of the remaining claim on
May 18, 2001. Final judgment was entered on June 4,
2001. Thereafter, on June 27, 2001, plaintiff noticed an
appeal to the Supreme Court of the Republic of the Marshall
Islands. On July 3, 2001, defendants filed a notice of
cross appeal. Oral argument on the appeal is scheduled for
April 17-19, 2002.

On August 7, 2000, a federal district court in Washington,
D.C. dismissed an international health-care cost recovery action
entitled Ontario v. Imperial Tobacco, Ltd.Plaintiffs
appealed to the United States Court of Appeals for the District
of Columbia. However, on November 29, 2001, the D.C. Court
of Appeals granted plaintiffs motion for a voluntary
dismissal of the appeal, thereby dismissing the case. In Obra
Social de Empleados de la Marina Mercante v. American Tobacco
Co., Inc., the Superior Court in Washington, D.C. granted
defendants motion to dismiss on January 13, 2001.
Plaintiffs appealed the dismissal to the D.C. Court of Appeals;
however, the parties agreed to dismiss the appeal on
October 22, 2001. Additionally, plaintiffs filed a separate
action in the same court on March 23, 2001; that case was
voluntarily dismissed on August 30, 2001. On May 22,
2001, the United States Court of Appeals for the District of
Columbia affirmed the federal district courts dismissal in
the following three matters: (1) Guatemala v. Tobacco
Institute, Inc.(a non-RJR Tobacco action); (2) Nicaragua
v. Liggett Group, Inc.(another non-RJR Tobacco case); and
(3) Ukraine v. American Brands, Inc.(a case involving
RJR Tobacco). Plaintiffs in each of these cases filed a petition
for writ of certiorari to the U.S. Supreme Court on
August 20, 2001. The Supreme Court, on October 29,
2001, denied the petitions. Most recently, on November 20,
2001, in Venezuela v. Philip Morris Cos., Inc.and
Espirito Santo, Brazil v. Brooke Group Ltd., a Florida
state court judge granted defendants motions to dismiss
these matters because the claims were too remote, indirect and
derivative to survive. Plaintiff appealed each case to the Third
District Court of Appeal of Florida on December 19, 2001.

Pursuant to the terms of the 1999 sale of RJRs
international tobacco business, Japan Tobacco Inc. assumed RJR
Tobaccos liability, if any, in the health-care cost
recovery cases brought by foreign countries.

Finally, 11 lawsuits are pending against RJR Tobacco in which
asbestos companies and/or asbestos-related trust funds allege
that they overpaid claims brought against them to
the extent that tobacco use, not asbestos exposure, was the
cause of the alleged personal injuries for which they paid
compensation. One of these lawsuits, Falise v. American
Tobacco Co., was dismissed by the United States District
Court for the Eastern District of New York (Weinstein, J.) on
November 2, 1999, due to a lack of subject matter
jurisdiction. This case was refiled on November 11, 1999.
Trial began on November 27, 2000. On January 22, 2001,
the judge declared a mistrial. The case was dismissed with
prejudice on June 29, 2001 after the plaintiff announced
that it would not retry the case. On May 24, 2001, a
Mississippi state court judge dismissed all claims by
Owens-Corning in a lawsuit similar to Falise.Owens-Corning appealed the dismissal to the Mississippi
Supreme Court on August 15, 2001. A similar case, H. K.
Porter Co., Inc. v. American Tobacco Co., is pending in the
United States District Court for the Eastern District of New
York (Weinstein, J.). In Fibreboard Corp. v. R. J. Reynolds
Tobacco Co., a case pending in state court in California,
Owens-Corning

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(Continued)


and Fibreboard asserted the same claims as those asserted in the
Mississippi case. Motions to dismiss those claims have been held
in abeyance pending the final determination of the Mississippi
case.

Antitrust Cases. A number of tobacco wholesalers, or
indirect purchasers, have sued United States cigarette
manufacturers, including RJR Tobacco, and its parent company,
RJR, alleging that cigarette manufacturers combined and
conspired to set the price of cigarettes, in violation of
antitrust statutes and various state unfair business practices
statutes, as a result of which plaintiffs suffered economic
injury. Of the 39 cases currently pending, 30 are pending in
state court and 9 are pending in federal court. Plaintiffs are
asking the court to certify the lawsuits as class actions and to
allow the respective plaintiffs to pursue the lawsuits as
representatives of other persons in individual states or
throughout the United States that purchased cigarettes directly
from one or more of the defendants. The federal cases have been
consolidated and sent by the Judicial Panel on Multidistrict
Litigation for pretrial proceedings in the United States
District Court for the Northern District of Georgia. On
November 30, 2000, the court dismissed plaintiffs
claims of fraudulent concealment, claims concerning conduct
outside the United States and allegations relating to non-price
conduct. A class of direct purchasers was certified by the court
on January 27, 2001. On February 22, 2001, plaintiffs
repleaded their fraudulent concealment allegations. These
allegations were dismissed on June 19, 2001. State court
cases on behalf of indirect purchasers have been dismissed in
Arizona, currently on appeal, and New York. A Minnesota court
denied class certification on November 21, 2001. A Kansas
court granted class certification on November 15, 2001.

On March 2, 2000, Liggett Group Inc. filed an antitrust
action against RJR Tobacco in the U.S. District Court for the
District of New Jersey. Subsequently, the court granted RJR
Tobaccos motion to transfer this action to the United
States District Court for the Middle District of North Carolina.
On May 3, 2001, the case, which alleged that RJR
Tobaccos Every-Day-Low-Price merchandising program is a
violation of the Sherman Antitrust Act and New Jersey antitrust
laws, was voluntarily dismissed.

In A.D. Bedell Wholesale Co. v. Philip Morris, Inc.,
filed on April 13, 1999, in the United States District
Court for the Western District of Pennsylvania, a cigarette
wholesaler alleged that the MSA restricts cigarette output and
otherwise restrains trade in violation of the Sherman Act. On
March 22, 2000, the district court entered an order granting
defendants motion to dismiss counts I and II of the
complaint, denying defendants motion to dismiss count III,
and denying as moot plaintiffs motion for partial summary
judgment. On April 11, 2000, the plaintiffs and defendant
Philip Morris, the only defendant to which count III applied,
filed a consent order dismissing count III of the amended
complaint. On April 18, 2000, plaintiffs appealed the
dismissal of counts I and II to the United States Court of
Appeals for the Third Circuit. On June 19, 2001, the Third
Circuit affirmed the district courts dismissal of counts I
and II, ruling that tobacco companies that entered into the MSA,
including RJR Tobacco, were immune from potential antitrust
liability that was alleged to arise out of the MSA. The finding
of antitrust immunity is consistent with that of all other
federal courts that have considered antitrust challenges to the
MSA. The plaintiffs filed a petition for rehearing and
suggestion for rehearing before the entire Third Circuit on
July 2, 2001. This petition was denied on July 24,
2001. On October 19, 2001, the plaintiffs filed a petition
for a writ of certiorari with the U.S. Supreme Court, which
denied the petition on January 7, 2002.

On July 30, 1999, Cigarettes Cheaper!, a retailer, filed an
antitrust counterclaim against RJR Tobacco in a gray market
trademark suit originally brought by RJR Tobacco in the United
States District Court for the Northern District of Illinois.
Cigarettes Cheaper! alleges that it was denied promotional
resources in violation of the Robinson-Patman Act. The district
court declined to dismiss the counterclaim. On January 23,
2001, the court granted Cigarettes Cheaper!s motion to
amend its counterclaim to include a violation of the Sherman Act
§1, claiming that RJR Tobacco conspired with other
retailers to deny promotions to Cigarettes Cheaper!, an
allegation that RJR Tobacco denies. On March 21, 2001, RJR
Tobaccos motion to add a trademark dilution claim against
Cigarettes Cheaper! was granted. On June 28, 2001, the
court granted RJR Tobaccos motion to strike with prejudice
several of Cigarettes Cheaper!s affirmative defenses.
These defenses related to: (1) alleged misrepresentations caused
by the packaging of cigarettes manufactured by RJR Tobacco for
export; (2) RJR Tobaccos No Bull
advertising campaign for its WINSTON cigarettes;

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(Continued)


(3) antitrust trademark misuse; (4) nominative fair
use; and (5) the first sale doctrine. Fact discovery closed
on October 18, 2001. Expert discovery is presently underway
and dispositive motions likely will be filed this spring or
summer. No trial date is yet set.

On May 10, 2000, the Customer Company, a retailer
affiliated with Cigarettes Cheaper!, filed a similar antitrust
claim against RJR Tobacco in the United States District Court
for the Northern District of California. This case has now been
settled. The settlement terms are confidential; however, the
settlement is not material to RJR Tobacco.

Tobacco Growers Case. On February 16, 2000, a
class action complaint, Deloach v. Philip Morris Cos.,
Inc., was brought against RJR Tobacco, other cigarette
manufacturers and others, in the United States District Court
for the District of Columbia on behalf of a putative class of
all tobacco growers and tobacco allotment holders, some 5,930 of
which are actually named in the first amended complaint.
Plaintiffs current theory, as reflected in their second
amended complaint, which was filed on September 2, 2000, is
that the defendants, Philip Morris, Inc., RJR Tobacco, Brown
& Williamson Tobacco Corp. and Lorillard Tobacco Co.,
engaged in bid-rigging of American burley and flue-cured tobacco
auctions beginning at least by 1996 and continuing to present.
Defendants actions are alleged to have held the auction
prices of tobacco at artificially low prices resulting in damage
to tobacco growers and allotment holders. In addition,
plaintiffs allege that defendants have engaged in a conspiracy
to force the elimination or destruction of the federal
governments tobacco quota and price support program
through an alleged illegal group boycott. On October 9,
2000, defendants filed a motion to dismiss the second amended
complaint and a motion to transfer venue to the United States
District Court for the Middle District of North Carolina. On
November 30, 2000, the court granted the motion to transfer
the case. On December 20, 2000, plaintiffs moved to amend
the complaint to add leaf-buying companies as defendants.
Plaintiffs motion to certify the class remains pending.

Scheduled Trials. As of February 7, 2002, RJR
Tobacco is a defendant in two cases currently being tried:
Burton v. R. J. Reynolds Tobacco Co., an individual case
being tried in federal court in Kansas, and Scott v. American
Tobacco Co., a medical monitoring class action. Jury
selection began in the Scott case on June 18, 2001.
After the jury was impaneled, various rulings required the
dismissal of several members of the original jury (nine jurors
and/or alternates). Jury selection began again on
October 22, 2001. On December 26, 2001,
defendants filed an application for supervisory writ to
the Fourth District of the Louisiana Court of Appeals
challenging certain aspects of the second round of jury
selection. Opening statements will not occur until that
application is decided.

Although trial schedules are subject to change and many cases
are dismissed before trial, it is likely that there will be an
increased number of tobacco cases, some involving claims for
possibly billions of dollars, against RJR and RJR Tobacco,
coming to trial during 2002. As of February 7, 2002, there
are 18 cases scheduled for trial. Fourteen Broin IIcases
also are scheduled to be tried in 2002.

Other Developments.RJR Tobacco is aware of a grand jury
investigation being conducted in North Carolina that relates to
the cigarette business of certain of its former affiliates. In
connection with this investigation, RJR Tobacco responded to
document subpoenas dated July 7, 1999 and June 1,
2000, respectively.

