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

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

Commission file number: 1-32258

Reynolds American Inc.

(Exact name of registrant as specified in its charter)

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

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

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

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

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

     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 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: 291,376,154 shares of common stock, par value $.0001 per share, as of October 9, 2009

 

 

INDEX

		Page
Part I — Financial Information
Item 1. Financial Statements
Condensed Consolidated Statements of Income (Unaudited) — Three Months and Nine Months Ended September 30, 2009 and 2008			3
Condensed Consolidated Statements of Cash Flows (Unaudited) — Nine Months Ended September 30, 2009 and 2008			4
Condensed Consolidated Balance Sheets — September 30, 2009 (Unaudited) and December 31, 2008			5
Notes to Condensed Consolidated Financial Statements (Unaudited)			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			71
Item 3. Quantitative and Qualitative Disclosures about Market Risk			90
Item 4. Controls and Procedures			91
Part II — Other Information
Item 1. Legal Proceedings			91
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			91
Item 5. Other Information			92
Item 6. Exhibits			93
Signature			94
EX-31.1
EX-31.2
EX-32.1
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

Part I — Financial Information

Item 1.		Financial Statements

REYNOLDS AMERICAN INC.

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,
		2009				2008				2009				2008
Net sales(1)		$	2,045			$	2,156			$	6,017			$	6,330
Net sales, related party			107				116				306				338
Net sales			2,152				2,272				6,323				6,668
Costs and expenses:
Cost of products sold(1)(2)(3)			1,138				1,229				3,337				3,698
Selling, general and administrative expenses			371				375				1,129				1,148
Amortization expense			7				5				22				16
Restructuring charge			—				91				—				91
Trademark impairment charge			—				173				453				173
Operating income			636				399				1,382				1,542
Interest and debt expense			60				68				190				208
Interest income			(5	)			(16	)			(15	)			(51	)
Gain on termination of joint venture			—				—				—				(328	)
Other expense, net			2				13				9				3
Income before income taxes			579				334				1,198				1,710
Provision for income taxes			217				123				451				630
Net income		$	362			$	211			$	747			$	1,080
Basic income per share:
Net income		$	1.24			$	0.72			$	2.56			$	3.67
Diluted income per share:
Net income		$	1.24			$	0.72			$	2.56			$	3.67
Dividends declared per share		$	0.85			$	0.85			$	2.55			$	2.55

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,
		2009				2008
Cash flows from (used in) operating activities:
Net income		$	747			$	1,080
Adjustments to reconcile to net cash flows from (used in) continuing operating activities:
Depreciation and amortization			109				106
Gain on termination of joint venture			—				(328	)
Restructuring charges, net of cash payments			(30	)			81
Trademark impairment charge			453				173
Deferred income tax expense			(184	)			38
Tobacco settlement accruals			79				(283	)
Other, net			(285	)			(39	)
Net cash flows from operating activities			889				828
Cash flows from (used in) investing activities:
Proceeds from settlement of short-term investments			17				208
Capital expenditures			(75	)			(95	)
Proceeds from termination of joint venture			24				164
Other, net			17				(13	)
Net cash flows (used in) from investing activities			(17	)			264
Cash flows from (used in) financing activities:
Dividends paid on common stock			(743	)			(752	)
Repurchase of common stock			(5	)			(207	)
Repayment of long-term debt			(200	)			—
Excess tax benefit from stock-based compensation			1				2
Other, net			1				2
Net cash flows used in financing activities			(946	)			(955	)
Effect of exchange rate changes on cash and cash equivalents			9				(23	)
Net change in cash and cash equivalents			(65	)			114
Cash and cash equivalents at beginning of period			2,578				2,215
Cash and cash equivalents at end of period		$	2,513			$	2,329
Income taxes paid, net of refunds		$	584			$	624
Interest paid		$	149			$	161

See Notes to Condensed Consolidated Financial Statements (Unaudited)

REYNOLDS AMERICAN INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in Millions)

		September 30,				December 31,
		2009				2008
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	2,513			$	2,578
Short-term investments			6				23
Accounts receivable, net of allowance (2009 — $1; 2008 — $1)			93				84
Accounts receivable, related party			65				91
Notes receivable			35				35
Other receivables			15				37
Inventories			1,095				1,170
Deferred income taxes, net			912				838
Prepaid expenses and other			342				163
Total current assets			5,076				5,019
Property, plant and equipment, net of accumulated depreciation (2009 — $1,563; 2008 — $1,549)			990				1,031
Trademarks and other intangible assets, net of accumulated amortization (2009 — $641; 2008 — $619)			2,795				3,270
Goodwill			8,174				8,174
Other assets and deferred charges			603				660
		$	17,638			$	18,154
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable		$	112			$	206
Tobacco settlement accruals			2,396				2,321
Due to related party			3				3
Deferred revenue, related party			13				50
Current maturities of long-term debt			300				200
Other current liabilities			1,097				1,143
Total current liabilities			3,921				3,923
Long-term debt (less current maturities)			4,144				4,486
Deferred income taxes, net			233				282
Long-term retirement benefits (less current portion)			2,614				2,836
Other noncurrent liabilities			370				390
Commitments and contingencies:
Shareholders’ equity:
Common stock (shares issued: 2009 — 291,374,965; 2008 — 291,450,762)			—				—
Paid-in capital			8,490				8,463
Accumulated deficit			(530	)			(531	)
Accumulated other comprehensive loss — (Defined benefit pension and post-retirement plans: 2009 — $(1,561) and 2008 — $(1,643), net of tax)			(1,604	)			(1,695	)
Total shareholders’ equity			6,356				6,237
		$	17,638			$	18,154

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 operating subsidiaries. RAI’s wholly owned subsidiaries include R. J. Reynolds Tobacco Company; Santa Fe Natural Tobacco Company, Inc., referred to as Santa Fe; Lane, Limited, referred to as Lane; Conwood Holdings, Inc.; and Conwood Company, 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 business combination of the U.S. business of Brown & Williamson Holdings, Inc., referred to as B&W, with R. J. Reynolds Tobacco Company on July 30, 2004.

     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 R.J. Reynolds Tobacco Holdings, Inc., referred to as 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. The RJR Tobacco segment consists of the primary operations of R. J. Reynolds Tobacco Company. The Conwood segment consists of Conwood Holdings, Inc., the primary operations of the Conwood companies and Lane. RAI’s wholly owned subsidiary, Santa Fe, among others, is included in All Other. The segments were identified based on how RAI’s chief operating decision maker allocates resources and assesses performance. Some of RAI’s wholly owned operating subsidiaries have entered into intercompany agreements for products or services with other RAI operating subsidiaries. As a result, certain activities of an operating subsidiary may be included in a different segment of RAI.

     RAI’s operating subsidiaries primarily conduct their business in the United States.

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, 2009, are not necessarily indicative of the results that may be expected for the year ending December 31, 2009.

     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, 2008. 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 11 and as otherwise noted.

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

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 was included either in pension expense or 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																For The Nine Months
		Ended September 30,																Ended September 30,
										Postretirement																Postretirement
		Pension Benefits								Benefits								Pension Benefits								Benefits
		2009				2008				2009				2008				2009				2008				2009				2008
Service cost		$	8			$	9			$	1			$	1			$	24			$	27			$	3			$	4
Interest cost			80				80				20				23				239				239				60				68
Expected return on plan assets			(84	)			(113	)			(5	)			(7	)			(253	)			(338	)			(15	)			(20	)
Amortization of prior service cost (credit)			1				5				(6	)			4				3				14				(18	)			12
Amortization of net loss (income)			24				1				4				(3	)			74				4				11				(9	)
Net periodic benefit cost (income)			29				(18	)			14				18				87				(54	)			41				55
Curtailments/special benefits1			—				7				—				—				—				7				—				—
Settlements			—				4				—				—				—				4				—				—
Total benefit cost (income)		$	29			$	(7	)		$	14			$	18			$	87			$	(43	)		$	41			$	55

Employer Contributions

     RAI disclosed in its financial statements for the year ended December 31, 2008, that it expected to contribute a minimum of $50 million to its pension plans in 2009. As of September 30, 2009, RAI expected to contribute up to $295 million to its pension plans in 2009, of which $168 million was contributed during the first nine months of 2009. The increase in the expected contribution amount in 2009 allows RAI to achieve targeted funded status and possibly reduce RAI’s future contributions.

