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 September 30, 2008

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		(I.R.S. Employer Identification Number)
incorporation or organization)

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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)

Large accelerated filer þ		Accelerated filer o		Non-accelerated filer o		Smaller reporting company o
				(Do not check if a smaller reporting company)

     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: 291,452,662 shares of common stock, par value $.0001 per share, as of October 10, 2008

 

 

INDEX

		Page
Part I — Financial Information
Item 1. Financial Statements
Condensed Consolidated Statements of Income (Unaudited) – Three Months and Nine Months Ended September 30, 2008 and 2007			3
Condensed Consolidated Statements of Cash Flows (Unaudited) – Nine Months Ended September 30, 2008 and 2007			4
Condensed Consolidated Balance Sheets (Unaudited) – September 30, 2008 and December 31, 2007			5
Notes to Condensed Consolidated Financial Statements (Unaudited)			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			63
Item 3. Quantitative and Qualitative Disclosures about Market Risk			81
Item 4. Controls and Procedures			81
Part II — Other Information
Item 1. Legal Proceedings			82
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			82
Item 6. Exhibits			83
Signature			84
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1

PART I – Financial Information

Item 1. Financial Statements

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Dollars in Millions, Except Per Share Amounts)
(Unaudited)

		For the Three Months								For the Nine Months
		Ended September 30,								Ended September 30,
		2008				2007				2008				2007
Net sales1		$	2,156			$	2,174			$	6,330			$	6,419
Net sales, related party			116				123				338				374
Net sales			2,272				2,297				6,668				6,793
Costs and expenses:
Cost of products sold1, 2, 3			1,229				1,250				3,698				3,768
Selling, general and administrative expenses			375				440				1,148				1,237
Amortization expense			5				5				16				17
Restructuring charge			91				—				91				—
Trademark impairment charge			173				—				173				—
Operating income			399				602				1,542				1,771
Interest and debt expense			68				81				208				257
Interest income			(16	)			(33	)			(51	)			(94	)
Gain on termination of joint venture			—				—				(328	)			—
Other (income) expense, net			13				(7	)			3				8
Income from continuing operations before income taxes and extraordinary item			334				561				1,710				1,600
Provision for income taxes			123				203				630				590
Income from continuing operations before extraordinary item			211				358				1,080				1,010
Extraordinary item – gain on acquisition			—				—				—				1
Net income		$	211			$	358			$	1,080			$	1,011
Basic income per share:
Income from continuing operations before extraordinary item		$	0.72			$	1.22			$	3.68			$	3.43
Extraordinary item			—				—				—				—
Net income		$	0.72			$	1.22			$	3.68			$	3.43
Diluted income per share:
Income from continuing operations before extraordinary item		$	0.72			$	1.21			$	3.68			$	3.43
Extraordinary item			—				—				—				—
Net income		$	0.72			$	1.21			$	3.68			$	3.43
Dividends declared per share		$	0.85			$	0.85			$	2.55			$	2.35

See Notes to Condensed Consolidated Financial Statements (Unaudited)

REYNOLDS AMERICAN INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Millions)
(Unaudited)

		For the Nine Months Ended
		September 30,
		2008				2007
Cash flows from (used in) operating activities:
Net income		$	1,080			$	1,011
Adjustments to reconcile to net cash flows from (used in) continuing operating activities:
Depreciation and amortization			106				106
Gain on termination of joint venture			(328	)			—
Restructuring charge, net of cash payments			81				(11	)
Trademark impairment charge			173				—
Deferred income tax expense			38				44
Loss on extinguishment of debt			—				19
Extraordinary item–gain on acquisition			—				(1	)
Other changes, that provided (used) cash:
Accounts and other receivables			(48	)			(18	)
Inventories			124				102
Related party, net			(14	)			(53	)
Accounts payable			(49	)			(56	)
Accrued liabilities including income taxes and other working capital			(28	)			363
Tobacco settlement accruals			(283	)			27
Pension and postretirement			(56	)			(323	)
Litigation bonds, net			5				92
Other, net			27				(14	)
Net cash flows from operating activities			828				1,288
Cash flows from (used in) investing activities:
Purchases of short-term investments			(56	)			(3,663	)
Proceeds from sale of short-term investments			208				4,154
Proceeds from settlement of long-term investments			6				—
Capital expenditures			(95	)			(95	)
Distributions from equity investees			27				9
Proceeds from termination of joint venture			164				—
Other, net			10				(4	)
Net cash flows from investing activities			264				401
Cash flows from (used in) financing activities:
Dividends paid on common stock			(752	)			(665	)
Repayment of long-term debt			—				(329	)
Proceeds from issuance of long-term debt			—				1,547
Repayment of term loan			—				(1,542	)
Deferred debt issuance cost			—				(15	)
Excess tax benefit from stock-based compensation			2				1
Proceeds from stock options exercised			1				—
Repurchase of common stock			(207	)			(60	)
Other, net			1				—
Net cash flows used in financing activities			(955	)			(1,063	)
Effect of exchange rate changes on cash and cash equivalents			(23	)			—
Net change in cash and cash equivalents			114				626
Cash and cash equivalents at beginning of period			2,215				1,433
Cash and cash equivalents at end of period		$	2,329			$	2,059
Income taxes paid, net of refunds		$	624			$	106
Interest paid		$	161			$	205

See Notes to Condensed Consolidated Financial Statements (Unaudited)

REYNOLDS AMERICAN INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in Millions)
(Unaudited)

		September 30,				December 31,
		2008				2007
Assets
Current assets:
Cash and cash equivalents		$	2,329			$	2,215
Short-term investments			52				377
Accounts receivable, net of allowance (2008 – $1; 2007 – $1)			79				73
Accounts receivable, related party			67				80
Notes receivable			33				1
Other receivables			63				25
Inventories			1,072				1,196
Deferred income taxes, net			852				845
Prepaid expenses and other			143				180
Total current assets			4,690				4,992
Property, plant and equipment, net of accumulated depreciation (2008 – $1,558; 2007 – $1,517)			1,053				1,073
Trademarks, net of accumulated amortization (2008 – $529; 2007 – $524)			3,229				3,407
Goodwill			8,174				8,174
Other intangibles, net of accumulated amortization (2008 – $84; 2007 – $73)			191				202
Other assets and deferred charges			1,081				781
		$	18,418			$	18,629
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable		$	169			$	218
Tobacco settlement accruals			2,159				2,449
Due to related party			2				7
Deferred revenue, related party			13				35
Current maturities of long-term debt			200				—
Other current liabilities			1,158				1,194
Total current liabilities			3,701				3,903
Long-term debt (less current maturities)			4,304				4,515
Deferred income taxes, net			1,220				1,184
Long-term retirement benefits (less current portion)			1,166				1,167
Other noncurrent liabilities			439				394
Commitments and contingencies:
Shareholders’ equity:
Common stock (shares issued: 2008 – 291,452,779; 2007 – 295,007,327)			—				—
Paid-in capital			8,459				8,653
Accumulated deficit			(541	)			(873	)
Accumulated other comprehensive loss (defined benefit pension and post- retirement plans: 2008 – $(293) and 2007 – $(306), net of tax)			(330	)			(314	)
Total shareholders’ equity			7,588				7,466
		$	18,418			$	18,629

See Notes to Condensed Consolidated Financial Statements (Unaudited)

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1 — Business and Summary of Significant Accounting Policies

Overview

     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; R. J. Reynolds Global Products, Inc., referred to as GPI; and Conwood Company, LLC, Conwood Sales Co., LLC, Scott Tobacco LLC and Rosswil LLC, collectively referred to as the Conwood companies.

     RAI was incorporated as a holding company in the state of North Carolina on January 5, 2004, and its common stock is listed on the NYSE under the symbol “RAI.” RAI was created to facilitate the transactions on July 30, 2004, to combine the U.S. assets, liabilities and operations of Brown & Williamson Holdings, Inc., formerly known as Brown & Williamson Tobacco Corporation and 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. These July 30, 2004, transactions generally are referred to as the B&W business combination.

     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, a North Carolina corporation.

     RAI’s reportable operating segments are RJR Tobacco and Conwood. RJR Tobacco consists of the primary operations of R. J. Reynolds Tobacco Company. Conwood consists of the Conwood companies and Lane. RAI’s wholly owned operating subsidiaries Santa Fe and GPI, among others, are included in All Other. The segments were identified based on how RAI’s chief operating decision maker allocates resources and assesses performance.

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 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 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 September 30, 2008, are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.

     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.

     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, 2007. Certain reclassifications were made to conform prior years’ financial statements to the current presentation. All dollar amounts, other than per share amounts, are presented in millions, except for amounts set forth in note 12 and as otherwise noted.

Pension and Postretirement

     Recognized gains or losses are annual 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 Statement of Financial Accounting Standards,

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

referred to as SFAS,  No. 87, “Employers’ Accounting for Pensions,” was included in pension expense, and as described in SFAS No. 106, “Employers’ Accounting for Postretirement Benefits other than Pensions,” was included in the postretirement benefit cost. 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.

     The components of the pension benefits and the postretirement benefits are set forth below:

		For The Three Months Ended																For The Nine Months Ended
		September 30,																September 30,
										Postretirement																Postretirement
		Pension Benefits								Benefits								Pension Benefits								Benefits
		2008				2007				2008				2007				2008				2007				2008				2007
Service cost		$	9			$	10			$	1			$	1			$	27			$	30			$	4			$	4
Interest cost			80				78				23				22				239				235				68				68
Expected return on plan assets			(113	)			(109	)			(7	)			(6	)			(338	)			(327	)			(20	)			(20	)
Amortization of prior service cost (credit)			5				—				4				(3	)			14				1				12				(9	)
Amortization of net loss (income)			1				11				(3	)			6				4				32				(9	)			17
Net periodic benefit (income) cost			(18	)			(10	)			18				20				(54	)			(29	)			55				60
Curtailments/special benefits1			7				—				—				—				7				—				—				—
Settlements			4				—				—				—				4				—				—				—
Total benefit (income) cost		$	(7	)		$	(10	)		$	18			$	20			$	(43	)		$	(29	)		$	55			$	60

Employer Contributions

     RAI disclosed in its financial statements for the year ended December 31, 2007, that it expected to contribute $7 million to its pension plans in 2008. As of September 30, 2008, RAI expects to contribute $17 million to its pension plans in 2008, of which $10 million was contributed during the first nine months of 2008.

     Due to the adverse changes in the financial markets, RAI’s pension assets have been negatively impacted. Through September 30, 2008, the overall year-to-date rate of return on the investments for the pension assets was approximately negative 16.3%.

Recently Adopted Accounting Pronouncements

     Effective January 1, 2008, RAI adopted SFAS No. 157, “Fair Value Measurements,” for financial assets and financial liabilities. SFAS No. 157 does not require any new fair value measurements but provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. RAI will adopt SFAS No. 157 for nonfinancial assets and nonfinancial liabilities on January 1, 2009. The adoption of SFAS No. 157 on financial assets and financial liabilities did not have a material impact on RAI’s consolidated results of operations, financial position or cash flows. RAI is currently assessing the impact of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities on its consolidated results of operations, financial position and cash flows.

