Form 10-K

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act. Yes ¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x

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

Indicate by check mark whether the registrant is a large accelerated filer, on accelerated filer, or a non-accelerated filer.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x

The aggregate market value of the Registrant’s voting stock held by non-affiliates of the Registrant as of June 30, 2006 was approximately $121,075,458. Shares of voting stock held by each executive officer and director and by each person who owns 10% 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, 2007: 79,287,714 shares of Common Stock.

Part III, Items 10, 11, 12, 13 and 14 of an amended Annual Report on Form 10-K/A of the Registrant, to be filed within 120 days after the close of the Registrant’s fiscal year, are incorporated by reference into Part III of this Annual Report on Form 10-K.

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 ADDITIONAL CAPITAL IN THE FUTURE THAT IS NECESSARY TO MAINTAIN 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 NEW SMOKELESS TOBACCO PRODUCTS, COMPETITION FROM COMPANIES WITH GREATER RESOURCES THAN THE COMPANY, THE COMPANY’S DECISION NOT TO JOIN THE TOBACCO MASTER SETTLEMENT AGREEMENT (“MSA”), THE EFFECT OF STATE STATUTES ADOPTED UNDER THE MSA AND ANY SUBSEQUENT MODIFICATION OF THE MSA, AND THE COMPANY’S DEPENDENCE ON KEY EMPLOYEES AND ON ITS STRATEGIC RELATIONSHIPS WITH BROWN & WILLIAMSON TOBACCO CORPORATION IN LIGHT OF ITS COMBINATION WITH RJ REYNOLDS TOBACCO COMPANY, INC. 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, available at www.sec.gov. The Company undertakes no obligation to update or advise upon any such forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events.

Star Scientific, Inc. (“Star”) and its wholly-owned subsidiary, Star Tobacco, Inc. (“ST” and together with Star, the “Company”) are technology-oriented tobacco companies with a mission to reduce toxins in tobacco leaf and tobacco smoke. The Company is engaged in:

(1) the development, implementation and licensing of scientific technology for the curing of tobacco so as to substantially prevent the formation of carcinogenic toxins present in tobacco and tobacco smoke, primarily the tobacco-specific nitrosamines (“TSNAs”);

(2) the manufacturing, sales, marketing and development of very low-nitrosamine smokeless tobacco products that also carry enhanced warnings beyond those required by the Surgeon General, including ARIVA^{^®} compressed powdered tobacco cigalett^{^®} pieces and STONEWALL Hard Snuff^{^®}; and

Through its StarCured^{^®} tobacco curing program in the period 1999-2003, the Company purchased or arranged for the purchase of very low-TSNA flue-cured tobacco (cured by farmers using the StarCured^{^®} tobacco curing process), for resale to Brown & Williams Tobacco Corporation (“B&W”). As described below in “Segments and Products — Leaf Tobacco”, the Company suspended the purchase and sale of such low-TSNA flue-cured tobacco in 2004. Because of its inability to purchase tobacco from its participating farmers, the Company in 2007 has sought to disband its StarCured^® tobacco curing program and to sell the tobacco curing barns that were being maintained by the participating farmers to those farmers or to other third parties. In March 2007, the Company closed on the sale of approximately 960 of its tobacco curing barns and anticipates completing sales of a total of approximately 990 curing barns this month.

Historically, the vast majority of the Company’s revenues have been generated through the sale of its discount cigarettes which are currently sold under the brands: SPORT^{^®}, MAINSTREET^{^®} and G-SMOKE^{^®}. In 2004, in order to consolidate its brands, the Company phased out its VEGAS^{^®} brand. Although cigarette sales have continued to be its most significant source of revenue, cigarette sales have decreased each year since 2000 and its long-term focus over the last several years has been on low-TSNA smokeless tobacco products. ST’s cigarettes are sold through approximately 73 tobacco distributors throughout the United States. However, the Company has sought to focus sales efforts in the states of Florida, Minnesota, Mississippi and Texas where it does not incur escrow obligations under the tobacco Master Settlement Agreement (“MSA”) and has successfully limited sales in the MSA states.

Star Scientific’s long-term focus continues 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. The Company fully accepts the evidence that links smoking tobacco with a variety of diseases and premature death and believes that it is highly unlikely that the health risks of smoked tobacco can be completely eliminated. Star believes it was the first company to state unequivocally 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^{^®}, a package “onsert” which contained not only scientifically verified comparative content data, but also additional health warnings. Nevertheless, in a world where an estimated 1.3 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, given available technology. 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^{^®} tobacco curing process. (See “Research and Development” below.) However, since the last half of 2003, the Company has deferred such research projects due to its cost-cutting efforts and has concentrated its resources and efforts on its patent infringement lawsuit against R.J. Reynolds Tobacco Company (“RJR”). The extent of future research efforts will depend, in part, on the results of the RJR litigation.

The Company has an exclusive, worldwide license from Regent Court Technologies, LLC under twelve patents issued and patents pending relating to methods to substantially prevent the formation of TSNAs in tobacco including the StarCured^{^®} tobacco curing process and the production of very low-TSNA tobacco products. The StarCured^{^®} tobacco curing process, as discussed herein, involves the control of certain conditions in tobacco curing barns, and in certain applications, uses microwave and/or electronic beam technology. The StarCured^{^®} process substantially prevents the formation in the tobacco leaf of the carcinogenic TSNAs, which are widely believed by medical and scientific experts to be among the most abundant and powerful cancer-causing toxins present in tobacco and in tobacco smoke.

The Company is the exclusive licensee of two patents that are the subject of its ongoing lawsuit against RJR. The United States District Court for the District Court of Maryland in the RJR patent infringement litigation in January issued a decision holding that the patents in issue in this case which relate to methods to substantially prevent the formation of TSNAs are invalid because they are indefinite as to the term “anaerobic condition”. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim. The outcome of this litigation is crucial for the Company with respect to its ability to expand the value of its patents and is currently the primary focus of the Company’s efforts to defend and enforce its intellectual property rights. See “Legal Proceedings” under Item 3 for more information on the RJR patent infringement action and see “Factors That May Affect Future Results” under Item 1 for further information on the importance of defending the Company’s intellectual property rights.

The Company believes it has the technology through its patent rights to reduce exposure to carcinogenic TSNAs, particularly the subgroups of nitrosamines commonly referred to as NNNs and NNKs, to the lowest possible levels. Further, the Company has demonstrated through the StarCured^{^®} barn program that its method for curing tobacco using the StarCured^{^®} 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 five years has centered on the development and commercialization of very low-TSNA, non-fermented smokeless tobacco products that can be used as alternatives 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 development and sale of very low-TSNA non-fermented smokeless tobacco products, as well as on encouraging other tobacco manufacturers to sublicense the StarCured^{^®} tobacco curing technology to produce very low-TSNA tobacco (with carcinogenic NNKs and NNNs that measure 200 parts per billion and below), provided the Company is successful in its current appeal concerning these patents and eventually establishing the enforceability of the patents relating to this process. The Company actively markets two very-low TSNA products: (1) ARIVA^{^®}, a compressed powdered tobacco “cigalett^{^®}”; and (2) STONEWALL Hard Snuff^{^®}, a non-fermented, spit-free^™“hard tobacco” product for moist snuff users. The tobacco in each of the Company’s smokeless products is 100% StarCured^{^®} very low-TSNA tobacco. Previously, the Company had manufactured a low-TSNA moist snuff (Stonewall^{^®} moist snuff) and a low-TSNA dry snuff (Stonewall^{^®} dry snuff). With the introduction of STONEWALL Hard

Snuff^{^®}, the Company discontinued the manufacture of Stonewall^{^®} moist snuff and has not been actively marketing Stonewall^{^®} dry snuff. To date, ARIVA^{^®} and STONEWALL Hard Snuff^{^®} have not generated significant revenues. The Company’s smokeless products are described in greater detail in “Segments and Products – Smokeless Tobacco”.

Star and B&W had been party to multiple, substantial commercial relationships for a number of years. These included arrangements with respect to the financing of StarCured^{^®} tobacco curing barns, purchases of StarCured^{^®} tobacco by B&W, and licensing arrangements related to StarCured^{^®} tobacco, other low-TSNA tobacco, and very low-TSNA cigarettes and smokeless tobacco products. See discussion in “Relationship with B&W” below regarding the history of the Company’s contractual arrangements with B&W, and the impact of the combination of the operations of B&W and RJR in 2004.

As noted above, historically the Company’s revenues have been generated principally through ST. ST, a Virginia corporation, was incorporated in 1990 and, until 1994, was primarily 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, which competed principally on the basis of price. Around the same time, ST commenced a research and development program relating to a range of tobacco products that deliver fewer 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 completed a share exchange with Eye Technology, Inc., a publicly held OTC Bulletin Board company based in Minneapolis, Minnesota. Eye Technology was organized as a Delaware corporation in 1985. While Eye Technology became ST’s parent corporation, in effect control of Eye Technology shifted to the former stockholders of ST and the management of ST became the management of Eye Technology. By December 30, 1998, the assets and liabilities that comprised the pre-merger business of Eye Technology had been sold or liquidated, and the stockholders of Eye Technology voted to change its name to Star Scientific, Inc. Star’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 in the future after further long-term peer reviewed clinical trials.

In each of 2000, 2001 and 2002, Star processed and sold approximately 19 million pounds of very low-TSNA flue-cured tobacco that had been cured using the StarCured^{^®} tobacco curing process. Substantially all 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 22.8%, 20.6% and 20.7% of the Company’s net sales in 2002, 2001 and 2000, respectively.

Under a Letter Agreement with Star, dated August 14, 2003 (the “Letter Agreement”), B&W agreed to purchase 15 million pounds of tobacco directly from the Company’s StarCured^{^®} farmers in 2003 and was relieved of its obligation to purchase tobacco from Star in the future. B&W further agreed to extend the Company’s loan repayment schedule for certain StarCured^{^®} barns that it financed from 60 months to 96 months. As a result of this extension, the balance of the notes are payable by the Company in equal consecutive monthly installments that began on January 3, 2006.

Beginning in 2004, Star notified its StarCured^{^®} farmers that since B&W was no longer obligated to purchase all of the tobacco produced by its participating StarCured^{^®} farmers, the Company could not commit to purchase tobacco from the StarCured^{^®} farmers. In 2004 and each year thereafter, Star advised its participating StarCured^{^®} farmers that they could use the StarCured^{^®} tobacco curing barns during the upcoming growing season, but that they would need to make arrangements to sell their tobacco to other parties. In 2005, following the lifting of controls on the production of tobacco and the elimination of price supports under Federal tobacco buyout legislation, the amount of tobacco cured in the StarCured^{^®} tobacco curing barns decreased significantly. In 2005, the Company wrote down the value of the tobacco curing barns by approximately $2.5 million to reflect the then-current value of the barns. In 2006, the production of tobacco rebounded and this resulted in an increase in the appraised value of the Company’s tobacco curing barns. Because the RJR business combination with B&W and ongoing uncertainties resulting from the current patent litigation have disrupted the Company’s ability to guarantee purchase of tobacco from farmers using these barns and because of the need for funding to support the ongoing patent litigation, the Company in 2007 sought to disband its StarCured^® tobacco curing program and to sell the tobacco curing barns that were being maintained by the participating farmers to those farmers or to other third parties. In March the Company sold approximately 960 of its tobacco curing barns and anticipates completing sales of a total of approximately 990 curing barns this month.

Over the past six years, the Company has been engaged in the development of very low-TSNA, non-fermented smokeless tobacco products that could provide adult tobacco users with a viable alternative to cigarettes for use in situations and environments where they cannot smoke or when they choose not to smoke. This development effort was encouraged by the Company’s Scientific Advisory Board and other independent scientific, medical, and public health advisors who urged Star to accelerate the development of smokeless products using 100% StarCured^{^®} very 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 throughout the World believe that the only major or prevalent biologically significant carcinogenic toxins in non-fermented smokeless tobacco are the TSNAs, particularly the NNNs and NNKs.

In September 2001, the Company introduced its first two very low-TSNA snuff products (a moist and a dry snuff) under the brand name Stonewall^{^®}. In November 2001, Star introduced ARIVA^{^®} cigalett^{^®} pieces as its first hard tobacco smokeless tobacco product. ARIVA^{^®} is a compressed powdered tobacco product designed to dissolve completely in the mouth without leaving any residue or requiring expectoration. Star’s sales of ARIVA^{^®} have been de minimis since its introduction compared to cigarette sales. In an effort to market a hard tobacco product to adult tobacco users who are familiar with using smokeless tobacco products, the Company during the second quarter of 2003 introduced a non-fermented spit-free^™“hard tobacco” product for moist snuff users, called STONEWALL Hard Snuff^{^®}, which is made from non-fermented 100% low-TSNA StarCured^{^®} tobacco plus natural and artificial flavorings, as well as other ingredients. In light of its increased emphasis on hard tobacco products, the Company discontinued the manufacturer of Stonewall^{^®} moist snuff and has not sought to actively market Stonewall^{^®} dry snuff.

ARIVA^{^®} and STONEWALL Hard Snuff^{^®} are currently marketed nationwide by ST through both its network of established tobacco distributors and through new distributors that ST has not previously utilized to market its cigarette products. In addition, the Company has introduced ARIVA^{^®} and STONEWALL Hard Snuff^{^®} through direct arrangements with several national retail chains, including CVS and RiteAid drug store chains and through other national distributors experienced with consumer products. While the Company’s sale of both ARIVA^® and STONEWALL Hard Snuff^® increased in 2006, sales continue to be de minimis compared to cigarette sales. The Company expects that the successful marketing of ARIVA^{^®} and STONEWALL Hard Snuff^{^®} on a broad basis will require the expenditure of substantial funds, which the Company will need to obtain from external financing, the availability of which cannot be assured. (See “Liquidity and Capital Resources” under Item 7 for more information on the Company’s liquidity.) In 2001, the Company entered into an agreement with B&W (the Hard Tobacco Agreement) to test market a very low TSNA smokeless tobacco product. This Hard Tobacco Agreement was terminated in December 2004. In the second quarter of 2004, the Company entered into an agreement with another tobacco manufacturer for the licensing of low-TSNA hard tobacco. Under that agreement, the manufacturer conducted an initial assessment of a hard tobacco product in 2004, but did not conduct a further test market as envisioned under the agreement. During 2006, the Company developed new “natural” flavors of hard snuff and conducted consumer preference studies for that product. The Company in early 2007 introduced this flavor in test market as STONEWALL^® Natural Hard Snuff and anticipates supporting that effort with increased marketing.

There were no export sales of smokeless tobacco products by the Company in 2006.

Traditionally, sales of discount cigarettes have represented the substantial majority of ST’s revenues and although the Company’s sale of discount cigarettes has experienced a decline since 2000, such sales have continued to be the Company’s primary revenue source. ST currently sells three brands of discount cigarettes through approximately 73 tobacco distributors throughout the United States. With the continued decrease in the volume of its cigarette sales, and in light of the Company’s desire to place its long-term focus on smokeless products associated with low-TSNA tobacco, the Company has continued to evaluate the viability of its discount business even though these discount brands accounted for approximately 100% of the Company’s net sales during 2005 and 2006. of its business and has been focused on transitioning from the smoked tobacco business to the sales of very low-TSNA smokeless tobacco products and the licensing of its technology for producing low-TSNA tobacco and related products. These cigarettes, which are sold as discount brands, accounted for approximately 100% of the Company’s net sales in both 2005 and 2006. 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 the four non-MSA states, Florida, Minnesota, Mississippi and Texas), pricing appropriate for discount cigarettes, and, to a lesser extent, brand recognition, product appearance and taste in order to compete in the marketplace. ST has chosen to focus its cigarette sales in the four non-MSA states because sales in those states are not subject to MSA escrow obligations and has successfully limited sales in the MSA states. (See “Liquidity and Capital Resources” under Item 7 and “Tobacco Master Settlement Agreement” under “Government Regulation” for a more detailed description of the cash implications of making payments into the MSA escrow

accounts.) ST has avoided any marketing or advertising 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 of cigarettes by the Company in 2006. In 2004, in order to consolidate its brands, the Company phased out its VEGAS^{^®} brand of cigarettes.

Presently, the Company uses a blend of “cut rag” tobacco in its discount cigarettes, but no StarCured^{^®} tobacco. The Company formerly included StarCured^{^®} very low-TSNA tobacco in its discount cigarettes, but discontinued this practice in 2002 in favor of using less expensive tobacco because it was not economically feasible to continue to use more expensive StarCured^{^®} tobacco in the highly cost-competitive market in which its cigarette products are sold, particularly in light of the impact of the MSA on the sales of its cigarette products. The Company has continued to use its StarCured^{^®} tobacco in all of its smokeless tobacco products.

Star launched the first low-TSNA cigarette, Advance^{^®}, in October 2000. Advance^{^®} was the first conventional cigarette specifically manufactured to diminish the amount of exposure to highly carcinogenic TSNAs. The Advance^{^®} cigarette reduced additional toxic smoke constituents through a unique activated carbon/acetate filter. Advance^{^®} 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. In 2001, B&W initiated a test market of a version of the Advance^{^®} cigarette in Indianapolis, Indiana and expanded the test market to Phoenix, Arizona in 2004. Following the combination of B&W and RJR in 2004, the test market was discontinued.

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^{^®} 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. To aid this development, the Company secured two Investigational New Drug Applications (“IND”) from the FDA. While the initial results of the IND protocol testing of these products were positive, the Company determined that further testing as well as the preparation and submission of required marketing applications to the FDA would not only be costly and time consuming, and require a major scientific infrastructure which the Company did not have and could not afford at the time, but also that further development of these products would not be feasible without support from a major pharmaceutical company. While the Company has explored entering into a joint venture partnership or other technology license arrangement as a means to develop cessation related products, at this point in time the Company is focused on other objectives, as set forth above.

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. Mike Bujakowski, General Manager of Star Tobacco, supervises a staff of three regional sales managers who direct ST’s field sales force. The sales force currently consist of 32 sales personnel and merchandisers who are located primarily in Mississippi and Texas.

It has been ST’s strategy to rely to a large degree upon the sale of its discount cigarette brands to distributors in the non-MSA states who, in turn, promote ST’s discount cigarette brands to retail customers in those states. ST provides its distributors with point-of-sale materials such as posters, pole signs, display racks and counter top and floor displays for redistribution to retailers. 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 smoked and smokeless tobacco products through approximately 117 tobacco distributors throughout the United States. Of these, approximately 73 are located in Florida, Mississippi, Minnesota, and Texas, where the Company’s sales force is now concentrated and where it does not have obligations to make payments into escrow under state qualifying statutes enacted pursuant to the MSA for sales of cigarette products. 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. One customer, Starco Impex, Inc., doing business as Wholesale Outlet, accounted for 44.2% of ST’s consolidated revenues in 2006 and 65.6% of ST’s outstanding receivables as of December 31, 2006. While ST sells its smoked and smokeless tobacco products through approximately 117 tobacco distributors, the number of distributors selling the Company’s smoked tobacco products increased from approximately 67 in 2005 to 73 in 2006. ST’s shipment volume for discount cigarettes during 2006 decreased approximately

21% to 950 million units from 2005’s shipment volume of approximately 1.2 billion units, reflecting significant competition from other manufacturers, a continued commitment by the Company to concentrate the field sales force and sales efforts in the four non-MSA states where it does not have escrow obligations and the continued focus on its series of smokeless tobacco products. In marketing ARIVA^{^®} hard tobacco cigalett^{^®} pieces and STONEWALL Hard Snuff^{^®}, the Company has sought to position these products using many of the same distribution channels that it uses for its cigarette sales. As part of its marketing and distribution effort, the Company also has negotiated agreements with a number of national retail chains, including CVS and RiteAid drug store chains and other national distributors experienced with selling consumer products.

In 2000-2002, Star purchased its low-TSNA flue-cured tobacco for its leaf tobacco sales from approximately 200 participating tobacco farmers (“StarCured^{^®} farmers”) who cured their tobacco in specially designed StarCured^{^®} barns pursuant to long-term contracts entered into with the Company. There were no sales of tobacco leaf during 2003 because under the August 14, 2003 Letter Agreement with B&W, described previously in this report, B&W agreed to purchase StarCured^{^®} tobacco directly from the Company’s participating StarCured^{^®} farmers. Beginning in 2004, Star notified the participating StarCured^{^®} farmers that since B&W was no longer obligated to purchase StarCured^{^®} tobacco from the Company, it was not in a position to purchase tobacco from them, and that while the farmers could continue to use the StarCured^{^®} tobacco curing barns, they would have to find other buyers for their tobacco. Because of the disruption to its program caused by the RJR/B&W business combination, and the ongoing burden and expense of the pending patent litigation with RJR, the Company in 2007 sought to disband its StarCured^® tobacco curing program and to sell the tobacco curing barns that were being maintained by the participating farmers to those farmers or to other third parties. In March 2007, the Company sold approximately 960 of its tobacco curing barns and anticipates completing sales of approximately 990 curing barns this month.

During 2006, ST purchased “cut rag” tobacco (tobacco that has been cut, processed and flavored to ST’s specifications for cigarettes) for its cigarettes from a third party supplier, which allowed ST to avoid having to dedicate substantial amounts of working capital to tobacco inventories (at the end of 2006, Star only inventoried enough tobacco for work-in-progress purposes) and to obtain less expensive tobacco. (See “Manufacturing” below for a description of the Company’s manufacture of cigarettes) ST continues to use all Virginia very low-TSNA flue-cured StarCured^{^®} tobacco in its smokeless tobacco products and believes that it will be able to obtain a sufficient supply of StarCured^{^®} tobacco for future needs from farmers who previously participated in the StarCured^® tobacco curing program.

Since 2000, Star maintained a burley tobacco program with a number of burley farmers in Kentucky in conjunction with the Burley Tobacco Growers Cooperative Association, Inc. In 2006, as it had done over the past several years, the Company did not purchase any burley tobacco from the farmers participating in its burley program. In 2007, the Company notified the farmers participating in its burley program that it would remove these barns from Kentucky and seek to sell the barns. Star is currently in the process of relocating all of its Kentucky barns, so that they can be sold to farmers producing flue-cured tobacco.

All of the flue-cured tobacco that the Company plans to use in Star’s smokeless tobacco products, but not in the Company’s discount cigarettes, has or will be cured in specially manufactured curing barns using the StarCured^{^®} tobacco curing process. The StarCured^{^®} tobacco curing process involves controlling certain conditions in the tobacco curing barns, and in certain applications, uses microwave and/or electronic beam technology. The tobacco curing barns were positioned on site at the farms of its participating StarCured^® farmers. Approximately 975 barns were maintained by farmers who produce flue-cured tobacco and approximately 60 barns were located in Kentucky in connection with the research, development and testing of the StarCured^{^®} tobacco curing process for burley tobacco.

As noted above, the Company in 2007 has sought to disband its StarCured^® tobacco curing program and to sell the tobacco curing barns that were being maintained by the participating farmers to those farmers or to other third parties. Under an Agreement with Star dated April 25, 2001, B&W agreed to finance all of the StarCured^{^®} tobacco curing barns. The initial loan balance for the barns was approximately $29 million as of April 2001. Since January 2006, the Company has been paying principal and interest on this debt and the loan balance as of December 31, 2006 was approximately $17.5 million, which is payable over the next seven years.

In early 2000, Star’s processing facility in Chase City, Virginia underwent a substantial expansion of its capacity to process significantly larger amounts of low-TSNA tobacco, 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 to install a state of the art laboratory to test for TSNAs. This expansion allowed Star to process approximately 19 million pounds of StarCured^{^®} tobacco during each of the three growing season from 2000-2002, and approximately 15 million pounds in 2003. In 2004 and again in 2005, the Company arranged for the Flue-Cured Cooperative Stabilization Corporation to sublease the receiving portion of its facility for four months (August – November 2004) and to operate a tobacco marketing center there during those growing seasons. In 2006, the Company did not enter into a sublease for this space.

Since January 1, 2003, the Company has reduced cost of goods sold by resuming the in-house manufacturing of all of its cigarettes at its Petersburg, Virginia manufacturing facility and by reducing the cost for tobacco and filters used in its discount cigarettes. The Company anticipates that the manufacturing capacity in Petersburg should be sufficient to satisfy the manufacturing needs for its cigarettes for the foreseeable future, given its current manufacturing levels. The Company will continue to manufacture cigarettes until it can transition from its smoked tobacco business.

In 2002, Star installed at Chase City a high-speed manufacturing line in a portion of its Chase City, Virginia tobacco receiving building for the production of ARIVA^{^®} hard tobacco cigalett^{^®} pieces, Stonewall^{^®} dry snuff and STONEWALL Hard Snuff^{^®}. The Company does not anticipate ordering additional equipment for its smokeless tobacco products until the existing production line is operating at nearly full capacity. The Company also has a second facility in Chase City adjacent to its receiving station. This facility has approximately 91,000 square feet of space that can accommodate both manufacturing lines and an expanded testing facility, and has 9,000 square feet of office space located on approximately nine acres of land. This facility was purchased during 2002 by the Mecklenburg County and Chase City Industrial Development Authorities and they, along with Star, renovated the facility to Star’s specifications. Star entered into a long-term lease with an option to purchase this facility. The Company is currently evaluating its current manufacturing capacity in Chase City, given the continued de minimis sales of ARIVA^{^®} and STONEWALL Hard Snuff^{^®}.

The Company believes its manufacturing facilities provide more than sufficient capacity for it to meet the current demand for its very low-TSNA smokeless products, as well as to meet the demand for cigarette products.

On October 12, 1999, the Company and B&W entered into a Master Agreement and entered into a Restated Master Agreement in April 2001. Under these agreements, B&W, among other things, agreed to purchase StarCured^{^®} tobacco.

In 2000-2002, Star produced and delivered to B&W approximately 19 million pounds of very low-TSNA StarCured^{^®} tobacco annually. In 2003 B&W purchased 19 million pounds of StarCured^® tobacco directly from the Company’s participating farmers. Pursuant to a Letter Agreement entered into in August 2003, B&W was relieved of its obligation to purchase additional StarCured^® tobacco.

Beginning in 2004, Star notified its StarCured^{^®} farmers that since B&W was no longer obligated to purchase all of the tobacco produced by its participating StarCured^{^®} farmers, the Company could not commit to purchase tobacco from them. Because of its inability to purchase tobacco from its participating farmers, the Company in 2007 has sought to disband its StarCured^® tobacco curing program and to sell the tobacco curing barns that were being maintained by the participating farmers to those farmers or to other third parties. B&W also manufactured cigarettes for ST pursuant to a Manufacturing Agreement entered into in January 2000 and supplied leaf tobacco to ST for use in its tobacco products, pursuant to a Supply Agreement entered into in January 2000. B&W ceased manufacturing cigarettes for Star as of December 31, 2002, and ceased supplying tobacco to Star in the first half of 2003.

Under the Restated Master Agreement and several subsequent agreements, B&W also agreed to restructure approximately $29 million of debt that B&W provided to support the Company’s purchase of StarCured^® tobacco curing barns. Pursuant to these agreements, B&W agreed to a 96 month repayment schedule consisting of equal consecutive monthly installments beginning on January 3, 2006. As of December 31, 2006, the debt is secured by tobacco leaf inventory and certain of the tobacco curing barns. 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. The loan balance was approximately $17.5 million as of December 31, 2006.