Subsequent Events

     RAI has evaluated events that occurred subsequent to September 30, 2009, through the financial statement issue date of October 27, 2009, and determined that there were no recordable or reportable subsequent events.

Recently Adopted Accounting Pronouncements

     Effective January 1, 2009, RAI adopted guidance for the measurements and disclosure of fair value for nonfinancial assets and nonfinancial liabilities. This new guidance 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. It also establishes a fair value hierarchy that distinguishes between independent and observable inputs and unobservable inputs based on the best information available. The adoption of this guidance on nonfinancial assets and nonfinancial liabilities did not have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

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

     Effective January 1, 2009, RAI adopted authoritative GAAP that addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share. As a result, unvested restricted shares outstanding under the Reynolds American Inc. Long-Term Incentive Plan, referred to as the LTIP, are included in basic EPS calculations. All prior-period earnings per share have been adjusted retrospectively to conform to the provisions of this authoritative GAAP, which slightly reduced basic and diluted net income per share for the nine months of 2008.

     Effective January 1, 2009, RAI adopted guidance for the 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. This guidance also seeks enhanced disclosure around derivative instruments in financial statements and how hedges affect an entity’s financial position, financial performance and cash flows. The adoption of this guidance did not have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

     Effective June 30, 2009, RAI adopted authoritative GAAP that provides additional clarification for estimating fair value when the volume and level of activity for the asset and liability have significantly decreased, as well as provides clarification on identifying circumstances that indicate a transaction is not orderly. The adoption of this authoritative GAAP did not have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

     Effective June 30, 2009, RAI adopted authoritative GAAP that provides additional clarification to make other-than-temporary impairments more operational and to improve the financial statement presentation of such impairments. The adoption of this authoritative GAAP did not have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

     Effective June 30, 2009, RAI adopted guidance requiring disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements. The adoption of this guidance did not have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

     Effective June 30, 2009, RAI adopted authoritative GAAP that establishes general standards of accounting for and disclosure of events that occur after the balance sheet date, but before financial statements are issued or are available to be issued. The adoption of this authoritative GAAP did not have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

     In June 2009, the Financial Accounting Standards Board, referred to as FASB, issued its Accounting Standards Codification, referred to as ASC. The ASC became the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities, effective for financial statements issued for interim and annual periods ending after September 15, 2009. The adoption of ASC had no impact on RAI’s consolidated results of operations, cash flows or financial position.

     Effective September 30, 2009, RAI adopted guidance clarifying the measurement of liabilities at fair value when no observable data is available. The adoption of this guidance did not have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

     RAI determines fair value of assets using 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 and expands disclosure about fair value measurements.

     Fair value is 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 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 on a recurring basis as of September 30, 2009, were as follows:

		Level 1				Level 2				Level 3				Total
Money market funds		$	2,257			$	—			$	6			$	2,263
Auction rate securities — corporate credit risk			—				—				23				23
Auction rate securities — financial insurance companies			—				—				21				21
Mortgage-backed security			—				—				14				14
Marketable equity security			20				—				—				20
Assets held in grantor trusts			14				—				—				14
Interest rate swaps — fixed to floating rate			—				231				—				231
Interest rate swaps — floating to fixed rate			—				21				—				21

     The fair value of the interest rate swaps, classified as a Level 2, utilized a market approach model using the notional amount of the interest rate swap multiplied by the observable inputs of time to maturity, interest rates and credit spreads. See note 10 for additional information on interest rate swaps.

     The fair value of the money market funds, classified as a Level 3, utilized an income approach model and was based upon expected future cash flows from accumulated cash in the fund and future maturities of the remaining securities held in the fund. During the first nine months of 2009, redemptions of $4 million were received from the Reserve Fund-Primary Fund, and redemptions of $13 million were received from the Reserve Fund-International Liquidity Fund. No current valuations had been issued by either fund, and RAI was unable to identify a similar fund that carried identical holdings. As a result, the observable transactions and 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 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, 2009.

     The fair value of the auction rate securities, either related to certain financial insurance companies or linked to the longer-term credit risk of a diverse range of corporations, including, but not limited to, manufacturing, financial and insurance sectors, classified as a Level 3, utilized an income approach model and were based upon the calculation of the weighted average present value of future cash payments, given the probability of certain events occurring within the market. RAI considers the market for auction rate securities to be inactive. The income approach 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 value for the mortgage-backed security, classified as a Level 3, utilized a market approach and was 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. The market approach utilized actual pricing inputs when observable and modeled pricing when unobservable. RAI has deemed the market for the mortgage-backed security to be inactive.

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

     The changes in financial assets classified as Level 3 investments as of September 30, 2009, were as follows:

		Money Market Funds								Mortgage-Backed Security
														Gross
						Estimated								Unrealized				Estimated
		Cost				Fair Value				Cost				Loss				Fair Value
Balance as of January 1, 2009		$	23			$	23			$	37			$	(16	)		$	21
Unrealized losses			—				—				—				(2	)			(2	)
Settlements			(17	)			(17	)			(5	)			—				(5	)
Balance as of September 30, 2009		$	6			$	6			$	32			$	(18	)		$	14

		Auction Rate Securities —												Auction Rate Securities —
		Corporate Credit Risk												Financial Insurance Companies
						Gross												Gross
						Unrealized				Estimated								Unrealized				Estimated
		Cost				Loss				Fair Value				Cost				(Loss) Gain				Fair Value
Balance as of January 1, 2009		$	95			$	(51	)		$	44			$	17			$	(2	)		$	15
Unrealized (losses) gains			—				(21	)			(21	)			—				6				6
Balance as of September 30, 2009		$	95			$	(72	)		$	23			$	17			$	4			$	21

     On January 1, 2009, RAI adopted authoritative GAAP related to the measurements and disclosure of fair value for nonfinancial assets and liabilities.

     The fair value of the trademarks measured on a nonrecurring basis, classified as Level 3, represent certain trademarks for which impairment during the first quarter of 2009 reduced their book value to fair value. The fair value determination utilized an income approach model and was based on a discounted cash flow valuation model under a relief from royalty methodology. This approach utilized unobservable factors such as royalty rate, projected revenues and a discount rate applied to the estimated cash flows. The determination of the discount rate was based on a cost of equity model, using a risk-free rate, adjusted by a stock beta-adjusted risk premium and a size premium. See note 3 for additional information with respect to the event during the first quarter of 2009 that required impairment testing of trademarks and the assumptions used therefor, as well as the consolidated amount of trademarks as of September 30, 2009.

     The fair value of nonfinancial assets was not measured as of September 30, 2009. Nonfinancial assets measured at fair value on a nonrecurring basis as of March 31, 2009, were as follows:

		Level 1				Level 2				Level 3				Total				Total Loss
Trademarks		$	—			$	—			$	875			$	875			$	(453	)

Note 3 — Intangible Assets

     The carrying amounts of indefinite-lived intangible assets by segment not subject to amortization were as follows:

		RJR
		Tobacco				Conwood				All Other				Consolidated
Trademarks		$	1,653			$	1,222			$	155			$	3,030
Other intangible assets			55				—				48				103
Balance as of December 31, 2008		$	1,708			$	1,222			$	203			$	3,133
Trademarks		$	1,277			$	1,152			$	155			$	2,584
Other intangible assets			99				—				4				103
Balance as of September 30, 2009		$	1,376			$	1,152			$	159			$	2,687

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

     Concurrent with the transfer of the management of tobacco products sold to certain U.S. territories, U.S. duty-free shops and U.S. overseas military bases, from R. J. Reynolds Global Products, Inc., referred to as GPI, to RJR Tobacco on January 1, 2009, a $44 million indefinite-lived intangible asset was transferred from All Other to RJR Tobacco.

     During the first quarter of 2009, President Obama signed into law an increase of $0.62 in the federal excise tax per pack of cigarettes as well as significant tax increases on other tobacco products, to fund expansion of the State Children’s Health Insurance Program, referred to as the SCHIP. The tax increases were effective April 1, 2009.

     The increase in federal excise tax was expected to adversely impact the net sales of RAI’s operating subsidiaries. This event was considered a triggering event and required the testing for impairment of the carrying value of trademarks and goodwill during the first quarter of 2009. As a result of this testing, RJR Tobacco recorded a trademark impairment charge of $377 million, and Conwood recorded a trademark impairment charge of $76 million in the first quarter of 2009. These charges were based on the excess of certain brands’ carrying values over their estimated fair values. The analysis of the fair value of trademarks was based on estimates of fair value on an income approach using a discounted cash flow valuation model under a relief from royalty methodology. The relief from royalty model included the estimates of the royalty rate that a market participant might assume, projected revenues and judgment regarding the 10.50% discount rate applied to those estimated cash flows. The determination of the discount rate was based on a cost of equity model, using a risk-free rate, adjusted by a stock beta-adjusted risk premium and a size premium.

