Annual Report — [x] Reg. S-K Item 405 — Form 10-K
Filing Table of Contents
Document/Exhibit Description Pages Size
1: 10-K405 Annual Report -- [x] Reg. S-K Item 405 94 478K
2: EX-10.46 Material Contract 2 7K
3: EX-10.47 Material Contract 1 6K
4: EX-10.48 Material Contract 49 126K
5: EX-10.49 Material Contract 29 80K
6: EX-10.50 Material Contract 13 36K
================================================================================
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934
For the fiscal year ended December 31, 2001
[_] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from to
----------- --------------
Commission File Number: 0-15324
STAR SCIENTIFIC, INC.
(Exact name of registrant as specified in its charter)
Delaware 52-1402131
(State of incorporation) (I.R.S. Employer Identification No.)
801 Liberty Way (804) 530-0535
Chester, VA 23836 (Registrant's telephone number,
(Address of principal executive offices) including area code)
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.0001 par value
(Title of Class)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the Registrant's voting stock held by
non-affiliates of the Registrant as of March 1, 2002 is approximately
$33,412,119. Shares of voting stock held by each executive officer and director
and by each person who owns 5% or more of the Registrant's voting stock have
been excluded in that such persons may be deemed affiliates of the Registrant.
This determination of affiliate status is not necessarily a conclusive
determination for other purposes.
Number of shares outstanding of each class of common equity as of March 1,
2002: 59,741,460 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE:
None
================================================================================
1
NOTE ON FORWARD-LOOKING STATEMENTS
This report on Form 10-K contains certain forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995. The
Company has tried, whenever possible, to identify these forward-looking
statements using words such as "anticipates", "believes", "estimates",
"expects", "plans", "intends" and similar expressions. These statements reflect
the Company's current beliefs and are based upon information currently available
to it. Accordingly, such forward-looking statements involve known and unknown
risks, uncertainties and other factors which could cause the Company's actual
results, performance or achievements to differ materially from those expressed
in, or implied by, such statements. These risks, uncertainties and contingencies
include, without limitation, the challenges inherent in new product development
initiatives particularly in the smokeless tobacco area, the uncertainties
inherent in the progress of scientific research, the Company's ability to raise
the capital necessary to grow its business, potential disputes concerning the
Company's intellectual property, risks associated with litigation regarding such
intellectual property, potential delays in obtaining any necessary government
approvals of the Company's low-TSNA tobacco products, market acceptance of the
Company's proposed new smokeless tobacco products, competition from companies
with greater resources than the Company, the Company's decision not to join the
Master Settlement Agreement ("MSA") and its decision to challenge the
constitutionality of the MSA, the effect of state statutes adopted under the MSA
and any subsequent modification of the MSA, the Company's dependence on key
employees and on its strategic relationships with Brown & Williamson Tobacco
Corporation. The impact of potential litigation, if initiated against or by
individual states that have adopted the MSA, could be materially adverse to the
Company.
See additional discussion under "Factors That May Affect Future Results"
under Item 1 below, and other factors detailed from time to time in the
Company's other filings with the Securities and Exchange Commission.
2
PART I
Item 1. Business
General
Star Scientific, Inc. ("Star") and its wholly-owned subsidiary, Star
Tobacco, Inc. ("ST", formerly Star Tobacco & Pharmaceuticals, Inc., and together
with Star, the "Company") are technology-oriented tobacco companies with a
mission to reduce toxins in tobacco leaf and tobacco smoke. The Companies are
engaged in: (1) the development and implementation of scientific technology for
the curing of StarCured(TM) tobacco so as to retard or significantly reduce the
formation of carcinogenic toxins present in tobacco and tobacco smoke, primarily
the tobacco specific nitrosamines ("TSNAs"); (2) the sales, marketing and
development of tobacco products that expose adult tobacco users to substantially
lower levels of carcinogenic toxins, namely TSNAs, that are sold with enhanced
health warnings and comparative content information so that adult tobacco
consumers will have the option to make informed choices about the use of tobacco
products which pose a range of serious health risks (the TSNA levels in the
Company's tobacco products will continue to be reduced to very low levels,
measured in parts per billion, using the StarCured(TM) tobacco curing process);
(3) the sales, marketing and development of very low-nitrosamine smokeless
tobacco products which also carry enhanced warnings beyond those required by the
Surgeon General (in 2001, the Company introduced three new smokeless products,
Stonewall(TM) moist and dry snuffs, and ARIVA(TM) compressed powdered tobacco
cigalett(TM) pieces); (4) the manufacture and sale of four discount cigarette
brands which currently contain 24% very low-TSNA StarCured(TM) tobacco; and (5)
in the future continued focus on developing smoking cessation products if it can
secure a joint venture partner or corporate pharmaceutical partner with a
significant regulatory infrastructure.
The Company's primary focus will continue to be the research, development
and sale of products that expose adult tobacco users to lower levels of toxins.
The Company's overall objective is to ultimately reduce the range of serious
health hazards associated with the use of smoked and smokeless tobacco products.
Accordingly, its primary corporate mission is to demonstrate the commercial
viability of products that expose adult tobacco users to fewer toxins and are
potentially less harmful, although, given the present limited state of the
research efforts of Star and others in this area, the Company in discussing its
low-TSNA products has shared with adult consumers the fact that there is not now
sufficient evidence to demonstrate that reduced toxin delivery can be quantified
in terms of reduced health risk. The Company fully accepts the evidence that
links smoking tobacco and a variety of diseases and premature death and believes
that it is unlikely that the health risks of smoked tobacco can be completely
eliminated. Star believes it was the first Company to state unequivocably that
"there is no such thing as a safe cigarette", and to affix to the back of the
package of its first premium low-TSNA product, Advance(R), a package "onsert"
which contained not only scientifically verified comparative content data, but
also additional health warnings. Nevertheless, in a world where an estimated 1.2
billion people smoke and use other conventional tobacco products, there is an
urgent need to reduce the toxicity of tobacco products to the maximum extent
possible. Accordingly, the Company believes that it has a corporate
responsibility to continue to expand its research and development efforts to
manufacture tobacco products in the least hazardous manner possible given
available technology, particularly through the StarCured(TM) tobacco curing
process. The Company believes it has the technology to reduce carcinogenic
TSNAs, particularly the subgroups of nitrosamines which are commonly referred to
as NNNs and NNKs, to the lowest possible levels and has demonstrated that the
method it has developed for curing tobacco using the StarCured(TM) tobacco
curing process can be scaled up to meet broad commercial needs in the United
States and abroad. Given the fact that tobacco smoke contains over 4,000
constituents, 43 of which are known carcinogens, the Company's focus over the
last two years has been directed to the development and introduction of very
low-TSNA smokeless tobacco products which can be used as an alternative to
cigarettes in situations where adult tobacco users either cannot or choose not
to smoke. The Company expects that in the future its focus will continue to be
on the sale of smokeless tobacco products. The Company is also committed to
continuing to advocate meaningful federal regulation for all tobacco products
and has publicly announced its support for reasoned regulation of tobacco
products by the United States Food and Drug Administration (the "FDA").
The Company has an exclusive, worldwide license under patents issued and
patents pending relating to methods to prevent or substantially reduce the
formation of TSNAs in tobacco including the StarCured(TM) tobacco curing
process.
3
The Company's revenues are generated principally through ST. ST's
predecessor, a closely held private company, was organized in 1990 and, until
1994, primarily was engaged in the business of manufacturing cigars and
cigarettes for others as a contract manufacturer. By late 1994, ST had commenced
development and commercialization of its own brands of discount cigarettes using
primarily Virginia, flue-cured tobacco and competed principally on the basis of
price. At about that same time, ST commenced a program of research and
development relating to the development of a range of tobacco products that
deliver less toxins as well as tobacco cessation products. Shortly thereafter,
ST shifted its near-term research to technology focused on reducing the
carcinogenic TSNAs, particularly the NNNs and NNKs, in the tobacco leaf and
tobacco smoke. In February 1998, ST merged with Eye Technology, Inc., a
publicly-held OTC Bulletin Board company based in Minneapolis, Minnesota. While
Eye Technology technically was the surviving corporation, in effect control of
the surviving corporation shifted to the former stockholders of ST and the
management of ST became the management of the survivor in the merger. By
December 30, 1998, the assets and liabilities that comprised the pre-merger
business of Eye Technology, Inc. had been sold or liquidated, and the
stockholders of Eye Technology voted to change its name to Star Scientific, Inc.
The Company's primary corporate focus from that time forward has centered on the
sales, marketing and development of tobacco products which expose adult tobacco
users to lower levels of toxins and potentially may be proven to reduce risk,
and, on a more long-term basis, development of smoking cessation products either
with a joint venture partner or a corporate pharmaceutical partner with
significant resources, and/or experience in scientific and regulatory
infrastructure that can assist and accelerate the FDA's New Drug Application
regulatory process necessary for market entry.
The StarCured(TM) tobacco curing process, to which the Company has an
exclusive license, as discussed herein, from Regent Court Technologies, LLC
("Regent Court"), involves the control of certain conditions in tobacco curing
barns, and in certain applications, uses microwave and/or electronic beam
technology. The StarCured(TM) process retards or substantially reduces the
formation in the tobacco leaf of the carcinogenic TSNAs, which are widely
believed by recognized medical and scientific experts to be among the most
abundant and powerful cancer-causing toxins present in tobacco and in tobacco
smoke. In 2000 and again in 2001, the Company processed approximately 19 million
pounds of very low-TSNA flue-cured tobacco using the StarCured(TM) process. Star
has focused on the production of StarCured(TM) flue-cured tobacco since this
variety is used exclusively in the Company's new smokeless products. At the same
time, the Company believes that this process can be applicable to burley and
other varieties of tobacco on a broad-scale commercial basis and continues to
support research and technological development directed to varieties other than
flue-cured tobacco.
Star's long-term strategy is to encourage other tobacco manufacturers to
sublicense the StarCured(TM) tobacco curing technology to produce very low-TSNA
tobacco (with carcinogenic NNKs and NNNs that measure 200 parts per billion and
below). Further, Star is committed to continuing to explore the development of
products that expose adult tobacco users to lower levels of toxins and are
potentially less harmful than conventional smoked tobacco, such as smokeless
tobacco products, as well as in the future the development of tobacco cessation
products. In September 2001, the Company introduced two very low-TSNA snuff
products (a moist and a dry snuff) under the brand name Stonewall(TM). In
November 2001, the Company initiated the test market of its compressed powdered
tobacco "cigalett"(TM) pieces under the brand name ARIVA(TM). The tobacco in
both Stonewall(TM) and ARIVA(TM) is 100% StarCured(TM) very low-TSNA tobacco.
The Company also markets four brands of discount cigarettes, namely, SPORT(R),
MAINSTREET(R), VEGAS(R) and G-SMOKE(R), all of which contain 24% very low-TSNA
flue-cured tobacco, and utilize a carbon/acetate filter that reduces additional
toxins found in cigarette smoke.
On April 25, 2001, the Company and Brown & Williamson Tobacco Corporation
("B&W"), the third largest tobacco company in the United States, entered into a
series of new comprehensive long-term agreements (the "April 25, 2001
Agreements") that amended agreements previously entered into with B&W. Among
other things, the agreements provide for B&W to take over all aspects of the
sale of Advance(R), the low-TSNA cigarette which was jointly developed by the
Company and B&W and first test marketed by the Company in October 2000, in
return for royalty payments to the Company. B&W subsequently launched an
expanded test market of Advance(R) in approximately 1,500 stores in
Indianapolis, Indiana in November 2001 and potentially may market this brand on
a national basis, if the current market test is successful. The agreements also
provide B&W with the exclusive marketing rights for the Company's compressed
powdered cigalett(TM) pieces in the United States (subject to the
4
Company's own rights), in return for paying the Company a royalty plus the cost
of manufacturing the cigaletts(TM). Among other things, the agreements also
restate various loan agreements made by B&W to the Company during 1999 and 2000,
and provide for the purchase of StarCured(TM) tobacco by B&W over the growing
seasons from 2001-2003, with the right to purchase additional tobacco in future
years (see "Relationship with B&W").
Segments and Products
See Note 12 of the Company's Consolidated Financial Statements for
financial information about the Company's segments.
Leaf Tobacco
In 1999, Star processed and sold over 3.5 million pounds of StarCured(TM)
very low-TSNA tobacco. In each of 2000 and 2001, Star processed and sold
approximately 19 million pounds of very low-TSNA flue-cured tobacco that had
been cured using the StarCured(TM) tobacco curing process. The vast majority of
these sales were made to B&W, pursuant to Star's contractual arrangements with
B&W described elsewhere in this report. These sales accounted for approximately
20.6%, 20.7%, and 10.0% of the Company's net sales in 2001, 2000 and 1999,
respectively. This included a royalty of $1.5 million in 2001 from B&W on its
purchases of other low-TSNA tobacco. Under the April 25, 2001 Agreements, it is
anticipated the Company will process approximately 18-20 million pounds of very
low-TSNA flue-cured tobacco in each of the next two growing seasons, for sale to
B&W and for use in the Company's own brands. The tobacco will be cured using the
StarCured(TM) tobacco curing process.
The bulk of processed tobacco sales occur in the third and fourth quarter
of each year, resulting in higher revenues in those quarters. The Company's
long-term goal is to derive an increasingly larger percentage of its revenues
from sublicensing the StarCured(TM) tobacco curing process to major cigarette
manufacturers. During 2001, approximately eighty-five percent (85%) of all
flue-cured tobacco in the U.S. was cured in a manner to reduce the levels of
TSNAs in the cured tobacco leaf. In May 2001, the Company filed suit against R.
J. Reynolds Tobacco Company ("R.J. Reynolds") for patent infringement relating
to R.J. Reynolds' efforts to have farmers produce low-TSNA tobacco using the
technology to which Star is the exclusive licensee.
Smokeless Tobacco Products
Over the past two years, the Company has been engaged in the development
of smokeless tobacco products that could provide adult tobacco users with a
viable alternative to cigarettes in situations and environments when they can't
smoke or when they would prefer not to smoke. This effort was encouraged by the
Company's Scientific Advisory Board and other independent scientific, medical,
and public health advisors who encouraged Star to accelerate the development of
smokeless products using 100% StarCured(TM) low-TSNA tobacco, because smokeless
products have far fewer toxins than conventional cigarettes. Cigarette smoke
contains more than 4,000 chemical compounds, 43 of which are known to be
carcinogenic. A number of respected scientists and researchers believe that the
major or significant toxins in smokeless tobacco are the TSNAs, particularly the
NNNs and NNKs. In labelling and promoting its smokeless tobacco products, the
Company has made no direct or implied health or therapeutic claims, consistent
with its stated belief that, at this time, there is not sufficient peer reviewed
scientific evidence to demonstrate that reduced toxin delivery can be quantified
in terms of reduced health risk.
On September 28, 2001, the Company introduced its first two very low-TSNA
snuff products (a moist and a dry snuff) under the brand name Stonewall(TM). On
November 14, 2001, Star introduced its flagship hard tobacco cigalett(TM) pieces
(ARIVA(TM)). ARIVA(TM) is a compressed powdered tobacco product designed to
dissolve completely in the mouth without leaving any residue. Sales of Star's
smokeless products were de minimus in 2001. ARIVA(TM) and Stonewall(TM) are
being marketed nationwide by ST through its network of established tobacco
distributors and through new distributors with whom ST has not previously had a
relationship. In addition, the Company has sought to introduce ARIVA(TM) and
Stonewall(TM) through direct arrangements with several national retail chains
and through national distributors experienced with consumer products. Following
the successful limited test market of its smokeless products, Star decided it
was appropriate to expand distribution. Accordingly, by March 2002, the
Company's smokeless products had been placed in more than 10,000 convenience and
retail store locations. The Company anticipates greatly expanding the number of
stores in which its smokeless products will be available during 2002.
5
Discount Cigarettes
ST manufactures and sells four brands of discount cigarettes through
approximately 260 tobacco distributors throughout the United States. These
cigarettes, which are sold as discount brands, accounted for approximately
79.4%, 79.3%, and 90.0% of the Company's net sales in 2001, 2000 and 1999,
respectively. ST does not engage in extensive advertising or marketing programs
for its cigarette products, but relies primarily upon communications with
distributors, product placement by its field sales force (the field sales force
focuses primarily on placing ST's products with retailers in Florida, Minnesota,
Mississippi and Texas), pricing appropriate for discount cigarettes, and, to a
lesser extent, on brand recognition, product appearance and taste in order to
compete in the marketplace. ST has avoided any marketing efforts aimed at young
persons, and the Company is committed to keeping its products out of the hands
of youngsters. There were no export sales by the Company in 2001.
All of ST's discount cigarettes contain 24% StarCured(TM) flue-cured very
low-TSNA tobacco. As of July 1, 1999, ST changed all of its filters to activated
carbon/acetate because several leading health advocates and respected research
scientists believe that activated charcoal (carbon) filters reduce certain vapor
phase toxins found in tobacco smoke. Since January 2001, the Company has
undertaken to increase the amount of activated charcoal in its filters to 30
milligrams for all new production of ST's discount brands. The Company is
evaluating whether continued use of these filters is appropriate on a
going-forward basis. The Company intends to continue to use its StarCured(TM)
very low-TSNA tobacco in its discount cigarettes, although the Company does not
have any evidence to support the conclusion that reducing a range of toxins in
cigarette smoke will correspond to a reduced health risk.
Low-TSNA Cigarettes
Star launched the first very low-TSNA cigarette, Advance(R), in October
2000 in two test markets--Richmond, Virginia and Lexington, Kentucky. Advance(R)
was the first conventional cigarette to be manufactured to deliver fewer
carcinogenic TSNAs. The Advance(R) cigarette reduced additional toxic smoke
constituents through a unique "dalmatian-type" activated carbon/acetate filter.
Advance(R) also differed from conventional premium brands because it provided
adult tobacco consumers with enhanced health warnings (not required by the
Surgeon General), on the back of the package and "onserts" that contained
comparative content information and additional health-related information.
Under the April 25, 2001 Agreements with B&W, B&W agreed to take over all
aspects of the sales, marketing and distribution of Advance(R). On November 4,
2001, B&W initiated a test market of its version of Advance(R) in Indianapolis,
Indiana. That test market is ongoing and, if successful, B&W will undertake a
future rollout of the product. Under the April 25, 2001 Agreements, Star
receives a royalty on each carton of Advance(R) sold by B&W. Sales of Advance(R)
during the Company's test market and royalty payments from B&W during 2001 were
de minimus.
Tobacco-Flavored Chewing Gum and Lozenges and Chewing Gum Containing Tobacco
Extract
Prior to the decision to concentrate on the development of products for
adult tobacco users that incorporate very low-TSNA StarCured(TM) tobacco, the
Company sought to develop both cessation products and a product intended to help
patients who relapsed after a trial of smoking cessation to prepare for another
cessation attempt. While the initial results of the testing of these products
was positive, the Company determined that the further testing and the
preparation and submission of required marketing applications to the FDA would
be costly and time consuming. The Company made the business decision that it was
unlikely that the development of cessation-related products on its own would
produce an adequate return on investment. Accordingly, the Company has explored
and will continue to explore entering into a joint venture, partnership and/or
technology license as a means to develop cessation-related products. The Company
would prefer to work with a major pharmaceutical company with significant
resources, experience and the scientific and regulatory infrastructure that can
assist and accelerate the approval process required for market entry.
6
Sales and Marketing
ST's four brands of discount cigarettes are each sold in a variety of
sizes and styles such as king size and 100s, soft pack and hinged box, regular
flavor and menthol, and full flavor, lights and ultra lights. ST utilizes its
own specified blend of tobaccos in each brand. The blend consists of Virginia
flue-cured, burley and oriental varieties of tobacco, which is typical of
American-style cigarettes.
It is ST's strategy to rely to a large degree upon distributors to promote
ST's brands to retail customers. ST provides to its distributor customers, for
redistribution to retailers, point-of-sale materials such as posters, pole
signs, display racks and counter top and floor displays. Also, ST produces
marketing materials for use by distributors and their direct sales force to
promote the sale of ST tobacco products to their retail customers.
ST sells its tobacco products through approximately 260 tobacco
distributors throughout the United States, although in 2001 its sales were
primarily in Florida, Mississippi, Minnesota and Texas. Of these 260
distributors, approximately 100 are located in Florida, Mississippi, Minnesota,
and Texas where the Company's sales force is now concentrated and in which it
does not have purported obligations to make payments into escrow under state
qualifying statutes enacted pursuant to the Tobacco Master Settlement Agreement
(the "Master Settlement Agreement" or "MSA"). The distributors maintain state
and, where applicable, municipal government tobacco product licenses, and apply
state and/or local tax stamps when needed to resell the tobacco products. ST
delivers its products directly to distributors mainly by common carrier trucks.
ST's distributor customers primarily serve convenience stores, gas stations and
other outlets and retail stores. No one distributor accounted for more than 11%
of ST's revenue in 2001. The overall number of distributors was reduced from
approximately 325 in 2000 to approximately 260 in 2001 due to price increases as
well as the Company's focus on enhancing its market share in four states:
Florida, Minnesota, Mississippi, and Texas. ST's shipment volume during 2001
decreased approximately 31% to 3.5 billion units from 2000's shipment volume of
5.0 billion units, reflecting a continued focus by the Company to concentrate
the field sales force and sales efforts in four states and to develop and launch
a series of smokeless tobacco products, which the Company believes will be the
primary focus of its business in the future.
In marketing ARIVA(TM) hard tobacco cigalett(TM) pieces and Stonewall(TM)
moist and dry snuffs, the Company has sought to position the products in the
smokeless sector of the tobacco market using many of the same distribution
channels that it uses for cigarette sales. As part of the marketing and
distribution effort, the Company also has negotiated agreements with a number of
national retail chains and national distributors selling consumer products.
Three of the Company's officers, Mr. Jonnie R. Williams, Star's Chief
Executive Officer, Mr. David M. Dean, Star's Vice President of Sales and
Marketing, and Mr. Sheldon Bogaz, ST's Vice President of Trade Operations, lead
the Company's sales and marketing activities. Mr. Randy Escamilla, National
Sales Manager, supervises a staff of seven regional sales representatives who
direct ST's field sales force.
During 2001, ST repositioned and consolidated its field sales force in
response to increased competition from foreign and domestic companies selling
discount brands. By the end of 2001, ST had 88 field sales personnel and
merchandisers primarily positioned in Florida, Minnesota, Mississippi and Texas.
In 2002, ST will continue to selectively expand its field sales force, primarily
in those states.
Purchasing
Star purchases its very low-TSNA flue-cured tobacco for its leaf tobacco
sales from approximately 200 participating tobacco farmers (StarCured(TM)
farmers) who cure their tobacco in specially designed StarCured(TM) barns
pursuant to long-term contracts entered into with the Company. Star believes
that it will be able to purchase a sufficient supply of flue-cured,
StarCured(TM) leaf tobacco from these farmers for its own use and to satisfy
commitments to B&W for the foreseeable future. The Company anticipates that it
will be able to process the tobacco purchased from the farmers within its Chase
City processing facility within one to three days of delivery to the facility.
During 2001, the majority of tobacco used in ST's cigarettes was purchased
from B&W's Export Leaf Division in "cut rag" form, meaning that the tobacco has
been cut, processed and flavored to ST's specifications, and is ready
7
when delivered to ST for the manufacturing process. ST expects to continue
purchasing "cut rag", low-TSNA StarCured(TM) tobacco and other tobacco for the
next several years from B&W's Export Leaf Division, and thereafter to either
continue purchasing "cut rag" tobacco from B&W Export Leaf Division or to
purchase increasing amounts of tobacco needed for its business from other
sources. Buying tobacco from B&W's Export Leaf Division allows ST to avoid
having to dedicate substantial amounts of working capital to tobacco
inventories.
At the end of 2001, Star had approximately 858,000 pounds of burley
tobacco in inventory, which will be utilized as part of the blend in Star's four
discount brands. In 2001, Star continued its R&D to attempt to perfect the
StarCured(TM) tobacco curing process for burley tobacco in conjunction with the
University of Kentucky's Department of Agronomy, The Burley Tobacco Growers
Cooperative Association, Inc. and Star's scientific and technical advisors. Star
believes that the StarCured(TM) process is applicable to burley tobacco, and the
Company will conduct additional experiments with the University of Kentucky this
growing season. However, because the tobacco in Star's smokeless tobacco
products is 100% flue-cured very low-TSNA StarCured(TM) tobacco, the Company's
need for a low-TSNA burley tobacco is expected to decline as the Company shifts
its emphasis to smokeless tobacco products. Moreover, no assurances can be given
at this time that the low-TSNA StarCured(TM) tobacco curing process for burley
tobacco will be successfully developed and commercialized.
At the end of 2001, Star had approximately 1.4 million pounds of redried
strip StarCured(TM) tobacco paid for by B&W and held in inventory by B&W on
Star's behalf. This tobacco will be used as part of the blend in Star's discount
cigarettes as well as in Star's smokeless tobacco products.
Manufacturing
All of the flue-cured tobacco which the Company plans to use in 2002 and
thereafter, either for sale to B&W and potentially other parties, or for gradual
incorporation into ST's own cigarettes, or in Star's smokeless tobacco products,
will be cured using the StarCured(TM) tobacco curing process. The StarCured(TM)
tobacco curing process involves controlling certain conditions in the tobacco
curing barns and in certain applications, uses microwave and/or electronic beam
technology. The specially designed curing barns that utilize the StarCured(TM)
tobacco processing technology are manufactured exclusively for Star by Powell
Manufacturing Company of Bennettsville, South Carolina ("Powell"). Specially
designed barns, which are owned or leased by the Company, are erected on site at
the tobacco farms and provide Star with its source of very low-TSNA tobacco. A
total of 1,125 Star barns have been manufactured and approximately 920 were
delivered to farmers who currently produce flue-cured tobacco. In 2000, 100
barns were delivered to farmers in Kentucky in connection with the research,
development and testing of the StarCured(TM) tobacco curing process for burley
tobacco in conjunction with the previously-mentioned joint program with The
Burley Tobacco Growers Cooperative Association, Inc.
Star does not anticipate purchasing any additional barns from Powell in
2002 because the Company has sufficient barns in place to process approximately
20 million pounds of StarCured(TM) flue-cured tobacco, which will meet the
Company's needs for this growing season. Under the April 25, 2001 Agreements
with B&W, B&W agreed to finance all of the StarCured(TM) tobacco curing barns on
an interest-free basis through January 1, 2005. Subsequent to April 2001, Star
entered into a series of sale/leaseback transactions for approximately 400 barns
and, as part of these transactions, has reduced its long-term indebtedness to
B&W from approximately $29 million to $23.7 million. Also, in 2001, Star sold 91
curing barns to Golden Leaf Tobacco Company, Inc. for $1.85 million as part of a
sale and licensing arrangement. The $1.85 million was used to reduce long-term
debt owed to B&W because the barns were held as collateral for this debt. Under
the license agreement, Golden Leaf is obligated to pay royalties on
StarCured(TM) tobacco and other low-TSNA tobacco it uses once the Company begins
to receive royalties from tobacco companies other than B&W. As discussed above,
Star has entered into a series of sale/leaseback transactions in which Star has
financed the barns with certain financial institutions and agreed to repurchase
the barns at the end of the lease period, thus ultimately having the ability to
retain control of the barns.
In early 2000, Star's processing facility in Chase City, Virginia
underwent a substantial expansion of its capacity to process significantly
larger amounts of very low-TSNA tobacco, as well as to provide sufficient space
for the installation of new equipment to be used in conjunction with the
manufacturing of the Company's smokeless tobacco products and the installation
of a state of the art laboratory to test for TSNAs. This expansion allowed Star
to process approximately 19 million pounds of StarCured(TM) tobacco during each
growing season in 2000 and 2001.
8
As a result of the expansion, the Chase City facility will have more than
adequate capacity for volumes anticipated for B&W under the April 25, 2001
Agreements and for Star's need for tobacco.
ST expanded its cigarette manufacturing capability in 2000 by outsourcing
a portion of its manufacturing through a contract with B&W to manufacture
cigarettes. The Company undertook this outsourcing to avoid the need to buy new
cigarette manufacturing equipment. In 2002, Star also installed at Chase City a
high-speed manufacturing line for the production of ARIVA(TM) hard tobacco
cigalett(TM) pieces and Stonewall(TM) dry snuff, and a second manufacturing line
has been ordered. Plans are currently underway for the installation of these
manufacturing lines in a second facility in Chase City, adjacent to the existing
Star facility. This second facility has approximately 91,000 square feet of
warehouse space and 9,000 square feet of office space located on approximately
nine acres of land. This facility is the process of being acquired by the
Virginia Economic Development Authority ("EDA") and, as contemplated, the EDA
will finance the renovations of the facility to Star's specifications. Star will
enter into a long-term lease with an option to purchase this facility. The
Company has added further manufacturing capacity at its Petersburg, Virginia
facility for the production of Stonewall(TM) moist snuff.
The Company believes its manufacturing facilities, together with the
additional contract manufacturing relationship now in place with B&W, will allow
it to respond to the growing demand for its smokeless products, as well as
demand for cigarette products for the foreseeable future.
Relationship with B&W
On October 12, 1999, the Company and B&W entered into a Supply Agreement
under which B&W agreed to purchase StarCured(TM) tobacco. During 1999 and 2000,
Star produced and delivered to B&W approximately 3.5 million pounds and 19
million pounds, respectively, of very low-TSNA StarCured(TM) processed tobacco.
Some of this tobacco has been or will be purchased by the Company for use in
ST's own discount cigarettes, and in Star's new hard tobacco and moist and dry
snuff products.
In addition during 2000, B&W collaborated with the Company in the
development of the Advance(R) low-TSNA cigarette. B&W also has been
manufacturing cigarettes for ST, supplying leaf tobacco to ST for use in its
tobacco products, and warehousing burley tobacco for Star.
Under the April 25, 2001 Agreements, B&W agreed to purchase at least 15
million pounds of StarCured(TM) tobacco over three growing seasons (2001-2003)
with the right to purchase additional amounts of StarCured(TM) tobacco during
those years and in future years. B&W also agreed to restructure approximately
$29 million of debt into long-term, interest-free debt with interest and
principal payments beginning in January 2005 and continuing over five years.
