UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

VECTOR GROUP LTD.

(Exact name of registrant as specified in its charter)

Delaware		1-5759		65-0949535
(State or other jurisdiction of incorporation or organization)		Commission File Number		(I.R.S. Employer Identification No.)

(Address, including zip code and telephone number, including area code,
of the principal executive offices)

     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.
þ Yes o No

     Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

o Large accelerated file           þ Accelerated filer            o Non-accelerated filer

     Indicate by check mark whether the Registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. o Yes þ No

     At November 13, 2006, Vector Group Ltd. had 56,889,286 shares of common stock outstanding.

 

 

VECTOR GROUP LTD.

FORM 10-Q

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION
Item 1. Vector Group Ltd. Consolidated Financial Statements (Unaudited):
Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005			2
Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and September 30, 2005			3
Consolidated Statement of Stockholders’ Equity for the nine months ended September 30, 2006			4
Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and September 30, 2005			5
Notes to Consolidated Financial Statements			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			60
Item 3. Quantitative and Qualitative Disclosures About Market Risk			87
Item 4. Controls and Procedures			87
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			89
Item 1A. Risk Factors			89
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			89
Item 6. Exhibits			89
SIGNATURE			91
Ex-10.3 Closing Agreement
Ex-31.1 Section 302 Certification of CEO
Ex-31.2 Section 302 Certification of CFO
Ex-32.1 Section 906 Certification of CEO
Ex-32.2 Section 906 Certification of CFO
Ex-99.1 Material Legal Proceedings

VECTOR GROUP LTD. AND SUBSIDIARIES

(Dollars in Thousands, Except Per Share Amounts)
Unaudited

		September 30,				December 31,
		2006				2005
						Restated(1)
ASSETS:
Current assets:
Cash and cash equivalents		$	143,417			$	181,059
Investment securities available for sale			24,485				18,507
Accounts receivable — trade			8,494				12,714
Inventories			77,158				70,395
Deferred income taxes			27,344				26,179
Assets held for sale			1,437				—
Other current assets			2,377				10,245
Total current assets			284,712				319,099
Property, plant and equipment, net			62,192				62,523
Long-term investments, net			32,934				7,828
Investments in non-consolidated real estate businesses			29,287				17,391
Restricted assets			8,528				6,743
Deferred income taxes			51,228				69,988
Intangible asset			107,511				107,511
Other assets			22,594				12,469
Total assets		$	598,986			$	603,552
LIABILITIES AND STOCKHOLDERS’ EQUITY:
Current liabilities:
Current portion of notes payable and long-term debt		$	54,956			$	9,313
Accounts payable			5,762				15,394
Accrued promotional expenses			14,697				18,317
Accrued taxes payable, net			10,504				32,392
Settlement accruals			34,600				22,505
Deferred income taxes			4,824				3,891
Accrued interest			2,506				5,770
Other accrued liabilities			18,321				20,518
Total current liabilities			146,170				128,100
Notes payable, long-term debt and other obligations, less current portion			103,418				238,242
Fair value of derivatives embedded within convertible debt			96,810				39,371
Non-current employee benefits			20,246				17,235
Deferred income taxes			127,461				145,892
Other liabilities			7,964				5,646
Commitments and contingencies			—				—
Stockholders’ equity:
Preferred stock, par value $1.00 per share, authorized 10,000,000 shares			—				—
Common stock, par value $0.10 per share, authorized 100,000,000 shares, issued 59,691,870 and 53,417,525 shares and outstanding 56,887,956 and 49,849,735 shares			5,689				4,985
Additional paid-in capital			154,579				133,325
Unearned compensation			—				(11,681	)
Accumulated deficit			(43,983	)			(70,633	)
Accumulated other comprehensive loss			(6,940	)			(10,610	)
Less: 2,803,914 and 3,567,790 shares of common stock in treasury, at cost			(12,428	)			(16,320	)
Total stockholders’ equity			96,917				29,066
Total liabilities and stockholders’ equity		$	598,986			$	603,552

The accompanying notes are an integral part
of the consolidated financial statements.

VECTOR GROUP LTD. AND SUBSIDIARIES

		Three Months Ended								Nine Months Ended
		Sept. 30,				Sept. 30,				Sept. 30,				Sept. 30,
		2006				2005				2006				2005
						Restated(1)								Restated(1)
Revenues*		$	137,665			$	124,965			$	368,724			$	342,251
Expenses:
Cost of goods sold*			88,329				77,880				230,974				202,780
Operating, selling, administrative and general expenses			23,635				27,109				69,362				76,485
Operating income			25,701				19,976				68,388				62,986
Other income (expenses):
Interest and dividend income			2,281				1,380				6,383				3,260
Interest expense			(10,779	)			(8,141	)			(27,795	)			(22,363	)
Change in fair value of derivatives embedded within convertible debt			(3,464	)			1,131				(1,225	)			2,258
Loss on extinguishment of debt			(1,306	)			—				(16,166	)			—
Gain on investments, net			1,433				8				1,386				1,433
Gain from conversion of LTS notes			—				—				—				9,461
Equity in loss on operations of LTS			—				—				—				(299	)
Equity income from non-consolidated real estate businesses			2,121				4,184				9,726				6,202
Other, net			81				13				158				69
Income from operations before (benefit) provision for income taxes and minority interests			16,068				18,551				40,855				63,007
Income tax (benefit) expense			(3,550	)			7,727				13,934				30,018
Minority interests			—				(779	)			—				(2,403	)
Income from continuing operations			19,618				10,045				26,921				30,586
Discontinued operations:
Income from discontinued operations, net of minority interests and taxes			—				—				—				82
Gain on disposal of discontinued operations, net of minority interests and taxes			—				—				—				2,952
Income from discontinued operations			—				—				—				3,034
Net income		$	19,618			$	10,045			$	26,921			$	33,620
Per basic common share:
Income from continuing operations		$	0.33			$	0.22			$	0.47			$	0.67
Income from discontinued operations		$	—			$	—			$	—			$	0.06
Net income applicable to common shares		$	0.33			$	0.22			$	0.47			$	0.73
Per diluted common share:
Income from continuing operations		$	0.32			$	0.21			$	0.46			$	0.63
Income from discontinued operations		$	—			$	—			$	—			$	0.06
Net income applicable to common shares		$	0.32			$	0.21			$	0.46			$	0.69
Cash distributions declared per share		$	0.38			$	0.36			$	1.14			$	1.09

The accompanying notes are an integral part
of the consolidated financial statements.

VECTOR GROUP LTD. AND SUBSIDIARIES

																										Accumulated
										Additional																Other
		Common Stock								Paid-In				Accumulated				Unearned				Treasury				Comprehensive
		Shares				Amount				Capital				Deficit				Compensation				Stock				Loss				Total
Balance, December 31, 2005, restated(1)			49,849,735			$	4,985			$	133,325			$	(70,633	)		$	(11,681	)		$	(16,320	)		$	(10,610	)		$	29,066
Net income			—				—				—				26,921				—				—				—				26,921
Forward contract adjustments, net of taxes			—				—				—				—				—				—				227				227
Unrealized gain on investment securities, net of taxes			—				—				—				—				—				—				3,443				3,443
Total other comprehensive income			—				—				—				—				—				—				—				3,670
Total comprehensive income			—				—				—				—				—				—				—				30,591
Reclassifications in accordance with SFAS No. 123(R)			—				—				(11,681	)			—				11,681				—				—				—
Effect of stock dividend			2,708,295				271				—				(271	)			—				—				—				—
Distributions on common stock			—				—				(68,071	)			—				—				—				—				(68,071	)
Exercise of options, net of 19,302 shares delivered to pay exercise price			129,926				13				1,587				—				—				(371	)			—				1,229
Conversion of debt			4,200,000				420				79,522				—				—				4,263				—				84,205
Beneficial conversion feature associated with issuance of convertible debt, net of taxes			—				—				16,833				—				—				—				—				16,833
Amortization of deferred compensation			—				—				3,064				—				—				—				—				3,064
Balance, September 30, 2006			56,887,956			$	5,689			$	154,579			$	(43,983	)		$	—			$	(12,428	)		$	(6,940	)		$	96,917

The accompanying notes are an integral part
of the consolidated financial statements.

VECTOR GROUP LTD. AND SUBSIDIARIES

		Nine Months Ended
		Sept. 30,				Sept. 30,
		2006				2005
						Revised(1)
Net cash provided by operating activities		$	14,985			$	28,136
Cash flows from investing activities:
Proceeds from sale or maturity of investment securities			13,467				3,268
Purchase of investment securities			(12,339	)			(500	)
Proceeds from sale or liquidation of long-term investments			205				—
Purchase of long-term investments			(25,266	)			(128	)
Investments in non-consolidated real estate businesses			(7,350	)			(6,250	)
Distributions from non-consolidated real estate businesses			—				5,500
Increase in restricted assets			(1,777	)			(842	)
Issuance of LTS common stock			—				(1,500	)
Issuance of LTS notes			—				(1,750	)
Capital expenditures			(8,948	)			(5,164	)
Proceeds from sale of property, plant and equipment			159				—
Discontinued operations			—				66,912
Net cash (used in) provided by investing activities			(41,849	)			59,546
Cash flows from financing activities:
Proceeds from issuance of notes payable and long-term debt			118,146				44,959
Repayments of notes payable and long-term debt			(67,993	)			(3,542	)
Borrowings under revolver			390,610				328,086
Repayments on revolver			(380,052	)			(319,359	)
Distributions on common stock			(67,438	)			(50,326	)
Issuance of restricted stock			—				63
Proceeds from exercise of options			1,229				2,778
Deferred financing charges			(5,280	)			(2,168	)
Discontinued operations			—				(39,213	)
Net cash used in financing activities			(10,778	)			(38,722	)
Net (decrease) increase in cash and cash equivalents			(37,642	)			48,960
Cash and cash equivalents, beginning of period			181,059				110,004
Cash and cash equivalents, end of period		$	143,417			$	158,964

The accompanying notes are an integral part
of the consolidated financial statements.

VECTOR GROUP LTD.

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

	(a)		Basis of Presentation:
			The consolidated financial statements of Vector Group Ltd. (the “Company” or “Vector”) include the accounts of VGR Holding LLC (“VGR Holding”), Liggett Group LLC (“Liggett”), Vector Tobacco Inc. (“Vector Tobacco”), Liggett Vector Brands Inc. (“Liggett Vector Brands”), New Valley LLC (“New Valley”) and other less significant subsidiaries. The Company owned all of the limited liability company interests of New Valley at September 30, 2006 and owned 57.7% of the common shares of its corporate predecessor, New Valley Corporation, at September 30, 2005. All significant intercompany balances and transactions have been eliminated.
			Liggett is engaged in the manufacture and sale of cigarettes in the United States. Vector Tobacco is engaged in the development and marketing of low nicotine and nicotine-free cigarette products and the development of reduced risk cigarette products. New Valley is engaged in the real estate business and is seeking to acquire additional operating companies and real estate properties.
			As discussed in Note 14, New Valley’s real estate leasing operations, sold in February 2005, are presented as discontinued operations for the nine months ended September 30, 2005. The 2005 interim condensed consolidated statement of cash flows has been revised to separately disclose the operating, investing and financing portions of the cash flows attributable to discontinued operations. These amounts had previously been reported on a combined basis as a separate caption outside operating, financing and investing activities.
			The interim consolidated financial statements of the Company are unaudited and, in the opinion of management, reflect all adjustments necessary (which are normal and recurring) to state fairly the Company’s consolidated financial position, results of operations and cash flows. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s amended Annual Report on Form 10-K, as amended, for the year ended December 31, 2005, which will be further amended as discussed in Note 2. The consolidated results of operations for interim periods should not be regarded as necessarily indicative of the results that may be expected for the entire year.
			The Company has reclassified $1,678 of equipment deposits made in the fourth quarter of 2005 from Other assets to Restricted assets on its December 31, 2005 consolidated balance sheet to conform to current year presentation. This change in classification did not affect the Company’s consolidated statements of operations or cash flows for the three and nine months ended September 30, 2006 and 2005 or its statement of stockholders’ equity as of September 30, 2006 and December 31, 2005.