     On October 10, 2008, the Financial Accounting Standards Board, referred to as FASB, issued FASB Staff Position, referred to as FSP, No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” FSP FAS 157-3 clarifies the application of SFAS No. 157, “Fair Value Measurements,” in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 is effective immediately, including prior periods for which financial statements have not been issued. RAI has adopted FSP FAS 157-3 effective with the financial statements ended September 30, 2008. The adoption of FSP FAS 157-3 had no impact on RAI’s consolidated results of operations, financial position or cash flows.

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

Recently Issued Accounting Pronouncements

     In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133.” SFAS No. 161 seeks qualitative disclosures about the objectives and strategies for using derivatives, quantitative data about the fair value of and gains and losses on derivative contracts, and details of credit-risk-related contingent features in hedged positions. SFAS No. 161 also seeks enhanced disclosure around derivative instruments in financial statements, accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and how hedges affect an entity’s financial position, financial performance and cash flows. SFAS No. 161 is effective for RAI as of January 1, 2009. RAI does not expect the adoption of SFAS No. 161 to have a material impact on its results of operations, financial position or cash flows.

     In April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the Useful Life of Intangible Assets.” FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets.” The objective of FSP FAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R) and GAAP. FSP FAS 142-3 is effective for financial statements issued for years beginning after December 15, 2008, and interim periods within those years and is applied prospectively to intangible assets acquired after the effective date. RAI does not expect the adoption of FSP FAS 142-3 to have a material impact on its financial position, results of operations or cash flows.

Note 2—Intangible Assets

     The changes in the carrying amount of trademarks by segment during the nine months ended September 30, 2008, were as follows:

		RJR Tobacco								Conwood								All Other
		Indefinite				Finite				Indefinite				Finite				Indefinite
		Life				Life				Life				Life				Life				Consolidated
Balance as of January 1, 2008		$	1,826			$	41			$	1,374			$	11			$	155			$	3,407
Impairment included in operating income			(173	)			—				—				—				—				(173	)
Amortization expense			—				(5	)			—				—				—				(5	)
Balance as of September 30, 2008		$	1,653			$	36			$	1,374			$	11			$	155			$	3,229

     During the third quarter of 2008, RJR Tobacco made the decision to change its brand portfolio strategy and reclassified the KOOL brand from a growth brand to a support brand. RJR Tobacco recorded an impairment charge of $173 million during the third quarter of 2008 as a result of impairment testing conducted on the KOOL trademark triggered by this change in brand portfolio strategy. This charge was based on the excess of KOOL’s carrying value over its fair value using the present value of estimated future cash flows assuming a discount rate of 10.5%. The discount rate was determined by adjusting the enterprise discount rate by an appropriate risk premium to reflect an asset group risk. The impairment charge is reflected as a decrease in the carrying value of the KOOL trademark in the condensed consolidated balance sheet (unaudited) as of September 30, 2008, as a trademark impairment charge in the condensed consolidated statement of income (unaudited) for the three and nine months ended September 30, 2008, and had no impact on cash flows.

     The changes in the carrying amount of other intangibles by segment during the nine months ended September 30, 2008, were as follows:

		RJR Tobacco								All Other
		Indefinite								Indefinite
		Life				Finite Life				Life				Consolidated
Balance as of January 1, 2008		$	55			$	100			$	47			$	202
Amortization expense			—				(11	)			—				(11	)
Balance as of September 30, 2008		$	55			$	89			$	47			$	191

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

     Indefinite-lived intangibles include acquired trademarks and distribution rights and agreements. Finite-lived intangible assets as of September 30, 2008, were as follows:

						Accumulated
		Gross				Amortization				Net
Contract manufacturing		$	151			$	62			$	89
Technology-based			3				3				—
Total other intangibles			154				65				89
Trademarks			95				48				47
		$	249			$	113			$	136

     As of September 30, 2008, the estimated remaining amortization associated with finite-lived intangible assets was expected to be expensed as follows:

Year			Amount
Remainder of 2008			$	6
2009				22
2010				20
2011				20
2012				19
2013				18
Thereafter				31
			$	136

Note 3—Restructuring

     In the third quarter of 2008, RAI and RJR Tobacco announced changes in their organizational structures to streamline non-core business processes and programs in order to allocate additional resources to strategic growth initiatives. The reorganizations will result in the elimination of approximately 600 full-time jobs, expected to be substantially completed by December 31, 2009.

     Under existing benefit plans, $84 million of severance-related cash benefits and $7 million of non-cash pension-related benefits comprised a restructuring charge of $91 million. Of this charge, $81 million was recorded in the RJR Tobacco segment. None of the cash portion of the charge was paid as of September 30, 2008. Accordingly, in the condensed consolidated balance sheet (unaudited) as of September 30, 2008, $36 million was included in other current liabilities and $48 million was included in other noncurrent liabilities. The cash benefits are expected to be substantially paid by December 31, 2010.

     The component of the restructuring charge accrued and utilized was as follows:

		Employee Severance
		and Benefits
Original accrual		$	91
Utilized in 2008			(7	)
Balance as of September 30, 2008		$	84

Note 4—Termination of Joint Venture

     In 2002, R.J. Reynolds Tobacco C.V., an indirect wholly owned subsidiary of RAI and referred to as RJRTCV, and an affiliate of Gallaher Group Plc, referred to as Gallaher, formed a joint venture, with each party owning a 50% membership interest. The joint venture, R. J. Reynolds-Gallaher International Sarl, marketed American-blend cigarettes primarily in Italy, France and Spain.

     On April 18, 2007, an affiliate of Japan Tobacco Inc. acquired Gallaher, and Gallaher subsequently notified RJRTCV that the acquisition constituted a change of control of Gallaher within the meaning of the joint venture

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

agreement. Pursuant to the terms of the joint venture agreement, RJRTCV elected to terminate the joint venture prior to its expiration date. The joint venture was terminated on December 31, 2007.

     The joint venture agreement provided that upon a termination of the joint venture, the value of all the trademarks each joint venture member or its affiliate licensed to the joint venture, other than NATURAL AMERICAN SPIRIT, would be calculated and that the party whose licensed trademarks were determined to be of greater value would be required to pay the other party an amount, referred to as the Termination Amount, equal to one-half of the difference between the values of the parties’ respective trademarks. On February 20, 2008, following the parties’ negotiations regarding the trademarks’ values, RJRTCV and Gallaher Limited, an affiliate of Gallaher, entered into a valuation payment settlement agreement, pursuant to which Gallaher Limited agreed to pay RJRTCV a Termination Amount equal to euros 265 million, or approximately $388 million using a February 20, 2008, exchange rate of 1.4625. Of this amount, euros 106 million, or 40%, was paid in April 2008, and the remaining 60% is to be paid in six equal annual installments commencing April 2009. Of this receivable, $32 million, including imputed interest, and $161 million are included in notes receivable and other assets and deferred charges, respectively, in RAI’s condensed consolidated balance sheet (unaudited) as of September 30, 2008. Related to the gain on termination of the joint venture of $328 million, approximately $118 million of deferred tax was recorded and included in deferred income taxes, net in the noncurrent liability section of the condensed consolidated balance sheet (unaudited) as of September 30, 2008.

     In the first quarter of 2008, an indirect subsidiary of RJR Tobacco sold the AUSTIN trademark, a brand formerly sold through the joint venture, resulting in a gain of $6 million. GPI continues to sell NATURAL AMERICAN SPIRIT to the primary markets of the former joint venture in addition to other international markets.

Note 5—Income Per Share

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

		For the Three Months								For the Nine Months
		Ended September 30,								Ended September 30,
		2008				2007				2008				2007
Income from continuing operations before extraordinary item		$	211			$	358			$	1,080			$	1,010
Extraordinary item — gain on acquisition			—				—				—				1
Net income		$	211			$	358			$	1,080			$	1,011
Basic weighted average shares, in thousands1			291,425				294,169				293,083				294,454
Effect of dilutive potential shares:
Options			190				243				209				249
Restricted stock			428				294				427				226
Diluted weighted average shares, in thousands			292,043				294,706				293,719				294,929

Note 6—Fair Value Measurement

     On January 1, 2008, RAI adopted SFAS No. 157, “Fair Value Measurements,” as clarified by FSP FAS 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” for financial assets and financial liabilities. SFAS No. 157 provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. SFAS No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity, and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances.

     SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, essentially an exit price.

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

     The levels of the fair value hierarchy established by SFAS No. 157 are:

Level 1: inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2: inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. A Level 2 input must be observable for substantially the full term of the asset or liability.

Level 3: inputs are unobservable and reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.

     Financial assets carried at fair value as of September 30, 2008, were as follows:

		Level 1				Level 2				Level 3				Total
Money market funds		$	2,023			$	—			$	52			$	2,075
Auction rate notes			—				—				108				108
Mortgage-backed securities			—				—				27				27
Assets held in grantor trusts			16				—				—				16
Interest rate swaps			—				106				—				106
Total assets at fair value		$	2,039			$	106			$	187			$	2,332

     The fair value for the interest rate swaps, classified as a Level 2, was derived using the notional amount of the interest rate swap multiplied by the observable inputs of time to maturity, interest rates and credit spreads.

     The fair value for the money market funds, classified as a Level 3, were based upon expected future cash flows from accumulated cash in the fund and future maturities of the remaining held securities. During September 2008, the managers of the Reserve Fund-Primary Fund and Reserve Fund-International Liquidity Fund, both AAA-rated money market funds, quit accepting purchases into the funds and did not honor redemption requests that would cause the fund to liquidate outstanding holdings into a volatile market at a loss. At September 30, 2008, there still had not been any purchases into or redemptions out of these money market funds. In addition, no valuations had been issued by either fund. RAI was unable to identify a similar fund that carried identical holdings. As a result, the observable transactions or pricing were not current. The funds did issue a detailed listing of the securities that were held and not matured, as well as their face value and maturity date. This observable data, along with unobservable factors such as discount rate, and assumptions about fund liquidation of accumulated cash and the collectability of the outstanding underlying securities were used to determine the fair value of the funds as of September 30, 2008.

     The fair values for the auction securities, whose risk is tied to longer term debt or capital issued by a diverse range of corporations, including but not limited to, manufacturing, financial and insurance sectors, classified as a Level 3, were based upon calculating the weighted average present value of future cash payments, given the probability of certain events occurring within the market. Although RAI considers the market for auction rate notes to be inactive, the models utilized observable inputs, including LIBOR-based interest rate curves, corporate credit spreads and corporate ratings/market valuations. Additionally, unobservable factors incorporated into the models included default probability assumptions, recovery potential and how these factors changed as collateral ratings migrated from one level to another.