Pursuant to one of the April 25, 2001 Agreement, B&W initiated a test market of the low-TSNA Advance^® cigarette. Further, pursuant to another agreement entered into on April 25, 2001 (the “Hard Tobacco Agreement”), as amended, B&W had a non-exclusive right to purchase and sell hard tobacco manufactured by Star, in return for royalty payments on the sales of these products. On December 14, 2004, Star received notice from RJR (as purported successor to Brown & Williamson Tobacco Corporation) and Brown & Williamson Holdings, Inc. (formerly known as Brown & Williamson Tobacco Corporation) that the hard tobacco market test conducted under the Hard Tobacco Agreement was unsuccessful and that consequently the Hard Tobacco Agreement was terminated on December 14, 2004. Under the terms of the Hard Tobacco

Agreement, as a result of the this termination, B&W and RJR, as the purported and self-described successor to B&W, are prohibited from manufacturing, selling or distributing a hard tobacco product, or competing with Star in the manufacture, sale or distribution of a hard tobacco product, for a period of four years.

In the fourth quarter of 2003, Star and B&W also entered into a letter agreement which, in part, restructured and consolidated all of Star’s outstanding trade payables to B&W. Under this letter agreement, the then-total trade payables due to B&W was to be paid in monthly principal payments of $250,000 beginning in January 2004 (later extended to January 2005) as well as monthly interest at an interest rate of prime plus 1% on the outstanding balance. As of December 31, 2006 the balance on the note payable was $1,961,743.

On July 30, 2004, RJR, a subsidiary of B&W, and certain of their affiliated tobacco businesses combined operations under the publicly traded holding company, Reynolds American Inc. (“RAI”), which is 42% owned by British American Tobacco PLC, the parent of B&W. In the patent litigation discussed herein, RJR took the position that the new operating entity established as a result of this combination transaction assumed all of the rights and obligations under the agreements previously entered into between Star and B&W, and moved to dismiss the Company’s patent infringement lawsuit against RJR on that basis. After full briefing, the Court denied RJR’s motion to dismiss, and found that B&W had attempted to assign the Star/B&W agreements to the new subsidiary but that Star had not consented to the assignment. The Court further found that the de facto merger doctrine did not apply. In its ruling the Court did leave open the question of what impact, if any, the combination may have on the future licensing arrangements with RJR, but noted that those considerations did not impact the claims asserted in the patent litigation. Star has also been advised by Brown & Williamson Holdings, Inc., the surviving B&W entity, that the tobacco and cigarette division of B&W has been combined with the operations of RJR.

For additional information on our relationship with B&W, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as “General” and “Manufacturing” under this Item 1.

In the discount cigarette segment of the market, price is one of the principal competitive factors. However, customer familiarity with brands, market accessibility and service also play a role. The Company’s primary competition for cigarettes traditionally has been from the four “majors”, that is, Philip Morris, the brands of which accounted for approximately 50% of all cigarette sales in the United States in 2006, R.J. Reynolds and B&W (now RAI), Lorillard, and 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, the Company has faced increased competition from foreign manufacturers who are not participating members of the MSA. Despite the requirements of the MSA, many of the newer discount competitors have not made deposits into escrow accounts required by the MSA. Due to the price-sensitive nature of the discount segment of the cigarette market, this has allowed these newer discount competitors to undercut the current discount market and unfairly compete against ST for discount cigarette sales. Although a number of states have initiated litigation against some of these companies for failure to make escrow payments on sales in those states, the threat of litigation has not adequately resolved this issue.

In 2001, Vector Group, Ltd. introduced a reduced-toxin cigarette that it represented contained fewer toxins, including TSNAs, than other conventional brands. It appears that this brand was not successful in its market entry. Vector also introduced a cigarette brand manufactured with genetically modified tobacco and made similar types of claims for this product. It also appears that this brand was not successful in its market entry. In November 2001, B&W began an expanded test market in Indianapolis, Indiana of its version of the Advance^{^®} low-TSNA cigarette that Star and B&W jointly developed and expanded the test market to Phoenix, Arizona in 2004. 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 United States that claims to have reduced levels of carcinogens. U.S. Smokeless Tobacco also has been test marketing a pouch smokeless tobacco product which it claims has low levels of TSNAs. In 2006, both Phillip Morris and RAI introduced into test market smokeless tobacco pouches designed to provide an alternative to cigarettes.

ARIVA^{^®} compressed tobacco cigalett^{^®} pieces are intended to compete with conventional cigarettes and to be used by adult smokers in situations and environments when they cannot or choose not to smoke. Accordingly, the Company believes ARIVA^{^®} will primarily compete for market share against large tobacco manufacturers that dominate the cigarette industry, as opposed to traditional competitors in the smokeless market. ARIVA^{^®} is priced competitively with cigarettes.

The Company’s STONEWALL Hard Snuff^{^®} primarily competes with other smokeless tobacco companies such as US Smokeless Tobacco Company, Conwood and Swedish Match, because STONEWALL Hard Snuff^{^®} is intended to compete with moist snuff tobacco products. STONEWALL Hard Snuff^{^®}is priced at a discount to traditional moist snuff products. B&W obtained very low-TSNA StarCured^{^®} tobacco from Star or its participating StarCured^{^®} farmers during the 1999-2003 growing seasons. Further, the United States Department of Agriculture (“USDA”) announced in 2002 that it would not provide full price supports for flue-cured tobacco that was not cured in a manner to reduce or limit the levels of TSNAs in the cured tobacco leaf, and the tobacco industry earlier had announced an initiative to facilitate the production of low-TSNA flue cured tobacco. As a result, virtually all flue-cured tobacco grown in the United States since 2001 has been cured in a manner to reduce the levels of TSNAs. Star believes that, if it is successful in commercializing its unique low-TSNA tobacco products and enforcing the patents for the technology used to produce such products, to which it is the exclusive licensee, many of the major tobacco companies will also seek to market such low-TSNA tobacco products and may seek to sublicense the technology for producing low-TSNA tobacco from the Company.

Smoking cessation products that are approved for sale in the United States by the FDA are 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”. Some of these products are sold over the counter and others are available by prescription. Although such pharmaceutical products are not intended to be substitutes for tobacco products, it is generally recognized that many smokers use such products for tobacco maintenance. Accordingly, such products may compete with ARIVA^{^®} in the “When You Can’t Smoke”^® market. 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’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.

The manufacture and sale of cigarettes and other tobacco products are subject to extensive federal and state governmental regulation in the United States and by comparable authorities in many foreign countries. The manufacture and sale of tobacco products is regulated by the Tax and Trade Bureau (the “TTB”) under authority of the Department of the Treasury, and the Internal Revenue Code of 1986, as amended (26 U.S.C. § 5701 et seq.) and the Company has been granted manufacturing licenses from the TTB for its facilities in Chester, Chase City and Petersburg, Virginia. Also, the Federal Trade Commission (the “FTC”) regulates the warnings on tobacco product labels and the advertising of tobacco products under the Federal Cigarette Labeling and Advertising Act (15 U.S.C. §§ 1331- 1341) and the Comprehensive Smokeless Tobacco Health Education Act of 1986 (15 U.S.C. §§ 4401- 4408). In accordance with these statutes, the Company has submitted plans for the labeling and advertising of its tobacco products that have been approved by the FTC in its role as the agency responsible for implementing these statutes. Many states also require manufacturers of tobacco products to obtain a cigarette license or a tobacco product license in order to sell tobacco products. Where required, the Company has obtained the necessary state licenses to permit it to sell cigarettes and other tobacco products. States also regulate the age at which adult consumers may purchase tobacco products and the locations where tobacco products can be sold. Many states over the past few years have placed increased restrictions on the purchase and use of tobacco products.

Multiple bills have been introduced in both the United States Congress and in several state legislatures during the past five years which, if enacted, would have significantly changed the United States tobacco industry. Some of these federal bills contained 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 specific standards. In February 2007, bills calling for regulation of all tobacco products by the FDA were introduced in both the Senate and the House. These bills, HR 1108 and S 625, both titled “The Family Smoking Prevention and Tobacco Control Act”, contain many of the same types of provisions that had appeared in earlier bills. Star is unable to predict what effect, if any, these provisions, if enacted, would have on the Company’s low-TSNA tobacco curing technology or on 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 was the first tobacco company to support comprehensive and equitable jurisdiction within the Food and Drug Administration of all products containing tobacco.

In October 2004, Congress passed the Fair and Equitable Tobacco Reform Act of 2004 (“FSC/ETI”) which provides for the end of the Federal tobacco quota program by means of a $10 billion buyout of the tobacco quota system that is being financed by assessments on tobacco manufacturers. Under the prior system that existed since the Great Depression, the government gave tobacco farmers “quotas” that essentially granted the exclusive right to grow tobacco. Each year, the Department of Agriculture set the amount of tobacco that growers could bring to annual markets.

The buyout is paid for by all tobacco manufacturers over a ten-year period based on each company’s percentage of sales. The apportionment of responsibility for payments to quota holders is approximately 96% to cigarette manufacturers, and the remaining 4% is divided among other tobacco product manufacturers, based on market share.

The Department of Agriculture, which is responsible for structuring the payment program to tobacco growers, issued regulations relating to the assessment of the buyout cost in February 2005. Under the regulations, the assessment for the cost of the program is made quarterly based on the prior quarter’s taxable amount of cigarettes. In 2006, we made quarterly payments of approximately $483,000, $707,000, $747,000 and $831,000. In 2005, we made quarterly payments of approximately $1,140,000, $1,149,000, $961,000 and $727,000. These included payment of a portion of a separate assessment of $1,128,093 for certain loan loss costs and administrative costs that was issued in the third quarter of 2005 and that the Company paid over six quarters. The final payment on the assessment was made in the fourth quarter of 2006. With the exception of the separate assessment, the quarterly payments have been approximately $0.50 per carton. All of the major tobacco companies, as well as Star, have increased prices to cover the cost of the buyout and the additional buy-out cost has been reflected in higher overall prices for tobacco products. In 2005, overall tobacco production decreased significantly, primarily due to uncertainty relating to the buyout program. Tobacco production rebounded significantly in 2006. It is expected that the elimination of price supports and limits on tobacco cultivation ultimately will result in lower prices for domestically grown tobacco leaf which could, in turn, result in a further reduction of the cost of tobacco used in the Company’s cigarettes.

On March 21, 2000, in FDA v. Brown & Williamson Tobacco Corporation, 529 U.S. 120 (2000), the United States Supreme Court held that 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 Congress will act to grant authority to the FDA over tobacco products, although legislation that would create such authority has been introduced in each session of Congress over the past several years and bills that would vest FDA with jurisdiction over all tobacco products were introduced in both the Senate and the House in February 2007. 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. Over the last six years, the Company has publicly stated its position in favor of reasoned FDA regulation of all tobacco products.

In December 2001 and early 2002, three citizen petitions were filed with the FDA seeking to have ARIVA^{^®} regulated as a drug product and/or a food. Because ARIVA^{^®} is a smokeless tobacco product that is intended to provide tobacco satisfaction, makes no health claims, and is licensed as a tobacco product by the Tax and Trade Bureau, the Company asserted that the FDA lacked any statutory authority to regulate ARIVA^{^®} based on the Supreme Court decision in FDA v. Brown & Williamson. On August 29, 2003, the FDA issued a letter ruling denying the citizen petitions. In its ruling, the FDA conceded that it lacked jurisdiction over ARIVA^{^®} since it is a customarily marketed tobacco product.

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 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. Since 2001, support for PREPs has been the subject of an ongoing debate concerning whether any tobacco products should be considered to be less toxic and a viable alternative to cigarettes. Over the last several years, the scientific community has begun to recognize that certain forms of tobacco products, particularly low-TSNA smokeless tobacco products, deliver less toxins than smoked tobacco. At the same time, concern has been expressed by certain members of the public health community over the use of smokeless tobacco because of potential “unintended consequences” that may accompany a switch from the most lethal form of tobacco to a less toxic tobacco product.

The requirements for health warnings on cigarettes are 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. Both 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 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 met with FTC staff and shared its enhanced warning labels for Advance^{^®} prior to the initiation of the test marketing of Advance^{^®} in October 2000 and the enhanced warning labels for Stonewall^{^®} moist snuff and ARIVA^{^®} hard tobacco prior to the introduction of these products in 2001.

Manufacturers and importers of tobacco products are taxed pursuant to regulations promulgated by the Tax and Trade Bureau (“TTB”) 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 increased to $.39 per pack in 2002. Since 2002, smokeless tobacco in the form of snuff has been subject to federal tax at a rate of $.585 per pound. The manufacturing of tobacco products is also subject to regulation by the TTB. The Company currently has licenses from the TTB 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.

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 $0.30 per pack in Kentucky to $2.46 per pack in Rhode Island. 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 on 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 1.5 cents 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 price, respectively.

Minnesota, one of the four non-MSA states in which Star increasingly has focused its sales of discount cigarettes, passed a statute which took effect on July 1, 2003, requiring distributors in the state to pay an additional $0.35 per-pack fee on cigarettes purchased from manufacturers like Star that have not entered into a separate settlement with the State. Because the statute impacts all such non-participating manufacturers, its effect has tended to be uniform among these manufacturers. Further in August 2005, the state of Minnesota increased the tax rate by $1.005 per pack, consisting of a $0.255 sales tax increase and a $0.75 health impact fee. This tax has put further price pressure on discount cigarettes since the new tax was imposed on a per-pack basis and replaced a prior tax that was calculated as a percentage of the wholesale price.

Bills were introduced during the 2006 legislative sessions in each of the other three non-MSA states that would have imposed an additional user fee on non-participating manufacturers at a rate of $0.40 to $0.50 per pack on cigarettes sold by companies that have not entered into separate settlement agreements with those states. However, none of these bills were enacted into law. Similar types of legislative proposals have been introduced in Mississippi in 2007 and may be introduced in Florida and Texas this year. Passage of statutes in the non-MSA states that impose fees on manufacturers that have not previously settled with these states would be expected to impact on all such manufactures equally, but would make discount cigarettes more expensive and would lessen the competitive price advantage they currently enjoy compared to generic and premium brand cigarettes. A special session of the Texas legislature was convened in April 2006 to address school finance legislation which had been an issue in Texas since 2005. During the special session, the legislature enacted new funding legislation that included a $1.00 per-pack tax increase on cigarettes. That legislation was signed by the Governor and the cigarette tax increase portion of the statute took effect on January 1, 2007. The $1.00 per-pack tax increase, which applies to cigarettes produced by all manufacturers, has put increased pressure on the market for cigarettes in Texas generally and has resulted in decreased sales of cigarette products in Texas during the first quarter of 2007. Passage of statutes like that in Texas, that impose increased state taxes on all manufacturers, will result in discount cigarettes being more expensive and likely will lessen the competitive price advantage they currently enjoy compared to generic and premium brand cigarettes.

In addition, there have been a number of recently enacted statutes and legislative initiatives in MSA states that could further impact the Company’s ability to compete in these states, even though the Company has sought to limit sales in the MSA states. The Company has determined to cease sales in certain states in response to some of these developments. For example, Michigan, an MSA state, passed a fee statute in January 2004 that requires the payment of a $0.35 per-pack fee on cigarettes sold by non-participating manufacturers, which must be paid in advance, and is based on an estimate of projected sales by the State’s Department of Revenue. This fee is in addition to the MSA requirement that non-participating manufacturers deposit funds into escrow for each cigarette sold in an MSA state. Given the burden of making both escrow payments and fee payments, Star advised Michigan’s Department of Revenue that it would not sell its cigarette brands in Michigan in the future. In 2004, Utah and Alaska, two other MSA states, also passed legislation assessing a $0.35 and $0.25 per-pack fee respectively on cigarettes sold by non-participating manufacturers in those states. However, those statutes have had little impact on Star since the Company has had virtually no sales in Utah or Alaska during the past several years.

Legislation imposing a fee on cigarettes sold by non-participating manufacturers was introduced in the state legislatures in a number of MSA states in 2006 but none of these bills were enacted into law. Similar legislation has been introduced in the

Tennessee legislature this year, but to date, no such bills have been passed. The impact of these new statutes in the MSA states would be expected to have a negative impact on all non-participating manufacturers’ sales in these states, including Star. However, as previously noted, Star has sought to focus its cigarette sales in recent years in the four non-MSA states. During 2005, approximately 95% of our sales were in non-MSA states and for 2006 that percentage should be approximately 97%.

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 on 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. Three states, Massachusetts, Minnesota and Texas, have adopted laws and regulations regarding the disclosure by manufacturers of certain chemical constituents in their products. Although portions of the Massachusetts statute have been held to be unconstitutional, new legislation has been introduced in Massachusetts that would require similar types of disclosure. Star has complied and intends to continue to comply with such laws to the extent they are upheld, and believes both the Company and its customers will benefit from such disclosure.

On June 28, 2004, regulations went into effect in the State of New York requiring that cigarettes sold in that state meet certain fire safety standards. We decided it would not be economically feasible to develop a separate type of cigarette for sale in New York and have not attempted to become certified under the new regulations. As a result, we are not now selling cigarettes in New York and do not anticipate having sales of cigarettes in New York in the future. Bills relating to fire safety standards have been introduced in several other states and in Congress and California, Illinois, New Hampshire, Massachusetts and Vermont passed fire safety laws in 2006. The statute in Vermont became effective on May 1, 2006 and the statute in California became effective on January 1, 2007. We had few sales in either Vermont or California in 2006 and we advised those states that we would not seek to sell cigarettes in those states once these statutes became effective. The New Hampshire statute will become effective on October 1, 2007. The statutes in Illinois and Massachusetts become effective on January 1, 2008. Because of our continued efforts to limit sales in the MSA states, and the expectation that such reduction will continue in the future, we do not expect that these or similar statutes if passed in the MSA states will have a material impact on our sales when such statutes go into effect. Proposed fire safety statutes have been introduced in several of the MSA states in 2007, and in Texas, a non-MSA state, legislation was introduced in March 2007. We will continue to monitor these fire safety legislative initiatives as they move forward and, as appropriate, reassess our decision on the development of a cigarette that complies with such regulations.

In November 1998, 46 states, the District of Columbia (the “Settling States”) and several U.S. territories entered into the Tobacco Master Settlement Agreement (the “MSA” or “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 non-participating manufacturer, the Company is required to satisfy certain escrow obligations pursuant to statutes that the Master Settlement Agreement required the Settling States to adopt in order for such states to receive the full benefits of the settlement. Under such statutes the Company is obligated to deposit monies into escrow for sales of cigarettes in each of the Settling States during the preceding year, and in some cases, such deposits must be made on a quarterly basis. These amounts are adjusted annually by statute and to reflect inflation adjustments (at the higher of 3% or the Consumer Price Index), using 1999 as a base year for the calculation. The base amount for 2003 through 2006 was $3.35 per carton, as adjusted for inflation. For 2006, the adjusted amount was $4.29 per carton. The base amount for 2007 and thereafter is $3.77 per carton, as adjusted for inflation since 1999. Such escrowed funds will be available to satisfy tobacco-related judgments or settlements, if any, in the Settling States. In addition to the escrow deposits associated with the Company’s direct customer sales, the Company has been required to make additional escrow deposits related to sales of the Company’s cigarettes into the MSA states by the Company’s wholesale customers in the non-MSA states, which are referred to as indirect sales. All funds placed in escrow continue to be held by the Company. In March 2007, the Company entered into an agreement under which it received a payment of approximately $11.5 million in return for assigning to the purchasers the right to interest paid on the Company’s escrow fund and to any releases of the escrow principal for any overpayments, or, if these funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years. Star’s sale of smokeless tobacco products are not subject to the MSA escrow obligations.

In addition to the “level playing field” statutes, most of the MSA states have enacted statutes that require non-participating 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 focused its sales in the four states that are not part of the MSA over the last several years, these statutes could impact its ability to sell cigarettes in the MSA states, notwithstanding its substantial payments into escrow, since the states generally prohibit the sales of cigarettes by companies that are not certified as being MSA-compliant. Also, most MSA states have amended their qualifying statutes to limit the ability of Company’s to cap escrow payments for a particular year so that escrow payments must be made on each cigarette sold in an MSA state. Further, a number of states have required escrow payments to be made quarterly or on some other intermittent schedule. Currently, the Company is required to make quarterly payments in Georgia, Louisiana, Maine, Nevada, New Hampshire, New Mexico and Wyoming, although it has not had any sales in several of these states in 2006. Also, there are a number of other states that have passed quarterly payment statutes that are triggered when sales meet a certain threshold level. Because the Company has sought to limit its MSA sales, it has not met the minimum sales amount required to trigger quarterly escrow payment obligations in these states. The adoption of quarterly payment requirements in additional Settling States could exacerbate the impact of the MSA escrow obligations on the Company’s liquidity.

World Health Organization (“WHO”) Global Public Health Advocacy; Framework Convention on Tobacco Control

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” or “Treaty”). 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 toxicity reduction 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. On February 27, 2005 the FCTC went into effect. Although the U.S. signed the FCTC in May 2004, the White House has not sent the Treaty to the Senate for ratification. The State Department has reported that it is reviewing the FCTC for legal issues, particularly those impacting on “commercial free speech”. The U.S. has opposed the blanket advertising prohibitions in the FCTC, although prior to promulgation of the FCTC, nations with commercial free speech protections could have opted out of that provision in the treaty and still be a signatory to the FCTC. To date, 144 of the 168 nations that signed the FCTC have ratified this comprehensive document. It has been reported that there is continuing opposition to the treaty among some U.S. tobacco companies, and certain members of Congress. A two-thirds majority of the U.S. Senate is required to approve the Treaty.

UK Royal College of Physicians Statement on Tobacco Regulation and Statement On European Union Policy on Smokeless Tobacco

In December 2002, the British Royal College of Physicians issued a report titled: “Protecting Smokers, Saving Lives”. In that report, the Royal College of Physicians concluded that “the consumption of non-combustible tobacco is in the order of 10-1,000 times less hazardous than smoking, depending on the product.” In February 2003, an independent group of researchers and public health educators issued a report titled: “European Union Policy on Smokeless Tobacco – A Statement in Favour of Evidence-Based Regulation”. In the report, the researchers called on the European Union (“EU”) to reconsider the ban on smokeless tobacco products that has been in place in Europe, in part because, “smokeless tobacco is substantially less harmful than smoking, and evidence from Sweden suggest it is used as a substitute for smoking” In 2002 Swedish Match AB challenged in Great Britain’s High Court the validity of the European Union’s ban on the sale of smokeless tobacco products in all member countries (except Sweden, which received an exemption when it joined the EU in 1992). The British High Court stayed the proceeding and referred the challenge to the European Union’s High Court of Justice. Oral arguments were heard in September 2004, during which Swedish Match pointed out that maintaining a prohibition of the sale of snus did not take into account the development of scientific information about the relatively lesser risk associated with oral tobacco use when compared with data on smoking and disease. In December 2004, the EU High Court ruled that the prohibition, while in need of reformulation by the EU legislature, continues to be valid in principle.

In the mid-1990’s, Star commenced research and development activities based upon newly conceived technology for the processing of tobacco so as to substantially prevent the formation of TSNAs in cured tobacco. This technology is under exclusive license from Regent Court Technologies, LLC, a company in which Jonnie R. Williams, the technology’s inventor and the Company’s founder, current Chief Executive Officer and largest stockholder, is part owner. (See “Patents, Trademarks and Licenses.”) TSNAs are generally recognized by certain 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 very low-TSNA tobacco; (2) developing products that

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 process for producing very low-TSNA tobacco and tobacco products, with respect to which Star has exclusive rights to patents as well as patent applications that are pending (See “Patents, Trademarks and Licenses,” particularly “License Agreement with Regent Court”, beginning on page [17].)

The Company expects to maintain its spending on research at a de minimum level while it continues to concentrate on its patent infringement lawsuit against RJR. Consistent with its efforts to cut costs, the Company has deferred its research projects since the last half of 2003 and has not convened a meeting of its Scientific Advisory Board during this period. Presently, the Company’s research focus is directed to assessing the impact that products with reduced toxin levels may have on the range of serious health hazards associated with the use of conventional smoked and smokeless tobacco products and encouraging scientists in the U.S. and Europe to pursue TSNA-related research. While its research work has been deferred as a result of its lack of available working capital, the Company has designed several additional scientific studies to determine, among other things, whether a reduction in TSNAs can be equated with a reduction in health risk; to assess biomarker differences that can be equated to levels of various toxins in smoked versus smokeless tobacco; and to measure the impact of the decline in TSNA exposure in low-TSNA smokeless tobacco compared to traditional cigarette products. However, because of monetary constraints the Company is not moving forward with these studies at this time. When it initiates these studies, they will be conducted by independent laboratories and universities. The extent of future research and development efforts will depend, in part, on the results of the RJR litigation.

The process of curing or drying tobacco so that it is suitable for production of 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 five to seven days, and for burley tobacco, a month or more.

The StarCured^{^®} 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 formation of TSNAs. The StarCured^{^®} 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^{^®} tobacco curing process precludes the formation of 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, even though peer-reviewed scientific literature continues to emerge pointing out that a reduction of these carcinogens in smokeless tobacco can be expected to reduce health risks.

The technology for producing low-TSNA tobacco has been licensed to the Company in an agreement that grants to the Company exclusive worldwide rights with a right of sublicense. (See “Patents, Trademarks and Licenses”). It is the Company’s objective to achieve widespread acceptance of this tobacco curing technology as a standard for the manufacture of less toxic and potentially less harmful smoked and smokeless tobacco products and, in the future, as a basis for the use of very low-TSNA tobacco in the production of smoking cessation products. In the future, the Company hopes to work with a major pharmaceutical company to both consider the use of very low-TSNA tobacco in cessation products and to develop a product intended to help patients who have relapsed after a trial of smoking cessation to prepare for another cessation attempt, particularly if Congress mandates jurisdiction over all tobacco products to the FDA. However, as noted above, at the present time, the Company is focused on other objectives.

The Company’s commercial use of the StarCured^{^®} technology, including its role in the development of the Company’s smokeless tobacco products, is discussed in detail throughout this Item 1, including under “General”, “Segments and Products”, “Purchasing” and “Manufacturing”, above.

In 1997, Star submitted a cigarette product that it called “CigRx™” to the FDA as a pharmaceutical product. The objective of CigRx™ was to offer a low-TSNA product to help patients, who had relapsed after a trial of smoking cessation, prepare for another cessation attempt. 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™ 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 used in CigRx™ at the time of testing was 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™ 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 CigRx™ product with conventional brands in terms of breath levels of carbon monoxide, blood levels of nicotine, and urinary levels of TSNAs. With regard to the CigRx™ product, blood nicotine levels were somewhat higher and carbon monoxide was substantially lower. The subjects’ 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™ product were reduced substantially, consistent with published data showing that TSNAs leave the body over 90 to 120 days in an initial rapid phase and then in a slower phase during this period. The results of this study were significant in demonstrating that reductions of TSNA levels in tobacco resulted in reduced levels of TSNAs in the human body when study subjects smoked cigarettes containing tobacco with reduced levels of TSNAs. Following the study, Star’s strategy has changed and it advised the FDA that it would not seek approval for CigRx^® as a cessation product.

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/or (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 that decreases the risk of liability in a lawsuit of the type described above because the Company:

In the past, the Company maintained product liability insurance only with respect to claims that tobacco products manufactured by or for the Company contain any foreign object, i.e., any object that is not intended to be included in the manufactured product. Star currently does not maintain such insurance. The product liability insurance previously maintained did 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 such claims could have a materially adverse effect upon the Company.

