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SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2002

For the transition period from            to             

Commission File Number: 0-15324

STAR SCIENTIFIC, INC.

(Exact name of registrant as specified in its charter)

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

None

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

Common Stock, $.0001 par value

(Title of Class)

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x  

The aggregate market value of the Registrant’s voting stock held by non-affiliates of the Registrant as of June 30, 2002 is approximately $31,555,881. Shares of voting stock held by each executive officer and director and by each person who owns 5% or more of the Registrant’s voting stock have been excluded in that such persons may be deemed affiliates of the Registrant. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

Number of shares outstanding of each class of common equity as of March 1, 2003: 59,719,480 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE:

None

NOTE ON FORWARD-LOOKING STATEMENTS

This report on Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company has tried, whenever possible, to identify these forward-looking statements using words such as “anticipates”, “believes”, “estimates”, “expects”, “plans”, “intends” and similar expressions. These statements reflect the Company’s current beliefs and are based upon information currently available to it. Accordingly, such forward-looking statements involve known and unknown risks, uncertainties and other factors which could cause the Company’s actual results, performance or achievements to differ materially from those expressed in, or implied by, such statements. These risks, uncertainties and contingencies include, without limitation, the challenges inherent in new product development initiatives particularly in the smokeless tobacco area, the uncertainties inherent in the progress of scientific research, the Company’s ability to raise the capital necessary to grow its business, potential disputes concerning the Company’s intellectual property, risks associated with litigation regarding such intellectual property, potential delays in obtaining any necessary government approvals of the Company’s low-TSNA tobacco products, market acceptance of the Company’s smokeless tobacco products, competition from companies with greater resources than the Company, the Company’s decision to sell the assets of its discount cigarette business, risks that conditions to the completion of the sale of the Company’s cigarette business may not be met, the Company’s decision not to join the Master Settlement Agreement (the “MSA”), the effect of state statutes adopted under the MSA and any subsequent modification of the MSA, and the Company’s dependence on key employees and on its strategic relationships with Brown & Williamson Tobacco Corporation. The impact of potential litigation, if initiated against or by individual states that have adopted the MSA, could be materially adverse to the Company.

For a more detailed discussion of these risks, see “Factors That May Affect Future Results” under Item 1 below, and other factors detailed from time to time in the Company’s other filings with the Securities and Exchange Commission.

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PART I

Item 1.    Business

General

Star Scientific, Inc. (“Star”) and its wholly-owned subsidiary, Star Tobacco, Inc. (“ST”, formerly Star Tobacco & Pharmaceuticals, Inc., and together with Star, the “Company”) are technology-oriented tobacco companies with a mission to reduce toxins in tobacco leaf and tobacco smoke. The Companies are engaged in: (1) the development and implementation of scientific technology for the curing of tobacco so as to significantly reduce the formation of carcinogenic toxins present in tobacco and tobacco smoke, primarily the tobacco-specific nitrosamines (“TSNAs”); (2) the sales, marketing and development of tobacco products that expose adult tobacco users to substantially lower levels of carcinogenic toxins, namely TSNAs, and that are sold with enhanced health warnings so that adult tobacco consumers will have the option to make informed choices about the use of tobacco products which pose a range of serious health risks (the TSNA levels in the Company’s tobacco products will continue to be reduced to very low levels, measured in parts per billion, using the StarCured^™ tobacco curing process); (3) the sales, marketing and development of very low-nitrosamine smokeless tobacco products that also carry enhanced warnings beyond those required by the Surgeon General (in 2001, the Company introduced three new smokeless products, Stonewall^™ moist and dry snuffs, and ARIVA^™ compressed powdered tobacco cigalett^™ pieces); and (4) the manufacture and sale of four discount cigarette brands.

On February 18, 2003, the Company entered into an asset purchase agreement (the “Purchase Agreement”) to sell its cigarette business to North Atlantic Trading Company, Inc. (“NATC”). This Purchase Agreement was attached as Exhibit 2.1 to the Current Report on Form 8-K filed by Star on February 18, 2003. The Company will mail to stockholders an information statement at least 20 days prior to closing the transaction.

The Purchase Agreement provides for the sale by the Company of substantially all of the assets and assumption of certain liabilities related to the manufacture and marketing of discount cigarettes to NATC for a purchase price of approximately $80 million in cash, subject to the adjustments described in the Purchase Agreement. NATC generally will assume the liabilities related to the cigarette business, including liabilities arising from, or related to, the development, manufacture, advertising, marketing, distribution, sale, or use of cigarettes under the brands included in the cigarette business. The Company retains certain liabilities of the cigarette business, including funded debt and the obligation to make MSA escrow deposits with respect to sale of cigarettes prior to the closing.

Not included in the transaction are other assets of the Company, including its Bethesda, Maryland office and Chase City, Virginia facilities, its StarCured^™ tobacco curing equipment and barns, its leaf sales and smokeless tobacco business, as well as all of its rights as the exclusive licensee to patents held by Regent Court Technology, LLC (“Regent Court”). Further, the Company retains its existing Tobacco Master Settlement Agreement (the “MSA” or “Master Settlement Agreement”) escrow deposits, which currently amount to approximately $33.5 million.

As part of the transaction, NATC will make offers of employment to approximately 168 employees of the Company. This will include most of the employees who currently work in the Chester, Virginia and Petersburg, Virginia facilities, as well as the vast majority of the field sales force, which is primarily located in Florida, Texas, Mississippi and Minnesota.

Subsequent to the closing of the sale of the cigarette business, the Company will retain approximately 24 employees in Chase City, Virginia; Bethesda, Maryland; and Chester, Virginia who will continue to be involved in the Company’s leaf processing operations, the manufacture of very low-TSNA non-fermented smokeless tobacco products, principally ARIVA^™ compressed powdered cigalett^™ pieces, and the development of related very low-TSNA smokeless tobacco products, such as a spit-free^™ Stonewall^™ “hard tobacco” product for moist snuff users, which is currently in the developmental stage.

The Company anticipates that the transaction will close on or before July 15, 2003, subject to conditions outlined in the Purchase Agreement, including NATC’s ability to obtain financing for the transaction.

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Following the sale of the cigarette business, the Company’s primary focus will continue to be the research, development and sale of products that expose adult tobacco users to lower levels of toxins. The Company’s overall objective is to ultimately reduce the range of serious health hazards associated with the use of smoked and smokeless tobacco products. Accordingly, its primary corporate mission is to demonstrate the commercial viability of products that expose adult tobacco users to fewer toxins and are potentially less harmful. However, given the present limited state of the research efforts of Star and others in this area, the Company, in discussing its low-TSNA products, has shared with adult consumers the fact that there is not now sufficient evidence to demonstrate that reduced toxin delivery can be quantified in terms of reduced health risk. Accordingly, the Company does not make any direct or indirect therapeutic or health claims regarding its tobacco products. The Company fully accepts the evidence that links smoking tobacco and a variety of diseases with premature death and believes that it is unlikely that the health risks of smoked tobacco can be completely eliminated. Star believes it was the first company to state unequivocally that “there is no such thing as a safe cigarette”, and to affix to the back of the package of its first premium low-TSNA product, Advance^®, a package “onsert” which contained not only scientifically verified comparative content data, but also additional health warnings. Nevertheless, in a world where an estimated 1.2 billion people smoke and use other conventional tobacco products, there is an urgent need to reduce the toxicity of tobacco products to the maximum extent possible, given available technology. Accordingly, the Company believes that it has a corporate responsibility to continue to expand its research and development efforts to manufacture tobacco products in the least hazardous manner possible, given available technology, particularly through the StarCured^™ tobacco curing process. Further, the Company believes it has the technology to reduce carcinogenic TSNAs, particularly the subgroups of nitrosamines commonly referred to as NNNs and NNKs, to the lowest possible levels and has demonstrated that the method it has developed for curing tobacco using the StarCured^™ tobacco curing process can be scaled up to meet broad commercial needs in the United States and abroad.