There are provisions in the agreements that forgive one-half of the then-current
debt upon declaration by B&W that its test market of a cigalett(TM) product
is successful, and all of the remaining debt once B&W introduces a cigalett(TM)
product into distribution in retail locations in 15 states. Further, the
agreements provided that B&W would take over all aspects of the Advance(R)
low-TSNA cigarette and obtain an exclusive right (subject to Star's own rights)
to purchase and sell hard tobacco cigalett(TM) pieces, in return for royalty
payments on the sales of these products. In the case of the cigalett(TM) pieces,
B&W has to pay Star its manufacturing costs in addition to the royalty payments.
Finally, the agreements provide for the payment of royalties to Star on B&W's
purchases of StarCured(TM) tobacco and other low-TSNA tobacco based on terms set
forth in the agreements and Star's licensing agreements with other tobacco
companies. During 2001, Star received approximately $1.5 million of royalty
payments from B&W on its purchase of low-TSNA tobacco, all of which was used to
reduce Star's long-term debt to B&W.
Competition
In 2001, the Company introduced three smokeless tobacco products. The
tobacco in these products is 100% StarCured(TM) low-TSNA flue-cured tobacco. Two
of the products, Stonewall(TM) moist and dry snuffs, are designed to provide
adult snuff users with an opportunity to purchase products which expose them to
significantly lower levels of toxins. The Company's primary competition for the
Stonewall(TM) snuff products is expected to be other
9
smokeless tobacco companies such as US Smokeless Tobacco Company and Swedish
Match. ARIVA(TM) compressed tobacco cigalett(TM) pieces are intended to compete
against conventional cigarettes and to be used by adult smokers in situations
and environments when they cannot or choose not to smoke. The primary
competition for ARIVA(TM) is expected to be from the large tobacco manufacturers
that dominate the cigarette industry. However, as discussed herein, the Company
has entered into an agreement for B&W to purchase and sell a hard tobacco
product in return for the payment of royalties to Star.
The Company's primary competition for cigarettes is from the four
"majors," that is, Philip Morris, the brands of which accounted for more than
50% of all cigarette sales in the United States in 2001, R.J. Reynolds, B&W and
Lorillard, as well as Vector Group, Ltd. (the parent company of Liggett), each
of which has substantially greater financial and operating resources than the
Company. The Company also encounters significant competition from several other
smaller U.S. manufacturers of cigarettes, as well as importers of cigarettes
manufactured in foreign countries. Many of these manufacturers and importers
have substantially greater financial, manufacturing, marketing and other
resources than the Company. Further, despite the requirements of the MSA,
several newer discount competitors have not, and it appears do not intend to
make deposits into escrow accounts purportedly required by the MSA, allowing
these competitors to undercut the current discount market and unfairly compete
against ST for discount cigarette sales. Although several states have begun
litigation against some of these companies for failure to make escrow payments
on sales in those states, it is unclear whether such litigation will adequately
resolve this issue.
ST's current discount cigarettes compete principally on the basis of price
and, possibly, quality of product. Generally speaking, there are three price
categories of cigarettes in the United States, "premium," which includes such
brands as Marlboro(R) and Camel(R), "full-price," which includes such brands as
Doral(R) and GPC(R), and "discount," which as a group account for only a small
percentage of the U.S. cigarette market. Each of ST's brands is priced in the
discount category. Other competitive factors include package design, taste and
the amount of marketing support provided to distributors and retailers. At the
consumer level, brand loyalty also is a significant factor.
In 2000, the Company established an escrow account as required by the MSA
for sales of cigarettes in 1999, and beginning in 2000, and with increased
effort in 2001, has focused sales (and its field sales force) to increase its
market share in states that were not part of the MSA in order to minimize its
MSA escrow payment obligation. However, in the 46 states that did join the MSA,
ST faces significant competition from cigarette manufacturers and captive
distributors of overseas manufacturers who have not made MSA escrow payments.
Such companies are able to sell discount cigarettes at a substantial cost
reduction compared to ST and as a result ST is at a significant cost
disadvantage in competing with these entities.
In 2001, Vector Group, Ltd. introduced a reduced-toxin cigarette that it
represents contains less toxins, including TSNAs, than other conventional
brands. In November 2001, B&W also began an expanded test market in
Indianapolis, Indiana of its version of the Advance(R) low-TSNA cigarette that
Star and B&W jointly developed. As discussed above, the Company receives a
royalty on each carton of Advance(R) sold by B&W. Other companies have begun to
purchase low-TSNA tobacco and are expected to incorporate that tobacco into
their products. Such products may or may not be brought to market during 2002.
The Company believes that no other producer of discount cigarettes appears to be
incorporating very low-TSNA tobacco and activated carbon/acetate filters into
their discount brands. One Swedish company, Swedish Match, has worked with
various varieties of tobacco under crop management environments and other
methods in an effort to maintain low-TSNA levels in its smokeless products. In
2001, Swedish Match introduced a new smokeless tobacco product in the U.S. that
claims to have reduced levels of carcinogens.
B&W now has in its possession very low-TSNA tobacco from the 1999-2001
growing seasons. Also, the industry has initiated a program that is intended to
require all tobacco sold at auction to be cured in a manner that is intended to
result in reduced levels of TSNAs. As a result, approximately 85% of all
flue-cured tobacco grown in the U.S. in 2001 was cured in a manner to reduce the
levels of TSNAs. Further, the United States Department of Agriculture ("USDA")
has announced that in the future, it will not provide full price supports for
flue-cured tobacco that is not cured in a manner to reduce or limit the levels
of TSNAs in the cured tobacco leaf. Star believes if it is successful in
commercializing its unique very low-TSNA tobacco products and enforcing the
patents for such
10
technology to which it is the exclusive licensee, many of the major tobacco
companies will follow its lead and may seek to sublicense the StarCured(TM)
technology.
If, in the future, the Company is successful in developing and
commercializing smoking reduction or cessation products, it will encounter stiff
competition from well financed pharmaceutical companies. Smoking cessation
products that are approved for sale in the United States by the FDA are
primarily nicotine delivery products (nicotine only) designed to wean the smoker
from nicotine addiction over a period of time ranging from 30 days to six weeks.
These products are referred to as "nicotine replacement" therapies. Three
products, Nicorette(R), a nicotine chewing gum, and Nicotrol(R) and NicoDerm(R),
both transdermal nicotine patches, constitute substantially all of the U.S.
market for pharmaceutical nicotine. All of these products are sold over the
counter. Zyban(R), (bupropion), a prescription drug which originally was
developed and is still sold under another proprietary name as an antidepressant,
was introduced to the market in 1997 and has been demonstrated to be useful as a
cessation product. Star understands that sales of Zyban(R) to date have been
substantial and that Zyban(R) is often prescribed by physicians to be used in
conjunction with nicotine delivery products.
Star's principal competitors in the cessation market would include
GlaxoSmithKline, the McNeil Consumer Division of Johnson & Johnson and
Pharmacia-Upjohn, all of which have significant capital resources, research and
development staffs, facilities, experience in conducting clinical trials and
obtaining regulatory approvals, and experience in manufacturing and marketing
their products which are significantly greater than those of Star. For that
reason, among others, Star has delayed any further development efforts of a
possible cessation product pending the Company securing a joint venture partner
or corporate pharmaceutical partner with a significant scientific
infrastructure. In addition, there are several companies developing new
technologies aimed at smoking cessation therapies. There also are a number of
consumer products that do not require FDA approval as therapeutic drug products
but which nevertheless are advertised as alternatives to smoking or as an aid in
the reduction of smoking. For example, at least one of the leading United States
confectionery chewing gum manufacturers has advertised its gum products as an
alternative to cigarettes. There are also non-tobacco cigarettes produced with
fillers such as lettuce and herbs. In addition to the use of consumable products
for smoking cessation or reduction purposes, medical practitioners and others
have developed a variety of programs intended to assist a person in withdrawing
from nicotine dependence. Treatments used include psychological counseling,
hypnosis, group therapy and behavior modification techniques. There can be no
assurance that in the future Star will be in a position to overcome regulatory
barriers to marketing tobacco-containing cessation products, or that Star's
competitors will not succeed in developing technologies and products that are
more effective than Star's product candidates, that are less toxic than Star's
products, or that would render Star's products obsolete or non-competitive.
Government Regulation
The manufacture and sale of cigarettes, other tobacco products and
pharmaceutical products are subject to extensive federal and state governmental
regulation in the United States and by comparable authorities in many foreign
countries. These national agencies and other federal, state and local entities
regulate, among other things, research and development activities and the
testing, manufacture, safety, effectiveness, labeling, storage, record keeping,
approval, advertising and promotion of such products.
There are multiple bills pending before the 107th Congress and in several
state legislatures which, if enacted, would significantly change the United
States tobacco industry. Some of these federal bills contain provisions which
would provide substantial federal government funds for smoking cessation
programs and products, as well as incentives to tobacco companies and others to
produce less toxic or reduced-risk tobacco products under potential specific
standards. Star is unable to predict what effect, if any, these provisions, if
enacted, would have on Star's low-TSNA tobacco curing technology or the sale of
smoking cessation products and/or potentially reduced-risk tobacco products. The
Company believes, however, that any bill that requires manufacturers to reduce
or disclose levels of TSNAs in tobacco or tobacco smoke in a meaningful manner
would be beneficial.
Star announced its support of a bi-partisan tobacco labeling bill (S.
2125) introduced in the 106th Congress by Senators Frank Lautenberg (D. N.J.),
Richard Lugar (R. IND.), Richard J. Durbin, (D. ILL.), and Lincoln D. Chafee (R.
R.I.), on February 29, 2000, at a press conference held at the Dirksen Senate
Office Building in Washington, D.C. To the best of Star's knowledge, it was the
only tobacco company asked to support this bi-partisan bill which
11
focused on product disclosures not currently mandated by the Surgeon General or
HHS. The Senate bill, entitled the "Smoker's Right to Know and Truth in Tobacco
Labeling Act", would have significantly enhanced the current tobacco package
warning labels and required disclosure of toxic ingredients and health effects
of tobacco use. The bill would have required all manufacturers to disclose
cancer-causing agents, including carcinogenic TSNAs, as well as the percentage
of such carcinogens "relative to the average of such concentration of such
carcinogen in the sales weighted average of all cigarettes marketed in the
United States."
In March 2000, Representatives Greg Ganske (R, Iowa), John Dingell (D,
Michigan), and Henry Waxman (D, California) co-sponsored the introduction of the
"FDA Tobacco Authority Amendments Act." This bill would have given the FDA
regulatory power over all tobacco products. The Company actively supported this
bill, and wrote a letter to the sponsors asking them to consider an amendment
which would require manufacturers to follow standards adopted by the FDA before
making reduced risk claims.
In May 2000, Senators John McCain (R, Arizona) and William Frist, M.D. (R,
Tennessee) introduced Senate bill S. 2566 entitled "The National Youth Smoking
Reduction Act". The central goal of the legislation was to reduce the number of
youths who are smoking and to provide the FDA with regulatory authority over
tobacco products. Senator McCain echoed the views of the Company when he
commented that a significant aspect of the proposed bill would include language
that "provides a mechanism for lower-risk tobacco products to be tested,
reviewed and approved." Senator Frist introduced a similar bill in January 2001.
During the 107th Congress, which began in January 2001, a number of
proposals have been introduced in both the Senate and House of Representatives
which would provide the FDA with authority to regulate the manufacture, sale,
distribution, labeling and marketing of tobacco products. This includes H.R.
1097, introduced by Congressmen Ganske (R, Iowa), Dingell (D, Michigan), and
Waxman (D, California). The Company, as it did in the previous Congress, has
written Congressman Ganske indicating support for the bill. S.190 is a modified
FDA/tobacco bill (from the 106th Congress) introduced by Senator Frist, M.D. (D,
Tennessee). S.247 is a reintroduction of a bill by Senators Harkin (D, Iowa),
Chaffe (R, Rhode Island) and Graham (D, Florida) which includes FDA and other
tobacco control provisions. S.1976 is a comprehensive cancer control bill
introduced by Senator Feinstein (D, California) which includes the provision of
the McCain/Frist bill from the 106th Congress. H.R. 1043 is a reintroduction of
a bill by Congressman Waxman (D, California), which includes both FDA and other
tobacco control provisions. H.R. 2180 is a FDA/tobacco bill introduced by
Congressman Davis (R, Virginia). H.R. 3940 is a bill introduced by Congressmen
McIntryre (D, North Carolina) and Davis (R, Virginia), which includes the FDA
provisions of the Davis bill (H.R. 2180) as well as provisions to provide a
buyout for tobacco farmers.
Most of the bills introduced contain provisions governing reduced risk
products. The Company, as appropriate, will continue to follow these
legislative proposals in Congress and provide input, support and/or
recommendations. Should hearings be convened during the second session of the
107th Congress, the Company anticipates that it will seek an opportunity to
present its views.
President's Commission On Improving Economic Opportunity In Communities
Dependent Upon Tobacco Production
Star has been actively supporting the vast majority of the recommendations
of The President's Commission on "Improving Economic Opportunity in Communities
Dependent upon Tobacco Production while Protecting Public Health". Star is
keenly interested in supporting the American tobacco farming community and
assisting farmers in obtaining higher prices for very low-TSNA tobacco, while
promoting public health-related issues, by giving the farmers an opportunity to
produce very low-TSNA tobacco using StarCured(TM) tobacco curing barns that have
been provided to the farmers by Star. Star testified before the President's
Commission in Louisville, Kentucky, in 2000, and provided written comments on
the Commission's preliminary recommendations in March 2001. Star's Board of
Directors voted unanimously to endorse the recommendations of the President's
Commission in September 2001. Star believes it is the only tobacco company that
testified and supported the majority of the Commission's recommendations.
FDA Regulation
12
In 1996 the FDA promulgated regulations governing the sale and advertising
of tobacco products designed primarily to discourage the sale to, and
consumption by, adolescents and children. The authority of the FDA to promulgate
such regulations was challenged in the federal courts by the major tobacco
companies. A federal District Court upheld the FDA's authority to promulgate
such regulations but ruled that certain of the regulations restricting
advertising were invalid as violative of the constitutional right of free
speech. On appeal, the United States Court of Appeals for the Fourth Circuit
affirmed portions of the District Court opinion that held the FDA could not
regulate tobacco advertising and ruled that the executive branch of the United
States government, in particular the FDA, does not have any authority to
regulate tobacco products generally. The federal government appealed the Appeals
Court's ruling and the matter was heard by the United States Supreme Court in
late 1999. On March 21, 2000, the Supreme Court, in a five to four decision,
held that Congress has not given the FDA authority to regulate tobacco products
as customarily marketed.
Since the introduction of ARIVA(TM), two petitions have been filed with
the FDA seeking to have ARIVA(TM) regulated as a drug product and/or as a food.
Because ARIVA(TM) is a smokeless tobacco product that is intended to provide
tobacco satisfaction, the Company believes the FDA lacks any authority to
regulate ARIVA(TM) based on the March 21, 2000 decision of the Supreme Court
referenced above. Star has advised the FDA that it believes the petitions are
without merit and that its legal team will be filing responses in a timely
fashion. Given the decision by the Supreme Court, it is unclear whether Congress
will act to grant authority to the FDA over tobacco products, although
legislation that would create such authority has been introduced. However, the
Company believes that in the future, reasoned FDA regulation of all tobacco
products should better enable the Company to compete in its particular market
niche. The Company has publicly stated its position in favor of reasoned FDA
regulation of all tobacco products for approximately the last three years.
Institute of Medicine
On February 22, 2001, the Institute of Medicine issued a comprehensive
report, entitled "Clearing the Smoke: Assessing the Science Base for Tobacco
Harm Reduction," in response to a request from the FDA to assess the scientific
basis for possible harm reduction relating to the use of tobacco. This
voluminous report suggests, among other findings, that it is scientifically
feasible to design and manufacture a range of emerging "potential
reduced-exposure products" (which the report referred to as "PREPs"), but that,
without appropriate governmental regulation and independent scientific
evaluation of PREPs, the public is left without clear information regarding the
degree to which these products have reduced the risks associated with smoking.
The Company provided testimony before the Institute of Medicine and shared
certain of its scientific and applied research and findings related to the
development of products which deliver less of certain toxins (TSNAs) and other
gas and vapor-phase toxic substances in tobacco smoke. Star's innovative
products that deliver less toxins, and the StarCured(TM) process, were referred
to in the Institute of Medicine's discussion of PREPs.
Federal Trade Commission
The requirements for health warnings on cigarettes is governed by the
Federal Cigarette Labeling and Advertising Act. Similar requirements are imposed
on smokeless tobacco products under the Comprehensive Smokeless Tobacco Health
Education Act of 1986. These Acts impose labeling and advertising requirements
on the manufacturers, packagers and importers of cigarettes and smokeless
tobacco products and require any company wishing to sell such products within
the United States to submit a plan to the Federal Trade Commission (the "FTC")
explaining how it will comply with the warning label display requirements. Star
has submitted labeling plans for its cigarette and smokeless products to the FTC
in accordance with these Acts and before introducing its new products. Also,
Star shared with the FTC its enhanced warning labels for Advance(R) prior to the
initiation of the test marketing of Advance(R) in October 2000 and the enhanced
warning labels for Stonewall(TM) moist and dry snuff and ARIVA(TM) hard tobacco
prior to the introduction of these products in 2001.
Bureau of Alcohol, Tobacco and Firearms
13
Manufacturers and importers of tobacco products are taxed pursuant to
regulations promulgated by the federal Bureau of Alcohol, Tobacco and Firearms
(the "BATF") under authority of the Internal Revenue Code of 1986, as amended.
The Company's tobacco products are subject to tax under such regulations. The
federal excise tax on cigarettes rose from $.24 per pack in 1999 to $.34 in
2000, and has increased to $.39 per pack in 2002. Smokeless tobacco in the form
of snuff is subject to federal tax at a rate of $.585 per pound in 2002 and
thereafter. The manufacturing of tobacco products is also subject to regulation
by the BATF. The Company currently has licenses from the BATF to manufacture
tobacco products, including cigarettes and smokeless tobacco products. Such
licenses require that the Company adhere to strict regulations regarding the
manufacturing and transportation of its tobacco products.
State and Municipal Laws
The sale of cigarettes is subject to taxation through excise taxes in all
fifty states and smokeless tobacco is taxed in most jurisdictions. State excise
taxes on cigarettes range from $.025 per pack in Virginia to $1.11 per pack in
New York. Several states have no excise tax on smokeless tobacco and the rates
in other states vary significantly from state to state using formulas based on
weight or a percentage of the wholesale price of the product. For example, the
states of Alabama and North Dakota tax smokeless products at a rate of 3/4 of 1
cent per ounce and 16 cents per ounce, respectively, while the states of North
Carolina and Oregon impose an excise tax of 2% and 65% of wholesale cost,
respectively.
In addition, some states permit municipalities to impose an additional
sales tax, and many municipalities do so. The state and municipal sales taxes
are imposed upon wholesalers and/or retailers but not manufacturers, and
therefore the Company has no liability for such taxes. The Company is required
by many states, however, to report its shipments of cigarettes to
distributors/retailers located within their jurisdiction. Star is aware of at
least three states, Massachusetts, Minnesota and Texas, which have adopted laws
and regulations regarding the disclosure by manufacturers of certain chemical
constituents in their products. Star has and intends to continue to comply with
such laws to the extent they are upheld and believes it will benefit from such
disclosure.
Master Tobacco Settlement Agreement
In November 1998, 46 states and several U.S. territories entered into a
settlement agreement, the Master Settlement Agreement, to resolve litigation
that had been instituted against the major tobacco manufacturers. The Company
was not named as a defendant in any of the litigation matters and chose not to
become a participating manufacturer under the terms of the Master Settlement
Agreement. As a nonparticipating manufacturer, the Company is required to
satisfy certain purported escrow obligations under statutes which the Master
Settlement Agreement required participating states to pass, if they were to
receive the full benefits of the settlement. The so-called "level playing field"
statutes require nonparticipating manufacturers to fund escrow accounts that
could be used to satisfy judgments or settlements in lawsuits that may at some
future date be filed by the participating states against such nonparticipating
tobacco manufacturers. Under these statutes the Company is obligated to place an
amount equal to $1.88 per carton for 1999, $2.09 in 2000, $2.72 in 2001-2002,
$3.35 in 2003-2006 and $3.77 thereafter, in escrow accounts for sales of
cigarettes occurring in the prior year in each such state after the effective
date of each state specific statute. An inflation adjustment is also added to
these deposits at the higher of 3% or the Consumer Price Index each year. Such
escrowed funds will be available to satisfy tobacco-related judgments or
settlements, if any, in some states. If not used to satisfy judgments or
settlements, the funds will be returned to the Company 25 years after the
applicable date of deposit on a rolling basis. Also, absent a challenge to the
state specific statutes or some accommodation as to the escrow amounts, the
failure to place the required amounts in escrow could result in penalties to the
Company and potential restrictions on its ability to sell tobacco products
within particular states. Because all of the MSA states have passed the
so-called "level playing field" statutes, the Company expects that a material
portion of its cigarette sales will continue to be subject to such purported
escrow obligations.
As of January 1, 2000, thirty-eight states and the District of Columbia
had adopted so-called model "level playing field" statutes and Star's purported
net obligations under those statutes was approximately $11.6 million with
respect to 1999 sales. As of January 1, 2001, all forty-six MSA states had
adopted model "level playing field"
14
statutes. It is anticipated that after funding escrow accounts for 2001 sales
the Company will have deposited a total of approximately $32 million into escrow
under protest. The funds placed in escrow continue to be an asset of the Company
and the Company will receive the interest income generated by the escrow
deposits. In addition to the "level playing field" statutes, a number of states
have recently enacted statutes that require nonparticipating manufacturers to
certify that they are in full compliance with the escrow requirements of the MSA
as a condition to being permitted to sell cigarette products in those states.
While the Company has recently focused its sales in the four states that were
not part of the MSA, these statutes could impact on its ability to sell
cigarettes in the MSA states, notwithstanding its substantial payments into
escrow.
After almost two years of negotiations with the National Association of
Attorneys General ("NAAG"), the Company concluded that NAAG had little interest
in working with Star to come to a reasonable solution under which the Company
could become a participant in the Master Settlement Agreement. Accordingly, on
December 15, 2000, the Company filed a lawsuit in the United States District
Court for the Eastern District of Virginia requesting that the court declare
both the MSA and Virginia's Qualifying Statute unconstitutional and, therefore,
invalid. The Company's complaint challenges the MSA on the grounds that it
violates the Interstate Compact Clause and the Commerce Clause of the
Constitution of the United States. It challenges the Qualifying Statute on the
grounds that it violates the Equal Protection, Due Process, Takings and Commerce
Clauses of the Constitution. Neither Virginia Attorney General Kilgore nor any
other state attorney general has ever charged the Company with the tortious and
unlawful conduct asserted against other cigarette manufacturers in lawsuits by
various states which led to the execution of the MSA. Despite the absence of any
claim against the Company, which is focused primarily on producing less toxic
and potentially less hazardous tobacco and tobacco products, the MSA and the
Qualifying Statute impose a severe burden on its research and development
activities.
On March 12, 2001, the District Court heard oral argument on the
Commonwealth's Motion to Dismiss, after both sides exchanged briefs on all the
constitutional and related issues. On March 26, 2001, the District Court
dismissed the Company's complaint, but in its opinion, the District Court did
note that Star "must now suffer as a result of the bad faith of previous market
entrants." The District Court further noted that Star "has never been accused of
the fraudulent, collusive and intentionally dishonest activities of the Big
Four," "was not even in existence during the bulk of the time that these
activities were occurring," and has taken "every step to provide complete
disclosure about the harmful nature of its products." The District Court also
stated that the "financial burden on Star Scientific and others like it may
hamper efforts to develop new tobacco technologies." The Company promptly
appealed the District Court's ruling.
On January 22, 2002, the United States Court of Appeals for the Fourth
Circuit affirmed the decision of the District Court and later denied the
Company's request for rehearing. The Company plans to file a petition for writ
of certiorari with the United States Supreme Court asking that Court to review
the case, given its continuing belief that the MSA and the Virginia Qualifying
Statute are constitutionally flawed.
Virginia Incentive Rebates
In 1999, the Commonwealth of Virginia enacted legislation that explicitly
encouraged the manufacture and sale of "products that reduce the carcinogenic
TSNA levels in tobacco products." That legislation, pursuant to House Bill 2635
and Senate Bill 1165 (1999), provided that $2,000,000 should be made available
to the Virginia Economic Development Partnership to provide for economic
development incentive rebates to assist Virginia companies that reduce
carcinogenic TSNA levels in tobacco products and pass a portion of that rebate
on to Virginia tobacco farmers.
Star was the only company that qualified for those rebates, and in June
2000, was awarded $2 million by the Commonwealth of Virginia. Approximately
$275,000 of those funds was subsequently provided by the Company to certain
Virginia farmers to help defray their costs relating to the installation of the
Company's StarCured(TM) tobacco curing barns.
World Health Organization ("WHO") Global Public Health Advocacy
15
Star testified on October 13, 2000, at the World Health Organization
public hearings in Geneva, Switzerland on its view of the structure of a Global
Framework Convention on Tobacco Control ("FCTC"). In that testimony Star
reiterated its support for reasoned regulation of all tobacco products in the
U.S. and worldwide to create a more rational environment in which minimizing
toxicity rather than marketing creativity would determine relevant market share.
Star also testified before the WHO Scientific Advisory Committee on Tobacco
Product Regulation on February 1, 2001, and again reiterated its support for
reasoned world-wide tobacco regulation within the FCTC proposed structure.
Research and Development
In the mid-1990's, Star commenced research and development activities
based upon newly-conceived technology for the processing of tobacco so as to
retard or substantially reduce TSNAs to very low levels. This technology is
under exclusive license from Regent Court, a company in which the technology's
inventor and the Company's founder and current Chief Executive Officer, Jonnie
R. Williams, is part owner. (See "Patents, Trademarks and Licenses.") TSNAs are
generally recognized by health researchers and respected scientists to be among
the most potent and abundant carcinogens in tobacco and tobacco smoke. Star's
research and development activities have focused on: (1) perfecting and testing
methods for processing low-TSNA tobacco; (2) developing products which
incorporate Star's specially processed tobacco, including products for the
smoked and smokeless tobacco markets; (3) establishing a patent position; and
(4) developing relationships with tobacco farmers, as well as the tobacco
industry, with a view to the commercialization of Star's processes through
licensing and royalty arrangements, among other vehicles, to generate income for
the Company. Star's research and development efforts culminated in the
development of various aspects of the StarCured(TM) tobacco curing process, with
respect to which Star has exclusive rights to patents as well as patent
applications which are pending (See "Patents, Trademarks and Licenses"). Star
has convened a Scientific Advisory Board of highly regarded physicians,
scientists, researchers and public health experts to provide it with counsel on
how best to proceed in a variety of scientific and research oriented areas. In
2001, 2000, and 1999, the Company spent approximately $4.1 million, $1.7
million, and $0.5 million, respectively, on its research and development
activities.
StarCured(TM) Technology
The process of curing or drying tobacco so that it is suitable for
production into tobacco products begins immediately upon harvesting of the
tobacco leaf. The two principal varieties of tobacco leaf in the United States
are Virginia flue-cured tobacco and burley tobacco, both of which are typically
used in American-made cigarettes to produce what is referred to as an American
blend. Under conventional curing methods with Virginia flue-cured tobacco, the
leaves are placed in enclosed barns and are then exposed to gas-fired heat,
while with burley tobacco the leaves are hung in sheds to dry naturally. The
curing process for Virginia flue-cured tobacco takes approximately 5 to 7 days
and for burley tobacco a month, or more.
The StarCured(TM) technology is applicable to Virginia flue-cured tobacco
and, Star believes, to burley tobacco, and most likely to other varieties of
tobacco on a broad-scale commercial basis. Star's curing process essentially
arrests or eliminates microbial activity that normally occurs during curing,
thereby preventing the production of TSNAs. The StarCured(TM) curing technology
does not, however, alter or affect taste, color or the nicotine content of
tobacco. Star makes no claim or representation that the StarCured(TM) tobacco
curing process reduces any harmful chemical constituents in tobacco and/or
tobacco smoke other than TSNAs. Additionally, Star makes no claim that the
elimination of TSNAs reduces the risk of disease. Star has been careful not to
make any health claims, directly or indirectly, since there is not yet clinical
evidence to show that a reduction in these specific carcinogens in tobacco will
translate into a reduced health risk.
The StarCured(TM) technology has been licensed to the Company in an
agreement which grants to the Company exclusive worldwide rights with a right of
sublicense. (See "Patents, Trademarks and Licenses" below). It is the Company's
objective to achieve widespread acceptance of the StarCured(TM) tobacco curing
technology as a standard for the manufacture of less toxic and potentially less
harmful tobacco products and, in the future, as a basis for the use of very
low-TSNA tobacco in the production of smoking cessation products.
16
Star conducted a pilot program during the 1998 U.S. tobacco harvest season
(July through October). The purposes of this program were: (1) to continue to
test and perfect Star's curing processes in quantities and under conditions
which would serve as a model for future operations; (2) to test custom designed
equipment; (3) to provide processed tobacco to major manufacturers in quantities
for testing and test market purposes; and (4) to demonstrate the commercial
feasibility of adoption of Star's processes for widespread use in the production
of tobacco products. The program was operated from the Company's facility in
Chase City, Virginia. During 1999, Star processed over 3.5 million pounds of
StarCured(TM) tobacco. In 2000 and 2001, Star processed approximately 19 million
pounds of StarCured(TM) tobacco, which constituted approximately 30% of the
entire Virginia flue-cured crop in each of those years. During 2000 and 2001,
the Chase City receiving station was one of the five largest flue-cured tobacco
receiving stations in the U.S. and the largest in the Commonwealth of Virginia.
Development of Very Low-TSNA Cigarette and Smokeless Tobacco Products
Beginning in October 2000, Star test-marketed Advance(R), which the
Company believes was the first very low-TSNA premium cigarette to be sold in the
United States, which contained enlarged health warnings on the package,
comparative content information, and informational package "onserts" attached to
each pack that provided additional information regarding the health hazards of
smoking. Advance(R) utilized StarCured(TM) very low-TSNA flue-cured tobacco, as
well as other tobaccos (burley and oriental) selected for their low-TSNA levels.
Advance(R) also had a 40 mg activated carbon/acetate filter that reduced other
gas and vapor-phase toxic substances.