On December 22, 1998, Northern Brands International, Inc.
entered into a plea agreement with the United States Attorney
for the Northern District of New York. Northern Brands is a
now-inactive tobacco subsidiary that was part of the business of
R. J. Reynolds International B.V., a former Netherlands
subsidiary of RJR Tobacco which was managed by a former
affiliate, RJR-MacDonald, Inc. On May 12, 1999,
RJR-MacDonald, Inc. was sold to Japan Tobacco Inc. and
subsequently changed its name to JT-MacDonald, Inc. Northern
Brands was charged with aiding and abetting certain customers
who brought merchandise into the United States by means of
false and fraudulent practices . . . . It is understood
that JT-MacDonald, Inc., Japan Tobaccos international
operating company in Canada, is cooperating with an
investigation now being conducted by the Royal Canadian Mounted
Police relating to the same events that gave rise to the
Northern Brands investigation.

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(Continued)


On December 21, 1999, the government of Canada filed a
lawsuit in the United States District Court for the Northern
District of New York against RJR Tobacco, RJR, several currently
and formerly related companies, including Northern Brands, and
the Canadian Tobacco Manufacturers Council. The lawsuit alleges
that, beginning in 1991, the defendants conspired with known
distributors and smugglers to illegally import into Canada
tobacco products originally earmarked for export from Canada, in
a fashion that avoided the imposition of certain excise and
retail taxes and duty payments. On June 30, 2000, this case
was dismissed by the United States District Court for the
Northern District of New York. Plaintiff appealed the dismissal
to the United States Court of Appeals for the Second Circuit,
which, on October 12, 2001, affirmed the district
courts dismissal. On December 12, 2001, the Court of
Appeals denied Canadas petition for rehearing. Although
the international tobacco business was sold, RJR Tobacco
retained certain liabilities relating to the events disclosed
above.

Similar lawsuits have been filed against RJR Tobacco and its
affiliates, along with other cigarette manufacturers, by the
European Community and ten of its member states (Belgium,
Finland, France, Greece, Germany, Italy, Luxembourg, the
Netherlands, Portugal and Spain), Ecuador, Belize and Honduras.
These suits contend that RJR Tobacco and other tobacco companies
in the United States may be held responsible for damages caused
by cigarette smugglers under common law and under the federal
RICO statute. Each of these actions seeks compensatory, punitive
and treble damages. On July 17, 2001, the action brought by
the European Community was dismissed by the United States
District Court for the Eastern District of New York. However,
the European Community and its member states filed a similar
complaint in the same jurisdiction on August 6, 2001. On
October 25, 2001, the court denied the European
Communitys request of August 10, 2001, to reinstate
its original complaint. On November 9, 2001, the European
Community and the ten member states amended their complaint
filed on August 6, 2001, to change the name of defendant
Nabisco Group Holdings Corp. to RJR Acquisition, Inc. RJR
Tobacco and the other defendants filed motions to dismiss that
complaint on November 14, 2001, and the court heard oral
argument on those motions on January 11, 2002. As of
February 7, 2002, a decision is still pending. RJR Tobacco
and other defendants filed in the United States District Court
for the Southern District of Florida motions to dismiss the
actions brought by Ecuador, Belize and Honduras. These motions
have been briefed and argued, and have been taken under
advisement.

On May 23, 2001, Star Scientific, Inc. filed a patent
infringement action against RJR Tobacco in the United States
District Court for the District of Maryland. The suit alleges
infringement of U.S. Patent No. 6,202,649 entitled
Method of Treating Tobacco to Reduce Nitrosamine Content,
and Products Produced Thereby. RJR Tobacco denies that it
has infringed any valid claim of the Star patent. On
June 13, 2001, RJR Tobacco filed a declaratory judgment
action against Star Scientific in the United States District
Court for the Middle District of North Carolina, seeking a
declaration that the patent is invalid and not infringed by RJR
Tobacco. On October 3, 2001, the North Carolina federal
court granted Star Scientifics motion to stay, but denied
its motions to dismiss or transfer the case.

On or about October 30, 1998, a boat manufacturer, American
Marine Holdings, Inc., filed suit against RJR Tobacco claiming
that one of its boats was not properly identified in RJR Tobacco
cigarette advertising. The plaintiff claimed, among other
things, violations of the Lanham Act and breach of an alleged
oral contract. On April 12, 2001, the parties reached an
agreement to settle the matter. The related provision for
settlement is included in the accompanying consolidated
financial statements.



---

Litigation is subject to many uncertainties, and it is possible
that some of the tobacco-related legal actions, proceedings or
claims could be decided against RJR Tobacco or its affiliates,
including RJR, or indemnitees. Determinations of liability or
adverse rulings against other cigarette manufacturers that are
defendants in similar actions, even if such rulings are not
final, could adversely affect the litigation against RJR Tobacco
or its affiliates or indemnitees and could encourage an increase
in the number of such claims. A number of political,
legislative, regulatory and other developments relating to the
tobacco industry and

70



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##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


cigarette smoking have received wide media attention. These
developments may negatively affect the outcomes of
tobacco-related legal actions and encourage the commencement of
additional similar litigation.

Although it is impossible to predict the outcome of such events
on pending litigation and the rate at which new lawsuits are
filed against RJR Tobacco and RJR, a significant increase in
litigation and/or in adverse outcomes for tobacco defendants
could have an adverse effect on either or both of these
entities. RJR Tobacco and RJR each believe that they have a
number of valid defenses to any of those actions and intend to
defend those actions vigorously.

RJR believes that, notwithstanding the quality of defenses
available to it and RJR Tobacco in litigation matters, it is
possible that the results of operations or cash flows of RJR in
particular quarterly or annual periods or RJRs financial
condition could be materially affected by the ultimate outcome
of certain pending litigation matters, including bonding and
litigation costs. RJRs management is unable to predict the
outcome of the litigation or to derive a meaningful estimate of
the amount or range of any possible loss in any particular
quarterly or annual period or in the aggregate. Accordingly, no
liability for tobacco-related litigation is currently recorded
in the consolidated financial statements.

Environmental Matters

RJR and its subsidiaries are subject to federal, state and local
environmental laws and regulations concerning the discharge,
storage, handling and disposal of hazardous or toxic substances.
Such laws and regulations provide for significant fines,
penalties and liabilities, sometimes without regard to whether
the owner or operator of the property knew of, or was
responsible for, the release or presence of hazardous or toxic
substances. In addition, third parties may make claims against
owners or operators of properties for personal injuries and
property damage associated with releases of hazardous or toxic
substances. In the past, RJR Tobacco has been named a
potentially responsible party with third parties under the
Comprehensive Environmental Response, Compensation and Liability
Act with respect to several superfund sites. Regulations
promulgated by the U.S. Environmental Protection Agency and
other governmental agencies under various statutes have resulted
in, and likely will continue to result in, substantial
expenditures for pollution control, waste treatment, plant
modification and similar activities. RJR and its subsidiaries
monitor their environmental matters and, dependent upon the
probability of occurrence and reasonable estimation of cost,
accrue or disclose any material liability.

RJR was named in an insurance coverage suit filed
August 13, 1997, by another company named as a potentially
responsible party under CERCLA with respect to a superfund site
in Hawaii at which a former subsidiary of RJR had operations. In
this lawsuit, Del Monte Fresh Produce v. Firemans Fund
Insurance, filed in the First Circuit Court of the State of
Hawaii, the plaintiff sought a declaratory judgment that it is
entitled to insurance coverage for the site or, in the
alternative, that RJR is obligated to indemnify the plaintiff
under the terms of the agreement by which RJR sold that company
in 1989. On June 26, 2001, the plaintiff filed for
dismissal without prejudice as to all claims against RJR. A
motion for summary judgment filed by Firemans Fund
Insurance Company was denied by the court on August 6, 2001.

Del Monte Corporation has been named a defendant in two lawsuits
related to the same Hawaii superfund site, Board of Water
Supply of the City and County of Honolulu v. Shell Oil Companyand Akee v. The Dow Chemical Co., filed in the First
Circuit Court of the State of Hawaii on September 27, 1999,
and October 7, 1999, respectively. Also, Del Monte Corporation
has received a demand for indemnity from an entity that was a
chemical supplier to Del Monte Corporation and is named a
defendant in one of these lawsuits. Del Monte Corporation has
sought indemnity from RJR under the terms of the agreement by
which RJR sold Del Monte Corporation in 1989. RJR, in turn, has
provided notice of these claims to the buyers of the Del Monte
fresh fruit business, asserting the right to be indemnified by
the buyers for any liability arising out of such claims under
the terms of the agreement by which RJR sold the Del Monte fresh
fruit business in 1989.

71



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##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Pursuant to an agreement dated June 12, 2001, among RJR,
the buyers of the Del Monte fresh fruit business, Del Monte
Corporation and others, the buyers of the Del Monte fresh fruit
business agreed, from the date of the agreement forward, to
indemnify RJR for any liabilities imposed in either Board of
Water Supplyor Akeeand with respect to the
environmental investigation and remediation of the superfund
site in Hawaii currently being required by the EPA. RJR and the
buyers of the Del Monte fresh fruit business also agreed to
engage in good faith negotiations regarding RJRs asserted
right to be indemnified with respect to any liability, cost or
expense related to such matters that was incurred prior to the
date of the agreement. Based on an agreement reached between RJR
and the buyers of the Del Monte fresh fruit business on
December 3, 2001, the buyers have reimbursed RJR for the
amount of legal expenses claimed by RJR in defending the
Board of Water Supplyand Akee cases prior to the
parties agreement of June 12, 2001. Additionally,
pursuant to a settlement agreement executed in December 2001,
among the plaintiff and certain defendants, including the buyers
of the Del Monte fresh fruit business, the Board of Water
Supplycase, including all pending claims and cross-claims,
has been dismissed with prejudice. In accordance with the terms
of the settlement agreement, the plaintiff released the buyers
of the Del Monte fresh fruit business and all of their
predecessors, including RJR, from all claims asserted in
Board of Water Supply.

On June 1, 2001, RJR received notice from Del Monte
Corporation of a claim made against it by a Hawaii landowner who
has been sued by a lessee of its land, claiming injuries due to
pesticide contamination of the soil, allegedly caused by Del
Monte Corporation as a prior lessee of the land. The
landowner-defendant has tendered the claim to Del Monte
Corporation for defense and indemnity. Del Monte Corporation has
in turn tendered the claim to RJR for defense and indemnity,
claiming it is entitled to be indemnified under the terms of the
agreement by which RJR sold Del Monte Corporation. Based on the
plaintiffs failure to provide any factual information in
support of its claim that Del Monte Corporation was a prior
lessee of the subject land, Del Monte Corporation has agreed to
extend indefinitely the period during which RJR must respond to
the Del Monte Corporations tender of the claim to RJR for
defense and indemnity, subject to the right to terminate the
indefinite extension on fifteen days notice to RJR.

RJR Tobacco was notified by the EPA on June 11, 2000 of its
potential liability under CERCLA for a superfund site in Greer,
South Carolina. The notice and demand for reimbursement of costs
incurred by the EPA were sent to a group of companies previously
involved as potentially responsible parties in another superfund
site, which includes RJR Tobacco. The EPA alleges that some
waste from the cleanup of the other site was transported to the
site in question. RJR Tobacco has executed a tolling agreement
with the EPA. This tolling agreement provides for entry into
good faith negotiations with the EPA, and is not an admission of
fact or liability. The tolling agreement also should have no
impact on any defense RJR Tobacco may assert, other than a
defense based on the running of the statute of limitations.
Information is still being gathered from other potentially
responsible parties recently notified by the EPA.