Given the fact that tobacco smoke contains over 4,000 constituents, 43 of which are known carcinogens, the Company’s focus over the last three years has centered on the development and commercialization of very low-TSNA non-fermented smokeless tobacco products that can be used as an alternative to cigarettes in situations where adult tobacco users either cannot or choose not to smoke. The Company expects that in the future its focus will continue to be on the development and sale of very low-TSNA non-fermented smokeless tobacco products. For that reason, the Company recently entered into the Purchase Agreement with NATC under which the Company has agreed to sell to NATC substantially all of the assets relating to its discount cigarette business and to transition out of the smoked tobacco business. The Company is also committed to continuing to advocate meaningful federal regulation for all tobacco products and has publicly announced its support for reasoned regulation of tobacco products by the United States Food and Drug Administration (the “FDA”).

Star’s long-term strategy is to encourage other tobacco manufacturers to sublicense the StarCured^™ tobacco curing technology to produce very low-TSNA tobacco (with carcinogenic NNKs and NNNs that measure 200 parts per billion and below). Further, Star is committed to continuing to explore the development of products that expose adult tobacco users to lower levels of toxins and are potentially less harmful than conventional smoked tobacco, such as smokeless tobacco products. In September 2001, the Company introduced two very low-TSNA snuff products (a moist and a dry snuff) under the brand name Stonewall^™. In November 2001, the Company initiated the test market of its compressed powdered tobacco “cigalett”^™ pieces under the brand name ARIVA^™. The tobacco in both Stonewall^™ and ARIVA^™ is 100% StarCured^™ very low-TSNA tobacco.

During 2002, while discount cigarettes continued to constitute the substantial majority of the Company’s sales, the Company expanded distribution of its smokeless products, most notably ARIVA^™ compressed powdered cigalett^™ pieces. By the end of 2002, ARIVA^™ was available in approximately 35,000 retail locations in 48 states and in Bermuda.

The Company’s revenues have been generated principally through ST. ST, a Virginia corporation, was incorporated in 1990 and, until 1994, primarily was engaged in the business of manufacturing cigars and cigarettes for others as a contract manufacturer. By late 1994, ST had commenced development and commercialization of its own brands of discount cigarettes using primarily Virginia flue-cured tobacco and competed principally on the basis of price. At about that same time, ST commenced a program of research and development relating to a range of tobacco products that deliver fewer toxins as well as tobacco cessation products. Shortly thereafter, ST shifted its near-term research to technology focused on reducing the carcinogenic TSNAs, particularly the NNNs and NNKs, in the tobacco leaf and tobacco smoke.

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In February 1998, ST completed a share exchange with Eye Technology, Inc., a publicly held OTC Bulletin Board company based in Minneapolis, Minnesota. Eye Technology was organized as a Delaware corporation in 1985. While Eye Technology became ST’s parent corporation, in effect control of Eye Technology shifted to the former stockholders of ST and the management of ST became the management of Eye Technology. By December 30, 1998, the assets and liabilities that comprised the pre-merger business of Eye Technology had been sold or liquidated, and the stockholders of Eye Technology voted to change its name to Star Scientific, Inc. The Company’s primary corporate focus from that time forward has centered on the sales, marketing and development of tobacco products which expose adult tobacco users to lower levels of toxins and potentially may be proven to reduce risk. In addition, the Company, in the future, intends to explore engaging in the development of smoking cessation products either with a joint venture partner or a corporate pharmaceutical partner with significant resources, and/or experience in scientific and regulatory infrastructure that can assist and accelerate the FDA’s New Drug Application regulatory process necessary for market entry.

The Company has an exclusive, worldwide license from Regent Court under eight patents issued and patents pending relating to methods to substantially prevent the formation of TSNAs in tobacco including the StarCured^™ tobacco curing process. The StarCured^™ tobacco curing process, as discussed herein, involves the control of certain conditions in tobacco curing barns, and in certain applications, uses microwave and/or electronic beam technology. The StarCured^™ process substantially prevents the formation in the tobacco leaf of the carcinogenic TSNAs, which are widely believed by medical and scientific experts to be among the most abundant and powerful cancer-causing toxins present in tobacco and in tobacco smoke. In each of 2000, 2001 and 2002, the Company processed approximately 19 million pounds of very low-TSNA flue-cured tobacco using the StarCured^™ process. Star has focused on the production of StarCured^™ flue-cured tobacco since this variety is used exclusively in the Company’s smokeless products. At the same time, the Company believes that this process can be applicable to burley and other varieties of tobacco on a broad-scale commercial basis and continues to support research and technological development directed to varieties other than flue-cured tobacco.

On April 25, 2001, the Company and Brown & Williamson Tobacco Corporation (“B&W”), the third largest tobacco company in the United States, entered into a series of new comprehensive long-term agreements (the “April 25, 2001 Agreements”) that amended agreements previously entered into with B&W. Among other things, the agreements provided for B&W to take over all aspects of the sale of Advance^®, the low-TSNA cigarette that was jointly developed by the Company and B&W and first test marketed by the Company in October 2000, in return for royalty payments to the Company. B&W subsequently launched an expanded test market of Advance^® in approximately 1,500 stores in Indianapolis, Indiana in November 2001. That test market is continuing and B&W potentially may market this brand on a national basis, if the current market test is successful. The agreements also provided B&W with the exclusive marketing rights for the Company’s compressed powdered cigalett^™ pieces in the United States (subject to the Company’s own rights), in return for paying the Company a royalty plus the cost of manufacturing the cigaletts^™. Among other things, the agreements also restated various loan agreements made by B&W to the Company during 1999 and 2000, and provided for the purchase of StarCured^™ tobacco by B&W over the 2001-2003 growing seasons, with the right to purchase additional tobacco in future years. (See “Relationship with B&W” for more information on the Company’s agreements with B&W).

Segments and Products

See Note 12 of the Company’s Consolidated Financial Statements for financial information about the Company’s segments.

Leaf Tobacco

In each of 2000, 2001 and 2002, Star processed and sold approximately 19 million pounds of very low-TSNA flue-cured tobacco that had been cured using the StarCured^™ tobacco curing process. Substantially all of these sales were made to B&W, pursuant to Star’s contractual arrangements with B&W described elsewhere in this report. These sales accounted for approximately 22.8%, 20.6% and 20.7% of the Company’s net sales in 2002, 2001 and 2000, respectively. Star also received a royalty of $1.5 million in both 2002 and 2001 from B&W on B&W’s

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purchases of other low-TSNA tobacco. During 2003 and in the future, B&W will not be obligated under the April 25, 2001 Agreements to pay any further royalty for purchases of low-TSNA tobacco unless and until a royalty rate is established with one of the other three largest tobacco manufacturers. Under the April 25, 2001 Agreements, it is anticipated that the Company will process approximately 18-20 million pounds of very low-TSNA flue-cured tobacco during the 2003 growing season, for sale to B&W and for use in the Company’s smokeless tobacco products. The tobacco will be cured using the StarCured^™ tobacco curing process. If B&W reduces its StarCured^™ tobacco purchases in subsequent years below 15 million pounds per year, the Company will receive a credit of $0.80 for each pound reduction up to a total of $12 million.