     The fair values for the mortgage-backed securities, classified as a Level 3, were based upon the calculation of an overall weighted average valuation, derived from the actual, or modeled, market pricing of the specific collateral, depending on availability. These mortgage-backed securities have not had any market activity throughout 2008, and therefore, RAI has deemed the market for these securities to be inactive. However, the underlying collateral continues to perform favorably, and the security continues to pay interest on time and within terms.

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

     The changes in the Level 3 investments as of September 30, 2008, were as follows:

		Money Market Funds												Auction Rate Notes												Mortgage-Backed Securities
						Gross												Gross												Gross
						Realized				Estimated								Unrealized				Estimated								Unrealized				Estimated
		Cost				Loss				Fair Value				Cost				Loss				Fair Value				Cost				Loss				Fair Value
Balance as of January 1, 2008		$	—			$	—			$	—			$	145			$	(18	)		$	127			$	45			$	(1	)		$	44
Transfers into Level 3			54				—				54				—				—				—				—				—				—
Unrealized losses			—				—				—				—				(19	)			(19	)			—				(11	)			(11	)
Realized losses			—				(2	)			(2	)			—				—				—				—				—				—
Settlements			—				—				—				—				—				—				(6	)			—				(6	)
Balance as of September 30, 2008		$	54			$	(2	)		$	52			$	145			$	(37	)		$	108			$	39			$	(12	)		$	27

Note 7—Investments

     Short-term investments classified as available-for-sale were as follows:

		September 30, 2008												December 31, 2007
						Gross												Gross
						Realized				Estimated								Unrealized				Estimated
		Cost				Loss				Fair Value				Cost				Loss				Fair Value
Reserve Fund — Primary Fund		$	37			$	(1	)		$	36			$	—			$	—			$	—
Reserve Fund — International Liquidity Fund			17				(1	)			16				—				—				—
Federal agency securities and treasury bills and notes			—				—				—				206				—				206
Auction rate notes			—				—				—				145				(18	)			127
Mortgage-backed securities			—				—				—				45				(1	)			44
		$	54			$	(2	)		$	52			$	396			$	(19	)		$	377

     During the third quarter of 2008, the Reserve Funds, which are money market funds, were reclassified to short-term investments from cash equivalents due to the liquidity restrictions issued by the fund managers preventing immediate withdrawals. The Primary Fund is made up of investments in securities that primarily include bank notes, certificates of deposit, commercial paper and floating-rate discount notes. The International Liquidity Fund consists of investments in securities that include bank notes, certificates of deposit, commercial paper and floating-rate discount notes. Included in both the Primary Fund and the International Liquidity Fund were investments in Lehman Brothers Holdings Inc., referred to as Lehman. On September 15, 2008, Lehman filed for protection under Chapter 11 of the federal Bankruptcy Code. The value of RAI’s pro rata share of indirect holdings in the Lehman investments has been impaired and recognized as a loss in other (income) expense, net in the condensed consolidated statement of income (unaudited) for the three- and nine-month periods ended September 30, 2008.

     No additional impairment was recorded on the Reserve Funds beyond the Lehman impairment as the Reserve Funds will distribute cash as assets mature or are sold. In addition, RAI has the intent and the ability to hold the investments in the Reserve Funds until maturity and, at this time, the Reserve Funds expect maturity at stated face value.

     The investments in federal agency securities and treasury bills and notes were liquidated during the second quarter of 2008 to meet working capital needs.

     Auction rate notes are instruments with long-term contractual maturities, but have historically been highly liquid. Historically, they have repriced at intervals ranging from 7 to 49 days, and therefore, the fair values have approximated carrying values. However, during 2007, adverse changes in the financial markets caused certain auction rate notes to revalue lower than their carrying value and become less liquid. The auction rate notes were reclassified to a long-term investment during the second quarter of 2008 as RAI believes a successful auction is not likely to occur within the next year. The auction rate notes were included in other assets and deferred charges in RAI’s condensed consolidated balance sheet (unaudited) as of September 30, 2008. The funds associated with the auction rate notes will not be accessible until a successful auction occurs or a buyer is found.

     The mortgage-backed securities were reclassified to a long-term investment as of March 31, 2008, as a result of a restructuring with the original issuer. These securities were included in other assets and deferred charges in RAI’s condensed consolidated balance sheet (unaudited) as of September 30, 2008. This restructured investment extends the

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

life of the security, but is supported by the same underlying collateral that carries the same economic risks. As of September 30, 2008, RAI received $6 million in principal payments on these mortgage-backed securities.

     RAI intends, and has the ability, to hold the auction rate notes and mortgage-backed securities for a period of time sufficient to allow for the anticipated recovery in fair value. These investments will be evaluated on a quarterly basis.

     Long-term investments classified as available-for-sale were as follows:

		September 30, 2008
						Gross
						Unrealized				Estimated
		Cost				Loss				Fair Value
Auction rate notes		$	145			$	(37	)		$	108
Mortgage-backed securities			39				(12	)			27
		$	184			$	(49	)		$	135

     There were no long-term investments classified as available-for-sale at December 31, 2007.

     RAI reviews impairments associated with the above in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and FSP FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” to determine the classification of the impairment as temporary or other-than-temporary. RAI considers the auction rate notes and mortgage-backed securities to be temporarily impaired as of September 30, 2008, with the unrealized loss included in accumulated other comprehensive loss in the condensed consolidated balance sheet (unaudited) as of September 30, 2008. Such unrealized loss did not reduce net income for the three- or nine-month periods ended September 30, 2008.

Note 8—Inventories

     The major components of inventories were as follows:

		September 30,				December 31,
		2008				2007
Leaf tobacco		$	841			$	967
Other raw materials			51				45
Work in process			55				48
Finished products			172				163
Other			33				24
Total			1,152				1,247
Less LIFO allowance			80				51
		$	1,072			$	1,196

     RJR Tobacco will perform its annual LIFO inventory valuation at December 31, 2008, as interim periods represent an estimate of the expected annual valuation.

Note 9—Income Taxes

     The provision for income taxes in the third quarter of 2008 was $123 million, or an effective rate of 36.8%, compared with $203 million, or an effective rate of 36.2%, in the third quarter of 2007. The provision for income taxes for the first nine months of 2008 was $630 million, or an effective rate of 36.8%, compared with $590 million, or an effective rate of 36.9%, in the first nine months of 2007. The effective rate for the first nine months of 2008 was favorably impacted by a lower tax rate related to the gain on the termination of the Reynolds-Gallaher International Sarl joint venture.

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

     The effective rate exceeds the federal statutory rate of 35% primarily due to the impact of state taxes and certain other nondeductible items, offset by the domestic production activities deduction of the American Jobs Creation Act enacted on October 22, 2004.

     The gross accruals for unrecognized income tax benefits, including interest and penalties, reflected in other noncurrent liabilities were $164 million and $172 million at September 30, 2008, and December 31, 2007, respectively. RAI accrues interest and penalties related to accruals for income taxes and reflects these amounts in tax expense. The gross amount of interest accrued at September 30, 2008, and December 31, 2007, was $50 million and $49 million, respectively. The gross amount of penalties of $12 million was accrued at each of September 30, 2008, and December 31, 2007.

     The gross increases in unrecognized tax benefits related to tax positions were $13 million for the nine months ended September 30, 2008. Included in this amount were $10 million attributable to current year tax positions and $3 million attributable to prior-year tax positions.

     The gross decreases in unrecognized tax benefits were $22 million for the nine months ended September 30, 2008. Included in this amount were $3 million attributable to prior-year tax positions, $14 million attributable to settlements with taxing authorities and $5 million attributable to statute of limitation expirations.

     As of September 30, 2008, $60 million of unrecognized tax benefits and $43 million of interest and penalties, if recognized, would affect the effective tax rate.

     Included in the provision for income taxes for the three months and nine months ended September 30, 2008, was $2 million and $11 million of additional tax expense including $1 million and $3 million of interest expense, net of federal benefit, and penalties associated with unrecognized tax benefits, respectively. Comparable amounts for the three months and nine months ended September 30, 2007, were $4 million and $12 million of additional tax expense, including $1 million and $5 million of interest expense, net of federal benefit, and penalties, respectively.

     RAI and its subsidiaries may be subject to income taxes in the United States, certain foreign jurisdictions and multiple state jurisdictions. A number of years may elapse before a particular matter for which RAI has established an accrual is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. RAI’s major taxing jurisdictions and related open tax audits are discussed below.

     The IRS completed its examination and issued an assessment for the years 2002 and 2003. RAI filed a protest in 2006, and a formal settlement agreement was signed during the first quarter of 2008. Overpayments from prior year audits exceed the settlement agreement amount, and a refund of $2 million was received in April 2008. Amended state returns will be prepared in 2008 to reflect these federal adjustments. The additional state income tax associated with these returns is reflected in the accruals for unrecognized income tax benefits.

     RAI has filed a federal consolidated income tax return for the years 2004 through 2007. The statute of limitations remains open for the years 2005 through 2007. There are no IRS examinations scheduled at this time for these open years.

     In December 2007, North Carolina completed its examination of RJR Tobacco for years 2000 through 2002 and issued a total assessment of $37 million: $21 million related to tax, $8 million related to interest and $8 million related to penalties. RJR Tobacco filed a protest in January 2008. RJR Tobacco will continue to work with North Carolina to resolve issues identified and assessed for years 2000 through 2002. A complete resolution is not anticipated within the next 12 months. However, in the event a complete resolution of this audit is reached during the next 12 months, RJR Tobacco could recognize additional expense of up to $13 million, inclusive of tax, interest, net of federal benefit, and penalties.

     It is expected that the amount of unrecognized tax benefits will change in the next 12 months. Excluding the impact of North Carolina’s assessment for years 2000 through 2002, RAI does not expect the change to have a significant impact on its consolidated results of operations, financial position or cash flows.

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

Note 10—Borrowing Arrangements

     On June 28, 2007, RAI entered into a Fifth Amended and Restated Credit Agreement, which, as subsequently amended, is referred to as the Credit Facility. The Credit Facility provides for a five-year, $550 million revolving credit facility, which may be increased to $900 million at the discretion of the lenders upon the request of RAI. The Credit Facility’s maturity date of June 28, 2012, may be extended, at the discretion of the lenders upon RAI’s request, in two separate one-year increments. Effective March 31, 2008, the Credit Facility was amended by:

	•		adding a further exception to the covenant that restricts the sale of assets, so as to permit the disposition of real properties and related assets, whether by donation or sale below fair market value, in an aggregate amount not to exceed $15 million;
	•		modifying the covenant limiting the amount of cash, Marketable Investments and Investment Equities that a Non-Guarantor Subsidiary, that is not a Domestic Subsidiary, as such terms are defined in the Credit Facility, may hold; and
	•		modifying certain related definitions.