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) – (Continued)
(Unaudited)

	(b)		Estimates and Assumptions:
			The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. Significant estimates subject to material changes in the near term include restructuring and impairment charges, inventory valuation, deferred tax assets, allowance for doubtful accounts, promotional accruals, sales returns and allowances, actuarial assumptions of pension plans, embedded derivative liability, the tobacco quota buy-out, settlement accruals and litigation and defense costs. Actual results could differ from those estimates.
	(c)		Share-Based Payments:
			Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” using the “modified prospective method” with guidance provided by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” Under the modified prospective method, the share-based compensation cost recognized beginning January 1, 2006 includes compensation cost for (i) all share-based payments granted prior to, but not vested as of, January 1, 2006, based on the grant date fair value originally estimated in accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”) and (ii) all share-based payments granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Compensation cost is recognized ratably using the straight-line attribution method over the expected vesting period. In addition, pursuant to SFAS No. 123(R), the Company is required to estimate the amount of expected forfeitures when calculating the compensation costs, instead of accounting for forfeitures as incurred, which was the Company’s previous method. As of January 1, 2006, the cumulative effect of adopting the estimated forfeiture method was not significant. Prior periods are not restated under this transition method (see Note 10).
	(d)		Earnings Per Share:
			Information concerning the Company’s common stock has been adjusted to give effect to the 5% stock dividends paid to Company stockholders on September 29, 2006 and September 29, 2005. The dividend was recorded at par value of $271 in 2006 since the Company had an accumulated deficit. In connection with the 5% stock dividends, the Company increased the number of outstanding stock options by 5% and reduced the exercise prices accordingly. All per share amounts have been presented as if the stock dividends had occurred on January 1, 2005.
			In March 2004, the FASB’s Emerging Issue Task Force (“EITF”) reached a final consensus on Issue No. 03-6, “Participating Securities and the Two-Class Method under FASB Statement 128”, which established standards regarding the computation of earnings per share (“EPS”) by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company. Earnings available to common stockholders for the period are reduced by the contingent interest associated with the Company’s convertible notes issued in 2004, 2005 and 2006. The convertible debt issued by the Company in 2004, 2005 and 2006, which are a participating security due to the contingent interest feature, had no impact on EPS for the nine months ended September 30, 2006 and 2005, as the dividends on the common stock into which the debt is convertible increased

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

			interest expense and reduced earnings available to common stockholders so there were no unallocated earnings under EITF Issue No. 03-6.
			As discussed in Note 10, the Company has stock option awards which provide for common stock dividend equivalents at the same rate as paid on the common stock with respect to the shares underlying the unexercised portion of the options. These outstanding options represent participating securities under EITF Issue No. 03-6. Because the Company accounted for the dividend equivalent rights on these options as additional compensation cost in accordance with APB Opinion No. 25, these participating securities had no impact on the calculation of basic EPS in periods ending prior to January 1, 2006. Effective with the adoption of SFAS No. 123(R) on January 1, 2006, the Company recognizes payments of the dividend equivalent rights ($1,578 and $4,734 for the three and nine months ended September 30, 2006, respectively) on these options as reductions in additional paid-in capital on the Company’s consolidated balance sheet. As a result, in its calculation of basic EPS for the three and nine months ended September 30, 2006, the Company has adjusted its net income for the effect of these participating securities as follows:

		Three Months				Nine Months
		Ended				Ended
		Sept. 30, 2006				Sept. 30, 2006
Net income		$	19,618			$	26,921
Income attributable to participating securities			(1,330	)			(1,871	)
Net income available to common stockholders		$	18,288			$	25,050

Basic EPS is computed by dividing net income available to common stockholders by the weighted-average number of shares outstanding, which includes vested restricted stock. Diluted EPS includes the dilutive effect of stock options and unvested restricted stock grants. Basic and diluted EPS were calculated using the following shares for the three and nine months ended September 30, 2006 and 2005:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
			2006			2005					2006				2005
Weighted-average shares for basic EPS			56,207,561				46,300,534				53,533,407				46,188,907
Plus incremental shares related to stock options and unvested restricted stock grants			1,390,841				2,551,052				1,449,170				2,224,312
Weighted-average shares for diluted EPS			57,598,402				48,851,586				54,982,577				48,413,219

The following stock options, non-vested restricted stock and shares issuable upon the conversion of convertible debt were outstanding during the three and nine months ended September 30, 2005 and the three and nine months ended September 30, 2006 but were not included in the computation of diluted EPS because the exercise prices of the options and the per share expense associated with the restricted stock were greater than the average market price of the common shares during the respective periods, and the impact of common shares issuable under the convertible debt were anti-dilutive to EPS.

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Number of stock options			603,129				490,902				509,328				592,023
Weighted-average exercise price		$	20.28			$	30.11			$	21.06			$	27.47
Weighted-average shares of non- vested restricted stock			635,236				17,120				651,746				5,769
Weighted-average expense per share		$	18.73			$	18.62			$	18.72			$	18.62
Weighted-average number of shares issuable upon conversion of debt			12,560,900				12,442,446				12,491,732				11,189,838
Weighted-average conversion price		$	18.95			$	20.09			$	18.99			$	20.39

	(e)		Comprehensive Income:
			Other comprehensive income is a component of stockholders’ equity and includes such items as the unrealized gains and losses on investment securities available for sale, forward foreign contracts and minimum pension liability adjustments. Total comprehensive income for the three and nine months ended September 30, 2006 and 2005 is as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
				Restated										Restated
Net income		$	19,618			$	10,045			$	26,921			$	33,620
Forward contract adjustments, net of income taxes			(50	)			(121	)			227				(543	)
Net unrealized gains on investment securities available for sale:
Change in net unrealized gains, net of income taxes			553				6				4,293				736
Net unrealized gains reclassified into net income, net of income taxes			(878	)			(6	)			(850	)			(925	)
Change in unrealized gains, net of income taxes			(325	)			—				3,443				(189	)
Total comprehensive income		$	19,243			$	9,924			$	30,591			$	32,888

The components of accumulated other comprehensive loss were as follows as of September 30, 2006 and December 31, 2005:

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

		September 30,				December 31,
		2006				2005
Net unrealized gains on investment securities available for sale		$	4,071			$	628
Forward contracts adjustment			(372	)			(599	)
Additional pension liability			(10,639	)			(10,639	)
Accumulated other comprehensive loss		$	(6,940	)		$	(10,610	)

	(f)		Financial Instruments:
			As required by SFAS No. 133, derivatives embedded within the Company’s convertible debt are recognized on the Company’s balance sheet and are stated at estimated fair value as determined by a third party at each reporting period. Changes in the fair value of the embedded derivatives are reflected within the Company’s consolidated statements of operations as “Change in fair value of derivatives embedded within convertible debt.”
			The Company uses forward foreign exchange contracts to mitigate its exposure to changes in exchange rates relating to purchases of equipment from third parties. The primary currency to which the Company is exposed is the Euro. A substantial portion of the Company’s foreign exchange contracts is effective as hedges. The fair value of forward foreign exchange contracts designated as hedges is reported in other current assets or current liabilities and the change in fair value of the contracts during the period is recorded in other comprehensive income. The fair value of the forward foreign exchange contracts at September 30, 2006 was a liability of approximately $9.
	(g)		Revenue Recognition:
			Revenues from sales are recognized upon the shipment of finished goods when title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, the sale price is determinable and collectibility is reasonably assured. The Company provides an allowance for expected sales returns, net of any related inventory cost recoveries and recoverable excise taxes. Certain sales incentives, including buydowns, are classified as reductions of net sales in accordance with EITF Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”. In accordance with EITF Issue No. 06-3, “How Sales Taxes Should be Presented in the Income Statement (Gross versus Net)”, the Company’s accounting policy is to include federal excise taxes in revenues and cost of goods sold. Such revenues totaled $48,153 and $127,956 for the three and nine months ended September 30, 2006 and $42,413 and $112,856 for the three and nine months ended September 30, 2005, respectively. Since the Company’s primary line of business is tobacco, the Company’s financial position and its results of operations and cash flows have been and could continue to be materially adversely affected by significant unit sales volume declines, litigation and defense costs, increased tobacco costs or reductions in the selling price of cigarettes in the near term.
	(h)		Contingencies:
			The Company records Liggett’s product liability legal expenses and other litigation costs as operating, selling, general and administrative expenses as those costs are incurred. As

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

			discussed in Note 8, legal proceedings covering a wide range of matters are pending or threatened in various jurisdictions against Liggett.
			The Company records provisions in the consolidated financial statements for pending litigation when it determines that an unfavorable outcome is probable and the amount of the loss can be reasonably estimated. Except as discussed in Note 8, (i) management has not concluded that it is probable that a loss has been incurred in any of the pending smoking-related litigation; (ii) management is unable to make a meaningful estimate of the amount or range of loss that could result from an unfavorable outcome of pending smoking-related litigation; and (iii) accordingly, management has not provided any amounts in the consolidated financial statements for unfavorable outcomes, if any. Litigation is subject to many uncertainties, and it is possible that the Company’s consolidated financial position, results of operations or cash flows could be materially adversely affected by an unfavorable outcome in any such smoking-related litigation.
	(i)		New Accounting Pronouncements:
			In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”. SFAS No. 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. The provisions of SFAS No. 154 require, unless impracticable, retrospective application to prior periods’ financial statements of (i) all voluntary changes in accounting principles and (ii) changes required by a new accounting pronouncement, if a specific transition is not provided. SFAS No. 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate, which requires prospective application of the new method. SFAS No. 154 is effective for all accounting changes made in fiscal years beginning after December 15, 2005. The current period impact of the application of SFAS No. 154 is discussed below in connection with the application of EITF Issue No. 05-8, “Income Tax Effects of Issuing Convertible Debt with a Beneficial Conversion Feature”.
			In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations – an Interpretation of SFAS Statement No. 143” (“FIN 47”). FIN 47 clarifies the timing of liability recognition for legal obligations associated with the retirement of a tangible long-lived asset when the timing and/or method of settlement are conditional on a future event. FIN 47 is effective for fiscal years ending after December 15, 2005. The application of FIN 47 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
			In September 2005, the EITF reached a consensus on Issue No. 04-13, “Inventory Exchanges”. EITF Issue No. 04-13 required two or more inventory transactions with the same party to be considered a single nonmonetary transaction subject to APB Opinion No. 29, “Accounting for Nonmonetary Transactions”, if the transactions were entered into in contemplation of one another. EITF Issue No. 04-13 is effective for the Company for new arrangements entered into after April 2, 2006. The adoption of EITF Issue No. 04-13 did not have a material impact on the Company’s financial position, results of operations or cash flows.
			Effective January 1, 2006, the Company adopted EITF Issue No. 05-8, “Income Tax Effects of Issuing Convertible Debt with a Beneficial Conversion Feature.” In Issue No. 05-8, the EITF concluded that the issuance of convertible debt with a beneficial conversion feature creates a temporary difference on which deferred taxes should be provided. The consensus is required to be applied in fiscal periods beginning after December 15, 2005, by retroactive restatement of

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

prior financial statements retroactive to the issuance of the convertible debt. The adoption of EITF Issue No. 05-8 reduced income tax expense by $267 and $585 for the three and nine months ended September 30, 2006, respectively. The retrospective application of EITF Issue No. 05-8 reduced income tax expense by $114 and $309 for the three and nine months ended September 30, 2005, respectively. A reconciliation of the net impact of the application of EITF Issue No. 05-8 at December 31, 2005 on the Company’s consolidated balance sheet is as follows:

