UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2006

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

For the transition period from                      to                     

 

Reynolds American Inc.

(Exact name of registrant as specified in its charter)

North Carolina		20-0546644
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

401 North Main Street
Winston-Salem, NC 27101
(Address of principal executive offices) (Zip Code)

(336) 741-2000
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed from last report)

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

     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. (check one)

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

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: 147,765,978 shares of common stock, par value $.0001 per share, as of April 21, 2006

 

 

INDEX

		Page
Part I – Financial Information
Item 1. Financial Statements
Condensed Consolidated Statements of Income (Unaudited) – Three Months Ended March 31, 2006 and 2005			3
Condensed Consolidated Statements of Cash Flows (Unaudited) – Three Months Ended March 31, 2006 and 2005			4
Condensed Consolidated Balance Sheets (Unaudited) – March 31, 2006 and December 31, 2005			5
Notes to Condensed Consolidated Financial Statements (Unaudited)			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			50
Item 3. Quantitative and Qualitative Disclosures about Market Risk			68
Item 4. Controls and Procedures			68
Part II – Other Information
Item 1. Legal Proceedings			69
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			69
Item 6. Exhibits			70
Signature			71

PART I – Financial Information

Item 1. Financial Statements

REYNOLDS AMERICAN INC.

		For the Three Months
		Ended March 31,
		2006				2005
Net sales1		$	1,815			$	1,812
Net sales, related party			145				145
Net sales			1,960				1,957
Costs and expenses:
Cost of products sold1, 2			1,165				1,111
Selling, general and administrative expenses			342				364
Amortization expense			7				15
Operating income			446				467
Interest and debt expense			35				24
Interest income			(36	)			(17	)
Other expense, net			–				4
Income from continuing operations before income taxes			447				456
Provision for income taxes			167				175
Income before extraordinary item			280				281
Extraordinary item – gain on acquisition			65				–
Net income		$	345			$	281
Basic income per share:
Income from continuing operations		$	1.90			$	1.91
Extraordinary item			0.44				–
Net income		$	2.34			$	1.91
Diluted income per share:
Income from continuing operations		$	1.90			$	1.90
Extraordinary item			0.44				–
Net income		$	2.34			$	1.90
Dividends declared per share		$	1.25			$	0.95

See Notes to Condensed Consolidated Financial Statements (Unaudited)

REYNOLDS AMERICAN INC.

		For the Three Months Ended
		March 31,
		2006				2005
Cash flows from (used in) operating activities:
Net income		$	345			$	281
Adjustments to reconcile to net cash flows from (used in) operating activities:
Depreciation and amortization			44				53
Restructuring and asset impairment charges, net of cash payments			(6	)			(23	)
Acquisition restructuring charges, net of cash payments			(39	)			(27	)
Deferred income tax expense			17				9
Extraordinary item – gain on acquisition			(65	)			–
Other changes, that provided (used) cash:
Accounts and notes receivable			(16	)			(1	)
Inventories			36				64
Related party, net			–				31
Accounts payable and accrued liabilities including income taxes and other working capital			(119	)			125
Tobacco settlement and related expenses			(345	)			(407	)
Pension and postretirement			(187	)			20
Other, net			25				5
Net cash flows from (used in) operating activities			(310	)			130
Cash flows from (used in) investing activities:
Purchases of short-term investments			(2,265	)			(2,642	)
Proceeds from short-term investments			3,161				2,788
Capital expenditures			(41	)			(18	)
Distribution from equity investees			3				1
Proceeds from sale of business			3				–
Other, net			1				–
Net cash flows from investing activities			862				129
Cash flows from (used in) financing activities:
Dividends paid on common stock			(184	)			(140	)
Proceeds from exercise of stock options			2				1
Tax benefit from exercise of stock options			2				–
Repurchase of common stock			–				(3	)
Net cash flows used in financing activities			(180	)			(142	)
Net change in cash and cash equivalents			372				117
Cash and cash equivalents at beginning of period			1,333				1,499
Cash and cash equivalents at end of period		$	1,705			$	1,616
Income taxes paid, net of refunds		$	208			$	36
Interest paid		$	23			$	6
Tobacco settlement and related expense payments		$	967			$	959

See Notes to Condensed Consolidated Financial Statements (Unaudited)

REYNOLDS AMERICAN INC.

		March 31,				December 31,
		2006				2005
Assets
Current assets:
Cash and cash equivalents		$	1,705			$	1,333
Short-term investments			476				1,373
Accounts and notes receivable, net of allowance (2006 – $7; 2005 – $7)			120				99
Accounts receivable, related party			36				67
Income tax receivable			154				159
Inventories			1,030				1,066
Deferred income taxes			866				865
Prepaid expenses			132				98
Assets held for sale			–				5
Total current assets			4,519				5,065
Property, plant and equipment, net of accumulated depreciation (2006 – $1,457; 2005 – $1,426)			1,050				1,053
Trademarks, net of accumulated amortization (2006 – $507; 2005 – $504)			2,185				2,188
Goodwill			5,672				5,672
Other intangibles, net of accumulated amortization (2006 – $46; 2005 – $42)			222				226
Other assets and deferred charges			279				315
		$	13,927			$	14,519
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable		$	73			$	43
Tobacco settlement and related accruals			1,909				2,254
Due to related party			8				31
Deferred revenue, related party			61				69
Current maturities of long-term debt			190				190
Other current liabilities			1,433				1,562
Total current liabilities			3,674				4,149
Long-term debt (less current maturities)			1,545				1,558
Deferred income taxes			562				639
Long-term retirement benefits			1,185				1,374
Other noncurrent liabilities			243				246
Commitments and contingencies:
Shareholders’ equity:
Common stock (shares issued: 2006 – 147,760,903; 2005 – 147,432,945)			–				–
Paid-in capital			8,699				8,694
Accumulated deficit			(1,477	)			(1,638	)
Accumulated other comprehensive loss – (cumulative minimum pension liability: 2006–$502, net of tax; 2005–$502, net of tax)			(504	)			(503	)
Total shareholders’ equity			6,718				6,553
		$	13,927			$	14,519

See Notes to Condensed Consolidated Financial Statements (Unaudited)

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1–Summary of Significant Accounting Policies

Basis of Presentation

     The accompanying interim condensed consolidated financial statements (unaudited) have been prepared in accordance with accounting principles generally accepted in the United States of America, referred to as U.S. GAAP, for interim financial information and, in management’s opinion, contain all adjustments, consisting only of normal recurring items, necessary for a fair presentation of the results for the periods presented. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. For interim reporting purposes, certain costs and expenses are charged to operations in proportion to the estimated total annual amount expected to be incurred primarily based on sales volumes. The results for the interim period ended March 31, 2006, are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

     The condensed consolidated financial statements (unaudited) include the accounts of Reynolds American Inc., referred to as RAI, and its wholly owned subsidiaries. RAI’s wholly owned subsidiaries include its operating subsidiaries, R. J. Reynolds Tobacco Company, Santa Fe Natural Tobacco Company, Inc., referred to as Santa Fe, Lane Limited, referred to as Lane, and R. J. Reynolds Global Products, Inc., referred to as GPI.

     RAI was created to facilitate the July 30, 2004, transactions to combine the U.S. assets, liabilities and operations of Brown & Williamson Holdings, Inc., referred to as B&W, an indirect, wholly owned subsidiary of British American Tobacco p.l.c., referred to as BAT, with R. J. Reynolds Tobacco Company, a wholly owned operating subsidiary of R. J. Reynolds Tobacco Holdings, Inc., referred to as RJR. As a result of the business combination, B&W owns approximately 42% of RAI’s outstanding common stock, and previous RJR stockholders were issued shares of RAI common stock in exchange for their existing shares of RJR common stock, resulting in their ownership of approximately 58% of RAI’s common stock outstanding. Also, as part of the combination transactions, RAI acquired from an indirect subsidiary of BAT the capital stock of Cigarette Manufacturers Supplies Inc., referred to as CMSI, which owns all of the capital stock of Lane, and RJR became a wholly owned subsidiary of RAI.

     References to RJR Tobacco prior to July 30, 2004, relate to R. J. Reynolds Tobacco Company, a New Jersey corporation and a wholly owned subsidiary of RJR. References to RJR Tobacco on and subsequent to July 30, 2004, relate to the combined U.S. assets, liabilities and operations of B&W and R. J. Reynolds Tobacco Company.

     The equity method is used to account for investments in businesses that RAI does not control, but has the ability to significantly influence operating and financial policies. The cost method is used to account for investments in which RAI does not have the ability to significantly influence operating and financial policies. RAI has no investments in entities greater than 20% for which it accounts by the cost method, and has no investments in entities greater than 50% for which it accounts by the equity method. All material intercompany balances have been eliminated.

     In the first quarter of 2006, RAI recorded an adjustment of $65 million to the gain related to the acquisition of RJR’s former parent, Nabisco Group Holdings Corp., referred to as NGH, which occurred in 2000, primarily reflecting the favorable resolution of associated tax matters. Including this adjustment, the net after-tax gain on the acquisition of NGH was $1.8 billion.

     The condensed consolidated financial statements (unaudited) should be read in conjunction with the consolidated financial statements and related footnotes, which appear in RAI’s Annual Report on Form 10-K for the year ended December 31, 2005. Certain reclassifications were made to conform prior years’ financial statements to the current presentation.

     All dollar amounts are presented in millions unless otherwise noted.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Master Settlement Agreement and Federal Tobacco Buyout Expenses

Cost of products sold includes the following components for MSA settlement and federal tobacco buyout expenses:

		For The Three Months Ended
		March 31,
		2006				2005
Settlement		$	622			$	617
Phase II growers’ liability offset			–				(65	)
Total settlement expense		$	622			$	552
Federal tobacco quota buyout		$	66			$	64
Federal quota tobacco stock liquidation assessment			(9	)			3
Total quota buyout expense		$	57			$	67

     For additional information, see “–Governmental Health-Care Cost Recovery Cases – MSA and Other State Settlement Agreements” and “–Tobacco Buyout Legislation” in note 7.

Intangible Assets

     The changes in the carrying amount of trademarks during the three months ended March 31, 2006, were as follows:

		RJR Tobacco								Santa Fe				Lane
		Indefinite				Finite				Indefinite				Indefinite
		Life				Life				Life				Life				Consolidated
Balance as of January 1, 2006		$	1,947			$	61			$	155			$	25			$	2,188
Amortization expense			–				(3	)			–				–				(3	)
Balance as of March 31, 2006		$	1,947			$	58			$	155			$	25			$	2,185

     The changes in the carrying amount of other intangibles during the three months ended March 31, 2006, were as follows:

		RJR Tobacco								Lane				GPI
		Indefinite								Indefinite				Indefinite
		Life				Finite Life				Life				Life				Consolidated
Balance as of January 1, 2006		$	16			$	131			$	35			$	44			$	226
Amortization expense			–				(4	)			–				–				(4	)
Balance as of March 31, 2006		$	16			$	127			$	35			$	44			$	222

     In December 2005, GPI acquired from Japan Tobacco Inc., its U.S. duty-free and U.S. overseas military businesses relating to certain brands. The acquisition was accounted for as a purchase, with its cost of $45 million allocated on the basis of the estimated fair market value of the inventory and intangible assets acquired, determined with the assistance of an independent appraisal firm. The related rights were previously sold to Japan Tobacco Inc. in 1999 as a part of the sale of RJR’s international tobacco business.

     There were no significant changes in the carrying amounts of goodwill during the three months ended March 31, 2006.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

     Indefinite-lived intangibles include acquired distribution agreements of RJR Tobacco and Lane and acquired rights of GPI. Details of finite-lived intangible assets as of March 31, 2006, were as follows:

						Accumulated
		Gross				Amortization				Net
Consumer database		$	3			$	3			$	–
Customer contracts			16				16				–
Contract manufacturing			151				26				125
Technology-based			3				1				2
Total other intangibles			173				46				127
Trademarks			84				26				58
		$	257			$	72			$	185

     As of March 31, 2006, the estimated remaining amortization expense associated with finite-lived intangible assets in each of the next five years was as follows:

Year		Amount
Remainder of 2006		$	21
2007			25
2008			24
2009			22
2010			20
2011			19
Thereafter			54
		$	185

Stock-Based Compensation

     In the first quarter of 2006, RAI adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” issued by the Financial Accounting Standards Board in December 2004. This statement is a revision of SFAS No. 123 and supersedes Accounting Principles Board No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS No. 123(R) addresses all forms of share-based payment awards, including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. RAI’s adoption of SFAS No. 123(R) did not have a material impact on its financial condition, results of operations or cash flows primarily because all of RAI’s outstanding stock options are fully vested. See note 9 for additional disclosures related to stock-based compensation as required by SFAS No. 123(R).

Pension and Postretirement

     Recognized gains or losses include changes in the amount of either the benefit obligation or the market-related value of plan assets resulting from experience different from that assumed or from changes in assumptions. The minimum amortization of unrecognized gains or losses, as described in SFAS No. 87, “Employers’ Accounting for Pensions,” is included in pension expense. Prior service costs, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the average remaining service period for active employees. The market-related value of plan assets recognizes changes in fair value in a systematic and rational manner over five years.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Components of net benefit cost

		For The Three Months Ended
		March 31,
										Postretirement
		Pension Benefits								Benefits
		2006				2005				2006				2005
Service cost		$	9			$	14			$	1			$	2
Interest cost			76				77				22				20
Expected return on plan assets			(91	)			(82	)			(7	)			(6	)
Amortization of transition asset			–				–				–				–
Amortization of prior service cost			–				1				(3	)			(4	)
Amortization of net loss			17				16				6				4
Net periodic benefit cost			11				26				19				16
Settlements			–				1				–				–
Total benefit cost		$	11			$	27			$	19			$	16

Employer contributions

     RAI disclosed in its financial statements for the year ended December 31, 2005, that it expected to contribute $231 million to its pension plans in 2006. Of this amount, RAI contributed $201 million to its pension plans during the first three months of 2006.

Recently Issued Accounting Pronouncements

     In September 2005, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 04-13, “Inventory Exchanges.” EITF No. 04-13 requires 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 No. 04-13 is effective for RAI for new arrangements entered into after April 1, 2006. RAI does not expect the adoption of EITF No. 04-13 to have a material impact on its financial condition, results of operations or cash flows.

Note 2–Restructuring and Asset Impairment Charges

2004 Acquisition Restructuring Costs

     The components of the 2004 acquisition restructuring costs accrued and utilized were as follows:

		Employee
		Severance and				Relocation/
		Benefits				Exit Costs				Total
Original accrual		$	171			$	101			$	272
Utilized in 2004			(60	)			(26	)			(86	)
Balance, December 31, 2004			111				75				186
Utilized in 2005			(40	)			(28	)			(68	)
Adjusted in 2005			–				9				9
Adjustment to goodwill			1				(16	)			(15	)
Balance, December 31, 2005			72				40				112
Utilized in 2006			(36	)			(3	)			(39	)
Balance, March 31, 2006		$	36			$	37			$	73

     In connection with the allocation of the cost of the business combination as to assets acquired and liabilities assumed, RJR Tobacco accrued restructuring costs of $272 million in 2004. Of these costs, $171 million relate to the severance of approximately 2,450 former B&W employees in operations, sales and corporate functions, of which 2,139 have been terminated as of March 31, 2006. Other accruals include the cost to relocate former B&W employees retained and transferred from facilities that are being exited. Additionally, other exit costs include contract terminations and the closure of the acquired headquarters, a leased facility in Louisville, Kentucky, as well as the closure of a leased warehouse and certain leased sales offices, net of expected sub-lease income.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

     During 2005, RJR Tobacco determined that, under the 2004 acquisition restructuring plan, the employment of approximately 15 additional former B&W employees would be terminated, which resulted in an accrual of $1 million. The 2005 reduction in relocation/exit costs of $16 million is primarily due to lower-than-expected losses on home sales. Also, in 2005, $9 million was expensed in selling, general and administrative, primarily relating to lower-than-expected sub-lease income on closed facilities.

     As of March 31, 2006, $193 million of the accrued amount had been paid. In the condensed consolidated balance sheet (unaudited) as of March 31, 2006, $51 million is included in other current liabilities and $22 million is included in other noncurrent liabilities.

2003 Restructuring and Asset Impairment Charges

     The components of the 2003 restructuring and asset impairment charges recorded and utilized were as follows:

		Employee
		Severance								Contract
		and				Asset				Termination/
		Benefits				Impairment				Exit Costs				Total
Original charge		$	292			$	28			$	53			$	373
Utilized in 2003			(92	)			(28	)			(52	)			(172	)
Balance, December 31, 2003			200				–				1				201
Incurred in 2004			–				–				1				1
Utilized in 2004			(91	)			–				(2	)			(93	)
Adjusted in 2004			(34	)			–				–				(34	)
Balance, December 31, 2004			75				–				–				75
Utilized in 2005			(58	)			–				–				(58	)
Balance, December 31, 2005			17				–				–				17
Utilized in 2006			(6	)			–				–				(6	)
Balance, March 31, 2006		$	11			$	–			$	–			$	11

     During 2003, in response to continuing challenges of an intensely competitive environment, RJR and RJR Tobacco incurred restructuring and asset impairment charges of $373 million, or $225 million after tax. Of these charges, RJR Tobacco incurred $287 million related to severance and benefits, $28 million related to asset impairments, primarily reflecting abandonment of certain merchandising fixtures not yet shipped to retailers, and $34 million related to professional fees for valuation and consulting services, as well as the discontinuation of certain event-marketing programs and other associated exit costs. The remaining $24 million was incurred by RJR.