The Company is the licensee under a license agreement (the “License Agreement”) with Regent Court Technologies, LLC, which is owned by Jonnie R. Williams, the Company’s founder, Chief Executive Officer and largest shareholder, and Francis E. O’Donnell, Jr., M.D., the beneficiary of the O’Donnell Trust, which is the Company’s largest shareholder after Mr. Williams. 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 prevent the formation of TSNAs, and to develop products containing such tobacco, whether such patent rights and know-how are now in existence or hereafter developed. The License Agreement provides the Company an exclusive license to any 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 to any method of extracting one or more substances from tobacco for the purpose of incorporating such substance or substances in a product or products. Absent a material breach of the License Agreement, the Agreement will continue until the expiration of the last of the applicable patents, which includes twelve current patents and any additional patents issued to Regent Court during the term of the License Agreement. Generally, patents have a term of twenty years from the initial date of filing of a patent application. As of the date of this filing, the latest expiration date of a patent subject to the License Agreement is May 6, 2021. In the Company’s patent litigation against RJR, the United States District Court for the District of Maryland in January 2007 issued a ruling finding that two of the Company’s patent which are at issue in that litigation are invalid because the term “anaerobic condition” as used in the patents is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim.

The Company is obligated to pay to Regent Court a royalty of 2% on the net sales of its products and the products of any affiliated sublicensees, and 6% on all fees and royalties received by the Company from unaffiliated sublicensees, less any related research and development costs incurred by the Company as well as costs incurred enforcing the patent rights.

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 filed by the Company 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. Regent Court may also terminate the Licensing Agreement in the event of the purchase of Star’s stock or assets.

The License Agreement obligates the Company to enforce 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.

Under the License Agreement, the Company has exclusive rights to the issued patents listed below, which are the only United States’ patents issued to Regent Court, and related pending patent applications. The issued and pending patents cover the current technology for substantially preventing the formation of TSNAs in tobacco. In the Company’s patent litigation against RJR, the United States District Court for the District of Maryland in January 2007 issued a ruling finding that two of the Company’s patent which are at issue in that litigation are invalid because the term “anaerobic condition” as used in the patents is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim.

Corresponding patent filings have been initiated in numerous foreign countries. There can be no assurance that patents will issue from any of the pending applications, that claims that 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.

The Company is the exclusive licensee to the following United States’ patents under the License Agreement with Regent Court:

The Company believes that it is the World leader in curing technology that consistently produces very low-TSNA tobacco.

As of December 31, 2006, the Company employed approximately 117 full-time employees compared to 144 as of December 31, 2005. The net reduction of 27 persons was a result of the reduction in the field sales force in Texas in early 2006, the elimination of the field sales force in Florida in the first half of 2006, and normal attrition during the year.

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, from time-to-time, 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 on both a formal and informal basis 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 a 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, scientific, medical and public health consultants, independent investigators and research organizations.

The Company’s website is www.starscientific.com. The Company makes its periodic Annual Report on Form 10-K and quarterly reports on Form 10-Q and current report on Form 8-K available, free of charge, on its website as soon as reasonably

practicable after such material is electronically filed with, or furnished to, the SEC. The information and links provided on our website is not incorporated by reference into this Annual Report on Form 10-K and should not be considered a part of this report. The Company is an electronic filer and those filings can be viewed on www.sec.gov

The Company’s business has been operating at a loss for the past four years and continues to use more cash than is being generated from operations; absent improving results of operations, we will need to raise additional capital by early 2009 to meet working capital needs

The Company has been operating at a loss for the past four years. In addition, the Company is required to make annual MSA escrow payments that are not accounted for in working capital. The Company expects this year’s total escrow deposits (which are due in April 2007 for 2006 sales) to be approximately $500,000 based on its prior payments, a decrease in total cigarette sales in 2006 and its successful efforts to limit sales in MSA states.

Our future prospects in the long term are dependent on the distribution and consumer acceptance of our low-TSNA smokeless tobacco products as well as the continued development of new low-TSNA smokeless tobacco products, independently and through alliances with other tobacco manufacturers, given the decrease in cigarette sales over the past four years. Also, our long term prospects will be dependent on our ability to begin generating significant revenues through royalties from the patented tobacco curing process to which we are the exclusive licensee. However, our ability to generate revenues through such royalty payments will also be dependent upon the successful completion of our ongoing patent infringement lawsuit against RJR. In that lawsuit, the United States District Court for the District of Maryland in January 2007 issued a ruling finding that two of the Company’s patent which are at issue in that litigation are invalid because the term “anaerobic condition” as used in the patents is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim.

The recurring losses generated by our operations continue to impose significant demands on our liquidity. In 2006, we generated $10.0 million through the sale of our common stock by entering into certain securities purchase and registration rights agreements (the “Purchase Agreements”) and through exercise of warrants issued under Purchase Agreements. In March 2007, the Company entered into an agreement under which it received a payment of approximately $11.5 million in return for assigning to the purchasers the right to interest paid in the Company’s escrow fund and any releases of the escrow principal for any overpayments, or, if those funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years. Also, the Company in March 2007 sold approximately 960 of its tobacco curing barns for approximately $11.2 million and anticipates completing sales of a total of approximately 990 curing barns this month for an aggregate purchase price of approximately $11.6 million.

With the proceeds from these transactions, we believe that we will have sufficient funds to support our operations through 2008. Absent the successful completion of our ongoing patent infringement lawsuit against RJR, the exercise of outstanding warrants, a substantial improvement in revenues and/or royalties from smokeless tobacco products, we believe that it will be necessary to pursue additional sources of funds in early 2009. However, depending upon market conditions and the price of our common stock, we may decide to seek additional funds before that time.

Our cigarette business, which has generated a substantial majority of our revenues in the past, continues to experience declines in shipments as well as increased market pressures and we may not be able to reverse this trend

A substantial majority of our revenues historically has been derived from sales of our discount cigarettes which are sold though Star Tobacco, Inc. (“ST”), our wholly owned subsidiary. Since 2000, however, our discount cigarette business has experienced a significant decline in sales, partly caused by intensified pricing competition from foreign manufacturers (see “Competition from other tobacco companies has adversely affected us and may continue to do so”).

Despite our efforts to reenergize cigarette sales, shipments in 2006 continued to decline compared to prior years and we face potential and actual increases in regulatory and excise tax costs. Accordingly, we cannot guarantee we will be able to reverse the downward trend in our discount cigarette business. Given the continued decline in cigarette sales, we will continue to evaluate the prospects for our cigarette business in general and in particular, sales in MSA states, in light of the additional regulatory and MSA burdens of operating in those states.

In addition, we must pay a portion of our gross profits on cigarette sales into escrow in April of each year to meet our obligations under the MSA. Because the funds deposited into escrow are not available to meet our other cash needs, even if we were able to generate net income from our cigarette business, we would not necessarily generate positive cash flow from operations, when taking into account these escrow payments. Additionally, beginning in January 2005 we have been required to make further payments pursuant to the tobacco farmer buyout program which were not required in previous years. This

program has added a cost of approximately $0.50 to each carton of cigarettes sold by us effective January 1, 2005 and a comparable cost for smokeless products which will continue over the ten-year life of the program. As part of this program, we also may be subject to assessments for certain loan loss costs and administration costs. These assessments will be charged to operations when assessed and paid over several quarters, if allowed, rather than over the life of the buyout program. We completed making payments on one such assessment in December 2006, which was in the amount of $1.1 million and had been paid in installments over six quarters beginning in the first quarter of 2005.

If we are not able to increase our revenues and gross profits from cigarette sales, our ability to earn net income and generate positive cash flow from operations will depend on our ability to grow our revenues from royalties and sales of our smokeless tobacco products, which have provided only de minimis revenues to date.

Our success in commercially exploiting our licensed tobacco curing technology and low-TSNA smokeless tobacco products 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 not be available 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 to the Company. Moreover, 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.

In particular, we have been prosecuting patent infringement claims against RJR in the United States District Court for the District of Maryland. The two patents for producing low-TSNA tobacco that are at issue in our patent infringement litigation against RJR have been held to be invalid on the basis that the term “anaerobic condition” is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim. Unless the decision of the District Court is reversed on appeal, we will not be able to enforce or license the two patents for producing low-TSNA tobacco that are at issue in our patent litigation against RJR. Also, if the Court were to rule against the Company on the inequitable conduct defense that was tried in early 2005, and which is currently pending, we would be required to appeal that decision and obtain a reversal in order to be in a position to enforce the patents.

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.

Our prospects for success as a technology-oriented tobacco company with a mission to reduce toxins in tobacco leaf and tobacco smoke are dependent, over the long term, on the distribution and consumer acceptance of our very low-TSNA smokeless tobacco products, and our ability to license our patented technology as well as on the continued development of new very low-TSNA smokeless tobacco products, independently and through alliances with tobacco manufacturers and potentially other third parties

We have previously announced our plan to concentrate our long-term efforts on our very low-TSNA smokeless tobacco products, our receipt of royalty fees for hard tobacco products and on licensing our patented technology for producing low-TSNA tobacco. However, to date these royalties and sales of our smokeless tobacco products have been de minimis. In the

Company’s patent litigation against RJR, the United States District Court for the District of Maryland in January 2007 issued a ruling finding that two of the Company’s patent which are at issue in this litigation are invalid because the term “anaerobic condition” as used in the patents is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim.

Beginning in September 2001, we introduced three new smokeless tobacco products, Stonewall^{^®} moist and dry snuffs and ARIVA^{^®} hard tobacco cigalett^{^®} pieces. Beginning in the second quarter of 2003, we began a commercial test market of a new, non-fermented spit-free^{^®} “hard tobacco” product for moist snuff users, called STONEWALL Hard Snuff^{^®}. Given the Company’s decision to focus on hard snuff smokeless tobacco products, the Company has discontinued manufacturing Stonewall^{^®} moist snuff and is not actively marketing Stonewall dry snuff.

To date, sales of our smokeless products have been slower than expected, in part, we believe, due to the lack of consumer awareness of those products, particularly ARIVA^{^®} and STONEWALL Hard Snuff^{^®} and lack of sufficient capital to increase consumer awareness of and acceptance of those products. It is not certain whether our low-TSNA smokeless tobacco products will be accepted by the market in sufficient volume to support our operations. Adult tobacco users may decide not to purchase our products due to taste or other preferences, or because of the extensive health warnings contained on the packaging for our products. Our efforts to successfully market ARIVA^{^®} and STONEWALL Hard Snuff^{^®} will require the expenditure of substantial funds, which we will need to obtain from external financing, the availability of which cannot be assured, and ultimately these products may not be accepted in the national marketplace.

If the Company is not successful in its efforts to offer very low-TSNA smokeless tobacco products to adults as alternatives to cigarettes and other smokeless products or generate revenue through the related technology to which we are the exclusive licensee, we will not have sufficient sales of other products to offset declining cigarettes revenues. This would adversely affect our sales volumes, operating income and cash flows, as well as our ability to pay our debts.

The combination transaction between RJR and B&W may impact negatively upon the Company

On July 30, 2004, RJR, a subsidiary of B&W, and certain of their affiliated tobacco businesses combined operations under the new publicly traded holding company, Reynolds American Inc., which is 42% owned by British American Tobacco PLC, the parent company of B&W. Star and B&W had been party to multiple, substantial commercial relationships for a number of years prior to this combination, and Star and RJR are currently involved in significant patent infringement litigation. During the pending patent litigation described above, RJR took the position that the new operating entity resulting from the combination of RJR and B&W, assumed all of the rights and obligations under the agreements previously entered into between Star and B&W, and moved to dismiss our patent infringement case on this basis. After full briefing the Court denied RJR’s motion to dismiss, and found that B&W had attempted to assign the Star/B&W agreements to the new subsidiary, and that Star had not consented to the assignment. The Court further found that the de facto merger doctrine did not apply. In its ruling the Court did leave open the question of what impact, if any, the combination may have on the future licensing arrangements with RJR, but noted that those considerations did not impact on the claims asserted in the present litigation.

We have had important relationships with B&W that post-merger with RJR could become risks

Prior to the combination of B&W and RJR, we had important business relationships with B&W, including licensing and royalty agreements relating to the purchase of StarCured^{^®} tobacco and other low-TSNA tobacco as well as the financing of curing barns.

Under our Restated Master Agreement with B&W, as amended by several letter agreements we owed B&W for the purchase of StarCured^® tobacco curing barns. Beginning January 1, 2006, interest began accruing on the debt at prime plus 1% and we began making payments on the principal balance of the debt. These payments are due in 96 monthly installments of approximately $208,116. The debt is secured by tobacco leaf inventory and a certain portion of our tobacco curing barns. Once the outstanding loan balance is reduced to $10 million, the collateral will be released by B&W. The loan balance on the long-term debt was $17,472,503 as of December 31, 2006. As of January 1, 2006, we also had another note payable obligation to B&W. This debt is being repaid in monthly principal payments of $250,000 plus monthly interest payments at prime plus 1% on the outstanding balance. The outstanding balance on this debt as of December 31, 2006 was $1,961,743.

Pursuant to a Hard Tobacco Agreement entered into with B&W in April 2001, B&W test marketed a hard tobacco product in 2003 and again in 2004. In December 2004, Star was notified by RJR that the test market was not successful and that, as a result, the Hard Tobacco Agreement was terminated. In the past, B&W has purchased significant quantities of StarCured^{^®} tobacco from us, which we in turn purchased from our participating StarCured^{^®} farmers. B&W has not purchased tobacco from us since 2004 and does not have an obligation to make purchases from us in the future. Because of our inability to purchase tobacco from our participating farmers, the Company in 2007 sought to disband its StarCured^® tobacco curing program and to sell the tobacco curing barns that were being maintained by the participating farmers to those farmers or to other third parties.

In recent years, B&W has granted us a number of concessions under our agreements, including deferring interest and principal payments, consenting to our incurrence of additional indebtedness and agreeing to modify the Hard Tobacco Agreement to allow us to pursue similar licensing arrangements with third parties. B&W’s failure to grant us similar concessions in the future could have a number of adverse consequences, including restricting our pursuit of business opportunities with B&W or third parties, limiting our ability to raise funds through debt financing and requiring payment of our obligations to them in circumstances where we may not have sufficient funds available to do so. Post-merger with B&W, Star has no operational relationship with RJR, under the agreements entered into with B&W. In addition, we are involved in patent litigation against RJR for infringement of our tobacco curing technology. Given those facts, we do not anticipate that we would have the same type of cooperative relationship with RJR as we had with B&W or that RJR would be inclined to grant concessions similar to those that we received from B&W.

All of our revenue for discount cigarette sales since 2000 was derived from sales in the United States. The U.S. cigarette market has been contracting in recent years and pricing pressures in the discount cigarette business have been increasing. As the U.S. cigarette market continues to contract, this trend could adversely affect our sales volumes, operating income and cash flows. The market for smokeless products is much smaller than the market for smoked tobacco products, and all of our revenue from smokeless tobacco product sales to date has been derived from sales in the United States, except for de minimis amounts of ARIVA^{^®} sold in Bermuda, Turkey and Norway which were discontinued prior to 2006. Accordingly, we do not currently have access to foreign markets to offset the impact of the declining U.S. cigarette market.

The tobacco industry is highly competitive. Our primary competition for conventional cigarettes has been the “major” cigarette manufacturers, each of which has substantially greater financial and operating resources than we do. We have encountered 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. STONEWALL Hard Snuff^{^®} competes with major smokeless manufacturers, and ARIVA^{^®} competes with traditional cigarette manufacturers, because ARIVA^{^®} is positioned as an alternative to cigarettes in situations where adult cigarette users cannot or choose not to smoke. 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.

Tobacco companies may use low-TSNA tobacco that does not infringe on the technology to which we are the exclusive licensee or may develop technology for low-TSNA tobacco that could make our technology obsolete

Virtually all flue-cured tobacco grown in the United States since 2001 has been cured in a manner to reduce the levels of TSNAs. If competitors produce low-TSNA tobacco that does not infringe on the technology to which we are the exclusive licensee, or develop other tobacco products with less toxins that can compete with our very low-TSNA products, this could adversely affect our operating income and cash flows. Additionally, competitors may develop new technology for low-TSNA tobacco that could make our current technology obsolete.

We may not be able to enforce or license our patents for producing low-TSNA tobacco

The two patents for producing low-TSNA tobacco that are at issue in our patent infringement litigation against RJR have been held to be invalid on the basis that the term “anaerobic condition” is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim. Unless the decision of the District Court is reversed on appeal, we will not be able to enforce or license the two patents for producing low-TSNA tobacco that are at issue in our patent litigation against RJR. Also, if the Court were to rule against the Company on the inequitable conduct defense that was tried by the Court in early 2005, and which is currently pending, we would be required to appeal that decision and obtain a reversal in order to be in a position to enforce the patents.

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 increases in state excise taxes on smoked and smokeless tobacco products. For example, Texas increased the per-pack tax for cigarettes by $1.00 as of January 1, 2007. 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 1.5 cents per ounce and 65 cents per ounce, respectively, while the states of North Carolina and Oregon impose an excise tax of 3% and 65% of wholesale cost, respectively. Present state excise taxes for cigarettes range from $0.30 per pack in Kentucky to $2.46 per pack in Rhode Island. Increased excise taxes may result in declines in sales volume for the industry as a whole. This result could adversely affect our operating income and cash flows. In addition, several states have imposed additional fees on cigarettes sold by manufacturers who are not signatories to the MSA or who have not previously entered into settlements with the non-MSA states. Such additional fees could adversely impact on our sales volumes and cash flows. Also, a number of MSA states have passed statutes or regulations requiring that cigarettes meet prescribed fire safety standards. We have decided that it would not be economically feasible to develop a separate cigarette for sale in these states, and we will no longer sell cigarettes in those states once such statutes and regulations go into effect.

We currently have licenses from the TTB 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 TTB, 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 Congress will act to grant such authority to the FDA, although legislation that would create such authority has been introduced previously in Congress and new bills that would grant FDA authority over all tobacco products were introduced in both the Senate and House in February 2007.

In late 2004, tobacco quota buyout legislation was enacted into law which requires all tobacco manufactures to pay for the cost of the buyout over the next ten years. Beginning in January 2005, we have been required to make payments of approximately $0.50 per carton for our cigarette products and a comparable cost for smokeless tobacco products. As part of the program, we also are subject to assessments for certain loan loss costs and administrative costs. These assessments will be recorded when received and paid over several quarters, rather than over the life of the buyout program. The Company, and other tobacco manufacturers have increased prices to cover the cost of the buyout program. While the increased cost could have a negative impact on purchases of cigarettes by consumers, the impact of this added cost is expected to be proportional across the industry.

We have substantial obligations under state laws adopted under the Master Settlement Agreement

Pursuant to the terms of the Master Settlement Agreement, we have an obligation to deposit into escrow accounts a base amount equal to $3.35 per carton for sales in 2006 and $3.77 per carton each year thereafter, for sales of cigarettes occurring in each MSA Settling State. A cumulative inflation adjustment is also added to these deposits at the higher of 3% or the Consumer Price Index each year. For sales in 2006, the total escrow cost per carton was $4.29. 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 escrow requirement, a substantial portion of our net income from operations has been unavailable for our use and the amount required to be placed in escrow may exceed the net cash flow generated by each carton sold. As a result, we have experienced negative cash flows from operations, which, among other things, has affected our ability to apply the capital generated from our present cigarette sales to the further scientific development of less toxic and potentially less hazardous tobacco products and to the growth of our business. In addition, the escrow obligations could impede our ability to distribute dividends to our stockholders.

We have tried to mitigate the costs of the MSA by focusing our field sales force and our efforts on increasing market share in states that were not participants in the MSA, among other approaches. The MSA States 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. The Company is in full compliance for escrow obligations through 2006 and currently has approximately $38.3 million in escrow. The Company will be required to make deposits into escrow of 2006 sales by April 15, 2007.

In addition, most of the MSA states have enacted statutes that require non-participating 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 are not part of the MSA, failure to comply with these statutes would negatively impact on the Company’s ability to sell cigarettes in those MSA states, notwithstanding our substantial payments into escrow.

We may be assessed additional sales and use taxes by the Commonwealth of Virginia

In a letter dated October 7, 2004, the Company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to the Company and that the sales and use tax assessment plus penalties and interest together, as of October 7, 2004, totaled approximately $988,000. The Company continues to challenge this assessment and has filed a request for reconsideration with the Commissioner of Taxation, and is prepared to file a judicial action if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue. While the Company is optimistic that its request for reconsideration will be accepted based on prior rulings in similar cases, if the assessment is not reversed, the Company will be required to pay the tax, penalties and interest due.

In 2004, the Company was notified that its 2001 tax return had been selected for examination by the Internal Revenue Service (“IRS”). In the course of its conduct of this examination, the IRS has expanded the scope of the examination to include all of the Company’s returns that have been filed for the years ended December 31, 2002 through 2004. In 2005, the Company’s request for a private letter ruling, which related to the years under IRS examination, was resolved generally in its favor. The statute of limitations for taxable years 2001 and 2002 have been extended by mutual agreement through September 15, 2007. All information requested by the IRS in connection with its examination has been provided by the Company. The IRS may request additional information as the examination is ongoing. There have been some discussions with the IRS relating to the timing of certain deductions and a brief supporting the Company’s position has been submitted. Since the Company’s returns for such years are currently under examination and the timing of certain deductions has been raised, it is reasonably possible that adjustments may be proposed that result in liability to the Company. The Company has estimated a range of potential liability of from $0 to approximately $1.7 million. The Company believes the returns filed for such years are substantially correct and intends to vigorously contest any proposed liability through all available means including judicial proceedings if necessary.

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 relating to the use 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. In the past, we maintained product liability insurance only with respect to claims that tobacco products manufactured by or for us contained any foreign object, i.e. any object that is not intended to be included in the manufactured product. We currently do not maintain such insurance. The product liability insurance we previously maintained did 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, beginning in 2001, we 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.

If we are successful in 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 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.

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 our business or that given the losses that the Company has suffered over the past four years that we will have the financial ability to do so. The loss of the services of key personnel or the termination of relationships 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, 2006, our executive officers, directors and their associates, own an aggregate of approximately 29.2% 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 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 stock price has been and may continue to be volatile and an investment in our common stock could suffer a decline in value

The trading price of the shares of our common stock has been and may continue to be highly volatile. Since 2005, our stock has traded at prices ranging from $1.68 on August 2, 2006, to $6.49 on February 23, 2005, and $3.25 on December 29, 2006 and $0.78 as of February 5, 2007. We receive only limited attention by securities analysts and may experience an imbalance between supply and demand for our common stock resulting from low trading volumes. The market price of our common stock may fluctuate significantly in response to a variety of factors, most of which are beyond our control, including the following:

The stock market has, from time to time, experienced extreme price and volume fluctuations, which have particularly affected the market prices for small companies and which have often been unrelated to their operating performance. These broad fluctuations may adversely impact the market price of our common stock. In addition, sales of substantial amounts of our common stock in the public market could lower the market price of our common stock.

On January 31, 2007, our stock traded below $1.00 per share and remained below $1.00 per share for five days. After closing at $1.00 on February 7, 2007, the stock traded below $1.00 per share and remained below $1.00 per share for 14 days. Under rules of the NASDAQ Global Market, if our stock trades below $1.00 a share for 30 consecutive business days, the NASDAQ will issue a notice of intent to delist the Company if its shares do not trade above $1.00 per share for ten consecutive business days during the next 180 calendar days and we do not otherwise comply with NASDAQ listing requirements. While this period may subsequently be extended, if the Company’s shares do not trade at above $1.00 for substantial periods, there is a possibility that the Company could face delisting on the NASDAQ exchange, which could have a negative effect on the market price for our shares.

Future sales of our common stock would have a dilutive effect on current stockholders

If we issue additional shares of our common stock for sale in future financings, our stockholders would experience dilution.

Our research & development efforts may not result in commercially viable products and may continue to be curtailed by our lack of available research funds

Consistent with our efforts to cut costs, the Company deferred certain research projects beginning in the last half of 2003. We expect our spending on research for 2007 to be at a de minimis level, while we continue to concentrate our efforts and resources on our ongoing patent infringement lawsuit against RJR. Presently, our research focus is directed to assessing the impact that products with reduced toxin levels may have on the range of serious health hazards associated with the use of conventional smoked and smokeless tobacco products. While our research work has been deferred as a result of the lack of available working capital, the Company has designed several additional scientific studies to assess, among other things, whether a reduction in TSNAs can be equated with a reduction in health risk, biomarker differences that can be equated to levels of various toxins in smoked versus smokeless tobacco, and the impact of the decline in TSNA exposure in low-TSNA smokeless tobacco compared to traditional cigarette products. However, because of monetary constraints we are not moving forward with these studies at this time. When we initiate these studies, they will be conducted by independent laboratories and universities. We hope to renew our research and development efforts in 2007, subject to the availability of funds. However, such research 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:

Failure to develop new products or to improve our current products could have a material and adverse impact on our net sales, operating income and cash flows.

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results, as a result, current and potential stockholders could lose confidence in our financial reporting, which could harm our business and our stock price

The Company has previously determined that its internal control over financial reporting is effective and our outside auditors have issued a report concurring in that assessment. If the Company fails to maintain its internal controls over financial reporting, this could cause investors to lose confidence in our reported financial information, which could have a negative impact on the trading price for our stock.

The Company’s executive, marketing, sales and administrative offices are located in Chester, Virginia, which consist of 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. The Company has given notice that it intends to move out of this facility in March 2007, at that time, the staff will relocate to the single story office building that the Company owns in Petersburg, Virginia.

The Company’s cigarette 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 also leases a 14,000 square foot warehouse in Petersburg, Virginia, about one mile from its manufacturing facilities, pursuant to a one year lease. The Company will use this space in Petersburg to manufacture and to warehouse its 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 that was to expire in December 2006, but which has been extended through June 2007. This additional space houses the Company’s executive, administrative, legal and scientific offices. This location in Bethesda, Maryland was selected to provide Star’s scientific and medical consultants access to the FDA, National Institutes of Health and the U.S. National Medical Library, as well as access to Congress, the Executive branch of government and the various Federal agencies in the greater Washington, D.C. area. The Company is in the process of seeking to reduce the amount of leased space that it maintains in Bethesda, Maryland.

The Company leases two adjacent buildings and parcels of land in Chase City, Virginia. The first property consists of seven acres of land and an approximately 100,000 square foot building thereon in Chase City, Virginia, which has been used in processing tobacco utilizing the Company’s StarCured^{^®} tobacco curing method and for manufacturing ARIVA^{^®}, Stonewall^{^®} dry snuff and STONEWALL Hard Snuff^{^®}. The Company has approximately three years remaining on a ten-year lease for this property, and it has an option to purchase the property at any time during the term of the lease.

The second Chase City property has approximately 91,000 square feet of warehouse/manufacturing space and 9,000 square feet of office space and is located on approximately nine acres of land. This facility was purchased during 2002 by the

Mecklenburg and Chase City Industrial Development Authorities and renovated to Star’s specifications. The Company has approximately five years remaining on an initial ten-year lease which is then to be renegotiated for an additional ten year period. The Company also has an option to buy the property at any time during the lease.

The Company believes its manufacturing facilities will allow it to respond to the demand for its smokeless products, its tobacco receiving needs, as well as the demand for cigarette products into the foreseeable future.

In May 2001, Star filed a patent infringement action against RJR in the United States District Court for Maryland, Southern Division to enforce Star’s rights under U.S. Patent No. 6,202,649 (‘649 Patent), which claims a process for substantially preventing the formation of TSNAs in tobacco. On July 30, 2002, the Company filed a second patent infringement lawsuit against RJR in the same Court based on a new patent issued by the U.S. Patent and Trademark Office on July 30, 2002 (Patent No. 6,425,401). The new patent is a continuation of the ‘649 Patent, and on August 27, 2002 the two suits were consolidated.

