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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, 2003
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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
incorporation or organization) Identification No.)
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, 2003 was approximately $430 million.
At March 12, 2004, Vector Group Ltd. had 39,087,653 shares of common
stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III (Items 10, 11, 12 and 13) from the definitive Proxy Statement
for the 2004 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
TABLE OF CONTENTS
Page
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PART I
Item 1. Business....................................................................... 1
Item 2. Properties..................................................................... 35
Item 3. Legal Proceedings.............................................................. 36
Item 4. Submission of Matters to a Vote of Security Holders;
Executive Officers of the Registrant........................................... 36
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.......... 39
Item 6. Selected Financial Data........................................................ 40
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations...................................................... 41
Item 7A. Quantitative and Qualitative Disclosures About Market Risk..................... 63
Item 8. Financial Statements and Supplementary Data.................................... 63
Item 9. Changes In and Disagreements with Accountants on Accounting and
Financial Disclosure....................................................... 63
Item 9A. Controls and Procedures........................................................ 63
PART III
Item 10. Directors and Executive Officers of the Registrant............................. 64
Item 11. Executive Compensation......................................................... 64
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters................................................ 64
Item 13. Certain Relationships and Related Transactions................................. 64
Item 14. Principal Accounting Services and Fees......................................... 64
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K................ 65
SIGNATURES................................................................................... 74
PART I
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:
- the manufacture and sale of cigarettes in the United States
through our subsidiary Liggett Group Inc., and
- the development and marketing of the low nicotine and
nicotine-free QUEST cigarette products and the development of
reduced risk cigarette products through our subsidiary Vector
Tobacco 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
enhanced distribution and marketing capabilities.
In October 2003, we announced that we would close Vector Tobacco's
Timberlake, North Carolina cigarette manufacturing facility in order to reduce
excess cigarette production capacity and improve operating efficiencies
company-wide. Production of QUEST and Vector Tobacco's other cigarette brands
has been moved to Liggett's state-of-the-art manufacturing facility in Mebane,
North Carolina.
The Mebane facility currently produces in excess of 9 billion units per
year, but maintains the capacity to produce approximately 16 billion units per
year. Vector Tobacco has contracted with Liggett to produce its cigarettes and
has transitioned production from Timberlake to Mebane. All production ceased at
Timberlake by December 31, 2003. As part of the transition, we eliminated
approximately 150 positions.
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, New Jersey and increased its ownership to 50% in Douglas Elliman
Realty, LLC, which operates 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 35.9% of our common stock.
Financial information relating to our business segments can be found in
Note 22 to our consolidated financial statements. 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 and nicotine-free cigarette products as well as
the development of reduced risk cigarette products and, for these purposes,
exclude the operations of Medallion.
1
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 in the United States.
According to data from Management Science Associates, Inc., Liggett's domestic
shipments of approximately 9.8 billion cigarettes during 2003 accounted for 2.6%
of the total cigarettes shipped in the United States during such year. This
market share percentage represents an increase of 0.1% from 2002 and an increase
of 0.4% from 2001. Historically, Liggett has produced 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 higher retail prices to
adult smokers with a strong preference for branded products, whereas discount
cigarettes are marketed at lower retail prices to adult smokers who are more
cost conscious. In recent years, the discounting of premium cigarettes has
become far more significant in the marketplace. This has led to brands that were
traditionally considered premium brands to become more appropriately categorized
as branded discount, despite their premium list price. Liggett's EVE brand would
fall into that category. Approximately 94.6% of Liggett's unit volume in 2003
was in the discount segment, which Liggett's management believes has been the
primary growth segment in the industry for over a decade.
Liggett's cigarettes are produced in approximately 240 combinations of
length, style and packaging. Liggett's current brand portfolio includes:
- LIGGETT SELECT - the second largest brand in the deep discount
category;
- EVE - a leading brand of 120 millimeter cigarettes in the
branded discount category;
- JADE - the industry's newest free-standing branded discount
menthol brand;
- PYRAMID - the industry's first branded discount brand; and
- USA and various control and private label brands.
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 50.9% of Liggett's unit volume in 2003, 42.1% in 2002 and
31.6% in 2001. According to Management Science Associates data, Liggett held a
share of approximately 9.4% of the overall discount market segment for 2003
compared to 8.3% for 2002 and 7.6% for 2001.
Liggett's premium cigarettes represented approximately 6.2% in 2003,
9.0% in 2002 and 15.5% in 2001 of Liggett's revenues. According to Management
Science Associates data, Liggett's unit share of the premium market segment was
approximately 0.2% in 2003, 0.3% in 2002 and 0.3% for 2001. 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.
2
Liggett introduced nationally a new premium cigarette, JADE, in
September 2001. JADE is a menthol cigarette with unique holographic packaging.
JADE's sales represented 14.2% of Liggett's total premium unit sales during
2003, 27.8% during 2002 and 17.7% during 2001.