     During 2004, RJR Tobacco decided that approximately 750 sales positions that were expected to be outsourced would not be eliminated and had approximately 100 other less-than-expected workforce reductions, primarily in manufacturing. Accordingly, associated severance and related benefits of $34 million, or $20 million after tax, was reversed from the restructuring charge during 2004.

     After the adjustments during 2004, the workforce reduction was approximately 22%, or approximately 1,680 full-time employees, in operations and corporate functions. The workforce reduction was substantially completed during the fourth quarter of 2004. The remaining accrual represents severance that will substantially be paid by December 31, 2007.

     The cash portion of the restructuring and asset impairment charges to date is approximately $225 million, of which $171 million relates to employee severance costs and $54 million relates to exit costs. As of March 31, 2006, $214 million of this amount had been paid. Of the $115 million non-cash portion of the charges, $87 million related to benefit charges and $28 million related to asset impairments. In the condensed consolidated balance sheet (unaudited) as of March 31, 2006, $9 million is included in other current liabilities and $2 million is included in other noncurrent liabilities. No significant additional charges are expected to be incurred in connection with the 2003 restructuring plan.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

2002 Restructuring and Asset Impairment Charges

     The components of the 2002 restructuring and asset impairment charges recorded and utilized were as follows:

		Employee
		Severance								Contract
		and				Asset				Termination/
		Benefits				Impairment				Exit Costs				Total
Original charge		$	102			$	115			$	7			$	224
Utilized in 2002			(44	)			(115	)			(2	)			(161	)
Balance, December 31, 2002			58				–				5				63
Utilized in 2003			(27	)			–				–				(27	)
Adjusted in 2003			(2	)			–				(3	)			(5	)
Balance, December 31, 2003			29				–				2				31
Incurred in 2004			–				40				–				40
Utilized in 2004			(23	)			(40	)			–				(63	)
Adjusted in 2004			(2	)			–				–				(2	)
Balance, December 31, 2004			4				–				2				6
Incurred in 2005			–				3				–				3
Utilized in 2005			(3	)			(3	)			–				(6	)
Adjusted in 2005			–				–				(1	)			(1	)
Balance, December 31, 2005			1				–				1				2
Balance, March 31, 2006		$	1			$	–			$	1			$	2

     In 2002, RJR Tobacco recorded a pre-tax restructuring charge of $224 million, $135 million after tax, in response to changing competitive practices within the tobacco industry.

     During 2003, $5 million of the charge was reversed, reflecting less-than-expected workforce reductions and exit costs of field sales offices, and during 2004, RJR Tobacco reversed $2 million for employee severance and benefits, due to less-than-expected workforce reductions. As adjusted, the employee severance and benefits relate to the elimination of approximately 500 full-time positions in operations support and corporate functions, which were substantially completed as of December 31, 2004. During 2005, $1 million of the charge was reversed relating to the sale of the packaging operations.

     Contract termination and exit costs included certain contract terminations and lease terminations of 15 sales offices. Exit costs also included the separation of the non-tobacco businesses held for sale.

     The asset impairment resulted from the remeasurement of the non-tobacco businesses at the lower of their carrying value or fair value less cost to sell. Based on the results of negotiations, a revaluation of the fair value of RJR Tobacco’s packaging operations resulted in additional impairment of $40 million in the fourth quarter of 2004. During 2005, the remaining assets relating to the additional non-tobacco business were revalued and resulted in additional impairment of $3 million.

     Assets held for sale and liabilities related to assets held for sale in the condensed consolidated balance sheets are classified in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” As of December 31, 2005, the carrying amounts of the major classes of assets in the disposal group included $5 million primarily for equipment and facilities related to the Lane pipe manufacturing business, which was sold in the first quarter of 2006, and was unrelated to the 2002 restructuring. In 2005, RJR Tobacco completed the sale of its packaging operations to a consortium of five packaging companies for $48 million. In connection with this sale transaction, during 2005, RJR Tobacco recorded a net loss on sale of assets of $24 million.

     RJR Tobacco agreed to provide severance and related benefits to employees who would not receive offers for ongoing employment from the consortium of buyers. Accordingly, the loss includes approximately $27 million for severance and related benefits to be paid by RJR Tobacco to approximately 170 employees. RJR Tobacco also agreed to provide a transition bonus to eligible employees who continue to work during the transition period, which is expected to be up to 24 months. With the termination of the packaging employees, RJR Tobacco incurred a net curtailment gain of $10 million, reflecting $3 million of pension expense and $13 million of postretirement income. Pursuant to various exclusive requirements-based supply contracts, with terms of seven to nine years, entered into between the buyers and

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

RJR Tobacco, RJR Tobacco will continue to obtain its packaging materials from certain of the buyers. As a result of certain transitional supply pricing, which is above current market prices, $14 million was accrued as part of the loss. As a result, anticipated purchases over the transition period will be recorded at approximate current market prices. Of the charges incurred during the second quarter of 2005 related to the sale of the packaging operations, $9 million of these accruals were included in other current liabilities and $14 million were included in other noncurrent liabilities, in the condensed consolidated balance sheet (unaudited) as of March 31, 2006.

     The cash portion of the 2002 restructuring and asset impairment charges is expected to be $55 million and primarily relates to employee severance costs. As of March 31, 2006, $53 million of this amount had been paid. The $204 million non-cash portion included $44 million related to employee benefits, $158 million related to asset impairments and $2 million related to the write-off of prepaid promotional rights that were terminated. In the condensed consolidated balance sheet (unaudited) as of March 31, 2006, $2 million is included in other current liabilities.

Note 3–Income Per Share

     The components of the calculation of income per share were as follows:

		For the Three Months
		Ended March 31,
		2006				2005
Income from continuing operations		$	280			$	281
Extraordinary item – gain on acquisition			65				–
Net income		$	345			$	281
Basic weighted average shares, in thousands1			147,477				147,384
Effect of dilutive potential shares:
Options, in thousands			165				200
Diluted weighted average shares, in thousands			147,642				147,584

Note 4–Inventories

     The major components of inventories were as follows:

		March 31,				December 31,
		2006				2005
Leaf tobacco		$	798			$	853
Raw materials			33				32
Work in process			51				57
Finished products			176				156
Other			31				31
Total			1,089				1,129
Less LIFO allowance			59				63
		$	1,030			$	1,066

     RAI recorded $1 million of expense from expected LIFO layer liquidations for the three-month period ended March 31, 2006. RAI will perform its annual LIFO inventory valuation at December 31, 2006, and interim periods represent an estimate of the expected annual valuation.

Note 5–Financial Instruments

     RJR uses interest rate swaps to manage interest rate risk on a portion of its debt obligations. When entered into, these financial instruments are designated as hedges of underlying exposures. During 2002, RJR entered into interest rate swap agreements to modify the interest characteristics of $1.25 billion, a portion of its publicly registered notes, with fixed rates of 6.5% to 7.75%, due in 2006 to 2012, so that the interest payable effectively becomes variable.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

During 2005, swaps were settled related to the $310 million of notes due in 2006 that were purchased in response to RJR’s tender offer. As of March 31, 2006, the average interest rate on RJR’s $1.7 billion long-term debt was 7.01% after the effect of the swaps. The interest rate swaps’ notional amounts and termination dates match those of the outstanding notes. As of March 31, 2006, these fair value hedges were perfectly effective, resulting in no recognized net gain or loss. The unrealized gain on the hedges resulting from the change in the hedges’ fair value was $11 million and $24 million at March 31, 2006, and December 31, 2005, respectively, included in other assets and deferred charges, and is equal to the increase in the fair value of the hedged long-term debt.

     Under certain conditions, including RJR’s guaranteed secured debt rating remaining either one level below BBB- by S&P or Baa3 by Moody’s, or lower, any fair value that results in a liability position of the interest rate swaps will require full collateralization with cash or securities. In addition, because RJR and the guarantors, including RAI and RJR Tobacco, have pledged substantially all of their assets, including the stock of certain of their subsidiaries, to secure their obligations under RJR’s revolving credit facility, such pledge also has secured their obligations under these interest rate swap agreements.

Note 6–Long-Term Debt

     On December 7, 2005, RJR filed a registration statement with the SEC which became effective January 10, 2006, in order to issue registered notes in exchange for the $500 million privately placed notes issued on June 22, 2005. The terms of the exchange notes are identical to the terms of the private placement notes, except that the transfer restrictions and registration rights relating to the private placement notes do not apply to the exchange notes. At the expiration of the exchange offer on February 14, 2006, 100% of the privately placed 6.5% secured notes due 2010, and 100% of the privately placed 7.3% secured notes due 2015, had been validly tendered for exchange and not withdrawn, and were accepted by RJR.

     On March 14, 2006, RJR filed with the SEC a shelf registration statement, immediately effective upon filing, for an indeterminate amount of debt securities. Pursuant to this shelf registration statement, RJR may issue debt securities guaranteed by its parent, RAI, and certain of RJR’s subsidiaries, including RJR Tobacco. As of March 31, 2006, no debt securities have been issued thereunder.

Note 7–Commitments and Contingencies

Litigation Affecting the Cigarette Industry

Overview

     Introduction

     Various legal proceedings, including litigation claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RAI’s operating subsidiaries’ products, are pending or may be instituted against RJR Tobacco or its affiliates, including RAI and RJR, or indemnitees, including B&W. In connection with the business combination of RJR Tobacco and the U.S. cigarette and tobacco business of B&W on July 30, 2004, RJR Tobacco agreed to indemnify B&W and its affiliates against, among other things, any litigation liabilities, costs and expenses incurred by B&W or its affiliates arising out of the U.S. cigarette and tobacco business of B&W. Accordingly, the cases discussed below include cases brought solely against RJR Tobacco and its affiliates, including RAI and RJR; cases brought against both RJR Tobacco, its affiliates and B&W; and cases brought solely against B&W and assumed by RJR Tobacco in the business combination. See note 1 above for further discussion of the business combination of RJR Tobacco and the U.S. cigarette and tobacco business of B&W.

     During the first quarter of 2006, process in 17 tobacco-related cases was served against RJR Tobacco or its affiliates or indemnitees, including B&W. On March 31, 2006, there were 1,281 cases (including 964 individual smoker cases pending in West Virginia state court as a consolidated action) pending in the United States against RJR Tobacco or its affiliates or indemnitees, including B&W, as compared with 1,351 on March 31, 2005, pending against RJR Tobacco or its affiliates or indemnitees, including B&W, and 1,334 on March 31, 2004, pending against RJR Tobacco or its affiliates or indemnitees, without reference to B&W.

     As of April 13, 2006, 1,282 tobacco-related cases were pending against RJR Tobacco or its affiliates or indemnitees: 1,274 in the United States; three in Puerto Rico; three in Canada; one in the Virgin Islands and one in

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Israel. Of the 1,282 total cases, 35 cases are pending against B&W that are not also pending against RJR Tobacco. The U.S. case number does not include the 2,626 Broin II cases, which involve individual flight attendants alleging injuries as a result of exposure to environmental tobacco smoke, referred to as ETS or secondhand smoke, in aircraft cabins, pending as of April 13, 2006, and discussed below. The following table lists the number of U.S. tobacco-related cases by state that were pending against RJR Tobacco or its affiliates or indemnitees as of April 13, 2006:

		Number of
State		U.S. Cases
West Virginia			968	*
Florida			95
Mississippi			51
Missouri			30
New York			25
Maryland			23
Louisiana			21
California			13
Illinois			8
Alabama			3
Pennsylvania			3
Washington			3
Georgia			3
Minnesota			4
District of Columbia			3
Tennessee			3
Connecticut			2
Michigan			2
Oregon			2
Delaware			2
Texas			1
Ohio			1
Kansas			1
North Carolina			1
New Mexico			1
South Dakota			1
Massachusetts			1
Vermont			1
New Jersey			1
Indiana			1
Total			1,274

Of the 1,274 pending U.S. cases, 47 are pending in federal court, 1,226 in state court and one in tribal court.

     The following table lists the categories of the U.S. tobacco-related cases pending against RJR Tobacco or its affiliates or indemnitees as of April 13, 2006, compared with the number of cases pending against RJR Tobacco, its affiliates or indemnitees as of February 3, 2006, as reported in RAI’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005, filed with the SEC on February 27, 2006, and a cross-reference to the discussion of each case type.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

						Change in
						Number of
		RJR Tobacco’s				Cases Since
		Case Numbers as of				February 3,
Case Type		April 13, 2006				2006				Page Reference
Individual Smoking and Health			1,226				+3				21
Flight Attendant – ETS (Broin II)			2,626			No Change					22
Class-Action			21				-1				23
Governmental Health-Care Cost Recovery			3			No Change					27
Other Health-Care Cost Recovery and Aggregated Claims			3			No Change					30
Master Settlement Agreement-Enforcement and Validity*			4			No Change					31
Asbestos Contribution			1			No Change					32
Antitrust			7			No Change					32
Other Litigation			9				+2				33

     In July 2000, a jury in the Florida state court case Engle v. R. J. Reynolds Tobacco Co. rendered a punitive damages verdict in favor of the “Florida class” of approximately $145 billion, with approximately $36.3 billion and $17.6 billion being assigned to RJR Tobacco and B&W, respectively. RJR Tobacco, B&W and the other defendants appealed this verdict. On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court’s final judgment and remanded the case to the Miami-Dade County Circuit Court with instructions to decertify the class. On October 23, 2003, the plaintiffs asked the Florida Supreme Court to review the case. On May 12, 2004, the Florida Supreme Court accepted the case. Oral argument occurred on November 3, 2004. Although RJR Tobacco remains confident in the bases for appeal in this case, it cannot predict the final outcome of the appellate process. See “–Class-Action Suits” below for a further description of the Engle case.

     In November 1998, the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, entered into the Master Settlement Agreement, referred to as the MSA, with 46 U.S. states and certain U.S. territories and possessions. These cigarette manufacturers previously settled four other cases, brought on behalf of Mississippi, Florida, Texas and Minnesota, by separate agreements with each state. The MSA and other state settlement agreements:

	•		settled all health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions;
	•		released the major U.S. cigarette manufacturers from various additional present and potential future claims;
	•		imposed future payment obligations on RJR Tobacco, B&W and other major U.S. cigarette manufacturers; and
	•		placed significant restrictions on their ability to market and sell cigarettes.

     The aggregate cash payments made by RJR Tobacco under the MSA and other state settlement agreements were $1.8 billion in 2003, $2.0 billion in 2004 and $2.7 billion in 2005. These amounts do not include payments made in connection with B&W’s U.S. brands prior to July 30, 2004. RJR Tobacco estimates its payments, including payments made in connection with B&W’s U.S. brands acquired in the business combination, will be approximately $2.6 billion in each of 2006 and 2007 and will exceed $2.7 billion thereafter. These payments are subject to adjustments for, among other things, the volume of cigarettes sold by RJR Tobacco, RJR Tobacco’s market share and inflation. See “–Governmental Health-Care Cost Recovery Cases — MSA and Other State Settlement Agreements” below for a detailed discussion of the MSA and the other state settlement agreements, including RJR Tobacco’s monetary obligations under these agreements. RJR Tobacco records the allocation of settlement charges as products are shipped.

     Certain Terms and Phrases

     Certain terms and phrases used in this disclosure may require some explanation. The terms “judgment” or “final judgment” refer to the final decision of the court resolving the dispute and determining the rights and obligations

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

of the parties. At the trial court level, for example, a final judgment generally is entered by the court after a jury verdict and after post-verdict motions have been decided. In most cases, the losing party can appeal a verdict only after a final judgment has been entered by the trial court.

          The term “damages” refers to the amount of money sought by a plaintiff in a complaint, or awarded to a party by a jury or, in some cases, by a judge. “Compensatory damages” are awarded to compensate the prevailing party for actual losses suffered — if liability is proved. In cases in which there is a finding that a defendant has acted willfully, maliciously or fraudulently, generally based on a higher burden of proof than is required for a finding of liability for compensatory damages, a plaintiff also may be awarded “punitive damages.” Although damages may be awarded at the trial court stage, a losing party generally may be protected from paying any damages until all appellate avenues have been exhausted by posting a supersedeas bond. The amount of such a bond is governed by the law of the relevant jurisdiction and generally is set at the amount of damages plus some measure of statutory interest, modified at the discretion of the appropriate court or subject to limits set by court or statute.

          The term “settlement” refers to certain types of cases in which cigarette manufacturers, including RJR Tobacco and B&W, have agreed to resolve disputes with certain plaintiffs without resolving the case through trial. The principal terms of settlements entered into by RJR Tobacco are explained in the following disclosure.

          Accounting for Tobacco-Related Litigation Contingencies

          In accordance with generally accepted accounting principles, RAI and RJR Tobacco will record any loss concerning tobacco-related litigation at such time as an unfavorable outcome becomes probable and the amount can be reasonably estimated. For the reasons set forth below, RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, including B&W, when viewed on an individual basis, is not probable. RJR Tobacco and its affiliates believe that they have a number of valid defenses to the smoking and health tobacco litigation claims against them, as well as valid bases for appeal of adverse verdicts against them. RAI, RJR Tobacco and their affiliates and indemnitees have, through their counsel, filed pleadings and memoranda in pending smoking and health tobacco litigation that set forth and discuss a number of grounds and defenses that they and their counsel believe have a valid basis in law and fact. Based on their experience in the smoking and health tobacco litigation against them and the strength of the defenses available to them in such litigation, RJR Tobacco and its affiliates believe that their successful defense of smoking and health tobacco litigation in the past will continue in the future. During the first quarter of 2006, RJR Tobacco accrued $5 million relating to a settlement agreement in principle reached in a California case involving distribution of free cigarettes. This amount is included in other current liabilities in the March 31, 2006 condensed consolidated balance sheet (unaudited) and in selling, general and administrative expenses in the condensed consolidated statement of income (unaudited) for the three month period ended March 31, 2006 and is expected to be paid in the second quarter of 2006. See “-Other litigation and developments” below for additional information. No other liability for pending smoking and health tobacco litigation currently is recorded in RAI’s condensed consolidated financial statements (unaudited). RJR has liabilities totaling $94 million that were recorded in 1999 in connection with certain indemnification claims asserted by Japan Tobacco Inc., referred to as JTI, against RJR and RJR Tobacco relating to certain activities of Northern Brands International, Inc., a now inactive, indirect subsidiary of RAI formerly involved in the international tobacco business. For further information on Northern Brands and related litigation and the indemnification claims of JTI, see “-Other Litigation and Developments” and “-Other Contingencies and Guarantees” below.

