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Securities And Exchange Commission
Washington, D.C. 20549
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FORM 10-K
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
VECTOR GROUP LTD.
(Exact name of registrant as specified in its charter)
DELAWARE 1-5759 65-0949535
(State or other jurisdiction of Commission File Number (I.R.S. Employer Identification No.)
incorporation or organization)
100 S.E. SECOND STREET, MIAMI, FLORIDA 33131
(Address of principal executive offices) (Zip Code)
(305) 579-8000
(Registrant's telephone number, including area code)
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE ON
TITLE OF EACH CLASS WHICH REGISTERED
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Common Stock, par value $.10 per share New York Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: None
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934, as amended (the "Exchange Act"), during the preceding 12 months (or for
such shorter period that the Registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days.
[X] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 Regulation S-K is not contained herein, and will not be contained, to
the best of the Registrant's knowledge, in definitive proxy or information
statement incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filed
(as defined in Exchange Act Rule 12b-2). [X] Yes [ ] No
The aggregate market value of the common stock held by non-affiliates
of Vector Group Ltd. as of June 30, 2002 was approximately $400,000,000.
At March 28, 2003, Vector Group Ltd. had 36,962,073 shares of common
stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III (Items 10, 11, 12 and 13) from the definitive Proxy Statement
for the 2003 Annual Meeting of Stockholders to be filed with the Securities and
Exchange Commission no later than 120 days after the end of the Registrant's
fiscal year covered by this report.
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VECTOR GROUP LTD.
FORM 10-K
T A B L E O F C O N T E N T S
PAGE
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PART I
Item 1. Business..................................................................................... 1
Item 2. Properties................................................................................... 31
Item 3. Legal Proceedings............................................................................ 32
Item 4. Submission of Matters to a Vote of Security Holders;
Executive Officers of the Registrant......................................................... 33
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters........................ 35
Item 6. Selected Financial Data...................................................................... 36
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................................... 37
Item 7A. Quantitative and Qualitative Disclosures About Market Risk................................... 56
Item 8. Financial Statements and Supplementary Data.................................................. 57
Item 9. Changes In and Disagreements with Accountants on Accounting and
Financial Disclosure..................................................................... 57
PART III
Item 10. Directors and Executive Officers of the Registrant........................................... 58
Item 11. Executive Compensation....................................................................... 58
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters.............................................................. 58
Item 13. Certain Relationships and Related Transactions............................................... 58
Item 14. Controls and Procedures...................................................................... 58
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................. 59
SIGNATURES............................................................................................. 68
CERTIFICATIONS......................................................................................... 70
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ITEM 1. BUSINESS
OVERVIEW
Vector Group Ltd., a Delaware corporation, is a holding company for a
number of businesses. We hold these businesses through our wholly-owned
subsidiary VGR Holding Inc. We are engaged principally in:
o the development and marketing of the low nicotine and nicotine-free
QUEST cigarette products and the reduced carcinogen OMNI cigarette
products through our subsidiary Vector Tobacco Inc., and
o the manufacture and sale of cigarettes in the United States through
our subsidiary Liggett Group Inc.
During 2002, the sales and marketing functions, along with certain
support functions, of our Liggett and Vector Tobacco subsidiaries were combined
into a new entity, Liggett Vector Brands Inc. This company coordinates and
executes the sales and marketing efforts for all of our tobacco operations. With
the combined resources of Liggett and Vector Tobacco, Liggett Vector Brands has
approximately 430 salespersons, and enhanced distribution and marketing
capabilities.
Our majority-owned subsidiary, New Valley Corporation, is currently
engaged in the real estate business and is seeking to acquire additional
operating companies. In December 2002, New Valley acquired two office buildings
in Princeton, N.J. and increased its ownership to 50% in Montauk Battery Realty
LLC, which owns the largest residential brokerage company in the New York
metropolitan area.
We are controlled by Bennett S. LeBow, our Chairman and the Chairman of
New Valley, who beneficially owns approximately 34.4% of our common stock.
For the purposes of this discussion and segment reporting in this
report, references to the Liggett segment encompass the manufacture and sale of
conventional cigarettes and includes the former operations of The Medallion
Company, Inc. acquired on April 1, 2002 (which operations are held for legal
purposes as part of Vector Tobacco). References to the Vector Tobacco segment
include the development and marketing of the low nicotine, nicotine-free and
reduced carcinogen products and, for these purposes, exclude the operations of
Medallion.
VECTOR TOBACCO INC.
Vector Tobacco, a wholly-owned subsidiary of VGR Holding, is engaged in
the development and marketing of the low nicotine and nicotine-free QUEST
cigarette products and the reduced carcinogen OMNI cigarette products.
QUEST. In January 2003, Vector Tobacco introduced QUEST, its brand of
low nicotine and nicotine-free cigarette products. QUEST is designed for adult
smokers who are interested in reducing their levels of nicotine intake and is
available in three different varieties, each with decreasing amounts of nicotine
- - QUEST 1, 2 and 3. QUEST 1, the low nicotine variety, contains 0.6 milligrams
of nicotine. QUEST 2, the extra-low nicotine variety, contains 0.3 milligrams of
nicotine. QUEST 3, the nicotine-free variety, contains only trace levels of
nicotine - no more than 0.05 milligrams of nicotine per cigarette. QUEST
cigarettes utilize proprietary and patent pending processes that enable the
production of nicotine-free tobacco that smokes, tastes and burns like tobacco
in conventional cigarettes.
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QUEST is initially available in New York, New Jersey, Pennsylvania,
Ohio, Indiana, Illinois and Michigan. These seven states account for
approximately 30% of all cigarette sales in the United States. Based on the
success of the product in these markets, Vector Tobacco currently expects to
market QUEST nationwide later in 2003. All three QUEST varieties are being sold
in hard packs and are priced comparable to other premium brands. A multi-million
dollar advertising and marketing campaign, with advertisements running in
magazines and regional newspapers, is supporting the product launch. The brand
is also supported by significant point-of-purchase campaigns. Vector Tobacco has
established a website, www.questcigs.com, and a toll free hotline,
1-866-QUEST123, to provide consumers with additional information about QUEST.
The QUEST cigarettes are produced using a patent pending process, which
genetically modifies the tobacco plant to produce nicotine-free tobacco.
Management believes that, based on testing at Vector Tobacco's research
facility, the QUEST 3 product will contain trace levels of nicotine that have no
discernible physiological impact on the smoker, and that, consistent with other
products bearing "free" claims, QUEST 3 may be labeled as "nicotine-free" with
an appropriate disclosure of the trace levels. The QUEST 3 product is similarly
referred to in this report as "nicotine-free". As the process genetically blocks
formation of nicotine in the root of the plant, the tobacco leaf taste is not
affected. Cigarettes produced with this technology have been tested in focus
groups, with such tests indicating that these cigarettes smoke, taste and burn
like conventional cigarettes.
QUEST is intended for adult smokers who may want to transition to
nicotine-free smoking and is not intended as a smoking cessation device. QUEST
is not marketed for smoking cessation, and it has not yet been proven to help
smokers quit. To emphasize this important point for consumers, Vector Tobacco
has included the following additional prominent warning on its QUEST
advertising: "WARNING: This product is NOT intended for use in quitting smoking.
QUEST is for smokers seeking to reduce nicotine exposure only." Vector Tobacco
makes no claims that QUEST is safer than other cigarette products.
Management believes that the technology used to produce the QUEST
product may also allow smokers to reduce their daily consumption of cigarettes,
and may ultimately be a successful bridge to smoking cessation. Vector Tobacco
intends to apply to the FDA for approval of an FDA-regulated tobacco-based
product bearing specific smoking cessation claims when necessary testing data
has been obtained. A number of national and international public health agencies
have made recommendations calling for the removal of nicotine from tobacco
products. Legislation was introduced in Congress in 1995 which would have
lowered nicotine to non-addictive levels over a period of six years. Management
believes that it is generally understood by health advocates that phasing out
nicotine in cigarettes should enable millions of smokers who want to quit
smoking to do so more easily.
OMNI. In November 2001, Vector Tobacco launched OMNI nationwide, the
first reduced carcinogen cigarette that smokes, tastes and burns like other
premium cigarettes. In comparison to comparable styles of the leading U.S.
cigarette brand, OMNI cigarettes produce significantly lower levels of many of
the recognized carcinogens and toxins that the medical community has identified
as major contributors to lung cancer and other diseases in smokers. While OMNI
has not been proven to reduce health risks, management believes that the
significant reduction of carcinogens is a step in the right direction. The data
show lower levels in OMNI of the main carcinogens and toxins in both mainstream
and sidestream tobacco smoke, including polycyclic aromatic hydrocarbons (PAHs),
tobacco specific nitrosamines (TSNAs), catechols and organics, with somewhat
increased levels of nitric oxide and formaldehyde. Mainstream smoke is what the
smoker directly inhales and sidestream smoke, which is the major component of
environmental tobacco smoke, is released from the burning end of a cigarette.
During 2002, acceptance of OMNI in the marketplace was limited, with
revenues of approximately $5.1 million on sales of 70.7 million units. Vector
Tobacco has been unable, to date, to achieve the anticipated breadth of
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distribution and sales of the OMNI product, due, in part, to the lack of success
of its advertising and marketing efforts in differentiating OMNI with consumers
through the "reduced carcinogen" message. Over the next several years,
management plans to conduct appropriate studies as to the effects of OMNI's
reduction of carcinogens and, based on these studies, to review the marketing
and positioning of the OMNI brand in order to formulate a strategy for its
long-term success.
OMNI cigarettes are produced using a patent pending process developed
by Vector Tobacco. Traditional tobacco is treated with a complex catalytic
system that significantly reduces the levels of certain carcinogens and other
toxins. Additionally, OMNI employs the use of an innovative carbon filter, which
reduces a wide range of harmful compounds in smoke, yet has no impact on OMNI's
premium taste. Vector Tobacco is committed to continuing its research to find
new, innovative ways to further reduce carcinogens as well as other identified
substances that may play a role in smoking-related diseases.
Published scientific literature indicates that excessive exposure to
both mainstream and environmental tobacco smoke is the single leading cause of
preventable disease and early mortality in the United States as well as other
countries. Consequently, it is widely accepted by the medical healthcare
community that significantly reducing exposure to tobacco smoke and the many
carcinogenic and toxic constituents in the smoke (preferably by abstaining from
smoking), will substantially improve the health of a large percentage of the
American population. However, despite various types of smoking cessation
programs currently available, the introduction over the last 20 years of several
different types of nicotine-replacement devices and a dramatic reduction in
cigarette advertising, approximately 45 million adult Americans (about 22%)
continue to smoke. Globally, there are more than one billion current smokers and
the World Health Organization estimates that by 2030 over ten million people
will die each year because of smoking related diseases. These ominous statistics
underscore the pressing need to develop alternatives to the existing types of
tobacco products in order to provide the smoker who cannot or will not quit with
a product that contains reduced concentrations of known carcinogens and toxins.
OMNI cigarettes have been developed with this in mind. While Vector
Tobacco makes no health claims for OMNI, the development of the product rests on
the basic principle that significantly reducing the concentrations and exposure
to known tobacco toxins may potentially result in decreased harm, with complete
abstinence from smoking, of course, providing the greatest benefit. Scientists
have determined that, in addition to a number of substances, collectively called
"organics", that contribute directly and indirectly to a spectrum of
tobacco-related diseases, PAHs and TSNAs are among the most potent and dangerous
substances in tobacco smoke in relation to lung cancer incidence. Furthermore,
additional risk to the smoker and nonsmoking bystander occur through the release
from a lit cigarette of sidestream tobacco smoke, which is the most prominent
indoor source of PAHs, and, according to certain authorities, a leading cause of
preventable disease and mortality in the United States. Analysis by validated
methodologies conducted at independent testing laboratories as well as Vector
Tobacco's research division have confirmed that OMNI cigarettes significantly
reduce the concentration of many of the PAHs, TSNAs and organics that may reach
the smoker and nonsmoker when compared to comparable styles of the leading
competitive brand. Refinements to the OMNI product will continue to be made by
Vector Tobacco to achieve further reductions in harmful constituents. Vector
Tobacco has established a website, www.omnicigs.com, which contains detailed
product information and a listing of data concerning OMNI.