Effective February 1, 2004, Liggett reduced the JADE and EVE list
prices to the branded discount level from the premium price level. During 2003,
the net list prices for JADE and EVE were at the branded discount level after
giving effect to promotional spending.
The source of industry data in this report is Management Science
Associates, an independent third-party database management organization that
collects wholesale shipment data from various cigarette manufacturers and
provides analysis of market share, unit sales volume and premium versus discount
mix for individual companies and the industry as a whole. Management Science
Associates' information relating to unit sales volume and market share of
certain of the smaller, primarily deep discount, cigarette manufacturers is
based on estimates derived by it. Liggett management believes that the volume
and market share information published by Management Science Associates for
these manufacturers is understated and, correspondingly, share information for
the larger manufacturers, including Liggett, is overstated by Management Science
Associates.
We believe that Liggett has gained a sustainable cost advantage over
its competitors through its various settlement agreements. Under the Master
Settlement Agreement reached in November 1998 with 46 state attorneys general
and various territories, Liggett's four major competitors must make settlement
payments to the states and territories based on how many cigarettes they sell
annually. Liggett, however, is not required to make any payments unless its
market share exceeds approximately 1.65% of the U.S. cigarette market.
Additionally, as a result of the Medallion acquisition, Vector Tobacco likewise
has no payment obligation unless its market share exceeds approximately 0.28% of
the U.S. market.
In November 1999, Liggett acquired an industrial facility in Mebane,
North Carolina. Liggett completed the relocation of its tobacco manufacturing
operations from its old plant in Durham, North Carolina to the Mebane facility
in October 2000. Effective January 1, 2004, Liggett produces all of Vector
Tobacco's cigarette brands at the Mebane facility pursuant to a contract
manufacturing agreement.
At the present time, Liggett has no foreign operations. Liggett does
not own the international rights to Eve, which is marketed by Philip Morris in
foreign markets. Prior to 2003, Liggett exported other cigarette brands
primarily to Eastern Europe and the Middle East. Revenues from export sales were
$0.2 million for 2002 and $0.9 million for 2001. Operating income attributable
to export sales amounted to approximately $36,000 in 2002 and $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. 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 continuing to upgrade 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 from
LIGGETT SELECT and its other brands in the discount segment. Liggett's strategy
for EVE and JADE is to improve the profitability of these brands through
expanded distribution and targeted promotional strategies focused on the
consumer. In addition, Liggett may bring other niche-driven brands to the market
in the future. Liggett may also pursue strategic acquisitions of smaller tobacco
manufacturers.
3
Sales, Marketing and Distribution. Liggett's products are distributed
from a central distribution center in Mebane 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 90% of customers
pay more rapidly through electronic funds transfer arrangements. Liggett's
largest single customer, Speedway SuperAmerica LLC, accounted for approximately
16.6% of its revenues in 2003, 16.5% of its revenues in 2002 and 23.5% of its
revenues in 2001. Sales to this customer were primarily in the private label
discount segment and constituted approximately 17.7% in 2003, 18.1% in 2002 and
27.9% in 2001 of Liggett's revenues from 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. 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
enhanced distribution and marketing capabilities. In connection with the
formation of the Liggett Vector Brands entity, we took a restructuring charge of
$3.46 million in the first quarter of 2002, related to the reorganization of our
business. As of March 31, 2003, these restructuring activities had been
substantially completed.
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. 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, 2003, virtually all of
Liggett's commitments were for the purchase of foreign tobacco.
Liggett's 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 distributors who
supply supermarkets and convenience stores.
4
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.
During 2003, Liggett leased two 100 millimeter box packers, which will
allow Liggett to meet the growing demand for this cigarette style, and a new
filter maker to improve product quality and capacity. These operating lease
agreements provide for payments totaling approximately $4.5 million.
The Mebane facility currently produces in excess of 9 billion units per
year, but maintains the capacity to produce approximately 16 billion units per
year. Vector Tobacco has contracted with Liggett to produce its cigarettes and
has transitioned production from its Timberlake facility, which has been closed,
to Mebane. All production ceased at Timberlake by December 31, 2003. As part of
the transition, we have eliminated approximately 150 positions.
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 manufacturers and importers, most of which sell 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. However, in recent years, a number of these
smaller companies have been able to overcome these competitive barriers due to
excess production capacity in the industry and the cost advantage for certain
manufacturers and importers created by the Master Settlement Agreement.
Recently, during the phase-in payment period under the Master
Settlement Agreement, these smaller manufacturers and importers have generally
not yet been impacted to a significant degree by the agreement and, because of
their significant cost advantages, 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 competes 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' and importers' deep
discount brands.