          RJR Tobacco and its affiliates and indemnitees continue to win the majority of smoking and health tobacco litigation claims that reach trial, and a very high percentage of the tobacco-related litigation claims brought against them continue to be dismissed at or before trial. Generally, RJR Tobacco and its affiliates and indemnitees have not settled, and currently RJR Tobacco and its affiliates do not intend to settle, any smoking and health tobacco litigation claims. It is the policy of RJR Tobacco and its affiliates to vigorously defend all tobacco-related litigation claims.

          The only smoking and health tobacco litigation claims settled by RJR Tobacco and B&W involved:

	•		the MSA and other settlement agreements with the states of Mississippi, Florida, Texas and Minnesota, and the funding by various tobacco companies of a $5.2 billion trust fund contemplated by the MSA to benefit tobacco growers; and
	•		the original Broin flight attendant case discussed below under “—Class-Action Suits.”

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

In addition, certain antitrust cases, including the DeLoach antitrust case, discussed below under "—Antitrust Cases,” and certain MSA enforcement actions, discussed below under “—MSA—Enforcement and Validity,” also were settled separately by RJR Tobacco and B&W. Despite valid legal defenses, the decision to settle these matters resulted from unique circumstances that RJR Tobacco believes do not apply to the other tobacco-related litigation cases pending against RJR Tobacco, B&W and their respective affiliates.

          The circumstances surrounding the MSA and other state settlement agreements and the funding of a trust fund to benefit the tobacco growers are readily distinguishable from the current categories of smoking and health cases involving RJR Tobacco, B&W and their respective affiliates. The claims underlying the MSA and other state settlement agreements were brought on behalf of the states to recover funds paid for health-care and medical and other assistance to state citizens suffering from diseases and conditions allegedly related to tobacco use. The MSA and other state settlement agreements settled all the health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions and contain releases of various additional present and future claims. In accordance with the MSA, various tobacco companies agreed to fund a $5.2 billion trust fund to be used to address the possible adverse economic impact of the MSA on tobacco growers. A discussion of the MSA and other state settlement agreements, and a table depicting the related payment schedule under these agreements, is set forth below under “—Governmental Health-Care Cost Recovery Cases — MSA and Other State Settlement Agreements.”

          The states were a unique set of plaintiffs and are not involved in any of the smoking and health cases remaining against RJR Tobacco or its affiliates and indemnitees, including B&W. Although RJR Tobacco, B&W and certain of their respective affiliates continue to be defendants in health-care cost recovery cases similar in theory to the state cases but involving other plaintiffs, such as hospitals, Native American tribes and foreign governments, the vast majority of such cases have been dismissed on legal grounds. Indeed, eight federal courts of appeals have ruled uniformly that unions cannot successfully pursue such cases. As a result, no union cases are pending against RJR Tobacco or its affiliates or indemnitees. RJR Tobacco and its affiliates, including RAI, believe that the same legal principles that have resulted in dismissal of union and other types of health-care cost recovery cases either at the trial court level or on appeal should compel dismissal of the similar pending cases.

          The U.S. Department of Justice case brought against various industry members, including RJR Tobacco and B&W, discussed below under “— Governmental Health-Care Cost Recovery Cases,” also can be distinguished from the circumstances surrounding the MSA and the other state settlement agreements. Under its Medical Care Recovery Act and Medicare Secondary Payer Act claims, the federal government made arguments similar to the states and sought to recover federal funds expended in providing health care to smokers who have developed diseases and injuries alleged to be smoking-related. The only remaining claims in this case involve alleged violations of the federal Racketeer Influenced and Corrupt Organizations Act statute, referred to as RICO. Under this statute, the federal government sought disgorgement of profits from the defendants in the amount of $280 billion. Overruling the trial court, the U.S. Court of Appeals for the District of Columbia held that disgorgement is not an available remedy. On July 18, 2005, the government filed a petition for writ of certiorari with the U.S. Supreme Court on this issue. On October 17, 2005, the Supreme Court denied the petition. This ruling eliminates the government’s claims for $280 billion and limits the government’s potential remedies principally to forward-looking relief, including measures such as those already included in the MSA. Trial of the case concluded on June 9, 2005, and post-trial submissions were completed on October 9, 2005.

          Similarly, the other cases settled by RJR Tobacco can be distinguished from existing cases pending against RJR Tobacco and its affiliates and indemnitees, including B&W. The original Broin case, discussed below under “—Class-Action Suits,” was settled in the middle of trial during discussions with the federal government concerning the possible settlement of the claims underlying the MSA and other state settlement agreements, among other things. The Broin case was settled at that time in an attempt to remove this case as a political distraction during the industry’s settlement discussions with the federal government and a belief that further Broin litigation would be resolved by a settlement at the federal level.

          The DeLoach case, discussed below under “—Antitrust Cases,” was a unique antitrust case brought by a unique class of plaintiffs: a class of all tobacco growers and tobacco allotment holders. The class asserted that the defendants, including RJR Tobacco and B&W, engaged in bid-rigging of U.S. burley and flue-cured tobacco auctions. Despite valid legal defenses, RJR Tobacco and B&W separately settled this case to avoid a long and contentious trial with the tobacco growers. The remaining antitrust cases pending against RJR Tobacco and B&W involve different types of plaintiffs and different theories of recovery under the antitrust laws and should not be affected by the settlement of the DeLoach case.

          Finally, as discussed under “—MSA—Enforcement and Validity,” RJR Tobacco and B&W each has settled cases brought by states concerning the enforcement of the MSA. Despite valid legal defenses, these cases were settled

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

to avoid further contentious litigation with the states involved. Each MSA enforcement action involves alleged breaches of the MSA based on specific actions taken by the particular defendant. Accordingly, any future MSA enforcement action will be reviewed by RJR Tobacco on the merits and should not be affected by the settlement of prior MSA enforcement cases.

          Even though RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, when viewed on an individual basis, is not probable, the possibility of material losses related to tobacco litigation is more than remote. However, RAI’s management is unable to predict the outcome of such litigation or to reasonably estimate the amount or range of any possible loss, other than with respect to certain indemnification claims asserted by JTI. Moreover, notwithstanding the quality of defenses available to RJR Tobacco and its affiliates and indemnitees in tobacco-related litigation matters, it is possible that RAI’s results of operations, cash flows or financial condition could be materially adversely affected by the ultimate outcome of certain pending or future litigation matters. See “-Cautionary Statement Concerning Tobacco-Related Litigation,” below.

     Theories of Recovery

          The plaintiffs seek recovery on a variety of legal theories, including negligence, strict liability in tort, design defect, special duty, voluntary undertaking, breach of warranty, failure to warn, fraud, misrepresentation, unfair trade practices, conspiracy, unjust enrichment, medical monitoring, public nuisance and violations of state and federal antitrust and RICO laws. In certain of these cases, the plaintiffs claim that cigarette smoking exacerbated injuries caused by exposure to asbestos.

          The plaintiffs seek various forms of relief, including compensatory and punitive damages, treble or multiple damages and statutory damages and penalties, creation of medical monitoring and smoking cessation funds, disgorgement of profits, and injunctive and other equitable relief. 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

          The defenses raised by RJR Tobacco or its affiliates and indemnitees include, where applicable and otherwise appropriate, preemption by the Federal Cigarette Labeling and Advertising Act of some or all claims arising after 1969, the lack of any defect in the product, assumption of the risk, contributory or comparative fault, lack of proximate cause, remoteness, lack of standing and statutes of limitations or repose. RAI and RJR have asserted additional defenses, including jurisdictional defenses, in many of the cases in which they are named.

     Scheduled Trials

          Trial schedules are subject to change, and many cases are dismissed before trial. However, it is likely that there will be an increased number of tobacco-related cases against RJR Tobacco or its affiliates and indemnitees, some involving claims for amounts ranging possibly into the hundreds of millions and even billions of dollars, coming to trial during 2006 and the first quarter of 2007. The following table lists the trial schedule, as of April 13, 2006, for RJR Tobacco or its affiliates and indemnitees, including B&W, through March 31, 2007.

Trial Date		Case Name/Type		Defendant(s)		Jurisdiction
September 21, 2004		United States of America [DOJ] v.		RJR Tobacco, B&W		U. S. District Court
[Post-trial]		Philip Morris USA Inc.				(Washington, DC)
		[Health-Care Reimbursement]
May 1, 2006		Kimball v. R.J. Reynolds Tobacco		RJR Tobacco		U. S. District Court
		Co.				Western District
		[Individual]				(Bellingham, WA)
June 5, 2006		Bell v. Brown & Williamson Tobacco		RJR Tobacco, B&W		Circuit Court
		Corp.				Jackson County
		[Individual]				(Independence, MO)
September 5, 2006		Nuzum v. Brown & Williamson		RJR Tobacco, B&W		Circuit Court
		Tobacco Corp.				Jackson County
		[Individual]				(Independence, MO)

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Trial Date		Case Name/Type		Defendant(s)		Jurisdiction
October 10, 2006		Williams v. Brown & Williamson		RJR Tobacco, B&W		Circuit Court
		Tobacco Corp.				St. Louis County
		[Individual]				(St. Louis, MO)
November 27, 2006		Beasley v. Brown & Williamson		RJR Tobacco, B&W		Circuit Court
		Tobacco Corp.				Jackson County
		[Individual]				(Independence, MO)
November 27, 2006		Hausrath v. Philip Morris USA, Inc.		B&W		NY Supreme Court
		[Individual]				Erie County
						(Buffalo, NY)
February 12, 2007		Strong v. R.J. Reynolds Tobacco Co.		RJR Tobacco, B&W		U. S. District Court
		[Individual]				Southern District
						(Jackson, MS)
February 20, 2007		Coy v. Philip Morris Inc.		RJR Tobacco, B&W		U. S. District Court
		[Individual/ETS]				Southern District
						(Miami, FL)
March 19, 2007		Smith v. R.J. Reynolds Tobacco Co.		RJR Tobacco		U. S. District Court
		[Individual]				Eastern District
						(New Orleans, LA)
March 19, 2007		In Re: Tobacco Litigation (Individual		RJR Tobacco, B&W		Circuit Court
		Personal Injury Cases)				Ohio County
		[Individual/Consolidated]				(Wheeling, WV)

     Trial Results

          From January 1, 1999 through April 13, 2006, 51 smoking and health and health-care cost recovery cases in which RJR Tobacco or B&W were defendants have been tried. Verdicts in favor of RJR Tobacco, B&W and, in some cases, RJR Tobacco, B&W and other defendants, were returned in 34 (including four mistrials) cases, tried in Florida (10), New York (4), Missouri (4), Tennessee (3), Mississippi (2), California (2), West Virginia (2), Ohio (2), Connecticut (1), Louisiana (1), New Jersey (1), Pennsylvania (1), South Carolina (1) and Texas (1).

          Additionally, from January 1, 1999 through April 13, 2006, verdicts have been returned in 21 smoking and health cases in which RJR Tobacco, B&W, or their respective affiliates were not defendants. Verdicts were returned in favor of the defendants in 11 cases — four in Florida, two in California, and one in each of New Hampshire, New York, Pennsylvania, Rhode Island and Tennessee. Verdicts in favor of the plaintiffs were returned in nine cases, four in California, and two in each of Florida and Oregon and one in Illinois. The defendants’ appeals or post-trial motions are pending in these cases.

          One case was tried in the first quarter of 2006 in which RJR Tobacco or B&W was a defendant. In VanDenBurg v. Brown and Williamson Tobacco Corp., an individual smoker case, a Missouri state court jury returned a verdict in favor of the defendants, including RJR Tobacco and B&W, on February 22, 2006. The plaintiff has filed a motion for a new trial.

          The following chart reflects the verdicts and post-trial developments in the smoking and health cases that have been tried since January 1, 1999 and are still pending in 2006, in which juries have returned verdicts in favor of the plaintiffs and against RJR Tobacco or B&W, or both.

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
July 7, 1999-Phase I April 7, 2000-Phase II July 14, 2000-Phase III		Engle v. R. J. Reynolds   Tobacco Co. [Class Action]		Circuit Court, Miami-Dade County (Miami, FL)		$12.7 million compensatory damages against all the defendants; $145 billion punitive damages against all the defendants, of which approximately $36.3 billion and $17.6 billion was assigned to RJR Tobacco and B&W, respectively.		On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court and remanded the case to the Miami-Dade County Circuit Court with instructions to decertify the class. On May 12, 2004, the Florida Supreme Court agreed to review the case. Oral argument occurred on November 3, 2004. The Florida Supreme Court decision is pending.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
March 20, 2000		Whiteley v. Raybestos-   Manhattan, Inc. [Individual]		Superior Court, San Francisco County (San Francisco, CA)		$1.72 million compensatory damages against RJR Tobacco and Philip Morris; $20 million punitive damages, of which $10 million each was assigned to RJR Tobacco and Philip Morris.		On April 7, 2004, the California Court of Appeal reversed the judgment and remanded the case for a new trial. On January 27, 2006, the judge denied the defendants’ motion to change venue. On February 12, 2006, the defendants filed a petition for writ of mandate with the California Court of Appeal seeking an order vacating the trial court’s denial of the defendants’ motion to change venue. The petition was denied on March 24, 2006.
October 12, 2000		Jones v. Brown &   Williamson Tobacco Corp. [Individual]		Circuit Court, Hillsborough County (Tampa, FL)		$200,000 compensatory damages against RJR Tobacco. B&W was dismissed from the case in September 2002, prior to trial.		RJR Tobacco granted new trial on December 28, 2000; new trial decision affirmed by Florida’s Second District Court of Appeal on August 30, 2002. On August 31, 2005, the Florida Supreme Court denied review for lack of jurisdiction. The plaintiff dismissed all claims against RJR Tobacco on April 19, 2006.
December 12, 2001		Kenyon v. R. J.   Reynolds Tobacco Co. [Individual]		Circuit Court, Hillsborough County (Tampa, FL)		$165,000 compensatory damages against RJR Tobacco.		After exhausting its state court appeals, RJR Tobacco paid the plaintiff approximately $196,000 (judgment plus interest). RJR Tobacco also paid approximately $1.3 million in attorneys’ fees to the plaintiff’s counsel.
June 11, 2002		Lukacs v. R. J. Reynolds   Tobacco Co. [Engle class member]		Circuit Court, Miami-Dade County (Miami, FL)		$500,000 economic damages, $24.5 million noneconomic damages and $12.5 million loss of consortium damages against Philip Morris, B&W and Lorillard, of which B&W was assigned 22.5% of liability. Court has not entered final judgment for damages. RJR Tobacco was dismissed from the case in May 2002, prior to trial.		Judge reduced damages to $25.125 million of which B&W’s share is approximately $6 million. Final judgment will be entered only if the Engle appeal is resolved in favor of the class. If a judgment is entered, B&W intends to appeal.
November 4, 2003		Thompson v. Brown &   Williamson Tobacco Corp. [Individual]		Circuit Court, Jackson County (Independence, MO)		$1.05 million compensatory damages against Philip Morris and B&W, of which $209,351 was assigned to B&W.		The case is on appeal to the Missouri Court of Appeals. Oral argument occurred on November 3, 2005.
December 18, 2003		Frankson v. Brown &   Williamson Tobacco Corp. [Individual]		Supreme Court, Kings County (Brooklyn, NY)		$350,000 compensatory damages; 50% fault assigned to B&W and two industry organizations; $20 million in punitive damages, of which $6 million was assigned to		On January 21, 2005, the plaintiff stipulated to the court’s reduction in the amount of punitive damages from $20 million to $5 million, apportioned as follows: $0 to American Tobacco; $4 million to

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
						B&W, $2 million to a predecessor company and $12 million to two industry organizations.		B&W; $500,000 to the Counsel for Tobacco Research and $500,000 to the Tobacco Institute. On January 25, 2005, B&W appealed the trial court’s denial of post-trial motions. Oral argument is scheduled for May 8, 2006.
May 21, 2004		Scott v. American   Tobacco Co. [Class Action]		District Court, Orleans Parish (New Orleans, LA)		$591 million against RJR Tobacco, B&W, Philip Morris, Lorillard, and the Tobacco Institute for a smoking cessation program.		The case is on appeal to the Louisiana Court of Appeals. On September 29, 2004, the defendants posted a $50 million bond and noticed their appeal. RJR Tobacco posted $25 million toward the bond. Oral argument occurred on April 12, 2006. At the Court’s request the parties submitted post-argument briefs on April 28, 2006.
February 2, 2005		Smith v. Brown &   Williamson Tobacco Corp. [Individual]		Circuit Court, Jackson County (Independence, MO)		$2 million in compensatory damages (reduced to $500,000 because of jury’s findings that the plaintiff was 75% at fault); $20 million in punitive damages.		On June 1, 2005, B&W filed its notice of appeal.
March 18, 2005		Rose v. Brown &   Williamson Tobacco Corp. [Individual]		Supreme Court, New York County (Manhattan, NY)		RJR Tobacco found not liable; $3.42 million in compensatory damages against B&W and Philip Morris, of which $1.71 million was assigned to B&W; $17 million in punitive damages against Philip Morris only.		On August 18, 2005, B&W filed its notice of appeal. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the approximate amount of $2.058 million on February 7, 2006.