In April 2003, the parties filed dispositive Motions for Summary Judgment. Star filed a Motion for Summary Judgment on Claim Construction and Definiteness, and RJR filed six Motions for Summary Judgment asserting various defenses. Pursuant to an Order dated September 15, 2003, the Court appointed a Special Master to prepare Reports and Recommendations (“R&Rs”) for the Court on Star’s Motion for Summary Judgment and five of RJR’s six Motions for Summary Judgment. The Special Master issued R&Rs on all six of the Summary Judgment Motions and on March 31, 2004, the Court issued final rulings on five of the six Summary Judgment Motions that had been reviewed by the Special Master. In its March 31, 2004 rulings, the Court adopted without modification the Special Master’s R&Rs, which collectively recommended that the Court deny RJR’s Summary Judgment Motions, and that Star’s Motion for Summary Judgment on claim construction and definiteness be granted in part and denied in part. The Court also issued an order denying RJR’s Motion for Summary Judgment seeking to limit Star’s damages claim, which had not been reviewed by the Special Master. On June 24, 2004, the Court issued a final order adopting without modification the Special Master’s last R&R which recommended that the Court deny the final RJR Summary Judgment Motion.

On August 17, 2004, Star was informed that the case was transferred from Judge Alexander Williams to Judge Marvin J. Garbis. Judge Garbis over the next several months issued a series of orders concerning various aspects of the case. These orders set an initial trial date of January 24, 2005, permitted additional discovery of certain defenses raised by RJR and the filing of two additional Motions for Summary Judgment. Subsequently, the Court ordered that it would bifurcate RJR’s defense of inequitable conduct before the patent office and would have that defense tried before Judge Garbis beginning on January 31, 2005. That portion of the case was tried during the period January 31, 2005 to February 8, 2005. At the conclusion of the bench trial, the Court advised the parties that it would take the matter under advisement, and expected to issue a ruling on this portion of the case at the same time that it rules on the two additional Summary Judgment Motions that were filed by RJR on January 25, 2005. Briefing on these motions was completed on March 11, 2005.

On January 19, 2007, the Court granted RJR’s Motions for Summary Judgment in part and denied these motions in part. On its motion for Summary Judgment on the Effective Filing Date of the Patents, the Court established September 15, 1999 as the effective filing date, but denied RJR summary judgment of invalidity with regard to the patents-in-suit. On RJR’s motion for Summary Judgment on Indefiniteness, the Court granted the motion on the basis that the term “anaerobic condition” was indefinite. On January 19, 2007, the Court also advised the parties that it would seek to issue the ruling on RJR’s inequitable conduct defense before the end of February. In a letter to all counsels dated February 26, 2007, the Court stated that it was not in a position to issue a ruling on the inequitable conduct defense prior to the end of the month, but would seek to issue its decision in March 2007. On March 5, 2007, the Company filed a motion requesting the Court to permit the immediate filing of an appeal on an interlocutory basis while it completes its ruling on the inequitable conduct defense.

The Company will file a notice of appeal with the United States Court of Appeals for the Federal Circuit with respect to the District’s Court ruling on indefiniteness and the effective date of the claims of the patent-in-suit, once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim. If the Court were to rule against the Company on the inequitable conduct defense, we would also appeal that decision to the Federal Circuit Court of Appeals.

The Company has entered into fee arrangements with counsel in several litigation and related matters under which certain costs related to the litigation are being advanced by counsel on the Company’s behalf. Given the contingent nature and the fact that a probability assessment of liability cannot be made at this time, no accrual has been made for this contingent liability. The Company has paid or accrued all existing obligations. Also, as part of its fee arrangements in certain of these matters, the Company has agreed to pay counsel a percentage of any damage award and a percentage of the resulting payments the Company actually receives in the event that the litigation is resolved in its favor, in return for a cap on fee payments during the litigation.

In 2002, the Virginia Department of Taxation asserted a Virginia Sales and Use Tax assessment for the period January 1, 1999, through March 31, 2002, against the Company with respect to its tobacco-curing barns in the amount of $860,115. The Company applied for a correction of the assessment and a total abatement of the tax on the grounds that its barns are exempt from sales and use taxes under the industrial use and processing exemption and/or the agricultural exemption. In a letter dated October 7, 2004, the Company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to the Company and that the sales and use tax assessment plus penalties and interest together, as of October 7, 2004, totaled approximately $988,000. The Company continues to challenge this assessment and has filed a request for reconsideration with the Commissioner of Taxation, and is prepared to file a judicial action if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue. While the Company is optimistic that its request for reconsideration will be accepted based on prior rulings in similar cases, if the assessment is not reversed the Company will be required to pay the tax, penalties and interest due. The Company does not believe that it is probable that an obligation has been incurred and, as a result, no amounts have been accrued for this cost.

On March 12, 2002, Governor Warner of the Commonwealth of Virginia announced that the Company would receive a grant of $300,000, which was provided shortly thereafter, to assist Mecklenburg County and Chase City in the acquisition of the Company’s new processing facility adjacent to its existing tobacco receiving station in Chase City, Virginia. In late 2004, the Company responded to inquiries from the State to show its level of investment and hiring for its Chase City operations and to substantiate the actual results achieved compared to the original projections described in the grant application. In its response, the Company requested that the grant be extended for an additional year, given certain delays which have been encountered in connection with the launch of its smokeless tobacco products, including the filing of several unsuccessful Citizen’s Petitions with the FDA that sought to have the Company’s low-TSNA hard tobacco products regulated as a drug by the FDA rather than as conventional snuff tobacco products. In late October 2006, the Company received a request for a further update on the status of this grant. The Company in November filed a further response and requested a further extension of the grant. Depending on the level of investment and hiring recognized by the State, the Company may be required to return some or all of the $300,000 in grant funding, but the Company’s management does not anticipate that the Company will be required to repay this amount.

On December 15, 2006, Star held its annual meeting of stockholders. The matters voted upon at the meeting and the corresponding results are set forth below.

The common Stock of the Company (the “Common Stock”) is traded on the NASDAQ Global Market System under the symbol “STSI.” Set forth below are the high and low sales prices for each full quarterly period during 2005 and 2006, as reported by NASDAQ. From time to time, during the periods indicated, trading activity in the Common Stock was infrequent. As of March 1, 2007, there were approximately 697 registered holders of Common Stock.

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.

Comparison of five-year cumulative return among Star Scientific, the S&P Tobacco Industry Group, and the S&P Composite

The current composition of S & P Industry Group 30203010 - Tobacco - is as follows:

The Stock Performance Group shall not be deemed to be “soliciting materials” or to be “filed” with the Securities and Exchange Commission or subject to the liabilities of Section 18 under the Securities and Exchange Act of 1934. In addition, it shall not be deemed incorporated by reference by any statement that incorporates this annual report on Form 10-K by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that we specifically incorporate this information by reference.

In 2006, Star granted its directors (the “Purchaser Class”) options to purchase Star’s Common Stock as described in Star’s Quarterly Reports on Form 10-Q filed during 2006 or during the fourth quarter 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 October 11, 2005, options for 50,000 shares of common stock with an exercise price of $3.54 were granted to two members of the Purchaser Class in a private offering in accordance with Section 4(2) of the Securities Act of 1933 as amended and on November 20, 2006, options for 50,000 shares of common stock with an exercise price of $3.91, were granted to one member of the Purchaser Class in a private offering in accordance with Section 4(2) of the Securities Act of 1933.

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, 2006, 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.

The following discussion provides an assessment of our consolidated results of operations, capital resources, and liquidity and should be read together with the financial statements and related notes included elsewhere in this report. This discussion includes forward-looking statements based on current expectations that involve risks and uncertainties and should be read together with the discussion under the captions “Factors That May Affect Future Results” and “Note on Forward-Looking Statements” elsewhere in this report.

Our long-term focus continues to be the research, development and sale of products, particularly very low-TSNA smokeless tobacco products that expose adult tobacco users to lower levels of toxins, as well as licensing of our low-TSNA technology. Our overall objective is to ultimately reduce the range of serious health hazards associated with the use of smoked and smokeless tobacco products. We fully accept the evidence that links smoking tobacco with a variety of diseases and premature death and believe it is highly unlikely that the health risks of smoked tobacco can be completely eliminated and that no safe cigarettes will ever be manufactured. We believe we were the first company to state unequivocally that “there is no such thing as a safe cigarette”. Further, we were the first company to affix to the back of the package of our first premium low-TSNA product, Advance^{^®}, a package “onsert” which contained not only scientifically verified comparative content data, but also additional health warnings. Nevertheless, in a world where an estimated 1.3 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, given available technology. Accordingly, we believe we have a corporate responsibility to continue our research and development efforts to manufacture tobacco products in the least hazardous manner possible, given available technology, particularly through the StarCured^{^®} tobacco curing process. While we have deferred our research projects because of cost-cutting efforts necessitated by our lack of available working capital, we expect to renew those efforts after the completion of our patent infringement lawsuit against RJR, although the extent of future research efforts will depend, in part, on the results of the RJR litigation, which is currently pending appeal to the United States Court of Appeals for the Federal Circuit.

We believe we have the technology, through our exclusive patent licenses, to reduce exposure to carcinogenic TSNAs, particularly the subgroups of nitrosamines commonly referred to as NNNs and NNKs, to the lowest possible levels (with carcinogenic NNKs and NNNs that measure 200 parts per billion and below) and have demonstrated that our method for curing tobacco using the StarCured^{^®} tobacco curing process can be scaled up to meet broad commercial needs in the United

States and abroad. Our focus on very low-TSNA, non-fermented smokeless tobacco products (in addition to the eventual licensing of our technology) is based, in part, on the fact that tobacco smoke contains over 4,000 constituents, 43 of which are known carcinogens.

Over the last several years, we have expended significant effort and money on the development of our very low-TSNA tobacco and smokeless tobacco products, our patent infringement litigation against RJR, and our attempts to market our smokeless products. While product licensing royalties and smokeless tobacco sales have been de minimis to date, we will continue our efforts to develop and sell smokeless tobacco products and enter into licensing arrangements for such products.

We experienced a reduction in revenue and gross margins in 2006, as well as a net loss of approximately $12.3 million. Our future prospects are dependent, in the near term, on the improvement in the performance of our discount cigarette business and, on the distribution and consumer acceptance of our low-TSNA smokeless tobacco products as well as the continued development of new low-TSNA smokeless tobacco products, independently and through alliances with other tobacco manufacturers; and, in the future, on our ability to begin generating significant revenues through royalties from the patented tobacco curing process to which we are the exclusive licensee. However, our ability to generate revenues through such royalty payments will also be dependent upon the successful completion of our ongoing patent infringement lawsuit against RJR. In that litigation, the United States District Court for the District of Maryland in January 2007 issued a ruling that two of the Company’s patent which are at issue in this litigation are invalid because the term “anaerobic condition” as used in the patents is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim.

The recurring losses generated by our operations continue to impose significant demands on our liquidity. In 2006, we generated $10.0 million through the sale of common stock by entering into securities purchase and registration rights Agreements (“the Purchase Agreements”) and through the exercise of warrants issued under Purchase Agreements. In March 2007, the Company entered into an agreement under which it received approximately $11.5 million in return for assigning to the purchasers the right to interest paid in the Company’s escrow fund and to any releases of the escrow principal for any overpayments, or, if those funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years. Also, in March 2007, the Company sold approximately 960 of its tobacco curing barns for approximately $11.2 million and anticipates completing sales on a total of approximately 960 curing barns this month for an aggregate purchase price of approximately $11.6 million.

With the proceeds of the Company’s financings in 2007 we anticipate that we will have sufficient funds to support our operations through 2008, notwithstanding continued intensified competition, especially from wholesalers selling deep discount foreign manufactured cigarettes, in the non-MSA states. However, absent the successful completion of our ongoing patent infringement lawsuit against RJR, the exercise of outstanding warrants or a substantial improvement in revenues and/or royalties from smokeless tobacco products, we believe that it will be necessary to pursue additional sources of funds in early 2009. However, depending upon market conditions and the price of our common stock, we may determine to seek additional funds before that date.

Discount Cigarettes. Since 2000, our discount cigarette business has experienced a significant decline in sales, partly caused by intensified pricing competition from wholesalers selling deeply discounted foreign manufactured cigarettes. In addition, a portion of our gross profits on cigarette sales must be paid into escrow to meet our obligations under the MSA. Our cigarettes are sold through approximately 73 tobacco distributors throughout the United States, although we have successfully sought to focus sales efforts in the states of Florida, Minnesota, Mississippi and Texas, where we do not incur escrow obligations under the MSA.

Cigarette sales and associated gross profits have continued to trend downward over the last several years, particularly when consideration is given to the Company’s MSA escrow requirements. For the year ended December 31, 2006, we experienced a net operating loss and a decrease in truckload sales over 2005. Also, increasing regulatory requirements in both MSA and non-MSA states, as well as increased pricing competition, have continued to adversely impact on the sales of discount cigarettes. This trend has continued into the first quarter of 2007 and has been exacerbated by the $1.00 per pack tax increase that became effective on cigarette sales in Texas as of January 1, 2007. Moreover, there continues to be significant competition in the non-MSA states, especially wholesalers selling deeply discounted foreign manufactured cigarettes, and pressures on the cigarette industry in general.

While the Federal buyout legislation for tobacco quota resulted in an increase of approximately $0.50 per carton in cigarette costs beginning January 1, 2005, Star along with the rest of the industry has raised prices to cover those costs. The elimination of price supports and limits on tobacco cultivation has resulted in lower prices for domestically grown tobacco

leaf which could, in turn, result in a reduction of the cost of tobacco used in the Company’s cigarettes, although, to date, prices have remained about the same. While costs of the tobacco buyout program are also assessed on smokeless tobacco products, those costs will be minimal for the foreseeable future given the Company’s de minimis sales of smokeless products to date.

Notwithstanding the challenges facing our discount cigarette business the sale of discount cigarettes in the four non-MSA states has been our principal source of revenue over the past several years. We will continue to evaluate the prospects for the cigarette business in general given the overall trend of decreasing sales, and sales in MSA states, in particular, given the additional regulatory and MSA burdens of operating in those states.

Smokeless Tobacco. Sales of our smokeless tobacco products increased in 2006 and were 57.6% higher than 2005 sales. However, sales of our smokeless products continue to be de minimis and it will take significantly greater sales of smokeless products for this business segment to operate at break-even levels.

STONEWALL Hard Snuff^{^®} now represents a majority of our hard tobacco sales. We continue to seek to increase the distribution and consumer acceptance of low-TSNA smokeless tobacco products as well as the improvement of our existing very low-TSNA products and the development of other smokeless tobacco products, independently and through alliances with other tobacco manufacturers. Our working capital constraints over the last several years have limited both our direct marketing of smokeless products and our research and development efforts which, if successful, would likely contribute to consumer acceptance of our smokeless tobacco products. We do not expect to increase our financial efforts to broadly market smokeless products, or to significantly advance our research and development efforts, in the near term. In 2006, the Company developed new “natural” flavors of hard snuff and conducted consumer preference studies for that product. The Company in early 2007 introduced this flavor into test market and anticipates supporting that effort with increased marketing.

Licensing. We have an exclusive, worldwide license from Regent Court Technologies, LLC under twelve patents issued and patents pending relating to methods to substantially prevent the formation of TSNAs in tobacco, including the StarCured^{^®} tobacco curing process and the production of very low-TSNA tobacco products. The StarCured^{^®} tobacco curing process, as discussed herein, involves the control of certain conditions in tobacco curing barns, and in certain applications, uses microwave and/or electronic beam technology. The StarCured^{^®} process substantially prevents the formation in the tobacco leaf of the carcinogenic TSNAs, which are widely believed by medical and scientific experts to be among the most abundant and powerful cancer-causing toxins present in tobacco and in tobacco smoke. We continue to pursue means of collecting royalties with respect to this curing technology, including through arrangements described below and our patent infringement lawsuit against RJR. However, in the Company’s patent litigation against RJR, the United States District Court for the District of Maryland in January 2007 issued a ruling finding that two of the Company’s patent which are at issue in this litigation are invalid because the term “anaerobic condition” as used in the patents is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim.

Pursuant to the Hard Tobacco Agreement entered into with B&W in April 2001, B&W engaged in a test market of a hard tobacco product using our very low-TSNA smokeless tobacco and we received de minimis royalties from the sale of smokeless products by B&W. We were notified in December 2004 that the test market was not successful and that, as a result, the Hard Tobacco Agreement was being terminated. We would expect that any additional royalties arising from our agreements with B&W would be dependent on the successful completion of our patent litigation against the combined RJR and B&W operating entity.

In the second quarter of 2004, we entered into an agreement with another tobacco manufacturer for the licensing of low-TSNA hard tobacco. Under that agreement, the manufacturer conducted an initial assessment of a hard tobacco product, but did not conduct a further test market as envisioned under the agreement.

While licensing of our exclusive patent rights is a major potential source of additional revenue for us, fully realizing this potential will depend on our ability to successfully defend and enforce our patent rights and to obtain a reversal on appeal of the decision issued by the United States District Court for the District of Maryland that the patents at issue in our lawsuit against RJR are invalid because of the indefiniteness of the term “anaerobic condition”.

Impact of the MSA. We continue to experience negative cash flows from operations, particularly when the escrow obligations arising under the MSA are taken into account. We have deposited into escrow a net amount of approximately $38.3 million for sales of cigarettes in MSA states. We are currently seeking to determine the extent of our 2006 escrow obligation, but expect that this obligation will be approximately $500,000, based on information which we have on direct sales, the level of indirect sales by our customers to MSA states in prior years, and reports received from such states to date.

We deposited a total of approximately $1.0 million into escrow for our obligations for 2005 sales. This compares to a net amount of approximately $3.9 million that we deposited in 2005 for 2004 sales. To minimize the impact of these MSA obligations on our liquidity, over the last several years we have successfully focused our cigarette sales primarily in the four non-MSA states where we are not required to make deposits into escrow, and have enhanced our efforts to prevent our cigarettes intended for the non-MSA states from being diverted into MSA states. However, in the near term we must continue to make MSA escrow deposits, but expect that these amounts will continue to decrease based on information which we have on direct sales in MSA states and the level of indirect sales by our customers to MSA states.

Recent Legislation Impacting Sales of Discount Cigarettes. Over the last several years there have been significant increases in the regulatory burdens faced by our cigarette business. Minnesota, one of the four non-MSA states in which we increasingly have focused our sales of discount cigarettes, passed a statute which took effect on July 1, 2003, requiring distributors in the state to pay an additional $0.35 per-pack fee on cigarettes purchased from manufacturers like us that have not entered into a separate settlement with the State. Because the statute impacts on all such non-participating manufacturers, its effect has tended to be uniform among these manufacturers. Further, in August 2005, the state of Minnesota increased the tax rate by $1.005 per pack, consisting of a $0.255 sales tax increase and a $0.75 health impact fee. This tax has put further price pressure on discount cigarettes since the new tax was imposed on a per pack basis and replaced a prior tax that was calculated as a percentage of the wholesale price.

Bills were introduced during the 2006 legislative sessions in each of the other three non-MSA states that would have imposed an additional user fee on non-participating manufacturers at a rate of $0.40 to $0.50 per pack on cigarettes sold by companies that have not entered into separate settlement agreements with those states. However, none of these bills were enacted into law. Similar types of legislative proposals have been introduced in Mississippi in 2007 and similar legislative initiatives may be introduced in Florida and Texas this year. Passage of statutes in the non-MSA states that impose fees on manufacturers that have not previously settled with these states would be expected to impact on all such manufactures equally, but would make discount cigarettes more expensive and lessen the competitive price advantage they currently enjoy compared to generic and premium brand cigarettes. A special session of the Texas legislature was convened in April 2006 to address school finance legislation which had been an issue in Texas since 2005. During the special session, the legislature enacted new funding legislation that included a $1.00 per-pack tax increase on cigarettes. That legislation was signed by the Governor and the cigarette tax increase portion of the statute took effect on January 1, 2007. The $1.00 per-pack tax increase will be applied to cigarettes produced by all manufacturers and it is expected that the new tax will put increased pressure on the market for cigarettes in Texas generally. Passage of statutes like that in Texas, that impose increased state taxes on all manufacturers, will result in discount cigarettes being more expensive and likely will lessen the competitive price advantage they currently enjoy compared to generic and premium brand cigarettes.

In addition, there are numerous recently enacted statutes and legislative initiatives in MSA states that could further impact our ability to compete in these states, even though we successfully have sought to limit sales in the MSA states. We have determined to cease sales in certain states in response to some of these developments.

Michigan, an MSA state, passed a fee statute in January 2004 that requires the payment of a $0.35 per-pack fee on cigarettes sold by non-participating manufacturers, that must be paid in advance, and is based on an estimate of projected sales by the State’s Department of Revenue. This fee is in addition to the MSA requirement that non-participating manufacturers deposit funds into escrow for each cigarette sold in an MSA state. Given the cost burden of making both the escrow payments and fee payments, we advised Michigan’s Department of Revenue that we would not sell our cigarette brands in Michigan in the future. Utah and Alaska, MSA states where we had virtually no sales in 2005, also have passed additional per-pack fees imposed on cigarettes sold by non-participating manufacturers. Legislation imposing a fee on cigarettes sold by non-participating manufacturers was introduced in a number of other MSA states in 2006, but none of these bills were enacted into law. The impact of these new fee statutes in the MSA states would be expected to have a negative impact on all non-participating manufacturers’ sales in these states, including Star. However, as previously noted, we have sought to focus our cigarette sales in recent years in the four non-MSA states. During the year ended December 31, 2005, approximately 95% of our cigarette sales were in non-MSA states and we believe that the percentage of sales in non-MSA states during 2006 will be approximately 97%.

January 1, 2008. Because of our continued efforts to limit sales in the MSA states, and the expectation that such reduction will continue in the future, we do not expect that these or similar statutes if passed in the MSA states will have a material impact on our sales when such statutes go into effect. Proposed fire safety statutes have been introduced in several of the MSA states in 2007. We will continue to monitor these fire safety legislative initiatives as they move forward and, as appropriate, reassess our decision not to develop a cigarette that complies with such regulations.

The Department of Agriculture which is responsible for structuring the payment program to tobacco growers under the tobacco quota buyout program, issued regulations relating to the assessment of the buyout cost pursuant to the Fair and Equitable Tobacco Reform Act of 2004 in February 2005. Under the regulations, the assessment are made quarterly based on the prior quarters taxable amount of cigarettes removed from bond. In 2006, we made quarterly payments of approximately $483,000, $707,000, $747,000 and $831,000. This included payment of a portion of a separate assessment of $1,128,093 for certain loan loss costs and administrative costs in the third quarter of 2005 that was paid over six quarters. The final assessment payment was made in the fourth quarter of 2006. With the exception of the assessment, the quarterly payments have been approximately $0.50 per carton. All of the major tobacco companies, as well as Star, have increased prices to cover the cost of the buyout which have been reflected in higher overall prices for tobacco products. In 2005, tobacco production decreased significantly primarily due to uncertainty relating to the buyout program. Tobacco production rebounded significantly in 2006. It is expected that the elimination of price supports and limits on tobacco cultivation ultimately will result in lower prices for domestically grown tobacco leaf which could, in turn, result in a further reduction of the cost of tobacco used in the Company’s cigarettes which may be of some help in competing with deeply discounted foreign manufactured cigarettes.

As part of the buyout program, the USDA in August 2005 assessed a separate charge of $287 million for Commodity Credit Corporation tobacco loan losses and $4.5 million in administrative fees on an industry wide basis. The Company’s portion of that assessment was $1.1 million, which the USDA permitted the Company to pay over six quarters with the final payment being made during the fourth quarter of 2006. During the ten year life of the buyout program, the USDA could assess up to approximately $250 million in additional loan loss costs or administrative fees. At this point it is unknown when, or if, any such assessments will be made in the future.

RJR Litigation. In May 2001, we filed a patent infringement action against RJR in the United States District Court for the District of Maryland, to enforce our rights under U.S. Patent No. 6,202,649 (“649 Patent”), which claims a process for substantially preventing the formation of TSNAs in tobacco. On July 30, 2002, we filed a second patent infringement lawsuit against RJR in the same court based on a new patent issued by the U.S. Patent and Trademark Office on July 30, 2002 (Patent No. 6,425,401). The new patent is a continuation of the `649 Patent, and on August 27, 2002, the two suits were consolidated. See Part II, Item 1 of this report for additional information on the history of this litigation.

Trial in this case commenced on January 31, 2005 before the Court on RJR’s defense of inequitable conduct before the patent office. At the conclusion of the bench trial of this portion of the case, the Court advised the parties that it would take the matter under advisement, and expected to issue a ruling on this portion of the case at the same time that it rules on two additional Summary Judgment Motions that were filed by RJR on January 25, 2005. Briefing on these motions was completed on March 11, 2005. In January 2007, the United States District Court for the District of Maryland issued a ruling that two of the Company’s patent which are at issue in this litigation are invalid because the term “anaerobic condition” as used in the patents is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim. Also, if the Court were to rule against the Company on the inequitable conduct defense that was tried in early 2005, and which is currently pending, we would be required to appeal that decision and obtain a reversal in order to be in a position to enforce the patents. The lawsuit against RJR is the centerpiece of our announced policy of protecting the intellectual property to which we are the exclusive licensee under our license arrangement with Regent Court Technologies.

Merger of B&W and RJR. In 2004, B&W and certain of its affiliated tobacco businesses combined operations under the new publicly traded holding company, Reynolds American Inc., which is 42% owned by British American Tobacco PLC, the former parent of B&W. We have a variety of agreements with B&W. Given our pending patent infringement lawsuits against RJR, it is difficult to evaluate the precise impact which the transaction between B&W and RJR will have on us and our operations. However, the fact that B&W and RJR have combined their operations could have a negative impact on the range of existing agreements which we have entered into with B&W, including future royalties under our agreements relating to the Advance^{^®} low-TSNA cigarette for which no royalties were received since 2004, and potential royalties. For example, following the combination, RJR took the position in our litigation that the new operating entity established as a result of this combination transaction assumed all of the rights and obligations under the agreements previously entered into between us and B&W, and moved to dismiss the case on that basis. After full briefing, the Court denied RJR’s motion to dismiss, and found that B&W had attempted to assign the Star/B&W agreements to the new subsidiary, that we had not consented to the

assignment and that the de facto merger doctrine did not apply to vitiate the need for our consent. In its ruling the Court did leave open the question of what impact, if any, the combination may have on the future licensing arrangements with RJR, but noted that those considerations did not impact on the claims asserted by us in the patent litigation.

In recent years, B&W has granted us a number of concessions under our agreements, including deferred interest and principal payments, consenting to our incurrence of additional indebtedness and agreeing to modify the now-terminated Hard Tobacco Agreement to allow us to pursue similar licensing arrangements with third parties. B&W’s failure to grant similar concessions in the future could have a number of adverse consequences, including restricting the pursuit of business opportunities with B&W or third parties, limiting the Company’s ability to raise funds through debt financing and requiring payment of our obligations to B&W.

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 is recognized when tobacco products are shipped to customers and title passes. The Company also records appropriate provisions for rebates and discounts and credits for returns. The amounts are estimated due to the variability in credits (due to promotional programs in the field), allowances for collectability, and allowances for product which may be returned by customers after a sale is completed. In order to quantify these estimates, the Company makes quarterly estimates in these areas based on the available quarterly information and historical experience.

The Company did not recognize any royalty revenues in 2006, and had de minimis royalty revenues in 2005 and 2004.

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 asset by estimating the future net cash flows expected to result from the asset, including eventual disposition using a weighted average cash flow probability method. 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.