		Long-Term				Additional
		Deferred				Paid-in				Accumulated				Stockholders’
		Income Taxes				Capital				Deficit				Equity
December 31, 2005, as restated, prior to adoption of EITF 05-8		$	137,381			$	141,184			$	(69,981	)		$	37,577
Application of EITF 05-8:
Establishment of deferred tax liability			7,859				(7,859	)			—				(7,859	)
Increase to income tax benefit for the year ended December 31, 2004			(27	)			—				27				27
Decrease to income tax expense for the year ended December 31, 2005			(406	)			—				406				406
Decrease to extraordinary item, unallocated goodwill			1,085				—				(1,085	)			(1,085	)
Revised balance, as restated, December 31, 2005		$	145,892			$	133,325			$	(70,633	)		$	29,066

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Instruments”. SFAS No. 155 amends SFAS Nos. 133 and 140 and relates to the financial reporting of certain hybrid financial instruments. SFAS No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of fiscal years commencing after September 15, 2006. The Company has not completed its assessment of the impact of this standard on its consolidated financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)”, which is effective for fiscal years beginning after December 15, 2006 with earlier adoption encouraged. This interpretation was issued to clarify the accounting for uncertainty in income taxes recognized in the financial statements by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company has not completed its assessment of the impact of this standard on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 clarifies that fair value should be based on assumptions

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

that market participants would use when pricing an asset or liability and establishes a fair value hierarchy of three levels that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. SFAS No. 157 requires fair value measurements to be separately disclosed by level within the fair value hierarchy. The provisions of SFAS No. 157 will become effective for the Company beginning January 1, 2008. Generally, the provisions of this statement are to be applied prospectively. Certain situations, however, require retrospective application as of the beginning of the year of adoption through the recognition of a cumulative effect of accounting change. Such retrospective application is required for financial instruments, including derivatives and certain hybrid instruments with limitations on initial gains or losses under EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities”. The Company has not completed its assessment of the impact of this standard on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” SFAS No. 158 requires an employer to recognize the overfunded or underfunded status of their benefit plans as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur as a component of other comprehensive income. The funded status is measured as the difference between the fair value of the plan’s assets and its benefit obligation. In addition, SFAS No. 158 requires an employer to measure benefit plan assets and obligations that determine the funded status of a plan as of the end of its fiscal year. The Company presently measures the funded status of its plans at September 30 and the new measurement date requirements become effective for the Company for the year ended December 31, 2008. The prospective requirement to recognize the funded status of a benefit plan and to provide the required disclosures will become effective for the Company on December 31, 2006. The adoption of SFAS No. 158 will have no impact on the Company’s results of operations or cash flows. Based on the funded status of the Company’s pension and postretirement benefit plans as reported in its December 31, 2005 Annual Report on Form 10-K, the adoption of SFAS No. 158 will result in a $1,398 reduction of “Non-current employee benefits,” which is included in other liabilities, a $534 reduction of “Deferred income taxes,” which is included in other assets, and an $864 decrease to “Accumulated Other Comprehensive Loss,” which is included in stockholders’ equity. The ultimate impact is contingent on plan asset returns and the assumptions that will be used to measure the funded status of each of the Company’s pension and postretirement benefit plans as of December 31, 2006.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated. The provisions of SAB 108 are required to be applied beginning December 31, 2006. The Company does not expect the adoption of SAB 108 to impact its consolidated financial statements.

2. RESTATEMENT OF FINANCIAL RESULTS

     On November 9, 2006, the Company determined that it would restate its financial statements for each of the years ended December 31, 2004 and 2005, and selected financial data for each of the years 2004 and 2005 appearing in Item 6 of its Annual Report on Form 10-K, as amended, for the year ended December 31, 2005, as well as its interim financial statements for the quarters ended March 31, 2005 and 2006, June 30, 2005 and 2006, and September 30, 2005. The restatement will correct an error in the computation of the amortization of the debt discount created by the embedded derivative and the beneficial conversion feature associated with the Company’s 5% variable interest senior convertible notes due 2011. The restatement adjustments affected the Company’s previously reported interest expense, the related income tax effect, and extraordinary items, as well as the Company’s previously reported deferred financing costs, long-term debt, additional paid-in-capital and accumulated deficit balances. The effects of the restatement are reflected in the Company’s consolidated financial statements and accompanying notes included herein. See Note 16 — Restated Financial Information. See also Notes 1, 2, 7, 10, 11 and 13 to the consolidated financial statements. All periods presented are unaudited.

     The aggregate net effect of the restatement was to increase stockholders’ equity by $4,781 as of June 30, 2006, $4,142 as of March 31, 2006, $3,422 as of December 31, 2005 and $336 as of December 31, 2004. The restatement also increased net income for the three months ended March 31, 2006 and 2005 by $720 ($0.01 per diluted common share) and $731 ($0.01 per diluted common share), respectively, and decreased net loss for the three months ended June 30, 2006 by $639 ($0.01 per diluted common share) and increased net income for the three months ended June 30, 2005 by $1,071 ($0.02 per diluted common share). In addition, the restatement adjustments increased net income for the six months ended June 30, 2006 and 2005 by $1,359 ($0.03 per diluted common share) and $1,802 ($0.04 per diluted common share), respectively. The restatement increased net income for the three months ended September 30, 2005 by $810 ($0.02 per diluted common share) and increased net income for the nine months ended September 30, 2005 by $2,612 ($0.05 per diluted common share). Further, the restatement increased net income by $3,291 ($0.08 per diluted common share) and $336 ($0.01 per diluted common share) for the years ended December 31, 2005 and 2004, respectively.

     The restatement adjustments will correct the previous amortization method used in calculating the amortization of the debt discount created by the embedded derivative and beneficial conversion feature associated with the Company’s 5% variable interest senior convertible notes due 2011. The Company previously amortized the debt discount on its 5% variable interest senior convertible notes due 2011 using an erroneous amortization method that did not result in a consistent yield on the convertible debt over its term.

     The revised financial statements and selected financial data for the periods referenced above will be included, as applicable, in an amended Annual Report on Form 10-K, as amended, for the year ended December 31, 2005, and in amended Quarterly Reports on Form 10-Q for the quarters ended March 31, 2006 and June 30, 2006. The revised interim financial statements for the quarter ended September 30, 2005 have been included within this Quarterly Report on Form 10-Q for the quarter ended September 30, 2006. The Company expects to file the amended documents as promptly as practicable. Until the Company files the amended filings, its previously published financial statements relating to these periods and not covered in this Form 10-Q should not be relied upon.

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

3.		RESTRUCTURING
		The components of the combined pre-tax restructuring charges relating to the 2004 Liggett Vector Brands restructurings for the nine months ended September 30, 2006 are as follows:

		Employee				Contract
		Severance				Termination/
		and Benefits				Exit Costs				Total
Balance, December 31, 2005		$	713			$	1,403			$	2,116
Utilized			(514	)			(420	)			(934	)
Balance, September 30, 2006		$	199			$	983			$	1,182

4.		INVESTMENT SECURITIES AVAILABLE FOR SALE
		Investment securities classified as available for sale are carried at fair value, with net unrealized gains or losses included as a component of stockholders’ equity, net of taxes and minority interests. For the three and nine months ended September 30, 2006 and 2005, net realized gains were $1,433, $8, $1,386 and $1,433 respectively.
		The components of investment securities available for sale and the associated gross unrealized gains and losses, before income tax effect, at September 30, 2006 are as follows:

						Gross				Gross
						Unrealized				Unrealized				Fair
		Cost				Gain				Loss				Value
Marketable equity securities		$	10,106			$	7,847			$	935			$	17,018
Marketable debt securities			7,517				7				57				7,467
		$	17,623			$	7,854			$	992			$	24,485

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

		Marketable equity securities available for sale as of September 30, 2006 include New Valley’s 11,111,111 shares of Ladenburg Thalmann Financial Services Inc., which were carried at $11,667 (see Note 12).
		The Company’s marketable debt securities have a weighted average maturity of 1.65 years at September 30, 2006 and mature from October 2006 to March 2010.

5.		INVENTORIES
		Inventories consist of:

		September 30,				December 31,
		2006				2005
Leaf tobacco		$	33,937			$	35,312
Other raw materials			3,214				3,157
Work-in-process			1,076				1,685
Finished goods			42,797				34,653
Inventories at cost			81,024				74,807
LIFO adjustments			(3,866	)			(4,412	)
		$	77,158			$	70,395

		The Company has a leaf inventory management program whereby, among other things, it is committed to purchase certain quantities of leaf tobacco. The purchase commitments are for quantities not in excess of anticipated requirements and are at prices, including carrying costs, established at the date of the commitment. At September 30, 2006, Liggett had leaf tobacco purchase commitments of approximately $10,742. There were no leaf tobacco purchase commitments at Vector Tobacco at that date.
		Included in the above table was approximately $1,041 at September 30, 2006 and $1,208 at December 31, 2005 of leaf inventory associated with Vector Tobacco’s QUEST product, which is carried at its estimated net realizable value.
		LIFO inventories represent approximately 95% of total inventories at September 30, 2006 and 92% of total inventories at December 31, 2005.

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

6.		PROPERTY, PLANT AND EQUIPMENT
		Property, plant and equipment consist of:

		September 30,				December 31,
		2006				2005
Land and improvements		$	1,418			$	1,418
Buildings			13,732				13,718
Machinery and equipment			97,299				98,037
Leasehold improvements			3,226				2,724
Construction-in-progress			7,136				2,960
			122,811				118,857
Less accumulated depreciation			(60,619	)			(56,334	)
		$	62,192			$	62,523

		Depreciation and amortization expense on property, plant and equipment for the three and nine months ended September 30, 2006 was $2,486 and $7,477, respectively. Depreciation and amortization expense on property, plant and equipment for the three and nine months ended September 30, 2005 was $2,737 and $8,281, respectively. Future machinery and equipment purchase commitments at Liggett were $1,107 at September 30, 2006.
		During the second quarter of 2006, Liggett Vector Brands recognized an impairment charge of $324 associated with its decision to dispose of an asset to an unrelated third party. As a result, the Company has classified this asset with a net book value at September 30, 2006 of $1,325 within “Assets held for sale” in its consolidated balance sheet at September 30, 2006.
		The Company has also included equipment with a net book value of $112, which was owned and held for sale by Liggett at September 30, 2006, within “Assets held for sale” in its consolidated balance sheet at September 30, 2006.
		In February 2005, New Valley completed the sale of its two office buildings in Princeton, New Jersey for $71,500. (Refer to Notes 12 and 14). The Company recorded a gain of $2,952, net of minority interests and income taxes, in the first quarter of 2005 in connection with the sale.

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

7.		NOTES PAYABLE, LONG-TERM DEBT AND OTHER OBLIGATIONS
		Notes payable, long-term debt and other obligations consist of:

		September 30,				December 31,
		2006				2005
						(Restated)
Vector:
3.875% Variable Interest Senior Convertible Debentures due 2026, net of unamortized net discount of $83,862*		$	26,138			$	—
5% Variable Interest Senior Convertible Notes due 2011, net of unamortized net discount of $55,261 and $58,655*			56,603				53,209
6.25% Convertible Subordinated Notes due 2008			—				132,492
Liggett:
Revolving credit facility			10,558				—
Term loan under credit facility			3,095				3,482
Equipment loans			14,200				9,828
Vector Tobacco:
Notes payable – Medallion acquisition due 2007			35,000				35,000
V.T. Aviation:
Note payable			7,681				8,300
VGR Aviation:
Note payable			4,719				4,867
Other			380				377
Total notes payable, long-term debt and other obligations			158,374				247,555
Less:
Current maturities			(54,956	)			(9,313	)
Amount due after one year		$	103,418			$	238,242

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

Variable Interest Senior Convertible Debt — Vector:

Vector has issued two series of variable interest senior convertible debt. Both series of debt pay interest on a quarterly basis at a stated rate plus an additional amount of interest on each payment date. The additional amount is based on the amount of cash dividends paid during the prior three-month period ending on the record date for such interest payment multiplied by the total number of shares of its common stock into which the debt will be convertible on such record date (the “Additional Interest”).

The Company has filed a registration statement with respect to the resale of both series of its variable interest senior debt and the common stock issuable upon conversion of the debt.