RJR and its subsidiaries have been engaged in a continuing
program to assure compliance with federal, state and local
environmental laws and regulations. Although it is difficult to
identify precisely the portion of capital expenditures or other
costs attributable to compliance with environmental laws and
regulations and to estimate the cost of resolving these CERCLA
matters, RJR does not expect such expenditures or other costs to
have a material adverse effect on the business, results of
operations or financial condition of RJR or its subsidiaries.

Other Contingencies

Until the acquisition by merger by Philip Morris Companies, Inc.
of Nabisco from NGH on December 11, 2000, NGH and Nabisco
were members of the consolidated group of NGH for U.S. federal
income tax purposes. Each member of a consolidated group is
jointly and severally liable for the U.S. federal income tax
liability of other members of the group as well as for pension
and funding liabilities of the other group members. NGH, now
known as RJR Acquisition Corp., continues to be jointly and
severally liable for these Nabisco liabilities prior to
December 11, 2000.

72



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


In connection with Philip Morris acquisition by merger of
Nabisco and RJRs subsequent acquisition by merger of NGH,
Philip Morris, Nabisco and NGH entered into a voting and
indemnity agreement that generally seeks to allocate tax
liabilities ratably based upon NGHs taxable income and
that of Nabisco, had the parties been separate taxpayers. If
Philip Morris and Nabisco are unable to satisfy their
obligations under this agreement, NGH, now known as RJR
Acquisition Corp., would be responsible for satisfying them.

In connection with the sale of the international tobacco
business to Japan Tobacco Inc. on May 12, 1999, RJR and RJR
Tobacco agreed to indemnify Japan Tobacco against (1) any
liabilities, costs and expenses arising out of the imposition or
assessment of any tax with respect to the international tobacco
business arising prior to the sale, other than as reflected on
the closing balance sheet, (2) any liabilities, costs and
expenses that Japan Tobacco or any of its affiliates, including
the acquired entities, may incur after the sale in respect of
any of RJRs or RJR Tobaccos employee benefit and
welfare plans and (3) any liabilities, costs and expenses
incurred by Japan Tobacco or any of its affiliates arising out
of certain activities of Northern Brands. Although it is
impossible to predict the outcome of the Northern Brands
litigation or the amount of liabilities, costs and expenses, a
significant adverse outcome regarding any of these items could
have an adverse effect on either or both of RJR and RJR Tobacco.

Commitments

At December 31, 2001, commitments totaled $245 million,
primarily for marketing-related activities and operating lease
commitments. The operating lease amounts for each of the next
five years are: 2002  $19 million; 2003 
$10 million; 2004  $3 million; 2005  $1
million; and 2006  $1 million. Rent expense was $43
million during 2001 and $44 million during each of 2000 and 1999.

Note 15  Financial Instruments

Foreign Currency Arrangements

At December 31, 2001, RJR Tobacco held a forward currency
exchange contract to purchase seven million Euros with a term of
less than 12 months as a hedge of an unrecognized firm
commitment for the purchase of equipment. As of
December 31, 2001, the foreign currency cash flow hedge was
effective and, accordingly, no gain or loss was realized. The
unrealized gain resulting from the increase in its fair value
was insignificant. There were no forward currency exchange
contracts outstanding at December 31, 2000.

Credit Risk

RJR and its subsidiaries minimize counterparty credit risk
related to their financial instruments by using major
institutions with high credit ratings.

Note 16  Stockholders Equity

RJRs authorized capital stock at December 31, 2001
consisted of 50 million shares of preferred stock, par value
$.01 per share, and 290 million shares of common stock, par
value $.01 per share. The preferred stock, none of which is
issued or outstanding, ranks senior to common stock as to
dividends and liquidation preferences.

During 2001, RJR repurchased 8,727,600 shares of its common
stock with an aggregate cost of $494 million. Of these amounts,
5,100,100 shares with an aggregate cost of $289 million
completed a $350 million repurchase program authorized by
RJRs board of directors on December 12, 2000. The
remaining 3,627,500 shares with an aggregate cost of $205
million were repurchased under an authorization by RJRs
board of directors on July 18, 2001. This program
authorizes the repurchase of shares of RJRs common stock
over time in the open market, with a maximum aggregate cost of
$300 million, to enhance stockholder value. The stock
repurchases are funded by dividends from RJR Acquisition Corp.
utilizing the cash proceeds of the

73



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


NGH acquisition. The timing of repurchases and the number of
shares repurchased will depend upon market conditions.

From November 1999 through December 31, 2001, cumulative
repurchases under all programs were 19,970,739 shares with an
aggregate cost of $780 million. Shares held through repurchase,
in addition to 144,683 shares cancelled, less 304,590 shares
granted, pursuant to employee benefit plans, are included in
treasury stock in the consolidated balance sheets.

Note 17  Stock Plans

As of December 31, 2001, RJR had two stock plans, the
Amended and Restated Equity Incentive Award Plan for Directors
and the 1999 Long Term Incentive Plan, as amended on
December 5, 2001.

The EIAP provides for grants of stock options and deferred stock
units to outside directors. Under certain circumstances,
directors may elect to receive shares of common stock in lieu of
deferred stock units. A maximum of 500,000 shares of common
stock may be issued under this plan, of which 381,527 shares
were available for grant as of December 31, 2001. Options
granted upon becoming a director may be exercised between six
months and ten years at a price that is the market value of the
stock on the grant date. Prior to April 2000, each outside
director was awarded an annual grant of stock options that
vested in three years and was exercisable for ten years.
Effective in April 2000, the annual grant of stock options was
amended to provide annual awards of deferred stock units and
quarterly grants of deferred stock units. Deferred stock units
granted under the EIAP have a value equal to, and bear dividends
at the same rate as, one share of RJRs common stock. The
dividends are paid as units in an amount equal to the number of
common shares that could be purchased with the dividends on the
date of payment. As soon as practicable following his or her
last year of service on the board, the director is paid in cash
for the units in the quarterly grants and in common stock, or in
cash if the director elects, for the units in the annual grants.
Cash payments are based on the average closing price of
RJRs common stock during December of the year preceding
payment.

The 1999 LTIP provides for grants of incentive stock options,
other stock options, stock appreciation rights, restricted
stock, performance units and performance shares to key
employees. The total number of shares of common stock authorized
for grant under the plan is 8,000,000 shares, plus 5,772,814
shares issuable under the NGH Long Term Incentive Plan awards
that, in connection with the spin-off, were converted into RJR
options or shares of restricted common stock. Of this
authorization, 4,304,076 shares were available for grant as of
December 31, 2001.

On June 15, 1999, as a result of the spin-off, 17,065,066
options held by employees to purchase common stock of NGH,
formerly known as RJR Nabisco Holdings Corp., were equitably
adjusted into 18,354,932 options for NGH shares and 5,456,114
options for RJR shares. The spin-off did not change the value of
the option grant, ratio of exercise price to market value,
vesting provision or exercise period. The allocation of RJR
options was transferred into the 1999 LTIP.

Also, in connection with the spin-off, holders of restricted
stock under the NGH LTIP received one RJR restricted share for
every three NGH restricted shares. The resulting 316,700
restricted shares were transferred into the 1999 LTIP. The
five-year vesting provisions of the restricted shares remain
unchanged for those held by continuing employees of RJR and its
subsidiaries and lapsed on those held by employees of the sold
international tobacco business and NGH. Compensation expense
related to the shares held by continuing employees of RJR and
its subsidiaries was insignificant in each of 2001, 2000 and
1999. At December 31, 2001, 43,333 shares remained
restricted. Unless forfeited, restrictions on all of these
shares will lapse in 2003. The unamortized portion remaining in
stockholders equity at December 31, 2001 was
insignificant.

In 1999, RJR granted 777,000 shares of restricted stock in
tandem with 3,108,000 options, included in the following option
table, to eligible employees under the 1999 LTIP. On each
vesting date, each eligible employee will receive the portion of
the tandem award with the highest value, the vesting shares of
RJR common stock or tandem stock options, unless he or she has
previously made an affirmative election

74



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


otherwise. Generally, these shares may not be disposed of, or
transferred while restricted during the three- to five-year
vesting period. Of these restrictions, 334,500 will lapse in
2002 and 167,250 will lapse in each of 2003 and 2004, unless the
related shares are forfeited. Since the date of grant, 108,000
shares have been forfeited. The market price of the stock on the
grant date was charged to stockholders equity as unearned
compensation and was amortized on a straight-line basis over the
vesting periods through September 2000. Since the fourth quarter
of 2000, it has been more probable that holders will forfeit the
restricted stock grant at vesting and elect to exercise the
related tandem options. Accordingly, amortization of the
unamortized equity to compensation expense was suspended. During
2001, a reversal of previous compensation expense of $1 million
resulted from the forfeiture of unvested restricted shares.
Compensation expense of $4 million and $3 million was recorded
in 2000 and 1999, respectively. The unamortized portion
remaining in stockholders equity at December 31, 2001
was $13 million.

In 2000, RJR granted 673,898 shares of restricted stock at
$17.03 to eligible employees under the 1999 LTIP. Generally,
these shares may not be disposed of or transferred during the
three-year vesting period. These restrictions will lapse in
2003, unless the related shares are forfeited. Since the date of
grant, 25,374 shares have been forfeited and restrictions on
9,782 shares have lapsed. Because the actual number of shares
granted may increase or decrease based on certain performance
factors, this grant is accounted for as a variable grant and,
accordingly, the fair value is being charged to
stockholders equity as unearned compensation and is being
amortized over the three-year vesting period. During 2001 and
2000, including amortization of expected performance shares and
dividends on forfeited shares, compensation expense was $17
million and $11 million, respectively, and the unamortized
portion remaining in stockholders equity at
December 31, 2001 was $15 million.

During 2001, RJR granted 304,590 shares of restricted stock at
$52.96 to eligible employees under the 1999 LTIP. Generally,
these shares may not be disposed of or transferred during the
three-year vesting period. These restrictions will lapse in
2004, unless the related shares are forfeited. Because the
actual number of shares granted may increase or decrease based
on certain performance factors, this grant is accounted for as a
variable grant and, accordingly, the fair value is being charged
to stockholders equity as unearned compensation and is
being amortized over the three-year vesting period. During 2001,
1,764 restricted shares were forfeited and restrictions on 190
shares lapsed. During 2001, including amortization of expected
performance shares and dividends on forfeited shares,
compensation expense was $6 million and the unamortized portion
remaining in stockholders equity at December 31, 2001
was $12 million.