The bulk of processed tobacco sales occur in the third and fourth quarter of each year, resulting in higher revenues in those quarters. The Company’s long-term goal is to derive an increasingly larger percentage of its revenues from sublicensing its tobacco curing technology to major cigarette manufacturers. During 2002 and 2001, approximately ninety-nine percent (99%) and eighty-five percent (85%), respectively, of all flue-cured tobacco in the United States was cured in a manner to reduce the levels of TSNAs in the cured tobacco leaf. In May 2001, the Company filed suit against R. J. Reynolds Tobacco Company (“R.J. Reynolds”) for patent infringement relating to R.J. Reynolds’ efforts to have farmers produce low-TSNA tobacco using the technology to which Star is the exclusive licensee. In August 2002, the Company filed a second suit against R.J. Reynolds for patent infringement, which in September was consolidated with the first suit filed in May 2001 (see “Legal Matters”).

Smokeless Tobacco Products

Over the past three years, the Company has been engaged in the development of very low-TSNA non-fermented smokeless tobacco products that could provide adult tobacco users with a viable alternative to cigarettes for use in situations and environments when they cannot smoke or when they would prefer not to smoke. This effort was encouraged by the Company’s Scientific Advisory Board and other independent scientific, medical, and public health advisors who encouraged Star to accelerate the development of smokeless products using 100% StarCured^™ very low-TSNA tobacco, because smokeless products have far fewer toxins than conventional cigarettes. Cigarette smoke contains more than 4,000 chemical compounds, 43 of which are known to be carcinogenic. A number of respected scientists and researchers throughout the world believe that the only major or significant toxins in non-fermented smokeless tobacco are the TSNAs, particularly the NNNs and NNKs.

On September 28, 2001, the Company introduced its first two very low-TSNA snuff products (a moist and a dry snuff) under the brand name Stonewall^™. On November 14, 2001, Star introduced its flagship hard tobacco cigalett^™ pieces (ARIVA^™). ARIVA^™ is a compressed powdered tobacco product designed to dissolve completely in the mouth without leaving any residue or requiring expectoration. Sales of Star’s smokeless products were de minimis in 2001 and 2002. ARIVA^™ and Stonewall^™ are being marketed nationwide by ST through its network of established tobacco distributors and through new distributors with whom ST has not previously had a relationship. These sales have been generated in part through our existing sales force. After the sale of the discount cigarette business, our sales force will decrease significantly. This could adversely impact our relationships with established tobacco distributors. In addition, the Company has introduced ARIVA^™ and Stonewall^™ through direct arrangements with several national retail chains and through national distributors experienced with consumer products. Following the limited test market of its smokeless products, Star decided it was appropriate to expand distribution. Accordingly, by March 31, June 30, September 31 and December 31 of 2002, respectively, the Company’s smokeless products had been placed in more than 12,000, 30,000, 33,000, and approximately 35,000 convenience and retail store locations, respectively. In the fourth quarter of 2002, the Company sold 7,780 cartons of ARIVA^™ (10 packs equal one carton), compared to 16,800, 69,420 and 73,800 for the 3^rd, 2^nd and 1^st quarters of 2002, respectively. The decline in sales of ARIVA^™ since the second quarter resulted from the fact that initial sales were primarily derived from original placements of the product in stores. The Company anticipates future sales will be derived from a combination of initial sales to retail, convenience and tobacco departments of drug stores and re-orders from existing customers. Overall, the sales of smokeless products continue to represent a nominal portion of the Company’s total sales. Despite the broad distribution of ARIVA^™, sales have been slower than expected, in part, we believe, due to the lack of customer familiarity with ARIVA^™ and lack of funds to properly communicate product information to adult tobacco users. As a result, the time period for generating significant revenue and cash flow from the introduction of ARIVA^™ will be longer than originally expected and it will take longer for the smokeless products to support themselves on a stand-alone basis. During 2003, the Company anticipates continuing to expand the number of stores in which ARIVA^™ will be available, but cannot be

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sure that ARIVA^™ will be accepted into the national marketplace or produce sufficient revenues to support the Company’s initiative to focus primarily on smokeless tobacco products.

We believe that the acceptance of ARIVA^™ has been impacted by a number of factors, including, among others: (1) the fact that ARIVA^™ requires a change in habit by smokers, i.e. using a smokeless product rather than a smoked product; (2) publicly stated opposition to ARIVA^™ by certain Attorneys General and certain public health advocacy groups which has appeared in various newspapers and FDA filings; (3) ARIVA^™ requires smokeless warning labels that may be unfamiliar to and/or misunderstood by cigarette smokers; (4) the need to develop name brand recognition with consumers; and (5) difficulty in obtaining capital required for large scale consumer education and marketing directed to adult tobacco users. The Company expects that the successful marketing of ARIVA^™ on a broad basis will require the expenditure of substantial funds, which the Company will need to obtain from the sale of the cigarette business or other external financing, the availability of which cannot be assured. (See “Liquidity and Capital Resources” under Item 7 for more information on the Company’s current liquidity.) ARIVA^™ can currently be found in the following chain stores: CVS Pharmacies, Rite Aid Drug Stores, Albertsons/Osco, Sav-on, and 7-Eleven franchises. Eckerd Drug introduced ARIVA^™ during the first quarter of 2003, and Hudson News (airport terminals, bus terminals and train station stores) introduced ARIVA^™ on an expanded basis during the first quarter of 2003.

As part of the NATC Purchase Agreement, the Company will sell to NATC certain equipment leased by the Company and located at its Petersburg, Virginia facility that is used in the production of Stonewall^™ moist snuff. While the Company will continue to sell its Stonewall^™ moist snuff, it does not anticipate purchasing replacement equipment. Rather, the Company is completing the pre-marketing testing and development of a new non-fermented smokeless spit-free^™ “hard tobacco” product for moist snuff users, called Stonewall^™ Hard, which is made from 100% low-TSNA StarCured^™ tobacco plus natural and artificial flavorings as well as other ingredients. The Company anticipates beginning test marketing of this product during 2003.

Discount Cigarettes

Traditionally, sales of discount cigarettes have represented the substantial majority of ST’s revenues. Until the closing of the sale of the cigarette business to NATC pursuant to the Purchase Agreement, ST will continue to sell four brands of discount cigarettes through approximately 200 tobacco distributors throughout the United States. We anticipate the sale of the cigarette business will close on or before July 15, 2003. If the proposed sale of the cigarette business to NATC is not closed, ST will continue to manufacture discount cigarettes until the Company can transition from the smoked tobacco business. These cigarettes, which are sold as discount brands, accounted for approximately 75.1%, 79.4%, and 79.3% of the Company’s net sales in 2002, 2001 and 2000, respectively. ST does not engage in extensive advertising or marketing programs for its cigarette products, but relies primarily upon communications with distributors, product placement by its field sales force (the field sales force focuses primarily on placing ST’s products with retailers in the four non-MSA states, Florida, Minnesota, Mississippi and Texas), pricing appropriate for discount cigarettes, and, to a lesser extent, on brand recognition, product appearance and taste in order to compete in the marketplace. ST has chosen to focus its cigarette sales in the four non-MSA states because sales in those states are not subject to MSA escrow obligations. (See “Liquidity and Capital Resources” under Item 7 and “Tobacco Master Settlement Agreement” under “Government Regulation” for a more detailed description of the cash implications of making payments into the MSA escrow accounts.) ST has avoided any marketing efforts aimed at young persons, and the Company is committed to keeping its products out of the hands of youngsters. There were no export sales by the Company in 2002.

