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Brooke Group Ltd. 1992 Stockholders" Report

BROOKE GROUP LTD. DEAR FELLOW SHAREHOLDER: I am extremely pleased to tell you about the important stddes that have been made over the past several months resulting in a restructured and highly focused Brooke Group. Today, Brooke Group is primarily a tobacco company, through our Liggett Group Inc. and Liggett-Ducat J.S.C. subsidiaries. In addition, Brooke Group is developing commercial real estate properties in Moscow and elsewhere, and continues to hold valuable minority investments and ownership in smaller businesses whose potential we are seeking to develop or whose value we intend to maximize. Liggett Group Inc. Liggett Group, the successor to Liggett & Myers Tobacco Company, has a long history, dating back to 1873, as one of America's leading tobacco companies. Liggett manufactures such well known cigarette brands as L & M, Chesterfield, Eve, Lark, and leading discount brands Pyramid and Class A, as well as producing private brands and other contmlled-labal brands for major customers in the United States. The tobacco industry has seen major changes in pricing and brand positioning over the past year, and Liggett Group has responded with a strategy to reduce costs and concentrate on the discount segment of the market. Throughout the past year, Uggett has effectively streamlined its operations. We have taken dramatic steps in downsizing our pemonnel and consolidating our New York marketing and administrative functions into one operating facility in Durham, North Carolina. In June, the company welcomed Edward A. Horrigan, Jr., former Vice Chairman of the Board of RJR Nabisco, Inc., and Chairman and Chief Executive Officer of R.J. Reynolds Tobacco Company, as the new Chairman and Chief Executive Officer of Uggett Group. We believe that our continuing efforts will help Liggett become a low cost producer of cigarettes, which should result in profitability even in the current price war environment. If the current pdco war situation eases, we expect that Liggett will then generate a strong profit stream. As part of our efforts to reduce costs, we have also converted one of the office buildings at our 25-acre Liggett campus into available commercial space which has already been leased to third parties at attractive rates for the Durham area. Liggett.Ducat The past several months have seen important developments at Liggett-Ducat, which is engaged in cigarette manufacturing in R~s~a and the development of real estate in downtown Moscow. In July 1993, the Liggett-Ducat joint venture was restructured into a joint stock company 58% owned by Brooke Group, 30% owned by Russian employees of the Ducat factory, and 12% owned by the company's management. We believe that the calculated dsk originally taken by Brooke Group in making this investment, at the time when the former Soviet Union had just begun to open its markets, has the potential to translate into a tremendous growth opportunity for the future. LJggett-Ducat's cigarette business is the successor to Factory Ducat, which owns and produces several of the most popular cigarette brands in Russia, such as Stolichnaya, Astra, Pdma and Belomorkanal. The

Contingent Value Rights, on October 6, 1993, Breoke Group spun off SkyBox Intemationai as a separete, publicly traded entity, and on October 15, 1993, Brooke Group announced the redemption of its CVR's for $0.36 per right. On October 14, SkyBox announced that eamings for the first nine months of 1993 were $19.4 million, or $2.08 per share, and thi~l quarter earnings were $7.2 million, or $0.75 per share. As the ongoing owner of both common and preferred stock in SkyBox, Brooke Group looks forwan:l to sharing in SkyBox's continued growth and success. In another development, Brooke Group and its wholly-owned subsidiary BGLS signed an agreement with a group of investors to exchange the equity that Brooke Group expects to receive in the reorganized New Valley for a package with a stated value of $111 million, consisting of $89 million of BGLS bonds and $22 million in cash, subject to certain contingencies. Since Brooke Group had written down its investment in New Valley to zero, this will be recorded as a gain of $111 million when the transaction doses, which is expected to occur in the first quarter of 1994. In late 1992, BGLS settled its lawsuit against Liberty Service Corp., which resulted in a pre-tax gain to Brooke Group of approximately $75 million. Conclusion Today, Brooke Group is primarily a multinational tobacco company with a significant real estate development business. We have spent a great deal of time and effort restructuring the company, reducing debt, and today we are focused on Liggett and Liggett-Ducat, two companies with strong business prospects. We will continue to pursue our goal of delivering value to our shareholders. Bennett ~. LeBow Chairman November 1, 1993

