UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549


_______________





FORM
10-Q


_______________





(Mark
One)


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


For the
quarterly period ended September 30,
2009





or





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


For the
transition period from ______ to ______





Commission
file number: 001-33710








CLEAN
DIESEL TECHNOLOGIES, INC.


(Exact
name of registrant as specified in its charter)





Delaware
            06-1393453(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification No.)





10 Middle Street  Suite 1100,
      Bridgeport, CT
            06604(Address
      of principal executive offices)
            (Zip
      Code)





(203) 416-5290(Registrant’s
      telephone number, including area code)





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 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 TNo £





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).        Yes £  No  __





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.





Large Accelerated Filer
            £
            
            Accelerated
      Filer
            TNon-Accelerated
      Filer
            £
            (Do not
      check if a smaller reporting company.)
            Smaller
      reporting company
            £





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





As of
November 6, 2009, there were 8,213,988 outstanding shares of the registrant’s
common stock, par value $0.01 per share.










CLEAN DIESEL TECHNOLOGIES, INC.





Quarterly
Report on Form 10-Q


for the
Quarter Ended September 30, 2009





INDEX








PagePART
      I.
            FINANCIAL
      INFORMATIONItem
      1.
            Financial Statements
            3Condensed Consolidated Balance Sheets as of September 30, 2009
      (Unaudited)and December 31, 2008
            3Condensed Consolidated Statements of Operations for the Three
      and Nine Months Ended September 30, 2009 and 2008
      (Unaudited)
            4Condensed Consolidated Statements of Cash Flows for the Nine
      Months Ended September 30, 2009 and 2008 (Unaudited)
            5Notes to Condensed Consolidated Financial Statements
      (Unaudited)
            6Item
      2.
            Management’s Discussion and Analysis of Financial Condition and
      Results of Operations
            18Item
      3.
            Quantitative and Qualitative Disclosures about Market
      Risk
            29Item
      4.
            Controls and Procedures
            29PART
      II.
            OTHER
      INFORMATIONItem
      6.
            Exhibits
            30SIGNATURES
            31


- 2
-
 Index


PART
      I.
            FINANCIAL
      INFORMATION


Item
      1.
            Condensed
      Consolidated Financial Statements





CLEAN
DIESELTECHNOLOGIES, INC.


Condensed
Consolidated Balance Sheets


(in
thousands, except share data)





September 30,
            
            
            December 31,2009
            
            
            2008(Unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
            
            $
            4,224
            
            
            $
            3,976Investments
            
            
            11,725
            
            
            
            6,413Accounts
      receivable, net of allowance of $263 and $359,
respectively
            
            
            163
            
            
            
            637Inventories,
      net
            
            
            901
            
            
            
            974Other
      current assets
            
            
            124
            
            
            
            219Total
      current assets
            
            
            17,137
            
            
            
            12,219Investments
            
            ─
            
            
            
            5,127Patents,
      net
            
            
            1,062
            
            
            
            1,027Fixed
      assets, net of accumulated depreciation of $338 and $505,
      respectively
            
            
            322
            
            
            
            296Other
      assets
            
            
            61
            
            
            
            78Total
      assets
            
            $
            18,582
            
            
            $
            18,747Liabilities
      and Stockholders’ EquityCurrent
      liabilities:Accounts
      payable
            
            $
            184
            
            
            $
            501Accrued
      expenses
            
            
            900
            
            
            
            534Short-term
      debt
            
            
            7,697
            
            
            
            3,013Customer
      deposits
            
            ─
            
            
            
            8Total
      current liabilities
            
            
            8,781
            
            
            
            4,056CommitmentsStockholders’
      equity:Preferred
      stock, par value $0.01 per share: authorized 100,000; no shares issued and
      outstanding
            
            ─
            
            
            ─Common
      stock, par value $0.01 per share: authorized 12,000,000; issued and
      outstanding 8,178,304 and 8,138,304 shares, respectively
            
            
            82
            
            
            
            81Additional
      paid-in capital
            
            
            74,479
            
            
            
            73,901Accumulated
      other comprehensive loss
            
            
            (426
            )
            
            
            (406
            )Accumulated
      deficit
            
            
            (64,334
            )
            
            
            (58,885
            )Total
      stockholders’ equity
            
            
            9,801
            
            
            
            14,691Total
      liabilities and stockholders’ equity
            
            $
            18,582
            
            
            $
            18,747





The
accompanying notes are an integral part of the condensed consolidated financial
statements.


- 3
-
 Index


CLEAN
DIESELTECHNOLOGIES, INC.


Condensed
Consolidated Statements of Operations


(in
thousands, except per share amounts) (Unaudited)





Three
      Months Ended
              September
      30,
            
            
            Nine
      Months Ended
              September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Revenue:Product
      sales
            
            $
            225
            
            
            $
            1,415
            
            
            $
            879
            
            
            $
            6,432Technology
      licensing fees and royalties
            
            
            28
            
            
            
            165
            
            
            
            95
            
            
            
            368Total
      revenue
            
            
            253
            
            
            
            1,580
            
            
            
            974
            
            
            
            6,800Costs
      and expenses:Cost
      of product sales
            
            
            217
            
            
            
            1,174
            
            
            
            668
            
            
            
            5,232Cost
      of licensing fees and royalties
            
            ─
            
            
            ─
            
            
            ─
            
            
            ─Selling,
      general and administrative
            
            
            1,324
            
            
            
            2,403
            
            
            
            4,837
            
            
            
            7,447Severance
      charge
            
            
            448
            
            
            ─
            
            
            
            958
            
            
            ─Research
      and development
            
            
            128
            
            
            
            162
            
            
            
            314
            
            
            
            316Patent
      amortization and other expense
            
            
            56
            
            
            
            65
            
            
            
            128
            
            
            
            143Operating
      costs and expenses
            
            
            2,173
            
            
            
            3,804
            
            
            
            6,905
            
            
            
            13,138Loss
      from operations
            
            
            (1,920
            )
            
            
            (2,224
            )
            
            
            (5,931
            )
            
            
            (6,338
            )Other
      income (expense):Interest
      income
            
            
            46
            
            
            
            125
            
            
            
            187
            
            
            
            481Other
      income (expense), net
            
            
            (26
            )
            
            
            (282
            )
            
            
            295
            
            
            
            (257
            )Net
      loss
            
            $
            (1,900
            )
            
            $
            (2,381
            )
            
            $
            (5,449
            )
            
            $
            (6,114
            )Basic
      and diluted loss per common share
            
            $
            (0.23
            )
            
            $
            (0.29
            )
            
            $
            (0.67
            )
            
            $
            (0.75
            )Basic
      and diluted weighted-average number of common shares
      outstanding
            
            
            8,138
            
            
            
            8,138
            
            
            
            8,138
            
            
            
            8,137





The
accompanying notes are an integral part of the condensed consolidated financial
statements.


- 4
-
 Index


CLEAN
DIESEL TECHNOLOGIES, INC.


Condensed
Consolidated Statements of Cash Flows


(in
thousands) (Unaudited)





Nine
      Months Ended
              September
      30,2009
            
            
            2008Operating
      activitiesNet
      loss
            
            $
            (5,449
            )
            
            $
            (6,114
            )Adjustments
      to reconcile net loss to cash used in operating
activities:Depreciation
      and amortization
            
            
            139
            
            
            
            110(Recovery)
      provision for doubtful accounts, net
            
            
            (148
            )
            
            
            499Compensation
      expense for equity instruments
            
            
            579
            
            
            
            1,033Gain
      on investment, net
            
            
            (185
            )
            
            ─Abandonment
      of patents and equipment
            
            
            16
            
            
            ─Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            622
            
            
            
            335Inventories,
      net
            
            
            73
            
            
            
            262Other
      current assets and other assets
            
            
            112
            
            
            
            68Accounts
      payable, accrued expenses and other liabilities
            
            
            41
            
            
            
            (640
            )Net
      cash used for operating activities
            
            
            (4,200
            )
            
            
            (4,447
            )Investing
      activitiesSale
      of investments
            
            ─
            
            
            
            7,100Patent
      costs
            
            
            (88
            )
            
            
            (220
            )Purchase
      of fixed assets
            
            
            (121
            )
            
            
            (110
            )Net
      cash (used for) provided by investing activities
            
            
            (209
            )
            
            
            6,770Financing
      activitiesProceeds
      from short-term debt
            
            
            4,735
            
            
            
            3,000Repayment
      of short-term debt
            
            
            (51
            )
            
            ─Stockholder-related
      charges
            
            ─
            
            
            
            (14
            )Proceeds
      from exercise of stock options
            
            ─
            
            
            
            24Net
      cash provided by financing activities
            
            
            4,684
            
            
            
            3,010Effect
      of exchange rate changes on cash
            
            
            (27
            )
            
            
            (159
            )Net
      increase in cash and cash equivalents
            
            $
            248
            
            
            $
            5,174Cash
      and cash equivalents at beginning of the period
            
            
            3,976
            
            
            
            1,517Cash
      and cash equivalents at end of the period
            
            $
            4,224
            
            
            $
            6,691Supplemental
      non-cash activities:Unrealized loss on available-for-sale securities
            
            $
            ─
            
            
            $
            750Accumulated depreciation of abandoned assets
            
            $
            270
            
            
            $
            ─Supplemental
      disclosures:Cash
      paid for interest
            
            $
            55
            
            
            $
            ─





The
accompanying notes are an integral part of the condensed consolidated financial
statements.


- 5
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 Index


CLEAN
DIESEL TECHNOLOGIES, INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





Note
1.  Significant Accounting Policies





Basis
of Presentation:





In this
Quarterly Report on Form 10-Q, the terms “CDT,” “Clean Diesel,” “Company,” “we,”
“us,” or “our” mean Clean Diesel Technologies, Inc. and its wholly-owned
subsidiary, Clean Diesel International, LLC.





The
accompanying unaudited condensed consolidated financial statements have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission (SEC) and in accordance with accounting principles generally accepted
in the United States of America (GAAP) for interim financial
information.  Certain information and note disclosures normally
included in financial statements prepared in accordance with GAAP have been
omitted or condensed.  These interim condensed consolidated financial
statements should be read in conjunction with Clean Diesel’s consolidated
financial statements and notes thereto included in our Annual Report on Form
10-K for the year ended December 31, 2008.





The
unaudited condensed consolidated financial statements reflect all adjustments
which, in the opinion of management, are necessary for a fair statement of the
results of operations, financial position and cash flows for the interim periods
presented.  All such adjustments are of a normal recurring
nature.  The results for interim periods are not necessarily
indicative of results which may be expected for any other interim period or for
the full year.





The
Company has performed an evaluation of subsequent events through November 9,
2009, which is the date the financial statements were issued.





Reclassifications:





Some
amounts in prior years’ financial statements have been reclassified to conform
to the current year’s presentation.





Revenue
Recognition:





The
Company generates revenue from sales of emission reduction products including
Purifier system hardware; ARIS®
advanced reagent injection system injectors and dosing systems; fuel-borne
catalysts, including the Platinum Plus®
fuel-borne catalyst products and concentrate; and license and royalty fees from
the ARIS system and other technologies.





Revenue
is recognized when earned.  For technology licensing fees paid by
licensees that are fixed and determinable, accepted by the customer and
nonrefundable, revenue is recognized upon execution of the license agreement,
unless it is subject to completion of any performance criteria specified within
the agreement, in which case it is deferred until such performance criteria are
met.  Royalties are frequently required pursuant to license agreements
or may be the subject of separately executed royalty
agreements.  Revenue from royalties is recognized ratably over the
royalty period based upon periodic reports submitted by the royalty obligor or
based on minimum royalty requirements.  Revenue from product sales is
recognized when title has passed and our products are shipped to our customer,
unless the purchase order or contract specifically requires us to provide
installation for hardware purchases.  For hardware projects in which
we are responsible for installation (either directly or indirectly by
third-party contractors), revenue is recognized when the hardware is installed
and/or accepted, if the project requires inspection and/or
acceptance.