The relationship between smoking and disease occurrence is exceedingly
complex. Vector Tobacco has begun the process of devising and funding studies of
the health impact of its new OMNI product. Vector Tobacco does not presently
have any objective evidence that OMNI cigarettes will reduce the known health
risks of cigarette smoking to the smoker or nonsmoking bystander, and no health
claims are being made by Vector Tobacco. Moreover, to underscore and ensure that
the smoker is aware of this important fact, Vector Tobacco has added an
additional prominent warning to the OMNI package and advertising, which states
that: "WARNING: Smoking is addictive and dangerous to your health. Reductions in
carcinogens
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(PAHs, nitrosamines, catechols, and organics) have NOT been proven to result in
a safer cigarette. This product produces tar, carbon monoxide, other harmful
by-products, and increased levels of nitric oxide."
MANUFACTURING AND MARKETING. Both QUEST and OMNI are priced as premium
cigarettes and marketed by the sales representatives of Liggett Vector Brands.
In the first quarter of 2002, Vector Tobacco began production of OMNI at a
facility it had purchased in Timberlake, North Carolina, and converted into a
modern cigarette manufacturing plant. Production of QUEST commenced at the
Timberlake plant in the fourth quarter of 2002. The OMNI product uses
traditional tobaccos, and the QUEST 3 product uses genetically modified tobacco
grown specifically for Vector Tobacco in Pennsylvania, Illinois, Mississippi and
Louisiana. The Quest 1 and 2 products use a mixture of the genetically modified
tobacco as well as traditional tobaccos.
The introduction of the new QUEST and OMNI brands requires the
expenditure of substantial sums for advertising and sales promotion. The
advertising media presently used includes magazines, newspapers, direct mail and
point-of-sale display materials. Sales promotion activities are conducted by
distribution of store coupons, point-of-sale display advertising, advertising of
promotions in print media, and personal contact with distributors, retailers and
consumers.
Expenditures by Vector Tobacco for research and development activities
were $9.7 million in 2002, $12.6 million in 2001 and $6.2 million in 2000.
COMPETITION. The cigarette industry is highly competitive. Vector
Tobacco's competitors generally have substantially greater resources than it
has, including financial, marketing and personnel resources. Other major tobacco
companies have stated that they are working on reduced risk cigarette products
and have made publicly available only limited additional information concerning
their activities at this time. Philip Morris has recently announced that it
plans to introduce a reduced risk product during 2003. R. J. Reynolds Tobacco
Company has stated it will begin during 2003 a phased expansion of a cigarette
product that primarily heats rather than burns tobacco into a select number of
retail chain outlets. In 2002, Brown & Williamson Tobacco Corporation announced
it was test marketing a new cigarette with reduced levels of many toxins. There
is a substantial likelihood that other major tobacco companies will continue to
introduce new products that are designed to compete directly with Vector
Tobacco's reduced nicotine, nicotine-free and reduced carcinogen products.
REGULATION. Federal or state regulators may object to Vector Tobacco's
reduced carcinogen and low nicotine and nicotine-free cigarette products as
unlawful or allege they bear deceptive or unsubstantiated product claims, and
seek the removal of the products from the marketplace, or significant changes to
advertising claims. Various concerns regarding Vector Tobacco's advertising
practices have been expressed to Vector Tobacco by certain state attorneys
general. Vector Tobacco is negotiating in an effort to resolve these concerns.
Allegations by federal or state regulators, public health organizations and
other tobacco manufacturers that Vector Tobacco's products are unlawful, or that
its public statements or advertising contain misleading or unsubstantiated
health claims or product comparisons, may result in litigation or governmental
proceedings. Vector Tobacco's business may become subject to extensive domestic
and international government regulation. Various proposals have been made for
federal, state and international legislation to regulate cigarette manufacturers
generally, and reduced constituent cigarettes specifically. It is possible that
laws and regulations may be adopted covering issues like the manufacture, sale,
distribution and labeling of tobacco products as well as any express or implied
health claims associated with reduced carcinogen and low nicotine and
nicotine-free cigarette products and the use of genetically modified tobacco. A
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system of regulation by agencies like the Food and Drug Administration, the
Federal Trade Commission or the United States Department of Agriculture may be
established. In addition, a group of public health organizations have submitted
a petition to the FDA, alleging that the marketing of the OMNI product is
subject to regulation by the FDA under existing law. Vector Tobacco has filed a
response in opposition to the petition. The FTC has also expressed interest in
the regulation of tobacco products made by tobacco manufacturers, including
Vector Tobacco, which bear reduced carcinogen claims. The ultimate outcome of
any of the foregoing cannot be predicted, but any of the foregoing could have a
material adverse impact on Vector Tobacco's business, operating results and
prospects.
INTELLECTUAL PROPERTY. Vector Tobacco is the exclusive sublicensee of
the technology for reducing or eliminating nicotine in tobacco through certain
genetic engineering techniques. Patent applications for this invention have been
filed in the United States, India and every nation that was a member of the
Patent Cooperation Treaty in 1998, approximately 100 countries in all. Patents
have been issued in more than 10 foreign countries. The applications in the
United States and in other countries remain pending.
Vector Tobacco has filed United States patent applications relating to
the use of palladium and other compounds to reduce the presence of carcinogens
and other toxins. Vector Tobacco plans to file these patent applications
internationally and plans to file additional patent applications relating to
this invention as warranted by its ongoing research. Additional patent
applications related to OMNI have been filed and others are currently being
considered.
The process to reduce carcinogens and toxins from cigarette smoke was
developed by Dr. Robert Bereman, Vice President of Chemical Research at Vector
Research Ltd. Dr. Bereman was formerly a Professor in the Department of
Chemistry at North Carolina State University. The process to genetically modify
tobacco seeds to reduce or eliminate nicotine was developed by Dr. Mark A.
Conkling, Vice President of Genetic Research at Vector Research. Dr. Conkling
was formerly Associate Professor in the Department of Genetics and Director of
the Biotechnology Program at North Carolina State University.
RISKS. Vector Tobacco's new product initiatives are subject to
substantial risks, uncertainties and contingencies which include, without
limitation, the challenges inherent in new product development initiatives, the
ability to raise capital and manage the growth of its business, potential
disputes concerning Vector Tobacco's intellectual property, intellectual
property of third parties, potential extensive government regulation, third
party allegations that Vector Tobacco products are unlawful or bear deceptive or
unsubstantiated product claims, potential delays in obtaining the tobacco, other
raw materials and any technology needed to produce Vector Tobacco's products,
market acceptance of Vector Tobacco's products, competition from companies with
greater resources and the dependence on key employees. See the section entitled
"Risk Factors".
LIGGETT GROUP INC.
GENERAL. Liggett, which is the operating successor to the Liggett &
Myers Tobacco Company, is currently the sixth largest manufacturer of cigarettes
in the United States in terms of unit sales. Substantially all of Liggett's
manufacturing facilities are located in Mebane, North Carolina.
Liggett is a wholly-owned subsidiary of Brooke Group Holding Inc., our
predecessor and a wholly-owned subsidiary of VGR Holding.
Liggett manufactures and sells cigarettes primarily in the United
States. Based on published industry sources, Liggett's domestic shipments of
approximately 9.82 billion cigarettes during 2002 accounted for 2.5% of the
total cigarettes shipped in the United States during such year. This market
share percentage represents an increase of 12.3% from 2001 and 63.5% from 2000.
Liggett produces both premium cigarettes as well as discount cigarettes (which
include among others, control label, private label, branded discount and generic
cigarettes). Premium cigarettes are generally marketed under well-recognized
brand names at full retail prices to adult smokers with strong preference for
branded products, whereas discount cigarettes are marketed at lower retail
prices to adult smokers who are more cost conscious. Liggett's cigarettes are
produced in approximately 240 combinations of length, style and packaging.
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Liggett's premium cigarettes represented approximately 7.2% in 2002,
15.5% in 2001 and 16.0% in 2000 of Liggett's net sales. Based on published
industry sources, Liggett's share of the premium market segment was
approximately 0.3% in 2002, 0.3% for 2001 and 0.2% for 2000. Until May 1999,
Liggett produced four premium cigarette brands: L&M, CHESTERFIELD, LARK and EVE.
As part of the Philip Morris brand transaction (which is further described
below) which closed in May 1999, Liggett transferred the L&M, CHESTERFIELD, and
LARK brands.
Liggett introduced nationally a new premium cigarette, JADE, in
September 2001. JADE is a menthol cigarette with unique holographic packaging.
JADE's sales represented 27.8% of Liggett's total premium unit sales during 2002
and 17.7% during 2001.
In 1980, Liggett was the first major domestic cigarette manufacturer to
successfully introduce discount cigarettes as an alternative to premium
cigarettes. In 1989, Liggett established a new price point within the discount
market segment by introducing PYRAMID, a branded discount product which, at that
time, sold for less than most other discount cigarettes. In 1999, Liggett
introduced LIGGETT SELECT, one of the fastest growing brands in the deep
discount category. LIGGETT SELECT is now the largest seller in Liggett's family
of brands, comprising 42.1% of Liggett's unit volume in 2002, 31.6% in 2001 and
11.1% in 2000. Based on published industry sources, Liggett held a share of
approximately 8.5% of the overall discount market segment for 2002 compared to
7.7% for 2001 and 5.3% for 2000.
The source of industry data in this report is Management Science
Associates. This data does not include all shipments of some manufacturers that
Management Science Associates is presently unable to monitor effectively.
Liggett believes that the industry total domestic shipment volume does not fully
include deep-discount volume.
In November 1999, Liggett acquired an industrial facility in Mebane,
North Carolina. Liggett completed the relocation of its tobacco manufacturing
operations from its old facility in Durham, North Carolina to the Mebane
facility in October 2000.
At the present time, Liggett has only minimal foreign operations.
Liggett does not own the international rights to its largest premium cigarette
brand, EVE, which is marketed by Philip Morris in foreign markets, thereby
adversely affecting Liggett's ability to profitably penetrate those markets.
Liggett exports other cigarette brands primarily to Eastern Europe and the
Middle East. Export sales of approximately 18.8 million cigarettes accounted for
approximately 0.2% of Liggett's 2002 total unit sales volume. Revenues from
export sales were $0.2 million for 2002 as compared to $0.9 million for 2001.
Operating income attributable to export sales in 2002 amounted to approximately
$36,000 compared to operating income of $0.3 million in 2001. In 2000, Liggett
effectively terminated its export business, other than to complete existing
contracts, as domestic margins, on even the lowest priced brands, exceeded those
of its export sales.
BUSINESS STRATEGY. Liggett's business strategy is to capitalize upon its
cost advantage in the United States cigarette market due to the favorable
treatment Liggett has received under the settlement agreements with the state
attorneys general and the Master Settlement Agreement described below. Liggett's
long-term business strategy is to continue to focus its marketing efforts on the
discount segment of the market and to pursue niche opportunities in the premium
segment. Liggett will seek to increase its profitability by upgrading the
efficiency of its manufacturing operation at the Mebane facility and by better
targeting of marketing and selling costs using market research and analysis.