Under the April 25, 2001 Agreements with B&W, B&W assumed all
responsibility for the test marketing of Advance(R) and the anticipated national
rollout of the product following a successful test market. In November 2001, B&W
initiated an expanded test market of Advance(R) in Indianapolis, Indiana
(approximately 1,500 retail outlets). B&W's version of Advance(R) continues to
use very-low TSNA StarCured(TM) tobacco and other low-TSNA tobaccos, and a
modified Trionic(TM) Filter. The packages of Advance(R) continue to have
enlarged health warning and package onserts that provide comparative information
on the major toxins in Advance(R) and two leading light brands. Star receives a
royalty on the sale of each carton of Advance(R).
During 2001, Star continued its efforts to develop several smokeless
tobacco products whose tobacco consisted of all low-TSNA StarCured(TM) tobacco.
In September 2001, the Company introduced two such products, Stonewall(TM) moist
snuff and Stonewall(TM) dry snuff. In November 2001, the Company introduced
ARIVA(TM) hard tobacco cigalett(TM) pieces. ARIVA(TM) provides adult tobacco
users an alternative to cigarettes in situations and environments when they
can't smoke or choose not to smoke.
Prior Development of CigRx(TM)
In 1997 Star submitted a cigarette product that it called "CigRx(TM)" to
the FDA as a pharmaceutical product. The objective was to offer a product to
help patients who relapse after a trial of smoking cessation to prepare for
another cessation attempt while reducing exposure to TSNAs. Star is not aware of
any other company submitting a tobacco product for FDA clearance. Star's
strategy has since changed, and it will not seek FDA approval for CigRx(TM). A
Phase I study, under an FDA-reviewed protocol, was completed at the Virginia
Commonwealth University under the direction of Professor William Barr, Director
of the Center for Drug Studies. The study, involving male and female subjects,
was a cross-over study designed to test in vivo elimination or reduction of
TSNAs following the smoking of CigRx(TM) cigarettes compared to the subjects'
normally used cigarettes. These test cigarettes were made entirely from
flue-cured Virginia tobacco with no added flavorings. The average total TSNA
levels in the tobacco itself at the time of testing were about 100 parts per
billion, as compared to more than 3,000 parts per billion in popular brands. As
measured by the current FTC method, the CigRx(TM) cigarettes used in the study
delivered substantially less carbon monoxide (4.8 milligrams versus 12.2
milligrams) and about half as much tar (7.0 milligrams versus 14.0 milligrams)
compared to an average of the best selling full-flavored cigarettes. The study
contrasted Star's product with conventional brands in terms of breath levels of
carbon monoxide, blood levels of nicotine, and urinary levels of TSNAs. On the
CigRx(TM) product, blood nicotine levels were somewhat higher and carbon
monoxide was substantially lower. Urinary levels of TSNA (as measured by NNAL)
were analyzed by the American Health Foundation. The average levels of NNAL and
its metabolite after nine days on the CigRx(TM)
17
product were reduced substantially, consistent with published data showing that
TSNAs leave the body slowly over 90 to 120 days.
Product Liability
In the United States, there have been numerous and well-publicized
lawsuits against the largest manufacturers of cigarettes and other tobacco
products initiated by state and municipal governmental units, health care
providers and insurers, individuals (for themselves and on a class-action basis)
and by others. The legal theories underlying such lawsuits are varied, but are
generally based upon one or more of the following: (1) manufacturer defendants
have deceived consumers about the health risks associated with tobacco product
consumption; (2) such defendants knew or should have known about various harmful
ingredients of their products and failed to adequately warn consumers about the
potential harmful effects of those ingredients; and (3) such defendants knew of
the addictive attributes of nicotine and have purposefully manipulated their
product ingredients so as to enhance the delivery of nicotine.
The Company believes that it has conducted its business in a manner which
decreases the risk of liability in a lawsuit of the type described above because
the Company:
. has attempted to consistently present to the public the most current
information regarding the health risks of long-term smoking and
tobacco uses generally;
. has always acknowledged the addictive nature of nicotine;
. has never targeted adolescent or young persons as customers;
. has not advertised its tobacco products to consumers except for
point-of-sale materials;
. has conducted research on the chemical or other constituents of its
products only in the course of efforts to reduce the delivery of
toxins;
. has stated unequivocally that smoking involves a range of serious
health risks, is addictive, and that smoked cigarettes products can
never be produced in a "safe" fashion; and
. did not produce its own brands until late 1994/early 1995, and the
volume of sales has not been substantial in relation to the volume
generated by the larger manufacturers.
The Company maintains product liability insurance which is limited to any
claims that tobacco products manufactured by or for the Company contain any
foreign object. Such insurance does not cover health-related claims such as
those that have been made against the major manufacturers of tobacco products.
The Company does not believe that insurance for health-related claims can
currently be obtained. Although, to date, no health-related lawsuit has ever
been filed against Star, a lawsuit based upon claims not covered by its product
liability insurance could have a materially adverse effect upon the Company.
Patents, Trademarks and Licenses
License Agreement with Regent Court
The Company is the licensee under a license agreement (the "License
Agreement") with Regent Court, of which Jonnie R. Williams, the Company's
founder and Chief Executive Officer and Francis E. O'Donnell, Jr., M.D., the
beneficiary of the O'Donnell Trust, which is the Company's largest shareholder,
are the owners. The License Agreement provides, among other things, for the
grant of an exclusive, worldwide, irrevocable license to the Company, with the
right to grant sublicenses, to make, use and sell tobacco and products
containing tobacco under the licensor's patent rights and know-how relating to
the processes for curing tobacco so as to eliminate TSNAs or reduce them to
insignificant levels, and to develop products containing such tobacco, whether
such patent rights and
18
know-how are now in existence or hereinafter developed. This license includes
inventions of Regent Court and its affiliates during the term of the License
Agreement relating to the production, treatment or curing of tobacco, or a
method of manufacturing a product containing tobacco, and of extracting one or
more substances from tobacco for the purpose of incorporating such substance or
substances in a product or products.
The Company is obligated to pay to Regent Court a royalty of 2% on all net
sales of products by it and any affiliated sublicensees, and 6% on all fees and
royalties received by it from unaffiliated sublicensees, less any related
research and development costs incurred by the Company. The License Agreement
expires with the expiration of the last of any applicable patents. Seven United
States patents have been issued, and additional patent applications are pending
in the United States and in approximately 80 foreign jurisdictions. To date, the
Company has paid no royalties under the License Agreement.
The License Agreement may be terminated by the Company upon 30 days'
written notice. The License Agreement may also be terminated by Regent Court
upon (a) a default in the payment of royalties or a failure to submit a correct
accounting continuing for at least 30 days after written notice or (b) a
material breach of any other obligation of the Company under the License
Agreement continuing for at least 60 days after written notice. A material
breach may include a sublicense of the Patent Rights (as defined in the License
Agreement) without obtaining a written agreement of the sublicensee to be
obligated to Regent Court under the License Agreement. The Company is also
obligated to provide Regent Court with copies of all patent applications by it
relating to the Patent Rights. For purposes of determining materiality, a breach
is deemed material if such breach results in a loss of royalties exceeding
$100,000.
The License Agreement obligates the Company to prosecute and pay for
United States and foreign patent rights. The License Agreement contains other
provisions typically found in a patent license agreement, such as provisions
governing patent enforcement and the defense of any infringement claims against
the Company and its sublicensees. The License Agreement further provides that
any obligation or liability related to patent infringement matters brought
against the Company will be borne by the Company. The Company has agreed to
indemnify and defend the licensor and its affiliates against losses incurred in
connection with the Company's use, sale or other disposition of any licensed
product or the exercise of any rights under the License Agreement. Regent Court
has made no representations to the Company in any documents regarding the
efficacy of the licensed technology.
Patents and Proprietary Rights
Under the License Agreement, the Company has exclusive rights to seven
issued patents and pending patent applications, which are the only patents
issued to or applied for by Regent Court. The issued and pending patents cover
the current technology for reducing the level of TSNAs in tobacco. Corresponding
patent filings have been initiated in numerous foreign countries. The Company
has no rights to any other patent or patent applications. There can be no
assurance that patents will issue from any of the pending applications, that
claims which may be allowed thereunder will be sufficient to protect the
intellectual property owned or licensed by the Company, or that the Company or
Regent Court has or will develop or obtain the rights to any additional products
or processes that are patentable. In addition, no assurance can be given that
any patents issued to or licensed by the Company will not be challenged,
invalidated, infringed or circumvented, or that the rights granted thereunder
will provide competitive advantages to the Company.
On November 6, 2001, the United States Patent Office issued a patent to
Regent Court for treating tobacco to reduce nitrosamine content. On January 15,
2002, it issued another patent to Regent Court for reducing nitrosamine levels
and on February 26, 2002, issued a patent to Regent Court relating to the
use of tobacco extracts. Under the License Agreement, the Company has exclusive
rights to these patents.
The Company believes that it is the world leader in curing technology
which consistently produces very low-TSNA tobacco.
Employees and Consultants
19
As of December 31, 2001, the Company employed approximately 200 full-time
employees. From time to time, the Company engages temporary personnel to augment
its regular employee staff. Further, the Company utilizes the services of
consultants, scientific and technical experts and independent contractors to
provide key functions in the scientific, medical, public health care,
compliance, technological, legal, communications, financial and related areas.
The use of such outside providers enables the Company to secure unique expertise
in a wide variety of areas that it might otherwise not be in a position to
secure or which it would otherwise be required to secure through the hiring of
many additional Company-employed personnel at potentially greater cost to the
Company. Substantially all of the Company's research and development efforts
have been, and are expected to continue to be conducted, pursuant to contractual
arrangements with universities and scientific, medical and public health
consultants and investigators.
Factors That May Affect Future Results
The Market May Not Accept Our Smokeless Tobacco Products
Substantially all of our revenues in 1999, 2000 and 2001 were derived from
sales of ST's four brands of discount cigarettes. The other portion of our
revenue stream was generated by the sales of StarCured(TM) processed leaf
tobacco and through the sale of smokeless tobacco products that were introduced
in the fall of 2001. The U.S. cigarette business has been contracting in recent
years and the market for smokeless products is much smaller than the market for
smoked tobacco products. The Company has previously announced its plan to
concentrate its efforts on its low-TSNA smokeless tobacco products. If the
Company is not successful in its efforts to offer low-TSNA smokeless tobacco
products as adult alternatives to cigarettes, we may not have sufficient sales
of other products to offset these effects, which would adversely affect our
sales volumes, operating income and cash flows.
While we produced and test marketed our three very low-TSNA smokeless
tobacco products, Stonewall(TM) moist and dry snuffs and ARIVA(TM), and have
been encouraged by the initial results, ultimately these products may not be
accepted in the national marketplace. Adult tobacco users may decide not to
purchase our products due to taste or other preferences or due to the extensive
health warnings contained on the packaging for the Company's products.
We Are Dependent on the Domestic Tobacco Business
All of our revenue in 1999, 2000 and 2001 was derived from sales in the
United States. The U.S. cigarette business has been contracting in recent years
and the market for smokeless products is much smaller than the market for smoked
tobacco products. If the U.S. cigarette market continues to contract, we may not
have significant tobacco sales abroad to offset these effects. This trend could
adversely affect our sales volumes, operating income and cash flows.
Competition From Other Cigarette Makers Could Adversely Affect Us
The tobacco industry is highly competitive. Our primary competition for
conventional cigarettes is from the "major" cigarette manufacturers, each of
which has substantially greater financial and operating resources than we do. We
continue to encounter significant competition from several other smaller U.S.
manufacturers of cigarettes, as well as importers of cigarettes manufactured in
foreign countries. Many of these manufacturers and importers have substantially
greater financial, manufacturing, marketing and other resources than we do. Our
smokeless tobacco products Stonewall(TM) moist and dry snuffs compete with major
smokeless manufacturers. Those companies generally have substantially greater
financial and operating resources than we do. Also, these companies have a more
established presence in the smokeless tobacco industry than we do. Our ARIVA(TM)
compressed powdered tobacco cigalett(TM) pieces compete with the major cigarette
manufacturers and, to a lesser extent, with manufacturers of smokeless tobacco
products. Approximately 85% of all flue-cured tobacco grown in the U.S. in 2001
was cured in a manner to reduce the levels of TSNAs. Further, the USDA has
announced that it will not provide full price supports for flue-cured tobacco
that is not cured in a manner to reduce or limit the levels of TSNAs in the
cured tobacco. At least one other tobacco company has begun to incorporate
low-TSNA tobacco into its cigarettes products and others
20
have begun to purchase low-TSNA tobacco and are expected to incorporate that
tobacco in their products. Additionally, our competitors may also develop other
less toxic tobacco products that can compete with our very low-TSNA products.
The Tobacco Industry Is Subject to Substantial and Increasing Regulation and
Taxation
Various federal, state and local laws limit the advertising, sale and use
of cigarettes and smokeless tobacco products, and these laws have proliferated
in recent years. If this trend continues, it may have material and adverse
effects on our sales volumes, operating income and cash flows. In addition,
cigarettes and smokeless tobacco products are subject to substantial and
increasing excise taxes. The federal excise tax on cigarettes rose from $.34 per
pack in 2000 to $.39 per pack in 2002. The Federal Excise Tax on smokeless
tobacco products is substantially lower ($0.585 per pound). A number of states
have recently considered an increase in state excise taxes on smokeless tobacco
products. While several states have no excise tax on smokeless products, tax
rates in other states vary considerably. For example, the states of Alabama and
North Dakota tax smokeless products at a rate of 3/4 of 1 cent per ounce and 16
cents per ounce, respectively, while the states of North Carolina and Oregon
impose an excise tax of 2% and 65% of wholesale cost, respectively. Present
state excise taxes for cigarettes range from $.025 per pack in Virginia to $1.11
per pack in New York. Increased excise taxes may result in declines in overall
sales volume. This result could adversely affect our operating income and cash
flows.
We currently have licenses from the BATF to manufacture cigarettes and
smokeless tobacco products. To the extent that we are unable to maintain our
current licenses or to obtain any additional licenses required by the BATF, this
could materially and adversely affect our operations.
In 1996, the FDA promulgated regulations governing the sale and
advertising of tobacco products. These regulations were designed primarily to
discourage the sale to, and consumption by, adolescents and children. The
authority of the FDA to promulgate such regulations was challenged in the
federal courts. On March 21, 2000, the United States Supreme Court in a five to
four decision held that the Congress has not given the FDA authority to regulate
tobacco products as customarily marketed. Given the decision by the Supreme
Court it is unclear whether the 107th Congress will act to grant such authority
to the FDA, although legislation that would create such authority has been
introduced in Congress.
We Have Substantial Obligations Under State Laws Adopted Under the Master
Settlement Agreement
Absent a successful legal challenge to the MSA and/or statutes passed by
various states in connection with the Master Settlement Agreement entered into
in 1998 between the major tobacco companies and 46 states, or an agreement with
NAAG with respect to the funding of the required escrow amount in April of each
year, beginning April 2000, we have a purported obligation to place in escrow
accounts an amount equal to $1.88 per carton for 1999, $2.09 in 2000, $2.72 in
2001-2002, $3.35 in 2003-2006 and $3.77 thereafter, for sales of cigarettes
occurring in the prior year in each such state after the effective date of each
state specific statute. An inflation adjustment is also added to these deposits
at the higher of 3% or the Consumer Price Index each year. The failure to place
such required amounts into escrow could result in severe penalties to us and
potential restrictions on our ability to sell tobacco products within particular
states. Because of this purported escrow requirement, a substantial portion of
our net income from operations will be unavailable for our use and the amount
required to be placed in escrow for each carton sold may exceed the net cash
flow generated by each carton sold. This will adversely affect our ability to
apply the capital generated from our present cigarette sales toward the further
scientific development of less toxic and potentially less hazardous tobacco
products and the growth of our business. In addition, the escrow obligations
will impede our ability to distribute dividends to our stockholders. The
Company, under protest, initially placed approximately $11.6 million into escrow
in April 2000. It is anticipated that after funding its escrow accounts for 2001
sales the Company will have deposited, under protest, a total of approximately
$32 million into escrow.
We have tried to mitigate the costs of the MSA by focusing our field sales
force and seeking to increase market share in states that were not participants
in the MSA, among other approaches, to lessen the harmful effects of what we
believe to be an unconstitutional compact that impermissibly regulates
interstate commerce. Once ST sells product to independent distributors it is not
in a position to monitor subsequent sales by such entities and it does not
21
do so. However, certain of the Attorneys General in MSA States and NAAG have
taken the position that the Company is responsible to escrow funds for any sales
in MSA States whether made by ST directly or by a third party to whom ST has
sold product. In response to demands made by certain Attorneys General, the
Company has made upward adjustments, under protest, to its escrow accounts. It
is anticipated that further demands by MSA states will require additional
adjustments to the MSA Escrow Account. While we do not anticipate any
modification to the MSA, any such modification could increase our escrow payment
obligations, which could enhance the adverse effects of the MSA on our business.
Our Current Supply Contracts and Other Contracts with B&W May Not Be Extended
Under the April 25, 2001 Agreements, B&W will purchase at least 15 million
pounds of StarCured(TM) tobacco annually through 2003 and has the right to
purchase additional tobacco in later years. In 1999, 2000, and 2001, B&W
purchased approximately 3.5 million, 19 million and 19 million pounds,
respectively, of StarCured(TM) tobacco. If B&W were to stop purchasing our
tobacco that has been cured using the StarCured(TM) tobacco curing process, it
could materially and adversely affect our sales volumes, operating income and
cash flows. Additionally, we currently have other business relationships with
B&W. B&W has: (1) loaned us a total of $29 million, which was primarily used to
purchase specially manufactured curing barns, (2) entered into licensing and
royalty agreements relating to the sales of Advance(R), the purchase of
StarCured(TM) tobacco and other low-TSNA tobacco, and the manufacture and sales
of ARIVA(TM), (3) agreed to manufacture cigarettes for us and (4) agreed to
supply tobacco to us. The termination of any of these agreements could
materially and adversely affect our business operations.
Lawsuits May Affect Our Profitability; We Have Limited Insurance Coverage
We are not, nor have we ever been, named as a defendant in any legal
proceedings involving claims arising out of the sale, distribution, manufacture,
development, advertising, marketing and claimed health effects of our tobacco
products. While we believe that the risk of being named a defendant in such a
lawsuit is relatively low, we may be named as a defendant in the future as there
has been a noteworthy increase in the number of these cases pending. Punitive
damages, often in amounts ranging into the hundreds of millions, or even
billions of dollars, are specifically pleaded in a number of these cases in
addition to compensatory and other damages. We maintain product liability
insurance which is limited to any claims that tobacco products manufactured by
or for us contain any foreign object. Such insurance does not cover
health-related claims such as those that have been made against the major
manufacturers of tobacco products. We do not believe that such insurance
currently can be obtained. Accordingly, our inclusion in any of these actions or
any future action could have a material and adverse effect on our financial
condition. In addition, we recently embarked on the test market and distribution
of new smokeless tobacco products. To the extent the sale and distribution of
such products results in any health-related claims, such claims could have a
material and adverse effect on our financial condition.
We May Not Properly Manage Our Growth
If we are successful in maintaining and increasing market acceptance for
our products, we will be required to manage substantial volume from our
customers. To accommodate any such growth and compete effectively, we will be
required to attract, integrate, motivate and retain additional highly skilled
sales, technical and other employees. We face competition for these people. Our
ability to successfully manage such volume also will be dependent on our ability
to scale up our tobacco processing and production operations. There can be no
assurance that we can overcome the challenge of scaling up our processing and
production operations or that our personnel, systems, procedures and controls
will be adequate to support our future operations. Any failure to implement and
improve our operational, financial and management systems or to attract,
integrate, motivate and retain additional employees required by future growth,
if any, could have a material and adverse effect on our business and prospects,
financial condition and results of operations.
We May Not Be Successful in Protecting Our Intellectual Property Rights
22
Our success in commercially exploiting our licensed tobacco curing
technology depends in large part on our ability to defend issued patents, to
obtain further patent protection for the technology in the United States and
other jurisdictions, and to operate without infringing upon the patents and
proprietary rights of others. Additionally, we must be able to obtain
appropriate licenses to patents or proprietary rights held by third parties if
infringement would otherwise occur, both in the United States and in foreign
countries.
Patent positions are uncertain and involve complex legal and factual
questions for which important legal principles are unresolved. Any conflicts
resulting from third party patent applications and patents could significantly
reduce the coverage of our patents and limit our ability to obtain meaningful
patent protection. If patents are issued to other companies that contain
competitive or conflicting claims, we may be required to obtain licenses to
these patents or to develop or obtain alternative technology. Such licensing
agreements, if required, may be unavailable on acceptable terms or at all. If
such licenses are not obtained, we could be delayed in or prevented from
pursuing the development or commercialization of our products.
Litigation, which could result in substantial cost, may also be necessary
to enforce any patents to which we have rights, or to determine the scope,
validity and unenforceability of other parties' proprietary rights which may
affect our rights. There are always risks in any litigation. U.S. patents carry
a presumption of validity and generally can be invalidated only through clear
and convincing evidence. We may also have to participate in interference
proceedings declared by the U.S. Patent and Trademark Office to determine the
priority of an invention, which could result in substantial cost. The mere
uncertainty resulting from the institution and continuation of any
technology-related litigation or interference proceeding could have a material
and adverse effect on our business and prospects. See the discussion of the R.J.
Reynolds litigation in "Legal Proceedings".
We may also rely on unpatented trade secrets and know-how to maintain our
competitive position, which we seek to protect, in part, by confidentiality
agreements with employees, consultants, suppliers and others. There can be no
assurance that these agreements will not be breached or terminated, that we will
have adequate remedies for any breach, or that our trade secrets will not
otherwise become known or be independently discovered by competitors.
We Depend On Key Personnel
We depend upon the continued services of our senior management team for
our continued success. The loss of any one of the Company's Chief Executive
Officer, Jonnie R. Williams, the Company's Chairman, President and Chief
Operating Officer, Paul L. Perito, the Vice President of Sales and Marketing,
David M. Dean, the Company's Chief Financial Officer, Christopher G. Miller or
the Company's General Counsel, Robert E. Pokusa, could have a serious negative
impact upon our business and operating results. To minimize the present risk of
the loss any one of these senior executives, the Company has hired additional
senior management and continues to search for other senior executives who will
be able to share some of the responsibilities now assumed by Messrs. Williams,
Perito, Miller, Dean or Pokusa.
The Company's success depends in large part on its ability to attract and
retain, on a continuing basis, consulting services from highly qualified
scientific, technical, management, financial and marketing personnel.
Competition for such personnel is intense and there can be no assurance that the
Company will be able to attract and retain the personnel necessary for the
development and operation of its business. The loss of the services of its key
personnel or the termination of its contracts with independent scientific and
medical investigators could have a material and adverse effect on the Company's
business.
Management and Significant Stockholders Can Exercise Influence over the Company
Based upon stock ownership as of December 31, 2001, our executive
officers, directors and their associates, own an aggregate of approximately 75%
of our outstanding shares. As a result, these persons acting together may have
the ability to control matters submitted to our stockholders for approval and to
control the management and affairs of the Company. This concentration of
ownership may have the effect of delaying or preventing a change in control of
the Company, impede a merger, consolidation, or takeover or other business
combination, or discourage a
23
potential acquirer from attempting to obtain control. This concentration of
control could also have a negative effect on the market price of our shares.
Our Research & Development Efforts May Not Result in Commercially Viable Product
We continue to allocate significant resources towards research and
development, including for the development of new smokeless tobacco products and
a commercially viable application of the StarCured(TM) technology to burley
tobacco. In 2001, 2000 and 1999, the Company spent approximately $4.1 million,
$1.7 million, and $0.5 million, respectively, on its research and development
activities. Our continuing research and development efforts may not result in
new products reaching the market, or in any improvements to our current
products. This could occur for a number of reasons, including if potential new
products:
. fail to receive any necessary regulatory approvals on a timely basis
or at all;
. are precluded from commercialization by proprietary rights of third
parties; or
. are uneconomical or fail to achieve market acceptance.
Failure to develop new products or to improve our current products could
materially adversely affect our net sales, operating income and cash flows.
If We Require Additional Funding, and Are Unable to Raise Necessary Funds on
Acceptable Terms, it Will Be Difficult to Implement Our Growth Strategy
As described further in "Liquidity and Capital Resources," we believe that
our existing working capital together with earnings from our operations and
additional sale/leaseback transactions will be sufficient to meet our liquidity
and capital requirements in the foreseeable future. However, our need to raise
additional funds to meet our working capital and capital requirements will
depend upon numerous factors, including the results of our marketing and sales
activities, any escrow obligations under the MSA, the success of our new product
development efforts, and other factors described under "Factors That May Affect
Future Results."
If we do require additional funds, we are not sure we will be able to
raise sufficient funds on acceptable terms or at all. Failure to raise
sufficient funds could affect our ability to meet our debt service and other
obligations and would affect our ability to carry out our growth strategy. This
could materially adversely affect our ability to pursue our growth strategy.
Item 2. Properties
The Company's executive, marketing, sales and administrative offices are
located in Chester, Virginia. The Company has approximately six years remaining
on an eight-year lease for a 45,000 square foot warehouse facility, including
7,000 square feet of office space. The warehouse space is used for storing and
shipping tobacco products.
An additional 5,600 square feet of office space is currently being leased
by the Company in Bethesda, Maryland pursuant to a lease expiring in 2005. This
additional space houses executive, administrative, and scientific offices. This
location in Bethesda was selected to afford Star's scientific and medical
consultants access to the FDA, National Institutes of Health and the U.S.
National Medical Library.
The Company's cigarette and Stonewall(TM) moist snuff manufacturing
facilities are located in Petersburg, Virginia. The Company owns its Petersburg
facilities, which consist of a 50,000 square foot, four-story manufacturing
building and an adjacent 6,000 square foot, single-story office building. The
Company leases a 10,000 square foot warehouse in Petersburg, Virginia, about one
mile from its manufacturing facilities, pursuant to a month-to-month lease.
The Company leases seven acres of land and an approximately 100,000 square
foot building thereon in Chase City, Virginia, which is used in processing
tobacco utilizing the Company's StarCured(TM) tobacco curing method and
24
for manufacturing ARIVA(TM) and Stonewall(TM) dry snuff. During 2000, this
facility was expanded from approximately 50,000 square feet to its current size
by completing a construction project which cost approximately $500,000. The
Company has approximately eight years remaining on a ten-year lease for the
Chase City property, which covers the expanded facility, and it has an option to
purchase the property at any time during the term of the lease.
The Company considers its facilities adequate for the purposes for which
they are used. However, the Company is currently planning on relocating its
Chase City manufacturing operation to a site adjacent to the existing Chase City
facility in order to be in a position to expand its manufacturing capacity for
ARIVA(TM).
Item 3. Legal Proceedings
After almost two years of negotiations with the National Association of
Attorneys General, the Company concluded that NAAG had little interest in
working with Star to come to a reasonable solution under which the Company could
become a participant in the Master Settlement Agreement. Accordingly, on
December 15, 2000, the Company filed a lawsuit in the United States District
Court for the Eastern District of Virginia requesting that the court declare
both the MSA and Virginia's Qualifying Statute unconstitutional and, therefore,
invalid. The Company's complaint challenges the MSA on the grounds that it
violates the Interstate Compact Clause and the Commerce Clause of the
Constitution of the United States. It challenges the Virginia Qualifying Statute
on the grounds that it violates the Equal Protection, Due Process, Takings and
Commerce Clauses of the Constitution. Neither Virginia Attorney General Kilgore
nor any other state attorney general has ever charged the Company with the
tortious and unlawful conduct asserted against other cigarette manufacturers in
lawsuits by various states which led to the execution of the MSA. Despite the
absence of any claim against the Company, which is focused primarily on
producing less toxic and potentially less hazardous tobacco and tobacco
products, the MSA and the Virginia Qualifying Statute impose a severe burden on
its research and development activities.
On March 12, 2001, the District Court heard oral argument on the
Commonwealth's Motion to Dismiss, after both sides exchanged briefs on all of
the constitutional and related issues. On March 26, 2001, the District Court
dismissed the Company's complaint, but in its opinion, the District Court did
note that Star "must now suffer as a result of the bad faith of previous market
entrants." The Court further noted that Star "has never been accused of the
fraudulent, collusive and intentionally dishonest activities of the Big Four,"
"was not even in existence during the bulk of the time that these activities
were occurring," and has taken "every step to provide complete disclosure about
the harmful nature of its products." The District Court also stated that the
"financial burden on Star Scientific and others like it may hamper efforts to
develop new tobacco technologies." The Company promptly appealed the District
Court's ruling.
On January 22, 2001, the United States Court of Appeals for the Fourth
Circuit affirmed the decision of the District Court and later denied the
Company's request for rehearing. The Company plans to file a petition for
certiorari with the Supreme Court asking the Court to review the case, given its
continuing belief that the MSA and the Virginia Qualifying Statute are
constitutionally flawed.
On June 12, 2001, Star filed a second lawsuit challenging the MSA and
Indiana's Qualifying Statute in the United States District Court for the
Southern District of Indiana, which suit raised claims similar to those in the
complaint in the Commonwealth of Virginia. The Indiana lawsuit also raised the
contention that Star is not subject to any escrow obligation in Indiana because
it has no substantial nexus to the state, and Star moved for a preliminary
injunction on this issue. On August 20, 2001, the District Court issued a ruling
denying the motion for preliminary injunction and dismissing the substantial
nexus claim. At the same time, the court deferred ruling on the remainder of the
claims pending further development of the record and a ruling by the U.S. Court
of Appeals for the Fourth Circuit in the Company's challenge to the MSA and the
Virginia Qualifying Statute.
In May 2001, the Company filed a patent infringement action against R.J.
Reynolds in the District Court of Maryland Southern Division to enforce the
Company's rights under U.S. Patent No. 6,202,649 (`649 patent). R.J. Reynolds
filed a motion to dismiss the action as well as a motion to strike certain
allegations in the complaint. On November 19, 2001, the Court denied R.J.
Reynolds motion to dismiss and to strike and granted the Company's
25
motion to file a supplemented claim. The case is now proceding in the discovery
phase, with a discovery deadline of September 30, 2002.
In June 2001, R.J. Reynolds filed a complaint against the Company for
declaratory judgment in the United States District Court for the Middle District
of North Carolina. In that case, R.J. Reynolds sought a judgment declaring that
the `649 patent has not been infringed and that the patent is invalid. The
Company filed a motion to stay, dismiss or transfer the North Carolina action,
given the earlier filing in the Maryland District Court. The Court on October 3,
2001 granted the Company's motion in part and the North Carolina case is now
stayed.