Generally,
our license agreements are non-exclusive and specify the geographic territories
and classes of diesel engines covered, such as on-road vehicles, off-road
vehicles, construction, stationary engines, marine and railroad
engines.  At the time of the execution of our license agreement, we
assign the right to the licensee to use our patented
technologies.  The up-front fees are not subject to refund or
adjustment.  We recognize the license fee as revenue at the inception
of the license agreement when we have reasonable assurance that the technologies
transferred have been accepted by the licensee and collectability of the license
fee is reasonably assured.  The nonrefundable up-front fee is in
exchange for the culmination of the earnings process as the Company has
accomplished what it must do to be entitled to the benefits represented by the
revenue.  Under our license agreements, there is no significant
obligation for future performance required of the Company.  Each
licensee must determine if the rights to our patented technologies are usable
for their business purposes and must determine the means of use without further
involvement by the Company.  In most cases, licensees must make
additional investments to enable the capabilities of our patents, including
significant engineering, sourcing of and assembly of multiple
components.  Our obligation to defend valid patents does not represent
an additional deliverable to which a portion of an arrangement fee should be
allocated.  Defending the patents is generally consistent with our
representation in the license agreement that such patents are legal and
valid.


- 6
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 Index


Valuation
of Accounts Receivable:





Management
reviews the creditworthiness of a customer prior to accepting an initial
order.  Upon review of the customer’s credit application and
confirmation of the customer’s credit and bank references, management
establishes the customer’s terms and credit limits.  Credit terms for
payment of products are extended to customers in the normal course of business
and no collateral is required.  We receive order acknowledgements from
customers confirming their orders prior to our fulfillment of
orders.  To determine the allowance for doubtful accounts receivable
which adjusts gross trade accounts receivable downward to estimated net
realizable value, management considers the ongoing financial stability of the
Company’s customers, the aging of accounts receivable balances, historical
losses and recoveries, and general business trends and existing economic
conditions that impact our industry and customers.  In cases where the
Company is aware of circumstances that may impair a specific customer’s ability
to meet its financial obligations, we record a specific allowance against
amounts due from that customer, and thereby reduce the net recognized receivable
to the amount the Company reasonably believes will be collected.  An
account is written off only after management has determined that all available
means of collection, including legal remedies, are exhausted.





Cost
of Revenue:





Our cost
of product sales includes the costs we incur to formulate our finished products
into saleable form for our customers, including material costs, labor and
processing costs charged to us by our outsourced blenders, installers and other
vendors, packaging costs incurred by our outsourced suppliers, freight costs to
customers and inbound freight charges from our suppliers.  Our
inventory is primarily maintained off-site by our outsourced
suppliers.  To date, our purchasing, receiving, inspection and
internal transfer costs have been insignificant and have been included in cost
of product sales.  In addition, the costs of our warehouse of
approximately $21,000 per year are included in selling, general and
administrative expenses.  Cost of licensing fees and royalties is zero
as there are no incremental costs associated with the revenue.





Patent
Expense:





Patents,
which include all direct incremental costs associated with initial patent
filings and costs to acquire rights to patents under licenses, are stated at
cost and amortized using the straight-line method over the remaining useful
lives, ranging from one to twenty years.  During the nine months ended
September 30, 2009, we capitalized $88,000 of patent costs and recorded
abandonment of approximately $13,000 of patents, net.  Indirect and
other patent-related costs are expensed as incurred.  Patent
amortization expense for the three and nine months ended September 30, 2009 was
$14,000 and $40,000, respectively, and for the three and nine months ended
September 30, 2008 was $17,000 and $45,000, respectively.  At
September 30, 2009 and December 31, 2008, the Company’s patents, net of
accumulated amortization, were $1,062,000 and $1,027,000,
respectively.





Basic
and Diluted Loss per Common Share:





Basic
loss per share is computed by dividing net loss by the weighted-average shares
outstanding during the reporting period.  Diluted loss per share is
computed in a manner similar to basic earnings per share except that the
weighted-average shares outstanding are increased to include additional shares
from the assumed exercise of stock options and warrants, if dilutive, using the
treasury stock method.  The Company’s computation of diluted net loss
per share for the three and nine months ended September 30, 2009 and 2008 does
not include common share equivalents associated with 876,410 and 812,178
options, respectively, and 407,493 and 424,992 warrants, respectively, and
40,000 unvested restricted shares under a stock award in 2009 as the result
would be anti-dilutive.


- 7
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 Index


Income
Taxes:





At
September 30, 2009, there were no unrecognized tax benefits.  It is
the Company’s policy to classify in the financial statements accrued interest
and penalties attributable to a tax position as income taxes.





Utilization
of CDT's U.S. federal tax loss carryforwards for the period prior to December
12, 1995 is limited as a result of the ownership change in excess of 50%
attributable to the 1995 Fuel-Tech N.V. rights offering to a maximum annual
allowance of $734,500.  Utilization of CDT's U.S. federal tax loss
carryforwards for the period after December 12, 1995 and before December 30,
2006 is limited as a result of the ownership change in excess of 50%
attributable to the private placement which was effective December 29, 2006 to a
maximum annual allowance of $2,518,985.  Utilization of CDT's tax
losses subsequent to 2006 may be limited due to cumulative ownership changes in
any future three-year period.





We file
our tax returns as prescribed by the tax laws of the jurisdictions in which we
operate.  Our tax years ranging from 2006 through 2008 remain open to
examination by various taxing jurisdictions as the statute of limitations has
not expired.





Selling,
General and Administrative Expense:





Selling,
general and administrative expense is summarized as the following:





(in
      thousands)Three
      Months Ended
            
            
            Nine
      Months EndedSeptember
      30,
            
            
            September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Compensation
      and benefits
            
            $
            784
            
            
            $
            1,176
            
            
            $
            2,833
            
            
            $
            3,256Non-cash
      stock-based compensation
            
            
            159
            
            
            
            259
            
            
            
            569
            
            
            
            797Total
      compensation and benefits
            
            
            943
            
            
            
            1,435
            
            
            
            3,402
            
            
            
            4,053Professional
      services
            
            
            127
            
            
            
            215
            
            
            
            545
            
            
            
            1,247
            *Travel
            
            
            78
            
            
            
            183
            
            
            
            266
            
            
            
            548Sales
      and marketing expenses
            
            
            13
            
            
            
            108
            
            
            
            70
            
            
            
            337Rents,
      utilities, property taxes, maintenance
            
            
            75
            
            
            
            103
            
            
            
            295
            
            
            
            302Business
      taxes and insurance
            
            
            40
            
            
            
            1
            
            
            
            200
            
            
            
            193Office
      supplies, postage, dues, seminars
            
            
            22
            
            
            
            62
            
            
            
            77
            
            
            
            173Bad
      debt (recovery) provision
            
            
            (14
            )
            
            
            258
            
            
            
            (148
            )
            
            
            499Depreciation
      and all other
            
            
            40
            
            
            
            38
            
            
            
            130
            
            
            
            95Total
      selling, general and administrative expenses
            
            $
            1,324
            
            
            $
            2,403
            
            
            $
            4,837
            
            
            $
            7,447





*  Professional
      services in the year-to-date 2008 period included $227,000 of non-cash
      stock-based compensation charges for fair value of
    warrants.





Aggregate
non-cash stock-based compensation charges incurred by the Company in the three
and nine months ended September 30, 2009 were $161,000 and $579,000,
respectively, (including $2,000 and $10,000, respectively, in research and
development expenses) and in the three and nine months ended September 30, 2008
were $262,000 and $1,033,000, respectively (including $3,000 and $9,000,
respectively, in research and development expenses) (see Note
6).


- 8
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 Index


Fair
Value of Financial Instruments:





The
Company’s assets carried at fair value on a recurring basis are its investments
(see Note 2).  The investments have been classified within level 3 in
the valuation hierarchy as their valuation requires substantial judgment and
estimation of factors that are not currently observable in the market due to the
lack of trading in the securities.  The valuation may be revised in
future periods as market conditions evolve.





Certain
financial instruments are carried at cost on our condensed consolidated balance
sheets, which approximates fair value due to their short-term, highly liquid
nature.  These instruments include cash and cash equivalents, accounts
receivable, prepaid expenses, accounts payable, customer deposits, accrued
expenses and short-term debt.





Recently
Adopted and Recently Issued Accounting Pronouncements:





In June
2009, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standard (“SFAS”) No. 168, “The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles, a
replacement of FASB Statement No. 162.”  This statement modifies the
Generally Accepted Accounting Principles (“GAAP”) hierarchy by establishing only
two levels of GAAP, authoritative and nonauthoritative accounting
literature.  Effective July 2009, the FASB Accounting Standards
Codification (“ASC”), also known collectively as the “Codification,” is
considered the single source of authoritative U.S. accounting and reporting
standards, except for additional authoritative rules and interpretive releases
issued by the SEC.  The Codification was developed to organize GAAP
pronouncements by topic so that users can more easily access authoritative
accounting guidance.  It is organized by topic, subtopic, section, and
paragraph, each of which is identified by a numerical
designation.  This statement is effective for interim and annual
periods ending after September 15, 2009.  The Company adopted the
Codification for the quarter ended September 30, 2009.  Upon adoption,
this standard had no material effect on the Company’s financial position,
results of operations or cash flows.





Effective
beginning second quarter 2009, the Financial Instruments Topic, ASC 825-10,
requires disclosures about fair value of financial instruments in quarterly
reports as well as in annual reports.  We elected to fair value the
auction rate securities right (see Note 2).





On
January 1, 2009, the Company adopted a new accounting standard issued by the
FASB related to accounting for business combinations which provides revised
guidance on how acquirers recognize and measure the consideration transferred,
identifiable assets acquired, liabilities assumed, noncontrolling interests, and
goodwill acquired in a business combination.  This standard also
expands required disclosures surrounding the nature and financial effects of
business combinations.  This standard will be applied prospectively
for acquisitions beginning in 2009 or thereafter.





On
January 1, 2009, the Company adopted a new accounting standard issued by the
FASB that establishes requirements for ownership interests in subsidiaries held
by parties other than the Company (sometimes called “minority interests”) be
clearly identified, presented, and disclosed in the consolidated statement of
financial position within equity, but separate from the parent’s
equity.  All changes in the parent’s ownership interests are required
to be accounted for consistently as equity transactions and any noncontrolling
equity investments in deconsolidated subsidiaries must be measured initially at
fair value.  Upon adoption, this standard had no material effect on
the Company’s financial position, results of operations or cash
flows.





On
January 1, 2009, the Company adopted a new accounting standard issued by the
FASB that permits delayed adoption of new guidance regarding certain
non-financial assets and liabilities, which are not recognized at fair value on
a recurring basis, until fiscal years and interim periods beginning after
November 15, 2008.  As permitted, the Company elected to delay the
adoption of the new accounting standard for qualifying non-financial assets and
liabilities, such as fixed assets and patents.  This standard had no
material impact on the Company’s financial position, results of operations or
cash flows.


- 9
-
 Index


On
January 1, 2009, the Company adopted a new accounting standard issued by the
FASB that requires enhanced disclosures about an entity's derivative and hedging
activities.  These enhanced disclosures will discuss: (a) how and why
a company uses derivative instruments; (b) how derivative instruments and
related hedged items are accounted for; and (c) how derivative instruments and
related hedged items affect a company’s financial position, results of
operations and cash flows.  This standard had no material impact on
the Company’s financial position, results of operations or cash
flows.





On
January 1, 2009, the Company adopted a new accounting standard that amends the
factors that should be considered in developing renewal or extension assumptions
used to determine the useful life of a recognized intangible
asset.  The intent of the new requirements is to improve the
consistency between the useful life of a recognized intangible asset and the
period of expected cash flows used to measure the fair value of the
asset.  This standard had no material impact on the Company’s
financial position, results of operations or cash flows.