In the EIAP and the 1999 LTIP, at December 31, 2001, there
were 4,344,054 options outstanding, of which 1,664,144 were
exercisable, with an exercise price range of $23.32 to $33.71,
and a weighted average remaining contractual life of
7.4 years. Additionally, there were 49,722 options
outstanding and exercisable, with an exercise price range of
$36.24 to $48.33, and a weighted average remaining contractual
life of 4.6 years. The changes in RJRs stock options
during 2001, 2000 and 1999 were:

|                             |  |         |            |          |  |         |       |          |  |         |            |          |  |   |       |  |  |  |           |   |  |   |       | 
|---------------------------- |  | ------- | ---------- | -------- |  | ------- | ----- | -------- |  | ------- | ---------- | -------- |  | - | ----- |  |  |  | --------- | - |  | - | ----- | 
|                             |  |         |            |          |  |        
|                             |  | 2001    |            | 2000     |  | 1999   
|                             |  |         |            |          |  |        
|                             |  |         |            | Weighted |  |         |       | Weighted |  |         |            | Weighted
|                             |  |         |            | Average  |  |         |       | Average  |  |         |            | Average 
|                             |  |         |            | Exercise |  |         |       | Exercise |  |         |            | Exercise
|                             |  | Options |            | Price    |  | Options |       | Price    |  | Options |            | Price   
|                             |  |         |            |          |  |         |       |          |  |         |            |         
|Balance at beginning of year |  |         | 6,096,570  |          |  | $       | 28.76 |          |  |         | 8,492,564  |          |  | $ | 28.43 |  |  |  |          |   |  | $ |      | 
|                            
|                            
|                            
|                            
|Options transferred in       |  |         |           |          |  |         |      |          |  |         |           |          |  |   |      |  |  |  | 5,456,114 |   |  |   | 28.02 | 
|                            
|                            
|                            
|                            
|Options granted              |  |         |           |          |  |         |      |          |  |         |           |          |  |   |      |  |  |  | 3,199,500 |   |  |   | 29.01 | 
|                            
|                            
|                            
|                            
|Options cancelled            |  |         | (220,000   | )        |  |         | 27.50 |          |  |         | (138,371   | )        |  |   | 27.52 |  |  |  |          |   |  |   |      | 
|                            
|                            
|                            
|                            
|Options exercised            |  |         | (1,482,794 | )        |  |         | 28.23 |          |  |         | (2,257,623 | )        |  |   | 27.58 |  |  |  | (163,050  | ) |  |   | 26.13 | 
|                             |  |         |            |          |  |         |       |          |  |         |            |          |  |   |       |  |  |  |           |   |  |   |       | 
|Balance at end of year       |  |         | 4,393,776  |          |  |         | 29.01 |          |  |         | 6,096,570  |          |  |   | 28.76 |  |  |  | 8,492,564 |   |  |   | 28.43 | 
|                             |  |         |            |          |  |         |       |          |  |         |            |          |  |   |       |  |  |  |           |   |  |   |       | 
|Exercisable at end of year   |  |         | 1,713,866  |          |  |         | 28.76 |          |  |         | 3,108,731  |          |  |   | 28.55 |  |  |  | 5,325,068 |   |  |   | 28.09 | 
|                             |  |         |            |          |  |         |       |          |  |         |            |          |  |   |       |  |  |  |           |   |  |   |       | 

75



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##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Compensation costs related to employee stock plans are measured
and expensed utilizing the intrinsic value based method. During
1999, the amortization of tandem restricted stock held was
recorded as compensation expense and, as a result, approximated
compensation expense had it been based on fair value.
Furthermore, related pro forma results would have approximated
those reported. During 2000, had compensation expense been based
on the fair value, net income would have been reduced by $3
million or $.03 per basic share and per diluted share. During
2001, had compensation expense been based on the fair value, net
income would have been reduced by $5 million or $.05 per basic
share and per diluted share. The impact of pro forma
compensation cost was based on fair value at grant date, using a
Black-Scholes methodology assuming a 5.96% risk-free interest
rate, a weighted average expected life of 4.2 years,
expected volatility of 33.0% and no dividend yield.

76



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##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Note 18  Retirement Benefits

RJR and its subsidiaries sponsor a number of non-contributory
defined benefit pension plans covering most employees, and also
provide certain health and life insurance benefits for retired
employees and their dependents. The changes in benefit
obligations and plan assets, as well as the funded status of the
pension plans at December 31 were:

|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |      |  
|--------------------------------------------------------------------- | -------------------------------------- | ---------------- | ----- | -------------- | - | ---- | ----- | ---- | - | - | ---- | ---- | - | - | ---- | ---- | -
|                                                                      |                                        |                  |       |                |   |     
|                                                                      |                                        |                  |       | Postretirement
|                                                                      |                                        | Pension Benefits |       | Benefits      
|                                                                      |                                        |                  |       |               
|                                                                      |                                        | 2001             |       | 2000           |   | 2001 |       | 2000
|                                                                      |                                        |                  |       |                |   |      |       |     
|Change in benefit obligation:                                         |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Obligation at beginning of year                                       |                                        | $                | 2,462 |                |   | $    | 2,270 |      |   | $ | 675  |      |   | $ | 589  |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Service cost                                                          |                                        |                  | 35    |                |   |      | 31    |      |   |   | 6    |      |   |   | 6    |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Interest cost                                                         |                                        |                  | 179   |                |   |      | 176   |      |   |   | 54   |      |   |   | 49   |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Actuarial loss                                                        |                                        |                  | 48    |                |   |      | 148   |      |   |   | 69   |      |   |   | 75   |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Plan amendments                                                       |                                        |                  | 6     |                |   |      | 5     |      |   |   |     |      |   |   |     |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Benefits paid                                                         |                                        |                  | (188  | )              |   |      | (190  | )    |   |   | (64  | )    |   |   | (50  | )   
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Settlements                                                           |                                        |                  | (13   | )              |   |      | (11   | )    |   |   |     |      |   |   |     |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Acquisition of NGH                                                    |                                        |                  |      |                |   |      | 33    |      |   |   |     |      |   |   | 6    |     
|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|Obligation at end of year                                             |                                        | $                | 2,529 |                |   | $    | 2,462 |      |   | $ | 740  |      |   | $ | 675  |     
|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|Change in plan assets:                                                |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Fair value of plan assets at beginning of year                        |                                        | $                | 2,260 |                |   | $    | 2,499 |      |   | $ |     |      |   | $ |     |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Actual return on plan assets                                          |                                        |                  | 1     |                |   |      | (156  | )    |   |   |     |      |   |   |     |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Employer contributions                                                |                                        |                  | 100   |                |   |      | 98    |      |   |   | 64   |      |   |   | 50   |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Benefits paid                                                         |                                        |                  | (188  | )              |   |      | (190  | )    |   |   | (64  | )    |   |   | (50  | )   
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Settlements                                                           |                                        |                  | (13   | )              |   |      | (11   | )    |   |   |     |      |   |   |     |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Acquisition of NGH                                                    |                                        |                  |      |                |   |      | 20    |      |   |   |     |      |   |   |     |     
|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|Fair value of plan assets at end of year                              |                                        | $                | 2,160 |                |   | $    | 2,260 |      |   | $ |     |      |   | $ |     |     
|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|Funded status:                                                        |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Funded status                                                         |                                        | $                | (369  | )              |   | $    | (202  | )    |   | $ | (740 | )    |   | $ | (675 | )   
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Unrecognized transition asset                                         |                                        |                  |      |                |   |      |      |      |   |   | (15  | )    |   |   | (21  | )   
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Unrecognized prior service cost                                       |                                        |                  | 9     |                |   |      |      |      |   |   |     |      |   |   |     |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|Unrecognized net actuarial loss                                       |                                        |                  | 379   |                |   |      | 117   |      |   |   | 169  |      |   |   | 109  |     
|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|Net amount recognized                                                 |                                        | $                | 19    |                |   | $    | (85   | )    |   | $ | (586 | )    |   | $ | (587 | )   
|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|Amounts recognized in the consolidated balance
    sheets consist of: |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|                                                                      | Accrued benefit liability              |                  | $     | (181           | ) |      | $     | (104 | ) |   | $    | (586 | ) |   | $    | (587 | )
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|                                                                      | Intangible asset                       |                  |       | 13             |   |      |       | 7    |   |   |      |     |   |   |      |     |  
|                                                                     
|                                                                     
|                                                                     
|                                                                     
|                                                                      | Accumulated other comprehensive income |                  |       | 187            |   |      |       | 12   |   |   |      |     |   |   |      |     |  
|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     
|Net amount recognized                                                 |                                        | $                | 19    |                |   | $    | (85   | )    |   | $ | (586 | )    |   | $ | (587 | )   
|                                                                      |                                        |                  |       |                |   |      |       |      |   |   |      |      |   |   |      |     

77



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


As of December 31, 2001, all of the pension plans
experienced accumulated benefit obligations in excess of plan
assets, for which the projected benefit obligation, accumulated
benefit obligation and fair value of plan assets were $2,529
million, $2,340 million and $2,160 million, respectively. As of
December 31, 2000, for the plans with accumulated benefit
obligations in excess of plan assets, the projected benefit
obligation, accumulated benefit obligation and fair value of
plan assets were $89 million, $76 million and $15 million,
respectively.

|                                           |                             |                  |      |                |   |      |      |      |   |      |      |      |  |   |    |    |  |   |    |    |  |   |    |    | 
|------------------------------------------ | --------------------------- | ---------------- | ---- | -------------- | - | ---- | ---- | ---- | - | ---- | ---- | ---- |  | - | -- | -- |  | - | -- | -- |  | - | -- | -- | 
|                                           |                             |                  |      |                |   |      |      |     
|                                           |                             |                  |      | Postretirement
|                                           |                             | Pension Benefits |      | Benefits      
|                                           |                             |                  |      |               
|                                           |                             | 2001             |      | 2000           |   | 1999 |      | 2001 |   | 2000 |      | 1999
|                                           |                             |                  |      |                |   |      |      |      |   |      |      |     
|Components of total benefit cost (income): |                             |                  |      |                |   |      |      |      |   |      |      |      |  |   |    |    |  |   |    |    |  |   |    |   
|                                          
|                                          
|                                          
|                                          
|Service cost                               |                             | $                | 35   |                |   | $    | 31   |      |   | $    | 39   |      |  | $ | 6  |    |  | $ | 6  |    |  | $ | 6  |   
|                                          
|                                          
|                                          
|                                          
|Interest cost                              |                             |                  | 179  |                |   |      | 176  |      |   |      | 169  |      |  |   | 54 |    |  |   | 49 |    |  |   | 44 |   
|                                          
|                                          
|                                          
|                                          
|Expected return on plan assets             |                             |                  | (220 | )              |   |      | (229 | )    |   |      | (195 | )    |  |   |   |    |  |   |   |    |  |   |   |   
|                                          
|                                          
|                                          
|                                          
|Amortization of transition asset           |                             |                  |     |                |   |      |     |      |   |      |     |      |  |   | (6 | )  |  |   | (6 | )  |  |   | (6 | ) 
|                                          
|                                          
|                                          
|                                          
|Amortization of prior service cost         |                             |                  | (3   | )              |   |      | (3   | )    |   |      | (3   | )    |  |   |   |    |  |   |   |    |  |   |   |   
|                                          
|                                          
|                                          
|                                          
|Amortization of net loss (gain)            |                             |                  | 2    |                |   |      | (7   | )    |   |      | 2    |      |  |   | 9  |    |  |   | 1  |    |  |   | 6  |   
|                                           |                             |                  |      |                |   |      |      |      |   |      |      |      |  |   |    |    |  |   |    |    |  |   |    |   
|Net periodic benefit cost (income)         |                             |                  | (7   | )              |   |      | (32  | )    |   |      | 12   |      |  |   | 63 |    |  |   | 50 |    |  |   | 50 |   
|                                          
|                                          
|                                          
|                                          
|Curtailment/special benefits               |                             |                  |     |                |   |      |     |      |   |      | 14   |      |  |   |   |    |  |   |   |    |  |   | 1  |   
|                                          
|                                          
|                                          
|                                          
|Settlements                                |                             |                  | 4    |                |   |      | 2    |      |   |      |     |      |  |   |   |    |  |   |   |    |  |   |   |   
|                                           |                             |                  |      |                |   |      |      |      |   |      |      |      |  |   |    |    |  |   |    |    |  |   |    |   
|                                           | Total benefit cost (income) |                  | $    | (3             | ) |      | $    | (30  | ) |      | $    | 26   |  |   | $  | 63 |  |   | $  | 50 |  |   | $  | 51 | 
|                                           |                             |                  |      |                |   |      |      |      |   |      |      |      |  |   |    |    |  |   |    |    |  |   |    |   