     The trademark impairment charge is reflected as a decrease in the carrying value of the trademarks in the condensed consolidated balance sheet (unaudited) as of September 30, 2009, as a trademark impairment charge in the condensed consolidated statement of income (unaudited) for the nine months ended September 30, 2009, and had no impact on cash flows.

     Details of finite-lived intangible assets subject to amortization as of September 30, 2009, were as follows:

						Accumulated
		Gross				Amortization				Net
Contract manufacturing		$	151			$	78			$	73
Trademarks			95				60				35
		$	246			$	138			$	108

     Pre-tax amortization expense for intangible assets was $7 million and $5 million for the three months ended September 30, 2009 and 2008, respectively, and $22 million and $16 million for the nine months ended September 30, 2009 and 2008, respectively. The estimated remaining amortization associated with finite-lived intangible assets is expected to be expensed as follows:

Year		Amount
Remainder of 2009		$	6
2010			26
2011			23
2012			20
2013			16
Thereafter			17
		$	108

     For the impairment testing of the goodwill of RAI’s reporting units during the first quarter of 2009, triggered by the federal excise tax increase, each reporting unit’s estimated fair value was compared with its carrying value. A reporting unit is an operating segment or one level below an operating segment. The determination of estimated fair value of each reporting unit was calculated primarily utilizing an income approach model, based on the present value of the estimated future cash flows of the reporting unit assuming a discount rate. The determination of the discount rate was based on a weighted average cost of capital and cost of equity, described above as utilized in the

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

trademark valuation. Additionally, the aggregate estimated fair value of the reporting units, determined with the use of the income approach model, was compared with RAI’s market capitalization. In considering RAI’s market capitalization, an estimated premium to reflect the fair value on a control basis was applied. The estimated fair value of each reporting unit, determined utilizing the income approach and RAI’s market capitalization, was greater than its respective carrying value.

Note 4 — Restructuring Charges

2008 Restructuring Charge

     In 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, $83 million of severance-related cash benefits and $7 million of non-cash pension-related benefits comprised a restructuring charge of $90 million in 2008. Of this charge, $81 million was recorded in the RJR Tobacco segment. Of the cash portion of the charge, $33 million was paid as of September 30, 2009. Accordingly, in the condensed consolidated balance sheet (unaudited) as of September 30, 2009, $36 million was included in other current liabilities, and $14 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			(12	)
Adjusted in 2008			(1	)
Balance as of December 31, 2008			78
Utilized in 2009			(28	)
Balance as of September 30, 2009		$	50

Note 5 — Income Per Share

     On January 1, 2009, RAI adopted authoritative GAAP that address whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share. Unvested restricted shares awarded under the 2007 and 2008 LTIP grants have been determined to be participating securities because they have non-forfeitable dividend rights equivalent to common shares. Accordingly, these restricted shares are included in the basic EPS calculation for the third quarter and first nine months of 2009 and retrospectively in the basic EPS calculation for the third quarter and first nine months of 2008.

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

     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,
		2009				2008				2009				2008
Net income		$	362			$	211			$	747			$	1,080
Basic weighted average shares, in thousands			291,371				292,388				291,380				294,050
Effect of dilutive potential shares:
Options			130				190				137				209
Stock units			419				—				224				—
Diluted weighted average shares, in thousands			291,920				292,578				291,741				294,259

Note 6 — Investments

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

		September 30, 2009												December 31, 2008
																		Gross
										Estimated								Realized								Estimated
		Cost				Redemptions				Fair Value				Cost				Loss				Redemptions				Fair Value
Reserve Fund — Primary Fund		$	7			$	(4	)		$	3			$	37			$	(1	)		$	(29	)		$	7
Reserve Fund — International Liquidity Fund			16				(13	)			3				17				(1	)			—				16
		$	23			$	(17	)		$	6			$	54			$	(2	)		$	(29	)		$	23

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

		September 30, 2009																December 31, 2008
										Gross												Gross				Gross
										Unrealized				Estimated								Realized				Unrealized				Estimated
		Cost				Redemptions				(Loss) Gain				Fair Value				Cost				Loss				Loss				Fair Value
Auction rate securities — corporate credit risk		$	95			$	—			$	(72	)		$	23			$	95			$	—			$	(51	)		$	44
Auction rate securities — financial insurance companies			17				—				4				21				50				(33	)			(2	)			15
Mortgage-backed security			37				(5	)			(18	)			14				37				—				(16	)			21
Marketable equity security			2				—				18				20				2				—				—				2
		$	151			$	(5	)		$	(68	)		$	78			$	184			$	(33	)		$	(69	)		$	82

     RAI has five investments in auction rate securities linked to corporate credit risk, four investments in auction rate securities related to financial insurance companies, one investment in a mortgage-backed security and one investment in a marketable equity security. Investments classified as available-for-sale were carried at fair value and included in other assets and deferred charges, and unrealized gains and losses, net of tax, were reported in accumulated other comprehensive loss in RAI’s condensed consolidated balance sheet (unaudited) as of September 30, 2009. The funds associated with the auction rate securities will not be accessible until a successful auction occurs or a buyer is found. The mortgage-backed security matures in March 2010. RAI is in the process of evaluating its alternatives surrounding extending this investment beyond 2010.

     RAI reviews these investments on a quarterly basis to determine if it is probable that RAI will realize some portion of the unrealized loss and to determine the classification of the impairment as temporary or other-than-temporary. Since the adoption of authoritative GAAP in June 2009, RAI recognizes the credit loss component of an other-than-temporary impairment of its debt securities in earnings, and the noncredit component in other comprehensive loss for those securities which RAI does not intend to sell and as to which it is more likely than not that RAI will not be required to sell the securities prior to recovery.

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

     In determining if the difference between amortized cost and estimated fair value of the auction rate securities or the mortgage-backed security was deemed either temporary or other-than-temporary impairment, RAI evaluated each type of long-term investment using a set of criteria including decline in value, duration of the decline, period until anticipated recovery, nature of investment, probability of recovery, financial condition and near-term prospects of the issuer, RAI’s intent and ability to retain the investment, attributes of the decline in value, status with rating agencies, status of principal and interest payments and any other issues related to the underlying securities. Additionally, RAI evaluated any credit loss within the fair market valuation by comparing the net amortized cost of the securities to the discounted present value of anticipated future cash flows.

     RAI determined the change in the fair value of the investments in the auction rate securities linked to corporate credit risk was temporary as of September 30, 2009, primarily based on estimated cash flows of the investments, present and expected defaults of the underlying collateral and RAI’s ability and intent to hold such investments. RAI also determined the present value of anticipated future cash flows exceeded the net amortized cost of the investment and therefore did not have any credit loss to recognize. RAI believes the decline in the fair value of the securities is related to present market conditions and that the investments will continue to be carried at less than cost until economic conditions improve. RAI believes it is probable these securities will eventually recover, and RAI has no intention of, and does not believe there will be a requirement for, selling these securities in the foreseeable future.

     In 2008, three of the four investments in auction rate securities related to financial insurance companies were other-than-temporarily impaired. During the first nine months of 2009, the fair value of those three investments increased above their amortized cost, generating unrealized gains. The decline in the fair value of the remaining investment has been determined by RAI to be temporary as of September 30, 2009, primarily based on estimated cash flows of this security, near-term prospects and financial condition of the issuer and RAI’s ability and intent to hold such investment. RAI also determined the present value of anticipated future cash flows exceeded the net amortized cost of the investment and therefore did not have any credit loss to recognize. RAI believes the decline in the fair value of this security is related to present market conditions and that this investment will continue to be carried at less than cost until economic conditions improve. RAI believes it is probable this security will eventually recover, and RAI has no intention of, and does not believe there will be a requirement for, selling any of these securities in the foreseeable future.