Assumptions underlying the weighted average cash flow probability involve estimating future cash flows from operations and ultimate sale of the business at cessation of operations over varying periods of time. Several alternative scenarios are used which include a variety of probability estimates. Should these estimates change, conclusions regarding impairment could change accordingly.

The Company assesses impairment of long-lived assets based on asset groups with separately identifiable cash flows, such as the Company’s discount cigarette and smokeless operations, StarCured^{^®} tobacco curing barns, and the patented technology.

Each quarter an impairment analysis is conducted by management to determine the value of the barns. Government regulation and the market for equipment used in producing tobacco plays a role in determining the value of the long-lived assets. In the third and fourth quarters of 2005, the Company wrote down the value of the tobacco curing barns by approximately $2.1 million and $0.4 million, respectively, after conducting an analysis of the current market value for the barns in light of the diminished utilization of the barns during 2005 as a result of the elimination of price supports and quotas for tobacco. In 2006, the production of tobacco rebounded and this resulted in a substantial increase in the value of its tobacco curing barns, so that the Company’s StarCured^® tobacco curing barns are reflected on the Company’s books at a value which is substantially below their current market value.

The Company generally determines depreciation based on the estimated useful lives of its assets and records depreciation on a straight-line method over such lives. With regard to the tobacco curing barns, depreciation is recognized using a “units of production” method of accounting to more closely match depreciation with the period during which such depreciation takes place, and which in this case of the curing barns, is in the third and fourth quarters of each fiscal year, which is during the tobacco curing season.

Throughout the 2004 growing season, there had been a fairly constant use of the Company’s StarCured^{^®} tobacco curing barns by the participating StarCured^{^®} farmers. Given the consistent level of production in prior years, the Company calculated depreciation on the barns in 2004 using the “units of production” method of accounting to take into account that the barns are used only during the tobacco-curing season – from August to November. In 2005, the Company recorded an impairment charge of approximately $2.5 million to reflect the fair value impairment of the curing barns as a result of the elimination of the price supports and quotas for tobacco in 2005. In 2006, the production of tobacco rebounded and this resulted in a substantial increase in the value of its tobacco curing barns, so that the Company’s StarCured^® tobacco curing barns are now carried at a book value that is substantially below their current market value.

Amounts deposited into MSA escrow accounts are required to be held in escrow for 25 years and have been reported as a non-current asset in the Company’s consolidated financial statements, given the restrictions placed on the use of these funds. In March 2007, the Company entered into an agreement under which it received a payment of approximately $11.5 million in return for assigning to the purchasers the right to interest paid on the Company’s escrow fund and to any releases of the escrow principal for any overpayments, or, if these funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years.

To date, the Company has not been sued by an MSA state in an attempt by such state to collect on amounts that have been deposited into escrow by the Company. The probability that such suits will be filed in the future is generally unknown, although there will be an incentive for such suits to be filed prior to the time that the funds deposited into escrow are returned to the Company. If such suits are filed, the Company will attempt to assess the viability of such suits in order to determine what impact such pending litigation would have on the Company’s MSA escrow funds and its obligations to protect the funds.

Please refer to Item 6, “Selected Financial Data” which appears on page 33 of this report to view the five year comparative results of operations and selected financial data.

Net Sales. During 2006, the Company’s net sales decreased to $37.7 million, reflecting a decrease of $8.7 million, or 18.7% from 2005 net sales of $46.4 million. The Company sold approximately 950 million cigarettes during 2006, compared with sales of approximately 1.2 billion cigarettes during 2005, representing a decrease of approximately 21%. The decline in unit sales was principally due to continued pricing competition from wholesalers buying from foreign manufacturers, particularly in the four non-MSA states in which the Company is currently focusing its sales efforts (as discussed in greater detail in “Competition” under Item 1) and the Company’s successful efforts to limit sales in the MSA states.

The average wholesale price charged by the Company for its cigarettes increased 4.1% from $7.56 per carton during 2005 to $7.87 per carton during 2006. Pricing was fairly consistent throughout the year.

The Company sold 9,700 cartons of ARIVA^{^®} during 2006, compared with sales of 7,740 cartons during 2005, representing an increase of approximately 25.3%. Sales in both 2005 and 2006 were related primarily to repurchase orders. While sales of ARIVA^® have increased on a year-to-year basis over the past several years, sales of our smokeless tobacco products continue to be de minimus compared to cigarette sales. The Company believes that the acceptance of ARIVA^{^®} has been adversely impacted by a number of factors, including, among others: (1) lack of consumer familiarity with ARIVA^{^®}, (2) the fact that ARIVA^{^®} requires a change in habit by smokers, i.e. using a smokeless product rather than a smoked product; (3) publicly stated opposition to ARIVA^{^®} in 2002 and 2003 by certain state attorneys general and certain public health advocacy groups which appeared in various newspapers and FDA filings; (4) ARIVA^{^®} requires Federally mandated smokeless warning labels that may be unfamiliar to and/or misunderstood by cigarette smokers; (5) the need to develop brand name recognition with consumers; and (6) difficulty in obtaining capital required for large-scale consumer education and marketing directed to adult tobacco users.

The Company sold 25,640 cartons of STONEWALL Hard Snuff^{^®} during 2006 compared with 14,680 cartons during 2005, representing an increase of approximately 74.7%. STONEWALL Hard Snuff^{^®} now represents a majority of Star’s hard tobacco sales. Currently the Company believes that more than 10,000 locations nationwide have either STONEWALL Hard Snuff^®, ARIVA^® or both available and the Company has been seeking to increase the number of stores carrying these products. Sales of STONEWALL Hard Snuff^{^®} and ARIVA^{^®} continue to be impacted by the Company’s working capital constraints which allow only limited expenditures for marketing and product placement, but combined sales of ARIVA^® and STONEWALL Hard Snuff^® increased by 57.6% over 2005.

Gross Margin. During 2006, overall gross margin increased to $6.0 million compared to $5.3 million in 2005, despite lower volumes and increased manufacturing costs for cigarettes. The increase in gross margin was primarily due to the fact that the

gross margin in 2005 was negatively impacted by the one-time USDA assessment in August 2005 of $1.1 million which the Company expensed at that time. The gross margin in 2006 also included higher sales prices for the Company’s cigarette products.

The Company’s average cost-of-goods sold for discount cigarettes in 2006 increased by approximately 14.7%, to a blended average of approximately $2.03 per carton, compared with a blended average cost of $1.77 per carton during 2005. This increase was primarily due to the decreasing volume of cigarette production. Fixed direct manufacturing expenses were not able to be spread over a larger volume of cigarette production and, as a result, the average cost per carton increased.

While the average wholesale price charged by the Company for its cigarettes increased 4.1% from $7.56 per carton during 2005 to $7.87 per carton during 2006, the price increases were partially offset by the fact that the average cost per carton increased by 14.7% from $1.77 per carton during 2005 to $2.03 per carton in 2006. In summary, the average price per carton during 2006 increased by 31 cents per carton while the average cost per carton rose 26 cents. As a result, the margin during 2006 increased by an average price of 5 cents per carton as compared with 2005.

Federal excise tax remained at $3.90 per carton during both 2005 and 2006. Beginning on January 1, 2005, there was an increased cost of approximately $.50 per carton for the tobacco farmer buyout legislation. In addition to the $0.50 per carton charge, the USDA in August 2005 assessed the Company a charge of $1.1 million for its portion of the Commodity Credit Corporation loan losses on tobacco and administrative costs. The USDA permitted the Company to pay this amount over six quarters in installments of approximately $190,000 per quarter, but because the USDA assessed this amount in the third quarter of 2005, the Company expensed the full amount during that quarter. The last payment for this assessment was paid during the fourth quarter of 2006.

The Company anticipates that the manufacturing capacity at its Petersburg, Virginia, facility should be sufficient to satisfy the manufacturing needs for its cigarettes for the foreseeable future.

The calculation of the per-carton cost does not include any amount reflecting the MSA deposit per carton to be funded in April 2007 for sales made in MSA states during 2006. Historically MSA escrow payments have neither been expensed nor accrued for income statement purposes because the escrow deposit remain the property of the Company on its balance sheet. The deposits into the MSA escrow accounts do negatively impact the Company’s cash flow since the funds are unavailable for use by the Company. (See “Liquidity and Capital Resources” below for more information on the Company’s liquidity.) In March 2007, the Company assigned its rights to the interest earned on the MSA deposits and to any releases of principal in return for a payment of approximately $11.5 million.

Due to the under-utilization of the smokeless tobacco packaging equipment, and much higher costs for smokeless products, the Company’s gross profit for smokeless products was negative during both 2005 and 2006. The Company recorded charges of $1.1 million and $1.2 million for write-downs of ARIVA^{^®} and STONEWALL Hard Snuff^{^®} inventory to net realizable value during the years ended December 31, 2006 and 2005, respectively. Due to the low capacity utilization of smokeless tobacco manufacturing and packaging equipment in 2005, unit manufacturing costs increased significantly on a per unit basis. As a result, the inventory was written down to its net realizable value.

Total operating expenses decreased approximately $6.6 million or 26.7% to $18.3 million for 2006 from $24.6 million in 2005. Marketing and distribution costs decreased by approximately $2.3 million from $8.3 million in 2005 to $6.1 million in 2006 primarily due to decreased salaries and commissions that resulted from the reduction in the sales force in early 2006. General and Administrative costs decreased approximately $1.9 million to $10.6 million for 2006 from $12.5 million in 2005 primarily due to decreased legal expenses of approximately $2.3 million because of reduced activity while the Company awaited rulings in the patent infringement lawsuit against RJR. Depreciation expense related to StarCured^{^®} barns increased from $1.1 million in 2005 to $1.4 million in 2006 primarily due to the significantly increased volume of tobacco being cured in the StarCured^{^®} barns during 2006. The much lower volume of tobacco cured in 2005 was primarily due to the uncertainty concerning the tobacco buyout program. Research and development costs increased slightly from $0.1 million in 2005 to $0.2 million in 2006.

Interest Income. In 2006, the Company had de minimis net interest income because it had approximately equal amounts of interest expense ($1.9 million) and interest income. This compares to interest expense of $0.7 million and interest income of $1.4 million, for a net interest income of $0.7 million in 2005. The higher interest expense during 2006 resulted primarily from interest on the long-term notes from B&W. On January 1, 2006, the Company began paying interest and principal on its long-term notes from B&W, which as of January 1, 2006, had a principal balance of approximately $20 million. The higher interest income during 2006 was primarily due to increased interest income earned on the Company’s MSA escrow fund. In 2006, the Company received for its own account the current interest on the amounts in escrow.

Income Tax Benefit. The Company had zero income tax benefit in both 2006 and 2005. In 2004, the tax benefits were reduced due to a valuation allowance established since it is not more likely than not that such benefits will be realized. The valuation allowance in both 2005 and 2006 resulted in a zero income tax benefit.

Loss on Conversion of Long-term Debt to Equity. On January 10, 2005, Manchester Securities converted its $9.0 million convertible debenture into 3,179,810 shares of the Company’s common stock, which reflected an adjusted conversion price from $3.73 to $2.897, and $212,000 of accrued and unpaid interest. As a result of this transaction, the debenture was fully converted and cancelled with Manchester having no rights under the Debenture. As a result of the conversion of debt into equity, the Company recorded a non-cash charge during the first quarter of 2005 of $4.8 million to reflect the cost of the discount provided for in the conversion, as well as to expense the remaining portion of the unamortized costs of the initial debt issuance. There were no similar expenses in 2006.

common stock. Under its terms, the $2 million promissory note was nonrecourse as to accrued interest and 85% of the principal amount of the note, and reflected an inducement to the COO to join the Company and resign his senior partnership with a national law firm. In connection with the payment by the COO, the Company incurred an expense of $1.8 million due to the write-off of $1.7 million of the note receivable due and approximately $0.1 million of accrued interest. As a result of the payment, the Company incurred a non-cash charge in the second quarter and recorded a reduction of $300,000 in officers’ notes receivable in the third quarter to reflect the cash payment on July 27, 2005. There were no similar expenses in 2006.

Net Loss. The Company had a consolidated net loss of $12.3 million for 2006 compared with a consolidated net loss of $25.1 million reported for 2005. The net loss in 2006 reflected primarily lower volumes of cigarette sales and increased cigarette manufacturing costs, offset partially by an increase in pricing. The higher loss in 2005 reflected, in addition to significant operating losses, an approximate $4.8 million loss on the conversion of debt into equity, an impairment loss on the write-down of the Company’s tobacco curing barns of approximately $2.5 million, an approximate $1.8 million loss due to the write-off of the note receivable due to officer, and the one-time USDA charge for its portion of the Commodity Credit Corporation loan losses of approximately $1.1 million.

In 2006, the Company had basic and diluted losses per share of $(0.16) compared to basic and diluted net loss per share of $(0.34) in 2005.

Please refer to Item 6, “Selected Financial Data” which appears on page 30 of this report to view the five year comparative results of operations and selected financial data.

Net Sales. During 2005, the Company’s net sales decreased to $46.4 million, reflecting a decrease of $20.3 million, or 30.4% from 2004 net sales of $66.7 million. The Company sold approximately 1.2 billion cigarettes during 2005, compared with sales of approximately 1.8 billion cigarettes during 2004, representing a decrease of approximately 32%. The decline in unit sales was principally due to continued pricing competition from wholesalers buying from foreign manufacturers, particularly in the four non-MSA states in which the Company is currently focusing its sales efforts.

The average wholesale price charged by the Company for its cigarettes increased 4.7% from $7.21 per carton during 2004 to $7.56 per carton during 2005. The strongest pricing levels were achieved in the first and second quarters of 2005 at approximately $8.30 per carton and eroded downward in the third quarter to approximately $6.45 per carton due to larger promotions and discounting, and recovered to approximately $7.76 per carton during the fourth quarter. The decreased pricing performance in the last six months of 2005 was due primarily to intensified competition in the deep discount segment from wholesalers buying foreign manufactured cigarettes and efforts to promote product in the Gulf Coast states following the hurricane activity in that area during the third quarter.

Beginning in 2002, ARIVA^{^®} was broadly distributed in retail outlets throughout the United States. Based on the continued de minimis sales of ARIVA^{^®} and the passage of time from the initial placement of the product, management believes the number of locations actively carrying ARIVA^{^®} as of the end of 2005 continues to be less than 5,000 stores.

The Company sold 7,740 cartons of ARIVA^{^®} during 2005, compared with sales of 6,780 cartons during 2004, representing an increase of approximately 14.1%. Sales in both 2005 and 2004 were related primarily to repurchase orders. The Company believes that the acceptance of ARIVA^{^®} has been adversely impacted by a number of factors, including, among others: (1) lack of consumer familiarity with ARIVA^{^®}, (2) the fact that ARIVA^{^®} requires a change in habit by smokers, i.e. using a smokeless product rather than a smoked product; (3) publicly stated opposition to ARIVA^{^®} in 2002 and 2003 by certain state attorneys general and certain public health advocacy groups which appeared in various newspapers and FDA filings; (4) ARIVA^{^®} requires Federally mandated smokeless warning labels that may be unfamiliar to and/or misunderstood by cigarette smokers; (5) the need to develop brand name recognition with consumers; and (6) difficulty in obtaining capital required for large-scale consumer education and marketing directed to adult tobacco users.

The Company sold 14,680 cartons of STONEWALL Hard Snuff^{^®} during 2005 compared with 20,540 cartons during 2004, representing a decrease of approximately 29.6%. Some of that decrease reflects the fact that STONEWALL Hard Snuff^{^®} was only introduced in the later part of 2003, and initial stocking orders were still being received in early 2004. In 2005, most of the orders were for restocking of product rather than initial product placement. By the beginning of the second quarter of 2004, STONEWALL Hard Snuff^{^®} had been introduced into approximately 7,000 locations and that number has remained fairly constant since that time. STONEWALL Hard Snuff^{^®} now represents a majority of Star’s hard tobacco sales. Sales of STONEWALL Hard Snuff^{^®} and ARIVA^{^®} continue to be impacted by the Company’s working capital constraints which allow only limited expenditures for marketing and product placement.

During 2005, the Company did not earn any royalties on sales of the Advance^{^®} low-TSNA cigarette. During 2004, B&W test marketed Advance^{^®} in Indianapolis, Indiana and Phoenix, Arizona. However, following the combination of B&W and RJR in 2004, the test market of Advance^{^®} was discontinued.

Pursuant to a Hard Tobacco Agreement entered into with B&W in April 2001, B&W began to test market a hard tobacco product named Interval^{^®} in Louisville, Kentucky on December 15, 2003, and a similar dissolvable hard tobacco product in the summer of 2004. During both 2003 and 2004, the Company had de minimis revenues from royalties on the sale of these products. In December 2004, Star was notified by RJR and Brown & Williamson Holdings, Inc. that the test market was not successful and that, as a result, the Hard Tobacco Agreement was terminated.

Gross Margin. During 2005, overall gross margin decreased to $5.3 million compared to $12.8 million in 2004. The decline was due to the lower volume as well as the lower prices for the Company’s cigarette products, partially offset by reduced manufacturing costs for the Company’s three brands of discount cigarettes. As of December 31, 2004, the Company had consolidated its four brands of discount cigarettes to three brands by discontinuing the Vegas^{^®} brand.

The Company’s average cost-of-goods sold for discount cigarettes in 2005 increased by approximately 11.2%, to a blended average of approximately $1.77 per carton, compared with a blended average cost of $1.59 per carton during 2004. In 2004, the Company had reduced its cost-of-goods sold by reducing the cost for tobacco and filters used it its discount cigarettes.

However, in 2005, as volumes dropped, especially in the last six months of the year, fixed direct manufacturing expenses were not able to be spread over a larger volume of cigarette production and the average cost per carton increased. Thus, while the average wholesale price charged by the Company for its cigarettes increased 4.7% from $7.21 per carton during 2004 to $7.56 per carton during 2005, the price increases were offset somewhat by the fact that the average cost per carton increased by 11.2% from $1.59 per carton during 2004 to $1.77 per carton in 2005.

Federal excise tax remained at $3.90 per carton during both 2004 and 2005. However, there was an increased cost of approximately $.50 per carton for the tobacco farmer buyout legislation which began on January 1, 2005. In addition to the $0.50 per carton charge, the USDA in August 2005 assessed the Company a charge of $1.1 million for its portion of the Commodity Credit Corporation loan losses on tobacco and administrative costs. The USDA permitted the Company to pay this amount over six quarters in installments of approximately $190,000 per quarter, but because the USDA assessed this amount in the third quarter of 2005, the Company expensed the full amount during that quarter notwithstanding that payments will be spread over the next six quarters.

The Company anticipates that the manufacturing capacity at its Petersburg, Virginia, facility should be sufficient to satisfy the manufacturing needs for its cigarettes for the foreseeable future. Also, management has continued to seek less expensive raw materials for its cigarette products.

The calculation of the per-carton cost does not include any amount reflecting the MSA deposit per carton to be funded in April 2006 for sales made in MSA states during 2005. MSA escrow payments are neither expensed nor accrued for income statement purposes because the escrow deposit remains the property of the Company on its balance sheet. However, the deposits into the MSA escrow accounts do negatively impact the Company’s cash flow since the funds earn a low rate of interest, and are otherwise unavailable for use by the Company.

Due to the under-utilization of the smokeless tobacco packaging equipment, and much higher costs for smokeless products, the Company’s gross profit for smokeless products was negative during both 2004 and 2005. The Company recorded charges of $1.2 million and $1.3 million for the write-down of ARIVA^{^®} And STONEWALL Hard Snuff^{^®} inventory to net realizable value during the years ended December 31, 2005 and 2004, respectively. Due to the low capacity utilization of smokeless tobacco manufacturing and packaging equipment in 2005 and 2004, unit manufacturing costs increased significantly on a per unit basis and, as a result, the inventory was written down to its net realizable value.

Total operating expenses decreased to $24.6 million for 2005 from $28.7 million in 2004. General and Administrative costs decreased from $16.1 million in 2004 to $12.5 million in 2005, primarily due to legal costs decreasing by approximately $1.4 million. Depreciation expense related to StarCured^{^®} barns and general/administrative related expenses decreased from $2.6 million in 2004 to $1.1 million in 2005 primarily due to decreased volumes of tobacco being cured in the StarCured^{^®} barns, which also resulted in the $2.5 million impairment loss on the barns which was taken in 2005. Marketing and distribution costs decreased by approximately $1.7 million. Research and development costs increased by $0.1 million.

Interest Income. The Company had interest expense of $0.7 million and interest income of $1.4 million, for a net interest income of $0.7 million in 2005. This compares to interest expense of $2.9 million and interest income of $0.3 million, for a net interest expense of $2.6 million in 2004. The higher interest income during 2005 was due to higher cash balances as well as increased interest income from the Company’s MSA escrow fund. The Company receives for its own account the current interest on the amounts in escrow. The higher interest expense in 2004 resulted primarily from interest charges on the $4.5 million borrowed from the Company’s Chief Executive Officer (“CEO”), interest on the Manchester Securities debenture and interest on the B&W restructured account payable. This interest expense was partially offset by interest income generated by the Company’s MSA Escrow Fund; however, the escrow fund interest rates are very low due to the conservative investment options permitted by the escrow agreements. The Company receives for its own account the current interest on the amounts in escrow.

Income Tax Benefit. The Company had zero income tax benefit in 2005 compared to an income tax benefit of $1.8 million in 2004. The tax benefit was directly attributable to the loss experienced in 2004; however, in 2004 the tax benefits were reduced due to a valuation allowance established since it is not more likely than not that such benefits will be realized. The valuation allowance in 2005 resulted in a zero income tax benefit.

Write-off of Note Receivable, Officer. On July 27, 2005, the Company’s President and Chief Operating Officer (“COO”) tendered to the Company a payment of $300,000 as full satisfaction of a nonrecourse and unsecured $2 million promissory note issued to the Company in 1999. The COO issued the note in 1999 to purchase two million shares of the Company’s common stock. Under its terms, the $2 million promissory note was nonrecourse as to accrued interest and 85% of the principal amount of the note, and reflected an inducement to the COO to join the Company and resign his senior partnership with a national law firm. In connection with the payment by the COO, the Company incurred an expense of $1.8 million due to the write-off of $1.7 million of the note receivable due and approximately $0.1 million of accrued interest. As a result of the payment, the Company incurred a non-cash charge in the second quarter and recorded a reduction of $300,000 in officers’ notes receivable in the third quarter to reflect the cash payment on July 27, 2005.

Net Loss. The Company had a consolidated net loss of $25.1 million for 2005 compared with a consolidated net loss of $16.6 million reported for 2004. The net loss primarily reflects the impact of lower volumes of cigarette sales, increased cigarette manufacturing costs, and a number of non-cash costs including the $4.8 million conversion cost of the convertible debt, the $2.1 million impairment loss on the barns, the $1.7 million write-off of the note receivable and the impact of the reduced tax benefit due to the valuation allowance.

In 2005, the Company had basic and diluted losses per share of $(0.34) compared to basic and diluted net loss per share of $(0.27) in 2004.

As of December 31, 2006, we had a working capital surplus of approximately $4.2 million. Future cash needs over the subsequent year include:

In addition, certain contingencies exist that could require the Company to make significant cash payments, including challenging the Virginia Department of Taxation’s sale and use tax assessment of $988,564 with respect to our curing barns. An administrative proceeding relating to this challenge may be concluded in 2007. The Company continues to challenge this assessment and has filed a request for reconsideration with the Commissioner of Taxation, and is prepared to file a judicial action if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue. While the Company is optimistic that its request for reconsideration will be accepted based on prior rulings in similar cases, if the assessment is not reversed, the Company will be required to pay the tax, penalties and interest due.

It is anticipated that sales in 2007 will continue to be negatively impacted by the continued pressure on the deep discount cigarette market in the four non-MSA states as well as the $1.00 per pack increase in the cigarette excise tax in the State of Texas, that became effective on January 1, 2007. In March 2007, the Company entered into an agreement under which it received a payment of approximately $11.5 million in return for assigning to the purchasers the right to interest paid in the Company’s escrow fund and to any releases of the escrow principal for overpayments, or, if those funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years. Also, in March 2007, the Company sold approximately 960 of its tobacco curing barns for approximately $11.2 million and anticipates completing sales on a total of approximately 990 curing barns this month for an aggregate purchase price of approximately $11.6 million. With the proceeds from these transactions, we anticipate that we will have sufficient funds to support our operations through 2008. However, absent the exercise of outstanding warrants, a substantial improvement in revenues and/or royalties from smokeless tobacco products, or a significant improvement of the volume of sales of cigarettes, we believe that it will be necessary to pursue additional sources of funds in early 2009. However, depending upon market conditions and the price of our common stock, we may decide to seek additional funds before early that date.

We expect to continue to pursue opportunities for licensing our smokeless tobacco products and expanding our sales and marketing efforts. While we may seek to obtain funds in the future through debt financing, there are significant limitations on our ability to obtain new debt financing, including our agreements with B&W. Moreover, our ability to raise future financings on terms acceptable to us (including through the exercise of outstanding warrants) will depend on a number of factors, including the performance of our stock price and our operational performance. Any equity financing will be dilutive to our existing shareholders.

As of December 31, 2006, we had positive net working capital of approximately $4.2 million, approximately $4.3 million in cash and cash equivalents and $4.8 million of accounts receivable, compared to a net working capital of approximately $9.0 million, $11.5 in cash and cash equivalents, and $2.4 million in accounts receivable, as of December 31, 2005.

Net Cash Provided By (Used In) Operating Activities. In 2006, $10.6 million of cash was used in operating activities compared to $14.0 million of cash used in operating activities during 2005. This reduction in the amount of cash used by operations during 2006 was primarily due to the decreasing volume of cigarettes sold and increasing cost of goods sold, offset somewhat by a higher price per carton.

Net Cash Provided By (Used In) Financing Activities. In 2006, $4.5 million of cash was generated by financing activities versus $20.7 million of cash generated by financing activities in 2005. The funds generated during 2006 principally included $6.0 million in proceeds from a common stock and $4.0 million in proceeds from the exercise of warrants. The funds generated during 2005 were from the $26.2 million in net proceeds from the sales of our common stock. During 2006, approximately $5.5 million was used for repayment of notes payable and capital leases compared to $5.0 million used for such purposes in 2005.

Net Cash Provided by (Used In) Investing Activities. During 2006, approximately $15,000 of cash was used in by investing activities versus $1.0 million of cash generated by investment activities during 2005. The cash generated during 2005 primarily resulted from the collection of $0.9 million of notes receivable from officers and deposits released from leases.

Net Cash Used in MSA Escrow Payments. During 2006, we deposited approximately $1.0 million for our escrow obligations for 2005 sales in MSA states and approximately $0.1 million for quarterly payments for 2006 sales. During 2005, we deposited approximately $3.8 million for our escrow obligation for 2004 sales in MSA states plus we made additional net deposits of $0.2 million for quarterly payments for 2005 sales. The lower amount deposited in 2006 was due to the Company’s efforts to minimize its cigarette sales in MSA states.

While we obtained $10.0 million in financing in 2006, we had a consolidated net loss of approximately $12.3 million and substantial cash outlays, including principal payments of approximately $4.5 million as we reduced our notes payable to B&W from approximately $24.9 million at the end of 2005 to $19.4 million at the end of 2006.