     On October 5, 2008, Lehman Commercial Paper Inc., a lender in the Credit Facility and referred to as LCPI, filed for protection under Chapter 11 of the federal Bankruptcy Code. RAI has never borrowed under the Credit Facility, but given LCPI’s bankruptcy filing, there can be no assurance that LCPI would loan to RAI LCPI’s pro rata share of any borrowing requests made by RAI. Subject to the terms and conditions in the Credit Facility, RAI has the right to replace a lender in certain circumstances, including upon a lender defaulting in its obligation to make loans. If any lender were to default in its obligation to make loans, there can be no assurance as to when or whether RAI could find an acceptable replacement lender. LCPI’s commitment under the Credit Facility is $52 million.

     Certain of RAI’s subsidiaries, including its material domestic subsidiaries, referred to as the Guarantors, have guaranteed RAI’s obligations under the Credit Facility and under RAI’s outstanding senior notes, referred to as the Notes. Until the credit ratings actions described below, RAI had pledged substantially all of its assets, including the stock of its direct subsidiaries, to secure its obligations under the Credit Facility, and the Guarantors had pledged substantially all of their assets to secure their guarantees of RAI’s obligations under the Credit Facility. Until such credit ratings actions, the Notes and related guarantees had been secured by any Principal Property, as such term is defined in the indenture governing the Notes, of RAI and certain of the Guarantors, and the stock, indebtedness or other obligations of RJR Tobacco.

     On May 2, 2008, S&P raised its corporate credit rating for RAI from BB+, a non-investment grade rating, and a positive outlook, to BBB-, an investment grade rating, and a stable outlook. On June 20, 2008, Moody’s, consistent with its notching practices for an investment grade issuer, withdrew its corporate credit rating of Ba1, a non-investment grade rating, for RAI, and upgraded the Notes from Ba1 to Baa3, an investment grade rating. Moody’s also revised its outlook for RAI from positive to stable.

     Pursuant to the terms of the loan documents relating to the Credit Facility, Notes and related guarantees, which terms provide for a release of collateral if RAI obtains investment grade corporate credit ratings, with not worse than stable outlooks, from each of S&P and Moody’s, the collateral securing the Credit Facility, Notes and related guarantees was released automatically on June 20, 2008, upon the ratings issued by Moody’s on that date. The relevant loan documents do not provide for a release of the Guarantors’ guarantees of the Credit Facility and the Notes upon any ratings upgrades and, therefore, such guarantees remain in effect. In addition, on June 20, 2008, given the release of the collateral which had secured the Credit Facility and the related guarantees, Moody’s lowered the investment grade rating for the Credit Facility from Baa1 to Baa3. The collateral for the Credit Facility, Notes and related guarantees will be reinstated if RAI’s corporate credit rating issued by each of S&P and Moody’s is lowered to at least one level below the lowest rating level established as investment grade, or if RAI’s corporate credit rating issued by either S&P or Moody’s is lowered to at least two levels below the lowest rating level established as investment grade.

Note 11—Financial Instruments

     RAI and RJR use interest rate swaps to manage interest rate risk on a portion of their respective debt obligations. When entered into, these financial instruments are designated as hedges of underlying exposures.

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

     Swaps existed on $1.6 billion principal amount of debt as of September 30, 2008. Including the impact of swaps, the average interest rate on the principal amount of RAI’s consolidated $4.4 billion long-term debt was 5.87% as of September 30, 2008.

     The interest rate swaps’ notional amounts and termination dates match those of the corresponding outstanding notes. As of September 30, 2008, these fair value hedges were perfectly effective, resulting in no recognized net gain or loss. The unrealized gains on the hedges resulting from the change in the hedges’ fair value were $106 million and $119 million at September 30, 2008, and December 31, 2007, respectively, included in other assets and deferred charges in the condensed consolidated balance sheets (unaudited) and were equal to the increase in the fair value of the hedged long-term debt.

     Under certain conditions, any fair value that results in a liability position of certain interest rate swaps may require full collateralization with cash or securities. No swaps were in a liability position as of September 30, 2008.

Note 12—Commitments and Contingencies

Tobacco Litigation — General

Introduction

     Various legal proceedings or claims, including litigation claiming that 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, the Conwood companies or their affiliates, including RAI and RJR, or indemnitees, including B&W. These pending legal proceedings include claims relating to cigarette products manufactured by RJR Tobacco or certain of its affiliates and indemnitees, as well as claims relating to smokeless tobacco products manufactured by the Conwood companies. A discussion of the legal proceedings relating to cigarette products is set forth below under the heading “— Litigation Affecting the Cigarette Industry.” All of the references under that heading to tobacco-related litigation, smoking and health litigation and other similar references are references to legal proceedings relating to cigarette products and are not references to legal proceedings involving smokeless tobacco products, and case numbers under that heading include only cases involving cigarette products. The legal proceedings relating to the smokeless tobacco products manufactured by the Conwood companies are discussed separately under the heading “— Smokeless Tobacco Litigation” below.

     In connection with the B&W business combination, RJR Tobacco agreed to indemnify B&W and its affiliates against certain 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 B&W business combination. In addition, pursuant to this indemnity, RJR Tobacco expensed less than $1 million during the first nine months of 2008 and $2 million during the first nine months of 2007, for funds to be reimbursed to BAT for costs and expenses incurred arising out of certain tobacco-related litigation.

Certain Terms and Phrases

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

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

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 certain settlements entered into by RJR Tobacco and B&W are explained below under “— Accounting for Tobacco-Related Litigation Contingencies.”

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 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, the Conwood companies and their 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, or by the Comprehensive Smokeless Tobacco Health Education Act, 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.

Accounting for Tobacco-Related Litigation Contingencies

     In accordance with GAAP, RAI and its subsidiaries, including RJR Tobacco and the Conwood companies, as applicable, record any loss concerning 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, or the loss of any particular claim concerning the use of smokeless tobacco against the Conwood companies, when viewed on an individual basis, is not probable.

     RJR Tobacco and its affiliates believe that they have 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. 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. 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.

     No liability for pending smoking and health tobacco litigation was recorded in RAI’s consolidated balance sheet (unaudited) as of September 30, 2008. RJR has liabilities totaling $94 million that were recorded in 1999 in connection with certain indemnification claims not related to smoking and health 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, referred to as Northern Brands. For further information on Northern Brands and related litigation and the indemnification claims of JTI, see “—

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

Litigation Affecting the Cigarette Industry — Other Litigation and Developments” and “— Other Contingencies” below.

          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 Master Settlement Agreement 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 Master Settlement Agreement to benefit tobacco growers; and

     • the original Broin flight attendant case discussed below under “— Litigation Affecting the Cigarette Industry — Class-Action Suits.”

          The circumstances surrounding the MSA 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 or its affiliates and indemnitees. The claims underlying the MSA 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 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 a table depicting the related payment schedule, is set forth below under “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — MSA.”

          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. Although RJR Tobacco and certain of its affiliates and indemnitees 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. RJR Tobacco and its affiliates, including RAI, believe that the same legal principles that have resulted in dismissal of health-care cost recovery cases either at the trial court level or on appeal should compel dismissal of the similar pending cases.

          The pending U.S. Department of Justice case brought against various industry members, including RJR Tobacco and B&W, discussed below under “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases,” also can be distinguished from the circumstances surrounding the MSA. 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. These claims were dismissed, and the only claim remaining in the case involves alleged violations of civil provisions of the federal Racketeer Influenced and Corrupt Organizations Act, referred to as RICO. A comprehensive discussion of this case is set forth below under “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases.”

          As with claims that were resolved by the MSA, the other cases settled by RJR Tobacco can be distinguished from existing cases pending against RJR Tobacco and its affiliates and indemnitees. The original Broin case, discussed below under “— Litigation Affecting the Cigarette Industry — Class-Action Suits,” was settled in the middle of trial during negotiations concerning a possible nation-wide settlement of claims similar to those underlying the MSA.

          Likewise, RJR Tobacco and B&W separately settled the antitrust case DeLoach v. Philip Morris Cos., Inc., which was brought by a unique class of plaintiffs: a class of all tobacco growers and tobacco allotment holders. 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 DeLoach case and the antitrust cases currently pending against RJR Tobacco and B&W involve different types of plaintiffs and different theories of recovery under the antitrust laws than other cases pending against RJR Tobacco and its affiliates and indemnitees.

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

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

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.

          The Conwood companies also believe that they have valid defenses to the smokeless tobacco litigation against them. The Conwood companies have asserted and will continue to assert some or all of these defenses in each case at the time and in the manner deemed appropriate by the Conwood companies and their counsel. No verdict or judgment has been returned or entered against the Conwood companies on any claim for personal injuries allegedly resulting from the use of smokeless tobacco. The Conwood companies intend to defend vigorously all smokeless tobacco litigation claims asserted against them. No liability for pending smokeless tobacco litigation was recorded in RAI’s consolidated balance sheet (unaudited) as of September 30, 2008.

Cautionary Statement

          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, or the loss of any particular pending case concerning the use of smokeless tobacco against the Conwood companies, 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 any particular litigation pending against RJR Tobacco, the Conwood companies or their affiliates or indemnitees, or to reasonably estimate the amount or range of any possible loss.

          Although RJR Tobacco believes that it has valid bases for appeals of adverse verdicts in its pending cases, and RJR Tobacco and RAI believe they have 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. 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 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 or its affiliates or indemnitees, 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 position could be materially adversely affected by the ultimate outcome of certain pending litigation matters against RJR Tobacco or its affiliates or indemnitees.

          Similarly, smokeless tobacco litigation is subject to many uncertainties. Notwithstanding the quality of defenses available to the Conwood companies, it is possible that RAI’s results of operations, cash flows or financial position could be materially adversely affected by the ultimate outcome of certain pending litigation matters against the Conwood companies.

Litigation Affecting the Cigarette Industry

Overview

          Introduction.  In connection with the B&W business combination, RJR Tobacco agreed to indemnify B&W and its affiliates against, among other things, certain 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 B&W business combination.

          During the third quarter of 2008, 24 tobacco-related cases were served against RJR Tobacco or its affiliates or indemnitees. On September 30, 2008, there were 3,207 cases, including 686 individual smoker cases pending in West Virginia state court as a consolidated action and 2,310 Engle Progeny Cases, involving 8,827 individual plaintiffs, pending in the United States against RJR Tobacco or its affiliates or indemnitees, as compared with 1,283 total cases on

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

September 30, 2007, and 1,419 total cases on September 30, 2006, pending in the United States against RJR Tobacco or its affiliates or indemnitees.