3.875% Variable Interest Senior Convertible Debentures due 2026:

In July 2006, the Company sold $110,000 of its 3.875% variable interest senior convertible debentures due 2026 in a private offering to qualified institutional buyers in accordance with Rule 144A under the Securities Act of 1933. The Company used the net proceeds of the offering to redeem its remaining 6.25% convertible subordinated notes due 2008 and for general corporate purposes.

The debentures pay interest on a quarterly basis at a rate of 3.875% per annum plus Additional Interest (the “Debenture Total Interest”). Notwithstanding the foregoing, however, the interest payable on each interest payment date shall be the higher of (i) the Debenture Total Interest and (ii) 5.75% per annum. The debentures are convertible into the Company’s common stock at the holder’s option. The conversion price, which was $20.48 per share at September 30, 2006, is subject to adjustment for various events, including the issuance of stock dividends.

The debentures will mature on June 15, 2026. The Company must redeem 10% of the total aggregate principal amount of the debentures outstanding on June 15, 2011. In addition to such redemption amount, the Company will also redeem on June 15, 2011 and at the end of each interest accrual period thereafter an additional amount, if any, of the debentures necessary to prevent the debentures from being treated as an “Applicable High Yield Discount Obligation” under the Internal Revenue Code. The holders of the debentures will have the option on June 15, 2012, June 15, 2016 and June 15, 2021 to require the Company to repurchase some or all of their remaining debentures. The redemption price for such redemptions will equal 100% of the principal amount of the debentures plus accrued interest. If a fundamental change (as defined in the Indenture) occurs, the Company will be required to offer to repurchase the debentures at 100% of their principal amount, plus accrued interest and, under certain circumstances, a “make-whole premium”.

5% Variable Interest Senior Convertible Notes Due November 2011:

In November 2004, the Company sold $65,500 of its 5% variable interest senior convertible notes due November 15, 2011 in a private offering to qualified institutional investors in accordance with Rule 144A under the Securities Act of 1933. The buyers of the notes had the right, for a 120-day period ending March 18, 2005, to purchase up to an additional $16,375 of the notes. At December 31, 2004, buyers had exercised their rights to purchase an additional $1,405 of the notes, and the remaining $14,959 principal amount of notes were purchased during the first quarter of 2005. In April 2005, Vector issued an additional $30,000 principal amount of 5% variable interest senior convertible notes due November 15, 2011 in a separate private offering to qualified institutional investors in accordance with Rule 144A. These notes, which were issued under a new indenture at a net price of 103.5%, were on the same terms as the $81,864 principal amount of notes previously issued in connection with the November 2004 placement.

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

The notes pay interest on a quarterly basis at a rate of 5% per annum plus Additional Interest (the “Notes Total Interest”). Notwithstanding the foregoing, however, during the period prior to November 15, 2006, the interest payable on each interest payment date is the higher of (i) the Notes Total Interest and (ii) 6.75% per year. The notes are convertible into the Company’s common stock at the holder’s option. The conversion price, which was $17.60 at September 30, 2006, is subject to adjustment for various events, including the issuance of stock dividends.

The notes will mature on November 15, 2011. The Company must redeem 12.5% of the total aggregate principal amount of the notes outstanding on November 15, 2009. In addition to such redemption amount, the Company will also redeem on November 15, 2009 and at the end of each interest accrual period thereafter an additional amount, if any, of the notes necessary to prevent the notes from being treated as an “Applicable High Yield Discount Obligation” under the Internal Revenue Code. The holders of the notes will have the option on November 15, 2009 to require the Company to repurchase some or all of their remaining notes. The redemption price for such redemptions will equal 100% of the principal amount of the notes plus accrued interest. If a fundamental change (as defined in the indenture) occurs, the Company will be required to offer to repurchase the notes at 100% of their principal amount, plus accrued interest and, under certain circumstances, a “make-whole premium”.

Embedded Derivatives on the Variable Interest Senior Convertible Debt:

The portion of the Debenture Total Interest and the Notes Total Interest which is computed by reference to the cash dividends paid on the Company’s common stock is considered an embedded derivative within the convertible debt, which the Company is required to separately value. Pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities”, the Company has bifurcated these embedded derivatives and, based on a valuation by a third party, estimated the fair value of the embedded derivative liability. The resulting discount created by allocating a portion of the issuance proceeds to the embedded derivative is then amortized to interest expense over the term of the debt using the effective interest method. Changes to the fair value of these embedded derivatives are reflected quarterly in the Company’s consolidated statements of operations as “Change in fair value of derivatives embedded within convertible debt.” The value of the embedded derivative is contingent on changes in interest rates of debt instruments maturing over the duration of the convertible debt as well as projections of future cash and stock dividends over the term of the debt.

The estimated initial fair values of the embedded derivatives associated with the 3.875% convertible debentures and the 5% convertible notes were $56,214 and $42,042, respectively.

A summary of non-cash interest expense associated with the embedded derivative liability for the three and nine months ended September 30, 2006 and 2005 is as follows:

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
						Restated								Restated
3.875% convertible debentures		$	515			$	—			$	515			$	—
5% convertible notes			763				611				2,173				1,640
		$	1,278			$	611			$	2,688			$	1,640

A summary of non-cash changes in fair value of derivatives embedded within convertible debt is as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
3.875% convertible debentures		$	2,099			$	—			$	2,099			$	—
5% convertible notes			1,365				(1,131	)			(874	)			(2,258	)
		$	3,464			$	(1,131	)		$	1,225			$	(2,258	)

The following table reconciles the fair value of derivatives embedded within convertible debt at September 30, 2006.

		3.875%				5%
		Convertible				Convertible
		Debentures				Notes				Total
Balance at December 31, 2005		$	—			$	39,371			$	39,371
Issuance of 3.875% convertible debentures			56,214				—				56,214
Loss (gain) from changes in fair value of embedded derivatives			2,099				(874	)			1,225
Balance at September 30, 2006		$	58,313			$	38,497			$	96,810

Beneficial Conversion Feature on Variable Interest Senior Convertible Debt:

After giving effect to the recording of the embedded derivative liability as a discount to the convertible debt, the Company’s common stock had a fair value at the issuance date of the debt in excess of the conversion price resulting in a beneficial conversion feature. EITF Issue No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Convertible Ratios”, requires that the intrinsic value of the beneficial conversion feature be recorded to additional paid-in capital and as a discount on the debt. The discount is then amortized to interest expense over the term of the debt using the effective interest method.

The initial intrinsic value of the beneficial conversion feature associated with the 3.875% convertible debentures and the 5% convertible notes was $28,381 and $22,138, respectively. As discussed in Note 1(i), in accordance with EITF Issue No. 05-8, the beneficial conversion feature has been recorded, net of income taxes, as an increase to stockholders’ equity.

VECTOR GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in Thousands, Except Per Share Amounts) — (Continued)
(Unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
						Restated								Restated
Amortization of beneficial conversion feature:
3.875% convertible debentures		$	218			$	—			$	218			$	—
5% convertible notes			439				320				1,220				796
Interest expense associated with beneficial conversion feature		$	657			$	320			$	1,438			$	796

Unamortized Debt Discount:

The following table reconciles unamortized debt discount at September 30, 2006.

		3.875%				5%
		Convertible				Convertible
		Debentures				Notes				Total
Balance at December 31, 2005, restated		$	—			$	58,654			$	58,654
Issuance of 3.875% convertible debentures-embedded derivative			56,214				—				56,214
Issuance of 3.875% convertible debentures-beneficial conversion feature			28,381				—				28,381
Amortization of embedded derivative			(515	)			(2,173	)			(2,688	)
Amortization of beneficial conversion feature			(218	)			(1,220	)			(1,438	)
Balance at September 30, 2006		$	83,862			$	55,261			$	139,123

6.25% Convertible Subordinated Notes Due July 15, 2008 — Vector:

In July 2001, Vector completed the sale of $172,500 (net proceeds of approximately $166,400) of its 6.25% convertible subordinated notes due July 15, 2008 through a private offering to qualified institutional investors in accordance with Rule 144A under the Securities Act of 1933. The notes paid interest at 6.25% per annum and were convertible into Vector’s common stock, at the option of the holder. The conversion price was subject to adjustment for various events, and any cash distribution on Vector’s common stock resulted in a corresponding decrease in the conversion price. In December 2001, $40,000 of the notes were converted into Vector’s common stock, in October 2004, $8 of the notes were converted and, in June 2006, $70,000 of the notes were converted. The Company recorded a loss of $14,860 for the nine months ended September 30, 2006 on the conversion of the $70,000 of notes principally as a result of the issuance of 962,531 shares of common stock as an inducement for conversion. On August 14, 2006, Vector redeemed the remaining outstanding notes at a redemption price of 101.042% of the principal amount plus accrued interest. The Company recorded a loss of $1,306 in the third quarter of 2006 on the retirement of the notes.

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Revolving Credit Facility — Liggett:

Liggett has a $50,000 credit facility with Wachovia Bank, N.A. (“Wachovia”) under which $10,558 was outstanding at September 30, 2006. Availability as determined under the facility was approximately $24,250 based on eligible collateral at September 30, 2006. The facility is collateralized by all inventories and receivables of Liggett and a mortgage on its manufacturing facility. Borrowings under the facility bear interest at a rate equal to 1.0% above the prime rate of Wachovia. The facility requires Liggett’s compliance with certain financial and other covenants including a restriction on Liggett’s ability to pay cash dividends unless Liggett’s borrowing availability under the facility for the 30-day period prior to the payment of the dividend, and after giving effect to the dividend, is at least $5,000 and no event of default has occurred under the agreement, including Liggett’s compliance with the covenants in the credit facility, including an adjusted net worth and working capital requirement. In addition, the facility imposes requirements with respect to Liggett’s adjusted net worth (not to fall below $8,000 as computed in accordance with the agreement) and working capital (not to fall below a deficit of $17,000 as computed in accordance with the agreement). At September 30, 2006, management believes that Liggett was in compliance with all covenants under the credit facility; Liggett’s adjusted net worth was $50,358 and net working capital was $31,041, as computed in accordance with the agreement.

100 Maple LLC, a company formed by Liggett in 1999 to purchase its Mebane, North Carolina manufacturing plant, has a term loan of $3,095 outstanding under Liggett’s credit facility at September 30, 2006. The remaining balance of the term loan was repaid on November 2, 2006. Interest was charged at the same rate as applicable to Liggett’s credit facility, and the outstanding balance of the term loan reduced the maximum availability under the credit facility. Liggett guaranteed the term loan, and a first mortgage on the Mebane property and manufacturing equipment collateralized the term loan and Liggett’s credit facility.

Equipment Loans — Liggett:

In October and December 2001, Liggett purchased equipment for $3,204 and $3,200, respectively, through the issuance of notes guaranteed by the Company, each payable in 60 monthly installments of $53 with interest calculated at the prime rate. The notes issued in October 2001 were paid in full in October 2006.

In March 2002, Liggett purchased equipment for $3,023 through the issuance of a note, payable in 30 monthly installments of $62 and then 30 monthly installments of $51. Interest is calculated at LIBOR plus 2.8%.

In May 2002, Liggett purchased equipment for $2,871 through the issuance of a note, payable in 30 monthly installments of $59 and then 30 monthly installments of $48. Interest is calculated at LIBOR plus 2.8%.

In September 2002, Liggett purchased equipment for $1,573 through the issuance of a note guaranteed by the Company, payable in 60 monthly installments of $26 plus interest calculated at LIBOR plus 4.31%.

In October 2005, Liggett purchased equipment for $4,441 through a financing agreement payable in 24 installments of $112 and then 24 installments of $90. Interest is calculated at 4.89%. Liggett was required to provide a security deposit equal to 25% of the funded amount ($1,110).

In December 2005, Liggett purchased equipment for $2,273 through a financing agreement payable in 24 installments of $58 and then 24 installments of $46. Interest is calculated at 5.03%. Liggett was required to provide a security deposit equal to 25% of the funded amount ($568).

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In August 2006, Liggett purchased equipment for $7,922 through a financing agreement payable in 30 installments of $191 and then 30 installments of $103. Interest is calculated at 5.15%. Liggett was required to provide a security deposit equal to 20% of the funded amount ($1,584).

