Tobacco Documents Online

SI~.CURITIFS AND EXCHANGE COMMISSION Washington, D.C, 20549 Form 10-K ANNUAl, REPORT PURSUANT 10 SFXgTION 13 OR 15(d) OF Till,; SECURn'IES EXCIIANGE A~-~T OFi1934 I,br tile Fiscal "ll.ar F.nded June 30, 1985 Conlmission File No. 2-88812 ADVAN CED TOBACCO PRODUCTS, INC. (ExacI name of reglstnmt as sp0clfied in it~ charter) Slate 6f l~xas (Slate or other jurisdiction of ilIcorl~rallon Or orgarlizatiort) 121 Interparg Boulevard, Suite 108 San Antonio, Texas 78216 (Addlc~ of principal e×ccutivc offic©s) (Zip Code) R¢~istranI's telephone number, including area code: (512) 496-9994 74-2285214 (I.RS F.nzployer Identification NO,) SeCurities registered pursuant to Seclioa 12(h] of the Act: Nolle Se, euritics registered pursuant to Section 12(g) of the Act: Oanlrnon ~qtoek, $~1 par ~lue Warrants to purcha'.e (k',nunon Stock (Tglc of Class) Indicateh'c c, cktuark'~het er heregIsra t(1) a~l'~eda re|~r..req redttabe fiedb~'Se¢ on 5 or IS(d) of file S~urilies Exchange A¢I of 1934 d~lring Ihe preceding 12 month~ tar for such sllorter periled ~hal tile regi~iraul was requh'ed to file such relmrts], and (2) has been subjecl It~ ~ueh filing requir~ment~ for the 1~1 90 days "~, ~ No • As ol Augtl'~t 30, 1985 the aggregate irlarket ~afiie of the voling stock held b) na~l-affiliates of {he rel~i~trant ~a~ appr(~xfomleiy $51,9791922. A'; of 8epl~nlhel¸ 20, ] 98S, tile nlllnher of outslanding shares tff (!t ~nlllloll ~loek, sg.gl par value fol¸ ~,~1~ II nt'ed lobacco I'r~duct~ ~ras 7,083,890.

ITEM ]. Bug]nest. Advanced Tobacco Products, Part I Inc., the Company, has developed a smoke-free tobacco product (the "FAVOR Smoke-Free Cigarettedr) w has the appearance and feel and provideE a sensation sJmi]ar to a conventional C~garette, but which delivers nicot±ne satlsfactJon to the user by inhalation of nicotine vapor in a manner not requiring the combustion of tobacco. The Company intends to market FAVOR as a pleasurable nicotin p~oduct and not as a product intended to discourage or reduce smoking or to hav~ therapeutic benefits. The Company believes me users of the smoke-free cigarette will be smokers of conventional cigarettes who wish to enjoy the inhalation of nicotine in smoki restricted environments. Development of the smoke-free cigarette was commenced in 1977 by Mr. J. P. Ray, President of the Company. During 1978 and 1979 medical tests were performed regarding the nicotine delivered by the smo~e-free cigarette. In 1978 MI. Ray applied for a United States patent and a number of foleiqn patents intended to cover the technology underlylilg the smoke-free clgarette. A United States patent relating to the FAVOR Smoke-Free Cigarette was issued on August 18, 1981 and e/even foreign patents were subsequently issued (four ad- ditional foreign patents are pendlng). The Company was formed in April, 1983, under the name S. A. Vend, inc., which was c~anged to Advanced Tobacco Pioduets, Inc. in January, ]984. On September ]9, ]983, the -2-

Company entered into an agreement with NCC Group, Ltd., a p~*tne~ship formed by Mr. Ray in August, 1982 to finance the development and testing of the smoke-free cigarette, under which the Company has acquired the technology relating to the smoke-free cigarette and other nicotine products and the United States and foreign patents and patent applications relating to such technology. Unless the context requires other- wise, all references to the "Company" include NCC ~ Ltd. Group, Mr. Ray and other previous owners of the patents and technology acqulred by the Company through NCC Group, Ltd. During thd period since inception the Company's activities have consisted o~ product development, development of manufacturing capacity, clinical and consumer testing, and the development of promotional and advertising plans. During the period from inception in April, 1983, through June 30, 1985, the Company had an accumulated net loss of $I,818,130. The Company does not anticipate that it will have significant sales until after September of 1985 when the initial co~ercial introduction of its smoke-free cigarette will occur. Furthermore, the Company antlcipates that its operations could result in decreases in its cash for at least the next 12 months. GENERAL DESCRIPTION OF THE PRODUCT The FAVOR Smoke-Free Cigarette consists essentially of an active surface contalning a nicotlne solution blended with carriers and f]avorants inserted within a small tube having the shape, weight and size of a conventional cigarette. When the user draws air through the smoke-free c/gazette a small amount of nicotine vapor is emitted into the air inhaled by the user. The smoke-free -3-

cigarette includes a plastic tube, a porous plastic element which contains the nicotine and flavorlng and is wrapped with conventlonal cigarette t~pping paper. The nicotine solution used Jn the smoke-free olgarette is blended wlth flavorants for the purpose of approximating the flavors of leading brands of "regular", "menthol", and "light" conventional cigarettes. These flavorants are available to the Company from suppliers of flavorants to the eonventlonal cigarette industry. The nicotine inhaled from the smoke-free cigarette is not derived from the combustion of tobacco as is the case with a conventional cigarette; the user inhales none of the carbon monoxide or tars produced by tobacco combustion which the United States S~rgeon General has determined may cause cancer and increase the risk of heart disease. In addition, use of the smoke-free cigarette does not expose the user or others to the smoke and the related odor associated with the use of conventional cigarettes and, as a result, may be enjoyed where conventional cigarette smoking is prohlbited or ~s socially unacceptable. The Company intends to market the sMoke-free cigarette as a pleasurable nicotine product and not as a product intended to discourage or reduce smoking or to have therapeutic benefits. The Company believes that the Surgeon General's determination that cigarette smoking ls dangerous to smokers' health and the legal and social trend toward the protection of non-smokers from the effects of cigarette smoke have created a market for a product that delivers nlcotine in a form and manner similar to that enjoyed by smokers of conventional • cigarettes while avoiding the principal negative effects of cigarette smoking. -4~

Th~ Company is not aware of any currently available product which provides the conventional cigarette smoker with a means of enjoying the inhalation of nicotine in circumstances in which conventional cigarette smoking is illegal or socially unacceptable. Consequently, the Company believes that its smoke-free cigarette is a unique alternative for conventional cigarette smokers who desire nicotlne inhalation pleasure without negative social consequences or legal restrictions. The Company intends to initially offer the smoke-free cigarettes in packs of six at a retail price approximately the same as, or slightly less than, a pack of twenty conventional cigarettes. Each pack of six smoke-free cigarettes will have a nicotine delivery capacity intended to satisfy the average smoker of conventional cigarettes for an entire day. Because the nicotine delivery capacity of a smoke-free cig- arette is determined primarily by the amount of nicotine it contains, a single smoke-free cigarette can be manufactured with the nicotine delivery capacity of several cigars or conventional clgarettes. However, because the smoke-free cigarette Is more efficient as a means of nlcotlne delivery than are cigars and conventional cig- arettes, a smoke-free cigarette can be manufactured to deliver an amount of nicotine equivalent to several conventional cigarettes or cigars while containlng only an amount of nicotine comparable to that contained in a single cigarette of some brands of conventional cigarettes and less than Js contained in most cigars. The Company expects initially to manufacture the smoke-free cigarette in a form such that each normal "puff" on a FAVOR Smoke-Free Cigarette will deliver an amount of vaporlzed nicotine which1 the Company believes is within a range of amounts of nicotine delivered by a normal puff on -5-

MARKETING The Company believes that most users of the smoke-free cigarette w±ll be current smokers of conventional cigarettes who wish to reduce their health concerns el to enjoy nicotine in environments where smoking is ferbidden el w~en others may De offended by conventional cigarrette smoke and odor• The number of conventional cigarette smokers who will pur- chase and use the smoke-free cigarette on a sustained basis, however, cannot be reliably estimated. Nevertheless, the Company believes that lts profitability will not require a large percentage penetration of the conventional c~garette market because an independent study indicates % that in 1982 there~were approximately 56 million American smokers smoklng approximately 633 billion conventional cigarettes at a retail cost of approximately $23.4 ballion ( and that in 1981 more than four trillion conventional cigarettes were manufactured worldwide]. EGC Assoelates, Inc., an independent market research firm retained by lhe Company, completed a study of consumer acceptance of the smoke-free cigarette involving shopping mall intercept interviews in Los Angeles, Chicago, San Antonio, Oklahoma City and Columbus, Ohio. Of the 550 cagarette smokers interviewed after sampling the smoke-free cigarette, 44% indicated they would be "very likely" to purchase the smoke-free cigarette on a trial basls if it were available, 30% indicated they would be "somewhat likely" to do so, and 26% indicated that it was not too likely" that they would purchase the smoke-free cigarette on a trial basis. Of those interviewed, 12% indicated they would be willing to pay mole for "a days worth" of the smoke-free cigarette than for a pack of conventional cigarettes, 46% indicated they would pay the same -6-

amount, 41% indiGated they would pay slightly less than such amount, and 5% did hot know what they would pay. The study attempted to measure only the initial interest of consumers in the smoke-free cigarette and may not be indicative of a level of sustained acceptance of the smoke-free cigarette in the markets tested or in other markets. During 1985 the Company employed Moskow~tz & Jaoobs of valhalla, N.Y. Mr. Howard Moskowitz is a recognized authority on taste and sensory perception. Mr. Moskowitz conducted sever~l Focus Group Studies to define the taste for the Regular, Menthol, and Light smoke-free cigarettes. He also studled the purchase intent and his findings paralleled those of the original EGC study. The Company h~s developed its advertising and promotion plan with the assistance of an advertising and promotion firm. During 1984 & 1985 the Company continued consumer testing in order to further develop £ts advertislng and promotion program. Th~ introductlo~ of the smoke-free cigarettes to the retail market in selected major Texas cities will beg~n in September 1985 and then expand its market throughout the United States and selected Foreign countries consistent with its production and marketing capacity and results of its initial marketing. The Company anticipates two significant marketlng advantages not enjoyed by its conventional cigarette competitors. These are television and the uniqueness of its product. Television is believed to be the most cost-effec[ive means of mass consumer advertising for this product. Second, the Company believes that the introduction of its smoke-free clgarettes will require less promotion and advertising than is the ease in the introduction of new conventional cigarette brands or smokeless tobacco products because zhe FAVOR Smoke-Free Cigarette is a novel form of nicotine dellvery and therefore more likely to benefit from comsumer -7-