          As of October 10, 2008, 922 tobacco-related cases were pending against RJR Tobacco or its affiliates or indemnitees: 917 in the United States; one in Puerto Rico; three in Canada; and one in Israel. Of the 917 total U.S. cases, 25 cases are pending against B&W that are not also pending against RJR Tobacco. The U.S. case number does not include the 2,620 Broin II or the 2,310 Engle Progeny Cases, as discussed below, pending as of October 10, 2008. 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 October 10, 2008, exclusive of the Broin II and Engle Progeny Cases:

		Number of
State		U.S. Cases
West Virginia			692	*
Maryland			38
New York			24
Florida			24
Missouri			20
Louisiana			17
Mississippi			14
California			11
Illinois			7
Connecticut			4
Ohio			4
Pennsylvania			4
Kentucky			4
District of Columbia			3
Georgia			3
Delaware			2
Washington			2
Alabama			2
Kansas			2
Maine			2
Minnesota			2
New Mexico			2
North Carolina			2
South Dakota			2
Tennessee			2
Vermont			2
Wisconsin			2
Arizona			1
Michigan			1
New Jersey			1
Oregon			1
South Carolina			1
Alaska			1
Arkansas			1
Colorado			1
Hawaii			1
Idaho			1
Indiana			1
Iowa			1
Mariana Islands			1
Massachusetts			1
Montana			1
Nebraska			1
Nevada			1
New Hampshire			1

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

		Number of
State		U.S. Cases
North Dakota			1
Oklahoma			1
Rhode Island			1
Utah			1
Virginia			1
Wyoming			1
Total			917	**

          The following table lists the categories of the U.S. tobacco-related cases pending against RJR Tobacco or its affiliates or indemnitees as of October 10, 2008, compared with the number of cases pending against RJR Tobacco, its affiliates or indemnitees as of July 11, 2008, as reported in RAI’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2008, filed with the SEC on August 4, 2008, and a cross-reference to the discussion of each case type.

						Change in Number
		RJR Tobacco’s				of Cases Since
		Case Numbers as of				July 11, 2008
Case Type		October 10, 2008				Increase/(Decrease)				Page Reference
Individual Smoking and Health			825				8				29
Engle Progeny (Number of Plaintiffs)*			2,310 (8,825)				67				30
Broin II			2,620				(1	)			31
Class-Action			15				(1	)			31
Health-Care Cost Recovery			4			No Change					36
MSA-Enforcement and Validity			60			No Change					40
Antitrust			2			No Change					42
Other Litigation			11				1				43

          Four pending cases against RJR Tobacco and B&W have attracted significant attention: the Florida state court class-action case, Engle v. R. J. Reynolds Tobacco Co., the Louisiana state court class-action case, Scott v. American Tobacco Co., the federal RICO case brought by the U.S. Department of Justice, and the federal lights class action Schwab [McLaughlin] v. Philip Morris USA, Inc.

          In 2000, a jury in Engle rendered a punitive damages verdict in favor of the “Florida class” of approximately $145 billion against all defendants. On July 6, 2006, the Florida Supreme Court, among other things, affirmed an appellate court’s reversal of the punitive damages award, decertified the class going forward, preserved several class-wide findings from the trial, including that nicotine is addictive and cigarettes are defectively designed, and authorized class members to avail themselves of these findings in individual lawsuits under certain conditions. After subsequent motions were resolved, the Florida Supreme Court issued its mandate on January 11, 2007, thus beginning a one-year period in which former class members were permitted to file individual lawsuits. On October 1, 2007, the U.S. Supreme Court denied the defendants’ petition for writ of certiorari. As of October 10, 2008, RJR Tobacco had been served in 2,310 Engle Progeny Cases in both state and federal courts in Florida. These cases include approximately 8,825 plaintiffs. The number of cases likely will change due to individual plaintiffs being severed from multi-plaintiff cases.

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

          In 2004, a jury in Scott returned a verdict in favor of the “Louisiana class” for $591 million to establish a state-wide smoking cessation program. In 2007, the Louisiana Court of Appeals upheld class certification, significantly reduced the scope of recovery, and remanded the case for further proceedings. The Louisiana and U.S. Supreme Courts denied the defendants’ applications for writ of certiorari. In July 2008, the trial court entered an amended judgment in favor of the class for approximately $263 million plus interest from June 30, 2004. The defendants have filed an emergency application for writ of mandamus or supervisory writ with the Louisiana Court of Appeals.

          In the U.S. Department of Justice case, brought in 1999 in the U.S. District Court for the District of Columbia, the government sought, among other forms of relief, the disgorgement of profits pursuant to the civil provisions of RICO. The U.S. Court of Appeals for the District of Columbia ruled in 2005 that disgorgement is not an available remedy in the case. The bench trial ended in June 2005, and the court, in August 2006, issued its ruling, among other things, finding certain defendants, including RJR Tobacco and B&W, liable for the RICO claims, imposing no direct financial penalties on the defendants, but ordering the defendants to make certain “corrective communications” in a variety of media and enjoining the defendants from using certain brand descriptors. Both sides have appealed to the U.S. Court of Appeals for the District of Columbia, and the trial court’s order has been stayed pending the appeal. Oral argument occurred on October 14, 2008. A decision is pending.

          In September 2006, the U.S. District Court for the Eastern District of New York in Schwab certified a nation-wide class of “lights” smokers. On November 16, 2006, the U.S. Court of Appeals for the Second Circuit granted the defendants’ motions to stay the district court proceedings and for review of the class certification ruling. On April 3, 2008, the Second Circuit decertified the class. The case was returned to the trial court for further proceedings.

          For a detailed description of these cases, see “— Class-Action Suits — Engle Case,” “— Class-Action Suits – Medical Monitoring and Smoking Cessation Cases,” “— Health-Care Cost Recovery Cases — Department of Justice Case” and “— Class-Action Suits — ‘Lights’ Cases” below.

          In November 1998, the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, entered into 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, including the four 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 payment obligations in perpetuity on RJR Tobacco, B&W and other major U.S. cigarette manufacturers; and

     • placed significant restrictions on their ability to market and sell tobacco products.

          MSA payments are subject to adjustments for, among other things, the volume of cigarettes sold, market share and inflation. See “— Health-Care Cost Recovery Cases — MSA” below for a detailed discussion of the MSA, including RAI’s operating subsidiaries’ monetary obligations under these agreements. RJR Tobacco records the allocation of settlement charges as products are shipped.

          Scheduled Trials.  Trial schedules are subject to change, and many cases are dismissed before trial. The following table lists the trial schedule, as of October 10, 2008, for RJR Tobacco or its affiliates and indemnitees through September 30, 2009.

Trial Date		Case Name/Type		Defendant(s)		Jurisdiction
October 6, 2008 [ONGOING]		Vermont v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Superior Court Chittenden County
		[MSA Enforcement (Eclipse)]				(Burlington, VT)
November 24, 2008		Hess v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)

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

Trial Date		Case Name/Type		Defendant(s)		Jurisdiction
December 1, 2008		Sherman v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
December 17, 2008		Williams v. Brown & Williamson		RJR Tobacco, B&W		Circuit Court
		[Individual]				City of St. Louis
						(St. Louis, MO)
January 5, 2009		Hargroves v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Hillsborough County
						(Miami, FL)
January 5, 2009		Brown v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
January 5, 2009		Cohen v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
January 5, 2009		Stephens v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
January 19, 2009		Levine v. R.J. Reynolds Tobacco Co.		RJR Tobacco, B&W		Circuit Court
		[Individual]				Palm Beach County
						(West Palm Beach, FL)
February 2, 2009		Tate v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
February 2, 2009		Cohen v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
February 2, 2009		Goldthorpe v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
March 9, 2009		Gelep v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Pinellas County
						(St. Petersburg, FL)
April 27, 2009		Abbott v. Philip Morris USA Inc.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Barbanell v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Bronstein v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Cohen v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Dawson v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Kaplan v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Lapidus-Carlson v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)

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

Trial Date		Case Name/Type		Defendant(s)		Jurisdiction
April 27, 2009		Lopez v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Marrazzo v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Morrissette-Stege v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Palmieri v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Rohr v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Salvino v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Tucci v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
April 27, 2009		Walsh v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County (Ft. Lauderdale, FL)
June 29, 2009		Digati v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
June 29, 2009		Greene v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
June 29, 2009		Grossman v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County
						(Ft. Lauderdale, FL)
June 29, 2009		Naugle v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Broward County
						(Ft. Lauderdale, FL)
June 29, 2009		Samuels v. R.J. Reynolds Tobacco Co. [Engle Progeny]		RJR Tobacco		Circuit Court Broward County (Ft. Lauderdale, FL)
July 13, 2009		Bell v. Brown & Williamson Tobacco Corp. [Individual]		RJR Tobacco; B&W		Circuit Court Jackson County
						(Independence, MO)
August 3, 2009		Woods v. R.J. Reynolds Tobacco Co.		RJR Tobacco; B&W		U.S. District Court
		[Individual]				Southern District
						(Jackson, MS)
August 5, 2009		Coley v. 3M Company		RJR Tobacco		Superior Court
		[Other]				New Castle County
						(Wilmington, DE)

          Trial Results.  From January 1, 1999 through October 10, 2008, 54 smoking and health and health-care cost recovery cases in which RJR Tobacco or B&W were defendants were tried. Verdicts in favor of RJR Tobacco, B&W and, in some cases, RJR Tobacco, B&W and other defendants, were returned in 37 cases, including four mistrials, tried in Florida (11), 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), Texas (1) and Washington (1).

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

          Additionally, from January 1, 1999 through October 10, 2008, verdicts were returned in 22 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 13 cases — five in Florida, three 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, two in each of Florida and Oregon and one in Illinois.

          No cases were tried in the first nine months of 2008 in which RJR Tobacco was a defendant.