Each of these equipment loans is collateralized by the purchased equipment.

Notes for Medallion Acquisition — Vector Tobacco:

The purchase price for the 2002 acquisition of The Medallion Company, Inc. (“Medallion”) included $60,000 in notes of Vector Tobacco, guaranteed by the Company and Liggett. Of the notes, $25,000 have been repaid with the final quarterly principal payment of $3,125 made on March 31, 2004. The remaining $35,000 of notes bear interest at 6.5% per year, payable semiannually, and mature on April 1, 2007.

Note Payable — V.T. Aviation:

In February 2001, V.T. Aviation LLC, a subsidiary of Vector Research Ltd., purchased an airplane for $15,500 and borrowed $13,175 to fund the purchase. The loan, which is collateralized by the airplane and a letter of credit from the Company for $775, is guaranteed by Vector Research, VGR Holding and the Company. The loan is payable in 119 monthly installments of $125, including annual interest of 2.31% above the 30-day commercial paper rate, with a final payment of $2,868 based on current interest rates.

Note Payable — VGR Aviation:

In February 2002, V.T. Aviation purchased an airplane for $6,575 and borrowed $5,800 to fund the purchase. The loan is guaranteed by the Company. The loan is payable in 119 monthly installments of $40, including annual interest of 2.75% above the 30-day average commercial paper rate, with a final payment of $4,011 based on current interest rates. During the fourth quarter of 2003, this airplane was transferred to the Company’s direct subsidiary, VGR Aviation LLC, which assumed the debt.

8.

CONTINGENCIES

Smoking-Related Litigation:

Overview. Since 1954, Liggett and other United States cigarette manufacturers have been named as defendants in numerous direct and third-party actions predicated on the theory that cigarette manufacturers should be liable for damages alleged to have been caused by cigarette smoking or by exposure to secondary smoke from cigarettes. New cases continue to be commenced against Liggett and other cigarette manufacturers. The cases generally fall into the following categories: (i) smoking and health cases alleging personal injury brought on behalf of individual plaintiffs (“Individual Actions”); (ii) smoking and health cases primarily alleging personal injury or seeking court-supervised programs for ongoing medical monitoring and purporting to be brought on behalf of a class of individual plaintiffs (“Class Actions”); (iii) health care cost recovery actions brought by various foreign and domestic governmental entities (“Governmental Actions”); and (iv) health care cost recovery actions brought by third-party payors including insurance companies, union health and welfare trust funds, asbestos manufacturers and others (“Third-Party Payor Actions”). As new cases are commenced, the costs associated with defending these cases and the risks relating to the

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inherent unpredictability of litigation continue to increase. The future financial impact of the risks and expenses of litigation and the effects of the tobacco litigation settlements discussed below are not quantifiable at this time. For the nine months ended September 30, 2006, Liggett incurred legal fees and other litigation costs totaling approximately $3,452 compared to $3,715 for the nine months ended September 30, 2005.

Individual Actions. As of September 30, 2006, there were approximately 142 cases pending against Liggett (excluding approximately 975 individual cases pending in West Virginia which have been consolidated), and in most cases other tobacco companies, where one or more individual plaintiffs allege injury resulting from cigarette smoking, addiction to cigarette smoking or exposure to secondary smoke and seek compensatory and, in some cases, punitive damages. Of these, 76 were pending in Florida (57 of which are abated pending resolution of Engle), 19 in Mississippi, 17 in Missouri and 12 in New York. The balance of the individual cases were pending in eight states and territories.

There are currently four individual cases pending where Liggett is the only tobacco company defendant. In April 2004, in the Davis v. Liggett Group Inc. case, a Florida state court jury awarded compensatory damages of $540 against Liggett. In addition, plaintiff’s counsel was awarded legal fees of $752. Liggett has appealed both the verdict and the award of legal fees. In March 2005, in the Ferlanti v. Liggett Group Inc. case, a Florida state court granted Liggett’s motion for summary judgment. The plaintiff appealed and in June 2006, the appellate court reversed and remanded back to the trial court. Discovery is pending. Trial has been scheduled in Missouri state court for May 2007 in the Frost v. Liggett Group Inc., et al. case. There is no activity in the other remaining case where Liggett is the sole tobacco company defendant.

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, concealment, 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 Organizations Act (“RICO”), state RICO 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. Although alleged damages often are not determinable from a complaint, and the law governing the pleading and calculation of damages varies from state to state and jurisdiction to jurisdiction, compensatory and punitive damages have been specifically pleaded in a number of cases, sometimes in amounts ranging into the hundreds of millions and even billions of dollars. 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, statute of limitations, equitable defenses such as “unclean hands” and lack of benefit, failure to state a claim and federal preemption.

Jury awards representing material amounts of damages have been returned against other cigarette manufacturers in recent years. The awards in these individual actions are for both compensatory and punitive damages. Over the last several years, after conclusion of all appeals, damage awards have been paid to several individual plaintiffs by other cigarette manufacturers including an award of $5,500 in compensatory damages and $50,000 in punitive damages, plus $27,000 in interest, paid in 2006 by Philip Morris in the Boeken v. Philip Morris case. Liggett was not a party to these actions.

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The following is a brief description of several of the pending cases where jury awards against other manufacturers are on appeal:

	•		In March 1999, an Oregon state court jury found in favor of the plaintiff in Williams v. Philip Morris. The jury awarded $800 in compensatory damages and $79,500 in punitive damages which was subsequently reduced by the trial court to $32,000. In June 2002, the Oregon Court of Appeals reinstated the $79,500 punitive damages award. In October 2003, the United States Supreme Court set aside the Oregon appellate court’s ruling and directed the Oregon court to reconsider the case in light of the State Farm decision, limiting punitive damages. In June 2004, the Oregon appellate court reinstated the original jury verdict. In February 2006, the Oregon Supreme Court reaffirmed the $79,500 punitive damages jury verdict. In May 2006, the United States Supreme Court granted defendant’s petition for writ of certiorari and oral argument was heard on October 31, 2006.
	•		In March 2002, an Oregon state court jury found in favor of the plaintiff in Schwarz v. Philip Morris and awarded $169 in compensatory damages and $150,000 in punitive damages. In May 2002, the trial court reduced the punitive damages award to $100,000. In May 2006, the Oregon Court of Appeals affirmed the compensatory damages award. It also vacated the punitive damages award and remanded for a new trial on the amount of punitive damages. The plaintiffs petitioned the Oregon Supreme Court to review the decision. In October 2006, the Oregon Supreme Court announced that it would defer further action in the case until the United States Supreme Court decides the Williams case.
	•		In October 2002, a California state court jury found in favor of the plaintiff in Bullock v. Philip Morris and awarded $850 in compensatory damages and $28,000,000 in punitive damages. In December 2002, the trial court reduced the punitive damages award to $28,000. In August 2006, the California Supreme Court denied plaintiff’s petition to overturn the trial court’s reduction in the punitive damage award and granted defendant’s petition for review of the punitive damage award, with further action deferred pending the United States Supreme Court’s decision on punitive damages in the Williams case.
	•		In November 2003, in Thompson v. Brown & Williamson Tobacco Corp., et al., a Missouri state court jury awarded $2,100 in compensatory damages. In August 2006, the Missouri Court of Appeals affirmed the award. The defendants have filed an application for transfer to the Missouri Supreme Court.
	•		In December 2003, in Frankson v. Brown & Williamson Tobacco Corp., et al., a New York state court jury awarded $350 in compensatory damages. In January 2004, the jury awarded $20,000 in punitive damages. The deceased smoker was found to be 50% at fault. In June 2004, the court increased the compensatory damages to $500 and decreased the punitive damages to $5,000. The defendants filed a motion for leave to appeal to the New York Court of Appeals, which was denied on October 5, 2006.
	•		In October 2004, in Arnitz v. Philip Morris, a Florida state court jury awarded $600 in damages but found that the plaintiff was 60% at fault, thereby reducing the verdict against Philip Morris to $240. In July 2006, the Florida Second District Court of Appeals affirmed the lower court’s decision. On October 16, 2006, the defendant paid $1,094 in judgment, interest and attorneys’ fees and thereafter, filed a petition for discretionary review with the Florida Supreme Court.
	•		In February 2005, in Smith v. Brown & Williamson Tobacco Corp., et al., a Missouri state court jury awarded $2,000 in compensatory damages and $20,000 in punitive damages. The defendants have appealed to the Missouri Court of Appeals.

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•

In March 2005, in Rose v. Philip Morris, a New York state court jury awarded $3,400 in compensatory damages and $17,100 in punitive damages. The defendants have appealed to the Supreme Court of New York, Appellate Division, First Department.

In 2003, the Mississippi Supreme Court, in Lane v. R.J. Reynolds Tobacco Company, et al., ruled that the Mississippi Product Liability Act “precludes all tobacco cases that are based on product liability.” In a 2005 decision, the Mississippi Supreme Court, in King v. R.J. Reynolds Tobacco Company, et al., ruled that certain claims against cigarette manufacturers may remain available to plaintiffs.

Class Actions. As of September 30, 2006, there were 11 actions pending for which either a class has been certified or plaintiffs are seeking class certification, where Liggett, among others, was a named defendant. Two of these cases are alleged price fixing cases pending in state court. Many of these actions purport to constitute statewide class actions and were filed after May 1996 when the Fifth Circuit Court of Appeals, in the Castano v. American Tobacco Co. case, reversed a federal district court’s certification of a purported nationwide class action on behalf of persons who were allegedly “addicted” to tobacco products.

The Castano decision has had a limited effect with respect to courts’ decisions regarding narrower smoking-related classes or class actions brought in state rather than federal court. For example, since the Fifth Circuit’s ruling in the Scott v. American Tobacco Co., Inc. case, a court in Louisiana (Liggett is not a defendant in this proceeding) certified an “addiction-as-injury” class action that covered only citizens in the state. In May 2004, the Scott jury returned a verdict in the amount of $591,000, plus prejudgment interest, on the class’ claim for a smoking cessation program. The case is on appeal. Two other class actions, Broin, et al., v. Philip Morris Companies Inc., et al., (Liggett has been dismissed from this case) and Engle, et al., v. R.J. Reynolds Tobacco Company, et al., were certified in state court in Florida prior to the Fifth Circuit’s decision.

In May 1994, the Engle case was filed against Liggett and others in Miami-Dade County, Florida. The class consisted of all Florida residents who, by November 21, 1996, have suffered, presently suffer or have died from diseases and medical conditions caused by their addiction to cigarette smoking. Phase I of the trial commenced in July 1998 and in July 1999, the jury returned the Phase I verdict against Liggett and other tobacco companies. The Phase I verdict concerned certain issues determined by the trial court to be “common” to the causes of action of the plaintiff class. The jury made several findings adverse to the defendants including that defendants’ conduct “rose to a level that would permit a potential award or entitlement to punitive damages.” Phase II of the trial, which commenced November 1999, was 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. In April 2000, the jury awarded compensatory damages of $12,704 to the three plaintiffs, to be reduced in proportion to the respective plaintiff’s fault. The claim of one of the three plaintiffs, in the amount of $5,831, was subsequently dismissed as time barred and the Florida Supreme Court found that Liggett was not liable to the other two plaintiffs. In July 2000, the jury awarded approximately $145,000,000 in punitive damages against all defendants including $790,000 against Liggett. The trial court entered a final order of judgment against the defendants in November 2000. Liggett and the other defendants appealed.