     RAI determined the change in the fair value of the investment of the mortgage-backed security, classified above sub-prime at inception, was also temporary as of September 30, 2009, primarily based on estimated cash flows of the security as well as the underlying collateral. RAI also determined the present value of anticipated future cash flows exceeded the net amortized cost of the investment and therefore did not have any credit loss to recognize. RAI believes the decline in the fair value of the mortgage-backed security is related to present market conditions and that this investment will continue to be carried at less than cost until economic conditions surrounding the housing markets improve. RAI believes it is probable this security will recover as the lowering of interest rates and the assistance of government-related funds will result in refinancing opportunities. In addition, during the first nine months of 2009, RAI received $5 million in principal payments on the mortgage-backed security. RAI has no intention of, and does not believe there will be a requirement for, selling this security in the foreseeable future and has the ability to allow financial markets to recover and ultimately realize the value of this investment.

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

Note 7 — Inventories

     The major components of inventories were as follows:

		September 30, 2009				December 31, 2008
Leaf tobacco		$	875			$	993
Other raw materials			61				60
Work in process			80				58
Finished products			204				145
Other			38				26
Total			1,258				1,282
Less LIFO allowance			163				112
		$	1,095			$	1,170

     RJR Tobacco will perform its annual LIFO inventory valuation at December 31, 2009, as interim periods represent an estimate of the expected annual valuation.

Note 8 — Income Taxes

     The provision for income taxes in the third quarter of 2009 was $217 million, for an effective rate of 37.5%, compared with $123 million, for an effective rate of 36.8%, in the third quarter of 2008. The provision for income taxes in the first nine months of 2009 was $451 million, for an effective rate of 37.6%, compared with $630 million, for an effective rate of 36.8%, in the first nine months of 2008. The effective tax rate for the first nine months of 2009 was unfavorably impacted by increases in unrecognized income tax benefits and increases in tax attributable to accumulated and undistributed foreign earnings. 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, but was offset by unfavorability related to tax reserves and U.S. taxes recorded on foreign earnings.

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

     The gross accruals for unrecognized income tax benefits, including interest and penalties, reflected in other noncurrent liabilities were $161 million and $159 million at September 30, 2009 and December 31, 2008, 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, 2009 and December 31, 2008, was $53 million and $50 million, respectively. The gross amount of penalties accrued was $12 million at September 30, 2009 and December 31, 2008.

     Gross increases in unrecognized tax benefits related to tax positions were $7 million for the nine months ended September 30, 2009, consisting of $5 million for current year tax positions and $2 million for prior year tax positions.

     Gross decreases in unrecognized tax benefits were $8 million for the nine months ended September 30, 2009, consisting of $2 million for prior year tax positions, $3 million for settlement with taxing authorities and $3 million for statute expirations.

     As of September 30, 2009, $56 million of unrecognized tax benefits and $45 million of interest and penalties, if recognized, would affect the effective tax rate.

     Included in the provision for income taxes for the nine months ended September 30, 2009, was $4 million of additional tax expense, including $3 million of interest expense, net of federal benefit, and penalties associated with unrecognized tax benefits. Comparable amounts for the three and nine months ended September 30, 2008, were $2 million and $11 million of additional tax expense, including $1 million and $3 million of interest expense, net of federal benefit, and penalties, respectively.

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

     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.

     RAI filed a federal consolidated income tax return for the years 2005 through 2008. The statute of limitations remains open for the years 2006 through 2008. There are no IRS examinations scheduled at this time for these open years.

     In 2007, the State of 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 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, cash flows or financial position.

Note 9 — Borrowing Arrangements

     On June 28, 2007, RAI entered into a Fifth Amended and Restated Credit Agreement, which, as subsequently amended, provides for a five-year, $498 million revolving credit facility, which may be increased up to $848 million at the discretion of the lenders upon the request of RAI.

     Effective July 3, 2009, RAI entered into a Second Amendment to Credit Agreement, referred to as the Second Amendment, amending RAI’s credit facility. The Second Amendment amends the credit facility by, among other things:

	•		terminating the revolving loan commitment of Lehman Commercial Paper Inc., which filed for protection under Chapter 11 of the federal Bankruptcy Code on October 5, 2008, and thereby reducing the total revolving loan commitment under the credit facility from $550 million to $498 million;
	•		amending the definition of “Lender Default” and certain related definitions;
	•		granting RAI the right under certain circumstances to terminate the revolving loan commitment of a Defaulting Lender, as defined in the credit facility, if RAI is unable to replace such Defaulting Lender; and
	•		otherwise clarifying the rights and responsibilities of the parties to the credit facility upon the occurrence of a Lender Default.

Note 10 — Financial Instruments

Fair Value of Debt

     The estimated fair value of RAI’s and RJR’s outstanding long-term notes in the aggregate, was $4.3 billion and $3.5 billion with an effective average annual interest rate of approximately 5.5% and 5.7%, as of September 30, 2009 and December 31, 2008, respectively. The fair values are based on available market quotes, credit spreads and discounted cash flows, as appropriate.

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

Interest Rate Management

     RAI and RJR use interest rate swaps to manage interest rate risk on a portion of their respective debt obligations.

     Interest rate swaps existed on the following principal amounts of debt:

		Fixed to Floating Rate				Floating to Fixed Rate				Fixed to Floating Rate
		September 30, 2009				September 30, 2009				December 31, 2008
RJR 7.25% notes, due 2012		$	44			$	44			$	57
Total swapped RJR debt			44				44				57
RAI 7.25% notes, due 2012			306				306				393
RAI 7.625% notes, due 2016			450				450				450
RAI 6.75% notes, due 2017			700				700				700
Total swapped RAI debt			1,456				1,456				1,543
Total notional amount		$	1,500			$	1,500			$	1,600

     Historically, the interest rate swap agreements were derivative instruments that qualified for hedge accounting. RAI and RJR assess at the inception of the hedge whether the hedging derivatives are highly effective in offsetting changes in fair value of the hedged item. Ineffectiveness results when changes in the market value of the hedged debt are not completely offset by changes in the market value of the interest rate swap. There was no ineffectiveness recognized related to derivative instruments during 2009 or 2008. As detailed below, at September 30, 2009, RAI and RJR had no derivative instruments designated as hedges.

     On January 6, 2009, the fair value of RAI’s and RJR’s fixed to floating interest rate swaps, designated as hedges, was $258 million. RAI and RJR locked in the value of these swaps by entering into offsetting floating to fixed interest rate swap agreements in the notional amount of $1.5 billion with maturity dates ranging from June 1, 2012 to June 15, 2017. The floating to fixed interest rate swaps were entered into with the same financial institution that holds a notional amount of $1.5 billion of fixed to floating interest rate swaps and have a legal right of offset. The future cash flows, established as a result of entering into the January 6, 2009, floating to fixed interest rate swaps, total $321 million, and will be amortized and effectively reduce net interest costs over the remaining life of the notes. Concurrent with entering the floating to fixed interest rate swap agreements on January 6, 2009, which were not designated as hedging instruments, RAI and RJR removed the designation of fair value hedge from the fixed to floating interest rate swaps.

     On January 7, 2009, RAI and RJR terminated an interest rate swap agreement in the notional amount of $100 million with a maturity date of June 1, 2012. The resulting gain of approximately $12 million will be amortized to effectively reduce interest expense over the remaining life of the notes.

     As a result of these actions, RAI and RJR have economically decreased the fixed rate on $1.6 billion of debt to a fixed rate of interest of approximately 4.0%.

     As of September 30, 2009, a summary of interest rate swaps outstanding was as follows:

		Fixed to Floating		Floating to Fixed
Pay		Floating based on one and six month LIBOR		4.0% fixed
Receive		7.1% fixed		Floating based on one and six month LIBOR
Weighted average maturity		6.22 years		6.22 years

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

     Interest rate swaps are presented in the condensed consolidated balance sheets at fair value as follows:

		September 30, 2009				December 31, 2008
		(Unaudited)
Designated as hedging instrument:
Other assets and deferred charges		$	—			$	287
Long-term debt (less current maturities)			—				(287	)
Not designated as hedging instrument:
Other assets and deferred charges			256				—
Long-term debt (less current maturities)			(244	)			—
Other noncurrent liabilities			(4	)			—

     Interest rate swaps impacted the condensed consolidated statements of income (unaudited) as follows:

		For the Three Months								For the Nine Months
		Ended September 30,								Ended September 30,
		2009				2008				2009				2008
Interest and debt expense		$	(12	)		$	(11	)		$	(36	)		$	(31	)
Other (income) expense, net			(11	)			—				(7	)			—

Credit Risk

     RAI and its subsidiaries minimize counterparty credit risk related to their financial instruments by using major financial institutions.