In July 2001, Harry Powell filed a lawsuit against the Company in San
Diego County Superior Court, pursuant to California Business and Professional
Code Section 17200. Plaintiff alleges that the Company failed to fully comply
with California's Qualifying Statute, despite the fact that the Company
deposited approximately $882,000 into escrow for sales of cigarettes in
California in 2000. The Company moved to dismiss the complaint on the basis that
any determination as to deposits into escrow rested with the Attorney General's
office. To date, the Court has taken this issue under review and has asked the
Attorney General's office for its position. In response to this inquiry, the
Attorney General's office indicated that it does not intend to intervene in the
case and that if it turns out that it has any dispute with the Company over its
escrow obligation it would raise this with the Company and give it a reasonable
opportunity to make any additional deposit required, before taking any action
against it. Based on the response from the Attorney General's office, the
Company is moving to dismiss the action or stay the case.
Since the introduction of ARIVA(TM), two petitions have been filed with
the FDA seeking to have ARIVA(TM) regulated as a drug product and/or as a food.
Because ARIVA(TM) is a smokeless tobacco product that is intended to provide
tobacco satisfaction, the Company believes the FDA lacks any authority to
regulate ARIVA(TM) based on the March 21, 2000 decision of the Supreme Court in
FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120 (2000). Star has advised
the FDA that it believes the petitions are without merit and that its legal team
will be filing responses in a timely fashion.
The Company is not involved in any other material legal proceedings.
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable.
PART II
Item 5. Market for Common Equity and Related Stockholder Matters
Until March 21, 2000, the Common Stock of the Company was traded in the
over-the-counter market and was quoted on the OTC Bulletin Board under the
symbol "STSI." On March 21, 2000, the Common Stock of the Company commenced
trading on the NASDAQ National Market System under the symbol "STSI." Set forth
below are (a) the high and low bid prices (which reflect prices between dealers
and do not include retail markup, markdown or commission and may not represent
actual transactions) for each full quarterly period during 2001 through March
20, 2002, as reported by the National Quotation Bureau and (b) the high and low
sales prices from March 21, 2001 and for each quarterly period thereafter, as
reported by NASDAQ. From time to time, during the periods indicated, trading
activity in the Company's stock was infrequent. As of March 1, 2002, there were
approximately 871 record holders of the Company's Common Stock.
2001 High Low
---- ------ ------
First Quarter ............................................ $2.438 $1.438
Second Quarter ........................................... $3.250 $1.188
Third Quarter ............................................ $2.900 $1.920
Fourth Quarter ........................................... $3.650 $2.500
26
2000 High Low
---- ------ ------
First Quarter ............................................ $7.500 $5.625
Second Quarter ........................................... $6.750 $3.375
Third Quarter ............................................ $5.000 $3.750
Fourth Quarter ........................................... $4.063 $2.031
The Company has never paid dividends on its Common Stock, and the Board of
Directors currently intends to retain any earnings for use in the Company's
business for the foreseeable future. Any future determination as to the payment
of such cash dividends would depend on a number of factors including future
earnings, results of operations, capital requirements, the Company's financial
condition and any restrictions under credit agreements outstanding at the time,
as well as such other factors as the Board of Directors might deem relevant. No
assurance can be given that the Company will pay any dividends in the future.
Unregistered Option Grants.
In 2001, Star granted its directors, officers, employees and consultants
(the "Purchaser Class") options to purchase Star's Common Stock as described
below. All options described below were granted under the Star Scientific, Inc.
1998 Stock Option Plan or the Star Scientific, Inc. 2000 Equity Incentive Plan.
On each of the dates set forth below, the options described were offered to one
member of the Purchaser Class in a private offering in accordance with Section
4(2) of the Securities Act of 1933, as amended.
27
Date of Grant Exercise Price Options Granted
(per share)
--------------------------------------------------------------------------------
03/15/2001 $1.8125 250,000
03/30/2001 $1.4688 50,000
04/13/2001 $1.30 50,000
06/08/2001 $2.63 25,000
06/09/2001 $2.41 25,000
07/09/2001 $2.51 22,500
07/27/2001 $2.65 37,736
08/31/2001 $2.21 25,000
10/12/2001 $2.60 100,000
11/01/2001 $3.31 10,000
11/19/2001 $2.90 25,000
11/20/2001 $3.26 25,000
11/28/2001 $3.02 50,000
12/26/2001 $2.78 25,000
28
Item 6. Selected Financial Data
The selected consolidated financial data of the Company for and as of the
end of each of the periods indicated in the five-year period ended December 31,
2001 have been derived from the audited consolidated financial statements of the
Company. The selected consolidated financial data should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" in Item 7 and the consolidated financial statements of the Company,
including the notes to those consolidated financial statements contained
elsewhere in this report.
[Enlarge/Download Table]
Year Ended December 31,
-----------------------------------------------------------
2001 2000 1999 1998 1997
------ ------ ------ ------ ------
(In thousands, except per share data)
Statement of Operations Data:
Net Sales ........................................... $174,783 $223,051 $ 99,325 $ 19,445 $ 20,764
Cost of goods sold (excludes federal excise tax) ... 79,548 93,952 31,879 7,669 10,033
Gross Profit ........................................ 36,413 45,508 33,625 2,938 2,920
Operating income (loss) ............................. 4,564 17,648 16,937 (2,812) (1,752)
Net income (loss) ................................... 3,025 10,041 11,515 (4,196) (1,986)
Basic income (loss) per share ....................... 0.05 0.17 0.32 (0.51) (0.58)
Diluted income (loss) per share ..................... 0.05 0.17 0.23 (0.51) (0.58)
Weighted average shares outstanding ................. 59,742 59,008 36,207 8,327 3,435
[Enlarge/Download Table]
Year Ended December 31,
-----------------------------------------------------------
2001 2000 1999 1998 1997
------ ------ ------ ------ ------
(In thousands, except per share data)
Balance Sheet Data:
Cash and cash equivalents ........................... 3,085 16,747 17,205 103 11
Property, plant & equipment ......................... 21,577 27,401 10,974 1,704 2,416
MSA escrow funds .................................... 28,444 11,605 -- -- --
Total assets ........................................ 79,339 69,467 38,709 4,435 4,120
Long-term obligations ............................... 29,818 13,272 7,505 612 1,099
Stockholders' equity (deficit) ...................... 28,524 25,276 12,319 (639) (1,742)
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operation
The following discussion of the results of operations and financial
condition of the Company should be read in conjunction with the Company's
consolidated financial statements and related notes included elsewhere in this
29
report. This discussion contains forward-looking statements based on current
expectations that involve risks and uncertainties. See "Factors That May Affect
Future Results" and "Note on Forward-Looking Statements."
Critical Accounting Policies
Accounting principles generally accepted in the United States of America
require estimates and assumptions to be made that affect the reported amounts in
the Company's consolidated financial statements and accompanying notes. Some of
these estimates require difficult, subjective and/or complex judgments about
matters that are inherently uncertain, and as a result, actual results could
differ from those estimates. Due to the estimation processes involved, the
following summarized accounting policies and their application are considered to
be critical to understanding the business operations, financial condition and
results of operations of the Company.
Revenue Recognition
Revenue is recognized when tobacco products are delivered to customers and
title passes. The Company also records appropriate provisions for uncollectible
accounts and credits for returns. In connection with its leaf segment the
company sells low-TSNA StarCured(TM) tobacco at a price approximately equal to
its purchase price. The Company is the primary obligor to the farmers from whom
the tobacco is purchased and has general inventory risk. Due to these factors,
and others, the Company records tobacco leaf sales at gross amounts. Royalty
revenues are recognized when earned.
MSA Escrow Fund
Cash deposits restricted pursuant to the MSA are reflected as a
non-current asset in the Company's consolidated financial statements. All
interest earned on this account is unrestricted and reflected in current
earnings.
Results of Operations--Fiscal 2001 Compared to Fiscal 2000
During 2001, the Company's net sales decreased to $174.8 million,
reflecting a decrease of $48.3 million, or 22% from 2000 net sales. Net sales in
2001 included $34.4 million in very low-TSNA StarCured(TM) tobacco sold to B&W,
delivered in the third and fourth quarters of 2001, which compares to a total of
$46.2 million in third and fourth quarter sales in 2000. Additionally, the
Company received $1.5 million of non-cash royalty during the third and fourth
quarters of 2001 from B&W for purchases of low-TSNA tobacco which was not
StarCured(TM) tobacco. This royalty was applied to reduce long-term loans which
B&W has provided to the Company. Once the debt to B&W has been reduced to zero,
the royalty payments shall be made in cash.
Other than the very low-TSNA StarCured(TM) tobacco sales made to B&W and
royalties paid by B&W for purchases of other low-TSNA tobacco, substantially all
of the Company's revenues in 2001 were derived from sales of ST's four brands of
"discount" cigarettes. ST's shipment volume during 2001 decreased approximately
31% to 3.5 billion units from 2000's shipment volume of 5.0 billion units,
reflecting a continued focus by the Company to concentrate the field sales force
and sales efforts in four states and to develop and launch a series of smokeless
tobacco products. Increases in product pricing helped to offset reductions in
net sales and gross margins created by the lower sales volume.
During 2001, overall gross margin decreased to $36.4 million compared to
$45.5 million in 2000. Higher pricing associated with sales of the Company's
four brands of discount cigarettes was partially offset by increased costs due
to the inclusion of 24% very low-TSNA StarCured(TM) tobacco in the discount
brands and a carbon/acetate filter that reduces additional toxins found in
cigarette smoke. The margins on the sales of StarCured(TM) tobacco leaf to B&W
decreased substantially from $4.1 million in 2000 to $(1.1) million in 2001.
This decrease was attributable to a change in focus in the April 25, 2001
Agreements with B&W from income generated on the sale of tobacco to B&W to an
income stream from royalty payments on products produced using StarCured(TM)
tobacco and royalty payments on the purchase of StarCured(TM) tobacco and other
low-TSNA tobacco. These agreements include anticipated royalty payments on such
products as Advance(R), ARIVA(TM) or a form of ARIVA(TM) to be sold by B&W's
sales force, and royalties on purchases by B&W of other low-TSNA tobacco and
StarCured(TM) tobacco, once Star's patent position is established. All royalties
are to be paid as a credit toward reducing the amount of
30
outstanding debt arising from B&W's loans to the Company until the debt is
extinguished, at which time the royalties will be paid in cash. During 2001, B&W
paid a total of $1.5 million (in the form of debt reduction) for royalties for
low-TSNA tobacco other than StarCured(TM) tobacco and a minimal amount of
royalties in connection with its test market of Advance(R). The price that B&W
was willing to pay for StarCured(TM) tobacco under the April 25, 2001
Agreements, was, in part, dictated by the prices that competitors, such as R. J.
Reynolds, were paying farmers for other low-TSNA tobacco. Under the agreements
with B&W, the Company has continued to pay the farmers participating in its
StarCured(TM) program a premium for producing StarCured(TM) tobacco, consistent
with its prior commitment to the farming community. Also, as noted above (Item 3
Legal Proceedings) the Company has filed a patent infringement action against
R.J. Reynolds in connection with its program to acquire other low-TSNA tobacco.
As a percent of sales, the Company's gross margins from overall operations
increased from 20.4% in 2000 to 20.8% in 2001. This reflects increased margins
for the sales of discount cigarettes in spite of the loss from processing
StarCured(TM) tobacco. ST's four discount cigarette brands experienced a
decrease in excise taxes paid as a percentage of cigarette net sales from 47.3%
in 2000 to 42.2% in 2001. Further, operating income was affected by the
expansion of ST's discount cigarette market in Florida, Minnesota, Mississippi,
and Texas, which benefited from the expansion of its sales force during 2001, as
well as marketing and incentive programs at the wholesale/distributor level to
achieve increased market penetration. Depreciation costs were $2.9 million in
2001 compared to $2.2 million in 2000, primarily related to the Company's
tobacco curing barns. This depreciation cost is a cost of sales of the
StarCured(TM) tobacco. R&D, product development, legal and consulting expenses
for medical, health, compliance, communications, and technical advice associated
with the Company's growth and new product launches also contributed to the
Company's lowered profit margin, as did litigation costs associated with the
Company's challenge to the MSA and its patent infringement suit against R.J.
Reynolds.
Marketing and distribution expenses totaled $11.7 million in 2001 compared
to $13.0 million for 2000, a decrease of $1.3 million, which is in line with the
decreased sales volume and, in part, reflects salary and incentive compensation
payments to sales personnel. The Company's anticipates marketing and
distribution expenses to grow significantly during 2002 as the Company's focuses
on the expansion of its new low-TSNA smokeless products.
General and administrative expenses for 2001 totaled $16.1 million
compared to $13.2 million for 2000, an increase of $2.9 million primarily
attributable to additions to the Company's management team and legal and
consulting costs associated with the Company's fulfillment of its compliance
obligations as a publicly-held company, pursuance of its legal and public health
strategies in the legislative, regulatory and executive agency arenas, its
technical recruitment efforts and increased scientific consulting connected with
its new product initiatives.
Research and development expenses were $4.1 million in 2001 versus $1.7
million in 2000 and were specifically related to the continued development of
the Company's low-TSNA reduction technology as well as the development of the
three smokeless products introduced into the market during 2001, i.e.
Stonewall(TM) moist and dry snuffs and ARIVA(TM). These expenses consisted
primarily of costs incurred by the Company for consulting services, salaries,
professional fees and expenses in connection with the Company's continuing
research and development programs.
Income tax expense was $2.0 million in 2001 versus $7.0 million in 2000,
which reflects the lower pre-tax income during 2001. The Company paid a tax rate
of 39.6% during 2001, versus 41.1% during 2000.
Higher net interest income in 2001 of $0.5 million compared to a loss of
$0.6 million during 2000 was the result of decreased interest expense from the
credit facility with B&W, and interest income generated by the Company's deposit
into the MSA escrow fund.
Net income of $3.0 million for 2001 compares with $10.0 million for 2000,
a decrease of $7.0 million. In 2001 and 2000, the Company had basic and diluted
earnings per share of $0.05 and $0.17, respectively. In 2001, basic and diluted
weighted average shares outstanding were 59,741,600 and 60,392,426,
respectively, versus 59,008,127 and 60,645,061, respectively, for 2000.
31
Results of Operations--Fiscal 2000 Compared to Fiscal 1999
During 2000, the Company's net sales increased to $223.1 million,
reflecting an increase of $123.7 million, or 125% over 1999 net sales. Net sales
in 2000 included $46.2 million in very low-TSNA tobacco sold to B&W, delivered
primarily in the third and fourth quarters of 2000, which compares to a total of
$9.8 million in fourth quarter sales in 1999. The Company did not have any leaf
sales in the third quarter of 1999.
Other than the very low-TSNA tobacco sales made to B&W, substantially all
of the Company's other revenues in 2000 were derived from sales of ST's four
brands of "discount" cigarettes. ST's shipment volume during 2000 increased
approximately 79% to 5.0 billion units over 1999's shipment volume of 2.8
billion units, reflecting a continued upswing in sales of the ST's cigarettes as
a result of growing the customer base, including the addition of several major
retail chains and a concentration of the field sales force in four states.
Slight increases in product pricing also contributed to higher net sales.
During 2000, gross margin increased to $45.5 million compared to $33.6
million in 1999. As a percent of sales, however, the Company's gross margins
from our overall operations decreased from 33.8% in 1999 to 20.4% in 2000.
Specifically, ST's four discount cigarette brands experienced an increase in
excise taxes (from $12 per 1,000 cigarettes in 1999 to $17 per 1,000 cigarettes
in 2000), resulting in an increase in excise taxes paid as a percentage of
cigarette net sales from 34.1% in 1999 to 37.5% of cigarette net sales in 2000.
Further, operating income was affected by the expansion of ST's discount
cigarette market, which required the addition of a sales force in early 2000, as
well as marketing and incentive programs at the wholesale/distributor level to
achieve increased market penetration. Depreciation costs were $2.2 million in
2000 compared to $0.7 million in 1999, reflecting the increase in the number of
barns and the amount of tobacco processed. Finally, R&D, product development,
legal and consulting expenses for specific medical, health, compliance,
communications, and technical advice associated with the Company's growth and
new product launches also contributed to the Company's lowered profit margin.
Marketing and distribution expenses totaled $13.0 million for 2000, an
increase of $6.7 million over 1999, which is in line with the increased sales
volume and, in part, reflects salary and incentive compensation payments to
sales personnel. The Company's marketing and distribution expenses are expected
to grow significantly during 2001 as the Company expands its commercialization
capabilities.
General and administrative expenses for 2000 totaled $13.2 million
compared to $9.9 million for 1999, an increase of $3.3 million primarily
attributable to increased operating costs for the Company's greatly expanded
barn program and additions to the Company's management and consulting team.
Other components of general and administrative expenses were relatively flat
when compared to the comparable periods in 1999; however, there were some cost
increases associated with the higher sales volume, as well as increased legal
and consulting costs associated with the Company's fulfillment of its compliance
obligations as a publicly-held company, pursuance of its legal and public health
strategies in the legislative, regulatory and executive agency arenas, its
technical recruitment efforts, expansion of its Scientific Advisory Board and
increased scientific consulting.
Research and development expenses were $1.7 million in 2000 versus $0.5
million in 1999 and were specifically related to the development of the
Company's TSNA reduction technology and associated low-TSNA products. These
expenses consisted primarily of costs incurred by the Company for consulting
services, and professional fees and expenses in connection with the Company's
continuing research and development programs.
Higher income tax expense in 2000 reflects the use of the Company's net
operating loss carryover from previous years during 1999 to lower the Company's
1999 income tax expense.
Higher net interest expense in 2000 was the result of interest expense
from the credit facility with B&W, partially offset by the interest income
generated by the Company's deposit into the MSA escrow fund.
Net income of $10.0 million for 2000 compares with $11.5 million for 1999,
a decrease of $1.5 million. In 2000, the Company had basic and diluted earnings
per share of $0.17, respectively, compared with basic earnings of $0.32 and
diluted earnings of $0.23 in 1999. In 2000, basic and diluted weighted average
shares outstanding were 59,008,127 and 60,645,061, respectively versus
36,207,390 and 50,301,998, respectively, for 1999. The number of
32
basic shares increased primarily due to the conversion of Class B Preferred
Stock to Common Stock in April 1999. With the completion of that conversion,
there were no further outstanding shares of any preferred stock.
Liquidity and Capital Resources
Accounts receivable and accounts payable throughout 2001 were current and
the Company has normal industry terms with all of its suppliers. In 2001, cash
used in investing activities exceeded cash generated by operating and financing
activities. In 2001, $0.4 million of cash was provided by operating activities
compared to $13.1 million of cash provided in 2000. The decrease in cash
provided by operating activities was primarily due to the Company's decrease in
gross margin. In 2001, $5.8 million of cash was provided by financing activities
versus $17.4 million of cash in 2000, generated by proceeds from notes issued to
B&W. Cash used in investment activities decreased to $3.0 million in 2001 from
$19.4 million in 2000 due to the fact that the Company had acquired a total of
1,125 curing barns by the end of 2000 and no further purchases were required in
2001 to meet the Company's needs for StarCured(TM) tobacco.
During 2001, the Company incurred a net $(1.0) million in capital
expenditures, compared to $18.6 million in 2000. Approximately $0.5 million of
capital expenditures during 2001 were focused on leasehold improvements at the
Chase City, Virginia, tobacco processing facility in connection with the
installation of the ARIVA(TM) manufacturing line but were offset by the
sale/leaseback arrangements for certain of the Company's tobacco curing barns.
The higher capital expenditures during 2000 were principally related to the
StarCured(TM) tobacco barn production program with Powell. Star does not
anticipate purchasing any additional barns from Powell in 2002 because the
Company continues to have sufficient barns in place to process approximately 20
million pounds of StarCured(TM) flue-cured tobacco, which will meet the
Company's needs for this growing season.
As part of the April 25, 2001 Agreements, Star and B&W restructured
approximately $29 million in debt (including approximately $16 million in
short-term debt) into long-term, non-interest bearing debt with a five-year
repayment schedule beginning January 2005. The debt is secured by tobacco leaf
inventory, the tobacco curing barns, and a first priority security interest in
the Company's intellectual property. Star and ST have guaranteed payment of the
other's obligations. Once the outstanding loan balance is reduced to $10
million, the collateral, except for the Star and ST guarantees, will be released
by B&W.
Under the April 25, 2001 Agreements, B&W will purchase at least 15 million
pounds of very low-TSNA StarCured(TM) tobacco during the 2002 and 2003 growing
seasons, with the right to continue to purchase additional StarCured(TM) tobacco
after the initial three-year period. B&W will purchase additional very low-TSNA
StarCured(TM) tobacco from Star during each of the next two growing seasons,
which Star will have the right, but not the obligation, to repurchase under
existing terms for its own needs at a price which will compensate B&W for its
costs. For the next two years, farmers who grow and process StarCured(TM)
tobacco will receive a $0.10 per pound premium over the B&W contract pricing
schedule for flue-cured tobacco. As a result of agreeing to pay a premium to the
StarCured(TM) farmers, Star anticipates negative profit margins for its leaf
tobacco sales to B&W during the 2002 and 2003 growing seasons similar to the
margins experienced during the 2001 growing season.
If B&W requires additional StarCured(TM) tobacco that Star cannot supply
due to capacity constraints, B&W may purchase StarCured(TM) tobacco curing barns
for its own use and, in that event, B&W will pay Star a royalty of $0.15 per
pound for the StarCured(TM) tobacco that is not otherwise subject to a royalty
or used in products for which B&W pays Star a product royalty. If such tobacco
is subject to a royalty or used in products for which a product royalty is paid,
then B&W will pay to Star the higher of $0.15 per pound or the existing royalty
for the StarCured(TM) tobacco.
At the end of three years, Star and B&W will negotiate in good faith for
the purchase of StarCured(TM) tobacco by B&W. If B&W does not purchase at least
15 million pounds of StarCured(TM) tobacco in the later years, then for each
pound purchased below 15 million pounds Star Scientific will receive an $0.80
per pound reduction of its outstanding debt obligations, up to a total reduction
of $12 million on a cumulative basis.
Additionally, under the April 25, 2001 Agreements, B&W has the exclusive
right, subject only to Star's own rights to distribute its own cigalett(TM)
product, to purchase and sell a new, smokeless hard snuff tobacco (cigalett(TM))
33
product. If B&W determines the market test of the cigalett(TM) product is
successful, B&W will forgive one-half of the debt outstanding from Star
Scientific under the restructured loan agreement. If after the completion of the
test marketing program, B&W sells the cigalett(TM) product in retail locations
in at least 15 states, then B&W will forgive all of the debt obligations of
Star.
In 2001, Star sold 91 curing barns to Golden Leaf Tobacco Company, Inc.
for $1.85 million as part of a sale and licensing arrangement. The $1.85 million
in proceeds were used to reduce long-term debt owed to B&W because the barns
were held as collateral for these loans. Under the license agreement, Golden
Leaf is obligated to pay royalties on StarCured(TM) tobacco and other low-TSNA
tobacco it uses once the Company begins to receive royalties from tobacco
companies other than B&W.
Beginning in August, 2001, Star entered into a series of sale/leaseback
transactions involving the sale of approximately 400 barns for approximately
$10.8 million in net proceeds through December 2001. In order to obtain the
release the collateral from B&W, the Company agreed that for every dollar raised
in sale/leaseback transactions, the Company would pay 4/14ths of the proceeds to
B&W as a reduction of long-term debt. The Company anticipates additional
sale/leaseback transactions will close during 2002 for estimated proceeds of
$5,000,000, which will be subject to the 4/14ths pay-down of debt. Star also
anticipates converting an existing operating lease agreement into a capital
lease which would free up a $1.268 million security deposit.
The sale and licensing agreement with Golden Leaf, the sale/leaseback
transactions described above, and royalty payments during 2001 of $1.5 million
resulted in reductions in the Company's long-term loans to B&W from
approximately $29 million in December 2000 to $23.7 million at year-end.
The Company, through ST, has an available $7.5 million line of credit with
a working capital lender, which expires January 2005. This line of credit is
collateralized by accounts receivable and other assets from its cigarette
business. On both December 31, 2001 and December 31, 2000, the Company had no
borrowings under this line of credit.
Under the Master Settlement Agreement and the model `level playing field'
statutes enacted by each of the settling states, absent a successful legal
challenge to the state specific statutes or an agreement with the NAAG with
respect to the funding of the required escrow accounts, the Company is
purportedly obligated to place an amount equal to $1.88 per carton for 1999,
$2.09 in 2000, $2.72 in 2001-2002, $3.35 in 2003-2006 and $3.77 thereafter, in
escrow for sales of cigarettes occurring in each MSA state after the effective
date of each state specific statute. An inflation adjustment is also added to
these deposits at the higher of 3% or the Consumer Price Index each year. Such
escrowed funds will be used to pay judgments in tobacco-related litigation or
settlements, if any, and if not so used returned to the Company after 25 years.
On April 14, 2000, under protest, the Company placed into escrow approximately
$11.6 million for sales made in 1999. On April 14, 2001, under protest, the
Company placed into escrow approximately $13.1 million for sales made in 2000.
In response to demands made by certain Attorneys General, the Company under
protest made additional deposits of approximately $300,000, $1.3 million, $1.8
million, and $400,000 respectively, to its escrow account in the last three
quarters of 2001 and the first quarter of 2002. The Company anticipates that
there may be further adjustments to its escrow deposits for 1999 and 2000 sales.
The Company also anticipates that with payments for year 2001 sales, which must
be deposited by April 15, 2002, the escrow fund immediately after that funding
will total approximately $32 million. The funds placed in escrow will continue
to be an asset of the Company and the Company will receive the interest income
generated by the escrow deposit. However, these escrow obligations will
significantly impede the Company's ability to apply the capital generated from
its cigarette sales as it sees fit and the amount required to be placed in
escrow for each carton sold may exceed the net cash flow generated by each
carton sold. Based on Star's projected sales for future years, the Company will
have to pay significant sums into these escrow accounts to meet the Master
Settlement Agreement requirements. The Company has attempted to mitigate these
MSA payments by, among other things, focusing its efforts on increasing market
share in states in which it does not have purported obligations to make payments
into escrow under state qualifying statutes enacted pursuant to the MSA, and on
sales of smokeless tobacco products for which MSA payments are not required.
On March 12, 2002, Governor Warner of the Commonwealth of Virginia
announced that the Company would be receiving a grant of $300,000 to assist
Mecklenburg County in the acquisition of the Company's new processing facility
adjacent to its existing tobacco receiving station in Chase City, Virginia.
Furthermore, the Company is
34
eligible for a further grant of $500,000, but does not anticipate receiving any
cash from this grant until five years after the award date, at which time the
Company believes it shall receive approximately $100,000 a year for five years.
The Company has reason to believe that it will receive other substantial
incentives, including tax rebates, employee training and property tax refunds,
in connection with the expansion of its ARIVA(TM) manufacturing facilities in
Chase City, Virginia.
During 2000 and 2001, the Company focused significant amounts of R&D and
capital resources in developing and bringing to test market its low-TSNA
smokeless products based on the recommendations of its Scientific Advisory Board
and the fact that smoked tobacco contains over 4,000 constituents, 43 of which
are carcinogenic. If Star were not to be successful in achieving the market
penetration and consumer acceptance for its smokeless products, primarily its
compressed powdered cigalett(TM) pieces, brand named ARIVA(TM), that it
anticipates, Star's sales volumes, operating income and cash flows could be
materially affected. If the product launch is accomplished as envisioned, the
Company is expected to achieve break-even results for the first two quarters of
2002.
Following the recent tragedies on September 11, 2001, the Company has not
experienced a disruption of its sales, orders or any other matters affecting the
Company's business. Moreover, at this point in time, management does not
anticipate a material adverse impact on its results of operations or financial
position as a result of the tragedies.
Assuming the successful national launch of ARIVA(TM), and consummation of
additional sale/leaseback transactions during 2002, the Company believes that
its existing working capital, together with anticipated earnings from its
operations, will be sufficient to meet its liquidity and capital requirements in
the foreseeable future. The Company's need, if any, to raise additional funds to
meet its working capital and capital requirements will depend upon numerous
factors, including the results of its marketing and sales activities, any escrow
obligations it may be required to comply with under the MSA, the success of the
Company's new product development efforts and the other factors described under
"Factors That May Affect Future Results."
Future Commitments and Funding Sources
At December 31, 2001, the Company's contractual cash obligations, with
initial or remaining terms in excess of one year, were as follows (in
thousands): (a)
[Enlarge/Download Table]
Amount of Commitment
($) Expired By Year
Ended December 31,
------------------
YEAR Long-Term Debt Capital Leases Operating Annual Total
---- -------------- -------------- --------- ------------
Leases
------
2002 775,210 3,760,595 2,092,327 6,628,132
2003 -- 3,760,595 1,881,028 5,641,623
2004 -- 3,099,642 1,658,265 4,757,907
2005 4,593,956 656,334 1,658,265 6,908,555
2006 4,593,956 -- 999,039 5,592,995
Thereafter 13,781,868 -- 674,210 14,456,078
-----------------------------------------------------------------------------
TOTAL 23,744,990 11,277,166 8,963,334 43,985,490
Less Amount Representing Interest 1,399,776
Present Value of Minimum lease payments 9,877,390
(a) See Notes 5 and 6 in the accompanying financial statements for
additional information regarding our debt and commitments.
35
Effect of Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued SFAS No.
142, "Goodwill and Other Intangible Assets". SFAS No. 142 requires, among other
things, that companies no longer amortize goodwill, but instead test goodwill
for impairment at least annually. In addition, SFAS No. 142 requires that the
Company identify reporting units for the purposes of assessing potential future
impairments of goodwill, reassess the useful lives of other existing recognized
intangible assets, and cease amortization of intangible assets with an
indefinite useful life. An intangible asset with an indefinite useful life
should be tested for impairment in accordance with the guidance in SFAS No. 142.
SFAS No. 142 is required to be applied in fiscal years beginning after December
15, 2001. SFAS No. 142 requires the Company to complete a transitional goodwill
impairment test six months from the date of adoption. The Company is also
required to reassess the useful lives of the other intangible assets within the
first interim quarter after adoption of SFAS No. 142.