Individual Smoking and Health Cases

          As of April 13, 2006, 1,226 individual cases, including 964 individual smoker cases in West Virginia state court in a consolidated action, were pending in the U.S. against RJR Tobacco, B&W, as its indemnitee, or both. This category of cases includes smoking and health cases alleging personal injury brought by or on behalf of individual plaintiffs, but does not include the Broin II cases discussed below. A total of 1,220 of the individual cases are brought by or on behalf of individual smokers or their survivors, while the remaining six cases are brought by or on behalf of individuals or their survivors alleging personal injury as a result of exposure to ETS.

          Below is a description of the individual smoking and health cases against RJR Tobacco or B&W, or both, which went to trial or were decided or remained on appeal, since January 1, 2006.

          On August 15, 2003, a state court jury in Pennsylvania returned a verdict in favor of B&W in Eiser v. Brown & Williamson Tobacco Corp. On January 19, 2006, the Superior Court of Pennsylvania affirmed the verdict. The plaintiff’s application for reargument en banc was denied on March 29, 2006.

          On November 4, 2003, in Thompson v. Brown & Williamson Tobacco Corp., a Missouri state court jury awarded $2.1 million in compensatory damages against B&W and Philip Morris. B&W was found to be 10% at fault, Philip Morris was found to be 40% at fault, and the plaintiff was found to be 50% at fault. As a result, B&W’s share of the final judgment was approximately $210,000. The defendants appealed to the Missouri Court of Appeals. Oral argument occurred on November 3, 2005.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          On December 18, 2003, in Frankson v. Brown & Williamson Tobacco Corp., a New York state court jury awarded $350,000 in compensatory damages against B&W and two former tobacco industry organizations, the Tobacco Institute and the Council for Tobacco Research. The defendants as a group and the deceased smoker were each found to be 50% at fault. On January 8, 2004, the jury awarded $20 million in punitive damages, of which $6 million was assigned to B&W, $2 million was assigned to American Tobacco, a predecessor company to B&W, and $6 million was assigned to each of the Council for Tobacco Research and the Tobacco Institute. On June 22, 2004, the trial judge granted a new trial unless the parties consented to an increase in compensatory damages to $500,000 and a decrease in punitive damages to $5 million, of which $4 million would be assigned to B&W. On January 21, 2005, the plaintiff stipulated to the reduction in punitive damages from $20 million to $5 million, apportioned as follows: $0 to American Tobacco; $4 million to B&W; and $500,000 to each of the Council for Tobacco Research and the Tobacco Institute. On January 25, 2005, B&W appealed the trial court’s denial of post-trial motions. Briefing is complete. Oral argument is scheduled for May 8, 2006.

          On February 1, 2005, a Missouri state court jury returned a split verdict in Smith v. Brown & Williamson Tobacco Corp., finding in favor of B&W on two counts — fraudulent concealment and conspiracy, and finding in favor of the plaintiffs on the negligence count (which incorporates failure to warn and product defect claims). The plaintiffs were awarded $2 million in compensatory damages; however, the jury found the plaintiff to be 75% at fault (and B&W 25% at fault), and thus the compensatory award was reduced to $500,000. The jury also found that there were aggravating circumstances, which provided an entitlement to punitive damages. On February 2, 2005, the jury returned a verdict awarding the plaintiffs $20 million in punitive damages. On June 1, 2005, B&W filed its notice of appeal. Pursuant to its indemnification obligation, RJR Tobacco will post a supersedeas bond in the approximate amount of $24.3 million.

          On March 18, 2005, in Rose v. Brown and Williamson Tobacco Corp., a New York state court jury returned a verdict in favor of RJR Tobacco but returned a $3.42 million compensatory damages verdict against B&W and Philip Morris, of which $1.71 million was assigned to B&W. A punitive damages verdict of $17 million against Philip Morris only was returned by the jury on March 28, 2005. On August 18, 2005, B&W filed its notice of appeal. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the approximate amount of $2.058 million on February 7, 2006.

          On February 22, 2006, in VanDenBurg v. Brown and Williamson Tobacco Corp., a Missouri state court jury returned a verdict in favor of the defendants, including RJR Tobacco and B&W. In March 2006, the plaintiff filed a motion for new trial requesting evidentiary hearing.

Broin II Cases

          As of April 13, 2006, there were 2,626 lawsuits pending in Florida brought by individual flight attendants for personal injury as a result of illness allegedly caused by exposure to ETS in airplane cabins, referred to as the Broin II cases. In these lawsuits, filed pursuant to the terms of the settlement of the Broin v. Philip Morris, Inc. class action, discussed below under "—Class-Action Suits,” each individual flight attendant will be required to prove that he or she has a disease and that the individual’s exposure to ETS in airplane cabins caused the disease. Punitive damages are not available in these cases.

          On October 5, 2000, the Broin court entered an order applicable to all Broin II cases that the terms of the Broin settlement agreement do not require the individual Broin II plaintiffs to prove the elements of strict liability, breach of warranty or negligence. Under this order, there is a rebuttable presumption in the plaintiffs’ favor on those elements, and the plaintiffs bear the burden of proving that their alleged adverse health effects actually were caused by exposure to ETS. Below is a description of the Broin II cases against RJR Tobacco and B&W that went to trial, were decided, remained on appeal or were otherwise pending, since January 1, 2006.

          In Janoff v. Philip Morris, Inc., a Florida state court jury found in favor of the defendants, including RJR Tobacco and B&W, on September 5, 2002. The judge granted the plaintiff’s motion for a new trial on January 8, 2003. The defendants appealed to the Florida Third District Court of Appeal, which, on October 27, 2004, affirmed the trial court’s order. The defendants filed a notice of intent to invoke the discretionary jurisdiction of the Florida Supreme Court on June 17, 2005. On November 1, 2005, the Florida Supreme Court refused to hear the case. At this time, the plaintiff has not made any indication that the case will be retried.

          In Swaty v. Philip Morris, Inc., a Florida state court jury found in favor of the defendants, including RJR Tobacco and B&W, on May 3, 2005. The plaintiff filed a notice of appeal on July 21, 2005. Briefing is underway.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Class-Action Suits

          Overview

          As of April 13, 2006, 21 class-action cases were pending in the United States against RJR Tobacco or its affiliates or indemnitees, including B&W. In May 1996, in Castano v. American Tobacco Co., the Fifth Circuit Court of Appeals overturned the certification of a nationwide class of persons whose claims related to alleged addiction to tobacco products. Since this ruling by the Fifth Circuit, most class-action suits have sought certification of statewide, rather than nationwide, classes. Class-action suits based on claims similar to those asserted in Castano or claims that class members are at a greater risk of injury or injured by the use of tobacco or exposure to ETS are pending against RJR Tobacco and its affiliates and indemnitees, including B&W, in state or federal courts in California, Florida, Illinois, Louisiana, Minnesota, Missouri, New York, Oregon, Washington, West Virginia and the District of Columbia. Cases in which classes have been certified or class certification decisions are pending are discussed below.

          The pending class actions against RJR Tobacco or its affiliates or indemnitees, including B&W, include 11 cases alleging that the use of the terms “lights” and “ultra lights” constitutes unfair and deceptive trade practices. Such suits are pending in state or federal courts in Florida, Illinois, Louisiana, Minnesota, Missouri, New York and Washington. Each of these cases is discussed below.

          Finally, certain third-party payers have filed health-care cost recovery actions in the form of class actions. These cases are discussed separately below.

          Few smoker class-action complaints have been certified or, if certified, have survived on appeal. Seventeen federal courts that have considered the issue, including two courts of appeals, and most state courts have rejected class certification in smoking and health cases. Only one federal district court has certified a smoker class action — In re Simon (II) Litigation — which was filed in the U.S. District Court for the Eastern District of New York. In Simon (II), on September 19, 2002, the court certified a nationwide mandatory, non-opt-out punitive damages class. On February 14, 2003, the U. S. Court of Appeals for the Second Circuit granted the defendants’ petition to review the class certification decision. On May 6, 2005, the U. S. Court of Appeals for the Second Circuit, in a unanimous opinion, decertified the class. On August 8, 2005, the Second Circuit denied plaintiffs’ petition for rehearing and remanded the case for further proceedings to the District Court. On February 6, 2006, the court entered an order dismissing the case, but stayed the order for 30 days to give the class representatives, now individual plaintiffs, an opportunity to retain new counsel. On March 20, 2006, final judgment dismissing the case was entered. On February 10, 2003, in Simms v. Philip Morris, Inc., the U. S. District Court for the District of Columbia denied certification of a proposed nationwide class of smokers who purchased cigarettes while underage. The plaintiffs have filed several motions for reconsideration of the order that denied class certification. The case has been stayed pending resolution of United States v. Philip Morris USA, Inc.

          Medical Monitoring and Smoking Cessation Cases

          Classes have been certified in several state court class-action cases in which either RJR Tobacco or B&W is a defendant. On November 5, 1998, in Scott v. American Tobacco Co., a Louisiana state appeals court affirmed the certification of a medical monitoring or smoking cessation class of Louisiana residents who were smokers on or before May 24, 1996. On February 26, 1999, the Louisiana Supreme Court denied the defendants’ petition for review. Jury selection began on June 18, 2001 and was completed on September 23, 2002. Opening statements occurred on January 21, 2003. On July 28, 2003, the jury returned a verdict in favor of the defendants, including RJR Tobacco and B&W, on the plaintiffs’ claim for medical monitoring and found that cigarettes were not defectively designed. In addition, however, the jury made certain findings against the defendants, including RJR Tobacco and B&W, on claims relating to fraud, conspiracy, marketing to minors and smoking cessation. With respect to these findings, this portion of the trial did not determine liability as to any class member or class representative. What primarily remained in the case was a class-wide claim that the defendants, including RJR Tobacco and B&W, pay for a program to help people stop smoking. On March 31, 2004, phase two of the trial began to address the scope and cost of smoking cessation programs. On May 21, 2004, the jury returned a verdict in the amount of $591 million on the class’s claim for a smoking cessation program. On September 29, 2004, the defendants posted a $50 million bond (pursuant to legislation that limits the amount of the bond to $50 million collectively for MSA signatories) and noticed their appeal. RJR Tobacco posted $25 million (i.e., the portions for RJR Tobacco and B&W) towards the bond. Oral argument occurred on April 12, 2006. The defendants’ post-argument briefs were filed on April 28, 2006.

          In addition to the Scott case, two other medical monitoring class actions have been brought against RJR Tobacco, B&W, and other cigarette manufacturers. In Blankenship v. American Tobacco Co., the first tobacco-related

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

medical monitoring class action to be certified and to reach trial, a West Virginia state court jury found in favor of RJR Tobacco, B&W and other cigarette manufacturers on November 14, 2001. The West Virginia Supreme Court affirmed the judgment for the defendants on May 6, 2004. In Lowe v. Philip Morris, Inc., an Oregon state court judge dismissed the medical monitoring complaint on November 4, 2003, for failure to state a claim. The plaintiffs appealed, and oral argument before the Oregon Court of Appeals occurred on September 26, 2005. A decision is pending.

          Engle Case

          Trial began in July 1998 in Florida state court in Engle v. R. J. Reynolds Tobacco Co., in which a class consisting of Florida residents, or their survivors, alleges diseases or medical conditions caused by their alleged “addiction” to cigarettes. On July 7, 1999, the jury found against RJR Tobacco, B&W and the other cigarette-manufacturer defendants in the initial phase, which included common issues related to certain elements of liability, general causation and a potential award of, or entitlement to, punitive damages.

          The second phase of the trial, which consisted of the claims of three of the named class representatives, began on November 1, 1999. On April 7, 2000, the jury returned a verdict against all the defendants. It awarded plaintiff Mary Farnan $2.85 million, the estate of plaintiff Angie Della Vecchia $4.023 million and plaintiff Frank Amodeo $5.831 million. The jury also found, however, that Frank Amodeo knew or should have known of his claim prior to May 5, 1990. RJR Tobacco believes that the legal effect of that finding should be to bar his claim based on the applicable statute of limitations.

          The trial court also ordered the jury in the second phase of the trial to determine punitive damages, if any, on a class-wide basis. On July 14, 2000, the jury returned a punitive damages verdict in favor of the “Florida class” of approximately $145 billion against all the defendants, with approximately $36.3 billion and $17.6 billion being assigned to RJR Tobacco and B&W, respectively.

          On November 6, 2000, the trial judge denied all post-trial motions and entered judgment. In November 2000, RJR Tobacco and B&W posted appeal bonds in the amount of $100 million each, the maximum amount required pursuant to a Florida bond cap statute enacted on May 9, 2000, and intended to apply to the Engle case, and initiated the appeals process. On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court’s final judgment and remanded the case to the Miami-Dade County Circuit Court with instructions to decertify the class. On May 12, 2004, the Florida Supreme Court agreed to review the case. Oral argument occurred on November 3, 2004. The Florida Supreme Court has not yet ruled.

          On May 7, 2001, three of the non-RJR Tobacco and non-B&W defendants entered into agreements with the Engle class to deposit an additional $1.86 billion into separate escrow accounts to ensure that the stay of execution in effect pursuant to the Florida bond cap statute will remain in effect as to these three defendants throughout the appellate process, regardless of the results of a challenge, if any, to the Florida bond statute. Approximately $700 million of the total amount deposited by these three defendants is non-refundable and will go to the trial court to be distributed, regardless of the result of the appeal. RJR Tobacco and B&W did not enter into a similar agreement with the Engle class. Although RJR Tobacco cannot predict the outcome of any possible challenges to the Florida bond statute, RJR Tobacco remains confident of the applicability and validity of the statute in the Engle case.

          RJR Tobacco and/or B&W have been named as a defendant(s) in several individual cases filed by members of the Engle class. One such case, in which RJR Tobacco was dismissed prior to trial, Lukacs v. Philip Morris, Inc., was tried against Philip Morris, Liggett and B&W, and resulted in a verdict for the plaintiffs on June 11, 2002. The Florida state court jury awarded the plaintiffs a total of $37.5 million in compensatory damages. The jury assigned 22.5% fault to B&W, 72.5% fault to the other defendants and 5% fault to plaintiff John Lukacs. On April 1, 2003, the Miami-Dade County Circuit Court granted in part the defendants’ motion for remittitur and reduced the jury’s award to plaintiff Yolanda Lukacs, on the loss of consortium claim, from $12.5 million to $0.125 million decreasing the total award to $25.125 million. No final judgment will be entered until the Engle appeal is resolved, so the time to appeal this case has not yet begun to run.

          California Business and Professions Code Cases

          On November 30, 2000, in Daniels v. Philip Morris Cos., Inc., a San Diego Superior Court judge, based on a California unfair business practices statute, certified a class consisting of all persons who, as California resident minors, smoked one or more cigarettes in California between April 2, 1994 and December 1, 1999. The court granted the defendants’ motions for summary judgment on preemption and First Amendment grounds and dismissed the action on

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

October 21, 2002. On October 6, 2004, the California Court of Appeal, Fourth Appellate District, Division One, affirmed the trial court. On February 16, 2005, the California Supreme Court granted the plaintiffs’ petition for review. Briefing is complete. Oral argument has not been scheduled.

          On April 11, 2001, in Brown v. American Tobacco Co., Inc., the same judge in San Diego granted in part the plaintiffs’ motion for class certification. The class is composed of residents of California who smoked at least one of the defendants’ cigarettes from June 10, 1993 through April 23, 2001, and who were exposed to the defendants’ marketing and advertising activities in California. Certification was granted as to the plaintiffs’ claims that the defendants violated § 17200 of the California Business and Professions Code pertaining to unfair competition. The court, however, refused to certify the class under the California Legal Remedies Act and on the plaintiffs’ common law claims. Following the November 2004 passage of a proposition in California that changed the law regarding cases of this nature, the defendants filed a motion to decertify the class. On March 7, 2005, the court granted the defendants’ motion. The plaintiffs filed a notice of appeal on May 19, 2005. Briefing is complete. Oral argument has not been scheduled.

          “Lights” Cases

          As noted above, “lights” class-action cases are pending against RJR Tobacco or B&W in Illinois (2), Missouri (2), Minnesota (2), Louisiana (2), Florida (1), Washington (1) and New York (1). On November 14, 2001, in Turner v. R. J. Reynolds Tobacco Co., an Illinois state court judge (Madison County) certified a class defined as “[a]ll persons who purchased defendants’ Doral Lights, Winston Lights, Salem Lights and Camel Lights, in Illinois, for personal consumption, between the first date that defendants sold Doral Lights, Winston Lights, Salem Lights and Camel Lights through the date the court certifies this suit as a class action....” On June 6, 2003, RJR Tobacco filed a motion to stay the case pending Philip Morris’ appeal of the Price v. Philip Morris case, which is discussed below. On July 11, 2003, the judge denied the motion, and RJR Tobacco appealed to the Illinois Fifth District Court of Appeals. The Court of Appeals denied this motion on October 17, 2003. However, on October 24, 2003, a justice on the Illinois Supreme Court ordered an emergency stay of all proceedings pending review by the entire Illinois Supreme Court of RJR Tobacco’s emergency stay/supremacy order request filed on October 15, 2003. On November 5, 2003, the Illinois Supreme Court granted RJR Tobacco’s motion for a stay pending the court’s final appeal decision in Price. This case includes both RJR Tobacco and RJR as defendants.