          The following chart reflects the verdicts and post-trial developments in the smoking and health cases that have been tried and remain pending as of October 10, 2008, in which verdicts have been returned 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. The Florida Supreme Court on July 6, 2006, affirmed the dismissal of the punitive damages award and decertified, on a going-forward basis, the class. The court preserved a number of class-wide findings from Phase I of the Engle trial, and authorized class members to avail themselves of those findings in individual lawsuits, provided they commence those lawsuits within one year of the date the court’s decision becomes final. In addition, the court reinstated compensatory damage verdicts in favor of two plaintiffs in the amounts of $2.85 million and $4.023 million, respectively. In the third quarter of 2007, the U.S. Supreme Court denied the defendants’ petition for writ of certiorari and petition for rehearing. As a result, on February 8, 2008, RJR Tobacco paid approximately $5.9 million relating to the damages verdicts mentioned above, which was determined using the total amount of the verdicts together with accrued interest beginning November 7, 2000. On May 14, 2008, the trial court granted the parties’

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

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
								motion to sever moving plaintiffs’ claims. Plaintiffs Raymond Lacey, Michael Matyi and Loren Lowery have filed new cases. Plaintiff Howard Engle filed a stipulation for dismissal with prejudice, which the court ordered on July 2, 2008. On July 2, 2008, plaintiff Marilyn Calhoun filed a motion for relief from judgment.
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 non-economic damages and $12.5 million loss of consortium damages against Philip Morris, B&W and Liggett, of which B&W was assigned 22.5% of liability. Final judgment was entered in the amount of $24.8 million plus interest applicable at the yearly statutory rates from July 11, 2002. 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. On January 2, 2007, the defendants moved to set aside the June 11, 2002, verdict and to dismiss the plaintiffs’ punitive damages claim. On January 3, 2007, the plaintiffs filed a motion for entry of judgment, which the court deferred until the U.S. Supreme Court completed review of Engle and after further submissions by the parties. On January 28, 2008, the defendants filed a submission asking the court to set aside the verdict and to dismiss the case. The court granted the plaintiff’s motion for entry of judgment on August 14, 2008. Pursuant to that verdict, the plaintiff will recover the sum of $24.8 million plus interest at the yearly statutory rates from July 11, 2002. On August 25, 2008, the defendants filed a motion for reconsideration of, or in the alternative, to alter or amend the order on the plaintiffs’ motion for entry of judgment. A hearing occurred on October 21, 2008. A decision is pending.
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		On January 21, 2005, the plaintiff stipulated to the court’s reduction in the amount of punitive damages from $20

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

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
						million in punitive damages, of which $6 million was assigned to B&W, $2 million to a predecessor company and $12 million to two industry organizations.		million to $5 million, apportioned as follows: $0 to American Tobacco; $4 million to B&W; $500,000 to the Council for Tobacco Research and $500,000 to the Tobacco Institute. On June 26, 2007, final judgment was entered in the amount of approximately $6.8 million, including interest and costs. The defendants filed a notice of appeal on July 3, 2007. Briefing is complete. Oral argument has not been scheduled. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the amount of $8.018 million on July 5, 2007.
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, jointly and severally, for a smoking cessation program.		On September 29, 2004, the defendants posted a $50 million bond and noticed their appeal to the Louisiana Court of Appeal. RJR Tobacco posted $25 million toward the bond. On February 7, 2007, the Louisiana Court of Appeals limited the size of the class, and rejected the award of pre-judgment interest and most of the specific components of the smoking cessation program. However, the court upheld the class certification and found the defendants responsible for funding smoking cessation for eligible class members. On July 21, 2008, the trial court entered an amended judgment in the case. The court found that the defendants are jointly and severally liable for funding the cost of a court-supervised smoking cessation program and ordered the defendants to deposit approximately $263 million, together with interest from June 30, 2004, into a trust for the funding of the program. The court also stated that it would favorably

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

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
								consider a motion to return to defendants a portion of unused funds at the close of each program year in the event the monies allocated for the preceding program year were not fully expended because of a reduction in class size or underutilization by the remaining plaintiffs. On August 27, 2008, the court denied the defendants’ request for permission to pursue an appeal. On September 9, 2008, the defendants filed an emergency application for writ of mandamus or supervisory writ with request for stay and expedited consideration. The same day, the Louisiana Court of Appeals stayed all proceedings pending further order of the court.
February 2, 2005		Smith v. Brown & Williamson Tobacco Corp. [Individual]		Circuit Court, Jackson County (Independence, MO)		$2 million in compensatory damages which was 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. On July 31, 2007, the Missouri Court of Appeals affirmed the compensatory damages award but ordered a new trial on punitive damages. The Missouri Supreme Court accepted transfer of the case from the court of appeals, but on July 31, 2008, retransferred the case to the Missouri Court of Appeals.
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 amount of $2.058 million on February 7, 2006. On April 10, 2008, the New York Supreme Court, Appellate Division reversed the judgment in the plaintiffs’ favor and ordered that the case be dismissed. On May 8, 2008, the plaintiffs filed a notice of appeal. Oral argument is scheduled for November 18, 2008.

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

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
August 17, 2006		United States v. Philip Morris USA, Inc. [Governmental Health-Care Cost Recovery]		U.S. District Court, District of Columbia (Washington, DC)		RJR Tobacco and B&W were found liable for civil RICO claims; were enjoined from using certain brand descriptors and from making certain misrepresentations; and were ordered to make corrective communications on five subjects, including smoking and health and addiction, to reimburse the U.S. Department of Justice appropriate costs associated with the lawsuit, and to maintain document web sites.		On September 11, 2006, RJR Tobacco and B&W filed their notices of appeal. On October 16, 2006, the government filed its notice of appeal. The court of appeals granted the defendants’ motion to stay the district court’s order on October 31, 2006. Oral argument occurred on October 14, 2008. A decision is pending.
May 2, 2007		Whiteley v. R.J. Reynolds Tobacco Co. [Individual]		Superior Court, San Francisco County, (San Francisco, CA)		$2.46 million in compensatory damages jointly against RJR Tobacco and Philip Morris; $250,000 punitive damages against RJR Tobacco only.		On September 5, 2007, the court denied RJR Tobacco’s motion for judgment notwithstanding the verdict or, in the alternative, for a new trial. RJR Tobacco filed its notice of appeal on October 3, 2007. Briefing is underway. On May 5, 2008, the court issued an order approving deposit in lieu of appellate bond. RJR Tobacco purchased and deposited with the court approximately $2.6 million in U.S. Treasury bills in lieu of a supersedeas bond to stay enforcement of the judgment pending appeal.

Individual Smoking and Health Cases

          As of October 10, 2008, 825 individual cases, including 687 individual smoker cases in West Virginia state court in a consolidated action, were pending in the United States 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 or Engle Progeny Cases discussed below. A total of 822 of the individual cases are brought by or on behalf of individual smokers or their survivors, while the remaining three 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 during the period from January 1, 2008, to September 30, 2008, or remained on appeal as of September 30, 2008.

          In Whiteley v. R. J. Reynolds Tobacco Co., the retrial of Whiteley v. Raybestos-Manhattan, a case filed in April 1999 in Superior Court, San Francisco County, California and originally tried in 2000, the jury awarded the plaintiff $2.46 million in compensatory damages jointly against RJR Tobacco and Philip Morris on May 2, 2007, and returned a punitive damages verdict award of $250,000 against RJR Tobacco on May 9, 2007. RJR Tobacco’s motion for judgment notwithstanding the verdict or, in the alternative, for a new trial was denied on September 5, 2007. RJR Tobacco filed its notice of appeal to the Court of Appeal for the State of California, First Appellate District, on October 3, 2007. Briefing is underway. On May 5, 2008, the court issued an order approving deposit in lieu of appellate bond. RJR Tobacco purchased and deposited with the court approximately $2.6 million in U.S. Treasury bills in lieu of a supersedeas bond to stay enforcement of the judgment pending appeal.

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

     On August 15, 2003, a jury returned a verdict in favor of B&W in Eiser v. Brown & Williamson Tobacco Corp., a case filed in March 1999 in the Court of Common Pleas, Philadelphia County, Pennsylvania. The plaintiff, Lois Eiser, sought compensatory and punitive damages in an amount in excess of $50,000, together with interest, costs and attorneys’ fees in this wrongful death action against B&W. On January 19, 2006, the Superior Court of Pennsylvania affirmed the verdict. On September 22, 2006, the Pennsylvania Supreme Court granted the plaintiff’s petition to appeal, and on December 28, 2007, remanded the case to the Eastern District of the Superior Court for further review. Briefing is underway.

     On December 18, 2003, in Frankson v. Brown & Williamson Tobacco Corp., a case filed in August 2000 in Supreme Court, Kings County, New York, a 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, in an action brought against the major U.S. cigarette manufacturers, including RJR Tobacco, who was dismissed prior to trial, and B&W, seeking $270 million in compensatory damages, unspecified punitive damages, attorneys’ fees, costs and disbursements. Other manufacturers were dismissed before trial. The plaintiff, Gladys Frankson, alleged that Mr. Frankson became addicted to nicotine, was unable to cease smoking, developed lung cancer and died as a result. 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, assigning $6 million to B&W, $2 million to American Tobacco, a predecessor company to B&W, and $6 million 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.

     After all post-trial motions, and appeals there from, were denied, judgment was entered in favor of the plaintiffs for $175,000 in compensatory damages, the original jury award reduced by 50%, and $5 million in punitive damages, the amount to which the plaintiff stipulated. On June 26, 2007, final judgment was entered against the defendants in the amount of approximately $6.8 million, including interest and costs. The defendants filed a notice of appeal to the Appellate Division, New York Supreme Court, Second Department on July 3, 2007. Briefing is complete. Oral argument has not been scheduled. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the amount of $8.018 million on July 5, 2007.

     On February 1, 2005, a jury returned a split verdict in Smith v. Brown & Williamson Tobacco Corp., a case filed in May 2003 in Circuit Court, Jackson County, Missouri, finding in favor of B&W on two counts, fraudulent concealment and conspiracy, and finding in favor of the plaintiff on negligence, which incorporates failure to warn and product defect claims. The plaintiff, Lincoln Smith, claimed that the defendant’s tobacco products caused Mrs. Smith’s death from lung cancer and sought an unspecified amount of compensatory and punitive damages. The plaintiff was awarded $2 million in compensatory damages and $20 million in punitive 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. B&W appealed to the Missouri Court of Appeals, and on July 31, 2007, the court affirmed the compensatory damages and ordered a new trial on punitive damages. The Missouri Supreme Court agreed to accept transfer of the case from the court of appeals, and on July 31, 2008, retransferred the case to the Missouri Court of Appeals.

     On March 18, 2005, in Rose v. Brown & Williamson Tobacco Corp., a case filed in December 1996 in New York Supreme Court, County of New York, a 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. The action was brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover $15 million in compensatory damages and $35 million in punitive damages. The plaintiffs, Norma Rose and Leonard Rose, allege that their use of the defendants’ products caused them to become addicted to nicotine and develop lung cancer, chronic obstructive pulmonary disease and other smoking related conditions and/or diseases. Oral argument on B&W’s appeal in the Appellate Division, New York Supreme Court, First Department occurred on December 12, 2006. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the amount of $2.058 million on February 7, 2006. On April 10, 2008, the Appellate Division reversed the judgment in the plaintiffs’ favor and ordered that the case be dismissed. On May 8, 2008, the plaintiffs filed a notice of appeal. Oral argument is scheduled for November 18, 2008.

Engle Progeny Cases

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

     Pursuant to the Florida Supreme Court’s July 6, 2006, ruling in Engle v. R. J. Reynolds Tobacco Co., which decertified the class, former class members had one year from January 11, 2007, in which to file individual lawsuits. In addition, some individuals who filed suit prior to January 11, 2007, and who claim they meet the conditions in Engle, also are attempting to avail themselves of the Engle ruling. Lawsuits by individuals requesting the benefit of the Engle ruling, whether filed before or after the January 11, 2007, mandate, are referred to as the Engle Progeny Cases. As of October 10, 2008, RJR Tobacco had been served in 2,310 Engle Progeny Cases in both state and federal courts in Florida. These cases include approximately 8,825 plaintiffs. The number of cases likely will change due to individual plaintiffs being severed from multi-plaintiff cases. For further information on the Engle case, see “— Class-Action Suits — Engle Case,” below.