BROOKE GROUP LTD. INDEX PART I Page Item 1. Business .................................................................................................... .. 2 Item 2. Properties .................................................................................................... 14 Item 3. L~gal Proceedings .......................................................................................... 14 Item 4. Submission of Matters to a Vote of Secunty Holders ................................................. 15 Executive Officers of the Registrant ................................................................................. 15 Item 5. Item 6. Item 7. Item 8. Item 9. PART II Market for the Registrant's Common Stock and Related Stockholder Matters .................... 19 Selected Financial Data .................................................................................... 19 Management's Discussion and Analysis of Financial Condition and Results of Operations .... 19 Financial Statements and Supplementary Data ......................................................... 19 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .... 19 Item 10. Item 11. Item 12. Item 13. PART III Directors and Executive Officers of the Registrant .................................................... 20 Executive Compensation ................................................................................... 20 Security Ownership of Certain Beneficial Owners and Managemem ............................... 20 Certain Relationships and Related Transactions ....................................................... 20 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ............................... 21 Signatures .................................................................................................... ............ 36 -1-

PART I Item 1. Business Brooke Group Ltd. (the "Company"), a Delaware corporation founded in 1980, is principally engaged in the manufacture and sale of cigarettes and the production and sale of collectible picture products and related accessories. The Company also has investments in a number of additional companies engaged in a diverse group of businesses. In December 1992 the Company determined that it would hold its investments in its information processing systems business (MAI Systems Corporation ("MAI")) for sale. Financial information about the effect of the discontinuance of this business and other less significant discontinued businesses appears in Note 3 to the Company's consolidated financial statements and is incorporated by reference. In addition, information set forth in Items 1, 2 and 3 in MAI's Annual Report on Form 10-K for the year ended September 30, 1992 is incorporated herein by reference. In April 1993, MAI filed for protection under Chapter 11 of the Federal Bankruptcy Code. Described below are the operations of the Company's remaining segments. Financial information about the Company's remaining industry segments, its foreign and domestic operations and export sales is incorporated by reference to Note 20 of the Company's consolidated financial statements. Tobacco General The Company's tobacco business is conducted through its wholly-owned subsidiary, Liggett Group Inc. ("Liggett"), a Delaware corporation, which is the ultimate operating successor to the Liggett & Myers Tobacco Company formed in 1873, engaged primarily in the manufacture and sale of cigarettes. Liggett produces four full-price cigarette brands: L&M, Chesterfield, Lark & Eve. Liggett's full-price branded cigarettes represented in the years ended December 31, 1992, 1991 and 1990 approximately 50%, 47% and 51% of net sales (excluding federal excise taxes) and contributed substantially to Liggett's -2-

Liggett's long-term business strategy in the full-price segment of the market is to maintain its share of that segment of the market by consistently offering advertising and promotional programs with the objective of maximizing the profitability of its full-price brands. Liggett's long-term business strategy in the price/value segment of the market is to maintain its market share and increase its profitability by providing consistently high quality products and services at prices and terms comparable to those available in the market. Principal Products Full-price branded cigarettes are generally marketed under well-recognized brand names at full retail prices to adult smokers with strong preference for branded products, whereas price/value cigarettes are marketed at lower retail prices to adult smokers that are more cost conscious. Liggett's full-price branded and price/value cigarettes are produced in over 300 combinations of lengths, styles and packaging. Sales, Marketing and Distribution The majority of Liggett's products are distributed from a central distribution center in Durham, North Carolina to approximately 47 public warehouses located throughout the United States. These warehouses serve ,as local distribution centers for Liggett's customers. Liggett's products are transported from the central distribution center to the warehouses via third party trucking companies to meet pre-existing contractual obligations to its customers. Liggett's customers are primarily candy and tobacco distributors, the military, and large grocery, drug and convenience store chains. Liggett manufactures and markets the third largest selling brand family of cigarettes to the U.S. military. Liggett offers its customers payment terms and promotional incentives consistent with industry practices. Customers typically pay for purchased goods within two weeks following delivery from Liggett. None of Liggett's customers accounted for more than 10% of revenues in 1992. Liggett's marketing and distribution functions are performed by approximately 280 full- and part-time direct sales people, together with merchandisers (independent contractors) and food broker companies. -4-