          On December 18, 2001, in Howard v. Brown & Williamson Tobacco Corp., another Madison County, Illinois state court judge certified a class defined as “[a]ll persons who purchased Defendant’s Misty Lights, GPC Lights, Capri Lights and Kool Lights cigarettes in Illinois for personal consumption, from the first date that Defendant sold Misty Lights, GPC Lights, Capri Lights and Kool Lights cigarettes in Illinois through this date.” On June 6, 2003, the trial judge issued an order staying all proceedings pending resolution of the Price v. Philip Morris case, discussed below. The plaintiffs appealed this stay order to the Illinois Fifth District Court of Appeals, which affirmed the Circuit Court’s stay order on August 19, 2005.

          A “lights” class-action case is pending in the same jurisdiction in Illinois against Philip Morris, Price v. Philip Morris, Inc., formerly known as Miles v. Philip Morris, Inc. Trial began on January 21, 2003. On March 21, 2003, the trial judge entered judgment against Philip Morris in the amount of $7.1 billion in compensatory damages and $3 billion in punitive damages to the State of Illinois. Based on Illinois law, the bond required to stay execution of the judgment was set initially at $12 billion. Because of the difficulty of posting a bond of that magnitude, Philip Morris pursued various avenues of relief from the $12 billion bond requirement. On April 14, 2003, the trial judge reduced the amount of the bond. He ordered the bond to be secured by $800 million, payable in four equal quarterly installments beginning in September 2003, and a pre-existing $6 billion long-term note to be placed in escrow pending resolution of the case. The plaintiffs appealed the judge’s decision to reduce the amount of the bond. On July 14, 2003, the appeals court ruled that the trial judge exceeded his authority in reducing the bond and ordered the trial judge to reinstate the original bond. On September 16, 2003, the Illinois Supreme Court ordered that the reduced bond be reinstated and agreed to hear Philip Morris’ appeal without need for intermediate appellate court review. On December 15, 2005, the Illinois Supreme Court reversed the lower state court’s decision and sent the case back to the lower court with instructions to dismiss the case. On January 5, 2006, the plaintiffs filed a petition for rehearing. In the event RJR Tobacco and its affiliates or indemnitees, including B&W, lose the Turner or Howard cases, or one or more of the other pending “lights” class action suits, RJR Tobacco could face similar bonding difficulties depending upon the amount of damages ordered, if any, which could have a material adverse effect on RJR Tobacco’s, and consequently RAI’s, results of operations, cash flows or financial condition.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          A “lights” class-action case is pending against each of RJR Tobacco and B&W in Missouri. On December 31, 2003, in Collora v. R. J. Reynolds Tobacco Co., a Missouri state court judge in St. Louis certified a class defined as “[a]ll persons who purchased Defendants’ Camel Lights, Camel Special Lights, Salem Lights and Winston Lights cigarettes in Missouri for personal consumption between the first date the Defendants placed their Camel Lights, Camel Special Lights, Salem Lights and Winston Lights cigarettes into the stream of commerce through the date of this Order.” On January 14, 2004, RJR and RJR Tobacco, the only named defendants, removed this case to the U. S. District Court for the Eastern District of Missouri. On September 30, 2004, the case was remanded to the Circuit Court for the City of St. Louis. On September 23, 2005, RJR Tobacco again removed the case to the U. S. District Court for the Eastern District of Missouri, based on the U. S. Court of Appeals for the Eighth Circuit’s August 25, 2005 decision in Watson v. Philip Morris Companies, Inc., which upheld the federal officers removal statute as a basis for removal in “lights” cases. The plaintiffs’ motion to remand was granted on April 18, 2006.

          In Black v. Brown & Williamson Tobacco Corp., B&W removed the case to the U. S. District Court for the Eastern District of Missouri on September 23, 2005. On October 25, 2005, the plaintiffs filed a motion to remand, which was granted on March 17, 2006, returning the case back to the Circuit Court of the City of St. Louis.

          Schwab [McLaughlin] v. Philip Morris USA, Inc., a nationwide “lights” class action, was filed on May 11, 2004, in the U.S. District Court for the Eastern District of New York , against RJR Tobacco and B&W, as well as other tobacco manufacturers. The plaintiffs’ motion for class certification and summary judgment motions by both sides were heard on September 12, 2005 and September 13, 2005. Although trial was scheduled to commence on January 9, 2006, the court decided to permit several months of additional discovery before deciding the class certification issue.

          RJR Tobacco and B&W, respectively, removed two Louisiana “lights” class actions to federal court. In Harper v. R. J. Reynolds Tobacco Co., on January 27, 2005, the federal judge denied the plaintiffs’ motions to remand. The plaintiffs appealed the denial of the motion to remand on February 15, 2005. Oral argument is tentatively scheduled for July 10, 2006. On June 17, 2005, RJR Tobacco filed a motion for summary judgment based on federal preemption. In Brown v. Brown & Williamson Tobacco Corp., B&W filed a similar motion for summary judgment on July 5, 2005. On September 14, 2005, B&W’s motion was granted in part by dismissing with prejudice the plaintiffs’ Louisiana Unfair Trade and Consumer Protection Act claims. The remainder of the motion was denied. On December 2, 2005, the judge denied B&W’s motion for reconsideration, but the judge granted an immediate appeal. In January 2006, B&W filed a petition to the U.S. Court of Appeals for the Fifth Circuit for permission to appeal, which was granted on February 10, 2006. Briefing is underway.

          In Dahl v. R. J. Reynolds Tobacco Co., a Minnesota state court judge dismissed the case on May 11, 2005, because the “lights” claims are preempted by the Federal Cigarette Labeling and Advertising Act. On July 11, 2005, the plaintiffs filed a notice of appeal with the Minnesota Court of Appeals for the Fourth Judicial District. During the pendency of the appeal, RJR Tobacco removed the case to the United States District Court for the District of Minnesota, based on Watson v. Philip Morris Companies, Inc. (described above). On October 17, 2005, the plaintiffs filed a motion to remand, which was denied on February 14, 2006. On March 7, 2006, the parties requested that the case be transferred to the U. S. Court of Appeals for the Eighth Circuit, which was granted on March 9, 2006. The plaintiffs have appealed the order that granted the transfer and the order that denied their motion to remand. On April 5, 2006, the Eighth Circuit dismissed the plaintiffs’ appeal of the order denying remand for lack of jurisdiction. The plaintiffs may address the remand decision in the appeal of the preemption ruling.

          In Thompson v. R.J. Reynolds Tobacco Co., also pending in Minnesota, RJR Tobacco removed the case on September 23, 2005 to the United States District Court for the District of Minnesota, also based on Watson v. Philip Morris Companies, Inc. On October 21, 2005, the plaintiffs filed a motion to remand, which was denied on February 14, 2006.

          In Huntsberry v. R. J. Reynolds Tobacco Co. (Washington), the plaintiffs’ motion for class certification was denied on April 21, 2006. Finally, in Rios v. R. J. Reynolds Tobacco Co. (Florida), the case is dormant pending plaintiffs’ counsel’s attempt to appeal the Florida Fourth District Court of Appeal’s decertification in Hines v. Philip Morris, Inc.

          Broin Settlement

          RJR Tobacco, B&W and other cigarette manufacturer defendants settled one class-action suit, Broin v. Philip Morris, Inc., in October 1997. This case had been brought in Florida state court on behalf of all flight attendants of U.S. airlines alleged to be suffering from diseases or ailments caused by exposure to ETS in airplane cabins. The settlement agreement required the participating tobacco companies to pay a total of $300 million in three annual $100 million installments, allocated among the companies by market share, to fund research on the early detection and cure of

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

diseases associated with tobacco smoke. It also required those companies to pay a total of $49 million for the plaintiffs’ counsel’s fees and expenses. RJR Tobacco’s portion of these payments was approximately $86 million; B&W’s portion of these payments was approximately $57 million. The settlement agreement bars class members from bringing aggregate claims or obtaining punitive or exemplary damages and also bars individual claims to the extent that they are based on fraud, misrepresentation, conspiracy to commit fraud or misrepresentation, RICO, suppression, concealment or any other alleged intentional or willful conduct. The defendants agreed that, in any individual case brought by a class member, the defendant will bear the burden of proof with respect to whether ETS can cause certain specifically enumerated diseases, referred to as “general causation.” With respect to all other issues relating to liability, including whether an individual plaintiff’s disease was caused by his or her exposure to ETS in aircraft cabins, referred to as “specific causation,” the individual plaintiff will have the burden of proof. Florida’s Third District Court of Appeal denied various challenges to this settlement on March 24, 1999, and subsequently denied motions to reconsider. On September 7, 1999, the Florida Supreme Court approved the settlement. The Broin II cases, discussed above, arose out of the settlement of this case.

Governmental Health-Care Cost Recovery Cases

     MSA and Other State Settlement Agreements

          In June 1994, the Mississippi attorney general brought an action, Moore v. American Tobacco Co., against various industry members, including RJR Tobacco and B&W. This case was brought on behalf of the state to recover state funds paid for healthcare and other assistance to state citizens suffering from diseases and conditions allegedly related to tobacco use. Most other states, through their attorneys general or other state agencies, sued RJR Tobacco, B&W and other U.S. cigarette manufacturers based on similar theories. The cigarette manufacturer defendants, including RJR Tobacco and B&W, settled the first four of these cases scheduled for trial — Mississippi, Florida, Texas and Minnesota — by separate agreements with each such state.

          On November 23, 1998, the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, entered into the MSA with attorneys general representing the remaining 46 states, the District of Columbia, Puerto Rico, Guam, the Virgin Islands, American Samoa and the Northern Marianas. The MSA became effective on November 12, 1999, and settled all the health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions and contained releases of various additional present and future claims.

          In the settling jurisdictions, the MSA released RJR Tobacco, B&W, and their affiliates and indemnitees, including RAI, from:

	•		all claims of the settling states and their respective political subdivisions and other recipients of state health-care funds, relating to past conduct arising out of the use, sale, distribution, manufacture, development, advertising, marketing or health effects of, the exposure to, or research, statements or warnings about, tobacco products; and
	•		all monetary claims of the settling states and their respective political subdivisions and other recipients of state health-care funds, relating to future conduct arising out of the use of or exposure to, tobacco products that have been manufactured in the ordinary course of business.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          Set forth below are tables depicting the unadjusted tobacco industry settlement payment schedule and the settlement payment schedule for RAI’s operating subsidiaries under the MSA and other state settlement agreements and related information for 2004 and beyond:

Unadjusted Original Participating Manufacturers’ Settlement Payment Schedule

																										2010 and
		2004				2005				2006				2007				2008				2009				thereafter
		(Dollars in Millions)
First Four States’ Settlements: (1)
Mississippi Annual Payment		$	136			$	136			$	136			$	136			$	136			$	136			$	136
Florida Annual Payment			440				440				440				440				440				440				440
Texas Annual Payment			580				580				580				580				580				580				580
Minnesota Annual Payment			204				204				204				204				204				204				204
Remaining States’ Settlement:
Annual Payments(1)			7,004				7,004				7,004				7,004				7,143				7,143				7,143
Additional Annual Payments (through 2017)(1)			—				—				—				—				861				861				861
Base Foundation Funding			25				25				25				25				25				—				—
Growers’ Trust (through 2010) (2)			500				500				500				500				500				295				295
Offset by federal tobacco buyout (2)			—				(500	)			(500	)			(500	)			(500	)			(295	)			(295	)
Minnesota Blue Cross and Blue Shield			—				—				—				—				—				—				—
Total		$	8,889			$	8,389			$	8,389			$	8,389			$	9,389			$	9,364			$	9,364

RAI’s Operating Subsidiaries’ Settlement Expenses and Payment Schedule

RJR Tobacco’s settlement expenses(3)		$	2,169			$	2,583				—				—				—				—				—
RJR Tobacco’s cash payments(3)		$	2,037			$	2,718				—				—				—				—				—
Other operating subsidiaries’ settlement expenses		$	14			$	17				—				—				—				—				—
Other operating subsidiaries’ cash payments		$	9			$	14				—				—				—				—				—
RJR Tobacco’s projected settlement expenses			—				—				>$2,550				>$2,700				>$2,700				>$2,700				>$2,700
RJR Tobacco’s projected cash payments			—				—				>$2,600				>$2,550				>$2,700				>$2,700				>$2,700

          The MSA also contains provisions restricting the marketing of cigarettes. Among these provisions are restrictions or prohibitions on the use of cartoon characters, brand-name sponsorships, apparel and other merchandise, outdoor and transit advertising, payments for product placement, free sampling and lobbying. The MSA also required the dissolution of three industry-sponsored research and trade organizations.

          The MSA and other state settlement agreements have materially adversely affected RJR Tobacco’s shipment volumes. RAI believes that these settlement obligations may materially adversely affect the results of operations, cash flows or financial condition of RAI and RJR Tobacco in future periods. The degree of the adverse impact will depend, among other things, on the rate of decline in U.S. cigarette sales in the premium and discount categories, RJR Tobacco’s share of the domestic premium and discount cigarette categories, and the effect of any resulting cost advantage of manufacturers not subject to the MSA and other state settlement agreements.

     Department of Justice Case

     On September 22, 1999, the U. S. Department of Justice brought an action in the U. S. District Court for the District of Columbia against various industry members, including RJR Tobacco and B&W. In its complaint, the government sought to recover federal funds expended in providing health care to smokers who have developed diseases and injuries alleged to be smoking-related, and, in addition, pursuant to the federal RICO statute, sought disgorgement of profits the government contends were earned as a consequence of a RICO racketeering “enterprise.” On December 27, 1999, the defendants filed a motion to dismiss. On September 28, 2000, the court granted the non-Liggett

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

defendants’ motion to dismiss the plaintiff’s Medical Care Recovery Act claim and Medicare Secondary Payer claim. The court denied the motion with respect to the RICO claims.

          On May 23, 2003, the court denied the defendants’ first motion for partial summary judgment, which sought legal preclusion of many aspects of the DOJ’s lawsuit regarding advertising, marketing, promotion and warning claims. The court simultaneously granted partial summary judgment for the government on certain affirmative defenses.

          In the fall of 2003, the defendants filed nine additional summary judgment motions, including motions regarding the government’s RICO claims, and the government filed six additional summary judgment motions, including motions regarding certain of the industry’s affirmative defenses. The defendants’ motions included a motion for partial summary judgment to dismiss the government’s disgorgement claim. Such motion was denied by the court in May 2004, and the defendants then appealed the ruling to the U.S. Court of Appeals for the District of Columbia Circuit. In February 2005, the appeals court ruled that disgorgement is not an available remedy in this case. After the government’s petition for panel rehearing and rehearing en banc was denied, the government filed, in July 2005, a petition for writ of certiorari with the U.S. Supreme Court. In October 2005, the Supreme Court denied the government’s petition. This ruling eliminated the government’s claim for $280 billion and limits the government’s potential remedies principally to forward-looking relief, including measures such as those already included in the MSA.

          The bench (non-jury) trial began on September 21, 2004, and closing arguments concluded on June 10, 2005. Also on June 10, 2005, the court ordered the parties to file a variety of post-trial submissions. On July 22, 2005, the court granted a motion to intervene filed by six organizations, including the American Cancer Society, to allow them to “contribute their perspective on what appropriate and legally permissible remedies may be imposed should liability be found.” On August 15, 2005, the parties filed their proposed findings of fact. Post-trial briefing was completed on October 9, 2005.

     Local Government Cases

          Some local government entities have filed lawsuits based largely on the same theories and seeking the same relief as the state attorneys general cases. However, as of April 13, 2006, there were no such cases pending.

     International Cases

          A number of foreign countries have filed suit in state and federal courts in the U. S. against RJR Tobacco, B&W and other tobacco industry defendants to recover funds for health-care, medical and other assistance paid by those foreign governments to their citizens. In Venezuela v. Philip Morris Cos., Inc., Florida’s Third District Court of Appeal affirmed the trial court’s dismissal on October 1, 2002. The Florida Supreme Court declined Venezuela’s petition for review. The court further indicated that it would not entertain a motion for rehearing. In light of the Venezuela decision, on August 25, 2003, the Circuit Court of Miami-Dade County, Florida, granted the defendants’ motion for judgment on the pleadings in two additional cases brought by foreign sovereigns — Republic of Tajikistan v. Brooke Group Ltd., Inc. and State of Tocantins, Brazil v. Brooke Group Ltd., Inc. This ruling led 22 other foreign nations to dismiss their cases.

          There are two health-care reimbursement cases currently pending against RJR Tobacco and its affiliates or indemnitees, including B&W, in the U. S., both in Delaware: Republic of Panama v. The American Tobacco Co. and State of Sao Paulo v. The American Tobacco Co. The cases, originally filed in Louisiana, were consolidated and then dismissed by the trial court on the basis that Louisiana is not an appropriate forum. The plaintiffs have asked the trial court for reconsideration and, at the same time, noticed an appeal to the Louisiana Court of Appeals. These plaintiffs filed new cases in the Superior Court for the State of Delaware in and for New Castle County on July 19, 2005. A hearing on the defendants’ motion to dismiss occurred on April 7, 2006. A decision is pending.

          Two other health-care reimbursement cases are pending against RJR Tobacco or B&W outside the U. S., one in each of Canada and Israel. Other foreign governments and entities have stated that they are considering filing such actions in the U. S.