During the 3^rd quarter of 2002, in an effort to increase the competitiveness of discount cigarettes in the rapidly growing fourth tier (discount segment) of the market, which now constitutes more than 10% of the overall cigarette market, the Company announced plans to reduce, or entirely replace, the 24% StarCured^™ very low-TSNA tobacco in its leading brand, MainStreet^®, with other less expensive low-TSNA tobacco, and to consider such a change in its other brands. Presently, the Company is using a blend of “cut rag” tobacco in its discount cigarettes that contains low-TSNA flue-cured tobacco, but no StarCured^™ tobacco. In addition, until the 3^rd quarter of 2002, the Company utilized more costly carbon/acetate filters on all of its discount cigarettes. Due in part to questioning by certain members of the public health advocacy community of the added benefit of such filters, the Company also replaced carbon/acetate filters with more conventional acetate filters that are standard in the industry.

Low-TSNA Cigarettes

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Star launched the first low-TSNA cigarette, Advance^®, in October 2000 in two test markets—Richmond, Virginia and Lexington, Kentucky. Advance^® was the first conventional cigarette to be manufactured to deliver fewer carcinogenic TSNAs. The Advance^® cigarette reduced additional toxic smoke constituents through a unique activated carbon/acetate filter. Advance^® also differed from conventional premium brands because it provided adult tobacco consumers with enhanced health warnings (not required by the Surgeon General), on the back of the package and “onserts” that contained comparative content information and additional health-related information.

Under the April 25, 2001 Agreements, B&W agreed to take over all aspects of the sales, marketing and distribution of Advance^®. On November 5, 2001, B&W initiated a test market of its version of Advance^® in Indianapolis, Indiana. That test market is ongoing. If B&W determines that its test market is successful, then B&W will undertake a further rollout of the product. Under the April 25, 2001 Agreements, Star receives a royalty on each carton of Advance^® sold by B&W. Sales of Advance^® during the Company’s test market, and royalty payments from B&W during 2001 and 2002 were de minimis. This business arrangement was consistent with the Company’s long-term objective of moving out of the combusted cigarette business and focusing on the licensing of its technology.

Tobacco-Flavored Chewing Gum and Lozenges and Chewing Gum Containing Tobacco Extract

Prior to the decision to concentrate on the development of products for adult tobacco users that incorporate very low-TSNA StarCured^™ tobacco, the Company sought to develop both cessation products and a product intended to help patients who relapsed after a trial of smoking cessation to prepare for another cessation attempt, and secured two Investigational New Drug Applications (“IND”) from the FDA. While the initial results of the IND protocol testing of these products were positive, the Company determined that the further testing and the preparation and submission of required marketing applications to the FDA would be costly and time consuming, as well require a major scientific infrastructure, which the Company did not have and could not afford at the time. Accordingly, the Company made the business decision that it was unlikely that the development of cessation-related products on its own would produce an adequate return on investment. The Company has explored entering into a joint venture, partnership and/or technology license as a means to develop cessation-related products. The Company would have preferred to work with a major pharmaceutical company with significant resources and experience and the scientific and regulatory infrastructure that can assist and accelerate the approval process required for market entry. However, at this point in time, the Company is focused on other objectives, as set forth above.

Sales and Marketing

In marketing ARIVA^™ hard tobacco cigalett^™ pieces and Stonewall^™ moist and dry snuffs, the Company has sought to position the products in the smokeless sector of the tobacco market using many of the same distribution channels that it uses for cigarette sales. As part of the marketing and distribution effort, the Company also has negotiated agreements with a number of national retail chains and national distributors selling consumer products.

Three of the Company’s officers, Mr. Jonnie R. Williams, Star’s Chief Executive Officer, Mr. David M. Dean, Star’s Vice President of Sales and Marketing, and Mr. Sheldon Bogaz, ST’s Vice President of Trade Operations, lead the Company’s sales and marketing activities. Mr. Randy Escamilla, National Sales Manager, supervises a staff of five regional sales managers who direct ST’s field sales force. The Purchase Agreement contemplates Messrs. Bogaz and Escamilla joining NATC in connection with the sale of the cigarette business.

During 2002, ST repositioned and consolidated its field sales force in response to increased competition from foreign and domestic companies selling discount brands. By the end of 2002, ST had 78 field sales personnel and merchandisers primarily positioned in Florida, Minnesota, Mississippi and Texas.

It has been ST’s strategy to rely to a large degree upon distributors to promote ST’s discount cigarette brands to retail customers. ST provides to its distributor customers, for redistribution to retailers, point-of-sale materials such as posters, pole signs, display racks and counter top and floor displays. Also, ST produces marketing materials for use by distributors and their direct sales force to promote the sale of ST tobacco products to their retail customers.

ST sells its tobacco products through approximately 200 tobacco distributors throughout the United States, although in 2002 its sales of discount cigarettes were primarily in Florida, Mississippi, Minnesota and Texas. Of these 200 distributors, approximately 69 are located in Florida, Mississippi, Minnesota, and Texas where the Company’s sales force is now concentrated and where it does not have purported obligations to make payments into

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escrow under state qualifying statutes enacted pursuant to the MSA for sales of cigarette products. The distributors maintain state and, where applicable, municipal government tobacco product licenses, and apply state and/or local tax stamps when needed to resell the tobacco products. ST delivers its products directly to distributors mainly by common carrier trucks. ST’s distributor customers primarily serve convenience stores, gas stations and other outlets and retail stores. No one distributor accounted for more than 14% of ST’s revenue in 2002. The overall number of distributors was reduced from approximately 260 in 2001 to 200 in 2002 due to price increases, as well as the Company’s focus on enhancing its market share in four states: Florida, Minnesota, Mississippi, and Texas. ST’s shipment volume for discount cigarettes during 2002 decreased approximately 18% to 2.9 billion units from 2001’s shipment volume of 3.5 billion units, reflecting a continued commitment by the Company to concentrate the field sales force and sales efforts in four states and to develop and launch a series of smokeless tobacco products, which the Company believes will be the primary focus of its business in the future. Sales of smokeless tobacco products have been generated in part through our existing sales force. After the sale of the discount cigarette business, our sales force will decrease significantly. This could adversely impact our relationships with established tobacco distributors.

Purchasing

Star purchases its low-TSNA flue-cured tobacco for its leaf tobacco sales from approximately 200 participating tobacco farmers (“StarCured^™ farmers”) who cure their tobacco in specially designed StarCured^™ barns pursuant to long-term contracts entered into with the Company. Star believes that it will be able to purchase a sufficient supply of flue-cured, StarCured^™ leaf tobacco from these farmers for its own use and to satisfy commitments to B&W for the foreseeable future. The Company anticipates that it will be able to process the tobacco purchased from the farmers within its Chase City processing facility within one to three days of delivery to the facility.