On
January 1, 2009, the Company adopted new requirements related to guidance on
determining what types of instruments or embedded features in an instrument held
by a reporting entity can be considered indexed to its own stock for the purpose
of evaluating the first criteria of the scope exception in accounting standards
about derivatives.  The adoption of these new rules had no material
impact on the Company’s financial position, results of operations or cash
flows.





In April
2009, the FASB issued new accounting guidance related to interim disclosures
about the fair values of financial instruments.  This guidance
requires disclosures about the fair value of financial instruments whenever a
public company issues financial information for interim reporting
periods.  This guidance is effective for the Company’s interim periods
ending after June 15, 2009 consolidated financial statements and will be applied
on a prospective basis.  This accounting guidance was adopted June 30,
2009 and had no material impact on the Company’s financial position, results of
operations or cash flows.





In April
2009, the FASB issued new requirements regarding determining fair value when the
volume and level of activity for the asset or liability have significantly
decreased and identifying transactions that are not orderly.  This
requirement is effective for the Company’s interim and annual periods ending
after June 15, 2009 and will be applied on a prospective basis.  This
rule was adopted June 30, 2009 and had no material impact on the Company’s
financial position, results of operations or cash flows.





In April
2009, the FASB issued new accounting guidance regarding accounting for assets
acquired and liabilities assumed in a business combination that arise from
contingencies.  This guidance applies to all assets acquired and all
liabilities assumed in a business combination that arise from
contingencies.  This guidance states that the acquirer will recognize
such an asset or liability if the acquisition-date fair value of that asset or
liability can be determined during the measurement period.  If the
acquisition date fair value cannot be determined, the acquirer applies the
recognition criteria to determine whether the contingency should be recognized
as of the acquisition date or after it.  This new accounting standard
is effective January 1, 2009 for business combinations
prospectively.





In May
2009, the FASB issued a new accounting standard that establishes general
standards of accounting for and disclosure of events that occur after the
balance sheet date but before financial statements are issued or are available
to be issued.  This new standard sets forth (1) the period after the
balance sheet date during which management of a reporting entity should evaluate
events or transactions that may occur for potential recognition or disclosure in
the financial statements; (2) identifies the circumstances under which an entity
should recognize events or transactions occurring after the balance sheet date
in its financial statements; and (3) the disclosures that an entity should make
about events or transactions that occurred after the balance sheet
date.  This standard provides largely the same guidance on subsequent
events which previously existed only in auditing literature.  This
standard is effective for interim or annual financial periods ending after June
15, 2009.  The Company has performed an evaluation of subsequent
events through November 9, 2009, which is the date the financial statements were
issued.


In June
2009, the FASB issued an amendment of accounting standards that improves the
relevance, representational faithfulness, and comparability of the information
that a reporting entity provides in its financial statements about a transfer of
financial assets; the effects of a transfer on its financial position, financial
performance, and cash flows; and a transferor’s continuing involvement, if any,
in transferred financial assets.  This standard is effective as of the
beginning of each reporting entity’s first annual reporting period that begins
after November 15, 2009, for interim periods within that first annual reporting
period and for interim and annual reporting periods thereafter.  The
Company is evaluating the impact the adoption of this standard will have on its
financial statements.  The Company does not expect its adoption will
have a material impact on the Company’s consolidated financial
statements.


- 10
-
 Index


In June
2009, the FASB issued an amendment to the accounting standards that improves
financial reporting by enterprises involved with variable interest entities and
to address (1) the effects on certain provisions as a result of the elimination
of the qualifying special-purpose entity concept and (2) constituent concerns
about the application of certain key provisions, including those in which the
accounting and disclosures do not always provide timely and useful information
about an enterprise’s involvement in a variable interest entity.  This
standard is effective as of the beginning of each reporting entity’s first
annual reporting period that begins after November 15, 2009, for interim periods
within that first annual reporting period, and for interim and annual reporting
periods thereafter.  The Company is evaluating the impact the adoption
of this standard will have on its financial statements.  The Company
does not expect its adoption will have a material impact on the Company’s
consolidated financial statements.





In August
2009, the FASB issued an amendment to the accounting standards related to the
measurement of liabilities that are recognized or disclosed at fair value on a
recurring basis.  This standard clarifies how a company should measure
the fair value of liabilities and that restrictions preventing the transfer of a
liability should not be considered as a factor in the measurement of liabilities
within the scope of this standard.  This standard is effective for the
Company on October 1, 2009.  The Company does not expect the impact of
its adoption to be material to its consolidated financial
statements.





Note
2.  Investments





The
Company’s investments consist of auction rate securities (“ARS”) and an auction
rate securities right (“ARSR”).  The Company accounts for its ARS
investments based upon accounting standards that provide for determination of
the appropriate classification of investments.  Available-for-sale
securities are carried at fair value, with unrealized holding gains and losses,
net of tax, reported as a separate component of stockholders’
equity.  Trading securities are carried at fair value, with unrealized
holding gains and losses included in other income (expense) on our consolidated
statements of operations.





The
Company’s ARSR investment is accounted for based upon a standard that provides a
fair value option election that allows entities to irrevocably elect fair value
as the initial and subsequent measurement attribute for certain assets and
liabilities.  Changes in fair value are recognized in earnings as they
occur for those assets or liabilities for which the election is
made.  The election is made on an instrument by instrument basis at
initial recognition of an asset or liability or upon an event that gives rise to
a new basis of accounting for that instrument.





The
Company’s investments are reported at fair value in accordance with accounting
standards that accomplish the following key objectives:





·
            Defines
      fair value as the price that would be received to sell an asset or paid to
      transfer a liability in an orderly transaction between market participants
      at the measurement date;


·
            Establishes
      a three-level hierarchy (“valuation hierarchy”) for fair value
      measurements;


·
            Requires
      consideration of the Company’s creditworthiness when valuing liabilities;
      and


·
            Expands
      disclosures about instruments measured at fair
  value.





The
valuation hierarchy is based upon the transparency of inputs to the valuation of
an asset or liability as of the measurement date.  A financial
instrument’s categorization within the valuation hierarchy is based upon the
lowest level of input that is significant to the fair value
measurement.  The three levels of the valuation hierarchy are as
follows:





·
            Level
      1 – inputs to the valuation methodology are quoted prices (unadjusted) for
      identical assets or liabilities in active
  markets.


·
            Level
      2 – inputs to the valuation methodology include quoted prices for similar
      assets and liabilities in active markets, and inputs that are observable
      for the asset or liability, either directly or indirectly, for
      substantially the full term of the financial
  instrument.


·
            Level
      3 – inputs to the valuation methodology are unobservable and significant
      to the fair value measurement.


- 11
-
 Index


The
Company’s investments as of September 30, 2009 and December 31, 2008 have been
classified within level 3 as their valuation requires substantial judgment and
estimation of factors that are not currently observable in the market due to the
lack of trading in the securities.  The fair value of the investments
may be revised in future periods as market conditions
evolve.  Investments are comprised of the following:





(in
      thousands)September 30,
            
            
            December 31,2009
            
            
            2008Auction
      rate securities
            
            $
            10,677
            
            
            $
            10,235Auction
      rate securities right
            
            
            1,048
            
            
            
            1,305Total
      investments
            
            $
            11,725
            
            
            $
            11,540Classified
      as current assets
            
            
            11,725
            
            
            
            6,413Classified
      as non-current assets
            
            $
            ─
            
            
            $
            5,127





Our ARS
are variable-rate debt securities, most of which are AAA/Aaa rated, that are
collateralized by student loans substantially guaranteed by the U.S. Department
of Education.  While the underlying securities have a long-term
nominal maturity, the interest rate is reset through dutch auctions that are
typically held every 28 days. The contractual maturities of our ARS range from
2027 to 2047. Auctions for our ARS have failed since February 2008 resulting in
illiquid investments for the Company.  Our ARS were purchased and held
through UBS.  In October 2008, the Company received an offer (the
“Offer”) from UBS AG for a put right permitting us to sell to UBS at par value
all ARS previously purchased from UBS at a future date (any time during a
two-year period beginning June 30, 2010).  The Offer also included a
commitment to loan us 75% of the UBS-determined value of the ARS at any time
until the put is exercised.  We accepted the Offer on November 6,
2008.  Our right under the Offer is in substance a put option (with
the strike price equal to the par value of the ARS) which we recorded as an
asset, measured at its fair value, with the resultant gain recognized in our
statement of operations.





For the
period through the date the Company accepted the Offer, the Company classified
the ARS as available-for-sale; thereafter, the Company transferred the ARS to
the trading category.





The fair
value of the ARS was approximately $10.7 million (par value of $11.7 million) at
September 30, 2009 and $10.2 million at December 31, 2008.  We sold
$7.1 million of these investments in 2008.  The fair value of the ARS
was determined utilizing a discounted cash flow approach and market evidence
with respect to the ARS’s collateral, ratings and insurance to assess default
risk, credit spread risk and downgrade risk.  The Company also
recorded the ARSR at an initial fair value of $1.3 million.  The fair
value of the ARSR was based on an approach in which the present value of all
expected future cash flows were subtracted from the current fair market value of
the securities and the resultant value was calculated as a future value at an
interest rate reflective of counterparty risk.  In the three and nine
months ended September 30, 2009, we recorded a gain of $31,000 and $441,000,
respectively, on the ARS and a loss of $7,000 and $256,000, respectively, on the
ARSR, resulting in a $24,000 and $185,000 net gain, respectively, included in
other income (expense) on our condensed consolidated statements of
operations.





Classification
of investments as current or non-current is dependent upon management’s intended
holding period, the security’s maturity date and liquidity considerations based
on market conditions.  At September 30, 2009, the Company classified
all investments as current based on management’s intention and ability to
liquidate the investments by June 30, 2010.  At December 31, 2008, the
Company classified $6.4 million of the investments as current based on
management’s intention to use such securities as consideration if UBS demands
payment on its loan prior to the date the Company exercises the
ARSR.





The
Company will be exposed to credit risk should UBS be unable to fulfill its
commitment under the Offer.  There can be no assurance that the
financial position of UBS will be such as to afford the Company the ability to
acquire the par value of its ARS upon exercise of the ARSR.





Interest
income for the three months ended September 30, 2009 and 2008 was approximately
$46,000 and $125,000, respectively, and for the nine-month periods then ended
was approximately $187,000 and $481,000, respectively.  Accrued
interest receivable at September 30, 2009 and December 31, 2008 was
approximately $4,000 and $11,000, respectively.


- 12
-
 Index




Note
3.  Inventories





Inventories
are stated at the lower of cost or market with cost determined using the average
cost method.  Inventories consist of the following:





(in
      thousands)September 30,
            
            
            December 31,2009
            
            
            2008Finished
      Platinum Plus fuel-borne catalyst
            
            $
            129
            
            
            $
            144Platinum
      concentrate/metal
            
            
            426
            
            
            
            578Hardware
            
            
            388
            
            
            
            268Other
            
            
            9
            
            
            
            6$
            952
            
            
            $
            996Less:
      inventory reserves
            
            
            (51
            )
            
            
            (22
            )Inventories,
      net
            
            $
            901
            
            
            $
            974





Note
4.  Short-term Debt





On July
25, 2008, the Company borrowed $3.0 million from the demand loan facility with
UBS collateralized by our ARS, a facility we had arranged in May
2008.  Management determined to draw down the entire facility as a
matter of financial prudence to secure available cash.  The loan
facility was available for our working capital purposes and required that we
continue to meet certain collateral maintenance requirements, such that our
outstanding borrowings could not exceed 50% of the value of our ARS as
determined by the lender.  No facility fee was
required.  Borrowings bore interest at a floating interest rate per
annum equal to the sum of the prevailing daily 30-day Libor plus 25 basis
points.