          On November 12, 1998, the government of British Columbia enacted legislation creating a civil cause of action permitting the government to directly recoup the costs of health-care benefits incurred for B.C. residents arising from tobacco-related disease. The government filed suit against Canadian defendants and numerous foreign defendants served ex juris, including RJR Tobacco. On February 21, 2000, in response to certain defendants’ motions, the Supreme Court of British Columbia ruled that the legislation was unconstitutional. The government’s action was dismissed, and service ex juris was set aside for that reason. The government then enacted a revised statute and brought a new action. Three Canadian defendants challenged the legislation on constitutional grounds and certain foreign

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

defendants (including RJR Tobacco) moved to set aside service ex juris. On June 5, 2003, the government’s action was dismissed, and service ex juris was set aside. The government appealed. On May 20, 2004, the Court of Appeal held that the statute was constitutionally valid and remitted the ex juris motions to the trial court for further consideration. On June 22, 2004, the Canadian defendants, as well as three ex juris defendants, appealed to the Supreme Court of Canada. On September 28, 2005, the Supreme Court ruled that the statute is constitutionally valid. On June 23, 2005, the trial court found that service was proper. On July 19, 2005, RJR Tobacco filed its notice of appeal of this ruling. The appellate hearing occurred in February 2006. A decision is pending.

     On September 1, 1998, the General Health Services filed a statement of claim against certain cigarette manufacturers, including RJR Tobacco and B&W, in the District Court of Jerusalem, Israel. In 2002, the plaintiff obtained leave to serve RJR Tobacco and B&W outside the jurisdiction. On behalf of RJR Tobacco, JTI filed a motion challenging the grant of leave, which was denied. JTI appealed the decision to the Supreme Court. A hearing occurred on February 14, 2005, and a decision is pending.

     Pursuant to the terms of the 1999 sale of RJR Tobacco’s international tobacco business, JTI assumed RJR Tobacco’s liability, if any, in the health-care cost recovery cases brought by foreign countries.

Other Health-Care Cost Recovery and Aggregated Claims Cases

     Although the MSA settled some of the most potentially burdensome health-care cost recovery actions, many other such cases have been brought by other types of plaintiffs. Unions, groups of health-care insurers, a private entity that purported to self-insure its employee health-care programs, Native American tribes, hospitals, universities, taxpayers and senior associations have advanced claims similar to those found in the governmental health-care cost recovery actions. These cases largely have been unsuccessful on remoteness grounds, which means that one who pays an injured person’s medical expenses is legally too remote to maintain an action against the person allegedly responsible for the injury.

          As of April 13, 2006, three other health-care cost recovery cases were pending in the U. S. against RJR Tobacco, B&W, as its indemnitee, or both.

     Union Cases

          As of April 13, 2006, there were no pending lawsuits by union trust funds against cigarette manufacturers.

          Numerous trial court judges have dismissed union trust fund cases on remoteness grounds. The first and only union case to go to trial to date was Iron Workers Local No. 17 v. Philip Morris, Inc., which was tried in federal court in Ohio. On March 18, 1999, the jury returned a unanimous verdict for the defendants, including RJR Tobacco and B&W. The plaintiffs dismissed their appeal of the verdict.

          Since March 1999, the U. S. Courts of Appeals for the Second, Third, Fifth, Seventh, Eighth, Ninth, Eleventh and District of Columbia Circuits all have ruled in favor of the tobacco industry in similar union cases. The U. S. Supreme Court has denied petitions for certiorari filed by unions in cases from the Second, Third, Ninth and District of Columbia Circuits.

     Native American Tribe Cases

          As of April 13, 2006, one Native American tribe case was pending before a tribal court in South Dakota against RJR Tobacco and B&W, Crow Creek Sioux Tribe v. American Tobacco Co. The case is dormant at this time.

     Hospital Cases

          As of April 13, 2006, one case brought by one or more hospitals was pending against cigarette manufacturers, including RJR Tobacco and B&W: City of St. Louis v. American Tobacco Co., Inc., pending in the Circuit Court of the City of St. Louis, Missouri. 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. On June 28, 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. On March 7, 2006, the defendants filed a motion to transfer the case to the court en banc and to appoint five special judges to enable the case to be heard by a full seven member court, which was denied on March 13, 2006. In an order dated May 2, 2006, the Missouri Supreme Court resolved a discovery dispute, the pendancy of which had stayed the case, in favor of RJR Tobacco and B&W. The case will now be remanded to the trial court where a new discovery and trial schedule will be set.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

     Other Cases

          On August 4, 2005, the United Seniors Association filed a case against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, in the U. S. District Court for the District of Massachusetts. The plaintiff is bringing the action as a “private attorney general” pursuant to the private cause of action provisions of the Medicare as Secondary Payer statute. The case seeks to recover for the Medicare program all of the expenditures that the Medicare program made from August 4, 1999, to present for the health care services rendered to Medicare’s beneficiaries for the treatment of diseases attributable to smoking including, but not limited to, coronary heart disease, chronic obstructive pulmonary disease, lung cancer, emphysema, peripheral vascular disease and atherosclerosis. On October 24, 2005, the defendants filed a motion to dismiss or, in the alternative, transfer the case to the U. S. District Court for the Middle District of Florida. A hearing is scheduled for May 24, 2006.

          Effective August 2005, Minnesota enacted a “health impact fee” that imposes a $0.75 per pack fee on cigarettes, which is in addition to that state’s cigarette excise tax of $0.48 per pack. The stated purpose of the health impact fee is “to recover for the state health care costs related to or caused by tobacco use.” RJR Tobacco and other cigarette manufacturers filed a motion in Minnesota state court asserting that imposition of the health impact fee violates the terms of the settlement agreement entered into between participating manufacturers and Minnesota in 1998. For additional information concerning the status of this pending matter, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Governmental Activity.” Minnesota’s health impact fee also led to the January 2006 filing of a class action complaint in the Fourth Judicial District of Minnesota State Court on behalf of “consumers of cigarettes and other tobacco products in the State of Minnesota from August 1, 2005 to the present.” The class-action complaint names RJR Tobacco and various other entities as defendants, and asserts an unjust enrichment claim, seeks the imposition of a constructive trust with respect to the monies collected pursuant to the health impact fee, and requests that these monies “be distributed by the best means practicable to the Class members.” This case has been transferred to the court presiding over RJR Tobacco’s above-referenced motion seeking to enforce the terms of the parties’ 1998 settlement agreement.

MSA-Enforcement and Validity

          As of April 13, 2006, there were four cases pending against RJR Tobacco or B&W concerning the enforcement and validity of the MSA and other state settlement agreements. This amount excludes 26 additional cases filed subsequent to April 13, 2006, and discussed below, relating to disputed payments under the MSA.

          On April 7, 2004, a class action lawsuit, Sanders v. Philip Morris USA, Inc., was filed in the Superior Court of Los Angeles County against RJR, RJR Tobacco, Philip Morris, Altria and B&W. The case was brought on behalf of California residents who purchased cigarettes in California from April 2, 2000 to the present. The plaintiff generally alleged that the MSA was anticompetitive in that the defendants used the terms of the MSA to reduce competition and to raise the price of cigarettes. The plaintiff voluntarily dismissed this state court case, and on June 9, 2004, filed a new action in the U. S. District Court for the Northern District of California. The defendants are RJR Tobacco, B&W, Philip Morris, Lorillard and Bill Lockyer, in his capacity as Attorney General for the State of California. The plaintiff asserts claims for declaratory and injunctive relief based on preemption and Supremacy Clause grounds (alleging that the MSA supposedly is inconsistent with the federal antitrust laws), for injunctive relief based on claimed violations of the Sherman Act, for damages and injunctive relief based on claimed violations of California’s state antitrust law (the Cartwright Act), for an accounting of profits based on claimed statutory and common law theories of unfair competition, and for restitution based on claimed unjust enrichment. On March 29, 2005, the U. S. District Court for the Northern District of California granted the defendants’ motion to dismiss with prejudice. The plaintiff’s notice of appeal was filed on April 18, 2005. Briefing is complete. Oral argument has not been scheduled.

          On May 27, 2004, the State of Texas filed a motion to enforce B&W’s 1998 settlement agreement with that state. The motion alleges that B&W owes the state approximately $16.4 million in past settlement payments, plus interest, with respect to cigarettes that B&W contract manufactured for Star Tobacco, Inc. The motion also alleges that B&W’s entry into the business combination agreement with RJR violates a provision of the Texas settlement agreement that requires all parties to the settlement agreement to consent to its assignment. The motion asks the court to award damages, order an accounting, and prohibit B&W from assigning the settlement agreement without the consent of the state. On March 28, 2005, the U. S. District Court for the District of Texas, Texarkana Division, entered final judgment in favor of B&W. On April 27, 2005, the State of Texas filed a notice of appeal to the U. S. Court of Appeals for the Fifth Circuit. Briefing is complete. Oral argument has not been scheduled.

          On March 28, 2005, the National Association of Attorneys General, referred to as NAAG, sent a notice, signed by 40 Attorneys General that one or more of the states intend to initiate proceedings against RJR Tobacco for violating Section III(r) of the MSA, the various Consent Decrees implementing the MSA and/or consumer fraud statutes in various states, all in connection with RJR Tobacco’s advertisements for ECLIPSE cigarettes. After a June 2005 meeting between representatives of RJR Tobacco and NAAG, the Vermont Attorney General filed suit in July 2005, in

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

the Vermont Superior Court alleging that certain Eclipse advertising violated both the MSA and the Vermont Consumer Fraud Statute. The State of Vermont is seeking declaratory, injunctive, and monetary relief. RJR Tobacco has answered the complaint. Discovery is underway.

          On April 13, 2005, the Mississippi Attorney General notified B&W of its intent to seek approximately $3.9 million in additional payments under the Mississippi Settlement Agreement. The Mississippi Attorney General asserts that B&W failed to report in its net operating profit or its shipments cigarettes manufactured by B&W under contract for Star Tobacco or its parent, Star Scientific, Inc. On April 28, 2005, B&W advised the state that it did not owe the state any money. On August 11, 2005, the Mississippi Attorney General filed a Notice of Violation, Motion to Enforce Settlement Agreement, and Request for an Accounting by Defendant Brown & Williamson Holdings, Inc., formerly known as Brown & Williamson Tobacco Corporation. In this filing, Mississippi estimated that its damages now exceed $5.0 million. This matter is currently in the discovery phase.

          RJR Tobacco has settled certain cases concerning the enforcement of the MSA and other state settlement agreements. In California v.
R. J. Reynolds Tobacco Co., a case involving the placement of advertising in magazines, the trial court, in a decision issued in 2002, found that “although youth may not have been directly targeted...RJR indirectly targeted youth thereby violating the MSA.” The parties ultimately settled the case in December, 2004, and RJR Tobacco paid approximately $11.4 million in civil penalties and $5.9 million in attorneys’ fees. Additionally, RJR Tobacco agreed to avoid advertising in magazines with more than 15% teen readership

          On October 5, 2004, RJR Tobacco and its affiliates and indemnitees, including B&W, settled certain claims alleging that B&W’s “Kool Mixx” advertising campaign violated the MSA’s prohibitions on youth targeting, placement of tobacco brand names in media and tobacco brand name merchandise. Although the companies admitted no wrongdoing in the settlement agreement, RJR Tobacco paid a total of $1.5 million, $1.46 million of which will be paid to four not-for-profit organizations for youth smoking prevention programs. In addition, RJR Tobacco agreed to certain restrictions on selected elements of marketing support for future Kool Mixx promotions.

     The MSA includes an adjustment, referred to as an NPM Adjustment, that potentially reduces RJR Tobacco’s and other participating manufacturers’ annual payment obligations. Certain requirements must be satisfied before the NPM Adjustment, which relates to a specified market year, is available. An independent auditor designated under the MSA must determine that the participating manufacturers have experienced a certain market share loss to those manufacturers, referred to as NPMs, that do not participate in the MSA, and an independent firm of economic consultants must find that the disadvantages of the MSA were a significant factor contributing to such loss. For 2003, the MSA independent auditor determined that the participating manufacturers suffered a market share loss sufficient to trigger an NPM Adjustment. In March 2006, the independent economic consulting firm issued a final, non-appealable determination that the disadvantages of the MSA were “a significant factor contributing” to the 2003 market share loss. Based on the foregoing determinations, on April 17, 2006, RJR Tobacco placed approximately $647 million of its MSA payment into a disputed payments account, in accordance with a procedure established by the MSA. That amount represented RJR Tobacco’s share of the 2003 NPM Adjustment as calculated by the MSA independent auditor.

     The settling states contend they have diligently enforced their respective Qualifying Statutes, within the meaning of the MSA, and that RJR Tobacco and other participating manufacturers are not entitled to the 2003 NPM Adjustment. The settling states also contend that this dispute must be resolved by MSA courts in each of the 52 settling states and territories. RJR Tobacco believes that the MSA requires that this dispute be resolved by arbitration before a panel of three former federal judges. Between April 13 and May 2, 2006, 26 of the settling states filed legal proceedings in their respective courts seeking declaratory orders that they diligently enforced their Qualifying Statutes during 2003 and/or orders compelling RJR Tobacco and the other participating manufacturers that placed money in the disputed payments account to pay such disputed amounts to the settling states. RJR Tobacco intends to defend these proceedings vigorously by, among other things, moving to compel arbitration as provided in the MSA.

     To date, courts in two states, Connecticut and New York, have addressed whether disputes concerning the 2003 NPM Adjustment are arbitrable. Courts in both states have held that arbitration is required under the MSA. The decision in Connecticut is currently on appeal to the Connecticut Supreme Court.

Asbestos Contribution Cases

          As of April 13, 2006, one lawsuit was pending against RJR Tobacco and B&W in which asbestos companies and/or asbestos-related trust funds allege that they “overpaid” claims brought against them to the extent that tobacco use, not asbestos exposure, was the cause of the alleged personal injuries, Fibreboard Corp. v. R. J. Reynolds Tobacco Co., pending in state court in California. Motions to dismiss those claims have been stayed indefinitely.

Antitrust Cases

          A number of tobacco wholesalers and consumers have sued U.S. cigarette manufacturers, including RJR Tobacco and B&W, in federal and state courts, alleging that cigarette manufacturers combined and conspired to set the price of cigarettes in violation of antitrust statutes and various state unfair business practices statutes. In these cases, the plaintiffs asked the court to certify the lawsuits as class actions on behalf of other persons who purchased cigarettes directly or indirectly from one or more of the defendants. The federal cases against RJR Tobacco and B&W were consolidated and sent by the Judicial Panel on Multi-District Litigation for pretrial proceedings in the U. S. District Court for the Northern District of Georgia. The court certified a nation-wide class of direct purchasers on January 27, 2001. The court granted the defendants’ motion for summary judgment in the consolidated federal cases on July 11, 2002, and the U. S. Court of Appeals for the Eleventh Circuit affirmed that decision on September 22, 2003. As of April 13, 2006, all state court cases on behalf of indirect purchasers have been dismissed, except for one case pending in each of Kansas and New Mexico. The Kansas court granted class certification on November 15, 2001, while the New Mexico court granted class certification on May 14, 2003. On February 8, 2005, the New Mexico Court of Appeals affirmed the trial court’s certification order. The defendants have moved for summary judgment in New Mexico.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          In a gray market trademark suit originally brought by RJR Tobacco in 1999 in the U. S. District Court for the Northern District of Illinois, Cigarettes Cheaper! asserted antitrust counterclaims, alleging that it was denied promotional resources in violation of the Robinson-Patman Act and that RJR Tobacco had violated Section 1 of the Sherman Antitrust Act. On June 25, 2003, the court granted RJR Tobacco’s motion for summary judgment on Cigarettes Cheaper!’s counterclaim alleging an illegal conspiracy under the Sherman Antitrust Act, but denied the motion with respect to the counterclaims alleging price discrimination under the Robinson-Patman Act. The court severed RJR Tobacco’s trademark claims (including a trademark dilution claim) from the defendants’ Robinson-Patman claims. Trial on the trademark claims began on April 25, 2004, and on May 5, 2004, the jury returned a verdict in favor of RJR Tobacco on all counts in the amount of $3.5 million. Trial began on the Robinson-Patman claims on September 14, 2004, and on October 15, 2004, the jury returned a unanimous verdict in favor of RJR Tobacco. On December 8, 2004, the plaintiff appealed to the U. S. Court of Appeals for the Seventh Circuit. Oral argument occurred on September 12, 2005, and RJR Tobacco is awaiting the ruling.

          On February 16, 2000, an antitrust class-action complaint, DeLoach v. Philip Morris Cos., Inc., was brought against RJR Tobacco, B&W and other cigarette manufacturers and others, in the U. S. District Court for the District of Columbia on behalf of a class of all tobacco growers and tobacco allotment holders. The plaintiffs asserted that the defendants conspired to fix the price of tobacco leaf and to destroy federal government’s tobacco quota and price support program. On November 30, 2000, the case was moved to U. S. District Court for the Middle District of North Carolina. In May 2003, the plaintiffs reached a court-approved settlement with B&W and other cigarette manufacturer defendants, but not RJR Tobacco. The settling defendants agreed to pay $210 million to the plaintiffs, of which B&W’s share was $23 million, to pay the plaintiffs’ attorneys’ fees as set by the court, of which B&W’s share was $9.8 million, and to purchase a minimum amount of U.S. leaf for ten years, expressed as both a percentage of domestic requirements, with 35% for B&W, and as a minimum number of pounds per year, with 55 million pounds for B&W.

          On April 22, 2004, RJR Tobacco and the plaintiffs settled, and the court approved that settlement on March 21, 2005. Under that settlement, RJR Tobacco paid $33 million into a settlement fund, which included costs and attorneys fees. RJR Tobacco also agreed to purchase annually a minimum of 90 million pounds, including the assumed obligation of B&W, of domestic green leaf flue-cured and burley tobacco combined for the next 10 years, beginning with the 2004 crop year. As agreed in settlement, the obligation to purchase leaf was extended an additional year because the federal government eliminated the tobacco price quota and price support program at the end of 2005.