curiosity and word-of-mouth publicity. The Company believes that such publicity is likely to occur due to the continuing publicity regarding the health risks of smoking and legal restrletlons on smoking in public places, publicity surrounding the recent introduction of Dew Chemical Co~pany of its N~oorette nicotine chewing gum~ and publicity normally associated wlth newly introduced novel consumer products. The Company's strategy of area by area introduction of the smoke-free cigarette is intended to help control its adve~tisihg and promotional cost by allowing the Company to concentrate its initlal advertising in select key markets in order to initiate its anticipated word-of-mouth advantage. The Company p~ans to introduce its smoke-free c~garette through a multi-media advertising program emphasizing television advertising, but also including magazine, newspaper and outdoor billboard advertising. This program has been developed by the Company with the assistahce of its advertising agency, The Richards Group, Inc. of Dallas. The Company's strategy will be to dlstribute its smoke-free cigarettes through the same retail outlets through which conventional cigarettes are sold. The Company anticipates selling directly to supermarkets, drug stores, and tobacco wholesalers through brokers. The Company expects that tobacco who]esalels will re-distribute the smoke-free cigarettes to restaurants. newsstands and other retailers of tobacco products. The Company does not anticlpate any significant delay or difficulties in establishing Satis- factory distribution relationships because the Company believes, based on management's experience with the introductlon of other consumer products, that demand by brokers and tobacco wholesalers for now consumer product is sufficient to facilitate the wholesale and retail distrlbution of the anticipated quantltJes o~ the smoke-free cigarette. -8-

COMPETITION The Company believes that its principal competitors will be manufacturers of conventional cigarettes, Most, if not all, of which have financial, promotional, advertising, manufacturing and other resources substantially in excess of the Company's• The Company's ability to finance promotional activities is small when compared with such large and experienced competltors. However, because the smoke-free cigarette is a novel concept in the ~eligery of nicotine satisfaction, the Company believes that the promotional and adver- tls~ng costs required to introduce its product will be substantially less than the cgsts normally incurred in the introduction of a conventional cig~ette brand into the highly competitive conventional cigarette market. The Company believes the use of television advertislng will also provide the Company with a competitive advantage over conventional cigarette manufacturers who are pro- hibited by the Federal Cigarette Labeling and Advertising Act from advertising conventional cigarette products on television. Further, since the Company anticipates that the direct man~fact~rlng costs of a pack of smoke-free cigarettes wlll be no greater than a pack of conventional cigarettes with less nicotine delivery capacity, the Company anticipates that it will be able to offer a substantial cost per unit advantage to the consumer, if necessary, for competitive purposes, because of the heavy tax component of the retail price of conventional cigarettes. The Company intends, however, initially to sell packs of six FAVOR Smoke-Free Cigarettes at approximately the same factory price as most packs of 20 conventional cigarettes• • In addltion to other factors, the Company anticipates that it wlll enjoy a direct manufacturing cost advantage over manufacturers of -9-

conv~ntial is less complicated, resulting in a smaller skilled labor among manufacturing personnel handling and storage of tobacco will not be olgarettcs because the Company's manufacturing equipment percentage of and because costly required. The Company believes that the smoke-free cigarette is competitive with conven- tional cigarettes because the smoke-free cigarette can often be used in situations in which smoking conve~tional cigarettes is undesirable or prohibited. In addition, although th4 Company does not clmim that the smoke-free cigarette possesses any t~erapeutio benefits, the public may percelve the smoke-free cigarette to be less harmful than conventional cigarettes. In addition kS manufacturers of conventional cigarettes, the Company will be competing w~th manufacturers of conventional smokeless tobacco products such as chewing tobacco add snuff, and of alternative nicotine delivery products such as Dew Chemical Company's Nicorette nicotine chewing gum, many, ~f not all, of which also have financial, promotional, advertising, manufacturing and other resources far greater than those of the Company. The Company may also experience substantial competition from manu- facturers of future nicotine delivery products similar to the smoKe-free cigarettes unless the Company is able successfully to assert patent infringement actions with respect to such products. MANUFACTURING While the smoke-free cigarette resembles a conventional cigarette, it consists of a plastic tube, a plastic element, with which the nieotiDe has been impregnated, and conventional cigarette tipplng paper. The individual units are then hermetically pouched in a barrier ~10-

mat~xial with a gold foil-like appearance. This pouch 16 then boxed Jn a conventional hinged lid box with six units in each pack. The pack is then overwrapped with polypropolene clear film and a tear tape ~s added. The packs are cartoned in groups of ten with sixty cartons comprising a master case. All processing involving raw nicotine, loading agents and flavorings can be done off-line and is being performed in a separate facility, thereby reducing the risk of a plant shutdown in the ca~e ofian aoeldental spill or other such oecurence. In addition, handllng'of the chemlcal elements in this manner will ensure a very clean environment In the actual assem- bling and packaging process. The product development and manufacturing operations currently occupy approximately 12,000 square feet. This space is adequate for both labor- atory and office areas for Manufacturing, Product Development and for two operational production lines which the Company currently has ~n place. The projected direct manufacturing cost of a pack of Favor smoke-free cigarettes is approximately $.16 when volume dictates full utilization of the machinery on a two-shift basis. The utilization of two lines running a two-shift operation will produce approximately 4,560,000 packs of smoke-free cigarettes per month. The cost of modifying, refurbishing and making operational the pro- duction line utilizing the various machines discussed above is approx- imately $500~000 per production line. PATENTS AND TRADEMARKS The Company is the owner of United States Patent No, 4,284,089, which was issued on August 18, 1981, and will expire on August i~, ]998. This patent relates to the technology underlying the smoke-free cigarette. The Company has been advised by its patent eout%sel that -]l-

the product which it intends to market, as well as The process which it intends to use in manufacturing its product, does not infringe any known existing patent rights of other parties. Three additional United States patent applications have been filed in the ordinary course of the Company's research and develop- ment activities with regard to nicotine delivery. The Company cannot predict whether any particular patent appl~ed for will be granted, i The Company is also the owner of patents issued by eleven for- eJgn countries paralleling its United States patent. The Company intends to seek additional foreign patents in selected countries paralleling currently pending United states patent applications. The Company is not able to determine at this time whether its patents or those which may eventually be issued from pending applications will secure long-term competitive advantages for the Company. None of the Company's patent rights have been liti- gated or subjected to judicial scrutiny, and the Company belleves that many courts have been unsympathetic to the holders of patents relating to relatively simple inventions such as the smoke-free cigarette in patent infringement actions seeking to assert such patents. Therefore, if the Company's patent rights are tested in litigation, there can be no assurance that patent rights affording substantial competitive protection to the Company will be upheld or that such rlghts would prevent the marketing of competing products similar in concept to the FAVOR Smoke-Free Cigarette. Therefore it is possible that if a competitor could demonstrate significant d~fference Detween the form of a competing product or the related manufacturing process and the smoke-free cigarette; -]2-

the Company would not be able to prevent the competitor from marketing such a product. The Company intends vlgorously to defend its patent rights agalnst infringement by competitors, but the Company's limited resources may make it difficult or impossible to sustai~ any such defenses, ~owever meritorious. The Company has obtained from the Unlted States Patent and Trademark Office a registration of the trademark '~FAVOR" for use in connection with its smoke-free cigarette. ~n addition, the Company holds five foreign reglstrations for the trademark "FAVOR" and has twenty-six pending foreign trademark applications. GOVERNMENTAL R~GULATION AND TAMATION General Governmental regulation and taxation of tobacco products, including cigarettes, generally oonslsts of the television advertising prohibitions and labeling requirements of the Federal Cigarette Labeling and Advertising Act and similar state statutes or regulations, and federal and state cigarette excise taxes. The Company believes that its smoke-free cigarette ks not subject to significant state or federal governmental regulation or taxatioN. The Company's belief, however, is based upon the opinion of its counsel, Matthews & Branscomb, San Antonio, Texas, and, to the extent such opinions relate to matters wlthin the jurisdiction of or relating to the FDA, its special FDA counsel Burditt & Calkins, Washington, D.C., generally to the effect sun~arized below. Such opinlons are based primarily upon s~¢h counsels' literal interpretation of several significant statutes and regulations applicable to cerbain tobacco products, but which do not specifically include or exclude the Smoke-Free -13-

Cigarette as a regulated or specially taxed product. Such opinions are not binding upon any court or governmental agency and the Company has not sought any ruling or determination, nor is it aware of a[*y controlling precedents under any such statutes or regulations. FDA Cigarette Regulation Although tobacco products are not specifically excluded from the provisions of the Federal Food, Drug and ~osme£ic Act (the "FDC Act"), the Food and Drug Administra£ion (the "FDA") has refused to assert 3urisdiction over conventional Cigarettes by maintaining th~ position that the FDC Act does not apply to cigarettes containing nicotine or nicotine separately. The FDA'S position was affirmed in 1980 by the United States Court of Appeals for the District of Columbia Circuit in Action on Smoking and Health v. Harris. It is Managements belief that the FDA's position with regard to tobacco products has been modified only when a maIlufacturer of a tobacco product claims that its product is thera- peutically or medicinally beneficial as well as pleasurable or when the users of the product intend therapeutic or medicinal effects. The Company does not claim any therapeutic or medicinal effects from the use of the smoke-free cigarette nor does it intend to market the FAVOR Smoke-Free Cigarette claimin9 any such effects. The Company does not believe that use of the smoke-free cigarette, unlike the use of conventional cigarettes, will increase the user's rlsk of lung disease or cancer because the smoke-free cigarette does not contain any of the ingredients that the Surgeon General has concluded ~ncrease such risks, but the Company does believe that use of the smoke-free cJgarette will not leduce the user's rlsk of lung disease or cancer or -14-