Liggett intends to continue to reinvest a portion of cost savings and a portion
of any future price increases in marketing to grow its volume and income in the
discount segment. Liggett's strategy in the premium segment of the market is to
improve the profitability of its premium brands, EVE and JADE, through targeted
promotional strategies and extensions of the brands. In addition, Liggett may
bring other niche-driven premium brands to the market in the future. Liggett may
also pursue strategic acquisitions of smaller tobacco manufacturers.
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SALES, MARKETING AND DISTRIBUTION. Liggett's products are distributed
from factory distribution centers in Mebane and Timberlake, North Carolina to 20
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 centers 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, warehouse club chains, and large grocery, drug and convenience store
chains. Liggett offers its customers discount payment terms, traditional rebates
and promotional incentives. Customers typically pay for purchased goods within
two weeks following delivery from Liggett, and approximately 70% of customers
pay more rapidly through electronic funds transfer arrangements. Liggett's
largest single customer, Speedway SuperAmerica LLC, accounted for approximately
17.1% of its net sales in 2002, 23.5% of its net sales in 2001 and approximately
29.4% of its net sales in 2000. Sales to this customer were primarily in the
private label discount segment and constituted approximately 18.4% in 2002,
27.9% in 2001 and 35.0% in 2000 of Liggett's sales of discount cigarettes.
During 2002, the sales and marketing functions, along with certain
support functions, of our Liggett and Vector Tobacco subsidiaries were combined
into a new entity, Liggett Vector Brands Inc. This company coordinates and
executes the sales and marketing efforts for all of our tobacco operations.
With the combined resources of Liggett and Vector Tobacco, Liggett Vector
Brands has approximately 430 salespersons, and enhanced distribution and
marketing capabilities. In connection with the formation of the Liggett Vector
Brands entity, we took a charge of $3.46 million in the first quarter of 2002,
related to the reorganization of our business. As of December 31, 2002, our
reorganization accrual has been reduced by payments and impairment of $2.98
million and the remaining balance was $.48 million.
TRADEMARKS. All of the major trademarks used by Liggett are federally
registered or are in the process of being registered in the United States and
other markets where Liggett's products are sold. Trademark registrations
typically have a duration of ten years and can be renewed at Liggett's option
prior to their expiration date. In view of the significance of cigarette brand
awareness among consumers, management believes that the protection afforded by
these trademarks is material to the conduct of its business. All of Liggett's
trademarks are owned by its wholly-owned subsidiary, Eve Holdings Inc., except
for the JADE trademark, which is licensed on a long-term exclusive basis from a
third-party for use in connection with cigarettes.
MANUFACTURING. Liggett purchases and maintains leaf tobacco inventory
to support its cigarette manufacturing requirements. Liggett believes that there
is a sufficient supply of tobacco within the worldwide tobacco market to satisfy
its current production requirements. Liggett stores its leaf tobacco inventory
in warehouses in North Carolina and Virginia. There are several different types
of tobacco, including flue-cured leaf, burley leaf, Maryland leaf, oriental
leaf, cut stems and reconstituted sheet. Leaf components of American style
cigarettes are generally the flue-cured and burley tobaccos. While premium and
discount brands use many of the same tobacco products, input ratios of tobacco
products may vary between premium and discount products. Domestically grown
tobacco is an agricultural commodity subject to United States government
production controls and price supports which can substantially affect its market
price. Foreign flue-cured and burley tobaccos, some of which are used in the
manufacture of Liggett's cigarettes, are generally 30% to 35% less expensive
than comparable domestic tobaccos. Liggett normally purchases all of its tobacco
requirements from domestic and foreign leaf tobacco dealers, much of it under
long-term purchase commitments. As of December 31, 2002, virtually all of
Liggett's commitments were for the purchase of foreign tobacco.
Liggett's new cigarette manufacturing facilities in Mebane, North
Carolina were designed for the execution of short production runs in a
cost-effective manner, which enable Liggett to manufacture and market a wide
variety of cigarette brand styles. Liggett's cigarettes are produced in
approximately 240 different brand styles under Eve's trademarks and brand names
as well as private labels for other companies, typically retail or wholesale
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distributors who supply supermarkets and convenience stores. Liggett believes
that its existing facilities are sufficient to accommodate a substantial
increase in production.
Beginning in October 2001, Liggett upgraded the efficiency of its
manufacturing operation with the addition of four new state-of-the-art cigarette
makers and packers as well as related equipment. The installation of the new
lines continued through May 2002. The total cost of these upgrades was
approximately $20 million. During 2002, Liggett also installed a new tobacco
dryer that has improved both production capacity and the quality of blends. The
cost of the new dryer was approximately $2.9 million.
While Liggett pursues product development, its total expenditures for
research and development on new products have not been financially material over
the past three years.
COMPETITION. Liggett's competition is now divided into two segments.
The first segment is made up of the four largest manufacturers of cigarettes in
the United States: Philip Morris USA Inc., R.J. Reynolds Tobacco Company, Brown
& Williamson Tobacco Corporation and Lorillard Tobacco Company. The four largest
manufacturers, while primarily premium cigarette based companies, also produce
and sell discount cigarettes. The second segment of competition is comprised of
a group of smaller companies, most of which are producing lower quality, deep
discount cigarettes.
Historically, there have been 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, for premium
brands, strong brand loyalty.
Recently, during the phase-in payment period under the Master
Settlement Agreement, these smaller manufacturers have generally not yet been
impacted to a significant degree by the agreement and have primarily focused on
the deepest discount segment of the market. Liggett's management believes, while
these companies have significantly increased market share through competitive
discounting in this segment, they will lose their cost advantage over time as
their payment obligations under the Master Settlement Agreement increase and the
agreement's provisions are more effectively enforced by the states.
In the cigarette business, Liggett must now compete on a dual front.
The four major manufacturers compete among themselves and with Liggett for
premium brand market share on the basis of brand loyalty, advertising and
promotional activities, and trade rebates and incentives. These four competitors
all have substantially greater financial resources and most of their brands have
greater sales and consumer recognition than Liggett's premium brands. Liggett's
discount brands must also compete in the marketplace with the four major
manufacturers' discount brands as well as the smaller manufacturers' deep
discount brands.
Based on published industry sources, Philip Morris' and RJR's sales
together accounted for approximately 72% of the domestic cigarette market in
2002. Liggett's domestic shipments of approximately 9.82 billion cigarettes
during 2002 accounted for 2.5% of the approximately 391.4 billion cigarettes
shipped in the United States during that year, compared to 9.08 billion
cigarettes in 2001 (2.2%) and 6.44 billion cigarettes (1.5%) during 2000.
Industry-wide shipments of cigarettes in the United States have been
generally declining for a number of years, with published industry sources
estimating that domestic industry-wide shipments decreased by approximately 3.7%
(14.9 billion units) in 2002. Liggett's management believes that industry-wide
shipments of cigarettes in the United States will generally continue to decline
as a result of numerous factors, including health considerations, diminishing
social acceptance of smoking, legislative limitations on smoking in public
places, federal and state excise tax increases and settlement-related expenses,
which have contributed to large cigarette price increases.
8
Historically, because of their dominant market share, Philip Morris and
RJR have been able to determine cigarette prices for the various pricing tiers
within the industry and the other cigarette manufacturers have brought their
prices in line with the levels established by the two industry leaders. Off-list
price discounting by manufacturers, however, has substantially affected the
average price differential at retail, which can be significantly less than the
manufacturers' list price gap. Recent discounting by manufacturers has been far
greater than historical levels, and the actual price gap between premium and
deep-discount cigarettes is also greater than historical levels. This has led to
significant movement by consumers from the premium to deep-discount segments.
ACQUISITION OF MEDALLION. On April 1, 2002, a subsidiary of ours
acquired the stock of The Medallion Company, Inc., and related assets from Gary
L. Hall, Medallion's principal stockholder. The total purchase price consisted
of $50 million in cash and $60 million in notes, with the notes guaranteed by us
and Liggett. Medallion is a discount cigarette manufacturer selling product in
the deep discount category, primarily under the USA brand name. Medallion is a
participant in the Master Settlement Agreement between the state attorneys
general and the tobacco industry. Medallion has no payment obligations under the
Master Settlement Agreement unless its market share exceeds approximately 0.28%
of total cigarettes sold in the United States (approximately 1.1 billion units
in 2002).
Following the purchase of the Medallion stock, Vector Tobacco merged
into Medallion and Medallion changed its name to Vector Tobacco Inc., and we
shifted the operations of Medallion to our Timberlake, North Carolina plant. For
purposes of this discussion and segment reporting in this report, references to
the Liggett segment encompass the manufacture and sale of conventional
cigarettes and include the former operations of Medallion (which operations are
held for legal purposes as part of Vector Tobacco).
PHILIP MORRIS BRAND TRANSACTION. In November 1998, we and Liggett
granted Philip Morris options to purchase interests in Trademarks LLC which
holds three domestic cigarette brands, L&M, CHESTERFIELD and LARK, formerly held
by Liggett's subsidiary, Eve.
Under the terms of the Philip Morris agreements, Eve contributed the
three brands to Trademarks, a newly-formed limited liability company, in
exchange for 100% of two classes of Trademarks' interests, the Class A Voting
Interest and the Class B Redeemable Nonvoting Interest. Philip Morris acquired
two options to purchase the interests from Eve. In December 1998, Philip Morris
paid Eve a total of $150 million for the options, $5 million for the option for
the Class A interest and $145 million for the option for the Class B interest.
The Class A option entitled Philip Morris to purchase the Class A
interest for $10.1 million. On March 19, 1999, Philip Morris exercised the Class
A option, and the closing occurred on May 24, 1999.
The Class B option entitles Philip Morris to purchase the Class B
interest for $139.9 million. The Class B option will be exercisable during the
90-day period beginning on December 2, 2008, with Philip Morris being entitled
to extend the 90-day period for up to an additional six months under certain
circumstances. The Class B interest will also be redeemable by Trademarks for
$139.9 million during the same period the Class B option may be exercised.
On May 24, 1999, Trademarks borrowed $134.9 million from a lending
institution. The loan is guaranteed by Eve and is collateralized by a pledge by
Trademarks of the three brands and Trademarks' interest in the trademark license
agreement (discussed below) and by a pledge by Eve of its Class B interest. In
connection with the closing of the Class A option, Trademarks distributed the
loan proceeds to Eve as the holder of the Class B interest. The cash exercise
price of the Class B option and Trademarks' redemption price were reduced by the
amount distributed to Eve. Upon Philip Morris' exercise of the Class B option or
9
Trademarks' exercise of its redemption right, Philip Morris or Trademarks, as
relevant, will be required to obtain Eve's release from its guaranty. The Class
B interest will be entitled to a guaranteed payment of $500,000 each year with
the Class A interest allocated all remaining income or loss of Trademarks.
Trademarks has granted Philip Morris an exclusive license of the three
brands for an 11-year term expiring May 24, 2010 at an annual royalty based on
sales of cigarettes under the brands, subject to a minimum annual royalty
payment of not less than the annual debt service obligation on the loan plus $1
million.
If Philip Morris fails to exercise the Class B option, Eve will have an
option to put its Class B interest to Philip Morris, or Philip Morris'
designees, at a put price that is $5 million less than the exercise price of the
Class B option (and includes Philip Morris' obtaining Eve's release from its
loan guaranty). The Eve put option is exercisable at any time during the 90-day
period beginning March 2, 2010.
If the Class B option, Trademarks' redemption right and the Eve put
option expire unexercised, the holder of the Class B interest will be entitled
to convert the Class B interest, at its election, into a Class A interest with
the same rights to share in future profits and losses, the same voting power and
the same claim to capital as the entire existing outstanding Class A interest,
i.e., a 50% interest in Trademarks.
LEGISLATION, REGULATION AND LITIGATION. Reports with respect to the
alleged harmful physical effects of 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. In 1997, Liggett publicly acknowledged that, as
the Surgeon General and respected medical researchers have found, smoking causes
health problems, including lung cancer, heart vascular disease and emphysema.