          Pursuant to an amended complaint filed in the U. S. District Court for the Eastern District of Tennessee on October 23, 2003, in Smith Wholesale Co. v. R.J. Reynolds Tobacco Co., Smith Wholesale and Rice Wholesale asserted federal antitrust claims in connection with RJR Tobacco’s termination of distribution agreements with the plaintiffs. Additional wholesalers, together with the states of Tennessee and Mississippi, have joined the case as plaintiffs. On June 3, 2005, the District Court granted summary judgment in RJR Tobacco’s favor. On June 23, 2005, the district court dismissed the entire case. On June 23, 2005, the plaintiffs filed a notice of appeal of the summary judgment and dismissal. RJR Tobacco reached a non-monetary settlement with one wholesaler and with the states of Tennessee and Mississippi on July 22, 2005. Those plaintiffs have dropped their appeal. RJR Tobacco terminated its distribution agreement with four plaintiffs, and those plaintiffs moved for preliminary injunctions in the district court and court of appeals. The courts denied those motions on November 28 and November 29, 2005, respectively. Oral argument in the U.S. Court of Appeals for the Sixth Circuit occurred on April 21, 2006. In March 2006, McLane Company, Inc., a distributor and RJR Tobacco’s largest customer, acquired one of the remaining wholesaler plaintiffs, whose claim for damages in this case is approximately $3 million.

          On January 11, 2006, Smith Wholesale filed another lawsuit against RJR Tobacco and its customer, H.T. Hackney Corp., in Carter County, Tennessee Circuit Court. Smith Wholesale seeks $60 million in damages and a preliminary injunction against RJR Tobacco’s termination of Smith Wholesale’s direct-buying status. The court has not set a hearing date on the preliminary injunction. The case was removed to federal court on January 26, 2006. RJR Tobacco filed a motion to dismiss on February 13, 2006. On February 21, 2006, the plaintiffs filed a motion to remand and a motion to deter briefing schedule on defendants’ motion to dismiss.

Other Litigation and Developments

          On January 24, 2003, RJR and RJR Tobacco each were served with a subpoena issued by a federal grand jury sitting in the Southern District of New York. The subpoena seeks the production of documents relating to the sale and distribution of cigarettes in international markets. RJR and RJR Tobacco have responded appropriately to the subpoena and otherwise cooperated with this grand jury investigation. Although this investigation has been dormant for some time now, it remains a pending matter.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          By purchase agreement dated May 12, 1999, referred to as the 1999 Purchase Agreement, RJR and RJR Tobacco sold the international tobacco business to Japan Tobacco Inc., referred to as JTI. RJR and RJR Tobacco retained certain liabilities relating to the activities of Northern Brands International, Inc., referred to as Northern Brands, including those relating to a 1998 guilty plea entered in the United States District Court for the Northern District of New York, as well as an investigation conducted by the Royal Canadian Mounted Police, referred to as RCMP, for possible violations of Canadian law related to the activities that led to the Northern Brands guilty plea and certain conduct by Stanley Smith, a former executive of RJR-Macdonald, Inc., referred to as RJR-MI, which led to the termination of his severance agreement. Under its reading of the indemnification provisions of the 1999 Purchase Agreement, JTI has requested indemnification for any damages arising out of the matters described below.

	•		In February 2003, the RCMP filed criminal charges in the Province of Ontario against and purported to serve summonses on JTI-Macdonald Corp., referred to as JTI-MC, Northern Brands, R. J. Reynolds Tobacco International, Inc., referred to as RJR-TI, R. J. Reynolds Tobacco Co. (Puerto Rico), referred to as RJR-PR, and eight individuals associated with RJR-MI and/or RJR-TI during the period January 1, 1991 through December 31, 1996. The charges allege fraud and conspiracy to defraud Canada and the Provinces of Ontario and Quebec in connection with the purchase, sale, export, import and/or re-export of cigarettes and/or fine cut tobacco. In October 2003, Northern Brands, RJR-TI and RJR-PR each challenged both the propriety of the service of the summonses and the jurisdiction of the court. On February 9, 2004, the Superior Court of Justice ruled in favor of these companies. The government filed a notice of appeal from that ruling on February 18, 2004, but has not actively pursued an appeal. A preliminary hearing was commenced on April 11, 2005 for the purpose of determining whether the Canadian prosecutor has sufficient evidence supporting the criminal charges to justify a trial of the defendants that have been properly served to date. A decision is still pending.
	•		In July 2003, a Statement of Claim was filed against JTI-MC and others in the Superior Court of Justice, Ontario Canada by Leslie and Kathleen Thompson. Mr. Thompson is a former employee of Northern Brands and JTI-MC’s predecessor, RJR-MI. Mr. and Mrs. Thompson have alleged breach of contract, breach of fiduciary duty and negligent misrepresentation, among other claims. They are seeking lost wages and other damages, including punitive damages, in an aggregate amount exceeding $12 million.
	•		On September 18, 2003, RJR, RJR Tobacco, RJR-TI, RJR-PR, and Northern Brands were served with a statement of claim filed in August 2003 by the Attorney General of Canada in the Superior Court of Justice, Ontario, Canada. Also named as defendants are JTI and a number of its affiliates. The statement of claim seeks to recover taxes and duties allegedly not paid as a result of cigarette smuggling and related activities. As filed, the Attorney General’s statement of claim seeks to recover $1.5 billion Canadian in compensatory damages and $50 million Canadian in punitive damages, as well as equitable and other forms of relief. (However, in the Companies’ Creditor Arrangement Act proceeding described below, the Attorney General amended and increased Canada’s claim to $4.3 billion Canadian). The parties have agreed to a stay of all proceedings pending in the Superior Court of Justice, subject to notice by one of the parties that it wishes to terminate the stay.
	•		In August 2004, the Quebec Ministry of Revenue (1) issued a tax assessment, covering the period January 1, 1990 through December 31, 1998, against JTI-MC for alleged unpaid duties, penalties and interest in an amount of about $1.36 billion Canadian; (2) issued an order for the immediate payment of that amount; and (3) obtained an ex parte judgment to enforce the payment of that amount. On August 24, 2004, JTI-MC applied for protection under the Companies’ Creditor Arrangement Act in the Ontario Superior Court of Justice, Toronto, Canada, referred to as CCAA Proceedings, and the court entered an order staying the Quebec Ministry of Revenue’s proceedings against JTI-MC. The stay has been extended to May 31, 2006. In November 2004, JTI-MC filed a motion in the Superior Court, Province of Quebec, District of Montreal, seeking a declaratory judgment to set aside, annul and declare inoperative the tax assessment and all ancillary enforcement measures and to require the Quebec Minister of Revenue to reimburse JTI-MC for funds unduly appropriated, along with interest and other relief. On May 3, 2005, the court in the CCAA Proceedings entered a Crown Claims Bar Order establishing June 27, 2005, as the deadline for Canada, and any of its Provinces and Territories, to assert any individual civil or statutory claim, except criminal claims, against JTI-MC for taxes and revenues owed as a result of Contraband Tobacco Activities, as defined in the Order. As of June 27, 2005, Canada and several Provinces filed Crown claims against JTI-MC in the CCAA Proceedings in the following amounts: Canada ($4.3 billion Canadian); Ontario ($1.5 billion Canadian); New Brunswick ($1.5 billion Canadian); Quebec ($1.4 billion Canadian);

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

			British Columbia ($450 million Canadian); Nova Scotia ($326 million Canadian); Prince Edward Island ($75 million Canadian) and Manitoba ($23 million Canadian).
	•		On November 17, 2004, a Statement of Claim was filed against JTI-MC in the Supreme Court of British Columbia by Stanley Smith, a former executive of RJR-MI, for alleged breach of contract and other legal theories. Mr. Smith is claiming $840,000 Canadian for salary allegedly owed under his severance agreement with RJR-MI, as well as other unspecified compensatory and punitive damages.

          In addition, in a letter dated March 31, 2006, counsel for JTI stated that JTI would be seeking indemnification under the 1999 Purchase Agreement for any damages it may incur or may have already incurred arising out of the Southern District of New York grand jury investigation mentioned above, a now-terminated Eastern District of North Carolina grand jury investigation, and various actions filed by the European Community and others in the United States District Court for the Eastern District of New York, referred to as EDNY, against RJR Tobacco and certain of its affiliates on November 3, 2000, August 6, 2001 and October 30, 2002 (see below) and against JTI on January 11, 2002. Although RJR and RJR Tobacco recognize that, under certain circumstances, they may have indemnification obligations to JTI under the 1999 Purchase Agreement, RJR and RJR Tobacco disagree with JTI as to whether the circumstances relating to any of these matters give rise to any indemnification obligation by RJR and RJR Tobacco. RJR and RJR Tobacco conveyed their position to JTI, and the parties have agreed to resolve their differences at a later time. For further information on the JTI indemnification claims, see “-Other Contingencies and Guarantees” below.

          Following the dismissal of a similar complaint filed by the European Community on November 3, 2000, against RJR Tobacco, certain of its affiliates and others, on August 6, 2001, the European Community and ten of its member states filed a civil RICO action against RJR Tobacco, certain of its affiliates and others in the EDNY. This suit generally contends that RJR Tobacco and other tobacco companies may be held responsible under the federal RICO statute, the common law and other legal theories for taxes and duties allegedly unpaid as a result of cigarette smuggling. A similar complaint was filed against B&W and other defendants by various Departments of the Republic of Colombia. On February 25, 2002, the EDNY granted the defendants’ motions to dismiss these suits. The U. S. Court of Appeals for the Second Circuit affirmed the dismissals, and, on January 9, 2006, the Supreme Court denied the plaintiffs’ petition for a writ of certiorari.

          On October 30, 2002, the European Community and ten of its member states filed another complaint in the EDNY against RJR, RJR Tobacco and several currently and formerly related companies. The complaint contains many of the same or similar allegations found in the earlier complaint filed in August 2001 and also alleges that the defendants, together with certain identified and unidentified persons, engaged in money laundering and other conduct violating civil RICO and a variety of common laws. The complaint also alleges that the defendants manufactured cigarettes that were eventually sold in Iraq in violation of U.S. sanctions. The plaintiffs seek compensatory, punitive and treble damages among other types of relief. This matter remains pending, but all proceedings were stayed while the plaintiffs sought review first by the Second Circuit and then by the Supreme Court of the dismissal of their August 2001 complaint (see above). This case remains stayed while the court and the parties work out a scheduling order.

          On December 20, 2000, October 15, 2001, and January 9, 2003, RJR Tobacco and the other defendants named in each of the European Community cases mentioned above filed applications in the Court of First Instance in Luxembourg challenging the competency of the European Community to bring each of the actions and seeking an annulment of the decision to bring each of the actions. On January 15, 2003, the Court of First Instance entered a judgment denying the first two applications, principally on the grounds that the filing of the first two complaints did not impose binding legal effects on RJR Tobacco and the other defendants. On March 21, 2003, RJR and its affiliates appealed that judgment to the Court of Justice of the European Communities. The application for annulment filed in connection with the third European Community complaint is still pending before the Court of First Instance, but the court stayed the proceedings pending resolution of the appeals from the January 15, 2003, judgment denying the admissibility of the first two applications. A hearing and oral argument on the appeals were held on January 24, 2006, and a decision by the Court of Justice is pending.

          RJR Tobacco has been served in two reparations actions brought by descendants of slaves, claiming that the defendants, including RJR Tobacco, profited from the use of slave labor. These two actions have been transferred to the U. S. District Court for the Northern District of Illinois by the Judicial Panel on Multi-District Litigation for coordinated or consolidated pretrial proceedings with other reparation actions. RJR Tobacco is named, but has not been served, in another reparations case. That case was conditionally transferred to the Northern District of Illinois on January 7, 2003, but the plaintiffs contested that transfer, and the Judicial Panel on Multi-District Litigation has not yet issued a final ruling on the transfer. The plaintiffs filed a consolidated complaint on June 17, 2003. On July 18, 2003, the defendants moved to dismiss the plaintiffs’ complaint. That motion was granted on January 26, 2004, although the court allowed the plaintiffs to file an amended complaint, which they did on April 5, 2004. In addition, several plaintiffs attempted to appeal the trial court’s January 26, 2004 dismissal. Because the dismissal was not a final order, that appeal was dismissed by the U.S. Court of Appeals for the Seventh Circuit. On July 6, 2005, the trial court granted the defendants’ motion to dismiss the amended complaint with prejudice. On August 3, 2005, the plaintiffs filed a notice of appeal to the Seventh Circuit. On December 22, 2005, the Seventh Circuit issued a briefing schedule.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

     On June 8, 2001, in California v. R.J. Reynolds Tobacco Co., the Attorney General of the State of California sued RJR Tobacco in California state court alleging that RJR Tobacco violated California state law by distributing free cigarettes and free coupons for discounts on cigarettes on “public grounds,” even though the promotions occurred within an “adult-only facility” at a race track and certain festivals. RJR Tobacco answered the complaint on July 19, 2001, asserting that its promotions complied with all laws, including California state law and that this California state law is preempted by the Federal Cigarette Labeling and Advertising Act. On March 29, 2002, the court ruled that RJR Tobacco’s distribution of free cigarettes violated the law, but the distribution of free coupons for discounts on cigarettes did not. On April 29, 2002, the judge assessed a civil fine against RJR Tobacco of $14.8 million. On October 30, 2003, the California Court of Appeal, Second Appellate District, affirmed the trial court’s decision. On December 22, 2005, the Supreme Court of California affirmed the decision with respect to liability, but remanded the case to the trial court to determine if the fine imposed was excessive under the United States Constitution. On January 19, 2006, RJR Tobacco filed a motion to stay issuance of the remittitur pending petition for a writ of certiorari to the U.S. Supreme Court, which was granted on February 1, 2006. The parties settled the case on March 22, 2006. RJR Tobacco agreed to pay $3.1 million in civil penalties, $900,000 in attorneys’ fees and costs, and $1 million to PHI, a nonprofit organization that oversees the Public Health Trust, which manages litigation settlements and will use the amount made available from this settlement to fund tobacco control advocacy and education. RJR Tobacco accrued these amounts in selling, general and administrative expenses in the condensed consolidated statement of income (unaudited) for the three month period ended March 31, 2006 and expects to pay these amounts in the second quarter of 2006. The Supreme Court of California must approve the settlement for it to become final.

     On May 23, 2001 and July 30, 2002, Star Scientific, Inc., referred to as Star, filed two patent infringement actions, which have been consolidated, against RJR Tobacco in the U.S. District Court for the District of Maryland. Both patents at issue are entitled “Method of Treating Tobacco to Reduce Nitrosamine Content, and Products Produced Thereby,” and bear United States Patent Nos. 6,202,649 and 6,425,401. RJR Tobacco has filed counterclaims seeking a declaration that the claims of the two Star patents are invalid, unenforceable and not infringed by RJR Tobacco. Between January 31 and February 8, 2005, the court held a first bench trial on RJR Tobacco’s affirmative defense and counterclaim based upon inequitable conduct. The court has not yet issued a ruling on the issue of inequitable conduct. Additionally, in response to the court’s invitation, RJR Tobacco filed two summary judgment motions on January 20, 2005, which have been fully briefed by the parties. Furthermore, the court has requested additional briefing on certain claim construction issues. The court has indicated that it will rule on RJR Tobacco’s two pending summary judgment motions and the issue of inequitable conduct at the same time. The court has not set a trial date for the remaining issues in the case.

     On September 22, 2005, RJR Tobacco filed a case in the U.S. District Court for the Western District of North Carolina against Market Basket Food Stores and other cigarette retailers and wholesalers located in the states of North Carolina, Tennessee, Virginia and Kentucky to stop and remedy the ongoing conspiracy to abuse RJR Tobacco’s marketing programs, including the buy-down and coupon programs. The complaint alleged violations of Federal and North Carolina RICO and the North Carolina Unfair and Deceptive Trade Practices Act, along with common law fraud, breach of contract and conspiracy. A motion for preliminary injunction requested that the court enjoin certain defendants from performing the fraudulent acts detailed in the complaint. The motion is pending. On February 8, 2006, the judge stayed discovery in the case.

     Finally, in the first quarter of 2005, Commonwealth Brands, Inc., referred to as Commonwealth, was served with two individual smoking and health cases, Croft v. Akron Gasket in Cuyahoga County, Ohio, and Ryan v. Philip Morris, U.S.A., Inc. in Jay County, Indiana. Commonwealth requested indemnity from RJR Tobacco pursuant to the Asset Purchase Agreement dated July 24, 1996, between Commonwealth and B&W, referred to as the 1996 Purchase Agreement. As a result of the business combination of RJR Tobacco and the U.S. cigarette and tobacco business of B&W, RJR Tobacco agreed to indemnify Commonwealth for these claims to the extent, if any, required by the 1996 Purchase Agreement.

Cautionary Statement Concerning Tobacco-Related Litigation

     Even though RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees when viewed on an individual basis, is not probable, the possibility of material losses related to such litigation is more than remote. Litigation is subject to many uncertainties, and generally it is not possible to predict the outcome of the litigation pending against RJR Tobacco

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

or its affiliates, including RAI, or indemnitees, including B&W, or to reasonably estimate the amount or range of any possible loss.