have a therapeutic or medicinal effect on any user suffering such a condition. Nevertheless, users of the smoke-free cigarette may believe the smoke-free cigarette has therapeutic or medicinal effects which could increase the risk that the FDA could take the position that the smoke-free cigarette is subject to the FDC Act, and, in any event, the FDA may determine, based on statements by the Company or any other relevant evidence, that the smoke-free cigarette ks subject to FDA approval and regula%iono~ The term "drug," as defined in the FDC Act, includes "articles (other than food) intended to affect the structure or any function ~f the body .... Although cigarettes and the nicotine delivere~ thereby do affect certain body functions, in 1953 the United States Court of Appeals for the Second Circuit in F.T.C.v. Llgett & Myers Tobacco Co., construed the Federal Trade Commission Act, which employs an identical definition of "drug," so as to exclude conventional cigarettes from such definition. In reaching this conclusion, the Oourt relied upon the legislative history of the FDC Act and admiN- zstrative interpretation of the Federal Trade Commission Act. The court noted that while cigarettes and the nicotine delivered thereby might be deemed to have a "soothing" effect on the body, it was doubtful that Congress intended for every substance which produces a soothing effect to be considered a ~'drug" for regulatory purposes. Because of the foregoing, the Company does not believe the smoke-free cigarette will be subject to FDA regulation. Hewever~ there is a possibility that the FDA could consider the FAVOR Smoke- Free Cigarette to be a "drug" under the FDC Act, and while the Com- -15-

pany would vigorously oppose and appeal such a determination, it is possible that the Company would be unsuccessful In its Opposition and appeal. Under the FDC ACt, a "new drug" must be the subject of an approved new drug application in order to move lawfully in interstate coJ~lerce. The Company has ~ot filed a notice of claimed investigational exemption for a new drug or a new drug application for the smoke-free cigarette. Should FDA regulation i be imposed, introductlon of the smoke-free cigarette into the United States market could be delayed for an indefinite period pending testing by the Company to demonstrate the safety and effectiveness 6f the product. In addition, should FDA regulation f be imposed, the'~ompany may fail to obtain the FDA approval that would be needed to conduct approprlate tests or the Company may otherwise fail to obtain approval of a new drug application. Any FDA approval of the smoke-free elgarette could be conditioned upon restrictions materially adverse to the Company's marketing efforts, such as a requirement that a prescription be obtained for each purchase of smoke-free cigarettes. If the smoke-free cigarette is marketed in interstate commerce under such circumstances without an approved application, the Company could be in violation of the FDC Act and such violation could result in seizure of the the product, injunctions and criminal penalties. FDA Smoking Deterrent Regulation ................................ The most recently publlshed FDA action regarding smoking rel- ated products has been its proposal in 1982 of rules on Smoking Deterrent Drug Products• The proposed rules would establish cond- itions under which over-the-counter smoking deterrent' products would -]6-

generally be recognized as safe and effective and not misbranded. These rules do not purport to regulate nlcotine, but are intended to regulate those products which claim to deter or reduce smoking. If these proposed rules become effective and if the smoke-free cigarette were advertised or marketed as a product to ~educe or or deter smoking, the Company would be required to conform to the labeling and testing requirements of these rules as finally adopted. The Company intends, however, to market the smoke-free cigarette as a pleasurable nicotine product and not as a pr6duot intended to reduce or deter smoking. Therefore, the Company does not believe that the smoke-free clgarette would be subject to the FDA'S pro- posed rules. Nevertheless, the FAVOR Smoke-Free Cigarette may be deemed to De subject to the proposed rules because of user perceptions of the effect of the product. Taxation of Cigarettes Under the Internal Revenue Code The Infernal Revenue Code of 1954, as amended (the "Code"), and the regulations promulgated thereunGer by the Bureau of AlcohOl, Tobacco and Firearms (the "SATE") generally deal with the taxation of the manufacture and sale of cigarettes and cigars. Smoking tobaceo~ chewing tobacco and snuff are exclHded from taxatlon by deflnltJons contained in the Code and by specific BATE regulatlon, The Code and BATF regulation definition of a 'Pcigarette" iDcludes a product which is a "roll of tobacco" wrapped in paper or other substances. Because the smoke-free cigarette contains a nicoti~e sol~tlon instead of a "roll of tobacco," the Company believes that it is not a "cigarette" as defined by the Code and BATF regulatlons. In a ruling (ATF Rullng 78-2) attempting to clarlfy the deflnition of t'ciqarette" under the Code and BATF Regulatlons, the BATF held -17-

that "a clgarette-style smoking product which contains no tobacco, tobacco-derived compo~ent or resin, nicotine or nicotine derivative is not a cigarette .... " Although the quoted languaqe could indi- cate that the BATF considers any cigarette-style smoking product which eoDtains nicotine to be a "cigarette" for such purposes, the BATF has not indicated by publlshed action known to the Company whether in its view a cigarette-style nlcotine product llke the smoke-free cigarette which is not smoked would'be a~clgarette as defined in the Code or HATF regulations. The Federal Cigarette Labeling and Advertising Act The labelln~ requirements and television advertising prohib- % itJons of the Federal Cigarette Labeling and Advertising Act (the "Advertising Act") apply only to cigarettes. The deflnltion of "cigarette" under the Advertlsing Act is identical to the "roll of tobacco" definitio~ of "cigarette" ~sed in the Code and the BATF regulations. The Federal Trade Commission, the fedsral agency [hlough which the Advertising Act is enforced, has not expressly ruled on the question of whether a clgarette-style product which contalns a tobacco derived component such as nicotine would be a "c~garette" as defined in the Advertlsing Act. Again, because the smoke-free cigarette contains a nicotine solution instead of a "roll of tobacco" and in the Company's opinion does not give rise to the health concerns addressed by the Advertising Act, the Company believes that the smoXe-free cigarette is not a "cigarette" as defined by the Advertlsing Act. However, because the smoke-free cigarette nicotlner has the appearance of a conventional olgarette and contains there can be no assurance that the FTC would concur with -18-

the Company~s posltlon. The Federal Hazardous Substances Act The Federal Hazardous Substances Act (the "Substanaes Act") provides the Consumer Product Safety Commission ("CPSC'~) with the authority to regulate the labeling, packaging, manufacturing and sale of products determined by the CPSC to be "hazardous substances" within the meaning of the S~hstanoes. A~t ~nd the regulations promulgated thereunder. The Substances Act specif- ically excludes "tobacco and tobacco products" from its scope. TO the Company's knowledge, the CPSC has not ruled on the question of whether nicotine or the smoke-free cigarette is a "tobacco product'' under the,Substances Act. The Company believes that because the nicotine used in the sm0ke-free cigarette is derived entirely from tobacco, the smoke-free olgarette Is a "tobacco product" not regulated under the Substances Act. State Regulation and Taxation State regulation of tobacco products generally consists of taxlng laws and regulatlons and the regulatlon of the use of tobacco products, primarily cigars and cigarettes. Although ~ost states tax all tobacco products, cigarettes and cigars are generally taxed at the highest rate. State statutes taking cigarettes and cigars arc believed by the Company to be generally inapplicable to sMoke-free cigarettes because definitions of th8 taxed product generally include "a roll of tobacco for smoking," without specifying nicotine alone as the relevant substance. However, to the Company's knowledge no state or municipal taxing authority has interpreted any such law or regulation in the -]9-

~p~clilc ~ont~xt of the smok~-freo clgarette~ The Company believes that the smoke-free cigarette will be generally subject to state and municlpal taxation as a smokeless tobacco product such as chewing tobacco and snuff. The use of tobacco smoking products is primarily regulated by state statutes and municipal ordinances prohibiting public smoking. The prohibitions in these state statutes and municipal ordinances generally proscribe "smoking tobac6o" i~ certain public places. The Company believes that the' state and municipal prohibitions are generally inapplicable to the use of its smoke-free cigarettes because such us~ does not involve "smoking." However, to the~Company's knowledge no prohibition on public smoklng has been interpreted in the specific context of the smoke-free cigarettes. Many states have enacted hazardous substance laws simllar to the federal Substances Act. TO the Company's knowledge these laws have not generally been enforced against tobacco or tobacco products, even when tobacco products are not specifically excluded as hazardous substances as is the case under the federal Substances Act. Texas, the state in which the Company intends to initially manufacture and market the FAVOR Smoke-Free Cigarette, has a hazardous substance law similar to the federal Substances Act, and which to the Company's knowledge has not been applied to tobacco or tobacco products. Unlike the Substances Act, however, there is no speclfic Texas statutory exclusion of tobacco or tobacco products. No Texas court or agency has interpre%ed Texas' hazardous substance law in the specific context of the smoke-free cigaxette. There can therefore be no assurance that -20-

Texas or any other state will a tobacco product. EMPLOYEES AS of June 30, 1985, the including elght officers, on0 consider the smoke-free cigarette Company had thirty-one employees, clerical employed in marketing, twelve employees including one supervisor in manufacturing, four laboratory personnel and six administrative clerical personnel.i The Company antl- cipates hiring additional managerial p~rso~nel ,in the areas of marketing and manufactuing. The Company expects to hire at least an additional 15 hourly manufacturing, shipping and maintenance employees per shift. < RES|ARCH AND DEVELOPMENT The Company conducts an ongoing research and development program pursuant to which it intends to improve its manufacturing processes and products and develop additional tobacco-related products. ITEM 2. PROPERTIES The Company owns tangible property consisting of lab equipment, offlee equipment, production equlpment and leasehold improvements with a cost totaling $i,225,662 located in San Antonio, Texas. ITEM 3. LEGAL PROCEEDINGS None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS -21-

(a) Market Information. The initial public offering of the Company's par value $0.01 eon~lon stock (the "Co,on Stock~') was completed on May 23, 1984, at a price of $6.50 per unit, (each "unit" consisting of one share of cor~non stock and one warrant, herelnafter referred to as the "Warrant," to purchase one-half share of Common Stock;. Units (ATPIU), common (ATPI), and warrants (~TPIW) have been authorized for quotation in the over-the-counter market under the National Association of Securities Dealers Automatic Quotation system ("NASDAQ~'] The following table sets forth the high and low % last price of the Company's Units, Cor~non Stock and Warrants reported for the fiscal periods indicated. The prices given are the last bld prices reported on NASDAQ. Bid prices represent prices between dealers, do not include retail markups, markdowns or cornmlssions, and may not represent actual transactions. -22-

UNITS EIGfl LOW COMMON STOCK HIGH LOW WARRANTS HIGH LOW (b; 1985 1985 1985 1985 FOURTH THIRD SECOND FIRST QUARTER QUARTER QUARTER QUARTER 12 3/8 I0 5/8 8 i/4 5 8 5 i/2 3 518 " 4 10 1/4 9 7 4 6 3/4 4 1/8 3 3 7/8 2 I/8 I 1716 Holders. --. .... 2_ There were approximately 462 the Company's 2 1 1/2 1/2 7/8 1/4 i/4 shareholders of record of Common stock at Septembor 20, 1985. [c) Divldends. The Company has not declared or paid any dividends on its Common Stock and currently intends for the foreseeable future to follow a policy of retainin~ earnings for use in its operatlons and expanslon of its business. 1984 FOURTH QUARTER 6 1/2 i/2 4 3/4 i/4 N/A N/A N/A N/A -23-