In May 2003, Florida’s Third District Court of Appeals reversed the trial court’s final judgment and remanded the case with instructions to decertify the class. In July 2006, the Florida Supreme Court affirmed in part and reversed in part the May 2003 Third District Court of Appeals decision. Among other things, the Florida Supreme Court affirmed the decision decertifying the class and the order vacating the punitive damages award, but preserved several of the Phase I findings (including that: (i) smoking causes lung cancer, among other diseases; (ii) nicotine in cigarettes is addictive; (iii)

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defendants placed cigarettes on the market that were defective and unreasonably dangerous; (iv) the defendants concealed material information; (v) the defendants agreed to misrepresent information relating to the health effects of cigarettes with the intention that the public would rely on this information to its detriment; (vi) all defendants sold or supplied cigarettes that were defective; and (vii) all defendants were negligent) and allowed class members to proceed to trial on individual liability issues (utilizing the above findings) and compensatory and punitive damage issues, provided they commence their individual lawsuits within one year of the date the court’s decision becomes final. The defendant tobacco companies have moved for reconsideration and/or clarification of the decision. If the Florida Supreme Court’s decision is allowed to stand, it could result in the filing of a large number of individual personal injury cases in Florida.

In May 2000, legislation was enacted in Florida that limits the size of any bond required to stay execution of a punitive damages verdict, pending appeal, to the lesser of the punitive award plus twice the statutory rate of interest, $100,000 or 10% of the net worth of the defendant, but the limitation on the bond does not affect the amount of the underlying verdict. In November 2000, Liggett filed a $3,450 bond in order to stay execution of the Engle judgment, pending appeal. Legislation limiting the amount of the bond required to file an appeal of an adverse judgment has been enacted in more than 30 states.

In May 2001, Liggett, Philip Morris and Lorillard Tobacco Company reached an agreement with the Engle class, which provided assurance of Liggett’s ability to appeal the jury’s July 2000 punitive damage verdict. As required by the agreement, Liggett paid $6,273 into an escrow account to be held for the benefit of the Engle class, and released, along with Liggett’s existing $3,450 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, the Company recorded a $9,723 pre-tax charge to the consolidated statement of operations for the first quarter of 2001. In light of the Florida Supreme Court’s July 2006 decision decertifying the Engle class, entitlement to the escrowed monies will have to be determined by the court.

In June 2002, the jury in a Florida state court action entitled Lukacs v. R.J. Reynolds Tobacco Company, et al. awarded $37,500 in compensatory damages in a case involving Liggett and two other tobacco manufacturers. In March 2003, the court reduced the amount of the compensatory damages to $24,860. The jury found Liggett 50% responsible for the damages incurred by the plaintiff. The Lukacs case was the first case to be tried as an individual Engle class member suit following entry of final judgment by the Engle trial court; the claims of all other individuals who are purported members of the class were stayed or “abated” pending appellate review of the Engle verdict. Entry of the final judgment in Lukacs, along with plaintiff’s motion to tax costs and attorneys’ fees, was stayed pending appellate review of the Engle final judgment. Liggett may ultimately be required to bond the amount of the judgment against it to perfect its appeal.

Class certification motions are pending in a number of putative class actions. Classes remain certified against Liggett in West Virginia (Blankenship), Kansas (Smith) and New Mexico (Romero). Smith and Romero are alleged price fixing cases. Several classes remain certified against others in the industry. A number of class certification denials are on appeal.

There are currently two cases pending in which plaintiffs allege that cigarette manufacturers conspired to fix cigarette prices in violation of antitrust laws. In Smith v. Philip Morris, et al., a Kansas state court granted class certification in November 2001. In April 2003, class certification was granted in Romero v. Philip Morris, et al., pending in New Mexico state court, and was affirmed in February 2005 by the New Mexico Supreme Court. In June 2006, the trial court in Romero granted defendants’ motions for summary judgment. Plaintiffs have appealed.

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In April 2001, a California state court in Brown, et al., v. The American Tobacco Co., Inc., et al. granted in part plaintiffs’ motion for class certification and certified a class comprised of adult residents of California who smoked at least one of defendants’ cigarettes “during the applicable time period” and who were exposed to defendants’ marketing and advertising activities in California. In March 2005, the court issued a ruling granting defendants’ motion to decertify the class based on a recent change in California law. In April 2005, the court denied plaintiffs’ motion for reconsideration of the order which decertified the case. The plaintiffs have appealed. Liggett is a defendant in the case.

Class action suits have been filed in a number of states against individual cigarette manufacturers, alleging, among other things, that the use of the terms “light” and “ultra light” constitutes unfair and deceptive trade practices, among other things. One such suit, Schwab v. Philip Morris, et al., pending in federal court in New York, seeks to create a nationwide class of “light” cigarette smokers and includes Liggett as a defendant. The action asserts claims under RICO. The proposed class is seeking as much as $200,000,000 in damages, which could be trebled under RICO. In November 2005, the court ruled that if the class is certified, the plaintiffs would be permitted to calculate damages on an aggregate basis and use “fluid recovery” theories to allocate them among class members. Fluid recovery would permit potential damages to be paid out in ways other than merely giving cash directly to plaintiffs, such as establishing a pool of money that could be used for public purposes. On September 25, 2006, the court granted plaintiff’s motion for class certification. Trial had been scheduled to commence in January 2007. On October 6, 2006, the defendants filed a motion requesting the United States Court of Appeals for the Second Circuit to review the class certification decision and to stay the district court’s decision pending that review. On October 24, 2006, the United States Court of Appeals for the Second Circuit granted a temporary stay of the pre-trial and trial proceedings until a three-judge panel has an opportunity to rule on the defendants’ petition for review of the class certification order. A hearing on the petition for review has been scheduled for December 5, 2006.

In March 2003, in a class action brought against Philip Morris on behalf of smokers of light and ultra light cigarettes, a state court judge in Illinois in the Price, et al., v. Philip Morris case awarded $7,100,500 in actual damages to the class members, $3,000,000 in punitive damages to the State of Illinois (which was not a plaintiff), and approximately $1,800,000 in attorney’s fees and costs. In December 2005, the Illinois Supreme Court reversed the lower state court’s decision and remanded, with instructions to dismiss the case. Plaintiffs filed a motion to stay mandate until final disposition of their petition for writ of certiorari to the United States Supreme Court. This motion was granted.

Although not technically a class action, in In Re: Tobacco Litigation (Personal Injury Cases), a West Virginia State court has consolidated approximately 975 individual smoker actions that were pending prior to 2001 for trial of certain common issues. The consolidation was affirmed on appeal by the West Virginia Supreme Court. Trial has been set for March 2007 on certain liability and punitive damages claims allegedly common to the consolidated claims. In January 2002, the court severed Liggett from the trial of the consolidated action.

Governmental Actions. As of September 30, 2006, there were five Governmental Actions pending against Liggett. In these proceedings, both foreign and domestic governmental entities seek reimbursement for Medicaid and other health care expenditures. The claims asserted in these 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,

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conspiracy, public nuisance, claims under state and federal statutes governing consumer fraud, antitrust, deceptive trade practices and false advertising, and claims under RICO.

A health care recovery case is pending in Missouri state court brought by the City of St. Louis, Missouri, and approximately 50 area hospitals against Liggett and other cigarette manufacturers. This case seeks recovery of costs expended by hospitals on behalf of patients who suffer, or have suffered, from illnesses allegedly resulting from the use of cigarettes. In June 2005, the court granted defendants’ motion for summary judgment as to claims for damages which accrued prior to November 16, 1993. The claims for damages which accrued after November 16, 1993 are still pending. The case has been remanded to the trial court where discovery is proceeding.

In Republic of Panama v. The American Tobacco Company, et al., and State of Sao Paulo v. The American Tobacco Company, et al., the cases, originally filed in Louisiana state court, were consolidated and then dismissed by the trial court on the basis that Louisiana is not an appropriate forum. The plaintiffs asked the trial court for reconsideration and, at the same time, noticed an appeal to the Louisiana Court of Appeals. The plaintiffs filed new cases in Delaware state court in July 2005. A hearing on the defendants’ motion to dismiss occurred in April 2006, and in July 2006, the Delaware court entered an order dismissing the cases. The plaintiffs have appealed.

In Crow Creek Sioux Tribe v. American Tobacco Company, et al., pending in South Dakota tribal court, a Native American tribe is seeking equitable and injunctive relief for damages incurred by the tribe in paying for the expenses of indigent smokers. The case is dormant at this time.

Federal Government Action. In September 1999, the United States government commenced litigation against Liggett and other tobacco companies in the United States District Court for the District of Columbia. The action sought to recover an unspecified amount of health care costs paid for and furnished, and to be paid for and furnished, by the federal government for lung cancer, heart disease, emphysema and other smoking-related illnesses allegedly caused by the fraudulent and tortious conduct of defendants, to restrain defendants and co-conspirators from engaging in alleged fraud and other allegedly unlawful conduct in the future, and to compel defendants to disgorge the proceeds of their unlawful conduct. The action asserted claims under three federal statutes, the Medical Care Recovery Act (“MCRA”), the Medicare Secondary Payer provisions of the Social Security Act (“MSP”) and RICO. In September 2000, the court dismissed the government’s claims based on MCRA and MSP.

Trial of the case concluded in June 2005. Thereafter, the government filed a proposed Final Judgment and Order requesting: (i) $14,000,000 for a smoking cessation and counter-marketing program; (ii) so-called “corrective statements;” (iii) disclosures; and (iv) enjoined activities.

On August 17, 2006, the trial court entered a Final Judgment and Remedial Order against each of the cigarette manufacturing defendants, except Liggett. The Final Judgment, among other things, ordered the following relief against the non-Liggett defendants: (i) the defendants are enjoined from committing any act of racketeering concerning the manufacturing, marketing, promotion, health consequences or sale of cigarettes in the United States; (ii) the defendants are enjoined from making any material false, misleading, or deceptive statement or representation concerning cigarettes that persuades people to purchase cigarettes; (iii) the defendants are permanently enjoined from utilizing “lights”, “low tar”, “ultra lights”, “mild”, or “natural” descriptors, or conveying any other express or implied health messages in connection with the marketing or sale of cigarettes as of January 1, 2007; (iv) the defendants must make certain corrective statements on their websites, and in television and print media advertisements; (v) the defendants must maintain internet document websites until 2016 with access to smoking and health related documents; (vi) the

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defendants must disclose all disaggregated marketing data to the government on a confidential basis; (vii) the defendants are not permitted to sell or otherwise transfer any of their cigarette brands, product formulas or businesses to any person or entity for domestic use without a court order, and unless the acquiring person or entity agrees to be bound by the terms of the Final Judgment; and (viii) the defendants must pay the appropriate costs of the government in prosecuting the action, in an amount to be determined by the trial court.

No monetary damages were awarded other than the government’s costs. The United States Court of Appeals for the District of Columbia has granted the defendants’ request for a stay pending appeal. It is unclear what impact, if any, the Final Judgment will have on the cigarette industry as a whole. While Liggett was excluded from the Final Judgment, to the extent that it leads to a decline in the industry-wide shipments of cigarettes in the United States, Liggett’s sales volume, operating income and cash flows could be materially adversely affected.

Third-Party Payor Actions. As of September 30, 2006, there were four Third-Party Payor Actions pending against Liggett. The Third-Party Payor Actions typically have been commenced by insurance companies, union health and welfare trust funds, asbestos manufacturers and others. In Third-Party Payor Actions, claimants have set forth several theories of relief sought: funding of corrective public education campaigns relating to issues of smoking and health; funding for clinical smoking cessation programs; disgorgement of profits from sales of cigarettes; restitution; treble damages; and attorneys’ fees. Although no specific amounts are provided, it is understood that requested damages against the tobacco company defendants in these cases might be in the billions of dollars.

Nine federal circuit courts of appeals and several state appellate courts have ruled that Third-Party Payors did not have standing to bring lawsuits against cigarette manufacturers, relying primarily on grounds that plaintiffs’ claims were too remote. The United States Supreme Court has refused to consider plaintiffs’ appeals from the cases decided by five federal circuit courts of appeals.

In June 2005, the Jerusalem District Court in Israel added Liggett as a defendant in an action brought by the largest private insurer in that country, Clalit Health Services, against the major United States tobacco manufacturers. The court ruled that, although Liggett had not sold product in Israel since 1978, it may still have liability for damages resulting from smoking of its product if it did sell cigarettes there before 1978. Motions filed by the defendants are pending before the Israel Supreme Court seeking appeal from a lower court’s decision granting leave to plaintiffs for foreign service of process.