The weighted average actuarial assumptions used for the pension
and postretirement benefit plans as of December 31 were:

|                                       |  |      |       |      |  |  |       | 
|-------------------------------------- |  | ---- | ----- | ---- |  |  | ----- | 
|                                       |  | 2001 |       | 2000
|                                       |  |      |       |     
|Discount rate                          |  |      | 7.40% |      |  |  | 7.50% | 
|                                      
|                                      
|                                      
|                                      
|Expected return on pension plan assets |  |      | 9.50% |      |  |  | 9.50% | 
|                                      
|                                      
|                                      
|                                      
|Rate of compensation increase          |  |      | 5.00% |      |  |  | 5.00% | 

For measurement purposes, a 13% annual rate of increase in the
pre-65 per capita cost of covered health care was assumed for
the HMO plan for 2001. The rate was assumed to decrease to 9%
for 2002 and then decrease by 1% per year to an ultimate rate of
5%. The annual rate of increase for post-65 per capita cost of
covered care for the HMO plan was assumed to be 13% for 2001,
10% for 2002, decreasing 1% per year to an ultimate rate of 5%.
Additionally, for the indemnity plan, a 10% annual rate of
increase in the pre-65 per capita cost of covered health care
was assumed for 2001. The rate was assumed to decrease to 9% for
2002, 8% for 2003, then decrease by .5% per year to an ultimate
rate of 5%. The annual rate of increase for post-65 per capita
cost of covered care for the indemnity plan was assumed to be
12% for 2001, decreasing by 1% to an ultimate rate of 5%.
Assumed healthcare cost trend rates have a significant effect on
the amounts reported for the healthcare plans. A
one-percentage-point change in assumed healthcare cost trend
rates would effect:

|                                              |  |              |    |              |  |   |     |  
|--------------------------------------------- |  | ------------ | -- | ------------ |  | - | --- | -
|                                              |  | 1-Percentage |    | 1-Percentage
|                                              |  | Point        |    | Point       
|                                              |  | Increase     |    | Decrease    
|                                              |  |              |    |             
|Total of service and interest cost components |  | $            | 2  |              |  | $ | (2  | )
|                                             
|                                             
|                                             
|                                             
|Postretirement benefit obligation             |  |              | 36 |              |  |   | (31 | )

In connection with the NGH acquisition in 2000, plan assets and
benefit obligations attributable to certain former NGH employees
were transferred to RJR, which resulted in an increase in
pension plan assets of $20 million and an increase in pension
plan benefit obligations of $33 million. Postretirement benefit
obligations of $6 million were also acquired by RJR.

In connection with the reorganization in 1999, the assets and
liabilities of the Retirement Plan for Employees of RJR Nabisco,
Inc., referred to as the old plan, were split into two new
plans, one for employees

78



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


and former employees of RJR and its subsidiaries and the other
for employees and former employees of Nabisco and NGH. The split
of the assets and liabilities of the old plan was in accordance
to an agreement with the Pension Benefit Guaranty Corporation.
The PBGC agreement required contributions of $58 million in each
of the five years beginning in 1999, as well as contribution of
the RJR plans normal cost beginning in 2000 through the
end of the agreement. The agreement is expected to continue for
five years; however, there are certain circumstances under which
it could be extended.

In connection with the close-down of the New York headquarters,
special termination benefits were provided to employees
resulting in a 1999 one-time charge of $14 million for pension
benefits and $1 million for postretirement benefits.

RJR and its subsidiaries sponsor a qualified defined
contribution plan, and following a participants
contribution, match 50% based on a maximum of 6% of a
participants compensation. The expense related to this
plan was $12 million in each of 2001, 2000 and 1999.

Note 19  Segment Information

RJR has one reportable operating segment, RJR Tobacco, which
comprised more than 90% of RJRs total consolidated assets
at December 31, 2001 and substantially all of RJRs
consolidated income from continuing operations during 2001, 2000
and 1999. At December 31, 2001, the consolidated total
assets also included the remaining proceeds from the NGH
acquisition. The consolidated income from continuing operations
included corporate costs and interest income on the NGH proceeds.

RJR Tobacco manufactures and markets cigarettes in the United
States. During 2001, 2000 and 1999, sales made by RJR Tobacco to
McLane Company, Inc. and its affiliate, Wal-Mart Stores, Inc.,
comprised 20%, 19% and 17%, respectively, of RJRs
consolidated revenue. No other customer accounted for 10% or
more of RJRs consolidated revenue during those years.

79



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Note 20  Quarterly Results of Operations
(Unaudited)

|                                             |                                              |       |       |        |  |       |       |        |  |   |       |      |   |   |       |     | 
|-------------------------------------------- | -------------------------------------------- | ----- | ----- | ------ |  | ----- | ----- | ------ |  | - | ----- | ---- | - | - | ----- | --- | 
|2001                                         |                                              | First |       | Second |  | Third |       | Fourth
|                                             |                                              |       |       |        |  |       |       |       
|Net sales (1)                                |                                              | $     | 1,950 |        |  | $     | 2,269 |        |  | $ | 2,273 |      |   | $ | 2,093 |    
|                                            
|                                            
|                                            
|                                            
|Gross profit                                 |                                              |       | 1,113 |        |  |       | 1,293 |        |  |   | 1,357 |      |   |   | 1,262 |    
|                                            
|                                            
|                                            
|                                            
|Income from continuing operations            |                                              |       | 100   |        |  |       | 127   |        |  |   | 128   |      |   |   | 89    |    
|                                            
|                                            
|                                            
|                                            
|Discontinued operations, net of income taxes |                                              |       |      |        |  |       |      |        |  |   | (9    | )    |   |   |      |    
|                                            
|                                            
|                                            
|                                            
|Net income                                   |                                              |       | 100   |        |  |       | 127   |        |  |   | 119   |      |   |   | 89    |    
|                                            
|                                            
|                                            
|                                            
|Per share data (2):                          |                                              |       |       |        |  |       |       |        |  |   |       |      |   |   |       |    
|                                            
|                                            
|                                            
|                                            
|Basic:                                       |                                              |       |       |        |  |       |       |        |  |   |       |      |   |   |       |    
|                                            
|                                            
|                                            
|                                            
|                                             | Income from continuing operations            |       |       | 1.00   |  |       |       | 1.29   |  |   |       | 1.34 |   |   |       | .95 | 
|                                            
|                                            
|                                            
|                                            
|                                             | Discontinued operations, net of income taxes |       |       |       |  |       |       |       |  |   |       | (.10 | ) |   |       |    | 
|                                            
|                                            
|                                            
|                                            
|                                             | Net income                                   |       |       | 1.00   |  |       |       | 1.29   |  |   |       | 1.24 |   |   |       | .95 | 
|                                            
|                                            
|                                            
|                                            
|Diluted:                                     |                                              |       |       |        |  |       |       |        |  |   |       |      |   |   |       |    
|                                            
|                                            
|                                            
|                                            
|                                             | Income from continuing operations            |       |       | .98    |  |       |       | 1.26   |  |   |       | 1.31 |   |   |       | .93 | 
|                                            
|                                            
|                                            
|                                            
|                                             | Discontinued operations, net of income taxes |       |       |       |  |       |       |       |  |   |       | (.09 | ) |   |       |    | 
|                                            
|                                            
|                                            
|                                            
|                                             | Net income                                   |       |       | .98    |  |       |       | 1.26   |  |   |       | 1.22 |   |   |       | .93 | 




|                                             |                                              |  |       |     |  |  |       |      |  |  |       |      |  |  |       |       |  
|-------------------------------------------- | -------------------------------------------- |  | ----- | --- |  |  | ----- | ---- |  |  | ----- | ---- |  |  | ----- | ----- | -
|2000 (Restated)                              |                                              |  |       |     |  |  |       |     
|                                             |                                              |  |       |     |  |  |       |     
|Net sales (1)                                |                                              |  | 1,904 |     |  |  | 2,053 |      |  |  | 2,089 |      |  |  | 2,012 |      
|                                            
|                                            
|                                            
|                                            
|Gross profit                                 |                                              |  | 1,078 |     |  |  | 1,168 |      |  |  | 1,207 |      |  |  | 1,169 |      
|                                            
|                                            
|                                            
|                                            
|Income (loss) from continuing operations     |                                              |  | 80    |     |  |  | 109   |      |  |  | 117   |      |  |  | (7    | )    
|                                            
|                                            
|                                            
|                                            
|Discontinued operations, net of income taxes |                                              |  |      |     |  |  |      |      |  |  |      |      |  |  | 53    |      
|                                            
|                                            
|                                            
|                                            
|Extraordinary item, net of income taxes      |                                              |  |      |     |  |  |      |      |  |  |      |      |  |  | 1,475 |      
|                                            
|                                            
|                                            
|                                            
|Net income                                   |                                              |  | 80    |     |  |  | 109   |      |  |  | 117   |      |  |  | 1,521 |      
|                                            
|                                            
|                                            
|                                            
|Per share data (2):                          |                                              |  |       |     |  |  |       |      |  |  |       |      |  |  |       |      
|                                            
|                                            
|                                            
|                                            
|Basic:                                       |                                              |  |       |     |  |  |       |      |  |  |       |      |  |  |       |      
|                                            
|                                            
|                                            
|                                            
|                                             | Income (loss) from continuing operations     |  |       | .77 |  |  |       | 1.08 |  |  |       | 1.17 |  |  |       | (.07  | )
|                                            
|                                            
|                                            
|                                            
|                                             | Discontinued operations, net of income taxes |  |       |    |  |  |       |     |  |  |       |     |  |  |       | .53   |  
|                                            
|                                            
|                                            
|                                            
|                                             | Extraordinary item, net of income taxes      |  |       |    |  |  |       |     |  |  |       |     |  |  |       | 14.76 |  
|                                            
|                                            
|                                            
|                                            
|                                             | Net income                                   |  |       | .77 |  |  |       | 1.08 |  |  |       | 1.17 |  |  |       | 15.22 |  
|                                            
|                                            
|                                            
|                                            
|Diluted:                                     |                                              |  |       |     |  |  |       |      |  |  |       |      |  |  |       |      
|                                            
|                                            
|                                            
|                                            
|                                             | Income (loss) from continuing operations     |  |       | .77 |  |  |       | 1.07 |  |  |       | 1.16 |  |  |       | (.07  | )
|                                            
|                                            
|                                            
|                                            
|                                             | Discontinued operations, net of income taxes |  |       |    |  |  |       |     |  |  |       |     |  |  |       | .52   |  
|                                            
|                                            
|                                            
|                                            
|                                             | Extraordinary item, net of income taxes      |  |       |    |  |  |       |     |  |  |       |     |  |  |       | 14.58 |  
|                                            
|                                            
|                                            
|                                            
|                                             | Net income                                   |  |       | .77 |  |  |       | 1.07 |  |  |       | 1.16 |  |  |       | 15.03 |  









|    |                                                                                                                                                                                                                                          
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Adoption of EITF No. 00-14 required the classification of
    certain sales incentive costs as reductions of net sales, and
    also resulted in shifting a portion of those costs to other
    interim periods within the annual period.
|(2) | Income per share is computed independently for each of the
    periods presented. The sum of the income per share amounts for
    the quarters may not equal the total for the year.                                                     

Note 21  Condensed Consolidating Financial
Statements

Separate financial statements and other disclosures have not
been presented concerning RJR Tobacco and RJR Acquisition Corp.
because such information is not believed to be material to
holders of the exchange notes. RJR Tobacco and RJR Acquisition
Corp. are wholly owned subsidiaries of RJR, and have fully and
unconditionally guaranteed the exchange notes. Because the
guarantees are full and unconditional and joint and several, the
following condensed consolidating financial statements include:
the accounts and activities of RJR, the issuer of the debt
securities; RJR Tobacco and RJR Acquisition Corp., the
guarantors; other subsidiaries of RJR and RJR Tobacco that are
not guarantors; and elimination adjustments.