Since 1966, federal law has required that cigarettes manufactured,
packaged or imported for sale or distribution in the United States include
specific health warnings on their packaging. Since 1972, Liggett and the other
cigarette manufacturers have included the federally required warning statements
in print advertising, on billboards and on certain categories of point-of-sale
display materials relating to cigarettes. The Federal Cigarette Labeling and
Advertising Act requires that packages of cigarettes distributed in the United
States and cigarette advertisements (other than billboard advertisements) in the
United States bear one of the following four warning statements: "SURGEON
GENERAL'S WARNING: Smoking Causes Lung Cancer, Heart Disease, Emphysema, and May
Complicate Pregnancy"; "SURGEON GENERAL'S WARNING: Quitting Smoking Now Greatly
Reduces Serious Risks to Your Health"; "SURGEON GENERAL'S WARNING: Smoking by
Pregnant Women May Result in Fetal Injury, Premature Birth, and Low Birth
Weight"; and "SURGEON GENERAL'S WARNING: Cigarette Smoke Contains Carbon
Monoxide". The law also requires that each person who manufactures, packages or
imports cigarettes annually provide to the Secretary of Health and Human
Services a list of ingredients added to tobacco in the manufacture of
cigarettes. Annual reports to the United States Congress are also required from
the Secretary of Health and Human Services as to current information on the
health consequences of smoking and from the FTC on the effectiveness of
cigarette labeling and current practices and methods of cigarette advertising
and promotion. Both federal agencies are also required annually to make such
recommendations as they deem appropriate with regard to further legislation. In
addition, since 1997, Liggett has included the warning "Smoking is Addictive" on
its cigarette packages.
In August 1996, the FDA filed in the Federal Register a Final Rule
classifying tobacco as a "drug" or "medical device", asserting jurisdiction over
the manufacture and marketing of tobacco products and imposing restrictions on
the sale, advertising and promotion of tobacco products. Litigation was
commenced challenging the FDA's authority to assert such jurisdiction, as well
10
as challenging the constitutionality of the rules. In March 2000, the United
States Supreme Court ruled that the FDA does not have the power to regulate
tobacco. Liggett supported the FDA rule and began to phase in compliance with
certain of the proposed FDA regulations.
Since the Supreme Court decision, various proposals and recommendations
have been made for additional federal and state legislation to regulate
cigarette manufacturers. Congressional advocates of FDA regulation have
introduced legislation that would give the FDA authority to regulate the
manufacture, sale, distribution and labeling of tobacco products to protect
public health, thereby allowing the FDA to reinstate its prior regulations or
adopt new or additional regulations. The ultimate outcome of these proposals
cannot be predicted.
In August 1996, Massachusetts enacted legislation requiring tobacco
companies to publish information regarding the ingredients in cigarettes and
other tobacco products sold in that state. In December 1997, the United States
District Court for the District of Massachusetts enjoined this legislation from
going into effect on the grounds that it was preempted by federal law. In
November 1999, the First Circuit affirmed this ruling. In September 2000, the
federal district court permanently enjoined enforcement of the law. In October
2001, the First Circuit reversed the district court's decision, ruling that the
ingredients disclosure provisions are valid. The entire court, however, agreed
to re-hear the appeal, reinstating the district court's injunction in the
meantime. In December 2002, the First Circuit ruled that the ingredients
disclosure provisions violated the constitutional prohibition against unlawful
seizure of property by forcing firms to reveal trade secrets. The decision was
not appealed by the state. Notwithstanding the foregoing, in December 1997,
Liggett began complying with this legislation by providing ingredient
information to the Massachusetts Department of Public Health. Several other
states have enacted, or are considering, legislation similar to that enacted in
Massachusetts.
In 1993, Congress amended the Agricultural Adjustment Act of 1938 to
require each United States cigarette manufacturer to use at least 75% domestic
tobacco in the aggregate of the cigarettes manufactured by it in the United
States, effective January 1994, on an annualized basis or pay a domestic
marketing assessment based upon price differentials between foreign and domestic
tobacco and, under certain circumstances, make purchases of domestic tobacco
from the tobacco stabilization cooperatives organized by the United States
government. After an audit, the United States Department of Agriculture informed
Liggett that it did not satisfy the 75% domestic tobacco usage requirement in
1994 and Liggett paid a $5.5 million assessment. Since the levels of domestic
tobacco inventories on hand at the tobacco stabilization organizations were
below reserve stock levels, Liggett was not obligated to make purchases of
domestic tobacco from the tobacco stabilization cooperatives.
In February 1996, the United States Trade representative issued an
"advance notice of proposed rule making" concerning how tobaccos imported under
a previously established tobacco rate quota should be allocated. Currently,
tobacco imported under the quota is allocated on a "first-come, first-served"
basis, meaning that entry is allowed on an open basis to those first requesting
entry in the quota year. Others in the cigarette industry have suggested an
"end-user licensing" system under which the right to import tobacco under the
quota would be initially assigned on the basis of domestic market share. Such an
approach, if adopted, could have a material adverse effect on Liggett.
In January 1993, the Environmental Protection Agency released a report
on the respiratory effect of secondary smoke which concluded that secondary
smoke is a known human lung carcinogen in adults and, in children, causes
increased respiratory tract disease and middle ear disorders and increases the
severity and frequency of asthma. In June 1993, the two largest domestic
cigarette manufacturers, together with other segments of the tobacco and
distribution industries, commenced a lawsuit against the agency seeking a
determination that the agency did not have the statutory authority to regulate
11
secondary smoke and that given the current body of scientific evidence and the
agency's failure to follow its own guidelines in making the determination, its
classification of secondary smoke was arbitrary and capricious. In July 1998, a
federal district court vacated those sections of the report relating to lung
cancer, finding that the agency may have reached different conclusions had it
complied with relevant statutory requirements. The federal government appealed
the court's ruling. In December 2002, the United States Court of Appeals for the
Fourth Circuit rejected the industry challenge to the EPA report ruling that it
was not subject to court review. Issuance of the report may encourage efforts to
limit smoking in public areas.
Cigarettes are subject to substantial federal, state and local excise
taxes which, in general, have been increasing. The federal excise tax on
cigarettes is currently $0.39 per pack. State and local sales and excise taxes
vary considerably and, when combined with sales taxes, local taxes and the
current federal excise tax, may currently be as high as $4.10 per pack. Proposed
further tax increases in various jurisdictions are currently under consideration
or pending. In 2002, 21 states passed excise tax increases, ranging from $0.07
per pack in Tennessee to as much as $1.81 per pack in New York City and New York
State combined. Congress has considered significant increases in the federal
excise tax or other payments from tobacco manufacturers, and significant
increases in excise and other cigarette-related taxes have been proposed or
enacted at the state and local levels. Management believes that increases
in excise and similar taxes have had an adverse impact on sales of cigarettes.
In August 2000, the New York state legislature passed legislation
charging the state's Office of Fire Prevention and Control with developing
standards for "fire safe" or self-extinguishing cigarettes. On December 31,
2002, the OFPC issued proposed standards for public comment. Six months from the
issuance of the final standards, all cigarettes offered for sale in New York
state will be required to be manufactured to those standards. It is not possible
to predict the impact of this law on us until the final standards are published.
Similar legislation is being considered by other state legislatures and at the
federal level.
There are various other legislative efforts pending on the federal and
state level which seek, among other things, to restrict or prohibit smoking in
public buildings and other areas, further restrict displays and advertising of
cigarettes, require additional warnings, including graphic warnings, on
cigarette packaging and advertising, ban vending machine sales and curtail
affirmative defenses of tobacco companies in product liability litigation. If
adopted, at least certain of the foregoing legislative proposals could have a
material adverse impact on Liggett and us.
While attitudes toward cigarette smoking vary around the world, a
number of foreign countries have also taken steps to discourage cigarette
smoking, to restrict or prohibit cigarette advertising and promotion and to
increase taxes on cigarettes. Those restrictions are, in some cases, more
onerous than restrictions imposed in the United States. Due to Liggett's lack of
foreign operations and minimal export sales to foreign countries, the risks of
foreign limitations or restrictions on the sale of cigarettes are limited to
entry barriers into additional foreign markets and the inability to expand the
existing markets.
The cigarette industry continues to be challenged on numerous fronts.
The industry is facing increased pressure from anti-smoking groups and an
increase in smoking and health litigation, including private class action
litigation and health care cost recovery actions brought by governmental
entities and other third parties, the effects of which, at this time, we are
unable to evaluate. As of December 31, 2002, there were approximately 305
individual suits, approximately 39 purported class actions or actions where
class certification has been sought and approximately 46 governmental and other
third-party payor health care recovery actions pending in the United States in
which Liggett was a named defendant. In addition to these cases, during 2000, an
action against cigarette manufacturers involving approximately 1,260 named
individual plaintiffs was consolidated before a single West Virginia state
12
court. Liggett is a defendant in most of the cases pending in West Virginia.
These cases are referred to herein as though commenced against Liggett (without
regard to whether such cases were actually commenced against Liggett or against
Brooke Group Holding, our predecessor, and a wholly-owned subsidiary of VGR
Holding). The plaintiffs' allegations of liability in those cases in which
individuals seek recovery for injuries allegedly caused by cigarette smoking are
based on various theories of recovery, including negligence, gross negligence,
breach of special duty, strict liability, fraud, misrepresentation, design
defect, failure to warn, breach of express and implied warranties, conspiracy,
aiding and abetting, concert of action, unjust enrichment, common law public
nuisance, property damage, invasion of privacy, mental anguish, emotional
distress, disability, shock, indemnity and violations of deceptive trade
practice laws, the Federal Racketeer Influenced and Corrupt Organization Act,
state racketeering statutes and antitrust statutes. In many of these cases, in
addition to compensatory damages, plaintiffs also seek other forms of relief
including treble/multiple damages, medical monitoring, disgorgement of profits
and punitive damages. Defenses raised by defendants in these cases include lack
of proximate cause, assumption of the risk, comparative fault and/or
contributory negligence, lack of design defect, statutes of limitations,
equitable defenses such as "unclean hands" and lack of benefit, failure to state
a claim and federal preemption.
The claims asserted in the health care cost recovery actions vary. In
most of these cases, plaintiffs assert the equitable claim that the tobacco
industry was "unjustly enriched" by plaintiffs' payment of health care costs
allegedly attributable to smoking and seek reimbursement of those costs. Other
claims made by some but not all plaintiffs include the equitable claim of
indemnity, common law claims of negligence, strict liability, breach of express
and implied warranty, breach of special duty, fraud, negligent
misrepresentation, conspiracy, public nuisance, claims under state and federal
statutes governing consumer fraud, antitrust, deceptive trade practices and
false advertising, and claims under RICO.
In September 1999, the United States government commenced litigation
against Liggett and the other tobacco companies in the United States District
Court for the District of Columbia. The action seeks to recover an unspecified
amount of health care costs paid for and furnished, and to be paid for and
furnished, by the Federal Government for lung cancer, heart disease, emphysema
and other smoking-related illnesses allegedly caused by the fraudulent and
tortious conduct of defendants, to restrain defendants and co-conspirators from
engaging in fraud and other unlawful conduct in the future, and to compel
defendants to disgorge the proceeds of their unlawful conduct. The complaint
alleges that such costs total more than $20 billion annually. The action asserts
claims under three Federal statutes: the Medical Care Recovery Act, the Medicare
Secondary Payer provisions of the Social Security Act and RICO. In December
1999, Liggett filed a motion to dismiss the lawsuit on numerous grounds,
including that the statutes invoked by the government do not provide a basis for
the relief sought. In September 2000, the court dismissed the government's
claims based on the Medical Care Recovery Act and the Medicare Secondary Payor
provisions, and the court reaffirmed its decision in July 2001. In the September
2000 ruling, the court also determined not to dismiss the government's claims
based on RICO, under which the government continues to seek court relief to
restrain the defendant tobacco companies from allegedly engaging in fraud and
other unlawful conduct and to compel disgorgement.