5
According to Management Science Associates data, Philip Morris' and
RJR's unit sales together accounted for approximately 72% of the domestic
cigarette market in 2003. Liggett's domestic shipments of approximately 9.8
billion cigarettes during 2003 accounted for 2.6% of the approximately 371.5
billion cigarettes shipped in the United States during that year, compared to
9.8 billion cigarettes in 2002 (2.5%) and 9.1 billion cigarettes (2.2%) during
2001. RJR and Brown & Williamson announced in October 2003 plans to combine
their United States tobacco businesses. This transaction, if completed, will
further consolidate the dominance of the domestic cigarette market by Philip
Morris and the newly created Reynolds American.
Industry-wide shipments of cigarettes in the United States have been
generally declining for a number of years, with Management Science Associates
data indicating that domestic industry-wide shipments decreased by approximately
5.1% (20 billion units) in 2003. Liggett's management believes this decline may
be overstated due to volume for various smaller manufacturers being understated
by Management Science Associates. However, Liggett's management does believe
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 high cigarette price
levels in recent years.
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 and similar promotional activity 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 has changed accordingly.
This has led to shifts in price segment performance depending upon the actual
retail price gaps of products at retail.
Acquisition of Medallion. In April 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
participating manufacturer under the Master Settlement Agreement. 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 2003).
Following the purchase of the Medallion stock, Vector Tobacco merged
into Medallion and Medallion changed its name to Vector Tobacco Inc. 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.
6
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
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.
Upon the closing of the exercise of the Class A option and the
distribution of the loan proceeds on May 24, 1999, Philip Morris obtained
control of Trademarks, and we recognized a pre-tax gain of $294.1 million in our
consolidated financial statements and established a deferred tax liability of
$103.1 million relating to the gain. As discussed in Note 12 to our consolidated
financial statements, the Internal Revenue Service has issued to us a notice of
proposed adjustment asserting, for tax purposes, that the entire gain should
have been recognized by the Company in 1998 and 1999.
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 development of reduced risk 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 six different menthol and nonmenthol varieties, each with
decreasing amounts of nicotine - QUEST 1, 2 and 3. QUEST 1, the low
7
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,
patented and patent pending processes and materials that enable the production
of cigarettes with nicotine-free tobacco that smokes, tastes and burns like
tobacco in conventional cigarettes. All six QUEST varieties are being sold in
hard packs and are priced comparable to other premium brands.
QUEST was 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. A multi-million
dollar advertising and marketing campaign, with advertisements running in
magazines and regional newspapers, supported the product launch. The brand
continues to be supported by significant point-of-purchase campaigns, as well as
store-related and periodic newspaper advertisements. 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 premium segment of the tobacco industry is currently experiencing
intense competitive activity, with increased discounting of premium brands at
all levels of retail. Given these marketplace conditions, and the results that
we have seen to date with QUEST, we intend to take a measured approach to
expanding the market presence of the brand. In November 2003, Vector Tobacco
introduced three menthol varieties of QUEST in the seven state market. In
addition, we are utilizing the information that we have obtained since the
introduction of the QUEST non-menthol product to more specifically target our
focus in the seven state market in the coming months. Based upon those results,
the success of the menthol product and market conditions in the premium segment,
we will make a determination on the timing of a national launch of QUEST at a
later date.
Vector Tobacco also introduced QUEST and QUEST Menthol into an
expansion market in Arizona in January 2004. Arizona accounts for approximately
1% of the industry volume nationwide.
QUEST brand cigarettes are currently marketed to permit adult smokers,
who wish to continue smoking, to gradually reduce their intake of nicotine. The
products are not labeled or advertised for smoking cessation. 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.
In October 2003, we announced that Jed E. Rose, Ph.D., Director of Duke
University Medical Center's Nicotine Research Program and co-inventor of the
nicotine patch, had conducted a study at Duke University Medical Center to
provide preliminary evaluation of the use of the QUEST technology as a smoking
cessation aid. In the preliminary study on QUEST, 33% of QUEST 3 smokers were
able to achieve four-week continuous abstinence, a standard threshold for
smoking cessation. Management believes these results show real promise for the
QUEST technology as a smoking cessation aid and has asked the Food and Drug
Administration to supply us with guidance as to the additional research and
regulatory filings necessary to market QUEST as a smoking cessation product.
The nicotine-free tobacco in QUEST cigarettes is produced by
genetically modifying nicotine-producing tobacco plants, using a combination of
patented and patent pending processes and materials to produce tobacco plants
which are essentially nicotine-free. 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
8
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.
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. During
2003, OMNI sales activity was minimal as Vector Tobacco has not been actively
marketing the OMNI product. Vector Tobacco was unable to achieve the anticipated
breadth of 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,
our in-house research program, together with third-party collaborators, plans to
conduct appropriate studies as to the human effects of OMNI's reduction of
carcinogens and, based on these studies, management will 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.
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 the 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.