Note 11 — 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 has agreed to indemnify B&W and its affiliates, including its indirect parent, British American Tobacco p.l.c., referred to as BAT, 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 each of the first nine months of 2009 and 2008 for funds to be reimbursed to BAT for costs and expenses incurred arising out of certain tobacco-related litigation.

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

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 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 for claims arising after 1986, 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

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

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, 2009. However, as of September 30, 2009, RJR Tobacco had an accrual for $2 million related to non-smoking and health litigation, and RJR, and its subsidiary RJR Tobacco, had liabilities totaling $94 million that were recorded in 1999 in connection with certain non-smoking and health indemnification claims asserted by JTI 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 “— 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 State Settlement Agreements and the funding by various tobacco companies of a $5.2 billion trust fund contemplated by the MSA to benefit tobacco growers; and
	•		the original Broin flight attendant case discussed below under “— Litigation Affecting the Cigarette Industry — Class-Action Suits.”

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

     The states were a unique set of plaintiffs and are not involved in any of the smoking and health cases remaining against RJR Tobacco or its affiliates and indemnitees. 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 State Settlement Agreements. Under its Medical Care Recovery Act and Medicare Secondary Payer Act claims, the federal government made arguments similar to the states and sought to recover federal funds expended in providing health care to smokers who have developed diseases and injuries alleged to be smoking-related. 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

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

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 State Settlement Agreements, 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 State Settlement Agreements.

     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 — State Settlement Agreements — Enforcement and Validity,” RJR Tobacco and B&W each has settled certain cases brought by states concerning the enforcement of State Settlement Agreements. Despite valid legal defenses, these cases were settled to avoid further contentious litigation with the states involved. These enforcement actions involve alleged breaches of State Settlement Agreements based on specific actions taken by particular defendants. Accordingly, any future enforcement actions involving State Settlement Agreements will be reviewed by RJR Tobacco on the merits and should not be affected by the settlement of prior 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, 2009.

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 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, or difficulties in obtaining the bonding required to stay execution of judgments on appeal,

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

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 2009, 19 tobacco-related cases were served against RJR Tobacco or its affiliates or indemnitees. On September 30, 2009, there were 4,163 cases, including 654 individual smoker cases pending in West Virginia state court as a consolidated action and 3,323 Engle Progeny Cases, involving approximately 8,740 individual plaintiffs, pending in the United States against RJR Tobacco or its affiliates or indemnitees, as compared with 3,207 total cases on September 30, 2008, pending in the United States against RJR Tobacco or its affiliates or indemnitees.

     As of October 9, 2009, 211 tobacco-related cases were pending against RJR Tobacco or its affiliates or indemnitees: 201 in the United States; one in Puerto Rico; eight in Canada; and one in Israel. Of the 201 total U.S. cases, 24 cases are pending against B&W that are not also pending against RJR Tobacco. The U.S. case number does not include the 2,596 Broin II or the 3,326 Engle Progeny Cases, as discussed below, pending as of October 9, 2009.

     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 9, 2009, exclusive of the Broin II and Engle Progeny Cases:

		Number of
State		U.S. Cases
Florida			25
New York			22
Missouri			20
Louisiana			16
Maryland			13
California			12
Illinois			9
Mississippi			6
West Virginia			6	*
Georgia			4
Connecticut			4
Pennsylvania			4
Alabama			4
Ohio			3
District of Columbia			3
New Mexico			3
Kentucky			2
Delaware			2
Washington			2

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

		Number of
State		U.S. Cases
Kansas			2
Minnesota			2
North Carolina			2
South Dakota			2
Tennessee			2
Vermont			2
Wisconsin			2
New Jersey			2
Arkansas			1
Maine			1
Arizona			1
Michigan			1
Oregon			1
South Carolina			1
Alaska			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
North Dakota			1
Oklahoma			1
Rhode Island			1
Utah			1
Virginia			1
Wyoming			1
Texas			1
Total			201	**

     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 9, 2009, compared with the number of cases pending against RJR Tobacco, its affiliates or indemnitees as of July 10, 2009, as reported in RAI’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2009, filed with the SEC on July 31, 2009, and a cross-reference to the discussion of each case type.

						Change in
						Number of
		RJR Tobacco’s				Cases Since
		Case Numbers as				July 10, 2009				Page
Case Type		of October 9, 2009				Increase/(Decrease)				Reference
Individual Smoking and Health			106				(16	)			28
West Virginia IPIC (Number of Plaintiffs)*			1(654	)		No Change(-33		)			30
Engle Progeny (Number of Plaintiffs)**			3,326 (8,741	)			50(-38	)			30
Broin II			2,596				(21	)			31
Class-Action			15				(3	)			32
Health-Care Cost Recovery			4			No Change					38
State Settlement Agreements-Enforcement and Validity			59			No Change					43
Antitrust			2			No Change					46
Other Litigation and Developments			14				1				47

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

     Three 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., and the federal RICO case brought by the U.S. Department of Justice.

     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 9, 2009, RJR Tobacco had been served in 3,326 Engle Progeny Cases in both state and federal courts in Florida. These cases include approximately 8,741 plaintiffs. The number of cases will likely change due to individual plaintiffs being severed from multi-plaintiff cases. In addition, as of October 9, 2009, RJR Tobacco was aware of 28 additional cases that have been filed but not served (with 307 plaintiffs).

     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. On December 15, 2008, the trial court signed the order for appeal of the amended judgment. Oral argument on the defendants’ appeal occurred on September 1, 2009. A decision is pending.

     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 appealed to the U.S. Court of Appeals for the District of Columbia. On May 22, 2009, the U.S. Court of Appeals largely affirmed the finding of liability against the tobacco company defendants and remanded to the trial court for further proceedings. The defendants sought rehearing and/or rehearing en banc, but that motion was denied by the appellate court on September 22, 2009. On September 28, 2009, the defendants filed a motion to stay issuance of the mandate pending the filing and disposition of petitions for writ of certiorari to the U.S Supreme Court.

     For a detailed description of these cases, see “— Class-Action Suits — Engle Case,” “— Class-Action Suits — Medical Monitoring and Smoking Cessation Cases” and “— Health-Care Cost Recovery Cases — Department of Justice Case” 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, Washington, D.C. 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. These State Settlement Agreements:

	•		settled all health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions;
	•		released the major U.S. cigarette manufacturers from various additional present and potential future claims;
	•		imposed future payment obligations 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 cigarettes and smokeless tobacco products.

     Payments under the State Settlement Agreements are subject to various adjustments for, among other things, the volume of cigarettes sold, relevant market share and inflation. See “— Health-Care Cost Recovery Cases — State

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

Settlement Agreements” below for a detailed discussion of the State Settlement Agreements, 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. It is likely, however, that RJR Tobacco and other cigarette manufacturers will face an increased number of tobacco-related trials in 2009 compared to recent years. The following table lists the non-Engle Progeny tobacco-related trials scheduled, as of October 9, 2009, for RJR Tobacco or its affiliates and indemnitees through September 30, 2010. There are 62 Engle Progeny cases against RJR Tobacco and/or B&W set for trial through September 30, 2010, but it is not known how many of these cases will actually be tried.

Trial Date		Case Name/Type		Defendant(s)		Jurisdiction
November 18, 2009		Williams v. Brown and Williamson Tobacco Corp. [Individual]		RJR Tobacco, B&W		Circuit Court City of St. Louis (St. Louis, MO)
February 1, 2010		In Re: Tobacco Litigation — IPIC v. R. J. Reynolds Tobacco Co. [Individual]		RJR Tobacco, B&W		Circuit Court Kanawha County (Charleston, WV)
March 5, 2010		Izzarelli v. R. J. Reynolds Tobacco Co. [Individual]		RJR Tobacco		U.S. District Court District of Connecticut (Bridgeport, CT)
May 18, 2010		Power v. John Crane-Houdaille, Inc. [Individual]		RJR Tobacco, B&W		Circuit Court Baltimore City (Baltimore, MD)
June 7, 2010		City of St. Louis v. American Tobacco Company [Health Care Reimbursement]		RJR Tobacco, B&W		Circuit Court City of St. Louis (St. Louis, MO)
July 5, 2010		Rials v. Philip Morris USA, Inc. [Individual]		RJR Tobacco		U.S. District Court Southern District (Jackson, MS)
July 19, 2010		Bell v. Brown & Williamson Tobacco Corp. [Individual]		RJR Tobacco, B&W		Circuit Court Jackson County (Kansas City, MO)

     Trial Results. From January 1, 1999 through October 9, 2009, 60 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 39 cases, including four mistrials, tried in Florida (13), 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).