In June 2001, the United States Attorney General assembled a team of
three Department of Justice lawyers to work on a possible settlement of the
federal lawsuit. The government lawyers met with representatives of the tobacco
industry, including Liggett, in July 2001. No settlement was reached, and no
further meetings are planned. In a January 2003 filing with the court, the
government alleged that disgorgement by defendants of approximately $289 billion
is an appropriate remedy in the case. Discovery in the case has commenced, and
trial has been scheduled for September 2004.
Approximately 38 purported state and federal class action complaints
have been filed against the cigarette manufacturers for alleged antitrust
violations, including Liggett and Brooke Group Holding. The actions allege that
the cigarette manufacturers have engaged in a nationwide and international
conspiracy to fix the price of cigarettes in violation of state and federal
antitrust laws. Plaintiffs allege that defendants' price-fixing conspiracy
raised the price of cigarettes above a competitive level. Plaintiffs in the 31
state actions purport to represent classes of indirect purchasers of cigarettes
in 16 states; plaintiffs in the seven federal actions purport to represent a
13
nationwide class of wholesalers who purchased cigarettes directly from the
defendants. The federal class actions have been consolidated and, in July 2000,
plaintiffs in the federal consolidated action filed a single consolidated
complaint that did not name Liggett or Brooke Group Holding as defendants,
although Liggett has complied with discovery requests. The court granted
defendants' motion for summary judgment in the consolidated federal cases in
July 2002, which decision has been appealed by plaintiffs to the U.S. Court of
Appeals for the Eleventh Circuit. Oral argument is scheduled for April 2003.
State court cases have been dismissed in Arizona, which is currently on appeal,
and in New York and Florida. Class certification has been denied by courts in
Minnesota and Michigan. A Kansas court granted class certification in November
2001, and the trial in that case is currently scheduled to commence in October
2003. Liggett is one of the defendants in the Kansas case.
In 1996, 1997 and 1998, Brooke Group Holding and Liggett entered into
settlements of smoking-related litigation with the Attorneys General of 45
states and territories. The settlements released Brooke Group Holding and
Liggett from all smoking-related claims, including claims for health care cost
reimbursement and claims concerning sales of cigarettes to minors.
In November 1998, Philip Morris, RJR, Brown & Williamson, Lorillard and
Liggett entered into the Master Settlement Agreement with 46 states, the
District of Columbia, Puerto Rico, Guam, the United States Virgin Islands,
American Samoa and the Northern Marianas to settle the asserted and unasserted
health care cost recovery and certain other claims of those settling
jurisdictions. As described above, Brooke Group Holding and Liggett had previous
settlements with a number of these settling states. The Master Settlement
Agreement has received final judicial approval in each of the 52 settling
jurisdictions.
Liggett has no payment obligations under the Master Settlement
Agreement unless its market share exceeds a base share of 125% of its 1997
market share, or approximately 1.65% of total cigarettes sold in the United
States. As a result of the Medallion acquisition on April 1, 2002, Vector
Tobacco has no payment obligations under the MSA except to the extent its market
share exceeds a base amount of approximately 0.28% of total cigarettes sold in
the United States. During 1999 and 2000, Liggett's market share did not exceed
the base amount. Based on published industry sources, domestic shipments by
Liggett and Vector Tobacco accounted for 2.2% of the total cigarettes shipped in
the United States during 2001 and 2.5% during 2002. On April 15 of any year
following a year in which Liggett's and Vector Tobacco's market shares exceed
their base shares, Liggett and Vector Tobacco will pay on each excess unit an
amount equal (on a per-unit basis) to that paid during such following year by
the original participating manufacturers under the annual and strategic
contribution payment provisions of the Master Settlement Agreement, subject to
applicable adjustments, offsets and reductions. In April 2002, Liggett and
Vector Tobacco paid a total of $31.1 million for their 2001 MSA obligations.
Liggett and Vector Tobacco have expensed $35.4 million for their estimated
Master Settlement Agreement obligations for 2002 as part of cost of goods sold.
Under the annual and strategic contribution payment provisions of the Master
Settlement Agreement, the original participating manufacturers (and Liggett and
Vector Tobacco to the extent their market shares exceed their base shares) are
required to pay the following annual amounts (subject to certain adjustments):
YEAR AMOUNT
- ---- ------
2003..................................... $6.5 billion
2004 - 2007.............................. $8.0 billion
2008 - 2017.............................. $8.1 billion
2018 and each year thereafter........... $9.0 billion
These annual payments will be allocated based on relative unit volume
of domestic cigarette shipments. The payment obligations under the Master
Settlement Agreement are the several, and not joint, obligations of each
participating manufacturer and are not the responsibility of any parent or
affiliate of a participating manufacturer.
14
The Master Settlement Agreement replaces Liggett's prior settlements
with all states and territories except for Florida, Mississippi, Texas and
Minnesota. Each of the states of Florida, Mississippi, Texas and Minnesota,
prior to the effective date of the Master Settlement Agreement, negotiated and
executed settlement agreements with each of the other major tobacco companies
separate from those settlements reached previously with Liggett. Because these
states' settlement agreements with Liggett provided for "most favored nation"
protection for both Brooke Group Holding and Liggett, any payments due these
states by Liggett (with certain possible exceptions) have been eliminated.
In May 1994, an action entitled ENGLE, ET AL. V. R.J. REYNOLDS TOBACCO
COMPANY, ET AL., Circuit Court, Eleventh Judicial Circuit, Dade County, Florida,
was filed against Liggett and others. The class consists of all Florida
residents and citizens, and their survivors, who have suffered, presently suffer
or have died from diseases and medical conditions caused by their addiction to
cigarettes that contain nicotine. Phase I of the trial commenced in July 1998
and in July 1999, the jury returned the Phase I verdict. The Phase I verdict
concerned certain issues determined by the trial court to be "common" to the
causes of action of the plaintiff class. Among other things, the jury found
that: smoking cigarettes causes 20 diseases or medical conditions, cigarettes
are addictive or dependence producing, defective and unreasonably dangerous,
defendants made materially false statements with the intention of misleading
smokers, defendants concealed or omitted material information concerning the
health effects and/or the addictive nature of smoking cigarettes and agreed to
misrepresent and conceal the health effects and/or the addictive nature of
smoking cigarettes, and defendants were negligent and engaged in extreme and
outrageous conduct or acted with reckless disregard with the intent to inflict
emotional distress. The jury also found that defendants' conduct "rose to a
level that would permit a potential award or entitlement to punitive damages."
The court decided that Phase II of the trial, which commenced November 1999,
would be a causation and damages trial for three of the class representatives
and a punitive damages trial on a class-wide basis, before the same jury that
returned the verdict in Phase I. On April 7, 2000, the jury awarded compensatory
damages of $12.7 million to the three plaintiffs, to be reduced in proportion to
the respective plaintiff's fault. The jury also decided that the claim of one of
the plaintiffs, who was awarded compensatory damages of $5.8 million, was not
timely filed. On July 14, 2000, the jury awarded approximately $145 billion in
the punitive damages portion of Phase II against all defendants including $790
million against Liggett. The court entered a final order of judgment against the
defendants on November 6, 2000. The court's final judgment also denied various
of defendants' post-trial motions, which included a motion for new trial and a
motion seeking reduction of the punitive damages award. Liggett intends to
pursue all available post-trial and appellate remedies. Oral argument before
Florida's Third District Court of Appeals was held in November 2002. An opinion
from this intermediate appellate court is expected in 2003. If this verdict is
not eventually reversed on appeal, or substantially reduced by the court, it
will have a material adverse effect on Vector. Phase III of the trial will be
conducted before separate juries to address absent class members' claims,
including issues of specific causation and other individual issues regarding
entitlement to compensatory damages.
Management is not able to predict the outcome of the litigation pending
against Brooke Group Holding or Liggett. Litigation is subject to many
uncertainties. An unfavorable verdict was returned in the first phase of the
ENGLE smoking and health class action trial pending in Florida. In July 2000,
the jury awarded $790 million in punitive damages against Liggett in the second
phase of the trial, and the court has entered an order of final judgment.
Liggett intends to pursue all available post-trial and appellate remedies. If
this verdict is not eventually reversed on appeal, or substantially reduced by
the court, it will have a material adverse effect on us. Liggett has filed the
$3.45 million bond required under the bonding statute enacted in 2000 by the
15
Florida legislature which limits the size of any bond required, pending appeal,
to stay execution of a punitive damages verdict. On May 7, 2001, Liggett reached
an agreement with the class in the ENGLE case, which will provide assurance to
Liggett that the stay of execution, currently in effect pursuant to the Florida
bonding statute, will not be lifted or limited at any point until completion of
all appeals, including to the United States Supreme Court. As required by the
agreement, Liggett paid $6.27 million into an escrow account to be held for the
benefit of the ENGLE class, and released, along with Liggett's existing $3.45
million statutory bond, to the court for the benefit of the class upon
completion of the appeals process, regardless of the outcome of the appeal. As a
result, we recorded a $9.7 million pre-tax charge to the consolidated statement
of operations for the year ended December 31, 2001. In June 2002, the jury in an
individual case brought under the third phase of the ENGLE case awarded $37.5
million of compensatory damages against Liggett and two other defendants and
found Liggett 50% responsible for the damages. The verdict will be subject to
the outcome of the ENGLE appeal. It is possible that additional cases could be
decided unfavorably and that there could be further adverse developments in the
ENGLE case. Management cannot predict the cash requirements related to any
future settlements and judgments, including cash required to bond any appeals,
and there is a risk that those requirements will not be able to be met. An
unfavorable outcome of a pending smoking and health case could encourage the
commencement of additional similar litigation. Management is unable to make a
meaningful estimate with respect to the amount or range of loss that could
result from an unfavorable outcome of the cases pending against Brooke Group
Holding or Liggett or the costs of defending such cases. The complaints filed in
these cases rarely detail alleged damages. Typically, the claims set forth in an
individual's complaint against the tobacco industry pray for money damages in an
amount to be determined by a jury, plus punitive damages and costs. These damage
claims are typically stated as being for the minimum necessary to invoke the
jurisdiction of the court.
It is possible that our consolidated financial position, results of
operations or cash flows could be materially adversely affected by an
unfavorable outcome in any such smoking-related litigation.
Liggett's management is unaware of any material environmental
conditions affecting its existing facilities. Liggett's management believes that
current operations are conducted in accordance with all environmental laws and
regulations. 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 not had a material effect on the capital
expenditures, earnings or competitive position of Liggett.
Liggett's management believes that it is in compliance in all material
respects with the laws regulating cigarette manufacturers.
See Note 15 to our consolidated financial statements, which contains a
description of legislation, regulation and litigation and of the Master
Settlement Agreement and Brooke Group Holding's and Liggett's other settlements.
LIGGETT-DUCAT LTD.
In August 2000, Brooke (Overseas) Ltd., a wholly-owned subsidiary of
VGR Holding, completed the sale of all of the membership interests of Western
Tobacco Investments LLC to Gallaher Overseas (Holdings) Ltd. Brooke (Overseas)
held its 99.9% equity interest in Liggett-Ducat Ltd., a Russian joint stock
company, through its subsidiary Western Tobacco Investments LLC. Liggett-Ducat,
one of Russia's leading cigarette producers since 1892, produced or had rights
to produce 26 different brands of cigarettes, including Russian brands such as
Pegas, Prima, Novosti and Belomorkanal, and American blend cigarettes under the
names Dukat and LD.