X'~E% ~. ~'f~w~cd.TF~lD "r'~.b!/x.b~CZAL DATA The following table sets forth for the indioated periods selected historical financial information for the Company. Such information is derived from the financial statements of the Company following page 48 hereof and should be read in conjunction with such financial statements, the related notes thereto, and the information included under Item 7, "Manag~ment's Discussion and • % Analysis of Financial Condition and Results of operations." 4 -24-

5ELECTED FZ~ANCIAL DATA ............................... Reven~es - i~terest ~nses N~t LOSS Ne~ DOSS Per Sh~e ~f Co~on $t~ck Wei~ht~ ~ver~e N~ber of Shares of wor~in~ ~api~a~ prcvi~d by (~sed i~l Operatable Cash D~viden~s -ncne paid Perio~: Total a~e~s b~nq-term dc~¢ TOtal s~areh~Id~r~' ~uity ~i,000 $ 7,120,89~ ~ ~,261,275 $4,2~1.275 $I,000 $ 7,575,7]i $ 6,$36~257 $6,~,257 0 ~ 0 £1.000 $ 7~5~5~794 $ 5.~21.6~7 $5,8~I,687

i¸ ~ i: i~ i iii '! '~ ITEM 7. MkNAGEMENT'S DISCUSSION AND ANALYSIS OF ~FINANCIAL ..................................................... ______ CONDITION AND RESULTS OF OPERATION ...................... ..........--. RESULTS OF OPERATIONS Preparatlon for manufacturing and marketing of the smoke-free cigarette along with slgnificant improvements in product engineering characterize operations for fiscal year 1985. The Company's revenues for the year,ended June 30, 1985 consisted of Inter%st of $639,246 com- pared with interest of $60,891 in 1984. The fncrease was the result of having the $7,000,000 proceeds from the initial public offering less fiscal year 19~5 expenditures available for the entire year of 1985. Expenses i~reased in 1985 to $2,344,560 from $173,707 in 1984 as a .I result of on golng product development and preparatlon for the manufac- turing and marketing of the Company s ~roduet in september of 1985. expense Q~S%~ted primarily oflsalaries, General and administrative consulting fees, and legal fees. The net Ioss of $1,705,314 in 1985 compares to an oprating loss of $112,816 in 1984. The company does not believe inflation has had any significant effect on its operations. LIQUIDITY AND CAPITAL RESOURCES During the period since inception, the Company's activlties have consisted of product development, development of manufacturing capaDillty, consumer testlng, and the development of promotional and advertising plans. Since inception in April, 1983 lhlough June 30, 1985 the Company had an accumulated net loss of $1,818,130. The Company's major sources of capital to date have been the net proceeds from a private placement of Common Stock in January, {984 of $220,000 and a public offering of Common Stock and Warrants'in May of 1984 with net proceeds of approximately $7,000.000. Primary -26. • i! Ii i~I ! ii

uses o~ capital have been the purchase o[ production equlpment for $993,149 and the financing of operating expenses of $2,344,860. The Company has working capital resources of approxl~ately $4,261,000 as of dune 30, 1985. The Company will purchase $9fi0~000 ~n manufacturing equipment in early 1986 and during the next two-year ~eriod, the Company plans to spend a mlnimum of Costs and market research. expenditures could increase AS indicated above, th~ Company anticipates eor~eroi~l of its initial product, FAVOR the smoke-free cigarette, and of revenue fro~ operations no earlier than Septmeber, 1985. $3,100,000 in advertising and promotional The Company's advertising and promotional substantially during the second year of work. introduction the receipt Accord- Jngly, the Comp~ly expects that its operations will continue to result in operating losses for at least the first six to twelve months of the current fiscal year. Furthermore, depending On market penetration, the Company anticipates that its operations could result in decrease in its cash until June 30, 1986. The Company anticipates that its current cash on hand will be sufficient to meet its projected cash reguiremenfs for at least the next twleve months. Expected levels of market penetration should allow the Company to maintain adequate cash balances. If the Company comme~ces its plan~ed expansion during the second half of the current fiscal year, and should anticlpated sales reven~os fail to materialize, the costs and expenses associated with such expan- sion COuld cause operatlng losses to continue and result in a cash short-fall. The amount of cash available and the degree of market penetration will be the governing factors in the speed with which the Company conducts its market expansion. To the extent that the Company's cash might be insufficient for any reason, the Company will endeavor to -27-

raise additional capital through bank borrowings, additional sales of equlty or other securities, or other means, but has not made any such arrangements with any third party. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following f~nancial statements and opinion are included in th~s ITEM 8 and may be found in the appendix of financial statements following page 48. Financial Statements Page ........................ opinion of Independent Public Accountants F-I Balance S~eets at June 30, 1985, and 1984. ~ F-2-3 Statements bf Loss for the years ended June 30, 1985, and 1984 and the period from April, 1983 (Date of Inceptlon) to June 30i 1985. F-4 Statements of Changes in Shareholders' P-5 Equity for the years ended June 30, 1985 and 1984 and for the period from April 1983 (Date of Inception) to June 30, 1983. Statements of Changes for the years ended June 30, 1985 and 1984 and the period from Aprii 1983 (Date of Inception) to June 30, 1983 and the period from 1983 {Date of Ineeption) to June 30, 1985. Notes to Financial Statements F-6 F-7-11 -28-

ITEM 9. DISAGREEMENT ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM i0. DIRECTORS AND EXECUTIVE OFFICERS OF ADVANCED ~BACCO PRODUCTS, INC. (a) Directors and Executive Officers Set forth below is certain information regarding the directors and executive officers of Advanced Tobacco Products, Inc. Position with Advanced Name Age Gerald R. Mazur~ 65 J. Philip Ray 50 Edmund G. vimond, Jr. 49 James D. Simonscn 45 James J. Harkness 47 Ira D. Hill 50 Gerald K. Hofer 42 William S. Paxton 41 Jack R. Crosby 57 Edward C, Gardere 52 Stan Richards 52 (h) Business Experience Tobacco Products, Inc. Chairman of the Board of Directors, Chief Executive Officer, and Director President and Director Vice Chairman of the Board of Directors, Chairman of the Marketing Committee and Director Executive ViCe President, Chief oporating Officer, Secretary and Director Vice President ° Marketing Vice President - Technology Vice President ° Finance, Treasurer Vice President - Manufacturing D~ rector Director Director Mr. Mazur, age 65, has been Chairman aild Chief Executive Officer of the Company since April, 1983. Mr, Mazur was a founder -29-

and director Of Datapoint Corporation of San Antonio, Texas~ a manufacturer of electronic data processing systems, and was employed by Datapoint Corporation in various capacities from 1968 to 1971, including Chairman of its Board of Directors and Chief Executive Officer. Since 1971, Mr. Mazur has been an investor in and sponsor of various real estate and oil and gas enterprises and is a partner in an independent insuzance brokezage film. Mr. Ray, age 50, has been President of the Company since January of 1984. Mr. Ray is the founder and general partner of NCC Group. Ltd, since 1977 has been engaged in research and development activities re- lating to the SmOke-Free Cigarette and other nicotine produc~s. Mr Ray was a founder and director of Batapoint Corporation and served as its President and Chief Operating Officer from 1968 to 1973. From 1973 until 1977, Mr. Ray was engaged in electronic data processing research and development. Prior to organizing Batapoint Corporation in 1968, M~. Ray was Program Manager of the Dynatronics Division of Genera/ Dynamzcs Corporation, Manager of Engineering for International Data Systems Corporation, and Project Engineer for Texas Instruments, Inc. Mr. Vimond, age 49, was the company's Chief Marketing Officer from August 1983 until April 1985 and has been Chairman of the Marketing Committee of the Board of Directors of the Company slnce April of 1985. Prior to joining the Company, Mr. Vimond was President and Chief Executive Officer of R.J. Eeynolds Tobacco International, Inc., from 1980 to 1982. In 1978 and 1979, Mr. Vimond was Group Vice Presld~nt of American cyanamid CorpocatoJn with responsibility for the marketing of household products. toi]etrlos and fragrances, ]neludi[Ig products sold under the brand names "Pine Sol", "Breok", "Old Spice", "Nina Ricoi", "Pierre Cardin", and "Cie." F2om 1970 to 1977, Mr. Vimond was employed primarily in consumer products -30-

marketing executive positions by various subsidiaries of Johnso~ & Johnson, Inc., including Personal Products Company of which he was President in 1976 and 1977. Personal Products Company manufactures and Sells feminine hygiene products under the brand names "Modess", "Stayfroe", and "Carefree". Since 1982, Mr. Vimond has "been a p]incipal in Lemont Consulting Group, a marketing and management consulting flrm in New York City. Mr, Si~onsen, age 45, has bee~ Vice President and Chief Executive Officer of the company since January, 1984 and was appointed to the Company's Board of Directors in June, 1984. Prior to Joining fhe Company, Mr. Si~lonsen was Vice President - Human Relations of Data- point Corporatlon Trom February, 1978 until DecemDer, 1983. From 1970 unt~ February, 1978 Mr. Simonsen was Director of Industrial Relations of Datapoint Corporation. Mr. Simonsen has extensive experience in exe0utive recruitment, compensation planning and corporate admlnistration. Mr. Harkness, age 47, has been Vice President of the Company since November 1984. Prlor to joining the Company, Mr. Harkness was Director of Marketing for National Convenience Stores, a 1100 store chain. He held various Marketing Merchandislng and Operation positions with the Walgreen Drug Co. for 19 years. Dr. Hall, age 50, has been a Vice President of the company since January, 1984. Prior to joining the Company Dr. Hill was Vice President, Technology, of ]nternational Flavors & Fragrances, Inc. from 1979 througN 1983, responsible for, among other matters, research and development of fragrance concentrates re* use in plastics. From 1974 to 1979, D[. Hill wa~ Research a~d D~velopme~t VlCe Preslde~t o~ International Flavors & Fragrances, Inc. From 1970 to ]974 Dr. Hill served as Manager, Research -31-