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 143, "Accounting for Asset Retirement
Obligations" ("SFAS No. 143"). This standard requires that obligations
associated with the retirement of tangible long-lived assets be recorded as
liabilities when those obligations are incurred, with the amount of the
liability initially measured at fair value. Upon initially recognizing a
liability for an asset retirement obligation, an entity must capitalize the cost
by recognizing an increase in the carrying amount of the related long-lived
asset. Over time, this liability is accreted to its present value, and the
capitalized cost is depreciated over the useful life of the related asset. Upon
settlement of the liability, an entity either settles the obligation for its
recorded amount or incurs a gain or loss upon settlement. SFAS No. 143 is
effective for financial statements issued for fiscal years beginning after June
15, 2002; we will adopt SFAS No. 143 effective January 1, 2003. We do not expect
that the adoption of this statement will have a material impact on our results
of operations, financial position or cash flows.
In August 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" ("SFAS No. 144"), which supercedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed of." SFAS No. 144 applies to all long-lived assets, including
discontinued operations and consequently amends APB Opinion No. 30, "Reporting
the Results of Operations-Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions". Based on SFAS No. 121, SFAS No. 144 develops one accounting model
for long-lived assets that are to be disposed of by sale, as well as addresses
the principal implementation issues. SFAS No. 144 requires that long-lived
assets that are to be disposed of by sale be measured at the lower of book value
or fair value less cost to sell. Additionally, SFAS No. 144 expands the scope of
discontinued operations to include all components of an entity with operations
that (1) can be distinguished from the rest of the entity and (2) will be
eliminated from the ongoing operations of the entity in a disposal transaction.
SFAS No. 144 is effective for financial statements issued for fiscal years
beginning after December 15, 2001, and we have adopted SFAS No. 144 effective
January 1, 2002. We do not expect that the adoption of SFAS No. 144 will have a
material impact on our results of operations, financial position or cash flows.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company has not entered into any transactions using derivative
financial instruments or derivative commodity instruments and believe that its
exposure to market risk associated with other financial instruments (such as
investments and borrowings) and interest rate risk is not material.
Item 8. Financial Statements
This information is contained on F-1 through F-39 hereof and is
incorporated into Part I of this report by reference.
36
Item 9. Changes in and Disagreements with Accountants and Financial Disclosure
None.
PART III
Item 10. Directors and Executive Officers of the Registrant
During the September 2001 Stockholders Meeting, the stockholders voted to
eliminate the Classified Board of Directors. Thereafter, Directors serve for a
one-year term and until the election and qualification of their successors, or
their earlier resignation or removal. The following is the current listing of
the Board of Directors, as of March 30, 2002:
John R. Bartels, Jr. Mr. Bartels, 67, has served as a director of the
Company since January 2002. Since 1988, Mr. Bartels has been a senior partner at
the law firm of Bartels & Feurelsen LLP and has served as a member of the Board
of Directors, and general counsel, of Florida Digital Network, Inc. Mr. Bartels
also has served as special labor counsel to several corporations and local
businesses. Mr. Bartels received his B.A., Magna Cum Laude, from Harvard
University in 1956, and an LL.B. in 1960, graduating in the top 15% of his
class. He attended the University of Munich in 1957 as a Fulbright Scholar where
he was an Adenauer Scholar. His professional credits include: Adjunct Professor,
Rutgers University School of Law 1969-1971; Instructor, Trial Advocacy, Pace Law
School 1978-1986, Assistant U.S. Attorney, Southern District of New York,
1964-1968; Recipient, Outstanding Service Award, U.S. Department of Justice
1970; Chief, Organized Strike-Force, U.S. Department of Justice, Newark, New
Jersey. In 1972 and 1973, Mr. Bartels was counsel to Governor Nelson
Rockefeller, where he served as Chief Investigator on the "Hoover Commission" to
investigate and recommend improvements to New York City government.
Additionally, from 1972 to 1973, Mr. Bartels was the Deputy Assistant Attorney
General for the U.S. Department of Justice, Criminal Division. From 1973 to
1975, he was an Administrator for the U.S. Drug Enforcement Administration and
in 1974 he was a Delegate from the U.S. Delegation to the U.N. Commission of
Narcotic Drugs. Mr. Bartels' professional memberships include The New York State
and American Bar Associations, and he is a Fellow of the American College of
Trial Lawyers. Mr. Bartels was a recipient of the Pace Law School Leadership
Award in 1990 and received the Commissioner's Award from the Royal Mounted
Canadian Police in 1974.
Robert J. DeLorenzo, M.D., Ph.D., M.P.H. Dr. DeLorenzo, 54, has served as
a director of the Company since February 1998 and served as Chairman of the
Company's Board of Directors from February 1998 until August 2000. Dr. DeLorenzo
served as the Company's Chief Executive Officer from October 1998 through
November 1999. He previously served as Chairman of the Department of Neurology,
and is the George B. Bliley Professor of Neurology, and Professor of
Pharmacology and Toxicology and Biochemistry and Biophysics at Virginia
Commonwealth University, as well as Neurologist-in-Chief of the Medical College
of Virginia Hospitals and Director of the Molecular Neurobiology Laboratories at
the Medical College of Virginia. Prior to 1985, Dr. DeLorenzo was on the
neurology faculty at Yale University. Dr. DeLorenzo has authored over 300
original publications and has received numerous research awards including the
Jacob Javits Award from the National Institutes of Health and the Jordi-Folch-Pi
Award from the American Society of Neurochemistry. He serves on the editorial
boards of several scientific journals and served on and chaired National
Institutes of Health Study Sections. Dr. DeLorenzo holds a Ph.D. in
neuropharmacology from Yale University, an M.D. from Yale University School of
Medicine and an M.P.H. from the Yale School of Epidemiology and Public Health.
Lloyd A. Jones. Mr. Jones, 48, has served as a director of the Company
since November 2001. He was employed with the United States Department of
Agriculture (USDA) for over 25 years and served as the State Director of the
Farmers Home Administration, now known as the Rural Development Mission Area,
from March 1990 to June 2001 serving three consecutive Presidential
administrations. During his tenure with the USDA, Mr. Jones was responsible for
managing a loan and grant portfolio in excess of $2.5 billion and directed the
annual processing of $175 million Federal dollars into the Commonwealth of
Virginia. These funds were instrumental in supporting economic development
activities for rural Virginia such as business start-ups and expansion,
essential community facilities and infrastructure development and housing. Mr.
Jones is currently an independent consultant specializing in economic
development with particular emphasis on business development and expansion. He
is an
37
experienced senior manager and has been recognized nationally for his management
strategy and capability. Mr. Jones is a native of Mecklenburg County, Virginia
and is a strong advocate of the agriculture industry. He is a 1976 graduate of
Virginia State College (University) with a B.S. degree in Agriculture Business.
Whitmore B. Kelley. Mr. Kelley, 58, has served as a director of the
Company since April 2001. Mr. Kelley is the principal shareholder of Berkshire
Holding Corporation, which he founded in 1967, and has served as Vice Chairman
since 1990. Berkshire is a leader in the engineering and production of
contamination control products for critical environments, with subsidiary
operations throughout Europe and Asia. Mr. Kelley founded Ridefilm Corporation
in 1990, the first simulator film studio, which is now owned by Imax
Corporation. From 1998-2000, Mr. Kelley was the Vice Chairman of the Gilder
Group, a publishing, consulting and conference company. From 1997-2001, Mr.
Kelley served as President and Vice Chairman of the Don Johnson Company, a
company that develops television and feature film products. In 1999, Mr. Kelley
founded Hon Tre Partners, a company that is engaged in the high-end restaurant
business, and serves as Chairman. Since 1992, Mr. Kelley has served on the Board
of PJC Technologies, an advanced custom circuit board company. In 1999, he
founded and is currently is Chairman Emeritus of The Special Opportunities
Group, LLC, a venture capital company. Mr. Kelley serves on the Board of
Directors of various corporations and nonprofit organizations in the United
States, Asia and Europe.
Martin R. Leader. Mr. Leader, 61, has served as a director of the Company
since June 2000. Mr. Leader is a retired partner of the law firm of Shaw Pittman
in Washington, D.C. Prior to his service at Shaw Pittman, Mr. Leader was a
senior partner with the law firm of Fisher Wayland Cooper Leader & Zaragoz in
Washington, D.C. from 1973 to 1999. Mr. Leader played a prominent role in the
roll-up of the radio and television industries. He is a director of the Sinclair
Broadcast Group, Inc. and has served on the Board of Directors of various
private companies. Mr. Leader has served on the staff of the Office of Opinions
and Review of the Federal Communications Commission. He is a member of the
District of Columbia Bar and of the Federal Communications Bar Association. Mr.
Leader attended the school of the Museum of Fine Arts, Boston and was an art
teacher at Montgomery Bell Academy, Nashville, Tennessee, and graduated from
Tufts University and Vanderbilt University Law School.
Patrick M. McSweeney. Mr. McSweeney, 59, has served as a director of the
Company since January 2002. He is the President of McSweeney & Crump, P.C., a
Richmond, Virginia law firm. Mr. McSweeney serves on the board of directors of
various private companies. From 1971 through 1973, he served in various
positions at the United States Department of Justice, including Acting Assistant
Attorney General in charge of the Office of Legislative Affairs and Deputy
Director of the Executive Office for United States Attorneys. He also served in
the Virginia state government as Executive Director of the Commission on State
Governmental Management (1974-77), as counsel to the Governor's Management Study
(1971-72), and as staff attorney to the Commission on Constitutional Revision
(1968). In 1992-1996, he chaired the Republican Party of Virginia. He is a
graduate of the University of Virginia and the University of Richmond Law
School, served as law clerk to the Honorable Albert V. Bryan, Sr., United States
Circuit Judge, taught courses in political science at Virginia Commonwealth
University and currently writes a weekly column on state politics for The Daily
Press (Newport News, Virginia).
Christopher G. Miller. Mr. Miller, 43, has served as a director of the
Company since April 2000. He served as the Company's Acting Chief Financial
Officer from April 2000 until September 2000, and as Chief Financial Officer
beginning in September 2000. He is a founder and serves as Chief Executive
Officer of The Special Opportunities Group, LLC. Prior to his service at The
Special Opportunities Group, Mr. Miller served as Chief Financial Officer of The
Gilder Group from 1998 to 1999, Founder and Chief Executive Officer of American
Healthcare, Ltd. from 1994 to 1998, Founder and Chief Executive Officer of
International Medical Care, Ltd. from 1992 to 1993, and Chief Financial Officer
and Executive Vice President of Hospital Corporation International from 1991 to
1992. Upon his graduation from Harvard Business School, Mr. Miller was employed
by Bear Stearns Companies Inc. in New York as an Associate in Investment
Banking. Mr. Miller serves on the Board of Directors of XiTec, SignalQuest, Ana
Mandara and Zhou Li's Marco Polo Collections. Mr. Miller graduated from the U.S.
Military Academy at West Point in 1980 with a B.S. in Engineering and received
an MBA from Harvard Business School in 1987.
Paul L. Perito. Mr. Perito, 65, is the Company's Chairman, President and
Chief Operating Officer. He has served as Chairman of the Company since August
2000, as a director of the Company since December 1999 and as the Company's
President and Chief Operating Officer since November 1999. Mr. Perito served as
the Company's Executive Vice President, General Counsel and Chief Ethics Officer
from June 1999 through November 1999.
38
Previously, Mr. Perito was a senior partner in the law firm of Paul, Hastings,
Janofsky & Walker LLP ("PHJ&W") from July 1991 until June 1999 when he became a
senior counsel to the firm at the time he joined the Company. Mr. Perito
resigned his position as senior counsel to PHJ&W as of March 31, 2001 after
serving as National Co-Chair of the White Collar Corporate Defense Practice
Group at PHJ&W since 1991, and Chair of the Litigation Department in that firm's
Washington, D.C. office since 1995. Prior to his re-entry into private practice,
he served as Chief Counsel and Deputy Director of the White House Special Action
Office on Drug Abuse Prevention ("Drug Czar's Office") from 1971 to 1973. Mr.
Perito was confirmed by the Senate for that position in March 1972. From 1970 to
1971, Mr. Perito served as Chief Counsel and Staff Director to the U.S. House of
Representatives Select Committee on Crime. Immediately prior to serving the
Congress, Mr. Perito was an Assistant United States Attorney in the Southern
District of New York, U.S. Department of Justice from 1966 to 1970. Mr. Perito
graduated from Tufts University, Magna Cum Laude and Phi Betta Kappa and from
the Harvard Law School. Mr. Perito was a Rotary International Scholar at the
Victoria University of Manchester in Manchester, England and in Lund University,
Lund, Sweden in P.P.E. in 1960-61 before entering Harvard Law School. Mr. Perito
graduated from Harvard Law School (LLB/JD), as an Edward John Noble Scholar, in
1964 and was thereafter admitted to the Bar of the Commonwealth of
Massachusetts. He is also a member of the District of Columbia Bar and is
admitted to practice in numerous federal District Courts, Courts of Appeal and
the United States Supreme Court. Mr. Perito is the President of the Harvard Law
School Association of Greater Washington and a member of the Executive Committee
of the Harvard Law School Association.
Leo S. Tonkin. Mr. Tonkin, 64, has served as a director of the Company
since October 1998. He established the Washington Workshops Foundation in 1967,
and has served as Founding Director since that time. Since 1999 he also has
served as President and Director of Travel Seminars, Inc. He served as a member
of the White House Conference on Youth in 1971, Special Assistant to the
Chairman of the U.S. House of Representatives Select Committee on Crime, Legal
Consultant to the U.S. House of Representatives Higher Education Subcommittee,
and Executive Director of the Commissioners' Council on Higher Education in
Washington, D.C. He has served as Chairman of the Board of Trustees of St.
Thomas Aquinas College and as a Board member of Southeastern University and
Immaculata College. He is a vice president of the London, England Federation of
Youth Clubs and advisor to the Retinitis Pigmentosa Foundation in California.
Mr. Tonkin is a graduate of Johns Hopkins University and received his law degree
from Harvard Law School. He holds an honorary Doctor of Pedagogy degree from St.
Thomas Aquinas College and the State University of New York.
Jonnie R. Williams. Mr. Williams, 45, has served as the Company's Chief
Executive Officer since November 1999. Mr. Williams was one of the original
founders of ST, and served as Chief Operating Officer ("COO"), Executive Vice
President ("EVP") and a Director of the Company since October 1998. On July 1,
1999, in order to concentrate upon the expanding demands of Star's sales and new
product development, Mr. Williams resigned as COO and EVP to assume the primary
responsibilities of Director of Product Development and Sales. Mr. Williams, a
principal stockholder of the Company, is also the inventor of the
StarCured(TM)tobacco curing process for reducing and/or virtually eliminating
the formation of TSNAs in tobacco and tobacco smoke. Mr. Williams has been
involved in venture capital start-up bio-tech companies for over a decade where
he has been either a major shareholder or a co-founder of the following
companies: LaserSight, LaserVision and VISX. Mr. Williams is also one of the
owners of Regent Court and is a principal in Jonnie Williams Venture Capital
Corp.
Executive Officers of the Company who are not Directors
Sheldon L. Bogaz. Mr. Bogaz, 36, has served as ST's Vice President of
Trade Operations since October 2000 and is responsible for managing customer
relationships, developing new business, and formulating and implementing pricing
and trade programs. He served as the Vice President of Sales and Trade
Operations of the Company from September 1995 to October 2000. Prior to joining
the Company in 1995, Mr. Bogaz served as a Commercial Lender with NationsBank
from 1992 to 1995. He holds a Bachelor of Science Degree in Business
Administration from Virginia Commonwealth University.
David M. Dean. Mr. Dean, 42, has served as Vice President of Sales and
Marketing of the Company since November 1999. From 1998 to October 1999, he
served as a Principal of Group Insurance Concepts of Virginia, L.C., an employee
benefits consulting firm and an affiliate of Northwestern Mutual. From 1984 to
1998, Mr. Dean was employed with Trigon Blue Cross/Blue Shield in Richmond,
Virginia, where he held a variety of executive
39
positions over a 14 year period, including Vice President of the Eastern Region
from 1994 to 1996, Vice President of Sales from 1996 to 1997 and Vice President
of Sales and Account Management for the Eastern and Western Regions from 1997 to
1998. Trigon Blue Cross/Blue Shield is the largest health insurer in Virginia.
Mr. Dean is a graduate of Elon College.
Paul H. Lamb, III. Mr. Lamb, 69, has served as President and Chief
Executive Officer of ST since January 1999. From 1990 to 1994, he served as
President of ST, and he has served as a director of ST since 1990. He served as
a consultant to the Company from 1994 until assuming his current position in
January 1999. From 1986 to 1990, Mr. Lamb founded and operated Lamb Services,
Ltd., an engineering consulting firm, and from 1958 to 1986 he was employed with
Brown & Williamson Tobacco Corporation where he held a variety of engineering
positions. Mr. Lamb served as a director of the Southside Regional Medical
Center in Petersburg, Virginia for twenty-six years. Mr. Lamb graduated from
Virginia Military Institute (VMI) with a degree in civil engineering.
Robert E. Pokusa. Mr. Pokusa, 51, has served as General Counsel of the
Company since March 2001. From 1991 to March 2001, he was associated with Paul,
Hastings, Janofsky & Walker LLP during which time he worked on a number of
matters for the Company and concentrated his practice in the areas of complex
civil litigation and administrative law. From 1980 to 1991, Mr. Pokusa was
associated with the law firms of Perito, Duerk & Carlson; Finley, Kumble,
Wagner, Hiney, Underburg, Manley, Meyerson & Casey; and Washington, Perito and
Dubuc. Mr. Pokusa received his Bachelor of Arts Degree from Montclair State
University and his law degree from The American University, Washington College
of Law. He is a member of the Virginia and District of Columbia bars.
Section 16 (a) Beneficial Ownership Reporting Compliance
Section 16 of the Securities Exchange Act of 1934, as amended (the
"Exchange Act") requires directors and executive officers and persons, if any,
owning more than ten percent of a class of the Company's equity securities to
file with the Securities and Exchange Commission (the "SEC") initial reports of
ownership and reports of changes in ownership of the Company's equity and equity
derivative securities. Based solely upon a review of the copies of such reports
furnished to the Company, or written representations from reporting persons, the
Company believes that all required persons during 2001 were in compliance.
Item 11. Executive Compensation
Summary Compensation Table
The following table sets forth, for each individual who served as Chief
Executive Officer and the other most highly compensated officers of the Company
(the "Named Executive Officers"), certain information concerning compensation.
[Enlarge/Download Table]
Other Annual
Compensation Long Term All Other
Annual Compensation ($) Compensation Awards Compensation
------------------- --- ------------------- ------------
Restricted Securities
Stock Underlying
Salary Bonus Award Options
Name and Principal Position Year ($) ($) ($)(1) (#)
--------------------------- ---- --- --- ------ ---
Jonnie R. Williams 2001 1,000,000 900,000 75,015 -- -- --
Chief Executive Officer(2) 2000 1,000,000 1,400,000 287,906 -- -- --
1999 1,000,000 1,400,000 -- -- -- --
Paul L. Perito 2001 1,000,000 900,000 31,868 -- -- --
Chairman, President and Chief 2000 1,000,000 900,000 -- -- -- --
Operating Officer(3) 1999 350,432 250,000(4) 25,000(5) -- 1,000,000 --
David M. Dean 2001 250,000 196,641 59,412 -- -- --
Vice President of Sales and Marketing 2000 251,500 120,229 11,334 -- 350,000 --
1999 49,563 -- 3,436 -- -- --
40
[Download Table]
Christopher G. Miller 2001 191,077 300,000 13,525 -- 250,000 --
Chief Financial Officer 2000 32,769 -- 31,500(6) -- 63,000 --
1999 -- -- 6,667(6) -- 38,000(6) --
Sheldon L. Bogaz 2001 -- 241,782 21,336 -- -- --
Vice President ST 2000 -- 261,239 20,926 -- 250,000 --
1999 -- 306,546 10,119 -- -- --
Robert E. Pokusa 2001 273,736 500 12,072 -- 50,000 --
General Counsel
(1) The Company did not award any stock appreciation rights to the executive
officers or make any long-term incentive plan payouts in 2001, 2000, 1999,
1998 and 1997.
(2) Mr. Williams was appointed Chief Executive Officer in November 1999. Mr.
Williams served as Director of Product Development and Sales of the
Company from June 1999 to November 1999 and served as the Company's Chief
Operating Officer and Executive Vice President from October 1998 through
June 1999.
(3) Mr. Perito was elected as the Company's Chairman in August 2000. Mr.
Perito was appointed as the Company's President and Chief Operating
Officer in November 1999. Mr. Perito served as the Company's Executive
Vice President, General Counsel, Secretary and Chief Ethics Officer from
June 1999 until November 1999.
(4) The Company paid Mr. Perito $250,000 in the form of a signing bonus in
1999 and paid Mr. Perito a bonus of $250,000, based on the Company's and
Mr. Perito's performance, in March 2000.
(5) Represents the difference between the price paid by Mr. Perito for
2,000,000 shares of the Company's Common Stock and the fair market value
of such stock as determined by the Company in compliance with Internal
Revenue Service regulations.
(6) Represents consulting fees paid to Mr. Miller prior to his employment with
the Company.
Option Grants During 2001
The following table sets forth, for the Named Executive Officers, certain
information concerning stock options granted to them during 2001. The Company
has never issued stock appreciation rights. Options were generally granted at an
exercise price equal to the fair market value of the Common Stock at the date of
grant. The term of each option granted is generally ten years from the date of
grant. Options may terminate before their expiration dates, if the optionee's
status as an employee or a consultant is terminated or upon the optionee's death
or disability.
[Enlarge/Download Table]
Potential Realizable
Value at Assumed Rates
of Stock Price
Appreciation for Option
Individual Grants Term(1)
----------------------- ------------------------
% of Total
Options Exercise
Granted to or Base
Options Employees in Price
Name Granted Fiscal Year ($/Sh) Expiration Date 5%($) 10%($)
---- ------- ----------- ------ --------------- ----- ------
Jonnie R. Williams None 0% -- -- -- --
Paul L. Perito None 0% -- -- -- --
David M. Dean None 0% -- -- -- --
Sheldon L. Bogaz None 0% -- -- -- --
Christopher G. Miller 250,000 34.7% $1.8125 3/15/11 407,250 648,500
Robert E. Pokusa 50,000 6.9% $1.4688 3/30/11 81,450 129,700
(1) The dollar amounts under these columns are the result of calculations at
the 5% and 10% rates set by the Securities and Exchange Commission and
therefore are not intended to forecast possible future appreciation, if
any, of the stock price of the Company. If the Company's stock price were
in fact to appreciate at the assumed 5% or 10% annual rate for the
ten-year term of these options, a $1,000 investment in the Common Stock of
the Company would be worth $1,629 and $2,594, respectively, at the end of
the term.
41
Aggregated Option Exercises in 2001 and Year-End Option Values
The following table sets forth, for the Named Executive Officers, certain
information concerning options exercised during fiscal 2001 and the number of
shares subject to both exercisable and unexercisable stock options as of
December 31, 2001. The values for "in-the-money" options are calculated by
determining the difference between the fair market value of the securities
underlying the options as of December 31, 2001 ($2.53 per share) and the
exercise price of the officer's options. The Company has never issued stock
appreciation rights.
[Enlarge/Download Table]
Number of Securities
Underlying Unexercised Value of Unexercised
Number of Options at In-The-Money Options at
Shares December 31, 2001 December 31, 2001($)
Acquired on Value ----------------- --------------------
Name Exercise(#) Realized($) Exercisable Unexercisable Exercisable Unexercisable
---- ----------- ----------- ----------- ------------- ----------- -------------
Jonnie R. Williams -- -- -- -- -- --
Paul L. Perito -- -- 1,000,000 -- $ 842,500 --
David M. Dean -- -- 350,000 -- -- --
Sheldon Bogaz -- -- 250,000 -- -- --
Christopher Miller -- -- 288,000 75,000 $ 269,750 $ 67,438
Robert E. Pokusa -- -- 25,000 25,000 $ 26,530 $ 26,530
The Company does not have a defined benefit plan or actuarial pension
plan. During 2001, the Company did not have a "long-term incentive plan", and
the Company did not make any "long-term incentive awards", as such terms are
defined in Item 402 of Regulation S-K. During 2001, no stock options were
exercised by any optionee.
Board of Directors Compensation
Each independent director of the Company, as classified as such by the
Board of Directors ("Independent Directors"), is granted a stock option to
purchase up to 50,000 shares of Common Stock on the date such Independent
Director is first elected to the Board of Directors, exercisable over a
three-year period, in equal installments on each of the first three
anniversaries of the date of grant. As an annual retainer, each Independent
Director additionally receives a stock option to purchase up to 25,000 shares of
Common Stock granted on each anniversary of such Independent Director's initial
election to the Board of Directors, exercisable immediately. Each stock option
granted to an Independent Director under the Company's 2000 Equity Incentive
Plan will be exercisable at a price equal to the fair market value of the Common
Stock on the date of grant (as determined in accordance with the Plan).
Each Independent Director also receives a payment of $2,500 for his
participation in each meeting of the Board of Directors and any committee
meeting attended personally and $1,500 for his participation in each meeting of
the Board of Directors and any committee meeting attended telephonically,
subject to a cap of $4,000 for multiple in-person meetings on the same day and
$2,500 for multiple telephonic meetings on the same day.
Messrs. Bartels, Jones, Kelley, Leader, McSweeney and Tonkin currently are
designated as Independent Directors. This designation is intended solely for the
purpose of clarifying which directors are entitled to compensation for their
services as directors. Directors not designated as Independent Directors
generally are those who in the past have been, or currently are being,
compensated by the Company for other services rendered, or who have waived their
right to receive director compensation. Directors who are employees receive
compensation in their capacity as Company employees but do not receive any
compensation for board or committee meetings, nor do they receive the "Options
Package" made available to individuals serving as Independent Directors.
Employment Agreements
42
During April 1999, the Company entered into an employment agreement with
Mr. Perito which expires June 15, 2002. In addition to a $1,000,000 base salary,
the agreement, as amended, provides for annual performance bonuses as approved
by the Compensation Committee. The agreement with Mr. Perito also granted him
the right to purchase 2,000,000 shares of the Company's common stock at $1 per
share, and the Company agreed to finance the purchase with a loan bearing
interest at 7% (due annually) with all principal due in July 2005. The stock
purchase occurred in 1999, and the related $2,000,000 note receivable is
presented as a reduction of stockholders' equity in the 2001, 2000 and 1999
balance sheets. Since the note is non-recourse with respect to accrued unpaid
interest and 85% of the principal, this stock purchase right has been accounted
for as an option. The Company has recognized interest income of approximately
$140,000, $134,000 and $90,000 during 2001, 2000 and 1999, respectively, in
connection with the note. In connection with the aforementioned agreement, Mr.
Perito was also granted qualified stock options to purchase 1,000,000 share of
stock at $111/16 per share, the price of the Company's common stock on the date
of grant. Such options vested immediately.
Upon termination by the Company of Mr. Perito's employment without Cause
or by Mr. Perito for Good Reason (as defined in the employment agreement), the
Company will be obligated to pay to Mr. Perito all salary, benefits, bonuses and
other compensation that would be due under the employment agreement through the
end of the term of the employment agreement. Upon termination of Mr. Perito's
employment as a result of his death or disability, the Company will be obligated
to pay to Mr. Perito all salary, benefits, bonuses and other compensation that
would be due under the employment agreement for a period of one year from the
date of such termination. In connection with certain transactions that may
result in a change in voting control of the Company (each, a "Disposition
Transaction") or certain changes in the Company's senior management, Mr. Perito
will be entitled to terminate the employment agreement, to a one-time
termination payment of $2,500,000 and to participate in the Disposition
Transaction upon the same terms and conditions as certain principal stockholders
of the Company. The Company also will be obligated to reimburse Mr. Perito for
any taxes which may become due as a result of the application of Section 280G of
the Code to the payment described in the preceding sentence.
On October 6, 2000, the Company entered into an employment agreement with
David Dean, as the Vice President of Sales and Marketing, which expired on
December 31, 2001. In addition to a $250,000 base salary, the agreement provided
for a commission on the sale of cigarettes made by the Company up to a maximum
of $250,000 per year during 2000 and 2001. The agreement with Mr. Dean also
granted him the right to purchase 350,000 shares of the Company's common stock
at $4.00 per share, of which 175,000 options vested as of the date of the
employment agreement, and the remaining balance of 175,000 options, vested in
equal monthly increments over the twelve-month period following execution of the
employment agreement. Upon termination by the Company of Mr. Dean's employment
without Cause or by Mr. Dean for Good Reason (as defined in the employment
agreement), the agreement provided that the Company would be obligated to pay to
Mr. Dean all salary and commissions that would be due under the employment
agreement through the end of the term of the employment agreement. Under the
terms of Mr. Dean's employment agreement, termination for Good Reason included,
but was not limited to, certain transactions resulting in a change in voting
control of the Company or a disposition of a majority of the Company's income
producing assets. Furthermore, in the event Mr. Dean did not accept the position
of president and chief operating officer of ST in the event of a sale of ST, Mr.
Dean could terminate his employment for Good Reason. The Company is currently
negotiating a new form of employment agreement with David Dean as the Vice
President of Sales and Marketing.
On September 15, 2000, the Company entered into an employment agreement
with Christopher G. Miller, the Chief Financial Officer, which was to expire on
September 15, 2002, with certain renewal options. In addition to a $120,000 base
salary, the agreement provided for annual performance bonuses as approved by the
Compensation Committee. The agreement with Mr. Miller also granted him the right
to purchase 50,000 shares of the Company's common stock at $4.00 per share, of
which 25,000 shares vested on September 15, 2001 and 25,000 shares vest on
September 15, 2002. As of March 15, 2001, the Company entered into an Amended
and Restated Employment Agreement with Mr. Miller, which expires on March 15,
2003, with certain renewal options. In addition to a base salary of $225,000,
the agreement provides for discretionary performance bonuses as approved by the
Compensation Committee. This amended and restated agreement supercedes the
September 15, 2000 employment agreement, except as to the option granted to Mr.