Manufacturing and Marketing. The QUEST brands are priced as premium
cigarettes and marketed by the sales representatives of Liggett Vector Brands,
which coordinates and executes the sales and marketing efforts for all our
tobacco operations. In the fourth quarter of 2002, Vector Tobacco began
production of QUEST at a facility it had purchased in Timberlake, North
Carolina, and converted into a modern cigarette manufacturing plant. In October
2003, we announced that we would close Vector Tobacco's Timberlake facility in
order to reduce excess cigarette production capacity and improve operating
efficiencies company-wide. Production of QUEST and Vector Tobacco's other
cigarette brands has been moved to Liggett's state-of-the-art manufacturing
facility in Mebane, North Carolina.
The Mebane facility currently produces in excess of 9 billion units per
year, but maintains the capacity to produce approximately 16 billion units per
year. Vector Tobacco has contracted
9
with Liggett to produce its cigarettes and has transitioned production from
Timberlake to Mebane. All production ceased at Timberlake by December 31, 2003.
As part of the transition, we eliminated approximately 150 positions.
As a result of these actions, we currently expect to realize annual
cost savings of approximately $23 million beginning in 2004. We recognized
pre-tax restructuring and impairment charges of $21.3 million in 2003, and
additional charges of approximately $0.2 million will be taken in the first
quarter 2004. Approximately $2 million relates to employee severance and benefit
costs, $0.7 million to contract termination and exit and moving costs, and $18.8
million to non-cash asset impairment charges. Machinery and equipment to be
disposed of was reduced to fair value less costs to sell. The asset impairment
charges are based on management's current estimates of the values we will be
able to realize on sales of excess machinery and equipment, and may be adjusted
in future periods based on the actual amounts realized.
Vector Tobacco has entered into negotiations to sell the Timberlake
facility, including all equipment not relocated to Mebane.
The OMNI product uses traditional tobaccos, and the QUEST 3 product
uses genetically modified tobacco grown specifically for Vector Tobacco. The
Quest 1 and 2 products use a mixture of the genetically modified tobacco as well
as traditional tobaccos.
The introduction of the QUEST and OMNI brands required the expenditure
of substantial sums for advertising and sales promotion. The advertising media
used included magazines, newspapers, direct mail and point-of-sale display
materials. Sales promotion activities are conducted by distribution of store
coupons, point-of-sale display and advertising, advertising in print media, and
personal contact with distributors, retailers and consumers.
Expenditures by Vector Tobacco for research and development activities
were $9.8 million in 2003, $9.7 million in 2002 and $12.6 million in 2001.
Competition. The cigarette industry is highly competitive. Vector
Tobacco's competitors generally have substantially greater resources than it,
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 at this time only limited additional
information concerning their activities. Philip Morris has announced that it is
developing products that potentially reduce smokers' exposure to harmful
compounds in cigarette smoke and may introduce such a product during 2004. R. J.
Reynolds Tobacco Company has stated that in 2003 it began a phased expansion
into a select number of retail chain outlets of a cigarette product that
primarily heats rather than burns tobacco, which it claims reduces the toxicity
of its smoke. In 2002, Brown & Williamson Tobacco Corporation announced it was
test marketing a new cigarette with reduced levels of many toxins which it may
introduce on a national basis. 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.
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 and more than 70 countries. Patents have been issued
in 15 countries, including the United States. Patent applications in various
countries around the world 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 has filed these patent applications
internationally and may file additional patent applications relating to this
invention as warranted by its ongoing research. Additional patent applications
related to OMNI are currently being considered.
10
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.
Additionally, extensive research related to the biological basis of
tobacco-related disease is being conducted at Vector Tobacco and together with
third-party collaborators. This research is being directed by Dr. Anthony P.
Albino, our Vice President of Public Health. Vector Tobacco believes that as
this research progresses, it will generate additional intellectual property.
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 or
prohibition, third party allegations that Vector Tobacco products are unlawful
or bear deceptive or unsubstantiated product claims, potential delays in
obtaining 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".
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
state 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 and 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 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 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 Federal Trade
Commission 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.
11
In August 1996, the Food and Drug Administration 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 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. Proposed legislation has also been
introduced in Congress that would eliminate the federal tobacco quota system and
impose assessments on manufacturers of tobacco products to compensate tobacco
growers and quota holders for the elimination of their quota rights. The
ultimate outcome of these proposals cannot be predicted, although they could
have a material adverse effect on Liggett and us.
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 2002, the United States
Court of Appeals for 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. Liggett began complying with
this legislation in December 1997 by providing ingredient information to the
Massachusetts Department of Public Health and, notwithstanding the appellate
court's ruling, has continued to provide ingredient disclosure. Liggett also
provides ingredient information annually, as required by law, to the states of
Texas and Minnesota. Several other states are considering ingredient disclosure
legislation.
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. Manufacturers failing to
satisfy these standards are obligated to 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.
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 tariff 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 and us.
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
secondary smoke and that given the 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
12
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.
A wide variety of federal, state and local laws limit the advertising,
sale and use of cigarettes, and these laws have proliferated in recent years.