In
November 2008, the Company accepted the Offer from UBS AG (see Note
2).  UBS committed to loan us 75% of the value of the ARS as
determined by UBS at any time until the ARSR is exercised.  We applied
for the loan which UBS committed would be on a no net cost basis to the
Company.  UBS approved our credit application on January 14, 2009 and
approved a $6.5 million credit facility pursuant to its Offer.  In
January 2009, we received $3.5 million proceeds from UBS under the approved no
net cost loan.  On September 4, 2009, we arranged an increase of the
credit line to $7.7 million and received $1.3 million proceeds from
UBS.  The outstanding balance of the short-term debt at September 30,
2009 was $7,697,000.





Our ARS
serve as collateral for the loan which is payable upon demand.  If UBS
should demand repayment prior to the commencement of the exercise period for our
ARSR (June 30, 2010), UBS will arrange alternative financing with substantially
the same terms and conditions.  If alternative financing cannot be
established, UBS will purchase our pledged ARS at par value.  Interest
is calculated at the weighted average rate of interest we earn on the
ARS.  Interest is payable monthly.  Interest expense for the
three and nine months ended September 30, 2009 was approximately $25,000 and
$57,000, respectively, and for each of the three and nine months ended September
30, 2008 was approximately $14,000.  Accrued interest payable at
September 30, 2009 was approximately $3,000.





Note
5.  Stockholders’ Equity





In March
2009, we issued 40,000 restricted shares of our common stock under our Incentive
Plan (see Note 6).





In the
first nine months of 2009, 17,499 of the Company’s warrants expired
(weighted-average exercise price of $7.50).  At September 30, 2009,
the Company had 407,493 warrants outstanding, exercisable at a weighted-average
exercise price of $11.51 with a weighted-average remaining life of 2.7
years.  There was no activity in the Company's outstanding warrants
during the nine months ended September 30, 2008.





In the
first nine months of 2008, we issued 15,246 shares of our common stock upon the
exercise of 27,166 stock options.  In connection therewith, we
received approximately $24,000 in cash and the surrender of 12,920 stock options
(see Note 6).





Note
6.  Stock-Based Compensation





The
Company maintains a stock award plan approved by its stockholders, the Incentive
Plan (the “Plan”).  Under the Plan, awards may be granted to
participants in the form of incentive stock options, non-qualified stock
options, stock appreciation rights, restricted stock, performance awards,
bonuses or other forms of share-based awards or cash, or combinations of these
as determined by the board of directors.  Awards are granted at fair
market value on the date of grant and typically expire ten years after date of
grant.  Participants in the Plan may include the Company’s directors,
officers, employees, consultants and advisors (except consultants or advisors in
capital-raising transactions) as the board of directors may
determine.  The maximum number of awards allowed under the Plan is
17.5% of the Company’s outstanding common stock less the then outstanding
awards, subject to sufficient authorized shares.


- 13
-
 Index


Share-based
compensation cost recognized under ASC 718 was approximately $161,000 and
$262,000 for the three months ended September 30, 2009 and 2008, respectively,
and $579,000 and $1,033,000 for the nine months ended September 30, 2009 and
2008, respectively.  Of such 2009 nine-month total, $569,000 is
classified in selling, general and administrative expenses and $10,000 in
research and development expenses, and of such 2008 nine-month total, $1,024,000
is classified in selling, general and administrative expenses ($797,000 as
employee compensation and $227,000 as investor relations compensation for
advisory services) and $9,000 is included in research and development
expenses.  Compensation costs for stock options which vest over time
are recognized over the vesting period.  As of September 30, 2009,
there was approximately $0.3 million of unrecognized compensation cost related
to stock options granted under the Plan.  The cost is expected to be
recognized over a weighted-average period of 0.6 years.





The
following table summarizes information concerning stock options outstanding
including the related transactions under the Plan for the nine months ended
September 30, 2009:





Number
      of Shares*
            
            
            Weighted-
      Average Exercise Price
            
            
            Weighted-Average
      Remaining Contractual Term in
      Years
            
            
            Aggregate
      Intrinsic ValueOptions
      Outstanding as of December 31, 2008
            
            
            972,578
            
            
            $
            11.72Granted
            
            
            
            
            
            $
            Exercised
            
            
            
            
            
            $
            Forfeited
            
            
            (71,668
            )
            
            $
            9.60Expired
            
            
            (24,500
            )
            
            $
            4.50Options
      outstanding as of September 30, 2009
            
            
            876,410
            
            
            $
            10.40
            
            
            
            4.2
            
            
            $
            Options
      exercisable as of September 30, 2009
            
            
            791,410
            
            
            $
            10.78
            
            
            
            3.7
            
            
            $
            





*  Table
does not include 40,000 shares issued in 2009 as a stock award under the
Plan.





The
aggregate intrinsic value (market value of stock less option exercise price) in
the preceding table represents the total pretax intrinsic value, based on the
Company’s closing stock price on September 30, 2009, which would have been
received by the holders had all holders of awards and options in the money
exercised their options as of that date.




No stock
options were exercised in the nine months ended September 30,
2009.  For the nine months ended September 30, 2008, proceeds received
from the exercise of stock options were approximately $24,000 and were included
in financing activities on the Company’s condensed consolidated statements of
cash flows.  In addition, for the nine months ended September 30,
2008, 12,920 shares were surrendered upon the exercise of options to fund the
purchase.  The total intrinsic value of stock options exercised for
the nine months ended September 30, 2008 was $288,000.





In 2009,
the board of directors awarded 40,000 shares to the newly-elected Chief
Executive Officer at an average market price of $1.625 per share, representing
the high and low market price on the date of award, March 30,
2009.  These shares vest as to one-third of the total on each of
February 10, 2010, 2011 and 2012.  The total fair value of the award
was $65,000 which is being charged to expense over the vesting
period.


- 14
-
 Index


During
the nine months ended September 30, 2008, the board of directors granted 28,000
option shares to employees at a weighted average exercise price of $13.36 per
share.  These options vest as to one-third, immediately upon grant and
as to one-third, upon each of the first and second anniversaries of
grant.  The weighted-average fair value at the date of grant for
options granted during the nine months ended September 30, 2008 was $10.31 per
share and was estimated using the Black-Scholes option pricing model with the
following weighted-average assumptions:





Expected
      term in years
            8.63Risk-free
      interest rate
            3.69%Expected
      volatility
            92.4%Dividend
      yield
            0%





The
Company estimates the fair value of stock options using a Black-Scholes option
pricing model.  Key input assumptions used to estimate the fair value
of stock options include the expected term, expected volatility of the Company’s
stock, the risk free interest rate, option forfeiture rates, and dividends, if
any.  The expected term of the options is based upon the historical
term until exercise or expiration of all granted options.  The
expected volatility is derived from the historical volatility of the Company’s
stock on the U.S. NASDAQ Capital Market (the Over-the-Counter market prior to
October 3, 2007) for a period that matches the expected term of the
option.  The risk-free interest rate is the constant maturity rate
published by the U.S. Federal Reserve Board that corresponds to the expected
term of the option.  ASC 718 requires forfeitures to be estimated at
the time of grant in order to estimate the amount of share-based awards that
will ultimately vest.  The estimate is based on the Company’s
historical rates of forfeitures.  ASC 718 also requires estimated
forfeitures to be revised, if necessary, in subsequent periods if actual
forfeitures differ from those estimates.  The dividend yield is
assumed as 0% because the Company has not paid dividends and does not expect to
pay dividends in the future.





Note
7.  Commitments





The
Company was obligated under a five-year sublease agreement through March 31,
2009 for its principal office (3,925 square feet) at an annual cost of
approximately $128,000, including utilities and parking.  The Company
is obligated under a seven-year lease expiring December 2015 for its relocated
U.S. headquarters at 10 Middle Street, Bridgeport, Connecticut (5,515 square
feet) at an annual cost of approximately $141,000, including
utilities.  We have a lease for 1,942 square feet of office space
outside London, U.K. through March 2013 at an annual cost of approximately
$65,000, including utilities and parking.  We also lease 2,750 square
feet of warehouse space in Milford, Connecticut at an annual cost of
approximately $21,000 (including utilities) through July 2009.  We
have arranged to rent the warehouse facility on a month to month basis after
July 2009 as we explore alternative solutions with the intent to reduce our
warehousing costs.





Effective
October 28, 1994, Fuel Tech, Inc., successor to Fuel-Tech N.V. (“Fuel Tech”),
the company that spun CDT off in a rights offering in December 1995, granted two
licenses to the Company for all patents and rights associated with its platinum
fuel-based catalyst technology.  Effective November 24, 1997, the
licenses were canceled and Fuel Tech assigned to CDT all such patents and rights
on terms substantially similar to the licenses.  In exchange for the
assignment commencing in 1998, the Company was obligated to pay Fuel Tech a
royalty of 2.5% of its annual gross revenue attributable to sales of the
platinum fuel-borne catalysts.  The royalty obligation expired in
December 2008.  CDT, as assignee and owner, maintains the technology
at its expense.  Royalty expense incurred under this obligation for
the three months and nine months ended September 30, 2008 was approximately
$5,000 and $14,000, respectively.  Royalties payable to Fuel Tech at
December 31, 2008 were $20,700.





Note
8.  Related Party Transactions





The
Company terminated its Management and Services Agreement with Fuel Tech
effective February 1, 2009.  That agreement required the Company to
reimburse Fuel Tech for management, services and administrative expenses
incurred on the Company’s behalf at a rate equal to an additional 3% to 10% of
the costs paid on the Company’s behalf, dependent upon the nature of the costs
incurred.  In 2008 and until the termination in 2009, the Company
reimbursed Fuel Tech for the expenses associated with one Fuel Tech
officer/director who also serves as an officer/director of CDT.  This
CDT officer/director became a part-time employee of the Company on February 1,
2009.  The Company’s condensed consolidated statements of operations
include charges from Fuel Tech of certain management and administrative costs of
$0 and $18,000, respectively, in the three-month periods ended September 30,
2009 and 2008 and approximately $6,000 and $53,000, respectively, in the nine
months ended September 30, 2009 and 2008.


- 15
-
 Index


Note
9.  Significant Customers





For the
three and nine months ended September 30, 2009 and 2008, revenue derived from
certain customers comprised 10% or more of our consolidated revenue
(“significant customers”) as set forth in the table below:





Three
      Months Ended
              September
      30,
            
            
            Nine
      Months Ended
              September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Customer
      A
            
            *
            
            
            *
            
            
            13.6%
            
            
            *Customer
      B
            
            20.0%
            
            
            *
            
            
            11.5%
            
            
            *Customer
      C
            
            *
            
            
            *
            
            
            10.4%
            
            
            *Customer
      D
            
            11.6%
            
            
            *
            
            
            *
            
            
            *Customer
      E
            
            *
            
            
            16.4%
            
            
            *
            
            
            15.6%





*
            Represents less than 10% revenue
      for that customer in the applicable period.  There were no other
      customers that represented 10% or more of revenue for the periods
      indicated.





At
September 30, 2009, Clean Diesel had one customer (such customers is not
included in the table above) that represented approximately 30.2% of its gross
accounts receivable balance.





Note
10.  Comprehensive Loss





Components
of comprehensive loss follow:





(in
      thousands)Three
      Months Ended
            
            
            Nine
      Months EndedSeptember
      30,
            
            
            September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Net
      loss
            
            $
            (1,900
            )
            
            $
            (2,381
            )
            
            $
            (5,449
            )
            
            $
            (6,114
            )Other
      comprehensive income (loss):Foreign
      currency translation adjustment
            
            
            (64
            )
            
            
            (180
            )
            
            
            (20
            )
            
            
            (159
            )Unrealized
      loss on available- for-sale securities
            
            ─
            
            
            ─
            
            
            ─
            
            
            
            (750
            )Comprehensive
      loss
            
            $
            (1,964
            )
            
            $
            (2,561
            )
            
            $
            (5,469
            )
            
            $
            (7,023
            )





Note
11.  Geographic Information





CDT sells
its products and licenses its technologies throughout the world.  A
geographic distribution of revenue consists of the following:





(in
      thousands)Three
      Months Ended
              September
      30,
            
            
            Nine
      Months Ended
              September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Revenue:U.S.
            