Miller under that agreement. The amended and restated agreement with Mr. Miller
also grants him the right to purchase 250,000 shares of the Company's common
stock at $1.844 per share, of which 100,000 options vest immediately, 100,000
vest on March 15, 2002, and 50,000 vest on September 15, 2002. Upon termination
by the Company of Mr. Miller's employment without Cause, the Company will be
obligated to
43
pay to Mr. Miller severance payments equal to six months salary, paid on a
monthly basis. Furthermore, if there is a change of control of the Company (as
defined in the employment agreement), and Mr. Miller's agreement does not
continue in effect after such a change in control, the Company will, within 60
days of notifying Mr. Miller of such termination, pay to Mr. Miller (a) a lump
sum payment equal to all salary then due and payable and (b) severance payments
equal to six months salary, paid on a monthly basis.
On March 30, 2001, the Company entered into an employment agreement with
Robert E. Pokusa, the General Counsel, which is to expire on March 30, 2003. The
agreement provides for a base salary of $385,000 and for discretionary annual
bonuses as approved by the Company's Chief Operating Officer and the Chief
Executive Officer. The agreement also grants Mr. Pokusa the right to purchase
50,000 shares of the Company's common stock at $1.4688 per share of which 25,000
shares vested on March 30, 2001 and 25,000 vest on March 30, 2002. Upon
termination by the Company of Mr. Pokusa's employment agreement without cause,
the Company will be obligated to pay to Mr. Pokusa severance payments equal to
six months salary, paid on a monthly basis. Furthermore, if there is a change in
control of the Company (as defined in the employment agreement), and Mr.
Pokusa's agreement does not continue in effect after such change of control, the
Company will, within 60 days of notifying Mr. Pokusa of such termination, pay to
Mr. Pokusa (a) a lump sum payment equal to all salary then due and payable and
(b) severance payments equal to six months salary, paid on a monthly basis.
Messrs. Williams and Bogaz do not have employment agreements with the
Company. The Company anticipates entering into employment agreements with
Messrs. Williams and Bogaz in the near future.
Compensation Committee Interlocks and Insider Participation
None.
44
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth as of March 1, 2002 certain information
with respect to the beneficial ownership of the Company's Common Stock by each
beneficial owner of more than 5% of the Company's voting securities, each
director and each named executive officer, and all directors and executive
officers of the Company as a group, except as qualified by the information set
forth in the notes to this table. As of March 1, 2002, there were 59,741,460
shares of the Company's Common Stock outstanding.
[Enlarge/Download Table]
Shares
Beneficially Percentage
Name Owned(1) Owned(2)
---- -------- --------
Kathleen M. O'Donnell as Trustee for Irrevocable Trust #1 FBO(3) ....................... 17,309,576 29.0%
Francis E. O'Donnell, Jr., M.D. and the Francis E. O'Donnell, Jr. Descendants' Trust
709 The Hamptons Lane
Chesterfield, MO 63017
Jonnie R. Williams(4) .................................................................. 16,524,819 27.7%
Prometheus Pacific Growth Fund entities ................................................ 5,202,640 8.7%
P.O. Box 1062
George Town, Grand Cayman, B.W.I.(5)
Francis E. O'Donnell, Jr., M.D.(6) ..................................................... 3,368,362 5.6%
709 The Hamptons Lane
Chesterfield, MO 63017
Paul L. Perito(7) ...................................................................... 3,049,000 5.0%
7475 Wisconsin Ave, Suite 850
Bethesda, MD 20814
Robert DeLorenzo, M.D., Ph.D., M.P.H.(8) ............................................... 1,521,000 2.5%
David M. Dean(9) ....................................................................... 455,300 *
Christopher G. Miller(10) .............................................................. 378,000 *
Sheldon L. Bogaz(11) ................................................................... 211,100 *
Robert E. Pokusa(12) ................................................................... 120,000 *
7475 Wisconsin Ave, Suite 850
Bethesda, MD 20814
Leo S. Tonkin(13) ...................................................................... 100,000 *
45
[Enlarge/Download Table]
Whitmore B. Kelley(14) ................................................................. 63,000 *
Martin R. Leader(15) ................................................................... 60,200 *
Patrick M. McSweeney(16) ............................................................... 9,950 *
John R. Bartels, Jr .................................................................... 8,500 *
Lloyd A. Jones ......................................................................... 0 *
All Directors, Executive Officers and Officers (15 Persons) ............................ 22,525,869 35.9%
(1) Beneficial ownership is determined in accordance with rules of the
Securities and Exchange Commission and includes shares over which the
indicated beneficial owner exercises voting and/or investment power.
Shares of Common Stock subject to options currently exercisable or
exercisable within 60 days, by April 30, 2002, are deemed outstanding for
purposes of computing the percentage ownership of the person holding such
securities, but not deemed outstanding for purposes of computing the
percentage ownership of any other person. Except as indicated, and subject
to community property laws where applicable, the persons named in the
table above have sole voting and investment power with respect to all
shares of voting stock shown as beneficially owned by them. Unless
otherwise noted, the address for each of the above persons is c/o Star
Scientific, Inc. 801 Liberty Way, Chester, Virginia 23836.
(2) The "Percentage Owned" calculations are based on the outstanding shares of
Common Stock as of March 1, 2002.
(3) Includes 15,041,214 shares owned by a trust for the benefit of Francis E.
O'Donnell, Jr., M.D., over which Kathleen O'Donnell, as trustee, has sole
voting and investment power and 2,268,362 shares owned by a trust for the
benefit of Dr. O'Donnell's children over which Mrs. O'Donnell, as trustee,
has sole voting and investment power. Excludes 400,000 shares owned by
Hopkins Capital Group II, LLC, 200,000 shares owned by Hopkins Capital
Group III, LLC and 200,000 shares owned by Hopkins Capital Group IV, LLC,
each of which is a wholly-owned affiliate of Irrevocable Trust #1.
(4) Includes 15,424,819 shares held by Mr. Williams. Also includes 1,100,000
shares held by Regent Court of which Mr. Williams is deemed to have
beneficial ownership by virtue of his ownership interest in Regent Court
and over which he shares voting and investment power with Dr. O'Donnell.
(5) Includes 2,700,000 shares held by Prometheus Pacific Growth Fund LDC and
2,502,640 shares held by Prometheus Pacific Growth Fund, Inc.
(6) Includes 2,268,362 shares owned by a trust for the benefit of Mr.
Williams' children, over which Dr. O'Donnell has sole voting and
investment power. Also includes 1,100,000 shares held by Regent Court of
which Dr. O'Donnell is deemed to have beneficial ownership by virtue of
his ownership interest in Regent Court and over which he shares voting and
investment power with Mr. Williams.
(7) Includes 2,000,000 shares held by Mr. Perito, 1,000,000 shares which Mr.
Perito has the right to acquire upon exercise of stock options which are
presently exercisable and an aggregate of 49,000 shares held by his
children or in trust for the benefit of his children, of which Mr. Perito
disclaims beneficial ownership.
46
(8) Includes 300,000 shares held by Dr. DeLorenzo's children. Dr. DeLorenzo
disclaims beneficial ownership of shares held by his children. Includes
1,000,000 shares which Dr. DeLorenzo has the right to acquire upon
exercise of stock options which are presently exercisable.
(9) Includes 350,000 shares which Mr. Dean has the right to acquire upon
exercise of stock options which are presently exercisable and 1,100 shares
owned by Mr. Dean's spouse.
(10) Includes 288,000 shares which Mr. Miller has the right to acquire upon
exercise of stock options which are presently exercisable.
(11) Includes 150,000 shares which Mr. Bogaz has the right to acquire upon
exercise of stock options which are presently exercisable.
(12) Includes 50,000 shares which Mr. Pokusa has the right to acquire upon
exercise of stock options which are presently exercisable
(13) Includes 100,000 shares which Mr. Tonkin has the right to acquire upon
exercise of stock options which are presently exercisable.
(14) Includes 63,000 shares which Mr. Kelley has the right to acquire upon
exercise of stock options which are exercisable presently or within 60
days.
(15) Includes 50,000 shares which Mr. Leader has the right to acquire upon
exercise of stock options which are presently exercisable.
(16) Includes 5,000 shares which are held by the McSweeney Burtch & Crump
Profit Sharing Trust and 550 shares which are held jointly by Mr.
McSweeney's wife and son.
Item 13. Certain Relationships and Related Transactions
Mr. Williams and Dr. O'Donnell jointly own an airplane. The Company has
utilized the airplane for business travel throughout the United States and to
Mexico to client, vendor and scientific or technical consultant locations that
are not near or easily accessible to airports with regularly scheduled or
frequent commercial airline services. Payments made by the Company to Dr.
O'Donnell and Mr. Williams with respect to aircraft expenses were $258,992 in
2001, $191,680 in 2000, $290,020 in 1999 and were billed at cost.
On December 31, 1999, Mr. Williams signed a promissory note for $1,087,806
in connection with a loan by the Company to Mr. Williams in the same amount. The
promissory note was repayable on December 31, 2000 and bore interest at 5.66%.
Mr. Williams repaid this note via compensation reduction. On December 31, 2000,
Mr. Williams signed a promissory note for $800,000 in connection with a loan by
the Company to Mr. Williams in the same amount. The promissory note initially
was repayable on December 31, 2001 and the Company and Mr. Williams extended
this loan for another year. The promissory note is currently repayable on
December 31, 2002 and bears interest at the minimum applicable federal rate.
In 2001, 2000 and 1999, the Company paid $1,099,559, $1,946,159 and
$940,000, respectively, to PHJ&W with respect to various services and legal
matters relating to a broad variety of professional issues connected with the
Company's business. Mr. Perito was a partner of such firm until June 1999 and
senior counsel to the firm until he resigned from the position of senior counsel
on March 31, 2001. Mr. Perito received no income from PHJ&W based on any work it
performed for the Company. Mr. Pokusa was also of counsel to Paul, Hastings
until March 30, 2001.
In 1999, 2000, and 2001, the Company paid $26,193, $288,198 and $372,493
to McSweeney & Crump, P.C. (formerly McSweeney, Burtch & Crump) with respect to
various legal services connected with the Company's business. Mr. McSweeney has
been and continues to be a named partner in this firm. In addition to payments
to the
47
firm, Mr. McSweeney was paid $82,500 and $37,500 as a consultant to the Company
during 2000 and 2001, respectively. Mr. McSweeney was subsequently elected to
the Board of Directors in January 2002.
In 2000, the Company paid $20,000 to John R. Bartels, Jr. as a consultant
in connection with issues relating to the tobacco Master Settlement Agreement,
among other matters. Mr. Bartels was subsequently elected to the Board of
Directors in January 2002.
In 2000 and 2001, the Company paid $10,500 and $25,000, respectively, to
Dr. DeLorenzo as a consultant in connection with issues relating to Star's
pending patent applications.
Mr. Lloyd A. Jones was elected to the Board of Directors in November 2001.
Beginning in January 2002, the Company retained Mr. Jones as a consultant in
connection with the Company's expansion of its Chase City facility and its
interaction with the Virginia Economic Development Authority. Mr. Jones has been
paid on a month-to-month basis for these services at a rate of $3,000 per month.
Until December 31, 2001, the Company employed Chayet Communications Inc.,
a company owned by Neil Chayet, a former director of the Company, for
communications and legal consulting. Services rendered by Chayet Communications
included communications, consulting with the public health and legal sectors on
matters relating to the labeling of new products and the development of enhanced
health warning and comparative content disclosure. In this capacity, Chayet
Communications received $96,000 during both 2000 and 2001. In 1999, Mr. Chayet
received options to purchase 15,000 shares at an exercise price of $5.70 per
share, and in 2001, he received options to purchase 22,500 shares at an exercise
price of $2.51 per share. These options are fully vested.
In 2000, the Company paid Mark W. Johnson, a director of the Company until
July 2001, $100,000 for consulting services performed up until June 30, 2000.
Such services rendered by Mr. Johnson included the development of a strategic
plan for the Company and recommendations to implement such plan. In 1999, Mr.
Johnson received options to purchase 43,000 shares of Common Stock at an
exercise price of $3.375 in exchange for consulting services. Mr. Johnson did
not receive any compensation during 2001.
In 2000, the Company paid Christopher G. Miller, a director of the
Company, $31,500 for consulting services performed from April 6, 2000 until
September 15, 2000 during the time that he was serving as the Acting Chief
Financial Officer. Mr. Miller also received options to purchase 25,000 shares of
Common Stock at an exercise price of $4.125 as part of compensation for these
services. On September 15, 2000, Mr. Miller signed an Employment Agreement with
the Company, and on March 15, 2001, signed an Amended and Restated Employment
Agreement (See Employment Agreements). In 1999, Mr. Miller received $6,667 and
options to purchase 38,000 shares of Common Stock at an exercise price of $3.375
in exchange for consulting services.
In 1999, Whitmore B. Kelley, a director of the Company since April 2001,
received $6,667 and options to purchase 38,000 shares of Common Stock at an
exercise price of $3.375 in exchange for consulting services. Mr. Kelley did not
receive any compensation during 2000 or 2001.
In August 2001, the Company made loans to Messrs. Bogaz, Dean, Miller and
Pokusa in the amount of $100,000, $180,000, $180,000 and $140,000 respectively,
for the purpose of their purchasing shares of the Company's common stock from an
affiliated entity (Irrevocable Trust #1 FBO Francis E. O'Donnell, Jr., M.D.).
Full Recourse Promissory Notes were executed by each of these officers. The
promissory notes have a term of four years with interest payments payable
annually at a rate of prime plus 1%.
48
Item 14. Exhibits and Reports on Form 8-K
1. Exhibits
Number Description
------ -----------
2.01 Asset Purchase Agreement between Star Scientific, Inc., a Delaware
Corporation and Eyetech, LLC, a Minnesota Limited Liability Company,
by Robert J. Fitzsimmons, an individual residing in St. Paul,
Minnesota, dated December 30, 1998(1)
2.02 Escrow Agreement between Star Scientific, Inc., a Delaware
Corporation, Eyetech, LLC, a Minnesota Limited Liability Company and
Robert J. Fitzsimmons, an individual residing in St. Paul,
Minnesota, and Jonnie R. Williams and Vincent Ellis as Escrow
Agents, dated February 16, 1999, and effective December 30, 1998(1)
3.01 Restated Certificate of Incorporation(2)
3.05 Bylaws of the Company as Amended to Date(2)
10.1 Stock Exchange Agreement between the Company and the stockholders of
Star Tobacco & Pharmaceuticals, Inc., dated February 6, 1998(5)
10.2 License Agreement between Star Tobacco & Pharmaceuticals, Inc., as
Licensee and Regent Court Technologies, Jonnie R. Williams, and
Francis E. O'Donnell, Jr., M.D., as Licensor, dated January 5,
1998(6)
10.3 Purchase and Sale Agreement between Prometheus Pacific Growth Fund
LDC, a Cayman Island Limited Duration Company, and Eye Technology,
Inc., a Delaware Corporation, dated July 10, 1998(8)
10.4 Amendment No. 1 to License Agreement between Regent Court
Technologies, Jonnie R. Williams, Francis E. O'Donnell, J.R., M.D.
and Star Tobacco & Pharmaceuticals, Inc., dated August 3, 1998(9)
10.5 1998 Stock Option Plan, as amended(10)
10.6 2000 Equity Incentive Plan(17)
10.7 Executive Employment Agreement dated as of April 27, 1999 entered
into by the Company, Jonnie R. Williams and Paul L. Perito(11)
10.8 Qualified Stock Option Agreement dated as of April 27, 1999 between
the Company and Paul L. Perito(12)
10.9 Amended and Restated Manufacture and License Agreement between the
Company and Powell Manufacturing Company, Inc., dated October 12,
1999(13)
10.10 Agreement between the Company and Brown & Williamson Tobacco
Corporation, dated October 12, 1999(13)
10.11 Loan Agreement between the Company and Brown & Williamson Tobacco
Corporation, dated October 12, 1999(13)
10.12 Security Agreement between the Company and Brown & Williamson
Tobacco Corporation, dated December 16, 1999(13)
10.13 Supply Agreement between Star Tobacco & Pharmaceuticals, Inc. and
Brown & Williamson Tobacco
49
Corporation, dated January 1, 2000(13)
10.14 Cigarette Manufacturing Agreement between Star Tobacco &
Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation,
dated January 1, 2000(13)
10.15 Loan and Security Agreement between Star Tobacco & Pharmaceuticals,
Inc. and Finova Capital Corporation, dated January 20, 2000(13)
10.16 Lease and Purchase Option Contract between the Company and the
Industrial Development Authority of the Town of Chase City,
Virginia, dated March 10, 2000(13)
10.17 Form of Director Indemnification Agreement(10)
10.18 Form of Officer Indemnification Agreement(10)
10.19 First Amendment to Loan and Security Agreement between Star Tobacco
& Pharmaceuticals, Inc. and Finova Capital Corporation, Business
Credit, dated April 12, 2000(10)
10.20 Modification Agreement among the Company, Jonnie R. Williams and
Paul L. Perito, dated December 1, 1999(10)
10.21 Second Modification Agreement among the Company, Jonnie R. Williams
and Paul L. Perito, dated October 6, 2000(17)
10.22 Executive Employment Agreement between the Company and David Dean,
dated October 6, 2000(17)
10.23 Restated Loan Agreement between the Company, Star Tobacco &
Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation,
dated August 21, 2000(14)
10.24 Restated Security Agreement between the Company and Brown &
Williamson Tobacco Corporation, dated August 21, 2000(14)
10.25 Security Agreement between Star Tobacco & Pharmaceuticals, Inc. and
Brown & Williamson Tobacco Corporation, dated August 21, 2000(14)
10.26 Guaranty Agreement between the Company and Brown & Williamson
Tobacco Corporation, dated August 21, 2000(14)
10.27 Guarantee Agreement between Star Tobacco & Pharmaceuticals, Inc. and
Brown & Williamson Tobacco Corporation, dated August 21, 2000(14)
10.28 Executive Employment Agreement dated as of September 15, 2000
between the Company and Christopher G. Miller(14)
10.29 Amended and Restated Executive Employment Agreement dated as of
March 15, 2001 between the Company and Christopher G. Miller(17)
10.30 Executive Employment Agreement dated as of March 30, 2001 between
the Company and Robert E. Pokusa(17)
10.31 Restated Master Agreement, dated April 25, 2001, by and between Star
Scientific, Inc. and Brown & Williamson Tobacco Corporation (18)
10.32 First Amendment to Restated Loan Agreement dated April 25, 2001,
among Star Scientific, Inc., Star Tobacco & Pharmaceuticals, Inc.
and Brown & Williamson Tobacco Corporation (16)
50
10.33 Hard Tobacco Agreement, dated April 25, 2001, between Brown &
Williamson Tobacco Corporation and Star Scientific, Inc. (16)
10.34 Trademark License and Royalty Agreement, dated April 25, 2001,
between Star Scientific, Inc. and Brown & Williamson Tobacco
Corporation (16)
10.35 Other Low TSNA Tobacco Royalty Agreement, dated April 25, 2001 by
and between Star Scientific, Inc. and Brown & Williamson Tobacco
Corporation (16)
10.36 First Amendment to Regent/B&W License Agreement, dated April 25,
2001, by and among Regent Court Technologies, Jonnie R. Williams,
Francis O'Donnell, Jr., Star Scientific, Inc. and Brown & Williamson
Tobacco Corporation (16)
10.37 Chase City License and Services Agreement, dated April 25, 2001,
between Star Scientific, Inc. and Brown & Williamson Tobacco
Corporation (16)
10.38 Exclusive License Agreement dated as of March 16, 2001 by and among
Regent Court Technologies and Star Scientific, Inc.(2)
10.39 Sublicense Agreement dated as of March 16, 2001 by and among Star
Scientific, Inc. and Star Tobacco & Pharmaceuticals, Inc.(2)
10.40 Consent to Assignment dated March 16, 2001 by and among Regent Court
Technologies, Jonnie R. Williams, Francis O'Donnell, Jr., Star
Tobacco & Pharmaceuticals, Inc., and Star Scientific, Inc.(2)
10.41 Amendment No. 1 dated April 5, 2001 to Exclusive License Agreement
by and among Regent Court Technologies and Star Scientific, Inc.(2)
10.42 Promissory Note dated August 20, 2001 of Christopher G. Miller(2)
10.43 Promissory Note dated August 20, 2001 of Robert E. Pokusa(2)
10.44 Promissory Note dated August 20, 2001 of Sheldon L. Bogaz(2)
10.45 Promissory Note dated August 20, 2001 of David M. Dean(2)
10.46 Promissory Note dated December 31, 2000 of Jonnie R. Williams
10.47 Amendment to Promissory Note dated December 31, 2000 of Jonnie R.
Williams
10.48 Master Lease Agreement Dated as of June 29, 2001 between General
Electric Capital Corporation and Star Scientific, Inc.
10.49 Master Lease Agreement Dated as of September 28, 2001 between Heller
Financial Leasing, Inc. and Star Scientific, Inc. and Star Tobacco,
Inc.
10.50 Master Lease Agreement Dated as of July 1, 2001 between General
Electric Capital Corporation and Star Scientific, Inc.
21 Subsidiaries of the Company(15)
24 Powers of Attorney (included on signature page)
(1) Incorporated by reference to the Company's Current Report on Form
8-K dated March 2, 1999
51
(2) Incorporated by reference to the Company's Quarterly Report on Form
10-Q for the quarter ended September 30, 2001
(3) Incorporated by reference to the Company's Annual Report on Form
10-KSA for the year ended December 31, 1996
(4) Incorporated by reference to the Company's Current Report on Form
8-K dated January 15, 1999
(5) Incorporated by reference to the Company's Current Report on Form
8-K dated February 19, 1998
(6) Incorporated by reference to the Company's Quarterly Report on Form
10-QSB for the quarter ended March 31, 1998
(7) Incorporated by reference to the Company's Quarterly Report on Form
10-QSB for the quarter ended September 30, 1998
(8) Incorporated by reference to the Company's Current Report on Form
8-K dated July 15, 1998
(9) Incorporated by reference to the Company's Current Report on Form
8-K dated September 11, 1998
(10) Incorporated by reference to the Company's Annual Report on Form
10-K for the year ended December 31, 1999
(11) Incorporated by reference to the Company's Quarterly Report on Form
10-QSB for the quarter ended June 30, 1999
(12) Incorporated by reference to the Company's Quarterly Report on Form
10-QSB for the quarter ended September 30, 1999
(13) Incorporated by reference to the Company's Registration Statement on
Form S-1/A dated May 8, 2000
(14) Incorporated by reference to the Company's Quarterly Report on Form
10-Q for the quarter ended September 30, 2000
(15) Incorporated by reference to the Company's Annual Report on Form
10-KSB for the year ended December 31, 1998
(16) Incorporated by reference from the Company's Current Report on Form
8-K/A dated November 29, 2001
(17) Incorporated by reference to the Company's Annual Report on Form
10-K for the year ended December 31, 2000
(18) Incorporated by reference to the Company's Current Report on Form
8-K filed May 17, 2001
2. Reports on Form 8-K
The Company filed a Current Report on Amended Form 8-K/A on November 29,
2001, describing the Company's contractual and financing arrangements with B&W
dated April 25, 2001.
52
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized in Virginia on the 29th
day of March, 2002.
STAR SCIENTIFIC, INC.
By: /s/ JONNIE R. WILLIAMS
Jonnie R. Williams
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Jonnie R. Williams and Paul L. Perito, or either
of them, his attorney-in-fact, each with the power of substitution, for him in
any and all capacities, to sign any amendments to this report, and to file the
same, with exhibits thereto and other documents in connection therewith, with
the Securities and Exchange Commission, hereby ratifying and confirming all that
each of said attorneys-in-fact, or his substitute or substitutes, may do or
cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons in the capacities indicated.
Signature Title Date
--------- ----- ----
/s/ JONNIE R. WILLIAMS Chief Executive Officer and March 29, 2002
-------------------------- Director
Jonnie R. Williams (Principal Executive Officer)
/s/ PAUL L. PERITO Chairman of the Board, March 29, 2002
-------------------------- President and Chief
Paul L. Perito Operating Officer
/s/ CHRISTOPHER G. MILLER Chief Financial Officer and March 29, 2002
-------------------------- Director
Christopher G. Miller (Principal Financial and
Accounting Officer)
/s/ JOHN R. BARTELS, JR. Director March 29, 2002
--------------------------
John R. Bartels, Jr.
/s/ ROBERT J. DELORENZO Director March 29, 2002
--------------------------
Robert J. DeLorenzo
53
/s/ LLOYD A. JONES Director March 29, 2002
--------------------------
Lloyd A. Jones
/s/ WHITMORE B. KELLEY Director March 29, 2002
--------------------------
Whitmore B. Kelley
/s/ MARTIN S. LEADER Director March 29, 2002
--------------------------
Martin R. Leader
/s/ PATRICK M. McSWEENEY Director March 29, 2002
--------------------------
Patrick M. McSweeney
/s/ LEO S. TONKIN Director March 29, 2002
--------------------------
Leo S. Tonkin
54
STAR SCIENTIFIC, INC. AND
SUBSIDIARY
DECEMBER 31, 2001 AND 2000
FINANCIAL STATEMENTS
Independent Auditors' Report
To the Board of Directors and Stockholders of
Star Scientific, Inc. and Subsidiary
Chester, Virginia
We have audited the accompanying consolidated balance sheets of Star Scientific,
Inc. and Subsidiary as of December 31, 2001 and 2000 and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 2001. Our audit also
included the financial statement schedule included on page F-39. These financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As discussed in Note 14, the Company elected not to join in the Master
Settlement Agreement ("MSA") among forty-six states, several U.S. territories
and a number of tobacco manufacturers, as a Subsequent Participating
Manufacturer. As a result thereof, the Company is purportedly required to
annually contribute funds into escrow under statutes which the MSA required
participating states to pass if they were to receive the full benefits of the
settlement. Such escrowed funds will be available to pay judgments in
tobacco-related litigation, if any, filed by the states and, if not used,
returned to the Company in twenty-five years. The Company's 2002 escrow
obligation is currently estimated to be approximately $4,200,000 which must be
funded by April 15, 2002. As further discussed in Note 14, management expects
that, based on prior experience, there may be additional escrow deposits
required in 2002 related to the Company's cigarette sales for 1999 through 2001.
However, the amount of such additional escrow requirements is not presently
determinable.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Star
Scientific, Inc. and Subsidiary as of December 31, 2001 and 2000 and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2001 in conformity with accounting
principles generally accepted in the United States of America. Also, in our
opinion, the related financial statement schedule, when considered in relation
to the basic consolidated financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.
/s/ AIDMAN, PISER & COMPANY, P.A.
February 22, 2002
Tampa, Florida
STAR SCIENTIFIC, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2001 AND 2000
ASSETS
2001 2000
------------ ------------
Current assets:
Cash and cash equivalents $ 3,084,612 $ 16,746,599
Accounts receivable, trade 3,188,412 5,472,503
Inventories 12,004,078 5,945,157
Prepaid expenses and other current
assets 371,715 443,565
Deferred tax asset 50,000 320,000
Refundable income taxes 2,264,516 --
------------ ------------
Total current assets 20,963,333 28,927,824
Property, plant and equipment, net 21,577,386 27,400,960
Idle equipment 2,071,800 --
Intangibles, net of accumulated
amortization, (2001, $331,806;
2000, $236,017) 985,585 709,969
Other assets 1,599,422 125,381
MSA Escrow funds 28,444,280 11,605,155
Deposits on property and equipment 3,697,214 697,947
------------ ------------
$ 79,339,020 $ 69,467,236
LIABILITIES AND STOCKHOLDERS' EQUITY
2001 2000
------------ ------------
Current liabilities:
Notes payable $ -- $ 15,950,000
Current maturities of long-term debt 775,210 111,176
Current maturities of capital lease
obligations 3,029,567 --
Accounts payable, trade 11,898,944 3,180,976
Federal excise taxes payable 1,841,637 6,481,351
Accrued expenses 1,888,789 2,593,396
Income taxes payable -- 1,702,000
------------ ------------
Total current liabilities 19,434,147 30,018,899
Deferred tax liability 1,105,000 900,000
Long-term debt, less current maturities 22,969,780 13,272,332
Capital lease obligations, less current
maturities 6,847,823 --
Deferred gains on sale leasebacks 457,867 --
------------ ------------
Total liabilities 50,814,617 44,191,231
------------ ------------
Commitments and contingencies -- --
Stockholders' equity:
Common stock/A/ 5,974 597,414
Preferred stock/B/ -- --
Additional paid-in capital 14,665,456 13,250,166
Retained earnings 17,252,973 14,228,425
Notes receivable, officers (3,400,000) (2,800,000)
------------ ------------
Total stockholders' equity 28,524,403 25,276,005
------------ ------------
$ 79,339,020 $ 69,467,236
/A/ ($.0001 par value in 2001, $.01 par value in 2000, 100,000,000 shares
authorized, 59,741,460 shares issued and outstanding in 2001 and 2000.)
/B/ (Class A, convertible, $.01 par value, 4,000 shares authorized, no shares
issued and outstanding; Series B, convertible; $.01 par value 15,000 shares
authorized, no shares issued and outstanding)
See notes to consolidated financial statements.
F2
STAR SCIENTIFIC, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2001, 2000, AND 1999
[Enlarge/Download Table]
2001 2000 1999
------------- ------------- ------------
Net sales $ 174,783,423 $ 223,051,180 $ 99,324,789
Less:
Cost of goods sold 79,548,480 93,951,534 31,878,879
Excise taxes on products 58,822,304 83,591,686 33,821,112
------------- ------------- ------------
Gross profit 36,412,639 45,507,960 33,624,798
------------- ------------- ------------
Operating expenses:
Marketing and distribution 11,684,344 12,973,670 6,253,265
General and administrative 16,078,671 13,183,842 9,899,165
Research and development 4,085,804 1,702,310 535,782
------------- ------------- ------------
Total operating expenses 31,848,819 27,859,822 16,688,212
------------- ------------- ------------
Operating income 4,563,820 17,648,138 16,936,586
------------- ------------- ------------
Other income (expense):
Interest income 1,134,791 1,236,628 227,648
Interest expense (597,143) (1,828,247) (85,604)
Loss on disposal of assets (161,044) -- --
Other 68,124 -- --
------------- ------------- ------------
444,728 (591,619) 142,044
------------- ------------- ------------
Income before income taxes 5,008,548 17,056,519 17,078,630
Income tax expense 1,984,000 7,016,000 5,564,000
------------- ------------- ------------
Net income $ 3,024,548 $ 10,040,519 $ 11,514,630
Basic income per common share $ .05 $ .17 $ .32
Diluted income per share $ .05 $ .17 $ .23
Weighted average shares outstanding - basic 59,741,600 59,008,127 36,207,390
Weighted average shares outstanding - diluted 60,392,426 60,645,061 50,301,998
See notes to consolidated financial statements.