The purchase price for the sale consisted of $334.1 million in cash and
$64.4 million in assumed debt and capital commitments. The proceeds generated
from the sale were divided among Brooke (Overseas) and Western Realty
Development LLC, a joint venture of New Valley and Apollo Real Estate Investment
Fund III, L.P., in accordance with the terms of the participating loan. Of the
net cash proceeds from the transaction, Brooke (Overseas) received $197.1
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million, New Valley received $57.2 million and Apollo received $68.3 million. We
recorded a gain of $161 million (including our share of New Valley's gain), net
of income taxes and minority interests, in connection with the sale in 2000.
NEW VALLEY CORPORATION
GENERAL. New Valley, a Delaware corporation, is engaged in the real
estate business and is seeking to acquire additional operating companies. New
Valley owns, through its New Valley Realty Division, two commercial office
buildings in Princeton, N.J. and a 50% interest in the former Kona Surf Hotel in
Kailua-Kona, Hawaii. New Valley also holds a 50% interest in Montauk Battery
Realty LLC, which owns the largest residential brokerage company in the New York
metropolitan area. In December 2001, New Valley completed the distribution to
its stockholders of its shares in Ladenburg Thalmann Financial Services Inc.,
its former majority-owned subsidiary engaged in the investment banking and
brokerage business. New Valley (NASDAQ: NVAL) is registered under the Securities
Exchange Act of 1934 and files periodic reports and other information with the
SEC.
As of March 21, 2003 VGR Holding holds, either directly or indirectly
through VGR Holding's wholly-owned subsidiary, New Valley Holdings, Inc.,
approximately 58.0% of the common shares of New Valley.
New Valley was originally organized under the laws of New York in 1851
and operated for many years under the name "Western Union Corporation". In 1991,
bankruptcy proceedings were commenced against New Valley. In January 1995, New
Valley emerged from bankruptcy. As part of the plan of reorganization, New
Valley sold the Western Union money transfer and messaging services businesses
and all allowed claims in the bankruptcy were paid in full.
In October 1999, New Valley's board of directors authorized the
repurchase of up to 2,000,000 common shares from time to time in the open market
or in privately negotiated transactions. As of December 31, 2002, New Valley had
repurchased 867,043 shares for approximately $3.3 million.
PLAN OF RECAPITALIZATION. New Valley consummated a plan of
recapitalization on June 4, 1999, following approval by New Valley's
stockholders. Pursuant to the plan of recapitalization:
o each $15.00 Class A senior preferred share ($100 liquidation) was
reclassified into 20 Common Shares and one Warrant exercisable for
five years,
o each $3.00 Class B preferred share was reclassified into 1/3 of a
common share and five warrants, and
o each outstanding common share was reclassified into 1/10 of a common
share and 3/10 of a warrant.
The recapitalization had a significant effect on New Valley's financial
position and results of operations. As a result of the exchange of the
outstanding preferred shares for common shares and warrants in the
recapitalization, New Valley's stockholders' equity increased by $343.4 million
from the elimination of the carrying value and dividend arrearages on the
redeemable preferred stock. Furthermore, the recapitalization resulted in the
elimination of the on-going dividend accruals on the existing redeemable
preferred shares of New Valley, as well as the redemption obligation for the
Class A preferred shares in January 2003. Also as a result of the
recapitalization, the number of outstanding common shares more than doubled, and
17
additional common shares were reserved for issuance upon exercise of the
warrants, which have an initial exercise price of $12.50 per common share. In
addition, we increased our ownership of the common shares from 42.3% to 55.1%,
and its total voting power from 42% to 55.1%. We currently own approximately 58%
of New Valley's common shares. If all outstanding warrants were exercised, the
percentage of the common shares that we own would decline to approximately 40%.
BUSINESS STRATEGY. Following the distribution of the Ladenburg Thalmann
Financial Services shares in 2001 and asset dispositions in Russia in December
2001 and April 2002 (discussed below), New Valley is engaged in the real estate
business and holds a significant amount of cash and other investments. The
business strategy of New Valley is to continue to operate its real estate
business and to acquire operating companies through merger, purchase of assets,
stock acquisition or other means, or to acquire control of operating companies
through one of such means. In the interim, New Valley's cash and investments
(aggregating approximately $96 million at December 31, 2002) are available for
general corporate purposes, including for acquisition purposes.
As a result of the distribution of the Ladenburg Thalmann Financial
Services shares, New Valley's broker-dealer operations, which were the primary
source of New Valley's revenues between May 1995 and December 2001, have been
treated as discontinued operations in its accompanying consolidated financial
statements. See "Discontinued Operations - Broker-Dealer".
NEW VALLEY REALTY DIVISION
ACQUISITION OF OFFICE BUILDINGS. On December 13, 2002, New Valley
completed the acquisition of two commercial office buildings in Princeton, N.J.
for an aggregate purchase price of $54 million. New Valley purchased the two
adjacent office buildings, located at 100 and 150 College Road West, from 100
College Road, LLC, an entity affiliated with Patrinely Group LLC and Apollo Real
Estate Investment Fund III, L.P. The two buildings were constructed in July 2000
and June 2001 and have a total of approximately 225,000 square feet of rentable
space.
New Valley acquired a fee simple interest in each office building
(subject to certain rights of existing tenants) and in the underlying land for
each property. Space in the office buildings is leased to commercial tenants
and, as of December 31, 2002, the office buildings were approximately 98%
occupied.
To finance a portion of the purchase price for the office buildings, on
the closing date, New Valley borrowed $40.5 million from HSBC Realty Credit
Corporation (USA). The loan has a term of four years, bears interest at a
floating rate of 2% above LIBOR, and is collateralized by a first mortgage on
the office buildings, as well as by an assignment of leases and rents. Principal
is amortized to the extent of $53,635 per month during the term of the loan. The
loan may be prepaid without penalty and is non-recourse against New Valley,
except for various specified environmental and related matters, misapplications
of tenant security deposits and insurance and condemnation proceeds, and fraud
or misrepresentation by New Valley in connection with the indebtedness.
Concurrently with the acquisition of the office buildings, New Valley
engaged a property-management affiliate of Patrinely Group LLC that had
previously managed the office buildings to act as the property manager for the
office buildings. The agreement has a one-year term, but may be terminated by
New Valley on 30 days' notice without cause or economic penalty (other than the
payment of one month's management fee).
HAWAIIAN HOTEL. In July 2001, Koa Investors, LLC, an entity owned by
New Valley, developer Brickman Associates and other investors, acquired the
leasehold interests in the former Kona Surf Hotel in Kailua-Kona, Hawaii in a
foreclosure proceeding. New Valley, which holds a 50% interest in Koa Investors,
has invested $5.9 million in the project and was required to make additional
investments of up to an aggregate of $6.6 million at December 31, 2002. New
Valley accounts for its investment in Koa Investors under the equity method and
recorded losses of $1.3 million in 2002 associated with the Kona Surf Hotel.
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The hotel is located on a 20-acre tract, which is leased under two
ground leases with Kamehameha Schools, the largest private land owner in Hawaii.
In December 2002, Koa Investors and Kamehameha amended the leases to provide for
significant rent abatements over the next ten years and extended the remaining
term of the leases from 33 years to 65 years. In addition, Kamehameha granted
Koa Investors various right of first offer opportunities to develop adjoining
resort sites.
Koa Investors is presently negotiating with Starwood Hotels and Resorts
Worldwide, Inc. to reopen the hotel as the Sheraton Keauhou Resort, a three star
family resort with approximately 530 rooms. Proposed improvements to the
property would include comprehensive room enhancements, construction of a fresh
water 13,000 square foot fantasy pool, lobby and entrance improvements, a new
gym and beachfront spa, retail stores and new restaurants. A 20,000 square foot
convention center, wedding chapel and other revenue producing amenities would
also be restored.
Koa Investors estimates that the cost of the hotel's renovation will be
approximately $45 million. Preliminary development is underway and, subject to
completing the necessary financing arrangements, the reopening of the hotel is
scheduled for late 2004. A predevelopment credit line of $5 million was obtained
in 2002 from a Taiwanese lender. Koa Investors is currently in discussion with
the lender to finance the planned renovation. However, no assurance can be given
that such financing will be available on terms acceptable to Koa Investors.
SALES OF SHOPPING CENTERS. In February 2001, New Valley sold its Royal
Palm Beach, Florida shopping center for $9.5 million before closing adjustments
and expenses and recorded a gain of $0.9 million on the sale. In May 2002, New
Valley disposed of its remaining shopping center in Kanawha, West Virginia and
recorded a gain of approximately $0.6 million for the year ended December 31,
2002, which represented the shopping center's negative book value, in connection
with the disposal. No proceeds were received in the disposal.
MONTAUK BATTERY REALTY LLC. During 2000 and 2001, New Valley acquired
for approximately $1.7 million a 37.2% ownership interest in B&H Associates of
NY, doing business as Prudential Long Island Realty, the largest independently
owned and operated real estate brokerage company on Long Island, and a minority
interest in an affiliated mortgage company. On December 19, 2002, New Valley and
the other owners of Prudential Long Island Realty contributed their interests in
Prudential Long Island Realty to Montauk Battery Realty LLC, a newly formed
entity. New Valley acquired a 50% interest in Montauk as a result of an
additional investment of approximately $1.4 million by New Valley and the
redemption by Prudential Long Island Realty of various ownership interests. As
part of the transaction, Prudential Long Island Realty renewed its franchise
agreement with The Prudential Real Estate Affiliates, Inc. for an additional
ten-year term. The owners of Montauk also agreed, subject to receipt of any
required regulatory approvals, to contribute to Montauk their interests in the
related mortgage company. New Valley accounts for its interest in Montauk on the
equity method and recorded income of $0.6 million in 2002 associated with
Montauk.
On March 14, 2003, Montauk purchased the leading New York City-based
residential brokerage firm, Insignia Douglas Elliman, and an affiliated property
management company, for $71.25 million. As a result of the acquisition,
Montauk's brokerage operations, to be known as Prudential Douglas Elliman, will
be the largest residential brokerage company in the New York metropolitan area.
New Valley invested an additional $9.5 million in subordinated debt and equity
of Montauk to help fund the acquisition.
RUSSIAN REAL ESTATE
BROOKEMIL LTD. In January 1997, New Valley purchased BrookeMil Ltd.
from Brooke (Overseas) Ltd., an indirect wholly-owned subsidiary of ours.
BrookeMil, which was engaged in the real estate development business in Moscow,
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Russia, was the developer of a three-phase complex on 2.2 acres of land in
downtown Moscow, for which it had a 49-year lease. In 1993, the first phase of
the project, Ducat Place I, a 46,500 sq. ft. Class-A office building, was
successfully built and leased. In April 1997, BrookeMil sold Ducat Place I to
one of its tenants, Citibank. In 1997, BrookeMil completed construction of Ducat
Place II, a premier 150,000 sq. ft. office building. Ducat Place II was leased
to a number of leading international companies and was one of the leading modern
office buildings in Moscow due to its design and full range of amenities. The
third phase, Ducat Place III, had been planned as an office tower. BrookeMil was
also engaged in the acquisition and preliminary development of the Kremlin sites
in Moscow.
WESTERN REALTY DEVELOPMENT. In February 1998, New Valley and Apollo
Real Estate Investment Fund III, L.P. organized Western Realty Development LLC
to make real estate investments in Russia. New Valley contributed the real
estate assets of BrookeMil, including the Ducat Place II office building and the
adjoining site for the proposed development of Ducat Place III, to Western
Realty Development, and Apollo contributed $73.3 million, including the
investment in Western Realty Repin LLC discussed below.