and Development, Environmental PlaNning, of Monsanto Industrlal Chemicals Co. Mr. Hofer, age 42, has been a Vice President of the Company since May, ]984. Prior to joining the Company, Mr. Hofer was Manager - Management Advlsory Services wlth Deloitte Haskins and Sells from'July 1981 until May 1984. Prior to entering the management consulting profession, Mr. Hofer was ChSef Financial Officer of the Biddle Company, a service company. Mr. Paxton, age 41, has been a V~ee President of the Company since August 1984. Prior to joining the Company, Mr. Paxton was Vice President of Operations at Florida Computer Graphics from February, 1982 until August, 1984. ~He was Vice President of OperatioNs at Digitex Systems from May, 1981 t~ August, 1982. Prior to May 1981, Mr. Paxton was employed by Datapoint Corporation where he established and operated new plant facil- ities in two Texas cities. Mr. Crosby, age 57, a director of the Company since January, 1984, is Chairman of The Rust Group an~ Managing General Partner of Rust Ventures, L. T. and Rust Capital, Ltd. for more than the last five years. Mr. Gardere, age 52, a director of the Company since December, ]983, has been Chairman of the Board of Directors and Chief Executlve Officer of Schneider, Selnet & Hickman, Inc., which served as the Repre- sentative of the Underwriters in the Company's recent stock offering, for more than the last five years. Mr. R~ehards, age 52, a director of the Company since December, 1983, has been President and Chief Executive Officer of The Richards Group, Inc., an advertising flrm of which he is the founder, fo~ more than the last five years. Directors are elected by the Company's shareholders for a -32-

term which continues unt~1 the next annual meeting of the Company's shareholders or until their respective successors are duly elected and qualified. The Company's officers are elected by the Board of Directors of the Company and hold office until their respective successors are duly electad and quallf~d. ITEM ]i. EXECUTIVE COMPENSATION Cas~* Compensation The following table sets forth the cash compensatlon paid to certain executive officers during the fiscal year ended J~ne 30, 1985. Name of Individual or Identity of group Gerald R. Mazur' J.P. Ray James D. $imonsen William Paxton Cash Capaclty Remuneration Chairman of the Board and $i00,000 Chief Executive Officer President and direotor 100,000 Executive Vice President and 86,740 Chief Operating Offfcer Vice President-Manufacturing 73,238 All executive officers as a group i~cluding the above (8 pGrsons) $530,000 Thc Company bel~eves that the aggregate i~cremental cost to it of the personal bsnefits does Not exceed 10% of the cash compensation paid tc any individual named in the table or, with respect to the group of all executive officers, 10% of the aggregate cash compensatlon paid to the members of such @roup. Directors Fees Directors who are not officers or employees of the Company are entitled to receive $50~ per Board meeting and certain travel eKp~nses for meetings of the Company's Board of Directors attended by them. Emplo~nent Agreements. -33~

The Company employs Gerald R. Mazur, J. P. Ray, Ira D. Mill and James D. SJmonsen under employment agreements expiring in 1987. These agreements provide that these employees of the Company shall receive the annual salaries indicated in the above cash compensation table as well as certain employee benefits. These agreements a~e terminable without cause by lhe Company upon the payment of three months' salary by the Company and contain confidentiality and non- competition provisions. The Company's agreement with Dr. Hill does not require his services full time, but provides that he must devote so much of his time to~the Company's business as may be reasonably necessary to carry out the specific assignments given him by the Company's President or Board of Directors and recognizes that he may spend in excess of 50% of his professional time o3 other business not competitive with the Company's nleotlne product business. Compensation Pursuant to Plans. ............................... (a) ATPI Incentive Stock Option Plan --.. ................................. On January 5, 1984, the Company's Board of Directors and shareholders adopted the Advanced Tobacco Products, Inc. 1984 Incentive Stock Option Plan (the "ATP Plan"), which authorizes the granting of stock options covering a maximum of 110,000 shares of Common Stock to officers and key management employees of the Company. The Board of Directors may grant optlons to eligible participants upon such terms as the Board of Directors may determine ~n its sole discretion, so long as consistent with the terms and purposes of the ATP Plan. Members of the Board of -34-

Directors are eliglble to participate in the ATP Plan provided they are employees and do not participate in the decision or vote of the Board of Directors conaerning the grant, purchase price, or other terms of any option of which they are a recipient. Under the ATP Plan, the exere/se price per share cannot be less than 100% (or 110% in the case of options granted to holders of ]0% or more of the then outstanding common Stock) of the fair • .% market value of the Companyds Common Stock as determlned by the Board of Directors on, and the exercise period for the option cannot exceed ten years from, the date the option is granted. An option granted under the ATP Plan may be exercised only after one ye~% of continued employment by the Company immediately following the date of grant of the option. Upon the first annual anniversary of bh~ date of grant, options shall be exercisable with respect to 25% of the underlying shares and thereafter options may become exercisable with respect £o no more than 25% of the underlying shares per year. Options granted under the ATP Plan are not transferable except by will or the laws of descent or distribution and arc exercisable only if the optionee, unless retirsd, deceased or disabled, is employeed by the Company at the time of eMercise. (b) $.A.Vend Incentive Stock option Plan In Aprll, 1983, the Company adopted its S.A. Vend, Inc. Incentive Stock option Plan (the "S.A. Vend Plan"). 1983 The terms of the S.A. Vend Plan are substantially the same as the ATP Plan except that options may be granted by the Board of Directors of ~he Company under the S.A. vend Plan w~thout -35-

restriction as to time of exercise and may be exerclsed within 90 days following termination of employment by the Company withou~ cause. The S.A. Vend Plan has been terminated except as to outstanding options covering 70,000 shares. (e) Nonqualifled Stock Options On August 16, 1984, the Company's Board of Directors adopted resolutions authorizing the granting by the~Board of Directors of stock options covering Co~on Stock to officers, key management employees, independent contractors providing services to the Company or Consultants of the Company. Under the resolutions, the exercise Pri~e per share cannot be less than 100% (or 110% in the case of options granted to holders of 10% or more of the then outstanding Common Stock) of the fair market value of the Company's Comalon Stock as determlned by the Board of Directors on, and the exercise perlod for the option cannot exceed ten years from, the date the option is granted. An Option granted under the nonqualified options may be exercised only after one year of continued assoc- iation wlth the Company immediately following the date of grant of the option. Upon the first annual anniversary of the date of grant, options shall be exercisable wlth respect to 25% of the underlying shares and thereafter options may become exercisable with respect to no more than 25% of the underlying shares per year. Options granted under the resolutions are not transferable except by wlll or the laws of descent or distribution and are exercisable only if the op[ionee, unless retired, deceased or disabled, is as~;oe~ated with the Company at the time of exercise whether as an employee, independent Contractor or consultant. -36L

Employee stock Purchase Plan On June 16, 1984 the Company's Board of Directors adopted a reso- lution authorizing an Employee Stock Purchase Plan within the meaning of section 423 of the Internal Revenue Code. The plan was approved by shareholders on November 13, 1984. Pursuant to the plan, Employees will be able to purchase common stock of the company, at a price less than the fair market value on the date of purchase, from funds • i accumulated through payroll deductions within (not more than) a 2?-month psriod from the effective date of any offering under the plan. Common stock Certificates will be issued after the expiration date of each such offering. Only Employees shall be eligible to purchase stock under the plan. All Employees of the Company shall be eligible as participants in its plan except for any such Employee who, immediately after the granting of an option, would own (or be deemed to own under the rules of Section 423(b} or 425(d) of the Code) stock of any and all classes possessing five percent (5%) or more of the total combined voting power or value of any and all classes of stock of the Company. If the effect o~ the granting of an option to an employee is such that his total stock ownership (as determined under Sections 423(b) (3) and 425(d) of the Code) equals or exceeds such five percent {5%] limitation, such option shal2 he entirely vold as if it had never been granted him. All eligible Employees shall have the same rights and privileges. Each offering under the plan shall specify the maximum number of shares available under such offering and the method of determining thc maximum number of shares which may be purchased pursuant to a~y offering by each participating employee, which shall bear uniform relationship to the basic or regular rate of compensatlon of all -37-

employees on the effective date of ~ueh offering, subject to any stated maxlmum number of shares that may be specified by the committee, and to the limitations described below. Pa~nent for shares of stock purchase by any participating employee pursuant to an offering shall be effected in installme~ts from funds accumulated through payroll deductions from the salary or wages paid to him by the Company, or as otherwise permitted by the Committee, under rules of uniform application over the time period specified in such offering, which time period shall terminate on or before the expiration date. All such payroll deductions shall require the prior authorization of the participating employees. The term an~ expiration date of each offering shall be specified in such offering, but in no event shall the expiration date of any offering be more than twenty-seven (27) months after the effe~tlve date of such offering. Notwithstanding any other provision be granted to any Employee which permits of the Plan, no option shall him to purchase stock pursuant to all unexplred efferings under all existing employee stock purchase plans of the Company accruing at a rate which exceeds at any time twenty-five thousand dollars ($25,000) of the fair market value of the stock (determined at the time such option is granted) during any calendar year Jn which such option is granted. The aggregate number of shares that may be sold pursuant to all offerings under the Plan shall not exceed 100,000 shares. The Board of Directors may amend its Plan except that shareholder approval must be obtained in order to increase the number of shares which may be optioned or to make any change in the Employees eliglble to participate in the plan. -3B-

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth certain information about the nominees, which i~cl~des all persons known by the Company to own more than 5% on the Common Stock ss of September 20, 1985, and all officers and directors of the Company as a group. Except as indloated, the Company believes that each of the below named i persons has sole voting and investment power with respect to the shares shown and owns the shares indicated beneficially and of record. Director Number Percent Name ~ Since of Shares of Class(1) J,P. Ray 1984 ]21 InterparE Blvd. Suite ]08 San Antonio, Texas 78216 Gerald R. Mazur(2) 1983 121 ]nterpark Blvd. Suite 108 San Antonio, Texas 78216 Jack R. Croshy(3) 1984 1300 Norwood Tower Austin, Texas 78701 Edmund G. Vimond, Jr. 1983 121 Interpark Bird. Suite 108 San Antonio, Texas 78216 James D. Simonsen(4) 1984 121 Interpark Blvd. Suite 108 Sa~ Antonio, Texas 78216 Edward C. sardere(5) 1984 2400 7nterfirst II Bldg. Dallas, Texas 75270 2,075,813 29.5% 586,994 8.1% 385,847 5.5% 93,600 1.3% 9,984 .1% 6,250 .]% Stan Richards(6) 1984 -39-