F3
STAR SCIENTIFIC, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31, 1999
[Enlarge/Download Table]
Preferred Stock
------------------ Retained
Series B Common Stock Additional Earnings
------------------ --------------------- Paid-In (Accumulated
Shares Amount Shares Amount Capital Deficit)
------- -------- ---------- -------- ----------- ------------
Balances, January 1, 1999 14,084 $ 143 9,819,740 $ 98,198 $ 6,668,392 ($ 7,326,724)
Conversion of preferred stock to
common (14,084) (143) 46,217,500 462,175 (462,032)
Amortization of unearned stock -
based compensation
Mandatory redeemable preferred
stock converted to common 20,000 200 43,800
Issuance of stock 2,000,000 20,000 1,980,000
Stock issued for services 39,000 390 97,405
Issuance of common stock to
charitable organizations 130,000 1,300 767,342
Stock-based compensation 536,278
Warrants exercised 522,960 5,229 1,040,691
Stock issuance costs associated with
warrants (40,000)
Advances to officer
Net income 11,514,630
------- -------- ---------- -------- ----------- ------------
Balances, December 31, 1999 -- $ -- 58,749,200 $587,492 $10,631,876 $ 4,187,906
======= ======== ========== ======== =========== ============
Unearned Notes
Compen- Receivable,
sation Officers Total
---------- ------------ ------------
Balances, January 1, 1999 ($ 79,167) $ -- ($ 639,158)
Conversion of preferred stock to
common --
Amortization of unearned stock -
based compensation 79,167 79,167
Mandatory redeemable preferred
stock converted to common 44,000
Issuance of stock (2,000,000) --
Stock issued for services 97,795
Issuance of common stock to
charitable organizations 768,642
Stock-based compensation 536,278
Warrants exercised 1,045,920
Stock issuance costs associated with
warrants (40,000)
Advances to officer
(1,087,806) (1,087,806)
Net income 11,514,630
---------- ------------ ------------
Balances, December 31, 1999 $ -- ($ 3,087,806) $ 12,319,468
========== ============ ============
See notes to consolidated financial statements.
F4
STAR SCIENTIFIC, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31, 2000
[Enlarge/Download Table]
Preferred Stock
---------------
Series B Common Stock Additional Notes
--------------- --------------------- Paid-In Retained Receivable,
Shares Amount Shares Amount Capital Earnings Officers Total
------ ------ ---------- -------- ----------- ----------- ----------- -----------
Balances, December 31, 1999,
carried forward $ -- 58,749,200 $587,492 $10,631,876 $ 4,187,906 ($3,087,806) $12,319,468
Collection of note receivable -- -- -- -- -- -- 287,806 287,806
Stock-based compensation -- -- -- -- 648,692 -- -- 648,692
Options exercised -- -- 24,820 248 44,392 -- -- 44,640
Warrants exercised 967,440 9,674 1,925,206 -- 1,934,880
Net income -- -- -- -- -- 10,040,519 -- 10,040,519
----- ------ ---------- -------- ----------- ----------- ----------- -----------
Balances, December 31, 2000 -- $ -- 59,741,460 $597,414 $13,250,166 $14,228,425 ($2,800,000) $25,276,005
===== ====== ========== ======== =========== =========== =========== ===========
See notes to consolidated financial statements.
F5
STAR SCIENTIFIC, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31, 2001
[Enlarge/Download Table]
Preferred Stock
---------------
Series B Common Stock Additional Notes
--------------- --------------------- Paid-In Retained Receivable,
Shares Amount Shares Amount Capital Earnings Officers Total
------ ------ ---------- --------- ----------- ----------- ----------- -----------
Balances, January 1, 2000, -- $ -- 59,741,460 $ 597,414 $13,250,166 $14,228,425 ($2,800,000) $25,276,005
carried forward
Change in par value -- -- -- (591,440) 591,440 -- -- --
Capital contribution -- -- -- -- 292,800 -- -- 292,800
Advances to officers -- -- -- -- -- -- (600,000) (600,000)
Stock-based compensation -- -- -- -- 531,050 -- -- 531,050
Net income -- -- -- -- -- 3,024,548 -- 3,024,548
------ ------ ---------- --------- ----------- ----------- ----------- -----------
Balances, December 31, 2001 -- $ -- 59,741,460 $ 5,974 $14,665,456 $17,252,973 ($3,400,000) $28,524,403
====== ====== ========== ========= =========== =========== =========== ===========
See notes to consolidated financial statements.
F6
STAR SCIENTIFIC, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
[Enlarge/Download Table]
2001 2000 1999
----------- ----------- ------------
Operating activities:
Net income $ 3,024,548 10,040,519 $ 11,514,630
Adjustments to reconcile net income
to net cash flows from operating activities:
Depreciation 2,913,388 2,211,143 745,205
Amortization of intangibles and other
non-cash charges 206,813 58,251 38,546
Deferred income taxes 475,000 2,966,000 (2,386,000)
Stock-based compensation expense 531,050 578,892 1,481,882
Marketing expense funded from capital
contribution 292,800 -- --
Repayment of debt funded through royalty
revenue (1,500,000) -- --
Increase (decrease) in cash resulting
from changes in:
Accounts receivable, trade 2,284,091 (1,872,538) (2,034,237)
Inventories (6,058,923) (2,374,548) (2,934,153)
Prepaid expenses and other current
assets 71,850 (104,775) (168,786)
Deposits on operating leases (1,268,559) -- --
Changes in other assets (139,942) -- --
Note receivable, officer charged to
compensation -- 287,806 --
Accounts payable 8,717,968 (311,669) 976,097
Federal excise taxes payable (4,639,714) 5,004,827 599,649
Accrued expenses (519,611) 1,150,875 796,406
Income taxes payable and refundable
taxes (3,966,515) (4,496,000) 6,198,000
Customer deposit -- -- 6,000,000
----------- ----------- ------------
Net cash flows from operating activities 424,244 13,138,783 20,827,239
----------- ----------- ------------
Investing activities:
Collections of notes receivable -- -- 17,213
Purchases of property, plant and equipment (955,091) (18,572,964) (10,014,665)
Proceeds from disposal of property and
equipment 1,852,300 5,102 --
Acquisition of intangible assets (321,385) (332,927) (240,681)
Deposits on property and equipment (2,999,266) (527,065) (193,700)
Advances to officers (600,000) -- (1,087,806)
----------- ----------- ------------
Net cash flows from investing activities (3,023,442) (19,427,854) (11,519,639)
----------- ----------- ------------
(Continued)
F7
STAR SCIENTIFIC, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
[Enlarge/Download Table]
2001 2000 1999
------------ ------------ ------------
Financing activities:
Proceeds from capital leases (sale/leasebacks) $ 10,842,731 -- --
Proceeds from notes payable -- 15,978,000 7,172,000
Payments on long-term debt (4,175,743) (521,943) (382,967)
Proceeds from issuance of common stock -- 1,979,520 1,045,920
Stock offering costs paid -- -- (40,000)
Payments on capital lease obligations (890,652) -- --
------------ ------------ ------------
Net cash flows from financing activities 5,776,336 17,435,577 7,794,953
------------ ------------ ------------
Deposits to MSA Escrow fund (16,839,125) (11,605,155) --
------------ ------------ ------------
Change in cash and cash equivalents (13,661,987) (458,649) 17,102,553
Cash and cash equivalents, beginning of year 16,746,599 17,205,248 102,695
------------ ------------ ------------
Cash and cash equivalents, end of year $ 3,084,612 $ 16,746,599 $ 17,205,248
============ ============ ============
Supplemental disclosure of cash flow
information:
Cash paid during the year for:
Interest $ 605,443 $ 1,581,348 $ 123,119
============ ============ ============
Income taxes $ 3,052,516 $ 8,502,000 $ 1,752,000
Supplemental schedule of non-cash investing
and financing activities:
Purchase of fixed assets financed by
long-term debt $ -- $ 97,772 $ --
Conversion of redeemable preferred stock
to equity $ -- $ -- $ 44,000
Notes payable reduced by proceeds from
equipment sale $ -- $ -- $ 255,000
Warrants issued in connection with
patent costs $ -- $ 69,800 $ --
Customer deposit converted to short-term
note payable $ -- $ 6,000,000 $ --
See notes to consolidated financial statements.
F8
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
1. Summary of significant accounting policies:
Nature of business:
Star Scientific, Inc. and its subsidiary, Star Tobacco, Inc. (collectively
referred to as the "Company" or "Star") has been engaged since 1990 in the
manufacture and sale of tobacco products. Star is also engaged in
extensive research and development activities relating to (1) the
development of proprietary scientific technology for the curing of tobacco
so as to prevent or retard the formation of certain toxic carcinogens
present in tobacco and tobacco smoke, namely, the tobacco specific
nitrosamines, for which patents have been issued, (2) the sales, marketing
and development of less toxic and potentially less harmful tobacco
products which have been cured pursuant to licensed patented technology,
(3) the manufacture and sale of discount cigarettes, with activated
charcoal filters and formulated with low nitrosamine tobacco, (4) the
sales, marketing and development of very low nitrosamine smokeless tobacco
products and (5) in the future, the research and continued development of
tobacco-smoking cessation products.
Principles of consolidation:
The accompanying consolidated financial statements include the accounts of
Star Scientific, Inc. and its wholly-owned subsidiary, Star Tobacco, Inc.
All intercompany accounts and transactions have been eliminated.
Liquidity and management's plans:
As discussed in Note 4, during 2001 the Company entered into a Restated
Master Agreement with Brown & Williamson Tobacco Corporation ("B&W")
whereby the Company will thereafter generate zero or slightly negative
gross margins on its tobacco leaf sales to B&W through 2003. The agreement
does contain provisions for the Company to earn royalties from B&W, but
all such royalties shall be applied to reduce the Company's obligation to
B&W for the foreseeable future. Additionally, as further discussed in Note
14, the Company makes significant escrow deposits associated with its
cigarette sales in the 46 states that are participants in the Master
Settlement Agreement and required by certain state statutes. As such,
operating cash flows from both tobacco and cigarette sales were
significantly reduced in 2001, and that trend is expected to continue in
2002.
The Company plans to continue its introduction of its three new smokeless
tobacco products in 2002 (Stonewall(TM) moist and dry snuffs and ARIVA(TM)
compressed powdered tobacco), which are expected to produce revenues and
gross profits and which are not subject to the escrow requirements of the
Master Settlement Agreement. However, the launch of these product on a
national basis will require significant capital for marketing and
promotions.
F9
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
1. Summary of significant accounting policies (continued):
Liquidity and management's plans (continued):
In contemplation of these conditions, management plans to augment working
capital generated from operations with cash proceeds from sale/leaseback
transactions involving the Company's tobacco curing barns and other
refinancing transactions. During 2001, approximately $10,800,000 was
generated from similar transactions. In the event that these additional
financing proceeds are insufficient or other cash requirements arise, the
Company may draw on its line of credit with a currently available limit of
$7,500,000 and, further, may be required to reduce operating expenses. The
degree to which these measures may be required, if at all, is uncertain
and is dependent upon numerous factors, including the results of the
Company's marketing and sales activities, the Master Settlement Agreement
escrow obligations the Company will be required to fund in 2002, and,
ultimately, the success of the Company's new products initiative.
Advertising Costs:
Advertising costs are expensed as incurred and are included in marketing
and distribution expenses. For the years ended December 31, 2001, 2000 and
1999, advertising costs were $329,000, $197,000, and $36,000,
respectively.
Use of estimates:
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of income and expenses during the reporting period. Actual results
could differ from those estimates.
Cash equivalents:
For purposes of the statements of cash flows, the Company classifies all
highly liquid investments with an original maturity of three months or
less as cash equivalents.
MSA Escrow fund:
Cash deposits restricted pursuant to the Master Settlement Agreement (Note
14) are reflected as a non-current asset in the accompanying balance
sheets. All interest earned on this account is unrestricted and reflected
in current earnings.
F10
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
1. Summary of significant accounting policies (continued):
Inventories:
Inventories are valued at the lower of cost or market. Cost is determined
on the first-in, first-out (FIFO) method.
Property, plant and equipment:
Property, plant and equipment are recorded at cost. Depreciation is
determined using the straight-line method over the estimated useful lives
of three to seven years for office equipment and machinery and equipment
and thirty-nine years for buildings and improvements. Depreciation for
barns is determined using the units of production method over the
estimated useful life of ten years. Amortization of assets under capital
leases are over the lease term or estimated useful life, as appropriate
using the units of production method.
Intangibles:
Intangibles consist primarily of licensing costs, patents and trademarks
and packaging design costs. Intangibles are amortized using the
straight-line method over a period of 15 years for trademarks, 17 years
for patents and licensing costs and 5 years for packaging design costs.
Income taxes:
Deferred income tax assets and liabilities are computed annually for
differences between the financial statement and federal income tax bases
of assets and liabilities that will result in taxable or deductible
amounts in the future, based on enacted tax laws and rates applicable to
the periods in which the differences are expected to affect taxable
income. Valuation allowances are established when necessary to reduce
deferred tax assets to the amount expected to be realized.
Employee stock-based compensation:
The Company has adopted the accounting provisions of Statement of
Financial Accounting Standards No. 123 - Accounting for Stock-Based
Compensation ("FAS 123"), which requires the use of the fair-value based
method to determine compensation for all arrangements under which
employees and others receive shares of stock or equity instruments
(warrants and options).
F11
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
1. Summary of significant accounting policies (continued):
Impairment of long-lived assets:
The Company reviews the carrying value of its long-lived assets whenever
events or changes in circumstances indicate that the historical
cost-carrying value of an asset may no longer be appropriate. The Company
assesses recoverability of the carrying value of the asset by estimating
the future net cash flows expected to result from the asset, including
eventual disposition. If the estimated future net cash flows are less than
the carrying value of the asset, an impairment loss is recorded equal to
the difference between the asset's carrying value and its fair value.
Segment reporting:
The Company has operations in two business segments and, as a result, has
adopted Statement of Financial Accounting Standards No. 131 - Disclosures
about Segments of an Enterprise and Related Information ("FAS131"). FAS
131 establishes standards for reporting information about operating
segments in annual financial statements. Operating segments are defined as
components of an enterprise about which separate financial information is
available and is evaluated on a regular basis by the chief operating
decision maker or decision making group, in deciding how to allocate
resources to an individual segment and in assessing performance of the
segment. The Company has identified these segments based on the nature of
business conducted by each. The identifiable segments are 1) the
manufacture and sale of discount cigarettes and smokeless tobacco products
to wholesalers, and 2) the sale of tobacco cured utilizing the Company's
proprietary technology and royalties thereon. This second segment also
includes costs incurred in the research and development of methods of
manufacturing less toxic and potentially less harmful tobacco products.
Effect of recent accounting pronouncements:
In June 2001, the Financial Accounting Standards Board issued SFAS No.
142, "Goodwill and Other Intangible Assets". SFAS No. 142 requires, among
other things, that companies no longer amortize goodwill, but instead test
goodwill for impairment at least annually. In addition, SFAS No. 142
requires that the Company identify reporting units for the purposes of
assessing potential future impairments of goodwill, reassess the useful
lives of other existing recognized intangible assets, and cease
amortization of intangible assets with an indefinite useful life. An
intangible asset with an indefinite useful life should be tested for
impairment in accordance with the guidance in SFAS No. 142. SFAS No. 142
is required to be applied in fiscal years beginning after December 15,
2001. SFAS No. 142 requires the Company to complete a transitional
goodwill impairment test six months from the date of adoption. The Company
is also required to reassess the useful lives of the other intangible
assets within the first interim quarter after adoption of SFAS No. 142.
F12
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
1. Summary of significant accounting policies (continued):
Effect of recent accounting pronouncements (continued):
The Company adopted SFAS No. 142 effective January 1, 2002; however, the
adoption of SFAS No. 142 is not expected to affect the classification or
useful lives of its intangible assets nor the amounts of amortization
expense or impairment losses, if any, to be recognized under the new
standards.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets". SFAS No. 144 replaces SFAS
No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of". SFAS No. 144 retains the fundamental
provisions of SFAS 121 for the recognition and measurement of the
impairment of long-lived assets to be held and used and the measurement of
long-lived assets to be disposed of by sale. Under SFAS No. 144,
long-lived assets are measured at the lower of carrying amount or fair
value less cost to sell. The Company adopted this standard effective
January 1, 2002. The Company does not believe adoption of this new
standard will have a significant impact on its financial position, results
of operations or cash flows.
Net income per common share:
Basic income per common share is computed using the weighted-average
number of common shares outstanding.
Diluted earnings per share is computed assuming conversion of all
potentially dilutive stock options and warrants. Potential common shares
outstanding are excluded from the computation if their effect is
antidilutive.
Revenue Recognition:
Revenue is recognized when tobacco products are delivered to customers and
title passes. The Company also records appropriate provisions for
uncollectible accounts and credit for returns. In connection with its leaf
segment, the Company currently sells low-TSNA StarCured(TM) tobacco to
Brown & Williamson Tobacco Corporation at a price approximately equivalent
to its purchase price. The Company is the primary obligor to the farmers,
from whom the tobacco is purchased, and has general inventory risk. Due to
these factors, and others, the Company records tobacco leaf sales and the
related cost of sales at gross amounts. Royalty revenues are recognized
when earned.
Shipping costs:
Shipping costs are included in marketing and distribution expenses and
aggregated approximately $1,650,000, $2,700,000 and $2,000,000 in 2001,
2000 and 1999, respectively.
F13
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
2. Inventories:
Inventories consist of the following:
2001 2000
----------- ----------
Tobacco leaf $ 7,575,307 $2,331,981
Raw materials 853,418 326,492
Packaging materials 1,148,564 1,046,988
Finished goods 2,426,789 2,239,696
----------- ----------
$12,004,078 $5,945,157
=========== ==========
3. Property, plant and equipment:
Property, plant and equipment consists of the following:
2001 2000
------------ ------------
Land $ 172,572 $ 172,572
Buildings 345,134 340,139
Leasehold improvements 1,182,960 567,991
Tobacco curing barns 19,899,247 25,312,445
Machinery and equipment 4,057,011 4,047,923
Office and sales equipment 1,260,621 1,136,203
------------ ------------
26,917,545 31,577,273
Less accumulated depreciation (5,340,159) (4,176,313)
------------ ------------
$ 21,577,386 $ 27,400,960
============ ============
During 2001, the Company entered into several sale-leaseback transactions
(see Note 6). Tobacco curing barns noted above include both owned and
leased barns as follows:
2001
-----------
Tobacco curing barns owned $ 9,219,342
Tobacco curing barns under capital lease
obligations 10,679,905
-----------
$19,899,247
===========
Amortization associated with these leased barns was $759,008 in 2001 and
is included in depreciation and amortization in the accompanying 2001
statement of operations.
Idle equipment consists of "burley" tobacco curing barns currently not in
use. The Company expects to continue its research regarding burley tobacco
during the 2002 growing season. Based on the results of the research, the
Company will make a determination of the further use of these barns. The
Company could retrofit these barns to allow for the curing of flue-cured
tobacco at minimal costs.
F14
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
4. Long-term supply agreement/major customer information:
During October 1999, the Company entered into an agreement (the "Master
Agreement") with Brown & Williamson Tobacco Corporation, ("B&W"), the
third largest tobacco company in the U.S., and the largest affiliate of
British American Tobacco, PLC, the second largest tobacco company in the
world. Under the agreement, B&W agreed to purchase quantities of the
Company's low nitrosamine tobacco leaf (StarCured(TM) tobacco) and
evaluate the potential for that tobacco in the marketplace. Additionally,
B&W agreed to finance the purchase/construction of tobacco curing barns to
assist the Company in its production of low nitrosamine tobacco products
to be marketed by the Company, B&W and others in the industry (see Note 5
regarding financing provided). Tobacco leaf sales to B&W were
approximately $34,500,000, $45,500,000 and $9,300,000 in 2001, 2000 and
1999, respectively.
In April 2001, the Company and B&W entered into a Restated Master
Agreement and related agreements. Key provisions of the agreements, which
restate and supercede the prior agreement, are as follows:
. B&W took over all aspects of the sales of Advance(R), the
branded low-nitrosamine cigarette that was jointly developed
by the Company and B&W, in return for the payment of a royalty
to Star on each carton of Advance(R) sold by B&W. Effective
September 2002, Star may produce and sell its own brand of
low-TSNA cigarette but is prohibited from participating in the
development or manufacture of low-nitrosamine cigarettes with
any US Tobacco company, other than B&W, for a period of three
years.
. B&W agreed to purchase 15,000,000 pounds per year of
StarCured(TM)Tobacco from Star in 2001, 2002, and 2003 at an
agreed-upon price with the right to purchase additional
tobacco in future years.
. Interest-bearing loans of $4,500,000 previously granted by B&W
to Star were converted to non-interest bearing indebtedness
and the maturity date of all loans (including previously
granted non-interest bearing loans) was extended to January
2005 (see Note 5). Intervening repayments of such indebtedness
are to be effected through the tobacco purchase royalties
noted above. When the debt has been reduced to less than
$10,000,000, certain liens on the assets securing the loans
will be released. Because these loans are to be repaid through
future revenues, interest is not imputed.
F15
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
4. Long-term supply agreement/major customer information (continued):
The following restated agreements are incorporated:
. Hard Tobacco Agreement. This agreement outlines test marketing
and a purchase right granted to B&W associated with Star's
compressed powdered tobacco cigalette(TM) pieces which are
designed to dissolve completely in the mouth without leaving
any residue. Under the agreement, B&W would pay Star a royalty
of $0.50 for each pack sold during the test market and
ten-year exclusivity period, reduced by 50% subsequent to that
period. Provided satisfactory test marketing is achieved, the
term of the agreement is ten years, automatically renewable
for seven successive ten-year periods.
. Other Low TSNA Tobacco Royalty Agreement. In recognition of
patents to which the Company is the exclusive licensee, B&W
agrees to pay royalties on low nitrosamine tobacco other than
StarCured(TM) tobacco purchased by B&W in the amount of
$1,500,000 in 2001 and 2002. Should any patent litigation
(currently Star is suing R.J. Reynolds for infringement of its
low-TSNA patent) result in a final judgment requiring royalty
payments by one or more of the Big 3 tobacco manufacturers, or
if Star enters into a licensing agreement with one of the Big
3 tobacco manufacturers, B&W will then pay Star a royalty on
other low-TSNA tobacco and StarCured(TM) tobacco at a rate
equal to one-half of that royalty rate. The 2001 and 2002
royalties will be used to reduce the indebtedness to B&W. To
the extent additional royalties are earned, they will be paid
first in debt reduction and then in cash.
. Amendment to Restated Loan Agreement. In addition to
provisions noted above, forgiveness of any loan balances due
B&W would be granted upon satisfactory completion of the hard
tobacco market test, 50% of the then outstanding indebtedness,
and forgiveness of the remainder of the indebtedness upon the
introduction of the hard tobacco cigalett(TM) by B&W into
retail outlets in at least 15 states.
F16
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
4. Long-term supply agreement/major customer information (continued):
. Trademark license and Royalty Agreement. A license subject to
a license fee of an initial $0.40 per carton is granted to
Star in connection with B&W's sale and manufacture of low-TSNA
Cigarettes (specifically, Advance(R)). A royalty-free
exclusive right and license is also granted to B&W for the use
of StarCure(TM) Inside or StarCured(TM) Mark for B&W branded
tobacco products. Royalties are to be offset against the loans
payable to B&W until such time as the debt is repaid and then
will be paid in cash.
. In connection with the sale-leasebacks discussed in Note 6,
B&W agreed to release collateral associated with assets
subject to those sale-leasebacks, provided 4/14's of the
proceeds of the sale-leasebacks were remitted to B&W and used
to reduce outstanding debt.
5. Notes payable and long-term debt:
Notes payable:
The Company has a $7,500,000 revolving line of credit agreement.
Borrowings under the line of credit are limited to 80% of eligible
accounts receivable, as defined, and bear interest at a rate linked to the
prime rate. The agreement places restrictions on new debt and the
Company's ability to further pledge its assets and stipulates a minimum
fixed charge coverage ratio, as defined. Borrowings under the line of
credit are secured by substantially all assets of Star Tobacco, Inc. not
otherwise pledged. There were no outstanding borrowings at December 31,
2001 or 2000.
Notes payable at December 31, 2000 consisted of advances aggregating
$15,950,000 pursuant to two credit agreements with B&W, the major domestic
tobacco company discussed in Notes 1 and 4. All borrowings were
collateralized by tobacco curing barns, tobacco leaf inventory, and
intellectual property which were renegotiated to provide for extended
maturities as noted above. The weighted average interest rate of
short-term borrowings outstanding at December 31, 2000 was 3.26%.
F17
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
5. Notes payable and long-term debt (continued):
Long-term debt consists of the following:
2001 2000
----------- -----------
Note payable due B&W,
collateralized by tobacco
curing barns, tobacco leaf
inventory, and intellectual
property; non-interest bearing
until 2005 payable via
royalties earned and possible
debt forgiveness, as defined,
(See Note 4) through January
2005, thereafter payable in 60
monthly installments with
interest at prime plus 1%. (a) $23,744,990 13,200,000
Other, repaid in 2001 -- 183,508
----------- -----------
23,744,990 13,383,508
Less current maturities 775,210 111,176
----------- -----------
$22,969,780 $13,272,332
=========== ===========
The future maturities of long-term debt without regard to potential royalty or
forgiveness reductions, are as follows:
Year ending December 31
-----------------------
2002 $ 775,210
2003 --
2004 --
2005 4,593,956
2006 4,593,956
Thereafter 13,781,868
-----------
$23,744,990
===========
(a) Includes previously accrued and imputed interest at December 31,
2001 of $270,733.
6. Lease obligations:
Sale/leaseback transactions:
During 2001, the Company entered into several sale-leaseback arrangement
transactions in which the Company retained substantially all use of the
property sold. As such, gains and losses associated with those
transactions, which aggregated approximately $495,000 and $68,000,
respectively, have been deferred and are being amortized in proportion to
the amortization of the leased assets. Net amortization of these gains and
losses approximated $35,000 in 2001.
F18
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
6. Lease obligations (continued):
The tobacco curing barns subject to the capital leases are discussed in
Note 3. The agreements provide for total monthly payments of approximately
$313,000 expiring through 2005 and are collateralized by the tobacco
curing barns.
Future minimum lease payments under capital leases are as follows:
Year ending December 31,
------------------------
2002 $ 3,760,595
2003 3,760,595
2004 3,099,642
2005 656,334
Imputed interest (1,399,776)
-----------
$ 9,877,390
===========
Operating leases:
The Company leases manufacturing machinery and equipment under a
non-cancelable operating lease agreement for approximately $55,000 per
month. The agreement, which provided for a $1,268,559 security deposit
(included in other assets in the accompanying 2001 balance sheet), is for
a five-year term.
The Company also leases its office and warehouse facilities and various
vehicles and minor operating equipment under non-cancelable operating
leases expiring in various years through 2010.
The following represents the future minimum rental payments required under
operating leases that have initial or remaining non-cancelable terms in
excess of one year as of December 31, 2001.
Year ending December 31,
------------------------
2002 $2,092,327
2003 1,881,028
2004 1,658,265
2005 1,658,265
2006 999,039
Thereafter 674,210
----------
$8,963,134
==========
Rent expense for all operating leases was approximately $2,096,000,
$1,553,000 and $153,000, for the years ended December 31, 2001, 2000 and
1999, respectively.
F19
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
7. Stockholders' equity:
Preferred stock:
Class A:
The Company has authorized 4,000 shares of $.01 par value Class A
Convertible Redeemable preferred stock. Each share of the Preferred Stock
is convertible into 80 shares of common stock of the Company at the option
of the holder and has voting rights equal to the number of common shares
issuable if converted. The Preferred Stock has the right to share in
dividends declared on the Company's common stock and has certain
liquidation preferences. No Class A preferred shares are outstanding.
Series B:
The Company has authorized 15,000 shares of $.01 par value Series B
Preferred Stock. The stock was convertible into common stock at the
holders' option prior to December 31, 2002 at 3,280 shares of common for
each share of Series B Preferred. Holders of Series B Preferred Stock were
entitled to 500 votes for each share held. During 1999, holders of all of
the 14,084 shares of Series B Preferred Stock converted their shares to
common. No Series B preferred shares are outstanding.
Common stock:
During 2001, the Company reduced the par value of its authorized common
stock from $.01 per share to $.0001 per share.
Common stock warrants:
Common stock warrants issued, redeemed and outstanding during the years
ended December 31, 2000 and 2001 are as follows:
Weighted
Average
Exercise
Price Per
Number Share
-------- --------
Issued during 1998 pursuant to private placements
of stock and outstanding January 1, 2000 976,880 $ 2.00
Exercised during 2000 (976,880) ($ 2.00)
-------- --------
Outstanding and exercisable at
December 31, 2000 and 2001 -- $ --
======== ========
F20
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
7. Stockholders' equity (continued):
Stock option plans:
The Company has adopted a 1998 Stock Option Plan and a 2000 Equity
Incentive Plan (the "Plans") which provide for grants of options to those
officers, key employees, directors and consultants whose substantial
contributions are essential to the continued growth and success of the
Company. The Plans provide for grants of both qualified and non-qualified
stock options to purchase up to 8,000,000 shares at a purchase price equal
to the fair market value on the date of grant in the case of qualified
options granted to employees.
F21
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
7. Stockholders' equity (continued):
Stock option plans (continued):
Common stock options and warrants issued, redeemed and outstanding during
the years ended December 31, 2001, 2000 and 1999 are as follows:
Weighted
Average
Exercise
Price Per
Number Share
---------- --------
Outstanding January 1, 1999 -- $ --
Options issued during 1999 3,258,406 2.17
---------- --------
Outstanding January 1, 2000 3,258,406 2.17
Options issued during 2000 1,200,000 4.10
Warrants issued during 2000 to patent counsel 210,526 2.38
Options exercised during 2000 (15,000) (1.66)
Options forfeited during 2000 (33,406) (8.56)
---------- --------
Outstanding December 31, 2000 4,620,526 2.84
Options forfeited during 2001 (300,000) (7.00)
Options issued during 2001 719,236 2.23
---------- --------
Options and warrants outstanding at
December 31, 2001* 5,039,762 $ 2.23
========== ========
*535,526 options were issued outside of the Plans.