Western Realty Development made a $30 million participating loan to
Western Tobacco Investments LLC which held Brooke (Overseas)'s interest in
Liggett-Ducat Ltd., which was engaged in the tobacco business in Russia. In
August 2000, Western Tobacco Investments was sold to Gallaher Group Plc and the
proceeds were divided between us and Western Realty Development in accordance
with the terms of the participating loan, which was terminated at the closing.
Through their investments in Western Realty Development, New Valley received
$57.2 million in cash proceeds from the sale and Apollo received $68.3 million.
New Valley recorded a gain of $52.5 million in connection with the transaction
in 2000.
On December 21, 2001, Western Realty Development sold to Andante
Limited, a Bermuda company, all of the membership interests in its subsidiary
Western Realty Investments LLC, the entity through which Western Realty
Development owned Ducat Place II and the adjoining Ducat Place III site. The
purchase price for the sale was approximately $42 million including the
assumption of mortgage debt and payables. Of the net cash proceeds from the
sale, New Valley received approximately $22 million, and Apollo received
approximately $9.5 million. New Valley recorded a loss of approximately $21.8
million in connection with the sale in 2001.
WESTERN REALTY REPIN. In June 1998, New Valley and Apollo organized
Western Realty Repin to make a loan to BrookeMil. The proceeds of the loan were
used by BrookeMil for the acquisition and preliminary development of the Kremlin
sites, two adjoining sites totaling 10.25 acres located on the Sofiskaya
Embankment of the Moscow River. The sites are directly across the river from the
Kremlin and have views of the Kremlin walls, towers and nearby church domes. The
Kremlin sites were planned for development as a residential and hotel complex,
subject to market conditions and the availability of financing.
On April 30, 2002, New Valley sold the shares of BrookeMil for
approximately $22 million before closing expenses. BrookeMil owned the two
Kremlin sites in Moscow, which were New Valley's remaining real estate holdings
in Russia. Under the terms of the Western Realty Repin participating loan to
BrookeMil, New Valley received approximately $7.5 million of the net proceeds
from the sale and Apollo received approximately $12.5 million of the proceeds.
New Valley recorded a gain on the sale of real estate of approximately $8.5
million for the year ended December 31, 2002 in connection with the sale.
DISCONTINUED OPERATIONS - BROKER-DEALER. In May 1995, a subsidiary of
New Valley acquired all of the outstanding shares of common stock and other
equity interests of Ladenburg Thalmann & Co. Inc. for $25.8 million, net of cash
acquired. Ladenburg Thalmann & Co. is a full service broker-dealer, which has
been a member of the New York Stock Exchange since 1876.
20
In December 1999, New Valley completed the sale of a 19.9% interest in
Ladenburg Thalmann & Co. to Berliner Effektengesellschaft AG, a German public
financial holding company. New Valley received $10.2 million in cash and
Berliner shares valued in accordance with the purchase agreement.
On May 7, 2001, GBI Capital Management Corp. acquired all of the
outstanding common stock of Ladenburg Thalmann & Co., and the name of GBI was
changed to Ladenburg Thalmann Financial Services Inc. New Valley received
18,598,098 shares, $8.01 million in cash and $8.01 million principal amount of
senior convertible notes due December 31, 2005. The notes issued to New Valley
bear interest at 7.5% per annum and are convertible into 3,844,216 shares of
Ladenburg Thalmann Financial Services common stock. Upon closing, New Valley
also acquired an additional 3,945,060 shares of Ladenburg Thalmann Financial
Services from the former Chairman of Ladenburg Thalmann Financial Services for
$1.00 per share. Following completion of the transactions, New Valley owned
53.6% and 49.5% of the common stock of Ladenburg Thalmann Financial Services, on
a basic and fully diluted basis, respectively. Ladenburg Thalmann Financial
Services (AMEX: LTS) is registered under the Securities Act of 1934 and files
periodic reports and other information with the SEC.
To provide the funds for the acquisition of the common stock of
Ladenburg Thalmann & Co., Ladenburg Thalmann Financial Services borrowed $10
million from Frost-Nevada, Limited Partnership and issued to Frost-Nevada $10
million principal amount of 8.5% senior convertible notes due December 31, 2005.
The notes issued to the Ladenburg Thalmann & Co. stockholders and to
Frost-Nevada are secured by a pledge of the Ladenburg Thalmann & Co. stock. In
June 2002, New Valley, Berliner and Frost-Nevada agreed with Ladenburg Thalmann
Financial Services to forbear until May 15, 2003 payment of the interest due to
them under the convertible notes on the interest payment dates commencing June
30, 2002 through March 31, 2003. In March 2003, the holders of the convertible
notes agreed to extend the interest forbearance period to January 15, 2005 with
respect to interest payments due through December 31, 2004. Interest on the
deferred amounts accrues at 8% on the New Valley and Berliner notes and 9% on
the Frost-Nevada note.
The actual number of shares of common stock issued to the former
Ladenburg Thalmann & Co. stockholders may be further increased and the
conversion prices of the senior convertible notes may be further decreased on or
about May 7, 2003, pending a final resolution of Ladenburg Thalmann Financial
Services' pre-closing litigation adjustments.
On November 30, 2001, New Valley announced that it would distribute its
22,543,158 shares of Ladenburg Thalmann Financial Services common stock to
holders of New Valley common shares through a special dividend. On the same
date, we announced that we would, in turn, distribute the 12,694,929 shares of
Ladenburg Thalmann Financial Services common stock that we would receive from
New Valley to the holders of our common stock as a special dividend. The special
dividends were accomplished through pro rata distributions of the Ladenburg
Thalmann Financial Services shares, paid on December 20, 2001 to holders of
record as of December 10, 2001. New Valley stockholders received 0.988 of a
Ladenburg Thalmann Financial Services share for each share of New Valley, and
our stockholders received 0.348 of a Ladenburg Thalmann Financial Services share
for each share of ours.
Following the distribution, New Valley continues to hold the $8.01
million principal amount of Ladenburg Thalmann Financial Services' senior
convertible notes and a warrant to purchase 100,000 shares of its common stock
at $1.00 per share.
In March 2002, Ladenburg Thalmann Financial Services borrowed $2.5
million from New Valley. The loan, which bears interest at 1% above the prime
rate, was due on the earlier of December 31, 2003 or the completion of one or
more equity financings where Ladenburg Thalmann Financial Services receives at
least $5.0 million in total proceeds. In July 2002, Ladenburg Thalmann Financial
Services borrowed an additional $2.5 million from New Valley on the same terms.
21
In November 2002, New Valley agreed, in connection with a $3.5 million loan to
Ladenburg Thalmann Financial Services by an affiliate of its clearing broker, to
extend the maturity of the notes to December 31, 2006 and to subordinate the
notes to the repayment of the loan.
During 2002, Ladenburg Thalmann Financial Services incurred significant
operating losses as its revenues and liquidity were adversely affected by the
overall declines in the U.S. equity markets and the continued weak operating
environment for the broker-dealer industry. Accordingly, New Valley evaluated
its ability to collect its notes receivable and related interest from Ladenburg
Thalmann Financial Services at September 30, 2002. These notes receivable
included the $5 million of notes issued in March 2002 and July 2002 and the
$8.01 million convertible note issued to New Valley in May 2001. Management
determined, based on current trends in the broker-dealer industry and Ladenburg
Thalmann Financial Services' operating results and liquidity needs, that a
reserve for uncollectibility should be established against these notes and
interest receivable. As a result, New Valley recorded a charge of $13.2 million
in the third quarter of 2002.
On October 8, 2002, Ladenburg Thalmann Financial Services borrowed an
additional $2 million from New Valley. The loan, which bore interest at 1% above
the prime rate, was repaid in December 2002 with the proceeds from the loan to
Ladenburg Thalmann Financial Services from an affiliate of its clearing broker.
Howard M. Lorber, Bennett S. LeBow and Richard J. Lampen, executive
officers and directors of New Valley, and Victor M. Rivas and Henry C.
Beinstein, directors of New Valley, also serve as directors of Ladenburg
Thalmann Financial Services. Mr. Rivas also serves as President and CEO of
Ladenburg Thalmann Financial Services. J. Bryant Kirkland III, New Valley's Vice
President, Treasurer and Chief Financial Officer, served as Chief Financial
Officer of Ladenburg Thalmann Financial Services from June 2001 to October 2002.
Messrs. LeBow and Lorber serve as executive officers and directors, and Mr.
Lampen serves as an executive officer, of us, and Robert J. Eide, a director of
Ladenburg Thalmann Financial Services, serves as a director of ours.
Following December 20, 2001, holders of New Valley's outstanding
warrants are entitled, upon exercise of a warrant and payment of the $12.50
exercise price per warrant, to receive a common share of New Valley and a cash
payment of $1.20, an amount equal to 0.988 of the current market price of a
share of Ladenburg Thalmann Financial Services common stock on December 20,
2001. The current market price was determined based on the average daily closing
prices for a share of Ladenburg Thalmann Financial Services common stock for the
15 consecutive trading days commencing 20 trading days before December 20, 2001.
OTHER INVESTMENTS. On January 15, 2003, New Valley announced it had
reached an agreement in principal with Globalstar L.P., pursuant to which New
Valley would invest $55 million as part of a plan of reorganization of
Globalstar. Globalstar, which is currently in bankruptcy, is engaged in the
global mobile satellite telecommunications services business. On January 30,
2003, New Valley announced that the agreement in principle had terminated due to
New Valley's inability to reach final agreement with Globalstar's Creditors
Committee. New Valley has had continuing discussions with Globalstar regarding a
proposed investment in its business.
At December 31, 2002, New Valley owned approximately 48% of the
outstanding shares of CDSI Holdings, Inc., which completed an initial public
offering in May 1997. CDSI holds a minority interest in a marketing services
company that provides direct mail and telemarketing services.
As of December 31, 2002, New Valley's long-term investments consisted
primarily of investments in limited partnerships and limited liability companies
of $3.2 million. New Valley is also required to make an additional investment in
one of these limited partnerships of up to $983,000 at December 31, 2002.
22
EMPLOYEES
At January 1, 2003, we had approximately 1,106 employees, of whom
approximately 300 were employed by Liggett, approximately 291 were employed by
Vector Tobacco and Vector Research and approximately 497 were employed by
Liggett Vector Brands. Approximately 20% of our employees are hourly employees
who are represented by unions. We have not experienced any significant work
stoppages since 1977, and we believe that relations with our employees and their
unions are satisfactory.
AVAILABLE INFORMATION
We file annual, quarterly and current reports, proxy statements and
other information with the Securities and Exchange Commission. These filings are
available to the public over the Internet at the SEC's web site at
http://www.sec.gov. You may also read and copy any document that we file at the
SEC's public reference room located at 450 Fifth Street, NW, Washington, DC
20549. Please call the SEC at 1-800-SEC-0330 for further information on the
public reference room.
We currently do not have a corporate Internet website and, accordingly,
cannot make our SEC filings available in this manner. However, you may request a
copy of our SEC filings, including Exhibit 99.1, Material Legal Proceedings, to
this Form 10-K, at no cost by writing, telephoning or faxing us as follows:
Vector Group Ltd.
100 S.E. Second Street, 32nd Floor
Miami, Florida 33131
Attn: Investor Relations
Telephone: (305) 579-8000
Fax: (305) 579-8016
23
RISK FACTORS
WE AND OUR SUBSIDIARIES HAVE A SUBSTANTIAL AMOUNT OF INDEBTEDNESS
We and our subsidiaries have significant indebtedness and debt service
obligations. At December 31, 2002, we and our subsidiaries had total outstanding
indebtedness of $338.3 million. In addition, subject to the terms of any future
agreements, we and our subsidiaries will be able to incur additional
indebtedness in the future. There is a risk that we will not be able to generate
sufficient funds to repay our debt. If we cannot service our fixed charges, it
would significantly harm us and the value of our common stock.