7557 Rambler ROad Dallas, Texas 75231 Officers ana directors as a group (ii persons)(7) 3,158,488 44.8% (i) Excludes 413,000 shares of common Stock covered .by out- standing options granted, an additional 167,000 shares of Common Stock reserved for issuance under the Company's incentive and non- qualified stock option plans, an additional 4;365 ~hares elected to be purchased by employees through the Employee Stock Purchase Plan of which an additional 95,835 have been reserved, 626,000 shares issuable upon exercise of th~ $7.00 per share Warrants included in the units issued pursuant to the~Company's public offering in May, 1984 ("Units"), and 200,000 shares iss~able upon exercise of Unit purchase warrants issued to Schneider, Bernet & Hickman~ Inc. incidental to the Company's public offering in May, 1984, and warrants included in Units underlying such Unit purchase warrants. (2) Excludes 354,695 shares held by various tr~sts created by, and custodians appointed by, Mr. Mazur for the benefit of his children and grandchildren. (3) Includes 375,853 shares held by a limited partnership of which Mr. Crosby is a partner. Excludes 10,000 shares under options to purchase Common Stock held by Mr. Crosby. See "Compensation Pursuant to Plans." [4) Excludes 165,000 shares under Optlon~ to purchase Con~non Stock held by Mr. Simonsen. See "compensation Pursuant to Plans." (5) Excludes i0,000 shares under options to purchase Conlmon Stock held by Mr. Sardere. See "Compensation Pursuant to Plans." (6) Excludes 10,000 shares under options to purchase Common -40-

Stock held by Mr. Richards, See "compe~satio~ Pursuant to Plans,'j (7) Does not include shares undcr warrants and options referred to In notes (3) through (7). -41- •

DESCR~=C~ Ger~id R. ~zur S,A.VE~D p~AN Edmund G. v~mond, Jr. S.A*VE~D pLAN S~.'*~AR~v OF OPT-=O~ T~/~$ACT=CNE ~'2h~ _~oll~Inq ~a~le ~e~-~ ~t~ a~ ~o eac~ d~recto~ executive officer w~o~ ccmpensatlon ~x~ccd~ S~0,CC~ ~-" ann~ an~ all officers and di-~ec~o~ as a ~r~u~ (i~ ~h~ nu~er o~ shares ~f ~-~e yea-~ ~e~ ,'u~e ~, 1985~u~e~ "-~e A~ ~lan* ~.~ ~.A.Ve~ p!~ a~ 13~ t~e ar~ou~'- ~f ~h~res pu~ch~s*~ ~ur~ to ~uch ~la~s or resolu- tions during eac~ perlod ~d ~he ma~e~ valu~ ~f SU~ s~ar~s on '=-he ~e of purchase, net of pu-~c~as~ pr~. ~-~'T- ED ~ EXERC=SED DATE S~ PRICE ~ATE S Y~ES GA-~N( I 1 ...................... ~._.~ ........................ 5.A.VE~D pL~ AT~ pL~-~ ~ongualif±e~ Op~on~ 0~11~/84 17,0~0 $4.5~ 2/11/85 84.000 S~.25

~!~~ ~o~ ~o~qu~!if±~d Op~±o~s C8/:5/84 !~,000 S4.50 ~rd =, Gar~ere $4.50 S~ ~ich~rds ~4.50 Off~cer~ a~ D~r~er~ as a ~r~u~ Ill ~erzon~l 265,0~0 $5.75(Zl ~2~6,45~

iTEM ]3. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Company has entered into an agreement with The RJcha~ds G1oup, inc. under which The Richards Group, IRe. will provide advertising and promotional services to the Company at rates and under terms considered by the Company to be reasonable and standard in the advertising industry and at /east as favorable as could be obtained from unaffiliatcd parties." Stab Richards, a d~reetor of the Company, is the founder, President, Chief Executive OffJcez and principal owner of The RJchards Group, ]no. During the ,years ended June 30, i985 and 1984, respectively, the Company was b~]]ed about $125,000 and $78,000 by The RJchards Group, Inc., an advertising and public relations firm. A di~ecto~ of the Company Js the president and principal owner of the Riehards Group, Inc. The Company paid legal fees of about $66,000 and $76,000 to Matthews and Branscomb during the years ended June 30, ]985 and 1984. Matthews and Branscomb, and some members of that firm, are shareholders of the Company. -44-

PART IV. JTf:M ~4, E×HIBI~S, F~NANCIAL STATEMENT SCHEDULES AND REPORTS ON f ORr4 B~K~ ~ T~ ~o~lO~lng d~c~t~ are fil~d a~ part of thi~ Ai~uaJ RepOit on ~o~rN 10~K~ I• ~'Jnancia] ~t~at~leDt~ ~'h~ financial sta~ement~ ~d op~io~ l~t~ ~n the /nd~x to f~anc~l ~t~tements an~ f~nanc~a~ st~e~ent ~edule~ f~l~o~ir~g the ~i~ature page at p~ 47 of this r~por~ 2~ f'~c~aJ ~ta~ement ~hedu~e~ ~h(~sched~e~ ~ted in the index to fina~ci~l fo~/ow~g the ~natu~e ~age at p~ ~7 of th~ 3~ F~×hib~ t ~ Th~ exh~bit~ ~t~d on the i~de× to exh~b~ ~o~ow~g the ~i~ature page at p~g~ 4? of ~h~ (bl The Comp~y d~ ~ot file any Current Repo~s o~ ~or~ ~K ~J~ ~h~ quarte~ ended Ju~le 30. I~85~ -45-

S] GN ~3'URI<S Pursuant to the requJrement.~ of Section ]3 or 15(d1 of the .qecurJtJes Exchange Act of ]934, the Req/stratlt has du]y caused this leport to be signed on its behalf by the undelsignod, thOl'OUI%to du]y autholJzcd, ~n the City of San Antonio, State of ~oxas, as of .~fp bcl 24, 1985. AI)VAN t'O}IA ~|)UC3'S, ]NC. . ChaJlnlan of tile Board S] GNA'J UR}<S ~g~'~ Li~ nt t ~t~e of 1934~ t~lJs repo~t zoquJrements of the Securities Exchange Act has been signed below by the fo]/o~ing persons on behalf el the Registrant and ]n the capacities al~d as of the 24th day of So er, 1985. ~n TJ t i e ~2~ Chairma:] of ~ho }oald of [)/z'e~tors, ChJef 5xecut/ve Offzcer, I 6ili761C " Se(ucta:y and Director Gdl~l])] K. }[ofog" VIce Prosidel]t - lJ[lance, ~i'l'casuIe[ ~46

ADVANCED TOBACCO PRODUCTS, INC. INDEX TO FINANCIAL 8TATMENTS AND FINANCIAL STATEMENT SCHEDULE8 (Items ]4 (a) and (d)) The following financial statements to item ]4 [a): are included in response Page F-t ()pinion of Independent Public Accountants Balance Sheets at June 30, 1985, and ]984. F-2-3 Statements of Loss for the years ended June 30, ]885, and 1984 and the period from April, 1983 (Date of Ino~ept~on) to June 30, 1985. F-4 Statements of Changes in Shareholders' 9'-5 RguJty for the years ended June 30, ]985 and ]984 and for the period from April, ]983 (Dale of Inception; to June 30, 1983. Statements of Changes in financial position for the years ended June 30, 1985 and 1984 and the period from April, ]983 (Date of Inception) to June 30, ]983 and the period from April ]983 (Date of Inception) to June 30, 1985. F-6 Notes to Financial Statements F-?-ll The fo/1owzng financial statement schedules a~e included ]n ~esponse to X2'DM 14 (d): Page S-I Schedule ] Marketable Securities- Othel+ Investments Schedule VIJ] Valuation and Qual/fying 8-2 Reserves All oLher schedules for which p]-ov/s~on is made ]n the applicable accounting regulations of the Securitles and Exchange Con~JssJon az:e no~ reguJ~ed undel the leJated iilstructions or are inapplicable and thelefore have been omitted or the inforroat~on ls presented in the eonsolldated fJnanc:al statements or ~eJateG notes • -47-

Deloitte Haskins, Sells 711 Nava'ro. Suite 337 San AnlOruo, leads 78205 I512) 224-1041 C~ble DE ItANDS OPINION OF INDEPENDENT PUBI,]C ACCOUNTANTS Advanced Tobacco Products, Inc.: Re have examined the financial statements and supplemental schedules, of Advanced Tobacco Products, Inc. (a development stage enterprise) listed in the accompanying index, Our examinations were made fn accordance with generally accepted auditing s~andards and, accordingly, included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. In our opinion, such financial statements present fairly the financial position of Advanced Tobacco Products, Inc. at June 38, 1985 and 1984 and tile results of its operations and the ehanRes in Its financial position for the years ended dune 30, 1985 and 1984, the period from April, 1983 (daLe of inception) to June 30, 1983, and the period from April, 1983 (date of inception) to June 30, 1985, in conformity with generally accepted accountinZ principles applied on a consistent basis. Also, in our opinion, such supplemental schedules, when considered itl re]arian to the basic financial statements, present fairly in all material respects the information shown therein. San Antonio, Texas September 17, 1985 FI

ADVANCED TOBACCO PRODUCTS, INC. (A Development Staqe Enterprise) BALANCE SHEETS ASSETS June 30, ]985 CURRENT ASSETSI Cash held J1~ money malket accounts ........ C~sh held Jn den~and deposit account ....... U.~. l'reasury bills at cost plus a~cruod interest (appro×~mates market) ........... Certificates of deposit ................... Receivables ............................... ]nvenlory - Raw matorJaJ ................. Prepaid inu~rance ......................... Total currerlt a~sots , . . , . .............. PROPERTY - AT ~ST: ~ oduct ~ on equipment ...................... Office equ J pme'~t .......................... Lab equipment. ~ ........................... Leasehold improvements .................... Tola] prope~'ty ............................ Less accumulated depreciation a~d Total nol prope*ty ....................... OTHER ASSETS: l~atei~ts, net of accumulated amo~tlzatio~ of $28,808 in ]985 and $2,2~6 ~n 1984 (Note 3] ................................ 01-ga~izatJon costs, net of accumulated amortlzation of $2,379 in ]985 and $182 in J984 ................................. Deposits .................................. TOTAl ................................... Sure 30, ]984 $2,097,788 $ 327,984 338,837 26,256 6,986,298 '2,200,000 23,855 99,512 15,855 12,295 4,775,845 7,352,833 993,149 144,899 ]7,845 66,394 21,220 1,225,662 17,845 (55,869) (524) ],169,793 17,321 350,192 3?6.784 8,596 10,793 3],831 $6,336,257 $7,757,791 See notes to financial statements. F2

ADVANCED TOBACCO PRODUCTS, INC. (A DeVelopment Stage EnteYprisD) BALANCE SHEETS LIAEJLIT]ES AND SHAREHOLDERS' EQUITY June 30, Ju~e 30, ]985 ]984 CURRRNT LIABILITIES: Accounts payable ......................... .$ AcCrued liabilities ....................... ])ofer~cd expenses ......................... Total cu~rent ]iabJl~ties .............. COMMITMENTS AND CONTINGENCIES (NOTE 6) SHAREHOLDERS' EQUITY: (Note 2) Preferred stoq~ - $]00 par value; 500,000 sha~es authori'zed; [*one issued Common sto0k - authorized, 30,000,000 shares of $.0] par va]ue; outstanding, 7,034,40] shares in ]985 and 6,987,600 shares in 1984 ..... Additional paad-/n capital ................ Deficit ................................... Tota] mhareho]ders' equlty ............. TOTAl ................................ 298,181 $ 215,907 ~3,536 16,030 ]52,873 514,570 231,937 70,344 69,876 7,569,479 7,568,734 (i.818,190) (112,816) 5,821,687 7,925,794 $6,336,257 $7,757,732 See notes to financial statements.