During 2002, pursuant to the Company’s Supply Agreement with B&W, the tobacco used in ST’s cigarettes was purchased from B&W’s Export Leaf Division in “cut rag” form, meaning that the tobacco had been cut, processed and flavored to ST’s specifications, and was ready when delivered to ST for the manufacturing process. ST expects to purchase “cut rag” tobacco from B&W’s Export Leaf Division or other sources until the closing of the sale of the cigarette business to NATC, at which time the Supply Agreement with B&W will terminate. If the transaction with NATC does not close, ST will purchase “cut rag” tobacco from B&W Export Leaf Division or purchase tobacco needed for its business from other sources. Buying tobacco from B&W’s Export Leaf Division or other sources allows ST to avoid having to dedicate substantial amounts of working capital to tobacco inventories. (See “Manufacturing” below for a description of the Company’s manufacture of cigarettes as well as its purchase of manufactured cigarettes.)

At the end of 2002, Star had approximately 347,000 pounds of burley tobacco in inventory at B&W facilities, which will be maintained by B&W until the closing of the sale of the cigarette business to NATC. In 2002, Star continued its research and development to attempt to perfect the StarCured^™ tobacco curing process for burley tobacco in conjunction with the University of Kentucky’s Department of Agronomy, The Burley Tobacco Growers Cooperative Association, Inc. and Star’s scientific and technical advisors. Star believes that the StarCured^™ process is applicable to burley tobacco, and the Company will continue its efforts with respect to burley tobacco experiments with the University of Kentucky this growing season. However, because the tobacco in Star’s smokeless tobacco products is 100% flue-cured low-TSNA StarCured^™ tobacco, the Company’s need for a low-TSNA burley tobacco is expected to decline as the Company shifts its emphasis to smokeless tobacco products. Moreover, no assurances can be given at this time that the low-TSNA StarCured^™ tobacco curing process for burley tobacco will be successfully developed and commercialized.

At the end of 2002, Star had approximately 1.0 million pounds of re-dried strip StarCured^™ tobacco paid for by B&W and held in inventory by B&W on Star’s behalf. This tobacco will be used in Star’s smokeless tobacco products.

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Manufacturing

All of the flue-cured tobacco that the Company plans to use in 2003 and thereafter, either for sale in leaf form to B&W and potentially other parties or in Star’s smokeless tobacco products, but not in the Company’s discount cigarettes, will be cured using the StarCured^™ tobacco curing process. The StarCured^™ tobacco curing process involves controlling certain conditions in the tobacco curing barns, and in certain applications, uses microwave and/or electronic beam technology. The specially designed curing barns that utilize the StarCured^™ tobacco processing technology have been manufactured exclusively for Star by Powell Manufacturing Company of Bennettsville, South Carolina (“Powell”). Specially designed barns, which are owned or leased by the Company, are erected on site at the tobacco farms and provide Star with its source of very low-TSNA tobacco. A total of 1,125 Star barns have been manufactured and approximately 935 have been delivered to farmers who currently produce flue-cured tobacco. In 2000, 100 barns were delivered to farmers in Kentucky in connection with the research, development and testing of the StarCured^™ tobacco curing process for burley tobacco in conjunction with the previously mentioned joint program with The Burley Tobacco Growers Cooperative Association, Inc.

Star does not anticipate purchasing any additional barns in 2003 because the Company has sufficient barns in place to process approximately 20 million pounds of StarCured^™ flue-cured tobacco, which will meet the Company’s needs for this growing season. Under the April 25, 2001 Agreements, B&W agreed to finance all of the StarCured^™ tobacco curing barns on an interest-free basis through January 1, 2005. That date has now been extended to June 1, 2005. Beginning in June 2005, this debt will be payable in 60 monthly installments. Subsequent to April 2001, Star entered into a series of sale/leaseback transactions for approximately 590 barns and, as part of these transactions and in order to have B&W release its collateral interest in the barns, Star agreed to pay 4/14^ths of the proceeds to B&W to reduce its long-term indebtedness. As of December 31, 2002, the Company owed B&W approximately $0.6 million for these payments, which will be repaid from the proceeds of the sale of the cigarette business. Also, in 2001, as a further reduction of outstanding debt owed to B&W, Star sold 91 curing barns to Golden Leaf Tobacco Company, Inc. for $1.85 million, as part of a sale and licensing arrangement. The $1.85 million was used to reduce long-term debt owed to B&W because the barns were held as collateral for this debt. From an initial loan balance of $29 million in April 2001, the Company has reduced the amount outstanding to approximately $21.4 million as of December 31, 2002. Under the sale/leaseback transactions Star has financed the barns with certain financial institutions and agreed to repurchase the barns at the end of the lease period, thus ultimately having the ability to retain control of the barns.

In early 2000, Star’s processing facility in Chase City, Virginia underwent a substantial expansion of its capacity to process significantly larger amounts of low-TSNA tobacco, as well as to provide sufficient space for the installation of new equipment to be used in conjunction with the manufacturing of the Company’s smokeless tobacco products and the installation of a state of the art laboratory to test for TSNAs. This expansion allowed Star to process approximately 19 million pounds of StarCured^™ tobacco during each growing season in 2000, 2001 and 2002. As a result of the expansion, the Chase City facility will have more than adequate capacity for volumes anticipated for B&W under the April 25, 2001 Agreements and for Star’s requirement for tobacco processing.

ST expanded its cigarette manufacturing capability in 2000 by outsourcing a portion of its manufacturing through a contract with B&W to manufacture cigarettes. During 2001 and 2002, B&W produced approximately 70% of the cigarettes that ST sold. Effective January 1, 2003, the Company and B&W terminated their Manufacturing Agreement under which B&W had produced cigarettes that ST had been selling from 1999 through 2002. Since January 1, 2003, the Company has been manufacturing all of its cigarettes in its Petersburg manufacturing facility. The Company anticipates that the manufacturing capacity in Petersburg should be sufficient to satisfy the manufacturing needs for its cigarettes through the closing of the sale of the cigarette business to NATC, or for the foreseeable future if the transaction with NATC does not close, given the current manufacturing levels which have been decreasing over the past several years as the Company has focused its sales of cigarettes in the four non-MSA states.

In 2002, Star also installed at Chase City a high-speed manufacturing line for the production of ARIVA^™ hard tobacco cigalett^™ pieces and Stonewall^™ dry snuff, and a second manufacturing line has been ordered. Plans are currently underway for the installation of these manufacturing lines in a newly renovated facility in Chase City, adjacent to the existing Star facility. This second facility has approximately 91,000 square feet of space that can accommodate both manufacturing lines and an expanded testing facility and 9,000 square feet of office space located on approximately nine acres of land. This facility was purchased during 2002 by the Mecklenburg County and Chase City Industrial Development Authorities and they, along with Star, renovated the facility to Star’s specifications. Star entered into a long-term lease with an option to purchase this facility. It is

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anticipated that, by the end of 2003, all of Star’s smokeless tobacco manufacturing operations and its laboratory for testing low-TSNA tobacco will be housed in this facility.

The Company believes its manufacturing facilities will allow it to respond to the demand for its smokeless products, as well as to the demand for cigarette products through the close of the sale of the cigarette business and beyond, if that transaction does not close.

Relationship with B&W

On October 12, 1999, the Company and B&W entered into an agreement (referred to as the “Master Agreement”) under which B&W, among other things, agreed to purchase StarCured^™ tobacco. On April 25, 2001, the Company and B&W entered into a Restated Master Agreement that provided for increased purchases of StarCured^™ tobacco by B&W. B&W agreed to purchase at least 15 million pounds of StarCured^™ tobacco over three growing seasons (2001-2003) with the right to purchase additional amounts of StarCured^™ tobacco during those years and in future years. At the end of the 2003 growing season, Star and B&W have agreed to negotiate in good faith for the purchase of StarCured^TM tobacco by B&W in later years. If B&W does not purchase at least 15 million pounds of StarCured^TM tobacco in the later years, then for each pound purchased below 15 million pounds Star will receive an $0.80 per pound reduction of its outstanding debt obligations, up to a total reduction of $12 million on a cumulative basis.