for 3.0% of the approximately 507 billion cigarettes shipped in the U.S. during such year, and Liggett's shipments of approximately 17.3 billion cigarettes in 1991 accounted for 3.4% of the approximately 509.1 billion cigarettes shipped in the U.S. during such year. Liggett suffered a reduction in its unit sales in 1992 primarily as a result of poor performance in sales of Pyramid cigarettes and as a result of other cigarette manufacturers taking significant generic accounts from Liggett. The Company believes that this was primarily due to the proliferation of price/value products offered by other manufacturers who used their greater resources by leveraging rebate programs tied to their full price products and by providing up-front payments. Consequently, Liggett's market share declined in 1992. The Maxwell Report estimates that domestic industry-wide consumer purchases declined by 1.5% to 2% in 1992. Liggett's management expects that industry-wide unit sales of cigarettes in the United States will continue to decline. Liggett's management believes that the decline is the result of numerous factors, including health considerations, diminishing social acceptance of smoking, legislative limitations on smoking in public places and federal and state excise tax increases which have augmented cigarette price increases. There are substantial barriers to entry into the cigarette business, including extensive distribution organizations, large capital outlays for sophisticated production equipment, substantial inventory investment, costly promotional spending, regulated advertising and strong brand loyalty. In this industry, the major cigarette manufacturers compete among themselves for market share on the basis of brand loyalty, advertising and promotional activities and trade and consumer rebates and incentives. Liggett's five major competitors all have greater financial resources than Liggett, and many of these competitors' brands have greater sales and consumer recognition than Liggett's brands. Government Regulation Reports with respect to the alleged harmfully physical effects associated with cigarette smoking have been publicized for many years and, in the opinion of Liggett's management, have had and may continue to have an adverse effect on cigarette sales. Since 1964, the Surgeon General of the United States and the Secretary of Health and Human Services have released a number of reports which claim that cigarette smoking is a causative factor with respect to a variety of health hazards, including cancer, heart disease and lung disease, and have recommended various government actions to reduce the incidence of smoking. -6-

restrictions or requirements relating to smoking including restrictions on public smoking. Certain employers have initiated programs restricting or eliminating smoking in the workplace. Other proposals previously presented to or currently before Congress and certain states and local government units include, but are not limited to, legislative efforts to further restrict or ban the advertising and promotion of cigarettes, to eliminate the income tax deductibility of expenses incurred for such advertising and promotion, to restrict or prohibit smoking in public buildings and other areas, to increase excise taxes, to require additional warnings on cigarette packaging and advertising, to ban vending machine sales, to eliminate the federal preemption defense in product liability actions, to place cigarettes under the regulatory jurisdiction of the Food and Drug Administration and to require that cigarettes meet certain fire safety hazards. If adopted, at least certain of the foregoing legislative proposals might have a material adverse impact on Liggett's business. While attitudes toward cigarette smoking vary around the world, a number of foreign countries also have taken steps to discourage cigarette smoking, to restrict or prohibit cigarette advertising and promotion and to increase taxes on cigarettes. Such restrictions are, in some cases, more onerous than restrictions imposed in the United States. The price of cigarettes includes federal excise taxes at the rate of $12.O0 per 1,000 cigarettes. This tax, which was levied as of January 1, 1993, increased the previous federal excise tax which had been at the rate of $10.00 per 1,000 cigarettes. Recent media reports have stated that the current administration is considering proposing a significant increase in this tax, and a substantial increase could accelerate the trend away from smoking. Excise and similar taxes on cigarettes, which are levied upon and typically paid by the distributors, are also in effect in the 50 states, the District of Columbia and many municipalities. These state and local taxes range from approximately $1.25 to $28.00 per 1,000 cigarettes. Management believes that Liggett is in compliance in all material respects with the laws regulating cigarette manufacturers. Compliance with federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, have no material effect on the capital expenditures, earnings and competitive position of Liggett. -8-