In August 2005, the United Seniors Association, Inc. filed a lawsuit in federal court in Massachusetts pursuant to the private cause of action provisions of the MSP seeking to recover for the Medicare program all expenditures on smoking-related diseases since August 1999. On August 28, 2006, the court granted the defendants’ motion to dismiss the complaint. The plaintiffs have appealed.

In Fibreboard Corporation, et al. v. The American Tobacco Company, et al., an action in California state court, the plaintiffs seek reimbursement for damages paid to asbestos victims for medical and other relief, which damages are allegedly attributable to tobacco companies. Motions to dismiss have been stayed since December 2001.

Settlements. In March 1996, March 1997 and March 1998, Liggett entered into settlements of smoking-related litigation with the Attorneys General of 45 states and territories. The settlements released Liggett from all smoking-related claims within those states and territories, including claims for health care cost reimbursement and claims concerning sales of cigarettes to minors.

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		In November 1998, Philip Morris, Brown & Williamson, R.J. Reynolds and Lorillard (the “Original Participating Manufacturers” or “OPMs”) and Liggett (together with any other tobacco product manufacturer that becomes a signatory, the “Subsequent Participating Manufacturers” or “SPMs”), (the OPMs and SPMs are hereinafter referred to jointly as the “Participating Manufacturers”) entered into the Master Settlement Agreement (the “MSA”) with 46 states, the District of Columbia, Puerto Rico, Guam, the United States Virgin Islands, American Samoa and the Northern Mariana Islands (collectively, the “Settling States”) to settle the asserted and unasserted health care cost recovery and certain other claims of those Settling States. The MSA received final judicial approval in each settling jurisdiction.
		The MSA restricts tobacco product advertising and marketing within the Settling States and otherwise restricts the activities of Participating Manufacturers. Among other things, the MSA prohibits the targeting of youth in the advertising, promotion or marketing of tobacco products; bans the use of cartoon characters in all tobacco advertising and promotion; limits each Participating Manufacturer to one tobacco brand name sponsorship during any 12-month period; bans all outdoor advertising, with the exception of signs 14 square feet or less, at retail establishments that sell tobacco products; prohibits payments for tobacco product placement in various media; bans gift offers based on the purchase of tobacco products without sufficient proof that the intended recipient is an adult; prohibits Participating Manufacturers from licensing third parties to advertise tobacco brand names in any manner prohibited under the MSA; and prohibits Participating Manufacturers from using as a tobacco product brand name any nationally recognized non-tobacco brand or trade name or the names of sports teams, entertainment groups or individual celebrities.
		The MSA also requires Participating Manufacturers to affirm corporate principles to comply with the MSA and to reduce underage usage of tobacco products and imposes restrictions on lobbying activities conducted on behalf of Participating Manufacturers.
		Liggett has no payment obligations under the MSA except to the extent its market share exceeds a market share exemption of approximately 1.65% of total cigarettes sold in the United States. As a result of the acquisition of The Medallion Company, Inc. in April 2002, Vector Tobacco has no payment obligations under the MSA, except to the extent its market share exceeds a market share exemption of approximately 0.28% of total cigarettes sold in the United States. According to data from Management Science Associates, Inc., domestic shipments by Liggett and Vector Tobacco accounted for approximately 2.5% of the total cigarettes shipped in the United States during 2003, 2.3% during 2004 and 2.2% during 2005. If Liggett’s or Vector Tobacco’s market share exceeds their respective market share exemption in a given year, then on April 15 of the following year, Liggett and/or Vector Tobacco, as the case may be, would pay on each excess unit an amount equal (on a per-unit basis) to that due by the OPMs for that year, subject to applicable adjustments, offsets and reductions. In 2003, Liggett and Vector Tobacco paid a total of $37,541 for their 2002 MSA obligations. At that time, approximately $7,604 was not paid based on Liggett’s and Vector Tobacco’s belief that their MSA payments for 2001 and 2002 should have been reduced as a result of market share loss to non-participating manufacturers, an “NPM Adjustment”. In June 2003, Liggett and Vector Tobacco entered into settlement agreements with the Settling States whereby Liggett and Vector Tobacco agreed to pay a total of $2,478 in April 2004 to resolve the dispute. In April 2004, Liggett and Vector Tobacco paid a total of $50,322 for their 2003 MSA obligations. In April 2005, Liggett and Vector Tobacco paid a total of $20,982 for their 2004 MSA obligations. In April 2006, Liggett and Vector Tobacco paid a total of $10,637 for their 2005 MSA obligations. Liggett and Vector Tobacco have expensed $24,101 for their estimated MSA obligations for the first nine months of 2006 as part of cost of goods sold.

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Under the payment provisions of the MSA, the Participating Manufacturers are required to pay the following base annual amounts (subject to applicable adjustments, offsets and reductions):

Payment Year		Base Amount
2006 – 2007		$	8,000,000
2008 and each year thereafter		$	9,000,000

		These annual payments will be allocated based on unit volume of domestic cigarette shipments. The payment obligations under the MSA 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.
		On March 30, 2005, the Independent Auditor under the MSA calculated $28,668 in MSA payments for Liggett’s 2004 sales. In April 2005, Liggett paid $11,678 of this amount and, in accordance with its rights under the MSA, disputed the balance of $16,990. Of the disputed amount, Liggett paid $9,304 into the disputed payments account under the MSA and withheld from payment $7,686. The $9,304, which has since been released to the Settling States although Liggett continues to dispute that this money is owed, represents the amount claimed by Liggett as an adjustment to its 2003 payment obligation under the MSA for the NPM Adjustment. At September 30, 2006, included in “Other assets” on the Company’s consolidated balance sheet was a receivable of $6,513 relating to such amount. The $7,686 withheld from payment represents $5,318 claimed as an adjustment to Liggett’s 2004 MSA obligation for the NPM Adjustment and $2,368 relating to the retroactive change, discussed below, to the method for computing payment obligations under the MSA which Liggett contends, among other things, is not in accordance with the MSA. Liggett withheld approximately $1,600 from its payment due under the MSA in April 2006 which Liggett claims as the NPM Adjustment to its 2005 payment obligation and $2,612 relating to the “gross” versus “net” dispute discussed below.
		The following amounts have not been accrued in the accompanying consolidated financial statements as they relate to Liggett’s and Vector Tobacco’s claim for an NPM adjustment: $6,513 for 2003, $3,789 for 2004, and approximately $800 for 2005.
		In March 2006, an independent economic consulting firm selected pursuant to the MSA rendered its final and non-appealable decision that the MSA was a “significant factor contributing to” the loss of market share of Participating Manufacturers for 2003. As a result, the manufacturers are entitled to a potential NPM Adjustment to their 2003 MSA payments. A Settling State that has diligently enforced its qualifying escrow statute in 2003 may be able to avoid application of the NPM Adjustment to the payments made by the manufacturers for the benefit of that state.
		Since April 2006, notwithstanding provisions in the MSA requiring arbitration, 37 Settling States have filed declaratory judgment actions, complaints or motions seeking a determination that they “diligently enforced” their respective escrow statutes enacted in connection with the MSA and, therefore, are immune from any downward adjustment to their 2003 annual payments. The Participating Manufacturers have filed motions to compel arbitration of the dispute. These actions are limited to the potential NPM Adjustment for 2003, which the Independent Auditor under the MSA previously determined to be as much as $1,200,000. To date, 22 of 23 courts that have decided the issue have ruled that the 2003 NPM Adjustment dispute is arbitrable. Many of the decisions compelling arbitration have been appealed. The Participating Manufacturers have appealed the decision of the North Dakota court that the dispute is not arbitrable. There is no certainty that the Participating Manufacturers will receive any adjustment as a result of these proceedings.

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		In October 2004, Liggett was notified that all Participating Manufacturers’ payment obligations under the MSA, dating from the agreement’s execution in late 1998, were recalculated utilizing “net” unit amounts, rather than “gross” unit amounts (which have been utilized since 1999). The change in the method of calculation could, among other things, require additional payments by Liggett under the MSA of approximately $12,300 for the periods 2001 through 2005, and require Liggett to pay an additional amount of approximately $2,800 in 2006 and in future periods by lowering Liggett’s market share exemption under the MSA.
		Liggett has objected to this retroactive change and has disputed the change in methodology. Liggett contends that the retroactive change from utilizing “gross” unit amounts to “net” unit amounts is impermissible for several reasons, including:

	•		utilization of “net” unit amounts is not required by the MSA (as reflected by, among other things, the utilization of “gross” unit amounts through 2005);
	•		such a change is not authorized without the consent of affected parties to the MSA;
	•		the MSA provides for four-year time limitation periods for revisiting calculations and determinations, which precludes recalculating Liggett’s 1997 Market Share (and thus, Liggett’s market share exemption); and
	•		Liggett and others have relied upon the calculations based on “gross” unit amounts since 1998.

		No amounts have been accrued in the accompanying consolidated financial statements for any potential liability relating to the “gross” versus “net” dispute.
		The MSA 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 MSA, negotiated and executed settlement agreements with each of the other major tobacco companies, separate from those settlements reached previously with Liggett. Liggett’s agreements with these states remain in full force and effect, and Liggett made various payments to these states during 1996, 1997 and 1998 under the agreements. These states’ settlement agreements with Liggett contained most favored nation provisions which could reduce Liggett’s payment obligations based on subsequent settlements or resolutions by those states with certain other tobacco companies. Beginning in 1999, Liggett determined that, based on each of these four states’ settlements or resolutions with United States Tobacco Company, Liggett’s payment obligations to those states had been eliminated. With respect to all non-economic obligations under the previous settlements, Liggett is entitled to the most favorable provisions as between the MSA and each state’s respective settlement with the other major tobacco companies. Therefore, Liggett’s non-economic obligations to all states and territories are now defined by the MSA.
		In 2003, in order to resolve any potential issues with Minnesota as to Liggett’s settlement obligations, Liggett negotiated a $100 a year payment to Minnesota, to be paid any year cigarettes manufactured by Liggett are sold in that state. In 2004, the Attorneys General for each of Florida, Mississippi and Texas advised Liggett that they believed that Liggett had failed to make all required payments under the respective settlement agreements with these states for the period 1998 through 2003 and that additional payments may be due for 2004 and subsequent years. Liggett believes these allegations are without merit, based, among other things, on the language of the most favored nation provisions of the settlement agreements. In December 2004, Florida offered to settle all amounts allegedly owed by Liggett for the period through 2003 for the sum of $13,500. In March 2005, Florida