ADVtGqCED ".~%B~CCO PRODUCTS, INC. (A Development Stage Ente3plise} STATEMENTS OF LOSS REVEt~UES -- IDLelest .......... . .... S EXPENSES: Manufacturln~ .................. Marketing (Note ?) .............. P~oduct development ...,..., .... Genera~ and ~dminist~a~ve (~ote 7) ........................ ~DtaJ, ........ , ..... ........ .... April, ]983 Year Year (Date of Ended EDded /ncopt~on) to June 30, June 30~ Ju~e 30, 1985 ]884 1988 638~846 $ 68~881 $ 700~137 ~361874 338,874 236~000 ~38,088 ~88~8~8 258~75 ~r~12~7~l 173~7~ ~8~8 ~4~68 ~7~87 ~8~ Net IOSS ...................... $(1,705,314) ====~==== ~et ioSS per sh81e o~ eon~non stock ............................. $(.24) ===== Weighted average number of shares Of cor~non stock outstanding ....................... 7,030,29? see ~OteS tO 1,194,366 3,832,482 f~anolal ~tatements. F4

A~VA%CS~TDBACCO pRC~UCT$, =N~. S_a~e _ .e_p .... C~e~ Sto~k Addi~i~na! .................... paid-in ~hares A-¢~n= ca~i%21 D~!c~= To=a= ~ALANCE, A~R=L, !9~ ............... Zs~=ance cf c~-.~ ~tock f~r c~sh ~n cx~hanq~ ~or: Legal ~erl.Sces ................ ~6,~5~ cash - ~r~va=e ~!ace~e~ ...... 55,009 Cas~ - ~ub!ic ~fferi~ ........ !,250,0~ A~s~s o~ ~CC Group 0~. ~%c~e 3~ ...................... 4,669,692 39,00~ 2~0 ~lg :,90~ 39,000 290 6!0~ -0- !,COC B,$73 :7,2~9 25r=~2 ~5 =r356 2,222 550 2S9,~59 22~,~ ~6,~97 359,251 4~5,94~ =ssuance of c~on ~tock ±n ~xch~q~ f~r: Cash warrant .............. (!,7~5,31~~ • ~ ~. ., w, _4 ~,~0~ 46~ 7!2 1,20~ 1 7 7

S~RC~ OP wQ~K~G CA~ITAL~ ~ssua~c~ ~f co~n s~c~ ...... ~et l~ss ...................... !.705.31~ Le~s 4eprec!atlon an~ amcrtlzatla~ n¢~ re~rlng we~k±~q caRi~al .............. ~84,13~! Addition of property .......... ~7,817 Addition O~ ~t~er a~s~s: Patents ..................... C~hcr ....................... 31,831 Total ~ses of werkin~ capital 2,8~¢,828 ~ncrea~e (~crease~ ~n w~r~ing capi=al ........ ... .............. $(2,859,62~! April, ~ April, :~8~ Year year ~D~te ~f !pate of June 3~* June 3~ ~une ~. June ~, C~A~G~S i~ CO~po~TS OF WORKIN~ CAPITAL: !ncrea~e~decrea~e; !~ curr~ Cash ....................... certificates ~f dep~ ..... inventory - ~aw ~ateria~ .... Prepaid insurance ........... ~incre~e; in current llabilitles: ACCOUnts payable ....... ... Accr,~e~ llabilitie~ ........ ~eferre~ ex~en~e~ .......... in~=e~sw (~ecr~aseJ in~rk~n~ capita! ..................... l,~l!:,i~O i0~,~94 1,731,~74 17,845 !,225,662 $ 2,0~2,~8~ $ 353.240 SI,O00 $2,436,623 (6.986.298) ~,98~.295 23,8~5 (82.274) I225,907: . (2~8,!~i) 147,4~62 II~.¢3Q] (B3,5!6) (!52.~?~ (152,~731

] • ADVAHC~D TOBACCO PRODUCTS, INC. (A Development Stage Enterprise) NOTES TO FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES o]gan]zation Advanced Tobaeeo Products, Inc., ("ATPI") was formed in Apli], J983 unde~ the name S.A. Vend, Inc. The ConLpany's name was changed to Advanced Tobacco Products, Inc. i~ January, l~4. The Compal]y ~s ~n the development stage ane is engaged in the development of a Smoke-Free cigarette. Fisca] Year The Company changed its fiscal year end in June, 1984 from Decembul 31 to June 30. Results of operations for the year endea June 30, 1984 ale the same as for the period from April, 1983 (inception) through June 30, J984 because operations did not com~lence until August, 1983. inventories inventories are stated at the lower of cost or market using the first-in, first-out method (FIFO). Propelty Depreciation Js recorded using the straight-]ine method over the estimated service life of the equipment of five years) Leasehold improvements are amortized over the lifo of the lease. O*gan]zation Costs OzganJzatJon costs consist of attorney's fees paid to one of the shareholders and are being amortized, since the date of the pub]it offering (See Note 2), uslng the straJght-J~ne method over a five year period. Patents ~nortizat/on is recorded using the stralght-lJne method over the remaining ]egal life of the patent. Loss Pel Share Net loss per share of Co~lon stock is computed by dividing ]]et ]oss for the pel Jod by the weighted average number of shares of ten,non stock OUtStanding after g~vJng let2oactJve effect to a stock sp]it {See Note 2). COn~On stock warrants and options are coam]on stock equivalents; they have been excluded from the weighted average lluINbel of shares, however, as their effect is antidilutive. F7

2. S~,R~I~OL~ERS' EQUITY In AInll, 1983, 39,000 shares of common stock wore sold to an organizing shareholder for $1,000. ~n September, 1983, 887,250 ~h~e~ of ~o~ol] stock were sold to a~ off~eer for $~6,162 ~nder the te~ms of an Ince~tive Stock Option PlaD. In September, 1983, 86,658 shares wore issued to the Company's ]ega] counsel in exchange for the value ($2,222) of legal service rendered. in JanUary, ]984, the Board of Directors and shareholders autholiged: {l) a~ increase in the authorized ooiTcnon stock to 30,000,000 shares and a change in the par value to $.0] a share, {2) a $9-fol-i stock split, and (3) the future issuance of 500,000 shares of $~00 par value preferred stock which may be divided and issued in aDy series. Shareholders' equity at Oune 30, 1983 and the nul~ber of shares approved, granted, a~d p~rchased ~nder the Company's Incentive Stock Option Plans have been adjusted ~etroact~ve/y to re,loci the stock split. in 3anuary, 3984, 55,000 shares of co~on stock were issued for $220,000 ($4.00 a share) in a private placement. On May 23, 19~4 the Company sold through its underwriters 1,250,000 uIlits c~$isting of one share of common stock and one warrant to purchase one-half share of common shocM. The warrants provide for a purchase price of $7.00 a share and are exercisable from August 2], 1984 to May 3~, 1986. Under ccrtaln conditions, the Coi11paT*y may accelerate the expiration date of the warrants. Proceeds fl"om the sale, net of u~derwriting discount and other public offoling costs, were $6,983,878. 3. OPTION ~ ACQUIRE ASSETS OF NCC GROUP, LTD. A n option to aoguire all the assets of NCC Group, Ltd. ("RCC"), including t~D ~:ights and palents to the non-eombustibl~ cigarette, in exchange fo~ co~on stock of ATPI, was exorcised on May 23, ]984. This acquisition was accounted for using the purchase method of accogn[in~. Assets acquired included the patent at NCC's cost of $379,000 and cash of $26,948 in exchange ior 4,669,692 net shares of comnlon stock. Prior to May 23, the Company reimbursed NCC $50,217 for expenses and public offerlng costs that NCC had paid for the company. F8

4. STOCK OPTiON AND PURCHASE PLANS On April 19, 1983, the Board of Directors o5 S.A. Vend, inc. approved an Incentive Stock Option Plan under which options to purchase 1,050,850 shares of common stock have been granted. In Janualy, 3984, the Company's Board of Directors approved the ATPI Incentive Stock Option Plan under which a maximum of 3]0,000 ~hares of con~non stock have been reserved. Options to purchase ]30,000 of these sha~es had been granted through June 30, ]985/ O1% August 16, ]984 the Company's Board of Directors adopted resolutions authorizing the granting of Non-Qualified Stock Options to officers, key management employees, independent contractors providing selvlces %o the Company or consultants. 1 In June, ]984 the Board of Directors authorized the establishment of ai% Employee Stock Purchase Plan, which was approved by stock- holders on November 13, 1984. Employees will be able to purchase co~on stock of the Company, at a price less than the fair market value on the da~e of purchase, flom funds accumulated through payroll deductions. The Plan provides for a maximum of ]00,000 shares to be sold during t~ te~m of the pJan, which expires in 1994. Purchase price is expected to be about ]5 percent below fair market value at the time of purchase. The plan became effective on Ju3y l, ]984. P9

"-~-~T2"~ NON~QUAL~'~ED $~CK p~C~ASE ~A~ ~R~CE S~ p~ SHA.~!~S ~C~ ~ut~a~!nc at Aur~l, ~u~$~an~in~ at ..... =~--~ ~-=-~==_ O