cards based on the ABC network television shows Full House, Perfect Strang~r~ and Family Mal;ters and certain comic book characters licensed by DC Comics. In December 1992, SkyBox introduced a limited edition set of trading cards commemorating DC Comics' Death of Superman comic book release. In 1993 SkyBox introduced a set of trading cards relating to the Disney film Aladdin. SkyBox sells its products directly to wholesale merchandise distributors, grocery wholesalers, periodical distributors, supermarkets, convenience store chains, drug store chains, toy and variety store chains, military commissaries and exchanges, mass merchandisers, wholesale clubs and hobby dealers. In order to service these customers better, and in connection with the aforementioned December 1991 realignment, SkyBox reorganized its sales and distribution operations. Prior to the reorganization, SkyBox sales were made primarily by SkyBox's own 200-person sales force. Subsequent to the reorganization, sales - have been made by a special SkyBox sales group dedicated to the servicing of hobby dealers and major national accounts, and through approximately 45 independent broker-representative firms, whose commissioned employees have- increased to approximately 2,500 the number of people selling SkyBox products. SkyBox maintains its product inventories in rented space in five public warehouses across the United States. In 1992, SkyBox experienced a decline in sales of its products, due primarily to a general contraction of the market for trading cards and the adoption by SkyBox of a more restrictive returns policy. Production SkyBox presently purchases the paper stock needed to produce its trading cards from two principal sources. Management of SkyBox believes that supplies of paper stock are available to meet its current and anticipated future needs at a reasonable cost. SkyBox currently uses multiple printing companies to print its trading card products. Paperboard used in the manufacturing process is delivered by SkyBox's suppliers directly to these printing companies. SkyBox uses several other vendors to perform cutting, collating and packaging of the products after they are printed. SkyBox believes that certain of its competitors also use these printing companies and vendors from time to time for the same type of services although some of SkyBox competitors also perform some of these functions in-house. Management of SkyBox believes that sufficient capacity exists in the United States to meet its demands for printing, as well as for cutting, collating and packaging services. 10-

to commence at or near the time of first release of the motion picture. Sales of entertainment-related products are planned, where possible, to counterbalance the seasonality of sports-related product sales. Working Capital SkyBox is required to invest significant amounts of working capital in the purchase of paper stock, printing services, and cutting, collating and packaging services, in order to have trading card products in inventory and available for distribution at the beginning of the relevant sport season (in the case of sports- related products) or at the release date of a motion picture (in the case of entertainment-related products). These working capital expenditures, made in advance of receiving any related revenue, can have a negative impact on SkyBox's cash flow during seasonal peak sale periods. Competition Many different companies hold licenses to produce, market and distribute sports and entertainment-related trading cards some of which sell their products only in regional or niche markets. Additional companies may be granted licenses to produce trading cards in the future, and licensors may commence production of their own sports trading cards, thus generating greater competition. Within the domestic trading card market, SkyBox's principal competitors are The Topps Company, Inc., Fleer Corp., Leaf, Inc. (Donruss), The Upper Deck Company, ProSet Inc. and Major League Marketing (Score). SkyBox believes that these six companies together with SkyBox account for a substantial majority of the total sales of all sports trading cards in the United States. With the exception of SkyBox and ProSet, all of the foregoing competitors have at least one major league baseball line of trading card products. Many of SkyBox's competitors produce basketball trading cards which compete directly with SkyBox's most significant sports products, the NBA Hoops ~ and SkyBox T, basketball trading cards. SkyBox believes that it competes not only with other companies that market trading cards, but also with companies that market gum and candy products, snack food products, small toys, comic books and other similar products. As a result, SkyBox competes for sales and retail distribution space with many companies in the food, candy, toy and publishing businesses, many of which are significantly larger and have greater resources than SkyBox. 12-