WE ARE A HOLDING COMPANY AND DEPEND ON CASH PAYMENTS FROM SUBSIDIARIES WHICH ARE
SUBJECT TO CONTRACTUAL AND OTHER RESTRICTIONS
We are a holding company and have no operations of our own. We hold our
interests in our various businesses through our wholly-owned subsidiary, VGR
Holding. In addition to our own cash resources, our ability to pay interest on
our convertible notes and to pay dividends on our common stock depends on the
ability of VGR Holding to make cash available to us. The purchase agreement for
the VGR Holding 10% senior secured notes due 2006 contains covenants which limit
the ability of VGR Holding to make distributions to us to 50% of VGR Holding's
net income, unless VGR Holding holds cash of $75 million after giving effect to
the payment of the distribution. VGR Holding's ability to pay dividends to us
depends primarily on the ability of Liggett, our wholly owned subsidiary, and
New Valley, in which we indirectly hold an approximately 58% interest, to
generate cash and make it available to VGR Holding. Liggett's revolving credit
agreement prohibits Liggett from paying cash dividends to VGR Holding unless
Liggett's borrowing availability exceeds $5 million for the thirty days prior to
payment of the dividend, and immediately after giving effect to the dividend,
and it is in compliance with the covenants in the credit facility, including an
adjusted net worth and working capital requirement.
As the controlling New Valley stockholder, we must deal fairly with New
Valley, which may limit its ability to enter into transactions with New Valley
that result in the receipt of cash from New Valley and to influence New Valley's
dividend policy. In addition, since we indirectly own only approximately 58% of
the common shares of New Valley, a significant portion of any cash and other
assets distributed by New Valley will be received by persons other than us and
our subsidiaries.
Our receipt of cash payments, as dividends or otherwise, from our
subsidiaries is an important source of our liquidity and capital resources. If
we do not have sufficient cash resources of our own and do not receive payments
from our subsidiaries in an amount sufficient to repay our debts, we must obtain
additional funds from other sources. There is a risk that we will not be able to
obtain additional funds at all or on terms acceptable to us. Our inability to
service these obligations would significantly harm us and the value of our
common stock.
LIGGETT FACES INTENSE COMPETITION IN THE DOMESTIC TOBACCO INDUSTRY
Liggett is considerably smaller and has fewer resources than all its
major competitors and as a result has a more limited ability to respond to
market developments. Published industry sources indicate that the three largest
manufacturers control approximately 83% of the United States cigarette market.
Philip Morris USA Inc. is the largest and most profitable manufacturer in the
market, and its profits are derived principally from its sale of premium
cigarettes. Based on published industry sources, Philip Morris had approximately
60.7% of the premium segment and 48.9% of the total domestic market during 2002.
During 2002, Liggett's share of the premium cigarette segment was 0.3%, and its
share of the total domestic cigarette market was 2.5%. Philip Morris and RJR,
the two largest cigarette manufacturers, have historically, because of their
dominant market share, been able to determine cigarette prices for the various
pricing tiers within the industry. The other cigarette manufacturers
historically have brought their prices into line with the levels established by
the two major manufacturers.
24
LIGGETT'S BUSINESS IS HIGHLY DEPENDENT ON THE DISCOUNT CIGARETTE SEGMENT
Liggett depends more on sales in the discount cigarette segment of the
market, relative to the full-price premium segment, than its major competitors.
Approximately 94.3% of Liggett's unit sales in 2002 were generated in the
discount segment. The discount segment is highly competitive with consumers
having less brand loyalty and placing greater emphasis on price. While the four
major manufacturers all compete with Liggett in the discount segment of the
market, the strongest competition for market share has recently come from a
group of small manufacturers, most of which are producing low quality, deep
discount cigarettes. While Liggett's share of the discount market increased to
8.5% in 2002 from 7.7% in 2001 and 5.3% in 2000, published industry sources
indicate that these other smaller manufacturers' discount market share increased
to 18.9% in 2002 from 16.2% in 2001 and 13.8% in 2000 due to their increased
competitive discounting. If the discount market pricing continues to be impacted
by these smaller manufacturers, margins in Liggett's largest market segment
could be negatively affected, which in turn could negatively affect the value of
our common stock.
LIGGETT'S MARKET SHARE HAS DECLINED IN RECENT PERIODS
In years prior to 2000, Liggett suffered a substantial decline in unit
sales and associated market share. Liggett's unit sales and market share have
increased during 2000, 2001 and 2002. This earlier market share erosion resulted
in part from its highly leveraged capital structure that existed until December
1998 and Liggett's limited ability to match other competitors' wholesale and
retail trade programs, obtain retail shelf space for its products and advertise
its brands. The decline in recent years also resulted from adverse developments
in the tobacco industry, intense competition and changes in consumer
preferences. Based on published industry sources, Liggett's overall domestic
market share during 2002 was 2.5%, compared with 2.2% for 2001 and 1.5% for
2000. Based on published industry sources, Liggett's share of the premium
segment during 2002 was 0.3% as compared to 0.3% in 2001 and 0.2% in 2000, and
its share of the discount segment during 2002 was 8.5%, up from 7.7% in 2001 and
5.3% for 2000. If Liggett's market share declines, Liggett's sales volume,
operating income and cash flows could be negatively affected, which in turn
could negatively affect the value of our common stock.
THE DOMESTIC CIGARETTE INDUSTRY HAS EXPERIENCED DECLINING UNIT SALES IN
RECENT PERIODS
Industry-wide shipments of cigarettes in the United States have been
generally declining for a number of years, with published industry sources
estimating that domestic industry-wide shipments decreased by approximately 3.7%
during 2002. Published industry sources estimate that domestic industry-wide
shipments decreased by 3.2% in 2001 compared to 2000 and increased by 0.1% in
2000 compared to 1999. Liggett's management believes that industry-wide
shipments of cigarettes in the United States will generally continue to decline
as a result of numerous factors. These factors include health considerations,
diminishing social acceptance of smoking and legislative limitations on smoking
in public places, federal and state excise tax increases and settlement-related
expenses which have contributed to large cigarette price increases. If this
decline in industry shipments continues and Liggett is unable to capture market
share from its competitors, or if the industry is unable to offset the decline
in unit sales with price increases, Liggett's sales volume, operating income and
cash flows could be negatively affected, which in turn could negatively affect
the value of our common stock.
LITIGATION AND REGULATION WILL CONTINUE TO HARM THE TOBACCO INDUSTRY
The cigarette industry continues to be challenged on numerous fronts.
New cases continue to be commenced against Liggett and other cigarette
manufacturers. As of December 31, 2002, there were approximately 305 individual
suits, 39 purported class actions and 46 governmental and other third-party
payor health care reimbursement actions pending in the United States in which
Liggett was a named defendant. A civil lawsuit has been filed by the United
States federal government seeking disgorgement of approximately $289 billion
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from various cigarette manufacturers, including Liggett. In addition to these
cases, an action against cigarette manufacturers involving approximately 1,260
named individual plaintiffs was consolidated before a single West Virginia state
court. Liggett is a defendant in most of the cases pending in West Virginia.
Approximately 38 other purported class action complaints have been filed against
the cigarette manufacturers for alleged antitrust violations. As new cases are
commenced, the costs associated with defending these cases and the risks
relating to the inherent unpredictability of litigation continue to increase.
An unfavorable verdict was returned in the first phase of the ENGLE
smoking and health class action trial pending in Florida. In July 2000, the jury
awarded $790 million in punitive damages against Liggett in the second phase of
the trial, and the court entered an order of final judgment. Liggett intends to
pursue all available post-trial and appellate remedies. If this verdict is not
eventually reversed on appeal, or substantially reduced by the court, it will
have a material adverse effect on us. Liggett has filed the $3.45 million bond
required under the bonding statute enacted in 2000 by the Florida legislature
which limits the size of any bond required, pending appeal, to stay execution of
a punitive damages verdict. On May 7, 2001, Liggett reached an agreement with
the class in the ENGLE case, which will provide assurance to Liggett that the
stay of execution, currently in effect under the Florida bonding statute, will
not be lifted or limited at any point until completion of all appeals, including
to the United States Supreme Court. As required by the agreement, Liggett paid
$6.27 million into an escrow account to be held for the benefit of the ENGLE
class, and released, along with Liggett's existing $3.45 million statutory bond,
to the court for the benefit of the class upon completion of the appeals
process, regardless of the outcome of the appeal. In June 2002, the jury in an
individual case brought under the third phase of the ENGLE case awarded $37.5
million of compensatory damages against Liggett and two other defendants and
found Liggett 50% responsible for the damages. The verdict will be subject to
the outcome of the ENGLE appeal. It is possible that additional cases could be
decided unfavorably and that there could be further adverse developments in the
ENGLE case. Management cannot predict the cash requirements related to any
future settlements and judgments, including cash required to bond any appeals,
and there is a risk that those requirements will not be able to be met.
In recent years, there have been a number of restrictive regulatory
actions from various Federal administrative bodies, including the United States
Environmental Protection Agency and the Food and Drug Administration. There have
also been adverse political decisions and other unfavorable developments
concerning cigarette smoking and the tobacco industry, including the
commencement and certification of class actions and the commencement of
third-party payor actions. These developments generally receive widespread media
attention. We are not able to evaluate the effect of these developing matters on
pending litigation or the possible commencement of additional litigation, but
our consolidated financial position, results of operations or cash flows could
be materially adversely affected by an unfavorable outcome in any
smoking-related litigation.
LIGGETT HAS SIGNIFICANT SALES TO A SINGLE CUSTOMER
During 2002, 17.1% of Liggett's net sales, 18.4% of Liggett's net sales
in the discount segment and 16.8% of our consolidated revenues were to Liggett's
largest customer. If this customer discontinues its relationship with Liggett or
experiences financial difficulties, Liggett's results of operations could be
materially adversely affected.
EXCISE TAX INCREASES ADVERSELY AFFECT CIGARETTE SALES
Cigarettes are subject to substantial federal, state and local excise
taxes which, in general, have been increasing. The federal excise tax on
cigarettes is currently $0.39 per pack. State and local sales and excise taxes
vary considerably and, when combined with sales taxes, local taxes and the
current federal excise tax, may currently be as high as $4.10 per pack. Proposed
further tax increases in various jurisdictions are currently under consideration
or pending. In 2002, 21 states passed excise tax increases, ranging from $0.07
per pack in Tennessee to as much as $1.81 per pack in New York City and New York
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State combined. Congress has considered significant increases in the federal
excise tax or other payments from tobacco manufacturers, and significant
increases in excise and other cigarette-related taxes have been proposed or
enacted at the state and local levels. Management believes that increases in
excise and similar taxes have had a adverse impact on sales of cigarettes.
Further substantial federal or state excise tax increases could accelerate the
trend away from smoking and could have an unfavorable effect on Liggett's sales
and profitability, which in turn could negatively affect the value of our common
stock.
VECTOR TOBACCO IS SUBJECT TO RISKS INHERENT IN NEW PRODUCT DEVELOPMENT
INITIATIVES
We have made and plan to continue to make significant investments in
Vector Tobacco's development projects in the tobacco industry. Vector Tobacco is
in the business of the development and marketing of the new low nicotine and
nicotine-free QUEST cigarette products and the reduced carcinogen OMNI products.
These initiatives are subject to high levels of risk, uncertainties and
contingencies, including the challenges inherent in new product development.
There is a risk that continued investments in Vector Tobacco will harm our
profitability (if any), liquidity or cash flow.
The substantial risks facing Vector Tobacco include:
RISKS OF MARKET ACCEPTANCE OF THE NEW PRODUCTS. In November 2001,
Vector Tobacco launched nationwide its reduced carcinogen OMNI c