80



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Condensed Consolidating Statements of Income

(Dollars in Millions) (Unaudited)





|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |       |       | 
|------------------------------------------------------------------------- | --------------------------------------------------------- | ---------- | ------ | ---------- | ----- | -------------- | ----- | ------------ | ----- | ------------ | ----- | ----- | ----- | - | ------ | ------ | ------ | - | ----- | ----- | ----- | 
|                                                                          |                                                           | Issuer     |        | Guarantors |       | Non-Guarantors |       | Eliminations |       | Consolidated
|                                                                          |                                                           |            |        |            |       |                |       |              |       |             
|For the Year Ended December 31,
    2001                                  |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Net sales                                                                 |                                                           | $          |       |            |       | $              | 8,585 |              |       | $            | 50    |       |       | $ | (50    | )      |        | $ | 8,585 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Cost of products sold                                                     |                                                           |            |       |            |       |                | 3,607 |              |       |              | 3     |       |       |   | (50    | )      |        |   | 3,560 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Selling, general and administrative expenses                              |                                                           |            | 32     |            |       |                | 4,065 |              |       |              | (352  | )     |       |   |       |        |        |   | 3,745 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Amortization of trademarks and goodwill                                   |                                                           |            |       |            |       |                | 260   |              |       |              | 102   |       |       |   |       |        |        |   | 362   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Interest and debt expense                                                 |                                                           |            | 138    |            |       |                | 12    |              |       |              |      |       |       |   |       |        |        |   | 150   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Interest income                                                           |                                                           |            | (4     | )          |       |                | (129  | )            |       |              | (4    | )     |       |   |       |        |        |   | (137  | )    
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Intercompany interest (income) expense                                    |                                                           |            | (10    | )          |       |                | 274   |              |       |              | (264  | )     |       |   |       |        |        |   |      |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Intercompany dividend                                                     |                                                           |            | (1,632 | )          |       |                | (698  | )            |       |              |      |       |       |   | 2,330  |        |        |   |      |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Other expense (income), net                                               |                                                           |            | (3     | )          |       |                | 16    |              |       |              |      |       |       |   |       |        |        |   | 13    |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          | Income from continuing operations before
    income taxes |            |        | 1,479      |       |                |       | 1,178        |       |              |       | 565   |       |   |        | (2,330 | )      |   |       | 892   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Provision for (benefit from) income taxes                                 |                                                           |            | (51    | )          |       |                | 300   |              |       |              | 199   |       |       |   |       |        |        |   | 448   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Equity income from subsidiaries                                           |                                                           |            | 1,235  |            |       |                | 357   |              |       |              |      |       |       |   | (1,592 | )      |        |   |      |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          | Income from continuing operations                         |            |        | 2,765      |       |                |       | 1,235        |       |              |       | 366   |       |   |        | (3,922 | )      |   |       | 444   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Loss on sale of discontinued businesses, net of
    income taxes          |                                                           |            |       |            |       |                |      |              |       |              | (9    | )     |       |   |       |        |        |   | (9    | )    
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          |                                                           | Net income |        | $          | 2,765 |                |       | $            | 1,235 |              |       | $     | 357   |   |        | $      | (3,922 | ) |       | $     | 435   | 
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|For the Year Ended December 31, 2000
    (Restated)                       |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Net sales                                                                 |                                                           | $          |       |            |       | $              | 8,060 |              |       | $            | 48    |       |       | $ | (50    | )      |        | $ | 8,058 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Cost of products sold                                                     |                                                           |            |       |            |       |                | 3,483 |              |       |              | 3     |       |       |   | (50    | )      |        |   | 3,436 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Selling, general and administrative expenses                              |                                                           |            | 42     |            |       |                | 3,615 |              |       |              | (315  | )     |       |   |       |        |        |   | 3,342 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Amortization of trademarks and goodwill                                   |                                                           |            |       |            |       |                | 260   |              |       |              | 106   |       |       |   |       |        |        |   | 366   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Impairment charge                                                         |                                                           |            |       |            |       |                |      |              |       |              | 89    |       |       |   |       |        |        |   | 89    |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Other operating expense                                                   |                                                           |            |       |            |       |                | (3    | )            |       |              |      |       |       |   |       |        |        |   | (3    | )    
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Interest and debt expense                                                 |                                                           |            | 164    |            |       |                | 4     |              |       |              |      |       |       |   |       |        |        |   | 168   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Interest income                                                           |                                                           |            | (1     | )          |       |                | (111  | )            |       |              | (7    | )     |       |   |       |        |        |   | (119  | )    
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Intercompany interest (income) expense                                    |                                                           |            | (11    | )          |       |                | 394   |              |       |              | (383  | )     |       |   |       |        |        |   |      |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Intercompany dividend                                                     |                                                           |            | (238   | )          |       |                | (861  | )            |       |              |      |       |       |   | 1,099  |        |        |   |      |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Other expense (income), net                                               |                                                           |            | 6      |            |       |                | 26    |              |       |              | (1    | )     |       |   |       |        |        |   | 31    |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          | Income from continuing operations before
    income taxes |            |        | 38         |       |                |       | 1,253        |       |              |       | 556   |       |   |        | (1,099 | )      |   |       | 748   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Provision for (benefit from) income taxes                                 |                                                           |            | (64    | )          |       |                | 317   |              |       |              | 196   |       |       |   |       |        |        |   | 449   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Equity income from subsidiaries                                           |                                                           |            | 2,825  |            |       |                | 360   |              |       |              |      |       |       |   | (3,185 | )      |        |   |      |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          | Income from continuing operations                         |            |        | 2,927      |       |                |       | 1,296        |       |              |       | 360   |       |   |        | (4,284 | )      |   |       | 299   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Income from discontinued operations                                       |                                                           |            |       |            |       |                | 53    |              |       |              |      |       |       |   |       |        |        |   | 53    |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          | Income before extraordinary item                          |            |        | 2,927      |       |                |       | 1,349        |       |              |       | 360   |       |   |        | (4,284 | )      |   |       | 352   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Extraordinary itemgain (loss) on
    acquisition, net of taxes           |                                                           |            | (1     | )          |       |                | 1,476 |              |       |              |      |       |       |   |       |        |        |   | 1,475 |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          |                                                           | Net income |        | $          | 2,926 |                |       | $            | 2,825 |              |       | $     | 360   |   |        | $      | (4,284 | ) |       | $     | 1,827 | 
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|For the Year Ended December 31,
    1999                                  |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Net sales                                                                 |                                                           | $          |       |            |       | $              | 7,412 |              |       | $            | 56    |       |       | $ |       |        |        | $ | 7,468 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Cost of products sold                                                     |                                                           |            |       |            |       |                | 3,283 |              |       |              | 9     |       |       |   |       |        |        |   | 3,292 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Selling, general and administrative expenses                              |                                                           |            | 43     |            |       |                | 3,184 |              |       |              | (303  | )     |       |   |       |        |        |   | 2,924 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Amortization of trademarks and goodwill                                   |                                                           |            |       |            |       |                | 260   |              |       |              | 106   |       |       |   |       |        |        |   | 366   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Headquarters close-down and related charges                               |                                                           |            | 143    |            |       |                |      |              |       |              |      |       |       |   |       |        |        |   | 143   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Other operating expense                                                   |                                                           |            |       |            |       |                | 21    |              |       |              |      |       |       |   |       |        |        |   | 21    |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Interest and debt expense                                                 |                                                           |            | 267    |            |       |                | 1     |              |       |              |      |       |       |   |       |        |        |   | 268   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Interest income                                                           |                                                           |            | (4     | )          |       |                | (85   | )            |       |              | (25   | )     |       |   |       |        |        |   | (114  | )    
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Intercompany interest (income) expense                                    |                                                           |            | (393   | )          |       |                | 620   |              |       |              | (227  | )     |       |   |       |        |        |   |      |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Other expense (income), net                                               |                                                           |            | (67    | )          |       |                | 7     |              |       |              | 118   |       |       |   |       |        |        |   | 58    |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          | Income from continuing operations before
    income taxes |            |        | 11         |       |                |       | 121          |       |              |       | 378   |       |   |        |       |        |   |       | 510   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Provision for (benefit from) income taxes                                 |                                                           |            | (16    | )          |       |                | 163   |              |       |              | 168   |       |       |   |       |        |        |   | 315   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Equity income from subsidiaries from continuing
    operations            |                                                           |            | 168    |            |       |                | 209   |              |       |              |      |       |       |   | (377   | )      |        |   |      |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          | Income from continuing operations                         |            |        | 195        |       |                |       | 167          |       |              |       | 210   |       |   |        | (377   | )      |   |       | 195   |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Income (loss) from discontinued operations                                |                                                           |            | (611   | )          |       |                | 1,162 |              |       |              | 1,847 |       |       |   |       |        |        |   | 2,398 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Equity income from subsidiaries from discontinued
    operations          |                                                           |            | 3,009  |            |       |                | 1,848 |              |       |              |      |       |       |   | (4,857 | )      |        |   |      |      
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          | Income before extraordinary item                          |            |        | 2,593      |       |                |       | 3,177        |       |              |       | 2,057 |       |   |        | (5,234 | )      |   |       | 2,593 |      
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Extraordinary itemloss on early
    extinguishment of debt, net of taxes |                                                           |            | (250   | )          |       |                |      |              |       |              |      |       |       |   |       |        |        |   | (250  | )    
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      
|                                                                          |                                                           | Net income |        | $          | 2,343 |                |       | $            | 3,177 |              |       | $     | 2,057 |   |        | $      | (5,234 | ) |       | $     | 2,343 | 
|                                                                          |                                                           |            |        |            |       |                |       |              |       |              |       |       |       |   |        |        |        |   |       |      




81



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Condensed Consolidating Statements of Cash Flows