     Additionally, from January 1, 1999 through October 9, 2009, 27 smoking and health cases in which RJR Tobacco, B&W, or their respective affiliates were not defendants were tried. Verdicts were returned in favor of the defendants in 15 cases, including two mistrials, tried in Florida (7), California (3), New Hampshire (1), New York (1), Pennsylvania (1), Rhode Island (1) and Tennessee (1). Verdicts in favor of the plaintiffs were returned in 11 cases tried in California (4), Florida (4), Oregon (2) and Illinois (1).

     One smoking and health case (and no health-care cost recovery case) in which RJR Tobacco was a defendant was tried in the third quarter of 2009. In Campbell v. R. J. Reynolds Tobacco Co., a jury returned a verdict in favor of the plaintiff on August 19, 2009. For a detailed description of the case, see “— Engle Progeny Cases” below.

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

     The following chart reflects the verdicts in the smoking and health cases that have been tried and remain pending as of October 9, 2009, in which verdicts have been returned in favor of the plaintiffs and against RJR Tobacco or B&W, or both.

								Cross-Reference to
Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
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.		See “— Engle Progeny Cases” below.
December 18, 2003		Frankson v. Brown & Williamson Tobacco Corp. [Individual]		Supreme Court, Kings County (Brooklyn, NY)		$350,000 compensatory damages; 50% fault assigned to B&W and two industry organizations; $20 million in punitive damages, of which $6 million was assigned to B&W, $2 million to a predecessor company and $12 million to two industry organizations.		See “— Individual Smoking and Health Cases” below.
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.		See “— Class-Action Suits — Medical Monitoring and Smoking Cessation Case” below.

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

								Cross-Reference to
Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
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.		See “— Individual Smoking and Health Cases” below.
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.		See “— Health-Care Cost Recovery Cases — Department of Justice Case” below.
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.		See “— Individual Smoking and Health Cases” below.
May 5, 2009		Sherman v. R. J. Reynolds Tobacco Co. [Engle Progeny]		Circuit Court, Broward County, (Ft. Lauderdale, FL)		$1.5 million in actual damages, 50% of fault assigned to RJR Tobacco which reduced the award to $775,000. No punitive damages awarded.		See “— Engle Progeny Cases” below.

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

								Cross-Reference to
Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
May 20, 2009		Brown v. R. J. Reynolds Tobacco Co. [Engle Progeny]		Circuit Court, Broward County, (Ft. Lauderdale, FL)		$1.2 million in actual damages; 50% of fault assigned to RJR Tobacco which reduced the award to $600,000. No punitive damages awarded.		See “— Engle Progeny Cases” below.
May 29, 2009		Martin v. R. J. Reynolds Tobacco Co. [Engle Progeny]		Circuit Court, Escambia County, (Pensacola, FL)		$5 million in actual damages, 66% of fault assigned to RJR Tobacco which reduced the award to $3.3 million, $25 million in punitive damages		See “— Engle Progeny Cases” below.
August 19, 2009		Campbell v. R. J. Reynolds Tobacco Co. [Engle Progeny]		Circuit Court, Escambia County, (Pensacola, FL)		$7.8 million in compensatory damages; 39% of fault assigned to RJR Tobacco which reduced the award to $3.04 million		See “— Engle Progeny Cases” below.

Individual Smoking and Health Cases

     As of October 9, 2009, 106 individual cases 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, Engle Progeny or West Virginia IPIC Cases discussed below. A total of 103 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, 2009 to September 30, 2009, or remained on appeal as of September 30, 2009.

     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, in May 2007, and returned a punitive damages verdict award of $250,000 against RJR Tobacco. 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 appealed. RJR Tobacco 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. On October 14, 2009, the California Court of Appeal affirmed the final judgment against RJR Tobacco. The defendants’ petition for rehearing is due on October 29, 2009.

     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 Superior Court for further review of certain issues. Briefing to the Superior Court is complete. A decision is pending.

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

     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.

     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. 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 September 29, 2009, the New York Supreme Court, Appellate Division, affirmed the compensatory damages award, set aside the punitive damages verdict and remanded the case to the Kings County Supreme Court for a new trial on punitive damages.

     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. On December 16, 2008, the Missouri Court of Appeals issued an opinion that affirmed in part, reversed in part, and remanded the case for further proceedings on the issue of punitive damages. Trial on the issue of punitive damages began July 27, 2009. On July 29, 2009, RJR Tobacco, on behalf of B&W, paid the compensatory damages verdict, plus interest, in the amount of approximately $700,000. On August 11, 2009, the jury returned a verdict for the plaintiffs finding B&W liable for damages for aggravating circumstances, and on August 20, 2009, returned a verdict for the plaintiffs and awarded the plaintiffs $1.5 million in punitive damages. On September 24, 2009, B&W filed a motion for a new trial and a motion for judgment notwithstanding the verdict.

     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. On December 16, 2008, the New York Court of Appeals affirmed the order. On August 17, 2009, the court discharged the supersedeas bond posted by RJR Tobacco. On October 5, 2009, the U.S. Supreme Court denied the plaintiff’s petition for writ of certiorari.

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

West Virginia IPIC

     In West Virginia, as of October 9, 2009, there were 694 cases (of which 654 are actions against RJR Tobacco and/or B&W) pending as a consolidated action, In re: Tobacco Litigation Individual Personal Injury Cases. These cases are proposed to be tried in Kanawha County Circuit Court in a single proceeding. The West Virginia Supreme Court of Appeals ruled that the U.S. Constitution does not preclude a trial in multiple phases in this case, and the U.S. Supreme Court declined to review the issue. The current trial plan provides for a three-phase proceeding, with certain elements of liability and entitlement to punitive damages being tried in Phase I. Phase II would address the ratio between any compensatory and punitive damages awarded. Phase III would address all remaining individual issues including medical and legal causation and compensatory damages. Trial is scheduled to begin February 1, 2010.

Engle Progeny Cases

     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 9, 2009, RJR Tobacco had been served in 3,326 Engle Progeny Cases in both state and federal courts in Florida. These cases include approximately 8,741 plaintiffs. The number of cases will likely change due to individual plaintiffs being severed from multi-plaintiff cases. Many of these cases are in active discovery, and several are expected to be tried in 2009. For further information on the Engle case, see “— Class-Action Suits — Engle Case,” below.

     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., was filed in February 2001, and is pending in Circuit Court, Miami-Dade County, Florida, against the major U.S. cigarette manufacturers 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 case was tried against Philip Morris, Liggett and B&W, and resulted in a verdict for the plaintiffs on June 11, 2002. The Florida state court jury awarded the plaintiffs a total of $37.5 million in compensatory damages. The jury assigned 22.5% fault to B&W, 72.5% fault to the other defendants and 5% fault to plaintiff John Lukacs. On April 1, 2003, the Miami-Dade County Circuit Court granted in part the defendants’ motion for remittitur and reduced the jury’s award to plaintiff Yolanda Lukacs on the loss of consortium claim from $12.5 million to $0.125 million, decreasing the total award to $25.125 million. On August 2, 2006, the plaintiff 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 verdict for the plaintiff and to dismiss the plaintiff’s punitive damages claim. On January 3, 2007, the plaintiff filed a motion for entry of judgment, which the court deferred until the U.S. Supreme Court completed its review of Engle and after further submissions by the parties. The court granted the plaintiff’s motion for entry of judgment on August 14, 2008 awarding the plaintiff, Robin Lukacs, as personal representative of the estate of John and Yolanda Lukacs, the sum of $24.8 million plus interest applicable at the yearly statutory rates from June 11, 2002. On October 17, 2008, the plaintiff withdrew her request for punitive damages. On November 12, 2008, the court entered final judgment. On December 1, 2008, the defendants filed a notice of appeal. Briefing is underway. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the amount of approximately $15.2 million on March 19, 2009.