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		reaffirmed its December 2004 offer to settle and provided Liggett with a 60 day notice to cure the alleged defaults. Liggett has recently offered Florida $2,500 in a lump sum to settle all alleged obligations through December 31, 2006 and $100 per year thereafter, to resolve all alleged future obligations under the settlement agreement. In November 2004, Mississippi offered to settle all amounts allegedly owed by Liggett for the period through 2003 for the sum of $6,500. In April 2005, Mississippi reaffirmed its November 2004 offer to settle and provided Liggett with a 60 day notice to cure the alleged defaults. No specific monetary demand has been made by Texas. Liggett has met with representatives of Mississippi and Texas to discuss the issues relating to the alleged defaults, although no resolution has been reached.
		Except for $2,000 accrued for the year ended December 31, 2005 and an additional $500 accrued during the third quarter of 2006, in connection with the foregoing matters, no other amounts have been accrued in the accompanying consolidated financial statements for any additional amounts that may be payable by Liggett under the settlement agreements with Florida, Mississippi and Texas. At September 30, 2006, $2,500 remained in settlement accruals on the Company’s consolidated balance sheet. There can be no assurance that Liggett will resolve these matters and that Liggett will not be required to make additional material payments, which payments could adversely affect the Company’s consolidated financial position, results of operations or cash flows.
		In August 2004, the Company announced that Liggett and Vector Tobacco had notified the Attorneys General of 46 states that they intended to initiate proceedings against one or more of the Settling States for violating the terms of the MSA. The Company’s subsidiaries alleged that the Settling States violated their rights and the MSA by extending unauthorized favorable financial terms to Miami-based Vibo Corporation d/b/a General Tobacco when, in August 2004, the Settling States entered into an agreement with General Tobacco allowing it to become a Subsequent Participating Manufacturer under the MSA. General Tobacco imports discount cigarettes manufactured in Colombia, South America.
		In the notice sent to the Attorneys General, the Company’s subsidiaries indicated that they sought to enforce the terms of the MSA, void the General Tobacco agreement and enjoin the Settling States and National Association of Attorneys General from listing General Tobacco as a Participating Manufacturer on their websites. Several SPMs, including Liggett and Vector Tobacco, filed a motion in state court in Kentucky seeking to enforce the terms of the MSA with respect to General Tobacco or, alternatively, to receive the same treatment as General Tobacco under the MSA’s most favored nation clause. In January 2006, the court entered an order denying the motion and finding that the terms of the General Tobacco settlement agreement were not in violation of the MSA. The judge also found that the SPMs, under these circumstances, were not entitled to most favored nation treatment. These SPMs have given notice of appeal in this case.
		There is a suit pending against New York state officials, in which importers of cigarettes allege that the MSA and certain New York statutes enacted in connection with the MSA violate federal antitrust and constitutional law. In September 2004, the court denied plaintiffs’ motion to preliminarily enjoin the MSA and certain related New York statutes, but the court issued a preliminary injunction against an amendment repealing the “allocable share” provision of the New York escrow statute. Additionally, in a suit pending in New York federal court, plaintiffs assert that the statutes enacted by New York and the other states in connection with the MSA violate the Commerce Clause of the United States Constitution. Similar lawsuits are pending in Kentucky, Arkansas, Kansas, Louisiana, Nebraska, Tennessee and Oklahoma. Liggett is not a defendant in these cases.
		Upcoming Trials. An individual action in New York state court is currently scheduled for trial in September 2007. Liggett is a defendant along with other tobacco companies. An individual action in Missouri, where Liggett is the sole tobacco company defendant, is currently scheduled for trial in

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		May 2007. Two other individual actions in Florida are likely to be set for trial during 2007. Liggett is the sole tobacco company defendant in one of these cases. The Schwab class action trial had been scheduled to commence in January 2007, but, it has been temporarily stayed pending further determination by the United States Court of Appeals for the Second Circuit. Trial dates, however, are subject to change.
		Liggett has also been served in three reparations actions brought by descendants of slaves. Plaintiffs in these actions claim that defendants, including Liggett, profited from the use of slave labor. Seven additional cases were filed in California, Illinois and New York. Liggett is a named defendant in only one of these additional cases, but has not been served. The cases were consolidated before the United States District Court for the Northern District of Illinois. In July 2005, the court granted defendants’ motion to dismiss the consolidated action. The plaintiffs took appeals from those dismissals to the United States Circuit Court for the Seventh Circuit and in September 2005, these appeals were consolidated by court order. The parties are briefing the appeal.
		Management is not able to predict the outcome of the litigation pending or threatened against Liggett. Litigation is subject to many uncertainties. In May 2003, a Florida intermediate appellate court overturned a $790,000 punitive damages award against Liggett and decertified the Engle smoking and health class action. In July 2006, the Florida Supreme Court affirmed in part and reversed in part the May 2003 intermediate appellate court decision. Although the Florida Supreme Court affirmed the decision to decertify the class and the order vacating the punitive damages award, the court upheld certain of the trial court’s Phase I determinations. These findings could result in the filing of a large number of individual personal injury cases in Florida which could have a material adverse effect on the Company. In June 2002, the jury in the Lukacs case, an individual case brought under the third phase of the Engle case, awarded $37,500 (subsequently reduced by the court to $24,860) of compensatory damages against Liggett and two other defendants and found Liggett 50% responsible for the damages. Entry of the final judgment in Lukacs, along with plaintiff’s motion to tax costs and attorneys’ fees, was stayed pending appellate review of the Engle final judgment. Liggett may ultimately be required to bond the amount of the judgment entered against it to perfect its appeal. In April 2004, a jury in a Florida state court action awarded compensatory damages of approximately $540 against Liggett in an individual action. In addition, plaintiff’s counsel was awarded legal fees of $752. Liggett has appealed both the verdict and the award of legal fees. On August 17, 2006, the trial court in the Department of Justice case entered a Final Judgment and Remedial Order against certain cigarette manufacturers. It is unclear what impact, if any, the Final Judgment will have on the cigarette industry as a whole. While Liggett was excluded from the Final Judgment, to the extent that the judgment leads to a decline in the industry-wide shipments of cigarettes in the United States, Liggett’s sales volume, operating income and cash flows could be materially adversely affected. It is possible that additional cases could be decided unfavorably and that there could be further adverse developments as a result of the decision in the Engle case, including the filing of a large number of individual personal injury cases in Florida. Liggett may enter into discussions in an attempt to settle particular cases if it believes it is appropriate to do so.
		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 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 seek money damages in an amount to be determined by a jury, plus punitive damages and costs.

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		It is possible that the Company’s 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 are unaware of any material environmental conditions affecting their existing facilities. Liggett’s and Vector Tobacco’s management believe that current operations are conducted in material compliance with all environmental laws and regulations and other laws and regulations governing cigarette manufacturers. Compliance with federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had a material effect on the capital expenditures, results of operations or competitive position of Liggett or Vector Tobacco.
		There are several other proceedings, lawsuits and claims pending against the Company and certain of its consolidated subsidiaries unrelated to smoking or tobacco product liability. Management is of the opinion that the liabilities, if any, ultimately resulting from such other proceedings, lawsuits and claims should not materially affect the Company’s financial position, results of operations or cash flows.
		Legislation and Regulation:
		Many cities and states have recently enacted legislation banning smoking in public places including offices, restaurants, public buildings and bars. Efforts to limit smoking in public places could have a material adverse effect on the Company.
		In January 1993, the Environmental Protection Agency (“EPA”) released a report on the respiratory effect of secondary smoke which concludes 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 of the major domestic cigarette manufacturers, together with other segments of the tobacco and distribution industries, commenced a lawsuit against the EPA seeking a determination that the EPA did not have the statutory authority to regulate secondary smoke, and that given the scientific evidence and the EPA’s failure to follow its own guidelines in making the determination, the EPA’s classification of secondary smoke was arbitrary and capricious. In July 1998, a federal district court vacated those sections of the report relating to lung cancer, finding that the EPA 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.
		In August 1996, the Food and Drug Administration (“FDA”) filed in the Federal Register a Final Rule classifying tobacco as a “drug” or “medical device”, asserting jurisdiction over the manufacture and marketing of tobacco products and imposing restrictions on the sale, advertising and promotion of tobacco products. Litigation was commenced challenging the legal authority of the FDA to assert such jurisdiction, as well as challenging the constitutionality of the rule. 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 regulations 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. In

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		October 2004, the Senate passed a bill, which did not become law, providing for FDA regulation of tobacco products. A substantially similar bill was reintroduced in Congress in March 2005. The ultimate outcome of these proposals cannot be predicted, but FDA regulation of tobacco products could have a material adverse effect on the Company.
		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 voluntarily 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, and the Senate bill providing for FDA regulation also calls for, among other things, ingredient disclosure.
		In October 2004, the Fair and Equitable Tobacco Reform Act of 2004 (“FETRA”) was signed into law. FETRA provides for the elimination of the federal tobacco quota and price support program through an industry funded buyout of tobacco growers and quota holders. Pursuant to the legislation, manufacturers of tobacco products will be assessed $10,140,000 over a ten year period to compensate tobacco growers and quota holders for the elimination of their quota rights. Cigarette manufacturers will initially be responsible for 96.3% of the assessment (subject to adjustment in the future), which will be allocated based on relative unit volume of domestic cigarette shipments. Management currently estimates that Liggett’s and Vector Tobacco’s assessment will be approximately $22,000 for the second year of the program which began January 1, 2006. The relative cost of the legislation to the three largest cigarette manufacturers will likely be less than the cost to smaller manufacturers, including Liggett and Vector Tobacco, because one effect of the legislation is that the three largest manufacturers will no longer be obligated to make certain contractual payments, commonly known as Phase II payments, that they agreed in 1999 to make to tobacco-producing states. The ultimate impact of this legislation cannot be determined, but there is a risk that smaller manufacturers, such as Liggett and Vector Tobacco, will be disproportionately affected by the legislation, which could have a material adverse effect on the Company.
		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. In 2005, nine states enacted increases in excise taxes and, in 2006, five states enacted increases in excise taxes. Further increases from other states are expected. Congress has considered significant increases in the federal excise tax or other payments from tobacco manufacturers, and various states and other jurisdictions have currently under consideration or pending legislation proposing further state excise tax increases. Management believes increases in excise and similar taxes have had an adverse effect on sales of cigarettes.
		Various states have adopted or are considering legislation establishing reduced ignition propensity 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 with developing standards for “self-extinguishing” or reduced ignition propensity cigarettes. All cigarettes manufactured for sale in New York State must be manufactured to specific reduced ignition propensity standards set forth in the regulations. Liggett and Vector Tobacco are in compliance with the New York reduced ignition propensity regulatory requirements. Since the passage of the New York law, the states of Vermont, California, New Hampshire and Illinois have passed similar laws utilizing the same technical standards, effective on May 1, 2006, January 1, 2007, October 1, 2007 and January 1, 2008, respectively. Massachusetts has also recently enacted

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		reduced ignition propensity standards for cigarettes, although currently there is no effective date for the legislation. 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 were to be varying standards from state to state.
		Federal or state regulators may object to Vector Tobacco’s low nicotine and nicotine-free cigarette products and reduced risk cigarette products it may develop 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 previously engaged in discussions in an effort to resolve these concerns and Vector Tobacco has, in the interim, suspended all print advertising for its Quest brand. If Vector Tobacco is ultimately unable to advertise its Quest brand, it could have a material adverse effect on sales of Quest. 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 governmental regulation. Various proposals have been made for federal, state and international legislation to regulate cigarette manufacturers generally, and reduced constituent cigarettes specifically. It is possible that laws and regulations may be adopted covering issues like the manufacture, sale, distribution, advertising and labeling of tobacco products as well as any express or implied health claims associated with reduced risk, low nicotine and nicotine-free cigarette products and the use of genetically modified tobacco. A system of regulation by agencies such as the FDA, the Federal Trade Commission (“FTC”) or the United States Department of Agriculture may be established. The FTC has expressed interest in the regulation of tobacco products 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 effect on the Company.
		In addition to the foregoing, there have been a number of other restrictive regulatory actions, adverse legislative and political decisions and other unfavorable developments concerning cigarette smoking and the tobacco industry. These developments may negatively affect the perception of potential triers of fact with respect to the tobacco industry, possibly to the detriment of certain pending litigation, and may prompt the commencement of additional similar litigation or legislation.
		Other Matters:
		In May 1999, in connection with the Philip Morris brand transaction, Eve Holdings Inc., a subsidiary of Liggett, guaranteed a $134,900 bank loan to Trademarks LLC. The loan is secured by Trademarks’ three premium cigarette brands and Trademarks’ interest in the exclusive license of the three brands by Philip Morris. The license provides for a minimum annual royalty payment equal to the annual debt service on the loan plus $1,000. The Company believes that the fair value of Eve’s guarantee was negligible at September 30, 2006.
		In February 2004, Liggett Vector Brands and another cigarette manufacturer entered into a five year agreement with a subsidiary of the American Wholesale Marketers Association to support a program to permit certain tobacco distributors to secure, on reasonable terms, tax stamp bonds required by state and local governments for the distribution of cigarettes. Under the agreement, Liggett Vector Brands has agreed to pay a portion of losses, if any, incurred by the surety under the bond program, with a maximum loss exposure of $500 for Liggett Vector Brands. To secure its potential obligations under the agreement, Liggett Vector Brands has delivered to the subsidiary of the Association a $100 letter of credit and agreed to fund up to an additional $400. Liggett Vector Brands has incurred