We continue to experience operating losses, which if not reversed will continue to negatively impact on our working capital. For 2006, sales of our discount cigarettes totaled approximately $37.7 million, a decrease of approximately $8.7 million or 18.4%, from approximately $46.4 million during 2005. Although our truckload sales decreased substantially compared to 2005, our prices increased by approximately 4.1% from $7.56 to $7.87. This increase in part, was possible because of our established relationships with our wholesalers and the demand for our brands of cigarettes at retail locations. Sales of our smokeless products continue to be de minimis. Our net working capital and results of operations do not reflect our obligation to make MSA escrow deposits for 2006 sales, which we estimate to be approximately $500,000 and which we must make in April 2007.

We have spent a significant amount in connection with the development and protection of our intellectual property portfolio, principally in connection with our patent infringement litigation against RJR. We recognize that in order to protect and defend our intellectual property, additional capital will need to be spent in connection with our ongoing patent litigation matters, including the cost of appealing the January 2007 decision by the United States District Court for the District of Maryland which ruled that the two patents at issue in the RJR litigation were indefinite and therefore invalid, and potentially an adverse ruling on RJR’s inequitable conduct defense.

Our inability to raise funds by early 2009 could have a material adverse effect on our ability to meet our working capital needs and continue operations.

B&W Agreements. Under the Restated Master Agreement, as amended by letter agreements dated December 4, 2002 and August 14, 2003, between B&W and the Company, we currently owe B&W approximately $17.5 million in long-term tobacco curing barn loans. Interest began to accrue on this debt at prime plus 1% as of January 1, 2006, and payment of principal and interest is due in 96 monthly, those payments also began on January 1, 2006. The debt is secured by tobacco leaf inventory and certain of our tobacco curing barns. Once the outstanding loan balance is reduced to $10 million, the collateral will be released by B&W.

In addition, we also had an obligation to B&W as a result of restructured accounts payable. The principal payments on this obligation were deferred until January 2005. Beginning in January 2005 that debt had been repaid through monthly principal payments of $250,000, plus interest at a rate of 1% over prime on the outstanding balance. The balance on this payable as of December 31, 2006 was $1,961,743.

Under the Other Low TSNA Tobacco Agreement, B&W is obligated to pay royalties to us on B&W’s purchases of StarCured^{^®} tobacco and other low-TSNA tobacco once a royalty rate is established with one of the other three largest tobacco manufacturers pursuant to the terms of the April 25, 2001 Agreements. In the second quarter of 2004, we entered into an agreement with another tobacco manufacturer for the licensing of low TSNA hard tobacco. Under that agreement, the manufacturer conducted an initial assessment of a hard tobacco product and the agreement anticipated that this would be followed up with a subsequent test market, although that test market has not been initiated. We do not anticipate receiving any royalties under that agreement for the foreseeable future. To enable us to pursue this agreement we granted B&W a three month extension of the date on which it would begin once again to pay royalties under the April 25, 2001 Other Low TSNA Tobacco Royalty Agreement, once a royalty rate is established with one of the other three largest tobacco manufacturers.

On July 30, 2004, RJR, a subsidiary of B&W, and certain of their affiliated tobacco businesses combined operations under the new publicly traded holding company, Reynolds American, Inc., which is 42% owned by British American Tobacco, PLC, the parent company of B&W. In the patent litigation discussed herein, RJR took the position that the new operating entity that resulted from the combination of RJR and B&W, assumed all of the rights and obligations under the agreements previously entered into between us and B&W, and moved to dismiss the case on that basis. After full briefing, the Court denied RJR’s motion to dismiss, and found that B&W had attempted to assign the Star/B&W agreements to the new subsidiary, that we had not consented to the assignment and that the de facto merger doctrine did not apply to vitiate the need for our consent. In its ruling the Court did leave open the question of what impact, if any, the combination may have on the future licensing arrangements with RJR, but noted that those considerations did not impact on the claims asserted by us in the patent litigation.

Master Settlement Agreement. We currently have approximately $38.3 million held in MSA escrow accounts. These funds will remain in escrow pursuant to the terms of the qualifying statutes, and will be available to satisfy state judgments for the type of claims asserted against the major tobacco manufacturers in the suits that resulted in the negotiation of the MSA. In March 2007, the Company entered into an agreement under which it received a payment of approximately $11.5 million in return for assigning to the purchasers the right to interest paid on the Company’s escrow fund and to any releases of the escrow principal for any overpayments, or, if these funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years. Consequently, these funds are not available to finance our working capital or other liquidity demands.

Under the qualifying statutes enacted pursuant to the MSA, we are responsible for making escrow payments on all of our cigarettes sold in any MSA state, regardless of where such products are manufactured. The MSA escrow deposit for 2006 sales is due on or before April 15, 2007, except for any quarterly payments required under the qualifying statutes in a number of the MSA states. In 2006, our sales of cigarette decreased approximately 21% from 1.2 billion units to 950 million units and we have sought to focus our sales in the four non-MSA states where we are not obligated to make escrow payments. Notwithstanding these facts, we have continued to make some sales to customers in MSA states and, based on our past experience, we anticipate that we will have escrow obligations for indirect sales made by our direct customers. We are currently seeking to determine the extent of our 2006 escrow obligation, but expect that this obligation will be approximately $500,000, based on information which we have on direct sales, the level of indirect sales by our customers to MSA states in prior years, and reports received from such states to date.

Litigation Costs. We have entered into fee arrangements with counsel in several litigation and related matters under which certain costs related to the litigation are being advanced by counsel on our behalf. Given the contingent nature and the fact that a probability assessment of liability cannot be made at this time, no accrual has been made for this contingent liability.

We have paid or accrued all existing obligations. Also, as part of our fee arrangements in certain of these matters, we have agreed to pay counsel a percentage of any damage award and a percentage of the resulting payments we actually receive in the event that the litigation is resolved in our favor in return for a cap on fee payments during the litigation.

We will appeal to the United States Court of Appeals for the Federal Circuit a decision by the United States District Court for the District of Maryland that the two patents at issue in our patent infringement lawsuit against RJR are indefinite and a related ruling once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim. Also, if the Court were to rule against the Company on the

inequitable conduct defense that was tried to the Court in early 2005, and which is currently pending, we would appeal that decision. In 2002, we were successful in having a declaratory judgment action brought by Philip Morris dismissed on the basis that no actionable controversy existed between the companies. We anticipate incurring significant expenses in terms of legal fees and costs in connection with the RJR litigation for the foreseeable future.

In the past we have maintained product liability insurance only with respect to claims that tobacco products manufactured by or for us contain any foreign object, i.e. any object that is not intended to be included in the manufactured product. We currently do not maintain such insurance and as a result are self-insured for this risk. The product liability insurance that we previously maintained did 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. We have never been named as a defendant in any legal proceedings involving claims arising out of the sale, distribution, manufacture, development, advertising, marketing or claimed health effects relating to the use of our tobacco products. While we may be named as a defendant in the future, we believe we have conducted our business in a manner which decreases the risk of liability in a lawsuit relating to product liability because we have:

Over the past several years, we have asserted several challenges to the MSA and qualifying statutes. These constitutional challenges were not successful and we are not currently engaged in any litigation challenging the constitutionality of the MSA and qualifying statutes. Also, we completed a comprehensive settlement relating to our obligation as a nonparticipating manufacturer under the MSA in June 2003. As a result, we do not anticipate incurring significant costs related to litigation arising out of the MSA in the future.

Tax Refunds and Assessments. In 2004, the Company was notified that its 2001 tax return had been selected for examination by the Internal Revenue Service (“IRS”). In the course of its conduct of this examination, the IRS has expanded the scope of the examination to include all of the Company’s returns that have been filed for the years ended December 31, 2002 through 2004. In 2005, the Company’s request for a private letter ruling, which related to the years under IRS examination, was resolved generally in its favor. The statute of limitations for taxable years 2001 and 2002 have been extended by mutual agreement through September 15, 2007. All information requested by the IRS in connection with its examination has been provided by the Company. The IRS may request additional information as the examination is ongoing. There have been some discussions with the IRS relating to the timing of certain deductions and a brief supporting the Company’s position has been submitted. Since the Company’s returns for such years are currently under examination and the timing of certain deductions has been raised, it is reasonably possible that adjustments may be proposed that result in liability to the Company. The Company has estimated a range of potential liability of from $0 to approximately $1.7 million. The Company believes the returns filed for such years are substantially correct and intends to vigorously contest any proposed liability through all available means including judicial proceedings if necessary.

In a letter dated October 7, 2004, we received notice from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to us and that the sales and use tax assessment plus penalties and interest together, as of October 7, 2004, totaled approximately $988,000. We continue to challenge this assessment and have filed a request for reconsideration with the Commissioner of Taxation, and are prepared to file a judicial action if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue. While the Company is optimistic that its request for reconsideration will be accepted based on prior rulings in similar cases, if the assessment is not reversed, the Company will be required to pay the tax, penalties and interest due.

Development Grants. On March 12, 2002, Governor Warner of the Commonwealth of Virginia announced that the Company would receive a grant of $300,000, which was provided shortly thereafter, to assist Mecklenburg County and Chase City in the acquisition of the Company’s new processing facility adjacent to its existing tobacco receiving station in Chase City, Virginia. In late 2004, the Company responded to inquiries from the State to show its level of investment and hiring for its Chase City operations and to substantiate the actual results achieved compared to the original projections described in the grant application. In its response, the Company requested that the grant be extended for an additional year, given certain delays which have been encountered in connection with the launch of its smokeless tobacco products, including the filing of several unsuccessful Citizen’s Petitions with the FDA that sought to have the Company’s low-TSNA hard tobacco products

regulated as a drug by the FDA rather than as conventional snuff tobacco products. In late October 2006, the Company received a request for a further update on the status of this grant. The Company in November filed a further response and requested a further extension of the grant. Depending on the level of investment and hiring recognized by the State, the Company may be required to return some or all of the $300,000 in grant funding, but the Company’s management does not anticipate that the Company will be required to repay this amount.

On March 14, 2007, the Company entered into an agreement under which it received approximately $11.5 million in return for the sale to the purchasers of all of its right, title and interest to interest paid in the Company’s escrow fund and to any releases of the escrow principal for any overpayments, or, if those funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years. Also, in March 2007, the Company sold approximately 960 of its tobacco curing barns for approximately $11.2 million and anticipates completing sales of a total of approximately 996 curing barns this month for an aggregate purchase price of approximately $11.6 million.

With the proceeds from these recent transactions, the Company anticipates that it will have sufficient funds to support its operations through 2008. Given the Company’s continued losses, absent the successful completion of its ongoing patent infringement lawsuit against RJR, the exercise of outstanding warrants, a substantial improvement in revenues from smokeless tobacco products, or a significant improvement of the volume of sales of cigarettes, the Company believes that it will be necessary to pursue additional sources of funds in early 2009. However, depending upon market conditions and the price of its common stock, the Company may decide to seek additional funds before that date.

Also, the Company expects to continue to pursue opportunities for licensing its smokeless tobacco products and expanding its sales and marketing efforts, particularly if the Company obtains additional funds that could be devoted to such activity. While the Company may seek to obtain funds in the future through debt financing, there are significant limitations on the Company’s ability to obtain new debt financing, including its agreements with B&W. Moreover, the ability to complete future financings on terms acceptable to the Company will depend on a number of factors, including the performance of the Company’s stock price and its operational performance. Any equity financing will be dilutive to its existing shareholders.

Our inability to raise funds by early 2009 could have a material adverse effect on our ability to meet our working capital needs and continue operations.

The Company does not have any off-balance sheet arrangements as defined by Item 303(a)(4) of Regulation S-K.

At December 31, 2006, the Company’s contractual cash obligations, with initial or remaining terms in excess of one year, were as follows (in thousands):

133, Accounting for Derivative Instruments and Hedging Activities, to permit fair value remeasurement for any hybrid financial instrument with an imbedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis. Prior to fair value measurement, however, interest in securitized financial assets must be evaluated to identify interest containing embedded derivatives requiring bifurcation. The amendments to SFAS 133 also clarify that interest-only and principal-only strips are not subject to the requirements of the SFAS, and that concentrations of credit risk in the form of subordination are not embedded derivatives. Finally, SFAS No. 155 amends SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to allow a qualifying special-purpose entity (SPE) to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 applies to all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006, with earlier application allowed. The Company does not anticipate that the adoption of this statement to have a material impact on its consolidated financial statements.

In 2006, the Financial Accounting Standards Board (“FASB”) issued a new interpretation, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), which became effective for fiscal years beginning after December 15, 2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition FIN 48 is applicable to the Company’s financial statement beginning with the first quarter report in 2007. The adoption of FIN 48 is expected to result in a charge of approximately $1.7 million to the beginning retained deficit and the Company’s financial position.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”). This Standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expand disclosures about fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The adoption of FAS 157 is not expected to have a material impact on the Company’s financial position, results or operations or cash flows.

In February 2007, the Financial Accounting Standards Board issued FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (FAS 159), which includes an amendment to FASB Statement No. 115. The statement permits entities to choose, at specified election dates, to measure eligible financial assets and financial liabilities at fair value (referred to as the “fair value option”) and report associated unrealized gains and losses in earnings. Statement 159 is effective for fiscal years beginning after November 15, 2007. As of December 31, 2006, the Company has not determined the effect that the fair value option, if elected, will have on the consolidated financial position or results of operations.

The Company has not entered into any transactions using derivative financial instruments or derivative commodity instruments and believes that its exposure to market risk associated with other financial instruments (such as investments and borrowings) and interest rate risk is not material.

The Company’s debt due to B&W, consisting of long-term loans and an account payable balance, bear an interest rate of prime plus 1%. As a result the Company is subject to interest rate exposure on those obligations.

In addition, the Company’s investments in the MSA-related escrow accounts are short-term, very high-quality investments. Consequently, the income generated by these investments is subject to fluctuation with changes in interest rates. The Company receives, for its own account, the current interest on the amounts in escrow, but this interest income is not sufficient to offset the Company’s cost of capital.

The Company’s consolidated financial balance sheets as of December 31, 2006 and 2005 and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006, together with the related reports of the Company’s Independent Registered Certified Public Accounting Firm, are contained on pages F-1 through F-8 and are incorporated herein by reference.

Item 9. Changes in and Disagreements with Accountants and Financial Disclosure

(a) Disclosure Controls and Procedures. The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Company’s Chief Executive Officer, Chief Financial Officer and Chairman of the Board, as appropriate, to allow timely decisions regarding required disclosure. As required by SEC Rule 13s-15 (b), the Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer and Chairman of the Board, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the fiscal year covered by this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive Officer, Chief Financial Officer and Chairman of the Board concluded that both our disclosure controls and procedures and our internal controls over financial reporting are effective at the reasonable assurance level.

Our internal and disclosure controls are evaluated on an ongoing basis by personnel in our organization. The overall goals of these various evaluation activities are to monitor our disclosure and internal controls and to make modifications as necessary, as disclosure and internal controls are intended to be dynamic systems that change (including improvements and corrections) as conditions warrant. Part of this evaluation is to determine whether there were any significant deficiencies or material weaknesses in our internal controls, or whether we had identified any acts of fraud involving personnel who have a significant role in the our internal controls. Significant deficiencies are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. Material weaknesses are particularly serious conditions where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and not be detected within a timely period by employees in the normal course of performing their assigned functions. As described below, Star Scientific, Inc. in 2006 identified areas for improvement in internal control over financial reporting that also apply to the Company’s disclosure controls and procedures and during 2006 we implemented additional controls and procedures.

In light of the weaknesses in internal controls that existed as of December 31, 2006, the Company also performed additional analyses and other post-closing procedures in an effort to ensure the Company’s consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 have been prepared in accordance with generally accepted accounting principles. Aidman Piser & Company, P.A.’s report, dated March 15, 2007, expressed an unqualified opinion on our consolidated financial statements.

(b) Management’s annual report on internal control over financial reporting

The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The internal control process has been designed under our supervision to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America.

Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, utilizing the framework established in “INTERNAL CONTROL—INTEGRATED FRAMEWORK” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2006 is effective.

Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that accurately and fairly reflect, in reasonable detail, transactions and dispositions of assets; and provide reasonable assurances that: (1) transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States; (2) receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, has been audited by Aidman Piser & Company, P.A., an independent registered certified public accounting firm, as stated in their report, included at pages F-2 and F-3. This report expresses an unqualified opinion on management’s assessment and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006.

(d) Changes in Internal Control over Financial Reporting. In connection with the evaluation of internal controls described above in paragraph (a) of Item 9A, Star Scientific, Inc. in 2006 identified several areas for improvement in internal control over financial reporting and, as described in the Company’s annual and quarterly filing, made changes to its policies and procedures during 2006 and 2007 that are intended to strengthen its disclosure controls and procedures, as well as its internal control over financial reporting.

Star Scientific, Inc., identified areas of improvement in its internal control over financial reporting related to the accrual of tobacco products returned from customers, ensuring correct revenue recognition and ensuring proper accounting and disclosure for stock based compensation. These matters resulted in no material misstatements of our consolidated financial statements as of and for the year ended December 31, 2006 or for the interim periods within that year.

To strengthen controls in these areas, management established additional controls to strengthen the internal control process with respect to accrual of returns, revenue recognition, and proper accounting and disclosure of stock based compensation. These controls currently include, among other things, the adoption of policies pursuant to which the following procedures will be performed:

Accrual of tobacco products returned from customers. In the past, returns were not always processed on a timely basis and some returns were not approved at the appropriate level. As such, there were delays in recording such adjustments in the financial records of the Company. In March 2007, the Company instituted new procedures to ensure that to the greatest extent possible, there is a “no return” policy and that any returns which are deemed necessary are authorized at the appropriate (General Manager) level. Further, the Company has modified its procedures to ensure that at the time of closing of the books for the quarter, the major customers are contacted to confirm the amounts of returns they have in their

warehouses match the Company’s estimated accrual for returned product which is still outstanding at the end of the quarter. The Company will estimate the amount of any returns that will not be posted until the following quarter and accrue amounts necessary in the appropriate period.

Revenue Recognition. In the past, all shipments from Star to its customers were documented by Star in its bill of lading as having shipping terms FOB origin. With the exception of one contract in which title is passed specifically at destination, all of Star’s shipments have shipping terms FOB origin. During late 2006, several small purchase orders were received which specified “FOB destination”. While Star’s shipping terms were not changed for these customers, Star accepted these purchase orders without change and therefore accepted the shipping terms contained in these orders. Any shipments which were made based on such purchase orders at the end of the quarter could not be recognized as revenue, because title would not pass until the product was received by the customer after the end of the quarter. The Company has instituted new procedures to ensure all purchase orders will be examined before being accepted to ensure that there are no special instructions or delivery terms which might interfere with revenue recognition for the quarter. Alternatively, if the orders are accepted as submitted, and if they contain some modification to the shipment terms and acceptance of title, then those orders will be recognized as revenue in the appropriate period.

Proper accounting and disclosure of stock based compensation. The Company identified areas for improvement in regards to internal controls over proper valuation, identification or modification, and accuracy of disclosure of all stock based compensation transactions. In March 2007, the Company instituted a new supervisory review policy for all calculations to ensure accuracy and completeness of the accounting for stock based compensation. In addition to the financial and technical review, the legal department will be consulted to ensure there are no omissions or errors with regard to transactions which have been authorized and the accuracy of the terms of issuance.

The Company has communicated to the Audit Committee and its auditors the above changes to internal control over financial reporting identified in its 2006 reports and has provided documentation to its auditors to substantiate the changes made from December 31, 2005 to through December 31, 2006.

Management believes that these actions and controls will strengthen its internal control over financial reporting and consequently strengthen its disclosure controls and procedures.

Part III, Item 10 of an amended Annual Report on Form 10-K/A, to be filed within 120 days after the close of the Registrant’s fiscal year, is incorporated by reference into Part III of this Annual Report on Form 10-K.

The Company has adopted a Code of Ethics that applies to all of its directors, officers (including its Chief Executive Officer, Chief Financial Officer, Controller and any person performing similar functions) and employees. The Company has filed a copy of this Code of Ethics as Exhibit 14.1 to this Form 10-K. The Company has also made the Code of Ethics available on its website at: http://www.starscientific.com

Part III, Item 11 of an amended Annual Report on Form 10-K/A, to be filed within 120 days after the close of the Registrant’s fiscal year, is incorporated by reference into Part III of this Annual Report on Form 10-K.

Part III, Item 12 of an amended Annual Report on Form 10-K/A, to be filed within 120 days after the close of the Registrant’s fiscal year, is incorporated by reference into Part III of this Annual Report on Form 10-K.

Part III, Item 13 of an amended Annual Report on Form 10-K/A, to be filed within 120 days after the close of the Registrant’s fiscal year, is incorporated by reference into Part III of this Annual Report on Form 10-K.

Part III, Item 14 of an amended Annual Report on Form 10-K/A, to be filed within 120 days after the close of the Registrant’s fiscal year, is incorporated by reference into Part III of this Annual Report on Form 10-K.

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 16th day of March, 2007.


STAR SCIENTIFIC, INC.

By:		/s/ JONNIE R. WILLIAMS
		Jonnie R. Williams Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated.

We have audited the accompanying consolidated balance sheets of Star Scientific, Inc. and Subsidiary as of December 31, 2006 and 2005, the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated 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.

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, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 16, subsequent to December 31, 2006, the Company sold the rights, title and interest in and to all income from and reversionary interest in its MSA escrow accounts (with a balance of $38,329,233 at December 31, 2006) for total cash proceeds of $11,498,770. Additionally, as further discussed in Note 16, subsequent to December 31, 2006, the Company sold approximately 960 of its tobacco curing barns (with a net carrying value of approximately $6.2 million as of December 31, 2006) for cash proceeds of approximately $11.2 million.

We also have audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Star Scientific, Inc. and Subsidiary’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2007, expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.

We have audited management’s assessment, included in the accompanying report entitled Management’s Annual Report on

Internal Control over Financial Reporting, that Star Scientific, Inc. and Subsidiary maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organization of the Treadway Commission (COSO). Star Scientific, Inc. and Subsidiary’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the consolidated financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of change in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Star Scientific, Inc. and Subsidiary did maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Star Scientific, Inc. and Subsidiary maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations (COSO).

We have also audited, in accordance with the standards of the Public Accounting Oversight Board (United States), the consolidated balance sheets of Star Scientific, Inc. and Subsidiary as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006 and our report dated March 15, 2007 expressed an unqualified opinion.

(2) the manufacturing, sales, marketing and development of very low-nitrosamine smokeless tobacco products that also carry enhanced warnings beyond those required by the Surgeon General, including ARIVA^{^®}compressed powdered tobacco cigalett^{^®}pieces and STONEWALL Hard Snuff^{^®}; and

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.

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.

The Master Settlement Agreement (“MSA” or Master Settlement Agreement”) escrow fund:

Cash deposits restricted pursuant to the MSA have been reflected as a non-current asset in the Company’s consolidated financial statements. Amounts deposited into MSA escrow accounts are required to be held in escrow for 25 years. In March 2007, the Company entered into an agreement under which it received a payment of approximately $11.5 million in return for assigning to the purchasers the right to interest paid on the Company’s escrow fund and to any releases of the escrow principal for any overpayments, or, if these funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years.

To date, the Company has not had any MSA state file suit to attempt to collect on amounts that have been deposited into escrow. The probability that such suits will be filed in the future is generally unknown, although there will be an incentive for such suits to be filed prior to the time that the funds deposited into escrow are returned to the Company. If such suits are filed, the Company will undertake to assess the viability of such suits and determine what impact such pending litigation would have on the value of the Company’s MSA escrow funds.

Accounts receivable are customer obligations due under normal trade terms. The Company sells its products to distributors and retail customers. The Company performs continuing credit evaluations of its customers’ financial condition and does not require collateral.

Management reviews accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. Any accounts receivable balances that are determined to be uncollectible are included in the allowance for doubtful accounts. The allowance for doubtful accounts contains a general accrual for remaining possible bad debts. The allowance for doubtful accounts at December 31, 2006 was approximately $48,000. Based on the information available, management believes the allowance is adequate. However, actual write-offs might exceed the recorded allowance.

Inventories are valued at the lower of cost or market. Cost is determined on the first-in, first-out (FIFO) method.

Effective January 1, 2006, the Company adopted Financial Accounting Starndard No. 151, “Inventory Costs” (FAS 11) an amendment of ARB No. 43, Chapter 4, to account for inventory costs. Pursuant to FAS 151, the Company accounts for idle facility expense, freight, handling costs and wasted materials as current period charges. In addition, FAS 151 requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities.

Property 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, machinery and equipment and thirty-nine years for buildings and improvements. Amortization of assets under capital leases are amortized over the lesser of the lease term or estimated useful life, as appropriate using the units of production method. In 2004, management re-evaluated the estimated useful lives of certain other depreciable assets and recorded a one-time charge of approximately $250,000. Those assets are now being depreciated over their remaining estimated useful lives.

With regard to the tobacco curing barns, depreciation is recognized using a “units of production” method of accounting to more closely match depreciation with the period in which such assets are used in the third and fourth quarters of each fiscal year. Through the 2004 growing season, there had been a fairly constant use of the Company’s StarCured^® tobacco curing barns by the participating StarCured^® farmers. Given the consistent level of production in prior years, the Company calculated depreciation on the barns using the “units of production” method of accounting to take into account that the barns are used only during the tobacco-curing season – from August to November. In 2005, the Company recorded an impairment charge of approximately $2.5 million to reflect the fair value impairment of the curing barns as a result of the elimination of price supports and quotas for tobacco in 2005.

Intangible assets consist primarily of licensing costs, patents and trademarks and packaging design costs. Intangibles are amortized using the straight-line method over a period of 17 years for patents and licensing costs and 5 years for packaging design costs (the assets’ estimated lives). Substantially all trademarks owned by the Company have indefinite lives and, as such, are not amortized.

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.

In September 2005, the Company adopted the accounting provisions of Statement of Financial Accounting Standards No. 123R – Share-based Payments (FAS 123R) replacing Accounting for Stock-Based Compensation (“FAS 123”), which are similar and require 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). The adoption of this standard had no significant impact on the Company’s 2005 results of operations.

The Company reviews the carrying value of its amortizing 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 asset by estimating the future undiscounted net cash flows expected to result from the asset, including eventual disposition, using a weighted average cash flow probability method. If the estimated future undiscounted 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.

The Company recorded approximately $2.5 million in impairment charges on long-lived assets (tobacco curing barns) during the year ended December 31, 2005.

Basic loss per common share is computed using the weighted-average number of common shares outstanding.

Diluted loss 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 (See Note 10).

Revenue is recognized when tobacco products are shipped to customers and title passes. The Company also records appropriate provisions for customer rebates and promotions and credits for returns. The amounts are estimated due to the variability in credits (due to promotional programs in the field), and allowances for product, which may be returned by customers after a sale is completed. In order to quantify these estimates, the Company makes quarterly estimates based on the available quarterly information and historical experience.

Royalty revenues on the Company’s patents are recognized when earned. Royalty revenues on the Company’s tobacco products are recognized when earned. The Company did not recognize any royalty revenues in either 2006 or 2005, and a de minimis amount in 2004.

Shipping costs are included in marketing and distribution expenses and aggregated approximately $793,000, $933,000, and $1,207,000, in 2006, 2005 and 2004, respectively.

Advertising costs are expensed as incurred and are included in marketing and distribution expenses. For the years ended December 31, 2006, 2005 and 2004, advertising costs were approximately $61,000, $19,000, and $27,000, respectively.

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.