            $
            111
            
            
            $
            271
            
            
            $
            489
            
            
            $
            673U.K./Europe
            
            
            91
            
            
            
            1,282
            
            
            
            374
            
            
            
            6,032Asia
            
            
            51
            
            
            
            27
            
            
            
            111
            
            
            
            95Total
            
            $
            253
            
            
            $
            1,580
            
            
            $
            974
            
            
            $
            6,800


- 16
-
 Index


The
Company has patent coverage in North and South America, Europe, Asia, Africa and
Australia.  As of September 30, 2009 and December 31, 2008, the
Company’s assets comprise the following:





(in
      thousands)September
      30,
            
            
            December
      31,2009
            
            
            2008U.S.
            
            $
            17,294
            
            
            $
            17,214Foreign
            
            
            1,288
            
            
            
            1,533Total
      assets
            
            $
            18,582
            
            
            $
            18,747





Note
12.  Severance Charges





During
the first quarter we incurred severance charges totaling $510,000 to be paid in
monthly installments until September 2010.  On February 10, 2009, the
Company’s Board of Directors elected Michael L. Asmussen, 38, as President and
Chief Executive Officer replacing Dr. Bernhard Steiner.  Mr. Asmussen
was also appointed to serve as a Director of the Company.  Effective
February 11, 2009, Dr. Steiner resigned as a Director of the
Company.  As a consequence of his termination of employment, Dr.
Steiner is entitled to salary of approximately $315,445 (EUR 241,500) per annum
until September 13, 2010, the remainder of his contract term, along with
specified expenses not to exceed an aggregate of approximately $4,300, to be
paid in monthly installments.





On August
4, 2009, the Board of Directors adopted a plan to implement a company-wide
reduction in force effective August 7, 2009.  In accordance with ASC
420, Exit or Disposal Cost Obligations, we recognized approximately $448,000 in
severance charges in the third quarter of 2009.





A summary
of the activity in the severance accrual is as follows:





(in
      thousands)Balance
      at December 31, 2008
            
            $
            Provisions
            
            
            958Payments
            
            
            413Balance
      at September 30, 2009
            
            $
            545





Note
13.  Subsequent Events





On
October 1, 2009, CDT directors, Michael Asmussen and Derek Gray, purchased
10,000 shares and 25,684 shares, respectively, of Clean Diesel common
stock.  Total shares acquired were 35,684 and total proceeds based on
the October 1, 2009 Nasdaq closing price of $1.65, were
$58,878.60.  The proceeds will be used for the general corporate
purposes of the Company.


The
shares are restricted shares issued pursuant to an exemption from registration
under Regulation D of the Securities Act of 1933, as amended.


- 17
-
 Index


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





Forward-Looking
Statements





Statements
in this Quarterly Report on Form 10-Q that are not historical facts, so-called
“forward-looking statements,” are made pursuant to the safe harbor provisions of
the Private Securities Litigation Reform Act of 1995.  Investors are
cautioned that all forward-looking statements involve risks and uncertainties,
including those detailed in the Company’s filings with the Securities and
Exchange Commission.  See Item 1A, “Risk Factors,” and Item 7,
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” in the Company’s Annual Report on Form 10-K for the year ended
December 31, 2008.





Results
of Operations





Three
Months ended September 30, 2009 Compared to Three Months ended September 30,
2008





Total
revenue in the three months ended September 30, 2009 was $253,000 compared to
$1,580,000 in the three months ended September 30, 2008, a decrease of
$1,327,000, or 84.0%, reflecting declines in product sales as well as licensing
fees and royalties.  Of our operating revenue for the three months
ended September 30, 2009, approximately 88.9% was from product sales and 11.1%
was from technology licensing fees and royalties.  Of our operating
revenue for the three months ended September 30, 2008, approximately 89.6% was
from product sales and 10.4% was from technology licensing fees and
royalties.  The mix of our revenue sources during any reporting period
may have a material impact on our operating results.  In particular,
our execution of technology licensing agreements, and the timing of the revenue
recognized from these agreements, has not been predictable.





Product
sales were $225,000 in the third quarter of 2009 compared to $1,415,000 in the
same 2008 quarter, a decrease of $1,190,000.  The decrease in product
sales was attributable primarily to lower demand for our Platinum Plus Purifier
Systems, a product comprised of a diesel particulate filter along with our
Platinum Plus fuel-borne catalyst, for compliance with the requirements of the
London Low Emission Zone.  We received approval in October 2007 from
Transport for London to supply our Purifier Systems as an emission reduction
solution that meets the standards established for the London Low Emission
Zone.  The deadlines for compliance with the London Low Emission Zone
will be phased in over time for different classifications of
vehicles.  February 2008 was the compliance deadline for vehicles
greater than 12 metric tons and July 2008 was the compliance deadline for motor
coaches and vehicles greater than 3.5 metric tons.  The next
compliance deadlines for the London Low Emission Zone are in 2010 and 2012,
although the Mayor of London has proposed suspension of the 2010
deadline.  The sales of our Purifier Systems for compliance with the
requirements of the London Low Emission Zone provide us with recurring revenue
from use of our Platinum Plus fuel-borne catalyst that enables the regeneration
of the diesel particulate filter.  We believe we will have the
opportunity to expand this business opportunity as additional low emission zones
are established throughout Europe and elsewhere.





Our
technology licensing fees and royalties were $28,000 in the three months ended
September 30, 2009 compared to $165,000 in the same quarter of 2008 and were
primarily attributable to royalties related to our ARIS®
technologies.  We have not executed new technology licensing
agreements in 2009.  We are continuing our efforts to consummate
technology license agreements with manufacturers and component suppliers for the
use of our ARIS technologies for control of oxides of nitrogen (NOx) using our
selective catalytic reduction (SCR) emission control, the combination of exhaust
gas recirculation (EGR) with SCR technologies, and hydrocarbon injection for
lean NOx traps, NOx catalysts and diesel particulate filter
regeneration.





Our total
cost of revenue was $217,000 in the three-month period ended September 30, 2009
compared to $1,174,000 in the three-month period ended September 30,
2008.  The decrease in our cost of sales is due to lower product sales
volume.  Our gross profit as a percentage of revenue was 14.2% and
25.7% for the three-month periods ended September 30, 2009 and 2008,
respectively, with the decrease primarily attributable to adjustment of
inventories to reflect realizable value.





Our cost
of revenue – product sales includes the costs we incur to formulate our finished
products into saleable form for our customers, including material costs, labor
and processing costs charged to us by our outsourced blenders, installers and
other vendors, packaging costs incurred by our outsourced suppliers, freight
costs to customers and inbound freight charges from our
suppliers.  Our inventory is primarily maintained off-site by our
outsourced suppliers.  To date, our purchasing, receiving, inspection
and internal transfer costs have been insignificant and have been included in
cost of revenue – product sales.  In addition, the costs of our
warehouse of approximately $21,000 per year are included in selling, general and
administrative expenses.  Our gross margins may not be comparable to
those of other entities, because some entities include all of the costs related
to their distribution network in cost of revenue and others like us exclude a
portion of such costs from gross margin, including such costs instead within
operating expenses.  Cost of revenue – licensing fees and royalties is
zero as there are no incremental costs associated with the
revenue.


- 18
-
 Index


Selling,
general and administrative expenses were $1,324,000 in the three months ended
September 30, 2009 compared to $2,403,000 in the comparable 2008 period, a
decrease of $1,079,000, or 44.9%.  The decrease in selling, general
and administrative costs is primarily attributable to lower compensation and
benefits, travel, professional services and bad debts.  Our cost
control initiatives to strictly control spending are ongoing and certain
improvements are apparent in our current operating costs.  Selling,
general and administrative expenses are summarized as follows:





(in
      thousands)Three
      Months EndedSeptember
      30,2009
            
            
            2008Compensation
      and benefits
            
            $
            784
            
            
            $
            1,176Non-cash
      stock-based compensation
            
            
            159
            
            
            
            259Total
      compensation and benefits
            
            
            943
            
            
            
            1,435Professional
      services
            
            
            127
            
            
            
            215Travel
            
            
            78
            
            
            
            183Sales
      and marketing expenses
            
            
            13
            
            
            
            108Rents,
      utilities, property taxes, maintenance
            
            
            75
            
            
            
            103Business
      taxes and insurance
            
            
            40
            
            
            
            1Office
      supplies, postage, dues, seminars
            
            
            22
            
            
            
            62Bad
      debt (recovery) provision
            
            
            (14
            )
            
            
            258Depreciation
      and all other
            
            
            40
            
            
            
            38Total
      selling, general and administrative expenses
            
            $
            1,324
            
            
            $
            2,403





Aggregate
non-cash charges for the fair value of stock options and warrants in the three
months ended September 30, 2009 were $161,000, of which $159,000 has been
included in selling, general and administrative expenses and $2,000 in research
and development expenses.  This compares to $262,000 in non-cash stock
option compensation expense in the three months ended September 30, 2008 (of
which $259,000 has been included in selling, general and administrative expenses
and $3,000 in research and development expenses).





Excluding
the non-cash stock-based charges, compensation and benefit expenses were
$784,000 for the three months ended September 30, 2009 compared to $1,176,000 in
the comparable prior year period, a decrease of $392,000, or 33.3%, due
primarily to the reduction in force implemented effective August 7,
2009.





On August
4, 2009, the Board of Directors adopted a plan to implement a company-wide
restructuring effective August 7, 2009.  We incurred severance charges
totaling $448,000 in the third quarter related to the reduction of approximately
44% of the company’s workforce.  In addition, non-executive members of
the Company’s Board of Directors agreed to receive 50% of their annual
compensation for the second half of 2009, totaling $41,250.





Bad debt
(recovery) provision decreased $272,000, or 105.4%, to a recovery of ($14,000)
in 2009 compared to a provision of $258,000 in the prior year.  Bad
debt as a percentage of product sales was (6.2%) in the three months ended
September 30, 2009 compared to 18.2% in the same period of 2008.





Research
and development expenses were $128,000 in the three months ended September 30,
2009 compared to $162,000 in the three months ended September 30, 2008, a
decrease of $34,000, or 21.0%.  Presently, we are working to overcome
gaps in our technology and product portfolios brought about by volatile markets
and past development setbacks.  In addition to development of new
products, our 2009 projects include field testing of fuel economy and emission
control technologies.  Research and development expenses for the three
months ended September 30, 2009 and 2008, respectively, include $2,000 and
$3,000 of non-cash charges for the fair value of stock options.


- 19
-
 Index


Patent
amortization and other patent expenses were $56,000 in the three months ended
September 30, 2009 compared to $65,000 in the same period in 2008, a decline of
$9,000 (13.8%).





Interest
income was $46,000 in the three months ended September 30, 2009 compared to
$125,000 in the three months ended September 30, 2008, a decrease of $79,000, or
63.2%, due to lower rates of return and lower invested balances.





Other
income (expense) was ($26,000) in the three months ended September 30, 2009
compared to ($282,000) in the comparable 2008 period, which 2008 amount was
primarily attributable to foreign currency transaction losses, net of
gains.  The 2009 other income (expense) includes foreign currency
transaction losses, net of gains of ($24,000), interest expense of ($25,000) and
gain, net on the fair value of investments of $24,000.





Nine
months ended September 30, 2009 Compared to Nine months ended September 30,
2008





Total
revenue for the nine months ended September 30, 2009 was $974,000 compared to
$6,800,000 in the first nine months of 2008, a decrease of $5,826,000, or 85.7%,
reflecting declines in product sales as well as licensing fees and
royalties.  Operating revenue in the nine months ended September 30,
2009 consisted of approximately 90.2% in product sales and 9.8% in technology
licensing fees and royalties.  Operating revenue in the nine months
ended September 30, 2008 consisted of approximately 94.6% in product sales and
5.4% in technology licensing fees and royalties.  The mix of our
revenue sources during any reporting period may have a material impact on our
operating results.  In particular, our execution of technology
licensing agreements, and the timing of the revenue recognized from these
agreements, has not been predictable.