For example, many local laws prohibit smoking in restaurants and other public
places, and many employers have initiated programs restricting or eliminating
smoking in the workplace. There are various other legislative efforts pending on
the federal and state level which seek, among other things, to 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. This trend has had, and is likely to continue to have, an adverse
impact on Liggett and us.
Cigarettes are subject to substantial and increasing federal, state and
local excise taxes. 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 exceed $4.00 per pack. Proposed further tax increases in various
jurisdictions are currently under consideration or pending. In 2003, 15 states
and the District of Columbia enacted increases in excise taxes. Congress has
considered significant increases in the federal excise tax or other payments
from tobacco manufacturers, and several states have pending legislation
proposing further state excise tax increases. In 2004, several states are likely
to impose additional taxes on cigarettes. Management believes that increases in
excise and similar taxes have had an adverse impact on sales of cigarettes.
Various state governments have adopted or are considering adopting
legislation establishing fire safety standards for cigarettes. Compliance with
this legislation could be burdensome and costly. In June 2000, the New York
State legislature passed legislation charging the state's Office of Fire
Prevention and Control, referred to as the "OFPC," with developing standards for
"fire-safe" or self-extinguishing cigarettes. The OFPC has issued regulations
requiring that by June 28, 2004 all cigarettes offered for sale in New York
state must be manufactured to certain self-extinguishment standards set out in
the regulations. Certain design and manufacturing changes will be necessary for
cigarettes manufactured for sale in New York to comply with the standards.
Inventories of cigarettes existing in the wholesale and retail trade as of June
28, 2004 that do not comply with the standards, may continue to be sold provided
New York state excise tax stamps have been affixed and such inventories have
been purchased in comparable quantities to the same period in the previous year.
Liggett and Vector Tobacco have not historically provided products that would be
compliant under these new OFPC regulations. Liggett and Vector Tobacco expect,
however, to supply compliant products by June 28, 2004. Similar legislation is
being considered by other state governments and at the federal level. Compliance
with such legislation could harm the business of Liggett and Vector Tobacco,
particularly if there are varying standards from state to state.
Federal or state regulators may object to Vector Tobacco's 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. Various concerns regarding
Vector Tobacco's advertising practices have been expressed to Vector Tobacco by
certain state attorneys general. Vector Tobacco has engaged in discussions 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
13
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 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 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.
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, 2003, there were approximately 377
individual suits, approximately 32 purported class actions or actions where
class certification has been sought and approximately 18 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, in 2000, an
action against cigarette manufacturers involving approximately 1,050 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. In
January 2002, the court severed Liggett from the trial of the consolidated
action. There are eight individual actions where Liggett is the only defendant,
with three of these cases currently scheduled for trial between April 2004 and
August 2004. 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 ("RICO"), 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 major 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
14
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 September 2000, the court dismissed the government's
claims based on the Medical Care Recovery Act and the Medicare Secondary Payor
provisions, reaffirming its decision in July 2001. In the September 2000 ruling,
the court also determined not to dismiss the government's RICO claims, 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 May 2003, the court denied the industry's motion
which sought partial summary judgment as to the government's advertising,
marketing, promotion and warning claims on the basis that these claims are
within the exclusive jurisdiction of the Federal Trade Commission. In January
2004, the court granted one of the government's pending motions and dismissed
certain equitable defenses of defendants. The remaining motions for summary
judgment filed by the government and defendants are still pending before the
court.
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. Trial has been scheduled for September
2004.
Approximately 38 purported state and federal class action complaints
were filed against the cigarette manufacturers, including Liggett, for alleged
antitrust violations. 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 nationwide class of wholesalers who
purchased cigarettes directly from the defendants. The federal class actions
were consolidated and, in July 2000, plaintiffs filed a single consolidated
complaint that did not name Liggett as a defendant, although Liggett complied
with discovery requests. In July 2002, the court granted defendants' motion for
summary judgment in the consolidated federal cases, which decision was affirmed
on appeal by the United States Court of Appeals for the Eleventh Circuit. State
court cases have been dismissed in 10 states and the District of Columbia. A
Kansas state court, in the case of Smith v. Philip Morris Companies Inc., et
al., granted class certification in November 2001. In April 2003, plaintiffs'
motion for class certification was granted in Romero v. Philip Morris Companies
Inc., a case pending in New Mexico state court, which decision has been
appealed. Liggett is one of the defendants in the Kansas and New Mexico cases.
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 received final judicial approval in each of the 52 settling
jurisdictions.