In February 2006, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 155 (SFAS No. 155), Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No. 133 and 140, to simplify and make more consistent the accounting for certain financial instruments. Specifically, SFAS No. 155 amends SFAS 133, Accounting for Derivative Instruments and Hedging Activities, to permit fair value remeasurement for any hybrid financial instrument with an imbedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis. Prior to fair value measurement, however, interest in securitized financial assets must be evaluated to identify interest containing embedded derivatives requiring bifurcation. The amendments to SFAS 133 also clarify that interest-only and principal-only strips are not subject to the requirements of the SFAS, and that concentrations of credit risk in the form of subordination are not embedded derivatives. Finally, SFAS No. 155 amends SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to allow a qualifying special-purpose entity (SPE) to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 applies to all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006, with earlier application allowed. The Company does not anticipate the adoption of this statement to have a material impact on its consolidated financial statements.

The Financial Accounting Standards Board (“FASB”) has recently announced a new interpretation, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), which will be effective for fiscal years beginning after December 15, 2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The adoption of FIN 48 is expected to result in a charge of approximately $1.7 million to the beginning retained deficit and the Company’s financial position.

The Company has been operating at a loss for the past three years. In addition, the Company is required to make annual MSA escrow payments that are not accounted for in working capital. The Company expects escrow deposits (which are due in April 2007 for 2006 sales) to be approximately $500,000 based on its prior payments, a decrease in total cigarette sales in 2006 and its successful efforts to limit sales in MSA states.

Star’s future prospects are dependent in the long term, on the distribution and consumer acceptance of the Company’s low-TSNA smokeless tobacco products as well as the continued development of new low-TSNA smokeless tobacco products, independently and through alliances with other tobacco manufacturers given the decline in cigarette sales over the past four years. Also, the Company’s long term prospects will be dependent on its ability to begin generating significant revenues through royalties from the patented tobacco curing process to which it is the exclusive licensee. However, the ability to generate revenues through such royalty payments will also be dependent upon the successful completion of the Company’s ongoing patent infringement lawsuit against RJR. In that lawsuit, the United States District Court for the District of Maryland in January 2007 issued a ruling finding that two of the Company’s patent which are at issue in this litigation are invalid because the term “anaerobic condition” as used in the patents is indefinite. That decision and a related ruling will be appealed to the United States Court of Appeals for the Federal Circuit once the Court issues a ruling on RJR’s inequitable conduct defense and a final judgment is entered or if leave is granted to file an interlocutory appeal in the interim. Also, if the Court were to rule against the Company on the inequitable conduct defense that was tried in early 2005, and which is currently pending, the Company would be required to appeal that decision and obtain a reversal in order to be in a position to enforce the patents.

The recurring losses generated by the Company’s operations continue to impose significant demands on its liquidity. In 2006, the Company generated $10.0 million through the sale of common stock. In March 2007, the Company entered into an agreement under which it received approximately $11.5 million in return for assigning the purchasers the right to future interest payments in the Company’s MSA escrow fund and to any releases of the escrow principal for overpayments, or, if those funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years. Also, in March 2007, the Company sold approximately 960 of its tobacco curing barns for an aggregate price of approximately $11.2 million.

As of December 31, 2006, the Company had a working capital surplus of approximately $4.2 million. Future cash needs over the subsequent year include:

In addition, there exist certain contingencies which could require the Company to make significant cash payments (see Note 15).

With the proceeds from these recent transactions in 2007, the Company anticipates that it will have sufficient funds to support its operations through 2008. Absent the successful completion of the Company’s ongoing patent infringement lawsuit against RJR, the exercise of outstanding warrants, or a substantial improvement in revenues and/or royalties from smokeless tobacco products, the Company believes that it will be necessary to pursue additional sources of funds in early 2009. However, depending upon market conditions and the price of its common stock, the Company may decide to seek additional funds before that time. There can be no assurance that the Company will be successful in obtaining such funding at commercially reasonable terms, if at all.

The Company’s long-term financial success is ultimately dependent upon the successful resolution of the Company’s patent infringement lawsuit against RJR (see Note 15) and the return to profitability through a combination of generation of sales of the Company’s low-TSNA tobacco and smokeless tobacco products, royalties from the licensing of the Company’s low-TSNA patents and products or improved cigarette sales.

During 2006 and 2005, the Company recorded a loss on inventory from write-down of smokeless inventory products to the lower of cost or market of $1.1 million and $1.3 million, respectively, which is included in cost of goods sold in the accompanying consolidated statements of operations.

During 2002 and 2001, the Company entered into several sale-leaseback transactions using the tobacco curing barns (see Note 8). Tobacco curing barns noted above include both owned and leased barns as follows:

Amortization expense associated with these leased barns approximated $668,000, and $1,650,000 in 2005 and 2004 respectively, and is included in depreciation expense in the accompanying consolidated statements of operations. There was no depreciation expense on leased barns in 2006. The Company also maintains and has earmarked for curing burley tobacco approximately 60 barns which are classified as “idle equipment”. These barns can be used for curing flue-cured tobacco. At present, it is anticipated that the barns will be moved from Kentucky and sold to farmers producing flue-cured tobacco.

Depreciation expense is included in the consolidated statement of operations for the years ended December 31, 2006, 2005 and 2004, as follows:

Amortization expense associated with the intangibles was $63,107, $63,383 and $63,106 in 2006, 2005 and 2004 respectively. An aggregate of $83,543 in trademarks have indefinite lives and are therefore not amortized. Expected future amortization of intangibles with finite lives is as follows:

In the event the Company is unsuccessful in the appeal on the judgment on the validity of their patents, as discussed in Note 15, recognition of an impairment loss related to certain patents with a carrying value of approximately $105,000 as of December 31, 2006 may be necessary. The consolidated financial statements do not include any adjustments that might result from this uncertainty.

In 2000-2002, Star produced and delivered to B&W approximately 19 million pounds of very low-TSNA StarCured^{^®} tobacco annually. In 2003 B&W purchased 19 million pounds validity of StarCured^® tobacco directly from the Company’s participating farmers. Pursuant to a Letter Agreement entered into in August 2003, B&W was relieved of its obligation to purchase additional StarCured^® tobacco.

Beginning in 2004, Star notified its StarCured^{^®} farmers that since B&W was no longer obligated to purchase all of the tobacco produced by its participating StarCured^{^®} farmers, the Company could not commit to purchase tobacco from them. In 2004 and each year thereafter, Star has advised its participating StarCured^{^®} farmers that they could use the StarCured^{^®} tobacco curing barns during the upcoming growing season, but that they would need to make arrangements to sell their tobacco to other parties. Because of its inability to purchase tobacco from its participating farmers, the Company in 2007 sought to disband its StarCured^® tobacco curing program and to sell the tobacco curing barns that were being maintained by the participating farmers to those farmers or to other third parties. Under the Restated Master Agreement and several subsequent agreements, B&W also agreed to restructure approximately $29 million of debt that B&W provided to support the Company’s purchase of StarCured^® tobacco curing barns. Pursuant to these agreements, B&W agreed to a 96 month repayment schedule consisting of equal consecutive monthly installments beginning on January 3, 2006. The debt is secured by tobacco leaf inventory and certain of the tobacco curing barns. Star and ST have guaranteed payment of the other’s obligations. Once the outstanding loan balance to B&W is reduced to $10 million, the collateral, except for the Star and ST guarantees, will be released by B&W. The loan balance was approximately $17.5 million as of December 31, 2006 (see Note 7).

6. Relationship with Brown & Williamson Tobacco Corporation (“B&W”) (continued):

In the fourth quarter of 2003, Star and B&W also entered into a letter agreement which, in part, restructured and consolidated all of Star’s outstanding trade payables to B&W as long-term debt. Under this letter agreement, the then-total trade payables due to B&W were to be paid in monthly principal payments of $250,000 beginning in January 2004 (later extended to January 2005) with monthly interest at an interest rate of prime plus 1% on the outstanding balance. As of December 31, 2006 the balance on the trade payable long-term debt was $1,961,743 (see Note 7).

The future maturities of long-term debt without regard to potential royalty offsets, are as follows:

Loss on Conversion of Long-term Debt to Equity. On January 10, 2005, the holder of a convertible debenture converted the $9.0 million convertible debenture into 3,179,810 shares of the Company’s common stock, which reflected an adjusted conversion price from $3.73 to $2.897, and $212,000 of accrued and unpaid interest. As a result of this transaction, the debenture was fully converted and cancelled with the holder of the debenture having no future rights under the Debenture. As a result of the conversion of debt into equity, the Company recorded a non-cash charge during the first quarter of 2005 of $4,833,466 to reflect the cost of the discount provided for in the conversion and the remaining unamoritized cost of the initial debt issuance were charged to expense.

During 2002 and 2001, the Company entered into several sale-leaseback arrangement transactions on barns in which the Company retained substantially all use of the property sold. As such, gains and losses associated with those transactions, which aggregated approximately $581,000, were deferred and were subsequently amortized in proportion to the amortization of the leased assets. Net amortization of these net gains approximated $16,000 and $181,000, in 2005 and 2004, respectively.

The Company leases manufacturing machinery and equipment (see Note 4) under non-cancelable operating lease agreements for approximately $35,000 per month. As of December 31, 2006, there is a security deposit of $500,000 and there are five (5) months remaining on a three-year term.

The Company also leases certain of its office and warehouse facilities and various vehicles and minor operating equipment under non-cancelable operating leases for approximately $61,000 per month; expiring through 2022.

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, 2006.

Rent expense for all operating leases was approximately $1,206,000, $1,360,000, and $1,310,000 for the years ended December 31, 2006, 2005 and 2004, respectively.

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.

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.

On March 3, 2006, the Company entered into a Securities Purchase and Registration Rights Agreement (the “Agreement”) with an existing shareholder (the “Investor”) whereby the Company sold to the Investor, for an aggregate purchase price of $6,000,000, a total of 2,000,000 shares (the “Shares”) of the Company’s common stock, $0.0001 par value per share (“Common Stock”), and warrants, at an exercise price of $3.00 per share, to purchase an additional 2,000,000 shares of Common Stock (the “March 2006 Warrant”), which were set to expire on June 30, 2007. The aggregate purchase price of $6,000,000 consisted of $600,000 payable upon execution of the Agreement and $5,400,000 payable pursuant to a promissory note (the “Note”) between the Investor and the Company entered into simultaneously with the Agreement. The Note is full recourse and secured by a pledge of the Shares, and initially carried no interest. The issuance of the Shares and the March 2006 Warrant were pursuant to the exemption from registration afforded by Section 4(2) of the Securities Act of 1933, and the Company filed a registration statement with respect to the resale of the Shares and the Common Stock issuable upon exercise of the March 2006 Warrant that became effective on July 3, 2006.

On June 15, 2006, the Company modified the payment terms for the Note by extending the final payment date from June 15, 2006 to July 17, 2006, and providing for interest at the Federal Funds rate on the outstanding principal amount from the date the Investor was advised that the Company’s Registration Statement relating to the shares and warrant shares became effective. On July 14, 2006, the Company again modified the payment terms for the Note by extending the final payment date from July 17, 2006 to September 18, 2006, and providing for no interest on the outstanding principal amount during this period. The Company modified the terms of this Note in connection with the Investor’s decision to exercise certain warrants held by the Investor by July 17, 2006. The Company accounted for this transaction as a modification of the Note pursuant to EITF 01-7, “Creditor’s Accounting for a Modification or Exchange of Debt Instruments”. On September 27, 2006, the Company received $1.5 million toward payment of the Note and received the final payment of the balance of the Note of $1.5 million on October 2, 2006.

On June 15, 2006, the Company amended certain Securities Purchase and Registration Rights Agreements (the “September Purchase Agreements”) it had executed with three investors in a September 2005 private placement as well as the Securities Purchase and Registration Rights Agreement it had executed with an investor in a February 2005 private placement (the “February Purchase Agreement” as amended, together with the September Purchase Agreements, the “Purchase Agreements”). In connection with the Purchase Agreements, the Company issued to these four investors warrants, at an exercise price of $4.00 per share, to purchase an aggregate of 2,900,000 shares of Common Stock with an expiration date of June 15, 2006. The June 15, 2006 amendments to the Purchase Agreements increased the warrant exercise price from $4.00 to $4.15 per share and extended the expiration date of the warrants for thirty days from June 15, 2006 to July 15, 2006.

On July 14, 2006, the Company entered into Securities Purchase and Registration Rights Agreements (the “July Purchase Agreements”) with the Company’s largest institutional investor and one of the Company’s largest private

investors (collectively, the “Investors”). Pursuant to the terms of the July Purchase Agreements, the Company agreed to reset the exercise price of certain existing warrants held by the Investors, which were due to expire on July 17, 2006, from $4.15 to $2.00 per share, and in exchange, the Investors agreed to exercise the warrants in their entirety whereby the Investors purchased 2,000,000 shares of the Common Stock for an aggregate of $4.0 million. Additionally, pursuant to the July Purchase Agreements, the Company agreed to grant the Investors warrants, at an exercise price of $3.00 per share, to purchase an additional 2,000,000 shares of Common Stock exercisable within five years of the grant date (the “July Warrants”). The Company can require the warrant holders to exercise the July Warrants if the price of the Common Stock exceeds $5.00 per share as quoted on the Nasdaq Global Market for twenty consecutive trading days and if other conditions specified in the July Warrants are met.

In connection with Securities Purchase and Registration Rights Agreements dated March 2006 and July 2006, the Company was required to adjust the strike price and the number of warrants issued to Manchester Securities Corporation (“Manchester”) under a 2004 warrant agreement for 502,681 shares (the “2004 Warrants”). Pursuant to the terms of the 2004 Warrants, because the Company in the March 2006 Agreement and the July 2006 Purchase Agreements sold shares of Common Stock at an effective price per share below $4.00 per share, Manchester was entitled to a reduction of the strike price under the 2004 Warrants from $4.00 per share to approximately $3.78 per share and to receive an additional grant of 28,754 warrants.

On February 27, 2007, the term of 1.2 million warrants held by the Joseph L. Schwarz was extended from February 28, 2007 to June 30, 2007. The exercise price of the warrants was also increased from $3.00 per share to $3.50 per share.

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.

Common stock options and warrants issued, redeemed and outstanding during the years ended December 31, 2006, 2005 and 2004 are as follows:

The following table summarizes information for options and warrants outstanding and exercisable at December 31, 2006.

The following table summarizes information for options and warrants outstanding and exercisable at December 31, 2005.

The following table summarizes information for options and warrants outstanding and exercisable at December 31, 2004.

A summary of the status of the Company’s nonvested stock options as of December 31, 2006, and changes during the year then ended, is presented below.

As of December 31, 2006, there was $85,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of approximately one year.

The fair value of options were estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

Total stock-based compensation (stock and stock option) cost recognized is as follows:

The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31:

(a) Securities outstanding that were excluded from the computation because they would have been anti-dilutive are as follows:

The provision for income tax expense varies from that which would be expected based upon applying the statutory federal rate to pre-tax accounting loss as follows:

At December 31, 2006, the Company had a net operating loss carry-forwards of approximately $85,000,000, which expire from 2009 through 2025. As a result of previous ownership changes, an aggregate of $532,000 in Federal loss carry-forwards are limited to $116,000 annually.

In 2004, the Company was notified that its 2001 tax return had been selected for examination by the Internal Revenue Service (“IRS”). In the course of its conduct of this examination, the IRS has expanded the scope of the examination to include all of the Company’s returns that have been filed for the years ended December 31, 2002 through 2004. In 2005, the Company’s request for a private letter ruling, which related to the years under IRS examination, was resolved generally in its favor. The statute of limitations for taxable years 2001 and 2002 have been extended by mutual agreement through September 15, 2007. All information requested by the IRS in connection with its examination has been provided by the Company. The IRS may request additional information as the examination is ongoing. There have been some discussions with the IRS relating to the timing of certain deductions and a brief supporting the Company’s position has been submitted. Since the Company’s returns for such years are currently under examination and the timing of certain deductions has been raised, it is reasonably possible that adjustments may be proposed that result in liability to the Company. The Company has estimated a range of potential liability of from $0 to $1.7 million. The Company believes the returns filed for such years are substantially correct and intends to vigorously contest any proposed liability through all available means including judicial proceedings if necessary.

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, 2006, 2005 and 2004.

Effective January 1, 1998, Star entered into an exclusive license agreement with Regent Court Technology, LLC, of which the Company’s founder, Chief Executive Officer and the Company’s largest shareholder, and the beneficiary of the O’Donnell Trust, which is the Company’s second 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 and to sublicense that technology to third parties. 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 2006, 2005 or 2004.

Due from (to) Stockholders consists of unsecured non-interest bearing advances from (to) stockholders of $50,698 and ($50,000) as of December 31, 2006 and 2005, respectively.

On July 27, 2005, the Company’s President and COO tendered to the Company a payment of $300,000 as full satisfaction of a nonrecourse and unsecured $2 million promissory note issued to the Company in 1999. The COO issued the note in 1999 to purchase two million shares of the Company’s common stock. Under its terms, the $2 million promissory note was nonrecourse as to accrued interest and 85% of the principal amount of the note, and reflected an inducement to the COO to join the Company and resign his senior partnership with a national law firm. In connection with the payment by the COO, the Company in the second quarter of 2005 incurred an expense of approximately $1.8 million due to the write-off of $1.7 million of the note receivable due and approximately $0.1 million of accrued interest.

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 matches these contributions at a rate of $0.75 for each $1.00 of employee contribution. The Company made contributions of approximately $193,000, $138,000 and $238,000, in 2006, 2005 and 2004, respectively.

The estimated fair value of cash and cash equivalents, trade receivables, MSA Escrow funds and trade payables approximate the carrying value due to their short-term nature, variable interest rates or interest rates charged at rates at which the company can currently borrow. The estimated fair-value amounts have been determined using an interest rate of 8%. Considerable judgment is required in developing estimates of fair value; therefore, the estimates presented herein are not necessarily indicative of the amounts that the Company would realize in a current market exchange.

Differences between fair value and carrying amount of long-term debt 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.

The Company has outstanding borrowings from B&W aggregating $19,434,246 and $24,931,638 at December 31, 2006 and 2005, respectively.

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.

The Company also had various customers representing in excess of 10% of sales as follows:

In November 1998, 46 states, the District of Columbia (the “Settling States”) and several U.S. territories entered into the Tobacco Master Settlement Agreement (the “MSA” or “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 non-participating manufacturer, the Company is required to satisfy certain escrow obligations pursuant to statutes that the Master Settlement Agreement required the Settling States to adopt in order for such states to receive the full benefits of the settlement. Under such statutes the Company is obligated to deposit monies into escrow for sales of cigarettes in each of the Settling States during the preceding year, and in some cases, such deposits must be made on a quarterly basis. These amounts are adjusted annually by statute and to reflect inflation adjustments (at the higher of 3% or the Consumer Price Index), using 1999 as a base year for the calculation. The base amount for 2003 through 2006 was $3.35 per carton, as adjusted for inflation. For 2006, the adjusted amount was $$4.29 per carton. The base amount for 2007 and thereafter is $3.77 per carton, as adjusted for inflation since 1999. Such escrowed funds will be available to satisfy tobacco-related judgments or settlements, if any, in the Settling States. If not used to satisfy judgments or settlements, the funds will be returned to the Company twenty-five years after the applicable date of deposit on a rolling basis. In addition to the escrow deposits associated with the Company’s direct customer sales, the Company has been required to make additional escrow deposits related to sales of the Company’s cigarettes into the MSA states by the Company’s wholesale customers in the non-MSA states, which are referred to as indirect sales. 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. Star’s sale of smokeless tobacco products are not subject to the MSA escrow obligations.

As of December 31, 2006, the Company had deposited into escrow a net amount of approximately $38.3 million for sales of cigarettes in Settling States during the period 1999-2006. During 2006, the Company deposited a total amount for 2005 sales of approximately $1.0 million, and deposited approximately $0.1 million as quarterly payments for 2006 sales. The Company expects that its total escrow obligation for 2006 sales (due in April of 2007) will be approximately $500,000, which reflects the Company’s successful efforts to limit sales in the Settling States and its trend of decreasing MSA obligations over the past years. These funds will remain in escrow pursuant to the terms of the applicable statutes, and will be available to satisfy state judgments for the type of claims asserted against the major tobacco manufacturers in the suits that resulted in the negotiation of the MSA, if such claims are successfully asserted and litigated against the Company. In March 2007, the Company entered into an agreement under which it received a payment of approximately $11.5 million in return for assigning to the purchasers the right to interest paid on the Company’s escrow fund and to any releases of the escrow principal for any overpayments, or, if these funds are not used to satisfy judgments or settlements by the Settling States, releases of the principal on a rolling basis after twenty-five years.

In addition to the “level playing field” statutes, most of the MSA states have enacted statutes that require non-participating 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 focused its sales in the four states that are not part of the MSA over the last several years, these statutes could impact its ability to sell cigarettes in the MSA states, notwithstanding its substantial payments into escrow, since the states generally prohibit the sales of cigarettes by companies that are not certified as being MSA-compliant. Also, most MSA states have amended their qualifying statutes to limit the ability of companies to cap escrow payments for a particular year so that escrow payments must be made on each cigarette sold in an MSA state. Further, a number of states have required escrow payments to be made quarterly or on some other intermittent schedule. Currently, the Company is required to make quarterly payments in Georgia, Louisiana, Maine, Nevada, New Hampshire, New Mexico and Wyoming, although it has not had any sales in several of these states in 2006. Also, there are a number of other states that have passed quarterly payment statutes that are triggered when sales meet a certain threshold level. Because the Company has sought to limit its MSA sales, it has not met the minimum sales amount required to trigger quarterly escrow payment obligations in these states. The adoption of quarterly payment requirements in additional Settling States could exacerbate the impact of the MSA escrow obligations on the Company’s liquidity.

On January 19, 2007, the Court granted RJR’s Motions for Summary Judgment in part and denied these motions in part. On its motion for Summary Judgment on the Effective Filing Date of the Patents, the Court established September 15, 1999 as the effective filing date, but denied RJR summary judgment with regard to the patents-in-suit. On RJR’s motion for Summary Judgment on Indefiniteness, the Court granted the motion on the basis that the term “anaerobic condition” was indefinite. In the event the Company is unsuccessful in the appeal on the judgment on the validity of their patents, as discussed in Note 15, recognition of an impairment loss related to certain patents with a carrying value of approximately $105,000 as of December 31, 2006 may be necessary. The consolidated financial statements do not include any adjustments that might result from this uncertainty.

On January 19, 2007, the Court also advised the parties that it would seek to issue the ruling on RJR’s inequitable conduct defense before the end of February. In a letter to all counsels dated February 26, 2007, the Court stated that it was not in a position to issue a ruling on the inequitable conduct defense prior to the end of the month, but would seek to issue its decision in March 2007. On March 5, 2007, the Company filed a motion requesting the Court to permit the immediate filing of an appeal on an interlocutory basis while it completes its ruling on the inequitable conduct defense.

if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue. While the Company is optimistic that its request for reconsideration will be accepted based on prior rulings in similar cases, if the assessment is not reversed the Company will be required to pay the tax, penalties and interest due. The Company does not believe that it is probable that an obligation has been incurred and, as a result, no amounts have been accrued for this cost in the accompanying consolidated financial statements.

On March 12, 2002, Governor Warner of the Commonwealth of Virginia announced that the Company would receive a grant of $300,000, which was provided shortly thereafter, to assist Mecklenburg County and Chase City in the acquisition of the Company’s new processing facility adjacent to its existing tobacco receiving station in Chase City, Virginia. In late 2004, the Company responded to inquiries from the State to show its level of investment and hiring for its Chase City operations and to substantiate the actual results achieved compared to the original projections described in the grant application. In its response, the Company requested that the grant be extended for an additional year, given certain delays which have been encountered in connection with the launch of its smokeless tobacco products, including the filing of several unsuccessful Citizen’s Petitions with the FDA that sought to have the Company’s low-TSNA hard tobacco products regulated as a drug by the FDA rather than as conventional snuff tobacco products. In late October 2006, the Company received a request for a further update on the status of this grant. The Company is in the process of updating its prior response and to request a further extension of the grant. Depending on the level of investment and hiring recognized by the State, the Company may be required to return some or all of the $300,000 in grant funding, but the Company’s management does not anticipate that the Company will be required to repay any of this amount.

On March 14, 2007, the Company sold the rights, title and interest in and to all income from and reversionary interest in its MSA escrow accounts (with a balance of $38,329,233 at December 31, 2006) for total cash proceeds of $11,498,770. In addition, the Company also sold the rights, title and interest in and to all income from and reversionary interest in the Company’s subsequent 2006 MSA escrow deposits to be made in April 2007 for an amount equal to $0.30 on each dollar deposited up to a maximum of $700,000 of total deposits. Although the escrow accounts will continue to be maintained in the Company’s name, because the Company is giving up its right to interest earned on the accounts and to any reversionary interest in the accounts this transaction will result in the Company recognizing a loss on the sale of the MSA escrow accounts of approximately $27,000,000 during the quarter ended March 31, 2007.

On March 13 and 14, 2007, the Company sold approximately 960 of its tobacco curing barns (with a net carrying value of approximately $6.2 million as of December 31, 2006) for cash proceeds of approximately $11.2 million. This transaction will result in the Company recognizing a gain on the sale of the tobacco curing barns of approximately $5,000,000 during the quarter ended March 31, 2007. In connection with the sale of the barns, the Company paid to R.J. Reynolds Tobacco Company approximately $2.9 million towards Notes Payable due B&W as included in long-term debt in the accompanying consolidated balance sheets, in order to obtain a release of certain collateralized barns.

The following is a summary of quarterly unaudited results of operations for the years ended December 31, 2006, 2005 and 2004:

Per share amounts for each quarter are required to be computed independently and, therefore, may not equal amounts computed on an annual basis.