Product
sales in the nine months ended September 30, 2009 were $879,000 compared to
$6,432,000 in the same prior year period, a decrease of $5,553,000, or
86.3%.  The decrease in product sales was attributable primarily to
lower demand for our Platinum Plus Purifier Systems, a product comprised of a
diesel particulate filter along with our Platinum Plus fuel-borne catalyst, for
compliance with the requirements of the London Low Emission Zone.  We
received approval in October 2007 from Transport for London to supply our
Purifier Systems as an emission reduction solution that meets the standards
established for the London Low Emission Zone.  The deadlines for
compliance with the London Low Emission Zone will be phased in over time for
different classifications of vehicles.  February 2008 was the
compliance deadline for vehicles greater than 12 metric tons and July 2008 was
the compliance deadline for motor coaches and vehicles greater than 3.5 metric
tons.  The next compliance deadlines for the London Low Emission Zone
are in 2010 and 2012, although the Mayor of London has proposed suspension of
the 2010 deadline.  The sales of our Purifier Systems for compliance
with the requirements of the London Low Emission Zone provide us with recurring
revenue from use of our Platinum Plus fuel-borne catalyst that enables the
regeneration of the diesel particulate filter.  We believe we will
have the opportunity to expand this business opportunity as additional low
emission zones are established throughout Europe and elsewhere.





Technology
licensing fees and royalties were $95,000 in the nine months ended September 30,
2009 compared to $368,000 in the same 2008 period, a decrease of $273,000, or
74.2%.  Technology licensing fees and royalties included fees upon
execution of new agreements and royalties from existing licensees, primarily for
use of our ARIS technologies.  We did not execute new technology
licensing agreements in 2009.  During the nine months ended September
30, 2008, we executed new technology licensing agreements with Headway Machinery
Co., Ltd. (Zhucheng City, China) and Hilite International, Inc. (Cleveland,
Ohio) and recognized revenue from license fees.  The Hilite license
provides for their use of our ARIS technologies for control of oxides of
nitrogen (NOx) using our selective catalytic reduction (SCR) emission control,
the combination of exhaust gas recirculation (EGR) with SCR technologies, and
hydrocarbon injection for lean NOx traps, NOx catalysts and diesel particulate
filter regeneration.  Pursuant to the Headway license, pending
finalization of regulatory mandates and successful completion of product
testing, we intend to supply our wire mesh filters along with Platinum Plus
fuel-borne catalyst to the supplier after the supplier completes initial
testing, which testing had been anticipated to be concluded late in 2008 but has
not yet been completed.  We are continuing our efforts to consummate
technology license agreements with manufacturers and component
suppliers.





Our total
cost of revenue was $668,000 in the nine-month period ended September 30, 2009
compared to $5,232,000 in the nine-month period ended September 30,
2008.  The decrease in our cost of sales is due to lower product sales
volume.  Our gross profit as a percentage of revenue was 31.4% and
23.1% for the nine-month periods ended September 30, 2009 and 2008,
respectively, with the increase attributable to the mix of higher margin product
sales.


- 20
-
 Index


Our cost
of revenue – product sales includes the costs we incur to formulate our finished
products into saleable form for our customers, including material costs, labor
and processing costs charged to us by our outsourced blenders, installers and
other vendors, packaging costs incurred by our outsourced suppliers, freight
costs to customers and inbound freight charges from our
suppliers.  Our inventory is primarily maintained off-site by our
outsourced suppliers.  To date, our purchasing, receiving, inspection
and internal transfer costs have been insignificant and have been included in
cost of revenue – product sales.  In addition, the costs of our
warehouse of approximately $21,000 per year are included in selling, general and
administrative expenses.  Our gross margins may not be comparable to
those of other entities, because some entities include all of the costs related
to their distribution network in cost of revenue and others like us exclude a
portion of such costs from gross margin, including such costs instead within
operating expenses.  Cost of revenue – licensing fees and royalties is
zero as there are no incremental costs associated with the revenue.





Selling,
general and administrative expenses were $4,837,000 in the nine months ended
September 30, 2009 compared to $7,447,000 in the same 2008 period, a decrease of
$2,610,000, or 35.0%.  The decrease in selling, general and
administrative costs is primarily attributable to lower professional services,
particularly investor relations and financial advisory services, lower
compensation and benefits, travel, marketing and bad debts.  We are
making a concerted effort in 2009 to contain our costs and eliminate those costs
that are redundant or deemed unnecessary.  Selling, general and
administrative expenses are summarized as follows:





(in
      thousands)Nine
      Months EndedSeptember
      30,2009
            
            
            2008Compensation
      and benefits
            
            $
            2,833
            
            
            $
            3,256Non-cash
      stock-based compensation
            
            
            569
            
            
            
            797Total
      compensation and benefits
            
            
            3,402
            
            
            
            4,053Professional
      services
            
            
            545
            
            
            
            1,247
            *Travel
            
            
            266
            
            
            
            548Sales
      and marketing expenses
            
            
            70
            
            
            
            337Rents,
      utilities, property taxes, maintenance
            
            
            295
            
            
            
            302Business
      taxes and insurance
            
            
            200
            
            
            
            193Office
      supplies, postage, dues, seminars
            
            
            77
            
            
            
            173Bad
      debt (recovery) provision
            
            
            (148
            )
            
            
            499Depreciation
      and all other
            
            
            130
            
            
            
            95Total
      selling, general and administrative expenses
            
            $
            4,837
            
            
            $
            7,447





*  Includes
$227,000 of non-cash stock-based compensation charges for fair value of
warrants.





The
Company’s aggregate non-cash charges for the fair value of stock options and
warrants in the nine months ended September 30, 2009 were $579,000, of which
$569,000 has been included in selling, general and administrative expenses and
$10,000 in research and development expenses.  This compares to
$1,033,000 in total non-cash stock-based compensation expense in the nine months
ended September 30, 2008 ($797,000 in compensation, $227,000 in professional and
$9,000 in research and development expenses).





Excluding
the non-cash stock-based charges, compensation and benefit expenses were
$2,833,000 for the nine months ended September 30, 2009 compared to $3,256,000
in the comparable prior year period, a decrease of $423,000, or 13.0%, primarily
due to a reduction in workforce.





On August
4, 2009, the Board of Directors adopted a plan to implement a company-wide
restructuring effective August 7, 2009.  We incurred severance charges
totaling $448,000 in the third quarter related to the reduction of approximately
44% of the company’s workforce.  In addition, non-executive members of
the Company’s Board of Directors agreed to receive 50% of their annual
compensation for the second half of 2009, totaling $41,250.  Total
severance charges in the nine months ended September 30, 2009 were $958,000,
comprised of the third quarter charge of $448,000 and a first quarter charge of
$510,000.  On February 10, 2009, the Company’s Board of Directors
elected Michael L. Asmussen, 38, as President and Chief Executive Officer
replacing Dr. Bernhard Steiner.  Mr. Asmussen was also appointed to
serve as a Director of the Company.  Effective February 11, 2009, Dr.
Steiner resigned as a Director of the Company.  As a consequence of
his termination of employment, Dr. Steiner is entitled to salary of
approximately $315,445 (EUR 241,500) per annum until September 13, 2010, the
remainder of his contract term, along with specified expenses not to exceed an
aggregate of approximately $4,300, together totaling $510,000, to be paid in
monthly installments until September 2010.


- 21
-
 Index


We have
restructured the Company so that each employee will manage resources based upon
data-driven revenue expectations.  As such, new processes are being
established to ensure organizational and individual discipline and
accountability.





Professional
fees include audit-related costs, investor relations and financial advisory
fees.  In addition to curtailment of outside agency use, a significant
component of the decrease in professional fees is attributable to stock-based
compensation charges for the fair value of warrants issued for investor
relations services.  Included in 2008 professional costs is a $227,000
non-cash compensation expense for stock warrants issued for financial advisory
services which represented the remaining stock-based amount that was amortized
over the period that services were rendered.





Bad debt
(recovery) provision decreased $647,000, or 192.0%, reflecting a recovery of
($148,000) in 2009 compared to a provision of $499,000 in the prior
year.  Bad debt as a percentage of product sales was (16.8%) in the
nine months ended September 30, 2009 compared to 7.8% in the same period of
2008.





We
relocated our U.S. corporate offices in January 2009 and incurred rent expense
on both our old and new U.S. headquarters due to the timing of our relocation
and expiration of the old lease.





Research
and development expenses were $314,000 in the nine months ended September 30,
2009 compared to $316,000 in the nine months ended September 30,
2008.  Our work for the California Showcase is ongoing along with
certain supplemental environmental programs sponsored by California Air
Resources Board (“CARB”).  Presently, we are working to overcome gaps
in our technology and product portfolios brought about by volatile markets and
past development setbacks.  In addition to development of new
products, our 2009 projects include field testing of fuel economy and emission
control technologies.  The 2008 projects included laboratory testing
on additive formulations.  Research and development expenses in the
nine months ended September 30, 2009 and 2008 include $10,000 and $9,000,
respectively, of non-cash charges for the fair value of stock options
granted.





It is an
essential requirement of the U.S. retrofit market that emissions control
products and systems are verified under the U.S. EPA and/or CARB protocols in
order to qualify for funding within the EPA and/or CARB programs.  As
promptly as possible, we intend to verify our Platinum Plus fuel-borne catalyst
in combination with a high performance diesel particulate filter under the CARB
protocol.  We have no assurance that our product will be verified by
CARB or that such a verification will be acceptable to the EPA.





We
believe that the lack of CARB verification will result in a shift of expected
U.S. retrofit revenue into future periods and that increased sales of our
Platinum Plus fuel-borne catalyst into several off-road market segments will
potentially offset some of that expected shortfall from the CARB verification
delay.  We do not expect to have full CARB verification in 2009 but
once our application has been accepted by CARB, we will have the opportunity to
be included on the U.S. Environmental Protection Agency (EPA) Emerging
Technologies list which would allow us to access funding within the EPA and/or
CARB programs.





Without
full CARB verification, our U.S. retrofit opportunities are limited although
certain jurisdictions have been satisfied with other of our
certifications.  We received the EPA registration in December 1999 for
the Platinum Plus fuel-borne catalyst for use in bulk fuel by refiners,
distributors and truck fleets.  In 2000, we completed the
certification protocol for particulate filters and additives for use with
particulate filters with VERT, the main recognized authority in Europe that
tests and verifies diesel particulate filters for emissions and health
effects.  In 2001, the Swiss environmental agency BUWAL approved the
Platinum Plus fuel-borne catalyst for use with particulate
filters.  In 2002, the U.S. Mining, Safety and Health Administration
accepted Platinum Plus fuel-borne catalyst for use in all underground
mines.  In 2007, we received accreditation for our Purifier System,
our Platinum Plus fuel-borne catalyst used with a diesel particulate filter, to
be sold for compliance with the emission reduction requirements established for
the London LEZ.


- 22
-
 Index


We have
shifted our focus for fuel economy and particulate matter reduction
opportunities in the U.S. to non-road sectors, including rail, marine, mining
and construction.  Our Platinum Plus fuel-borne catalyst is effective
with regular sulfur diesel, ultra-low sulfur diesel, arctic diesel (kerosene)
and biodiesel.  When used with blends of biodiesel and ultra-low
sulfur diesel, our Platinum Plus fuel-borne catalyst prevents the normal
increase in nitrogen oxides associated with biodiesel, as well as offering
emission reduction in particulates and reduced fuel
consumption.  Platinum Plus is used to improve combustion which acts
to reduce emissions and improve the performance and reliability of emission
control equipment.  Platinum Plus fuel-borne catalyst takes catalytic
action into engine cylinders where it improves combustion, thereby reducing
particulates, unburned hydrocarbons and carbon monoxide emissions, which also
results in improving fuel economy.  Platinum Plus fuel-borne catalyst
lends itself to a wide range of enabling solutions including fuel economy,
diesel particulate filtration, low emission biodiesel, carbon reduction and
exhaust emission reduction.  The improvement attributable to Platinum
Plus fuel-borne catalyst may vary as a result of engine age, application in
which the engine is used, load, duty cycle, speed, fuel quality, tire pressure
and ambient air temperature.  Generally, after use of Platinum Plus
fuel-borne catalyst during a conditioning period, our customers derive economic
benefits from the use of our Platinum Plus fuel-borne catalyst whenever the
price of diesel fuel is in excess of $1.75 per U.S. gallon.  Based
upon recent field fuel economy demonstration trials in a range of transportation
sectors, the improvements in fuel economy from using Platinum Plus fuel-borne
catalyst in these demonstrations ranged up to 12%.