Broin II Cases

     As of October 10, 2008, there were 2,620 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 in airplane cabins, that is, specific causation. Below is a description of the only Broin II case against RJR Tobacco and B&W that went to trial or was decided during the period from July 1, 2008 to September 30, 2008, or remained on appeal as of September 30, 2008.

     In Janoff v. Philip Morris, Inc., a case filed in February 2000 in Circuit Court, Miami-Dade County, Florida, a jury found in favor of the defendants, including RJR Tobacco and B&W, on September 5, 2002, in an action brought against the major U.S. cigarette manufacturers seeking to recover compensatory damages pursuant to the Broin settlement. The plaintiff, Suzette Janoff, alleged that as a result of exposure to ETS in airline cabins, she suffered from, among other illnesses, chronic sinusitis, chronic bronchitis and other respiratory and pulmonary problems. The judge granted the plaintiff’s motion for a new trial on January 8, 2003. The new trial date has not been scheduled.

Class-Action Suits

     Overview.  As of October 10, 2008, 15 class-action cases, exclusive of antitrust class actions, were pending in the United States against RJR Tobacco or its affiliates or indemnitees. In May 1996, in Castano v. American Tobacco Co., the Fifth Circuit Court of Appeals overturned the certification of a nation-wide 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 state-wide, rather than nation-wide, 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 in state or federal courts in California, Florida, Illinois, Louisiana, Minnesota, Missouri, New York and West Virginia. All pending class-action cases are discussed below.

     The pending class-actions against RJR Tobacco or its affiliates or indemnitees include seven cases alleging that the use of the term “lights” constitutes unfair and deceptive trade practices under state law or violates the federal RICO statute. Such suits are pending in state or federal courts in Illinois, Minnesota, Missouri and New York.

     Finally, certain third-party payers have filed health-care cost recovery actions in the form of class-actions.

     Few smoker class-action complaints have been certified or, if certified, have survived on appeal. Eighteen federal courts, including two courts of appeals, and most state courts that have considered the issue have rejected class certification in such cases. Apart from the Castano case discussed above, only two smoker class actions have been certified by a federal court: In re Simon (II) Litigation and Schwab [McLaughlin] v. Philip Morris USA, Inc., discussed below under “— ‘Lights’ Cases,” both of which were filed in the U.S. District Court for the Eastern District of New York and ultimately decertified.

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     Medical Monitoring and Smoking Cessation Cases.  On November 5, 1998, in Scott v. American Tobacco Co., a case filed in May 1996 in District Court, Orleans Parish, Louisiana, the trial court certified a medical monitoring or smoking cessation class of Louisiana residents who were smokers on or before May 24, 1996, in an action brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover an unspecified amount of compensatory and punitive damages. The plaintiffs allege that their use of the defendants’ products caused them to become addicted to nicotine. On July 28, 2003, the jury returned a verdict in favor of the defendants on the plaintiffs’ claim for medical monitoring and found that cigarettes were not defectively designed. However, the jury also made certain findings against the defendants on claims relating to fraud, conspiracy, marketing to minors and smoking cessation. Notwithstanding 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 pay for a program to help people stop smoking.

     On March 31, 2004, phase two of the trial began to address only 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, that is, the portions for RJR Tobacco and B&W, towards the bond. On February 7, 2007, the Louisiana Court of Appeals upheld the class certification and found the defendants responsible for funding smoking cessation for eligible class members. The appellate court also ruled, however, that the defendants were not liable for any post-1988 claims, rejected the award of prejudgment interest and struck eight of the 12 components of the smoking cessation program. In particular, the appellate court ruled that no class member, who began smoking after September 1, 1988, could receive any relief, and that only those smokers, whose claims accrued on or before September 1, 1988, would be eligible for the smoking cessation program. Plaintiffs have expressly represented to the trial court that none of their claims accrued before 1988 and that the class claims did not accrue until around 1996, when the case was filed. On March 2, 2007, the defendants’ application for rehearing and clarification was denied. The defendants’ application for writ of certiorari with the Louisiana Supreme Court was denied on January 7, 2008. The defendants’ petition for writ of certiorari with the U.S. Supreme Court was denied on June 10, 2008. On July 21, 2008, the trial court entered an amended judgment in the case. The court found that the defendants are jointly and severally liable for funding the cost of a court-supervised smoking cessation program and ordered the defendants to deposit approximately $263 million, together with interest from June 30, 2004, into a trust for the funding of the program. The court also stated that it would favorably consider a motion to return to defendants a portion of unused funds at the close of each program year in the event the monies allocated for the preceding program year were not fully expended because of a reduction in class size or underutilization by the remaining plaintiffs.

     On August 27, 2008, the court denied the defendants’ request for permission to pursue an appeal. On September 9, 2008, the defendants filed an emergency application for writ of mandamus or supervisory writ with request for stay and expedited consideration. The same day, the Louisiana Court of Appeals stayed all proceedings pending further orders of the court.

     Engle Case.  Trial began in July 1998 in Engle v. R. J. Reynolds Tobacco Co., a case filed in May 1994, and pending in Circuit Court, Miami-Dade County, Florida, in which a class consisting of Florida residents, or their survivors, alleges diseases or medical conditions caused by their alleged “addiction” to cigarettes. The action was brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking actual damages and punitive damages in excess of $100 billion each and the creation of a medical fund to compensate individuals for future health-care costs. 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 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.

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     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 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. The class appealed, and the Florida Supreme Court accepted the case on May 12, 2004.

     On July 6, 2006, the court affirmed the dismissal of the punitive damages award and decertified the class, on a going-forward basis. The court preserved a number of class-wide findings from Phase I of the trial, including that cigarettes can cause certain diseases, that nicotine is addictive and that defendants placed defective and unreasonably dangerous cigarettes on the market, and authorized former class members to avail themselves of those findings under certain conditions in individual lawsuits, provided they commence those lawsuits within one year of the date the court’s decision became final. The court specified that the class is confined to those Florida citizen residents who suffered or died from smoking-related illnesses that “manifested” themselves on or before November 21, 1996, and that were caused by an addiction to cigarettes. In addition, the court reinstated the compensatory damages awards of $2.85 million to Mary Farnan and $4.023 million to Angie Della Vecchia, but ruled that the claims of Frank Amodeo were barred by the statute of limitations. Finally, the court reversed the Third District Court of Appeal’s 2003 ruling that class counsel’s improper statements during trial required reversal.

     On August 7, 2006, RJR Tobacco and the other defendants filed a rehearing motion arguing, among other things, that the findings from the Engle trial are not sufficiently specific to serve as the basis for further proceedings and that the Florida Supreme Court’s decision denied defendants due process. On the same day, the plaintiffs also filed a rehearing motion arguing that some smokers who became sick after November 21, 1996, and who are therefore not class members, should nevertheless have the statute of limitations tolled since they may have refrained from filing suit earlier in the mistaken belief that they were Engle class members. On December 21, 2006, the Florida Supreme Court withdrew its July 6, 2006, decision and issued a revised opinion, in which it set aside the jury’s findings of a conspiracy to misrepresent and clarified that the Engle jury’s finding on express warranty were preserved for use by eligible plaintiffs. The court also denied the plaintiffs’ motion and confirmed that the class was limited to those individuals who developed alleged smoking-related illnesses that manifested themselves on or before November 21, 1996. The court issued its mandate on January 11, 2007, which began the one-year period for former class members to file individual lawsuits. As of October 10, 2008, 2,310 individual cases were filed in Florida as a result of the Engle decision. These cases include approximately 8,825 plaintiffs. For further information on the individual cases, see “— Engle Progeny Cases” above.

     On April 17, 2007, RJR Tobacco’s motions for discharge of RJR Tobacco’s and B&W’s civil supersedeas bonds related to the punitive damages award were granted. During the second quarter of 2007, RJR Tobacco received the full amount of the $100 million cash collateral that it had posted. On October 1, 2007, the defendants’ petition for writ of certiorari with the U.S. Supreme Court was denied. On November 26, 2007, the defendants’ petition for rehearing with the U.S. Supreme Court was denied. As a result, the verdicts in favor of Mary Farnan and Angie Della Vecchia, mentioned above, became final. On February 8, 2008, RJR Tobacco paid approximately $5.9 million relating to the compensatory damages verdicts mentioned above, which amount was determined using the total amount of the verdicts together with accrued interest beginning November 7, 2000. A final computation of interest due on those judgments will be determined by the trial court in 2008. On May 14, 2008, the court entered an order granting the motion for discharge and return of compensatory damages supersedeas bond. During the second quarter of 2008, RJR Tobacco received the cash collateral of $3.8 million that it posted for the compensatory damages bond. Also on May 14, 2008, plaintiffs Mary Farnan and Ralph Della Vecchia, as representative of the estate of Angie Della Vecchia, filed satisfactions of judgment and waived all claims for punitive damages and acknowledged full payment in satisfaction of the November 7, 2000, amended final judgment. The same day, the court granted the parties’ joint motion to sever moving plaintiffs’ claims. Plaintiffs Raymond Lacey, Michael Matyi and Loren Lowery have filed new cases. Plaintiff Howard Engle filed a stipulation for dismissal with prejudice, which the court ordered on July 2, 2008. On July 2, 2008, plaintiff Marilyn Calhoun filed a motion for relief from judgment.

     Prior to the Florida Supreme Court ruling on July 6, 2006, RJR Tobacco and/or B&W were named as a defendant(s) in several individual cases filed by members of the Engle class. One such case, Lukacs v. Philip Morris, Inc., a case filed in February 2001, and pending in Circuit Court, Miami-Dade County, Florida, was tried against Philip Morris, Liggett and B&W, and resulted in a verdict for the plaintiffs on June 11, 2002, in a personal injury action brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover an unspecified amount in compensatory and punitive damages. The plaintiff, John Lukacs, alleged that his use of the defendants’ brands caused his development of bladder, throat, oral cavity and tongue cancer. RJR Tobacco was voluntarily dismissed on May 1, 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

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

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. On August 2, 2006, the plaintiffs filed a motion for entry of partial judgment and notice of jury trial on punitive damages. On January 2, 2007, the defendants asked the court to set aside the jury’s June 11, 2002, verdict for the plaintiffs and to dismiss the plaintiffs’ punitive damages claim. On January 3, 2007, the plaintiffs filed a motion for entry of judgment, which the court deferred until the U.S. Supreme Court has completed its review of Engle and after further submissions by the parties. On January 28, 2008, the defendants filed a submission asking the court to set aside the verdict and to dismiss the case. The court granted the plaintiffs’ motion for entry of judgment on August 14, 2008. Pursuant to the verdict rendered, the plaintiff, Robin Lukacs, as personal representative of the estate of John and Yolanda Lukacs, will recover the sum of $24,835,000 and interest applicable at the yearly statutory rates from June 11, 2002. On August 25, 2008, the defendants filed a motion for reconsideration of, or in the alternative, to alter or amend the order on the plaintiffs’ motion for entry of judgment. A hearing on the motion occurred on October 21, 2008. A decision is pending. On October 17, 2008, the plaintiff withdrew her request for punitive damages.