During each of the years 2000, 2001 and 2002, Star produced and delivered to B&W approximately 19 million pounds of very low-TSNA StarCured^™ tobacco. Pursuant to the Restated Master Agreement, some of this tobacco has been purchased by the Company for use in ST’s own discount cigarettes, or in Star’s new hard tobacco and moist and dry snuff products. As of December 31, 2002, B&W is holding in inventory for the Company’s use approximately one million pounds of StarCured^™ tobacco worth approximately $3.7 million.

B&W also manufactured cigarettes for ST until December 31, 2002, pursuant to a Manufacturing Agreement entered into in January 2000 and has been supplying leaf tobacco to ST for use in its tobacco products, pursuant to a Supply Agreement entered into in January 2000, as well as warehousing burley tobacco for Star. As discussed above in “Manufacturing”, effective January 1, 2003, Star and B&W terminated the Manufacturing Agreement. The Supply Agreement will be terminated upon the closing of the sale of the discount cigarette business to NATC.

Under the Restated Master Agreement, B&W also agreed to restructure approximately $29 million of debt into long-term, interest-free debt with interest and principal payments initially beginning in January 2005 and continuing over five years. The date for repayment of the loans has subsequently been extended until June 1, 2005. Beginning in June 2005, this debt will be payable in 60 monthly installments. There are provisions in the agreements that forgive one-half of the then-current debt if B&W determines that its test market of a cigalett^™ product is successful, and all of the remaining debt once B&W introduces a cigalett^™ product into distribution in retail locations in 15 states.

Further, pursuant to one of the April 25, 2001 Agreements, B&W has taken over all aspects of the Advance^® low-TSNA cigarette in return for royalty payments (initially 40 cents per carton and which payments decrease over time) on the sales of that cigarette. Pursuant to another agreement entered into on April 25, 2001 (the “Hard Tobacco Agreement”), B&W has an exclusive right (subject to Star’s own rights) to purchase and sell hard tobacco cigalett^™ pieces, in return for royalty payments of 50 cents per package ($5 per carton) on the sales of these products during the test market and ten-year exclusivity period, reduced by 50% subsequent to that period. Provided satisfactory test marketing is achieved, the term of the agreement is ten years, automatically renewable for seven successive ten-year periods. In the case of the cigalett^™ pieces, B&W has to pay Star its manufacturing costs in addition to the royalty payments. Finally, under another agreement entered into on April 25, 2001 (the “Other Low-TSNA Tobacco Agreement”), B&W is obligated to pay royalties to Star on B&W’s purchases of StarCured^™ tobacco and other low-TSNA tobacco. During 2001 and 2002, Star received approximately $1.5 million each year of royalty payments from B&W on its purchase of low-TSNA tobacco, all of which was used to reduce Star’s long-term debt to B&W. During 2003 and in the future, B&W will not be obligated to pay any further royalty for purchases of low-TSNA tobacco until a royalty rate is established with one of the other three largest tobacco manufacturers pursuant to the terms of the April 25, 2001 Agreements.

In return for B&W releasing its security interests in the Company’s intellectual property and all assets included in the sale of the cigarette business to NATC and providing other consents, the Company at the closing of the sale of its discount cigarette business to NATC will pay $7.5 million of proceeds to B&W to reduce principal on the promissory notes entered into as part of the April 25, 2001 Agreements, and will pay all other outstanding obligations to B&W aside from such notes.

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For additional information on our relationship with B&W, including more detailed information regarding the agreements described above, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as “General” and “Manufacturing” under this Item 1.

Competition

ARIVA^™ compressed tobacco cigalett^™ pieces are intended to compete with conventional cigarettes and to be used by adult smokers in situations and environments when they cannot or choose not to smoke. The primary competition for ARIVA^™ is expected to be from the large tobacco manufacturers that dominate the cigarette industry, as opposed to traditional competitors in the smokeless market. However, as discussed herein, the Company has entered into an agreement for B&W to purchase and sell a “hard tobacco” cigalette^™-type product in return for the payment of royalties to Star. The Company’s primary competition for its Stonewall^™ snuff products is expected to be other smokeless tobacco companies such as US Smokeless Tobacco Company and Swedish Match because Stonewall^™ is competing with moist snuff products. ARIVA^™ is priced competitively with cigarettes, while Stonewall^™ is priced at a discount to traditional moist snuff products.

In the discount cigarette segment of the market, price is one of the principle competitive driving factors. However, customer familiarity with brands, market accessibility and service also play a role. The Company’s primary competition for cigarettes traditionally has been from the four “majors,” that is, Philip Morris, the brands of which accounted for approximately 50% of all cigarette sales in the United States in 2002, R.J. Reynolds, B&W and Lorillard, as well as Vector Group, Ltd. (the parent company of Liggett), each of which has substantially greater financial and operating resources than the Company. The Company also encounters significant competition from several other smaller U.S. manufacturers of cigarettes, as well as importers of cigarettes manufactured in foreign countries. Many of these manufacturers and importers have substantially greater financial, manufacturing, marketing and other resources than the Company. Further, the Company has faced increased competition from foreign manufacturers who are not participating members of the MSA. Despite the requirements of the MSA, many of the newer discount competitors have not made, and it appears do not intend to make, deposits into escrow accounts purportedly required by the MSA. Due to the price sensitive nature of the discount segment of the cigarette market, this has allowed these newer discount competitors to undercut the current discount market and unfairly compete against ST for discount cigarette sales. Although several states have begun litigation against some of these companies for failure to make escrow payments on sales in those states, it is unclear whether such litigation will adequately resolve this issue.

In 2001, Vector Group, Ltd. introduced a reduced-toxin cigarette that it represents contains fewer toxins, including TSNAs, than other conventional brands. In November 2001, B&W also began an expanded test market in Indianapolis, Indiana of its version of the Advance^® low-TSNA cigarette that Star and B&W jointly developed. As discussed above, the Company receives a royalty on each carton of Advance^® sold by B&W. Other companies have begun to purchase low-TSNA tobacco and are expected to incorporate that tobacco into their products. Such products apparently were brought to market in 2002 and it is anticipated that more low-TSNA tobacco will be incorporated into tobacco products in 2003. In particular Swedish Match has worked with various varieties of tobacco under crop management environments and other methods in an effort to maintain low-TSNA levels in its smokeless products. In 2001, Swedish Match introduced a new smokeless tobacco product in the United States that claims to have reduced levels of carcinogens.

B&W now has in its possession low-TSNA tobacco from the 1999-2002 growing seasons. Also, the industry has initiated a program that is intended to require all tobacco sold at auction to be cured in a manner that is intended to result in reduced levels of TSNAs. As a result, virtually all flue-cured tobacco grown in the United States in 2002 was cured in a manner to reduce the levels of TSNAs. Further, the United States Department of Agriculture (“USDA”) announced in 2002 that in the future, it will not provide full price supports for flue-cured tobacco that is not cured in a manner to reduce or limit the levels of TSNAs in the cured tobacco leaf. Star believes that, if it is successful in commercializing its unique low-TSNA tobacco products and enforcing the patents for such technology to which it is the exclusive licensee, many of the major tobacco companies will follow its lead and may seek to sublicense the technology for producing low-TSNA tobacco.