EPA
verifications were withdrawn on two of our products in January 2009 because
available test results were not accepted by EPA as meeting new emissions testing
requirements for NO2
measurement.  Although prior testing indicates satisfactory
performance can be achieved, we have no assurance that the EPA will determine
that the results of the proposed evaluations will meet the new standards, nor
whether additional testing which may be required by EPA will be adequate to
remove any remaining concern the EPA may have regarding use of our fuel-borne
catalyst.





Patent
amortization and other patent related expense, including abandonment of $13,000
of previously capitalized patents, was $128,000 in the nine months ended
September 30, 2009 compared to $143,000 in the same prior year period, a decline
of $15,000 (10.5%).  At each reporting period, the Company evaluates
the events or changes in circumstances that may indicate that patents are not
recoverable.





The types
of events and changes in circumstances that would indicate the carrying value of
our patents is not recoverable and therefore, impairment testing would be
triggered include the following: permanent elimination of mandated compliance
with emission reduction standards; reduction in overall market prevalence of
diesel engines; obsolescence of our technologies due to new discoveries and
inventions; and an adverse action or assessment against our
technologies.





Our
technology is comprised of patents, patent applications, trade or service marks,
data and know-how.  We consider the life of our technologies to be
commensurate with the remaining term of our U.S. and corresponding foreign
patents.  Our patents have expiration dates ranging from 2009 through
2026, with the majority of the material patents upon which we rely expiring in
2018 and beyond.  We believe that we have sufficient patent coverage
surrounding our core patents that effectively serves to provide us longer
proprietary protection.  Our technologies comprise technologies that
have been asserted as the technologies of choice by various automotive original
equipment manufacturers (OEMs) to meet mandates to comply with upcoming
regulatory requirements that go into effect starting in 2010 (EPA
2010).  We monitor evolving technologies in the automotive and other
applicable industries to evaluate obsolescence of any of our
patents.





Although
we have seen certain suspensions and delays in mandated emissions requirements,
we expect sufficient revenue over the remaining life of the underlying patents
to recover the carrying value of our patents.  We believe the emission
reduction mandates will be phased in over time so that despite volatility in our
revenue streams, we should realize the expected revenue from our
patents.  We have consistently applied our methodologies used for
valuing intangible assets in 2009 compared to 2008 but believe we incorporated
more educated assumptions about our opportunities based upon the third-party
market data that we did not have in the prior year.  Our intellectual
property strategy has been to build upon our base of core technology with newer
advanced technology patents developed or purchased by us.  In many
instances, we have incorporated the technology embodied in our core patents into
patents covering specific product applications, including product design and
packaging.  We believe this building-block approach provides greater
protection to us and our licensees than relying solely on our core
patents.


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In
evaluating the viability of our patents, we used a cash flow model with the
following assumptions:


·
            Liquidity/cash
      – We will maintain our patents in force in the appropriate geographical
      areas by paying the required maintenance and annuity fees.  We
      expect to continue to invest in our patents to ensure adequate coverage
      and protection from inventions related to our existing
      patents.  Our expected capital expenditures include funds for
      prosecution of additional and pending
patents.


·
            Revenue/growth
      rates – We based our royalty revenue projections upon third-party market
      data regarding volume production projections for various engine sizes and
      vehicle classifications.  We estimated our market penetration
      rates based upon our understanding of market share of our current
      licensees and expectations of future licensing activities.  We
      recognize certain contingent license fee revenue once volume milestones
      have been achieved.  We used an expected rate for
      non-refundable, upfront fees from future licensees because historically
      the timing and amount of license fees have been
      unpredictable.  Our year over year growth rates assumed for
      Purifier Systems were up to 3.5% based upon further mandated low emission
      zones.


·
            Sensitivity
      analysis – We evaluated the sensitivity of our revenue streams using
      judgmentally selected discount rates ranging from 8% to 15% should
      revenues not meet projected
targets.





We
continue to evaluate the impact of current revenue recognized versus budget and
its impact on expected revenue streams to evaluate the sensitivity of revenue
projections over the next 12 to 18 months.  We evaluate the impact of
postponements of mandated emission requirements to understand how that affects
our operating results and cash flows.  We believe that emissions
mandated requirements will continue to be established as legislation tightens
across the globe.  Our technologies as a group are proven in the
emissions reduction marketplace and will be used while the patents are in
effect.  We believe there will be expanded markets for our
technologies and different ways to monetize them in the
future.  Because of expected recoverability, we determined the patents
are not impaired.





Interest
income was $187,000 in the nine months ended September 30, 2009 compared to
$481,000 in the nine months ended September 30, 2008, a decrease of $294,000, or
61.1%, due to lower invested balances and rates of return during the 2009
period.





Other
income (expense) was $295,000 in the nine months ended September 30, 2009 and is
comprised of foreign currency transaction gains, net of losses of $168,000,
interest expense of ($57,000), a net gain on investments of $185,000 and
($1,000) all other. The Company had an unrealized gain on the fair value of its
investment in auction rate securities ("ARS") of $441,000 and an unrealized loss
of ($256,000) on its ARS put right ("ARSR"), resulting in an $185,000 net gain.
The 2008 other income (expense) consists of foreign currency transaction losses,
net of gains of $(244,000), interest expense of ($14,000) and $1,000 all
other.





We
compare the UBS-determined current value per the monthly statements from UBS to
the par value of the ARS, noting that UBS may have an interest in being
conservative in its values because we may seek additional loan advances from UBS
based upon 75% of their ARS value.  The UBS current value of our ARS
increased $1.5 million from December 31, 2008 to September 30,
2009.  Quarterly, we compare the UBS-determined current value to the
fair value computed by the Company with the assistance from a third party
valuation firm.  The compared values differed by approximately $1.6
million at December 31, 2008 and $0.5 million at September 30, 2009, with the
UBS values being lower.  In making our fair value determination, we
considered a range of fair value estimates with the assistance of our third
party valuation firm’s understanding of all available factors resulting in low,
mid-point and high fair value assessments with a total range of 3.3% between the
low and high fair values.  We believe that the use of the mid-point
range is appropriate based on the available information at September 30,
2009.





We note
that the UBS Valuation Methodology for Student Loan ARS considers many variables
in its cash flow modeling of student loan ARS including, but not limited
to:


General
      ARS considerations:


(a)
projected forward interest rates


(b) cost
of funds (e.g., perpetually failed auctions)


(c)
issuer optionality and redemption provisions


General
      collateral performance
considerations:


(a)
prepayment speeds


(b)
deferment and forbearance


(c)
delinquencies


(d) gross
default rates


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The above
assumptions, plus additional considerations, are formulated and applied by
UBS.  A cash flow, or series of cash flows, is generated for both the
student loan assets (i.e., the student loans and cash) as well as the
corresponding liabilities (i.e., the ARS and other debt
securities).  The scheduled interest and final principal payments on
each ARS note are then discounted to arrive at a net present value
(“NPV”).  Finally, the NPV for each security is adjusted to reflect
the current market liquidity for ARS and UBS’s proprietary valuation methodology
is routinely calibrated to observe market transactions.





We have
not relied upon the UBS-determined values as our fair value.  We have
used the third-party assessment to evaluate if the UBS values are reasonable as
well as evaluating the discount from par that several other public companies
used, companies that also have student loan ARS issued by UBS.  We
continue to caution our investors about the credit risk should UBS be unable to
fulfill its commitment under the Offer for a put right permitting us to sell to
UBS at par value all ARS previously purchased from UBS at a future date (any
time during a two-year period beginning June 30, 2010).  There
can be no assurance that the financial position of UBS will be such as to afford
the Company the ability to acquire the par value of its ARS upon exercise of the
ARS right.





In our
assessment of fair values, we monitor developments and changes in the student
loan ARS market.  Key general considerations for the third quarter
included the following:





•  During
the third quarter, indications of market liquidity have improved
somewhat.  ARS spreads have remained relatively stable over the course
of the quarter and, as such, we have held the liquidity risk premium constant on
our student loan ARS at the reduced level used last quarter.


•  Spreads
indicated by the Bloomberg/Bear Stearns Student Loan Index on AAA issues of 15
year or greater duration have decreased slightly from 187.36 basis points as of
June 30, 2009 to 178.0 basis points as of September 30, 2009.  This is
further evidence these spreads are on a downward trend from the all-time high of
436.37 bps as of December 31, 2008.


•  Probabilities
of default are slightly lower on most securities given falling credit spreads in
the market over the course of the quarter, and remain in the range of 0%-5% on a
cumulative basis for AAA securities.


•  Probabilities
of passing auction/return of capital within a 2-3 year period have remained
stable over the quarter.


•  LIBOR
interest rate forwards decreased relative to longer term treasury yields during
the quarter, which caused slight downward pressure on prices.


•  Monetary
actions over the past year have reduced yields on short-term treasury
securities.  In September, the Federal Funds rate remained unchanged,
at a target range of 0% to 0.25%.  Similarly, the discount rate
remained unchanged at 0.5%.


•  Recovery
rates remained unchanged for most securities over the course of the
quarter.


•  General
Credit Movements: The rating agencies continue their review of student loan ARS
structures, with focus on three major factors: (1) changes in levels of
over-collateralization, (2) excess spread compression, and (3) the impact of
prolonged auction failures.  None of our ARS have been
downgraded.


•  UBS
has reported full or partial redemption notices for a number of transactions for
which UBS served as lead broker-dealer that were redeemed for par
amount.





Based
upon the trends noted above, our key risk considerations for the third quarter
included the following:





Counterparty -Moderate as
counterparty structure remained unchanged in the quarter.


Complexity -Moderate as
complexity of security remained unchanged in the quarter.


Quality -Minimal/Moderate as
none of our ARS experienced downgrades, thus no increases in quality
risk.


Default -Minimal/Moderate;
this risk assessment remains unchanged for our ARS which maintained the same
credit rating.


Liquidity - Easing
pressures.


Trading Environment -Moderate due to easing liquidity pressures.


Asset Correlation -High as
all of our ARS continued to fail auction, asset correlation risk remained high
in the quarter.





In the
event that UBS is unable to perform upon our exercise of the ARS put right on or
after June 10, 2010, we would have to sell the underlying securities at a
discount which would negatively impact our future cash flows.


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Liquidity and Capital
Resources





We
require capital resources and liquidity to fund our global development and for
working capital.  Our working capital requirements vary from period to
period depending upon manufacturing volumes, the timing of deliveries and
payment cycles of our customers.  At September 30, 2009 and December
31, 2008, we had cash and cash equivalents of $4.2 million and $4.0 million,
respectively, to use for our operations.  Our working capital was $8.4
million at September 30, 2009 compared to $8.2 million at December 31, 2008
reflecting an increase of $0.2 million primarily attributable to the
classification of our investments to current from non-current, partially offset
by the increase in our short-term loan.





Net cash
used for operating activities was $4.2 million in the nine months ended
September 30, 2009 and was used primarily to fund the net loss of $5.4 million,
adjusted for non-cash items.  Included in the non-cash items was
stock-based compensation expense of $579,000, gain on fair value of investments
of ($185,000) and recovery of doubtful accounts ($148,000).