     Unfavorable judgments awarding compensatory damages, punitive damages or fines have been returned against RJR Tobacco and B&W in the Engle class-action case, which was reversed by the intermediate appellate court on May 21, 2003, but is now on appeal to the Florida Supreme Court, the Scott class-action case, a small number of individual smoking and health cases, a Broin II flight attendant ETS case and a California state law enforcement action. In addition, unfavorable judgments have been returned against RJR Tobacco in two MSA enforcement actions, and RJR has recorded liabilities in connection with certain indemnification claims asserted by JTI against RJR and RJR Tobacco concerning certain activities of Northern Brands and related litigation. Although RJR Tobacco believes that it has numerous bases for successful appeals in its pending cases, and RJR Tobacco and RAI believe they have a number of valid defenses to all actions, and intend to defend all actions vigorously, it is possible that there could be further adverse developments in pending cases, and that additional cases could be decided unfavorably against RAI, RJR Tobacco or their affiliates or indemnitees, including B&W.

     Determinations of liability or adverse rulings in such cases or in similar cases involving other cigarette manufacturers as defendants, even if such judgments are not final, could materially adversely affect the litigation against RJR Tobacco or its affiliates or indemnitees and they could encourage the commencement of additional tobacco-related litigation. In addition, a number of political, legislative, regulatory and other developments relating to the tobacco industry and cigarette smoking have received wide media attention. These developments may negatively affect the outcomes of tobacco-related legal actions and encourage the commencement of additional similar litigation.

     Although it is impossible to predict the outcome of such events on pending litigation and the rate new lawsuits are filed against RJR Tobacco and B&W, a significant increase in litigation or in adverse outcomes for tobacco defendants could have a material adverse effect on any or all of these entities. Moreover, notwithstanding the quality of defenses available to it and its affiliates and indemnitees in litigation matters, it is possible that RAI’s results of operations, cash flows or financial condition could be materially adversely affected by the ultimate outcome of certain pending litigation matters.

Tobacco Buyout Legislation

     On October 22, 2004, the President signed the Fair and Equitable Tobacco Reform Act of 2004, referred to as FETRA, eliminating the U.S. government’s tobacco production controls and price support program. The buyout of tobacco quota holders provided for in FETRA is funded by a direct quarterly assessment on every tobacco product manufacturer and importer, on a market-share basis measured on volume to which federal excise tax is applied. The aggregate cost of the buyout to the industry is approximately $9.9 billion, including approximately $9.6 billion payable to quota tobacco holders and growers through industry assessments over ten years and approximately $290 million for the liquidation of quota tobacco stock. As a result of the tobacco buyout legislation, the MSA Phase II obligations established in 1999 will be continued as scheduled through the end of 2010, but will be offset against the tobacco quota buyout obligations. RAI’s operating subsidiaries’ annual expense under FETRA, excluding the tobacco stock liquidation assessment, is estimated to be approximately $260 million. RAI’s operating subsidiaries incurred $81 million in 2005 related to assessments from quota tobacco stock liquidation. Of these amounts, approximately $33 million has been paid through the first quarter of 2006, and the remaining amount is scheduled to be paid, quarterly, by December 31, 2006. In the first quarter of 2006, a $9 million favorable adjustment was recorded relating to the tobacco stock liquidation assessment. Remaining contingent liabilities for liquidation of quota tobacco stock, if any, will be recorded when an assessment is made.

     RAI’s operating subsidiaries will record the FETRA assessment on a quarterly basis upon required notification of assessments. RAI’s operating subsidiaries estimate that their overall share of the buyout will approximate $2.4 billion to $2.9 billion prior to the deduction of permitted offsets under the MSA. In addition, future market pricing could impact the carrying value of inventory, and adversely affect RJR Tobacco’s financial condition and results of operations. Of the accrued but unpaid MSA Phase II obligations, $69 million was reversed in the fourth quarter of 2004, and $79 million was reversed in the first six months of 2005.

ERISA Litigation

     On May 13, 2002, in Tatum v. The R.J.R. Pension Investment Committee of the R. J. Reynolds Tobacco Company Capital Investment Plan, an employee of RJR Tobacco filed a class-action suit in the U.S. District Court for the Middle District of North Carolina, alleging that the defendants, RJR, RJR Tobacco, the RJR Employee Benefits Committee and the RJR Pension Investment Committee, violated the Employee Retirement Income Security Act of 1974, referred to as ERISA. The actions about which the plaintiff complains stem from a decision made in 1999 by

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

RJR Nabisco Holdings Corp., subsequently renamed Nabisco Group Holdings Corp., referred to as NGH, to spin off RJR, thereby separating NGH’s tobacco business and food business. As part of the spin-off, the 401(k) plan for the previously related entities had to be divided into two separate plans for the now separate tobacco and food businesses. The plaintiff contends that the defendants violated ERISA by not overriding an amendment to RJR’s 401(k) plan requiring that, prior to February 1, 2000, the stock funds of the companies involved in the food business, NGH and Nabisco Holdings Corp., referred to as Nabisco, be eliminated as investment options from RJR’s 401(k) plan. In his complaint, the plaintiff requests, among other things, that the court issue an order requiring the defendants to pay as damages to the RJR 401(k) plan an amount equal to the subsequent appreciation that was purportedly lost as a result of the liquidation of the NGH and Nabisco funds. On July 29, 2002, the defendants filed a motion to dismiss, which the court granted on December 10, 2003. On January 7, 2004, the plaintiff appealed to the U.S. Court of Appeals for the Fourth Circuit, which, on December 14, 2004, reversed the dismissal of the complaint and remanded the case for further proceedings. On January 20, 2005, the defendants filed a second motion to dismiss on other grounds, which remains pending. On February 6, 2006, the court entered an order staying the ruling on the defendants’ motion to dismiss for 60 days beginning on February 8, 2006, to allow the parties to engage in limited discovery. The period of limited discovery has ended. The parties will be filing supplemental briefs regarding the motion to dismiss; plaintiff’s opening brief is due May 5, 2006; the defendant’s brief is due May 25, 2006; and the plaintiff’s reply brief is due June 9, 2006.

Environmental Matters

     RAI and its subsidiaries are subject to federal, state and local environmental laws and regulations concerning the discharge, storage, handling and disposal of hazardous or toxic substances. Such laws and regulations provide for significant fines, penalties and liabilities, sometimes without regard to whether the owner or operator of the property knew of, or was responsible for, the release or presence of hazardous or toxic substances. In addition, third parties may make claims against owners or operators of properties for personal injuries and property damage associated with releases of hazardous or toxic substances. In the past, RJR Tobacco has been named a potentially responsible party with third parties under the Comprehensive Environmental Response, Compensation and Liability Act with respect to several superfund sites. RAI and its subsidiaries are not aware of any current environmental matters that are expected to have a material adverse effect on the business, results of operations or financial condition of RAI or its subsidiaries.

     Regulations promulgated by the U.S. Environmental Protection Agency and other governmental agencies under various statutes have resulted in, and likely will continue to result in, substantial expenditures for pollution control, waste treatment, plant modification and similar activities. RAI and its subsidiaries are engaged in a continuing program to comply with federal, state and local environmental laws and regulations, and dependent upon the probability of occurrence and reasonable estimation of cost, accrue or disclose any material liability. Although it is difficult to reasonably estimate the portion of capital expenditures or other costs attributable to compliance with environmental laws and regulations, RAI does not expect such expenditures or other costs to have a material adverse effect on the business, results of operations or financial condition of RAI or its subsidiaries.

Other Contingencies and Guarantees

     In connection with the business combination of RJR Tobacco and the U.S. cigarette and tobacco business of B&W on July 30, 2004, RJR Tobacco has agreed to indemnify B&W and its affiliates against any liabilities, costs and expenses incurred by B&W or its affiliates arising out of the U.S. cigarette and tobacco business of B&W. As a result of this indemnity, RJR Tobacco has assumed the defense of pending B&W-specific tobacco-related litigation, has paid the judgments and costs related to certain pre-business combination tobacco-related litigation of B&W, and has posted bonds on behalf of B&W, where necessary, in connection with cases decided since the business combination. In addition, pursuant to this indemnity, RJR Tobacco expensed $22 million during the fourth quarter of 2005 and $3 million during the first quarter of 2006 for funds to be reimbursed to BAT for costs and expenses incurred arising out of tobacco-related litigation. Although it is impossible to predict the possibility or amount of any additional future payments by RJR Tobacco under this indemnity, a significant indemnification claim by B&W against RJR Tobacco could have an adverse effect on any or all of RAI, RJR and RJR Tobacco.

     As a result of the business combination of RJR Tobacco and the U.S. cigarette and tobacco business of B&W, RJR Tobacco also has agreed to indemnify Commonwealth Brands, Inc. for certain claims brought in two individual smoking and health cases, Croft v. Akron Gasket and Ryan v. Philip Morris, U.S.A., Inc. See “-Other Litigation and Developments” above for further information on these cases.

     In connection with the sale of the international tobacco business to JTI, on May 12, 1999, pursuant to the purchase agreement, RJR and RJR Tobacco agreed to indemnify JTI against:

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

	•		any liabilities, costs and expenses arising out of the imposition or assessment of any tax with respect to the international tobacco business arising prior to the sale, other than as reflected on the closing balance sheet;
	•		any liabilities, costs and expenses that JTI or any of its affiliates, including the acquired entities, may incur after the sale with respect to any of RJR’s or RJR Tobacco’s employee benefit and welfare plans; and
	•		any liabilities, costs and expenses incurred by JTI or any of its affiliates arising out of certain activities of Northern Brands.

As described above in “– Other Litigation and Developments,” RJR Tobacco has received several claims for indemnification from JTI under these indemnification provisions in connection with the activities of Northern Brands and its affiliates. Although RJR and RJR Tobacco recognize that, under certain circumstances, they may have indemnification obligations to JTI under the 1999 Purchase Agreement, RJR and RJR Tobacco disagree whether the circumstances described in such claims give rise to any indemnification obligations by RJR and RJR Tobacco. RJR and RJR Tobacco have conveyed their position to JTI, and the parties have agreed to resolve their differences at a later date. RJR has liabilities totaling $94 million that were recorded in 1999 in connection with these indemnification claims.

     RJR Tobacco, Santa Fe and Lane have entered into agreements to indemnify certain distributors and retailers from liability and related defense costs arising out of the sale or distribution of their products. Additionally, Santa Fe has entered into an agreement to indemnify a supplier from liability and related defense costs arising out of the sale or use of Santa Fe’s products. The cost of such defense indemnification has been, and is expected to be, insignificant. RJR Tobacco, Santa Fe and Lane believe that the indemnified claims are substantially similar in nature and extent to the claims that they are already exposed to by virtue of their having manufactured those products.

     Under certain circumstances, including RJR’s guaranteed, secured debt rating remaining either one level below BBB- by S&P or Baa3 by Moody’s, or lower, any fair value that results in a liability position of the interest rate swaps will require full collateralization with cash or securities.

     RAI is not able to estimate the maximum potential amount of future payments, if any, related to these guarantees and indemnification obligations.

Employees

     At March 31, 2006, RAI and its subsidiaries had approximately 7,200 full-time employees and approximately 200 part-time employees. Of the 7,200 full-time employees, approximately 350 were located at the former B&W facilities. The Macon facility production and maintenance employees are covered by collective bargaining agreements that extended their employment through the anticipated facility closure in mid-2006. No other employees of RAI or its subsidiaries are unionized. On April 3, 2006, the United Tobacco Alliance, a partnership between two unions, the Bakery, Confectionery, Tobacco Workers and Grain Millers International Union and the International Association of Machinists and Aerospace Workers, petitioned the National Labor Relations Board to attempt to unionize some or all of RJR Tobacco’s manufacturing workforce. Previously, on March 3, 2005, RJR Tobacco’s production and maintenance employees employed in North Carolina voted not to be represented by the IAM by a two-to-one margin. An election among eligible RJR Tobacco employees will be held May 11 and 12, 2006.

Note 8–Shareholders’ Equity

														Accumulated
														Other				Total
		Common				Paid-In				Accumulated				Comprehensive				Shareholders’				Comprehensive
		Stock				Capital				Deficit				Loss				Equity				Income
Balance at December 31, 2005		$	–			$	8,694			$	(1,638	)		$	(503	)		$	6,553
Net income			–				–				345				–				345			$	345
Cumulative translation adjustment and other, net of tax			–				–				–				(1	)			(1	)			(1	)
Total comprehensive income																						$	344
Dividends – $1.25 per share			–				–				(184	)			–				(184	)
Restricted stock amortization			–				1				–				–				1
Stock options exercised			–				2				–				–				2
Tax benefit on stock-based compensation plans			–				2				–				–				2
Balance at March 31, 2006		$	–			$	8,699			$	(1,477	)		$	(504	)		$	6,718

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Note 9-Stock Plans

     In the first quarter of 2006, RAI adopted SFAS No. 123(R), “Share-Based Payment,” issued by the FASB in December 2004. This statement is a revision of SFAS No. 123 and supersedes APB No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS No. 123(R) addresses all forms of share-based payment awards, including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. RAI’s adoption of SFAS No. 123(R) did not have a material impact on its financial condition, results of operations or cash flows primarily because all of RAI’s outstanding stock options are fully vested.

     As of March 31, 2006, RAI had two stock plans, the Equity Incentive Award Plan for Directors of Reynolds American Inc., referred to as the EIAP, and the Reynolds American Inc. Long-Term Incentive Plan, referred to as the LTIP.

     The EIAP currently provides for (1) grants of deferred stock units to outside directors upon becoming a director or, provided the director did not receive an initial award upon his/her election to the board, upon appointment to the position of Non-Executive Chairman and (2) grants of deferred units on a quarterly and annual basis thereafter. Directors may elect to receive shares of common stock in lieu of their initial and annual grants of deferred stock units. A maximum of 500,000 shares of common stock may be issued under this plan, of which 335,498 shares were available for grant as of March 31, 2006. Deferred stock units granted under the EIAP have a value equal to, and bear dividend equivalents at the same rate as, one share of RAI’s common stock, and have no voting rights. The dividends are paid as additional units in an amount equal to the number of common shares that could be purchased with the dividends on the date of payment. As soon as practicable following his or her last year of service on the board, the director is paid in cash for the units granted quarterly and in common stock for the units granted initially and annually, unless the director elects to receive cash for the initial and annual grants. Cash payments are based on the average closing price of RAI’s common stock during December of the year preceding payment. Compensation expense related to the EIAP was less than $1 million for the three months ended March 31, 2006 and 2005.

     The LTIP provides for grants of incentive stock options, other stock options, stock appreciation rights, restricted stock, performance units and performance shares to key employees. The total number of shares of common stock authorized for grant under the LTIP is 13,772,814 shares. Of this authorization, 4,886,017 shares were available for grant as of March 31, 2006.

     In 2004, RAI granted 486,216 performance shares to eligible employees under the LTIP. The shares are phantom stock, payable in cash, based on the closing price of RAI stock on the date of vesting. The shares vest ratably over three years unless forfeited. The actual number of shares granted is fixed. The amount of the liability for the award is measured each period based on RAI’s current stock price. The effects of changes in the stock price, the portion of vesting period elapsed and dividends-in-kind paid concurrently with RAI dividends, are recognized as compensation expense. Since the date of grant, 59,533 shares were cancelled, and 154,810 have vested and were paid.

     In 2005, RAI granted 276,097 performance shares to eligible employees under the LTIP. The shares are phantom stock, payable in cash, based on the closing price of RAI stock on the date of vesting, March 2, 2008. The actual number of shares granted is fixed. The amount of the liability for the award is measured each period based on RAI’s current stock price. The effects of changes in the stock price, the portion of vesting period elapsed and dividends-in-kind paid concurrently with RAI dividends, are recognized as compensation expense. Since the date of grant, 6,309 shares were cancelled, and 1,417 have vested and were paid.

     On February 1, 2006, the Board of Directors of RAI approved the grant of certain awards, effective March 6, 2006, under the LTIP. Each award was split evenly in value between performance units and shares of restricted RAI common stock. The fair value of restricted shares at grant date was based on the per share closing price of RAI common stock on March 6, 2006, of $105.20, and 253,530 shares of restricted RAI common stock were granted. The shares of restricted RAI common stock generally will vest on March 6, 2009. Amortization based on the vesting period elapsed and dividends paid concurrently with RAI dividends are recognized as compensation expense.

     There are no other restricted stock awards outstanding as all previous awards vested concurrent with the completion of the business combination transaction on July 30, 2004.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

     Total compensation expense, including dividends, related to stock-based compensation and the related tax benefits recognized in the condensed consolidated statements of income (unaudited) were as follows:

		For the Three Months
		Ended March 31,
		2006				2005
2004 LTIP performance shares		$	5			$	6
2005 LTIP performance shares			3				1
2006 LTIP restricted stock			1				—
Total compensation expense		$	9			$	7
Total related tax benefits		$	4			$	3

     In the condensed consolidated balance sheet (unaudited) as of March 31, 2006, $12 million is included in other current liabilities and $18 million is included in other noncurrent liabilities relating to the 2004 and 2005 LTIP performance share grants. At March 31, 2006, there were $54 million of unrecognized compensation costs related to restricted stock, calculated at the March 6, 2006 ending stock price, and performance shares, calculated at the March 31, 2006 ending stock price, which are expected to be recognized over a weighted-average period of 2.3 years.

     In the EIAP and the LTIP, for various price ranges, the weighted average characteristics of stock options outstanding and exercisable at March 31, 2006, were as follows:

								Options Outstanding												Exercisable Options
												Average												Weighted
												Remaining				Weighted								Average
												Contractual				Average								Exercise
Exercise Price Range								Shares				Life (Years)				Exercise Price				Shares				Price
$ 23.32		-		$	33.71				287,441				3.8			$	27.17				287,441			$	27.17
$ 39.87		-		$	48.33				6,512				1.4			$	43.02				6,512			$	43.02
$ 69.79		-		$	69.79				10,000				6.2			$	69.79				10,000			$	69.79