15
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 in April 2002, Vector Tobacco
has no payment obligations under the Master Settlement Agreement 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. According to Management Science Associates
data, domestic shipments by Liggett and Vector Tobacco accounted for 2.2% of the
total cigarettes shipped in the United States during 2001, 2.5% during 2002 and
2.7% during 2003. On April 15 of any year following a year in which Liggett's
and/or Vector Tobacco's market shares exceed their base shares, Liggett and/or
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 March and April 2002, Liggett and Vector Tobacco paid a total of
$31.1 million for their 2001 Master Settlement Agreement obligations. In March
and April 2003, Liggett and Vector Tobacco paid a total of $37.5 million for
their 2002 Master Settlement Agreement obligations. Liggett and Vector Tobacco
have expensed $35.9 million for their estimated Master Settlement Agreement
obligations for 2003 as part of cost of goods sold. In June 2003, Liggett and
Vector Tobacco reached a settlement with the jurisdictions party to the Master
Settlement Agreement whereby they agreed to pay $2.5 million in April 2004. The
settlement resolved Liggett's and Vector Tobacco's claims that they were
entitled to a reduction in its Master Settlement Agreement payments as a result
of market share loss to non-participating manufacturers for payments based on
sales through December 31, 2002. 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
- ---- ------
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.
The Master Settlement Agreement replaces Liggett's prior settlements
with all states and territories except for Florida, Mississippi, Texas and
Minnesota. Each of these four states, 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, other than a $0.1 million a year
payment to Minnesota starting in 2003, to be paid any year cigarettes
manufactured by Liggett are sold in the state.
Cigarette manufacturers that have not signed the Master Settlement
Agreement ("non-participating manufacturers") are required by law to make escrow
deposits in each settling state where they sell cigarettes. The amount of escrow
deposit is based on the number of cigarettes the non-participating manufacturer
sells in the settling state. The escrow deposits are intended as a source of
funds to pay potential future judgments against the non-participating
manufacturers for smoking-related healthcare costs. Forty-two states have
passed, and various states are considering, legislation intended to prevent
non-participating manufacturers from
16
evading their escrow deposit obligations. Under this legislation, distributors
are prohibited from selling or applying excise tax stamps to any cigarette brand
that is not on a state-approved list. In order for a brand to be on the
state-approved list, the manufacturer must be a compliant party to the Master
Settlement Agreement, or must be a non-participating manufacturer that has made
all required escrow deposits. Failure to make escrow deposits in a settling
state could result in the loss of a non-participating manufacturer's ability to
sell tobacco products in that state. Additionally, 23 states have enacted, and
several other states have pending, legislation, known as an "allocable share"
amendment, that is designed to correct a loophole in the settling states' escrow
statutes. The loophole allows many non-participating manufacturers to obtain a
refund of monies deposited into escrow, and thereby reduce, in many cases
substantially, the amounts they deposit into escrow.
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. Phase III of the trial was to 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. In April 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. In July 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 in November 2000. The court's final judgment, which provided for
interest at the rate of 10% per year on the jury's award, also denied various
post-trial motions, including a motion for new trial and a motion seeking
reduction of the punitive damages award. Liggett appealed the court's order.
In May 2003, Florida's Third District Court of Appeals decertified the
Engle class and set aside the jury's decision in the case against Liggett and
the other cigarette makers, including the $145 billion punitive damages award.
The intermediate appellate court ruled that there were multiple legal bases why
the class action trial, including the punitive damages award, could not be
sustained. The court found that the class failed to meet the legal requirements
for class certification and that class members needed to pursue their claims on
an individualized basis. The court also ruled that the trial plan violated
Florida law and the appellate court's 1996 certification decision, and was
unconstitutional. The court further found that the proceedings were
irretrievably tainted by class counsel's misconduct and that the punitive
damages award was bankrupting under Florida law.
17
In October 2003, the Third District Court of Appeals denied class
counsel's motions seeking, among other things, a rehearing by the court. Class
counsel has filed a motion with the Florida Supreme Court to invoke
discretionary review on the basis that the Third District Court of Appeals
decision construes the due process provisions of the state and federal
constitutions and conflicts with other appellate and supreme court decisions. If
the appellate court's ruling is not upheld on further appeal, it will have a
material adverse effect on us.
Management is not able to predict the outcome of the litigation pending
against Brooke Group Holding or Liggett. Litigation is subject to many
uncertainties. In May 2003, a Florida intermediate appellate court overturned a
$790 million punitive damages award against Liggett and decertified the Engle
smoking and health class action. Class counsel in Engle is pursuing various
appellate remedies seeking reversal of the appellate court's decision. If the
appellate court's ruling is not upheld on further appeal, it will have a
material adverse effect on us. In November 2000, Liggett 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. In May 2001, Liggett reached an
agreement with the class in the Engle case, which provided assurance to Liggett
that the stay of execution, in effect pursuant to the Florida bonding statute,
would 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 first quarter of 2001. In June 2002, the jury in an
individual case brought under the third phase of the Engle case awarded $37.5
million (subsequently reduced by the court to $25.1 million) of compensatory
damages against Liggett and two other defendants and found Liggett 50%
responsible for the damages. The verdict, which was subject to the outcome of
the Engle appeal, has been overturned as a result of the appellate court's
ruling discussed above. 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 and Vector Tobacco's management is unaware of any material
environmental conditions affecting its existing facilities. Liggett's and Vector
Tobacco'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 or Vector Tobacco.