     On March 24, 2009, in Gelep v. R. J. Reynolds Tobacco Co., a case filed in October 1998 in Circuit Court, Pinellas County, Florida, a jury returned a verdict in favor of the defendants. The plaintiff, Mary Gelep, alleged that use of the defendants’ products caused Mr. Gelep to develop lung cancer, kidney cancer and other smoking related conditions and/or diseases which resulted in his death. The plaintiff was seeking an unspecified amount of actual and punitive damages. The plaintiff’s motion for new trial or, in the alternative, a motion for judgment notwithstanding the verdict was denied on April 30, 2009. On May 27, 2009, the plaintiff filed a notice of appeal to the Second District Court of Appeal, but in September 2009, the plaintiff voluntarily dismissed the appeal with prejudice and agreed to pay $50,000 in costs and attorneys’ fees to each of the defendants.

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     On May 5, 2009, a jury returned a verdict in favor of the plaintiff in Sherman v. R. J. Reynolds Tobacco Co., a case filed in September 2007 in the Circuit Court, Broward County, Florida. The plaintiff, Melba Sherman, alleged that as a result of using the defendants’ products, the decedent, John Sherman, developed lung cancer and died. The plaintiff sought actual damages and an unspecified amount of punitive damages. On May 8, 2009, the jury awarded actual damages of $1.5 million and found the decedent to be 50% at fault. No punitive damages were awarded. The court entered final judgment in the amount of $775,000 on June 8, 2009, which represents 50% of the actual damages award. In June 2009, RJR Tobacco filed a notice of appeal to the Fourth District Court of Appeal, and posted a supersedeas bond in the amount of approximately $900,000. On July 1, 2009, the plaintiff filed a notice of cross appeal of the final judgment.

     On May 20, 2009, a jury returned a verdict in favor of the plaintiff in Brown v. R. J. Reynolds Tobacco Co., a case filed in March 2007, in the Circuit Court, Broward County, Florida. The plaintiff alleged that the decedent, Roger Brown, developed smoking related diseases, which resulted in his death. The plaintiff sought actual damages and an unspecified amount of punitive damages. On May 22, 2009, the jury returned a verdict that the decedent was 50% at fault for his injuries and awarded actual damages of $1.2 million. No punitive damages were awarded. RJR Tobacco’s post-trial motions were denied on June 12, 2009. The same day, the court entered final judgment in the amount of $600,000, which represents 50% of the actual damages award. On July 2, 2009, RJR Tobacco filed a notice of appeal to the Fourth District Court of Appeal and posted a supersedeas bond in the amount of approximately $700,000.

     On May 29, 2009, in Martin v. R. J. Reynolds Tobacco Co., a case filed in October 2007 in the Circuit Court, Escambia County, Florida, a jury returned a verdict in favor of the plaintiff, found RJR Tobacco to be 66% at fault for the decedent’s injuries, and awarded $5 million in actual damages. The plaintiff alleged that as a result of Benny Martin’s use of the defendant’s tobacco products, he developed lung cancer and other medical conditions and died. The plaintiff, Mathilda Martin, sought an unspecified amount of actual and punitive damages. On June 1, 2009, the jury returned a punitive damages award of $25 million. The trial court denied RJR Tobacco’s various post-trial motions, including a motion for a new trial based on defects in the punitive damages phase, and alternatively, for remittitur of the punitive damages award. The court entered final judgment on September 13, 2009, awarding the plaintiff the sum of $3.3 million in compensatory damages and $25 million in punitive damages. RJR Tobacco filed a notice of appeal to the First District Court of Appeal on September 18, 2009. On October 6, 2009, RJR Tobacco posted a supersedeas bond in the amount of approximately $5 million. On October 8, 2009, the plaintiff filed a notice of cross-appeal of the final judgment.

     In Kaplan v. R. J. Reynolds Tobacco Co., a case filed in October 2007 in the Circuit Court, Broward County, Florida, jury prequalification began on May 27, 2009. The plaintiff alleged that as a result of her addiction to the defendants’ cigarettes, she suffers from chronic obstructive pulmonary disease and other alleged smoking-related medical conditions and diseases. The plaintiff is seeking an unspecified amount of actual and punitive damages. On June 1, 2009, the judge declared a mistrial. The case has been rescheduled for trial during the first quarter trial docket in 2010.

     On August 19, 2009, in Campbell v. R. J. Reynolds Tobacco Co., a case filed in December 2007 in the Circuit Court, Escambia County, Florida, a jury returned a verdict in favor of the plaintiff, found the decedent, Betty Campbell, to be 57% at fault, RJR Tobacco to be 39% at fault, and PM USA and Liggett Group each to be 2% at fault for the decedent’s injuries, and awarded $7.8 million in compensatory damages. No punitive damages were awarded. The plaintiff alleged that as a result of Mrs. Campbell’s addiction to cigarettes, she suffered and died from various smoking related diseases, including chronic obstructive pulmonary disease. On September 13, 2009, the court entered final judgment against RJR Tobacco in the amount of $3.04 million. The defendants have filed various post-trial motions and are awaiting a decision. On September 30, 2009, RJR Tobacco posted a supersedeas bond in the amount of approximately $3 million.

Broin II Cases

     As of October 9, 2009, there were 2,596 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

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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.

Class-Action Suits

     Overview. As of October 9, 2009, 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, Illinois, Louisiana, Minnesota, Missouri, West Virginia, Georgia and New Mexico. All pending class-action cases are discussed below.

     The pending class-actions against RJR Tobacco or its affiliates or indemnitees include eight 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 Mexico and are discussed below under “— ‘Lights’ Cases.”

     Finally, certain third-party payers have filed health-care cost recovery actions in the form of class-actions. These cases are discussed below under “— Health-Care Cost Recovery Cases.”

     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.

     Medical Monitoring and Smoking Cessation Case. 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. 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 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 (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. The 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.

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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 December 15, 2008, the trial court judge signed an order granting the defendants an appeal from the amended judgment. Oral argument in the Louisiana Court of Appeals occurred on September 1, 2009. A decision is pending.

     Peoples v. Reynolds American Inc., filed November 17, 2008 in the U.S. District Court for the Northern District of Georgia, is a purported RICO class action on behalf of Georgia smokers claiming that RAI, Altria and Lorillard, and/or their affiliates wrongfully influenced the federal government’s National Cancer Institute not to recommend CT scans as a routine lung cancer screening test for smokers. Plaintiffs claim that the NCI’s failure to endorse the test leads insurers to deny reimbursement and persuades doctors not to order the tests as a result. The plaintiffs seek a variety of damages, including damages under RICO, punitive damages, attorneys’ fees, interest and costs. On September 11, 2009, the court granted the defendants’ motion to dismiss for failure to state a claim.

     Jackson v. R. J. Reynolds Tobacco Co., filed in May 2009, in the U.S. District Court for the Northern District of Georgia, is another purported RICO class action on behalf of Georgia smokers claiming that the major U.S. cigarette manufacturers, including RJR Tobacco, influenced the National Cancer Institute not to recommend CT scans as a routine lung cancer screening test for smokers. The plaintiffs seek a variety of damages, including alleged contemplated damages under RICO, punitive damages, attorney’s fees, interest and costs. On July 13, 2009, the defendants filed a motion to stay the case and, in the alternative, motion to dismiss. The defendants also have filed a motion to dismiss for failure to state a claim.

     Engle Case. Trial began in July 1998 in Engle v. R. J. Reynolds Tobacco Co., a case filed in May 1994, 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.

     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

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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 the 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 9, 2009, 3,326 individual cases were filed in Florida as a result of the Engle decision. These cases include approximately 8,741 plaintiffs. For further information on the individual cases, see “— Engle Progeny Cases” above.

     In the second quarter of 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, and RJR Tobacco received the full amount of the $100 million cash collateral that it had posted. In the fourth quarter of 2007, the defendants’ petition for writ of certiorari and petition for rehearing with the U.S. Supreme Court were both 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. In May 2008, 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 January 7, 2009, plaintiff Marilyn Calhoun’s motion for relief from judgment, which sought to extend the deadline for filing Engle Progeny Cases beyond January 11, 2008, was denied by the Florida Supreme Court.

     Since the Florida Supreme Court’s July 6, 2006 opinion, six Engle Progeny Cases have proceeded to trial against RJR Tobacco or B&W. RJR Tobacco expects that other Engle Progeny Cases will proceed to trial against RJR Tobacco and/or B&W in 2009. For further information on Engle Progeny Cases, see “— Engle Progeny Cases” above.

     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. 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. On May 18, 2009, California Supreme Court issued an opinion reversing the decision issued by the trial court and affirmed by the California Court of Appeal that decertified the class to the extent that it was based upon the conclusion that all class members were required to demonstrate Proposition 64 standing, and remanded the case to the trial court for further proceedings regarding whether the class representatives have, or can demonstrate, standing. The defendants’ petition for rehearing was denied on August 12, 2009. The case was remanded to the trial court for further proceedings.