As noted
in the Results of Operations discussion above, bad debt (recovery) provision as
a percentage of product sales for the nine months ended September 30, 2009 and
2008 was (16.8%) and 7.7%, respectively.  The $647,000 decrease in our
bad debt expense in 2009 compared to 2008 was attributable to lower sales
activity and collections of past due amounts.  To the extent that we
have past due customer balances, we require prepayment on new orders and
establishment of payment plans on past due balances.  In September
2008, management added new staff in order to improve our collections of accounts
receivables and communications with customers.  We are using available
legal remedies as needed to improve our collection efforts, including
enforcement of personal guarantees.





Accounts
receivable, net decreased to $0.2 million at September 30, 2009 from $0.6
million at December 31, 2008 due primarily to collection of receivables and
lower sales activity.  Inventories, net and other current assets were
only slightly down at September 30, 2009 from the December 31, 2008
levels.  We increased our inventory reserve by $29,000 to reflect the
net realizable value of our inventories for items that have been slow
moving.  Our accounts payable, accrued expenses and other liabilities
increased slightly at September 30, 2009 compared to December 31, 2008
reflecting decreases in accounts payable and other liabilities that were more
than offset by an increase in accrued expenses.  The decreases in
accounts payable and other liabilities is due to the slow business
environment.  The increase in accrued expenses is primarily due to
accrued severance provisions in 2009 totaling $958,000 of which $413,000 had
been paid through September 30, 2009 (see Note 12 of Notes to the Condensed
Consolidated Financial Statements).  The $545,000 balance at September
30, 2009 to be paid in monthly installments through September 2010 as outlined
above.





Net cash
used for investing activities was $0.2 million in the nine months ended
September 30, 2009.  We capitalized fixed assets and improvements
associated with our U.S. headquarters to which we relocated in January
2009.  We also used cash for investments in our patents, including
patent applications in foreign jurisdictions.  We expect to continue
to invest in our intellectual property portfolio.





Cash
provided by financing activities was $4.7 million in the nine months ended
September 30, 2009 and was attributable to proceeds from borrowing from our
demand loan facility.  We are using the proceeds from short-term debt
for general working capital purposes.





In May
2008, we arranged a $3 million demand loan facility using our ARS as collateral
and in July 2008, borrowed those funds as a matter of financial prudence to
secure available cash.  In January 2009, UBS approved a $6.5 million
credit facility.  In January 2009, we drew down the additional
available cash as a matter of financial prudence.  In September 2009,
we arranged a further increase to the credit facility to $7.7 million and drew
down the additional available cash totaling $1.3 million.  The ARS
serve as collateral for the loan which is due upon demand (see Note 4 of Notes
to the Condensed Consolidated Financial Statements).





At
September 30, 2009, our investments are recorded at fair value and comprise ARS
and an ARSR and together totaled $11.7 million.  At September 30, 2009
and December 31, 2008, we held approximately $10.7 million and $10.2 million
($11.7 million par value), respectively, in investments in ARS collateralized by
student loans, primarily AAA/Aaa-rated, which are substantially guaranteed by
the U.S. Department of Education and approximately $1.0 million and $1.3
million, respectively, in investment in ARSR.  We sold $7.1 million of
the ARS investments in the nine months ended September 30,
2008.  However, starting on February 15, 2008 and continuing to date
in 2009, the Company experienced difficulty in effecting additional sales of
such securities because of the failure of the auction mechanism as a result of
sell orders exceeding buy orders.  Liquidity for these ARS is
typically provided by an auction process that resets the applicable interest
rate at pre-determined intervals.  These failed auctions represent
liquidity risk exposure and are not defaults or credit
events.  Holders of the securities continue to receive interest on the
investments, and the securities continue to be auctioned at the pre-determined
intervals (typically every 28 days) until the auction succeeds, the issuer calls
the securities, or they mature.


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In
October 2008, the Company received an offer (the “Offer”) from UBS for a put
right permitting us to sell to UBS at par value all ARS previously purchased
from UBS at a future date (any time during a two-year period beginning September
30, 2010).  The Offer also included a commitment to loan us 75% of the
UBS-determined value of the ARS at any time until the put is
exercised.  The Offer was non-transferable and expired on November 14,
2008.  On November 6, 2008, the Company accepted the
Offer.  The Company’s right under the Offer is in substance a put
option (with the strike price equal to the par value of the ARS) which it
recorded as an asset, measured at its fair value (pursuant to SFAS No. 159),
with the resultant gain recognized in earnings.





The fair
value of the Company’s ARS increased $441,000 in the nine months ended September
30, 2009, which gain was recognized in our condensed consolidated statement of
operations.  The fair value of the ARS was determined utilizing a
discounted cash flow approach and market evidence with respect to the ARS’s
collateral, ratings and insurance to assess default risk, credit spread risk and
downgrade risk.  The Company also recorded a loss on the ARSR of
$256,000 and recognized the loss in operations, which, together with the
$441,000 increase in fair value of the ARS, resulted in a $185,000 net gain to
operations in 2009.  The fair value of the ARSR was based on an
approach in which the present value of all expected future cash flows was
subtracted from the current fair market value of the securities and the
resultant value was calculated as a future value at an interest rate reflective
of counterparty risk.  The Company used an independent third party
valuation firm to assist it with its determination of fair values of the ARS and
ARSR.





Classification
of investments as current or non-current is dependent upon management’s intended
holding period, the security’s maturity date and liquidity considerations based
on market conditions.  At September 30, 2009, the Company classified
all investments as current based on management’s intention and ability to
liquidate the investments within the next twelve months.  At December
31, 2008, the Company classified $6.4 million of the ARS as current based on
management’s intention to use such securities as consideration if UBS demands
payment on its loan prior to the date the Company exercises the
ARSR.





The
Company will be exposed to credit risk should UBS be unable to fulfill its
commitment under the Offer.  There can be no assurance that the
financial position of UBS will be such as to afford the Company the ability to
acquire the par value of its ARS upon exercise of the put right.





Our
management believes that based upon the Company’s cash and cash equivalents and
investments at September 30, 2009, the current lack of liquidity in the credit
and capital markets will not have a material impact on our liquidity, cash flow,
financial flexibility or our ability to fund our operations for at least the
next 12 months.





We have
evaluated our cash burn and determined that we have sufficient resources to fund
operations through June 30, 2010, the date that the par value of the ARS will be
available to us from UBS.  Presently, we do not have liquidity sources
other than the UBS credit facility but believe we will have the ability to use
the ARS as collateral for additional borrowings, including possible third-party
financing as we near June 30, 2010.  We have reviewed a “worst case”
scenario regarding our cash (including the assumption of no additional cash from
collection of receivables) and concluded that we have sufficient resources for
the next 12 months to accomplish our plans.  We continue to pay our
obligations in the ordinary course as obligations become due.  We are
making a concerted effort in 2009 to contain our costs and eliminate those costs
that are redundant or considered unnecessary with strict controls over all
discretionary spending and travel costs.  We have significantly
reduced our ongoing cash requirements by curtailment of expenses and a 44%
reduction in our work force, effective August 7, 2009.  We have
restructured the Company so that each employee will manage resources based upon
data-driven revenue expectations, and we are establishing processes to ensure
organizational and individual discipline and accountability.





We have
incurred losses since inception aggregating $64.3 million, which amount includes
$4.8 million of non-cash preferred stock dividends.  We expect to
incur losses through 2010 with the expectation that we will achieve
profitability during 2011.  Although we have generated revenue
from sales of our Platinum Plus fuel-borne catalyst, Purifier Systems, ARIS
advanced reagent injector and dosing systems for selective catalytic reduction,
catalyzed wire mesh filters and from technology licensing fees and royalties,
revenue to date has been insufficient to cover our operating expenses, and we
continue to be dependent upon sources other than operations to finance our
working capital requirements.  Historically, we have been primarily
dependent upon funding from new and existing stockholders.  The
Company can provide no assurance that it will be successful in any future
financing effort to obtain the necessary working capital to support operations
or if such financing is available, that it will be on acceptable
terms.


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In the
event that our business does not generate sufficient cash and external financing
is not available or timely, we would be required to substantially reduce our
level of operations and capital expenditures in order to conserve cash and
possibly seek joint ventures or other transactions, including the sale of
assets.  These reductions could have an adverse effect on our
relationships with our customers and suppliers.  Our long-term
continuation is dependent upon the achievement of profitable operations and the
ability to generate sufficient cash from operations, equity financings and other
funding sources to meet our obligations.





No
dividends have been paid on our common stock and we do not anticipate paying
cash dividends in the foreseeable future.





Capital
Expenditures





As of
September 30, 2009, we had no commitments for capital expenditures and no
material commitments are anticipated in the near future.


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Item3.  Quantitative and Qualitative Disclosures about Market
Risk





Foreign Currency
Risk





Our
results of operations are subject to both currency transaction risk and currency
translation risk.  We incur currency transaction risk when we enter
into either a purchase or sale transaction using a currency other than our
functional currency, which is the U.S. dollar.  With respect to
currency translation risk, our financial condition and results of operations are
measured and recorded in the relevant domestic currency (U.K. pounds sterling)
then translated into U.S. dollars for inclusion in our consolidated financial
statements.  The Company held cash and cash equivalents denominated in
pounds sterling that amounted to approximately GBP 0.5 million (U.S. $0.8
million) at September 30, 2009 compared to approximately GBP 1.5 million (U.S.
$2.2 million) at December 31, 2008.  One pound sterling was equal to
approximately $1.60 at September 30, 2009; $1.82 at September 30, 2008; and
$1.45 at December 31, 2008.  A hypothetical 10% increase or decrease
in the U.S. dollar versus the U.K. pound sterling would have resulted in an
approximately $20,000 change of our revenues during 2009.





Commodity
Risk





We are
subject to the commodity risk of platinum prices, which could result in
unfavorable pricing to us for production of our Platinum Plus fuel-borne
catalyst.  We do not use any hedging or derivative contracts to
purchase our platinum.  The closing price per troy ounce of platinum
of $1,287 at September 30, 2009; $1,058 at September 30, 2008; and $922 at
December 31, 2008.   A hypothetical 10% increase or decrease in
the price of platinum would have resulted in approximately $80,000 change of our
cost of goods sold in 2009.





Item4. Controls and
Procedures





Evaluation
of Disclosure Controls and Procedures





The
Company’s management, with the participation of the Chief Executive Officer and
Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure
controls and procedures (as defined in Rule 15d-15(e) under the Securities
Exchange Act of 1934, as amended) as of the end of the period covered by this
Quarterly Report on Form 10-Q.  Based upon that evaluation, the
Company’s Chief Executive Officer and Chief Financial Officer concluded that
Clean Diesel had effective disclosure controls and procedures (as defined in
Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the
end of the period covered by this Quarterly Report on Form 10-Q.





Changes
in Internal Controls





In
connection with the evaluation by the Company’s Chief Executive Officer and
Chief Financial Officer of internal control over financial reporting that
occurred during the Company’s last fiscal quarter, no change in the Company’s
internal control over financial reporting was identified that has materially
affected, or is reasonably likely to materially affect, the Company’s internal
control over financial reporting.


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PART
      II.
            OTHER
      INFORMATION





Item
6. Exhibits





(a)
            Exhibits





Exhibit
              Number
            
            Description31(a)
            
            Certification
      of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Exchange
      Act.31(b)
            
            Certification
      of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Exchange
      Act.32
            
            Certification
      of Chief Executive Officer and Chief Financial Officer Pursuant to 18
      U.S.C. Section 1350.


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SIGNATURES








Pursuant
to the requirements 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.








CLEAN DIESEL TECHNOLOGIES,
    INC.(Registrant)Date:  November
      9, 2009
            By:
            /s/  Michael L.
      AsmussenMichael
      L. AsmussenDirector,
      President andChief
      Executive OfficerDate:  November
      9, 2009
            By:
            /s/  Ann B. RupleAnn
      B. RupleChief
      Financial Officer,Vice
      President and Treasurer






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