Liggett's management believes that it is in compliance in all material
respects with the laws regulating cigarette manufacturers.
18
See Note 16 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
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, New Jersey and a 50% interest in the former Kona Surf
Hotel in Kailua-Kona, Hawaii. New Valley also holds a 50% interest in Douglas
Elliman Realty, LLC, which operates 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 12, 2004, VGR Holding holds, either directly or indirectly
through VGR Holding's wholly-owned subsidiary, New Valley Holdings, Inc.,
approximately 58.1% 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, 2003, New Valley had
repurchased 1,185,615 shares for approximately $4.7 million.
19
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:
- each $15.00 Class A senior preferred share ($100 liquidation)
was reclassified into 20 Common Shares and one Warrant
exercisable for five years,
- each $3.00 Class B preferred share was reclassified into 1/3
of a common share and five warrants, and
- 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
additional common shares were reserved for issuance upon exercise of the
warrants, which have a current effective exercise price of $11.30 per common
share and expire on June 14, 2004. 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 58.1% 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 $84.5 million at December 31, 2003) 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 our 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, New
Jersey 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, 2003, the office buildings were approximately 98%
occupied.
20
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,
had invested $7.4 million in the project and had committed to make additional
investments of up to an aggregate of $5.1 million as of December 31, 2003. New
Valley funded $1.5 million of this amount in February 2004. New Valley accounts
for its investment in Koa Investors under the equity method and recorded losses
of $0.3 million and $1.3 million in 2003 and 2002, respectively, associated with
the Kona Surf Hotel. Koa Investors' losses primarily represent management fees
and the loss of a deposit on an adjoining golf course, which it determined not
to purchase. Koa Investors capitalizes all costs related to the acquisition and
development of the property.
The hotel, which is currently closed, 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 has entered into an agreement with Starwood Hotels and
Resorts Worldwide, Inc. for Starwood to manage the hotel when it reopens as the
Sheraton Keauhou Bay Resort & Spa, a four star family resort with approximately
525 rooms. The planned major renovation of the property includes comprehensive
room enhancements, construction of a fresh water 13,000 square foot fantasy
pool, lobby and entrance improvements, a new gym and spa, retail stores and new
restaurants. A 10,000 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 $55 million. Preliminary development is underway and, subject to
completing the necessary financing arrangements, the reopening of the hotel is
currently scheduled for late 2004. A predevelopment credit line of $6.5 million
has been obtained from a Taiwanese lender. Koa Investors is currently in
negotiations with a lender to provide construction financing for the planned
renovation. However, no assurance can be given that the necessary financing will
be available on terms acceptable to Koa Investors. Koa Investors has capitalized
all costs related to the acquisition and development of the property.
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 approximately $0.9 million on the sale. In
May 2002, New Valley disposed of its
21
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.
Douglas Elliman 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, which conducts business as Prudential Douglas Elliman Real Estate, formerly
known 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, Preferred Empire Mortgage Company. In
December 2002, New Valley and the other owners of Prudential Douglas Elliman
Real Estate contributed their interests in Prudential Douglas Elliman Real
Estate to Douglas Elliman Realty, LLC, formerly known as Montauk Battery Realty,
LLC, a newly formed entity. New Valley acquired a 50% interest in Douglas
Elliman Realty as a result of an additional investment of approximately $1.4
million by New Valley and the redemption by Prudential Douglas Elliman Real
Estate of various ownership interests. As part of the transaction, Prudential
Douglas Elliman Real Estate renewed its franchise agreement with The Prudential
Real Estate Affiliates, Inc. for an additional ten-year term. The owners of
Douglas Elliman Realty also agreed, upon receipt of the required regulatory
approvals, to contribute to Douglas Elliman Realty their interests in the
related mortgage company.
In March 2003, Douglas Elliman Realty purchased the New York City -
based residential brokerage firm, Douglas Elliman, LLC, formerly known as
Insignia Douglas Elliman, and an affiliated property management company, for
$71.25 million. With that acquisition, the combination of Prudential Douglas
Elliman Real Estate with Douglas Elliman has created the largest residential
brokerage company in the New York metropolitan area. Upon closing of the
acquisition, Douglas Elliman entered into a ten-year franchise agreement with
The Prudential Real Estate Affiliates, Inc. New Valley invested an additional
$9.5 million in subordinated debt and equity of Douglas Elliman Realty to help
fund the acquisition. The subordinated debt, which has a principal amount of
$9.5 million, bears interest at 12% per annum and is due in March 2013. As part
of the Douglas Elliman acquisition, Douglas Elliman Realty acquired Douglas
Elliman's affiliate, Residential Management Group LLC, which conducts business
as Douglas Elliman Property Management and is the New York metropolitan area's
largest manager of rental, co-op and condominium housing.