     “Lights” Cases. As noted above, “lights” class-action cases are pending against RJR Tobacco or B&W in Illinois (3), Missouri (2), Minnesota (2), and New Mexico (1). The classes in these cases generally seek to recover $50,000

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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.

     Many of these “lights” cases were stayed pending review of the Good v. Altria Group, Inc. case by the U.S. Supreme Court. On December 15, 2008, the U.S. Supreme Court decided that these claims are not preempted by the Federal Cigarette Labeling and Advertising Act or by the Federal Trade Commission’s, referred to as FTC, historic regulation of the industry. In light of this decision, it is likely that one or more of the stayed cases will become active in 2009.

     The seminal “lights” class-action case involves 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. On December 18, 2008, the plaintiffs filed a petition for relief from judgment, stating that the U.S. Supreme Court’s decision in Good v. Altria Group, Inc. rejected the basis for the reversal. The trial court granted the defendant’s motion to dismiss the plaintiffs’ petition for relief from judgment on February 4, 2009. On March 3, 2009, the plaintiffs filed a notice of appeal to the Illinois Appellate Court, Fifth Judicial District, requesting a reversal of the February 4, 2009 order and remand to the circuit court. Briefing is underway.

     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 of the denial of its emergency stay/supremacy order request 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 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.

     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. As a result of the U.S. Supreme Court’s decision in Good v. Altria Group, Inc., this case is likely to become active in 2009.

     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. As a result of the U.S. Supreme Court’s decision in Good v. Altria Group, Inc., this case is likely to become active in 2009.

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     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 appealed to 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 and remanded the case to the District Court. 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. On January 20, 2009, the Minnesota Supreme Court issued an order vacating the February 27, 2008, order that granted RJR Tobacco’s petition for review. As a result of the U.S. Supreme Court’s decision in Good v. Altria Group, Inc., the case is likely to become active in 2009. On July 22, 2009, the plaintiffs in this case and in Thompson v. R. J. Reynolds Tobacco Co. filed a motion to consolidate for discovery and trial. On October 7, 2009, the court companioned the two cases and reserved its ruling on the motion to consolidate, which it said will be reevaluated as discovery progresses.

     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., and that stay has now been lifted. In May 2009, the court entered an agreed scheduling order that bifurcates merits and class certification discovery, and the parties are engaged in class certification discovery. A class certification hearing is scheduled for January 7, 2010. This case is likely to remain active through 2009. On July 22, 2009, the plaintiffs in this case and in Dahl v. R. J. Reynolds Tobacco Co. filed a motion to consolidate for discovery and trial. On October 7, 2009, the court companioned the two cases and reserved its ruling on the motion to consolidate, which it said will be reevaluated as discovery progresses.

     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 was brought on behalf of persons who have allegedly been injured by (1) the defendants’ purported conspiracy pursuant to which defendants 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 requested 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. The plaintiffs filed an amended complaint on March 3, 2009, to add a claim of unjust enrichment and to include in the class individuals who smoked “light” cigarettes. RJR Tobacco and B&W answered the amended complaint on March 31, 2009. On July 5, 2009, the plaintiffs filed an additional motion for class certification. On September 8, 2009, the court granted the defendants’ motion for summary judgment on the pleadings concerning the lights claims as to all defendants other than Philip Morris.

     In Williams v. Philip Morris USA, Inc., a case filed in July 2009 in the U.S. District Court for the Eastern District of Arkansas against PM USA, Altria, RJR Tobacco and RAI, the plaintiffs brought the case on behalf of all Arkansas residents who from July 1, 2004, to the date of judgment, purchased, not for resale, the defendants’ cigarettes labeled as “light” or “ultra-light.” The plaintiffs allege breach of express warranty, breach of implied warranty of merchantability, fraudulent concealment, negligence, gross negligence and unjust enrichment. The plaintiffs seek a variety of damages, including actual, compensatory and consequential damages, restitution, disgorgement of profits, establishment of a trust for reimbursement and the funding of a smoking cessation program, punitive damages, attorneys’ fees and costs. On July 22, 2009, the plaintiffs filed an amended complaint omitting RJR Tobacco and RAI as defendants.

     In VanDyke v. R. J. Reynolds Tobacco Co., a case filed in August 2009 in the U.S. District Court for the District of New Mexico, the plaintiffs brought the case on behalf of all New Mexico residents who from July 1, 2004, to the date of judgment, purchased, not for resale, the defendants’ cigarettes labeled as “lights” or “ultra lights.” The

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

plaintiffs allege fraudulent misrepresentation, breach of express warranty, breach of implied warranties of merchantability and of fitness for a particular purpose, violations of the New Mexico Unfair Practices Act, unjust enrichment, negligence and gross negligence. The plaintiffs seek a variety of damages, including actual, compensatory and consequential damages to the plaintiff and the class but not damages for personal injury or health-care claims.

     On April 17, 2009, plaintiffs in several pending “lights” cases filed a motion before the Federal Panel on Multi-District Litigation to transfer and consolidate 11 “lights” cases for pretrial proceedings. Among the cases sought to be consolidated was Cleary, as well as nine additional cases currently pending against Philip Morris. Ultimately, Cleary was withdrawn from the request for consolidation, and the remaining cases, as well as additional cases filed thereafter, were consolidated and transferred to Judge John Woodcock of the U.S. District Court for the District of Maine by the Multi-District Litigation panel. Philip Morris and Altria are the only defendants in those cases.

     In the event RJR Tobacco and its affiliates or indemnitees lose one or more of the 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.

     Other Class Actions. Young v. American Tobacco Co., Inc., a case filed in November 1997 in Circuit Court, Orleans Parish, Louisiana, the plaintiffs brought 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 was 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;

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

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.

Health-Care Cost Recovery Cases

     Health-care cost recovery cases have been brought by a variety of plaintiffs. Other than certain governmental actions, these cases largely have been unsuccessful on remoteness grounds, which means that one who pays an injured person’s medical expenses is legally too remote to maintain an action against the person allegedly responsible for the injury.

     As of October 9, 2009, four health-care cost recovery cases were pending in the United States against RJR Tobacco, B&W, as its indemnitee, or both, as discussed below after the discussion of the State Settlement Agreements.

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

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

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

•

all claims of the settling states and their respective political subdivisions and other recipients of state health-care funds, relating to past conduct arising out of the use, sale, distribution, manufacture, development, advertising, marketing or health effects of, the exposure to, or research, statements or warnings about, tobacco products; and

•

all monetary claims of the settling states and their respective political subdivisions and other recipients of state health-care funds, relating to future conduct arising out of the use of or exposure to, tobacco products that have been manufactured in the ordinary course of business.

     Set forth below are tables depicting the unadjusted tobacco industry settlement payment schedule and the settlement payment schedule for RAI’s operating subsidiaries under the State Settlement Agreements, and related information for 2007 and beyond:

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

Unadjusted Original Participating Manufacturers’ Settlement Payment Schedule

																										2013 and
		2007				2008				2009				2010				2011				2012				thereafter
First Four States’ Settlements: (1)
Mississippi Annual Payment		$	136			$	136			$	136			$	136			$	136			$	136			$	136
Florida Annual Payment			440				440				440				440				440				440				440
Texas Annual Payment			580				580				580				580				580				580				580
Minnesota Annual Payment			204				204				204				204				204				204				204
Remaining States’ Settlement:
Annual Payments (1)			7,004				8,004				8,004				8,004				8,004				8,004				8,004
Base Foundation Funding			25				25				—				—				—				—				—
Growers’ Trust (2)			500				500				295				295				—				—				—
Offset by federal tobacco buyout(2)			(500	)			(500	)			(295	)			(295	)			—				—				—
Total		$	8,389			$	9,389			$	9,364			$	9,364			$	9,364			$	9,364			$	9,364
RAI’s Operating Subsidiaries’ Settlement Expenses and Payment Schedule
Settlement expenses		$	2,821			$	2,703				—				—				—				—				—
Settlement cash payments		$	2,616			$	2,830				—				—				—				—				—
Projected settlement expenses										$	>2,500			$	>2,700			$	>2,700			$	>2,700			$	>2,700
Projected settlement cash payments										$	>2,200			$	>2,500			$	>2,700			$	>2,700			$	>2,700