Smoking cessation products that are approved for sale in the United States by the FDA are designed to wean the smoker from nicotine addiction over a period of time ranging from 30 days to six weeks. These products are referred to as “nicotine replacement therapies”.

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Some of these products are sold over the counter and others are available by prescription. The manufacturer of at least one such product apparently perceives Star’s low-TSNA smokeless products as an alleged competitor in the “When You Can’t Smoke”^TM market, although such pharmaceutical products are not intended to be substitutes for tobacco products. There are also non-tobacco cigarettes produced with fillers such as lettuce and herbs. In addition to the use of consumable products for smoking cessation or reduction purposes, medical practitioners and others have developed a variety of programs intended to assist a person in withdrawing from nicotine dependence. Treatments used include psychological counseling, hypnosis, group therapy and behavior modification techniques. There can be no assurance that in the future Star’s competitors will not succeed in developing technologies and products that are more effective than Star’s product candidates, that are less toxic than Star’s products, or that would render Star’s products obsolete or non-competitive.

Government Regulation

The manufacture and sale of cigarettes, other tobacco products and pharmaceutical products are subject to extensive federal and state governmental regulation in the United States and by comparable authorities in many foreign countries. States regulate the age at which adult consumers may purchase tobacco products and the locations where tobacco products can be sold. The states over the past few years have placed increased restrictions on the purchase and use of tobacco products. Other federal, state and local entities regulate, among other things, research and development activities and the testing, manufacture, safety, effectiveness, labeling, storage, record keeping, approval, advertising and promotion of such products.

Multiple bills have been introduced in both the United States Congress and in several state legislatures during the past three years which, if enacted, would have significantly changed the United States tobacco industry. Some of these federal bills contained provisions which would provide substantial federal government funds for smoking cessation programs and products, as well as incentives to tobacco companies and others to produce less toxic or reduced-risk tobacco products under specific standards. Star is unable to predict what effect, if any, these provisions, if enacted, would have on Star’s low-TSNA tobacco curing technology or on the sale of smoking cessation products and/or potentially reduced-risk tobacco products. The Company believes, however, that any bill that requires manufacturers to reduce or disclose levels of TSNAs in tobacco or tobacco smoke in a meaningful manner would be beneficial.

During the 108^th Congress, which began on January 7, 2003, two bills from the 107^th Congress have been reintroduced: HR 140, Congressman McIntyre’s (D, North Carolina) bill formerly known as HR 3940 and HR 245, the bill introduced by Congressman Fletcher (R, Kentucky) during the previous session as HR 5035. Both of these bills contain language that describes a framework within the FDA that would regulate the labeling, marketing, advertising and sale of all tobacco products. It is unclear at this time whether these bills will be passed during this Congress. The Company will continue to follow these legislative proposals in Congress and provide input, support and/or recommendations that are based on our position that adult consumers have the right to fair, honest and

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balanced information about the tobacco products they may choose to purchase, and that tobacco products should be developed and manufactured in the least hazardous manner possible, given available technologies.

President’s Commission On Improving Economic Opportunity In Communities Dependent Upon Tobacco Production

Star has been actively supporting the vast majority of the recommendations of The President’s Commission on Improving Economic Opportunity in Communities Dependent upon Tobacco Production while Protecting Public Health. Star is interested in supporting the American tobacco farming community and assisting farmers in obtaining higher prices for low-TSNA tobacco, while promoting public health-related issues by, among other things, giving the farmers an opportunity to produce very low-TSNA tobacco using StarCured^™ tobacco curing barns that have been provided to the farmers by Star. Star testified before the President’s Commission in Louisville, Kentucky, in 2000, and provided written comments on the Commission’s preliminary recommendations in March 2001. Star’s Board of Directors voted unanimously to endorse the recommendations of the President’s Commission in September 2001. Star believes it is the only tobacco company that testified and supported the majority of the Commission’s recommendations.

FDA Regulation

On March 21, 2000, in FDA v. Brown & Williamson Tobacco Corporation, 529 U.S. 120 (2000), the United States Supreme Court held that Congress has not given the FDA authority to regulate tobacco products as customarily marketed.

In December 2001 and early 2002, three petitions were filed with the FDA seeking to have ARIVA^™ regulated as a drug product and/or as a food. Because ARIVA^™, is a smokeless tobacco product that is intended to provide tobacco satisfaction and is licensed as a tobacco product by the federal Alcohol and Tobacco Tax and Trade Bureau (the “TTB”, formerly the Bureau of Alcohol, Tobacco and Firearms), the Company believes the FDA lacks any statutory authority to regulate ARIVA^™, based on the decision of the Supreme Court in Brown & Williamson. Star has advised the FDA that it believes the petitions are without merit and its legal team filed responses to each of the petitions and to certain supplemental submissions. The FDA stated, in a letter dated July 17, 2002, that it was continuing to review issues raised in the first petition filed with the Agency on December 18, 2001. Given the decision by the Supreme Court, it is unclear whether Congress will act to grant authority to the FDA over tobacco products, although legislation that would create such authority has been introduced. However, the Company believes that in the future, reasoned FDA regulation of all tobacco products should better enable the Company to compete in its particular market niche. Over the last three years, the Company has publicly stated its position in favor of reasoned FDA regulation of all tobacco products.

Institute of Medicine

On February 22, 2001, the Institute of Medicine issued a comprehensive report, entitled “Clearing the Smoke: Assessing the Science Base for Tobacco Harm Reduction,” in response to a request from the FDA to assess the scientific basis for possible harm reduction relating to the use of tobacco. This voluminous report suggests, among other findings, that it is scientifically feasible to design and manufacture a range of emerging “potential reduced-exposure products” (which the report referred to as “PREPs”), but that, without appropriate governmental regulation and independent scientific evaluation of PREPs, the public is left without clear information regarding the degree to which these products have reduced the risks associated with smoking. The Company provided testimony before the Institute of Medicine and shared certain of its scientific and applied research and findings related to the development of products that deliver less of certain toxins (TSNAs) and other gas and vapor-phase toxic substances in tobacco smoke. Star’s innovative products that deliver fewer toxins, and the StarCured^™ process, were referred to in the Institute of Medicine’s discussion of PREPs.

Federal Trade Commission

The requirements for health warnings on cigarettes are governed by the Federal Cigarette Labeling and Advertising Act. Similar requirements are imposed on smokeless tobacco products under the Comprehensive Smokeless Tobacco Health Education Act of 1986. These Acts impose labeling and advertising requirements on the manufacturers, packagers and importers of cigarettes and smokeless tobacco products and require any company wishing to sell such products within the United States to submit a plan to the Federal Trade Commission (the

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“FTC”) explaining how it will comply with the warning label display requirements. Star has submitted labeling plans for its cigarette and smokeless products to the FTC in accordance with these Acts and before introducing its new products. Also, Star shared with the FTC its enhanced warning labels for Advance^® prior to the initiation of the test marketing of Advance^® in October 2000 and the enhanced warning labels for Stonewall^™ moist and dry snuff and ARIVA^™ hard tobacco prior to the introduction of these products in 2001.