New Valley accounts for its interest in Douglas Elliman Realty on the
equity method. New Valley recorded income of $1.2 million in 2003 and $0.6
million in 2002 associated with Douglas Elliman Realty. New Valley's equity
income from Douglas Elliman Realty includes interest earned by New Valley on the
subordinated debt and 46% of the mortgage company's results from operations.
Douglas Elliman Realty is engaged in the real estate brokerage business
through its subsidiaries Douglas Elliman and Prudential Douglas Elliman Real
Estate. The two brokerage companies have 47 offices with more than 2,250 real
estate brokers in the metropolitan New York area. The companies achieved
combined sales of approximately $6.8 billion of real estate for the year ended
December 31, 2003.
Douglas Elliman was founded in 1911 and has grown to be one of
Manhattan's leading residential brokers by specializing in the highest end of
the sales and rental marketplaces. It has nine New York City offices, more than
900 real estate brokers and sales volume of approximately $4 billion of real
estate for the year ended December 31, 2003.
Prudential Douglas Elliman Real Estate is headquartered in Huntington,
New York and is the largest residential brokerage company on Long Island with
approximately 37 offices. During 2003, Prudential Douglas Elliman Real Estate
closed approximately 6,955 transactions, representing sales volume of
approximately $2.8 billion of real estate. Prudential Douglas Elliman Real
Estate's 37 offices serve approximately 250 communities from Manhattan to
22
Montauk. In 2003, Prudential Douglas Elliman Real Estate was ranked as one of
the top 50 residential brokerage companies in the United States based on closed
sales volume by the Real Trends broker survey.
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,
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.
In December 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.
In April 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.
23
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.
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.
In May 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 common stock 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.
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.
In November 2002, New Valley agreed, in connection with a $3.5 million loan to
24
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 and Richard J. Lampen, executive officers and
directors of New Valley, Victor M. Rivas, a director of New Valley, and Henry C.
Beinstein, a director of New Valley and us, also serve as directors of Ladenburg
Thalmann Financial Services. Bennett S. LeBow, the Chairman and Chief Executive
Officer of New Valley, served as director of Ladenburg Thalmann Financial
Services until September 2003. Mr. Rivas also serves as President and CEO of
Ladenburg Thalmann Financial Services. Mr. Rivas will retire March 31, 2004 as
an officer and director 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.
New Valley's warrants expire on June 14, 2004.
As of December 31, 2003, New Valley's long-term investments consisted
primarily of investments in limited partnerships and limited liability companies
of $2.4 million. New Valley has committed to make an additional investment in
one of these limited partnerships of up to approximately $1 million at December
31, 2003.
EMPLOYEES
At January 1, 2004, we had approximately 1,143 employees, of whom
approximately 300 were employed by Liggett, approximately 200 were employed by
Vector Tobacco and Vector Research and approximately 625 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.
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AVAILABLE INFORMATION
Our website address is www.vectorgroupltd.com. We make available free
of charge on the Investor Relations section of our website
(http://vectorgroupltd.com/invest.asp) our Annual Report on Form 10-K, Quarterly
Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those
reports as soon as reasonably practicable after such material is electronically
filed with the Securities and Exchange Commission. We also make available
through our website other reports filed with the SEC under the Exchange Act,
including our proxy statements and reports filed by officers and directors under
Section 16(a) of that Act. Copies of our Code of Business Conduct and Ethics,
Corporate Governance Guidelines, Audit Committee charter, Compensation Committee
charter and Corporate Governance and Nominating Committee charter have been
posted on the Investor Relations section of our website and are also available
in print to any shareholder who requests it. We do not intend for information
contained in our website to be part of this Annual Report on Form 10-K.
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, 2003, we and our subsidiaries had total outstanding
indebtedness of $310.7 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, IN ORDER TO SERVICE OUR DEBT
AND TO PAY DIVIDENDS ON OUR COMMON STOCK
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 an amount in cash equal to the then
principal amount of the notes outstanding ($70 million at December 31, 2003)
after giving effect to the payment of the distribution. Under the terms of these
covenants, at December 31, 2003, VGR Holding was generally not permitted to pay
distributions to us except for tax sharing payments and specified amounts of
operating expenses. In addition, 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 our 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
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of our own and do not receive payments from our subsidiaries in an amount
sufficient to repay our debts and to pay dividends on our common stock, 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 and to continue to pay dividends on our
common stock would significantly harm us and the value of our common stock.
OUR LIQUIDITY COULD BE ADVERSELY AFFECTED IF TAXING AUTHORITIES PREVAIL IN THEIR
ASSERTION THAT WE INCURRED A TAX OBLIGATION IN 1998 AND 1999 IN CONNECTION WITH
THE PHILIP MORRIS BRAND TRANSACTION
In connection with the 1998 and 1999 transaction with Philip Morris
Incorporated where a subsidiary of Liggett contributed three of its premium
cigarette brands to Trademarks LLC, a newly-formed limited liability company, we
recognized in 1999 a pre-tax gain of $294.1 million in our consolidated
financial statements a