The following table summarizes information for options and warrants outstanding
and exercisable at December 31, 2001.
[Download Table]
Options and Warrants Outstanding Exercisable
------------------------------------------- --------------------------
Range of Weighted Avg. Weighted Avg. Weighted Avg.
Prices Number Remaining Life Exercise Price Number Exercise Price
---------- --------- -------------- -------------- --------- --------------
$1.00-2.00 2,835,000 7.92 yrs. $1.78 2,360,000 $1.77
2.01-3.00 994,762 7.04 yrs. 2.44 894,762 2.43
3.01-4.00 1,085,000 7.92 yrs. 3.82 766,805 3.91
4.01-5.00 125,000 7.13 yrs. 4.18 125,000 4.18
--------- --------- ----- --------- -----
$1.00-5.00 5,039,762 7.97 yrs. $2.47 4,146,567 $2.44
========= ========= ===== ========= =====
F22
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
7. Stockholders' equity (continued):
Stock option plans (continued):
Weighted average grant date fair values are as follows:
Number of Exercise Grant date
Options Price fair value
--------- --------- ----------
2001
Exercise price:
Equals market 99,000 $ 1.92 $ .24
Exceeds market 585,236 $ 2.24 $ .30
Less than market 35,000 $ 3.02 $ .51
2000
Exercise price equals market 1,410,526 $ 2.17 $ .66
1999
Exercise price equals market 3,210,000 $ 4.10 $ .25
In addition to stock options granted in 1999, the Company granted a stock
purchase right to acquire 2,000,000 shares of common stock at $1.00 per
share. This stock purchase right was accounted for as an option (see Note
14 - Employment Agreement) and had a grant-date fair value of $48,400.
The fair value of options and the stock purchase right granted in 1999
were estimated on the date of grant using the Black-Scholes option pricing
model with the following weighted average assumptions:
2001 2000 1999
---------- ---------- ----------
Expected life of options 2.53 years 2.25 years 1.25 years
Risk free interest rate 4.14% 6.24% 5.03%
Expected volatility 50% 50% 39%
Expected dividend yield 0% 0% 0%
Total stock-based compensation (stock, stock options and warrants) cost
recognized is as follows:
2001 2000 1999
-------- ---------- ----------
Employee $282,648 $ 258,166 $ 265,618
Non-employee consultants and
directors 248,402 320,726 447,622
Charitable institutions -- -- 768,642
Patent costs (capitalized) -- 69,800 --
-------- ---------- ----------
$531,050 $ 648,692 $1,481,882
======== ========== ==========
F23
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
8. Earnings per share:
The following table sets forth the computation of basic and diluted
earnings per share for the years ended December 31:
2001 2000 1999
----------- ----------- -----------
Net income $ 3,024,548 $10,040,519 $11,514,630
=========== =========== ===========
Denominator for basic earnings per
share-weighted average shares 59,741,600 59,008,127 36,207,390
Effect of dilutive securities:
Preferred stock -- -- 11,536,747
Warrants outstanding (a) -- -- 729,621
Stock options outstanding (a) 650,826 1,636,934 1,828,240
----------- ----------- -----------
Denominator for diluted earnings
per share-weighted average
shares adjusted for dilutive
securities 60,392,426 60,645,061 50,301,998
=========== =========== ===========
Earnings per common share - basic $ .05 $ .17 $ .32
=========== =========== ===========
Earnings per common share - diluted $ .05 $ .17 $ .23
=========== =========== ===========
(a) Securities outstanding that were excluded from the computation
because they would have been anti-dilutive are as follows:
2001 2000 1999
--------- --------- ---------
Stock options 4,724,410 3,023,066 1,430,166
Warrants -- -- 247,259
9. Income taxes:
Net deferred tax assets and liabilities consist of the following:
2001 2000
----------- -----------
Deferred tax assets:
Net operating loss carryforwards (subject
to annual limitation) $ 330,000 $ 380,000
Expenses not currently deductible 50,000 400,000
Other 45,000 20,000
----------- -----------
425,000 800,000
----------- -----------
Deferred tax liabilities:
Differing bases in property, plant and
equipment for tax and financial reporting
purposes (1,480,000) (1,280,000)
Tax imputed interest -- (100,000)
----------- -----------
(1,480,000) (1,380,000)
----------- -----------
($1,055,000) ($ 580,000)
=========== ===========
F24
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
9. Income taxes (continued):
Net deferred tax assets are reflected in the accompanying balance sheets
as follows:
2001 2000
---------- --------
Current asset $ 50,000 $320,000
========== ========
Non-current liability $1,105,000 $900,000
========== ========
Income tax expense consists of the following:
2001 2000 1999
---------- ---------- -----------
Current:
Federal $1,309,000 $3,420,000 $ 6,598,500
State 200,000 630,000 1,351,500
---------- ---------- -----------
1,509,000 4,050,000 7,950,000
Deferred 475,000 2,966,000 (1,061,000)
Increase (decrease) in valuation
allowance (a) -- -- (1,325,000)
---------- ---------- -----------
$1,984,000 $7,016,000 $ 5,564,000
========== ========== ===========
(a) During 1999, the Company reevaluated the deferred tax asset valuation
allowance based on the Company's current operations and determined that it
was more likely than not that these deferred tax assets would be
recoverable and, as such, decreased the previously recorded valuation
allowance.
The provision for income tax expense varies from that which would be
expected based upon applying the statutory federal rate to pre-tax
accounting income as follows:
2001 2000 1999
------ ------ ------
Statutory federal rate 34% 34% 34%
Non-deductible compensation
for stock options and grants 3 2 4
State tax provision, net of federal
benefit 4 5 3
Non-deductible officer
compensation -- -- 4
Change in deferred tax
asset valuation allowance -- -- (12)
------ ------ ------
41% 41% 33%
====== ====== ======
F25
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
9. Income taxes (continued):
At December 31, 2001 the Company had a net operating loss carryforward of
approximately $880,000, which expires from 2003 through 2009. As a result
of previous changes in the Company's ownership, the net operating loss
carryforward utilization is limited to $116,320 annually.
10. Related party transactions:
The Company has entered into certain transactions with companies and
trusts that are owned by members of management and stockholders. The
following is a summary of the significant related party transactions for
the years ended December 31, 2001, 2000 and 1999.
2001 2000 1999
---------- ---------- ----------
Business travel - aircraft expense $ 258,992 $ 191,680 $ 290,020
Legal fees (c) $1,099,559 $1,946,159 $ 940,000
Advances to officer outstanding (a) (d) $ 800,000 $ 800,000 $1,087,806
Collection of advance funded through
compensation expense $ -- $ 287,806 $ --
Note receivable, officer (d)
(See Note 14-Employment
Agreement) $2,000,000 $2,000,000 $2,000,000
Notes receivable, officers (d) (f) $ 600,000 $ -- $ --
Interest receivable on stock note
receivable officers (b) $ 119,419 $ 285,303 $ 94,889
Interest income on officer notes
and advances $ 185,030 $ 190,914 $ 94,889
Consulting fees paid
to organization controlled
by an officer/director (e) $ 96,000 $ 96,000 $ --
Tobacco purchases from/
commissions paid to organization
controlled by an officer/director
for processing tobacco $ -- $1,688,896 $ 627,577
Tobacco sales to an organization
controlled by an officer/director $ -- $ 709,478 $ 578,683
Consulting fees paid to directors $ 25,000 $ 142,000 $ --
(a) Unsecured note receivable due from officer, bearing interest at 5.66%.
1999 note collected in 2000 via compensation reduction; 2000 note matures
December 31, 2002.
(b) Included in prepaid expenses and other current assets in the accompanying
balance sheets.
(c) The Company paid legal fees to Paul Hastings, Janofsky & Walker LLP with
respect to various legal matters. An executive officer of the Company was
until March 31, 2001 senior counsel and a former partner of such firm but
received no compensation from the firm for work undertaken on behalf of
the Company.
(d) Presented as a reduction in stockholders' equity in the accompanying
balance sheets.
(e) Consulting fees paid to Chayet Communications, Inc. for communications
consulting, which ended December 31, 2001.
(f) Due August 2005, interest at prime plus 1% due annually.
F26
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
10. Related party transactions (continued):
Effective January 1, 1998, Star entered into a license agreement with
Regent Court Technologies, LLC, of which the Company's founder and Chief
Executive Officer, and the beneficiary of the O'Donnell Trust, which is
the Company's largest stockholder, are the owners. Pursuant to this
license agreement, Star has the exclusive world-wide rights to produce and
sell tobacco products with low-TSNA (tobacco specific nitrosamines)
tobacco. In connection with this agreement, Star is obligated to pay
royalties equal to 2% of all product sales (less certain costs incurred by
the Company) and 6% of any royalty income earned from sublicensing (less
certain costs incurred by the Company). Since the costs incurred by the
Company were in excess of the royalty obligations there were no royalties
due under this agreement for 2001, 2000 or 1999.
11. Employee benefit plan:
The Company is the sponsor of a defined contribution retirement plan under
Section 401(k) of the Internal Revenue Code. The plan covers all employees
who meet certain eligibility and participation requirements. Participants
may contribute up to 15% of their annual compensation. The Company may
make an annual discretionary contribution. The Company made contributions
of approximately $192,000, $79,000 and $44,000 in 2001, 2000 and 1999,
respectively.
12. Segment reporting:
The Company's reportable segments are strategic business units that offer
different products and have separate management teams. Commencing in 2000,
these segments are 1) the manufacture and sale of discount cigarettes and
smokeless tobacco products and 2) the sale of tobacco cured using licensed
technology. Financial information by business segment is as follows:
2001
---------------------------------------------
Discount
Cigarettes
and Smokeless
Leaf Tobacco
Tobacco Products Consolidated
------------ ------------ ------------
Sales $ 35,979,030 $138,804,393 $174,783,423
============
Cost of sales 37,078,541 42,469,939 $ 79,548,480
Excise taxes -- 58,822,304 58,822,304
------------ ------------ ------------
Gross profit (loss) ($ 1,099,511) $ 37,512,150 $ 36,412,639
============ ============ ============
Depreciation 2,433,269 480,119 $ 2,913,388
============
Research and development 3,800,959 284,845 $ 4,085,804
============
Property and equipment 20,257,444 1,319,942 $ 21,577,386
============
Capital expenditures 861,792 93,299 $ 955,091
============
Total assets 33,596,298 45,742,722 $ 79,339,020
============
F27
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
12. Segment reporting (continued):
2000
---------------------------------------------
Discount
Cigarettes
and Smokeless
Leaf Tobacco
Tobacco Products Consolidated
----------- ------------ ------------
Sales $46,224,079 $176,827,101 $223,051,180
============
Cost of sales 42,092,907 51,858,627 $ 93,951,534
Excise taxes -- 83,591,686 83,591,686
----------- ------------ ------------
Gross profit $ 4,131,172 $ 41,376,788 $ 45,507,960
=========== ============ ============
Depreciation 1,771,633 439,510 $ 2,211,143
============
Research and development 1,702,310 -- $ 1,702,310
============
Property and equipment 25,654,681 1,746,279 $ 27,400,960
============
Capital expenditures 18,357,023 313,713 $ 18,670,736
============
Total assets 27,671,956 41,795,280 $ 69,467,236
============
13. Fair value of financial instruments, concentrations and credit risk:
Fair value of financial instruments:
The estimated fair value of cash and cash equivalents, trade receivables,
MSA Escrow funds, long-term debt and trade payables approximate the
carrying amount due to their short-term nature or variable interest
component. The estimated fair-value amounts have been determined using
available market information and appropriate valuation methodologies.
However, considerable judgment is necessarily required in interpreting
market data to develop estimates of fair value. Accordingly, the estimates
presented herein are not necessarily indicative of the amounts that the
Company would realize in a current market exchange.
F28
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
13. Fair value of financial instruments, concentrations and credit risk
(continued):
Fair value of financial instruments (continued):
The estimated fair value of notes payable at December 31, 2001, is
summarized as follows:
2001
------------------------------
Carrying Estimated
Amount Fair Value
----------- -----------
Notes payable $23,744,990 $18,500,000
Differences between fair value and carrying amount are primarily due to
instruments that provide fixed interest or zero interest rates or contain
fixed interest rate elements. Inherently, such instruments are subject to
fluctuations in fair value due to subsequent movements in interest rates.
Concentrations:
Star had tobacco leaf sales to a major domestic tobacco company (B&W)
which represented approximately 21%, 21% and 9% of net leaf sales in 2001,
2000 and 1999, respectively in the leaf segment. Star had purchases from
this same company which represented 54%, 32% and 21% of cost of sales in
2001, 2000 and 1999, respectively. The Company also borrowed $15,950,000
and $7,172,000 in 2000 and 1999, respectively, from this same company to
finance property, plant and equipment acquisitions (see Notes 4 and 5).
Credit risk:
Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash and cash
equivalents and accounts receivable.
The Company maintains its cash and cash equivalents balances in three
financial institutions. Each of the balances in the domestic banks are
insured by the Federal Deposit Insurance Corporation up to $100,000.
Trade accounts receivable result from sales of tobacco products to its
various customers throughout the United States. Credit is extended to
customers after an evaluation for credit worthiness; however, the Company
does not require collateral or other security from customers.
F29
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
14. Commitments, contingencies, and other matters:
Obligations under master settlement agreement:
In November 1998, 46 states and several U.S. territories entered into a
settlement agreement (the "Master Settlement Agreement" or "MSA") to
resolve litigation that had been instituted against the major tobacco
manufacturers. The Company was not named as a defendant in any of the
litigation matters and chose not to become a participating manufacturer
under the terms of the Master Settlement Agreement. As a nonparticipating
manufacturer, the Company is required to satisfy certain purported escrow
obligations under statutes which the Master Settlement Agreement required
participating states to pass, if they were to receive the full benefits of
the settlement. The so-called "level playing field" statutes require
nonparticipating manufacturers to fund escrow accounts that could be used
to satisfy judgments or settlements in lawsuits that may at some future
date be filed by the participating states against such nonparticipating
tobacco manufacturers. Under these statutes the Company is obligated to
place an amount equal to $1.88 per carton for 1999, $2.09 in 2000, $2.72
for 2001 and 2002, $3.35 for 2003 through 2006 and $3.77 thereafter, in
escrow accounts for sales of cigarettes occurring in the prior year in
each such state after the effective date of each state specific statute.
An inflation adjustment is also added to these deposits at the higher of
3% or the Consumer Price Index each year. Such escrowed funds will be
available to satisfy tobacco-related judgments or settlements, if any, in
some states. If not used to satisfy judgments or settlements, the funds
will be returned to the Company 25 years after the applicable date of
deposit on a rolling basis. Also, absent a challenge to the state specific
statutes or some accommodation as to the escrow amounts, the failure to
place the required amounts in escrow could result in penalties to the
Company and potential restrictions on its ability to sell tobacco products
within particular states. Since all of the MSA states have passed the
so-called "level playing field" statutes, the Company expects that a
material portion of its cigarette sales will continue to be subject to
such purported escrow obligations.
F30
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
14. Commitments, contingencies, and other matters (continued):
Obligations under master settlement agreement (continued):
As of January 1, 2000, thirty-eight states and the District of Columbia
had adopted so-called model "level playing field" statutes. As of January
1, 2001, all forty-six MSA states had adopted model "level playing field"
statutes. It is anticipated that after funding escrow accounts for 2001
sales that the Company will have deposited a total of approximately
$32,000,000 into escrow under protest. In addition to the escrow deposits
associated with the Company's direct customer sales, the Company has,
under protest, been required to make additional escrow deposits related to
sales of the Company's cigarettes subsequently made by the Company's
direct customers in other states ("indirect sales") of approximately
$3,800,000 in 2001 and the first quarter of 2002. Based on its prior
experience, the Company expects that it may continue to be subject to
additional escrow obligations related to indirect sales which occurred
from 1999 through 2001. However, the Company is not presently able to
estimate the amount of this obligation. All funds placed in escrow
continue to be an asset of the Company, and the Company receives the
interest income generated by the escrow deposits.
In addition to the "level playing field" statutes, a number of states have
recently enacted statutes that require nonparticipating manufacturers to
certify that they are in full compliance with the escrow requirements of
the MSA as a condition to being permitted to sell cigarette products in
those states. While the Company has recently focused its sales in the four
states that were not part of the MSA, these statutes could impact on its
ability to sell cigarettes in the MSA states, notwithstanding its
substantial payments into escrow.
F31
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
14. Commitments, contingencies, and other matters (continued):
Obligations under master settlement agreement (continued):
After almost two years of negotiations with the National Association of
Attorneys General ("NAAG"), the Company concluded that the NAAG had little
interest in working with Star to come to a reasonable solution under which
the Company could become a participant in the MSA. Accordingly, on
December 15, 2000, the Company filed a lawsuit in the United States
District Court for the Eastern District of Virginia requesting that the
court declare both the MSA and Virginia's Qualifying Statute
unconstitutional and, therefore, invalid. The Company's complaint
challenges the MSA on the grounds that it violates the Interstate Compact
Clause and the Commerce Clause of the Constitution of the United States.
It challenges the Qualifying Statute on the grounds that it violates the
Equal Protection, Due Process, Takings and Commerce Clauses of the
Constitution. Neither Virginia Attorney General Kilgore nor any other
state attorney general has ever charged the Company with the tortuous and
unlawful conduct asserted against other cigarette manufacturers in
lawsuits by various states which led to the execution of the MSA. Despite
the absence of any claim against the Company, which is focused primarily
on producing less toxic and potentially less hazardous tobacco and tobacco
products, the MSA and the Qualifying Statute impose a severe burden on its
research and development activities.
On March 12, 2001, the District Court heard oral argument on the
Commonwealth's Motion to Dismiss, after both sides exchanged briefs on all
the constitutional and related issues. On March 26, 2001, the District
Court dismissed the Company's complaint, but in its opinion, the District
Court did note the Star "must now suffer as a result of the bad faith of
previous market entrants." The District Court further noted that Star "has
never been accused of the fraudulent, collusive and intentionally
dishonest activities of the Big Four," "was not even in existence during
the bulk of the time that these activities were occurring," and has taken
"every step to provide complete disclosure about the harmful nature of its
products." The District Court also stated that the "financial burden on
Star and others like it may hamper efforts to develop new tobacco
technologies." The Company promptly appealed the District Court's ruling.
On January 22, 2002, the United States Court of Appeals for the Fourth
Circuit affirmed the decision of the District Court and later denied the
Company's request for rehearing. The Company plans to file a petition for
writ of certiorari with United States Supreme Court asking that Court to
review the case, given its continuing belief that the MSA and the Virginia
Qualifying Statute are constitutionally flawed.
F32
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
14. Commitments, contingencies, and other matters (continued):
Obligations under master settlement agreement (continued):
On June 12, 2001, Star filed a second lawsuit challenging the MSA and
Indiana's Qualifying Statute in the United States District Court for the
Southern District of Indiana, which suit raised claims similar to those in
the complaint in the Commonwealth of Virginia. The Indiana lawsuit also
raised the contention that Star is not subject to any escrow obligation in
Indiana because it has no substantial nexus to the state, and Star moved
for a preliminary injunction on this issue. On August 20, 2001, the
District Court issued a ruling denying the motion for preliminary
injunction and dismissing the substantial nexus claim. At the same time,
the court deferred ruling on the remainder of the claims pending further
development of the record and a ruling by the U.S. Court of Appeals for
the Fourth Circuit in the Company's challenge to the MSA and the Virginia
Qualifying Statute.
Other litigation:
On May 23, 2001, the Company filed a patent infringement action, Star
Scientific, Inc. v. R.J. Reynolds Company, against R.J. Reynolds Tobacco
Company in the United States District Court for the District of Maryland.
The action has been brought to enforce the Company's rights under a United
States Patent issued on March 20, 2001.
On November 19, 2001, the Judge in the Maryland Case denied R.J. Reynold's
Motion to Dismiss and its Motion to Strike and granted Star Scientific's
Motion for Leave to File a Supplemented Complaint. On December 4, 2001,
R.J. Reynolds filed its answer and counterclaim, denying the principal
allegations in Star Scientific's complaint, asserting various affirmative
defenses, and seeking a declaratory judgment that the patent is invalid
and that R.J. Reynolds has not infringed any claim of the patent.
This case has now proceeded to the discovery phase. The discovery deadline
is September 30, 2002. Dispositive motions, if any, are due on December 1,
2002 and the trial date has yet to be set by the court.
F33
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
14. Commitments, contingencies, and other matters (continued):
Other litigation (continued):
In July 2001, an individual filed a lawsuit against the Company in San
Diego County Superior Court, pursuant to California Business and
Professional Code Section 17200. Plaintiff alleges that the Company failed
to fully comply with California's Qualifying Statute, despite the fact
that the Company deposited approximately $882,000 into escrow for sales of
cigarettes in California in 2000. The Company moved to dismiss the
complaint on the basis that any determination as to deposits into escrow
rested with the Attorney General's office. To date, the Court has taken
this issue under review and has asked the Attorney General's office for
its position. In response to this inquiry, the Attorney General's office
indicated that it does not intend to intervene in the case and that if it
turns out that it has any dispute with the Company over its escrow
obligation it would raise this with the Company and give it a reasonable
opportunity to make any additional deposits required, before taking any
action against it. Based on the response from the Attorney General's
office the Company is moving to dismiss the action or stay the case.
Since the introduction of ARIVA(TM), two petitions have been filed with
the FDA seeking to have ARIVA(TM) regulated as a drug product and/or as a
food. Because ARIVA(TM) is a smokeless tobacco product that is intended to
provide tobacco satisfaction, the Company believes the FDA lacks any
authority to regulate ARIVA(TM) based on the March 21, 2000 decision of
the Supreme Court which held that Congress has not given the FDA authority
to regulate tobacco products as customarily marketed. Star has advised the
FDA that it believes the petitions are without merit and its legal team
will be filing responses in a timely fashion.
Employment Agreement:
During April 1999, the Company entered into an employment agreement with
Paul L. Perito, Esq. currently the Company's Chairman, President and Chief
Operating Officer (the "officer"), which expires June 15, 2002. In
addition to a $1,000,000 base salary, the agreement, as amended, provides
for annual performance bonuses as approved by the compensation committee.
F34
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
14. Commitments contingencies and other matters (continued):
Employment Agreement (continued):
The agreement also granted the officer the right to purchase 2,000,000
shares of the Company's common stock at $1 per share, and the Company
agreed to finance the purchase with a loan bearing interest at 7% (due
annually) and all principal due July 2005. The stock purchase occurred in
1999, and the related $2,000,000 note receivable is presented as a
reduction of stockholders' equity in the accompanying balance sheets.
Since the note is non-recourse with respect to accrued unpaid interest and
85% of the principal, this stock purchase right has been accounted for as
an option. The Company has recognized interest income of approximately
$95,000, $140,000 and $134,000 during 2001, 2000 and 1999, respectively,
in connection with the note. In connection with the aforementioned
agreement, the officer was also granted qualified stock options to
purchase 1,000,000 shares of stock at $1.68 per share, the price of the
Company's common stock on the date of grant. Such options vested
immediately.
Upon termination by the Company of Mr. Perito's employment without Cause
or by Mr. Perito for Good Reason (as defined in the employment agreement),
the Company will be obligated to pay to Mr. Perito all salary, benefits,
bonuses and other compensation that would be due under the employment
agreement through the end of the term of the employment agreement. Upon
termination of Mr. Perito's employment as a result of his death or
disability, the Company will be obligated to pay to Mr. Perito all salary,
benefits, bonuses and other compensation that would be due under the
employment agreement for a period of one year from the date of such
termination. In connection with certain transactions that may result in a
change in voting control of the Company (each, a "Disposition
Transaction") or certain changes in the Company's senior management, Mr.
Perito will be entitled to terminate the employment agreement, to a
one-time termination payment of $2,500,000 and to participate in the
Disposition Transaction upon the same terms and conditions as certain
principal stockholders of the Company. The Company also will be obligated
to reimburse Mr. Perito for any taxes which may become due as a result of
the application of Section 280G of the Code to the payment described in
the preceding sentence.
F35
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
14. Commitments contingencies and other matters (continued):
Employment Agreement (continued):
On October 6, 2000, the Company entered into an employment agreement with
David Dean, as the Vice President of Sales and Marketing, which expired on
December 31, 2001. In addition to a $250,000 base salary, the agreement
provided for a commission on the sale of cigarettes made by the Company up
to a maximum of $250,000 per year during 2000 and 2001. The agreement with
Mr. Dean also granted him the right to purchase 350,000 shares of the
Company's common stock at $4.00 per share, of which 175,000 options vested
as of the date of the employment agreement, and the remaining balance of
175,000 options, vested in equal monthly increments over the twelve-month
period following execution of the employment agreement. Upon termination
by the Company of Mr. Dean's employment without Cause or by Mr. Dean for
Good Reason (as defined in the employment agreement), the agreement
provided that the Company would be obligated to pay to Mr. Dean all salary
and commissions that would be due under the employment agreement through
the end of the term of the employment agreement. Under the terms of Mr.
Dean's employment agreement, termination for Good Reason included, but was
not limited to, certain transactions resulting in a change in voting
control of the Company or a disposition of a majority of the Company's
income producing assets. Furthermore, in the event Mr. Dean did not accept
the position of president and chief operating officer of ST in the event
of a sale of ST, Mr. Dean could terminate his employment for Good Reason.
The Company is currently negotiating a new form of employment agreement
with David Dean as the Vice President of Sales and Marketing.
On September 15, 2000, the Company entered into an employment agreement
with Christopher G. Miller, the Chief Financial Officer, which was to
expire on September 15, 2002, with certain renewal options. In addition to
a $120,000 base salary, the agreement provided for annual performance
bonuses as approved by the Compensation Committee. The agreement with Mr.
Miller also granted him the right to purchase 50,000 shares of the
Company's common stock at $4.00 per share, of which 25,000 shares vested
on September 15, 2001 and 25,000 shares vest on September 15, 2002. As of
March 15, 2001, the Company entered into an Amended and Restated
Employment Agreement with Mr. Miller, which expires on March 15, 2003,
with certain renewal options. In addition to a base salary of $225,000,
the agreement provides for performance bonuses as approved by the
Compensation Committee. This amended and restated agreement supercedes the
September 15, 2000 employment agreement, except as to the option granted
to Mr. Miller under that agreement. The amended and restated agreement
also grants him the right to purchase 250,000 shares of the Company's
common stock at $1.844 per share, of which 100,000 options vest
immediately, 100,000 vest on March 15, 2002 and 50,000 vest on September
15, 2002. Upon termination by the
F36
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
14. Commitments contingencies and other matters (continued):
Employment Agreement (continued):
Company of Mr. Miller's employment without cause, the Company will be
obligated to pay to Mr. Miller severance payments equal to six months
salary, paid on a monthly basis. Furthermore, if there is a change of
control of the Company (as defined in the employment agreement) and Mr.
Miller's agreement does not continue in effect after such a change in
control, the Company will, within 60 days of notifying Mr. Miller of such
termination, pay to Mr. Miller (a) a lump sum payment equal to all salary
then due and payable and (b) severance payments equal to six months salary
paid on a monthly basis.
On March 30, 2001, the Company entered into an employment agreement with
Robert E. Pokusa, the General Counsel, which is to expire on March 30,
2003. The agreement provides for a base salary of $385,000 and for
discretionary annual bonuses as approved by the Company's Chief Operating
Officer and the Chief Executive Officer. The agreement also grants Mr.
Pokusa the right to purchase 50,000 shares of the Company's common stock
at $1.4688 per share of which 25,000 shares vested on March 30, 2001 and
25,000 vest on March 30, 2002. Upon termination by the Company of Mr.
Pokusa's Employment Agreement without cause, the Company will be obligated
to pay severance payments equal to six months salary, paid on a monthly
basis. Furthermore, if there is a change in control of the Company (as
defined in the Employment Agreement), and Mr. Pokusa's agreement does not
continue in effect after such change of control, the Company will, within
60 days of notifying Mr. Pokusa of such termination, pay Mr. Pokusa (a) a
lump sum payment equal to all salary then due and payable and (b)
severance payments equal to six months salary, paid on a monthly basis.
F37
STAR SCIENTIFIC, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
15. Quarterly results (unaudited):
The following is a summary of unaudited results of operations for the
years ended December 31, 2001 and 2000:
March June September December
---------- ---------- ---------- ----------
2001
----
Revenues 37,374,606 43,660,976 57,478,381 36,269,460
Gross profit 9,931,307 11,874,811 9,502,554 5,103,967
Net income 2,418,493 2,698,278 511,291 (2,603,514)
EPS - Basic .04 .05 .01 (.04)
EPS - Diluted .04 .05 .01 (.04)
March June September December
---------- ---------- ---------- ----------
2000
----
Revenues 46,513,142 42,238,508 75,600,259 58,699,271
Gross profit 9,831,419 10,695,034 15,550,340 9,431,167
Net income 2,005,262 1,726,913 4,687,223 1,621,121
EPS - Basic .03 .03 .08 .03
EPS - Diluted .03 .03 .08 .03
Per share amounts for each quarter are required to be computed
independently and, therefore, may not equal amounts computed on an annual
basis.
F38
STAR SCIENTIFIC, INC. AND SUBSIDIARY
SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS
DECEMBER 31, 2001 AND 2000
[Enlarge/Download Table]
Column A Column B Column C Column D Column E
-----------------------------------------------------------------------------------------------------
(1) (2)
Balance at Charged to Charged to Balance at
beginning of costs and other accounts, Deductions, end of
Description period expenses describe describe * period
-----------------------------------------------------------------------------------------------------
2001
Accumulated Depreciation of
Property Plant and Equipment $4,176,313 2,913,388 1,749,542* $5,340,159
Accumulated Amortization of
Patents and Trademarks $ 236,017 95,789 $ 331,806
2000
Accumulated Depreciation of
Property Plant and Equipment $1,988,658 2,211,143 23,488* $4,176,313
Accumulated Amortization of
Patents and Trademarks $ 205,216 30,801 $ 236,017
* - Accumulated depreciation on disposals
F39
Dates Referenced Herein and Documents Incorporated by Reference
↑Top
Filing Submission 0000928385-02-001206 – Alternative Formats (Word / Rich Text, HTML, Plain Text, et al.)
Copyright © 2024 Fran Finnegan & Company LLC – All Rights Reserved.
About — Privacy — Redactions — Help —
Sat., Apr. 27, 9:07:24.1am ET 