801 Liberty Way Chester, VA 23836		(804) 530-0535
(Address of principal executive offices)		(Registrant’s telephone number, including area code)


		Page
	Note on Forward Looking Statements	3

PART I	Item 1. Business	3

	Item 1A. Risk Factors	20

	Item 2. Properties	27

	Item 3. Legal Proceedings	28

	Item 4. Submission of Matters to a Vote of Security Holders	30

PART II	Item 5. Market for Common Equity and Related Stockholder Matters	31

	Item 6. Selected Financial Data	32

	Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations	33

	Item 7A. Quantitative and Qualitative Disclosures about Market Risk	51

	Item 8. Consolidated Financial Statements and Supplementary Data	51

	Item 9. Changes In and Disagreements with Accountants and Financial Disclosure	51

	Item 9A. Controls and Procedures	51

PART III	Item 10. Directors and Executive Officers of the Registrant	53

	Item 11. Executive Compensation	53

	Item 12. Security Ownership of Certain Beneficial Owners and Management	53

	Item 13. Certain Relationships and Related Transactions	54

	Item 14. Principal Accountant Fees and Services	54

	Item 15. Exhibits and Financial Statements	54

Signatures		60


Patent Number	Date of Issue	Description	Expiration Date
U.S. Patent No. 5,803,081	09/08/1998	Method of Treating Tobacco with microwave radiation to prevent formation of nitrosamines	06/28/2016

U.S. Patent No. 5,845,647	12/08/1998	Tobacco products improved by the use of propolis	06/28/2016

U.S. Patent No. 6,135,121 (Reissued as RE 38,123 E)	10/24/2000	Tobacco Products Having Reduced Nitrosamine Content	06/28/2016

U.S. Patent No. 6,202,649	03/20/2001	Method Of Preventing Nitrosamine Formation by Treating Tobacco in Controlled Environment	12/02/2016

U.S. Patent No. 6,311,695 B1	11/06/2001	Method Of Treating Tobacco With High Frequency Energy to Prevent Nitrosamine Formation	06/28/2016

U.S. Patent No. 6,338,348 B1	01/15/2002	Method Of Treating Tobacco With Microwave Energy to Prevent Nitrosamine Formation	06/28/2016

U.S. Patent No. 6,350,479 B1	02/26/2002	Method of Administering Alcohol Extracts Of Tobacco	06/04/2019

U.S. Patent No. 6,425,401	07/30/2002	Method Of Preventing Nitrosamine Formation By Treating Tobacco in Controlled Environment	12/02/2016

U.S. Patent No. 6,569,470 B2	05/27/2003	Method of Administering Alcohol Extracts of Tobacco	06/04/2019

U.S. Patent No. 6,668,839 B2	12/30/2003	Smokeless Tobacco Products Made from Powdered Tobacco	05/06/2021

U.S. Patent No. 6,834,654	12/28/2004	Smokeless Tobacco Product Made from Compressed Powdered Tobacco	05/01/2021

U.S. Patent No. 6,929,811 B2	8/16/2005	Method of Modulating Monoamine Oxidase (MAO) Activity Using Tobacco Alkaloids	06/04/2019


NOMINEE	FOR	WITHHOLD
Dr. Christopher C. Chapman	73,961,671	459,719
Marc D. Oken	73,961,871	459,719
Paul L. Perito	73,951,271	470,119
Leo S. Tonkin	73,954,871	466,519
David C. Vorhoff	73,961,671	459,719
Jonnie R. Williams	73,952,571	488,819


FOR	AGAINST	ABSTAIN
36,333,718	1,254,709	178,570


Large accelerated filer ¨		Accelerated filer x		Non-accelerated filer ¨


	2006				2005
	High		Low		High		Low
Quarter

First	$	3.50	$	2.23	$	6.49	$	3.49
Second		3.00		2.23		5.80		4.11
Third		3.09		1.68		4.63		3.11
Fourth		4.45		2.95		3.21		2.11


	FISCAL YEAR ENDING
COMPANY / INDEX / MARKET	2001	2002	2003	2004	2005	2006
Star Scientific, Inc.	100.00	41.50	73.52	200.99	92.89	128.46

S&P Tobacco Group	100.00	93.20	131.67	157.78	197.53	241.30

S&P Composite	100.00	77.90	100.25	111.15	116.61	135.03


	Years Ended December 31,
	2006			2005			2004			2003			2002
	(In thousands, except per share data)
Statement of Operations Data:
Net Sales	$	37,746		$	46,436		$	66,657		$	73,259		$	158,192
Cost of goods sold (excludes federal excise tax)		11,126			12,581			17,787			21,977			77,016
Gross Profit		6,013			5,267			12,791			14,746			26,719
Operating income (loss)		(12,280	)		(19,333	)		(15,956	)		(14,104	)		(4,852	)
Net income (loss)		(12,280	)		(25,062	)		(16,576	)		(16,661	)		(4,358	)
Basic income (loss) per share		(0.16	)		(0.34	)		(0.27	)		(0.28	)		(0.07	)
Diluted income (loss) per share		(0.16	)		(0.34	)		(0.27	)		(0.28	)		(0.07	)
Weighted average shares outstanding		77,836			73,096			62,137			59,719			59,729

	Year Ended December 31,
	2006			2005			2004			2003			2002
	(In thousands, except per share data)
Balance Sheet Data:
Cash and cash equivalents		4,297			11,533			7,703			0			14
Property, plant & equipment		10,066			11,641			15,182			18,877			21,353
MSA escrow funds		38,329			37,267			33,396			27,024			33,482
Total assets		60,937			67,780			69,517			60,305			89,299
Long-term obligations		14,975			19,434			34,227			31,637			31,028
Stockholders’ equity (deficit)		38,909			40,383			23,330			9,049			24,783


					Amount of Commitment ($) Expired By Year Ended December 31,
	TOTAL		Less Than 1 Year		1-3 Years		3-5 Years		More than 5 Years
Long-term Debt	$	19,434,246	$	4,459,135	$	4,994,784	$	4,994,784	$	4,985,543
Operating Leases		1,941,910		390,327		440,008		217,535		894,040

TOTAL	$	21,376,156	$	4,894,462	$	5,434,792	$	5,212,319	$	5,879,583


/s/ Jonnie R. Williams	/s/ Christopher G. Miller	/s/ Paul L. Perito
Jonnie R. Williams	Christopher G. Miller	Paul L. Perito
Chief Executive Officer (Principal Executive Officer)	Chief Financial Officer (Principal Financial and Accounting Officer)	Chairman of the Board, President and Chief Operating Officer


		Description

2.1		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)

3.1		Restated Certificate of Incorporation(2)

3.2		Bylaws of Star Scientific, Inc. as Amended to Date(2)

10.1		Stock Exchange Agreement between Eye Technology, Inc. and the stockholders of Star Tobacco & Pharmaceuticals, Inc., dated February 6, 1998(3)

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(4)

10.3		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(6)

10.4		1998 Stock Option Plan, as amended(7)

10.5		2000 Equity Incentive Plan, as amended(8)

10.6		Promissory Note dated April 27, 1999 of Paul L. Perito(18)

10.7		Qualified Stock Option Agreement dated as of April 27, 1999 between Star Scientific, Inc. and Paul L. Perito(9)

10.8		Agreement between the Company and Brown & Williamson Tobacco Corporation, dated October 12, 1999(10)

10.9		Loan Agreement between the Company and Brown & Williamson Tobacco Corporation, dated October 12 1999(10)



10.10		Security Agreement between the Company and Brown & Williamson Tobacco Corporation, dated December 16, 1999(10)

10.11		Supply Agreement between Star Tobacco & Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated October 12, 1999(10)

10.12		Lease and Purchase Option Contract between the Company and the Industrial Development Authority of the Town of Chase City, Virginia, dated March 10, 2000(10)

10.13		Form of Director Indemnification Agreement(7)

10.14		Form of Officer Indemnification Agreement(7)

10.15		Executive Employment Agreement between Star Scientific, Inc. and David Dean, dated October 6, 2000(8)

10.16		Restated Loan Agreement between Star Scientific, Inc., Star Tobacco & Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(11)

10.17		Restated Security Agreement between the Company and Brown & Williamson Tobacco Corporation, dated August 21, 2000(11)

10.18		Security Agreement between Star Tobacco & Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(11)

10.19		Guaranty Agreement between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(11)

10.20		Guarantee Agreement between Star Tobacco & Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(11)

10.21		Executive Employment Agreement dated as of September 15, 2000 between Star Scientific, Inc. and Christopher G. Miller(11)

10.22		Amended and Restated Executive Employment Agreement dated as of March 15, 2001 between Star Scientific, Inc. and Christopher G. Miller(8)

10.23		Executive Employment Agreement dated as of March 30, 2001 between Star Scientific, Inc. and Robert E. Pokusa(8)

10.24		Restated Master Agreement, dated April 25, 2001, by and between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(12)

10.25		First Amendment to Restated Loan Agreement dated April 25, 2001, among Star Scientific, Inc., Star Tobacco & Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation(12)

10.26		Trademark License and Royalty Agreement, dated April 25, 2001, between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(12)

10.27		Other Low TSNA Tobacco Royalty Agreement, dated April 25, 2001 by and between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(12)

10.28		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(12)



10.29		Chase City License and Services Agreement, dated April 25, 2001, between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(12)

10.30		Exclusive License Agreement dated as of March 16, 2001 by and among Regent Court Technologies and Star Scientific, Inc.(2)

10.31		Sublicense Agreement dated as of March 16, 2001 by and among Star Scientific, Inc. and Star Tobacco & Pharmaceuticals, Inc.(2)

10.32		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)

10.33		Amendment No. 1 dated April 5, 2001 to Exclusive License Agreement by and among Regent Court Technologies and Star Scientific, Inc.(2)

10.34		Promissory Note dated August 20, 2001 of Christopher G. Miller(2)

10.35		Promissory Note dated August 20, 2001 of Robert E. Pokusa(2)

10.36		Promissory Note dated August 20, 2001 of Sheldon L. Bogaz(2)

10.37		Promissory Note dated August 20, 2001 of David M. Dean(2)

10.38		Lease Agreement dated as of February 26, 2002 between GE Capital and Star Scientific, Inc.(14)

10.29		Contract with The Industrial Development Authority of Mecklenburg County, Virginia and The Industrial Development Authority of the Town of Chase City, Virginia, for a 10-year lease and option to purchase an approximately 91,000 square foot building at 89 Duckworth Road(15)

10.40		Amended and Restated Employment Agreement for Paul L. Perito, Esq. dated as of June 14, 2002(16)

10.41		Allonge, dated as of June 14, 2002, by and between Star Scientific, Inc. and Paul L. Perito, Esq.(16)

10.42		First Modification Agreement to Amended and Restated Employment Agreement for Paul L. Perito, Esq. dated as of November 1, 2002(16)

10.43		October 3, 2003 Letter Agreement between Star Scientific, Inc. and Brown and Williamson Tobacco Corporation. (17)

10.44		Convertible Debenture, dated March 25, 2004, issued by Star Scientific, Inc. to Manchester Securities, Corp. Debenture was amended and then converted. (17)

10.45		Warrant, dated March 25, 2004, issued by Star Scientific, Inc. to Manchester Securities, Corp. (17)

10.46		Securities Purchase Agreement, dated March 25, 2004 between Star Scientific, Inc. and Manchester Securities Corp. (17)

10.47		Registration Rights Agreement, dated March 25, 2004 between Star Scientific, Inc. and Manchester Securities Corp. (17)

10.48		Form of Reedland Warrant, dated as of March 25, 2004, issued by Star Scientific, Inc. (17)

10.49		Guaranty Agreement, dated March 25, 2004 issued by Star Tobacco, Inc. (17)

10.50		Securities Purchase Agreement, dated April 15, 2004 by and among Star Scientific, Inc., Elliott International, LP and Elliott Associates, LP (18)

10.51		Registration Rights Agreement, dated April 15, 2004 between Star Scientific, Inc., Elliott International, LP and Elliott Associates, LP (18)


10.52		Securities Purchase Agreement, dated April 15, 2004 between Star Scientific, Inc. and Portside Growth and Opportunity Fund (18)

10.53		Registration Rights Agreement, dated April 15, 2004 between Star Scientific, Inc. and Portside Growth and Opportunity Fund (18)

10.54		Second Restated Non-Circumvention and Finder’s Fee Agreement, dated April 15, 2004 between Star Scientific, Inc. and Reedland Capital Partners (18)

10.55		Security Purchase and Registration Rights Agreement, dated February 25, 2005 between Star Scientific, Inc. and Elliott International, LP (19)

10.56		Warrant dated February 25, 2005, issued by Star Scientific, Inc. to Elliott International LP (19)

10.57		Security Purchase and Registration Rights Agreement, dated February 25, 2005 between Star Scientific, Inc. and Elliott Associates, LP (19)

10.58		Warrant dated February 25, 2005, issued by Star Scientific, Inc. to Elliott Associates, LP (19)

10.59		Security Purchase and Registration Rights Agreement, dated February 25, 2005 between Star Scientific, Inc. and Delaware Charter Guarantee and Trust Company, FBO Joseph L. Schwarz IRA (19)

10.60		Warrant dated February 25, 2005, issued by Star Scientific, Inc. to Delaware Charter Guarantee and Trust Company, FBO Joseph L. Schwarz IRA (19)

10.61		Security Purchase and Registration Rights Agreement, dated February 25, 2005 between Star Scientific, Inc. and Iroquois Capital, LP (19)

10.62		Warrant dated February 25, 2005, issued by Star Scientific, Inc. to Iroquois Capital, LP (19)

10.63		Security Purchase and Registration Rights Agreement, dated February 25, 2005 between Star Scientific, Inc. and Fulcrum Global Partners LLC (20)

10.64		Warrant dated February 25, 2005, issued by Star Scientific, Inc. to Fulcrum Global Partners LLC (20)

10.65		Securities Purchase and Registration Rights Agreement, dated September 15, 2001, by and between Star Scientific, Inc. and Iroquois Capital (21)

10.66		Warrant, dated September 15, 2005, issued by Star Scientific, Inc. to Iroquois Capital (21)

10.67		Security Purchase and Registration Rights Agreement, dated September 15, 2005, between Star Scientific, Inc. and Elliott International, L.P. (21)

10.68		Warrant, dated September 15, 2005, issued by Star Scientific, Inc. to Elliott International, L.P. (21)

10.69		Security Purchase and Registration Rights Agreement, dated September 15, 2005, between Star Scientific, Inc. and Elliott Associates, L.P. (21)

10.70		Warrant, dated September 15, 2005, issued by Star Scientific, Inc. to Elliott Associates, L.P. (21)

10.71		Executive Employment Agreement with Jonnie R. Williams (22)

10.72		Second Amended and Restated Employment Agreement with Paul L. Perito (22)

10.73		Securities Purchase and Registration Rights Agreement, dated as of March 3, 2006, between the Company and Joseph L. Schwarz (23)


FOR	AGAINST	ABSTAIN
74,344,896	55,721	20,773



10.74		Common Stock Purchase Warrant, dated as of March 3, 2006, between the Company and Joseph L. Schwarz (23)

10.75		Promissory Note, dated as of March 3, 2006, between the Company and Joseph L. Schwarz (23)

10.76		Pledge Agreement, dated as of March 3, 2006, between the Company and Joseph L. Schwarz (23)

10.77		Amendment No. 1 to the Securities Purchase and Registration Rights Agreement, dated June 15, 2006, by and between Star Scientific, Inc. and Elliott Associates, L.P. (25)

10.78		Warrant dated June 15, 2006, issued by Star Scientific, Inc. to Elliott Associates, L.P. (25)

10.79		Amendment No. 1 to the Securities Purchase and Registration Rights Agreement, dated June 15, 2006, by and between Star Scientific, Inc. and Elliott International, L.P. (25)

10.80		Warrant dated June 15, 2006, issued by Star Scientific, Inc. to Elliott International, L.P. (25)

10.81		Amendment No. 1 to the Securities Purchase and Registration Rights Agreement, dated June 15, 2006, by and between Star Scientific, Inc. and Iroquois Capital (25)

10.82		Warrant dated June 15, 2006, issued by Star Scientific, Inc. to Iroquois Capital (25)

10.83		Amendment No. 3 to the Securities Purchase and Registration Rights Agreement, dated June 15, 2006, by and between Star Scientific, Inc. and Delaware Charter Guarantee and Trust Company, FBO Joseph L. Schwarz IRA (25)

10.84		Warrant dated June 15, 2006, issued by Star Scientific, Inc. to Delaware Charter Guarantee and Trust Company, FBO Joseph L. Schwarz IRA (25)

10.85		Securities Purchase and Registration Rights Agreement, dated July 14, 2006, by and between Star Scientific, Inc. and Iroquois Capital (24)

10.86		Warrant dated July 14, 2006, issued by Star Scientific, Inc. to Iroquois Capital (24)

10.87		Securities Purchase and Registration Rights Agreement, dated July 14, 2006, by and between Star Scientific, Inc. and Delaware Charter Guarantee and Trust Company, FBO Joseph L. Schwarz IRA (24)

10.88		Warrant dated July 14, 2006, issued by Star Scientific, Inc. to Delaware Charter Guarantee and Trust Company, FBO Joseph L. Schwarz IRA (24)

10.89		Amendment to Employment Agreement with Jonnie R. Williams (26)

10.90		Amendment to Second Amended Employment Agreement with Paul L. Perito (26)

10.91		Escrow Releases Purchase Agreement dated March 14, 2007 by and among QVT Associates LP, Whitebox Hedged High Yield Partners, LP, Star Scientific, Inc. and Star Tobacco, Inc.

14.1		Corporate Code of Business Conduct and Ethics, dated March 2004 (17)

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. § 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. § 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002


Signature	Title	Date

/s/ JONNIE R. WILLIAMS Jonnie R. Williams	Chief Executive Officer and Director (Principal Executive Officer)	March 16, 2007

/s/ JONNIE R. WILLIAMS As	Chairman of the Board, President and	March 16, 2007
ATTORNEY-IN-FACT	Chief Operating Officer
Paul L. Perito

/s/ CHRISTOPHER G. MILLER Christopher G. Miller	Chief Financial Officer (Principal Financial and Accounting Officer)	March 16, 2007

/s/ JONNIE R. WILLIAMS As	Director	March 16, 2007
ATTORNEY-IN-FACT
Christopher C. Chapman

/s/ JONNIE R. WILLIAMS As	Director	March 16, 2007
ATTORNEY-IN-FACT
Mark D. Oken

/s/ JONNIE R. WILLIAMS As	Director	March 16, 2007
ATTORNEY-IN-FACT
David C. Vorhoff

/s/ JONNIE R. WILLIAMS As	Director	March 16, 2007
ATTORNEY-IN-FACT
Leo S. Tonkin


		Page
Reports of Independent Registered Certified Public Accounting Firm:

Audit of Consolidated Financial Statements as of December 31, 2006 and 2005 and for the three years ended December 31, 2006		F-1

Audit of Internal Control over Financial Reporting as of December 31, 2006		F-2

Consolidated Balance Sheets as of December 31, 2006 and 2005		F-3

Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004		F-4

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2006, 2005 and 2004		F-5

Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004		F-6

Notes to Consolidated Financial Statements		F-8


	2006			2005
ASSETS
Current assets:
Cash and cash equivalents	$	4,297,467		$	11,532,598
Accounts receivable, trade, net of allowance for doubtful accounts of $48,277 (2006) and $148,277 (2005)		4,813,457			2,445,014
Inventories		1,393,291			2,495,046
Due from stockholders		50,698			—
Prepaid expenses and other current assets		645,219			495,716

Total current assets		11,200,132			16,968,374

Property and equipment, net		9,539,663			11,640,604
Idle equipment		526,500			526,500
Intangible assets, net of accumulated amortization		815,622			869,675
Other assets		526,607			507,210
MSA Escrow funds		38,329,233			37,267,241

	$	60,937,757		$	67,779,604

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term debt	$	4,459,135		$	5,497,392
Current maturities of capital lease obligations		—			45,755
Accounts payable, trade		996,789			959,600
Federal excise taxes payable		896,667			65,695
Tobacco buyout program liability		21,518			560,847
Accrued expenses		629,969			763,884
Due to stockholders		50,000			68,897

Total current liabilities		7,054,078			7,962,070
Long-term debt, less current maturities		14,975,111			19,434,246

Total liabilities		22,029,189			27,396,316

Commitments and contingencies (Notes 8, 11, 12 and 15)

Stockholders’ equity:
Common stock^A		7,925			7,515
Preferred stock^B		—			—
Additional paid-in capital		96,612,685			85,802,440
Accumulated deficit		(57,712,042	)		(45,426,667	)

Total stockholders’ equity		38,908,568			40,383,288

	$	60,937,757		$	67,779,604


	Common Stock					Additional Paid-in Capital			Accumulated Deficit			Notes Receivable, Officers			Total
	Shares		Amount			Additional Paid-in Capital			Accumulated Deficit			Notes Receivable, Officers			Total
Balances, January 1, 2004	59,719,460			5,972			15,431,605			(3,788,797	)		(2,600,000	)		9,048,780

Stock-based compensation	—			—			1,140,314			—			—			1,140,314
Issuance of common stock, net of stock issuance costs	6,292,877			629			28,564,370			—			—			28,564,999
Issuance of common stock and stock options as a part of loan issuance costs	173,611			17			912,236			—			—			912,253
Stock-based loan modification costs	—			—			239,276			—			—			239,276
Net loss	—			—			—			(16,576,055	)		—			(16,576,055	)

Balances, December 31, 2004	66,185,948		$	6,618		$	46,287,801		$	(20,364,852	)	$	(2,600,000	)	$	23,329,567
Stock-based compensation	—			—			458,658			—			—			458,658
Stock option exercise	460,517			46			550,214			—			—			550,260
Issuance of common stock and warrant exercise	5,500,000			550			25,599,450			—			—			25,600,000
Conversion of long-term debt	3,179,810			318			13,536,893			—			—			13,537,211
Write-off of note receivable, officer	—			—			—			—			1,700,000			1,700,000
Note receivable collections, officers	—			—			—			—			900,000			900,000
Repurchase and retirement of stock from officers	(174,860	)		(17	)		(632,976	)		—			—			(632,993	)
Contribution of stockholder gain on common stock trade	—			—			2,400			—			—			2,400
Net loss	—			—			—			(25,061,815	)		—			(25,061,815	)

Balances, December 31, 2005	75,151,415		$	7,515		$	85,802,440		$	(45,426,667	)	$	—		$	40,383,288
Stock-based compensation	—			—			689,905			—			—			689,905
Stock option exercise	100,000			10			120,740			—			—			120,750
Issuance of common stock	2,000,000			200			5,999,800			—			—			6,000,000
Proceeds from exercise of warrants to purchase common stock	2,000,000			200			3,999,800			—			—			4,000,000
Net loss	—			—			—			(12,285,375	)		—			(12,285,375	)

Balances, December 31, 2006	79,251,415		$	7,925		$	96,612,685		$	(57,712,042	)	$	—		$	38,908,568


	2006		2005
Tobacco leaf	$	50,644	$	47,784
Raw materials		176,169		267,026
Packaging materials		538,627		793,992
Finished goods		627,851		1,386,244

	$	1,393,291	$	2,495,046


	2006			2005
Land	$	159,879		$	159,879
Buildings		430,020			430,020
Leasehold improvements		1,140,197			1,140,197
Tobacco curing barns		19,031,711			19,031,711
Machinery and equipment		6,273,738			6,273,738
Office and sales equipment		1,204,627			1,199,443

		28,240,172			28,234,988
Less accumulated depreciation		(18,700,509	)		(16,594,384	)

	$	9,539,663		$	11,640,604


	2006			2005
Tobacco curing barns owned	$	21,825,303		$	21,290,493
Tobacco curing barns under an operating lease obligation		—			534,810
Impairment of barns		(2,267,092	)		(2,267,092	)

		19,558,211			19,558,211
Accumulated depreciation		(12,899,716	)		(11,523,109	)

	$	6,658,495		$	8,035,102


	2006			2005
Patents	$	958,542		$	958,542
Trademarks and other intangibles		427,560			418,914

		1,386,102			1,377,456
Less: accumulated amortization		(570,480	)		(507,781	)

	$	815,622		$	869,675


Years ending December 31,
2007	$	63,910
2008		64,713
2009		63,860
2010		62,383
2011		62,187
Thereafter		415,013

	$	732,066


	2006			2005
Notes payable due B&W, collateralized by tobacco leaf inventory and the Company’s remaining tobacco curing barns, payable in 96 monthly installments of approximately $208,000 plus interest at prime plus 1%, beginning January 1, 2006 through 2013 (see Note 16). The notes are also payable via royalties earned under agreements with B&W as defined (see Note 6).	$	17,472,503		$	19,969,895

Note payable due B & W, converted from accounts payable, interest at prime plus 1%, payable in monthly installments of $250,000 plus interest commencing January 1, 2005 through August 2007.		1,961,743			4,961,743

		19,434,246			24,931,638
Less current maturities		(4,459,135	)		(5,497,392	)

	$	14,975,111		$	19,434,246


Years ending December 31
2007	$	4,459,135
2008		2,497,392
2009		2,497,392
2010		2,497,392
2011		2,497,392
Thereafter		4,985,543

Total notes payable and long term debt	$	19,434,246


Year ending December 31,
2007	$	390,327
2008		220,004
2009		220,004
2010		131,015
2011		86,520
Thereafter		894,040

	$	1,941,910


	Number		Weighted Average Exercise Price Per Share
Options
Options outstanding at January 1, 2004	5,111,500			2.16
Options forfeited during 2004	(480,000	)		(3.66	)
Options issued during 2004	685,000			4.65

Options outstanding at December 31, 2004*	5,316,500			2.60
Options forfeited during 2005	(50,000	)		(5.60	)
Options exercised during 2005	(547,000	)		(2.09	)
Options issued during 2005	350,000			3.48

Options outstanding at December 31, 2005	5,069,500			2.74
Options forfeited during 2006	—			—
Options exercised during 2006	100,000			1.21
Options issued during 2006	250,000			2.40

Options outstanding at December 31, 2006	5,219,500		$	2.11


	Number		Weighted Average Exercise Price Per Share
Warrants
Warrants outstanding at January 1, 2004	410,526		$	2.01
Warrants issued during 2004	602,681			4.08

Warrants outstanding at December 31, 2004	1,013,207			3.24
Warrants issued during 2005	5,500,000			4.73
Warrants exercised during 2005	(1,900,000	)		5.00

Warrants outstanding at December 31, 2005	4,613,207		$	4.30
Warrants issued during 2006	4,028,754			3.01
Warrants exercised during 2006	(2,000,000	)		4.15
Warrants expired during 2006	(1,600,000	)		4.63

Warrants outstanding at December 31, 2006	5,041,961			3.05


Range of Prices	Options Outstanding						Exercisable
	Number	Weighted Avg. Remaining Life	Weighted Avg. Exercise Price		Aggregate Intrinsic Value		Weighted Avg.			Aggregate Intrinsic Value
	Number	Weighted Avg. Remaining Life	Weighted Avg. Exercise Price		Aggregate Intrinsic Value		Number	Exercise Price		Aggregate Intrinsic Value
$1.00-2.00	2,513,000	3.01	$	1.70			2,513,000	$	1.70
2.01-3.00	991,500	4.36		2.81			941,500		2.82
3.01-4.00	1,050,000	5.07		3.87			1,025,000		3.87
4.01-5.00	550,000	6.81		4.72			550,000		4.77
5.01-6.25	115,000	7.36		5.16			115,000		5.16

$1.00-6.25	5,219,500	4.18	$	2.11	$	4,338,505	5,144,500	$	2.14	$	4,315,005


Range of Prices	Warrants Outstanding						Exercisable
	Number	Weighted Avg. Remaining Life	Weighted Avg. Exercise Price		Aggregate Intrinsic Value		Weighted Avg.			Aggregate Intrinsic Value
	Number	Weighted Avg. Remaining Life	Weighted Avg. Exercise Price		Aggregate Intrinsic Value		Number	Exercise Price		Aggregate Intrinsic Value
$2.00-3.00	410,526	4.61	$	2.19			410,526	$	2.19
3.01-4.00	4,531,435	2.39		3.09			4,531,435		3.09
4.01-5.00	100,000	2.23		4.49			100,000		4.49

$2.00-5.00	5,041,961	2.37	$	3.05	$	1,433,947	5,041,961	$	3.05	$	1,433,947


	Number of Options	Exercise Price		Grant date fair value
2006 Activity

Exceeds market	250,000	$	2.40	$	1.37

2005 Activity

Equals market	350,000	$	3.48	$	1.16

2004 Activity

Equals market	685,000	$	4.65	$	1.74


Nonvested Stock Options	Shares (000)		Weighted Average Grant-Date Fair Value
Nonvested at December 31, 2005	150,000		$	1.13
Granted	—			—
Vested	(75,000	)		1.13
Forfeited	—			—
Nonvested at December 31, 2006	75,000		$	1.13


	2006			2005
Deferred tax assets:
Net operating loss carry-forwards (portions subject to annual limitation)	$	31,513,000		$	26,352,000
Credit carry-forward		501,000			501,000
Other		319,000			354,000

		32,333,000			27,207,000

Deferred tax liabilities:
Differing bases in property, plant and equipment for tax and financial reporting purposes		(1,336,000	)		(1,135,000	)
MSA Escrow payments taxable in future		(14,354,000	)		(13,957,000	)

		(15,690,000	)		(15,092,000	)

Valuation Allowance		(16,643,000	)		(12,115,000	)

	$	—		$	—


2006				2005
Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
$	19,434,246	$	25,379,867	$	24,931,638	$	33,189,894