     California Business and Professions Code Cases.   On April 11, 2001, in Brown v. American Tobacco Co., Inc., a case filed in June 1997 in Superior Court, San Diego County, California, the court granted in part the plaintiffs’ motion for certification of a class 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. The action was brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover restitution, disgorgement of profits and other equitable relief under California Business and Professions Code § 17200 et seq. and § 17500 et seq. 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. On March 7, 2005, the court granted the defendants’ motion to decertify the class. On September 5, 2006, the California Court of Appeal affirmed the judge’s order decertifying the class. On November 1, 2006, the plaintiffs’ petition for review with the California Supreme Court was granted. Supplemental briefing is complete. A decision is pending.

     “Lights” Cases.  As noted above, “lights” class-action cases are pending against RJR Tobacco or B&W in Illinois (2), Missouri (2), Minnesota (2) and New York (1). The classes in these cases generally seek to recover $50,000 to $75,000 per class member for compensatory and punitive damages, injunctive and other forms of relief, and attorneys’ fees and costs from RJR Tobacco and/or B&W. In general, the plaintiffs allege that RJR Tobacco or B&W made false and misleading claims that “lights” cigarettes were lower in tar and nicotine and/or were less hazardous or less mutagenic than other cigarettes. The cases typically are filed pursuant to state consumer protection and related statutes.

     The seminal “lights” class-action case involved RJR Tobacco’s competitor, Philip Morris, Inc. Trial began in Price v. Philip Morris, Inc. in January 2003. In March 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. Philip Morris pursued various avenues of relief from the $12 billion bond requirement. In December 2005, the Illinois Supreme Court reversed the lower court’s decision and sent the case back to the trial court with instructions to dismiss the case. In December 2006, the defendants’ motion to dismiss and for entry of final judgment was granted, and the case was dismissed with prejudice the same day. The plaintiffs’ motion to vacate and/or withhold judgment was dismissed by the court on August 30, 2007.

     In Turner v. R. J. Reynolds Tobacco Co., a case filed in February 2000 in Circuit Court, Madison County, Illinois, a judge certified a class on November 14, 2001. On June 6, 2003, RJR Tobacco filed a motion to stay the case pending Philip Morris’s appeal of the Price v. Philip Morris Inc. case mentioned above, which the judge denied on July 11, 2003. On October 17, 2003, the Illinois Fifth District Court of Appeals denied RJR Tobacco’s emergency stay/supremacy order request. 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. On October 11, 2007, the Illinois Fifth District Court of Appeals dismissed RJR Tobacco’s appeal and remanded the case to the circuit court. There is currently no activity in the case.

     In Howard v. Brown & Williamson Tobacco Corp., another case filed in February 2000 in Circuit Court, Madison County, Illinois, a judge certified a class on December 18, 2001. On June 6, 2003, the trial judge issued an order staying all proceedings pending resolution of the Price v. Philip Morris, Inc. case mentioned above. The plaintiffs

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appealed this stay order to the Illinois Fifth District Court of Appeals, which affirmed the Circuit Court’s stay order on August 19, 2005. There is currently no activity in the case.

     In the event RJR Tobacco and its affiliates or indemnitees lose the Turner or Howard cases, or one or more of the other pending “lights” class-action suits, RJR Tobacco could face 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 position.

     Schwab [McLaughlin] v. Philip Morris USA, Inc., a nation-wide “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 brought the case pursuant to RICO, challenging the practices of the defendants in connection with the manufacturing, marketing, advertising, promotion, distribution and sale of cigarettes that were labeled as “lights” or “light.” On September 25, 2006, the court issued its decision, among other things, granting class certification. On November 16, 2006, the U.S. Court of Appeals for the Second Circuit granted the defendants’ motions to stay the district court proceedings and for review of the class certification ruling. On April 3, 2008, the Second Circuit decertified the class. The case was returned to the trial court for further proceedings.

     A “lights” class-action case is pending against each of RJR Tobacco and B&W in Missouri. In Collora v. R. J. Reynolds Tobacco Co., a case filed in May 2000 in Circuit Court, St. Louis County, Missouri, a judge in St. Louis certified a class on December 31, 2003. On April 9, 2007, the court granted the plaintiffs’ motion to reassign Collora and the following cases to a single general division: Craft v. Philip Morris Companies, Inc. and Black v. Brown & Williamson Tobacco Corp., discussed below. On April 16, 2008, the court stayed the case pending U.S. Supreme Court review in Good v. Altria Group, Inc., a “lights” class action pending against Altria and Philip Morris USA.

     In Black v. Brown & Williamson Tobacco Corp., a case filed in November 2000 in Circuit Court, City of St. Louis, Missouri, 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. On April 16, 2008, the court stayed the case pending U.S. Supreme Court review in Good v. Altria Group, Inc.

     In Dahl v. R. J. Reynolds Tobacco Co., a case filed in April 2003, and pending in District Court, Hennepin County, Minnesota, a judge dismissed the case on May 11, 2005, ruling 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 U.S. District Court for the District of Minnesota. On February 28, 2007, the Eighth Circuit remanded the case to the Minnesota Court of Appeals, which on December 4, 2007, reversed the judgment in favor of the defendants on preemption grounds and remanded the case to the District Court of Hennepin County. On February 27, 2008, RJR Tobacco’s motion to stay its January 3, 2008 petition for review until the completion of the U.S. Supreme Court review in Good v. Altria Group, Inc. was granted.

     In Thompson v. R. J. Reynolds Tobacco Co., a case filed in February 2005 in District Court, Hennepin County, Minnesota, RJR Tobacco removed the case on September 23, 2005 to the U.S. District Court for the District of Minnesota. On August 7, 2006, the parties filed a stipulation to stay the case pending resolution of the appeal in Dahl v. R. J. Reynolds Tobacco Co. On October 29, 2007, the U.S. District Court remanded the case to the District Court for Hennepin County. On February 1, 2008, the court stayed the case until the completion of the appeal in Dahl v. R. J. Reynolds Tobacco Co. and Good v. Altria Group, Inc.

     Finally, Rios v. R. J. Reynolds Tobacco Co., a case filed in February 2002 in Circuit Court, Palm Beach County, Florida, is dormant pending plaintiffs’ counsel’s attempt to appeal the Florida Fourth District Court of Appeal’s decertification in Hines v. Philip Morris, Inc., a “lights” class-action case filed in February 2001 in Circuit Court, Palm Beach County, Florida against Phillip Morris only. On January 14, 2008, the Florida Supreme Court refused to hear plaintiff’s appeal in Hines v. Philip Morris, Inc. The plaintiffs in Rios brought the action against RJR Tobacco and RJR. On February 19, 2008, the court dismissed the case.

     Other Class Actions.  In Cleary v. Philip Morris, Inc., a case filed in June 1998, and pending in Circuit Court, Cook County, Illinois, the plaintiffs filed their motion for class certification on December 21, 2001, in an action brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W. The case is brought on behalf of persons who have allegedly been injured by (1) the defendants’ purported conspiracy pursuant to which defendants

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

concealed material facts regarding the addictive nature of nicotine, (2) the defendants’ alleged acts of targeting its advertising and marketing to minors, and (3) the defendants’ claimed breach of the public right to defendants’ compliance with the laws prohibiting the distribution of cigarettes to minors. The plaintiffs request that the defendants be required to disgorge all profits unjustly received through its sale of cigarettes to plaintiffs and the class, which in no event will be greater than $75,000 per each class member, inclusive of punitive damages, interest and costs. On March 27, 2006, the court dismissed count V, public nuisance, and count VI, unjust enrichment. On July 11, 2006, the plaintiffs filed a renewed motion for class certification.

     Young v. American Tobacco Co., Inc., a case filed in November 1997 in Circuit Court, Orleans Parish, Louisiana, is an ETS class action against U.S. cigarette manufacturers, including RJR Tobacco and B&W, and parent companies of U.S. cigarette manufacturers, including RJR, on behalf of all residents of Louisiana who, though not themselves cigarette smokers, have been exposed to secondhand smoke from cigarettes which were manufactured by the defendants, and who allegedly suffered injury as a result of that exposure. The plaintiffs seek to recover an unspecified amount of compensatory and punitive damages. On October 13, 2004, the trial court stayed this case pending the outcome of the appeal in Scott v. American Tobacco Co., Inc., discussed above under “— Medical Monitoring and Smoking Cessation Cases.”

     In Parsons v. A C & S, Inc., a case filed in February 1998 in Circuit Court, Ohio County, West Virginia, the plaintiff sued asbestos manufacturers, U.S. cigarette manufacturers, including RJR Tobacco and B&W, and parent companies of U.S. cigarette manufacturers, including RJR, seeking to recover $1 million in compensatory and punitive damages individually and an unspecified amount for the class in both compensatory and punitive damages. The class is brought on behalf of persons who allegedly have personal injury claims arising from their exposure to respirable asbestos fibers and cigarette smoke. The plaintiffs allege that Mrs. Parsons’ use of tobacco products and exposure to asbestos products caused her to develop lung cancer and to become addicted to tobacco. The case has been stayed pending a final resolution of the plaintiffs’ motion to refer tobacco litigation to the judicial panel on multi-district litigation filed in In Re: Tobacco Litigation in the Supreme Court of Appeals of West Virginia. On December 26, 2000, three defendants, Nitral Liquidators, Inc., Desseaux Corporation of North American and Armstrong World Industries, filed bankruptcy petitions in the U.S. Bankruptcy Court for the District of Delaware, In re Armstrong World Industries, Inc. Pursuant to section 362(a) of the Bankruptcy Code, Parsons is automatically stayed with respect to all defendants.

     Finally, in Jones v. American Tobacco Co., Inc., a case filed in December 1998 in Circuit Court, Jackson County, Missouri, the defendants removed the case to the U.S. District Court for the Western District of Missouri on February 16, 1999. The action was brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, and parent companies of U.S. cigarette manufacturers, including RJR, on behalf of tobacco product users and purchasers on behalf of all similarly situated Missouri consumers. The plaintiffs allege that their use of the defendants’ tobacco products has caused them to become addicted to nicotine. The plaintiffs seek to recover an unspecified amount of compensatory and punitive damages. The case was remanded to the Circuit Court on February 17, 1999. There has been limited activity in this case.

     Broin Settlement.  RJR Tobacco, B&W and other cigarette manufacturer defendants settled Broin v. Philip Morris, Inc. in October 1997. This case had been brought in Florida state court on behalf of flight attendants alleged to have suffered 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 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 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 airplane cabins, referred to as “specific causation,” the individual plaintiff will have the burden of proof. 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.