Trade and Tax Bureau

Manufacturers and importers of tobacco products are taxed pursuant to regulations promulgated by the TTB under authority of the Internal Revenue Code of 1986, as amended. The Company’s tobacco products are subject to tax under such regulations. The federal excise tax on cigarettes rose from $.24 per pack in 1999 to $.34 in 2000, and increased to $.39 per pack in 2002. Smokeless tobacco in the form of snuff is subject to federal tax at a rate of $.585 per pound in 2002 and thereafter. The manufacturing of tobacco products is also subject to regulation by the TTB. The Company currently has licenses from the TTB to manufacture tobacco products, including cigarettes and smokeless tobacco products. Such licenses require that the Company adhere to strict regulations regarding the manufacturing and transportation of its tobacco products.

State and Municipal Laws

The sale of cigarettes is subject to taxation through excise taxes in all fifty states, and smokeless tobacco is taxed in most jurisdictions. State excise taxes on cigarettes range from $.025 per pack in Virginia to $1.50 per pack in New York. Several states have no excise tax on smokeless tobacco and the rates in other states vary significantly from state to state using formulas based on weight or a percentage of the wholesale price of the product. For example, the states of Alabama and North Dakota tax smokeless products at a rate of ¾ of 1 cent per ounce and 16 cents per ounce, respectively, while the states of North Carolina and Oregon impose an excise tax of 2% and 65% of wholesale cost, respectively.

In addition, some states permit municipalities to impose an additional sales tax, and many municipalities do so. The state and municipal sales taxes are imposed upon wholesalers and/or retailers but not on manufacturers, and therefore the Company has no liability for such taxes. The Company is required by many states, however, to report its shipments of cigarettes to distributors/retailers located within their jurisdiction. Star is aware of at least three states, Massachusetts, Minnesota and Texas, that have adopted laws and regulations regarding the disclosure by manufacturers of certain chemical constituents in their products. Star has complied and intends to continue to comply with such laws to the extent they are upheld, and believes both the Company and its customers will benefit from such disclosure.

Tobacco Master Settlement Agreement

In November 1998, 46 states (the “Settling States”) and several U.S. territories entered into the Master Settlement Agreement to resolve litigation that had been instituted against the major tobacco manufacturers. The Company was not named as a defendant in any of the litigation matters and chose not to become a participating manufacturer under the terms of the Master Settlement Agreement. As a non-participating manufacturer, the Company is required to satisfy certain purported escrow obligations under statutes that the Master Settlement Agreement required participating states to pass, if they were to receive the full benefits of the settlement. The so-called “level playing field” statutes, or qualifying statutes, require non-participating manufacturers to fund escrow accounts that could be used to satisfy judgments or settlements in lawsuits that may at some future date be filed by the participating states against such non-participating tobacco manufacturers. Under these statutes the Company is obligated to place an amount equal to $1.88 per carton for 1999, $2.09 in 2000, $2.72 for 2001 and 2002, $3.35 for 2003 through 2006 and $3.77 thereafter, in escrow accounts for sales of cigarettes occurring in the prior year in each such state. An inflation adjustment is also added to these deposits at the higher of 3% or the Consumer Price Index each year. Such escrowed funds will be available to satisfy tobacco-related judgments or settlements, if any, in the settling states. If not used to satisfy judgments or settlements, the funds will be returned to the Company 25 years after the applicable date of deposit on a rolling basis. Also, absent a successful challenge to the state specific statutes, or some accommodation as to the escrow amounts, the failure to place the required amounts in escrow could result in penalties to the Company and potential restrictions on its ability to sell cigarettes within particular states. Because all of the MSA states have passed the so-called “level playing field” statutes, the Company expects

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that a material portion of its cigarette sales will continue to be subject to such purported escrow obligations. Star’s sale of smokeless tobacco products are not subject to the MSA escrow obligations.

As of January 1, 2001, all 46 MSA states had adopted model “level playing field” statutes. As noted above, under these statutes, the Company is required to place funds in escrow for each cigarette carton sold in a state that is a member of the MSA. After funding escrow accounts for 2001 sales, the Company has deposited approximately $33.5 million into escrow under protest, including for indirect sales, as described below. In addition to the escrow deposits associated with the Company’s direct customer sales, the Company has, under protest, been required to make additional escrow deposits related to sales of the Company’s cigarettes subsequently made by the Company’s direct customers in other states (“indirect sales”). To date, the Company has made approximately $4.5 million in escrow payments in connection with indirect sales that occurred in 1999, 2000 and 2001. The Company has received demands for additional escrow payments after making its escrow payments for 2001. However, the demands with regard to potential indirect sales have been suspended as a result of a standstill agreement and ongoing negotiations with the NAAG, as discussed below. The Company is not presently able to estimate the total amount of this possible obligation, which will depend on a number of factors, including a determination of the amount of indirect sales in particular states and a determination of whether the Company is obligated to escrow funds for all products it manufactured and sold, including product manufactured by B&W under its recently terminated manufacturing agreement with the Company, or only product the Company manufactured at its Petersburg, Virginia, facility. If the Company is only required to make escrow payments for cigarettes it manufactured at its Petersburg, Virginia facility, it could have potential obligations to B&W for additional costs that B&W incurred for producing cigarettes under the manufacturing agreement with the Company. Under either scenario, the amount of any additional obligation would be material and would require the Company, among other things, to raise substantial additional funds to meet such obligations. All funds placed in escrow continue to be an asset of the Company, and the Company receives the interest income generated by the escrow deposits. For additional information on the Company’s MSA escrow obligations, see “Liquidity and Capital Resources” under Item 7.

In addition to the “level playing field” statutes, a number of states have recently enacted statutes that require non-participating manufacturers to certify that they are in full compliance with the escrow requirements of the MSA as a condition to being permitted to sell cigarette products in those states. While the Company has recently focused its sales in the four states that were not part of the MSA, these statutes could impact on its ability to sell cigarettes in the MSA states, notwithstanding its substantial payments into escrow.

On December 15, 2000 and June 12, 2001, the Company filed lawsuits in the United States District Courts for the Eastern District of Virginia and the Southern District of Indiana, respectively, challenging the MSA and the qualifying statutes on a number of constitutional bases. On March 26, 2001, the District Court for the Eastern District of Virginia dismissed the Company’s complaint, but in its opinion, the court did note that Star “must now suffer as a result of the bad faith of previous market entrants.” The court further noted that Star “has never been accused of the fraudulent, collusive and intentionally dishonest activities of the Big Four,” “was not even in existence during the bulk of the time that these activities were occurring,” and has taken “every step to provide complete disclosure about the harmful nature of its products.” The court also stated that the “financial burden on Star and others like it may hamper efforts to develop new tobacco technologies.” The Company promptly appealed the court’s ruling.

On appeal, the United States Court of Appeals for the Fourth Circuit affirmed the decision of the District Court and on October 7, 2002, the Supreme Court denied the Company’s Petition for a Writ of Certiorari filed with the Supreme Court on May 20, 2002. The action by the Supreme Court effectively ends the Company’s constitutional challenge to the MSA. Based on the Supreme Court denial of the Company’s petition for a writ of certiorari, the Company is moving to dismiss its Indiana lawsuit.

In May 2002, the Company entered into negotiations with representatives of the National Association of Attorneys General (“NAAG”) regarding terms under which Star could become a Subsequent Participating Member of the MSA and resolve all currently contested issues relating to the MSA and state qualifying statutes, including its constitutional challenge to the MSA. In connection with those discussions, a Standstill Agreement was negotiated that provides that during the standstill period, the Settling States that executed the Standstill Agreement will not initiate any enforcement action against the Company relating to any claims for additional escrow funding and the

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compliance with state qualifying statutes, and the Company will not initiate any new actions against those Settling States. The Standstill Agreement was executed by 29 of t