(Dollars in Millions) (Unaudited)


|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |        |        |  
|--------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------- | -------------------------------------------------- | ----- | ---------- | ---- | -------------- | ----- | ------------ | ------ | ------------ | ---- | ------ | ------ | - | ------ | ----- | ----- | - | ------ | ------ | ------ | -
|                                                                                                                                              |                                                                      | Issuer                                             |       | Guarantors |      | Non-Guarantors |       | Eliminations |        | Consolidated
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |             
|For the Year Ended December 31,
    2001                                                                                                      |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|Cash flows from operating activities                                                                                                          |                                                                      | $                                                  | 1,003 |            |      | $              | 895   |              |        | $            | 420  |        |        | $ | (1,692 | )     |       | $ | 626    |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash flows from (used in) investing activities:                                                                                               |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Short-term investments                                               |                                                    |       |           |      |                |       | (207         | )      |              |      |       |        |   |        |      |       |   |        | (207   | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Intercompany notes receivable                                        |                                                    |       | (5         | )    |                |       | (9           | )      |              |      | 281    |        |   |        | (267  | )     |   |        |       |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Other, net                                                           |                                                    |       |           |      |                |       | (85          | )      |              |      | (15    | )      |   |        |      |       |   |        | (100   | )     
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                              |                                                                      | Net cash flows from (used in) investing activities |       |            | (5   | )              |       |              | (301   | )            |      |        | 266    |   |        |       | (267  | ) |        |        | (307   | )
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash flows from (used in) financing activities:                                                                                               |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Repurchase of common stock                                           |                                                    |       | (494       | )    |                |       |             |        |              |      |       |        |   |        |      |       |   |        | (494   | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Dividends paid on common stock                                       |                                                    |       | (320       | )    |                |       | (994         | )      |              |      | (698   | )      |   |        | 1,692 |       |   |        | (320   | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Repayments of long-term debt                                         |                                                    |       | (73        | )    |                |       |             |        |              |      |       |        |   |        |      |       |   |        | (73    | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Proceeds from exercise of stock options                              |                                                    |       | 45         |      |                |       |             |        |              |      |       |        |   |        |      |       |   |        | 45     |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Intercompany notes payable                                           |                                                    |       | 15         |      |                |       | (290         | )      |              |      | 8      |        |   |        | 267   |       |   |        |       |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                              |                                                                      | Net cash flows used in financing activities        |       |            | (827 | )              |       |              | (1,284 | )            |      |        | (690   | ) |        |       | 1,959 |   |        |        | (842   | )
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Net change in cash and cash equivalents                                                                                                       |                                                                      |                                                    | 171   |            |      |                | (690  | )            |        |              | (4   | )      |        |   |       |       |       |   | (523   | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|Cash and cash equivalents at beginning of year                                                                                                |                                                                      |                                                    | 14    |            |      |                | 2,424 |              |        |              | 105  |        |        |   |       |       |       |   | 2,543  |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash and cash equivalents at end of year                                                                                                      |                                                                      | $                                                  | 185   |            |      | $              | 1,734 |              |        | $            | 101  |        |        | $ |       |       |       | $ | 2,020  |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|For the Year Ended December 31,
    2000                                                                                                      |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|Cash flows from operating activities                                                                                                          |                                                                      | $                                                  | 615   |            |      | $              | 641   |              |        | $            | 432  |        |        | $ | (1,098 | )     |       | $ | 590    |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash flows from (used in) investing activities:                                                                                               |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Short-term investments                                               |                                                    |       |           |      |                |       | 109          |        |              |      | 1      |        |   |        |      |       |   |        | 110    |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Intercompany notes receivable                                        |                                                    |       | 2          |      |                |       | 34           |        |              |      | 811    |        |   |        | (847  | )     |   |        |       |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Net proceeds from acquisition                                        |                                                    |       |           |      |                |       | 1,519        |        |              |      |       |        |   |        |      |       |   |        | 1,519  |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Other, net                                                           |                                                    |       | (5         | )    |                |       | (50          | )      |              |      | (1     | )      |   |        |      |       |   |        | (56    | )     
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                              |                                                                      | Net cash flows from (used in) investing activities |       |            | (3   | )              |       |              | 1,612  |              |      |        | 811    |   |        |       | (847  | ) |        |        | 1,573  |  
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash flows from (used in) financing activities:                                                                                               |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Repurchase of common stock                                           |                                                    |       | (231       | )    |                |       |             |        |              |      |       |        |   |        |      |       |   |        | (231   | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Dividends paid on common stock                                       |                                                    |       | (322       | )    |                |       | (238         | )      |              |      | (860   | )      |   |        | 1,098 |       |   |        | (322   | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Repayments of long-term debt                                         |                                                    |       | (387       | )    |                |       |             |        |              |      |       |        |   |        |      |       |   |        | (387   | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Intercompany notes payable                                           |                                                    |       | 1          |      |                |       | (470         | )      |              |      | (377   | )      |   |        | 846   |       |   |        |       |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Other, net                                                           |                                                    |       | 238        |      |                |       | (164         | )      |              |      | (16    | )      |   |        | 1     |       |   |        | 59     |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                              |                                                                      | Net cash flows used in financing activities        |       |            | (701 | )              |       |              | (872   | )            |      |        | (1,253 | ) |        |       | 1,945 |   |        |        | (881   | )
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                              |                                                                      | Net cash flows related to discontinued operations  |       |            | 103  |                |       |              | (19    | )            |      |        |       |   |        |       |      |   |        |        | 84     |  
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Net change in cash and cash equivalents                                                                                                       |                                                                      |                                                    | 14    |            |      |                | 1,362 |              |        |              | (10  | )      |        |   |       |       |       |   | 1,366  |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|Cash and cash equivalents at beginning of year                                                                                                |                                                                      |                                                    |      |            |      |                | 1,062 |              |        |              | 115  |        |        |   |       |       |       |   | 1,177  |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash and cash equivalents at end of year                                                                                                      |                                                                      | $                                                  | 14    |            |      | $              | 2,424 |              |        | $            | 105  |        |        | $ |       |       |       | $ | 2,543  |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|For the Year Ended December 31,
    1999                                                                                                      |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|Cash flows from operating activities                                                                                                          |                                                                      | $                                                  | 138   |            |      | $              | 518   |              |        | $            | 273  |        |        | $ |       |       |       | $ | 929    |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash flows from (used in) investing activities:                                                                                               |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Net proceeds from the sale of the international
    tobacco business |                                                    |       | (35        | )    |                |       | 2,611        |        |              |      | 5,184  |        |   |        |      |       |   |        | 7,760  |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Short-term investments                                               |                                                    |       |           |      |                |       | (109         | )      |              |      | (1     | )      |   |        |      |       |   |        | (110   | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Other, net                                                           |                                                    |       |           |      |                |       | (55          | )      |              |      | (19    | )      |   |        |      |       |   |        | (74    | )     
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                              |                                                                      | Net cash flows from (used in) investing activities |       |            | (35  | )              |       |              | 2,447  |              |      |        | 5,164  |   |        |       |      |   |        |        | 7,576  |  
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash flows from (used in) financing activities:                                                                                               |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Repayments of long-term debt                                         |                                                    |       | (4,450     | )    |                |       |             |        |              |      |       |        |   |        |      |       |   |        | (4,450 | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Intercompany transfer                                                |                                                    |       | 5,216      |      |                |       | (881         | )      |              |      | (4,335 | )      |   |        |      |       |   |        |       |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Proceeds from issuance of long-term debt                             |                                                    |       | 1,244      |      |                |       |             |        |              |      |       |        |   |        |      |       |   |        | 1,244  |       
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Transfers and payments to former parent                              |                                                    |       | (1,968     | )    |                |       |             |        |              |      |       |        |   |        |      |       |   |        | (1,968 | )     
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                              | Other, net                                                           |                                                    |       | (185       | )    |                |       |             |        |              |      |       |        |   |        |      |       |   |        | (185   | )     
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                              |                                                                      | Net cash flows used in financing activities        |       |            | (143 | )              |       |              | (881   | )            |      |        | (4,335 | ) |        |       |      |   |        |        | (5,359 | )
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash flows related to discontinued operations
    (including income taxes paid on the gain on sale of the
    international tobacco business) |                                                                      |                                                    |      |            |      |                | (982  | )            |        |              | (987 | )      |        |   |       |       |       |   | (1,969 | )     
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|                                                                                                                                              |                                                                      | Net change in cash and cash equivalents            |       |            | (40  | )              |       |              | 1,102  |              |      |        | 115    |   |        |       |      |   |        |        | 1,177  |  
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|                                                                                                                                             
|Cash and cash equivalents at beginning of year                                                                                                |                                                                      |                                                    | 40    |            |      |                | (40   | )            |        |              |     |        |        |   |       |       |       |   |       |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       
|Cash and cash equivalents at end of year                                                                                                      |                                                                      | $                                                  |      |            |      | $              | 1,062 |              |        | $            | 115  |        |        | $ |       |       |       | $ | 1,177  |       
|                                                                                                                                              |                                                                      |                                                    |       |            |      |                |       |              |        |              |      |        |        |   |        |       |       |   |        |       

82



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)


Condensed Consolidating Balance Sheets

(Dollars in Millions)


(Unaudited)