5. FEDERAl, iNCOME TAXES The Company has net oporatJilg loss carryforwards of about $1,900,000, expiring Jn ]999 and ]n 2000, which may be used to reduce taxes against future earnings. The Company also has investment tax credits of about $]20,000 expiring Jn the year 2000. 6. COMMITMENTS AND CONTINGENCIES The Company occupies certaln manufacturing and office faeilitles under operating lease agreements expiring on December 3], ]989. Rental o×pense Js calculated on the total cost of the lease amort/zed on a stralght-]il]e bas/s over the term of the ]ease. Rental expense was $]50,420 fol" 1985 and $2,842 for 1984. Minumum future rentals under operating leases that have terms in excess of one year are as follows: Fiscal Straight I,]ne Year ~nort~zatJon ]986 $245,042 $144,325 1987 245,042 308,832 1988 245,042 308,832 1989 245,042 308,832 ]990 ]22,503 154,426 Cash Cancel/at]on Requirements Penalty .......................... $]85,299 ]23,533 61,766 On September 17, 1985 the Company entered into a commitment to purchase additional production equipment in the amount of approximately $950,000. The Company has made a payment of $239,899 toward the purchase price. 7. RELATED PARTY TRANSACTIONS The Company was billed about $125,000 Jn 1985 and $78,000 in 1984 by '/he R]ehards Group Inc., an advertising and public relations firm. A d~*ector of the Company is the president and principal owner of The RJchards Group Inc. The Company paid icgal fees of about $66,000 ]n ]985 and $76,000 ]n ]984 to Matthews and Branscomb. Matthews and B~anscomb, and some members of that firm, ale shareholders of the Company. F]]

A~'IA~CEDTOBACCO p~QD~CTS, I~C. N'1~mb~r Cf shar~ a~d t~e of ~ou~ ~f bo~ c~h i~e and~n~ercst ~o~u~ A Column ~ COIU~ C Cc!u~n D Co~u-n E A,~,Un~ ~f which equ±~ s~cu~1~y ~ar~et va~u~ of ~ssue~ ~4 ~acn ~c~ i~e a~ o~5e2 sccu~ ~c~ cf each ba~anc~ s~eet ~s~e carricd ~ ±s~ue ~atc ~se b~lance s~eet Ce~£~icat~s o~ ~e~'Mazke~

COlUmn A ACCVVULATED~ORT~ZA~=O~ PATS~T: ~pr!l, 1983 ~Date ~f Znce~tion) to ~une 30, 198~ ................... FOr the twelv~ ~nt~ ended ~Jn~ 30, i~84 .... F~r ~hc ~iv~ ~n~hs ~nd~d Jun~ 30, ~985 .... For the ~r!~frO~Aoril. ~983 (Date of inception) t~ 0un~ 3g, i~84 ....... ACCV~V~TED AM0~T:ZAT~O~ O~GAN=ZATI~ C05T$: For ~he ~riodfrom A~r~l, 1983 {Dat~ ~f I~¢ept£cn) to June 30. 1983 ................... Fcr ~he ~elve mont~ cn~e~ JUne 3~, I?B4 .... For th~ ~rio~ from A~il. i~8~ ~Date of fnce?t~n) to June 3~, ~984 ....... ~V~C3D _'2~BACCO ?q~DVCTS, INC. SC~DV~E V=== VASVAT~ON ~D~ALIFy~NG ~RVE$ Col,±.n q Co!~n C Column D Column E ............................... AddLt~s ~alance at Char~d to Balance a~ Se~nn~n~ Co~t~ an~ End o~per!¢~- Ex~en~e~ Deductions ofp.r~od $ -0- $ -0- $ -0- ~ -0~ -~. 2~2!6 -~- 2.216 2,216 26,592 -0- 28,@08 ~0- 2B,B0~ -O- 28,808 -0- -0- .0° .0. -0- 2,1~7 -~- 2.379 -0- 182 -0- !B2 -~- 2,379 -~- 2,37~

ADVANCEI) TOBACCO PRODUCTS ~NC. INDEX TO EXHIBITS (~tems ~4(a) and (c) The foJ~owing documents arc incorporated by reference or filed as Exhibits in response to ITEM i4(o): Exhibit No. Deserlption Form of Agreement A~o~g Underwriters, incl~ding Underwriting Agreement and Selected Dealers Agreement ~neorporated by ref0rence to Exhibit i of Registrant's Reglstrat~ofl StateMent of Form Form S-I (Registration ~o. 2-88812, as amended on May 23, ~984), the effective da~e thereof hereinafter, the "Registrant's Registration Statement" 2 ~greement to Ra~ Capital and acquire technology dated September ]9, 1983 between the Registrant add NCC Group, Ltd. by reference to Exhibit 2 of the Registrant s Registration Statement 3.] Restated Articles of Incorporation of the Registrant by reference to Exhibit 3.1 of the RegJstrant's Registration Statement Bylaws of the Reglstrant by reference to Exhibit 3.2 of the RegJstrant's Registration Statement 4.1 Specimen co~mon Stock Certificate by reference to Exhibit 4.1 of the Reqistrant's Registration Statement 4.2 Specimen of Warrant Cer[ifieate by reference to Exhibit 4.2 of the RegJstrant's Regist[atio~ Statement 4.3 Walrant Agreen~ent between Registrant and Frost National Rank as Warrant Agent by ~eferenee to Exhibit 4.3 Of the Registrant's Registration Statelnent 4.4 Articles Fo~r, NiDe and Ten of the Articles of ]neorporatlon of the Registrant (included in Exhibit 3.1) by ro~erei~ce to Exhibit 4.4 of the RegJstrant's Registration Statement 4.5 Eolm of Warrant Agreemenf and Representative Unit Purchase Wal~nt by reteyenoe to Exhibit 4.5 of t h~ Regls[ran£'s Registration Statement

5,] 5.2 5,3 ]0,] ]0.2 10.3 10.4 10.5 10.6 J0.7 ]0,8 10.9 opinion of Matthews & Branseomb regardlng Iegallty of securJtles by reference to Exhibit 5.1 of the Reg]strant's Registration Statement opinion of Matthews & Branscomb regarding FDA and other governmental regulation by reference to Exhibit 5.2 of the Registrant's Registration Statement Open]on of BurdJtt & Calking by reference to Exhibit 5.3 of the Rcgistrant's Registration Statement Acquisition Agreement between the Registrant and NCC Group, Ltd. (previously filed as part of Exhibit 2} by reference to Exhibit 10.l of the Registrant's RegJst*atJon Statement Agreement dated October 31, 1983, between the Registrant and The RJehard~ Group, Inc. of Dallas, Texas by reference to ExhlbJt 10.2 of the RegJstrant's Registration Statement Co1~dtment Letter dated January 9, 1984, from Am %-Jcanq]" Filtrona Company (equipment supplier) by re~erence to Exhibit 10.3of the Registrant's Registration Statement Co~nitment Letter dated January 6, 1984, from Raynor Adams & Associates, Inc. (equipment supplier) by reference to Exhlbit 10.4 of the Registrant's Registration Statement Commitment Letter dated June 20, ]983 from Harvey Machine Company, Inc. (equipment supplier) by reference to Exhibit 10.5 of the Registrant's Registration Statement Con~itment Letter dated January 9, 1984 from J. E. Uptmore & Associates, Inc. (lease space improvements} by reference to Exhibit 10.6 of the Registrant's Registration Statement Advanced Tobacco Products, Inc. ]984 Incentive Stock Option Plan by reference to Exhibit 10.7 of the Reglstrant's Registration Statement Form of Option Agreement under ]984 Advanced Tobacco Products, Inc. Incentive Stock Option Plan by reference to Exhibit ]0.8 of the Registrant's Registrar]ell Statement S. A. Vend, Inc. ]983 Incentive Stock Option Plan by reference to Exhibit ]0.9 of the Registrant's " Registratzon Statement

20,]0 10,11 10.22 ]g,~4 24,1 24,2 24~3 24,4 24.5 25 26.1 26.2 EmpSo~i~ent Agreement dated December 7, 1983, between the Registrant and Gerald R. Mazur by reference to Exhibit ]0.20 of the Registrant'£ Registration Statement ~p]oyment Agreement dated I)eoembe~ 23, 1983, between the Registrant and J. P. Ray by reference to Exhibit i0.1] of the Registraltt's Rogistratlon Stgtement Emp3o~,ent Agreement dated August ], 1983, between the RegJstzant and Edmund G. Vimond, Jr. by reference to Exhibit iS.J2 of the Registrant's Registration Statement Emp]o~nont Agreement dated November iS, ]983 between the Registrant and Zra D. Hill by reference to Exhibit ~0.13 of the Registrant's Registration Statement El~plo~0nt Agreement dated December 27, 1983 between the Registrant and James D. Simonsen by reference to EM~%ibit 10.14 Of t~e Registrani's Registration Statement Consent of Matthews & Branscomb (included Jn their opinions filed as Exhibits 5.1 and 5.2J by reference to Exhibit 24.1 of the Re~istrant's Registratio~ Statement Consent of Burdltt & Calkins (included in their opinion filed as Exhibit 5.3) by reference to Exhibit 24.2 of the Registrant's Registration Statement Consent of Deloitte Raskins & Sellsp independent public accountants (~ncluded as page If-5 to the Registration Statement) by reference to Exhibit 24.3 of the Regi£tlant's Rogistratio~ Statement Consent of EGC Associates, Inc. by reference to Exhibit 24.4 of the Registlant's Registration Statement Co~ent of Arrlold, White & ~drkee by reference to Exhibit 24.5 of the Registlant's Registration Stateme~t Powe* of Attolney (included on Signature Page of the Registration Statement) by reference to Exhibit 25 of the Registra~t's Registration Statement 1984 Emp]oyee Stock Purchase Plan of Advallced Tobacco Products, Inc. Form of Eniployoe*s Election to Participate Ml~der the ]984 Employee's Stock Purchase Plan of Advanced q'oba¢oo Products, ~nc.

26,3 Form of Nonqua]JfJed Stock Option Agreement Similar aqre~ment~ with substantJal~y tho ~ame te]~ms w3th tho exceptJo~ of the numbel of shares were granted to Ira D, Hill, James D. S~monsen, WJ]lJanl Paxton, A] Otto, Jack Crosby, Stan RJchard~ and Edward Ga~dere.

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