|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |        | 
|---------------------------------------- | ------------------------------------------ | ------ | ------ | ---------- |  | -------------- | ------ | ------------ |  | ------------ | ----- | ----- |  | - | ------- | ------- | - | - | ----- | ------ | 
|                                         |                                            | Issuer |        | Guarantors |  | Non-Guarantors |        | Eliminations |  | Consolidated
|                                         |                                            |        |        |            |  |                |        |              |  |             
|December 31, 2001                        |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                        
|                                        
|                                        
|                                        
|Assets                                   |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                        
|                                        
|                                        
|                                        
|Cash and cash equivalents                |                                            | $      | 185    |            |  | $              | 1,734  |              |  | $            | 101   |       |  | $ |        |         |   | $ | 2,020 |       
|                                        
|                                        
|                                        
|                                        
|Short-term investments                   |                                            |        |       |            |  |                | 207    |              |  |              |      |       |  |   |        |         |   |   | 207   |       
|                                        
|                                        
|                                        
|                                        
|Other current assets                     |                                            |        | 95     |            |  |                | 2,055  |              |  |              | 37    |       |  |   | (486    | )       |   |   | 1,701 |       
|                                        
|                                        
|                                        
|                                        
|Trademarks, net                          |                                            |        |       |            |  |                |       |              |  |              | 2,773 |       |  |   |        |         |   |   | 2,773 |       
|                                        
|                                        
|                                        
|                                        
|Goodwill, net                            |                                            |        |       |            |  |                | 6,875  |              |  |              |      |       |  |   |        |         |   |   | 6,875 |       
|                                        
|                                        
|                                        
|                                        
|Intercompany notes receivable            |                                            |        | 146    |            |  |                | 14     |              |  |              | 3,822 |       |  |   | (3,982  | )       |   |   |      |       
|                                        
|                                        
|                                        
|                                        
|Investment in subsidiaries               |                                            |        | 10,585 |            |  |                | 5,772  |              |  |              |      |       |  |   | (16,357 | )       |   |   |      |       
|                                        
|                                        
|                                        
|                                        
|Other noncurrent assets                  |                                            |        | 65     |            |  |                | 1,497  |              |  |              | 16    |       |  |   | (32     | )       |   |   | 1,546 |       
|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                         | Total assets                               |        | $      | 11,076     |  |                | $      | 18,153       |  |              | $     | 6,749 |  |   | $       | (20,857 | ) |   | $     | 15,122 | 
|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|Liabilities and stockholders
    equity |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                        
|                                        
|                                        
|                                        
|Tobacco settlement and related accruals  |                                            | $      |       |            |  | $              | 1,520  |              |  | $            |      |       |  | $ |        |         |   | $ | 1,520 |       
|                                        
|                                        
|                                        
|                                        
|Other current liabilities                |                                            |        | 664    |            |  |                | 1,080  |              |  |              | 14    |       |  |   | (486    | )       |   |   | 1,272 |       
|                                        
|                                        
|                                        
|                                        
|Intercompany notes payable               |                                            |        | 69     |            |  |                | 3,905  |              |  |              | 8     |       |  |   | (3,982  | )       |   |   |      |       
|                                        
|                                        
|                                        
|                                        
|Long-term debt (less current maturities) |                                            |        | 1,534  |            |  |                | 97     |              |  |              |      |       |  |   |        |         |   |   | 1,631 |       
|                                        
|                                        
|                                        
|                                        
|Other noncurrent liabilities             |                                            |        | 783    |            |  |                | 947    |              |  |              | 974   |       |  |   | (32     | )       |   |   | 2,673 |       
|                                        
|                                        
|                                        
|                                        
|Stockholders equity                     |                                            |        | 8,026  |            |  |                | 10,604 |              |  |              | 5,753 |       |  |   | (16,357 | )       |   |   | 8,026 |       
|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                         | Total liabilities and stockholders equity |        | $      | 11,076     |  |                | $      | 18,153       |  |              | $     | 6,749 |  |   | $       | (20,857 | ) |   | $     | 15,122 | 
|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|December 31, 2000                        |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                        
|                                        
|                                        
|                                        
|Assets                                   |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                        
|                                        
|                                        
|                                        
|Cash and cash equivalents                |                                            | $      | 14     |            |  | $              | 2,424  |              |  | $            | 105   |       |  | $ |        |         |   | $ | 2,543 |       
|                                        
|                                        
|                                        
|                                        
|Other current assets                     |                                            |        | 7      |            |  |                | 2,221  |              |  |              | 54    |       |  |   | (954    | )       |   |   | 1,328 |       
|                                        
|                                        
|                                        
|                                        
|Trademarks, net                          |                                            |        |       |            |  |                |       |              |  |              | 2,875 |       |  |   |        |         |   |   | 2,875 |       
|                                        
|                                        
|                                        
|                                        
|Goodwill, net                            |                                            |        |       |            |  |                | 7,303  |              |  |              |      |       |  |   |        |         |   |   | 7,303 |       
|                                        
|                                        
|                                        
|                                        
|Intercompany notes receivable            |                                            |        | 141    |            |  |                | 5      |              |  |              | 4,103 |       |  |   | (4,249  | )       |   |   |      |       
|                                        
|                                        
|                                        
|                                        
|Investment in subsidiaries               |                                            |        | 11,957 |            |  |                | 6,117  |              |  |              |      |       |  |   | (18,074 | )       |   |   |      |       
|                                        
|                                        
|                                        
|                                        
|Other noncurrent assets                  |                                            |        | 69     |            |  |                | 1,429  |              |  |              | 6     |       |  |   | 1       |         |   |   | 1,505 |       
|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                         | Total assets                               |        | $      | 12,188     |  |                | $      | 19,499       |  |              | $     | 7,143 |  |   | $       | (23,276 | ) |   | $     | 15,554 | 
|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|Liabilities and stockholders
    equity |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                        
|                                        
|                                        
|                                        
|Tobacco settlement and related accruals  |                                            | $      |       |            |  | $              | 1,394  |              |  | $            |      |       |  | $ |        |         |   | $ | 1,394 |       
|                                        
|                                        
|                                        
|                                        
|Other current liabilities                |                                            |        | 1,307  |            |  |                | 993    |              |  |              | 36    |       |  |   | (954    | )       |   |   | 1,382 |       
|                                        
|                                        
|                                        
|                                        
|Intercompany notes payable               |                                            |        | 54     |            |  |                | 4,195  |              |  |              |      |       |  |   | (4,249  | )       |   |   |      |       
|                                        
|                                        
|                                        
|                                        
|Long-term debt (less current maturities) |                                            |        | 1,576  |            |  |                | 98     |              |  |              |      |       |  |   |        |         |   |   | 1,674 |       
|                                        
|                                        
|                                        
|                                        
|Other noncurrent liabilities             |                                            |        | 815    |            |  |                | 843    |              |  |              | 1,009 |       |  |   | 1       |         |   |   | 2,668 |       
|                                        
|                                        
|                                        
|                                        
|Stockholders equity                     |                                            |        | 8,436  |            |  |                | 11,976 |              |  |              | 6,098 |       |  |   | (18,074 | )       |   |   | 8,436 |       
|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       
|                                         | Total liabilities and stockholders equity |        | $      | 12,188     |  |                | $      | 19,499       |  |              | $     | 7,143 |  |   | $       | (23,276 | ) |   | $     | 15,554 | 
|                                         |                                            |        |        |            |  |                |        |              |  |              |       |       |  |   |         |         |   |   |       |       




Note 22  Subsequent Events

On January 7, 2002, in connection with its agreement with
the PBGC as of May 20, 1999, RJR accelerated its expected
required contributions to the pension plan for 2002 and 2003. As
a result, the PBGC cancelled its $116 million letter of credit
required of RJR.

On January 16, 2002, RJR completed its acquisition of Santa
Fe Natural Tobacco Company, Inc. by acquiring 100% of Santa
Fes privately held voting stock for $340 million in cash,
subject to post-closing adjustments. Santa Fe is a wholly owned
operating subsidiary of RJR, and results of its operations
subsequent to the acquisition will be included in RJRs
consolidated financial statements.

On February 6, 2002, RJRs board of directors
authorized the repurchase of up to $1 billion of RJRs
common stock over time in the open market, to enhance
stockholder value. This program will be funded by dividends from
RJR Acquisition Corp. utilizing the cash proceeds of the NGH
acquisition and from cash provided by operating activities. The
timing of repurchases and the number of shares purchased under
this authorization will depend upon market conditions.

83



---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
(Continued)





Note 23  Restatement







During December 2003, RJR discovered a misclassification in the
2000 consolidated financial statements related to changes in RJR
Tobaccos tax exposure reserves between continuing
operations and gain on sale of discontinued businesses. In order
to reflect the appropriate classifications, RJR is restating its
2000 consolidated statement of income and portions of notes 2,
7, 12, 20 and 21 to the consolidated financial statements as
they relate to certain 2000 information. The restatement had no
effect on net income, net income per share or cash flows for the
year ended December 31, 2000, or the balance sheet as of
December 31, 2000, and no effect on any consolidated financial
statements for 2001. The effect of the reclassification in the
2000 consolidated statement of income is shown below.







|                           |                                                                  |                                        |     |            |  |             |    |       |   |   |     |      | 
|-------------------------- | ---------------------------------------------------------------- | -------------------------------------- | --- | ---------- |  | ----------- | -- | ----- | - | - | --- | ---- | 
|                           |                                                                  | As Previously                          |     |            |  |            
|                           |                                                                  | Reported                               |     | Adjustment |  | As Restated
|                           |                                                                  |                                        |     |            |  |            
|                           |                                                                  |                                       
|                           |                                                                  | (Dollars in Millions, Except Per Share
|                           |                                                                  | Amounts)                              
|                          
|                          
|                          
|                          
|Provision for income taxes |                                                                  | $                                      | 396 |            |  | $           | 53 |       |   | $ | 449 |     
|                          
|                          
|                          
|                          
|                           | Income from continuing operations                                |                                        |     | 352        |  |             |    | (53   | ) |   |     | 299  | 
|                          
|                          
|                          
|                          
|Discontinued operations:   |                                                                  |                                        |     |            |  |             |    |       |   |   |     |     
|                          
|                          
|                          
|                          
|                           | Gain on sale of discontinued businesses, net of
    income taxes |                                        |     |           |  |             |    | 53    |   |   |     | 53   | 
|                          
|                          
|                          
|                          
|Basic income per share:    |                                                                  |                                        |     |            |  |             |    |       |   |   |     |     
|                          
|                          
|                          
|                          
|                           | Income from continuing operations                                |                                        |     | 3.48       |  |             |    | (0.52 | ) |   |     | 2.96 | 
|                          
|                          
|                          
|                          
|                           | Gain on sale of discontinued businesses                          |                                        |     |           |  |             |    | .52   |   |   |     | 0.52 | 
|                          
|                          
|                          
|                          
|Diluted income per share:  |                                                                  |                                        |     |            |  |             |    |       |   |   |     |     
|                          
|                          
|                          
|                          
|                           | Income from continuing operations                                |                                        |     | 3.46       |  |             |    | (0.52 | ) |   |     | 2.94 | 
|                          
|                          
|                          
|                          
|                           | Gain on sale of discontinued businesses                          |                                        |     |           |  |             |    | 0.52  |   |   |     | 0.52 | 




84



---



##### 






PART IV







Item 14.  Exhibits, Financial Statement
Schedules, and Reports on Form 8-K







(a) The following documents are filed as a part of this report:









| |     |                                                                                            
| | --- | -------------------------------------------------------------------------------------------
| | (1) | Consolidated Statements of Income for the years ended December
    31, 2001, 2000 and 1999.







Consolidated Statements of Cash Flows
for the years ended December 31, 2001, 2000 and 1999.







Consolidated Balance Sheets as of
December 31, 2001 and 2000.






| |     |                                                                                                                                                                          
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |     | Consolidated Statements of Stockholders Equity and
    Comprehensive Income for the years ended December 31, 2001, 2000
    and 1999.                                   
|
|
|
| | (2) | Financial Statement Schedules have been omitted because the
    information required has been separately disclosed in the
    consolidated financial statements or notes.
|
|
|
| | (3) | See (c) below.                                                                                                                                                           
|




(b) No reports on Form 8-K were filed during the year ended
December 31, 2001.







(c) The following exhibits are filed as part of this report:







|        |      |  |  |                                                                                                                                                                                                                                                                   |  | 
|------- | ---- |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | 
|Exhibit |      | 
|Number  |      | 
|        |      | 
|        | 23.1 |  |  | Consent of Independent Auditors.                                                                                                                                                                                                                                 
|        | 31.1 |  |  | Certification of Chief Executive Officer relating to RJRs Annual Report on Form 10-K for the period ended December 31, 2001.                                                                                                                                    
|        | 31.2 |  |  | Certification of Chief Financial Officer relating to RJRs Annual Report on Form 10-K for the period ended December 31, 2001.                                                                                                                                    
|        | 32.1 |  |  | Certification of Chief Executive Officer and Chief Financial Officer relating to RJRs Annual Report on Form 10-K for the period ended December 31, 2001, pursuant to Section 18 U.S.C. §1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




85



---



##### 









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.









| |                                     
| | ------------------------------------
| | R.J. REYNOLDS TOBACCO HOLDINGS, INC.







Dated: March 9, 2004









| |     |                        
| | --- | -----------------------
| | By: | /s/ ANDREW J. SCHINDLER







| |                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------
| | Andrew J. Schindler 
     Chairman of the Board, President, 
          Chief Executive Officer and
    Director









| |     |                   
| | --- | ------------------
| | By: | /s/ DIANNE M. NEAL







| |                                                                                     
| | ------------------------------------------------------------------------------------
| | Dianne M. Neal 
     Executive Vice President and 
          Chief Financial Officer




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